Strategic Use of Regulation

Strategic Use of Regulation

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PRINTED FROM OXFORD HANDBOOKS ONLINE (www.oxfordhandbooks.com). (c) Oxford University Press, 2014. All RightsReserved. Under the terms of the l icence agreement, an individual user may print out a PDF of a single chapter of a title in OxfordHandbooks Online for personal use (for details see Privacy Policy).Subscriber: Pontificia Universidad Catolica del Peru (PUCP); date: 01 May 2015

PrintPublicationDate: Sep2010 Subject: BusinessandManagement,BusinessPolicyandStrategy,PublicandNonprofitManagement

OnlinePublicationDate: Sep2010

DOI: 10.1093/oxfordhb/9780199560219.003.0005

StrategicUseofRegulation CentoVeljanovskiTheOxfordHandbookofRegulationEditedbyRobertBaldwin,MartinCave,andMartinLodge

OxfordHandbooksOnline

AbstractandKeywords

Thefocusofthisarticleisthestrategicuseofregulationbyindustryandregulators,andtherulesandproceduresthathavebeenandcanbeputinplacetoreducewastefulattemptstogamethesystem.Regulationexiststogetindustry,organisations,andindividualstomodifytheirbehaviourtogaincompliancewiththelaw,andultimatelytoachievedesiredoutcomes.Yetitoperatesinaworldwherethelawisimperfect,enforcementandcompliancecostly,resourceslimited,andtheregulatorhasdiscretion.Regulationhastwootherfeaturesitgenerateswinnersandlosers;anditscreationandenforcementaretheoutcomeofpoliticalandlegalprocesses.Investinginrulechangecanbeaslucrativeasmaximisingprofitswithintherules.Itoftenpaystheindustrytoinvestintryingtoinfluenceandrespondtolegislatorsandregulatorstogainfavourableregulation,ortominimisetheimpactofunfavourableregulation.Keywords:regulation,industry,organisations,legalprocesses,legislators

5.1IntroductionThefocusofthischapteristhestrategicuseofregulationbyindustryandregulators,andtherulesandproceduresthathavebeenandcanbeputinplacetoreducewastefulattemptstogamethesystem.WhererelevantIhavedrawnonexamplesfromtheutilityindustriesandcompetitionlaw.

Regulationexiststogetindustry,organisations,andindividualstomodifytheirbehaviourtogaincompliancewiththelaw,andultimatelytoachievedesiredoutcomes.Yetitoperatesinaworldwherethelawisimperfect,enforcementandcompliancecostly,resourceslimited,andtheregulatorhasdiscretion.Regulationhastwootherfeaturesitgenerateswinnersandlosers;anditscreationandenforcementaretheoutcomeofpoliticalandlegalprocesses.Thisissimplytosaythatthestakessurroundingregulatorychangecanbehighandthestakeholderscanofteninfluencetheoutcome.Thelatterfactorpointstotheobviousthoughoftenneglectedfactthatfirmsandregulatorsnotonlyoperatewithintherulesofthegamebutalsocanchangethoserules.Investinginrulechangecanbeaslucrativeasmaximisingprofitswithintherules.Itoftenpaystheindustrytoinvestintryingtoinfluenceandrespondtolegislatorsandregulatorstogainfavourableregulation,ortominimisetheimpactofunfavourableregulation.

(p.88) 5.2StrategiesandtheRegulationGameThetermsgameandstrategyarenotdesignedtotrivialiseregulation,ortoimplythatitisfun.Agamerepresentstheinteraction(strategies)betweenitsvariousplayerssuchasfirms,regulator,consumers,andinterestgroups.Gametheoryformalisesthewaythesegamesareplayed,andthegamesareusedtoprovide


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simplifieddescriptionsofactualbehaviour(Baird,Gertner,andPicker,1994).Inthischapterwewillnotapplyformalgametheorybutsimplyoutlinesomeoftheconsiderationsaffectingtheregulationgame.

Cartelsprovideagoodillustrationofstrategyandgaming,andhowthesecanbeusedtodesignregulation.Thereceivedtheoryofcartelsisthatgamingamongtheparticipantsisendemic(Veljanovski,2004).Acartelisanagreementtoraiseprices,sharemarkets,andrestrictoutputbetweenfirmsinanindustry.Thispotentiallycomplexandlegallyunenforceableagreementgenerateshigherprofitsforitsmembers.However,anindividualmemberofthecartelcangenerateevenhigherprofitsifitsecretlyincreasesitssalesbyundercuttingthecartelprice(secretsales;hiddendiscountsandrebates;etc.)whileitscoconspiratorschargethecartelprice.Thusanendemicproblemofcartelsischeating,andthisisoftencitedasthebasisfortheclaimthatcartelsareinherentlyunstable.

Thecartelexampleillustratesseveralfeatures,whicharereflectedmoregenerallyintheregulatoryprocess.Thefirstisthatprivategainandcollectivegainoftendiverge.Underthecartelarrangementsallmembersarecollectivelybetteroffbyadheringtotheagreement,butindividuallybetteroffbybreakingtheagreementwhenothersadheretoit.Second,theexampleshowsthatgainsfromtradeareanecessarybutnotsufficientconditionforagreementandcompliance.Inparticular,cartelssufferfromwhateconomistsrefertoasopportunism,definedbyWilliamsonasselfseekingwithguile(Williamson,1985:30).Thatisasituationwhereallmembershaveanincentivetoappeartobeadheringtothecartelarrangementsbut(some)aresecretlyundercuttingtheircoconspirators'prices,i.e.gamingtheagreement.

