EUROPEAN INVESTMENTBANK

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1 TELECOMMUNICATIONS NETWORK DEVELOPMENT AND INVESTMENT IN THE EUROPEAN UNION European Investment Bank Projects Directorate Industry II JACQUES GIRARD HARALD GRUBER *^ί^α EUROPEAN INVESTMENTBANK

2 Telecommunications Network Development and Investment in the European Union Principal points Sector developments The telecommunications service industry is growing very rapidly, wiith average annual growth rates of 10% during the last five years. These growth rates should continue for the next five years. This increase of activity is a result of the interaction of technological improvements (micro-electronics, optical fibres) and institutional changes (liberalisation). Technological advances in micro-electronics and the development of optical fibre cables have dramatically increased the processing capacity of telecommunications networks. The Plain Old Telephone System (POTS) is becoming an interconnected information processing system and the basic building stone of the information society. It has become evident that only widespread liberalisation (i.e. privatisation and opening up to competition) would carry the right incentives for modernisation of what used to be profitable but sleepy state monopolies. The number of lines in the EU fixed telecommunications network reached some 180 million by end 1995, or 48 lines per 100 inhabitants. In addition, there were 19 million mobile telephone subscribers. Teledensity, the sum of fixed and mobile lines, has therefore reached 53 access paths per 100 inhabitants. Even though universal service seems to be achieved, i.e. neariy every household is equipped with a telephone, there are still large differences across EU-countries in terms of penetration and modernisation of the networks. In any case, the main source of growth in the future will not come from an increased subscriber base, but from increased services that will be feasible on a modernised network. In 1995 the telecommunications service market amounted to ECU 143 billion, of which ECU 17 billion (12% of the total) came from the mobile sector. The latter is expected to exhibit very high growth i.e. some 15 to 20% per year, over the next 5 years, and could represent up to 25% of the total revenue by the year Investments The expansion and modernisation of the fixed network has required huge investments, which have peaked during the years In 1995, operators in the EU-countries invested ECU 31 billion, or some 25% of their turnover. For the years , some ECU 87bn will be invested by télécoms operators to complete the expansion and modernisation of the fixed network in the EU. The mobile telephone sector alone is expected to invest about 31 bn ECU for the years This would bring the penetration rate of mobile telephones in the EU from 5.6% in 1995 to 17.2% in In some countries, investment in the mobile sector would be equivalent to, and may even exceed, the investment made for the fixed network. Moreover, as more and more players enter this industry and this sector converges with other sectors (e.g. computer, broadcasting, consumer electronics), the traditional public operators' investments will represent a declining fraction of the total investment requirements of the sector. The investment of these players is more dispersed and difficult to assess for the time being, but it is likely to be large. Tariffs and regulations Huge price decreases for telecommunications services have been observed as a result of technological advances and liberalisation. This has also affected the tariff setting, which used to be based on crosssubsidisation. Local calls and monthly rentals were cheap compared to the cost of providing these services. Long distance and international calls provided the subsidies for local calls and line rentals. This distorted pricing system, where tariffs did not reflect costs, turned out to be inefficient and not sustainable in a competitive environment. Liberalisation would attract competition in long distance and international calls, driving down prices. To compensate for this, prices for local calls and rentals have to increase. Liberalisation therefore means "re-balancing" of tariffs, i.e. bringing them closer to cost. The practice has shown that even though local tariffs have increased, long distance and international tariffs have decreased by much more, so that in the end the adjustment led to widespread net benefits to the user.

3 Cross-country comparison shows that cross-subsidisation is particulariy evident on long distance and intemational calls. Countries with higher tariffs on these segments include Austria, Italy, Portugal, Spain, Greece, Germany, Ireland and France. Operators in these countries will be more vulnerable to competition when the telecommunication markets start to be liberalised in Countries which have already opened up to competition (such as the UK and Sweden) are close to re-balancing their tariff structure and eliminating cross-subsidisation between different types of calls. "Non-competitive" countries still have to undertake considerable price cuts on long distance and international calls. Apart from the example of pioneering countries such as the UK and Sweden, the driving force behind liberalisation and dismantling of state monopolies has been the European Commission. The process is one of stages, but with accelerating speed. January 1998 is the deadline for complete liberalisation in most countries, including voice services. For mobile telecommunications, liberalisation already began in January Impact on operators The direct impact on the profits of incumbent operators as a result of liberalisation is strong, even though this may sometimes be overstated. Assuming a typical 70% gross margin on lost revenues, potential loss of profits would lie between 15 to 30% of present operating profits in static terms. The experience of liberalised markets, shows that a tough regulatory environment may have an effect on the performance of the incumbent operators that is similar to that of competition. Moreover, full infrastructure liberalisation will have a dramatic effect on investment cost and the prices of leased lines, and this will amplify the impact of services competition on the incumbent operators. Last, but not least, technology improvement in the form of digital transmission, fibre optics, micro-electronics and wireless telephony has lowered the barriers of entry and is probably the most important factor in challenging the incumbent operator's monopoly. To succeed in liberalised markets, public operators have to increase labour productivity. Most European operators now have labour productivity targets of 350 lines per employee for telephony services, against current levels of 200 to 250. Because an increase in the number of lines will be limited, this requires in many cases extensive shedding of staff with public operators, which presents a problem in most countries. Experience, however, shows that employment generated by the telecommunications sector through new services, more than outweighs the staff reduction by the public operator.

