National leased lines: Effective competition review and policy options

Transcription

1 National leased lines: Effective competition review and policy options Consultation document issued by the Director General of Telecommunications August 2000 Office of Telecommunications 50 Ludgate Hill London EC4M 7JJ Tel: Fax:

2 Contents Summary iii Chapter 1 Introduction 1 Chapter 2 International benchmarking 5 Chapter 3 Market analysis 14 Chapter 4 Policy options 35 Consultation 46 Annex A Notes on international benchmarking 47 Annex B Excessive prices and profits 50 Annex C Further questions for OLOs 53 Annex D Legal framework 56 Annex E Technical Details of proposed wholesale services 60 Annex F Financial modelling 61 Annex G Form of Price regulation of wholesale terminating segment services 68 Annex H Details of the Cost Benefit Analysis 73 Annex I Glossary 82 ii

3 Summary S1 Leased lines are permanent telecommunications links supplied by network operators to users which provide capacity dedicated to the user s exclusive use. Leased lines are used to carry high volumes of voice and data traffic. They are used by many business consumers, for example for voice and data traffic between different branches. They also used by operators and service providers and so underpin many other services. For example they provide the backbone for the mobile networks and Internet Service Providers use leased lines to connect to the Internet and to offer high speed internet access services to business consumers. In short leased lines are a key telecommunications service for many businesses and, in particular, are important for the development of e-commerce services in the UK. The market for retail leased lines was worth approximately 1.4 billion in 1998/99. S2 In November 1999, OFTEL announced it was launching a review of the state of competition in the market for national leased lines. This review is the first of OFTEL s planned market reviews as set out in its Strategy statement published in January The purpose of these market reviews is to assess the state of effective competition in relation to a particular market segment and, in the light of that assessment, determine what is the appropriate degree and type of regulation. S3 The review for national leased lines was prompted by concerns about the extent of competition, particularly in the wholesale market for leased lines, which meant that prices paid by UK users were not as competitive as they might be. International comparisons of leased line prices also suggested some concerns since while BT s prices were broadly comparable with other EU countries, the UK s competitive position had been eroded and further, in relation to the US, for most types of user US leased line prices are below those in the UK. S4 This Consultation Document presents OFTEL s conclusions from an update of international price comparisons; its review of competition in the UK national leased lines market; and its proposals for action. S5 As regards international price comparisons, OFTEL s further examination largely confirms the findings on November 1999 but highlights some additional evidence which raises concerns. While BT s prices are broadly in line with the European average, its prices are significantly above the cheapest countries in the EU in almost all cases. Also the UK s relative position has worsened over the last couple of years as other EU operators have liberalised their markets resulting in significant price falls. As regards US comparisons, OFTEL believes that its conclusion stated in the November Statement (summarised above) is still accurate. S6 OFTEL has considered the state of competition in both the relevant retail and wholesale markets for national leased lines. OFTEL s conclusions are that: the market for retail leased lines is not effectively competitive; the market for wholesale trunk segments (provision of capacity within an operator s trunk network) is prospectively competitive; the market for wholesale terminating segments (provision of capacity from a customer s premises to an operator s trunk network) is not and will not become effectively iii

4 competitive in the foreseeable future; and the market for retail leased lines will not become effectively competitive unless the lack of effective competition in the market for wholesale terminating segments is remedied. S7 This consultation document sets out 3 possible options to remedy the lack of effective competition in wholesale markets thereby promoting competition in retail leased lines. These are: (i) to encourage commercial negotiations between purchasers and BT. Such negotiations would be within the framework of the EC Interconnection Directive 97/33/EC (ICD). This places obligations on BT and purchasers to negotiate the supply of appropriate services. It also requires BT s prices for such services to be cost-oriented and the terms of supply to be non-discriminatory. OFTEL has powers to intervene to resolve disputes; (ii) OFTEL to take action on its own initiative rather than waiting for a dispute to arise. Under its powers under the ICD, OFTEL would specify the services that BT must offer. OFTEL proposes these would be wholesale terminating segments at all bandwidths and, as in (i), these would have to be provided on non-discriminatory terms and at cost-orientated prices; (iii) as in (ii) but in addition OFTEL would set and control the prices of the wholesale terminating segments to be offered by BT. This would involve OFTEL setting initial prices and then controlling prices for next 4 years by the means of an appropriate network charge control. S8 On balance, at this stage OFTEL considers that Option (iii) is likely to be the most appropriate regulatory action to promote competition in the market. S9 The consultation document also considers the option of imposing retail price controls on BT s retail prices of leased lines. (iv) Binding controls on retail prices. However, OFTEL believes that retail price controls would not constitute a proportionate response to the competition concerns identified. This is because, as explained above, OFTEL has concluded that the reason for the lack of effective competition in retail leased lines is the lack of effective competition in the market for wholesale terminating segments. (v) Safeguard retail price caps. OFTEL proposes that such safeguard caps are only likely to be appropriate for analogue retail leased lines since the competitive pressures created by its wholesale policy options are likely to stimulate sufficient retail competition to constrain retail prices for all other services. S10 OFTEL seeks comments from consumers and industry and others on the views set out in the Consultation Document. Thereafter Oftel will issue a Statement setting out its firm conclusions and the way forward. iv