Ontheothersideofthecoinregulationcanbedesignedtotakeadvantageofthestrategicincentivesandgamingamongthemembersofacartel.Legislatorsandregulatorshaveexploitedthistensionbygivingimmunitytowhistleblowersanddiscountingfinestothosewhocooperateinsecuringasuccessfulprosecutionoffellowcartelists.Thisgeneratesagreaterincentivetocheatonthecartel,thistimetoavoidwhataretodayveryhighfinancialpenalties(Veljanovski,2007a).Themembersofacartelhavetoconsiderthepay-offsfromadheringtothecartelagreement,versuscheatingbyundercuttingthecartelprice(andbeingsubjecttoretaliatoryactionsbyothermembersofthecartel),versusblowingthewhistletoavoidhighfines,criminalprosecutioninsomejurisdictions,andprivatedamageclaimsbyreportingthecarteltotheauthorities.Thesestrategieshavedifferentpay-offs,andchangeovertime.

(p.89) Itshouldbestressedthatthetermsstrategicandgamingarenotintendedtoindicateanabuseoftheregulatoryprocessorlaw.Rather,theyarethelegitimatepursuitofselfinterestinordertomaximisebeneficialoutcomesorminimisepotentialexpectedlosses.Thecartelexampleillustratesthatinsettingswherethereareasmallnumberoffirmswhorecognisetheirinterdependencebothfirmsandregulatorcaninfluencecommercialandregulatoryoutcomesbyactingstrategically.Ofcoursetheremaybeinstanceswheretheactionsofregulatedfirms,andindeedtheregulators,crossthelinetoabusetheprocessandbreakthelaw.

5.3TheEconomicsofRegulationThedominantviewinpoliticsandamongthepublicisthatregulationremediesmarketfailureandredistributeswealth,andthatiteffectivelyachievesthesetwoobjectivesonaverage.Isayonaveragebecausefewarenowsonaveastobelievethatregulatorsandgovernmentsdonotfailandspectacularlysoinsomecases.Thispublicinteresttheoryofregulation,orwhateconomistsrefertoasthemarketfailuresapproach,holdswidecurrency.

Thepublicinteresttheoryimplicitlyassumesthattheactorsintheregulatoryprocesssuppresstheirprivateintereststothoseofthegreaterpublicgood,or(whichislesslikely)thattheirselfinterestisalignedwiththepublicinterest.Italsoassumesthatthoseregulatedandbenefitingarepassiveactorsintheregulatorysystem.Whilethesemayserveasassumptionsforatheoryofwhatisgoodregulationtheydonotreflectreality.Clearlyfromthebeginningofcivilsociety,individualsandorganisationshavesoughttogainandsucceededingainingfavour,fromtheirkings,emperors,chieftains,andgovernments.

Modernregulationisacomplexinteractionbetweenpoliticians,civilservants,industry,interestgroups,regulatorybodies,andoccasionallyconsumers.Toexplainaspectsofthis,economistshavedevelopedtheoriesofregulation,whichstartwiththeassumptionthattheparticipantsintheregulatoryprocessareselfinterested.Firms,managers,andregulatorspursuetheirselfinterestwithintheeconomic,legal,andinstitutionalopportunitiesandconstraintstheyconfront.


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GeorgeStiglerwasthefirstcontemporaryeconomisttousethisassumptiontodevelopapositive(i.e.testable)theoryofregulation.Hetookthepositionthatregulationwasmotivatedbyitsabilitytoredistributewealth,panderingtosectionalinterestsfrominception,andnotasanafterthought.Heboldlystatedthat:Theparamountroletraditionallyassignedbyeconomiststogovernmentregulationwastocorrectthefailuresoftheprivatemarket(theunconsideredeffectsofbehaviouronoutsiders),butinfactthepremierroleofmodernregulationistoredistribute(p.90) income(1988:xii).ObviouslymanyothershadnotedthistendencybeforeStigler(includingKarlMarxandAdamSmith),butnot,itseems,postwaracademiceconomists.

Stigler'skeyinsight,refinedbyothers(e.g.Posner,1974;Peltzman,1976and1989;Becker,1983),wasthatregulationwasnotagivenbutsubjecttotheeconomists'lawsofsupplyanddemand.Hesawtheprimaryproducttransactedinthepoliticalmarketplaceaswealthtransfers.Thedemandforlegislationcamefromcohesivecoordinatedgroups,typicallyindustryorspecialinterestgroups,andhencewasskewedcomparedtothemarketplace.Thesupplysideoflegislationwaslesseasytodefinegiventhenatureofthepoliticalandlegislativeprocesses.Thestate,however,hasamonopolyoveronebasicresource:thepowerlegitimatelytocoerce.Thisleadstotheviewthatbecausethelegislativeprocessisskewedtothebenefitofcohesivegroupsthatcanlobbyeffectively,ittendstobecapturedby,ortooverlypanderto,specialinterestgroups.Indeed,thisgaverisetoapessimisticassessmentofthesustainabilityofaliberalandopensocietyaspoliticsandgovernmentbecameoverwhelmedbyspecialinterestgrouppoliticsthatundermineeconomicgrowthandsocialprogress(Olson,1982).Thecapturetheoriesofregulatoryagenciessharedthesesameconcerns.

AgoodillustrationofregulationbeingframedinresponsetodemandandsupplyconsiderationswastheUKprivatisationprogrammeofthe1980s(Veljanovski,1987).TheMinistershadtogainpoliticalsupportforprivatisationfromthemanagements,tradeunions,andtheconsumers/generalpublic.Thisresultedinanumberoftrade-offsespeciallyinthefaceofoppositionbytheexistingmanagementtomoreradicalrestructuringproposalsnobreakupofBritishGasandBritishTelecom,lighthandedregulation,andrestrictionsoncompetition.Thesewerepoliciesindirectresponsetonegotiatingstancestakenbythemanagementofthenationalisedindustrieswhichthreatenedtoopposeanddelayprivatisation.Inordertobuytheirsupport,policieswereadoptedthatwerenotinthelongterminterestsoftheconsumer.

