This article, available here, focuses on the assessment of mergers in markets where innovation plays an important role. Innovation considerations have always been on the radar of the European Commission (“Commission”) but came to the limelight with recent decisions in the agrochemical sector. A significant amount of literature has emerged in the last few years, mainly analysing the economics of innovation considerations in merger control.

Section II reviews the economic literature on the impact of competition on innovation incentives, while section III describes the debate among economists concerning the effects of horizontal mergers on innovation.

The paper begins with a description of the debate on the relationship between innovation and competition – the classical Arrow/Schumpeter/Aghion triad (with a pinch of Shapiro), which I will not rehash again. More importantly, the paper describes how the debate around mergers and innovation has become the subject of increasing attention among economists, particularly in the context of the consolidation of mobile telecommunications and the agrochemical industry.

This literature asks questions about what happens in an industry before and after a merger when innovation is an important parameter of competition. The authors review it, and arrive at a number of conclusions. First, it seems untenable to claim that the prospect of higher prices following a merger will suffice to create positive effects on innovation. Second, it is equally untenable to claim that R&D, being by definition an uncertain process, cannot and should not be assessed. Authorities are not constrained to look only at pipeline products, or to stay away from basic research which outcome is highly uncertain. Third, the economic framework has identified two main channels that capture the economic forces at play: the innovation externality channel (which is always negative for a merger) and the price coordination channel (which may reinforce or dilute the former). Fourth, innovation is important, but one should never forget that ultimately it is the impact on consumers that needs to be evaluated. When the price coordination channel spurs innovation after a merger, this ex post increase in price makes it unlikely that consumers will be able to reap the benefits from higher innovation, since a good part of their surplus will be extracted by the merging parties. Fifth, one should  distinguish between models where R&D drives profits away from rivals and models where innovation instead expands the profits of rivals. Sixth, and related to the previous point, various efficiencies can improve the effects of a merger, such as the ability to organise R&D efforts more efficiently. However, such efficiencies need to be merger specific.

Ultimately, the economics literature does not provide grounds for a presumption that mergers are generically bad for innovation and consumers. Still, the economics’ literature can guide enforcers in their policy choices. The authors take it from the literature on the topic in recent years that it is reasonable for competition authorities to begin their analysis from the guiding principle that, in the absence of merger-related efficiencies or uninternalised positive externalities, a horizontal merger is unlikely to have positive effects on innovation incentives.

Section IV looks at unilateral effects’ analysis in innovation markets.

Broadly speaking, competition authorities will be concerned about mergers that would reduce actual and/or potential competition in an existing market, as well as mergers that could reduce competition in a future market. Cases have shown that there are two channels through which the curtailment of innovation can occur, namely reduced incentives to continue current product development, and reduced incentive to begin the development of new products.

Mergers where the parties will compete on the basis of their innovation efforts typically arise when there is a link between the R&D efforts and a specific product/service, e.g. as in the pharmaceutical industry. However, if innovation competition is important in a market, the future competition of the merging parties could have been in products that do not currently exist in their portfolios. A merger between two innovators that leads to a discontinuation of a research pipeline leads to an adverse impact in the post-merger market because the discontinuation of research activities not only reduces variety and choice but also removes price competition in the post-merger market.

An interesting question for authorities is whether the reduction in the combined R&D efforts of the merged entity may lead to rationalisation and repositioning of the R&D for additional research pipelines. If this is the case, the merged entity will be more efficient than its pre-merger constituents. There is therefore a trade-off between competition in innovation spaces and coordination across innovation spaces. A merger may stimulate innovation if it enables the merging parties to better appropriate the social value of their innovation, to boost their innovation by internalising involuntary knowledge spill-overs as well as by bringing together complementary R&D assets, and if it allows greater scale economies in process innovation or enables cost efficiencies in R&D.

Section V considers the European Commission’s merger enforcement practice in innovation markets.

The Commission’s practice evolved over time. In earlier cases, the Commission adopted a concept of innovation that relied on proxies such as the number of patents, the number of new products and R&D spending. A review of this case law indicates that mergers involving important innovators in largely concentrated industries with high barriers to entry and no history of innovation are likely to be problematic from a merger control point of view. Such mergers are likely to lead to an overall reduction in innovation efforts and to a reduction in the number and quality of new products.

