Invest now: Deploying fiber to achieve political and corporate objectives

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1 31 05 Invest now: Deploying fiber to achieve political and corporate objectives Fiber is the future of fixed networks, but telecoms companies and policymakers must collaborate to get there. A whirlwind of consumer, technological, and public policy trends is blowing through the telecommunications industry. In most countries, the debate is heating up over the need to upgrade the existing copper access infrastructures that have remained more or less unchanged since the 19th century and some are taking action. This debate revolves around the rollout of fiber and the role it will play in next-generation access infrastructure. Deploying fiber infrastructure can significantly boost a country s competitive position, something that policymakers have noted. But the economics of deploying fiber remain challenging for private-sector incumbents. They are the industry s main infrastructure investors due to the high deployment costs that yield returns only in high-income, highdensity or new build areas. This mismatch in social incentives versus private incentives appears to lie at the core of the regulatory debate and the initiatives taken to support fiber. These issues are qualitatively different from those that have dominated regulatory thinking over the past two decades. Up to now, the intent was to open up existing networks and support competitive parity. As a result, policymakers have been trying multiple approaches to bridge the perceived social versus private gap, with some initiatives working more successfully than others. We believe that incumbents must evaluate their moves regarding fiber deployment now. Such an evaluation must consider the broader impact of limited fiber rollout on their overall business franchise. And this should be done in tandem with policy initiatives that address the underlying economic challenges involved in building new infrastructure. Such policy initiatives should not be confused with the tools and policies that address competition issues. Currently, several models are emerging that show incumbents can work effectively with policymakers to improve the economics and capture the broader economic benefits high-speed networks can create, while safeguarding competition. The economics of fiber Countries and cities like Malaysia, the United Arab Emirates, Japan, the US, Amsterdam, and Hong Kong are currently investing heavily in fiber. In developing economies, the rationale behind such investment is that it should attract multinational and outsourcing businesses along with the accompanying direct foreign investment. In more advanced countries, the economic argument is that fiber can improve productivity, and its deployment offers shovel-ready infrastructure-building opportunities for governments seeking to stimulate growth. Just prior to taking office, US President Barack Obama noted that increased broadband investment was a smart way to keep America competitive, while also creating new jobs and spending. Likewise, British Prime Minister Gordon Brown compared efforts to build the country s digital infrastructure to the roads and the bridges and the railways that were built in previous times to stimulate the economy. The economic benefits of high-speed broadband infrastructure for a country

2 32 01 Fiber investments can only generate returns for network operators in new developments and high-income, high-density areas Example for 30% household penetration USD per household New developments High-income, high-density areas Medium-income, low-density areas Investment 1,250 1,950 3,250 Customer value 1,500-2,000 1,500-2,000 1,000-1,500 Net present value ,250-1,750 Note: Margin for voice services 70%, ADSL 45%, IPTV 30%, WACC 15% SOURCE: McKinsey seem to be widely accepted with research showing a GDP increase of 0.6 to 0.7 percent annually for every 10 percent increase in broadband penetration. For network operators, however, the economics of fiber remain quite challenging due to the significant cost of rolling out these networks. In high-density, highincome areas, fiber rollouts could potentially yield modest positive returns, although it will mostly remain a risky venture depending on the operator s ability to fill the infrastructure and on the stability of the regulatory environment to preserve retail and wholesale pricing. In lower-income, low-density areas on the other hand, there is very little financial incentive for a private investor to roll out this infrastructure (Exhibit 1). When left to market forces, this essentially means that substantial fiber rollout will materialize in only a limited number of areas. In a greenfield context, it makes perfect economic sense to roll out fiber infrastructure, as the deployment costs are relatively low. Emerging markets such as China, India, and the Middle East will automatically achieve fiber networks of substantial size due to higher natural growth and the upgrading of their housing stock. In more developed markets where growth is limited, pursuing an infrastructure upgrade by means of a natural growth strategy would take decades. In such markets, substantial fiber rollouts are expected only in high-income, high-density areas or areas with several infrastructure players where competitive pressure will force infrastructure upgrades. In most other areas, markets will likely see a set of multiple solutions in the short term DSL broadband delivered via fiber to the curb (FTTC), for example. These solutions will not provide the same advantages as fiber (in terms of speed, for example), and they will create large operational complexities for operators managing them. It is evident that multiple access models will evolve in most countries. The objective of the ongoing regulatory debate, however, is to have fiber deliver a large proportion of access. Also, upgrading any interim access solution to fiber later in the game will likely be expensive a factor that amplifies the urgency for policymakers and the industry to think of ways to deliver fiber now. Regulatory uncertainty complicates the economics of fiber The benefits to the private sector of deploying fiber are further challenged as incumbents face additional uncertainties in the form of the regulatory frameworks that policymakers will use to grant access to the newly built fiber networks. While the private sector in many industries is well acquainted with funding infrastructure investments with long payoff times, telecoms

