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4.1 Telecoms regulatory policy aims to find the right balance on a number of trade-offs. This section describes these trade-offs, and gives a brief summary of how telecoms regulation in the UK has addressed them in the past. It then summarises Ofcom's analysis of how well the telecoms sector is delivering benefits to citizens and consumers

Trade-offs in telecoms regulatory policy

4.2 Telecoms regulatory policy aims to correct certain failures of the market, in the interests of citizens and consumers. Key outcomes include low prices, a high quality of service, a wide choice of products and providers, widespread access to services, and the introduction of new products over time.

4.3 Economists associate these benefits with achievement of three distinct types of 'efficiency':

• 'Allocative efficiency' is achieved when prices are close to cost. This ensures that all consumers who value a product at more than its cost are able to purchase it;
• 'Productive efficiency' means that the costs of production are minimised;
• 'Dynamic efficiency' means that firms have the correct incentives to invest (e.g. in new infrastructure) and to innovate (e.g. to generate new products). Greater reliability and other quality improvements, and the creation of new products and services, are critically-linked to investment and innovation.

4.4 In theory, a fully competitive market without distortions will deliver allocative, productive and dynamic efficiency without need for specific regulation. Competition between providers drives prices down to cost. It also ensures that costs are minimised, since a firm that fails to do so will find itself unable to compete. The incentive to invest and innovate is strong, since innovation provides an opportunity to launch attractive new products that command a premium over existing rivals, at least for a time.

4.5 Some telecoms markets are generally considered to have characteristics which mean that they are not fully competitive in this way. For example, many have very high barriers to new firms entering the market and being able to compete with existing suppliers. In some telecoms markets, one or more existing suppliers have such economies of scale that smaller competitors have much higher costs. Telecoms also displays significant network effects, where the addition of more customers to a network benefits existing customers. These types of characteristics tend to result in one or more companies in a market having what is known in competition law as 'market power'.

4.6 Given these characteristics, telecoms regulation aims to mimic a fully competitive market in achieving the three forms of economic efficiency. However, regulation typically involves some trade-offs between the three, and the overall optimum can rarely be achieved. For example, cost-based regulation of prices (such as rate of return regulation practised historically in the US) achieves allocative efficiency but may be poor for productive efficiency. This is because, with regulated prices falling in line with costs, cost-reducing measures yield little benefit to the producer. Dynamic efficiency may also be weak, especially when investment is risky, as the best that might be attained through investment is a regulated return on the investment cost. A price cap that is fixed for a period of time, although better for productive efficiency, risks prices becoming out of line with costs and may therefore be poor for allocative efficiency.

4.7 More generally, if investment and innovation are important for the development of the sector, ways must be found to reassure investors that returns will not be 'regulated away' after the investment is made. Commitment by the regulator and consistency of regulatory actions are important in this context.

4.8 Telecoms regulation is also complex due to the complicated structure of the industry. Most industries, including telecoms, consist of a sequence of stages of production, often referred to as a 'value chain'. In the electricity supply industry, for example, electricity is generated, then carried over the high-voltage transmission network or national grid, before being stepped down at the regional distribution network and supplied to the consumer. Telecoms networks are typically more complex than this. For example, the different stages of the network include: the phone or device (customer node), the access network, the access node, the backhaul network, the metro node, and the core network. Suppliers may provide services by either building or leasing each of these infrastructure layers. On top of this, service provision involves billing, distribution, customer care and other activities, and some types of telecoms service may also involve access to content. Figure 2 shows, in highly simplified terms, the route that a long-distance call may take through the network.

4.9 Regulation has tended to focus on promoting competition at one or more of these network levels. For example, if the incumbent was not required to offer wholesale access to the customer premises, competitors would be obliged to build their own access network if they wished to compete. This might be described as promoting competition in access infrastructure. Alternatively, a regulator may require the incumbent to offer an end-to-end wholesale product which competitors may resell to consumers, in order to promote competition at the service level. Between these extremes are many variants which combine elements of service-based and infrastructure-based competition.

4.10 There are trade-offs between promoting competition of these different types. A keenly-priced end-to-end wholesale product may generate significant competition at the service level but gives little incentive for investment in infrastructure, given the greater outlay and risk involved. However, infrastructure-based competition, if this flourishes, offers the prospect that further stages of the value chain become competitive, and regulation may then be drawn back from these parts of the network. However, this process may take time, with widespread competing infrastructure slow to develop, during which only a limited choice of suppliers is available to consumers. Moreover, unless retail prices are to be very high, the total margin between the retail price and the cost of access is limited, and a generous margin to stimulate competitive entry at one level implies that less is left over for entrants at the alternative stages. So this is why most regulation involves a choice - whether made explicitly or implicitly - between promoting competition at different stages of the value chain.

4.11 Technological change may affect the economics of different parts of the network - for example, the extent and nature of any scale effects. This in turn may affect the appropriate balance between these trade-offs.

