The biggest deal in town: Ofcom and BT negotiate a new regulatory settlement for the UK telecommunications market

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1 The biggest deal in town: Ofcom and BT negotiate a new regulatory settlement for the UK telecommunications market Simon Muys 1 When it comes to deals, everybody knows that size matters to corporate lawyers. So there is a delicious irony in the fact that it is regulatory hacks and not pin-striped corporate types who are currently negotiating what could be one of the most influential settlements in the UK; a deal with the potential to alter permanently the shape of the 60 billion UK telecommunications market. For the last twelve months, the UK communications regulator, Ofcom, have been undertaking a thorough and far-reaching review of regulation in the UK telecommunications market, referred to by Ofcom as their Strategic Review of Telecommunications ("the Review"). As the Review has progressed, it has become increasingly apparent that Ofcom have their sights set on negotiating a new regulatory contract to underpin the next stage of the market's development. Ofcom s objective for this so-called regulatory contract is to open up key telecoms markets enough to justify greater deregulation. Market reviews conducted by Ofcom and their predecessor, Oftel, during 2003 and 2004 concluded that BT held significant market power ( SMP ) in all narrowband call and exchange line retail markets as well as in many wholesale markets. The European regulatory framework for electronic communications, as applied in the UK by the Communications Act 2003 ( the Act ), makes it clear that, to the extent that an operator holds SMP in a market, appropriate regulatory controls must remain in place. 2 This means that Ofcom's ambitious deregulatory agenda demands that they address SMP issues. Ofcom are also acutely aware of the future competitive implications of BT's planned investment over the next few years in a massive, multi-billion pound new IP-based network, described as its 21 st Century Network ( 21CN ). Equivalence and the task of getting BT to the bargaining table The size and importance of these twin issues the problem of deregulating in the face of BT s persistent SMP in key markets and the competitive challenge posed by its 21CN plans may explain why the second phase of the Review, released in November 2003, was almost exclusively focussed on BT. 3 Ofcom clearly see these as the most fundamental regulatory challenges facing the UK telecoms 1 Simon Muys is an Australian qualified regulatory lawyer working in the telecommunications group at Olswang. 2 Article 16 of Directive 2002/21/EC of the European Parliament and of the Council of 7 March 2002 on a common regulatory framework for electronic communications networks and services (the Framework Directive) applied in the UK in section 87 of the Act. 3 Strategic Review of Telecommunications: Phase consultation document, Ofcom, 18 November 2004 (the Phase 2 Consultation ).

2 market over the next decade. At the heart of the Phase 2 consultation is a demand for BT to deliver something which the industry has been seeking for the last ten years: genuine equality of access. Ofcom s call this concept equivalence. Formerly, the goal of regulated wholesale products offered by BT was that they allow competitors to match the retail products of BT's downstream subsidiary - referred to by Ofcom as "output equivalence". Under the proposed regulatory contract, Ofcom is demanding that BT develop its wholesale products so that the same or a similar set of regulated wholesale inputs are offered to competitors and its own retail business, something Ofcom call "input equivalence". This new approach to equality of access resembles a severe form of non-discrimination and goes beyond anything imposed on incumbents in other Member States. Perhaps in an effort to entice BT to the table, Ofcom have bundled the negotiation of equivalence together with their review of a number of other key issues with substantial commercial implications for BT: Ofcom s consultation on the return BT ought to be allowed on the cost of its copper access network; 4 their approach to risk in the assessment of BT s cost of capital; 5 and the freedom of BT to price and bundle SMP and non-smp products in business services markets. 6 What might this new regulatory contract look like: what does Ofcom want from BT? BT responded to Ofcom s invitation by publishing its response to the Phase 2 Consultation on 3 February With both Ofcom and BT having now played their opening gambits, the time seems right to consider how this regulatory contract is shaping up, whether it is possible to guess what it might end up looking like, and what this means for the rest of the industry. So what precisely have the parties asked for? Ofcom s priority is achieving infrastructure competition or competition between networks themselves and not simply competition between services based on BT s underlying infrastructure. This means Ofcom are keen to drive competition as deep as possible down into the BT network. To do this, Ofcom needs BT to commit to both technical and organisational changes. In the short term, key priorities for Ofcom are the development of a fit-for-purpose wholesale line rental ( WLR ) product over the next 12 months in order to alleviate the local access bottleneck in 4 Valuing copper access: A consultation on principles, Ofcom, 9 December Ofcom s approach to risk in the assessment of the cost of capital: An Ofcom consultation, Ofcom, 26 January Ofcom discuss the importance of achieving replicability as a precursor to allowing BT more freedom to bundle SMP and non- SMP products in business services markets. BT Pricing of Services for Business Customers: A Statement published by Ofcom, Ofcom, 27 May Ofcom s Strategic Review of Telecommunications: Phase 2 consultation document, BT s response, published 3 February 2005 (the BT Response ).

