The number of broadband internet users in Japan exceeded ten million

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1 The Spectacular Growth of DSL in Japan and its Implications Hidenori FUKE Faculty of Informatics, Kansai University The number of broadband internet users in Japan exceeded ten million at the end of June 2003 according to a report by the MPHPT (Ministry of Public Management, Home Affairs, Posts and Telecommunications) 1.DSL, which is a relatively new service in Japan, dominates the broadband internet market with over 8 million users. Some providers launched the DSL service as late as The number of DSL users in Japan began to grow at the end of 2000 and the number of subscribers reached 8 million by the end of June One of the factors behind the growth is the pricing of DSL. According to the ITU (REYNOLDS, 2003), the price of broadband per 100kb/s data per month in Japan is the lowest in the world. The price of DSL is especially low. And has contributed to the growth of DSL. However, both of the two NTT local companies that are offering subscriber lines for DSL and Softbank Corp., which leads the DSL market via retail of NTT local companies' subscriber lines, are losing money. This paper analyses this peculiar phenomenon and examines its implications for the future. Slow start of DSL services in Japan Interconnection rules and unbundling The DSL service is quite a new service in Japan due to the slow adoption of line-sharing. Although Japan opened the telecommunications market up to full competition as early as 1985 together with the privatisation of the 1 The MPHPT is the successor ministry of the MPT (Ministry of Posts and Telecommunications) created at the time of the restructuring of Japanese government organisations in COMMUNICATIONS & STRATEGIES, no. 52, 4 th quarter 2003, p. 175.

2 176 COMMUNICATIONS & STRATEGIES no. 52 NTT Public Corporation, interconnection rules were not been clearly stipulated by the regulatory authority (i.e. the MPT) until 1997 and linesharing was not covered by the rules. When the NTT Public Corporation was given legal monopoly status, the imposition of strict ex ante regulation on its operation was justified. With the introduction of competition it became necessary to introduce a new regulatory regime. It is important to keep government intervention to a minimum and to leave matters in the hands of market forces in a competitive market. If a problem arises regarding fair competition it should be handled through the ex post application of competition law. The only areas where sector specific regulation is justified are interconnection so far as essential facilities are monopolised by a former public organisation and consumer protection so far as asymmetry in information exists between carriers and consumers 2. However, the regulatory framework introduced in 1985 was not free from the vestiges of the monopoly era 3. "NTT Corporation Law" that regulates the organisation and operation of NTT and "Telecommunications Business Law" that regulates telecommunications carriers including NTT and new competitive carriers imposed strict regulations not only on NTT, but also on competitive new carriers. New entry into the telecommunications market was controlled by the MPT through licensing procedures and every Type 1 carrier 4 was required to get authorisation for their tariff from the MPT. On the other hand, one of the important regulations in a competitive environment -interconnection rules- were not established. Without interconnection rules, interconnection conditions were left to voluntary negotiations between carriers involved, which led to fierce disputes between NTT and other carriers requesting interconnection with NTT's local telecommunications facilities. The absence of interconnection rules has resulted in an unfavourable environment for the development of the telecommunications industry. As 2 As for ex ante and ex post regulation, see FUKE, For details refer to FUKE, The Telecommunications Business Law enforced in 1985 to introduce competition divides telecommunications carriers into two categories - Type 1 and Type 2. Type 1 carriers are those that offer services on their own telecommunications line facilities, and Type 2 are those that offer services by leasing telecommunications line facilities from Type 1 carriers. This distinction was designed to promote the development of value added services through less rigid regulation and has contributed to the spectacular growth in this area. This distinction was abolished by the revision of the "Telecommunications Business Law" in 2003.

