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

26 what are the appropriate tests in the context of retail leased lines which BT must pass in order to demonstrate that prices and profits are not excessive. These are discussed in Annex B. Initial results from this work suggest that prices and profits of private circuits might be excessive, though this conclusion depends on the assumptions made about some of the inputs to the calculation. OFTEL will continue to investigate this issue so it can comment further in its final Statement. Conclusions on the market for retail leased lines 3.29 As a result of the above analysis, OFTEL s effective competition review of retail leased lines has concluded that the market is not effectively competitive. Despite the limited entry that has taken place, BT retains a very high market share, estimated at 83%. New suppliers face significant entry barriers. Price trends appear to show a lack of competitive pressure on prices. BT s return on the sales of retail leased lines is significantly above its cost of capital for regulated services of 12.5 % In light of this effective competition review of retail leased lines, OFTEL has decided that it is not appropriate to change BT s designation as having Significant Market Power (SMP) status for the purposes of the Leased Line Directive which was made in Wholesale markets 3.31 As explained in the November 1999 Statement, focussing purely on retail leased lines does not capture fully the dynamics of competition relating to leased lines. It is necessary to understand the relevant wholesale markets for leased lines. OFTEL believes that these markets correspond to the different components of a leased line. OFTEL has identified two such markets, the market for terminating segments and for trunk segments. These are both inputs into the provision of an end to end retail leased line. Figure 15 illustrates how these different wholesale segments make up an end to end or retail leased line and compares these to the components which BT uses for the purposes of pricing its end to end retail leased line. 22

27 Figure 15: Components of leased lines 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 3.32 OFTEL discussed the relevant wholesale market definitions for leased lines in some detail in its November 1999 Statement. Readers are referred to that statement for a full discussion of market definitions for leased lines. OFTEL continues to believe that its distinction between trunk segments and terminating segments is appropriate. Market for trunk segments 3.33 A trunk segment is capacity between the serving centres for leased lines located at trunk exchanges which are generally at the DMSU level of an operator's network. This is distinct from a main link, which is a connection between the serving centres for leased lines located at local exchanges (see Figure 15 above). Market shares 3.34 Market shares of operators for provision of trunk segments are not available. It is possible to make inferences about these market shares by looking at the market shares of end to end retail leased lines since it is reasonable to assume that operators selling a retail service are likely to use their own trunk networks. As discussed earlier in this chapter, BT has a high market share for retail end to end leased lines. This may imply a high market share in the market for trunk segments. However, OFTEL believes this may not necessarily indicate that BT has a high degree of market power in this market. This is because the reason for BT s relatively high market share in end to end circuits is likely to be due to lack of competition in the market for terminating segments rather than in trunk segments (see next section). Thus it is difficult to deduce accurately from this type of market share information, the extent to which effective competition exists in the provision of trunk segments. Instead the evidence of entry is considered to be more important. 23

28 Entry 3.35 A number of operators other than BT, such as C&W and Energis, have built out national core networks. Furthermore, formerly regional operators, such as MCI WorldCom, Colt, ntl, Norweb, Torch & Thus, are in the process of extending their networks to allow national trunk coverage. Operators who build core networks will potentially be in a position to compete with BT in the provision of trunk segments. Accordingly, competition in the market for trunk segments seems likely to develop in the future. Non-exclusive use of trunk networks 3.36 It appears that those operators investing in the core networks are not likely to exploit their trunk networks on an exclusive basis. The main reason for this is that given the large fixed costs of building a core network, operators need to ensure that these new assets are exploited efficiently. The possibility that no new infrastructure based operator will be able fill up its network fast enough by relying solely upon its own retail activities suggests that there is a good prospect of new carriers offering wholesale trunk transmission facilities to other carriers. This trend has already begun on a pan-european basis 3 and there is the possibility of it developing in the UK. If this trend does develop it should facilitate entry into the provision of national retail leased lines since it will allow entry by operators who have not built a trunk network. Conclusions on the market for terminating segments 3.37 As a result of the analysis set out above, OFTEL s effective competition review for the market for trunk segments has concluded that market is not yet effectively competitive. However, OFTEL believes that, given the entry which has occurred and the prospects of further entry, effective competition is in prospect for the market for trunk segments. Market for terminating segments 3.38 The second relevant wholesale market is that for terminating segments. A terminating segment is capacity between a customer s premises and the point of interconnection (POI) between BT and an OLO s network. To date, most OLOs POIs are located at the DMSU level. Therefore for the purposes of this chapter a terminating segment is understood to be capacity between a customer s premises, through a serving local BT exchange to a point of interconnection at any of BT s DMSU centres used for routing leased lines to that serving exchange. It should be noted that this is wider than the definition of a local end, which extends only as far as the local exchange level. Market definition 3.39 In the November 1999 Statement, OFTEL analysed relevant markets and suggested that a national market existed for terminating segments (with the possible exception of the Central London Zone (CLZ)). OFTEL also suggested that there was a possibility of defining separate markets for terminating segments based on high and low capacity since, in the past, the presence of high bandwidth suppliers had not appeared to effectively constrain the prices that BT was able to charge at lower bandwidths. However, OFTEL now believes that is 3 MCI WorldCom and Hermes have offered services on this basis. 24

29 appropriate to reconsider its view of the market definition for terminating segments in relation to bandwidth OFTEL is of the opinion that the distinction between markets for high and low capacity terminating segments may not be appropriate. This is because supply side substitution between suppliers of high and low capacity terminating segments seems likely to occur. If an operator is supplying a high capacity terminating segment it is likely to switch into the provision of a low capacity terminating segment in response to a small but significant increase in price and vice a versa. The reason for this is that most of the costs of providing terminating segments are not dependent on the bandwidth provided and therefore the costs of switching from high to low or low to high are small The analysis above considers the extent of substitutability in a situation where the supplier is already supplying a terminating segment to a customer s premises. However, there is another set of circumstances which also appears to be relevant. This is where a supplier has entered the market for the provision of terminating segments in the sense that it has extended its network beyond the DMSU level towards the customer. In this situation the relevant question is whether such a supplier would be as likely to supply a high bandwidth as low bandwidth terminating segments to connect a particular customer to its network. There is some evidence that suggests the supplier would not be indifferent between high and low bandwidth. For example in CLZ OLOs appear not to have provided sub 2 Mbit/s terminating segments notwithstanding the existence of access networks. This suggests that OLOs may face additional entry barriers to offering low bandwidth terminating segments to those face when offering high bandwidth terminating segments. If this is the case it provides some justification for identifying separate markets for high and low bandwidth terminating segments. OFTEL is seeking more information on this issue (see questions at the end of this chapter) However, distinguishing between markets for high and low bandwidth terminating segments creates the difficulty of deciding the bandwidth at which it is appropriate to make the distinction. This difficulty arises in part because when an OLO decides whether to build a particular terminating segment at a particular bandwidth the outcome will not depend solely on the specific bandwidth required by the customer in that case. Rather the decision will depend on the circumstances of the customer, in particular the total number of circuits and the other services which that customer requires or is likely to require in the future. Given the difficulties with identifying the appropriate bandwidth to make a distinction, OFTEL believes that it may be misleading to identify the bandwidth at which high and low capacity services may be distinguished. However, OFTEL has considered whether its conclusions would be different if separate national markets for high and low bandwidth terminating segments were identified and believes that this is unlikely On balance, therefore OFTEL has decided it is appropriate to identify one market for terminating segments at all bandwidths for the purpose of the effective competition review in this consultation document The other issue requiring consideration in the market definition for terminating segments is the geographic dimension. OFTEL believes that the main factor which will determine whether or not entry will occur for the provision of terminating segments is the traffic density in the local area. Therefore entry into the market for terminating segments is more likely in those geographical areas where traffic volumes are sufficiently high to justify the large sunk 25

30 costs involved. Thus competitive pressure may vary depending on the geographical area. However, to an extent, BT s nationally averaged prices suggest that competitive conditions in one area indirectly affect the prices in another area. Thus, a chain of substitution argument might suggest that a national market is likely to exist. For the purposes of this effective competition review, OFTEL has focussed on a national market for terminating segments while recognising, in the context of the discussion, that smaller geographical markets, such as CLZ, may exist. In the future, if geographic de-averaging occurs, it is likely that the relevant geographic markets may be smaller local markets. Market shares 3.45 OFTEL does not have any direct information on operators market shares in the market for terminating segments as many operators have been unable to provide OFTEL with this information. However, OFTEL does have information available which allows market share information to be inferred for the market for terminating segments. This can be done in two ways: firstly by looking at market shares in relation to access networks and secondly by considering market shares in relation to end to end retail leased lines The number of suppliers providing terminating segments depends partly on the extent to which operators have access networks. Table 4 shows the main operators who have access networks and are therefore in a position to compete in the market for terminating segments. Table 4: Operators share of number of exchange lines, June 1999 Operator Market share BT 85.2% Kingston 0.6% C & W 4.6% Cable 9.0% Others 0.6% Source: OFTEL Market Information 3.47 As can be seen, BT is the main operator having approximately 85% of all exchange lines. Some operators also have access networks but the extent of their networks is considerably smaller than that of BT s. Moreover, it is likely that cable networks are in largely residential areas so the extent to which they are likely to be in a position to provide leased line terminating segments connecting to business customers may be low. Regional operators, such as Torch, Norweb and Thus, may also compete in the supply of terminating segments in their respective geographical areas. Overall, BT s market share of exhange lines suggests that BT has a high market share for terminating segments This finding is supported by the market shares which can be inferred from data for end to end retail leased lines. BT s share for all retail leased lines in the UK is estimated to be 83% (based on 1998/9 data). This is clearly a very substantial share and furthermore BT s share of terminating segments will be in excess of this level since OLOs may currently purchase retail leased lines from BT to use as a terminating segments in order to provide their own end to end leased line. 26

31 3.49 As discussed above, OFTEL believes that competition in the provision of terminating segments is likely to vary between geographic areas of different density. Unfortunately, market share data is not available for terminating segments on separate geographic areas. However, on the basis of information available for retail leased lines, OFTEL has estimated market shares of terminating segments within CLZ and non-clz areas. This suggests BT s market share in both cases is substantial, outside CLZ it is estimated to be in excess of 86% and within CLZ it is estimated to be in excess of 74% Therefore, the market share evidence available suggests that BT has a very high market share in the national market for terminating segments. Entry barriers 3.51 OFTEL has also considered the entry barriers relating to the market for terminating segments in order to assess the state of competition OFTEL believes that strategic entry barriers exist. These result from the strategic advantages which incumbent operators possess. Such advantages derive from the asymmetry of timing between incumbent and new entrants. Strategic advantages crucially depend on the existence of sunk costs. The way in which these strategic (or first mover) advantages arises is explained below If operators decide to build terminating segments, they incur high sunk costs. Sunk costs include costs of digging and ducting fibre/copper wire from a customer s premise to the operator s trunk network. Costs are sunk because they are unrecoverable if the operator were to exit the market. OLOs are deterred from entering the market because they face a significant risk in not being able to recover their fixed costs of entry. This is primarily because of the strategic advantages enjoyed by BT but these are also reinforced by the behaviour of other OLOs and BT s economies of scale and scope BT has already incurred the sunk costs of entering the market. Therefore, whatever the pre-entry price set by BT, what matters for the profitability of entry is the price that would arise from competition between firms post-entry. If the expected post-entry price is such that the entrants post-entry profits fail to recover the fixed costs of entry and if the entrant foresees this, then entry will not take place. Accordingly, the threat that BT would reduce prices post-entry deters OLOs from entering the market for terminating segments This strategic barrier is reinforced for any particular OLO by the fact that other firms may be preparing to enter at the same time. This creates an increased risk of excess capacity post-entry and so a low post-entry price thus further deterring entry In addition BT s economies of scale and scope and which are not available to the entrant, may reinforce its strategic advantage. The economies of scale and scope are, in part, due to the ubiquity of BT s network and legacy effects derived from its former monopoly status. The effect of these is to lower the marginal costs faced by BT. From the point of view of a potential entrant, it is less profitable to compete with an incumbent firm who has a lower rather than higher marginal cost level, because the incumbent will compete more aggressively the lower its marginal costs. Thus, the economies of scale and scope mean that the risk of not recovering fixed costs of entry is greater and the strategic entry barrier is more effective. 27

32 3.57 The risk of non-recovery of fixed costs of entry could theoretically be reduced either through high up-front charges, so that they are recovered early in the contract, or by commitment to long term contracts, so that they can be recovered over a longer period of time. OLOs have suggested that neither of these options is feasible given customers preferences Given the importance of sunk costs for the analysis of effective competition, OFTEL is seeking further information from OLOs relating to entry barriers. The information requested is set out in Annex C In some geographical areas such as the CLZ, the barriers to entry have not been sufficient to deter the build out of terminating segments by OLOs. OFTEL considers that there are two key reasons why entry has occurred in the terminating segment in high-density geographical areas. Firstly, the extent to which costs are likely to be sunk are lower. This is because the greater density of potential customers increases the likelihood of being able to recover the fixed costs of entry through deploying resources to supply other services. Secondly, in higher density areas, geographically averaged pricing by BT will lead to prices being greater than the actual long run incremental cost (LRIC) for that area, due to the lower than average costs associated with higher density areas. This means that whilst BT continues to price on a geographically averaged basis, the LRIC that BT can price down to in that area, if entry were to occur, is higher than the LRIC faced by an entrant who has either entered only that specific geographic area or one who prices on a de-averaged basis. In other words, BT s strategic advantage in having sunk costs before the entrant is mitigated by the impact of BT s geographically averaged pricing structure coupled with geographic variation in the costs of provision Where the barriers to entry have not been sufficiently high to deter entry completely, it does appear that OLOs have been able to compete more effectively with BT in the retail market. Taking CLZ as an example of an area which has seen perhaps the most building of networks to provide terminating segments, Figure 16 shows that changes in the wholesale market have had a significant impact on OLO s ability to build a customer base for retail leased lines. OLOs appear not to have provided lower bandwidth services to the same extent as higher bandwidth services in CLZ. OFTEL finds this result somewhat puzzling, as it is not immediately clear why lower bandwidths are not supplied where access networks exist. This is an important question for the consultation (see questions at the end of this chapter). 28