3 33 02 South Korea, Hong Kong, and Japan are leading the pack in fiber deployment SOURCE: Global FTTH Council, May/June 2009 Global fiber-to-the-home/building penetration ranking, 2009 Percent of households South Korea 46.5 Hong Kong 30.0 Japan 29.0 Taiwan 16.0 Sweden 10.9 Norway 10.2 Slovenia 8.9 Andorra 6.6 Denmark 5.7 Iceland 5.6 US 5.5 Lithuania 3.3 Singapore 3.0 Countries with clear regulatory Netherlands 2.5 frameworks like South Korea, China 2.5 Hong Kong, and Japan have more Finland 2.4 widespread fiber deployments EU Italy 2.0 Estonia 1.9 Russia 1.8 Latvia 1.5 executives around the world voice major concerns about approaching investors without having clear-cut rules and regulations in place. At the core lies a regulatory moral hazard. The historical approach has been to enforce a wholesale regime that allows others to use the traditional but largely existing copper infrastructure. Operators now fear that this will be imposed on the fiber networks once they are built an approach that would spur aggressive wholesale pricing. Such a scenario would thus result in significant value erosion for the investing operator. Regulators and policymakers have legitimate concerns about the re-monopolization of the sector in the absence of clear and committed rules governing infrastructure sharing and cost recovery levels in fiber networks. Yet, without such clarity, it becomes very difficult for private incumbents to justify large infrastructure rollouts. In those countries where clear rules do exist, they are usually based on the provision of legacy copper services and are typically not conducive to investments in entirely new infrastructures. The competition-based approach has worked well, pushing down prices for most services, opening up networks, reducing cross-subsidies, and increasing real consumer choice over the past 20 years. But this in conjunction with the rise of mobility has significantly altered the attractiveness of investing in fixed networks. As a result, the industry s fixed infrastructure is under pressure from regulatory and market forces. A new regulatory strategy balancing the need for investment with the need to support competition may be required to prevent the erosion of fixed infrastructure. Such policy should acknowledge the differences in underlying network economics, the multiplying models of access to voice and data, and the differences in competitive intensity. It may lead to increased industry revenues in some areas, but at the cost of greater investment expenditure. In the EU for example, Viviane Reding (former European Commissioner for Information Society and Media) stated: It is very important that the conditions to invest exist and regulatory certainty is one of those conditions. Today, the regulatory landscape in Europe is unfortunately heavily fragmented in this respect. This situation might be one reason European countries seem to lag behind in terms of investments in fiber. In countries where a clear regulatory approach to fiber has been defined (for instance in South Korea, Hong Kong, and Japan), fiber rollouts seem more advanced (Exhibit 2). Three emerging ways to support fiber rollout Fiber s regulatory challenge means that most countries are experimenting with alternative approaches, each