3 H. FUKE 177 new common carriers asked to play on a level field with NTT, discussions were focused on the divestiture of NTT. This situation was improved by the introduction of new interconnection rules in 1997 and the reorganisation of NTT under a holding company structure in The new interconnection rules introduced in 1997 aimed to promote fair competition by ensuring that competitive new carriers may use NTT's local telecommunications facilities under the same conditions as NTT's longdistance department 6 in circumstances where the local market is actually monopolised by NTT. The interconnection rules are composed of two parts. One part consists of the rules applied to Type 1 carriers. This part stipulates general rules such as Type 1 carriers' obligation to interconnect. More important is the part applied to carriers with designated telecommunications facilities 7, i.e., NTT local companies. Two provisions are relevant for the purpose of this paper. Firstly, NTT local companies are required to unbundle designated telecommunications facilities into several functions and to set interconnection charges for each unbundled network function. Secondly, the TELRIC (Forward-looking Longrun Incremental Cost) pricing principle was adopted as of fiscal 2000 after a transition period during which the historical cost accounting method was utilised. DSL and unbundling However, this system did not take into account the DSL service offered by the line-sharing of metallic subscriber cables. DSL is offered through the high frequency range on the metallic cables. It is necessary to offer this high frequency range as a separate network function to promote competition in the DSL market, at least until facilities-based competition materialises. 5 NTT was reorganised as a holding company of two local companies (NTT-East and NTT- West), one long-distance company (NTT Communications), one mobile company (NTT DoCoMo) and one data processing company (NTT DATA). 6 This department became NTT Communications after the reorganisation of NTT in The term designated telecommunications facilities is used in the Telecommunications Business Law instead of essential facilities. The MPT designated NTT local companies intraprefecture telecommunications facilities as facilities under special obligations. Thus Japanese designated telecommunications facilities are wider than essential facilities as not only local telecommunications facilities, but also intra-prefecture long-distance facilities are included (FUKE, 2000).

4 178 COMMUNICATIONS & STRATEGIES no. 52 Line-sharing is an extreme pattern of unbundling. Although local transmission line (subscriber cable) is included in unbundled network elements, there was no provision for the unbundling of the subscriber line transmission function (line-sharing) 8 and co-location. Line-sharing is a typical example of problems with interconnection and unbundling. As Noam pointed out (NOAM, 2002, pp ), interconnection and unbundling is a matter of policy. If a regulatory authority intends to promote competition in a short period of time, it tends to set interconnection charges lower and to impose strict unbundling obligations. One of the ways to set interconnection charges is the TELRIC pricing principle. If it intends to promote competition and to keep POTS (Plain Old Telephone Service) as a universal service, it tends to set reasonsable interconnection charges for an incumbent carrier by applying the historical cost pricing principle and by not imposing severe unbundling obligations. A regulatory authority seeking to promote the development of broadband internet through competition tends to adopt the first policy. As far as competition policy remains within the scope of POTS, the first choice does not encounter fierce opposition. However, the situation has become more complicated as IP telephony expands with DSL. The main sources of revenue for incumbent carriers used to be monthly fixed charges for subscriber lines and call charges based on usage. The tariff structure used to be set in a way to cross-subsidize the loss in monthly fixed charges from call charges, especially from long-distance charges. With the growth of IP telephony, incumbent carriers not only help other ISPs (Internet Service Providers) through low priced line-sharing, but also lose revenue from call charges of POTS. They deprive them of call charges through DSL that depends on line-sharing whose prices are set by the TELRIC principle. It is more than natural for incumbent carriers to resist line-sharing, especially with the diffusion of IP telephony. When new competitive carriers tried to start DSL services on the basis of line-sharing and co-location throughout the end of the 1990s, NTT resisted the request for line-sharing and co-location. Many disputes between new carriers and NTT were reported. 8 Even in the case of the USA, the FCC did not take into account this kind of unbundling at the time of the 1996 Telecommunications Act and it imposed line-sharing obligation on incumbent local exchange carriers in 1999.

