2 February Deregulation in Europe Prepared for Deutsche Telekom

Transcription

1 2 February 2006 Deregulation in Europe Prepared for Deutsche Telekom

2 NERA Economic Consulting 15 Stratford Place London W1C 1BE United Kingdom Tel: Fax:

3 Contents Contents Executive Summary i 1. Introduction 1 2. The Rationale for Regulation Rationale for Regulation Design of Regulation 3 3. Rationale for Deregulation Potential Causes of Regulatory Failure Potential Costs of Regulation Potential Benefits of Deregulation 7 4. Regulation and Deregulation of Broadband Markets in Europe and the US The New European Regulatory Framework Overview of Broadband Regulation in Germany, UK, Italy and the Netherlands Germany United Kingdom Italy The Netherlands United States Previous Studies Quantifying the Impact of Broadband and Deregulation The Economic Benefits of Broadband The US 1996 Telecommunications Act Regulation of Local Loop Unbundling Regulation of Long Distance Telephony Regulation of Mobile Telephony Regulation of Market Entry Implications Measuring the Benefits of Broadband Deregulation Deregulation of Existing Broadband Services Deregulation of New Broadband Services 45 NERA Economic Consulting

4 Contents 7. Impact of Deregulation in Germany Deregulation of Existing Broadband Services Deregulation of New Broadband Services Summary of Potential Impact of Deregulation in Germany Impact of Deregulation in Other European Countries Deregulation Impact in Italy Deregulation Impact in the Netherlands Deregulation Impact in the UK Conclusions 70 NERA Economic Consulting

5 Executive Summary Executive Summary This report has been prepared by NERA Economic Consulting and Mercer Management Consulting on behalf of Deutsche Telekom. Its purpose is to examine the case for deregulation of certain telecommunications markets in Europe and to assess the potential benefits that would result. Reasons for Regulation In the vast majority of industries, market forces are considered to be the appropriate mechanism for achieving the best use of resources and for delivering benefits to consumers. However, market failure may prevent the efficient functioning of a market. In such cases, an important example of which is the existence of monopoly power over essential facilities such as customer access networks, the purpose of regulation is to try to eliminate the sources of the market failure or to mitigate their impact. Sources of Regulatory Failure Where markets are well established, there is normally a substantial amount of available information about demand conditions and costs. In such circumstances, if there is little prospect of competition developing, the benefits of regulation can be expected to outweigh the costs. However, in the case of services which are new or developing rapidly, regulatory authorities are likely to lack information and may not have the resources to acquire it. As a result it becomes difficult, if not impossible, for regulators to conduct sufficiently sophisticated, reliable, in-depth market analyses and to design and implement appropriate remedies based on these analyses. If, as a result, prices of regulated services do not reflect costs, this will send out the wrong market signals and may lead to a substantial misallocation of resources. Where market failure persists, regulation should be based on detailed market analysis. If the information available is insufficient to be able to conduct a robust review, a regulatory moratorium may be appropriate. Most importantly, regulation should only be implemented where its benefits exceed its costs. Consequences of Regulatory Failure and Justification for Deregulation If regulation of prices does not allow operators to recover their full costs, this is likely to deter future investment. Reduced or delayed investment slows the introduction of new and innovative services and results in costs remaining high and choice for consumers remaining limited. This runs contrary to the objectives of regulation. By allowing the market to determine prices, deregulation should remove the barriers to investment and innovation in new services that arise when, because of incomplete or imperfect information, the wrong regulatory remedies are chosen or incorrect prices are set. The resulting stimulus to the development of new services, of which broadband is an example, should lead to increases in consumer benefits, output and employment not just in the telecommunications industry but also in other parts of the economy. NERA Economic Consulting i