33 Figure 16: Shares of retail leased lines market segment in CLZ by bandwidth, 1998/9 CLZ Digital >2Mbits CLZ Digital 2Mbits CLZ Digital <2Mbits 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Source: Data from Operators and OFTEL estimates Future developments BT C&W Other 3.61 Over the next few years, the opportunity to collect traffic from unbundled local loops and the availability of wholesale unmetered internet access products at BT s local exchanges might make it viable for OLOs to build out networks, from the DMSU level at which OLOs networks are currently built, to the local exchange. However, OLOs have told OFTEL that this will take some considerable time and will be limited to those geographical areas where the volume of traffic makes it economical to do so. Therefore OFTEL believes that entry at this level will primarily be restricted to large metropolitan areas, such as CLZ. Significant build of access network, ie from customers to the local exchange, is not anticipated due to the likelihood of relatively low traffic volumes on these routes There is prospect in the future that Broadband Wireless Access (the Government intends to auction spectrum for BWA later this year) may reduce some of the barriers to entry (high sunk costs of digging and ducting) for the provision of terminating segments. However, BWA operators will still incur high fixed costs such as the supply of wireless customer premises equipment and the installation of base stations. This means that entry into the market for the provision of terminating segments by BWA operators is also likely to depend on traffic density and is therefore also likely to be concentrated around metropolitan areas OFTEL s conclusion is that there are high barriers to entry in respect of the market for terminating segments. These are particularly high in the segment from the customer s premises to the local exchange, but also significant in the local exchange to DMSU segment. The presence of these barriers is likely to restrict entry into the market for terminating segments for the foreseeable future. 29

34 Reliance on BT s network and BT s prices 3.64 As a result of the high entry barriers described above, OLOs may choose to purchase a terminating segment rather than self provide the segment. In such a case, they can choose to buy it from BT or from operators who have access networks. Since access networks of these operators are limited in geographical coverage and do not cover the whole of the UK, OLOs will, in many cases, be reliant on BT for the provision of terminating segments OFTEL has attempted to collect information from OLOs about the extent of this reliance on BT for terminating segments. Unfortunately data available on this is not comprehensive, however the available data suggests that many operators are reliant on BT particularly outside high-density areas and at low bandwidths. OFTEL is requesting further information from OLOs on the extent of their reliance on BT and further data should be available for the final Statement which is due to be published later this year. This information request is contained in Annex C Even in areas where OLOs may have a choice of operators and where the other operators may be more efficient than BT, OLOs may still have an incentive to purchase from BT. This appears to be due to the incentive to benefit from BT s national volume discounts in the same way as was discussed above in relation to the retail market From the information currently available, OFTEL believes that OLOs are in many cases reliant on BT to provide terminating segments. However, with one exception (see below), OLOs are not able to purchase a terminating segment from BT. Instead OLOs must purchase an end to end circuit for which BT charges a retail price. Given that in most cases, in providing a wholesale service to an OLO, BT will be likely to incur lower costs than when it provides a leased line to a retail customer, it can be argued that BT s charges to OLOs are likely to be high BT does offer OLOs a 2Mbit/s Partial Private Circuits (PPC). This is available only at 2Mbit/s. BT sells PPCs at adjusted retail prices ie retail prices adjusted to reflect the fact that BT is selling only one local end and part of a main link rather than an end to end leased line. However, because retail prices may be higher than competitive levels, adjusted retail prices for PPCs are likely to be higher than what would have been charged in a competitive market BT has not sold very many PPCs to OLOs. OFTEL understands that the main reason for this is that BT s volume and term discounts for retail leased lines are more favourable than for PPCs. As a result it is cheaper for OLOs to purchase an end to end leased rather than a PPC. OLOs have also told OFTEL that they are experiencing difficulties negotiating suitable migration arrangements from existing term and volume contracts with BT to allow them to take advantage of the PPC service. BT s price discrimination 3.70 As discussed above, BT currently provides OLOs with terminating segments, either in the form of end to end leased lines or, at 2Mbit/s, as a PPC, at retail rather than wholesale prices. However, the transfer charge for terminating segments which BT charges its own retail business selling end to end leased lines is an appropriate wholesale price. This 30

35 discriminatory pricing is likely to have had an adverse impact on the retail prices that OLOs can charge for end to end leased lines and so limit their ability to compete with BT in the retail leased lines market. Profitability 3.71 If an OLO wants to purchase a terminating segment, the only service on offer from BT is an end to end leased line, at retail prices. Thus OLOs may pay for more than they actually use or more than they require. In these circumstances, BT will, either not incur the costs relating to the provision of the network components comprising the second local end, or it will incur such costs unnecessarily. Therefore, in OFTEL s view, BT is likely to receive a larger margin on such sales and hence its return on capital employed (ROCE) for the provision of terminating segments can be considered to be higher than that for retail leased lines discussed earlier in paragraphs This finding supports OFTEL s finding that there are competitive concerns within the market for terminating segments. Conclusions on the market for terminating segments 3.72 OFTEL believes that competition is not effective in the provision of terminating segments. Furthermore, it appears that that competition is not likely to become effective in the foreseeable future Oftel considers that BT is dominant in the provision of terminating segments. BT s inferred market shares are high. The market is characterised by significant sunk costs such that entrants face high barriers to entry. Entry has occurred in limited areas. However, it is not anticipated that entry will occur on a sufficient scale in the near future to make the market effectively competitive. It also appears that there is scope for reductions in the price for terminating segments as a whole. OFTEL believes that, even if there are separate markets for high and low bandwidth terminating segments, these conclusions would be valid in relation to these separate national markets As explained in chapter 1, wholesale leased lines are an input into a number of services other than retail leased lines. Accordingly, there are other services which are likely to be affected by the lack of effective competition in the market for terminating segments. In particular there appear to be some other retail services where terminating segments are a very significant input to the final retail service. Such services include the provision of fixed link internet access, frame relay services and ATM services. OFTEL has received complaints relating to BT s behaviour in respect of those services, which are currently being considered. Implications of the effective competition review 3.75 In the current price control OFTEL relaxed retail price controls on leased lines expecting that competition would develop. Digital circuits above 64 kbit/s were removed from the retail price control and a simple safeguard cap was placed on analogue and digital circuits up to 64 kbit/s However competition has not developed to the extent anticipated. As discussed above, OFTEL s effective competition review for retail leased lines has concluded that the market segment is not effectively competitive. Despite the limited entry that has taken place, BT retains a very high market share, estimated at 83%. New suppliers face significant entry 31

36 barriers. Price trends appear to show a lack of competitive pressure on prices. BT s return on the sales of retail leased lines is significantly above its cost of capital for regulated services of 12.5 % OFTEL believes that it is very unlikely that effective competition in the provision of retail leased lines will develop if the barriers to competition which it has identified are not addressed. As explained in the previous sections, OFTEL believes that main barrier to competition is at the wholesale level and relates to the market for the provision of terminating segments The next chapter sets out the policy options OFTEL is considering. 32

37 Questions Chapter 3, question 1 Do you agree with OFTEL s view that retail leased lines are a separate economic market? Please provide information on both demand and supply side subsitutability in your answer, with data where possible. Chapter 3, question 2 Do you agree with OFTEL s assessment that the retail leased lines market is not currently effectively competitive? If possible, please supply data that supports your answer. Chapter 3, question 3 Do you agree with OFTEL s conclusion that the market for retail leased lines will not become effectively competitive unless the competition problems relating to wholesale terminating segments are addressed? If possible, please supply data that supports your answer. Chapter 3, question 4 Do you agree with OFTEL s market definitions relating to wholesale leased lines? (a) Do you believe that there is one wholesale market for terminating segments at all bandwidths? If not, please set out what markets exist at various bandwidths and why these bandwidths form separate markets. (b) Do you believe that there is one national geographic market for wholesale terminating segments or separate geographic markets? If you consider there are separate geographic markets, please set out reasons for your views and where you consider these geographic markets are located. Chapter 3, question 5 (a) Please explain why consumers purchase retail leased lines from BT in areas they have a choice of operator. Does BT s volume discount scheme provide incentives to purchase from BT instead of an another operator? If so, please provide any examples where BT s volume discount scheme may have, to some extent, influenced your choice of operator. (b) Please explain why OLOs may purchase terminating segments from BT in areas where they have a choice of operator. Does BT s volume discount scheme provide incentives for OLOs to purchase from BT instead from other OLO? If so, please provide examples. 33

38 Chapter 3, question 6 Please explain, why in areas where OLOs have entered the terminating segment market ie they have built out access networks, they do not provide analogue and kilostream retail leased lines to the same extent as higher bandwidth leased lines. Chapter 3, question 7 Do you agree with OFTEL s assessment that the market for terminating segments is not effectively competitive? If possible, supply data that supports your answer. In particular, OLOs are requested to supply data about the extent to which they rely on BT for the provision of terminating segments and to complete the questionnaire set out in Annex C. Chapter 3, question 8 Do you agree with OFTEL s assessment that there is the prospect of an effectively competitive wholesale market for the provision of trunk segments? If possible, supply data that supports your answer. In particular, OLOs are requested to supply data about the extent of their trunk networks, including information on the number and geographic distribution of points of interconnection which operators have with BT, and to what extent they are currently able to self-provide trunk segments or buy national long distance at competitive prices. 34

39 Chapter 4 Policy Options 4.1 This chapter discusses the policy options which OFTEL is considering in the light of the conclusions from the effective competition review as set out in chapter 3 Wholesale Policy Options Legal Framework 4.2 OFTEL considers that terminating segments are interconnection services covered by Article 4(1) of the Interconnection Directive 4 (The ICD). As a result, Annex II ICD operators have certain rights and obligations to negotiate interconnection for terminating segments. Fixed network operators that have been designated as having Significant Market Power (SMP) for the purposes of the ICD, such as BT, have additional obligations, for example they must supply interconnection services on non-discriminatory terms and at cost-orientated prices. Annex D sets out in more detail OFTEL s view on terminating segments and the ICD, and the additional obligations imposed on SMP operators. Option The first policy option, which OFTEL is considering, is to leave the provision of appropriate terminating segment services to be commercially negotiated within the framework provided by the rights and obligations set out in the ICD. Under BT's licence (Condition 45.1), BT has the obligation to offer to enter into an interconnection agreement for terminating segments within a reasonable period. Any terminating segment services which BT provides would have to be provided on non-discriminatory terms and conditions and at cost orientated prices. If commercial negotiations result in a failure to agree the terms and conditions under which terminating segments should be provided, an Annex II operator has the right to ask the Director General to resolve that dispute under Article 9(5) of the ICD. If the Director General was asked to settle such a dispute, he may do so by considering similar factors to those considered in this Consultation Document, including the interests of the user and the promotion of competition and the other criteria set out in Article 9(5) of the ICD. 4.4 It is not possible to discuss in detail what would be the likely outcomes of this policy option. This is because these would depend on the particular outcome of the commercial negotiations and also possibly the results of the resolution of a particular dispute(s). However, as explained above, given that the negotiations and the resolution of any dispute would take place within the framework provided by the ICD, it seems likely that the possible outcomes would probably be similar to those set out below in paragraphs The advantage of this policy option is that operators not OFTEL would specify the appropriate services to be provided. There are also disadvantages, however. It is not clear that commercial negotiation in this context is likely to lead to quick and adequate resolution of the significant competition concerns identified in chapter 3. If OFTEL were to leave the provision of terminating segments to commercial negotiation, with the possibility of 4 The Interconnection Directive: European Parliament and Council Directive 97/33/EC 35

40 subsequent intervention if the operators failed to reach an agreement, it is likely that this would lead to delay in addressing the competition problems identified. Option The second option, which OFTEL is considering, is to require, on its own initiative, BT to provide operators with Annex II status with appropriate wholesale terminating segment services at all bandwidths. Such services would be provided under the ICD and so would be provided on non-discriminatory terms, both in terms of price and quality of service, and at cost-orientated prices. Terminating Segment Services 4.7 Under Option 2 the services which BT would be required to offer are terminating segment services at all bandwidths. These are envisaged as being along the lines of the existing PPC, currently only available at 2Mbit/s. However, OFTEL recognises that if, in the future, OLOs roll out their networks to interconnect at BT s local exchange buildings then OLOs may wish to pick up terminating segments at Points of Interconnection at BT s local exchanges. 4.8 OFTEL is now formally consulting on the proposal that BT should provide two wholesale terminating segment services at all bandwidths on non-discriminatory terms and at costorientated prices: Service A: Capacity between a customer s premises, through a serving local BT exchange to an OLO s Point of Interconnection at any of BT s DMSUs centres used for routing leased lines to that serving exchange; and Service B: Capacity between a customer s premises and an OLO s Point of Interconnection at BT s serving exchange. 4.9 Figure 17 below depicts both of these services. Service A consists of the same network components as a local end and part of a main link to the DMSU. It is anticipated that the form of Service A will effectively be Service B plus an appropriate bandwidth link from the local exchange to the DMSU which will allow OLOs to aggregate traffic from more than one customer served by a local exchange in a single higher bandwith link to the DMSU POI. See Annex E for technical details of the two proposed services. 36