5 Chapter 1 Introduction Effective competition review 1.1 OFTEL s strategy is to achieve the best deal for the consumer primarily through effective competition. A key part of OFTEL s strategy is ensuring that the level of regulation is appropriate to the state of competition. OFTEL s strategy document of January 2000 (OFTEL s Strategy) outlined a programme of market reviews to assess the state of effective competition in key market segments and hence establish whether regulation relating to these segments was appropriate. This document presents, for consultation, the conclusions from the market review of national leased lines. 1.2 This effective competition review was launched by OFTEL s November 1999 Statement on National Leased Lines (November 1999 Statement). In that document, OFTEL set out its conclusions from an initial international price benchmarking exercise and an initial investigation into the state of competition for the provision of national leased lines. These were as follows: BT s prices were in line with the EU average but their relative advantage over some other countries had been eroded in recent years; competition concerns existed in the market for terminating segments (capacity between a customer s premises to an operator s trunk network); and competition appeared to be developing in the market for trunk segments (capacity between trunk exchanges). 1.3 As a result of these conclusions, OFTEL decided it was appropriate to carry out a full effective competition review. What is a leased line? 1.4 This section provides a general introduction to leased lines and to the terminology used in this consultation document. A leased line is a permanent connection providing capacity between two points dedicated to the user s exclusive use. OFTEL believes it is important to distinguish between wholesale leased lines and retail leased lines. Figure 1 shows the relationship between wholesale leased lines and retail leased lines. 1

6 Figure 1: Retail and Wholesale Leased Lines Retail end to end leased lines Other retail data services eg frame relay, ATM, fixed link internet access Other retail telecommunications services eg mobile calls Service Providers (without networks) Fixed network operators Mobile Network operators Wholesale leased lines 1.5 A wholesale leased line is a leased line which is used as an input in the provision of another telecommunications service that is purchased at the retail level by the final customer. It is therefore an intermediate service. Figure 1 demonstrates that a wide range of final or retail services may use wholesale leased lines as an input. The importance of the wholesale leased line as an input varies significantly between these services. Clearly in the case of retail leased lines the input is a significant cost element whilst for some other services such as mobile calls, the wholesale leased line would appear to be a relatively small cost element. Therefore the competitive situation in respect of wholesale leased lines will affect some retail services more directly than others. Wholesale leased lines 1.6 As explained in the November 1999 Statement, OFTEL believes that the wholesale leased lines sector can be split into two components which constitute separate economic markets. These components are terminating segments and trunk segments. These terms are illustrated in Figure 2. A terminating segment is capacity between a customer s premises, through a serving local BT exchange, to a point of interconnection between BT s network and an Other Licensed Operator s (OLOs) network at any of BT s DMSU centres used for routing leased lines to that serving exchange. A trunk segment is capacity between the serving centres for leased lines at trunk exchanges which are generally at the DMSU level of an operator s network. It is important to distinguish these components from the components which BT uses to construct its retail prices, namely local ends and main links. This distinction is also illustrated in Figure 2. The wholesale economic markets are discussed further in chapter 3. 2

7 1.7 A terminating segment is also sometimes referred to by other terminology such as a part leased circuits or a partial private circuit. For example, the European Commission in its Recommendation on leased lines interconnection pricing (Commission Recommendation on leased lines interconnect pricing, C(1999)3863, November 1999 ( Commission Recommendation )), which is discussed further in Annex D, uses the term leased line part circuits to identify particular wholesale leased lines which are provided by an incumbent operator to another interconnected operator. Figure 2: Different terminology used to describe a leased line End to end leased line - BT s pricing components - Local end Main link Local end Telecoms network Serving centre for LL at the Local exchange Serving centre for LL at the DMSU Serving centre for LL at the DMSU Serving centre for LL at the Local exchange Customer site 1 Terminating segment Trunk segment Terminating segment Customer site 2 Wholesaleeconomicmarketsforleasedlines Retail leased lines 1.8 A retail leased line, also referred to as an end to end leased line, is a permanent connection between two customer s premises dedicated to the customer s exclusive use. Such leased lines are final services in the sense that the customer does not use them as an input in the provision of other telecommunications services to other customers. Retail leased lines do not have usage based charges. Rather their price is usually dependent on the length of the leased line and its bandwidth. As a result, retail leased lines are particularly appropriate where a customer has two locations which are in frequent communication with one another. For example, leased lines may be used to connect local area networks of different sites, to provide branch sites with access to centrally held databases, or to provide video conferencing links between sites. 1.9 The price of a BT retail leased line is typically made up of a single connection charge and a rental charge for a local end and a main link. A local end refers to the connection between the customer s premises and the leased line serving centre at the local exchange and a main link is the connection between local exchanges. These terms are illustrated in Figure 2. There are some retail leased lines called own exchange circuits which do not have a main link. 3

