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Introduction

4.1 The previous chapter set out Ofcom's decision on SMP in the markets for mobile voice call termination services. In Chapter 5 of the May consultation, and Chapter 4 of the December consultation, there was a discussion of the evidence in relation to the likely detriments arising from SMP in mobile termination markets (in addition to proposals for an SMP finding).

4.2 Ofcom does not intend to re-visit these arguments in detail in this statement. Rather, a summary of Ofcom's position is provided, together with references to earlier consultations, followed by a discussion of points raised specifically in response to the December consultation.

Summary of position

4.3 Ofcom's view is that in the absence of regulation, the SMP held by the MNOs would lead to excessive termination charges. See paragraphs 4.3-4.9 of the December consultation for further discussion.

4.4 Ofcom believes that these excessive charges would lead to detriments for consumers, and that the 'waterbed' or 'swings and roundabouts' effect - by which excess profits from termination services may be returned to mobile users via lower retail prices - does not provide a justification for the structure of charges that would arise in the absence of regulation.

4.5 The first reason for concern is that the 'waterbed' effect may not be complete, i.e. competition in the retail market may not be sufficient to drive out all of the excess profit. If this was the case, then the benefit from reducing excessive termination charges would be clear, as it would prevent MNOs persistently earning excess profits overall. However, even assuming there was a complete 'waterbed' effect, there are four other relevant detrimental effects from excessive termination:

• the resulting reduction in economic efficiency;
• the undesirable distributional effects;
• the distortion of consumer choice; and
• the increased risk of anti-competitive behaviour.

4.6 These were outlined in some detail in the May and December consultations (see Chapters 5 and 4 respectively)

Responses to the December consultation

The likelihood that MNOs would set excessive termination charges

4.7 Orange submits that termination charges are subject to a 'downward ratchet effect' (Orange submission, page 3), and that the only appropriate 'base case' when considering regulation is the current level of charges. In Orange's view, it is a 'simple fact that absent (mobile voice call termination service) specific regulation no mobile operator could unilaterally increase its wholesale charges...'. Orange argues that it could only increase charges with BT's consent, which would be unlikely. This would mean that a dispute - and dispute resolution by Ofcom - is the only plausible outcome. Orange alleges that Ofcom has misinterpreted its powers to resolve disputes, and claims that it is open to Ofcom to refuse to allow an operator to increase its prices in resolving a dispute, whether or not that operator has SMP. Orange therefore claims that Ofcom has made a material error of fact in assuming that, in the absence of regulation, MNOs would raise their CTM rates to levels in excess of 20 pence per minute ("ppm").

4.8 Ofcom believes these points have been partially addressed in the December consultation (see paragraphs 4.3-4.9). The two (related) issues raised again are whether BT has countervailing buyer power, given its regulatory obligations, and whether dispute resolution would provide any additional constraint on an MNO's charges once a finding of 'no SMP' has been made.

4.9 Orange identifies BT's countervailing buyer power as a potential source of pressure on an MNO's charges. As discussed in paragraph 3.30 of this document, Ofcom does not believe that the existing regulatory framework would, in practice, allow BT (as an originating operator) to reject price increases by disconnecting an operator without SMP.

4.10 On the issue of what might happen if a dispute is raised, Ofcom cannot, as a matter of law, fetter its discretion in resolving a dispute. However, Ofcom rejects (what appears to be) Orange's main rationale in raising this allegation. Namely, Orange seems to be suggesting that it is always open to Ofcom to resolve a dispute by making a determination under section 190 of the Act prohibiting the relevant price increase to be made. Ofcom disagrees with that view.

4.11 Any determination by Ofcom resolving such a dispute must be aimed at achieving the policy objectives in Article 8 of the Framework Directive (see the Community requirements in section 4 of the Act). Furthermore, Article 20(3) of the Framework Directive also makes it clear that any obligations that Ofcom imposes in resolving the dispute must respect the provisions of the new Directives. Thus, in the light of these provisions, Ofcom needs to form a view as to what is the appropriate way of exercising all of its powers under the Act in the circumstances of each case.