5 H. FUKE 179 Growth of DSL The disputes were finally settled through the intervention of the MPT 9 and the FTC (Fair Trade Commission) 10 in NTT started to offer linesharing and co-location at the end of The price for line-sharing was set at a very low level, and Softbank Corp. (the holding company of Yahoo Japan) entered the market with an extremely aggressive pricing policy. The fact that DSL services are offered on NTT local companies' metallic subscriber lines, it is virtually impossible for providers of DSL to differentiate their products. The quality of DSL service is mainly determined by the quality of subscriber lines offered by NTT local companies. This has led to a situation where competition is primarily based on marketing abilities, including price. Other DSL service providers were obliged to match these low prices. The internet access market is still dominated by cellular access such as i- mode launched by NTTDoCoMo, dial-up access over traditional telephone lines and ISDN. As of June 2003 the total number of users with internet access in Japan was 95 million, of which cellular access accounted for 67.7% and dial-up for 20.8%. However, dial-up access has started to decline since November The decline is due to migration to broadband access, especially to DSL. There were only 152,000 DSL users at the end of December The number of users has shown spectacular growth since the end of 2001 as illustrated in figure 1, owing to line-sharing and aggressive marketing of Softbank Corp. It exceeded 8 million at the end of June The MPT revised two sets of regulations, namely Regulations for Enforcement of the Telecommunications Business Law and Regulations for Cost Calculation for the Interconnection Charges of Designated Telecommunications Facilities to introduce line-sharing. 10 The FTC found that a refusal to offer line-sharing and co-location violates Japanese antitrust law.

6 180 COMMUNICATIONS & STRATEGIES no. 52 Figure 1: Broadband internet in Japan Ten thousands CATV DSL FTTH Source: MPHPT Japan is now one of the most advanced countries in the world in terms of the deployment of broadband access. More than ten million (about 25%) households now enjoy a broadband environment. However, this rapid growth does not necessarily make all service providers happy. It has resulted in a situation whereby no DSL providers are making profits in spite of rapid market growth. DSL services based on line-sharing demonstrate the problems with competition policy relying on the unbundling of network functions of incumbent carriers. The following sections analyse the subject in greater detail. NTT's unbundling of the subscriber line transmission function NTT'S unbundling Line-sharing was enforced in September The price of line-sharing was determined by the TELRIC pricing principle. The application of the method was justified on the grounds that the subscriber line market is still monopolised by NTT local companies. The price for line-sharing approved by the MPT based on NTT local companies application in December 2000

7 H. FUKE 181 was 410 Yen (USD ) per line per month. The price has been reduced several times since then and it is a mere 168 Yen (less than USD1.40) now. The rules on co-location were also revised in October The charge approved in December for the use of the space in NTT local companies' buildings was 37,948 Yen (USD315.18) per m2 per year. Thus DSL service providers are able to locate their DSLAM (Digital Subscriber Line-Access Multiplexer) and other apparatus in NTT local companies' buildings at a nominal cost. The unbundling of NTT local companies' optical fibre cables is also required. NTT local companies' optical fibre cables were added to the designated telecommunications facilities and the obligation to unbundle optical fibre cable transmission function was imposed on NTT local companies. Although the TELRIC pricing method was not adopted in calculating the price of unbundled optical fibre transmission function and average cost method was adopted instead, the price was very low. The price for the subscriber optical fibre cable transmission function approved by the MPT in August 2001 was 5,231Yen (USD 43.45) per core per month. The price for toll optical fibre cable function was 4.29 Yen (USD 0.04) per core per metre per month. These prices fell to 4,603Yen (USD38.23) and 3.9 Yen (USD 0.03) in NTT local companies were required to set these prices very low not only because they are competing with new entrants including subsidiaries of electric power companies 12 that installed as many optical fibres as NTT local companies and offered very cheap services, but also because they must take into account cheap DSL. If NTT local companies want to set their retail prices of designated telecommunications facilities at a competitive level and to make up for the loss in the long run, they are required to set wholesale prices lower to avoid a price squeeze. The principle is to set the wholesale price of essential facilities lower than the retail price and to apply the wholesale price equally to the internal retail section of incumbent carriers and to new competitive carriers. Other competitive carriers can enjoy this low wholesale price without taking the risk of the investing in an uncertain business. This illustrates the problem with the designation of facilities used for emerging services as essential facilities as discussed in the last section. 11 Yen are converted into U.S. dollars at the rate of yen to the U.S. dollar, the rate as of August 1st, Here there is the problem of internal cross-subsidy from one regulated business to another regulated business.