8 Rather the two premises connected by the leased line are connected to the leased line serving centre at the same local exchange. With the exception of own exchange circuits, local ends and main links are not stand alone services and cannot be purchased from BT separately. Types of retail leased line 1.10 Leased lines may be provided at a variety of bandwidths. These range from analogue to digital circuits up to 622 Mbit/s. BT s principal retail leased line services are: SpeechLine: analogue circuits specifically designed for direct voice transmission; KeyLine: analogue circuits dedicated to low speed data transmissions; KiloStream: digital circuits in speeds from 2.4kbit/s to 64kbit/s can provide data and voice transmissions; KiloStream N: digital circuits available in increments of 64kbit/s from 64kbit/s to 1024kbit/s; MegaStream: high speed digital circuits over 2, 8, 34, 45, 140, 155 and 622 Mbit/s for large volumes of data and voice traffic; MegaStream Genus: 2, 34, 45, 140, 155 and 622 Mbit/s circuits delivered over Synchronous Digital Hierarchy (SDH) technology which offers increased resilience over circuits provided over Plesiochronous Digital Hierarchy (PDH). Scope and structure of the consultation document 1.11 This consultation document sets out the results of OFTEL s effective competition review of national leased lines. In this review it has considered the competitive position in relation to wholesale leased lines and retail leased lines. The structure of the consultation document is as follows In chapter 2, OFTEL presents the results of the further benchmarking work it has carried out in relation to prices of retail leased lines Chapter 3 sets out OFTEL s analysis of the retail and wholesale markets for national leased lines. This chapter discusses the principal indicators of effective competition as set out in OFTEL s Strategy, namely market structure, supplier and consumer behaviour. The chapter sets outs OFTEL s conclusions on the extent to which the wholesale and retail markets are effectively competitive Chapter 4 discusses the different policy options which OFTEL is considering in relation to national leased lines in the light of its conclusions of its effective competition review as set out in chapter 3. OFTEL s initial proposals are set out and the chapter presents the results of OFTEL s cost benefit analysis There are a number of annexes to the Consultation Document. These set out further details of international benchmarking work, a discussion of the appropriate tests for excessive pricing, further questions for OLOs, the legal framework, technical descriptions of services, detailed issues relating to price regulation, a summary of the financial modelling exercise carried out, an explanation of the cost benefit analysis carried out and a glossary. 4

9 Chapter 2 International benchmarking of retail leased line prices Introduction 2.1 In this chapter OFTEL presents the results of the work it has carried out benchmarking UK prices for retail leased lines. This work has two purposes in the context of OFTEL s effective competition review of national leased lines. Firstly, OFTEL believes it is appropriate for it to set out in greater detail than it has done previously how it believes UK prices compare with those in other countries. This is necessary because of the number of representations it has received about the UK s relative position in relation to this particular telecommunications service. Secondly, OFTEL s Strategy sets out that, as part of an effective competition review of particular telecommunications services, it will seek to measure the outcomes for UK customers. One way in which this can be done is through international benchmarking. Accordingly, OFTEL has considered to what extent UK customers are getting the best deal when compared with the position of customers in other countries. The results from this exercise provide a useful context to the detailed market analysis set out in the following chapter which considers whether the markets are effectively competitive. The comparisons presented use August 1999 data which is the most comprehensive data available to OFTEL. OFTEL has also considered less comprehensive but more recent data and this supports the conclusions set out in this chapter. 2.2 Price comparisons with other EU countries are particularly relevant as they include comparisons both with major competitor economies (such as France and Germany) as well as comparisons with countries having advanced telecoms markets (for example the Scandinavian countries). However, the market for leased lines in many EU countries is not yet fully competitive and OFTEL has received representations from consumers that the relevant comparison to make is between the UK and the US where the market for leased lines appears to be more competitive. There is clearly some basis to this view and OFTEL believes that it is therefore important to try to understand how the US and UK compare. However, for reasons explained in some detail later, it is not possible to carry out detailed price comparisons between the UK and the US and therefore the main focus of the chapter is on benchmarking UK prices with the rest of the EU. 2.3 In considering the international price comparisons OFTEL is investigating whether the UK is delivering the best deal for purchasers of leased lines. In assessing this OFTEL has considered how the UK compares with the EU average and also, particularly because the UK market was liberalised earlier, more challenging comparators. 2.4 In most cases, OFTEL has chosen to present comparisons with the third cheapest country to provide such a comparator. Choosing the third cheapest as a comparator is somewhat subjective and it will not necessarily be used in all other market reviews. However in the case of this market review it has been chosen to set a challenging basis for comparison which is consistent with approach adopted by the European Commission in setting best practice rates for interconnection and recommended price ceiling for wholesale leased lines. This approach is only valid where there are a reasonable number of other countries offering tariffs 5