4.12 As mentioned above, the December consultation addressed the efficiency and appropriateness of dealing with excessive termination charges via ex post regulation. In particular, paragraph 4.7 of the December consultation explained the extensive compliance and monitoring requirements entailed in the development and implementation of cost-based prices, indicating that ex ante regulation is likely to be preferable in this case.

4.13 Furthermore, the implication of Orange's suggestion above appears to be that price increase disputes could be referred frequently to Ofcom. If so, given the need for timely intervention and legal certainty across the industry, Ofcom considers that reliance on its powers to resolve disputes would not be the most appropriate way to achieve the objectives set out in Article 8.

4.14 In this context, Ofcom notes it has the power to resolve the price increase dispute in question by determining that it will not prevent the increase until it has exercised its powers to set, inter alia, an SMP condition (see section 190(4) of the Act). Accordingly, Ofcom does not accept that it has made a material error of fact in rejecting dispute resolution as a constraint on the MNOs' ability to price excessively.

4.15 T-Mobile also claims that the 'unregulated' charge scenario used in the December consultation in the cost-benefit analysis of regulation is implausible. It suggests that charges as high as 24.6ppm would not occur because:

1. "the assumed level is substantially above the level (13.42ppm) that existed prior to regulatory intervention^(-15-);
   
   
2. since 1998, unit costs have fallen and there are now greater competitive pressures on termination;
   
   
3. termination charges in markets that have remained unregulated have fallen significantly; and
   
   
4. one operator was willing to commit to the CC not to increase its termination rates whilst another was willing to commit to gradually reduce its rates." (T-Mobile, Part II, paragraph 29)

4.16 Ofcom notes the termination charge of 24.6ppm is an estimate derived from the Rohlfs model^(-16-) as being the monopoly price. While this would require a significant increase over current charges, and it may take some time for charges reach this level, Ofcom does not consider charges of this order of magnitude to be implausible in the absence of regulation. This view is consistent with evidence Vodafone presented to the CC inquiry (or 'CC report'^(-17-)) that, given the level of competition in the retail market, MNOs would be subject to pressures to set excessive charges, and that these charges could rise as high as 17-20ppm (see paragraph 2.441). Ofcom does not believe it can attach significant weight to evidence supplied by T-Mobile and Orange as to the previous level of charges, as these charges were set in the context of the informal regulatory pressure that existed prior to the imposition of formal regulation on these MNOs (formal regulation has been applied to Vodafone and BT Cellnet / O2's termination charges since at least 1995).

4.17 On T-Mobile's other points, while unit costs have fallen over the past few years, the estimate in the Rohlfs model uses estimates of incremental costs for 2005/06. Consequently, forecast reductions in unit costs are already accounted for in this estimate. Secondly, Ofcom is not aware of evidence that suggests that, in countries using the CPP arrangement, charges for mobile termination have fallen significantly in the absence of formal (or informal) regulation. Finally, the commitment by some MNOs not to increase charges suggests that this was likely to be a more favourable remedy for these MNOs than the alternative remedy (LRIC-based charging) that could have been - and was - proposed by the CC.

4.18 Ofcom therefore continues to believe that excessive termination charges would be set by MNOs in the absence of regulation. To the extent that the charge may not be as excessive as the monopoly level of 24.6ppm derived in the Rohlfs model, this will be relevant in considering the robustness of the cost-benefit (welfare) analysis. This is further addressed in the Charge Control chapter (paragraph 6.105).

Reduction in economic efficiency

4.19 Both the May and December consultations outlined the analysis of the efficiency losses resulting from excessive termination charges. Essentially, the losses result from the unbalanced structure of prices, leading to under-consumption of retail services which use wholesale termination services as inputs, and over-consumption of other mobile services.