4 Telecommunications Network Development and Investment in the European Union Table of Contents Page 1. Introduction 4 2. The Market S 3. The telecommunications network in Europe The fixed network The mobile network Overall assessment and international comparison Digitisation Optical fibre technology 8 4. Investment trends and outlook Fixed network Mobile network 9 5. Tariffs Fixed network tariffs Mobile network tariffs Leased lines Tariff trends and rebalancing in the EU Regulatory framework Community regulations for liberalisation Implications for tariffs and universal service Impact of competition on network operators Fixed network operators Mobile network operators 16 ANNEXES Table 1 - Public Telecommunication Investment in the European Union 18 Table 2 - Investment Estimates for Fixed Telecommunications in the EU Table 3 - Penetration and Investment Estimates for Mobile Telecommunications in the EU Table 4 - OECD-PJ Basket of telephone charges, February Table 5 - OECD Basket of Leased Line Charges, Table 6 - EIB Activity in Telecoms

5 Telecommunications Network Development and Investment in the European Union 1. Introduction The Bank has significantly financed the telecommunications sector in the EU. Financing amounted to some 2bn ECU per year over the period , or about 5% of the yeariy 35bn ECU telecommunications investment in the Union. Up to now, the financing was mainly devoted to investment programmes by the monopoly operator with good security, occasionally guaranteed by the public sector. However, as a result of technological changes, widespread liberalisation and the emergence of new competitors, the sector is undergoing profound changes which will also affect Bank lending. There will certainly be increased opportunities for lending, but there will also be more risk. From an eligibility point of view, the Bank's financing of projects in the telecommunications sector are justified by their contribution in improving communication links within and outside Europe and in providing the basic infrastructure for an "information society". As a result, the international competitiveness of the European market would be improved. Support for new, private, initiatives in particular would strengthen the European-wide process of liberalisation and reduce the non-innovative role of established monopolies. This is at the very heart of the current EU policy of the sector. This sector review illustrates the main features of the market and how these are about to change. It also tries to highlight new financing opportunities that may arise as a result, as well as the increased risks. 2. The market The telecommunications service industry is growing very rapidly, with average annual growth rates of 10% during the last five years. In 1995 the telecommunications service market amounted to ECU 143 billion, of which ECU 17 billion (12% of the total) came from the mobile sector (Figure 1). These high growth rates for the industry should continue also for the next five years. In particular mobile communications is expected to exhibit growth rates in the order of 15 to 20% per year, over the next 5 years, and could represent up to 25% of the total telecommunications service market by the year Figure 1. The breakdown of telecommunication services in W-Europe in 1995 Data services Cable TV services 3%,, Mobile... telecommunications 12% 4-

6 This increased growth in the service market is a result of the interaction of technological improvements (micro-electronics, optical fibres) and institutional changes (liberalisation). Technological advances in micro-electronics and the development of optical fibre cables have dramatically increased the processing capacity of telecommunications networks. The Plain Old Telephone System (POTS) is becoming an interconnected information processing system and the basic building stone of the information society. It has become evident that only widespread liberalisation (i.e. privatisation and opening up to competition) would carry the right incentives for modernisation of what used to be profitable but sleepy state monopolies. 3. The telecommunications network in Europe 3.1 The fixed network There are several measures of the size of the telecommunication networks. One is the number of lines per 100 inhabitants or the penetration rate. By 1995, there was an average of 48 mainlines per 100 people in the EU. Even if this appears quite high, it is still some 10 points less than in the United States. However, there is a considerable heterogeneity across countries (Figure 2). Sweden and Denmark display outstanding telephone penetration rates of respectively 69 and 61 lines per 100 people. EU-countries with a much lower penetration rate are Ireland, Portugal and Greece. But these countries are catching up and recorded the highest growth in mainlines during the last years, along with Germany whose increase in the number in lines was induced by unification. In general, the EU is approaching the point where each household is equipped with a telephone. There is only one country, Ireland, with a connection rate of less than 80 per cent of households and therefore still room for high growth rates for subscribers. However, this full penetration of households needs not be an absolute limit, as there are countries such as Denmark, Greece, France, Luxembourg and Sweden where there are more residential phones than the number of households. Figure 2. Telephone penetration rates (lines per 100 inhabitants) in the EU in 1995 Source: ITU 3.2. The mobile network Mobile communications is a new development and has big potential. Between 1989 and 1995 the number of mobile telecommunications subscribers increased at a compound annual growth rate of 42% meaning that by end 1995, there were already more than 19 million mobile subscribers in the EU. As figure 3 shows, the Nordic countries lead the way in terms of mobile penetration, with Sweden (22.9%), Finland (20.4%), and, to a lesser extent, Denmark (11.6%) having more than several times the EU average (5.2). In 1995 more mobile subscribers were added (6.6 million) than fixed mainlines (4 million). In general, one can observe that in most EU-countries, with high fixed network penetration rates and efficient mobile telecommunication provision more mobile customers are added than fixed line customers.

