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26|01|05

Speech to the Westminster eForum, 26 January 2005

Consultation Seminar on Ofcom's Strategic Review of Telecoms Wednesday, 26th January 2005

Good afternoon.

First of all let me say how delighted I am that the Westminster Media Forum has chosen to devote a full day to what some might argue is a rather technical subject.

Telecommunications attracts less interest from the media, opinion formers and politicians than broadcasting does, and when telecoms does rise to the top of the agenda, it's rarely as a good news story. It is usually a story about sluggish broadband roll-out, impenetrable mobile phone tariffs, directory enquiries confusion, premium rate scams and of course - that hardy perennial - warfare between the regulator and the fixed line incumbent.

And in a way, that is fair enough. Because telecommunications is not as an inherently interesting topic as many others. The interest of media, opinion formers and politicians is only piqued when it appears that something in the telecoms market is dysfunctional - at which point the call usually goes out to the regulator to do something about it. What we want is to enjoy the benefits of a world-class telecoms market - low prices, product innovation, high bandwidth, reliability, without having to think of the mechanics of how any of that is delivered. Few of us care about the fortunes of individual telcos or the commercial and technology choices which they face.

Like it or not - and I know a lot of telco executives don't - the public, media and over the last few years the analysts perception has been that telecoms is a utility, not a sector - to use Ben Verwaayen's phrase - with a wow factor. But of course the risks and rewards of investment in telecoms are not that of a traditional utility. And at the moment very large investments need to be made against a background of considerable uncertainty and investor scepticism - not so much the wow factor as the 'ow' factor.

I am confident that the Westminster Media Forum will still be here in ten or fifteen years time and there will still be an appetite to discuss the dissemination of content, even if the ecology of broadcasting looks very different at that point compared with today. Because culture and creativity are and will remain fundamentally important and relevant topics, the appetite for that debate will not change.

But I would like to think that there may be less need in ten to fifteen years time for the WMF to devote a full day to telecoms regulation. Because if we can get the regulatory framework right now, we will enjoy the benefits of a dynamic and competitive market structure. Predecessor regulators occasionally left a hostage to fortune for the future by claiming there would be no sector-specific telecoms regulation required beyond a different date. I do not say there will be no need for regulation at all - but with the right market and regulatory structure, we should certainly be able to cut some of the jungle of regulation that exists today.

But first of course we do have to get the regulatory framework right. There were one or two raised eyebrows when Ofcom announced its intention to conduct a strategic review of telecoms regulation. It was felt that the European regulatory framework for telecoms was so comprehensive - and of course the ink was still drying on the various directives - that there was really very little more that could be said about telecoms regulation.

As far as the European framework is concerned, when we took over the baton from Oftel we were told that all the EU-inspired market reviews would have been done. In practice - and for good reasons - some of the most important had been left to the end for Ofcom to pick up: for instance local loop unbundling and wholesale broadband access.

It quickly became apparent to the Board that the issues thrown up in each individual market review highlighted the need for a coherent policy approach. The EU framework provides the high level principles which guide us, and the specific directives provide a toolkit available for us to use. What we in Ofcom needed to provide was the bit in the middle - the detailed analysis of the market situation here in the UK , including the identification of the real barriers to competition - which allows us to use that toolkit effectively.

The second reason for a review now is that we were at a point of technology change in network architecture. I started by acknowledging that telecoms regulation can be a dull subject. A discussion of the topology of fixed telecoms networks, with its alphabet soup of WANs, LANs, DSLAMs, and so on can be confusing. And yet the changes which are taking place within and at the edge of networks are in their own way as transformative as the change from analogue to digital TV, and - a distinctly non-trivial point - will require very much larger sums of money to be invested.

The third reason is the most important of all, and it is the one already alluded to. For all the efforts expended on regulation over the last twenty years, and for all that the market has delivered some good outcomes, the current industry structure, certainly of the fixed line market, is not sustainable in the long-term. So, without a change of direction we fear that the achievements to date will actually go into reverse.

Many of you will be familiar with where we have come out so far. Three broad options: regulatory forbearance and let the market structure operate as it will; an Enterprise Act investigation into the structure of the market and, in particular of the incumbent; and 'true equality of access'.

