The impact of the Australian National Broadband Network on the Communications Sector A forensic view

Transcription

1 The impact of the Australian National Broadband Network on the Communications Sector A forensic view February

2 2 The impact of the Australian National Broadband Network on the communications sector a forensic view Contents Executive summary 4 The NBN changes everything 8 The NBN will drive massive structural change 10 New opportunities and threats 12 The NBN requires different regulation now and in the future 14 Longer term issues 15 A forensic view from Section 1: Understanding the NBN 18 Public money is pouring into fibre 20 Support for NBN Co 22 NBN Co s ownership and control 23 NBN Co s business case 24 NBN Co s business case assumptions 26 What happens to Telstra? 27 How should we judge the success of the NBN? 29

3 February Section 2: The NBN will drive massive structural change 32 Predictions for the future 32 The telecommunications sector 35 The evolving media sectors 38 Section 3: The impact of the NBN on regulation 42 Timing is key 44 Changes to the telecommunications regulatory environment 45 Regulatory change in the media sector 47 Section 4: Long term NBN issues 48 Pressure to price regulate NBN Co more aggressively 50 The threat of mission creep 52 Threats between private sector financing and regulation 54 NBN Co s long-term impact on network competitors 55 Introducing private sector equity investors to the NBN 56 Section 5: How to succeed in the post NBN world

4 4 The impact of the Australian National Broadband Network on the communications sector Executive summary

5 6 The impact of the Australian National Broadband Network on the communications sector a forensic view

6 February Australia s NBN investment is the largest in the world relative to its GDP and population. The project is unique in not involving any private sector funding, at least for its first decade. It will be closely watched by other nations. The AUD43 billion Australian National Broadband Network (NBN), to be deployed by the wholly Federal Government owned NBN Co Limited (NBN Co), is the largest infrastructure project ever proposed in Australia. The NBN will comprise a wholesale fibre to the home (FTTH) network connecting 93% of residential premises and broadband wireless and satellite coverage to the remaining 7% of the Australian population. Its capacity will significantly exceed current demand and it is premised on a 30 year business model. It represents a very different network and policy framework to everything that has preceded it for the last 20 years. This unprecedented project will deliver a range of outcomes not previously seen in the Australian communications sector that will have far reaching impacts on its structure. It will also be the first ubiquitous broadband network of its type deployed in an OECD country (other than limited geographies such as Singapore). It therefore represents the first example of the effects on a country s communications sector of the introduction of a ubiquitous fibre access network to an existing market structure. This paper is a summary of a strategic commercial legal and regulatory briefing being provided by Allen & Overy and Venture Consulting to communications sector participants. It provides a forensic analysis of the impact of the NBN on a variety of markets, including: an explanation of the NBN; an assessment of the NBN s impact on industry structure and pressures for M&A activity, joint ventures and alliances; likely regulatory developments in the telecommunications and media sectors; the longer term commercial and regulatory issues the NBN creates and the likely winners and losers; and an assessment of what companies should be doing to be successful post-nbn implementation. The NBN is the hub issue that is likely to address, create, accelerate or influence every other value shifting issue in the communications sector over the next 10 years. Every participant in the communications sector will need a strategic response to the NBN.

7 8 The impact of the Australian National Broadband Network on the communications sector a forensic view The NBN changes everything The NBN will be the most disruptive policy initiative since Australian telecommunications market liberalisation. The creation of a massive, government-funded, publicly owned, wholesale only access player represents a huge shift in the market environment: The return of Government to the market For the last twenty years, Australian telecommunications policy has focused on promoting private sector network and service competition at every level and the Commonwealth has progressively sought to exit its remaining Telstra shareholding. The Australian Government is now reentering the telecommunications sector through NBN Co. A ubiquitous network access company The NBN will cover the entire Australian population, 93% of premises by FTTH access, and the remaining 7% by wireless and satellite. While the NBN does not legally preclude other fibre based local access networks, it is based on the premise that only one such network will be economically efficient and that its commercial power will ultimately deliver this result. A wholesale only carrier The NBN is a structurally separate wholesale only network offering Layer 2 broadband services. This will lead to a reduction or an end to vertical integration and the value chain will change dramatically as revenues are apportioned between retailers, wholesalers and network companies. Inability to directly generate retail demand NBN Co s economics are entirely dependent on its wholesale carrier customers and service providers. NBN Co has no direct control over the retail services that will stimulate demand for its capacity. It is one step removed from the retail interface and its tools for generating demand are the relatively blunt instruments of wholesale service functionality and price.

