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Summary

1.1 This is the final statement to Ofcom’s review into valuing BT’s copper access network (i.e. the network assets BT uses between the telephone exchange and each user of telecommunications services). There are two elements to this: the valuation and the operational costs. BT recovers the costs associated with these assets through the charges it makes for their use. The valuation provides an element of the cost called the return on capital employed which is calculated as a percentage (the cost of capital) of the value of the assets and drives the amount of depreciation. The operational costs comprise all other costs such as maintenance and overheads.

1.2 The determination of the costs associated with the network is important because it forms part of the cost of some products provided by BT to other communications companies to enable them to provide services to their customers. These products include wholesale line rental (WLR) and local loop unbundling (LLU). WLR is used to provide telephone services and LLU is used mainly to provide broadband services. Clearly if the value of the network is not correct, then the amount BT charges communications companies for using the network may lead it to over-recover or under-recover against its costs, neither of which is in the interests of consumers. This statement is concerned with the method by which the value of the assets and the depreciation charges are calculated whilst a separate review has examined the cost of capital . The operational costs are allocated on the basis of the detailed attribution methods documented by BT.

1.3 Ofcom began this review in May 2004 in response to its belief, as a result of its strategic review of telecommunications , that it is now unlikely that within the near future any new operator will enter the UK communications industry and build a nationwide access network able to perform the same function as that owned and operated by BT. Although the cable companies have built large networks and are able to offer telephone and broadband services – as well as other services such as TV – in direct competition with BT, they only cover around half of UK homes. Ofcom does not believe the cable companies will significantly increase their coverage in the near future. This means that for a large number of UK homes and businesses BT is the only provider of local access to them and that this is unlikely to change in the near future. This lack of effective competition means that it is important to ensure that the price that other companies, and ultimately consumers, pay for using BT’s network is not too high.

1.4 At the outset this review was concerned with verifying that the method used to value BT’s network was accurate. With the exception of the way BT counts the amount of network equipment it has – discussed further below – Ofcom was satisfied that the method used by BT produced an answer for the value of the network which was as accurate as could reasonably be expected. However, in the course of this work Ofcom became concerned that, if certain changes were not made to reflect past changes in the path of cost recovery, there was the potential for BT in the future to recover more than the costs it had actually incurred. Ofcom has decided to make these changes to limit this over-recovery. It is expected that these changes will only be required once in order to correct the path of cost recovery, on a forward-looking basis, for the change in accounting treatment in 1997 to some access network assets.

1.5 In 1997 Ofcom’s predecessor, Oftel, changed the way BT accounts for its network assets in its regulatory accounts. These accounts are different to the statutory accounts BT presents to the City and are used by the regulator to understand BT’s costs. Oftel chose to value BT’s network assets based on how much it would cost to replace them at today’s prices (known as ‘current cost accounting’ or CCA) rather than how much BT spent on them when it bought them (known as ‘historical cost accounting’ or HCA). The reason for the change is that it allowed regulated prices to be set based on what it would cost to replace the network or for somebody else to build the same thing. Thus, if somebody could do it cheaper than BT then they should be encouraged to build their own network and under-cut BT’s prices. Ofcom still believes that this is the right way to do things where, as in most cases, entry signals are a major consideration.

1.6 At the time Oftel’s analysis showed that this change in accounting treatment would not result in BT over- or under-recovering its costs during the next price control period, which lasted until 2001. However, no analysis was performed to see what would happen after that as it was expected that competition would emerge as the main constraint on prices. In this review, Ofcom has looked again at cost recovery by BT and has determined that if nothing is done the current prices, as set by Ofcom, that BT charges competitors for access to its network will result in BT recovering more than its costs for all the copper access network assets that were already deployed at the time the change in accounting treatment was made, that is 1 August 1997. There should be no systematic over- or under-recovery of cost related to network assets purchased after 1997 as these have been consistently treated under current cost accounting.

1.7 Ofcom has therefore decided to create a regulatory asset value, or RAV, to represent the remaining value of the pre-1997 copper access network assets rather than continuing to value those assets at their current cost. The value of the RAV is set to equal the closing historical cost accounting value for the pre 1 August 1997 assets for the 2004/5 financial year and its value will be increased each year by the Retail Price Index to ensure it is not eroded by inflation. Over time the RAV will gradually disappear as the pre-1997 assets are gradually replaced with new ones.

1.8 Some responses to Part 2 of this review queried why Ofcom was not calculating whether and, if so, by how much BT had over-recovered in the past and whether this amount could be taken back. Ofcom does not believe that it is appropriate to take back money from BT that it has earned in the past, based on prices set by the regulator, as this would lead to huge uncertainty as to how prices today might be affected by decisions yet to be made.

1.9 In Part 2 of this review Ofcom did consider some more radical changes to the way the value of BT’s copper access network is calculated. This included basing the value of BT’s network on what somebody might spend if they were to build a brand new network today as opposed to simply replacing what BT has. Responses from those companies which do not have their own network were in favour of such an approach as it would lead to the result that might be expected if an effective competitor to BT were to build their own network. In contrast, those companies which do have their own network – BT and the cable companies – did not agree with this approach. Ofcom agrees that such an approach is not appropriate as there is a great deal of subjectivity in the modelling and it is important that the model is right if it is to be used. Also, the use of such a model could require Ofcom to become intrusively involved in BT’s internal network planning and investment decisions. It is Ofcom’s view that with the information available today it is better to base costs on something real, i.e. BT’s network, as a more objective way of determining what the replacement cost would be.