41 Figure 17: Proposed wholesale terminating segment services from customer s premise to OLO s Point of Interconnection Customer Serving centre forllatthe RCU/DLE BT s network Serving centre forllatthe DMSU PoI PoI OLO s network Potential Outcomes Increased competition in retail leased lines 4.10 As explained above, Option 2 would require BT to offer wholesale terminating segment services and do so on non-discriminatory terms at cost-orientated prices. OFTEL believes that this option should increase competition in the provision of retail leased lines by enabling OLOs to compete on fair terms with BT in the provision of end to end services. This should reduce BT s ability to leverage its dominance from terminating segments into retail leased lines. However, the benefits for customers in the form of lower retail prices which should arise from Option 2 may be restricted by BT s ability to set wholesale prices for wholesale terminating segment services in such a way that current retail prices may not fall substantially. Reduced barriers to switching 4.11 Option 2 would also have a pro-competitive impact by reducing some of the barriers to consumers switching. It will require BT to offer the wholesale services throughout the whole of the UK and thereby remove BT s ability to use its geographic coverage as a barrier to prevent consumers from switching to another supplier. In addition the non-discrimination obligation will not just apply to price but also to quality of service issues and lead times in originating service. BT will not be able to offer itself better terms in respect of these nonprice terms than it gives OLOs. 37

42 Migration 4.12 As discussed in chapter 3, OLOs cannot buy wholesale terminating segment services at all bandwidths at the moment. Therefore OLOs purchase end to end leased lines at retail prices. This has two important consequences. Firstly, not all end to end leased lines that are purchased to provide the connection between an OLO s trunk network and a customer s premises are purchased such that they terminate at a point of interconnection between the OLO s network and BT s. Rather some will terminate at a point on the OLO s network which is not a point of interconnection with BT. Secondly, OLOs will have existing contractual commitments relating to their purchases of leased lines. OFTEL is aware that in order for OLOs to begin to purchase Services A and B set out above they may need to make technical and commercial alterations to the way they currently purchase leased lines. If there are significant barriers to OLOs being able to make these alterations and so migrate to the new services this is likely to impact on when and the extent to which Option 2 will have the procompetitive consequences set out above. As part of this consultation OFTEL is therefore seeking information and the views of OLOs on this issue (see Questions at the end of the chapter). Potential for margin squeeze 4.13 Option 2 should prevent BT imposing a margin squeeze on competitors through discriminatory pricing in its charges for terminating segments. However, since BT is dominant in terminating segments and vertically integrated into the provision of retail leased lines, it has the scope to impose a margin squeeze on its competitors notwithstanding the nondiscrimination rules. The margin squeeze could be caused by BT raising the price for wholesale terminating segment services while reducing its price for retail leased lines. BT would be able to use profits it would make in the sale of terminating segments to subsidise its losses on retail leased lines. While this outcome is possible, OFTEL believes that it would be able to control any such anti-competitive behaviour either using its powers under the Competition Act 1998 or through the enforcement of licence conditions. Impact for retail services other than leased lines 4.14 As explained in chapter 1, wholesale leased lines and therefore terminating segments are an input into a number of retail services other than retail leased lines. Therefore Option 2 will impact on other retail services, particularly where terminating segments are a significant cost input notably retail leased lines and some other data services. OFTEL is currently investigating margin squeeze complaints in relation to a number of these services. It appears that a number of the concerns raised by complainants in these complaints would be resolved if Option 2 were implemented. Implementation 4.15 As explained in full in Annex D, it is OFTEL s view that the wholesale terminating segment services A and B are covered by the ICD and accordingly BT could be required by the Director General to provide these services. Therefore, if it was decided that Option 2 should be implemented, it is anticipated this would be done by means of a direction under the ICD. Such a direction would specify that these services are included in BT s Reference Interconnection Offer. The direction would specify an appropriate timescale by which BT would have to publish prices and other details regarding the services and be in a position to 38

43 provide the services. If subsequent disputes between operators in relation to the provision of these services occured then operators would have the right ask for the disputes to be resolved under the ICD Option Under Option 3 OFTEL is considering regulating BT s prices for wholesale terminating segment services. Therefore Option 3 can be summarised as Option 2 plus price control. BT would be required to offer wholesale terminating segment services, at all bandwidths, to other Annex II operators on non-discriminatory terms at cost orientated prices which are subject to price regulation. The price regulation would involve setting the initial prices for the services for the first year and then construction of an appropriate network charge control to regulate the prices for next 4 years. Is Price Regulation Appropriate? 4.17 OFTEL believes that there are two main issues which need to be considered in deciding whether price regulation of wholesale terminating segment services is appropriate The first issue concerns BT s current pricing behaviour and to what extent its current prices are excessive such that it is making supernormal profits. If BT s prices were excessive this would provide a stronger justification for imposing price regulation. Since the wholesale terminating segment services are not currently available it is not possible to examine the position in relation to the service which is to be regulated. Therefore, it is relevant to consider the extent to which supernormal profits are being made by BT on its sales of retail leased lines. As explained in chapter 3 and in Annex B, initial results suggest that BT may not pass all the appropriate tests for excessive profitability but further work is necessary The second issue relates cost efficiency. One of the main advantages of imposing price regulation in this context is that it would provide an incentive for BT to make cost efficiencies in relation to the provision of terminating segments. In a competitive market, firms have strong incentives to control and reduce costs. However in the case of a firm with market power it is possible that the firm will make fewer cost efficiencies due to the reduced pressure to seek cost savings. As explained in chapter 3, OFTEL believes that BT is dominant in the market for terminating segments and therefore it will not have these incentives to reduce costs and these cost inefficiencies would be likely feed into higher retail prices. However, if price cap regulation is introduced this will provide incentives for BT to make cost efficiency gains and thereby reduce retail prices from what they might have been if only Option 3 were implemented. Form of Price Regulation 4.20 OFTEL has considered, if it were to price regulate, what would be the form of the price regulation. A detailed discussion of these issues is set out in Annex G. Briefly, OFTEL is proposing that prices would be regulated on a LRIC plus a mark up (to allow the recovery of common costs) basis. OFTEL is also proposing that it would place one overall control on BT s prices for wholesale terminating segment services and not regulate individual prices at each bandwidth. BT s prices would be set on a geographically averaged basis but BT would be allowed to offer discounts from the averaged price in certain areas where it faced lower costs or more competition. These discounts would not, however, contribute to BT s 39

44 obligation to meet the overall price control. Thus, while BT would be able to lower its charges for wholesale terminating segment services in one geographical area, such as CLZ, it would not be able to raise prices in other geographic areas. Therefore, consumers in noncompetitive areas will be protected from higher retail prices resulting from higher terminating segment prices. Potential Outcomes 4.21 The potential outcomes arising from Option 3 will be those that have been discussed above in relation to Option 2, but with some important differences. In addition, two other possible impacts are also considered below. Alterations to Option 2 outcomes 4.22 One of the outcomes discussed above is increased competition in retail leased lines which should result in lower retail prices. Under Option 3 it is more certain that this outcome will occur and it is likely that price reductions will be greater than under Option 2. OFTEL will set the overall price level for wholesale terminating segment services by determining the amount of common costs between these services and other network services (such as PSTN and other data services) which BT is able to recover from wholesale terminating segment services. However, under Option 2 BT will be able to determine the amount of common costs to be recovered from wholesale terminating segment services (within constraints imposed by its licence and the CA), and it may choose to recover a greater amount of common costs than OFTEL would allow under Option 3. If this is the case, higher prices for wholesale terminating segment services will result under Option 2 than under Option 3 and therefore retail prices under Option 2 are likely to be higher than Option Inaddition, if Option 3 were implemented the scope for BT to conduct the margin squeeze discussed above would be reduced. The margin squeeze concerned would be caused by BT raising the price for wholesale terminating segment services while reducing its price for retail leased lines. However, under Option 3 BT s ability to raise the price of wholesale terminating segment services would be subject to a greater constraint than under Option 2 and therefore it is less likely that BT would be able to impose the margin squeeze. Cost efficiencies 4.24 It is anticipated that the wholesale price cap for terminating segments will provide BT with an incentive to make cost efficiency gains. Under Option 2 it is unlikely that this outcome will occur. This means that Option 3 is likely to result in lower retail prices than under Option 2. Rebalancing 4.25 OFTEL has considered whether, if it were to regulate BT s prices for wholesale terminating segement services, BT would have to rebalance its local end and main link retail prices. There are two types of rebalancing which are potentially of concern. The first relates to rebalancing between local end and main link prices and the other relates to rebalancing of 40

45 local end prices between different bandwidths. In relation to the first type of rebalancing, it appears that BT s overall returns on local ends cover both LRIC and a markup for common costs and also a reasonable return on capital and therefore it appears that rebalancing between main links and local ends is unlikely The second type of rebalancing is an alteration in relative prices of local ends at different bandwidths. OFTEL believes that, if the form of price cap explained above were adopted, such rebalancing will not be required. However, it does appear on the basis of cost information from the top down cost model that BT may choose to make adjustments to ensure that prices at individual bandwidth better reflect cost. In particular BT may increase the price of 2 Mbit/s local ends and reduce the price of kilostream local ends. If this occurred its effect would be that 2 Mbit/s own exchange circuits and short distance circuits may increase in price, while kilostream own exchange circuits and short distance circuits may fall. If a different form of price cap were adopted, where different bandwidths were subject to separate price caps, then this type of rebalancing may be required by the structure of the price cap. This issue is discussed further in Annex G. Implementation 4.27 If OFTEL were to implement Option 3, it is anticipated that it would set the initial wholesale pricing rules for wholesale terminating segment services which would apply until October 2001 and thereafter an appropriate network charge control would come into effect. To the extent that this price regulation can be satisfactorily implemented by way of a direction under the ICD, rather than by a specific licence condition, the Director General may pursue this route. Alternatively, the price regulation would be implemented as part of any licence modification required to implement the future PSTN charge controls according to the procedure as set out in section 12 of the Telecommunications Act 1984 (TAct). Retail Policy Options Option OFTEL has considered whether it is appropriate to introduce retail price controls on BT s retail prices for all retail leased lines In principle, this could be regarded as the appropriate response to OFTEL s finding that competition in the provision of retail leased line services is not effectively competitive as it would tackle directly the prices which consumers pay. Such a policy would introduce a price control on the end to end leased line service. However, an important conclusion of OFTEL s review of competition in relation to national leased lines was that competition problems at the retail level were caused by the position at the wholesale level and furthermore the state of competition in the two markets, trunk segments and terminating segments, was significantly different. In the case of trunk segments, OFTEL believes that the market is prospectively competitive whereas for terminating segments competition does not appear to be in prospect. Accordingly, OFTEL does not believe that the option of imposing a retail price control would be proportionate. The regulatory intervention would impact on the market for trunk segments which has the potential to become effectively competitive without regulatory intervention. This suggests that OFTEL should target regulation on the particular wholesale market which is not effectively competitive. Therefore OFTEL does not believe retail price caps would be proportionate to the competition problem identified. 41

46 Option The final policy option is safeguard retail price caps on BT s prices for retail leased lines. A safeguard price cap is a price control which prevents those price levels from increasing by more than the inflation rate during the period of the control. The purpose of such a price cap is not to be a binding constraint on the prices controlled, because it is implemented where OFTEL expects competiton to the service to become effectively competitive during the price control period, but rather to provide a safeguard for customers in case this judgment proves to be over optimistic As explained in chapter 3, OFTEL s review of effective competition in the provision of retail leased lines suggested that it was not competitive. Accordingly, OFTEL does not believe that retail safeguard caps on their own are an appropriate form of regulation to introduce. However, OFTEL has considered whether they may have a role if Option 2 or 3 are implemented. In particular OFTEL has considered whether the existing caps on analogue and digital up to 64 kbit/s, due to expire in July 2001 (subject to the rollover provisions) should be retained. As explained above, OFTEL believes that if Options 2 or 3 are implemented this should lead to increased competition in retail leased line services and therefore BT s prices of those services will be constrained. However, OFTEL has considered whether these competitive pressures are likely to be sufficient in the case of analogue and small digital services. Analogue Circuits 4.32 As discussed in chapter 3, to date there has been virtually no entry by OLOs into the provision of analogue services and the price cap has been binding on BT s prices. OFTEL believes that in the future, given the availability of appropriate wholesale inputs, it is possible that OLOs may begin supplying analogue services and therefore competition may be a sufficient constraint on BT s prices for analogue circuits. However, analogue circuits are a declining segment of the market and therefore operators may choose not to enter into the provision of these services. It is difficult to predict what will happen and therefore in order to protect consumers OFTEL believes it would be appropriate to retain the safeguard price cap on analogue services throughout the UK. Of course, if competition does develop the price cap will not be binding on BT s prices and therefore the regulation does not appear to be disproportionate to the competition concerns identified. Digital Circuits up to 64 kbit/s 4.33 As discussed in chapter 3, there has only been limited entry by OLOs into the provision of digital circuits up to 64 kbits and the existing safeguard cap has not been binding on BT s prices. As in the case of analogue services OFTEL believes that in the future, given the availability of appropriate wholesale inputs, more entry will occur and competition should constrain BT s prices. However to date entry by OLOs has been limited even in areas, such as CLZ, where OLOs have their own access networks which may suggest that even with the appropriate wholesale inputs available OLOs may not supply these bandwidths to a significant extent. Therefore there is a risk that competition will not be sufficient to constrain BT s prices. However, given that this is a growing segment of the market, on balance OFTEL believes that the safeguard cap is not appropriate. 42