OwenandBrauetigam(1974)inanearlycontributiontotheliteraturefirstreferredtoregulationasaregulatorygame.Theyclaimedthat,[N]oindustryofferedtheopportunitytoberegulatedshoulddeclineitechoingStigler'sview(1974:2).Thiswasandisprobablyanexaggeratedperspective,andperhapspeculiartothecollegiatenatureofUSregulatorycommissionsinthe1960sand1970swherepoliticalappointeesgeneratedmixedandmixedupobjectivessusceptibletolobbyingandpoliticalinfluence.

OwenandBrauetigamstressedthatfirmsneedtotakeregulationseriously.Theirkey,ifsomewhatobvious,pointisthatthestrategicuseofregulatoryprocessisatleastasimportanttoafirmasitsdecisionsoverkeycommercialvariablessuchasprices,output,andinvestment.Thisiscertainlythecasefortheutilitysector,suchasgas,electricity,energy,telecommunications,andrailways,wherethereissectorspecificregulation.MoregenerallythelobbyingofpoliticiansandMinistersbyfirmsaremost(p.91) obviouslyseenduringthelegislativephase.However,italsoexistsaspartoftheregulatoryprocess.Regulationisnotasetofrulessetdownbyparliamentandautomaticallyenforcedbypenalsanctions.Thestatutesoftenonlyprovidethebarescaffolding,leavingittoaspecialistregulatorybodytobuildthestructure.Statutesoftengiveregulatorswidediscretionandpowerstofillinthedetailsbydevelopingrules,codes,andprocedures,andtheymustenforcethese(whichitselfcreateslaw),andconsultovertheapplicationofthelawanditsreform.Thiswidediscretiongiventotheregulatorsgivesfirmsscopetoinfluencethem.

Theprocessofinvestinginregulatoryoutcomeshastwoconsequences.First,fromthefirm'sperspectiveitgeneratesexpectednetbenefits.Isayexpectedsincethereturntotheireffortsisnotcertain.Lobbyingandseekingtopreventburdensomeinterventionsorsecurefavourableonesisatbestanuncertainactivity.Itcanleadtoeithergainsorlosses.

Second,thelobbyingandstrategicactionsoffirmsarecostly.Indeedpublicchoiceeconomistshavefocusedonthetransactionscostsanddistortionsarisingfromfirms'participationintheregulatoryandpoliticalprocess(BuchananandTullock,1962;Tullock,1967and1976).Thistheyhavecalledrentseeking,definedasunproductiveandwastefulprofitseekingbyspecialinterestgroupstosecurefavourablelegislationdesignedto


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increasetheirwealth.However,thistypeofactivitycannotallbeclassifiedaswastefulunless,ofcourse,oneassumesthatthedevelopmentofeffectiveregulationisacostlessactivity.

Athirdpointworthmakingisthattheregulationgameisatwowaystreet.Industrycanseektomanipulateandinfluencetheregulator,buttheregulatorcanalsomakestrategicuseoftheformalandinformaltoolsavailabletoit.Thelawcannotbecomprehensive,andregulatorsaregivenfairlywidediscretiontoapplythelaw.Thissometimesleadstoextralegal,andsomewouldargueillegalandultraviresactions.Thismaybeexercisedinordertodealwiththeuncertaintyoverthefactsorwithlawsandregulationswhichareunderinclusiveandareanimperfectfittotheregulatorytasksrealorperceivedthatregulatorsmustpursue(ErlichandPosner,1974).Thisisexploredinmoredetailbelow.

Thereisafinalpointthatrequirescomment.Foraneconomicapproachtoregulationtohavevaluetheevolutionofdifferentregulatorystylesandtheactionsoffirmscannotbetreatedasrandomevents.Theyarisefromthestructureoftheindustry,technologicaldevelopments,andtheregulatoryframework,nottomentionthepersonalitiesofregulatorandseniorindustryexecutives.Ineconomictermsalltheseactorsseektomaximisenetreturnsintermsofthepay-offstheyperceivefromdifferentcoursesofaction.Oftenthesepay-offswillbeintermsofmonetaryreturns,butalsounquantifiablefactors,andbeinfluencedbybargainingpsychologies,e.g.theregulatororindustryisperceivedasweak.

Oneoftenseesnationaldifferencesinregulatoryprocessorwhatthepoliticalscientistshavecalledregulatorystyles(Vogel,1986).InthetelecommunicationssectortheIrishandDutchincumbentnetworkoperators(eircomandKPN(p.92) respectively)tendtobemoreaggressiveinchallengingtheregulatorthanBritishTelecomintheUK,whichhasahistoryofcapitulatingtotheregulator.Onecanattributethistoculturaldifferencesortotheobjectivefactssurroundingtheregulatorysystem.Theoreticalworkonthisisnotwelldeveloped.Butintheareaofsocialregulation(healthandsafetyandenvironmentalregulation)attemptshavebeenmadetomodelwhenanenforcementagencywilladoptapenalorcompliancemodel,underthelatterseekingtogaincompliancewithoutrecoursetotheformallaw.Someofthefactors,whichinfluencethischoice,arethecostsandimpactofdifferentenforcementinstruments,andthebudgetaryconstraintsfacingtheregulator(FennandVeljanovski,1988;Veljanovski,1983a,1983b,1983c).