3 the voice market and for progress made by BT and industry in delivering a workable form of local loop unbundling ( LLU ) to continue. Ofcom have already set a target of one million unbundled lines by the end of Organisationally, Ofcom are expecting BT to make changes to its management structures, incentives and business processes in order to support equality of access between its downstream business and wholesale customers. Another real and pressing concern for Ofcom is making the transition to next generation digital networks. Ofcom is conscious that uncertainty surrounding access and interconnection arrangements for the 21CN could stifle investment in competitive networks. For example, as part of the 21CN rollout, BT will be deploying Multiple Service Access Nodes ( MSANs ) in place of existing DSL Access Modules ( DSLAMs ) in local exchanges. Whilst the introduction of MSANs allows BT to turn on broadband services for its customers virtually instantly (a feature called broadband dialtone ), it also frustrates many of the competitive benefits of LLU as the unbundling process at the local exchange involves a substantially slower manual process. A further advantage of the 21CN technology for BT is that it requires fewer physical nodes: a factor which contributes significantly to the huge cost savings which it estimates will result from the new network. However this inevitably leads to a geographic rearrangement of networks which is likely to reduce the number of points at which competitive operators are able to interconnect with the 21CN. Over the last few years, a number of operators who compete with BT using wholesale call origination products such as Carrier Pre-selection ( CPS ) and indirect access have built out infrastructure to interconnect with the BT network, in some cases all the way out to BT s local exchanges. These operators are likely to face some substantial re-engineering costs in modifying their networks to interconnect with the new layout of the 21CN. Ofcom want to see BT come to the table prepared to commit to dealing with these issues. In a nutshell, they are expecting to see three things: BT move quickly to develop fit for purpose local access products including WLR and LLU; a change to the management structure and organisation of BT to reinforce the importance of equivalence; and firm proposals from BT on how it intends to plan and develop the 21CN in order to support input equivalence between its downstream business and wholesale customers. The BT Response It is difficult to miss the key message in the BT Response, which refers to certainty 8 and confidence no less than 50 times. BT had, according to some commentators, previously enjoyed an all-toocomfortable relationship with Ofcom s predecessor, Oftel. Yet during Ofcom's first twelve months, BT seems to have repeatedly been put on the defensive, including being required to respond to a 8 This also includes various references to uncertainty.