More recent cases witnessed a more explicit attempt to incorporate innovation in merger assessment. The poster child of this new approach is Dow/DuPont, where the Commission found specific evidence pointing toward lower incentives and lower ability to innovate post-merger, and thus the merger was approved subject to divestments focused on maintaining innovation in the market. However, there are other exaples of this new approach, such as GE/Alstom, Pfizer/Hospira, Medtronic/Covidien and Novartis/GlaxoSmithKline’s (GSK) oncology business. Under this case law, the Commission will analyse whether a merger will pose a threat to non-price competition in innovation. The Commission will assess closely a merger between two innovators that are active in similar pipeline products or research efforts, or when a transaction would eliminate an important competitive force and strengthen a company’s dominant position. Remedies in such cases usually aim to introduce new innovative competitors into the market to impose competitive constraints to prevent price increases and preserve innovation.

Section VI discusses how traditional market definition relates to innovation spaces.

Recent case law has illustrated how a product or a geographic market differs from an innovation space. A product market defined on the basis of a commercialised product can be much narrower than the space within which the innovation that will lead to the creation of this same product takes place. The assessment of innovation competition requires the identification of those companies which have the assets and capabilities to discover and develop new products which, as a result of the R&D effort, can be successfully commercialised. It is also important to identify and analyse those spaces in which innovation competition occurs in the industry. As such, one can define innovation spaces – a concept introduced by the US Licensing/IP Guidelines – by focusing on the overlapping R&D activities of the parties, including particular assets that are necessary for these activities, and then identifying competing activities as well as competing assets.

The assessment of innovation competition is different from the assessment of a product or techology market. Instead, a combination of standard market definition with the definition of innovation space is more prudent in assessing mergers, since it allows one to assess the impact of a merger not only on commecialised products/services, but also on the innovation behind the development and commercialisation of such products and services.

Section VII elaborates on how to analyse the unilateral effects of mergers on innovation.

One can identify the main types of mergers where competition concerns arise in innovation markets. These include mergers that involve overlaps of “pipeline-to-existing products”, as well as “pipeline-to-pipeline” overlaps where the relevant pipeline products are usually quite developed, likely to be commercialised and already known to target a specific product market – these are assessed as a merger with a potential competitor. In addition, the Commission will look at mergers where the effects take place at early stages of innovation, e.g. the merger will influence innovation efforts of the parties which have not yet taken shape of concrete products or which do not yet have a high probability of successful commercialisation. A merger involving innovation at earlier stages may have adverse effects as a result of discontinuation of overlapping R&D pipelines, as well as delay or re-orientation of R&D efforts. Innovation can be stifled by mergers which bring together important and close innovators with similar R&D capabilities in a sector where innovation is an important parameter of competition, the number of effective innovation players can be reliably identified and is limited, and barriers to entry are high.

In assessing mergers in innovation markets, a challenge for competition authorities is the uncertainty about whether R&D efforts will be successful. An assessment of the impact of a transaction on future markets is almost inevitably more speculative than an equivalent assessment focusing on existing markets. Nonetheless, innovation is a parameter that must be taken into account where relevant. The Commission’s approach is premised on factors such as contestability of markets, the existence of rivalry between competitors in a market, the potential for cannibalisation that will lessen the merging parties’ incentives to innovate, and the availability and effectiveness of IP rights in ensuring appropriability.

Looking for overlaps in R&D pipelines of the merging parties is the most easily quantifiable method, and the one most used by competition authorities. The Commission will assess whether the parties overlap within and across different stages of the innovation process, including discovery and early/late development. If there is a risk that overlapping R&D pipelines of research and early pipeline projects would be canceled, delayed or reoriented due to the increased risk of cannibalisation, this will raise alarms concerning the potential harm resulting from a merger. The Commission has also used patents as a measure of market power of the parties in relation to innovation and technological capacity.

Section VIII discusses merger remedies in innovation markets.

