TransActions - April 2002 (Vol 302)

Conscious Parallelism. Is It Really Just Price-Fixing?

The following article was written by Robert A. Jablon, a business associate of GDS Associates and a partner in the law firm of Spiegel & McDiarmid, Washington, D.C.

Price-fixing is illegal! Anti-trust laws forbid price-fixing, but antitrust laws are often misunderstood.  This may be by design. Many large, influential businesses that are subject to anti-trust laws, including privately-owned utilities and power suppliers with whom cooperative and municipal electric systems deal, have a strong interest in those laws being misunderstood.  However, one antitrust rule is known and universally accepted: competitors may not fix prices.

Power sellers are subject to the law.
Section One of the Sherman Antitrust Act declares every contract, combination or conspiracy in restraint of trade to be illegal.  This unquestionably includes power sellers agreeing to the prices at which they will sell electricity.

Under recent electricity deregulation some places have experienced roller coaster wholesale electricity prices.  A while back during a Midwest summer peak demand period wholesale electricity prices reached $10,000 a MWh.  The usual cost-based rate would have been significantly below $100 a MWh.  The California energy crisis resulted in transfers of billions of dollars from purchasers to sellers and the bankruptcy of California's largest electric utility.

In properly functioning competitive markets, prices such as these are virtually impossible.  Sellers will offer products at close to the incremental cost of the last unit of production that suppliers demand.  If a seller charges more, another seller will capture the sale by offering lower prices. This is what competition is all about. Although there are all sorts of difficulties with applying economic theories to predict market behavior, the magnitude of wholesale electricity prices is unexplainable under competitive market pricing theories.

One of my partners, Bob McDiarmid, quotes a client concerning the causes of last Spring's California electricity crisis: "So many things were done wrong that everybody's explanation has to be at least partially correct."  No matter where you are on the political spectrum, your ideas of fault could be vindicated.  However, one aspect of the crisis was plain: suppliers sold power at far above their marginal production costs.  Bids to sell wholesale power during off-peak periods were at or near price caps.  Even if you can justify high prices on-peak, how can you justify high prices during low customer demand off-peak periods?  The answer is. . .you can't.

How can 'above cost' prices be explained?
Assuming that the major California wholesale energy suppliers did not get together in a back room to set prices and allocate markets, how does one explain these electricity  prices at well above cost?  One explanation may be what economists and lawyers call "conscious parallelism."  This is where competing firms (or, more accurately, non-competing firms) price their products "interdependently".  A firm's pricing, production and sometimes marketing decisions are made with knowledge of what its competitors will likely do although there is no express agreement to set prices.

Conscious parallelism has been described as: the process, not in of itself unlawful, by which firms in a concentrated market might in effect share monopoly power, setting their prices at a profit-maximizing supracompetitive level by recognizing their shared economic interests and their interdependence with respect to price and output decisions.

In re Medical X-Ray Film Antitrust Litigation, 946 F. Supp. 209, 217 (E.D. N.Y. 1996), quoting Brooke Group Ltd. v. Brown & Williamson, 509 U.S. 209, 227 (1993).

Major sellers of wholesale power can often predict the daily and hourly demand for electricity.  They know what power resources are available to meet that demand.  They also know the prices at which electricity is being sold.  Thus, they can accurately predict the impacts of their individual decisions to add or withhold supply or to increase or decrease prices on more general market prices.  Sellers are aware that if they cut prices, they may sell more power, but at a loss in overall profitability.  They may not telephone or e-mail their competitors to tell them of their production and pricing decisions, but their actions along with the parallel actions of other sellers provide ample communications.  All market participants are "conscious" of what others are doing and they act in "parallel."

There is little difference to market performance or to the consumer between suppliers meeting in a back room to fix prices and suppliers pricing in parallel conscious of each others' actions.  In both cases consumers are bilked for billions of dollars.

The legal difference
There is a legal difference between direct price fixing and acts of conscious parallelism.  Under the antitrust laws price fixing is per se illegal.  There is no need for a plaintiff to prove injury to competition.  However, where plaintiffs claim acts of conscious parallelism, they may have to prove the existence of certain "plus" factors to show that defendants tacitly colluded rather than acted independently.  These would include evidence demonstrating that the defendants acted contrary to their economic interests or that they were motivated to enter into a price fixing conspiracy, among other things.  Motive to conspire, opportunity to conspire, high levels of interfirm communications and departures from normal business practices have been recognized as plus factors.

There are two substantial difficulties in assuming that wholesale electricity markets will work to protect against antitrust abuse without outside monitoring, law enforcement and regulation.  The first is that buyers tend to have significantly less knowledge than sellers.  Therefore, through their business conduct buyers cannot easily act to limit prices.  The second, and more important, is that in many situations, electricity is a product that buyers must buy.  A cooperative or municipal utility can hardly black out customers because it does not want to pay high prices for wholesale electricity.  Unless there are available protections against market abuses, there will be non-competitive prices.  Such protections include price caps, effective market monitoring, and antitrust enforcement.

To use a simple example, in normal markets, if sellers price milk at $100 a gallon, consumers will not buy and the price will drop.  However, cooperatives and municipals must buy enough electricity to meet demand, regardless of price.  Moreover, ultimate electricity consumers rarely even know the wholesale (or retail) cost of the electricity at the time they use it.  When prices rise, demand does not fall commensurably.  Therefore, the market is not self-correcting.