10 with which to compare the UK. Since only a limited number of countries offer high bandwidth circuits (above 2 Mbits) in these cases comparisons are also made with the cheapest country. Caveats 2.5 Comparing the prices of leased lines accurately is difficult (as OFTEL explained in its November 1999 Statement). Annex A explains the caveats that surround the price comparisons presented in this chapter and sets out the methodology used to construct the comparisons. It should be noted that the price comparisons reflect the UK s relative position; absolute values are not necessarily valid. European Comparisons individual lines 2.6 The figures below compare the UK price, based on BT s prices, for individual circuits with the EU average price and the price for the third cheapest EU operator. It should be noted that the EU average price is a simple unweighted average. The UK s rank within the sample of countries is also given. (NB A statement that the UK is ranked 1 st out of 14 countries indicates that it is the cheapest country, whereas if the UK is ranked 14 th it indicates it is the most expensive.) 2.7 Figure 3 shows the list price of a 64kbit/s leased line at 2 km, 50 km and 200 km as at August It shows that UK prices are in line with most other European countries, being slightly more expensive than the average for all of the circuit distances considered. The UK is ranked 12 out of 14 countries for a 2 km circuit and ranked 8 th for 50 and 200 km circuits. UK prices relative to the third cheapest country are over 100% higher for a 2 km circuit falling to 42% higher for a 200 km circuit. Figure 3: Rental per annum in Euro PPP for a 64 Kbit/s circuit 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, km 50km 200km Circuit length UK EU average 3rd cheapest Source: European Commission Fifth Implementation Report, Figure 4 shows the list price of a 2Mbit/s leased line at 2km, 50 km and 200 km as at August It shows that UK prices are cheaper than average for 2 and 50 km, but above average for 200 km circuits. The UK is ranked 3 rd,5 th and 9 th out of 15 countries for 2, 50 and 200 km circuits respectively. UK prices are 27% higher than the third cheapest country for 50km circuits and 81% higher for 200 km circuits. 6

11 Figure 4: Rental per annum in Euro PPP for a 2 Mbit/s circuit 60,000 50,000 40,000 30,000 20,000 10, km 50km 200km Circuit length UK EU average 3rd cheapest Source: European Commission Fifth Implementation Report, In the November 1999 Statement, comparisons above 2 Mbit/s were not presented because data was not available on sufficient countries. These problems still persist but OFTEL has decided that as this is an important growth area in the market the data that is available should be presented. However, the results should be treated with particular caution Figure 5 shows the list price of a 34Mbit/s leased line at 2 km, 50 km and 200 km as at August Data for this type of circuit is only available for a limited number of countries (8 countries). Given the limited number of countries with which comparisons can be made, the price of the cheapest country is also presented. It shows that the UK prices are somewhat cheaper than average for 50 km and 200 km but above average for 2 km circuits. The UK is ranked 6 th out of 8 countries for 2km circuits but is third cheapest for 50 and 200 km circuits. UK prices for 2 km circuits are 59% higher than the third cheapest country. UK prices are significantly higher than the prices for the cheapest country. Figure 5: Rental per annum in Euro PPP for a 34 Mbit/s circuit 35,000 30,000 25,000 20,000 15,000 10,000 5, km 50km 200km Circuit length UK EU average 3rd cheapest cheapest Source: European Commission Fifth Implementation Report, Data for 155Mbit/s circuits is even more sparse (5 countries) than for 34Mbit/s and again the results should be treated with caution. Given the limited number of countries with which comparisons can be made, the price of the cheapest country is also presented. What data there is indicates that UK prices are very close to average for 50 and 200 km but above average for 2 km circuits. The UK is ranked 5 th out of 5 countries for 2 km circuits but is the 7

12 third cheapest for 50 and 200 km circuits. UK prices for 2 km circuits are over 200% higher than the third cheapest country. UK prices are significantly higher than the prices for the cheapest country. Figure 6: Rental per annum in Euro PPP for a 155 Mbit/s circuit 100,000 80,000 60,000 40,000 20,000 UK EU average 3rd cheapest cheapest 0 2km 50km 200km Circuit length Source: European Commission Fifth Implementation Report, Figure 7 shows the list price of an analogue leased line at 2 km, 50 km and 200 km as at August It shows that the UK is cheaper than average for 2 and 50 km and very close to the average for 200 km. In each case the UK is ranked either 6 th /7 th cheapest out of 14 countries. UK prices are over 60% higher than the third cheapest country for a 2 km circuit rising to over 130% higher than the third cheapest country for a 200 km circuit. Figure 7: Rental per annum in Euro PPP for an analogue circuit 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, km 50km 200km circuit length UK EU average 3rd cheapest Source: European Commission Fifth Implementation Report, 1999 European Comparisons basket analysis 2.13 It is also possible to use a basket of leased lines of different distances and bandwidth in order to consider the overall average position from the point of view of a typical customer. The exact result will, of course, depend upon how the basket is constructed. For example, basket comparisons which give 2Mbit/s circuits a high weight will tend to present the UK in a more favourable position compared to baskets giving greater weight to 64kbit/s or analogue circuits. OFTEL has considered the results of such comparisons and believes that the 8