4.20 Orange and T-Mobile both comment critically on the cost-benefit analysis, with neither believing that the analysis (presented in Annex L of the December consultation) provided sufficient support for price controls. These criticisms were essentially that (a) Oftel's models understated the efficient charge for mobile termination, and (b) Oftel's "unregulated charge" scenario was implausible. T-Mobile also suggests that an assumption of excess profits, built into the cost-benefit analysis, was responsible for the result of welfare gains from regulation.

4.21 Ofcom has addressed the issue about the likelihood of excessive charges in the absence of regulation in the section above. Issues about the level of the 'efficient charge', incorporating LRIC, common cost recovery and an externality adjustment, have been addressed in much detail in both the May and December consultations. Notwithstanding issues which are further addressed in this document (see the Charge Control chapter), Ofcom believes that all of the relevant concerns of the MNOs have been addressed and that it is highly unlikely that the 'efficient charge' used in the welfare analysis is understated.

4.22 On T-Mobile's point about the 'assumption' of excess profits, Ofcom rejects the proposition that such an assumption is responsible for the result of welfare gains from regulation. As noted in the December consultation (paragraph L.34), the welfare comparison is between two scenarios - one scenario where mobile termination charges are high, and one in which they are capped by regulation - which are both explicitly zero-profit outcomes. That is, the measurement of the gain from regulation in no way relies on reductions in MNO profits.

Undesirable distributional effects

4.23 The December consultation set out the view that excessive termination charges were likely to have undesirable distributional consequences (paragraphs 4.21-4.37). Primarily, this was because there was an identifiable group (those who only owned a fixed phone) that paid high termination charges, but received no benefit from low mobile prices. This group was predominantly lower income.

4.24 Orange comments that the discussion in the December consultation was largely qualitative, and should have incorporated a quantitative assessment of distributional issues similar to the one it provided to the CC. T-Mobile comments extensively on this issue, suggesting at one point that Oftel, in proposing a price control, was "preferring a distributional goal over a consumer-welfare maximising one" (Part I, paragraph 3(a)) and that the price control was "based on Oftel's apparent desire to create a transfer from certain classes of consumers (broadly, net callers from mobiles) to other classes of consumers (broadly, net callers to mobiles)" (Part II, paragraph 18). T-Mobile also alleges Ofcom's approach is inconsistent with its obligations under the Act, questions whether fixed-only households are adversely affected by excessive termination charges, and whether it could be said that fixed-only households were worse off than mobile-only households.

4.25 It should be clear from the May (see, for example, paragraph 5.8) and December consultations (see, for example, paragraph 4.56) that the proposals in this document are not primarily designed to address distributional concerns. T Mobile is therefore incorrect when it states that Oftel's desire was to create transfers, or that Oftel preferred a distributional goal over a consumer welfare-maximising one. It was explained in the December consultation (paragraph 4.24) how the consideration of distributional effects fits in with the duties of Ofcom under the Act and the focus on the maximisation of benefits to end-users. Moreover, the December consultation set out in paragraph 5.161 the reasons why Ofcom considers the section 47 test has been satisfied in relation to the imposition of charge control. Further, in paragraph 5.160 Ofcom sets out why it believes the other relevant tests for the charge controls that are in the Act have been satisfied. Ofcom does not believe that T-Mobile's submission (Part II paragraphs 18-22) on its view of Ofcom's further obligations contains further points of relevance.

4.26 With regard to the evidence of the distributional effects of termination charges, again this was discussed in some detail in the December consultation (which contained further references to the CC inquiry). Ofcom's position is that it considers that it should take account of the fact that, even if there was a full waterbed effect, there are certain groups of consumers that are made substantially worse-off by excessive mobile termination charges. These groups (i.e. those who only use a fixed-line phone, or payphones) are predominantly lower-income^(-18-). The four MNOs seek to 'offset' this detriment by emphasising the benefits conferred on mobile-only users by excessive termination charges and consequent lower retail mobile prices. Ofcom does not, however, accept that it should therefore ignore the detriments to fixed-only users, and refrain from correcting the currently distorted pricing structure - which gives rise to substantial transfers towards mobile-only users - on the basis of the distributional benefits to these mobile-only users. As explained in paragraph 4.24 of the December consultation, Ofcom believes that this approach is in compliance with its duties under the Act.

