Vertical mergers - EWS/Marcroft NEIL PRATT ACE conference, November 2007

Agenda Framework for assessing input foreclosure Comments on EWS/Marcroft

Vertical merger analysis – preliminaries No direct loss of rivalry Efficiency rationales Elimination of double marginalisation Improved investment incentives Two main unilateral theories of harm Input foreclosure: restrict/degrade input supply Customer foreclosure: limit input purchases Large body of theory relating to vertical mergers and vertical foreclosure. Complex and subtle area – but for practitioners it is useful to bear in mind a few simple considerations No real rocket science here – but a sensible (and hopefully uncontroversial) jumping-off point for analysis

The input foreclosure mechanism Upstream entity Downstream rivals RRC? Efficiencies? CC used orthodox approach to input foreclosure – in line with approach set out in draft NHM guidelines Slide shows the diagram in the draft NHM guidelines – neatly capture basic logic of input foreclosure. Concern is that upstream division of vertically integrated firm will foreclose downstream rivals – via increased wholesale price, or reduced quality – reducing competition and harming customers Need to assess a range of factors – market power upstream, nature of downstream competition, and scale and nature of merger-related efficiencies No presumption of harm – factual analysis of specific case required to assess likely impact of merger Softer competition? Impact on customers?

Analytical framework Ability Incentive Effect Significance of input to downstream firms VI firm’s market power upstream Barriers to entry and expansion upstream Incentive Margins in upstream and downstream markets VI firm’s share of downstream market Extent of share-shifting to VI firm Impact on size of downstream market Effect Competitive significance of foreclosed rivals Impact on barriers to entry Competitive constraint from vertically integrated rivals Merger-specific efficiencies

Empirical analysis of incentive ‘Vertical arithmetic’ approach can be used to assess profitability of input foreclosure – e.g. Evraz/Highveld Thales/Finmeccanica/Alcatel Alenia Space & Telespazio Simple analysis can indicate likelihood of foreclosure Estimate cost from foregone upstream margin based on loss of input sales Estimate profit from additional downstream margin based on expected sales diversion More sophisticated simulation approach can help assess competitive effects

EWS/Marcroft - background Relatively low value deal in a difficult market Some tricky economic issues to resolve No economic advisers retained by parties Apparently limited data available to CC in certain areas Conflicting evidence from EWS and complainants

Vertical foreclosure: main lines of debate Efficiencies did not play a significant role EWS already vertically integrated Parties did not make strong efficiency claims Debate focused on two key issues: Marcroft’s pre-merger position in the wagon maintenance market EWS’s incentive to lower foreclose rivals in the haulage market

Marcroft’s pre-merger position CC relied on structural analysis of wagon maintenance market High share – 56% (volume) Only one rival with national coverage Self-supply not an effective constraint Some conflicting evidence on performance and conduct Poor financial performance of Marcroft Examples of failed attempts to increase prices/lost tenders CC concluded on balance that Marcroft had significant market power Appears to have been area of major focus for CC post-PF - significantly more attention given in final report Some 3rd party hauliers said that maintenance market was ‘fiercely competitive’

Two possible forms of input foreclosure Reduction in service quality to haulage companies Increased downtime, less reliable scheduling of works Could be targeted at selected customers Foreclosed customers would face higher costs, or lose contracts Increase in price of maintenance services Conflicting evidence on significance of maintenance relative to operating costs Price increase expected to have some negative impact on rivals

Limited evidence on incentive and effect Data limitations appear to have precluded application of vertical arithmetic CC points to size of haulage market compared to maintenance market and EWS’s high share Wabtec (and others) not seen as competitive alternative High-level approach to haulage market No concrete examples of potential foreclosure Not much on harm to end users

Final remarks EWS/Marcroft follows orthodox approach to vertical mergers Debate focused on empirical questions Market power of Marcroft Profitability and effect of foreclosure Threat of self-supply by e.g. Freightliner Data appears to have been quite limited and contentious in this case

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