6 Executive Summary Deregulation in Europe and the US The European Commission s regulatory framework is designed to encourage deregulation by requiring regulators to intervene only where an operator has been found to have significant market power (SMP) and where competition law is insufficient to ensure the efficient functioning of the market. The framework also recommends that regulating as far upstream as possible will stimulate downstream competition. Nevertheless, progress towards deregulation has varied across the EU. In all the European countries studied in this report, full and shared access to the metallic loop remains regulated since the national incumbents have been found to have SMP. However, access to the fibre local loop is not regulated in either Germany or Italy. The extent of deregulation of wholesale broadband access markets is much more varied. For example, the Dutch market for wholesale bitstream access for residential purposes is not regulated. In Germany, Deutsche Telekom is not required to offer wholesale bitstream access and it offers a DSL resale product on a voluntary basis. In contrast, the wholesale bitstream markets in Italy remain largely regulated. In the UK, broadband resale is unregulated and BT is to be organised in separate divisions to allow regulation to be focused on those services and points in the network where the true monopoly power lies. These differing regulations are the result of market analyses of different markets but are also likely to be the result of the regulator s overall strategy since regulators do not always pursue strictly economic goals. The US regulator (FCC) has taken significant steps towards deregulation of the telecommunications market by deciding not to regulate incumbents fibre deployments for five years and by not requiring incumbents to offer substitute services to competitors when they upgrade from copper to fibre networks. The FCC envisages that this will allow operators to respond better to changing consumer demands. It also expects that deregulation will lead to new advanced broadband access services becoming available to end-users sooner than would otherwise have been the case. Estimate of the Benefits of Deregulation The overarching message of empirical studies is that reforms aimed at making regulation less intrusive have the potential to deliver far-reaching benefits to society. One study in the US found that more intrusive unbundled network element (UNE) requirements in the US reduced the value of firms future capital investments by $16.3 billion. 1 This resulted in reduced choice and benefits for consumers. Other studies focused on the benefits resulting from the existence of an extensive broadband network and ubiquitous take-up. One report found that setting access charges to UNE too low resulted in $1.4 billion of foregone consumer surplus and $3.9 billion of lost output; 2 and another found that these regulations could result in up to $33.9 billion of foregone GDP and up to 223,000 fewer jobs at the economy-wide level in Eisenach et al (2003) Ellig (2005) Eisenach and Lenard (2003) NERA Economic Consulting ii

7 Executive Summary Estimates of the Potential Benefits of Deregulation in Europe As part of this study, NERA has estimated the effects of deregulation at the industry and economy-wide levels in different European countries between 2006 and For the purpose of this study, NERA has adopted a broad definition of broadband deregulation so that it covers any regulatory reform that is less intrusive than existing regulations and that allows operators to make decisions based on more on market considerations than being constrained by regulation. Examples of deregulation could include a moratorium on mandatory sharing of new infrastructure or regulating access charges so that they fully take account of the risks of investment or allowing companies to negotiate more commercial terms of access. NERA s quantifications are based on two assumptions: 1. That deregulation will increase the speed of take up of existing broadband services by end-users by one year; and 2. That deregulation will allow firms to invest fully in platforms that will allow the delivery of new broadband services. More specifically, they will invest the amounts that they have announced within the intended timescale. In the absence of deregulation, firms will invest less. Two cases have been examined: one where investment is reduced by around 25% over the next 3 years in the absence of deregulation and one where no investment takes place at all. At the level of the telecommunications industry, an increased take up of broadband services will increase turnover, value-added, employment and consumer surplus. At the same time, increased capital expenditure and purchases from suppliers will create a ripple effect through to other sectors of the economy. Starting with the national input-output tables for the countries concerned, NERA has derived Leontieff multipliers. These measure the impact that increased output or investment in one sector has on output, value added and employment in other sectors and enable us to measure increases in turnover, GDP and employment at the national level. A similar analysis has been conducted in respect of the greater investment in platforms capable of delivering new broadband services. Here higher capital expenditure and a greater level of sales of new broadband services will lead to increases in output, GDP and employment in the telecommunications industry and elsewhere in the economy. NERA s estimates of the benefits in each case are summarised in the tables below. Values are given in net present value (NPV) except for employment estimates using a 10% discount rate. NERA Economic Consulting iii

8 Executive Summary Table 1 Increases Due to Deregulation of Existing Broadband Services Billion (NPV 2006 to 2010 except employment) Industry effects Germany Italy Netherlands UK Turnover Consumer surplus Value-added Economy-wide effects Total turnover GDP Employment (average number) Source: NERA The benefits resulting from the deregulation of existing broadband services include the net benefits to all market players. Table 2 Increases Due to Deregulation of New Broadband Services Billion (NPV 2006 to 2008 except employment) Industry Germany Italy Netherlands UK Turnover Value-added Economy-wide effects Total turnover GDP Employment (average number) Source: NERA The lower end of range provided indicates the increases under the reduced investment scenario. The upper end of range indicates the increases under the no investment scenario. These figures do not take account of any impact of deregulation on the competitors of Deutsche Telekom, Telecom Italia, KPN and BT. This impact is likely to be complex. On the one hand the investment in new services by incumbent operators is likely to stimulate the whole market and lead to higher investment by competitors as well. However, their participation in the market depends on the conditions under which they gain access to the new facilities. If these conditions are unfavourable, the investment may lead to some loss of market share by competitors and, thus, to reduced investment on their part. Nevertheless, in a dynamic market, we would expect the net effect on the rest of the market to be positive. However, even if it is not, the impact is likely to be small relative to the benefits that flow from the incumbents investment. NERA Economic Consulting iv