4.12 The alternative positions that regulation may adopt on these trade-offs are likely to deliver various beneficial outcomes to citizens and consumers (through, for example, lower prices, greater innovation, more choice and so forth) in different measures. Therefore, an important issue for the Telecoms Review is the relative importance of these different outcomes. Economics provides an important mechanism for making these choices. For example it can, in theory, compare the merits of a 'static' benefit (such as lower prices), with a 'dynamic' benefit (such as faster innovation).

4.13 But sometimes, it is hard for this approach to access the information necessary to capture some of the more subtle considerations that are, nonetheless, very important to consumers. An important element of the Telecoms Review is the research that Ofcom is carrying out into the preferences of different types of consumer. Ofcom has carried out some initial research in Phase 1, based on secondary sources, and will commission more in Phase 2. Figure 3 shows the principal trends in consumer demand identified by our initial research, and these are discussed in more detail in Annex I.

Figure 2: Routing of a long distance call through the telecoms network

Figure 3: Trends in consumer demand

4.14 These trends have important implications when choosing the different types of benefit that telecoms regulation can deliver. For example, both residential consumers and SMEs display behaviour that implies that time and energy are becoming as important to them as money. Therefore, for some consumers, even quite low barriers to switching between suppliers (for example, price bundles that they find hard to compare), could prevent them from moving to alternative suppliers with lower prices. Similarly, these consumers would benefit from a telecoms service that made being a customer as untaxing as possible, through excellent levels of customer service. However, these consumers may not have the information they would need in order to choose such a better supplier.

4.15 In Phase 1, it is important for Ofcom to hear your views on what characteristics a well-functioning telecoms market would display. We want to understand what you consider to be the relative importance of the different benefits that the telecoms sector can deliver to citizens and consumers. For example, what is most important to you: that the market delivers low prices, or lots of choice, or that it is always the first in the world to deliver new products?

4.16 As well as informing us about the objectives of regulation, consumer feedback is important because it may have implications for the kind of activities that Ofcom should be involved with. For example, if you consider it particularly important that the market delivers clear, easily accessible information about prices and other aspects of choice, there may be a role for Ofcom in either helping to provide that information, or ensuring that it is provided properly by the market. Past decisions on regulatory
trade-offs

4.17 Over time, telecoms regulation in the UK has adopted different positions on these inherent regulatory trade-offs. Annex G discusses these past positions in more detail, and a summary is provided in this section.

4.18 When BT was privatised in 1984, the Government wished to create competition within all levels of fixed infrastructure. However, it was considered that multiple operators would not be strong enough to compete with BT's scale, so just a single competitor was licensed: Mercury. In order to encourage Mercury to compete using its own infrastructure, the Government included conditions in its licence which prevented it from leasing elements of BT's infrastructure, with the exception of interconnection for call termination. As well as creating this expected source of competitive pressure, the Government also wanted the benefits of lower prices to flow through to customers more rapidly than they might by competition alone. It therefore introduced a price cap on BT. Oftel was established to police the resultant licence conditions, including the price controls and interconnection agreements.

4.19 The 1991 Duopoly Review allowed more competitors into the market, and for the first time elements of service competition were permitted. For example, competitors to BT were allowed to lease infrastructure from BT, but only at retail prices. However, in the period after the Duopoly Review and up to 1997,
there was a strong focus on infrastructure competition, particularly in the access network. The restriction on BT being able to provide entertainment services in its own right, introduced initially in the 1980s to provide a measure of protection to the fledgling cable TV industry, was maintained throughout this period. In other cases where regulation might have encouraged service competition at the expense of infrastructure competition, or long-distance network competition at the expense of access infrastructure competition, decisions generally erred on the side of promoting access infrastructure competition. For example, while number portability was introduced early, Oftel deliberately did not introduce carrier pre-selection (CPS) in this period. While CPS could have brought rapid benefits in terms of increased service provider-based competition and lower prices, Oftel considered this would come at the expense of infrastructure-based competitors. Oftel also changed the basis on which interconnection charges were set, in a way that favoured networks that built their own access infrastructure.

4.20 In the period since 1998, the balance has moved towards service provider-based competition. Among other things, this was partly the result of the 1997
EU Directives, and partly due to many competitive providers stopping rolling out infrastructure, following the collapse of investor confidence in the telecoms sector. The measures that Oftel introduced which favoured competition using elements of BT's network on a wholesale basis included carrier pre-selection, wholesale line rental, flat rate internet access call origination (FRIACO), and interconnection to BT's broadband network at the ATM layer. As a result of measures such as carrier pre-selection and wholesale line rental, service providers are now rapidly gaining market share in the fixed residential market.

4.21 In mobile, though the same trade-offs apply in principle, infrastructure competition at all levels in the network has been more widespread and sustainable than in fixed. There are now five network operators, and in its review of the retail market for mobile calls and access, Oftel found no operator to have SMP. As a result, Oftel did not have to make many of the more difficult choices between promoting service provider competition and promoting infrastructure competition

The performance of the UK telecoms sector

4.22 The decisions that telecoms regulation has taken on these trade-offs over the last 20 years have helped shape today's UK telecoms sector. It is important that we now assess whether it is doing well or badly at delivering the kinds of benefits to citizens and consumers that were discussed above.