8 February Displacement of the copper local loop The underlying copper local network is being entirely replaced. The NBN is a once in a generation program to swap out the legacy network and replace it with fibre to the home. This will result in a much higher cost per subscriber than previous upgrades that delivered each prior successive improvement in broadband access (which were largely supported by new transmission equipment rather than new underlying transmission media). The removal of Telstra s vertical integration Billions of dollars of public funds are to be paid to decommission the Telstra local access network. Government is paying to shutdown existing competing networks and absorb their facilities and services. Telstra will progressively lose its vertical integration in the fixed local access network. Ubiquitous superfast broadband The NBN is based on a principle of ubiquitous access to high bandwidth. Universal access to basic services has been a long-standing policy principle, but ubiquitous access to the highest level of service will now be effectively guaranteed (subject to alternative technologies and more limited bandwidth for the most remote 7% of the population). Metropolitan to regional cross subsidies The cost per subscriber to deliver to the more remote regions in the higher deployment percentiles will be much greater than in core metropolitan areas. However, the NBN will offer national uniform pricing. This necessarily involves a very significant implicit cross subsidy from metropolitan to regional Australia. Regional broadband service costs will be embedded in the overall economics of the industry in the USO, access prices and potentially a cherry picking levy competing on metropolitan fibre access networks. This cost and its implications are not well understood. Pace of transition far from settled The rate of transition will be influenced by the final shape of the proposed deal between NBN Co and Telstra, the detail of the regulatory environment and the deployment plan selected by NBN Co. However, on balance, we expect change to come more rather than less quickly as firms seek competitive advantage in a changing environment.

9 10 The impact of the Australian National Broadband Network on the communications sector a forensic view The NBN will drive massive structural change These changes represent material threats and opportunities to many players in the telecommunications and media sectors and will accelerate opportunities in online sectors: Impact on existing networks Because of its capacity to carry all current fixed communications services and therefore to better integrate them the NBN has the ability, over the long term, to absorb many of the services that are carried over current fixed line telecommunications access networks as well as all wireless and wireline broadcast networks (including free to air (FTA) television, satellite television and HFC pay television). However, we expect that the NBN s high cost structure will mean that competing media networks keep operating for some time to come. Fixed market restructuring Although the incumbent players are well placed to defend their market shares through aggressive marketing, they will still need to shift their mind set from being a vertically integrated to a horizontal competitor. We believe that on balance this will create opportunities for entrants, resulting in more balanced market shares over time. Fixed customer switching We expect smaller existing players and entrants to try to seek to grow market share aggressively during the transition period. Customer switching behaviour is likely to be very interesting: whether existing customers transition through their existing retail provider or if the transition decision creates an opportunity for operators to acquire customers (eg by aggressive acquisition tactics or by local ballot)? In addition, the extent and robustness of opt-out measures for the build are yet to be settled. New carrier entrants NBN Co s products will allow infrastructure light entry in the immediate term. Disruptive brand based players (such as banks and retailers) could use the NBN to enter the market for communications services. Mobile networks The topography of long term evolution (LTE) wireless mobile networks is likely to become more integrated with the NBN than current mobile technologies, as wireless cells are efficiently established around the NBN and consumer handsets are configured to migrate seamlessly from high bandwidth wireless LANs in homes (supported by the NBN) to LTE cellular mobile networks outside the home. Do not expect mobile carriers to operate as separately from the NBN as they do today.

10 February Mobile carriers as broadband resellers The distinction between mobile and fixed line carriers will blur. Mobile only carriers will also become fixed line NBN resellers removing the advantage of horizontal integration. Media sector restructuring Fibre is able to carry high quality video streams over the top of other services. Traditional FTA and pay television transmissions could be carried entirely over the NBN and antennae and satellite dish networks could ultimately be removed in the long term. The media market is already changing rapidly, but the NBN will accelerate this process, providing ongoing opportunities for new aggregators (such as Fetch) and content providers (such as the US studios or Australian sports codes) to engage directly with consumers. We expect the NBN to accelerate the changes already seen in the sector as traditional and digital media broadcasters make their future distribution choices. Acceleration of media transition Providers of online services will instantly overcome capacity constraints and will be able to deliver high bandwidth services such as IPTV and VoD directly to consumers. Online brands will come into more direct competitive contact with traditional carriers and broadcasters. The markets and commercial arrangements for content rights and release windows,will shift, including sports and premium movies Control of the customer interface Within the home, consumers will expect services that are supplied over the one FTTH network to be integrated with each other and to displace the need for multiple items of consumer equipment. An emerging battle will develop over control of the set top box (or consumer computing platform) that supports the customer interface. Relative positions on that customer interface will influence customer choice. The telecommunications and media marketplaces will change out of recognition following the deployment of the NBN. However, the winners and losers will depend on the strategies adopted by individual players and the evolving regulatory landscape over the next five years.