1.10 For the same reason, Ofcom does not believe it is right to reduce BT’s valuation to account for spare and surplus network assets or for the fact that some of the network assets BT has deployed are no longer available new. Ofcom further believes that BT’s estimate of the manpower cost of building the network, the labour rate, is the most objective estimate available today of what it might be if the network were to be replaced. Ofcom also does not wish to change the way in which the cost of equipment used in both BT’s access and core networks, i.e. shared duct, is split between the two.

1.11 However, Ofcom does believe it is appropriate to adjust the accounting lives BT uses for it copper and duct access assets in its regulatory accounts. Ofcom proposes to align these more closely to international benchmarks and to typical service lives. Copper will therefore change from an accounting life of 15 years to 18 years and duct from a rolling 25 years (but effective average 38 years) to a straight line 40 years. Also, Ofcom believes it is appropriate to reduce prices that BT can charge if there is evidence that BT is operating its network inefficiently and this is something Ofcom will consider when the prices of services, e.g. WLR and LLU, are determined. Also, Ofcom expects that as BT establishes its Access Services Division – as outlined in Ofcom’s recent Notice under Section 155(1) of the Enterprise Act 2002 – it will need to look again at the sharing of costs between access and core and Ofcom will be involved in this process.

1.12 Finally, Ofcom explained in both Part 1 and Part 2 of this review about its concerns over the way in which BT currently counts the amount of equipment it has in its copper access network and the accuracy of the result. BT has explained to Ofcom that it is in the process of automating its paper records of equipment through its PIPeR project, in support of network operations, and that it expects that this can be used to provide a more accurate estimate in future of the total amount of equipment deployed in support of CCA valuations. Ofcom agrees that this is a promising route to solving the problems with the current method and will work with BT to agree a plan to migrate to the use of PIPeR and ensuring that the accuracy is improved.

1.13 Together with the change in the weighted average cost of capital for BT’s access network assets, as determined in Ofcom’s Cost of Capital review, the changes that Ofcom has decided to make result in an overall reduction of £17.31 in the estimated average cost for the financial year 2005/6 for the parts of the copper loop considered within the scope of this exercise (i.e. the D and E-side duct and copper). The revised cost of the in-scope components is £59.10 for the financial year 2005/6. These figures are necessarily estimates, since they are calculated with reference to assumed changes in the CCA valuation of the assets for which actual data will not be available until after the end of the financial year ending 31 March 2006.

1.14 Further, this number needs to be adjusted slightly when applied to each service to account for differing fault rates by service and the presence of Digital Access Carrier System (DACS) equipment on some loops (which allows two voice lines to share the same loop). Further work will be undertaken, as part of the current analysis by Ofcom into the cost of WLR and LLU services, in order to establish the cost of the copper loop for each line bearing such products. However, Ofcom considers that a reasonable estimate of costs for the parts of the copper loop considered within the scope of this exercise to be the following, for the financial year 2005/6:

• WLR – £58.51 per line; and
• LLU – £60.11 per line.

1.15 The WLR and LLU reviews will also consider the need for any efficiency factor which should be appropriately taken into account in respect of the costs relevant to the copper loop and any further adjustments to the level of operating costs which may appropriately be attributed to those products or to the cost of a copper loop.

1.16 The RAV relates only to assets which were in place at the time of the switch from HCA to CCA, i.e. 1 August 1997. All assets added after this date have been treated consistently under CCA and will continue to be so. This means that over time the asset base will move toward a full CCA valuation as pre-1997 assets are retired and replaced with new ones. As a result the RAV will gradually “unwind” and costs will be calculated on a full CCA basis. Due to the shorter asset life this effect is more rapid for copper than for duct. If it is assumed that duct has a 40 year life (in line with the accounting treatment outlined in this review) then in theory the last remaining assets included in the RAV will become fully depreciated in 2037/8. From this point forward all assets would be treated under a full CCA basis and would have been so throughout their life. In terms of the near term impact of this convergence, Ofcom estimates that the unwinding of the RAV means that the cost of the in-scope assets is likely to be approximately 3% higher in 2009/10 than in 2005/6. This impact relates to the unwinding of the RAV only, and does not take account of any other cost changes such as changing asset prices and their impact on the CCA valuation. Ofcom will give consideration to these effects in its analysis of LLU and WLR charges.

1.17 It should be noted that Ofcom has compiled these estimates based on the most recent data available to it in respect of current cost accounting data for the financial year 2004/5. The external audit of these figures is ongoing and audited versions of BT’s regulatory financial statements are not due to be published until early September. Furthermore, Ofcom wishes to obtain further data from BT to inform its analysis of historical and future trends in relation to operating costs. Therefore, although Ofcom believes that the data provided to it are likely to be sufficiently robust to support the numbers presented above, Ofcom may need to adjust these in the LLU and WLR consultations were substantial unexpected changes to the data to arise following completion of the audit process or of Ofcom’s review of the operating cost data supplied to it by BT.

1.18 Ofcom intends to implement the results of this review via the forthcoming fully unbundled rental charge consultation (expected early September 2005) and the WLR charge consultation expected later this year. In parallel Ofcom will work with BT and industry to determine how these results might be represented in the regulatory financial statements and how to migrate to PIPeR as the basis of preparing the valuation.

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