9 Executive Summary Conclusion A comparison of Tables 1 and 2 indicates that the benefits from deregulating existing broadband services are comparatively modest compared with the benefits from deregulating new broadband services. This is because existing services are already well established and the impact of deregulation is assumed to accelerate the process by just one year. The combined impact of deregulation of existing broadband services in the four countries under review is a 5.7 billion increase in GDP (on a net present value basis) over the next five years and an increase in employment of 21, In the case of deregulation of new broadband services, large sums of investment occur and these, together with related increases in output, lead to much greater benefits. When compared to the reduced investment scenario, the combined impact in the four countries under review is a 11.0 billion increase in GDP (on a net present value basis) over the next 3 years and an increase in employment of 63,749. When compared to the no investment scenario, the combined impact in the four countries under review is a 41.2 billion increase in GDP (on a net present value basis) over the next 3 years and an increase in employment of 238,926. These figures indicate the substantial potential gains from deregulation. They help to explain why many countries have already made preliminary steps towards deregulation. They also suggest that any regulatory changes or constraints which act to slow down the development of broadband services have a high cost attached to them. 4 This is calculated by summing the average (over the time period) annual expected increase in employment for each of the four countries. NERA Economic Consulting v

10 Introduction 1. Introduction This report has been prepared by NERA Economic Consulting and Mercer Management Consulting on behalf of Deutsche Telekom. Its purpose is to examine the case for deregulation of certain telecommunications markets in Europe and to assess the potential benefits that would result. While regulation is intended to promote the efficient functioning of markets, it can have unintended consequences and these may have a negative impact on the regulated market and result in adverse knock-on effects on the economy as a whole. For example, a regulatory authority may seek to reduce the monopoly power of an incumbent operator by regulating the prices of its network services so as to encourage competitive entry and the associated investment by competitors in downstream markets. However, this may reduce the incentive for the operator concerned to invest in innovative new services and may result in the delayed roll-out of new technologies. The problem of regulatory failure is particularly pertinent for new and emerging markets since these are characterised by a high degree of uncertainty which complicates the design of effective regulation. Furthermore, in markets where technological innovation and development are fast-paced, the relevant definition of the market is likely to change rapidly. This means that there is a danger that regulation may be too inflexible to adapt to the unpredictable and ever-evolving nature of the market. This report focuses on four European countries that have taken or have outlined their intention to take steps towards the deregulation of some of their national telecommunications markets, particularly those relating to the supply of broadband services. In each of these countries, NERA has analysed The steps each of the national regulatory authorities have taken or are proposing to take; and The outcome of deregulation so far (if any) Using this information, NERA has: Identified the expected industry-level economy-wide effects of deregulation; and Estimated the magnitude of the prospective benefits. In developing its analysis, NERA has also looked at deregulatory measures taken in the US and what the impact of these measures has been. NERA Economic Consulting 1

11 The Rationale for Regulation 2. The Rationale for Regulation In order to determine the benefits of deregulation it is important to understand why regulation exists in the first place. By understanding regulatory objectives it may be possible to identify methods that are more effective at achieving these objectives than interventionist ex ante regulation. This is because ex ante regulation may fail not just to achieve its stated objectives but may also result in unintended effects on the rest of the economy Rationale for Regulation Regulatory authorities typically pursue a number of different objectives and often these vary between jurisdictions as well as between industries. The main stated objectives of regulatory authorities include ensuring that users obtain the best possible prices, quality and choice, ensuring the efficient use of resources, promoting competition, and developing an environment that encourages investment and innovation. In addition there are often social objectives such as ensuring the provision of universal service and meeting the needs of disabled and other disadvantaged groups. In the Framework Directive 5 for electronic communications, the European Commission sets out the objectives of member states regulatory authorities as being the promotion of competition by inter alia: (a) ensuring that users, including disabled users, derive maximum benefit in terms of choice, price and quality; (b) ensuring that there is no distortion or restriction of competition in the electronic communications sector; (c) encouraging efficient investment in infrastructure, and promoting innovation; and (d) encouraging efficient use and ensuring the effective management of radio frequencies and numbering resources. In the vast majority of industries, market forces are considered to be the best mechanism for achieving the efficient allocation of resources. Therefore, regulatory authorities promote efficient entry to markets in order to stimulate competition. However, market failure may prevent the efficient functioning of a market; in such cases, regulators will aim to eliminate the sources of the market failure or to mitigate their impact. There are four main types of market failure that regulatory authorities may seek to correct. Firstly, asymmetric information may lead to quality degradation and/or may prevent consumers from switching suppliers because consumers do not have as much information as suppliers. Secondly, where competition is absent or there is only a limited prospect of actual or potential competition, a supplier may possess market power which will allow it to charge 5 Directive 2002/21/EC of the European Parliament and of the Council, 7 March 2002 on a common regulatory framework for electronic communications networks and services NERA Economic Consulting 2