13 conclusions from this type of analysis support the position presented above from individual circuit comparisons with UK prices generally in line with the European average but significantly higher than the 3 rd cheapest country. European comparisons 5 year price trends 2.14 The final aspect of European price comparisons considered is the change in prices of circuits over time. In order to do this, it has been necessary to use a different data source from that used for the individual price comparisons and therefore the data may not be entirely comparable to that presented earlier. Data is available for only 9 of the EU countries across the 5 year period (data is only available for Finland from Jan 1998 onwards and has not been included to ensure consistency in the time trends over 5 years) The figures below show the price trend for the UK price, the average price for 9 EU countries and the price of the third cheapest country. The average price is calculated as a simple unweighted average Figure 8 shows the trend of prices for a sub-set of the European countries for the last 5 years for a 30km 64kbit/s circuit. This shows that in 1995 UK prices were below average and close to the price for the third cheapest operator, but by 1999 the UK's relatively good position had been eroded with the UK moving from below average to above average. Figure 8: Rental per annum in Euro PPP for a 30km 64kbit/s circuit over the last 5 years 8,000 7,000 6,000 5,000 4,000 3,000 UK Average 3rd cheapest 2,000 1,000 0 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Source: Analysys "Cutting the Cost" 9

14 Figure 9: Rental per annum in Euro PPP for a 30km 2Mbit/s circuit over the last 5 years 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 UK Average 3rd cheapest 5,000 0 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul Figure 9 shows the time trend of prices for a sub-set of the European countries for the last 5 years for a 30 km 2Mbit/s circuit. The UK position moved from being well below to being just below average for the countries considered, although it has maintained its position as the third cheapest country Figure 10 shows the time trend of prices for a sub-set of the European countries for the last 5 years for a 30 km analogue circuit. While the picture is less clear in this case, there is some deterioration in the UK's relative position and the UK moves from being below to being about average for the countries considered. While in 1995 the UK was the third cheapest country, by 1999 the UK was significantly more expensive than the third cheapest country. Figure 10: Rental per annum in Euro PPP for a 30km analogue circuit over the last 5 years 3,500 3,000 2,500 2,000 1,500 1,000 UK Average 3rd cheapest Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Source: Analysys "Cutting the Cost" 10

15 UK / US Comparisons 2.19 As discussed in the November 1999 Statement, while it is appropriate to consider price comparisons for leased lines between the UK and the US, such comparisons are extremely difficult, indeed far more so than the intra-eu comparisons presented above The problems discussed in Annex A for the intra-eu comparisons are much worse when comparing with the US because: there is a wide range of operators in the US; prices differ significantly according to the route chosen; the extent of discounts is such that these cannot be ignored (it cannot be assumed that the discounts are the same order of magnitude as in Europe, as they are likely to be much larger); bespoke deals are widely offered Last year OFTEL commissioned a study from Tarifica to obtain a better understanding of UK and US comparisons and the results of this exercise were discussed in the November 1999 statement. The study revealed that meaningful price comparisons against US leased lines are almost impossible to carry out. This was because obtaining information from operators on the prices actually charged was very difficult and what data could be collected indicated that prices paid varied considerably according to a variety of factors which were unrelated to any quoted list price. On the basis of the data that could be collected, it was concluded that: installation is generally cheaper in the US than the UK in fact some operators may waive connection charges for contracts of 2 years and over; while published prices for some US operators may be higher than in the UK, the discounts available appear to be considerably higher; when discounts are taken into account, US operator prices appear to be much lower than BT's prices although this will depend on details of the route and the customer As part of OFTEL s further benchmarking work, it has considered whether it is possible to obtain additional quantitative data comparing UK and US prices. The following additional observations can be made following further investigation of the US market: Local ends are provided by monopoly Local Exchange Carriers (LECs) and as a result prices have to be filed, along with discounts, with the regulator and are therefore publicly available. A comparison of local ends would therefore be theoretically possible. However, this would not provide a comparison of the services purchased and prices paid by customers because they purchase end to end links which will generally include both local ends and a main link. Accordingly, such a comparison was not carried out. Main links are competitively provided and there is no requirement to publish and file prices for this component. Indeed prices are typically bespoke making any comparison particularly problematic. It is not therefore possible to make a direct comparison with main link prices in the UK. Operators in the US providing leased lines also almost always bundle circuits with a package of other services. Therefore, even if data on customer prices could be obtained it would not be possible to identify prices for leased lines separately from prices for a range of other telecoms services. 11