5.4RegulationasContractAnotherstrandofliterature,whichhasrelevance,comesfromtheeconomicsofcontracts(Veljanovski,2007b).Anumberofcommentatorsandscholarshavesuggestedthatregulationcanoftenbeviewedasaprocessofnegotiationwhererelationships,bargaining,strategicbehaviour,anddiscretionareusedinthefaceofuncertaintyandtransactionscosts.Theregulatoryprocessisseenashavingsimilarfeaturestocommercialnegotiationsandcontractualrelationshipssurroundinglongtermcapitalprojects(Goldberg,1976;Williamson,1985;andLevyandSpiller,1994).Thesecontractualnegotiationsinvolveafewparties,withindividualshavinghighstakes,andongoingrelationshipswhichtheymustadapttochangingcircumstances.Thesmallnumbersinvolved,togetherwiththefactthatthesequenceofperformanceandpaymentsmeanthatthepartiesmayactstrategicallyandinparticular,opportunisticallytogainadvantageoncethecontracthasbeenenteredinto.Further,thesebilateralandmultilateralnegotiationscaneasilybreakdownandrequiremoreformallegalresolutiontobreakanydeadlocks.Asthecartelexampleaboveshowed,gainsfromtradeareanecessarybutnotsufficientbasisforamutuallysatisfactoryagreement.

Somehavegoneasfarastocharacteriseregulationasacontractualbargainbetweenindustry,thelegislature,andregulators.Theideaofsomelegallybindingregulatorybargainis,however,fictitious.Thetermoftenisusedasshorthandtoreflectsupposedunderstandingsandperceptionsbetweengovernmentandindustryastothewayregulationwillbeenforcedandmodified.Forexample,autilitywillcomplainthattheregulatorandpoliticiansarebreakingaregulatorybargainbymakingpricecontrolsmoreonerousthanoriginallyexpected.However,itisoftennomorethanpublicrhetoricoftheregulatorygame.Insomejurisdictionsthisapproachismorecommon,suchastheUnitedStateswherethereisgreaterconstitutionalprotectionofprivateproperty(SidakandSpulber,1997).Sometimes(p.93) itdoesleadtolegalchallengesallegingunlawfulexpropriationofpropertyrights,e.g.Telstra'sunsuccessfulconstitutionalchallengeagainstthecompetitionregulatorforsettingaccesspricestoolow,thusillegallytakingitsproperty.1


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Theinteractionsbetweenfirmsandregulatorcantakedifferentforms.Likeallhumaninteractionsfirmscancooperate,andthistendstobethedominantstrategyincivilsociety.Thepartiescanandfrequentlydocooperatewiththeexpectedgiveandtakereflectingman'snaturaltendency,asnotedbyAdamSmith(1776),totruck,barter,andtrade.

Themodelofcooperativeregulationwasandisparticularlyaptforanumberofregulatoryregimesandcountries.ThenegotiatedmodelwasagooddescriptionoftherelationshipbetweenindustryandregulatorsintheUKduringthe1980sand1990swhereregulatorshadconsiderablediscretionandtheincumbentandotheroperatorsregulatedbylicenceconditions,whichcouldonlybemodifiedbymutualagreement,orfailingthis,referraltoanotherregulator(theMonopoliesandMergersCommission). ThesenegotiationstakeplaceinandareconditionedintheshadowofthelawtousethetitleofMnookinandKornhauser's(1979)oftenquotedarticle.

Ontheotherhandadominantoperatorandregulatorcanbeuncooperativeandantagonistic,resultinginfrequentnoncomplianceandlitigation.Aclassicexamplewastheantagonisticrelationshipthatdevelopedbetweenthegasregulator(Ofgas)andBritishGasinthe1980s.ThiswasinpartduetoaflawintheGasAct1988whichdidnotgivetheregulatorpowerstofostercompetition.Nonethelessthegasregulatorsoughttoencouragecompetition,whichBritishGasviewedasexceedingitspowers,andbeganopenlytochallengetheregulator.Ahighlyunproductiverelationshipdevelopedatseniorlevelsbetweenthetwo,whichledtotheeffectiveremovalofboththeregulatorandtheChairmanofBritishGas,andeventuallyledtothebreakupofBritishGas.Thesetypesofhighprofilebattlescontinue.Perhapsthemostnotoriousrecentexamplewastheongoingstand-offbetweentheAustralianCompetitionandConsumerCommission(ACCC)andTelstra,Australia'sincumbentfixedtelephonenetworkoperator,whichsawTelstrarefusetoinvestinanewgenerationnetwork.Underwhatcircumstancesandatwhichstagecooperationturnsintononcomplianceandoppositionwheretheregulatorysystemtipsisachallengeforstudentsofregulation(seeFennandVeljanovski,1988;Baldwin,1985;BaldwinandMcCrudden,1987;Hawkins,1984).

5.5Industry'sStrategicUseofRegulationIndustryhasanumberofoptionsitcanusetoinfluenceregulationandtheregulator.Itcanbargainwiththeregulator,manipulatetheinformationand(p.94) publicity,andasalastresortchallengetheregulatorinthecourtsorspecialistappealtribunals.Allthesehavecostsandbenefits.

5.5.1InformationmanipulationAclassicstrategyisthecontrolofinformationgiventotheregulator.Itisreceivedwisdomthatindustryhasbetterinformationthantheregulator.Thisisoftenreferredtoasinformationasymmetry,andasourceofbothmarketandregulatoryfailure.Theregulatedfirmisassumedtoknowthetruefacts,andtheregulatorisconstantlygropingaroundforthetruth.

Thisfactorcanbeexaggerated.Itmaybethecasethatatthebeginningofanewregulatoryphasethatindustryknowsbetterthantheregulator,butasthesystemmaturesthisfactordiminishes.Clearlytherewillbemanyinstanceswheretherelevantinformationisinthehandsoftheregulatedfirm.Butitwillalsobethecasethatthefirmhasalegalobligationtosupplyinformationtotheregulatorandhasclearreportingrequirements.Further,regulatorsoftenarerequiredtotakeawiderviewoftheissuesthatisofthecompetitiveeffectsandthisrequiresinformationoftennotinthepossessionoftheregulatedfirm.Thuswhenaregulatorlaunchesacompetitiontypeinquirytheregulatedfirmoftenhaslimitedinformationonthemarketshares,costs,andrevenuesofitsrivals.Theregulatoroftengainsthatinformationasitmakesgeneralinquiriesandreceivessubmissions.

