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G.1 This annex builds on the discussion in Section 4 of the main consultation document by summarising the evolution of telecoms sector regulation in the UK to date, highlighting the positions that have been taken in the past on the trade-offs in telecoms regulation.

It looks at three areas in turn:

• fixed line telecoms;
• mobile telecoms; and
• universal service regulation.

Fixed line telecommunications

The duopoly years (1984-91)

G.2 The British Telecommunications Act 1981 separated British Telecommunications (BT) from the Post Office. Although this act ended the statutory monopoly in telecoms, it was not until the privatisation of BT in 1984 that an explicit regulatory regime was deemed necessary. Unlike AT&T in the US, BT retained its vertically integrated structure. At the same time, the 1984 Telecommunications Act created the Office of Telecommunications, or Oftel, headed by the Director General of Telecommunications.

G.3 At the outset, regulation was never intended to be a permanent feature of the telecoms industry. To allow regulation to be relaxed in future, the Government wished to create competition within all levels of infrastructure. With BT having a 100 per cent market share, the Government decided that multiple competitors would not be sufficiently strong to provide the efficiency gains from competing infrastructures. Consequently, a decision was taken to license a single firm (Mercury) for a limited period during which it would grow sufficiently strong to provide competition to BT at all levels. In line with the desire for infrastructure-based competition, particularly in access infrastructure, a decision was taken from the outset not to allow Mercury to lease elements of BT's infrastructure (except for interconnection for call termination).

G.4 Although infrastructure competition was foremost on the Government's mind, privatisation had created a private sector monopolist, and thus safeguards on prices were required. Recognising the low productive efficiency incentives of rate-or-return regulation, the Littlechild Report proposed price-cap regulation. Price rises would be capped at inflation (as measured by the Retail Price Index) minus some 'X' percentage for a period of five years. During this period any cost reductions could be kept as profits, until the next review. Thus from 1984 to 1989 BT's retail prices were regulated at RPI-3%, and at RPI-4.5% until 1991.

G.5 For Mercury to be a viable competitor, it was not sufficient for it simply to build its own network. Suitable terms of interconnection between its network and BT's were essential. After direct negotiations between BT and Mercury failed, Oftel was forced to intervene. In coming to a decision, Oftel faced a dilemma due to the unbalanced nature of BT's tariffs. Before privatisation, there was an understanding that BT would fund certain unprofitable services that the Government deemed desirable, through cross-subsidisation with profitable services. The dilemma was that if Oftel allowed interconnection at marginal cost, Mercury could be less efficient than BT, yet could still make a profit by supplying only the products that BT used to subsidise its loss-making services. If Mercury proved to be successful, this would have left BT with an 'access deficit', such that it would have been harder to meet its fixed costs of providing access. However, without favourable interconnection terms, there was the possibility that Mercury would be unable to compete with the larger-scale BT.

G.6 This dilemma was reflected in Oftel's 1985 Interconnection Determination. It required that all BT's direct costs of providing interconnection should be paid by Mercury via some up-front charges and a per-minute charge for use of BT's local network. However, if Mercury's payments increased to greater than 7 per cent of BT's annual revenue, additional charges would be levied to reflect the unbalanced access tariffs. The interconnection charges themselves would be price-capped at RPI-3%.

Post-duopoly market (1991-93)

G.7 By 1991 Mercury had secured only 3 per cent of the market, and in late 1990, the Government's commitment not to license other companies expired. It was felt that the duopoly period had given Mercury sufficient chance to develop its business without competition. The Government had also come to the decision that promoting a single firm to provide infrastructure competition was not providing a competitive outcome rapidly enough. For these two reasons, the duopoly framework was reviewed, and ended in 1991.

G.8 The Duopoly Review marked a move towards introducing competition into both the network infrastructure and services. To facilitate competitive entry into call markets (and thus improving allocative efficiency), BT was permitted to resell leased lines to other competitors. However, wary of this eroding the incentives for competing firms to invest in access infrastructure, BT was only allowed to resell leased lines at the retail price level. Soon after the Review, a host of network providers such as Colt, Energis and the TV cable companies entered the network infrastructure market. The cable TV companies had started to provide broadcasting services in franchise regions during the duopoly years, although until the Review they had been forbidden from providing telephony services on their own account.