7 Figure 3. Mobile telephones per 100 inhabitants in the EU in 1995 Source: ITU 3.3. Overall assessment and international comparison Telecommunication access paths per 100 inhabitants (i.e. the sum of fixed and mobile phone lines) is a more accurate guide to the ability to access the network. This indicator suggests that the average tele-density in the EU-countries was more than one line for every two people in A comparison with the US situation shows that the EU is still lagging far behind the north Americans, with a telecom access path ratio in 1995 some 15 points below, due to less mainlines per 100 people (48 against 58%) and less mobile connections (5.2 against 9.8%). To the extent that the US shows the way for future development in the EU télécoms sector, one could thus assume that a significant growth potential exists, in terms of the number of customers, both on the fixed and the mobile segments Digitisation The full benefits of the innovations in the communication and information technologies will only accrue if all ways to send, receive and manage information are feasible with a single telecommunication infrastructure. The key condition for these developments, as far as public operators are concerned, is the digitisation of the network. In 1995, basically three fourths of the EU network was digitised. Since the late 1980's a number of EU-countries have boosted their rate of digitisation. In 1995 the EU (weighted) average ratio of digital mainlines was 74 per cent, against 32 per cent in However, there is quite a large heterogeneity in digitisation across countries (Figure 4). France and the Netheriands have been the initial pace setters with digitisation, with the United Kingdom and Sweden closely behind. These countries have already reached full digitisation, or will have done so within next year. All other countries are expected to have a fully digitised network within the year 2000, or shortly afterwards. -6

8 Figure 4. Digitisation rates (% of total lines) of the fixed network in the EU in 1995 Digital technology is spreading as well in mobile telecommunications since its introduction in 1992, accelerating the diffusion of mobile phones. The growth observed on the cellular market is now fully driven by digital technology, and it is expected that this technology will get neariy 70% of the market by 1997, as against 45% in 1995 (see figure 5). The spread of mobile telecommunications was grossly underestimated in the past. Digital technology has dramatically increased the potential of available value added services such as data transmission. Digital technology is, from this point of view, superior to the analogue technology. This explains the accelerated development of the mobile sector over the last three years, which is likely to continue for the next few years. Figure 5. Mobile telecommunication network (analogue and digital) development in the EU

9 3.5. Optical fibre technology Transmission technologies in telecommunications are evolving at a very rapid rate. There is a strong synergy between digital switching and digital transmission. Optical fibre cable, which is ideally suited to digital transmission is now the dominant technology for inter-exchange connections. The penetration of optical fibres in telecommunication cable has been gradual. It began on the trunk interexchange network. In several countries, these lines are now completely dominated by optical fibres. Optical fibre is now beginning to penetrate the local area network particulariy on the primary distribution cables (from the exchange to the primary distribution cabinets). It is expected that, in the future, optical fibre will also enter the secondary distribution channels (from the primary distribution cabinets to the subscribers). As penetration of optical fibres goes down the different layers of the network, demand for optical fibres expressed in fibre-km terms increases exponentially. However as local area costs are largely dominated by the costs of civil works (trenching), the replacement of existing copper cables by optical fibres will only take place when it is economically justified by, for example, the development of a new business area or the upgrading of a cable TV system. 4. Investment trends and outlook Public telecommunications operators in the EU-countries invested an estimated ECU 31 billion in This roughly corresponds, in real terms, to the level observed between 1983 and 1988, but below the average level (see annex table 1). One reason for the investment peak observed in is the very large spending in Germany. After reunification, the country started to expand and upgrade the telecommunications infrastructure in Eastern Germany. Another reason for this period of booming investment is the large expenditure for additional modern (digital) mainlines. About 85 million digital mainlines were added by the 15 EU-countries from 1990 to Some of these lines were for new customers, but most were upgrading the lines of existing customers. The EU-countries upgraded the lines of 53 million existing customers between 1990 and 1995, while some 32 million new customers were connected to the network: for every new customer there were 1.7 digital upgrades for the lines of existing customers. This trend of increasing digitisation accelerated over the period, with a ratio of 1.2 to 1 over and of 2.3 to 1 over This means that investment is increasingly geared towards modernisation rather than expansion. The costs associated with installing a fixed telecommunications network are dominated by the requirement to bury cable in the ground. As a result, the cost for a new digital line is lower when an existing (analogue) line is replaced compared to adding a new connection which involves additional local area network costs. This fact is illustrated by figure 6, which shows the cost for a new digital line against the proportion of replacement in total new lines: there is a trend of the cost to be lower the higher the proportion of replacement of analogue lines. However, some countries exhibit a bias toward higher or lower than expected unit cost per line: Germany and Austria are considerably above average, whereas the United Kingdom is considerably below average. This may well reflect the role that competition between operators and suppliers has played in stimulating cost effectiveness. 8-