12 The Rationale for Regulation prices that are above the economically efficient level. Market power may arise from factors including economies of scale and scope, barriers to entry, the possession of essential facilities or patent or licence protection. Thirdly, there may be externalities. A positive externality exists when the social benefits from consumption of a service are higher than the private benefits. The providers of the service will produce less than the optimal amount, as they cannot capture all the benefits for themselves. An example of a positive externality occurs when someone subscribes to a telephone service and thereby provides others with the ability to call them. This may justify regulatory measures to increase telephone penetration. A negative externality exists when the social costs of producing a service exceed the private costs. In this case, providers of the service will produce more than the optimal amount as they will fail to take into account all the costs. An example of a negative externality would be interference between different parties using the same radio spectrum. This provides a justification for regulation to ensure that such interference does not occur. Fourthly, market failure can result if a good is a public good. The key characteristics of a public good are that it is very difficult or impossible to prevent people from consuming it and one person s consumption does not reduce the amount available for consumption by others. What leads to market failure is that it is very difficult for a supplier to recoup the costs of its investment since it cannot charge people for the good because it is possible for them to consume it without paying. In the absence of other sources of revenue (e.g. advertising in the case of radio services) this will tend to lead to under-investment and under-provision. However, it is important for a regulator to distinguish between transitory and durable market failure. If the market failure is only transitory then it may be best to allow the market to develop so that this failure will be corrected. Durable market failure may be better remedied by ex ante regulation. Nevertheless, even in the presence of lasting market failure, regulation is only justified if the net benefits of the proposed regulation are higher than the costs of the market failure Design of Regulation There are two main ways to correct market failure: ex ante economic regulation and ex post competition policy. The former mandates precise regulations in response to market failure. The latter, as exemplified by competition policy, is less interventionist in that it does not set specific price, quantity or profit controls. Action is taken only in response to behaviour that is deemed to be abusive or anti-competitive. In conjunction with these policies, governments or regulatory authorities may also seek to promote entry to the market to promote competition and facilitate deregulation in the longer term. It is important that the design of regulation should take account of how the market functions and, in particular, how network providers and service providers compete with each other. This is because it is possible for operators to offer the same service (e.g. voice traffic) but over different technology platforms (e.g. fixed and mobile networks). Similarly, a given technology can be used to offer various different services. For example, the fixed network can be used to provide voice, data and multimedia services. NERA Economic Consulting 3

13 The Rationale for Regulation Approaches to economic regulation can be divided into two main categories: 1. Those that seek to regulate a given service; and 2. Those that seek to regulate a given technology. However, there are various reasons why regulation may not be the most effective tool for ensuring that markets function efficiently and these are common to both approaches. NERA Economic Consulting 4

14 Rationale for Deregulation 3. Rationale for Deregulation This section outlines some of the potential causes of regulatory failure and the costs that this may result in for the telecommunications industry and for the economy as a whole. These costs of regulation form the basis of the rationale for deregulation Potential Causes of Regulatory Failure A major reason why regulation may not lead to the efficient functioning of markets is that the information available to regulatory authorities when they make their decisions is generally imperfect and/or incomplete. This may be because the regulator is resource constrained or simply because it is impossible for anyone to predict how the market will develop. This is particularly important in the case of telecommunications given that the speed at which technological innovation occurs is one of the industry s most striking features. The pace of technological development makes it very difficult to predict with accuracy new technologies and how these will affect the way markets function. In the past, distinct services were offered over different types of networks. The public switched network was primarily involved in the provision of voice services. There were separate networks (private and public) for data services and cable and radio transmission networks for providing broadcast services. Now, however, ever increasing convergence means that these networks are being used to provide all types of communications services. As a result, inter-platform competition has increased. Also, the possibility of bundling products that are offered over the same platform makes it difficult for regulators to determine what the prices of individual services should be. Technological development means that costs are likely to fall over time which in turn makes it difficult to estimate what competitively determined prices would be. Such prices would reflect forward looking costs including the recovery of fixed and common costs and an appropriate return on capital reflecting the risks involved. Estimating these costs and identifying how they would be recovered in a competitive market is a complex and difficult task. That regulatory authorities can incorrectly estimate such costs is shown in published academic research, the bulk of which suggests that TELRIC prices for unbundled network elements calculated via the FCC s cost models are 19-67% below competitive levels, depending on the specific network element. 6 These problems of information are compounded by the fact that regulatory authorities may not have the resources to be able to track technological developments. This constraint also limits the regulator s ability to conduct detailed market analyses. This is important not just for the design of regulation but also for the timeliness of its implementation and enforcement. The regulatory authority will need to rely on information from operators in order to design and monitor regulation. However, this places a heavy burden on firms and the regulator itself. This is especially true since regulated firms may have the incentive to misrepresent 6 Ellig, J., Costs and Consequences of Federal Telecommunications and Broadband Regulations (February 2005) Working Paper in Regulatory Studies, Mercatus Center, George Mason University, NERA Economic Consulting 5