Theclaimthatasymmetryofinformationisendemicalsodiscountslearningasanimportantfeatureofregulationinpractice.Intheearlystagesofanewregulatoryapproachtheregulatedfirmsdohaveanadvantageastheyhirethebestexpertsandfilereportsthatperhapsintimidateofficialswithnoorlimitedexperienceoftheindustry,itseconomics,and/orthenewregulatoryframework.However,astimepassesbothpartiesbecomemoresophisticatedandknowledgeable,andabodyofprecedentbuildsup.WhereasintheearlydaysofUKutilityregulationtheregulatedfirm(andthoseseekingtochallengeit)couldsubmitreportswrittenusingbasiceconomicsandfactualassertions,todaythesereportswouldnotbetakenseriously.Thequalityoftheanalysisandthefactual

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researchnowhasahigherhurdletojumpasbothsideshavebuiltupbetterknowledgeandexperience.Indeedtodaythereisaprofessionalclassofregulatorswhichhasdecadesofexperience,andoftenincludeeconomists,lawyers,andindustryspecialistswhoareacknowledgedexpertsintheirfields.Theabilitytopullthewoolovertheregulator'seyeshasdiminished.

5.5.2MarketstructureSofarindustryhasbeenportrayedasamonolithicorunitaryforce.Butthisisrarelythecaseespeciallywherethereiscompetition,evenifonlyamongafew(p.95) firms.Indeedmarketstructureisacriticalfactorintheuseofstrategyanditssuccess.

Wherethereisamonopolistsubjecttoregulation,therelationshipbetweenregulatorandfirmtakesonthefeaturesofabilateralnegotiation.Thereismorelikelihoodofsuccessfulgamingsincethefirmcaneasilythreatentheregulator,andthereismoreofaninformationalasymmetrythanwouldbethecasewhereanumberoffirmsarevyingfortheregulators'attentionandfavours.

Moreover,oftenthereisasymmetricregulationoffirmsinanindustrydesignedtodealwiththemarketpoweroftheincumbentnetworkoperator.Thatis,onlyonefirmorseveralfirmsaresubjecttoregulation,whileothersareprotectedbyregulationtoensurethatcompetitionisfair.Inmanynetworkindustriestheregulatedincumbentnetworkoperatorfacescompetitionfromfirmsindownstreammarkets.Thesefirmshavedifferentandoftenconflictinginterests.Indeed,regulationappearsazerosumgamei.e.whatonepartygainstheotherloses.Fortheincumbentoperator,aregulatorydecisionwilloftenharmitwhileatthesametimebenefitingitssuppliers,competitors,andcustomers,whowilladoptvariousstrategiestogettheregulatortosupporttheirposition(s).Itssupplierswanthigherprices,itsrivalscheaperaccess,anditscustomerslowerprices.Thisissimplytosaythatindustryisnotmonolithicbutconsistsoffirmswithverydifferentandoftenconflictingpositions.

Mucheconomicregulationisaboutcontrollingmarketpowerandfosteringcompetition.Inmostnetworkindustries(gas,electricity,water,andlesssotelecommunications)thereisoftenoneverticallyintegratedoperator,whichoperatesaubiquitousnetworkortransmissionsystem,whichits(downstream)competitorsmustusetocompete.Theincumbentoperatorisoftenaccusedofactinginahighlystrategicmannertodelay,block,andraiseitsrivals'coststomakeentryandoperationunprofitableforcompetitorsusingitsnetwork.Thiscanariseevenwherethereareclearaccessandinterconnectionobligationsimposedontheincumbentnetwork.Thishassometimesledtoseveregamingofthesystem,andregulatoryresponsestominimisetheforeclosemarketsinthisway.

Thisproblembecomespronouncedwherethelawallowssuchdelayorisunclearanduntested.TheclassicexampleistheseriesofcourtcasesknownasClearCommunicationsvTelecomNewZealand. InNewZealandintheearly1990scompetitionlawandthecourtswereexclusivelyreliedontoregulatethetelecommunicationsindustry.Anentrant(ClearCommunications)soughtaccesstotheincumbent's(TelecomNewZealand)fixedtelephonenetwork.TodothisithadtotakeactionthroughtheNewZealandcourtsandeventuallytheHouseofLords.Thecasesresultedinlimitedaccessanddubiouslegalprecedent.Thestandardinterpretationofthisepisodeisthatinmonopolysituationswherecompetitionreliesonaccesstoanincumbent'snetwork,relianceonexpostcompetitionlawandthecourtsallowsforexcessivegamingofthelegalprocessandineffectiveregulation.Itisforthisreasonthatsectorspecificregulationhasbeenextensivelyusedinotherjurisdictions(andeventuallyinNewZealand).

(p.96) Theexanteregulatoryresponsetothisthreatrealorperceivedistomakeinterconnectionmandatory,withaccesspricessetonfair,reasonable,andnondiscriminatorylevels.Further,wheretheproblemappearsendemicandirremediableusingsuchbehaviouralremedies,regulatorshavepushedfortheseparationofnetwork,wholesale,andretailoperationsasinNewZealandandtheUK.

Suchstrategicactivitiesandgamingofthesystemarenottheexclusiveprovinceoftheregulatednetworkoperator.Itsrivalswillseektogainacommercialadvantageintheregulatorymarketplace,whichtheycannotachieveintherealmarket.Thesefirmsseerealreturnstoinvestingincomplaints,submissions,andlegalactionstopushtheregulatortotakeamoreactiviststancetogivegreaterandcheaperaccesstotheincumbent'snetwork.Theincumbentoperatorswillofteninterpretthisasgamingthesystem,seekingtogainadvantagebyfreeridingonitsinvestments.