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12 186 COMMUNICATIONS & STRATEGIES no. 52 such as optical fibres. The price of NTT local companies' "B-FLET'S" (optical fibre access) is now 4,300 Yen (USD35.71) per month for 100Mb/s. The number of users of optical fibre access has been steadily increasing and reached 0.45 million at the end of June In the case of retail, Softbank Corp. claims that its profitability will improve once it achieves critical mass and can reduce marketing costs. If this is to be believed, the problem lies with NTT local companies. Their profitability has been damaged by the migration from POTS to IP. Their revenue from POTS decreased annually by about 10% in recent years as mentioned in the above section. Revenues from internet access services could not make up for losses because of the low pricing of line-sharing, DSL and optical fibres. As analysed above, NTT local companies are caught in financial problems due not only to low-priced line-sharing and optical fibres, but also to the shift from POTS to IP Telephony. This is not a simple problem of NTT local companies' finances. All users cannot enjoy the diffusion of the internet and IP telephony. Socially handicapped people such as the elderly and people living in remote areas are likely to be left behind in the migration from POTS to IP. If NTT local companies raise the price of POTS to make up for the loss, more burden is put on these people. If it is politically difficult to change the price of POTS, NTT local companies must face further financial problems. Here we are caught in a dilemma between the short-term promotion of service-based competition and the long-term promotion of technological innovations. In the USA, the FCC published an order in August 2003 to relax the unbundling obligations of incumbent local exchange carriers (FCC, 2003c). However, this will endanger the growth of competitive DSL services in the short-term, calling into question the validity of the unbundling obligation in the age of broadband internet. Validity of unbundling obligation The evaluation of the unbundling obligation is closely related to the "essential facilities doctrine". The notion of "essential facilities" is a principle of law developed in the USA with the introduction of competition in public utilities. It "bars a monopolist's refusal to allow access to a facility whose availability is vital to the competitive capability of rivals in upstream or

13 H. FUKE 187 downstream markets." (KOVACIC, 1992, p. 3). This raised the question of the conditions whereby facilities are designated as essential facilities. In the telecommunications area, incumbent's facilities are treated as essential when it is neither practical nor reasonable for competitors to duplicate the incumbent's facilities 14. Thus local telephone facilities of incumbent carriers are looked upon as essential facilities and such obligations as unbundling of local telephone facilities and price setting based on the TELRIC principle are imposed on incumbent carriers in many countries including the USA, the EU and Japan. The problem is whether the unbundling obligation, especially with TELRIC pricing, will offer enough incentives to invest in new and competing infrastructure. The unbundling obligation of essential facilities has to some extent contributed to the development of competition, especially that of service-based competition in static POTS. However, it is doubtful whether it has contributed to the development of facilities-based competition through investment in "new and competing infrastructure." (FUKE, 2002) In the case of Japan, the share of competitive new carriers in POTS subscriber lines at the end of fiscal 2002 was a mere 0.88%, while their share in intraprefecture calls in terms of call numbers was 34.8%. These figures show that facilities-based competition in local market has progressed little and that the competition in local markets is mainly based on interconnection. New entries in local telephone markets by interconnecting with NTT local companies' facilities have accelerated since the introduction of carrier preselection in May Due to the fact that re-balancing of monthly basic charges was out of the question and interconnection charges based on the TELRIC principle are very low, it is more than natural that competitive carriers are not investing in local telecommunications facilities and are instead relying on the NTT local companies' local network. (FUKE, 2002). The same phenomenon can also be observed in the USA. Competition in local telephone markets is mainly based on resale and UNEs (Unbundled Network Elements) (FCC, 2003b). Although the unbundling of telecommunications network elements and the TELRIC pricing principle was advocated as one of the means to promote local competition in the USA after the enactment of the Telecommunications Act of 1996 and Japan's MPT adopted the method under pressure from the USA, the method has an intrinsic problem. As Crandall and Hausman pointed out (CRANDALL & HAUSMAN, 2000, p. 86), excessive enforcement of unbundling and this 14 MCI Communications v. AT&T, 708 F. 2d 1081 (7th Cir. 1983).

