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Partial Private Circuits Charge Control

Final Statement

Summary

In Ofcom’s Final Statement on the Review of the retail leased lines, symmetric broadband origination and wholesale trunk segments markets (“the LLMR Statement”) Ofcom concluded that BT has Significant Market Power (“SMP”) in the wholesale markets for low bandwidth (up to and including 8Mbit/s) and high bandwidth (above 8Mbit/s up to and including 155Mbit/s) traditional interface symmetric broadband origination (TISBO) in the UK (excluding the Hull area). These markets include leased lines services, and in particular Partial Private Circuits ("PPCs”) terminating segments. PPC terminating segments are wholesale leased line products that allow Altnets to compete with BT in the provision of end to end retail leased lines and other data services.

The LLMR Statement imposed on BT, amongst other SMP services conditions, Conditions G4 and GG4 which implement an interim charge control for PPC terminating segments services falling within the markets for low bandwidth and high bandwidth TISBO respectively (“the interim charge control”). Under those conditions, the interim charge control has remained in place. This document implementing the longer term PPC terminating segments charge control (“the PPC terminating segments charge control”) replaces the interim charge control.

It is Ofcom’s intention that the PPC terminating segments charge control set out in this document will give stability in the markets for PPC terminating segments and will encourage BT to reduce its costs of provision leading to the efficient supply of these services. This will also promote competition in the downstream markets, particularly retail leased lines.

The present document

On 24 June 2004 Ofcom set out its proposals to modify SMP services Conditions G4 and GG4 so as to control future prices for PPC terminating segments by means of an annual RPI-X% reduction. The formal Notification under the Communications Act 2003 (‘the Act’) recording Ofcom's specific proposals was published and stakeholders were invited to make representations within the consultation period ending on 30 July 2004.

This document sets out Ofcom’s final decisions for the PPC terminating segments charge control, having taken into account the representations of the stakeholders who responded to the consultation document. Respondents were invited to answer a number of specific questions regarding Ofcom’s proposals and these are addressed in detail in the main document.

Summary of Conclusions

The scope of the PPC terminating segments charge control is limited to the products and services relating to the provision of PPC terminating segments in the low and high bandwidth markets for TISBO, where BT has been found to have SMP. Radio Base Station ("RBS") backhaul and Local Loop Unbundling ("LLU") backhaul products and services have not been included within the scope of the PPC terminating segments charge control. Although in Ofcom’s view these backhaul products and services are technically equivalent to the PPC terminating segments products and services subject to the control, these services were not subject to the PPC Phase 2 Direction. Moreover, Ofcom considers that to extend the scope of this regulation at this time is unnecessary, given the requirement on BT to supply these services on equivalent terms to PPC terminating segments. As in the case of any additional PPC terminating segment products, RBS backhaul and LLU backhaul products require BT to comply with its other ex-ante and general competition law obligations.

The majority of respondents agreed with the proposed scope of the control. However, Ofcom received representations from some stakeholders that the scope of the PPC terminating segments charge control should be extended by 2005 to include all TISBO services (which includes RBS and LLU) and alternative interface symmetric broadband origination (AISBO) services.

Ofcom has decided that it is not reasonable or proportionate to extend the scope of this control. Ofcom concluded in the LLMR Statement that the scope of the PPC charge control should be limited to the PPC products and services for which charges were determined as part of the Phase 2 Direction. Therefore, Ofcom is not intending to extend the scope of the charge control at this stage. BT is subject to ex-ante obligations e.g. non-discrimination, cost orientation and the requirement to meet reasonable requests for supply, along with its obligations under general competition law, in the provision of LLU backhaul and RBS backhaul services. Moreover, BT is required to ensure that charges for LLU backhaul are consistent with charges applicable to those elements which are common to LLU backhaul and PPCs. These ex-ante conditions are expected to have the effect of constraining BT’s charges for these services.

Duration

The PPC terminating segments charge control will have a duration of four years, as this will provide stability in the market and increase incentives on BT to achieve efficiency savings. This is in keeping with other charge controls that have been implemented in the telecommunications sector in the UK and Ofcom believes there are insufficient reasons for departing from the standard approach.