Effects on consumer choice

4.27 Excessive termination charges feed through into higher retail prices for fixed-to-mobile and mobile-to-mobile (off-net) calls. However, on-net calls have no explicit termination charge, and mobile-to-fixed calls have a regulated (fixed) termination charge. Consequently, the view was expressed in the May and December consultations that consumers' choices are distorted between mobile and fixed calling, potentially driving consumers to use the higher resource-cost technology and reducing efficiency. It was commented that, in the longer term this was likely to distort competition between fixed and mobile operators.

4.28 T-Mobile claims that Oftel did not give serious consideration to the dynamic effects of its proposals; in particular, the impact on competition between MNOs and between the MNOs and BT.

4.29 Ofcom rejects T-Mobile's interpretation, and notes that in the December consultation specific consideration was given to both issues it refers to (see paragraphs 4.17-4.20 and 4.45-4.50 of the December consultation). In relation to competition between MNOs, Ofcom does not believe there are compelling reasons to believe regulation of termination charges would diminish competition markedly between MNOs. The regulatory proposals are designed to be competitively neutral between MNOs. In relation to the potentially higher switching barriers, Ofcom does believe it is important that consumers are able to switch between operators relatively freely. However, this does not justify artificially stimulating switching behaviour through excessive termination charges and below-cost subscription and handset prices. This would risk encouraging competition for its own sake, rather than because it delivers outcomes likely to be in the interests of end-users. To the extent that the price of mobile termination services better reflect costs, competition in retail markets is likely to be more effective in delivering outcomes favourable to all consumers.

4.30 In relation to the competition between MNOs and BT, Ofcom does not believe it would be sensible to encourage competition between MNOs and BT by providing MNOs with favourable regulatory treatment. Rather, Ofcom considers that sustainable competition and substitution between fixed and mobile services by consumers should be driven by the underlying costs of the technologies, facilitated by a neutral regulatory environment. There would be serious doubts as to the sustainability of competition between MNOs and BT if it were underwritten by the excessive pricing of mobile termination services purchased by fixed operators - whose own call termination charges are regulated.

Risk of anti-competitive behaviour

4.31 In paragraphs 4.51-4.55 of the December consultation, it was suggested that higher termination charges could increase the risk of anti-competitive behaviour by MNOs. Primarily, this was because other fixed and mobile operators used termination services as an input into retail services which were also sold by the MNO. While it was not claimed that any particular behaviour would necessarily be anti-competitive, it was noted that the greater the gap between wholesale price and cost, the greater the risk that certain types of behaviour (e.g. discrimination) would have an anti-competitive effect in retail markets.

4.32 T-Mobile claims that, contrary to Oftel's view, implementing a charge control will harm competition rather than reduce the risk of anti-competitive behaviour. It contends that it will reduce competitive pressure on BT, will reduce switching in the retail market, and favour 900 MHz operators (Vodafone and O2) over combined 900/1800 MHz operators (T-Mobile and Orange).

4.33 Ofcom has addressed T-Mobile's points in relation to competition between BT and MNOs and between MNOs in paragraphs 4.29 and 4.30 above. Ofcom rejects the suggestion that the proposed charge control favours any one type of operator - this is addressed in the Charge Control chapter (paragraphs 6.50-6.52) in more detail.

Incomplete pass-through of excessive termination charges to consumers

4.34 In the May and December consultations, it was noted that the 'waterbed' argument relied on the excessive profits earned by MNOs being competed away in retail markets. Although no SMP finding was made in relation to any of the MNOs in the retail mobile market, Oftel did not feel sufficiently confident to conclude that conditions were such as to ensure that the MNOs would always feed through excessive profits earned in supplying termination services into lower prices for retail mobile services. See paragraphs 4.38-4.44 of the December consultation.