47 Implementation 4.34 If Option 5 were to be implemented this would be done by means of a licence modification according to the procedure set out in section 12 of TAct. Future Option Introduction of Resale of end to end leased lines 4.35 In OFTEL s recent Price Control Review 5 (PCR), OFTEL asked about the impact on competition from the existence of resellers of BT s services. OFTEL discussed how the competitive impact of resale depends to a large extent on the terms on which resellers are able to gain access to BT s network. At present, Annex II operators purchase network interconnection services from BT at charges based on BT s costs, whereas resellers not deemed to have Annex II status purchase services from BT at charges based on BT s retail prices. The difference between the prices offered to Annex II operators and resellers essentially represents BT s profit margin, which is significant. One of the options in the PCR (Approach III) proposed that resale of BT s network services could offer greater opportunities to increase competition if charges to resellers were not based on BT s retail prices. Cost-based charges for resellers similar to those enjoyed by Annex II operators, may increase the scope for competition from resale Approach III could be extended to leased lines if Options 2 or 3 were adopted. This would mean that resellers should be able to obtain BT s end to end leased lines at the equivalent price of the Annex II price for terminating segment and retail priced trunk segments. This arrangement might enable resellers to place increased competitive pressure on the retail prices of leased lines, particularly if it were possible for resellers to purchase the trunk segments from other carriers If Approach III of the PCR is adopted in the future price control regime and if Option 2 or Option 3 were adopted, it is anticipated that Approach III would be extended to leased lines. The final statement of the leased lines review and the next statement of the PCR would co-ordinate any application of Approach III to leased lines. Conclusion and CBA 4.38 In this chapter OFTEL has discussed the various policy options which it is considering in the light of its conclusions of its effective competition review set out in chapter 3. On balance it is OFTEL s view that the most appropriate policy option is likely to be Option 3. This option will result in proportionate regulatory action. Option 3 targets regulation on the relevant wholesale market, namely the market for terminating segments, which OFTEL believes is the barrier to the development of effective competition in the provision of retail leased lines. Option 3 also appears to offer the best propsect of lower retail prices and creation of appropriate incentives for BT to make efficiency gains. In addition to the qualititive assessment of the various policy options OFTEL has attempted to quantify, so far as possible, the costs and benefits which would occur if the main policy options, namely Options 2, 3 and 4, were implemented. This cost benefit analysis (CBA) provides further evidence to suggest that Option 3 appears to be the most appropriate policy option to adopt Table 5 below presents the initial results of the CBA. A full discussion of the CBA is set 5 Price Control Review, OFTEL, March

48 out in Annex H. It should be noted that it has not been possible to quantify all the costs and benefits and therefore the figures presented below do not include all the relevant costs and benefits, however OFTEL believes the results provide a reaonably robust estimate of the likely costs and benefits. The table indicates that each of the three options considered has a net positive benefit. However, the results indicate that Option 3 generates the largest net benefit. Table 5: Central Estimate of the CBA Net Present Value of Benefits ( m) Option 2 Option 3 Option 4 Terminating Segments Price Capped Retail Price No Price Caps Terminating Segment Caps Net Present Benefit Net Present Cost Net Present Value On balance, at this stage, OFTEL considers Option 3 is likely to be the most appropriate regulatory action to promote competition in leased lines. Under this option BT would be required to offer wholesale terminating segment services (Services A & B), at all bandwidths, to other Annex II operators on non-discriminatory terms at cost-orientated prices and those prices would be subject to price cap regulation. In addition, on balance, OFTEL considers it would also be appropriate to pursue Option 5, safeguard retail price caps, in relation to analogue services. 44

49 Questions Chapter 4, question 1 Do you agree with OFTEL s initial proposals that Option 3 and Option 5, in relation to analogue services, are the most appropriate policy options to pursue? Chapter 4, question 2 Are the two proposed wholesale terminating segment services sufficient to allow OLOs to compete in the retail leased line market? Please justify your answer and give evidence of demand for the services. OLOs are particularly asked to comment on: (a) what bandwdiths of the services they would purchase; (b) the present arrangements they have with BT and on how they would migrate to the new services (please consider both existing technical and commercial arrangements (ie rearranging physical connections and the terms under which these connections are purchased)); and (c) whether the proposal to allow aggregation in the local exchange to DMSU link in Service A is appropriate and sufficient to meet their requirements. Chapter 4, question 3 Do you believe that there will be rebalancing in retail leased line prices as a result of Option 2 being implemented? If possible please supply data which supports your answer. Chapter 4, question 4 OLOs are asked to comment on whether they would begin providing retail analogue circuits if Option 2 were implemented and if not why. Chapter 4, question 5 OLOs are asked to comment on whether they would begin or increase their provision of digital circuits up to 64 kbits if Option 2 were implemented and if not why. Chapter 4, question 6 Should Approach III, described in OFTEL s PCR consultation be extended to leased lines? What are the advantages and disadvantages of this? What practical arrangements would need to be put in place so resellers without any network infrastructure could buy terminating segments from BT but trunk networks from OLOs? 45

50 Consultation OFTEL seeks the views of consumers, consumer organisations, industry and others on all the issues and questions contained in this Consultation Document but particularly the questions at the end of chapter 4. The deadline for comments is 27 October A further 2 weeks will be allowed to submit comments on comments. Comments should be made in writing and sent to: Heather Clayton Regulatory Policy OFTEL 50 Ludgate Hill London, EC4M 7JJ [email protected] Confidential responses should not be sent via the internet. Written comments will be made publicly available in OFTEL s Research and Intelligence Unit except where respondent indicate that responses, or parts of it, are confidential. Respondents are therefore asked to separate out any confidential material into a clearly marked annex. Intheinterestsof transparency, respondents are asked to avoid confidential markings wherever possible. Appointments to view written comments in OFTEL s Research and Intelligence Unit, which must be made in advance, can be arranged by ringing: (fax: ). If respondents would like to discuss the consultation document with the team at OFTEL working on the review, please contact Heather Clayton on or Tim Cross on Internet OFTEL would like to set up links between this Consultation Document and any responses placed on respondents own Internet pages. Please contact Jo Hamilton at OFTEL on or by at [email protected] to arrange this. OFTEL has a free based mailing list to help people stay informed about OFTEL s work. Each time an OFTEL document is published and placed on OFTEL s website subscribers to the list receive an informing them about the document. To register visit the What s New? page on the OFTEL website. Alternative formats Copies of the full Consultation Document are available on disk. The Summary can be made available in large print, braille and tape formats. Please contact the OFTEL Research and Intelligence Unit on for more information. 46

51 Annex A Notes on international benchmarking "Standard" incumbent prices A1 Comparisons of leased line prices in European countries are presented in chapter 2. These comparisons are all based on the "standard" prices offered by the incumbent operators and do not take account of discount schemes or offers from new entrants. While this approach clearly has some shortcomings, it is expected that this nonetheless provides a valid basis for comparison: in general incumbent operators continue to have a high market share particularly at lower bandwidths and on "thinner" routes (ie routes over which the aggregate demand for capacity is relatively low) and hence their prices reflect the experience of a large section of consumers; while new entrants are likely to offer attractive prices on certain routes, incumbent operators may well be the only operator able to offer circuits on any route; the discount schemes offered by incumbents are thought to be of a similar magnitude in different countries, hence while the comparisons will tend to overestimate the prices actually paid by consumers, the relative country rankings should not be greatly affected by failing to take account of discounts offered by the incumbent. A2 For a variety of other telecoms services, OFTEL has commissioned benchmarking studies which consider a wide range of tariffs/discount schemes offered both by the incumbent and new entrants. In the case of leased lines, this approach has not been attempted due, in part, to: new entrants may well offer bespoke (ie unpublished) tariffs and hence this information is hard to collect; new entrants may well offer tariffs on a route by route basis which makes an overall comparison more difficult both to carry out and to interpret; discounts are usually offered on the basis of volume of circuits or contract terms (eg length of contract) - detailed data on the purchasing requirements of users is required to model the impact of such discounts on average and this kind of data is not generally publicly available. A3 While it is believed that the comparisons presented are broadly representative in terms of identifying the UK position relative to that of other European countries, nonetheless the comparisons should be treated with a degree of caution. The comparisons are likely to be of greatest validity for a company requiring a limited number of lower capacity circuits in "nonprime" locations (eg a smaller company or branches of a larger multi-site company) and unable or unwilling to enter into a contract of longer than a year. Range of circuits A4 The comparisons presented are based on considering prices for a number of different circuit lengths (short 2km, medium km and long 200 km) for a number of different circuit types (Analogue, digital 64kbit/s, 2Mbit/s, 34Mbit/s and 155Mbit/s). This ensures that 47

52 a broad range of tariffs have been considered. This is important as different operators have different pricing structures and undue focus on a narrow range of circuits may lead to misleading conclusions. A5 As well as considering individual circuit comparisons it is also possible to consider a "basket" of leased lines. A basket approach is commonly used for voice telephony services. For leased lines, it is less clear that a basket approach is appropriate as: leased lines may well be purchased as a single item; data on the appropriate weights for a basket are not generally available on a widely recognised basis for the full range of customer types (eg baskets used by the OECD have been developed using data on distances provided by operators but an equal weighting of different circuit types). A6 Given this, the main focus of chapter 2 is on price comparisons for individual circuits. Comparisons are made on the basis of the most recent tariff data available and changes in prices over the last 5 years are also presented. In addition, the results of the OECD basket, the most frequently used basket in benchmarking studies, comparison are also discussed. Methodological issues A7 The different pricing structures of operators in some countries means that assumptions sometimes need to be made to enable tariffs to be presented on a comparable basis. Some of the countries for which this is the case are listed below: Sweden: prices differ according to the localities that the circuits connect, eg the price between 2 major cities will be different to the price between 2 small towns; Denmark: pricing is based on four regions, eg a 50km circuit will have a different cost if it is within one of the four regions than if it spans two regions; Luxembourg: prices are not distance dependent - circuits are priced according to whether they lie within a local area, the ends are in contiguous local areas or they cross noncontiguous local areas. A8 Given that additional assumptions need to be made to include these countries in the analysis, this raises a question over the comparability of the data. Accordingly, the exact comparisons with such countries should be treated with caution. This particularly relevant as the three countries referred to above all have relatively low leased line prices. A9 Prices are presented at Purchasing Power Parity exchange rates, the standard way of presenting telecoms international benchmarking comparisons. Using current exchange rates would tend to make the UK's relative price position worse, but would not affect the overall comparisons that can be drawn. A10 Comparisons are based on monthly rental charges. Comparisons of connection charges can also be made. While UK connection charges tend to be higher than average European prices, these are not the main source of expenditure on leased lines. If, for example, connection charges were included in the analysis, and were assumed to be written off over a 5 year period, then the relative position of the UK in the price comparisons presented would be unlikely to change. 48

53 Sources A11 Data is available from a variety of sources. OFTEL has chosen to present: data on individual circuits from the European Commission's Fifth Implementation Report 1 (tariffs valid as at August 1999) - this provides the most complete comparison of tariffs across all EU countries for different distances and circuit types. Note while there will have been some changes to tariffs since that date, this is unlikely to affect the overall conclusions; data on price changes over time from Analysys "Cutting the Cost" - this source explicitly provides a time series for a sub-set of EU countries allowing trends over the last 5 years to be charted. A12 There are a number of other sources proving similar types of pricing comparisons (including consultancy reports by Tarifica and Ovum). While there are some differences in the figures presented (due to differences in methodology, timing, the countries covered etc) data from these sources confirm the picture presented in Chapter 2. 1 "Fifth Report on the Implementation of the Telecommunications Regulatory Package", European Commission, Nov

54 Annex B Excessive prices and profits B1 Excessive prices for services are prices that are significantly above the relevant cost of providing those services. One approach to assessing excessive pricing is to consider whether revenues from the relevant service or group of services exceed its stand alone cost (SAC), including an appropriate allowance for a reasonable return on capital. The SAC of a service or group of services is the cost of providing the service or group of services on its own. The SAC of an individual service or group of services can be calculated either by an assessment of the costs of stand alone provision of the service(s) in question, or by summing the long run incremental costs (LRIC) of the relevant service(s) with the common costs shared between the relevant service(s) and other services. B2 Within this approach, there are two types of tests that would need to be satisfied in order to show that BT s returns from leased lines are not excessive. First, BT s revenues from leased lines should not recover more than the SAC of leased lines which consists of the LRIC of leased lines plus all the common costs that leased lines share with other services. This might be quite an easy test to pass if common costs are significant, since this test would allow leased line prices to be high enough to cover all the common costs shared by leased lines and other services. B3 The second type of test allows for the fact that some of the common costs might already be being recovered from services other than leased lines. In order to take such cost recovery into account, the second test requires that BT s revenues from groups of services do not exceed the costs of providing those groups of services. These types of test are sometimes referred to as combinatorial tests, as they involve the comparison of revenues and costs from combinations of services. The purposes of this type of test is, while recognising that BT has a choice as to how it recovers its common costs, to ensure that those common costs are only recovered once. The Stand Alone Cost Test B4 OFTEL has assessed the SAC test for leased lines. This involves comparing the revenues from leased lines with the sum of the LRIC of leased lines and the common costs shared between leased lines and other services. BT s leased line services share common costs with PSTN services and Other Data Services. BT appears to pass this test, since revenues from leased lines are considerably below the SAC of leased lines. B5 However, as noted above, for there to be no concern about BT s leased lines prices, it is also necessary for other tests, involving the recovery of common costs, to be passed. Since leased lines share common costs with PSTN services and Other Data Services, the further tests involve the way in which these common costs are recovered from those services. 50