4 34 03 Three main models to deploy high-speed networks are emerging Model Laissez-faire (US) Subsidy (Asia) Open access (Europe) Goal Push infrastructure Guarantee financial returns Make broadband accessible for everyone Push competition Description Favors infrastructure competition No unbundling of fiber Favors service competition Favors open-access wholesale networks High degree of network unbundling Favors fiber unbundling/open access Funding Operators fund the fiber network Government-subsidized deployments Operators and municipalities fund the fiber network Subsidies for rural/unprofitable areas only Differences in support from regulators and government is one of the key reasons for the diversity in rollout strategies SOURCE: McKinsey having slightly different ways of addressing the fundamental economics of new infrastructure. In this context, three different regulatory models are beginning to emerge (Exhibit 3): Laissez-faire model. In the US and Hong Kong, for example, the intent is to encourage infrastructure rollout while guaranteeing financial returns by relieving operators from network unbundling. In essence, this model provides regulatory certainty, ensuring that the benefits from fiber investment can be captured by those investing in the infrastructure. This seems to be one reason why Verizon, for instance, invested over USD 18 billion in the last five years in an FTTH network that currently covers 14.5 million premises in the US. The model fails to address the challenge of rolling out infrastructure in unprofitable areas; it might need to be complemented by some sort of subsidy model in the future. Subsidy model. Predominantly Asian countries such as Singapore, Malaysia, South Korea, and Japan use this model to some extent to encourage broadband access for everyone. The method is to offer tax incentives or direct subsidies to network operators to deploy fiber networks. Some countries have gone even further and have mandated several degrees of separation of the incumbent s network in order to create a neutral (government-owned) entity through which investments can be channeled. Examples where this is the case include Australia and New Zealand. Open access model. Mostly used in Europe and countries that have based their legislation on Europe s, this model strives to encourage competition in the market by mandating a high degree of network access based on unbundling. Here, alternative operators access the incumbent s network and customers by paying a wholesale access fee. Differentiation within the market serves as the basis for competition. Although this model does foster competition, it does not necessarily guarantee investment. More recently, the EU seemed to move closer to the subsidy model by introducing several incentives, including a 15 percent risk premium on wholesale costs to help telcos recoup investments. It also allowed subsidies in rural and unprofitable areas to enable companies to build local fiber networks. This investment challenge is fundamentally new to the regulation of telecoms networks. The objective now is a large-scale replacement of existing infrastructure versus the historical objective of creating viable competition. Structural separation of passive networks has been discussed as a potential solution to the fiber deployment problem; however, this would simply replace one (private) infrastructure operator with another (public) one. Such a venture would essentially deliver on the

5 35 open-access requirements but would largely ignore the economic challenges of the fiber investments required. Moreover, it may tie up large network operators and policymakers in years of wrangling. Business as usual is not an option, and more innovative ways of collaboration between local and national governments, operators, and regulators will be required. Broadly, governments can act to spur demand for highspeed broadband among citizens, provide investment support for industry players, and, perhaps most important of all, put forth a compelling vision of the economic benefits of a high fiber future. Regulators need to find the right ways within their economies to balance the need for competition against the creation of an investment-friendly environment. Why act now Governments are eager to invest in projects likely to boost economic growth and create jobs in the near term. Deploying fiber networks satisfies both of these objectives. Incumbent operators that do not adequately acknowledge the importance of a high-speed broadband infrastructure for their country might find themselves sooner than later in conflict with their politicians who have a much broader national interest. Eventually, these operators may be faced with an undesired industry outcome that can be detrimental to the core business, such as loss of control over their own infrastructure, substantial government funding of a competitor, or the creation of a new government-owned network operator. This is why operators need to look at the broader case for fiber infrastructure when making investment decisions. Policymakers must also play a role in supporting this process. Operators should proactively engage governments in their approach to drive fiber investment and collaborate financially whenever possible. This will be the way forward that is most likely to deliver the best economic outcome for both operators and the country. * * * Most countries are increasingly focused on upgrading the existing copper network access infrastructure with fiber. Deploying the new networks can significantly improve a country s GDP growth something that has captured the attention of policymakers. The economics of fiber, however, are less favorable for the private sector, which could only see positive benefits from their investment when rolling out fiber in affluent, densely populated, or greenfield areas. Current regulatory debate centers on this discrepancy between social and private incentives, along with the potential actions to support fiber rollout. Several models are emerging that show how the industry can work effectively with policymakers to improve the business case and obtain the broader social benefits fiber networks can offer. Incumbents should lead this industry dialog and evaluate their investments in fiber now. Failure to move in a timely manner could raise the political stakes bringing new competition or adverse regulation over time. Luis Enriquez is a Director in McKinsey s Brussels office. luis_enriquez@mckinsey.com Sanjeev Kohli is an Associate Principal in McKinsey s Dubai office. sanjeev_kohli@mckinsey.com Sergio Sandoval is an Engagement Manager in McKinsey s Brussels office. sergio_sandoval@mckinsey.com Wim Torfs is a Principal in McKinsey s Dubai office. wim_torfs@mckinsey.com