4.23 Figure 4 summarises how well different parts of today's telecoms sector are delivering benefits in terms of price, quality, choice and access to services, and how competition has developed. The scores are only intended for illustration, and represent a mixture of comparative measures (such as how well is the UK performing relative to other countries?), and absolute measures (such as how well has competition developed?). Annex H provides much more detail on our analysis. If you disagree with our assessment, please tell us why in your answer to Question 6 on page 23.

Exhibit 4. Summary of the benefits to consumers from the UK's telecoms sector

	Price	Quality of service and customer satisfaction	Service choice	Access to services	Competition
Fixed voice telephony	UK residential prices compare well with other countries; business prices above average	Very high levels of SME and residential consumer satisfaction; declining incidence of faults	Wide range of tariff structures and bundling options	Near ubiquitous take-up, only 1% of households do not own either a fixed nor a mobile phone	More competition in calls and access lines than other countries. Much of the call competition is from service providers, using alternative long distance networks. BT still provides most access infrastructure
Internet	Narrowband and entry level broadband prices compare well with comparable markets; higher speed broadband more expensive	High satisfaction with broadband, lower satisfaction with connection speeds of narrowband	Full range of narrowband price structures. Some choice of broadband connection speeds, contention ratios, but flexibility in price structures only just emerging	Ubiquitous availability of narrowband. Broadband only available recently in many areas, other areas need a "trigger" level of demand in an exchange, and some households and exchanges not DSL enabled	Many service providers, none with market shares over 30%. Infrastructure provision largely provided by BT and cable companies, almost all DSL lines use BT's access infrastructure
Mobile	Prices for pre-pay are lower than many other markets, and the UK is also relatively competitive in post-pay pricing	High overall satisfaction, less satisfaction on cost and value for money. Incidence of dropped calls improving	3G services starting to become available, and a full range of 2G and 2.5G tariff packages and devices	Mature networks cover almost all population and all except remote areas. Near-ubiquitous take-up amongst younger consumers; voice and text message usage increasing	High (licensing) barriers to entry at the network level, but least concentrated market in Europe. Some new service provider competition, but many existing service providers now bought by network operators
Corporate network services	Published leased line prices are above European average.	High levels of overall satisfaction with suppliers and reliability of service; less so for value for money and customer service.	These services the key focus of many Altnets. Competition has encouraged development of bespoke and tailored solutions.	Most large corporate businesses are using some form of data network service. May be reliant on BT infrastructure for some services.	At least six players with significant market share although BT still retains around half the market; more for lower capacity leased lines.

Key

Good

Poor

 

4.24 Figure 4 shows that in general, the UK is delivering a good balance of benefits to consumers. For example, residential fixed telephony prices are cheaper than many other countries, and there is a very wide choice of mobile services and tariff packages. However, there are a number of areas where its performance is less good. For example:

• fixed telephony prices for small businesses are slightly more expensive than some comparator countries;
• for some time, access to broadband in the UK lagged behind comparator countries, and many broadband offerings were more expensive in the UK than in some other countries. Although this is no longer the case, penetration of broadband is still lower than some European countries. However, broadband penetration is now growing very rapidly in the UK; and
• the prices of most categories of leased line are more expensive in the UK than the EU average.

4.25 Price, quality, choice and access to services are very traditional measures of performance. As we discuss above, one of the tasks for the Telecoms Review is to assess what other ways of measuring the performance of UK the telecoms sector might also be important.

4.26 The table also shows that competition is more established in some parts of the telecoms market than others. The extent of competition is very difficult to measure, and cannot be determined just by looking at market shares. It is possible, however, to identify some broad trends, and these are discussed in more detail in Annex H. For example:

• BT's competitors have gained more market share in retail fixed call markets than they have in fixed access. BT has around 69 per cent of residential fixed call revenues, and around 50 per cent of business revenues. BT also has around 80 per cent market share of residential access lines, and a higher share of business access lines. However, its share is lower than incumbents in some other European countries, largely as a result of the higher penetration in the UK of cable TV networks capable of offering telephony;
• with five network operators and a number of non-network-based service providers, the UK's mobile market is potentially one of the most competitive in Europe;
• a variety of ISPs supply both narrowband and broadband services to residential and business consumers. BT's share of DSL is lower at the retail level than the incumbents' in some other European countries. However, at the infrastructure level, broadband is almost exclusively supplied over two infrastructures: cable TV networks upgraded with cable modems, and DSL supplied by BT; and
• a variety of suppliers provide corporate network services in the UK, giving a wide choice to corporate consumers. Many of these providers have their own long distance networks, and they also provide local access to some customers in some locations. But much of the access infrastructure for corporate consumers
  is provided by BT on a wholesale basis to these alternative providers.

4.27 Annex H also discusses two other measures of the sector's performance: whether the level of investment has been efficient, and the financial performance of the UK telecoms industry. It describes how investment levels have fluctuated significantly in recent years, and how the financial performance of the sector has also been very mixed, with weak results in particular by alternative fixed network operators.

Question 6: How successful is the UK telecoms sector currently in delivering benefits to citizens and consumers?

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