Some respondents to the consultation document argued strongly for the charge control to be of shorter duration (2 years) or subject to a mid-term review because of uncertainty regarding the volume forecasts and costs for these services associated with a relatively new product market.

Further informal representations regarding the duration of the PPC price control have been made by some stakeholders since the consultation period ended. Ofcom has considered all representations but has decided that imposing a two year charge control, or a mid-term review, would not be appropriate as it would weaken the incentive properties of the RPI-X control and would undermine Ofcom’s objective of providing stability in the product market.

If there were significant changes in the low and high bandwidth markets for TISBO these would be assessed in the next LLMR. If material changes in the relevant product markets were found to have occurred, Ofcom would be required to review whether the PPC terminating segments charge control remained appropriate.

Form

An RPI-X form of charge control will be implemented. This form of charge control has been widely used in the regulation of UK utilities, including those in the telecommunications sector.

Structure

Ofcom considered a number of key issues in relation to the structure of the control. These included:

The construction of charge control baskets: Ofcom is imposing three separate baskets, one for PPC terminating segments equipment charges, one for low bandwidth PPC terminating segment connection and rental and maintenance charges and one for high bandwidth PPC terminating segment connection and rental and maintenance charges;

The weighting of the charge control baskets: Ofcom is using prior year revenue weights in order to check compliance with the charge control;

The treatment of BT's equipment costs within the charge control: Ofcom is using BT’s equipment purchase contract to inform the proposed value of X;

Geographic discounts: Ofcom is allowing BT to offer geographic discounts but these will not contribute to BT meeting its charge control obligations; and

Volume discounts: Ofcom is not allowing BT to offer volume discounts.

Efficiency Studies

The objective of the PPC terminating segments charge control is to bring BT’s charges into line with an efficient level of costs at the end of the charge control period. As part of this process it is important to understand the extent of BT’s efficiency/ inefficiency at the outset of the charge control so that if there is some inefficiency, its erosion can be reflected in the value of X.

Ofcom employed economic consultants NERA to carry out studies to examine the efficiency of BT's network relative to appropriate comparator companies, principally the US Local Exchange Carriers (LECs). These studies expand upon the comparative efficiency analysis which has previously been undertaken by NERA for Oftel in relation to other charge controls in place on BT.

NERA’s conclusion is that BT is in the region of 9% to 10% inefficient in its provision of services over its network as a whole relative to the top performing decile of the US LECs. It is reasonable to expect inefficiency existing at the start of the charge control period to be eliminated over the life of the four year control, just as competitive pressure would force companies to become efficient in a competitive market. The underlying rate of cost reduction over the period of the charge control is therefore adjusted to reflect the anticipated reduction in inefficiency.

The range of values for X in the June consultation reflected Ofcom’s view that BT’s inefficiency was likely to be in the range of 5-10%. This followed discussions between NERA and BT prior to publication of the final NERA report, and presentation of an alternative model specification by BT which, it was argued, was a better statistical fit of the LEC data, and which suggested that BT’s relative inefficiency is 1%. In Ofcom’s view the result from the alternative model specification was implausible, as it contradicted known cost trends for the period measured by the report and did not fit a priori expectations.

Most respondents supported Ofcom’s conclusions on the measure of BT’s relative inefficiency although some suggested that the relevant range was that concluded by NERA i.e. 9% to 10%. BT set out further arguments that a measure of 0% to 1% is more appropriate. After considering the responses to the consultation , Ofcom believes that the range proposed in the consultation document for BT’s relative inefficiency of 5% to 10% is reasonable, and has decided to use 7.5%, the midpoint of this range, as a measurement of inefficiency.

BT’s cost of capital

In deriving the values of X, the aim of the financial modelling exercise is to estimate charging constraints such that, by the end of the charge control period, BT is forecast to earn a level of return on the basket services that is equal to its weighted average cost of capital (WACC). As part of the current review Ofcom has updated its view on BT’s cost of capital, last calculated by Oftel in February 2001, because the constituent parameters of BT’s WACC tend to vary over time in line with changing equity and bond market conditions.