G.9 From 1991 to 1993, many of the regulatory issues arose from the changes made in the Review. Once again, the problem of interconnection was extremely important, especially for the new competitors. The process of securing interconnection which Mercury had followed was cumbersome, taking months of negotiation before it was referred to Oftel. If every provider had to go through this procedure to get interconnection, this would have created a significant barrier to entry. Consequently, in early 1994, Oftel decided that the December 1993 Mercury/BT Interconnection Determination would be used as the basis for determinations for all new entrants.

G.10 The level of the 1993 interconnection charges once again reflected the trade-off between mandating interconnection at marginal cost, thus encouraging allocative efficiency through service competition, and providing a means for BT to recoup its access deficit. Immediately after the Duopoly Review it was unclear whether the waiver from access contribution charges previously allowed would continue for both Mercury and the new competitors. Oftel's decision again attempted to balance the risk of 'cream-skimming' with the need for encouraging competition. The 1993 Interconnection Determination gave Mercury and other firms (through a separate determination in 1994) a full waiver to access deficit contributions on their first 10 per cent of market share, only paying when competition had eroded BT's market share to the point where cross subsidies would start to become unsustainable for BT.

Infrastructure competition (1994-97)

G.11 Determining the level of interconnection involved a myriad of problems around allocating common and joint costs, and therefore a longer-term solution was required. In 1994 Oftel required BT to separate its accounts for the network, retail and access businesses. Although undue discrimination was already prohibited,^(-14-) the requirement for accounting separation was introduced to provide greater transparency, to prevent BT discriminating between its retail arm and third parties.

G.12 The period of regulation from 1994 saw a strong shift in favour of infrastructure competition, particularly in access. It became clear that Oftel's long-term strategy was to promote network competition in favour of service competition, being "convinced that the key to achieving a vibrant market for services provided over telecommunication networks is the promotion of fair, efficient and sustainable network competition^(-15-)."

G.13 In the context of this shift, the trade-off between continuing unbalanced tariffs and promoting competition similarly shifted. Promoting competition in calls threatened competitors' incentive to invest in access infrastructure. Oftel's solution, put forward in the 1996 price review, moved towards infrastructure competition underpinned by the desire eventually to leave regulation to competition.^(-16-) BT would be allowed slowly to rebalance its tariffs, removing the necessity for an access deficit charge.

G.14 From 1996, competition in services remained subsidiary to competition in infrastructure as a goal. This affected Oftel's treatment of issues such as number portability and equal access. The lack of portability of numbers was cited as one of the main barriers to access infrastructure competition, as it acted as a barrier to consumers switching access providers. Therefore number portability was a high priority for Oftel. Following BT's refusal of a modification to its licence, the case was referred to the Monopolies and Mergers Commission (MMC) in 1995, who ruled in favour of Oftel.

G.15 In contrast, equal access (later called carrier preselection (CPS)) had the potential to undermine infrastructure competition. Equal access was a technology that allowed consumers automatically to pre-select a carrier to carry their calls, rather than dialling an access code before each call (known as indirect access). Oftel's view was reflected in the 1996 statement; "Oftel is concerned that [CPS's] introduction could discourage operators from developing alternative access networks if they risked the benefits of their investments to competing operators. Oftel concluded, on balance, that there is no case for directing BT to provide equal access."^(-17-)

