Article I, Section 8, Clause 3 of the United States Constitution states the following:

(The Congress shall have power) To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.

This clause, known commonly as the Commerce Clause, has been the source of far-ranging power for the federal government. Over the years, courts have held up actions by Congress to regulate commerce in numerous ways. Congress has broad power to pass almost any regulation on trade it can get through the voting process.

This has manifested itself in many ways. Often, regulation has been cast in the light of restricting business and free trade. Tariffs limit potential markets and consumer choice. Burdensome requirements like the Affordable Care Act had the side effect of artificially limiting growth efforts for small businesses. Environmental regulations nearly put the coal industry out of business before they were rolled back.

In many of these cases, regulations have been constructed to serve a social or political goal (protecting the environment, or protecting domestic jobs). Some regulations, like the Sherman Anti-Trust Act of 1890, were necessary to protect competition and prevent monopolies, ultimately promoting free trade and benefiting the consumer.

In this article, we're going to take a look at the flip side of this: when government regulations actually HELP companies create an economic moat for themselves.

We call this a REGULATORY BARRIERS moat.

So, what are some examples of regulatory barriers moats? How strong are they? What are some things to look for to determine if regulatory barriers are durable, or not? Let's find out...

Case #1: Copyright Law

Copyright law has provided companies with powerful, government-enforced protections that protect them from the competition using their ideas to create competing products.

There is probably no better example of a company using IP protections to build a long-term moat than Disney (DIS). Early Disney created (or sometimes "adapted" from the Brothers Grimm) a collection of memorable characters that they copyrighted with the U.S. Copyright Office. This protected Mickey Mouse, Cinderella, Snow White, and the whole gang from being used by anyone except Disney to make money for quite a period of time.

When Disney first created these characters, copyright protections were for about 30 years. Disney successfully lobbied to have them extended, first in 1976 to 75 years or the life of the author plus 50 years, and then again in 1998 to 120 years or the life of the author plus 70 years (dubbed the "Mickey Mouse Protection Act"!).

As a result, Disney's IP is now protected from being used by anyone else almost indefinitely! Only its very oldest works, like Mickey (which would expire in 2023, and even then only the original version), face any kind of competitive threat, long after they were viable money-makers. Disney will still own the exclusive economic right to characters like Buzz Lightyear, Iron Man, and Elsa for long after you or I are around to see them become public domain.

While copyright law is a source of competitive protection, it is more of a supporting factor than a primary moat. Unless developed IP earns some kind of economic advantage for the company (such as a strong brand), it isn't particularly useful as a competitive advantage.

Case #2: Patents

There is perhaps no more straightforward example of a regulatory barriers moat than patents.

A patent, simply described, is a government-issued property right that legally protects the inventor from unauthorized use of a utility or design that the patent office has determined to be novel (unique) and non-obvious. Patent terms are 20 years from the earliest patent filing date.

It is up to the inventor (often a company) to enforce their patent rights. If a violator is found, the patent holder can either come to a private arrangement to share or license the patent, or failing that, seek legal action where the government could step in and prevent the violator from doing business related to the patent.

As you can see, this is clearly a way to build a 20-year economic moat, as the government itself is protecting your company from competition.

Patents have been used in various industries, and in various ways, to protect business models.

Perhaps the most well-known way they are used is in pharmaceuticals. Novel chemical or biological formulations (e.g., new drugs) are patented, which provides the pharmaceutical company with a non-competitive market for a long period of time. As with most non-competitive markets, this allows the patent holder to charge very high prices for the product, earning excess profits. Once patent expiration is reached, competition pours in (often in the firm of generic drugs), and prices plummet.

Entire multi-billion dollar business models have been built around developing, collecting, and enforcing patents. Qualcomm (QCOM), a $100 billion dollar company, makes the bulk of its profits from licensing cellular 3G, LTE, and 5G patents that it either developed or acquired. Qualcomm's licensing business earns a cut of every mobile device that uses a cellular modem. This is a $4.6 billion dollar business that earns 64% profit margins! It has also survived patent challenges from a litany of well-financed, legal behemoths, including Apple (AAPL). This shows how powerful regulatory barrier moats based on patents can be.