55 Test Adjusted for Recovery of Common costs from PSTN PSTN adjustments B6 PSTN services have been regulated on the basis that BT should recover a certain proportion of its common costs from PSTN services. OFTEL believes that it is appropriate to deduct from the SAC of leased lines those common costs assumed to be recovered from PSTN services. This will reflect the fact that these costs are recoverable from PSTN services and so it would not be appropriate for leased lines prices to be set at a level which recovered those costs again. B7 The SAC test adjusted for recovery of common costs from the PSTN will therefore include the LRIC of leased lines and the common costs shared between leased lines and other services, minus the contribution to common costs allowed under the regulation of PSTN services. B8 OFTEL has also considered whether it would be appropriate to deduct from the SAC the full contribution to common costs actually earned on PSTN services. This approach would suggest that additional revenues earned above those assumed in the setting of the price control should also contribute towards the recovery of common costs by PSTN services and so should be taken into account in the adjustments to the SAC for leased lines. There are two types of PSTN service to consider, residential and business. OFTEL believes the appropriate approach is different in each case. B9 OFTEL believes that in the case of residential PSTN services it would be inappropriate to deduct these additional profits from the SAC. This is because it would undermine the incentive properties of the price cap which applies to residential services. The ability to earn these additional profits is an important incentive for efficient behaviour under price cap regulation. Basing the contribution of residential PSTN services towards the recovery of common costs on revenues, rather than on costs allocated when the control was set, would effectively constitute a profit cap. Profits would be reclassified as contributions to common costs, with prices of other services reduced to reflect the lower contribution to common costs required from those services. Hence in order not to impair the incentive properties under retail price regulation, OFTEL considers that the additional profits from residential PSTN services should not be included in the SAC test. However, OFTEL believes that business PSTN services should be treated differently since they are not subject to a price control. In that case it is appropriate for actual revenues, rather than costs allocated, to be the basis of business PSTN services contribution to common costs. B10 Thus the original SAC test is adjusted to include the common cost allowed to be recovered from PSTN services and the profits from business PSTN services. If BT failed the SAC test adjusted in this way, it would be possible to infer that BT was making excessive profits from the combination of leased lines and PSTN services. Initial results B11 OFTEL has attempted to consider whether or not BT would pass the test set out above on the basis of the information available. It appears that BT might fail this test, as BT s revenues from leased lines appear to exceed the stand-alone cost of leased lines adjusted for common cost recovery from PSTN services. This suggests that the prices of leased lines may 51

56 be excessive. The stand alone cost information is drawn from information supplied by BT to OFTEL in the course of this investigation and from regulatory accounting statements. Due to the lack of appropriate information, it has been necessary to estimate some elements used in this test such as the amount of retail common costs shared between leased lines and other parts of BT from regulatory financial information. Therefore the results should be considered as indicative rather than as conclusive. Extending the adjusted leased lines SAC test to other data services B12 As noted above, leased lines also have common costs with other data services (ODS). ODS are data transfer services such as Frame Relay and ATM services that utilise terminating segments. Therefore, if BT were to pass the adjusted test set out above, there is a further test which BT would have to pass to show that its leased lines prices were not excessive. This test would take into account the extent to which BT is recovering any of its common costs on ODS. This further test is appropriate because the adjusted test set out above would allow BT to recover from leased lines all costs shared between leased lines and ODS. However, if BT were recovering some of these common costs from ODS, it would clearly be inappropriate to allow BT to set leased line prices to cover all these common costs since this would allow BT to recover these common costs more than once. The further test which is therefore required is to establish whether the combined revenues of leased lines, PSTN and Other Data Services taken together exceed the combined costs. In this case this test would include revenues from ODS, the LRIC of ODS, the common costs between leased lines and ODS, and the common costs that they both share with other services. B13 Unfortunately OFTEL does not have revenue and LRIC cost information for ODS required to conduct the test set out in para B12 above. OFTEL has therefore been unable to conduct this test, but intends to obtain the relevant information from BT in order to do so. Further work B14 OFTEL s initial results have been based on 1998/99 data. As part of OFTEL s further work it will investigated the position using more up to date data. It recognises that this is particularly important because market conditions in the PSTN are changing quickly. In that regard it will also consider to what extent it is appropriate for increasing competitive pressures in PSTN services to lead to increased common cost recovery on leased lines. OFTEL aims to assess further excessive pricing in leased lines by BT, by gathering financial information from BT, with the intention of finalising its views on excessive pricing in its final statement. Questions Annex B, question 1 Is the proposed approach for judging whether BT s retail leased line prices are excessive appropriate? 52

57 Annex C Questions for operators (other than BT) on entry barriers for access networks Access Network Operators 1. Do you currently have an access network (links connecting customers premises to the core transmission/trunk network) which may support the provision of a leased line service? If no, go to question Please give details of the geographical regions where you have an access network. 3. If you wanted to expand you access network into another geographical area, what would be the typical timescale? Please indicate the main factors that would impact on this timescale giving examples where appropriate. 4. Do you currently use your own access network to support provision of leased line services? If no, please give reasons why the access network is not used to support this service. 5. If yes, please provide a breakdown of total revenues for each bandwidth by customer type e.g. retail, BT, OLO, MOLO (mobile operator). Please provide this information for 1997/98, 1998/99, 1999/2000. The table below provides a suggested format for your answer for 1997/98. Total revenues, m, 1997/98 Retail BT OLO MOLO Total <2 Mbit/s 2 Mbit/s 8 Mbit/s 34 Mbit/s and above 6. What other services are provided over the access network? Please provide total revenues from each of these services for 1997/98, 1998/99, 1999/00? 7. What major costs (digging, ducting, laying fibre etc) were incurred in setting up the network? Please quantify costs where possible. 8. If you were to stop supplying leased lines could you use the access network to supply other services? Please give details/examples of other services which could have been supplied. Which cost elements might you not be able to recover? What proportion of total costs would be unrecoverable? 9. What are the main costs associated with linking a customer s premises to your access network? Please quantify and disaggregate the costs as far as possible. 53

58 10. Are the costs significantly affected as a result of the bandwidth required by the customer? Please provide details / explanation. 11. Is the decision to build significantly affected as a result of the bandwidth required by the customer? If so, why? Building or Extending Access Networks 12. Do you have plans to build (or extend) an access network (links connecting customers premises to the core transmission/trunk network) which may support leased line services? 13. What factors are relevant to a decision to build an access network? 14. What are the major costs (digging, ducting, laying fibre etc) likely to be incurred in building such a network? Please quantify and disaggregate the costs as far as possible. 15. If you stopped supplying leased lines, which of the above cost elements would be recoverable from other uses or services? Please state the proportion of total costs that would be recoverable and indicate their alternative uses. No Access Network 16. If you don t have a UK wide access network in place, what factors determine whether you build to a customer s premises? Please provide information as to the significance of each of these factors. 17. Over what timescales would you be able to build out to a customer s premises? What are the main factors that will affect this timescale? 18. What are the main costs associated with linking a customer s premises to your transmission network? Please quantify and disaggregate the costs as far as possible. 19. Are the costs significantly affected as a result of the bandwidth required by the customer? Please provide details / explanation. 20. Is the decision to build significantly affected as a result of the bandwidth required by the customer? If so, why? 21. In order to provide services (end to end leased line, ATM services, high speed internet access etc.) to your retail customers do you buy leased lines from other operators in order to connect that customer to your transmission network? 22. If yes, how many circuits have you bought from BT/OLO during 1997/98, 1998/9, 1999/00? How many of these were located in Central London Zone? Please break the information down by bandwidth. The table below provides a suggested format for your response for 1997/98. 54

59 Total circuits, 1997/98 BT OLO Total CLZ Non CLZ CLZ Non CLZ <2 Mbit/s 2 Mbit/s 8 Mbit/s 34 Mbit/s and above 23. For each year, what percentage of the total number of circuits bought from other operators is used to provide: an end to end leased line service, high speed internet access, ATM services and other services (please specify what these are)? 55

60 Annex D Legal framework Interconnection Directive and part leased lines The Interconnection Directive 2 :(theicd) D1 The ICD requires that telecommunication networks be interconnected for the purpose of providing publicly available telecommunications services. These networks and services include the provision of leased line services. The ICD is implemented in the UK by the Telecommunications (Interconnection) Regulations (SI 1997/2931) ( the Interconnection Regulations ) which give the Director General certain powers, and specifies a number of conditions, relating to interconnection which have been incorporated in operators licences. The ICD and part leased lines: OFTEL's view D2. OFTEL uses the term terminating segments to refer to the provision of capacity between a customer s premises and an OLO s Point of Interconnection which can be at any serving local exchange or at a DMSU exchange used for routing leased lines to the local serving exchange. However, in the Commission s recent recommendation 3 (the Recommendation ), the Commission refers to such leased lines as part leased lines. In the interest of clarity, in this annex, OFTEL will use the Commission s term part leased lines to refer to terminating segments. D3 OFTEL anticipates that OLOs will buy part leased lines from BT in order to supply end users with a complete end to end leased line. Figure D1 illustrates this. Figure D1: Interconnection of networks to allow an OLO to provide an end to end leased line BT exchange (serving centre for leased line) Logical and physical linking of networks at a point of interconnection Customer 1 BT s network providing part leased line OLO s network completing leased line Customer 2 End to end leased line provided to customer 2 The Interconnection Directive: European Parliament and Council Directive 97/33/EC. 3 Commission Recommendation on Leased Lines interconnect pricing, C(1999)3863, November 1999 (Provisional Text). 56

61 D4 In the ICD, at Article 2(1)(a), interconnection is defined as: - [ ] the physical and logical linking of telecommunications networks used by the same or a different organisation in order to allow the users of one organisation to communicate with users of the same or another organisation, or to access services provided by another organisation. D5 As a part leased line (provided by BT) is a service consisting of the provision of capacity from a customer to an OLO s Point of Interconnection, the OLO s network will be physically and logically linked to BT s network at the Point of Interconnection. Thus, OFTEL is of the opinion that a part leased line is an interconnect service covered by Article 4(1) of the ICD: - Article 4(1) of the ICD states that: "[Annex II operators] shall have a right and, when requested by [other Annex II operators], an obligation to negotiate interconnection with each other for the purpose of providing the services in question [ ]" The ICD and part leased lines: European Commission's view D6 The view that part leased lines are covered by the ICD is not a position unique to OFTEL. The Commission in its recent Recommendation expressed the view that part leased lines are covered by the Interconnection Directive. At Recital 6 of the Recommendation (provisional text), the Commission states that: "Whereas, in accordance with Article 4(1) and Annex II category 2 of Directive 97/33/EC, organisations providing leased lines to users' premises have a right and an obligation to negotiate leased line interconnection (ie provision and interconnection of leased line part circuits) with other organisations in that category." Obligations under ICD D7 As a consequence of part leased lines being covered by Article 4(1) of the ICD, it is OFTEL s view, and that of the Commission at Paragraph 6 of the Explanatory Memorandum to the Recommendation 4, that operators as defined in Schedule 2 of the Interconnection Regulations ( Schedule 2 operators ) have rights and obligations to negotiate interconnection with each other for the provision of part leased lines services. These obligations are the same as those for other interconnection services and are set out in operators licences in Condition 9 (and 45 for operators with Significant Market Power): Schedule 2 operators have an obligation, if requested by another Schedule 2 operator, to negotiate with a view to concluding an interconnection agreement within a reasonable period (Condition 9). 4 At Paragraph 6, the Commission states that: "The Interconnection Directive 97/33/EC imposes on a fixed operator notified as having significant market power the obligation to provide cost-orientated leased line interconnection services to other operators for the purpose of providing end-to-end leased line services in the context of a liberalised environment and internal market principles (Annex 1 Part 2 of Directive 97/33/EC). These services should be provided under transparent, nondiscriminatory and cost-orientated conditions, and subject to regulatory approval (Articles 6 and 7 of Directive 97/33/EC)." 57