Such knowledge encourages conscious parallelism.  Indeed, it is difficult to satisfactorily explain wholesale electricity market behavior without reference to the doctrine.  This is not to say that there are not other, additional reasons for high wholesale electricity prices.  However, if we are to rely on competition to set prices, there needs to be a focused attention to antitrust doctrine to prevent abuses.

Another lesson from California
We learned in California that if we are to rely on competition in electricity or other energy markets to ensure reasonable prices, it is essential that we have institutions that are capable of dealing with market power and abusive trade practices.  Some courts and commentators have been hesitant to act to end conscious parallelism because its main element, that competitors seek knowledge of and act with an awareness of others' conduct, is common to virtually all business activity.  In recognition of its pernicious effects others have acted to treat conscious parallelism like other antitrust violations.  Where there is monopoly power to begin with and where an essential product is being sold, problems of conscious parallelism cannot be ignored without causing great economic harm.  The fact is worth repeating - otherwise, innocent market participants, including dependent cooperative and municipal systems and finally the public, will be bilked of billions of dollars.

GENERATION PROJECT DEVELOPMENT:  A CRITICAL ROLE FOR THE OWNER'S ENGINEER.

Today, many load-serving municipal, cooperative, and investor-owned facilities are insulating themselves from unstable market conditions by purchasing or participating in generating projects.  It is a wide departure from previous methods of securing resources through wholesale contracts.

Developing generating projects represents a major long-term investment for participants. Projects must be thoroughly and carefully analyzed before any commitment is made.  Execution of the project through all phases from initial feasibility assessment to start up and operation is the challenge for the owner's engineer. In some cases, people on-staff are fully capable of handling the entire project. In other cases, where on-staff expertise may be limited, the best course of action is to retain an experienced consulting engineering firm. The decision about using on-staff people vs. a consulting firm, or a combination of both, can be critical to the success of any large generation project. To make the right decision, four major topics must be considered.

1. Feasibility.
The first step in a generation project is to determine if the project is technically and financially feasible.  The owner's engineer will work with the financial analysts to ensure that the technical assumptions concerning the project such as projected cost, availability and heat rate are reasonable.  Other important considerations include a reasonable estimate of market prices, appropriate estimates of O&M and capital costs and finally, incorporation of these costs in a proven economic model that will accurately project the costs and economic viability of the project. 

If the project is found to be economically viable, the owner's engineer will turn his attention to the technical aspects of the project.  The owner's engineer will evaluate the proposed technology for the project and address questions such as:

• Is the proposed technology in common use?

• What has been the operating performance with the technology selected?

• Are the major components such as the combustion turbine, Heat Recover Steam Generators (HRSG) and duct burners of proven design, both individually and in combination with the other major components?

If the owner's engineer and project team determine that the proposed project is economically and technically viable, they must evaluate proposed developers and project sites.  The selected developer should have extensive experience in similar projects and a track record of completing these projects on schedule and within budget.  In addition, prior projects should be operating reliably and efficiently as a demonstration of the quality of the developer's workmanship.  Finally, the proposed site must be evaluated to ensure that access to gas, transmission and water resources is adequate.  Potential restraints due to air quality concerns and other environmental constraints must be identified.  Other potential issues such as endangered species and possible archeological sites must also be identified and evaluated. 

2. Project development.
Once a project is approved to move into the development phase, the owner's engineer shifts his role from investment analysis to maximizing the owner's return on his investment.  Key activities during the project development phase include:

• Technology selection - Selecting the specific equipment to meet the project requirements including design output, heat rate and delivery date.

• Contract negotiation - development of a contract with appropriate penalties and incentives that reflect the economic impact of performance variances.

• Support of Loan Application/Bond Issuance - development of an Engineer's Report to summarize owner's analyses of project viability for presentation to possible lenders.

• Permitting - timely procurement of all required permits is often the responsibility of the owner.  Engineering and technical support will be needed to assist the owner's permitting group.

3. Procurement and construction.
During this phase, the owner's engineer assumes a more traditional monitoring role.  In this role, the owner's engineer monitors all phases of the project to provide early identification of potential problems.  Project procurement activities are monitored to ensure that major components will be delivered in time to meet the project schedule.  Construction is closely monitored to ensure that the schedule is met and expenditures are in agreement with the budget.  Most projects do not proceed exactly as planned and recovery plans must be developed to regain the schedule.  The owner's engineer plays an important role in determining that any recovery plans are likely to have the desired effect without severely impacting the project budget.

4. Project start-up and operation
In this final phase, the engineer focuses on assisting the project in meeting and exceeding performance and economic goals.  Long before start-up actually commences, instruction manuals will have been prepared.  Operations and maintenance personnel will have to be effectively trained.  During the critical performance testing, the owner's engineer will monitor performance tests to be certain they are carried out according to applicable codes. Any discrepancies must be documented and assessed to determine both the performance and financial impacts as well as the appropriate corrective action.  Finally, the owner's engineer will assist in the development of an operating philosophy (mode selection) based on actual unit performance and market conditions. As operations continue, performance and costs should be subject to regularly scheduled monitoring and analysis.

In summary, the role of the owner's engineer is critical in a successful generating project.  The owner is ultimately responsible for oversight at each step of the process. The owner must protect his rights and his investment. The owner must ensure that the project will meet his needs efficiently and cost-effectively.

To meet these demands, the owner must integrate and oversee many technical and analytical skills.  The prudent owner will ensure that he has the needed experience and expertise on his project team long before the first shovel of dirt is turned.

For more information, please contact Bruce Walter at 512-494-0369 or by e-mail at info@gdsassociates.com.