Case #3: Permits

Permits are just another way that the government controls the competitive picture in any given industry.

Let's take a very clear cut example here: landfills. Landfills are a classic case of a "necessary evil", but that doesn't prevent people from fighting tooth and nail to keep them "out of my backyard".

As such, new landfill approvals are extremely rare. In fact, the U.S. has less than 1/3rd the number of active landfills as it had in 1990. Onerous facility permitting, licensing, environmental regulations, zoning, and other barriers, at all levels of government (federal, state, and local), makes opening a new landfill a near-impossible task.

This, of course, protects the incumbents that own a lot of the existing landfills. As a result, municipal trash disposal in the U.S. is basically an oligarchy between Waste Management (WM) (249 landfills), Republic Services (RSG) (195), and Waste Connections (WCN) (90). Nobody else has even half as many. While there are loads of local collection services, at the end of the day, it is likely that these small players end up paying one of these large landfill owners to dispose of the refuse.

So ask yourself, if there are a limited (declining) number of existing landfills, and governments will not grant permits to open new ones, how would a prospective competitor enter the market? The answer is that it is almost impossible to do so, unless one of the incumbents is so poorly run that it needs to shed assets. Given the competitive dynamics and "inevitable" nature of the industry, that is pretty unlikely.

Case #4: Regulatory Body Restrictions

Various federal agencies have broad powers when it comes to regulating particular markets. The more regulated a market is, the less attractive it is for new competitors to enter and take profit share. This has the side effect of protecting existing business for the incumbent players.

A good example here is the tobacco market. The Food and Drug Administration (FDA) has enacted incredibly crippling regulations on this industry, including a ban on almost all marketing activity, highly visible and threatening warning labels, and even restrictions on new product introductions unless specifically reviewed and approved by the FDA.

No new competitor in their right mind would want to - or even could - enter this market. The inability to develop new products and market them makes it essentially impossible to compete with brands that have long-established market share. Altria (MO), with its Marlboro brand, controls over 40% of the U.S. market (bigger than the next 7 brands combined). It has maintained this dominance for almost 50 years.

The tobacco market in the U.S. has congealed into just a few major players: Altria, British American Tobacco (BTI), which bought Reynolds (maker of Camels and Newports) in 2017, and Imperial Tobacco (Winston, Kool, Salem, Blu e-sigs, etc.). Barring more consolidation, it will likely remain that way for the foreseeable future. This allows the incumbents to comfortably, and profitably, follow a pattern of small price increases to offset declining smoking rates in the U.S., instead of constantly having to spend to develop new products and market to compete against new competitors.

Conclusion

Through various methods, government regulation of industries often (intentionally or not) create very favorable economic moats for companies operating within those industries. Copyright law, patents, permitting, and regulatory body oversight are just a few examples of REGULATORY BARRIERS moats.

We should mention, however, that regulatory barriers are one of our least favorite forms of an economic moat.

These kinds of moats are artificial. They have little to do with the economic value that a company is providing to its customers, unlike a network effect or a strong brand.

Governments can also be fickle things to rely on. Leadership changes frequently. Highly regulated industries become de-regulated, and industries operating with few government barriers find themselves quickly buried under oversight.

De-regulation can be disastrous for companies that rely on government protections to stay in business. Airline deregulation in the late 1970's was great for the consumer, increasing competition which led to lower fares and greater choice. But it was bad for the legacy airlines, leading to lower revenues set against the backdrop of high, inflexible fixed costs (particularly unionized labor). Once great airlines like Continental and Pan Am quickly went bankrupt, followed by virtually all the other legacy airlines at some point since. We talked about the tobacco companies benefiting from onerous regulation, but they could just as quickly be put out of business by outright illegalization.

The point here is that regulatory barriers moats can appear and disappear quickly. It is best to always be very careful when assessing the strength of a regulatory moat. If it is in the general interest of the public, you can have good confidence that it is a durable protection. If, in fact, the protecting regulation hurts the public good at large, it may not be very durable at all.