62 Schedule 2 Operators determined to have SMP have the obligation, if required by another Schedule 2 Operator, to offer to enter into an interconnection agreement with that Operator within a reasonable period (Condition 45.1). Schedule 2 Operators have the right to apply to the Director General for a direction in order to specify issues to be covered in an interconnection agreement (Conditions 9.2(a) and 45.2(a)). Schedule 2 operators may apply to the Director General for a direction laying down specific conditions to be observed by one or more parties (Conditions 9.2(b) and 45.2(b)). Schedule 2 operators have the right to apply to the Director General for a direction setting the time limits for negotiations to be concluded between operators in relation to an interconnection (Conditions 9.2(c) and 45.2(c)). Schedule 2 operators have the right to apply to the Director General for a direction settling a dispute between Schedule 2 Operators in respect of a failure to agree the terms of an interconnection agreement (Regulation 6(6) of the Interconnection Regulations). Schedule 2 Operators with SMP have the obligation to provide interconnection services at prices that are cost-oriented (Article 7(2) ICD, Schedule III Part II Interconnection Regulations). Schedule 2 Operators with SMP have the obligation to provide interconnection services under the same terms and conditions as it provides for its own services, or those of its subsidiaries or partners (Article 6(a) ICD, Schedule III Part I Interconnection Regulations and Condition 57). Implementation of policy options 1, 2 and 3 D8 As the part leased lines described in this Consultation Document are covered by the ICD, where BT's Reference Interconnection Offer (RIO) does not already provide for the provision of part leased lines, the Director General may specify that the supply of part leased lines be covered by the RIO. He may do this on his own initiative or at the request of an OLO. D9 In the case of policy option 1, which is to leave the terms and conditions of the provision of a part leased line(s) to commercial negotiation within the framework of the ICD, OFTEL may intervene at the request of an OLO or BT to resolve a dispute should commercial negotiations fail. In such a case, the Director General could, in determining an interconnection dispute, specify the terms and conditions on which part leased lines are to be provided. D10 If OFTEL were to implement policy option 2, OFTEL could, on its own initiative, specify the part leased line services that BT should provide. Under policy option 3, OFTEL could also, on its own initiative, specify the price that BT should provide these part leased lines. D11 If a direction was made that BT should provide part leased line services under Condition 45 of BT s Licence, then such services would be treated as Standard Services for the purposes of BT s Licence. This would have a number of implications including the requirement for BT, under Condition 78 of its Licence, to disclose costs and revenues relating to part leased lines services in a Financial Statements in a form and content agreed with the Director General. D12 If BT provided part leased line services under any of the options referred to, it would be required under its Licence and the ICD to provide those services under the same terms and 58

63 conditions, including price and quality of service, as it provides for its own services, or those of its subsidiaries or partners. Condition 57 (prohibition on undue preference and undue discrimination) and Condition 75 (prohibition on cross-subsidies) would apply, as would the provisions of the Competition Act In deciding whether or not to use his investigative and enforcement powers under the Telecommunications Act 1984 or the Competition Act 1998 to prevent anti-competitive behaviour, the Director General will follow the principles set out in OFTEL's guidelines on the Application of the Competition Act 1998 in the Telecommunications Sector (published January 2000). Leased Lines Directive D13 The Leased Lines Directive (Directive 92/44/EC, amended by 97/51/EC) ( the LLD ) places obligations on operators deemed by the National Regulatory Authority (NRA) to have significant market power (SMP) in the supply of leased lines in a particular geographic area. OFTEL has determined for the purposes of the LLD that BT, in respect of the UK (excluding Hull), and Kingston Communications, in respect of Hull, have SMP. BT and Kingston are, therefore, obliged to provide a minimum set of leased lines consisting of ordinary quality voice bandwidth analogue, special quality voice bandwidth analogue, 64kbit/s digital and 2Mbit/s digital. The LLD also requires that the prices for private circuits are transparent, nondiscriminatory and cost-oriented. This Directive is being reviewed as part of the 1999 review and OFTEL is contributing to that review. D14 In the November 1999 statement on national leased lines, OFTEL suggested that there may be scope for some targeted deregulatory measures, in particular, scope for allowing BT to offer unpublished discounts on its higher bandwidth end to end retail leased lines. However, after further consideration OFTEL does not believe that it has the discretion to implement such a policy. This is because of the requirements of the LLD with which BT, as a designated SMP operator must comply. The relevant requirements are: - Article 3(1) states that: "Member States shall ensure that information in respect of leased lines, offerings on technical characteristics, tariffs [ ] is published in accordance with the presentation given in Annex I." - Annex I, B on Tariffs states that tariffs shall [ ] include the initial connection charges, the periodic rental charges, and other charges. Where tariffs are differentiated, e.g. for reasons of different levels of quality of service or the number of leased lines provided to a user (bulk provision), this must be indicated. - Article 10(1)(b) states that: "When other tariff elements are applied, these must be transparent and based on objective criteria." Thus, the transparency would mean that the tariffs are unbundled to the extent necessary to ensure that the required information i.e. the information level required to comply with Article 10(1)(a), (b) and (c) - is easily accessible. D15 OFTEL is of the opinion that these requirements prevent BT from offering unpublished discounts on leased lines. For the purpose of publication of prices, the LLD applies to all leased lines (as defined by the LLD) provided by BT. 59

64 Annex E Technical details of proposed wholesale services E1 Presently, BT provides OLOs with Partial Private Circuits (PPCs), at 2Mbit/s only. The proposed service A: Customer to DMSU, would be provided in exactly the same way as BT provides PPCs but would be available at all bandwidths. Annex E, Figure 1: Interconnect for proposed service A Leased line serving centre at RCU/DLE Leased line serving centre at DMSU ADM BT traffic plus OLO traffic multiplexed ADM BT s core network Customer BT s local loop OLO PoI E2 Service A would provide the OLO with a link from the DMSU via BT s network to the local exchange and on to the customer via the appropriate medium (either fibre or copper). This is done by the provision of capacity within BT s link between DMSU and local exchange, using BT s local access network to provide access to the customer. Annex E, Figure 2: Interconnection of terminating segments at the local exchange Leased line serving centre at RCU/DLE OLO PoI Multiplexer Leased lines over fibre Optical distribution frame Leased lines over copper Main distribution frame Kilostream/HDSL multiplexer E3 For service B, it is proposed that the OLO will interconnect with BT s equipment in the DLE or Remote Concentrator building as shown above. 60

65 Annex F Financial modelling F1 In order to effectively assess the state of competition in the leased lines market it was necessary to investigate, in some detail, the costs and prices of leased lines. During the leased line review, BT provided information that helped OFTEL to form a view on how BT s costs might relate to its prices for leased lines. In addition, OFTEL commissioned consultants to create a bottom up model which was designed to illustrate the nature of the costs involved in providing leased lines and to give OFTEL greater visibility of these cost than BT s information systems could provide in the short time scale of the review. F2 The information from the modelling exercise is used principally to: provide estimates of the profitability of different segments of leased lines; provide information about the nature of the costs involved. F3 There are many overlaps with this work and OFTEL s work on the Price Control Review. Any proposals made as a result of the modelling work are therefore subject to co-ordination with the results of the consultation on the Price Control Review. It should be noted that the modelling and financial analysis of leased lines is scheduled to continue throughout the summer until the final statement on leased lines (planned for later this year), therefore, the results of the work so far should be viewed as preliminary. F4 Due to confidentiality issues, OFTEL cannot present the full findings of the modelling exercise carried out. However, summary results from the bottom up model can be presented here. The numbers presented in this annex should not be assumed to reflect BT s actual costs. The reconciliation exercise between BT s numbers and the bottom up model is not complete. Also it should be noted that bottom up models typically give accurate relative numbers but may be unreliable for actual numbers. Therefore the numbers in this annex are for illustration purposes only to demonstrate the issues involved in assessing the costs of leased lines. Modelling exercise F5 OFTEL appointed Europe Economics and Ryan Associates to carry out the bottom up modelling exercise. Two industry meetings were held during the review of leased lines at which OFTEL s consultants presented the methodologies used and the preliminary results of their work. The material presented at these meetings is available from: George Siolis or Jonathan Wilby (Ryan Associates) Europe Economics Chancery House, Chancery Lane London Tel: LRIC, LRIC+ and SACs F6 Incremental costs distinguish between the costs that vary with the increments of output - the incremental costs and the costs that are not sensitive to such output changes - the common 61

66 costs. Common costs of the network arise from economies of scope between different services provided by the network. For example, common costs may arise from the sharing of duct between the core network and the access network the cost of such duct would not be saved if either the core network or the access network were not provided; it would only be saved if both were not provided. F7 OFTEL considers that mark-ups over the incremental cost are necessary if BT is to be able to recover the common costs that it necessarily incurs in providing its network. There are extensive economies of scope between leased lines, PSTN and other network services, which result in the presence of a substantial amount of common costs. Prices that are set at LRIC plus a mark up to allow the recovery of common costs are referred to as LRIC+ prices. Provided BT is able to fully recover common costs from leased lines, PSTN and other network services, LRIC+ pricing of leased lines should be the equivalent of prices that would be found in a competitive market. F8 The bottom up model provides OFTEL with three sets of results for leased lines: Definition 1(referred to for convenience as LRIC): the cost of leased lines when leased lines are provided as an increment to existing services; Definition 2 (SAC): the costs of leased lines if leased lines are provided as a stand alone service; Definition 3 (referred to for convenience as LRIC+): the costs of leased lines if provided as part of a network providing leased lines, PSTN and data services. The costs under definition 3 include a share of the intra-access common costs or intra core common costs shared by all the services provided by the network. Definition 3 also includes a share of intra access/core common costs. F9 Table 1 shows the total results for the access and core network bottom up models. As can be seen, the SACs of leased lines are extremely high compared to LRIC (calculated under definition 1). The LRIC + (definition 3) is also high compared to the LRIC. Annex F, table 1: Total costs of retail national leased lines, bottom up model, sm Definition 1 (LRIC) Definition 2 (SAC) Definition 3 (LRIC +) Local ends Main links Total Bottom up modelling local ends F10 In order to derive LRIC + prices for individual local ends (or a terminating segment from a customer to local exchange), the bottom up access model first allocates intra-access common costs to leased lines on the basis of the percentage of total access lines (PSTN and leased lines) in the access network. Common access-core duct is allocated to access and core on the basis of total duct in the access network and total duct in the core network (i.e. common access/core duct is split in proportion to access and core specific duct). 62

67 Annex F, table 2: Total costs of leased lines in the access network, bottom up model, sm Definition 1 (LRIC) Definition 2 (SAC) Definition 3 (LRIC+) Directly Attributable Intra access common costs 0 2, Common access core duct Total Network Cost 250 2, F11 Intra-access common costs are those costs shared by the local ends of services within the access network. For example, the local ends of PSTN services and leased lines will share copper, fibre and duct in the access network. The common access-core duct is the cost of the duct that is shared by the access network and the core network. F12 Table 3 shows the different type of costs involved in the provision of leased lines in the access network. By far the greatest costs under definition 1 (LRIC) and definition 2 (LRIC+) are the electronics specific to kilostream and megastream leased lines. Annex F, table 3: Bottom up costs of leased lines in the access network by cost category Ms Option 1 (LRIC) Option 2 (SAC) Option 3 (LRIC+) Copper Fibre Kilostream Specific Megastream Specific Access Duct Common Duct Overhead Capital Network Operating Cost Total Network Cost 250 2, F13 The cost of these electronics tends to vary with the bandwidth of the leased line provided and so the costs of these electronics can be attributed to different bandwidths of leased lines. However, in order to derive a LRIC + price for individual local ends of different bandwidths, 158M of intra access common costs and access-core common costs need to be attributed to individual leased line local ends. LRIC+ of a local end F14 There are different ways which common costs can be marked up onto leased line local ends. Common costs can be: A. marked up in proportion to the directly attributable costs of the local end; B. marked up equally on each local end; C. marked up according to the capacity of the local end. 63

68 F15 Graph 1 shows bottom up LRIC + prices using the three different ways to mark up common costs on leased lines in the access network. Due to OFTEL s confidentiality commitment, the actual numerical results cannot be shown. Annex F, graph 1: LRIC+ of local ends with different methods of marking up common costs Common costs marked up in the same proportion on each local end Common costs marked up on directly attributable costs Common costs marked up on capacity of local end 64 Kbits 2 Mbits 8 Mbits 34 Mbits 45 Mbits 140 Mbits 155 Mbits a) Marking up common costs on the basis of capacity of the local end It is possible to mark up the common costs onto individual leased lines on the basis of the capacity that the line provides. That is, an 8Mb/s local end would pick up common costs 4 times greater than a 2Mb/s local end and a 155Mb/s local end would pick up 77 times more common costs than a 2Mb/s local end. b) Marking up common costs on the basis of the size of directly attributable costs OFTEL has used this methodology before. For example in the last Price Control Review to mark up the common access-core duct to access and conveyance. If this method were used to set a LRIC+ price for local ends of leased lines, since the directly attributable costs of high bandwidth leased lines are higher than lower bandwidth leased lines they would bear a greater proportion of the common costs. That is, if the directly attributable cost of a 155 Mb/s leased line is four times that of a 2Mb/s leased line, the 155Mb/s leased line would pick up four times the cost of a 2Mb/s leased line. c) Marking up common costs equally per local end Another alternative in the bottom-up model is to mark up the common costs equally per leased line local end. This would mean, for example, that all leased lines provided over 64