11 12 The impact of the Australian National Broadband Network on the communications sector a forensic view New opportunities and threats Corporate strategy, investment and enterprise value will shift markedly over the next 10 years as a result of the NBN. For those players able to adapt to the new environment quickly the opportunities are significant. The decline of voice service revenues Fibre is accelerating the transition of voice from core product to just another cloud based application, at least in revenue terms. As it becomes easier for voice to be carried over the top of broadband data streams, operators will either price it this way or watch voice minutes vanish in the same way that international minutes are moving into the cloud. Voice will remain an essential service but will no longer drive revenues. Integrated, fixed, mobile and internet With mobile devices becoming critical internet access devices, customers and businesses will want seamless access to the internet across their fixed and mobile connections from one provider creating opportunities for the largest players to bundle fixed and mobile, combined with other technologies such as WiFi. Integrated content Consumers will require all of their personal and enterprise applications, messaging and content integrated and replicated across mobile and fixed devices. While applications and messaging has been moving to this outcome for some time, bundling premium video entertainment across all platforms and devices has been the exception rather than the rule for primary rights holders and Australian market licensing has often been fragmented across different platforms. Utility broadband At the other end of the scale, there will be a market for basic internet connectivity. This could be retailed to sophisticated Government and corporate customers who combine it themselves with , security, and other services.

12 February ISP in a box Internet connectivity at Layer 3 could be wholesaled to new entrants, allowing anyone to become an ISP. Fast national market entry New entrants will be able to quickly secure national coverage, potentially using Layer 3 wholesale services. The NBN will deliver enormous scale to service providers without network capital costs. Scale and network ownership will no longer deliver retail service competitive advantages. Sector leverage It will become much simpler for strong equipment and service providers in one sector to leverage their position into adjacent sectors. For example, consumer device manufacturers, content rights holders and major online brands will all be able to more readily extend their service offering. Cloud based network centric services The NBN will allow much more bandwidth hungry applications to be hosted and data to be stored in the cloud. This will alter the manner in which software and IT services are consumed. Over time, the potential for data mining and customer specific services will be immense. Specific customer or product niches It is also likely to be much easier for innovative players to create new service offerings targeted at specific sub-categories of customers and niche communications services will be attractive. The economics of niche service and content providers will be improved by the NBN. Complementary investments There will be complementary network investments around the NBN for multicasting, backhaul and a variety of other cloud-based platforms for value added services. Speed of transition It remains far from clear how quickly the NBN will impact the market. This is because so many important decisions are still to be taken. The near term regulation of copper and mode of deployment will play a big role in the speed of transition to fibre. The terms of the agreement between Telstra and NBN Co will be important to migration arrangements, migration payments, continuation of the universal service obligation and on-going local loop pricing. Incentives to migrate customers to fibre will be affected by wireless and remaining HFC and other fixed networks. Moreover, operators will need to untangle agreements with Telstra and establish new arrangements with NBN Co.

13 14 The impact of the Australian National Broadband Network on the communications sector a forensic view The NBN requires different regulation now and in the future Many commentators have talked about the NBN leading to massive deregulation. However, we can see only a shift in regulatory focus. Shifting market power NBN Co will ultimately dilute the market power of other market participants, but will establish its own market power. Media regulation Australia is about to undertake a wideranging regulatory Convergence Review that could lead to considerable reform in the media sector. Many argue that traditional media and content regulation will ultimately no longer be justifiable or possible. Future NBN regulation Many Governments in the region are opting for a regulate tomorrow stance where new network companies are given a wider berth initially, but there is a promise of greater regulation (such as dark fibre unbundling) at some point in the future. The irrelevance of geography Jurisdictional boundaries have become increasingly irrelevant for some time now. However, the NBN will complete that process by allowing even high definition video content to be hosted anywhere. The nexus between content and location will be permanently severed.