G.16 The network charge controls introduced in 1997 again broadly supported access infrastructure competition. As part of the controls, the cost base used in deriving interconnection charges was changed from historic cost (HCA) on a fully allocated basis (which valued assets on the basis of what was paid for them), to a current cost (CCA) on a Long Run Incremental Cost basis (LRIC), which valued assets on the basis of their replacement costs. A corresponding change to the valuation of access network assets was made in the Retail Price Charge Review in 1997. This movement to a replacement valuation impacted the measurement of recoverable costs for regulatory purposes. At a simple level, for access infrastructure, labour is a significant proportion of the cost. As labour costs are increasing over time, the move to a replacement basis caused the level of costs deemed to be recovered by line rental to rise over time relative to HCA. This increased the incentive to invest in infrastructure. However, for usage-dependent elements of the network (such as termination and origination charges), equipment is a significant cost component, and the price of telecoms equipment tends to fall over time. Thus relative to historic cost, current cost using Long Run Incremental Cost reduced the amount that BT could charge for interconnection services. These lower charges benefited consumers directly through the reduction in service providers' costs and hence prices, but also indirectly through the competitive pressure on BT's prices.

G.17 In December 1997, BT still had a 83% market share in terms of fixed access lines, Mercury 7%, cable companies 7%, and other companies the remaining 3%.^(-18-)

Services competition (1998 onwards)

G.18 The end of the 1990s and the early 21st century saw the regulatory balance shift away from promoting infrastructure competition. The previously clear goal to promote infrastructure competition became complicated by three major events.

G.19 The first was the 1997 EU directives. The directives encouraged national regulators not to discriminate between firms that were building networks, and those that were not. They also mandated several elements of service competition that Oftel had previously ruled out as reducing the incentives to build infrastructure.

G.20 The second event was the collapse in investor confidence in the telecoms sector. This called into question the viability of investment in infrastructure. Significantly, one of the great hopes of infrastructure competition using new wireless technology, Ionica, went bankrupt in 1999. The rapid change in investor sentiment meant alternative network providers increasingly demanded access to BT's own infrastructure in order to offer new products, rather than building their own.

G.21 The third stimulus was the phenomenal growth of the internet. This had been partly stimulated by the provision of pay-as-you-go (at local rate) packages through the number translation services (NTS). As BT was the only firm able to provide an end-to-end service across the UK, this created a demand for new wholesale products. One of these was Flat Rate Internet Access Call Origination (FRIACO), a wholesale product introduced by BT in 2000 on Oftel's requirement, which delivered narrowband internet traffic on an unmetered basis from a customer to the tandem network.

G.22 As a result of the EU directives, the previous distinction between network providers (who had cost-based access to BT's network), and resellers (who had 'retail minus'-based access) blurred. This lengthened the list of those who could obtain wholesale interconnection rates and marked a shift away from a policy designed to encourage infrastructure build.

G.23 Along with the more general requirements mentioned, the EU directives mandated a number of service competition elements. As discussed above, Carrier Pre-Selection (CPS) had been rejected by Oftel as it encouraged service competition at the expense of infrastructure competition. However, with the introduction of the EU Numbering Directive in 1998 it became a mandated requirement. Consequently, in 2000, CPS was introduced. By the beginning of 2004, consumers using 2.75m BT lines had taken up the option of Carrier Pre-Selection.

G.24 The introduction of CPS and the relaxation of licensing requirements increased competition in the market for calls. However, it had not created competition in the provision of access lines. BT's ability to provide a bundled calls and access service to consumers was seen as a competitive advantage. To redress this, in August 2002 Oftel modified BT's licence to require it to provide a new 'Wholesale Line Rental' (WLR) product. This product was intended to allow alternative suppliers to rent access lines on wholesale terms from BT, and then resell the access lines to the end-user, issuing a single bill that covers both line rental and telephone calls. A revised WLR product, with similar objectives, is being launched.

G.25 The EU directives also speeded up the opening of BT's local loop to its competitors. Prior to 2001, BT had not been required to provide wholesale access to its local loops. With the roll-out of ADSL in the US and EU, there was increasing pressure to speed up the deployment of broadband within the UK. Consequently, in December 1998 Oftel published a paper entitled Access to Bandwidth^(-19-) detailing a number of different strategies to promote the roll-out of broadband. The decision was taken to mandate local loop unbundling (LLU). By the EU deadline of January 2001, BT had began to unbundle its loops. To date, the take-up of unbundled local loop by alternative carriers has been much lower than anticipated at the time, with only 8,919 loops unbundled up to January 2004.^(-20-)

G.26 The UK regulation implementing the Interconnection Directive also specifically required ATM-based interconnection to be introduced. Oftel based the price of ATM-based interconnection upon the price charged to ISPs (retail minus). This meant that if BT wanted to reduce the price charged to ISPs it must also reduce the ATM interconnection price.