16 2.23 As a result of the various difficulties it was felt that it would not be meaningful to carry out further US and UK price comparisons and therefore no further work was carried out for the purposes of the effective competition review. Furthermore, the fact that comparisons with the EU suggest that UK prices are only around the EU average and in almost all cases significantly higher than the third cheapest country in itself provides evidence that UK prices may not be as low as they could be, without the need for further evidence from the US. Conclusions 2.24 The overall picture from the European price comparisons, for the latest prices available, suggests that BT s prices for leased lines are generally significantly higher than the prices of the third cheapest EU country in almost all cases. However, BT s prices are broadly in line with the European average. This suggests that UK customers who purchase at least some of their requirements from BT, as the overwhelmingly majority of customers do, are not getting the best deal, at least when compared to other European countries In considering comparisons with the third cheapest operator there is a possibility that the countries that feature in the top three differ from circuit to circuit and that what is being illustrated is differences in pricing structure rather than overall lower prices. The composition of the top 3 countries across all circuit types and lengths has therefore been analysed. This analysis illustrates that some countries are fairly consistently within the top 3 countries. Sweden, Denmark and Germany all feature in the top 3 more frequently than the UK. The UK features in the top 3 only once for lower capacity circuits (2Mbit/s and below). Therefore OFTEL believes that the comparison provides a reliable indication that most UK customers are not getting the best deal. 12

17 Questions Chapter 2, question 1 Do you agree with OFTEL s conclusion that customers of retail leased lines in the UK are not getting the best deal compared to customers in other European countries and in the US? If possible, supply data that supports your answer. 13

18 Chapter 3 Market analysis 3.1 This chapter presents OFTEL s analysis of the extent of effective competition in national leased lines at a retail and at a wholesale level. As explained in chapter 1, wholesale leased lines are an input into retail leased lines and therefore the competitive position at both levels of the market needs to be considered. Retail leased lines market 3.2 OFTEL has considered whether retail national leased lines should be treated as a separate economic market. Generally the boundaries of a separate market will depend on the extent to which customers are able to switch to substitutes services (demand side substitutability) and the extent to which other operators, currently supplying other services, can switch into the supply of service being considered (supply side substitution). 3.3 As regards demand side substitutability, other data services eg frame-relay services / ATM services, may be substitutes for some customers of retail leased lines. However, for other customers, notably those who use leased line for voice applications, these other data services may not be realistic substitutes. Furthermore, these other data services appear to be suitable for customers who want to connect a large number of sites located in different geographical areas. This suggests that customers who only require dedicated capacity between two or a few points may not switch to other data services if the prices of retail leased lines rose by small but significant amount. Also, if customers only need to connect sites which are located close to each other (or within one geographical area) then they may be likely to continue to find leased lines cheaper than other data services even in the face of a price rise for retail leased lines. Thus, it does not appear to OFTEL that the extent of demand side substitution would be sufficient to justify a broader retail market than retail leased lines. 3.4 Consideration of supply side substitution leads to a similar conclusion.. Operators, who are not currently providing retail leased lines, will face considerable barriers to entry (this is explained in greater detail below) and are therefore unlikely to be able to easily switch into supplying retail leased lines. 3.5 OFTEL s initial conclusion is that retail leased lines constitute a separate economic market. 3.6 OFTEL s assessment of the extent of competition in retail leased lines, set out in this section, is based on the best market information available. However, this information is not complete; in particular it has not been possible to obtain detailed information from all OLOs. Therefore it has been necessary make various adjustments and estimates. Accordingly, the figures presented should be interpreted as giving an indication of the position rather than as a definitive statement. It should also be noted that the figures presented for retail leased lines will actually include revenues for wholesale leased lines. This because the data collected does not allow the retail and wholesale parts to be separated. 1 While this means that the absolute 1 In particular sales by BT to OLOs appear as retail sales. Some double accounting will occur where an OLO purchases a leased line from BT to provide a terminating segment and then sells that on to a retail customer as part of the OLO s end to end leased line. 14

19 values will be overstated, OFTEL believes that this will not affect the market shares of the different suppliers since the purchasing patterns amongst wholesale consumers is likely to be the same as retail consumers. Market size 3.7 Table 1 shows the size of the national end to end retail national leased line segment. Retail leased lines generated approximately 1.4bn of revenue for 1998/99. Table 1: Volumes and Revenues of Retail Leased Lines, 1998/99 Volumes at March 1999, 000 s Revenues in 1998/99, m Analogue <2Mbit/s Mbit/s >2Mbit/s 2 85 Total Source: OFTEL s Market Information; Data supplied by Operators and OFTEL estimates 3.8 Figure 11 shows that 86% of all leased lines are below 2Mbit/s. However, these circuits account for only 53% of total national leased line revenues. Circuits at 2Mbit/s account for 14% of volume but 41% of total revenues. Circuits above 2Mbit/s account for only 0.5% of total volume but 6% of total revenues. Figure 11: Proportion of total volume and total revenue accounted for by bandwidth 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Analogue <2Mbits 2 Mbits >2Mbits Volume Revenue Source: OFTEL s Market Information; Data supplied by Operators and OFTEL estimates 3.9 Over the last six years, three main trends emerge from both volume and revenue data for growth of national leased lines: analogue circuits have been declining year on year; all digital circuits have been increasing year on year; 15