4 Competition Act investigation initiated by Ofcom into a tariff increase 9 and a separate Statement of Objections issued under the Competition Act regarding an allegation of abuse of dominance in the wholesale broadband market. Ofcom have made no secret, during the Review, of their view that greater inroads need to be made into BT s market share in key markets. In the face of this barrage of attention from an ambitious young regulator, BT is feeling restless. In response, BT insists that its investment in 21CN is not a foregone conclusion and depends largely on the stability of the regulatory environment and the opportunity this affords BT to extract reasonable and commercial return on this investment. 11 In a show of good faith in the negotiating process, BT is establishing a new and independently managed Access Services division within BT with responsibility for BT s lines, duct and access infrastructure. On the question of equivalence, BT seems philosophical. Whilst challenging the legitimacy of equivalence as a regulatory concept, it nonetheless commits itself to achieving equivalence of some form, over the next three to four years. BT also used the opportunity to announce reductions in the price of its wholesale broadband product, IPStream, as well as future reductions in the price of full LLU. On the problems associated with equality of access to the 21CN, BT simply reaffirmed its commitment to work with industry to support input equivalence in the long term by developing an appropriate interconnection product for access to MSANs. BT also acknowledged the broadband dialtone problem and committed to examining how this could be overcome. Finally, and significantly, it agreed to negotiate with industry on compensation for operators incurring the costs of network rearrangement caused by the 21CN. Taken as a whole, the BT Response is a mixed bag. One the one hand, the establishment of the Access Services division is an important step toward improving the provisioning of access products and holds the promise of more than mere consultation window dressing. The creation of this new division appears to involve a deep internal reorganisation for BT with the establishment of a new Equality of Access board chaired by the BT Group CEO and including an Ofcom board member. The division will have its own code of practice, KPIs and bonus structure. Beyond the creation of the Access Services division, however, BT is offering little which is new or innovative. It has agreed to keep working with industry and the Telecoms Adjudicator to develop a fit-for-purpose LLU product and to continue work on WLR, in line with their existing workstreams. Responding to the Ofcom demand for input equivalence, the BT Response wrings its hands, insists that the concept is frightfully difficult to deliver, but could perhaps be introduced in a phased way, in relation to a limited number of products, over the next three to four years. 9 Case CW/00760/03/04, Ofcom own-initiative investigation against BT about potential anti-competitive exclusionary behaviour (case opened 31 March 2004). 10 Case CW/00613/04/03, Freeserve.com plc - BT's residential broadband pricing (case opened 16 April 2003) ("Freeserve/Wanadoo"). 11 BT also stresses the importance of confidence in the context of its 21CN investment in the BT response to Ofcom s consultation, Next Generation Networks future arrangements for access and interconnection. The BT response was published on 13 January 2005.

5 What does Ofcom want from BT? What does BT expect from OFCOM in return? fit for purpose LLU and WLR products; design and develop the 21CN to support input equivalence including dealing with the issues of MSAN interconnection and broadband dialtone; major structural and cultural change to support the objective of input equivalence. relax the price control in the residential voice services market and look to remove the control by mid 2006; review the residential voice services market and remove BT s SMP designation and obligations; allow BT to bundle SMP and non-smp or depart from published prices when responding to tenders for business services; conduct a market review for a separate market for large business services; conduct a review of the leased lines market, taking into account geographic differences in competition; review various wholesale markets, including narrowband wholesale and wholesale international services markets, with the aim of removing or modifying SMP conditions; revisit how universal service obligations are provided and funded; favourable response to the cost of capital and approach to risk in assessment of return on capital consultations; Enforcing the new contract There is an old West African proverb, famously quoted by Teddy Roosevelt, which suggests that when negotiating one should "speak softly and carry a big stick". When dealing with BT, Ofcom's big stick is the threat of a reference of the UK market to the Competition Commission under section 131 of the Enterprise Act. A market may be referred to the Commission under section 131 where any feature, or combination of features of the market prevents, restricts or distorts competition. Such a reference carries with it the possibility that the Commission might impose structural remedies, including structural separation. 12 However, BT is dismissive of the likelihood of such a reference and rejects outright the allegation that the UK market might be structurally or competitively unsound. BT is right to doubt the 12 The issue of reference to the Commission under s131 of the Enterprise Act is dealt within the Phase 2 Consultation as "Option 2" at paragraph 5.21.