G.27 In summary, fixed telecoms regulation has been characterised by trade-offs, in particular the trade-off between promoting service competition and network competition. In the early period the creation of a single infrastructure competitor to BT very much took precedence over greater service competition. However, the Duopoly Review created the scope for some service based competition. During the mid-1990s, the balance was firmly tilted strongly in favour of infrastructure providers, but was interrupted by the legal and financial developments of the late 1990s.

Mobile telecoms

G.28 The first two analogue cellular licences were granted in 1984 to Cellnet (now O2) and Vodafone. From the start, there have been two major differences relative to fixed line regulatory policy. Firstly, mobile operators have never had retail prices explicitly regulated using a price cap (indeed Oftel considered the retail mobile market competitive). Secondly, Vodafone and Cellnet were required to supply thirdparty service providers, and to do so on nondiscriminatory terms, the aim being to increase service competition over networks.

G.29 In the beginning of the 1990s, Oftel received several complaints from these service providers alleging unfair cross-subsidisation of the service provider operations owned by the mobile networks. In 1994, Oftel found that because the network operators exercised a considerable degree of influence over the retail price through their retail arms, independent service providers were subject to a 'margin squeeze'.

G.30 In 1989, two additional mobile licences were allocated; to a consortium which became Orange, and to One2One (now T-Mobile). The new companies built their infrastructure using backhaul transmission from BT bought largely at retail price levels. Competition between the mobile networks grew rapidly (with current market shares very similar). The introduction of pre-pay opened up access to many consumers, including low-usage consumers, and was accompanied by aggressive subsidies on handsets and an expansion in the range of distribution outlets.

G.31 Recently, the interconnection charges between mobile networks, and between fixed and mobile networks, have received significant attention. In 1998, the Monopolies and Mergers Commission (now the Competition Commission), concluded that the termination charges of Vodafone and Cellnet were too high. To counter this, these companies' termination charges were reduced to a ceiling of 11.7 pence per minute, and further reduced by RPI-9% until March 2002.

G.32 In 2001, Oftel revisited the termination charges, finding that each of the mobile providers had market power over termination of calls to their own subscribers. The review proposed to lower termination charges by RPI-12% until March 2006. This was appealed by several of the mobile networks and went to the Competition Commission. The Competition Commission's assessment went further than Oftel's analysis and in December 2002 it ruled that charges should fall 15% by July 2003 and be subject to RPI-15% until 2005.^(-21-)

G.33 In summary, because infrastructure competition has been much more widespread in mobile telecoms, the sector has not faced the same degree of regulatory intervention as the fixed market. From 1991 onwards consumers had the choice between four separate networks (now five with the launch of '3' in 2003), thus providing significant access competition. However, as in all telecoms, interconnection is one of the keys to service provision. This has been as much a problem in mobile as it has been in the fixed network.

Universal service obligations

G.34 In parallel with regulation to promote competition, regulation has also aimed to ensure that everyone, and in particular certain vulnerable groups, has access to certain telecoms services. This is known as universal service regulation, and the obligations on telecoms companies to provide these services are known as Universal Service Obligations (USOs). There is both an economic and a social rationale for such obligations.

Economic rationale for USOs

G.35 The economic rationale for USOs is based on network externalities. A customer will only pay to connect to a network if the benefits they themselves expect to receive are greater than the price. But all the other customers connected to the network would benefit too - because the number of people those other customers could use the network to connect to would have increased.

