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3.1 On 12 December 2003, Ofcom announced that it would be consulting throughout 2004 on a Strategic Review of Telecommunications ('the Telecoms Review')¹. The Review will be comprehensive, wide-ranging and evidence-based.

3.2 The Review will assess the options for enhancing value and choice in the UK telecommunications sector. It will have a particular focus on assessing the prospects for maintaining and developing effective competition in the UK telecoms markets, while also considering investment and innovation. This assessment will in turn shape the strategy through which Ofcom will promote competition or take other regulatory action to further the interests of consumers and citizens in the UK.

3.3 The review will comprise three phases:

• Phase 1: the current position and prospects for the telecoms sector;
• Phase 2: the options for Ofcom's strategic approach to telecoms regulation; and
• Phase 3: Ofcom's approach to telecoms regulation.

3.4 The key output of the Review will be a new settlement for telecoms regulation, with a statement issued by Ofcom by the end of 2004. This will enable casework and policy development to be located in a clear strategic framework, going forward to the end of the decade and beyond.

3.5 This document is the first of two consultation documents that Ofcom will be issuing as part of the Review, prior to our statement. It takes a forward look at the trends and challenges facing the sector in terms of changes in technologies, consumer demand and the telecoms industry. It asks for your views on all of these issues.

3.6 Anticipating the future is important because the telecoms sector is changing very rapidly. The regulatory strategy that Ofcom develops for today's telecoms sector will also be applied to tomorrow's. It is therefore very important that we can make the best possible judgements about how the sector is likely to evolve, and the responses we receive will be critical to those judgements.

3.7 Transparency and openness are key to Ofcom's regulatory approach, and we talk fully with all stakeholders throughout the consultation process.
In preparing this document, Ofcom has already held informal meetings with a number of telecoms companies, financial institutions, and consumer groups. Ofcom will also be engaging fully with stakeholders to obtain their views on this document.

3.8 This introductory section of this document describes:

• the rationale for the Telecoms Review;
• the role and importance of telecoms sector regulation;
• Ofcom's statutory framework; and
• the relationship between the Telecoms Review and other Ofcom initiatives.

The rationale for the Strategic Review of Telecoms

3.9 Ofcom has a statutory requirement to reduce regulation where possible, and this is embedded in our founding principles. This gives significant protection to our stakeholders. It guards against 'regulators regulating because that's what regulators do.' It also protects against persisting with regulation that is past its sell-by date. Telecommunications is subject to a large quantity of highly detailed, sector-specific regulation. This is over and above the rules that apply to the rest of the economy, such as competition and consumer protection law. This extra regulation inevitably imposes some costs on the industry and, indeed, on consumers. This is why proposals for new regulations include regulatory impact assessments, to weigh up the costs and benefits of intervention. Our starting point for this Review has to be to ask whether the costs of on-going, sector-specific regulation are justified.

3.10 The case for sector regulation was made and accepted in 1984 when BT was privatised ² and Oftel was established, and then again during the 1991 Duopoly Review. However, these assessments were highly specific to the circumstances of the time. By any standards, the sector has undergone very significant changes since 1984 and 1991.

3.11 Therefore, if continued sector regulation is required, we have to make the case for it from first principles. While it's unlikely there's a case for removing sector regulation entirely (and Ofcom must of course operate within the parameters laid out by the EU Regulatory Framework), we do believe that asking the question is a useful discipline for the Review. It will enable us to be proactive in identifying opportunities for deregulation.

3.12 There are a number of reasons why the time is right for the Review:

• to date, regulators have considered that there is not enough competition in the telecoms markets to allow sector-specific regulation to be withdrawn. This is contrary to the expectations of some commentators;
• fundamental changes in technology and consumer behaviour may render existing regulatory approaches obsolete; and
• other countries and markets are adopting different approaches to similar challenges, and we need to consider international and sectoral best practice.

In many telecoms markets, competition is not considered to have developed sufficiently to allow sector-specific regulation to be withdrawn.

3.13 In many parts of the economy, consumers are considered to be adequately protected by general competition and consumer protection laws alone. Telecoms, along with utility markets such as gas, electricity, water and rail, is additionally subject to a large-scale regime of ex-ante regulatory rules. In the case of telecoms, a key objective of these regulatory rules has been the promotion of competition. The underlying assumption has been that without significant effort, competition will not emerge.