14 188 COMMUNICATIONS & STRATEGIES no. 52 method is likely to damage the profitability of incumbent carriers and to deprive them and competing new carriers of the incentive to invest in new innovative facilities and thus to prevent the development of facilities-based competition. Two problems with essential facilities in Japan Thus even in the POTS market, the simple and strict application of the essential facilities doctrine has proved problematic. When the doctrine is applied in the internet market where industry structure has been changing rapidly, it becomes more problematic. As is demonstrated in the sections above, there are two problems. One is line-sharing for DSL service, while the other is unbundling of dark optical fibres. Firstly, when line-sharing is combined with low price setting based on the TELRIC principle it has proved effective in promoting competition and the deployment of DSL services, as the Japanese case shows. However, it has discouraged facilities-based competition. It is more important that IP telephony services are offered as a de facto "free" service on top of DSL. This has brought serious problems for incumbent carriers. Their revenues are declining with the diffusion of the internet, and especially IP telephony, and they can not compensate for the subsequent losses by expanding their internet business. They are no longer competitive in the DSL market due to the low pricing of line-sharing and are obliged to contend with minimum revenue from line-sharing. If this trend continues only those low telephone usage subscribers without PC skills will be left in their revenue base and they will face serious financial difficulties. Thus universal service will fall into crisis. Secondly, to make matters worse, the essential facilities doctrine is also applied to optical fibres. The designation of facilities in emerging markets as essential facilities also has the same kind of problems even, if the TELRIC principle is not implemented. In the case of emerging markets, it is not against competition law to set prices at lower levels in order to cultivate and materialise new markets and to recover costs in the long run. If the pioneer is asked to set wholesale prices at the same level for its retail department and for outside competitors, the pioneer may not be able to compete in the market or earn a profit even in the long run. On the other hand, competitive resellers can free ride on the low wholesale prices and earn profit without taking the risk of investing in new facilities in an uncertain market. As described in the above sections, NTT local companies are obliged to set the price of FTTH (Fibre To The Home) very low to compete with low priced

15 H. FUKE 189 DSL, and are obliged to price dark optical fibres very low because optical fibres are designated as essential facilities. Other competing broadband internet providers can take market share from NTT local companies through the use of unbundling network elements of NTT local companies without risking investment in an uncertain market. The bigger the investment in optical fibres, the bigger the loss the NTT local companies will suffer. Thus the unbundling obligation of optical fibres deprives NTT local companies of any incentive to invest. Conclusion From the analysis in this paper it is clear that regulations based on essential facilities doctrine are no longer valid in the changing industry structure from POTS to IP. While the incumbent carriers' monopoly in metallic subscriber lines has continued, DSL based on traditional metallic subscriber lines as well as various new access technologies such as Cable TV, FTTH, third generation cellular and wireless LAN are competing. In this emerging market, it is hard to say which technology will dominate. Even DSL is not free from intrinsic weaknesses. DSL, especially ADSL, is a technology that permits high-speed downloading from the internet, but does not accommodate high speed uploading. Therefore, DSL cannot support highspeed peer to peer communications. DSL is a transitional technology and it is not preferable to rely only on DSL for long. It is important to promote the development of other technologies while DSL grows the broadband internet market. However, investment in broadband infrastructure involves great risks. If we want to promote the deployment of broadband internet, it is important to balance the control of incumbent carriers' monopoly power with the creation of incentives to invest in new risky infrastructure. The author presents two proposals on the basis of the above understanding. Firstly, it is necessary to revise the pricing of line-sharing of metallic subscriber lines. The price of line-sharing is determined by applying the TELRIC principle. As previously discussed, the TELRIC principle is based on the hypothetical most efficient network model that does not reflect the actual networks of incumbent carriers. Thus it excludes the recovery of historical costs and puts incumbent carriers in financial difficulties. At a time when the structure of the info-communications industry is changing from POTS to IP, this inability to recover the cost of POTS is likely to put excessive burdens on incumbent carriers.