G.36 If there is a monopoly telecoms supplier, it is in the commercial interest of the supplier to 'internalise' this externality by reducing the price of access and increasing the price of calls, thus encouraging more people to join the network, and making money from other customers who then call them. If there is more than one supplier, however, the company providing the connection to a new customer may not be the same company that benefits from other people calling that new customer. Therefore competition tends to make it more complicated to internalise this externality.

G.37 There may also be other types of economic efficiency that a USO can address. For example, provision of telephony services to rural villages might reduce residents' need to come into town so frequently, thus reducing traffic congestion. These types of effects, while important, are extremely hard to measure.

Social rationale for USOs

G.38 Being connected to the telephone network is increasingly a requirement to participate fully in society, for example by accessing public services, such as the emergency services, NHS Direct or Childline. Therefore part of the rationale for USOs is to ensure that people on low incomes, those living in remote rural areas, disabled people and other vulnerable groups are still able to obtain the advantages of telephony and perform a full role in society. This role for USOs corresponds closely to Ofcom's duty towards citizens.

Current USO regulation

G.39 Under the Communications Act 2003, the Secretary of State sets out the extent to which networks, services and facilities are to be provided throughout the UK as universal services. The Secretary of State published her Universal Service Order on 25 July 2003. This order implements in part the EU Universal Service Directive, which addressed universal service and users' rights relating to electronic communications networks and services.

G.40 Some aspects of universal service are ensured by means of general conditions imposed on all providers of publicly available telephone services; for example, that measures to effect payment or disconnection must be proportionate and not unduly discriminatory. The remaining aspects of universal service are ensured through specific universal service obligations imposed on particular communications providers, designated by Ofcom as Universal Service Providers. Following consultation, Oftel designated BT as a universal service provider outside Hull, and Kingston Communications in the City of Hull. For example, BT is required to:

• provide a connection to the fixed telephone network at a uniform price following a reasonable request, and provide a connection that allows functional internet access;
• provide at least one scheme for consumers with special social needs who have difficulty affording telephone services;
• provide uniformly priced public call box services;
• ensure that tariffs for universal services do not entail payment for additional unnecessary services;
• provide a basic level of itemised billing at no extra charge;
• provide universal services that accord with defined quality thresholds;
• provide funds for a relay service for textphone users; and
• supply and maintain directories and databases for the provision of directory services.^(-22-)

G.41 Some of the historic issues around financing USOs were discussed earlier in this annex. The Universal Service Directive requires that where national regulators find that an operator is subject to an unfair burden in providing USOs, a mechanism should be introduced either to compensate the USO provider(s) from public funds, or to share the net cost of USOs between communications providers.

G.42 However, Oftel carried out analysis in its review of universal service from 1999-2001, which concluded that the net cost to BT of being a universal service provider was broadly neutral. Oftel's view was that, in view of the absence of effective competition in many retail markets, the cost of measures to protect vulnerable customers did not represent an unfair burden on BT and Kingston. Oftel recognised that as competition increases, the burden on BT and Kingston of universal service may increase, and consideration may need to be given to the provision of alternative methods of funding. This issue is considered further in Section 5 of the Phase 1 consultation document.

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Footnotes:

14:- Undue discrimination was a specific concept included in Telecommunications Act 1984 licences.

15:- Oftel: Promoting Competition In Services Over Telecommunication Networks, June 1996.

16:-"It has been a constant theme in all recent Oftel consultation documents that regulation is a poor substitute for the operation of an effectively competitive market. Oftel has made clear that its aim is to pull back from regulation as competition advances and to ensure that remaining rules match the market." Pricing of Telecommunications Services from 1997 - Statement, June 1996.

17:- Source: Oftel, Policy on Indirect Access, Equal Access and Direct Connection to the Access Network - Statement, July 1996.

18:- Source: Ofcom market intelligence.

19:- Source: Oftel, Access to Bandwidth, bringing higher bandwidth services to the consumer, December 1998.

20:- Source: BT.

21:- Vodafone and O2 were subject to RPI-15% while T-Mobile and Orange were subject to RPI-14%.

22:- Kingston is required to provide all except the last two of these in Hull; BT is responsible for the last two of these in the whole of the UK.

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