3.14 However, much of this sector-specific regulation has often been envisaged as a transitory measure, on the way to full competition. Statements made by successive Director Generals of Oftel, and the Government and its advisers ³ have implied a clear expectation that regulation of this kind would create sustainable competition, allowing sector regulation to wither away.

3.15 To date, this hasn't happened. Regulators have not considered that competition in many UK telecoms markets has emerged to the point where regulation could be withdrawn. This conclusion was confirmed by the Oftel market reviews conducted in 2003. These identified that BT holds a position of Significant Market Power (SMP) in all narrowband call and exchange line retail markets, as well as in many wholesale markets ⁴, and that all network operators hold SMP in relation to terminating calls to their own customers.

3.16 Direct regulation to protect consumers, by means such as retail price control, has also been applied to the sector while competition has been developing. But since competition hasn't developed as anticipated, regulators have maintained a consumer protection regime for far longer than was envisaged back in 1984. For example, it was only in 2002 ⁵ that Oftel felt there was enough competition in retail fixed voice telephony to contemplate removing certain retail price controls.

The sector has undergone very significant changes, and regulation may need to go the same way.

3.17 Not only was the regulatory framework expected by many to be transitory, but it also has its roots in a very different era: a time when the telecoms sector essentially consisted of a stable, fixed voice telephony market, with predictable growth, costs and network architecture. Annex G discusses the historical approach to regulation of the sector in some detail.

3.18 A number of fundamental changes have taken place in recent years, and more are in prospect. They bring into question the continued validity of some of the assumptions underlying the historical regulatory framework. A key objective of the Review is to understand the implications of these changes. The main ones are:

• a rise in demand for data services, and the growth of broadband;
• the growth in mobile and wireless networks;
• the increasing importance of innovation and service choice;
• the changes in consumer behaviour; and
• the changes in the financial and corporate environment.

Rise in demand for data services, and the growth of broadband.

3.19 Access and use of the internet has risen from 12 per cent of homes in early 1999 to around 50 per cent today. Approximately half of the traffic on the public switched telephony network, which was originally built for voice traffic, is now data. At the same time, business consumers are making ever-increasing use of Virtual Private Networks, often in place of leased lines.

3.20 The rise in demand for data services is leading to the creation of an entirely new telecoms network platform. This operates alongside the traditional core telephone network platform, but shares the copper into the home. At present, broadband remains the province of a minority of business and residential consumers. But in the next ten years broadband may move towards mass adoption, either gradually or possibly quite swiftly. The likely pattern of demand for broadband, and the scope for delivery of broadband products over different technology platforms, will be key issues for the Review.

3.21 These new data networks, which increasingly use Internet Protocol (IP), may display some distinct economic characteristics to the monopoly voice market in which current regulation has its roots. They may exhibit economies of scale to different extents, and at different places in the network. If so, regulation will need to recognise and respond to these new challenges.

Continued growth in mobile and wireless networks.

3.22 The mobile sector has now reached the point where penetration is comparable to fixed. In addition, the market has expanded from a single product - mobile voice telephony - to offer a huge range of additional services such as SMS, picture messaging, online information, entertainment services, and business-oriented services such as GPRS cards for laptops. A key issue for the Review will be to understand the likely future development of the mobile market. For example, there is already evidence of some switching of voice calls from fixed to mobile. Both fixed and mobile network operators have launched limited mobility services using Wireless LANs, and are considering launching devices that use both fixed and mobile networks for connectivity. The scope for convergence of fixed and mobile services, and whether the mobile providers could constitute a competitive constraint on fixed operators, will be important issues for the Review.

Innovation and service choice are increasingly important.

3.23 When BT was privatised, telecoms was largely a single product market: fixed voice telephony. There was little scope for innovation or service choice around this product. Now, of course, the situation is radically different. For example, the sector includes fixed and mobile services, voice and data products aimed at all customer segments, and complex managed network products for business customers. In all of these, innovation and service choice (in terms of functionality and features) are critical in delivering benefits to customers.

Changes in consumer behaviour.

3.24 A striking feature of recent times has been consumer behaviour which was not initiated, or even predicted, by service providers. The growth in text messaging, of file sharing, and of peer-to-peer communities are all examples of consumers exerting direct influence over the evolution of the market. As part of the Review, Ofcom will carry out research to try to understand what consumers value most in telecoms markets, as well as considering aspects of the market structure which continue to inhibit the effective exercise of consumer choice.

Changes in the financial and corporate environment.