14 February Longer term issues Looking to the future, the NBN structure as envisaged today will create a series of pressure points that will need to be navigated at some point. Together, they have the potential to deliver a very wide range of industry outcomes: Pressure to price regulate NBN Co will build over time A close assessment of the NBN Co business model, suggests that it will be earning an EBITDA of 79% and a return on equity (ROE) of 19.5% by the end of its business case assessment period (to make up for early losses). These figures are higher than international best practice for regulated industries. The Federal Government and ACCC will face significant political pressure to reign in any such monopoly profits in the long term, regardless of the impact on the overall project returns. Mission creep NBN Co has promised to remain a neutral wholesale-only player, but the pressure to act commercially and mission creep will be significant in the longer term as its managers seek new revenues and the Government seeks to demonstrate commercial success. A future move to private debt or equity funding may push this trend further if an extension of the role of NBN Co is required in order to generate commercial interest. The viability of the NBN pricing model will be tested The NBN will support all of the services carried over existing fixed networks, but the additional mass market services that cannot currently be supported by existing networks are not yet obvious. Even if the NBN carries current mass market video entertainment services, retail customers may resist a significant increase in average revenue per user (ARPU), meaning that the long term viability of usage based pricing remains as uncertain for NBN Co as it has proven for all other network owners. Knock on effects on network layer competition In opening up the non-contested residential fixed access sector the NBN may undermine a variety of highly contested network sectors. In the short to mid term the commercial and regulatory arrangements around the NBN are seeking to displace directly competitive copper and HFC networks (under the Telstra and possibly other arrangements) and to impose levies discouraging cherry picking by potential fibre access competitors. In the longer term the NBN may expand its backbone network and compete with other backbone providers. The NBN may also have unforeseen impacts on existing broadcast networks. NBN Co may also ultimately come to regard LTE mobile networks as competition not a complement. Finally NBN Co s foray into satellite services may also alter this sector. Long term strategy Management teams need to undertake an objective analysis of the potential risk and return of the various options open to them. They need to determine and quantify the impact of their decisions today on their business over the next five years and decide what services to launch, when to launch them, and how to deliver them. Successful companies will develop five year plans that balance fibre migration costs against future market positioning and profitability. Most importantly, they need to set an execution schedule and keep this under regular review as the market develops. Only companies that understand the fundamental impact that fibre will have on their businesses will prosper through this industry upheaval. Bold moves are risky, but could reap significant rewards. These decisions need to be made today.

15 16 The impact of the Australian National Broadband Network on the communications sector a forensic view A forensic view from 2011 The NBN is without doubt the biggest change in the Australian telecommunications industry since competition was introduced. Nevertheless, there has been surprisingly little forensic analysis of the NBN in terms of its implications for communications markets. The political debate has been heated, but the industry debate has been muted with most players championing the NBN. The media debate has been focused on the politics and personalities. There has been much talk about the magnitude of the costs and benefits of faster broadband, but little analysis of the NBN s implications for competition among existing telecommunications operators and broader ramifications for media and related communications industries The objective of this paper is to take a detailed, objective look at the NBN and provide a framework for understanding how it might change the Australian communications sector over the next decade. The outcome is critical to Australia s communications future and the wider economy. However, it is also instructive for other countries that may follow a similar communications development path. The authors have focused on identifying and explaining the likely commercial and regulatory impact of the NBN. Justin Jameson is the CEO of Venture Consulting, strategic advisers to the communications and media sectors and Michael Reede is a partner at Allen & Overy, a leading global law firm advising many of the world s largest communications sector participants. We both support the NBN and believe that it represents a visionary policy and that it will support Australia s economic growth long into the future. But, we also see many issues on the horizon. We are not interested in the short term macro-political debate and we have no specific criticism of NBN Co, which is executing efficiently on the challenging commercial and policy goals that it has been set by the Commonwealth (its sole shareholder). Instead, this paper focuses on the fundamental changes to the Australian communications markets that the deployment of the NBN will drive; the detailed commercial, policy and regulatory decisions that lie ahead; and the potential future issues that we will have to confront.

16 February To understand the way the NBN is likely to change the landscape it is helpful to understand its implications in three phases: Transition The pace and impact of the immediate transition to fibre, the legacy effects of competition from the copper world and the proposed transaction between Telstra and NBN Co. Near term The increasing competition and structural change this will drive in the near term from new products, price structures, changed incentives and the implementation of the NBN. Medium to long term structural issues that Government and the industry will need to address, new competitors, and complementary and competing new investment. This wide-ranging article considers the impact of the NBN across five sections: Section 1: Understanding the NBN explores the structure of the NBN, how it is being implemented and how we should judge its success Section 2: The NBN and structural change considers the likely impact of the NBN on established industry players and new entrants across the fixed, mobile and media sectors. Section 3: The impact of the NBN on regulation assesses the regulatory changes that will be needed over the next five years as the NBN is deployed commercially. Section 4: Long term NBN issues identifies the likely issues that will need to be addressed in the future based on the approach being taken to the NBN today. Section 5: Winning strategies for a post-nbn world considers strategies for success in a post NBN world including how they can be defined and delivered. The salient question for communications markets worldwide is, if you introduce a ubiquitous broadband fibre network, what is the effect on participants in the communications sector?