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Itshouldbesaidthateconomistsarenotpassiveparticipantsinthisprocess.Theroleofeconomicsandeconomistsinregulationhasincreasedsubstantially,althoughtheirinfluenceshouldnotbeexaggerated.Sometimes,economistshavebeencooptedbyfirmstoadvance(sometimes)noveltheoriestopersuadetheregulatorthatitshouldintervene.Inthelastseveraldecadesmodelshavebeendevelopedwhichfocusfirms'strategicbehaviourinthepresenceofswitching,information,andtransactionscosts.Thisliteratureinvariablyshowsthatafewlargerfirmscantakeadvantageofthesefrictionstoharmtheircompetitorsandraisetheirrivals'costs(SalopandSheffman,1983)andshouldberegulated.CassandHylton(1999:38)havecalledthisthenipandtuckeconomics,whichfinds:

reasonswhyseeminglyinnocentoratleastordinarybusinessactivityactuallycouldbedesignedtosubvertcompetitorsand,perhaps,competition.Writingsinthisgenredeploysophisticatedargumentstoestablishthatconductthatlooksambiguousorevenbenignshouldbetreatedascontrarytotheantitrustlaw'sconstraints.Thesewritingsfrequentlyrelyonsubtledistinctionstoseparatetheconducttheyfindprocompetitiveandadvocateantitrustremediesthatassertedlydo,ifnotperfectjustice,itsnextofkin.Thesewritingsalsotypicallyrelyoncomplexmathematicalorgametheoreticmodelstodemonstratethatimportantaspectsofordinarymarketcompetitioncanbreakdownundercertainassumptionsthataredifficult,ifnotimpossible,toverifyfromobservabledata.

5.5.3ReviewandaccountabilityAsnotedabovetheuseofstrategyandgamingthesystemisatwowaystreet,involvingfirmsandregulator.Itis,therefore,notsurprisingthatmechanismshavebeenputinplacetogoverntheregulationgamebygivingtheaffectedpartiestherighttoappealaregulator'sdecisioneitheronlegalgrounds,andincreasinglytoreviewitssubstantivemerits(socalledmeritsreview).

Overthelastdecadetheabilityoftheaffectedpartiestochallengearegulator'sdecisionhasincreased.Incommonlawcountriestherehasalwaysbeentheoption(p.97) ofjudicialreviewbutthegroundshavebeenfairlylimited.Theconcernoverregulators'unfettereddiscretionhasledprogressivelytothedevelopmentofspecialistappealbodieswithbothjudicialandfullmeritsreviewpowers.ThisisthecaseundertheECNewRegulatoryFramework forthecommunicationssector,whichrequiresMemberStatestosetupanappealprocessfordecisionsofnationalregulatoryauthorities.

Thecaseforallowingfirmstoappealaregulator'sdecisionsiseasytostateandsupport.Itkeepsregulatorshonestandforcesthemtocomplywithbestpractice,makingdecisionsonfactual(notspeculative)analysis,andinaccordancewiththelaw.ThevalueofmeritsreviewhasbeenobviousinEurope.TheEuropeanCommissionhasbeenrockedbymeritsreviewsundertakenbytheCourtofFirstInstance(CFI)in2004. Thisisaninterestingandappositeexample,asanelitedivisionofaregulatorwasrevealedtoengageinpoorqualitydecisionmaking.TheMergerTaskForce(MTF)oftheEuropeanCommission'scompetitiondirectorate(DGCOMP)pioneeredtheuseofeconomicstodealwithmergerclearance.ButinthreesuccessiveappealstheCFIannulledtheCommission'smergerdecisionsforfailingtosatisfytherequisitestandardofproof.ThejudgesconcludedthattheMTFhadfailedproperlytoanalysethefacts,reliedontheoreticalspeculationratherthanfactualassessments,andinsomecasescompromisedtherightsoftheparties.Morerecentdecisionssimplyconfirmthateventhebestintentionedregulatorscannotbereliedontoactproperly. Thesedecisionsnotonlyremediedtheproblemsidentifiedinthespecificcases,butledtoorganisationalreformswithintheEuropeanCommissiontoaddressweaknessesinitsproceduresandcompetence.

Ontheotherhand,thereareconcernsthatallowingthepartiestoappealaregulator'sdecisionscanbeusedtodelayandfrustratetheregulator,andweakentheeffectivenessofregulation.Theregulatorcanbeembroiledinconstantchallenges,consumingalargeamountofmanagementtimeandlimitedresources,prolongingthetimeperiodsasregulators'copperbottomtheirdecisions,whichruntohundredsofpages.RecentconsultationoverreformoftheregulatoryprovisionsoftheNewZealandCommerceAct1986havebeenbesetbygovernmentconcernsthatallowingfullmeritsreviewoftheCommerceCommission'sdecisionswouldresultintheemasculationoftheregulatoryprocess,andhavefailedtofindfavour(MED,2007).

Thisconcernovergamingthesystemisoverblownandcontrollablebysimplesubstantiveandproceduralsafeguards.Itisoverblownbecausefirmsdonotengageinlitigationlightly.Itiscostly,uncertain,diverts

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managementtimeandattractsadverseattention(reputationalrisks).Thisisespeciallysoforinvestorownedandpubliclylistedcompanies.Theprobabilityoflitigationisinverselyrelatedtotheclarityofthelawandthesoundnessoftheregulator'sdecision.Ifthelawisclearandtheregulatorimplementsitcorrectly,litigationhasalowprobabilityofsuccessandgeneratesnoprivate(andsocial)benefits.