15 Rationale for Deregulation information in order to avoid having their profits extracted by the regulator. This increases the burden on the regulator to verify all information received and this may be a costly process Potential Costs of Regulation For a well established service which cannot realistically be replicated by new entrants, the potential benefits of regulation may well exceed the costs. However, for services, where information is much less reliable and sometimes unavailable, and where there is the possibility that competition could develop by itself, there is a danger that the opposite may be true. If regulation is poorly designed, not only will it fail to achieve its objectives but it may also lead to a worse situation than if there had been no regulation. A major difficulty facing any regulatory authority is obtaining the necessary information on which to base its decisions. In the absence of reliable information on costs, prices may be set too low, in which case consumption of the service concerned will be above the economically desirable level and future investment will be deterred. Alternatively they could be set too high, in which case there will be a loss of consumer welfare and consumption will be too low. An important question when determining costs is what constitutes a reasonable rate of return. Investors require compensation for the opportunity cost of their investment. That is, the allowed rate of return should take into account what investors could have earned from investing elsewhere, as well as the risk involved. Account also needs to be taken of the impact of any uncertainty regarding future demand or costs and any irreversibility of investment. Where future cash flows are uncertain for example, in markets relying on new and innovative technology and where it is impossible to reverse the investment once it is made, there is a value in delaying investment until the situation becomes clearer. Any investment now involves giving up the option to delay and this option has a positive value. Consequently, investors need to be compensated for foregoing their option to delay investment. However, such considerations are not always fully taken into account by regulatory authorities and, even where they are, their importance may be under-estimated because of information problems. Aside from the issue of the risk of investments, the determination of a fair rate of return also needs to take into consideration how the profitability of a service varies over its lifecycle. Typically, a new service makes a loss because the size of the market is insufficient to allow the recovery of fixed costs at a price that consumers can afford. However, as demand increases, unit costs will tend to fall and profits will increase. If the firm is to make a reasonable rate of return over the life of the investment it will need to make a rate of return in its profitable years that compensates for the losses made at the beginning of the product life cycle. If regulation does not allow firms to make a sufficient return on their investments and does not, for example, take account of life cycle effects, this will reduce the incentives for firms to invest or cause investment to be postponed. As a result there will be fewer and/or delayed introductions of new and innovative services into the market. This in turn will lead to a reduction in the number of products and services available to consumers and, given that innovation often leads to lower costs, is likely to lead to end-user prices being higher than would otherwise be the case. NERA Economic Consulting 6