3.25 A basic assumption underlying the current regulatory structure is that where opportunities exist for companies to invest profitably in network infrastructure, they will do so. The UK telecoms sector was highly successful in attracting capital to finance business growth in the mid to late 1990s. However, with the crash in value of technology, media and telecoms stocks, the supply of external finance dried up. Understanding how companies will be able to secure capital for investment in the future is an important element of the Review.

In other countries and markets, different approaches to similar economic challenges have been adopted

3.26 As the telecoms market evolves, it is important to consider what lessons in telecoms regulation we can learn from other countries and other regulated industries.

3.27 Virtually all developed economies have followed a broadly similar path to the UK in their approach to telecoms regulation. The EU liberalisation package introduced in 1997 shared many features of the existing UK approach, though it introduced significant regulatory elements over and above those present in the UK. The more recent EU Communications Framework of 2002 can be seen as an evolution of the same core principles of regulation. Even the US, which initially attempted to break up a national monopoly into a series of regional monopolies and a separate long-distance and international company, partially reversed its decision in the Telecommunications Act 1996. It adopted a regulatory regime that had many similar features to the UK and European model. Indeed, the only major market where privatisation and liberalisation took place without detailed sector-specific regulation, New Zealand, endured a protracted process of suit and counter-suit under mainstream competition law. This was considered by many commentators to have delayed the development of competition considerably.

3.28 However, there are significant differences in emphasis between the approaches adopted in different countries. For example, in the US a doctrine seems to be emerging that seeks to stimulate Voice over IP services (VoIP) through regulatory forbearance. The issue of pricing calls to mobile has been largely avoided through the principle of 'receiving party pays', in contrast to the UK's 'calling party pays' approach. Examining the success of different countries' varying approaches will be a key objective of the Telecoms Review.

3.29 Different approaches have also been adopted to regulate different utility sectors in the UK. For example, in gas, vertically integrated generation, transmission and distribution companies are no longer a feature of the market. The natural monopoly elements of the market are separate entities which are subject to enduring regulation, whereas regulation has been relaxed in the elements of the market where sustainable competition can develop. In water, promotion of competition at the residential level has not been attempted. Though there are many features of telecoms that make it different, learning from the experience of other sectors, where relevant, will also be a key objective of the Review.

The role and importance of telecoms sector regulation

3.30 The telecoms sector plays a critical part in the UK's economy. It contributes over 2 per cent of GDP,⁶ and in 2002 it represented 7 per cent of all capital investment in the UK. Recent studies have also indicated that innovation in information and communication technologies (ICT) may be an important contributor to economic growth The role of telecoms in the economy is discussed in more detail in Annex F.

3.31 Telecoms plays more than just an economic role. The ability to communicate is a pre-condition for full and active involvement in society. Telecoms networks are also increasingly seen as content delivery platforms in their own right, offering a range of information, entertainment and commercial services. They can also help to promote the availability of services that particularly benefit society, such as educational material or health services to remote locations.

3.32 Regulation of the telecoms sector is important because not only does it affect telecoms' contribution to the economy, it also affects the sector's wider contribution to society. Telecoms policy can help to promote full inclusion of certain social groups and to address the dangers of regional isolation. Although the public debate on Ofcom's role in safeguarding the interests of the 'citizen' has tended to be centred on broadcasting policy, telecoms regulation also contributes to citizenship objectives in this way.

3.33 Since BT was privatised in 1984, regulatory policy has promoted effective competition, while safeguarding consumers' interests as that competition develops through various forms of direct regulation. Over time, different degrees of emphasis have been given to these two objectives. But the active promotion of competition has always been a powerful feature of the regime.

3.34 Competition can bring very significant benefits in terms of lower prices, faster innovation, greater choice and service availability. Therefore, regulation aims mainly to deal with the entrenched dominance of an incumbent, in order to deliver the full benefits of competition to consumers. Ofcom has a duty to further the interests of citizens and consumers through, where appropriate, the promotion of competition. So the scope for extending competition in telecoms will be a key issue for the Telecoms Review.

3.35 However, a regulatory regime designed to promote competition is not without costs or risks. By encouraging market entry, a regulator could create damaging market distortions. For example:

• It could distort economic incentives to the point where business opportunities are artificially constructed where none really exists. This could create a form of dependent competition which is unsustainable in the longer term without continued regulatory intervention, but where the form of that intervention itself reduces efficient investment by market participants.
• It could result in the risk-takers not being properly rewarded. For example, it could allocate the rewards for investing in unproven technology away from the company that takes the risk, either to other companies in the form of a right to access the new technology at cost, or to consumers through price controls. This may undermine the incentive to invest in such projects.