(p.98) Ontheotherhand,ifthelawispoorlyframedand/ortheregulatormakespoordecisionsthenmeritsreviewdoesencouragelitigationandthisisappropriate.Insomeareasthelawissobadlyframedandenforcedthatitinvitesgamingbehaviour.CartelprosecutionbytheEuropeanCommissionprovidesagraphicexample.ThemethodoffiningcartelistshasledtoanextraordinarilyhighappealratebecauseoftheECCommission'sinconsistentapplicationofitsownpenaltyguidelines.Thishasledtoapredictablestrategyamongthosefacingfines.Onceacartelhasbeendetected,thepartieshaveeveryincentivetocooperatewiththeCommissiontoobtainadiscountonthefinesthatwillbeimposedundertheECleniencyprocedure.However,oncethefineshavebeenimposedtheyarethenchallengedintheEuropeanCourtofFirstInstanceonsubstantiveandproceduralgroundsbecauseoftheunclearandinconsistentwaytheywerecalculatedbytheEuropeanCommission.Thefactsspeakforthemselvesunderthe1998PenaltyGuidelinesoneormorefirmsinover90%oftheprosecutedcartelsovertheperiod19982006appealeditsfine.Thisisanextraordinarilyhighappealrate,especiallygiventhatthePenaltyGuidelines(1998)weredesignedtointroducegreaterclarityandtransparencyinthewayfineswherecalculated(Veljanovski,2007a).

Theconcernthattherighttoappealwillbeabusedbyregulatedfirmsandtheirprotagonistsisbasedonanoptimisticassumptionthatitinevitablyleadstoafavourableoutcome.Howevermountinganappealisariskyaffair,whichcansometimesresultinharshersanctions.AnexamplehasbeenthecontinuingregulatorytusslesbetweenOftel/OfcomandtheUKmobilenetworkoperators.Oftel/Ofcomconcludedthatthepricepaidforafixed-to-mobilecallwasexcessivebecausethemobileoperatorhasaterminationmonopoly.Asaresultitimposedcontrolstoreducethepriceoffixedtomobilecalls.ThefirstattempttodothisbyOftelwaschallengedbythemobileoperatorswiththeresultthattheMonopoliesandMergersCommission(1999)reducedtheseverityoftheproposedpricecontrols.However,whenthepricecontrolswerenextreviewed,Oftelspecificallysoughttoavoidalegalchallengebyproposingalessstringentcontrolthanitsresearchindicatedwaswarranted.Theoperatorsagainchallengedtheproposalsonprinciple.UnfortunatelytheCompetitionCommission(2002)recommendedaworseoutcomeforthemobileoperatorstoughercontrolsonfixed-to-mobilecalls,andtheextensionofpricecontrolstomobiletomobilecalls.

Proceduralrulescanreducethelikelihoodofmisuseoftheappealsprocess.Therehasbeenalivelydebateoverwhetherornotregulators'decisionsshouldbeimplementedwhiletheappealisbeingheard.Ontheonehand,iftherearesignificantgroundsforanappealthenitmayresultinavoidablecostsiftheregulator'sdecisionsaimplementedandthenreversed.Ontheotherhand,ifanappealcanbeusedtofurtherdelayadecisionthennonmeritoriousappealsmaybecomeattractive.Forexample,thefirstchallengebytheUKmobileoperatorsinthelate1990sdelayedthepricecontrolandthereforewasworthtensofmillionstotheoperators,farexceedingthecostsoftheappeal.Itisnotsuggestedthatthiswas(p.99) theprimarymotivationoftheoperatorsasthereweremajorprinciplesatissueandoverwhichtherewasatthetimedeepdifferencesofopinionbetweentheregulator(Oftel)andthemobilecompanies.Butthefactthattheappealdelayedtheimplementationofalowersetoftariffsmadeitfinanciallyattractivetothemobileoperators.Thissituationislesscommontodayastheregulator'sdecisionisoftenimposedwhiletheappealisbeingheardorsubjecttoretrospectiveclawbackbybackdatingtheregulationiftheappealhasbeenunsuccessful.

5.6Regulators'UseofStrategyRegulatorscanalsoengageinstrategicmanoeuvresandgamingtoachievelegitimateandsometimesillegitimateoutcomes.Thiscanrangefromtheuseofopaquerulesandenforcementprocedures,tomoreovertpressures,whichforcethoseregulatedtomakesignificantandsometimesquestionableconcessions.Thiscanoccurinanumberofways.

Regulatorsoftenusevaguelaws,standards,softlaw,decisionalpractices,andnontransparentenforcementprocedurestocreateuncertaintyandtheimpressionofgreaterregulatorypowersandsanctionsthanexist.This,combinedwiththediscretiongiventheregulators,canoftenbeexploitedtogaincomplianceandagreementfrom


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thoseregulated.Theregulatorcanexaggeratetheallegedinfringementbyoverchargingtheregulatedfirm.Thisiswhentheregulatorthreatensamoreextensiveinvestigationandmoreseveresanctionstogetagreementtoamorelimitednumberofspecificregulatorychanges,eventhoughtheformerarenotlikelytobelegallysound.

Forexample,Ofcom'snegotiationwithBritishTelecomtogetagreementovertheoperationalseparationofBT'snetworkwholesaleandretailoperationswasconstantlycouchedintermsofathreatofaCompetitionCommissionreferralifagreementwerenotreached.TheimplicationthatOfcomtriedtocreateisthatareferraltotheCompetitionCommissionwouldmostlikelyresultinthebreakupofBTashadasimilarreferenceofBritishGas(MonopoliesandMergersCommission,1993),andsubsequentreferenceofBritishAirportsAuthorityBAA(CompetitionCommission,2009).However,theChairmanoftheCompetitionCommissionmadeitclearpubliclythattherewasnoautomaticpresumptionthatareferraltotheCompetitionCommissionwouldinevitablyleadtothedismantlingofBT.