17 18 The impact of the Australian National Broadband Network on the communications sector Section 1: Understanding the NBN

18 20 The impact of the Australian National Broadband Network on the communications sector a forensic view Public money is pouring into fibre Given the large public funding involved, many of these investments have become high profile, politically driven projects that are now too large to fail. Public money is now pouring into telecommunications networks in a manner not seen since long before the privatisations of the 1980s and 1990s. In the Asia Pacific region alone, over USD80 billion is expected to be invested in fibre deployments and initiatives over the next five to eight years. Although some of this projected investment may end up coming from private investors or not being invested at all, the volume of public funds likely to be committed is extremely high. Governments are underwriting fibre network builds because they believe the investment is necessary to drive broad productivity gains across the economy, at a time when incumbent operators balance sheets are not able to absorb the risks associated with such significant investments without guarantees of high returns. Australia s NBN will be at the forefront of these developments. In 2011 the NBN becomes a reality. It will be closely watched internationally as the largest public investment in broadband network technology in the world, relative to the size of its market. The effect of the NBN will be fundamental. Over the next decade there will be an enormous injection of capital in the telecommunications industry. The investment will be underwritten by the Australian Government, through the establishment of NBN Co as a wholesale only operator. The deployment of the NBN network platform is highly disruptive and will fundamentally change the Australian telecommunications, media and information technology sectors in the long term. The NBN is only part of that process, although it is a very material and capital intensive element of the wider communications landscape. It will accelerate many of the most important trends in the sector. This disruption creates more risk and opportunity than we have seen in 20 years and the opportunities are far more broadly spread than previous market upheavals driven by regulatory and policy decisions.

19 February Exhibit 1: Public investments in fibre infrastructure across the Asia Pacific region Country Policy Public Investment Australia Korea China New Zealand Malaysia Singapore to build a privately owned FTTN broadband network, reaching 93% of homes within 8 years Korea is one step ahead of the curve, and moving quickly to provide next generation broadband through its ukorea initiative its Broadband convergence Network (BcN) At the end of 2008, China announced that it will build its first nation-wide, high capacity, fibre-optic network in 2009 called for submissions on a proposal to build an FTTH network in NZ reaching 75% of the population PPP with TM to deploy a high-speed bb network capable of offering 10 to 100Mbps Commenced Next Gen National Infocomm Infrastructure (Next Gen NII) project in 2006, consisting of NBN and Wireless BB Network AUD43 billion the government launched the project in In total, it is estimated to have cost 40.3 trillion won (USD34 billion) Amount of planned investment has not been revealed (est USD20 billion) the government has previously invested over 700m yuan (USD103 million) in NGN, and is expected to invest a further CNY20 billion (USD2.9 billion) in wireless NGN nzd1.5 billion (USD1.1 billion) myr2.4 billion (USD758 million) Government will support the deployment of fiber infrastructure (through NetCo ) with SGD 750m grant (USD550 million). In addition they will support retail service providers (SerCos) with a grant of up to SGD250 million (USD184 million) Hong Kong In HK the pace of NGN has been driven by the market no investment Japan High FTTH penetration, with deployment to new homes since 2005 no investment low interest rates on loans to fund FTTH Note: USD exchange rate as of 11/08/10 Source: Press releases, ITU, Venture Consulting Analysis

20 22 The impact of the Australian National Broadband Network on the communications sector a forensic view Support for NBN Co In 2031, with the benefit of hindsight, we will no doubt reassess an NBN policy that could have been better executed. The NBN involves complex issues and rests upon a series of very significant assumptions, many of which are not based on any available empirical evidence. We cannot expect perfection, but we should expect the best possible decisions based on the information currently known to us. The NBN clearly represents an unprecedented investment of public funds in the communications sector. Within the political spectrum the major parties have either been for or against the NBN, shades of analysis and the discussions of specific issues have been relatively rare. Until now the NBN has been far too closely aligned with the 2010 Federal Election to allow a sensible debate to emerge. As a result public discussion regarding the NBN has tended to largely be defined by the binary philosophies of the true believers and those that oppose them. Many of the best public policy decisions have been founded on little more than a vision for a better future. However, as policy decisions become economic reality, and the details are defined, they need to be painstakingly assessed by affected stakeholders. However, for a sector typically marked by vigorous debate on most topics, the NBN has attracted widespread support like no other proposal since telecommunications market liberalisation. In a highly competitive telecommunications industry with relatively thin margins and a significant level of regulatory intervention, AUD43 billion of new investment is inevitably attractive, particularly when most of it is sourced from the Federal Government. For the equipment vendor community and online service providers there is everything to gain. Twenty years after telecommunications market liberalisation in Australia almost all agree that it was an excellent decision, although the manner of its execution was not ideal. Indeed the current rationale for the NBN is partly driven by the flawed market structures established by those earlier policies. The NBN is as significant a policy decision as liberalisation and it will influence Australian communications markets for the next 20 years.