10 υ UJ m σ> σ> Ο) ' Ό Ol c h. 0) α *- (Ο ο υ *.«c Ζ» αυυυ 40ÜU Figure 6. Cost of an additional digital line and replacement rate in total new lines (Average ) ^ D Ε ~R ìgressio ti line (Ri <=0.75) BÌ F EU 15 A NL DKBg 0 - ι L 1 UK Proportion of replacement In total new digitai lines.. ^ FI ^ ^ s" ^ % It should be noted that any resource which allows a company to reduce this investment cost (for example, existence of easily accessiblerightsof way, ducts, poles or overhead electricity cables which may make the installation of fibre easier and much less costly) is of strategic relevance when it comes to becoming a new competitor in the market. For this reason utility companies, such as electricity, gas, railways and water, are already involved in the preparation of providing alternative local loop infrastructures. Total investment in telecommunications is increasingly difficult to measure. As the number of players rises along with the erosion of public monopoly position in most countries, the well documented public telecommunications investments represent a declining share of overall investment in telecommunications. Examples of additional investments, include investment in mobile communication, or investment by users in equipment such as facsimile or private branch exchange. This trend is particulariy pronounced in countries where télécoms markets have been fully or partially liberalised such as the United Kingdom, the Netheriands and the Nordic countries. In the United States, where the situation is similar, OECD estimated that investment in public telecommunications in 1992 by local and long distance carriers represented only 60 per cent of overall investment in the telecommunications sector Fixed network In preparation for the 1998 "big bang", the liberalisation of the telecommunications sector, more rapid digitisation is now expected in most EU-countries, even those with a lower penetration rate where expansion of the network was, until recently, the dominant factor. It is likely that by the year 2000 the universal service obligation, i.e. each household is in principle equipped with a telephone, is satisfied. Moreover, most of the countries will also have achieved full digitisation by then. The investment requirements for full digitisation and universal service is estimated at some 85bn ECU until the year 2000, of which 69bn for digitalisation and 16bn for new lines'. For the expenditure in the individual countries see annex table Mobile network Mobile telecommunications have seen a very rapid development in the EU during the last five years. There has been a mix of technological, regulatory and economic factors that have mutually reinforced the diffusion path for mobile telecommunications. In the past, the penetration rate for mobile The underlying assumption is thiat by ttie year 2000 all existing lines should be digitised. Moreover, universal sen/ice entails that each household should tie supplied with a fixed telephone line. For the cost estimate, an average cost of 3000 ECU Is taken for the cost of a new line and 1500 ECU for digitisation of an existing line.

11 telephones has generally been underestimated. As a result of the rapid growth seen over the past two years, simple extrapolations may however induce overestimation of the potential for mobile communications. One can try to model penetration rates with a logistic diffusion function (the "S" curve). In this case the adoption of a mobile phone by the different agents is modelled in a similar way as diseases spread in biology. In other words, the flow of the adopters is related to the stock of existing adopters. At the beginning there is an acceleration in the adoption rate and then a decline once the population approaches saturation point. The penetration rates according to a logistic function for the different EU countries have thus been estimated (see annex table 3). One can notice that there is quite a different starting point between countries. There will also be differences in the year Total penetration rate in the EU is expected to increase from 5.6% in 1995 to 17.2% in This would imply that there are some 44 m new subscribers to mobile telecommunications. Assuming an average investment cost of 700 ECU per subscriber, the cumulative investment cost is 31 bn ECU by the year In a number of countries, investment in the mobile sector would thus be of neariy the same magnitude as the investments for the fixed network. In the case of the UK investment in mobiles could be even higher than for fixed telecommunications. The results should be interpreted with much caution, given the huge degree of uncertainty which surrounds the projections by country of the cellular market, as well as the rough methodology used to estimate the investment cost. In particular for certain small countries (Luxembourg, Greece) the figures projecting investment in the cellular market are likely to be overestimated. However, on a EU global level, these projections seem plausible. They show that the mobile sector has a major investment potential in the near future, not to mention the longer term. 5. Tariffs The market for telecommunications services used to have a highly distorted price system, i.e. tariffs did not reflect the underiying cost of services provided. Typical international and long distance call prices were significantly above cost and local tariffs and rental charges below cost; in other words, the former were cross-subsidising the latter. This system was typically regulated by the government with the aim of ensuring universal service. This was politically appealing because it shifted the financial burden mainly to customers with high willingness to pay (i.e. companies and wealthy persons). However, from an economic point of view, it was inefficient. It became clear that this scenario could not withstand a competitive environment: the competitors would enter the high price/profit services market and push down the prices, therefore local tariffs and rental charges would have to increase to cover costs as the scope for cross-subsidisation would be reduced. A so called tariff re-balancing would therefore set in. This section outlines the evolution of tariffs in the EU and outlines expected effects of competition. 5.1 Fixed network tariffs With the progressive liberalisation of the telecommunications market in the European Union, the analysis of tariff structures and levels is increasingly important in assessing the competitiveness of operators. Inter-country comparisons, which are a key element of such an analysis, are thus undertaken by referring to a basket of services. This is to avoid conditions specific to one country as much as possible. These baskets can determine whether a country's operator is expensive or inexpensive, and to what extent the introduction of competition is likely to lead to an erosion of its market shares. For business users, the Northern European countries, including Denmark, Finland, the Netheriands and Sweden, continue to offer the lowest prices by far, as annex table 4 shows. These countries have recently significantly liberalised their telecommunications market, while on the other hand the most expensive countries for business users, such as Austria, Greece, Italy, Spain, Germany, Ireland and Portugal, have retained monopoly provision of most of the télécoms services: the average annual spending by a business user in Austria is some three times the amount paid in Sweden or in the Netheriands. The tariff basket for residential users reflects a similar ranking of the EU-countries to the business basket. 10