20 the rates of growth in digital circuits has been higher for higher bandwidths. Market Shares 3.10 Table 2 shows how operators market shares have changed since 1996/7. This shows that while BT s share has fallen over the period, BT remains the main provider of retail leased lines. Its share of all retail leased lines in 1998/9 was 83%. The share of the next largest provider is much smaller at 7%. It should also be noted that BT s market shares is likely to understate its market power. This is because of the geographically averaged pricing structure which BT chooses to adopt. Such a pricing structure means that BT may prefer to lose market share in certain areas rather than reduce price everywhere. This is explained further in paragraph 3.24 below. Table 2: Estimated Revenue Market Shares (all end to end leased lines) percentages Operator 1996/7 1997/8 1998/9 BT C&W Cable Others Sources: OFTEL Market Information & Data from operators Note: Year on year comparisons is indicative only as they are not strictly comparable Entry 3.11 Table 2 shows there are a number of competitors to BT in the provision of retail leased lines. Such competitors have generally focussed on higher bandwidths and particular geographical areas There has been virtually no entry into the provision of analogue circuits. Figure 12 considers the entry in respect of digital circuits. It shows that entry has concentrated on circuits above 2Mbit/s, there has been some entry at 2Mbit/s but very little entry below 2Mbit/s. Since OFTEL has defined the relevant market as retail leased lines, including both high and low bandwidths, analysis of market power should not be based on the shares at each bandwidth depicted in Figure

21 Figure 12: Operators shares of leased lines at different bandwidths by revenue, 1998/99 Digital >2Mbits Digital 2Mbits Digital <2Mbits Analogue 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% BT Kingston C&W Cable Other Source: Data from Operators, OFTEL Market Information and OFTEL estimates 3.13 OFTEL believes that entry into the provision of retail leased lines also varies by geographical area. Available information suggests that entry is more likely in metropolitan areas where there is a large volume of traffic. OFTEL had attempted, prior to its November 1999 Statement, to collect information from operators broken down by geographical regions. Unfortunately, operators were not able to provide information at this level of detail. However, in the context of this review, OFTEL has managed to collect some information on operators shares of leased lines in Central London Zone (CLZ) and non-clz areas. OFTEL would have expected to find that BT s share within the CLZ area would be significantly reduced as a result of greater entry in these areas. However, Figure 13 suggests that BT continues to retain a significant market share in CLZ, although, as expected, its market share is lower in CLZ than in non-clz areas. Outside CLZ, there appears to have been only pockets of entry in some metropolitan areas where regional providers such as Norweb, Torch and Thus are located. 17

22 Figure 13: Operators shares of leased lines within CLZ and outside CLZ by revenue, 1998/99 Non-CLZ CLZ 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% BT Kingston C&W Cable Others Source: Data from Operators and OFTEL estimates Entry barriers Structure of wholesale market 3.14 OFTEL believes that one of the main barriers to entry for OLOs into provision of end to end retail leased lines is the structure of the wholesale market. In general OLOs have not built out large networks between the customer and DMSU and, as a result, have to rely on inputs (terminating segments) from BT in order to offer an end to end retail service. These terminating segments are provided at retail prices. BT is, however, able to transfer charge to itself at a wholesale price. OLOs are therefore hindered in their ability to compete with BT. This issue is discussed in greater detail in the section below on wholesale markets. Barriers to Customers Switching 3.15 Customers may face barriers in switching between suppliers. This may affect the extent to which competitors are able to enter into the provision of retail leased lines. In general, there appear to be four potential barriers to switching from the point of view of customers The most significant of these appear to be the volume discounts offered by BT, which depend on the total number of circuits across all geographical regions within the UK. Other operators often have limited geographical coverage and are therefore unable to offer a discount scheme that covers the whole of the UK. Some customers, therefore, have a greater incentive to choose BT to provide circuits in a given area even though another operator may 18

23 have been able to supply it more cheaply in that area, solely in order to benefit from BT s national volume discounts. This reduces the extent to which customers are likely to purchase from alternative suppliers Secondly, customers have expressed concern about multi-vendor circuits 2. The main concern expressed to OFTEL by customers in its 1998 customer survey was that multivendor circuits affected the quality of the service delivered by the operator on the circuit. This concern about the quality of multi-vendor circuits may discourage some consumers from switching to alternative providers Thirdly, customers may be locked into long-term contracts that may prevent them from switching between suppliers. Information from BT suggests that excluding its sales to OLOs and Mobile Other Licensed Operators (MOLOs), 65% of circuits bought have one-year term contracts. However, approximately 30% of non-olo and non-molo circuits are on 5-year term contracts. This suggests that at any point in time, some customers may find it difficult to switch easily between suppliers, as they are likely to face financial penalties for early termination of contracts Finally, it would appear that customers may face barriers in originating a new service with a supplier other than BT. Due to the ubiquity of BT s network, BT may be able to offer shorter lead times relative to other operators who may not have existing network in place. Thus customers may face some barriers in originating services with alternative suppliers. Price trends 3.20 Figure 14 shows BT s price trends between 1997 and 2000 in real terms ie allowing for inflation. Overall, during the four year period, BT s annual price trends have remained relatively flat, particularly for circuits below 34Mbit/s There was a substantial reduction in price for circuits at 34Mbit/s and 155Mbit/s at the end of Prices in real terms fell by 25% and 33% respectively in that year. This is largely accounted for by reduction in installation prices. However, provision of services at these bandwidths is very recent. Therefore some adjustment of prices may be expected at this early stage whilst the market settles at an appropriate price. In the last year, price changes in real terms at each bandwidth fell by only 2%. 2 A multi vendor circuit is where the supplier buys parts of a circuit from other operators in order to supply the consumer. 19