Thestrategicuseofregulationbyregulatorsisevidentwheretimelimitsareimportant.Oneareawherethisisthecaseismergerclearance.TheEuropeanmergerclearanceprocedureconsistsofatwophaseprocessPhaseIwheretheproposedmergerisvettedtoseeifitraisescompetitionconcerns,andifthere(p.100) aresuchconcernsaPhaseIIwhereafullcompetitiveassessmentisundertakenoverastandardperiodofthreemonths.APhaseIIinvestigationcanbeexpandedtotakeuptosixorsevenmonthsifthepartiesoffercommitment.ThethreatofaPhaseIIisoftenheldoverthepartiestogainconcessions(socalledundertakings)thattheEuropeanCommissionrequirestoclearthemerger.ThiscanbeusedbytheCommissiontoforcethepartiesintomakingconcessions,whicharenotessentialtoprotectcompetitiongiventhepressureonthepartiestoconcludethesale/acquisition.Obviouslyitishardtojudgewhetherthisisaseriousproblem,butexperiencehasshownthatforsomeperiodsthe(nowdefunct)MergerTaskforcewithintheEuropeanCommissionrevelledinitsabilitytonegotiatewiththepartiestoextractundertakings.ThefactthatsomeoftheMergerTaskforce'shighprofiledecisionstoblockmergerswereannulledwhenchallengedinthecourtsindicatethatmanysettledPhaseIclearancesmayalsohavebeendefective.

Anotherdeviceusedbyregulatorsispublicityandpublicopinion.Theuseofpressreleases,speeches,andinterimfindingstoshameandmakepublicdisagreementscanbeusedtomakethefirmmorecompliant.Suchpublicitycanhaveadversereputationaleffectsforthecompanyunderinvestigation,anddamagerelationshipswithitssuppliersandcustomers.ThishassometimesbeenanovertstrategyoftheUKOfficeofFairTrading(OFT)andotherregulators(suchasOfgas)inthepastwherepressreleasesandbriefingswereusedtoputpressureonfirmsinanongoinginquiry.Insomecasesthishasreachedexcessivelevelsamounting(intheCourt'sview)tosensationalistpublicity,asforexampletheOFTclaimthatMorrisons(asupermarketchain)wasguiltyofpricefixingwheninfactthiswasnotyettheoutcomeoftheOFT'sinvestigation.ThethreatofalibelactionforcedtheOFTtomakeanapologyandpay100,000indamages.

5.7ConclusionRegulationisafactoflifeforindustry.Itispartofdoingbusiness,anditcanhaveamajorimpactonafirm'sprofitabilityandgrowth.Itisobviousthatwherepossibleindustrywillseektoinfluenceregulation,andtoexploitthelatitudethattheregulatoryprocessallowsittogainmorefavourableoutcomes.Likewiseregulatorsliveinaworldwherethelawisoftenbroadbrushandwhichdelegatestothemoftenwidediscretiontoframetherulesanddeterminehowtheyareenforced.Infacttheyareoftengivenpowersanddutiestocreatetherulesofthegamethroughtheirrulemakingpowersandenforcementdecisions.Inthisenvironmenttheuseofstrategicresponsestoregulationandgamingofthesystemwillbeprevalent.

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Notes:(1.)TelstraCorporationLimitedvACCCFCA2008.TelstraaskedtheHighCourttoconsiderwhetheritsconstitutionalrightsunderSection51(XXI)oftheAustralianConstitution,thatthefederalgovernmentcanonlycompulsorilyacquirepropertyonjustterms,werebeingbreachedby11ofitsrivals,theCommonwealthgovernment,andtheACCC(whichsetspricesforcompulsorythirdpartyaccesstoTelstra'snetwork).TelstraarguedthattheaccesspricessetbytheACCCforitsrivalswerebelowcostandthustheywouldacquireaccesstoTelstra'spropertynotonjustterms.

(2.)Peacock(1984),Veljanovski(1987and1991).

(3.)ClearCommunicationsLtdv.TelecomCorp.ofNewZealandLtd(1992)5TCLR166;ClearCommunicationsLtdv.TelecomCorp.ofNewZealandLtd(PC)(1995)1NZLR285.

(4.)Directive2002/21/EConacommonregulatoryframeworkforelectroniccommunicationsnetworksandservices,24April2002.

(5.)CaseT342/99AirtoursvCommission(2002);CaseNo.IV.M1524Airtours/FirstChoice(1999);CaseT310/01SchneiderElectricvCommission(2002);CaseT5/02TetraLavalBVvCommission(2002).SeegenerallyVeljanovski(2004).

(6.)CaseT464/04Impalav.Commission,13July2006.

(7.)InFebruary2008theOFTwasroundlycriticisedinHighCourtforpublicrelationsexercisesseekingtoattractsensationalistpublicityasMorrisonwasgrantedleavetojudicialappeal.MorrisonwithdrewitsactionaftertheOFTapologisedandagreedtopayMorrisons100,000insettlementofitslibelactionagainsttheOFTarisingfromanOFTpressreleasesuggestingMorrisonswasguiltyofcompetitionlawbreaches(beforethatwasproven)inthe


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ongoinginvestigationintomilkpricing(WmMorrisonSupermarketsplc:anapology,OFTPressRelease54/08,23April2008).LaterthesameyearSeanWilliams,anewlyappointedexecutivedirectoroftheOFTwhomadethestatement,resigned.

CentoVeljanovskiCentoVeljanovskiisManagingPartneratCaseAssociates(London)andAssociateResearchFellowattheInstituteofAdvancedLegalStudiesattheUniversityofLondon.

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Strategic Use of Regulation