4.35 T-Mobile made a number of comments on Oftel's position.

The proposition that the current level of prices generates excess profits is used, inter alia, as a justification for regulation, to reject Ramsey pricing, to choose a very low value for the externality surcharge and to prop up Oftel's Cost-Benefit Analysis....Despite the proposition being a key part of Oftel's analysis, Oftel puts forward absolutely no evidence to support it. (T-Mobile, Part II, paragraph 26)

4.36 Ofcom rejects the notion that excess profits at the current level of prices are a key proposition in the regulation of mobile termination charges. As a first point, the issue is not one primarily about profits at the current level of prices - rather, the relevant consideration is whether, if termination charges were unregulated, the profits earned would be returned in the markets for retail mobile services.

4.37 Over time, as the retail market has become more competitive, it has become less likely that MNOs will be able to hold on to excess profits earned in supplying termination services. Nonetheless, Ofcom believes that in a market with a limited number of competitors and significant entry barriers (due to spectrum scarcity), it is unlikely that this pass-through would be complete, as it would imply that MNO profits are invariant to the level of termination charge. And, indeed, were this to be the case, the MNOs would be unconcerned about the level of termination charges. In fact, it is apparent that they are far from indifferent about their level, which calls into question their claims that termination profits would always be completely bid away in the retail market.

4.38 Secondly, as is made clear in the December consultation (paragraph 4.44), whether or not there is a complete 'waterbed' effect is not a definitive issue - that is, there are other arguments which support regulation even if the profits earned from excessive termination charges were completely competed away. Excess profits are also not used to underpin Ofcom's analysis of the other issues mentioned by T-Mobile, and these comments are dealt with in the appropriate sections of this Statement.

'3' and Inquam

4.39 '3' commented that Oftel did not specifically establish any detrimental effects associated with '3''s pricing of termination services, as it believed its prices had been effectively constrained. This is commented on in the previous chapter on SMP. Ofcom's position is that where excessive charges are set for termination services, there will be detrimental effects. Obviously, the magnitude of the detriment (and the proportionate remedies) will depend both on an operator's subscriber numbers and the proportion of calls to its subscribers that involve the supply of wholesale termination services. This is one reason for the decision to impose 'lighter' remedies on '3' and Inquam than on the other MNOs. However, to the extent that detriment exists (or is likely to exist), Ofcom believes that some remedies will be necessary to ensure that charges are constrained.

Conclusion

4.40 Ofcom does not consider that the arguments made in submissions to the December consultation provide sufficient justification for preserving excessive termination charges. In particular, the 'waterbed' effect (even if complete) does not provide a sufficient justification, fundamentally because it results in a structure of prices that is detrimental to economic efficiency and the interests of end-users. Additionally, excessive termination charges are likely to produce adverse distributional outcomes, distort the development of fixed and mobile competition, and increase the risk of anti-competitive behaviour. Consequently, Ofcom believes that there are likely to be adverse effects from excessive mobile termination charges, and believes this risk is sufficient to meet the tests in section 88(1) of the Act (on the setting of a charge control).

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Footnotes:

15. - Orange also claims that prior to 24 July 2003 charges were unregulated and in the region of 10.8ppm.

16. - The Rohlfs model refers to work undertaken by its consultant, Dr Jeffrey Rohlfs, on models of efficient pricing. For a description of this work, see A model of prices and costs of mobile network operators, 22 May 2002, available from the Ofcom website.

17. - Reports on references under section 13 of the Telecommunications Act 1984 on the charges made by Vodafone, O2, Orange and T-Mobile for terminating calls from fixed and mobile networks, presented to the Director General of Telecommunications, December 2002.

18. - Ofcom also notes that these many of these users do call mobile phones. Oftel submitted to the CC in 2002 that 59% of fixed only households make calls to mobiles. This means that about 3 million (12%) UK households make calls to mobiles from a fixed phone but do not own a mobile phone. See http://www.ofcom.org.uk/static/archive/oftel/publications/mobile/ctm_2002/
distribution120202.pdf for more information.

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