16 190 COMMUNICATIONS & STRATEGIES no. 52 Modelling of networks will face another challenge when network structure moves from POTS to IP. When traditional telephone services dominated the market, DSL was an incremental service to traditional telephone service. However, once IP telephony service was offered as one of the elements of DSL service, metallic subscriber lines were used only for DSL. Line-sharing for DSL is no longer an increment to a traditional telephone service, as a basic telephone service does not exist on metallic subscriber lines. Thus it is becoming increasingly inappropriate to apply the TELRIC pricing principle. Where no base services exist, it is impossible to apply an incremental approach. In the initial stage of the DSL diffusion, low priced line-sharing contributed to the rapid growth of DSL. However, it has been proved that excessively low pricing of line-sharing is distorting the broadband internet access market. As DSL is one of the most effective means to expand the deployment of broadband internet, at least in the initial stages of market development, and it is important to ensure the competitive supply of DSL services, the unbundling obligation of subscriber lines (line-sharing) should not be removed. What is required now is to balance the "levelling of the playing field" with the ensuring of the incumbent carriers' incentives to invest. The author proposes to revise the price of the unbundled subscriber line transmission function to a level where NTT local companies can earn reasonable profits from the service. Secondly, it is not appropriate to designate subscriber optical fibres as essential facilities. In the case of essential facilities, incumbent carriers have an obligation to offer wholesale services to their own retail section and competitors at the same price. If the incumbent carriers set retail prices very low for strategic reasons, the wholesale price will become very low accordingly. Thus other competitive carriers can free ride on incumbent carriers' business strategies and expand their FTTH service without investing in risky infrastructure. Many competitive carriers are not investing in fibre optical cables and are leasing dark fibres from NTT local companies instead. It is not fair to allow competitors to free ride on others' business decisions without taking risks through regulation. It is consequently necessary to cancel the designation of subscriber optical fibres as essential facilities and to promote competition among various technologies. In an emerging market of broadband internet, regulation that was effective in a traditional POTS age is no longer relevant. We need to put new wine into new bottles.

17 H. FUKE 191 References CHO Y. (2003): "Nikkan-no Burodobando Inta-netto Fukyu-no Seikoyoin Nikansuru Ichi-kosatsu" (A Study on the Success Factors for the Broadband Internet in Japan and Korea), a paper presented at Japan Society of Public Utility Economics 53rd Annual Conference, June 13th-14th. CRANDALL R. W. & HAUSMAN J. (2000): "Competition in U.S. Telecommunications Services: Effects of the 1996 Legislation", in PELTZMAN S. & WINSTON C. (eds), Deregulation of Network Industries: What's Next?, Brookings Institutions Press. Federal Communications Commission: - (2003a): High-Speed Services for Internet Access: Status as of December 31st, (2003b): Trends in Telephone Service. - (2003c): Report and Order on Remandand Further Notice of Proposed Rulemaking In the Matter of Review of the Section Unbundling Obligations of Incumbent Local Exchange Carriers, Implementation of the Local Competition Provisions of the Telecommunications Act of 1996 and Deployment of Wireline Services Offering Advanced Telecommunications Capability (FCC 03-36). FUKE H.: - (2000): Jyohotsusinsangyono Kozoto Kiseikanwa (Structural Change and Deregulation in the Telecommunications Industry), NTT-Publishing. - (2002): "Policy Options for the Promotion of Local Competition in Japan", a paper presented at ITS 2002 Biennal Conference, Seoul, Korea, August 19th, (2003): "Evaluation of New Regulatory Framework of European Union-From Japanese Perspective", a paper submitted at ITS 14th European Regional Conference, Helsinki, Finland, August 24th, KOVACIC W.E. (1992): "The antitrust Law and Economics of Essential Facilities in Public Utility Regulation", in CREW M. A. (ed), Economic Innovations in Public Utility Regulation, Klwer Academic Publishers. NikkeiBP (2003): Nikkei Communications, no.384, February 17th, NOAM E. M.: - (2001): Interconnecting the network of networks, MIT Press. - (2002): "Interconnection Practices", in CAVE M. E. et al (eds), Handbook of Telecommunications Economics, Volume 1, "Structure, Regulation and Competition", Elsevier Science B.V. REYNOLDS T. (2003): Promoting Broadband, ( reynolds. pdf)