Overall, using a broad range of parameters, Ofcom estimates BT’s pre-tax nominal cost of capital for BT to be approximately 13%. This is slightly higher than the estimate proposed in the consultation document (12.5%) due to the use of a slightly higher risk free rate to reflect more recent information.

Values of X

Ofcom has developed a cost forecasting model to calculate proposed values of X for the PPC terminating segments charge control, apart from the value of X for the equipment costs basket which is informed by BT’s current equipment purchase contract. The underlying methodology of Ofcom's approach is consistent with that used in other charge controls applicable to BT. The forecasting model uses a variety of inputs and data sources to calculate the values of X.

Respondents to the consultation broadly agreed with Ofcom’s adjustments to model parameter data provided by BT, in particular arguing that they would expect the volume of low bandwidth circuits to increase over the period of the control. BT disagreed with the adjustments Ofcom made to BT’s data, arguing that the volume forecasts were those being used internally within BT. BT also argued that Ofcom’s forecast of price reductions for cable and duct asset types were inappropriate and that modest price increases for these asset types were more likely. Ofcom has considered all the responses and has made adjustments to the values of the model parameters where these are appropriate.

Ofcom’s values of X for the PPC charge control to 2008/09

Basket	Value of X^(-1-)
POC end and third party end equipment charges	8.9%
Low bandwidth connection and rental and maintenance charges	4.0%
High bandwidth connection and rental and maintenance charges	6.5%

Introduction of Sub-caps

Ofcom, after considering responses to the June consultation document, is including in the charge control conditions sub-baskets for each of the main baskets. The sub-baskets for the low and high bandwidth baskets will require BT to reduce its connection charges and its rental and maintenance charges by RPI+0 in each year of the control. This is in response to concerns from respondents relating to BT’s ability to rebalance it charges between connection charges and rental and maintenance charges. The equipment sub-basket requires BT to reduce the charge for each individual item of equipment by RPI-3. This sub-basket reflects the additional flexibility offered BT by the change in the main equipment basket from an indexation of charges by RPI-8.9 to an aggregate basket approach and Ofcom’s belief that the prices BT will face for individual items of equipment will not, over the period of the control, increase in nominal terms.

Level of charges at start of control

The PPC terminating segments charge control will be applied to the current charges in place on 30 September 2004.

Prior to the publication of the consultation document, BT produced a model to derive individual charges for each service covered by the proposed PPC terminating segments charge control. However, use of the outputs derived directly from BT’s model would have resulted in significant increases in some charges and a change in the relative structure of prices. These outputs suggested a need for significant changes in the prices of BT’s PPC terminating segment charges, with prices rising overall. As set out in the consultation document, Ofcom is currently unable to endorse BT's model or its outputs due to uncertainty about the assumptions used in BT’s model and conflicting outputs (which indicated prices needed to rise) and profitability information (that indicated that BT was recovering its costs). In addition, the most up to date accounting information provided BT indicates that its overall profitability in providing PPC services is currently in excess of its cost of capital and therefore does not provide compelling evidence of a need for increased prices. Therefore, Ofcom is not proposing to revise starting charges for the charge control. This is consistent with the approach set out in the consultation.

Alternative BT proposals

Prior to publication of the consultation document, Ofcom offered BT the opportunity to put forward an alternative set of PPC terminating segments charges. Ofcom requested that BT’s proposal address the competition problems in the relevant markets and related markets at least as well as Ofcom’s proposals. BT’s proposal would have the effect of rebalancing trunk and terminating segment charges within the context of a significant aggregate reduction in prices over the 4 years of the proposed control. These were set out in Section 6 of the consultation proposals.

However, Ofcom continues to believe that its proposals for controlling PPC terminating segments are preferable, a view supported by all respondents apart from BT. Ofcom is therefore implementing a charge control on current PPC terminating segment charges, as set out in the consultation document.

Footnote:

1:- Values of X for the low bandwidth and high bandwidth charge control baskets are rounded down to the nearest quarter integer.

The full version of this statement is available via the link below.

Partial Private Circuits Charge Control - Final Statement [pdf]
Full print version

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