Let me be clear. The possibility of an Enterprise Act investigation is not simply a bogeyman to secure the façade of cooperation from BT. It is and must remain a real possibility if, reluctantly, we conclude that true equality of access cannot be achieved. One of the work-streams following on from our Phase 2 report is precisely on how the detailed process of an Enterprise Act investigation would work in practice. I will say more on this later.

Before setting out in more detail the nature of the solutions, however, I would like to say something further about the nature of the problem. In our phase 2 report, we were brutally clear about this, but I think our analysis bears reiteration today.

We asked what were the attributes of a well-functioning market. We were told that telecoms regulation has worked well drive down prices and drive out poor quality of service - the concerns that exercised policy-makers back in 1984.

In 2005, these remain important concerns, but consumers also want innovation, diversity and choice. Not a single vanilla voice telephony product, but many different flavours of voice and data, higher bandwidths, greater functionality, new applications, new content available across multiple platforms.

At a seminar we ran recently at Ofcom the representative of a consumer organisation questioned whether we were right to be focusing on promoting competition rather than safeguarding the interests of consumers. At one level, this is a fair point. Our duties are clear - competition is a means to an end, not an end in itself.

And yet we make no apology for believing that, if those attributes just mentioned are truly the measure of a well-functioning market, then only a market structure based on effective competition can deliver what consumers require. If this was a plain vanilla world, the regulator could theoretically intervene directly to impose low prices and guaranteed service quality. But it is very difficult to enforce innovation and even willing participation at an operational level via licence condition.

Innovation and creativity will be released where a market has many competitors - crucially including infrastructure-based competitors - creating a self-organising culture of innovation. The competitive interactions between a number of providers will provide the stimulus which a 'top down' or `side ways in' model of regulation cannot.

So we want effective and sustainable competition. Sounds easy. And yet it has proved very difficult to achieve in practice.

Over the course of the twenty years since liberalisation, we have pursued effective competition in a variety of different flavours. We have had a period of managed duopoly competition, a period of actively promoting access competition, and latterly an approach that considered infrastructure and services competition to be of equivalent value and importance.

Ideally, there would be scope for competition at every level of the value chain. Multiple service providers, multiple core networks, even multiple access networks. In mobile, we have had first two, then fourand now five, competing end-to-end infrastructure players. There remain some regulatory issues in relation to mobile, but it surely cannot be denied that the competition problems in the mobile market are an order of magnitude less significant than those in fixed.

We also tried a similar policy in the fixed market. In the early 1990s, Government and regulatory policy was geared towards the creation of competing fixed access infrastructure, initially through the cable networks, which it was hoped would be augmented by fixed wireless networks over time.

An interesting theoretical debate can be had as to whether the pro-cable policy, if pursued more vigorously and over a longer period of time, would have eventually proven successful. What Ofcom can say today is that the policy has created a strong and important source of competition in the market from the cable companies, where we now have two players with networks built to nearly 50% of UK homes, and with an existing subscriber base of 5.1 million including 1.81 million broadband subscribers.

Even so, we believe even a single cable player would be insufficient on its own to create an ideally competitive market in all areas - in particular because of its limited geographic spread. And we see no likelihood in the foreseeable future of cable networks being built out to the point where they are as ubiquitous as cable networks in for instance the US , the Netherlands or Belgium .

As for fixed wireless services, government and regulatory enthusiasm for this in the early 1990s was tempered by the headaches created by the collapse of Ionica and Atlantic Telecom. Now our position is clear. We are enthusiastic about wireless. We very much welcome the kind of investment being made by UK Broadband. But it is not sensible or viable to base a regulatory policy on technologies which remain unproven at this stage. Although our co-ordinated approach to wireless spectrum including liberalisation, trading, an auction programme of new spectrum and the increased use of licence exemption should all contribute to the further development of wireless as a complement and competition to fixed and mobile networks.

Hence, our conclusion has been that to a significant extent, BT's access network will remain a natural monopoly or what we have termed an 'enduring bottleneck' and will need to be regulated accordingly if competition is to thrive. But we have also concluded that there is scope for infrastructure-based competition in core networks, and in some cases in the 'middle mile' connecting core networks to access networks - what most in the industry refer to as backhaul.

But if competition is going to be at all effective, given the existence of these enduring bottlenecks, it will be necessary to ensure that access to these bottlenecks is available on genuinely fair terms to BT's competitors.