69 copper would bear equal common copper costs and similarly all leased lines provided over fibre would bear equal common fibre costs. However, it would be inappropriate to allocate common duct costs on this basis because since fibre uses duct more intensively than copper. Although a fibre pair is thinner than a copper pair, a fibre pair needs to be protected and the protective cover is space intensive. This being the case pairs provided on fibre would receive a higher allocation of duct costs than pairs provided on copper with the allocations being based on space occupancy. This approach would appear to be preferable since it allocates the common costs on an asset by asset basis in accordance, so far as possible, with the principles of cost causation in relation to that asset. LRIC+ of core segments F16 The bottom up model for the core network shows many different options including two different core network models, one reflecting BT s existing mix of PDH and SDH technologies and one reflecting a more optimised mix of transmission technologies. In order to derive the figures for LRIC + prices, the bottom up core model first allocates intra-core common costs on the basis of capacity, and common access-core duct on the basis of the proportion of core-specific duct over the total of core specific and access-specific duct. Annex F, table 4: Bottom up costs of leased lines in the core network by cost category Ms Definition 1 (LRIC) Definition 2 (SAC) Definition 3 (LRIC+) Directly attributable costs Intra core common costs Common access-core duct costs Total F17 The directly attributable costs shown in table 4 can more accurately be described as those costs that will be incurred as a direct consequence of leased lines being provided. The costs of the core network will effectively be shared by all of the leased line products and even by all of the other services using the transmission network, it is very difficult to attribute any costs directly to individual leased lines by bandwidth. Any LRIC + price for individual leased line segment is therefore very dependent on the method used to attribute common costs to individual leased lines. 2 More strictly speaking the mark-up would be equal if all classes of leased lines have two local ends and are provided over a single copper pair. If, for example, a leased line were provided over multiple pairs, it would attract a higher mark-up. 65

70 Annex F, table 5: Bottom up costs of leased lines in the core network Ms Option 1 (LRIC) Option 2 (SAC) PDH Electronics Regenerators SDH Electronics ADMs Regenerators Infrastructure Fibre Duct Overhead capital Operating costs Total Option 3 (LRIC+) F18 Costs which are shared between leased lines and the PSTN in the core network could be attributed to individual leased lines equally per line, on the basis of capacity per line, or by the length of the leased line. The bottom up model allows all of these options to be explored. F19 To a large extent, infrastructure costs in the core network such as duct, fibre and regenerators will be driven by the length of circuits rather than the capacity of circuits. It is reasonable to assume that many other costs, such as electronics do have capacity as their cost drivers. Annex F, graph 2 shows results from the bottom up model attributing infrastructure costs (duct and fibre) and the cost of regenerators to individual leased lines on the basis of length and all other costs on the basis of capacity. However, if these are the assumptions used, for high capacity circuits, the proportion of infrastructure costs that vary with distance is small compared to the amount of other common costs allocated to individual leased lines on the basis of capacity. This means that short terminating segments will appear relatively expensive compared to long distance terminating segments. F20 Results are shown for 50km core segments. Again, due to confidentiality reasons, numerical values cannot be shown. For comparison, the way OLOs may buy core capacity from BT at the moment is shown i.e. Interconnection Extension Circuits (IECs) in multiples of 2Mb/s and main link prices of retail leased lines. 66

71 Annex F, graph 2: LRIC+ of core segments with different methods of marking up common costs Retail leased line - main link 50km IEC - multiples of 2Mb/s 50km bottom up model 50km 64kb/s 2Mb/s 34Mb/s 140Mb/s 155Mb/s Conclusions F21 The modelling exercise has provided OFTEL with many useful results critical to OFTEL s assessment of effective competition, in particular: profitability of BT s local ends, main links and end to end leased lines; estimates using different methodologies to allow for common costs, of LRIC+ prices of terminating segments; and a greater understanding of the nature of BT s costs and how these costs might vary by bandwidth and distance. F22 OFTEL intends to continue with the bottom up modelling work until the final statement on leased lines is planned. Should the proposals to introduce wholesale terminating segments priced at LRIC+ be adopted, the bottom up model is expected to play a useful role in determining what the final price for terminating segments should be. 67

72 Annex G Price regulation of wholesale terminating segments services G1 As explained in chapter 4, OFTEL is considering implementing Option 2 under which BT s prices for wholesale terminating segment services would be subject to price regulation. This annex sets out for consultation the main issues relating to such price regulation. LRIC + Pricing G2 OFTEL believes that the appropriate basis for the price regulation is LRIC plus a mark up to allow the recovery of common costs (referred to as LRIC +). OFTEL believes that this is appropriate since it would promote economic efficiency because: setting charges based on forward-looking incremental costs corresponds to the level of the charge in a competitive market; and it will encourage operators who are at least as efficient as BT to build out their networks. Baskets and bandwidths G3 OFTEL has considered three main forms which the price regulation of terminating segments could take: (i) OFTEL specifies a LRIC + pricing rule for each individual bandwidth ie a basket for each bandwidth; (ii) OFTEL specifies separate baskets for low and high capacity terminating segments ie the maximum total common costs which should be recovered from low bandwidth terminating segments (2 Mbit/s and below) and the maximum common costs which should be recovered from high bandwidth terminating segment (above 2 Mbit/s) but in each case will not specify how the common costs should be recovered at a greater level of disaggregation; (iii) OFTEL specifies a single basket for all terminating segments ie the total maximum common costs which will recovered from terminating segments in total but will not specify how the common costs should be recovered from each bandwidth. G4 The key difference between the three forms is the extent to which OFTEL rather than BT will decided how on the recovery of common costs with form (i) requiring the most regulatory intervention and form (iii) the least. OFTEL believes that there are strong arguments for adopting a less rather than more interventionist approach in relating to the price regulation of terminating segments ie adopting form (ii) or form (iii). The disadvantages of a more interventionist approach are: since, in general terms there is no single right way to allocate common costs there is no clear right basis on which OFTEL could specify how the common costs should be recovered at each individual bandwidth; 68

73 the regulated firm, in this case BT, is likely to have better sources of information, especially relating to demand functions, to use in deciding how to recover the common costs and so is more likely to set economically efficient prices; there will be greater flexibility for prices to change over time, for example in response to changes in demand patterns, if OFTEL gives BT more freedom in deciding how it can recover its common costs. G5 OFTEL believes that these considerations suggest that form (i) is not the most appropriate form of price regulation for terminating segments and instead either form (ii) or (iii) should be used. G6 Under form (ii) OFTEL would decide on how much of the common costs relating to terminating segments should be recovered from low bandwidths and what proportion from high bandwidths. Clearly under this option BT is prevented from recovering most of its common costs from low bandwidth services and pricing the higher bandwidth services closer to LRIC or vice a versa. OFTEL believes that such a rule is likely only to be appropriate if there were separate economic markets for low and high bandwidth terminating segments. It has been argued in Chapter 3 that, on balance, separate markets are unlikely to exist at different bandwidths. However, if, as a result of the consultation exercise, OFTEL revises its view of the relevant market definitions this may impact on which form is considered to be the most appropriate. G7 OFTEL has considered what are the implications for rebalancing within BT s local end charges if different forms of price cap are adopted. Across all bandwidths BT s returns on local ends appear to cover both LRIC costs and a mark up for common costs and also a reasonable return on capital. This suggests that rebalancing will not be required if a price cap covers all local ends i.e. including both high and low bandwidth local ends. As discussed in chapter 4, BT may choose to rebalance returns between local ends due to the wide variability on current returns on local ends, when a wholesale terminating segment is introduced. In the case that some version of form (ii) is introduced, then some rebalancing may be required between local end prices at different bandwidths. It would appear most likely that the prices of kilostream local ends will fall and the price of 2 Mbit/s local ends will increase. G8 If this were the case, rebalancing will have the most pronounced impact on BT s customers who purchase short distance 2Mbit/s leased lines or own exchange circuits ie where the circuits costs are dominated by the cost of local ends. However any increase in wholesale prices for 2Mbit/s local ends should be offset by decreases in the prices of local ends at other bandwidths and by falling main link prices at 2 Mbit/s. G9 On balance, on basis of current information, OFTEL suggests that form (iii) is the most appropriate form of price regulation for terminating segments. It should be noted that, notwithstanding the form of the price regulation adopted, if BT were to recover its common costs relating to terminating segments in such a way that was anti-competitive then OFTEL could use its powers under BT s Licence and the Competition Act 1998 to control that behaviour. 69

74 Geographic averaging of network charges for wholesale terminating segment services G10 OFTEL has considered whether the prices for wholesale terminating segments services should be set on a geographically averaged or deaveraged basis. There are three difficulties with setting an averaged prices: since costs of terminating segments will vary depending upon the geographic location an averaged price will not trully reflect the costs of provision in the specific area; given these cost difference an averaged price will not provide an efficient entry signal; and geographically averaged price will make it more difficult for BT to respond to competition in particular geographical areas. G11 In view of these difficulties OFTEL has considered whether prices for wholesale terminating segments services should be set on a deaveraged basis. There are however two significant disadvantages to allowing BT complete freedom to deaverage these prices. Consumers in geographic areas which are less competitive or in which it is more costly to provide terminating segments would probably end up paying more for end to end retail leased lines than they do currently and when compared to consumers in higher density areas. The price control will include both competitive and non-competitive areas and therefore, in that form, its structure would give BT an additional incentive to price in a predatory manner in competitive areas and excessively in less competitive areas through its choices about where it choose to recover its common costs. G12 OFTEL believes that there is a way of finding a balance between the two extremes of complete geographic averaging and deaveraging. One way in which OFTEL suggest a balance can be found is for the prices of wholesale terminating segment services to be set on a geographically averaged basis, subject to the overall price control, but to allow BT to offer discounts from that averaged price in certain areas where it faced lower costs or more competition. These discounts would not however contribute to BT s obligation to meet the overall price control. Therefore under this proposal BT would be able charge lower prices for wholesale terminating segment services in a particular geographic area, but would not be able to raise prices in certain other geographic areas. G13 An important advantage of the proposal is that it would mean that the regulatory framework would take account of the fact that competition in terminating segments varies and is likely in the future to continue to vary between geographic areas. Therefore, in the case of CLZ, where as discussed in chapter 3 there is some evidence that the area is more competitive than the rest of the country, BT would be able to respond to competition by offering discounts from its geographically averaged price for terminating segments. OFTEL would investigate complaints that BT s discounts were anti-competitive under BT s licence or the Competition Act Cost recovery and PSTN pricing structure G14 OFTEL has considered how its proposals under Option C would impact on BT s ability to recover its costs on PSTN services. 70

75 G15 The issue arises because there is a level of traffic at which a customer is better off purchasing a private circuit rather than using a PSTN service to a specific destination. The point at which its arises will depend on the relative prices of PSTN and private circuit services. OFTEL s proposals are designed to result in the prices of private circuits reducing from current levels and this will affect the point at which it is economic to switch between PSTN and private circuits such that more customers may be induced to purchase leased lines rather than PSTN services. If this did occur it could have implications for BT s ability to recover its costs on PSTN services and so have implications for the PSTN pricing structure. G16 This possibility is not a new phemenon, however. For example, it already exists as a result of the competing PSTN carriers including those who use indirect access. OFTEL has made clear in those contexts that if BT had difficulty in recovering its costs on PSTN services, because of migration by customers to other services, then it would take appropriate action. Therefore, if OFTEL were to decide implement Option C then it would follow the same approach to this issue of cost recovery on PSTN services. Questions Annex G, question 1 Do you agree that LRIC + pricing is the most appropriate basis for pricing wholesale terminating segment services? Annex G, question 2 Do you agree it is most appropriate to have a single basket for terminating segment services of all bandwidths? If you disagree with this proposal and believe that prices should be set at each bandwith please explain how you believe the common costs should be allocated. If you disagree with this proposal and believe some variant of form (ii) should be adopted, please explain why and what the appropriate number of controls by bandwidth would be. Annex G, question 3 Do you agree that there should be separate baskets for the two components of Service A? Please explain, providing data if possible, what the respective competitive pressures are and are likely to be in relation to these two components. Annex G, question 4 Has OFTEL identified the advantages and disadvantages of geographic averaging of prices correctly? Annex G, question 5 Do you agree with the proposal that BT s prices for wholesale terminating segment services should be set on a geographically averaged basis but BT should be allowed to offer discounts from those prices which will not contribute towards meeting the overall price control? If not, 71

76 please suggest other ways of finding a balance between the advantages and disadvantages of geographic averaging. 72

77 Annex H Cost Benefit Analysis H1 In order to gain a clearer understanding of the potential costs and benefits of introducing new regulation, OFTEL carried out a cost benefit analysis of introducing wholesale terminating segments (option 2), price capped wholesale terminating segments (option 3) and an end to end retail price cap (option 4). Benefits Reduced prices Terminating segment (Both price capped and non-price capped) H2 The introduction of wholesale terminating segment service will address barriers to entry in the retail leased line market and should enable vigorous price competition to take place. Increased competition will lead to lower prices for retail leased lines. Lower prices lead to a higher demand and output and hence to a welfare gain. Price capped terminating segments are estimated to yield greater price reduction, because OFTEL will set overall price levels of terminating segments. In the absence of price caps, BT may set price on terminating segments which restrict the ability of OLOs to offer lower retail prices. Note that the Competition Act prohibitation of anti-competitive behaviour will prevent BT from pricing terminating segments at excessive prices. The price reductions are based on increased competition reducing prices towards costs. OFTEL has based its estimate of price reduction for the CBA on prices moving towards the level of competitive (or LRIC + mark up for common costs) prices. The LRIC plus allocation for common cost prices are based on the outcomes of top-down and bottom-up cost modelling (see Annex F). OFTEL has assumed a staged reduction in prices of digital leased lines with the availability of price capped terminating segments, by 10% in 2001 and by 20% from The size of the welfare gain is based an elasticity of demand for digital leased lines of 0.5 and assuming an underlying market growth of 10% per year. Retail price reductions from the availability of (non-price capped) terminating segments are 5% in 2001 and 10% from Retail Price Cap H3 The introduction of retail price caps will also lead to lower retail prices, due to one-off and ongoing reductions in retail prices when the price cap is introduced. Prices are not expected to fall to the same extent as under the competitive process from the introduction of wholesale terminating segments due to the practical difficulties in mimicking the competitive process by price regulation. One difficulty is the information asymmetries between the regulator and the regulated firm, which make it difficult for the regulator to know the actual costs of the regulated firm. Whereas in a competitive market, prices will be competed down to cost (including a reasonable rate of return). The information asymmetry suggests that a regulator will not in practice reduce prices to actual costs. OFTEL has estimated that overall prices will fall by 15% over the CBA period at a rate of 3% per year for the first 5 years. No further price reductions are assumed. 73