6 likelihood of a section 131 reference. With the continued development of WLR, LLU and the implementation of even piecemeal input equivalence, it is doubtful that Ofcom could point to the kind of serious structural problems in the local access market which would be needed in order to justify such a reference. Moreover, even if accepted by the Commission, the ensuing investigation would be costly, take several years to complete and introduce substantial uncertainty into the market at a time when capital is only now beginning to re-enter. It follows that, absent a viable threat of reference to the Commission, Ofcom's task of enforcing BT's obligations under the new regulatory contract is a difficult one. The concept of "equivalence" is new and seems to extend well beyond the established regulatory concept of "non discrimination". It is certainly difficult to imagine the CAT or European Commission accepting, if a decision by Ofcom was subsequently challenged by BT, that non-discrimination required BT to provide full input equivalence. One alternative might be for Ofcom to expand their use of co-regulatory schemes such as the Telecoms Adjudicator or industry codes under which BT and industry contractually commit to stricter or more detailed regulatory obligations than would otherwise apply to it; an approach which has been employed successfully in the UK electricity industry. The implications and risks of the proposed contract for industry After the first round of negotiations, it is apparent that both BT and Ofcom have a considerable amount of work to do before any settlement is reached. BT, with some justification, believes that equivalence probably exceeds the scope of Ofcom's statutory powers and so it expects some form of regulatory quid pro quo for supporting Ofcom in achieving this outcome. Whilst BT cannot expect that its entire list of counter-demands will be adopted (see table), at least some of the following outcomes seem likely: a move towards more narrowly defined SMP markets (whether geographically or on the basis of products or customers) - a move which would lower BT's market share in these markets at the expense of, at least in relation to smaller geographic markets, the cable companies who would perhaps then run the risk of being burdened with SMP access conditions of their own; reconsideration by Ofcom of their position on the marketing of business services to allow BT to bundle SMP and non-smp products offered to business customers; an outcome from the Cost of Copper and Cost of Capital reviews which is favourable to BT - a result which will directly impact the cost of a number of wholesale products such as WLR, LLU and partial private circuits as well as potentially affecting future Competition Act claims by competitors, given the importance of the cost base in supporting price-related abuse of dominance claims; some form of relaxation of the SMP conditions and price control for retail and wholesale voice services; and changes in the way in which universal service obligations are provided and funded.

7 The extent to which Ofcom are prepared to trade the winding back of SMP conditions as a means of encouraging BT towards equivalence remains to be seen. The worst possible outcome for industry would be for BT to undertake highly publicised but incomplete steps towards equivalence which Ofcom rewarded by prematurely easing SMP controls, potentially leaving the market without functioning equivalence and without the protection of sufficient SMP regulation. BT suggests that competition law offers an appropriate hedge against this risk. Yet BT's confidence in competition law is not shared by many in the industry. Despite numerous complaints, BT has still never been successfully challenged under the Competition Act. The most recent and high profile dispute involving BT, Freeserve/Wanadoo, is now limping through its third year and still seems at least 12 months away from any meaningful resolution. Moreover, whilst competition law might theoretically be available for substantial and sustained abuses, it offers little or no protection against the more common and subtle erosion of competition caused by faulty, delayed or incomplete processes, something which the industry have referred to as "cumulative immateriality". Conclusions The vital question now at the heart of the Strategic Review is how much protection Ofcom are prepared to trade away in order to purchase the co-operation Ofcom needs from BT if they are to achieve meaningful equivalence in the short term as well as input equivalence following the rollout of the 21CN? BT is pressing its advantage by urging Ofcom to reconsider their approach to some fundamental issues, including how key SMP markets are defined. If Ofcom do proceed to deregulate or lessen the stringency of current SMP controls, they will need to show far more resolve than their predecessor did in creatively applying competition law. The UK telecoms market simply cannot afford greater deregulation absent an aggressive competition regulator prepared to test the boundaries of abuse of dominance. This article was first published in the April 2005 edition of E-Commerce Law & Policy The information contained in this update is intended as a general review of the subjects featured and detailed specialist advice should always be taken before taking or refraining from taking any action. Olswang 2005