The requirements for appropriate remedies in innovation cases are not different from those involving other types of competition concerns. Commitments should be proportionate to the competition problem and able entirely to eliminate the anticompetitive impact. Structural remedies, and in particular divestitures, are preferred to behavioral ones. Divestments should encompass standalone R&D organizations/units. Any reverse carve-outs should be limited to prevent undermining the divestment’s viability and competitiveness, and to ensure the effectiveness of the divestment assets such as R&D facilities, IP rights, data, test results, documentation and know-how, as well as all necessary personnel including scientists, regulatory experts, technicians etc. The divestment package may also include necessary inputs and products, if they are needed to support the activities of the divested assets. In addition, the identity of the purchaser also needs careful assessment, since it will need to have the necessary expertise and capacity to maintain and enhance the innovation drive lost as a result of the merger.

Section IX looks at technological spillovers and synergies as efficiencies.

Synergies are particularly important in industries where value is created by systems that incorporate multiple components and by the ability to innovate. Horizontal mergers can improve the ability of the merger entity to innovate if they combine complementary assets, since then capabilities do not overlap. The question is how one measures overlaps in R&D capabilities. In Dow/DuPont, the European Commission used patents weighted by citations, as this was also regularly used by the parties to monitor, among other things, the competitive landscape. But in other industries this may not be so straightforward.

In practice, this brings up the question of the standard of proof, and in this respect the assessment of innovation is not any different from more standard assessments of price effects in a merger. Showing efficiencies remains subject to a very high standard of proof. Efficiency arguments need to be quantifiable, merger specific and verifiable. These are criteria that, as the case law has illustrated, are not easily met. In the context of innovation, many efficiency channels could be relevant in practice. These include, inter alia, opportunities to reallocate R&D efforts to reduce duplicative efforts, or the internalisation of involuntary knowledge spillovers. Because the identification of these efficiencies depends on industry-specific detailed knowledge, it would seem natural that the merging parties should be required to provide evidence showing that, in spite of the prima facie finding of a significant impediment of effective competition, the efficiency gains resulting from the merger will outweigh its likely negative impact.

Comment:

This is a comprehensive paper – it covers economic debates, case practice and conceptual challenges, all in a single package. While a bit discursive and, I feel, longer than it had to be, the paper provides a good overview of a number of issues that arise when one considers the relationship between mergers and innovation. 

While the tone of the paper is dispassioned and pedagogical, as if it were merely collecting the common wisdow on the topic, this is misleading. In effect, the paper is written so as to make a compelling case for merger intervention when innovation concerns arise. For example, the authors warn that their review of the literature might be biased, and I believe this is indeed the case. Regardless of whether their position is the correct one, the review clearly favours the view that horizontal mergers are likely to be detrimental to innovation, which is not shared by the literature as a whole. For example, maybe I misunderstood the papers I reviewed last week, but according to those papers there are more than simply two channels for innovation to have an effect on competition – and, as a comparison of this and those papers would make clear, the channels that are overlooked – or at least given less emphasis – in this paper are those that lend support to arguments that horizontal mergers can have beneficial effects on innovation.

Further, the argument that all possible benefits from a merger on innovation are efficiencies that should be proved by the merging parties is not an economic point at all – and, in any event, it is not shared even in the economic literature. As you may remember, some authors have distinguished between merger benefits that can affect the incentives to innovate (which would be part of the overall competitive effects’ assessment incumbent on the agency) and the ability to innovate (which are efficiencies strictu sensu).

The authors also develop a legal argument around their approach to the benefits of mergers to innovation, which seems to boil down to: ‘the Commission needs to prove anticompetitive effects, but since we are starting from a presumption of anticompetitive harm, the parties need to meet a very high standard for all efficiencies’. Not only does this seem to run against the General Court’s approach in GK Telecom regarding the standard of proof on the Commission for mergers, I fail to see how the Commission in the exercise of its powers will be able to avoid considering during the analysis of anticompetitive effects those factors that would promote competition in light of the Tetra Laval / Impala case law, should they be relevant. At the very least, the strict level of judicial review adopted by the European courts in this matter would put at risk any  Commission decision that did not engage with such factors fairly – regardless of whether the evidence is submitted by the merging parties or not.

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