21 February NBN Co s ownership and control What type of the company has the Federal Government tasked with this enormous responsibility? NBN Co itself is in many respects both a remarkable and yet also a relatively familiar entity. It has been established as a company, like any other formed under the Corporations Act, that is also a wholly-owned government business enterprise (GBE) with the intention that it operates commercially. This much is relatively typical of a range of GBEs. Its board is not comprised of political appointees (which can occur with some GBEs) but individuals from a range of commercial backgrounds, although arguably too few with specific experience in telecommunications. The Federal Government should be congratulated on avoiding the temptation of political appointments, although will successive governments adopt the same restraint over the next 20 years? Perhaps more unusual is that this particular GBE will have a truly national scope, not only because it operates nationally but, unlike any other utility in the country, it will interact with every single physical residential premise. At a wholesale level it will become the monopoly supplier of residential fixed high-speed local fibre access capacity to all of Australia s telecommunications carriers and, as a result, will underpin one of the most highly competitive and critical sectors in the country. NBN Co is expected to operate commercially (at least to the extent its return exceeds the long term government bond rate), yet it has been set a range of objectives by its shareholder that would never be pursued by a private sector entity and which make its economic performance challenging. It therefore has to maintain a unique balance between profit and policy objectives. NBN Co s shareholder, the Commonwealth of Australia, is represented by Federal Ministers, initially they are Senator Penny Wong (the Minister for Finance and Deregulation) and Stephen Conroy (The Minister for Broadband Communications and the Digital Economy). They are advised by their respective departments and individuals within those departments will be given responsibility for this asset and will wield considerable influence. A similar model once applied to Telstra, although for at least the last 15 years, and certainly since the Telstra 3 share offering, the Federal Government largely separated its responsibilities as a policy maker and as a shareholder. Indeed the individuals tasked with those separate functions often privately contested decisions within government from their different perspectives. In the recent past, the NBN has arguably tipped the balance in a national election. In the future, different governments may take a quite different view of the project given the NBN s considerable lifespan and economic realities, particularly given its significant impact on government finances and increasing demands for infrastructure investment in other sectors. It would be unrealistic to assume that political and business decisions will remain as separated as in the past. There is no escaping the fact that we are returning to a model of a wholly government owned carrier that is unlisted and therefore has no corporate disclosure obligations, but which will have major economic implications for the government of the day.

22 24 The impact of the Australian National Broadband Network on the communications sector a forensic view NBN Co s business case NBN Co does not necessarily require a profit motive that achieves private sector equity returns, but it needs to be a sound project with stable infrastructure style yields if it is to be ultimately externally project financed. As deployment of the Australian NBN shifts into a higher gear we are now in possession of a reasonably detailed outline of NBN Co s business case (the more comprehensive version released in late December 2010) which is set against the backdrop of the Federal Government s legislative package which is now completing its passage through a finely balanced Federal Parliament between February and May Finally we are awaiting the completion of the Federal Government s arrangements with Telstra, in respect of which we have received limited detail so far, but which corporate disclosure obligations are progressively forcing into the public domain in early 2011 and which are targeted for completion by mid 2011.

23 February NBN Co s business case predicts the following: By financial year 2021 the NBN will cover 13 million premises, it will have deployed 181,000 km of gigabyte capable passive optical network and 57,000 km of transit backhaul. Over the period to the end of financial year 2021 the Government s peak equity requirement is estimated to be AUD27.5 billion and debt funding is estimated at AUD13.4 billion for a total funding requirement of AUD$40.7 billion, including funding costs). The internal rate of return on the Government s equity funding is estimated to be 7.04%. The NBN will involve AUD35.9 billion of total construction capital expenditure to the end of the deployment period, of which replacement capital expenditure will comprise AUD1.3 billion and AUD10 billion will be spent on fibre connections. Operating expenditure to the end of 2020 will be AUD21.8 billion, of which AUD3.7 billion is related to decommissioning and infrastructure payments. Revenues to the end of 2020 are estimated at AUD20.8 billion. The proposed arrangements with Telstra will involve AUD11 billion of payments to Telstra (which effectively converts capex on a without Telstra basis to opex on a with Telstra basis). There is a variety of ways to express the total cost of the NBN, some of which exhibit breath taking numeric sleight of hand. We have adopted the AUD43 billion figure often quoted. However, the real issue is the relationship between capex, opex and revenue over time, peak funding and the mix of funding sources at various times. In the long term NBN Co is ultimately expected to raise a very significant amount of debt capital from private sector markets. The Federal Government s peak equity will reach AUD27.1 billion but between 2020 and 2022 (but most likely earlier) equity will be replaced with debt funding to reach a 1:1 debt to equity ratio. Therefore, unless this debt is Federal Government guaranteed (in which case why not continue to raise funds through the issue of government bonds), the project must ultimately be bankable by the private sector. This bankability is ultimately the test of the standalone commercial stability of NBN Co. Based on a Telstra deal scenario, NBN Co has estimated that the NBN deployment will take 9.5 years to complete (ie. by 2020) and is part of a 30 year business model. Given that the project is estimated to provide a 7.04% IRR, the revenue estimated from carrier customers (and therefore ultimately from consumers) is substantial. This is the great unknown variable in the model. Costs can be estimated with a reasonable degree of certainty, demand for existing services are a known quantity. It is the incremental consumer demand for new broadband services that provide the rationale for the project, and these are entirely unknown.