12 The tariff baskets for residential and business users are highly correlated and depend to a large extent on the prevailing market structure. The importance of market structure becomes even stronger when it comes to international tariff comparisons. Countries which have allowed competition in the sector are the least expensive countries for an international basket based on a fixed distribution of calls among adjacent countries and other EU-countries, the USA and Asia. While the OECD generally undertakes tariff comparisons in terms of purchasing power parity (PPP), we have used current exchange rates, which provide more accurate information on the cost to the consumer and is also the reference for competitors such as call-back operators. These call-back services were pioneered in the United States where suppliers took advantage of competitive rates to offer US prices to overseas customers abroad where local carriers charge much higher prices. The trend toward lower international tariffs has thus been further stimulated by call-back operators. For a business traveller or tourist, the exchange rate with their home country is thus a more relevant measure of the cost of an international call than the purchasing power parity of the local currency. Countries like Austria, Italy, Portugal and Spain, with expensive international tariff baskets, appear to be very vulnerable to competition from call-back services. Also, countries with relatively strong currencies such as Germany, the Netheriands and France, appear similariy attractive for call-back customers. On the other hand, countries with relatively inexpensive charges or in some cases weaker currencies, such as Denmark, Greece, Ireland, Sweden and the UK, would seem to be attractive hubbing sites for call-back operators Mobile network tariffs Mobile telecommunication is one of the most dynamic areas of the telecommunications sector and this is amplified by the reduction in prices over the last few years. The cost of handsets has fallen dramatically as a result of technological advances, economies of scale and of very vigorous competition among manufacturers. At the same time, the average cost of joining a mobile network (connection and rental) in the EU area has fallen by more than 30 per cent since In 1996 almost all EU-countries had competitive provision of mobile telecommunications, generally two service providers including the incumbent public operator. Nevertheless, there is still a large disparity of tariffs across countries. Nordic countries such as Sweden, Finland and Denmark have typically much lower tariffs than the other. Lower prices are themselves making mobile services affordable for a greater number of users. At the same time, there is a trend toward the convergence of fixed and mobile network capabilities in the form of cordless and cellular telecommunication. The gap between a basket of fixed and mobile services is narrowing especially in those countries where mobile telecommunications is subject to more competition and is therefore developing fast Leased lines Leased lines allow large users (e.g. business) to take advantage of volume discounts and to have control over their own telecommunication facilities and traffic. At the same time, leased lines provide a platform for competitors to incumbent public operators to offer a range of value added services and complement their own networks. As indicated in annex table 5, the OECD basket of leased line charges shows huge discrepancies among EU countries over different speeds and distances. However, correct comparisons of similar services in regard to leased lines is difficult, mainly because the sources generally fail to specify whether the cost of the end links (sometimes called telecommunication tails) to customer premises are included. In addition, some packages include redundancy in the form of a second line at a lower price or priority service restoration in the event of a network fault as customer options Tariff trends and rebalancing in the EU After the EU-countries decided in the eariy 1990's that télécoms markets should be liberalised in most member states by 1998, a number of remarkable price trends have followed. For instance, the average total cost of a basket of telecommunication services either for a business or a residential user has declined rapidly. Between 1993 and 1995, the average cost in the EU of a basket of telecommunication services for a business user has declined in real terms from ECU to ECU 878, and for a residential user from ECU 378 to ECU 275. Expressed in per cent, the actual decreases were respectively 25.5% and 27.3%. For international calls the reduction was even higher, i.e. 30%. -11

13 However, these gains for the users were not evenly spread throughout the EU. Hereafter we differentiate countries according to the status competition, and we distinguish a group of "competitive" countries with effective competition among operators (i.e. Denmark, Finland, the Netheriands, Sweden and the United Kingdom) and another group of "non-competitive" countries (i.e. the remaining countries of the EU) where competition among operators is weak or non existent. Several key trends emerge: The cost of average baskets decreased in competitive countries by an amount equivalent or greater than the decrease observed in non-competitive markets. This trend affects both the business and residential baskets, in contrast to eariier fears that residential customers could be penalised by the liberalisation of the sector. Moreover, the average tariff level of the baskets in competitive countries remains much lower than in non-competitive countries. This indicates that further drastic price cuts are likely to occur in non-competitive countries. Re-balancing between usage charges and fixed charges is occurring at a much faster rate in competitive countries. In other words, these countries have been lowering the contribution of usage charges relative to fixed charges such as rental and connection fees. While fixed charges are higher on average in competitive countries, usage charges are much lower and are reduced at a faster rate than in non-competitive countries. This suggests that noncompetitive countries are very far from having significantly re-balanced their tariff structures. Concerning the pricing of geographical distance in calls, one can observe that public operators in competitive markets have reduced tariffs at a relatively faster rate than in non-competitive markets, and implementing the greatest reductions (in relative terms) over shorter distances (see figure 7). As a result, the proportion between local and long distance rates is in the order of 1 to 3 in competitive countries, while it is of 1 to around 10 in non-competitive countries: this gives an idea of the order of magnitude for the future price cuts, especially on long distance calls, that one may expect after liberalisation in Figure 7. Tariff structure by distance of calls in competitive and non-competitive countries * IO o> 3 u UJ Local 5 0 km 10 0km 2 5 0km * "Competitive countries": Denmark, Finland, the Netheriands, Sweden and the United Kingdom. "Non-competitive countries": all other EU countries. 6. Regulatory framework In most Western European countries, telecommunications services used to be provided by a single organisation, on a regulated monopoly basis, at least until the late 1980's. In almost every case, the organisations were departments of the public sector administration, providing postal services as well as telecommunications services, where the latter cross-subsidised the former. The argument for monopoly provision of telecommunication services was mainly that of economies of scale due to the high set-up costs of networks, avoidance of duplication of networks, together with the social obligation to provide universal service at the same price throughout the country. 12