3.36 Ofcom therefore needs to weigh up very carefully the costs and benefits of regulatory intervention before deciding on its policy approach

Ofcom's statutory framework

3.37 The Communications Act 2003 gives Ofcom a set of duties which, although similar to the duties that Oftel had under the Telecommunications Act 1984, differ in some significant respects. Ofcom's principal duties are set out in section 3(1) of the Act. They are:

• to further the interests of citizens in relation to communications matters; and
• to further the interests of consumers in relevant markets, where appropriate, by promoting competition.

3.38 Section 3(4) requires that, in pursuing its duties under section 3(1), Ofcom must have regard, among other things, to 'the desirability of promoting competition in relevant markets' and to the desirability of encouraging investment and innovation in relevant markets.

3.39 Section 3(5) notes that Ofcom, in performing its duty of furthering the interests of consumers, must have regard, in particular, to their interests in respect of choice, price, quality of service and value for money.

3.40 Section 4 of the Communications Act sets out that Ofcom, in carrying out its functions, must also act in accordance with six European Community requirements that give effect to the EU regulatory framework. These requirements include:

• promoting competition in relation to the provision of electronic communications networks and services, and in relation to the provision and making available
  of services on facilities that are provided or made available in association with the provision of electronic networks and services;
• ensuring that Ofcom's activities contribute to the development of the European internal market; and
• taking account of the desirability of Ofcom's carrying out its functions in a manner which, as far as practicable, does not favour one form of electronic communications service, network or associated facility, or one means of providing or making available such a network, service or facility, over another.

3.41 Finally, Section 6 of the Communications Act requires Ofcom to keep the carrying out of functions under review with a view to ensuring that regulation by Ofcom does not involve:

• the imposition of burdens which are unnecessary; and
• the maintenance of burdens which have become unnecessary.

3.42 Therefore, in contrast to Oftel's regime, these duties and requirements present a new and different set of factors for Ofcom to consider before applying regulatory rules. For instance, Ofcom has an explicit duty to consider the impact of policy on the 'citizen' as well as the 'consumer'. We must also consider where competition would be 'appropriate'. And finally, the requirement to act in a consciously deregulatory fashion means that Ofcom must take a critical look at existing and planned regulation to ensure that it is both justified and 'fit for purpose'.

3.43 These duties, taken together, provide a powerful focus for Ofcom to review the operation of existing regulation and the scope for changes to regulation in the future. Once the review process has been concluded, Ofcom will decide which of its relevant regulatory powers are most suited to implementing its conclusions.

The relationship between the Telecoms Review and other Ofcom initiatives

3.44 In carrying out these duties, Ofcom is proceeding with regulatory initiatives in a number of other areas that feed into the Telecoms Review, and vice versa.

3.45 The Telecoms Review will build on the separate market reviews recently undertaken to implement the EU Directives in the telecoms sector. It is not designed to re-open these reviews. Instead, its objective is to take an over-arching look at the sector as a whole, in order to establish an overall strategy to ensure a clear and coherent approach to regulatory interventions at all levels.

3.46 One of the principles of the EU regulatory framework is that all regulatory interventions should be re-appraised regularly, to ensure that they remain appropriate. This process provides a natural opportunity to implement the conclusions of the Telecoms Review, in the event that they suggest that any particular intervention is out of line with the over-arching strategy. The European framework itself will be reviewed in due course and the conclusions of the Telecoms Review will inform Ofcom's thinking about any changes to that framework which would be desirable in the long run. In the meantime the current regulatory regime will continue and will be carried forward.

3.47 In parallel with this Review, Ofcom is also undertaking a review of the Universal Service Obligation (USO), dealing with the period up until the Universal Service Directive is reviewed in 2006. While the Telecoms Review will examine longer-term issues, such as the case for extending the USO to cover broadband, the USO review will concentrate on the current USO framework. In particular, the USO review will look at the policy on the provision (and removal) of public payphones, the issues raised by the relatively high number of disconnections, and the adequacy and appropriateness of text relay services for deaf people.

3.48 A number of the issues to be tackled by the USO review do have wider significance for the issues considered in the Telecoms Review. In particular, these centre on how to ensure the most appropriate balance between the interests of the citizen and the interest of the consumer (where these do not intersect), and the tension between promoting the overall economic welfare of consumers and the need to safeguard the interests of particular groups of consumers. In the Telecoms Review, we will address the overall policy context of USO measures, and provide forward-looking analysis of the possible evolution of USO policy in the light of changing market circumstances.