24 26 The impact of the Australian National Broadband Network on the communications sector a forensic view NBN Co s business case assumptions All business cases are sensitive to key assumptions, particularly a 30 year business case in a technologically volatile industry like telecommunications. The initial business cases for the FOXTEL and Optus Vision pay television networks were later undermined by the failure of key assumptions. The Federal Government has engaged Greenhill Caliburn, a leading corporate adviser, to review NBN Co s business case. The executive summary of its report was released on 14 February 2011 and it determined that the NBN Co business case had been completed to high professional standards. We agree, the quality of the business case is not an issue, it is a comprehensive document. Rather, it is the inherent volatility of core assumptions to which the business case is inevitably very sensitive that is the issue. Most importantly revenue projections and potential competition from other networks, particularly wireless networks. These are the great unknown factors that even the best business case can only estimate at this time. NBN Co s business case is subject to a range of key assumptions including: Completion of the Telstra transaction as anticipated in the original heads of agreement and the migration of services other than pay television from Telstra s HFC network to the NBN. Nationally uniform wholesale prices from premises to points of interconnection (POI), irrespective of delivery platform or geography. While this is a constraint for NBN Co, it is a policy article of faith that is central to NBN decision making. Approval of NBN Co s special access undertaking that will provide it with long term certainty and exempt it from the high degree of potential pricing volatility that occurs around typical access pricing time periods (generally only three years). A 30 year infrastructure project that will potentially be project financed cannot proceed around short term pricing cycles. NBN Co will service 100% of new real estate developments or greenfield sites and private sector carriers cannot cherry pick fibre rollouts in competition with NBN Co (ie competing fibre access networks to residential premises are not encouraged). Telstra will meet its USO obligations until displaced by the fibre build and then a USO Co will take up this responsibility for regions where NBN Co has built out. NBN Co will be granted more extensive carrier powers and immunities than those available to carriers since 1997 (ie a return to the more liberal deployment regime pre-1997, subject to community consultation). NBN Co is not required to provide dark fibre unbundling or a Layer 1 service (dark copper was a major issue for Telstra, but dark fibre would remove from the NBN Co business plan all of the benefits of using improved transmission equipment to extract increasing capacity from fibre in the future). The Greenhill Caliburn report itself emphasises that the longer term revenue forecasts for NBN Co contain inherent uncertainties and are subject to shifting technologies and consumer preferences. It also notes that trends towards mobile centric broadband networks could have significant long term implications for NBN Co. This is undoubtedly the case.

25 February What happens to Telstra? At the time of writing the arrangements between Telstra and the Commonwealth had not been finalised. Indeed they had been delayed until the first quarter of 2011 as a result of the need for NBN Co to release its business case and delays in key regulatory decisions. These proposed arrangements are quite extraordinary, but necessary. They are extraordinary because the Commonwealth has spent 20 years exiting any direct economic interest in the telecommunications sector and encouraging network competition, only to create a wholly publicly owned network vehicle and strike an agreement with Telstra to remove the cost and competitive threat associated with continued private sector activity in the local access network. Moreover, AUD11 billion will be paid as compensation for a network that would have ultimately become stranded and worthless as a result of the NBN. However, these are also necessary commercial arrangements because in the short to medium term the continued existence of Telstra s network would have forced up NBN Co s deployment costs and reduced its speed of penetration and therefore revenue. Given the scale of the arrangements, surprisingly little has been said about the detail of the Telstra deal. Press reports, Telstra s interim announcements on 10 February 2011 and industry speculation suggest the Telstra transaction will have the following elements: The original key commercial terms agreed between Telstra and NBN Co are expected to deliver AUD9 billion in post tax net present value to Telstra and a recent in-principle agreement is expected to deliver a further AUD2 billion in post tax NPV, for a total of AUD11 billion. These payments will be received incrementally as ongoing charges. The parties are on track to complete documentation to put a proposal to Telstra shareholders with a target of 1 July 2011 (accompanied by an independent experts report). In addition to shareholder approval the deal is subject to regulatory approval, price stability (thought to be a euphemism for maintenance of existing copper access pricing), confirmation of relevant tax arrangements and legislation governing NBN Co ownership rules and the USO. In response to the deployment of the NBN Telstra will progressively decommission its copper local access network freeing up duct access and exchange space and other facilities that will be made available to NBN for a charge. The Government has suggested that there will be a program to retain Telstra staff to assist in the roll-out of the NBN. NBN Co will not acquire this duct network or other facilities; it will simply acquire a long term right of use. Telstra will not transfer homes connected to its network to the NBN, rather they will lose connectivity to the Telstra network at the same time as they are offered connectivity to the NBN. Their connection will therefore transfer, whether as a result of an opt in (without much choice) or an opt out system (unless of course they become wireless only homes at this point). Telstra s compensation for this network decommissioning was formulated by reference to the revenue foregone on a per line basis. That is, the value of the transaction is not the market value of hard assets to be acquired by NBN Co. Rather, Telstra s valuation perspective was foregone profits and NBN Co presumably assessed its valuation on the basis of additional costs and foregone revenue had a deal not been struck.