14 However, over the last 15 years, advances in technology, which have reduced the cost and increased the functionality of telecom networks and services, and the realisation through experience of liberalised mari^ets that monopoly provision could be an inefficient way to serve users, have called into question the relevance of the prevailing regulatory regime. The experience made with liberalisation of telecommunications in a few countries (such as the US, the UK and Sweden) has demonstrated that competition is feasible and could produce a demand-led and market-driven telecommunications sector. At the same time this would also lead to more innovation in services, a broadening customer choice, an increase in investment and a reduction of costs and prices. These potential benefits led individual governments and the European Commission to initiate wide-ranging reform programmes with the objective of ending the monopoly provision of telecommunications services Community regulations for liberalisation The main direction of EU telecommunications policy was set in 1987 with the publication of the Green Paper on the development of the common market for telecommunications services and equipment. The Commission proposed the introduction of more competition combined with a higher degree of harmonisation, in orderte maximise the opportunities offered by the single EU market. On the basis of the favourable reaction from all market participants to the Green Paper, the Commission prepared an action programme supported by the Council and the other European Institutions. This programme included : Rapid full opening of the technical equipment market to competition; Full mutual recognition of type-approval for technical equipment; Progressive opening of the telecommunications services market to competition; Clear separation of regulatory and operational activities; Establishment of open access conditions to networks and services through the Open Network Provision (ONP) programme; Establishment of the European Telecommunications Standards Institute (ETSI), in order to stimulate European standardisation (which started in 1988); Full application of the Community's competition rules to the telecommunications sector. These actions have subsequently been implemented to a large extent through the adoption of a series of legislative measures, among which are: Open Network Provision Directive of 1990 (90/987): it harmonises the methods and conditions of public access to the network according to the principles of objectivity, transparency and nondiscrimination. Services Directive of 1990 (90/388): it provides for the gradual removal of special and exclusive rights granted by Member states to telecommunication operators for supply of value added (by end 1990) and data services (by ). Public Voice Telephony and Infrastructure Directive of 1996 (96/19); calls on member states to liberalise the provision of public voice telephony services throughout the Union by 1 January 1998, while maintaining universal service. Additional transition periods of up to five years could be granted to Spain, Ireland, Greece and Portugal to allow for necessary adjustments, particulariy of tariffs, and a possible additional period of two years could apply to countries with very small networks (e.g. Luxembourg), if justified. In view of these deadlines, restrictions on the use of alternative infrastructure should be lifted by 1996 and licensing and interconnection rules should be set down by Mobile Communications Directive of 1996 (96/2); it abolishes the special and exclusive rights in mobile communications, which was previously excluded from the Services Directive. It also aims at an eariy liberalisation (by 1997) of infrastructures and the right for mobile operators to directly interconnect. It also explicitly requests Member States not to refuse licences for the operation of alternative DCS 1800 mobile systems Implications for tariffs and universal service The opening up of telecommunications service markets to competition, as well as the regulatory requirements on pricing and the availability of new technologies, requires European operators to undertake major tariff reviews to correct historical imbalances and allow development of new services. In the Communication on tariffs of 1992 (SEC (92) 1050), the Commission set out guidelines for cost orientation and adjustment of pricing structures. This builds on the principles set out in the Open Network Provision Directive, that tariffs should be cost-oriented and that national regulatory authorities should ensure that cost accounting systems are put in place by the operators to provide transparent 13

15 information. In orderte meet the 1998 liberalisation deadline, most Member States have already started to re-balance national tariffs, involving lower prices for international and long-distance calls and consequently higher charges for local calls and basic connections. This tariff re-balancing is as such closely linked to the issue of universal service. The Commission's Communication (COM (93) 543) establishes the key elements of the policy of providing universal service for telecommunication in the Union. This defines the scope of universal service (i.e. a basic voice telephony service and a network access supporting it, as well as fax and low speed data access), the methodology to be followed for costing universal service (i.e. a "net cost" approach), and the possible funding mechanisms to share any identifiable burden associated with the provision of universal service (i.e. compensations may not be required for minimal burden; a national universal service fund may be established; a system of supplementary charges may be requested from market players by the incumbent operator). The document recognises that competition would improve service quality, bring down prices and extend penetration. However, at the same time affordability is essential to ensure that service will be genuinely universal. Flexible and targeted tariffs should play an important role, as concerns affordability for all users. 7. Impact of competition on network operators In the rapidly changing technological and regulatory environment, many opportunities are arising for new and existing companies as well as many threats to existing companies and, for all operators, increased uncertainties and risks. The incumbent operators of fixed telephony networks and services, who until recently felt sure of their continued domination due to the "natural monopoly" in transmission and distribution, have to adapt to the changing environment and the emerging competition. The threat of competition has already started to induce a response in terms of improved quality, business customer focus, new products and efficiency programmes. The mere fact of simply becoming a "contestable" market, even before new competitors have actually started operations, induces the telecommunications sector to register huge efficiency gains and dramatic improvements for the customers in terms of service quality and range of products. The customary design of POTS public investments is challenged by the opening up of the sector. Competition vyill arise not only on the network, but also between communication networks. This is already happening at a large scale in certain countries, such as the UK where cable TV companies are also offering telephone services. A further challenge is mobile communications, whose potential still has to be fully exploited Fixed network operators The incumbent operators are facing a situation where significant tariff reductions on the most profitable segments, international and long-distance, have to accompany increased investments for modernisation and/or upgrading of their networks. At the same time, experience of competition in more advanced countries has shown that an erosion of market shares is unavoidable at least in specific segments. As a result, most European télécoms incumbent operators will sooner or later face a decline in profitability, depending on the time scales of market share losses which may, in some cases, take more than a couple of years. Efficiency gains and overall market growth may also be able to offset part of the loss of revenues, but this is likely to be insufficient. As an example, a simplified model of telecommunications investment shows that under optimistic assumptions (the investment cost per line is ECU , operational costs are 15% of the investment cost, and a payback period of 15 years), break-even at a 10% discount rate would require an average revenue per line of some ECU 400 to 600 in real terms over a 15-year period. This can be compared with the actual range of values of the average revenue per line in the EU : from some ECU 400, in the most liberalised countries, to neariy ECU 1000, the other extreme which could thus be expected to reach the lower figure some years after liberalisation. Against this background it is clear that, unless radical efficiency gains and growth of value added services are achieved, public companies could face financial problems. They therefore have to adopt consistent investment strategies along with new managerial and commercial practices, while they need to accelerate their tariff re-balancing to minimise the impact of competition. 14