At one level, this is not really news. One or two regulatory lawyers said as much after the launch of phase 2. Regulation had long incorporated the principle of 'no undue discrimination' in access to bottlenecks - indeed I am led to believe that a licence condition of this kind appears in the rules regulating Victorian town gas suppliers.

But our proposals are, we hope, much more than old wine in new bottles. Within the concept of 'undue discrimination' there is clearly scope for differences of emphasis and intensity of application. In practice we believe that the evidence from the market shows that the interpretation of undue discrimination so far has been largely ineffective in addressing the root causes of competitive disadvantage.

In part this has been because of confusion between the test of undue discrimination required by competition law and the test of undue discrimination which is appropriate when regulating a vertically integrated monopoly that has inherited 100% market share. In the case of the latter, if we want to see any competition emerge in the market, we will need to go further in restricting scope for discrimination.

The final point on our diagnosis of the problems of the current market structure concerns regulation itself and its impact on the kind of competition which has emerged.

I have already mentioned that regulation has over that twenty year period since liberalisation gone through several phases in which there has been greater emphasis on one form of competition over another. Regulation has therefore in part encouraged a variety of different business models to develop.

To some degree a culture of regulatory dependency has been created. But it is even more unfortunate that in some cases the regulatory dependency of one business runs into direct conflict with another. This encourages a regulatory approach in which incremental adjustments are made to try and satisfy as many dependent groups as possible. As well as being inherently complicated, one consequence of this is that the kind of rewards to scale, which ought to emerge organically from the market are retarded by regulation. We end up with a market structure in which there are many small players and not enough strong, scale-based players.

It is fashionable to chastise the managements of the altnets for the poor financial performance of their businesses in recent times and no doubt mistakes have been made. But it is very important to recognise the extent to which regulation has unfortunately contributed to these problems.

So, if these are the problems, what are the solutions? I have already outlined the three choices as we see them, and these have been exhaustively discussed since the publication of the Phase 2 report. But I want to re-emphasise a couple of points which I think are important.

The first is that within our preferred choice of 'equality of access' there are two elements - product level equivalence, and changes to behaviour and governance - and both of these are equally important.

In relation to the latter, we have been described as having issued an ultimatum to BT to get its act together by the 3 rd of February when the consultation closes. In fact we have done nothing of the sort and nor should we. What we said was that changes to behaviour and governance would flow from changes in BT's own structure, procedures and transparency. In the first instance it must make sense that BT, in the knowledge of the issues we are concerned about but also understanding its own organisational culture, comes up with its own proposals for how to address these issues. We are certainly not expecting BT to complete any such transformation by February 3 rd. But we have made clear that we would like to see BT put forward substantive proposals in its consultation response that will take the debate forward significantly.

The product-level equivalence aspect has attracted less attention. And yet in many ways the issues that it raises are as difficult. We distinguished between equivalence of inputs - BT using exactly the same products, procedures, processes and gateways as its rivals - and equivalence of outputs, where BT continues to use its own unique products but the advantage that flows from this is offset in some way, perhaps through pricing. We made clear that equivalence of input is a strong preference, though we noted in some cases that it would be difficult to apply to legacy products without imposing excessive cost.

From industry reaction so far, it is clear that there is a strong preference for equivalence of input wherever possible. In particular it has been suggested that this is vital in relation to the Wholesale Line Rental product which many companies wish to use to provide further competition in voice services and - importantly - to be able to fully own their relationship with the customer. No doubt this also reflects some impatience in the industry, given that a fit for purpose WLR product was identified as being key to effective voice competition as long ago as five years ago. We await with interest BT's reaction on this point.

Achieving equality of access to enduring bottlenecks should allow us to focus our regulation more narrowly in the future and in particular should allow us to deregulate retail markets and remove wholesale regulation upstream of the bottleneck in question. But here BT has said - in my view not unreasonably - that Ofcom must walk the walk, as well as talk the talk. I expect a significant aspect of Phase 3 of our review will be firming up our deregulatory proposals in a number of areas. However, I want to make very clear that there is no question of deregulation in one area 'offsetting' concessions by BT in other areas. The regulatory framework simply does not work like that, and nor should it. Any deregulatory measure that we take will need to stand on its own merits.