3.49 In November 2003, Ofcom published a consultation paper which stated Ofcom's intention of introducing trading for some types of spectrum in 2004. Tradability of spectrum has important implications for telecoms regulation in, for example, the entry barriers to certain wireless telecoms markets. It will be important that the Telecoms Review takes account of the forms of spectrum trading which will be permissible in the market.

3.50 In summer 2004, Ofcom will begin a strategic review of the spectrum framework (the 'Spectrum Review'). This review will develop a long-term framework for the development of spectrum management which maximises the benefits from a range of different approaches. The ongoing work on the Telecoms Review will provide input into the Spectrum Review, and vice versa. The initial consultation document on the Spectrum Review will be published in early 2005.

3.51 Ofcom is currently undertaking an overview of broadband markets. Although this will be complete well before the results of the Telecoms Review are available, Ofcom will ensure where possible that the two reviews take a similar approach.

3.52 The results of the Telecoms Review will inform Ofcom's policy on a number of other regulatory issues which are currently under consideration. These include the issue of mandating access to wholesale end-to-end calls, a review of the Number Translation Services (NTS) framework, and the future of restrictions on BT's pricing of services for business customers. However, pending the outcome of the Telecoms Review, normal policy development will continue. In turn, we expect this continuing volume of casework to inform some of the strategic thinking in the Telecoms Review.

About this document

3.53 The remainder of this document discusses the evolution of the telecoms sector and possible implications for telecoms regulation. The remaining sections are structured as follows:

• Section 4 discusses the trade-offs inherent in regulating telecoms, and how the need for regulation is created by distortions in the telecoms market caused by the existence of market power;
• Section 5 discusses how the telecoms market may evolve in future, and how this might affect the need for regulation by altering market power in the telecoms market;
• Section 6 describes the next steps for the Telecoms Review;
• Annex A lists Ofcom's consultation principles;
• Annex B summarises the questions that we would like you to respond to;
• Annex C contains a cover sheet that we ask you use in responding to this consultation;
• Annex D contains the terms of reference to the Strategic Review of Telecoms, published in December 2003; and
• Annex E provides a glossary of technical words.

3.54 This document is supported by a number of further annexes that provide more background and detail, which are published separately and available to download at: www.ofcom.org.uk/consultations/current/ telecoms_review/annexa/

• Annex F discusses the role of telecoms in the economy;
• Annex G provides a review of telecoms regulation in the UK, highlighting past choices that have been made regarding the trade-offs discussed in Section 4;
• Annex H gives Ofcom's assessment of the performance of the telecoms sector to date. It assesses the sector's performance with consumers, the level of competition in different telecoms markets, the extent of innovation of investment in the sector to date, and the financial performance of the telecoms industry;
• Annex I identifies a number of trends in the behaviour and preferences of different types of consumer, and their possible implications; and
• Annex J identifies a number of trends in telecoms technology, and their possible implications.

3.55 Much of this document discusses 'consumers' of telecoms services. Ofcom uses this term, as it was used in the Communications Act, to mean all types of telecoms users: residential users (individuals or households), small and medium sized enterprises (SMEs), as well as large businesses.

3.56 Sometimes, we also discuss the role of BT as the incumbent fixed network operator in the UK. However, in Kingston upon Hull, Kingston Communications is the incumbent operator. Although we often refer only to BT for simplicity, we note that many of the same issues apply in relation to Kingston Communications in Hull.

Footnotes

1. Section 6 discusses the next steps for the Telecoms Review and Annex D provides the terms of reference.

2. BT was partlly privatised in 1984, and the Government retained a 49 per cent shareholding.

3. For example Regulation of British Telecommuniocations' Profitability, S.C. Littlechild, Department of Industry, 1983. In March 1996, Don Cruickshank, then Director General of Oftel, said, " I believe that the UK is genuinely at a turning point in the development of effective competition and that there will be dramatic changes in the market in the period ahead. Effective compertition is arround the corner - but it isn't here yet. the next set of controls on Bt's prices may well be the last."

4. The results of Oftel's market reviews are described in more detail in Annex H.

5. Statement on Oftel's review of the fixed telephony market, June 2002

6. Source: ONS Annual Business Inquiry 2002

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