16 Liberalisation cannot be considered alone. All operators face challenges in their home markets from a combination of liberalisation, regulation and technology. In liberalised countries, regulators control prices to protect customers from undue price increases. The experience from the UK and Swedish markets shows that a tough regulatory environment for prices had a similar impact on the performance of the incumbent operators than competition, even at a relatively late stage of competitive entry. Price caps2, now in place in almost all EU countries thus constitute an important signal of the speed at which the operators are forced to re-balance their tariffs: this is low in already liberalised countries, where costs are close to tariffs, with a CPI minus 0 to 3% per year up to 1998 in Netheriands, Sweden and Denmark, but as high as CPI minus 5 to 8% in France, Gemriany, Italy or Spain. While price caps are determined domestically, price comparisons with other European countries are becoming an increasingly important factor for service providers. It is worth here insisting again on the difference between competition on the network and competition between networks. With competition on the network the new entrants have to lease transmission capacity from the incumbent. With competition between networi^s, new entrants may choose either to use existing alternative networks, those owned by utilities or cable television companies, or completely new infrastructure construction. In the first case, it is obvious that high rental charges for leased lines will limit the effectiveness of competition in services. It was shown eariier in the less liberalised countries (in particular Austria, Italy, Germany, France and Spain) that the average tariff for a leased line from the incumbent is some 2 to 3 times higher than in the liberalised countries of the EU, and neariy 10 times the corresponding US tariff. Full infrastructure liberalisation, as expected by the Commission, would have a dramatic effect not only on the prices of leased lines, but more importantly would eventually amplify the impact of service competition on the incumbent operators. Last but not least, technology in the form of digital transmission, fibre optics, micro-electronics and wireless telephony, is probably the most effective factor undermining the position of the incumbent monopoly operator. It makes it not only cheaper for new competitors to enter the market, it also reduces the profit margin in liberalised markets. Something similar has happened in the computer industry, where large companies like IBM and Digital Equipment were forced into restructuring as prices fell faster than overheads. To the extent that telecom switches are now simply large computers, they are subject to the same price decline, with eventually similar effects on the télécoms sector. To succeed in liberalised markets, operators have started to adopt strategies aiming at increasing productivity, while expanding domestically and abroad in fast growing segments. Actually, the economic significance of the télécoms industry is increasing rapidly all over the worid: the evidence from already liberalised countries is that the industry is losing its narrow product characteristics of a utility and is becoming a mixed market of consumer and business products open to branding, variety and choice. Stimulated by tariff decreases and opening of the economies, long distance and international traffic in liberalised markets are growing at rates ranging from 10% to 12% per annum. Direct spending on telecommunications has increased from some 2% to more than 3% of GDP. As well as stimulating a wider range of new products and services, competition acts as a very strong incentive to improve service quality. Efficiency improvement is however key in this process, and this requires drastic manpower reductions: most European operators are now implementing labour productivity targets of 350 lines per employee for telephony services, against the current levels of 150 to 250. The important conclusion to draw is that all European operators have room for considerable efficiency gains, implementing the benefit of technology and lower equipment costs. The responses available to the incumbent operators to the threat of competition are a mix of the basic strategies: (i) to become a global service provider, focusing primarily on large and multinational customers to protect the domestic market and grow abroad (e.g. BT); (ii) to expand in multimedia, focusing primarily on residential customers, with a view to developing in cable television and new interactive services (Deutsche Telekom and Teledanmark have particular opportunities given their cable-tv ownership); (iii) to become a developing country operator, taking stakes in Eastern Europe (Telia, Teledanmark, Deutsche Telekom) or Latin America (Telefonica, France Telecom); Price caps formula imposed a celling on the evolution of a télécoms teriff basket, by reference to the Consumer Price Index (CPI), reduced by an efficiency factor of X%, i.e. "CPI minus X%". 15