78 Cost Efficiency Price Capped Terminating Segment H4 This benefit is based on increased cost efficiency by BT in response to a price control of terminating segments and increased competition in the retail market. Increased competition will increase the pressure on BT to make cost efficiency gains in the provision of retail leased lines. The wholesale price cap on terminating segments will also include an expected efficiency gain in the regulated price. Hence BT can be expected to make efficiency gains on both the wholesale and retail elements of leased lines. OFTEL has estimated the annual efficiency gain as a 1% reduction per year (or 10% over the CBA period) in the incremental costs of digital leased lines, based on independent research on potential efficiency gains by BT in PSTN and leased line services. Terminating Segment (no price cap) H5 In contrast to the price capped terminating segment, the introduction of a wholesale product without a price cap will not provide an incentive for BT to make efficiency gains on the terminating segment. Increased competition in the core will provide incentives for BT to make efficiency gains on this section of the network. OFTEL has estimated the efficiency gains as 1% per annum (or 10% over the CBA period) of BT s incremental cost of the core network for digital leased lines. Retail Price Cap H6 The retail price will include an expected efficiency gain into the price cap for end to end leased lines, to reflect the expected efficiency gains. However in the long run a price cap on main links as well as terminating segments is likely to discourage some element of cost saving in the provision of main links relative to the expected gains in a competitive environment. This is because a price cap shares the gains of efficiency savings between the regulated operator and consumers and hence may discourage the regulated operator from seeking additional cost efficiencies. However OFTEL has not incorporated the impact of this disincentive to make efficiency gains into its analysis. OFTEL has estimated the annual efficiency gain as a 1% per annum (or 10% over the CBA period) reduction in the incremental costs of digital leased lines. Other Benefits: Wholesale Terminating Segments H7 There are a number of other benefits arising from the introduction of wholesale terminating segments that OFTEL has not attempted to quantify at this stage. These benefits will not occur in most cases under retail price caps. Avoidance of inefficient entry H8 There maybe benefits from reducing the amount of inefficient entry into the market for terminating segments. Current prices for terminating segments are retail prices and this may induce inefficient entry by OLOs in the terminating segment market especially for high bandwidths. Inefficient entry would take place where OLOs costs of building out terminating segments were greater than the cost for BT to provide the equivalent terminating segment. A 74

79 retail price cap may also discourage inefficient entry as the overall returns on leased lines will be reduced. Increased Competition in Data services which use leased lines as an Input H9 A range of data service use leased lines as access circuits such as ATM and Frame Relay services. These data services will benefit from the introduction of wholesale terminating segments priced at LRIC+ as it will enable OLOs to use the wholesale service to provide access to their data networks. This should enable OLOs to compete more vigorously in the provision of data services and hence should result in benefits of the type discussed above such as reduced prices and improved cost efficiency. It will also reduce the risk of inefficient terminating segment construction for data services. Increased Choice H10 Consumers will benefit from increased choice as the availability of a wholesale terminating segment should enable OLOs to offer leased line services in parts of the country or bandwidths where they do not currently provide services. New entry may also occur in the leased line market as a result of the availability of a wholesale product. Increased choice is likely to result in non-price benefits to consumers such as selecting a supplier that more closely meets their quality of service requirements and improving the diversity of product options available to customers. This benefit will not arise under retail price caps, in fact the introduction of retail price caps may reduce the level of existing competition and reduce the consumers ability to choose between operators. Innovation H11 Increased competition arising from the introduction of wholesale terminating segments may lead to increased innovation in the provision of leased line services. OLOs may develop a greater range of products to meet diverse customer needs. Although innovation is likely to be constrained by specifications of the wholesale product available from BT. Increased innovation will not occur under retail price caps, in fact introduction of retail price caps may reduce the level of existing competition and hence reduce the level of innovation in the delivery of leased line services. Table 1: Estimate of the Net Present Value of the Benefits of a Wholesale Terminating segments Net Present Value of Benefits ( m) Option 2 Option 3 Option 4 Terminating Segments Price Capped Retail Price No Price Caps Terminating Segment Caps Price Reduction Cost efficiency Total Benefit

80 Costs Compliance Costs H12 Compliance costs are expected to increase for both BT and for OFTEL. In particular BT may face one-off costs associated with developing and producing regulatory accounts for the new wholesale product and complying with a new price control regime for leased lines. OFTEL will bear increased costs associated with developing and implementing a price control regime. However, OFTEL may also benefit from reduced licensing and competition complaints associated with the pricing of BT s leased lines. The introduction of retail price caps is expected to cause the greatest compliance costs due to the extent of the regulation, while wholesale terminating segments without price caps have the least compliance costs due to avoidance of the regulatory costs of setting prices. Interconnection costs: Terminating Segments H13 The availability of wholesale leased lines may lead to an increase in the number of interconnection points sought by OLOs. OFTEL notes that OLOs already have substantial interconnection points with BT. It is difficult to estimate how much new entry will occur in the wholesale market. OFTEL has based our estimate on 4 new OLOs entering by 2010 and 20 new interconnection points being established on average per OLO. Increase in Average Costs: Terminating Segments H14 OFTEL has not included any costs associated with increase in average cost due to the loss of economies of scale in the provision of leased lines. In the case of an industry where some costs are fixed or there are economies of scale, a reduction in the number of customers due to an increase in the number of competitors will lead to an increase in the average cost. In this case, BT may lose market share in the retail leased lines market due to the increased competition arising from regulation of the wholesale market. Therefore, it is plausible that BT s average costs particularly in the trunk network could increase. However there will be offsetting resource gains to the economy due to the increasing economies of scale experienced by OLOs with existing networks due to increased volumes. On the basis of current information, it is not clear whether the losses in economy of scale to BT will be greater or smaller than the gains in economies of scale to existing OLO s. Hence no cost or benefit has been included in the CBA. Table 2: Estimated Net Present Costs of the introduction of a wholesale terminating segment Net Present Value of Benefits ( m) Option 2 Option 3 Option 4 Terminating Segments Price Capped Retail Price No Price Caps Terminating Segment Caps Compliance Costs Interconnection Costs Total Costs

81 Base Case H15 The base case against which the costs and benefits of the wholesale terminating segments and the retail price cap are compared is that the current regulatory regime continues until This base case is used in order to demonstrate the costs and benefits of the regulatory options against the current environment. Measurement H16 In order to measure the costs and benefits, a number of assumptions have been made. The main assumptions are shown in Table 3. H17 The costs and benefits are estimated for the period , assuming that wholesale terminating segments are introduced from January A real discount rate of 6% is used, in line with the Government s test discount rate. The Government test discount rate is appropriate as the costs and benefits of this policy option are considered from a national perspective and not that of a telecommunication firm. Table 3: Central Assumptions Price reduction (options 2) Price reductions (option 3) Price reduction (option 4) Elasticity of Demand Central Assumption 5% in year 1 and 10% ongoing 10% in year 1 and 20% ongoing 3% per year for the first 5 years 0.5 Increase in Cost Efficiency 1% of BT s incremental costs 0.5% 1.5% Growth in market size 10% 5% 15% Interconnection and Compliance Costs Central Estimate of the CBA Table 4: Central Estimate of the CBA As described above Other Values Tested 5% 20% 10% 30% 2% 4% % overestimate 50% underestimate Net Present Value of Benefits ( m) Option 2 Option 3 Option 4 Terminating Segments Price Capped Retail Price No Price Caps Terminating Segment Caps Net Present Benefit Net Present Cost Net Present Value

82 H18 Table 4 shows the impact of bringing the costs and benefits together for all three options. The central estimate of the CBA for option 2 is a net present value of 37 million, option 3 of 182 million and option 4 of 145 million. H19 However this central estimate relies on the accuracy of the assumptions used in the CBA. Given the degree of uncertainty involved in the modelling of the future behaviour of any market, this is unlikely to occur. It is more sensible to examine how the results of the CBA change as the assumptions vary by reasonable amounts, and produce an estimated range of values. Sensitivity Analysis H20 Table 3 sets out most of the assumptions used in the CBA. These assumptions are tested as part of the sensitivity analysis. Table 5 shows the result of the sensitivity testing. The main results from the sensitivity analysis are: the result is robust for changes in any single assumption; the net present value of both option 2 and 3 are most sensitive to the expected price reduction and the price elasticity for end to end retail leased lines ; retail price caps are most sensitive to the to the estimated gain in cost efficiency; the net present value of all options are relatively insensitive to changes in the compliance and interconnection costs. H21 Table 5 shows the impact of changing one assumption at a time. H22 It is possible that more than one assumption will prove inaccurate. To test the robustness of the CBA to multiple changes in assumptions, two scenarios have been constructed. Scenario 1: In this scenario, retail prices fall by only 5% for options 2, 10% for option 3 and 2% per year for the first 5 years for option 4, the price elasticity is 0.1, cost efficiency gains are restricted to 2% of incremental cost. Costs are assumed to be 50% greater than the central estimate. This gives a net present value for Option 2 of (13) m Option3of 5m Option 4 of 40 m Scenario 2: In this scenario, retail prices fall by 20% for options 2, 30% for option 3 and 4% per year for the first 5 years for option 4, the price elasticity is 0.7, cost efficiency gains are 6% of incremental cost per year. Costs are 50% lower than the central estimate. This gives a net present value of: Option 1 of 193 m Option 2 of 494 m Option 3 of 220 m 78

83 Conclusion H23 The results show positive benefits of all proposals to regulate the leased line market. On current information, wholesale price caps on terminating segments yield the greatest net benefits. Although subject to considerable uncertainty, the results seem robust to a variety of different assumptions with a significant benefit of price capped terminating segments in almost every case. Furthermore, the balance of non-quantified costs and benefits also appears to favour terminating segments. 79

84 Terminating Segments (No Price Caps) Price Reduction Benefits Cost Efficiency Benefits Total Benefits Total Costs Standard Retail price reduction of only 10% Retail Price reduction of 30% Price elasticity of Price elasticity of Price elasticity of Cost efficiency of 6% of incremental cost Cost efficiency of 2% of incremental cost Compliance costs 50% greater than forecast Compliance costs 50% less than forecast Terminating Segments (Price Caps) Price Reduction Cost Efficiency Total Benefits Total Costs NPV Benefits Benefits Standard Retail price reduction of only 10% Retail Price reduction of 30% Price elasticity of Price elasticity of Price elasticity of Cost efficiency of 6% of incremental cost Cost efficiency of 2% of incremental cost Compliance costs 50% greater than forecast Compliance costs 50% less than forecast NPV 80

85 Retail Price Caps Price Reduction Benefits Cost Efficiency Benefits Total Benefits Total Costs Standard Retail price reduction of only 10% Retail Price reduction of 30% Price elasticity of Price elasticity of Price elasticity of Cost efficiency of 6% of incremental cost Cost efficiency of 2% of incremental cost Compliance costs 50% greater than forecast Compliance costs 50% less than forecast NPV 81

86 Annex I Glossary ATMservice data services using Asynchronous Transfer Mode technology, such as BT s Cellstream service or Energis s Cellconnect Central London Zone (CLZ) pricing BT offers reduced charges for some leased lines if both ends are within the 0171 exchange area. DSL technology digital subscriber line technology. DSMU (Digital Main Switching Unit) a trunk exchange primarily used for connecting calls between DLEs. DLE (Digital Local Exchange) the telephone exchange to which customer are directly connected (also referred to in this document simply as a local exchange ). Frame Relay service a packet switched data service providing for the interconnection of Local Area Networks and access to host computers at up to 2 Mbit/s. Leased line A permanently connected communications link between two premises dedicated to the customers exclusive use. Also known as a private circuit. Local end circuits The leased line between a customer s premises and the local exchange Main link The leased line between the local exchanges of the customer s premises. Mbit/s Mega (million) bits per second. A measure of speed of transfer of digital information. Multi-vendor circuits A leased line provided to a customer which uses the network infrastructure of more than one operator. eg one local end and a main link from operator A and a final mile circuit rented by operator A from operator B. Partial private circuit BT s Link to a Point of Interconnection product. This is a private circuit from a customer s premises to point of interconnection between BT and another operator s network. It is only available at 2Mbit/s to be purchased by PTOs. Own-exchange circuit A leased line linking two premises connected to the same local exchange. Terminating segment 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. Trunk segment A trunk segment is capacity between the serving centres for leased lines at trunk exchanges, that is between any of BT s DMSU centres used for routing leased lines. 82