Thursday, July 23, 2009

"Unreasonable" and legal arguments based on economic principles

I have been wading through the Federal Court's recent decision to reject a number of appeals from Telstra over ULLS and LSS arbitration decisions.

Let me first remind my readers (and myself) that as a lwayer I am strictly of the "bush" variety. Let me follow that by saying I have not been reading the judgement for all its fine detail. One of the interesting things about telco law has been that the absence of significant case law has mant that people like me can be as much use as a lawyer - because the interpretation has rested on the legislative wording.

This decision changes much of this. There are six areas in which Telstra claimed an error had occurred;
Pooling and Allocation Method
ULLS Model Terms
Call Diversion
Weighted Average Cost of Capital (WACC)
Line Costs
2007 LSS Pricing Principles

Each seems to reveal an interesting legal point for future consideration.

Pooling ad Allocation Method

This refers to a feature in the LSS and ULL pricing for which I take personal credit. The argument that the costs Telstra incurs for providing wholesale access to these services (e.g. ordering and provisioning systems) should be recovered across all copper pairs not just the pairs used for the service was first raised in submissions prepared by AAPT. It took me a while between my lawyer and economist to get it into a reasonable shape.

The argument got a life when Telstra stupidly responded to the 2003 indicative prices with an undertaking at those prices but repeating all its old arguments. This the ACCC interpreted as a "set-up" and consequently re-evaluated everything. This was when Optus joined the fray and improved the argument by pointing out that all copper customers in fact benefited from the competition that ensued.

Telstra's claim was that s152CR(1)(d) of the TPA required the Commission to "take into account" the direct costs of providing the service in determining the access price. The court found in this and an earlier case that he Commission did take the direct cost into account. Mosre specifically "taking into account" did not require the access charge to deal with the direct cost in any particular way.

ULLS Model Terms

This claim was somewhat similar in that the legislation required the ACCC to have required to model terms it was required to prepare under lgislation. Telstra claimed that the Commission had erred by not having regard to these terms.

Telstra failed in this claim in a number of ways. The most telling was that the adoption of the Pooling Method above meant that the 2003 model terms were not operative to the extent of any inconsistency. The court also demonstrated that the Commission did have regard to the model terms and explained their reasons for deviating from them.

Call Diversion

The call diversion claim rested on one of the underexplored areas of the access regime, s152CP(2) which enables the Commission determination to deal with any matter relating to acess. The judgement gives a great deal of consideration to the matter, both interegating the specifics of how the call diversion charge relates to the declared service for which the determination is made, and the legislative purposes of the access regime. It concludes that the Commission was entitled to make this determination.

This part of the judgement could be particularly useful were PartXIC to get much more continued future usage.

Weighted Average Cost of Capital

It is in the consideration of the process for determining the WACC that we see some really interesting arguments. There were two grounds claimed - that to a lay person - look the same. The first was that the ACCC made an error of law when determining the WACC as the ACCC based its determination of the WACC on a manifestly erroneous methodology involving economic principle. The second ground is that the ACCC acted so unreasonably and irrationally that no reasonable person could have so exercised the power.

Part of the argument resolved around whether assumptions in the CAPM of a homogeneous investor population were warranted, and Telstra's contention that the reality of a heterogenous investor base means a premium needs to be provided to the WACC. Telstra also identified what it called a "welfare assymetry" in setting the WACC, claiming that there are more dire onsequences from underestimating the WACC than overestimating it.

Telstra's principle claim in support of its contention was that the Commission had assumed a homogeneity of investor preferences in setting the WACC, but a hetergeneity of investor preference in rejecting the welfare asymetry argument.

The court first finds that there is nothing in the Act that actualy requires the ACCC to establish a WACC, and hence an error in determining it would not be an error in law, but an error in the ACCC's reasoning processes. The court also refers to authorities who distinguish between the claims that something is "illogica" and that reasoning can simply be wrong. Wrong reasoning does not become an error in law.

But the line that caught my eye was in relation to Telstra's capital strke argument wherein the court found "[The Commission] was at liberty to consider that in the real world investors do not behave in the way in which the capital strike proposition would have them behave." It continues;

It seems to me that the expression “assumptions” in relation to the CAPM is ambiguous. It may be that, outside the realm of economics, the word “assumption” is not the best word to refer to such things as homogeneity of expectations, no inflation and no personal income taxes. The CAPM does not assume those things in the real world in the sense that the CAPM loses its validity if they do not in fact reflect the real world. The CAPM makes assumptions in the sense of putting certain things to one side. The model can work and be a useful tool for the purpose of addressing only those things with which it deals.

This I think is the ultimte point for any consideration of "economic principles" together with questions of "manifestly erroneous methodology" or "unreasonably or irrationally". Any economic principle theory or model requires "certain things to be put to one side". It hence seems that it is a very high bar to ever argue that the way a decision maker relies on economic principles is unreasonable. More specifically the question of reasonableness actually lies outside the economic principle, not within it.

Line Costs

The line costs argument relates to whether the LSS should contribute a share of the line cost. It is a matter on which I always disagreed with my industry colleagues and argued should be included (on the same basis that the LSS specific costs should be pooled). Telstra however only ran the legal argument that there was no evidence for the finfding and that they Commission had failed to inquire. I personally found both to be too legally esoteric for me.

I would have been far more interested in seeing Telstra mount the claim in the terms attempted for the WACC. That is, that it is "manifestly erroneous methodology" or "unreasonably or irrationally" to pool the LSS specific costs but not "pool" the line costs. Maybe that will be round three.

Pricing Principles

Another esoteric point on whether the Comission could make pricing principles when principles already applied, and how the factof two separate pricing principles played out in the context of an arbitration that covered a period in the middle of which the second set of principles were made. I have not bothered to read the detail of this because I am more interested in the related part - that is - the Commission only has to have regard to the principles.


This judgement provides some interesting insights into what the requirements are for a decision maker to "have regard" to something or taking something "into account". It also provides some interesting guidance on the principle of "relating to". In both cases the conclusions seem to result in outcomes that confirm the very wide discretion of the ACCC. This might not be the loss for Telstra that it might at first seem. Telstra and Henry Ergas have argued that the ACCC has excessive discretion in Part XIC and the judgement only serves to demonstrate how wide that discretion is.

The more damaging element seems to be the conclusion about "manifestly erroneous methodology" or "unreasonably or irrationally" when used in the context of argument on economic principles. Put bluntly the court has really found that as any economic argument sets aside certain tings it can never be found to be manifestly unreasonable. It opens up a question of whether the whole field of competition law has gone up a blind alley by referring to some generic concepts in legislation and leaving it to subsequent economic and legal argument to work out the detail.

It is perhaps the more unfortunate reality that economic thery is not up to the task required of it by legislation. While we have a theory of physical mechanics that can, for example, let us conclude from the position and skid marks of two vehicles after a accident what their velocities were before it, our economic theory comes nowhere near the same level of specificity and continues to rely on theories that "set aside" certain things not because the effect of them might be small (like air resistance would be in the crash model) but because they make the model too hard.

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