17 (iv) to establish mobile businesses domestically and abroad, building up a portfolio of stakes in developed and developing countries. All these strategies are expensive, putting pressure on the strong cash-flow generation of existing operators' businesses, not only in the short term but also in the medium term: BT and the Scandinavian télécoms operators are already sustaining start-up losses abroad on an upward trend. These strategies have also resulted in a web of international cross-holdings and alliances. The forces driving companies towards partnerships are the perception that no operator has all the skills in-house to tackle the new market-place; that it is now a necessity to operate on a pan-european level and that risks are better mitigated through diversification Mobile network operators The table below summarises the main competitive features for mobile communications in the EU countries. This shows quite a heterogeneous picture. The number of operators can vary from 1 to 4. However, there is a trend for all countries to increase the number of different operators as the benefits of competition are very clear. The dominant operator is normally the incumbent fixed network operator, as this is generally also the first to have entered the mobile phone market. Mobile network operators in the EU Country Austria Belgium Denmark Finland France Germany Ireland Italy Luxembourg Portugal Spain Sweden UK Operators (Owner) Mobilkom (State) Maxmobil (Deutsche Telecom, Siemens) Belgacom Mobile (Belgacom, Airtouch) Mobistar (France Telecom, Telifa) Teledanmark (State) Sonophon Telecom Finland (State) Radiolinja (Regional telcos) France Telecom Mobile (State) SFR (Générale des Eaux, Vodafone) Bouygues DeTeMobil (Deutsche Telekom) Mannesmann Mobilfunk (Mannesmann, AirTouch) E-Plus (Veba, Thyssen, Bell South, Vodaphone) Telcom Eireann (State) Esat Digiphone (Telenor, Communicor) TIM (STET) Omnitel (Olivetti, Bell Atlantic, AirTouch) Luxmobil (State) TMN (State) Telecel Telefonica (State) Airtel (AirTouch, BT) Telia (State) Comvik (Kinnevik, Millicom) Nordic Tel (AirTouch, Vodafone) Cellnet (BT, Securicor) Mercury (Cabla and Wireless, US West) Vodafone Orange (Hutchinson) Market shares (Dec. 95) 100% 100% 69% 31% 88% 12% 68% 32% 56% 39% 6% 100% 97% 3% 100% 40% 60% 98% 2% 63% 21% 6% 43% 7% 43% 7% Year of competitor's entry end 1996 end

18 Infrastructure costs, which used to constitute the higher percentage of total costs for mobile communication costs, are becoming proportionally much less with the introduction of large up-front licence payments. Operators are also under regulatory pressure to build out rapidly after the high up-front investment of infrastructure purchases. At the same time mobile switches are becoming more 'intelligent' and modular in design and, as a result, contribute to reducing long-term replacement costs, since switches can be upgraded rather than changed out, thus keeping costs to the minimum. Such changes have radically transformed network economics in the mobile industry to the extent that national networks are being built in months rather than decades, offering a level of expansion and interconnection of networks never met before, with phenomenal social and economic implications. The risks of mobile operations depend on the prospect for future growth of the market, and the ability of the company to maintain its projected share. Market growth has, up to now, been systematically underestimated. But one should bear in mind that penetration rates have not reached a level supposed to correspond to a "mass market" size in most countries. This is estimated to be in the order of 10-12%, which corresponds to the 'professional' share of the market. Only in a few countries, notably Sweden, Finland and Denmark, are those rates now significantly above this level. In other words, while the speed at which the market develops may be underestimated, it remains to be seen whether conditions are met in a specific country for the penetration rate to reach the mass market threshold. Given higher and higher up-front fees, this situation is associated with very significant risks for new mobile projects. Licence fees for mobile phones in the EU Country Austria Belgium Spain Greece Italy Ireland GPD /head ($) Mobile phones/ 100 inhabitants Licence fee (m$) Fee/inh. ($)

19 ANNEX TABLE 1 PUBLIC TELECOMMUNICATION INVESTMENT IN THE EUROPEAN UNION (in ECU millions, at constant 1995 prices & exchange rates) Belgium Luxembourg Denmark Germany Greece Spain France Ireland Italy Netheriands Portugal United Kingdom Austria Sweden Finland EU 15 United States n.a. 1994(e) n.a. 1995(p) n.a. Source : OECD, ITU, PTO annual reports & PJ calculations TABLE 2 INVESTMENT ESTIMATES FOR FIXED TELECOMMUNICATIONS IN THE EU lines to be digitised (In m lines) lines for universal service (in m lines) cost for digitalisation (ECU bn) cost for new lines (ECU bn) ^^U Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netheriands Portugal Spain Sweden United kingdom TOTAL EU Source: PJ estimates 18

20 ANNEX TABLE 3 PENETRATION AND INVESTMENT ESTIMATES FOR MOBILE TELECOMMUNICATIONS IN THE EU estimated penetration* (%) new sultscriber (in million) ( ) total cost (ECUbn) ( ) Austria Belgium ÌDenmark Finland France \Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK total EU * using a logistic diffusion function Source: PJ estimates TABLE 4 OECD-PJ BASKET OF TELEPHONE CHARGES, FEBRUARY 1996 (Values express the average annual spending by user, in ECU at current exchange rates) Austria Belgium Denmark Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden UK EU average Fixed charges Business Usage charges user Total Fixed charges Residential Usage charges user Total Fixed charges Weighted Usage charges average Total International Business & Residential