26 28 The impact of the Australian National Broadband Network on the communications sector a forensic view While Telstra may not have wanted an NBN, this NBN provides an attractive environment for Telstra to develop its long term strategy. Customers will receive a basic package from their retail service provider that more or less replicates the performance and pricing of their existing service, but there will then be vigorous retail competition amongst NBN wholesale customers to move the retail customers up the value chain to higher bandwidth packages. Subject to accepting a form of structural separation that is yet to be defined, Telstra will retain the right to acquire next generation wireless spectrum, spectrum that may ultimately be used to compete with NBN Co. Telstra will avoid the cost of a fibre upgrade and continue to own all of its facilities, which presumably it can continue to use, subject to the primary rights of NBN Co. Telstra will keep its retail customer base initially, but subject to erosion as a result of the loss of its local network advantage. It will be free to continue its mobile wireless evolution around the NBN. At least for an interim period it will keep FOXTEL under its supervision as a shareholder and on a Telstra network. Finally it will receive AUD11 billion that it can re-invest in building a competitive advantage in content and mobile services. Telstra has already begun its transition and its February 2011 interim results confirmed its increasing investment in customer acquisition. Its surprise announcement on 14 February that it will be the first to launch an LTE mobile network is an early example of how it will re-invest its NBN dividend. Telstra s mobile and other wireless networks may yet become a direct competitor of the NBN. It now looks certain that Telstra will choose to structurally separate following strong encouragement to do so. The proposed arrangements with Telstra require it to decommission its copper network and grant access to its ducts, exchanges other facilities in a manner in which, it will argue, removes its market power and the need for more aggressive models for structural separation. Telstra s view will no doubt be that the creation of NBN Co and the access arrangements it will offer affects the type of structural separation that has been sought. Given the outcome of previous efforts to achieve effective operational separation and the ability for regulatory objectives to be lost in detailed implementation once Telstra gets involved, do not necessarily expect the structural separation of Telstra to achieve substantially more than is already achieved by the creation of NBN Co.

27 February How should we judge the success of the NBN? The Federal Government expects the NBN to become a monopoly national fixed line fibre access network to residential premises. Therefore, NBN Co will be able to cross subsidise its national revenue flows and offer a common entry level broadband price structure for all Australian premises across all the technologies used in the rollout This publicly owned, wholesale only access network being proposed in 2011 is quite different from the vertically integrated state monopoly of the Seventies and Eighties. It is intended to deliver a next generation network technology that the private sector currently sees as uneconomic to build. Had Australian telecommunications policy in 1990 structurally separated Telstra and retained a government owned wholesale only monopoly provider of local loop infrastructure we may now have a very different telecommunications sector. The Federal Government has identified its central policy objectives as: the delivery of significant improvement in broadband service quality to all Australians; addressing the lack of high speed broadband in Australia, particularly outside of metropolitan areas; and reshaping the telecommunications sector. It has emphasised its focus on rural and regional development and the potential for the NBN to reshape not only the telecommunications sector, but all Australian communications markets. These core objectives have been underscored by a series of empirical articles of faith that have now become synonymous with broadband policy: NBN Co will connect 93% of Australian homes, services and businesses with fibre to the premises technology providing broadband speeds of up to 100 megabits per second (although NBN Co has already announced that it wll exceed this benchmark). All remaining premises will be served with a combination of next generation fixed wireless and satellite technologies providing peak speeds of 12 megabits per second. NBN Co is a wholesale only carrier with an open access mandate. The first two of these objectives have a massive impact on scale and the cost that will flow through to the industry and ultimately to consumers. Ultimately users must pay for the NBN, both its economic and uneconomic components. Because it will most likely operate as the only fibre access network to residential and SME premises the third objective is essential and underscores the potential for mission creep by NBN Co. These articles of faith create a leviathan network that is subject to a series of massive, often conflicting, but carefully balanced economic forces.