24 Figure 14: BT s prices in real terms for retail leased lines by bandwidth, 2000 prices kbit/s 64*N kbit/s 2Mbit/s 8Mbit/s 34 Mbit/s 155 Mbit/s Note: Prices include rental and connection charges and assume that the length of the link required is 30km. Prices exclude discounts and CLZ prices. Prices for circuits above 2Mbit/s are shown on the secondary axis. Source: OFTEL 3.22 OFTEL has considered whether the stability of prices in real terms for all digital circuits reflects a lack of competitive pressure. In order to make such an assessment it is necessary to understand what has happened to costs over the time period. OFTEL s investigation into costs suggests that the cost volume relationship (CVR) for leased lines is relatively low. This implies that for any given increase in volumes, total costs rise by a smaller proportion and so average costs fall. Given that the volume of BT s digital leased lines has increased significantly over the past few years, the low CVR suggests that in a competitive market prices of digital leased lines should have fallen significantly In OFTEL s view the main reason why BT s prices may not have fallen in line with what might have been expected by the evidence on CVRs and volumes is the limited scope for price competition by OLOs. As explained in paragraph 3.14 above this is because the cost of inputs (terminating segments) faced by OLOs is a retail, not a wholesale price Also BT s choice of a geographically averaged pricing structure may hinder it in responding to price competition. From OFTEL s investigation into costs, it is apparent that costs vary significantly by geographic area. In lower cost areas, where some limited competition may exist, BT s geographically averaged prices may have prevented it from responding vigorously to price competition. This is because, under this pricing structure, reductions of price to meet competition in one area implies lower prices in other areas where costs may be higher. BT may therefore decide to suffer loss of market share for retail leased lines in more competitive areas rather than lose revenues in less competitive areas. This is likely to lead to a flatter price trend than if prices were not geographicallyaveraged. However, 20

25 OFTEL believes that this effect is likely to be secondary to the competition effect simply because the extent to which BT may be required to respond to price competition is small due to the limited amount of entry that has occurred. Retail Price Caps 3.25 Currently, analogue and digital circuits up to 64 kbit/s are subject to separate RPI +0 price caps. In the case of analogue circuits BT has raised its prices by the maximum permitted amount during the period of the price control ( ). While in the case of analogue circuits the price control has constrained price, in relation to digital circuits up to 64 kbit/s the price control has not been a binding constraint. BT has not changed its nominal prices during the price control period and therefore those prices have fallen slightly in real terms. However, OFTEL believes that it is likely that these prices have not kept pace with cost reductions, for the reasons explained above, which would suggest that competitive pressures are relatively weak. OFTEL therefore has now concluded that the competitive pressures have not been as great as expected when the safgaurd caps were set. Profitability 3.26 OFTEL has investigated BT s returns on retail leased lines. Table 3 shows BT s estimated Return on Capital Employed (ROCE) for the three main inland private circuits accounting product groups. In the timescale of the project it has not been possible for BT to breakdown cost and revenue information to allow returns to be analysed for specific retail services. However OFTEL believes these general accounting product groups provide a useful indication of the BT s profitability of retail leased lines. The costs used to calculate these returns are CCA, Fully Allocated Costs (FACs), which include retail costs and network costs for both installations and rentals. Table 3: OFTEL estimates of BT s ROCE for different leased line services 1998/99 Product ROCE Analogue 18% Kilostream and N*64 41% Megastream 32% Overall 31% 3.27 It is clear from Table 3 that BT s rates of return for retail leased lines overall are above both the cost of capital for BT s regulated services of 12.5% and BT s return on its whole Systems Business of 22% It is difficult to reach a definitive conclusion as to whether BT s returns for a particular individual service are excessive from an investigation of the returns made on a FAC basis. This is because BT is a multi-service firm and the costs of its various services are to a very significant extent common between the different services. BT can therefore choose how to recover these common costs from the different services. A return calculated on a FAC basis for a particular service is based on a certain allocation of common costs to that service. Therefore the fact return on one particular service is high may not reflect excessive profitability but simply the firm s decision to recover a relatively low proportion of common costs on that particular service. Given the prevalence of common costs Oftel has considered 21