16 Rationale for Deregulation One stark example of the cost of regulation is the delayed introduction of mobile communications in the US. It has been argued that indecision by the FCC and slow licensing procedures led to a ten year delay in the development of mobile communications in the US. 7 Although the technology was sufficiently developed to allow mobile services to have operated in the 1970s, it was not until 1983 that mobile services began to be deployed. This resulted in an estimated loss of consumer welfare of between $16.7 billion and $24.3 billion in 1994 prices, or about $76 per subscriber per month. 8 The author measures consumer welfare in terms of compensating variation, in other words, how much money consumers would need to have been given to allow them to purchase other goods and services to enjoy the same level of utility (consumer surplus) that they would have been able to enjoy had mobile services been available. 9 The size of these losses illustrates an important point, namely that the loss from not having a particular service is much higher than the adverse impact of higher prices since all consumers are deprived of having even the option to consume that service. Given that information is less than perfect, it is important that regulation only occurs where the potential benefits are high and hence are not likely to be offset by the costs of less than perfect regulation. The standard practice within the EU and increasingly elsewhere is to define markets and identify where there is market power. Only in those markets where there is market power, is regulation seen to be necessary. However, regulatory authorities also require good information when defining markets and determining which services should be regulated. Where technology is changing rapidly, it may be difficult to predict market developments and to identify which services are demand and supply side substitutes and fall within the definition of a market. It may also be difficult to identify whether there is market power and, if so, whether it is likely to endure or is merely transitory. The risk therefore exists that regulatory authorities may impose unnecessary ex ante regulation. In such circumstances there would be no benefits from regulation, while there would be likely to be costs. Consequently, it would be better to allow the market to develop and to monitor its progress and to regulate only when information is sufficiently reliable to determine the likely costs and benefits of intervention Potential Benefits of Deregulation The potential benefits of deregulation will depend on how it is implemented and whether the deregulated market would be able to function more efficiently than it would under regulation. In order for deregulation to be successful, market players must believe that the regulator will commit to its decision to deregulate and will not attempt to intervene in the market at a later date. To the extent that deregulation allows the market to function better than it would under Hausman, J., Mobile Telephone, (2002) Handbook of Telecommunications Economics, Volume 1, Ed M.E. Cave, S.K. Majumdar and I. Vogelsang This is the estimated consumer welfare loss from mobile phone networks not being available in The study assumed that microprocessors and other semi-conductor chips would have been more widely available and cheaper than they were had mobile phones been introduced 10 years earlier. This meant that costs and therefore prices were higher and, as a result, demand was lower in 1983 than it would have been in the absence of the regulatory delay. This utility need not necessarily be derived from buying and consuming mobile telephony services but can be derived from any other good or service. NERA Economic Consulting 7

17 Rationale for Deregulation regulation either because there is sufficient competition or because effective regulation is too costly to design and implement the benefits will be far-reaching. Prices will be set by the market and the danger of artificially high or low prices set on the basis of imperfect information will be reduced. As discussed in Section 3.1, this will benefit consumers and avoid distorting incentives for investment. These benefits are likely to be greatest where markets and technologies are relatively new and hence the dangers of setting incorrect regulated prices are greatest. Looking specifically at broadband services, regulation that requires operators to lower prices of wholesale broadband access reduces firms incentives to invest in new platforms for providing this service. Also, they will be deterred from introducing new services if they are obliged to offer their competitors access to them at regulated rates. Deregulation will remove both these disincentives to invest. The following two figures illustrate the above points with regard to European broadband retail markets, where regulators have extensively relied on service-based competition (through mandating access to the incumbent s DSL facilities in several forms: local loop unbundling, shared access, bitstream access). Such an approach is based on the presumption that greater intra-platform competition in the provision of DSL services (encouraged by relatively low regulated access prices) leads to a higher level of broadband diffusion. Figure 3.1 shows that implementation of this regulatory stance does not seem to have produced the desired effects. Broadband penetration in those countries where there is a lower level of market concentration (i.e. more competition) in the DSL segment of the broadband markets is not consistently higher than elsewhere. In fact, countries where DSL market shares are more evenly distributed among competitors (the incumbent fixed operator and each independent service-based competitor using the incumbent s wholesale broadband services) have, on average, slightly lower penetration (as illustrated by the regression line in the figure). This in turn suggests that such policies may be counter productive given that they run the risk of encouraging inefficient entry and discouraging the deployment of new facilities. NERA Economic Consulting 8

18 Rationale for Deregulation Figure 3.1 Penetration and intra-platform DSL broadband competition in EU-15 Countries* (first quarter 2004) 15.0 Penetration (broadband subscribers for 100 inhabitants) Netherlands United Kingdom Italy Concentration among DSL providers (Herfindahl-Hirschman Index, HHI) Germany * Excluding Greece, for which information was not available. Source: OECD and Distaso et al., Platform Competition and Broadband Uptake: Theory and Empirical Evidence from the European Union, mimeo, 2005 (available at ideas.repec.org/a/aea/aecrev/v91y2001i2p html). The implication of this is that deregulation in the market for existing broadband services, by which we mean the adoption of a regulatory approach which relies more on market forces and provides firms with the freedom and the incentives to make correct pricing and investment decisions (rather than leave them to the regulator), can deliver benefits by promoting the diffusion of broadband services. 10 Figure 3.2 provides evidence of the importance of facilities based investment in innovative sectors such as broadband. The graph plots penetration levels against the level of interplatform competition between DSL-based services on the one hand and all other platforms on the other (captured via the Herfindahl-Hirschmann Index calculated on the partition of total subscription between the two alternatives). 10 It would be incorrect to associate such deregulation with giving incumbents the right to refuse access to essential facilities. Artificially low access prices not only distort the competitive process by encouraging less efficient operators to enter the market, but they also discourage investment by both incumbents and operators operating alternative platforms (cable, wireless, fibre optic). NERA Economic Consulting 9

19 Rationale for Deregulation Figure 3.2 Penetration and inter-platform broadband competition in EU-15 Countries* (first quarter 2004) Penetration (broadband subscribers for 100 inhabitants) Netherlands Germany United Kingdom Italy Concentration between DSL platform and alternative platforms (Herfindahl-Hirschman Index, HHI) * Excluding Greece, for which information was not available. Source: OECD and Distaso et al., Platform Competition and Broadband Uptake: Theory and Empirical Evidence from the European Union, mimeo, 2005 (available at ideas.repec.org/a/aea/aecrev/v91y2001i2p html). The clear positive correlation between penetration and facility-based competition (i.e. lower concentration), shown in Figure 3.2, indicates the potential benefits of regulatory reforms that eliminate barriers to inter platform competition. This is especially important given that technological convergence across traditional fixed-line telephone networks, cable networks, wireless networks and satellite networks has widened the scope for workable competition in many retail services. To the extent that the market provides better signals and incentives for market players and regulation is currently deterring efficient investment, deregulation will lead to increased investment. The potential impact is very large. For example, one leading economist estimates that deregulation of US wireless markets in 1996 led to increased investment in new wireless infrastructure services of over $12 billion per year. 11 Increased investment will directly lead to higher output and employment. It will also tend to lead to reduced costs in the long term which are translated into lower prices for consumers. This in turn will result in higher consumer surplus for existing consumers and to more people being able to afford the services concerned. Secondly, investment will lead to new markets being served meaning that consumers who previously had no access to these services at any price are now able to buy the service. 11 Kahn, A.E, Unleash the Broadband Economy (2001), Wall Street Journal, 13 December 2001 NERA Economic Consulting 10

20 Rationale for Deregulation Other important benefits are the cost savings to firms from reduced costs of regulatory compliance. The costs of regulatory authorities are also significantly reduced by deregulation. This means that resources of firms and regulators can be diverted elsewhere. NERA Economic Consulting 11

21 Regulation and Deregulation of Broadband Markets in Europe and the US 4. Regulation and Deregulation of Broadband Markets in Europe and the US Most regulatory authorities and governments promote ubiquitous broadband coverage since the benefits of high speed internet access to both households and business users are high. In addition, these benefits are also likely to be sources of long term economic growth. There are a number of ways in which an end-user might access broadband. Currently, there are five main different types of platforms: Digital subscriber line (DSL) Coaxial cable (cable modem) Satellite connection Fixed wireless access Broadband over power lines It most markets, the majority of subscribers are served using DSL technology. Incumbent telephone companies typically have a near monopoly of the provision of DSL lines and are also vertically integrated so that they provide services to broadband customers in downstream retail markets. For this reason, these operators have been required to provide access to their networks. This has ranged from requiring incumbents to offer a wholesale service that can be resold by ISPs to end-users to requiring incumbents to allow competitors access to its unbundled local loops. However, as regulators have started to understand the market better, regulation has been more focused on upstream markets. This is because targeting regulation at the source of the problem (the presence of a competitive bottleneck 12 ) is more effective than attempting to remedy the symptoms (reduced downstream competition). Typically, these access requirements have only been applied to operators offering DSL services and tend not to apply to other forms of broadband access since providers using competing technologies do not generally have significant market power (SMP). Although deregulation has been implemented to varying degrees throughout Europe, up to now steps toward deregulation in Europe have been limited. Many of the EU-15 countries have deregulated parts of their voice call markets. However, broadband and related markets still remain regulated at least to some degree in all member states. This chapter focuses on those steps that have been taken towards deregulation of broadband access markets in Germany, the UK, Italy and the Netherlands. 12 In the communications market, the term competitive bottleneck is generally used to refer a network element or service that is essential for the provision of a given service. This bottleneck is owned by the incumbent operator but it is practically impossible to replicate generally because it is too expensive. If it is not profitable for an incumbent to allow competitors to access it there may be less competition in downstream markets than is efficient. NERA Economic Consulting 12

22 Regulation and Deregulation of Broadband Markets in Europe and the US 4.1. The New European Regulatory Framework Regulation of electronic communications in EU member countries is governed by a variety of directives, the most important of which are the Framework Directive 13 and the Access Directive 14. The Framework Directive sets out general objectives, principles and procedures for communications regulatory authorities. Its main objective is to promote access to inexpensive, world-class communications infrastructure and a wide range of services for individuals and for businesses. The key objectives of this latest regulatory framework are: To reduce regulatory barriers to entry for new entrants to the market; To promote light regulation since regulation should only be a temporary measure to promote entry and to ensure the competitive and efficient functioning of the market. As competition develops regulation should be rolled back and replaced with ex post competition law; To promote technological neutrality in recognition of the increasing convergence in the market and to allow sufficient flexibility of ex ante regulation; and To promote consistency in regulation across the European market while allowing national regulatory authorities sufficient flexibility to deal with conditions specific to national markets. Promoting technology neutrality focuses on promoting competition on the basis of services offered to end-users rather than on how those services are offered to consumers. This is in contrast to the approach adopted in the US. The Framework Directive highlights the need, in some circumstances, for obligations on operators to provide access to services to ensure the development of a competitive market. Such circumstances arise where there is not effective competition because a firm has significant market power and ex post application of competition laws does not provide sufficient incentives for that firm to offer those services. In order to determine whether this is the case, national regulatory authorities are required to analyse whether a given product or service market is effectively competitive, whether the market is prospectively competitive and whether any lack of competition is lasting. This analysis should also take into account whether the de facto market leader in a newly emerging market should be subject to such regulations. The Directive refers regulatory authorities to Community law for methods of determining whether an undertaking (operator) has significant market power. The Access Directive describes how in an open and competitive market, there should be no restrictions that prevent undertakings from negotiating access and interconnection arrangements between themselves but notes that in markets where undertakings rely on 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 Directive 2002/19/EC of The European Parliament and of The Council of 7 March 2002 on a common regulatory framework for electronic communications networks and services NERA Economic Consulting 13

23 Regulation and Deregulation of Broadband Markets in Europe and the US infrastructure provided by others (in other words, where a competitive bottleneck exists) there may be uneven negotiating power between undertakings. 15 In these cases, the European Commission determines that it is appropriate to establish a framework to ensure that the market functions effectively. This means that NRAs are able to impose proportionate obligations on undertakings that control access to end-users. The new regulatory framework also recognises that, while mandating access to network infrastructure may increase competition, national regulatory authorities need to balance the rights of an infrastructure owner to exploit its infrastructure for its own benefit and the rights of other service providers to access facilities that are essential for the provision of competing services. Nevertheless, where an operator does offer access to its network, the charge it sets would be subject to a price squeeze test to ensure that downstream competition would be possible. Article 12 of the Directive outlines the factors that an NRA should take account when considering whether to impose access obligations and whether such obligations would be proportionate: (a) The technical and economic viability of using or installing competing facilities, in the light of the rate of market development, taking into account the nature and type of interconnection and access involved; (b) The feasibility of providing the access proposed, in relation to the capacity available; (c) The initial investment by the facility owner, bearing in mind the risks involved in making the investment; (d) The need to safeguard competition in the long term; (e) Where appropriate, any relevant intellectual property rights; (f) The provision of pan-european services. By requiring regulators to conduct proper market analyses that look at the definition of the market in terms of the product and geographical scope as well as considering how competition may develop in the absence of regulation, this framework is intended to encourage regulators to adopt a less interventionist approach. Even where regulation is necessary to ensure the efficient functioning of the market (for example, where there is an enduring competitive bottleneck), defining a maximum set of regulatory obligations for operators may help to reduce the burden on operators and to reduce investors uncertainty over regulatory strategy. This move towards more market-based measures and a reduction in regulatory intervention, if applied properly by national regulatory authorities, should lead to the market functioning 15 Article 2 of the Access Directive defines access as making available facilities and/or services, to another undertaking, under defined conditions, on either an exclusive or non-exclusive basis, for the purpose of providing electronic communication services. This includes access to network elements and associated facilities such as twisted metallic pair local loop. Annex II to the directive includes a minimum list of items to be included in a reference offer for unbundled access to the local loop. NERA Economic Consulting 14

24 Regulation and Deregulation of Broadband Markets in Europe and the US more efficiently. It should also help to reduce the burden on operators in complying with regulations as well as the burden on regulators in enforcing compliance Overview of Broadband Regulation in Germany, UK, Italy and the Netherlands Table 4.1 below provides a summary of the existing regulation of broadband services in Germany, the UK, Italy and the Netherlands. Further details are provided in Sections 4.3 to 4.6. NERA Economic Consulting 15