Another attraction of our approach is that it enables us to provide greater clarity in terms of future investments by BT and the industry. One of the criticisms which may legitimately be made of any regulatory regime is that it creates uncertainty which in turn can chill investments. And as already noted, in telecoms some very big investments are going to be needed in the near future as the networks are transformed, and the largest likely investor is BT plc.

We are already taking steps to provide the necessary certainty. In parallel with the review we are consulting separately on BT's 21 st Century Network plans, on methodologies for the valuation of the cost of copper, on how we should calculate BT's cost of capital, and shortly we will be consulting on new network charge controls - the measures by which we regulate BT's interconnection pricing and what judgements we should make about the ownership of efficiency gains.

As well as providing clarity in terms of our future intentions - helpful in itself - we are seeking to apply the logic of the telecoms review in each of these areas. So in relation to the cost of capital, although BT is at the high end of the spectrum when it comes to the regulated returns that it is allowed to make compared with other regulated businesses, we do recognise the risky nature of the 21CN investment and the even riskier prospect of future investment in new access networks. In relation to the valuation of the copper network, we suggest that as there is little prospect of new access networks being built by rivals, the calculation should be based purely on the efficient cost of building a replacement network. In other words, we should not set these charges so as to incentivise new network build by others which is not likely to happen, however theoretically or theologically desirable that may be.

We see scope for what we have termed a new 'regulatory settlement'. That is to say, a possible outcome in which more tightly focused regulation delivering true equality of access then creates scope for deregulation elsewhere, and allows some of the regulatory barriers to investment - whether by BT or by others - to be removed.

Implicit in the idea of a 'settlement' is the sense that the industry, including BT, will be prepared to work towards a different regulatory outcome and operate in a different regulatory environment. Whilst our new approach would be subject to the appropriate legal underpinning, the path to implementation would be relatively smooth because all parties would see the merits of the new approach.

What if this is not possible? In particular, what if BT tells us on the 3 rd of February, that it cannot countenance the kind of equality of access - behavioural change and product level equivalence - that we have said is essential?

Much of what we have termed real equality of access could be achieved through the use of our existing sector powers. Product-level equivalence could be demanded as a super-charged remedy to the problem of discrimination. It might be possible to demand certain organisational and behavioural changes by BT as being necessary to underpin such a prohibition on discrimination.

But to impose such remedies in the face of BT's active hostility - and let me repeat, I very much hope this will not turn out to be the case - would be a very complicated and time-consuming task. It would need to be done case by case, product by product and market by market, with BT having the opportunity to appeal our decisions at every stage.

Much has been said about the delay and uncertainty that would be created by an Enterprise Act referral. But imposing real equality of access in the teeth of sustained opposition would impose even more delay and uncertainty and ironically would probably involve not one but several trips to the competition commission to resolve.

Second, our analysis suggests an endemic problem, manifest in many separate product markets, but all flowing from the same root cause, namely BT's control of enduring economic bottlenecks. Pursuing real equality of access using our sector powers would require that we address the issue incrementally. It would be difficult for us, and for the competition commission or competition appeals tribunal should they become involved in an appeal, to see the big picture. By contrast an Enterprise Act approach allows the Competition Commission to look at the entire market and the problems flowing from its structure in the round.

So there are reasons for thinking that an Enterprise Act referral, whilst undesirable in many ways, would be less undesirable than a protracted attempt to impose real equality of access via the sector powers route.

However we will have to wait beyond the 3 rd of February to see whether a settlement is truly possible. Indeed, a final resolution of the TSR may now possibly happen after a General Election, if it is to be on 9 May. (Simply because, by the time we have digested what we expect to be an extensive set of comments on 3 rd February and developed our final proposals, it will be in the immediate run up to a May election and, though we are an independent regulator, that is never the best time to be announcing decisions that could have significant market and public policy impact).

If all of this discussion so far sounds highly theoretical, let me now turn to the highly practical issue of what Ofcom is doing in the short term to strengthen the competitiveness of the broadband market.

We inherited a complex and interdependent set of regulatory interventions in relation to BT's wholesale broadband offerings. Broadly speaking, LLU was dead in the water: IPStream, the managed ISP product was successful but generating a lot of complaints about its pricing, and Datastream, the 'middle mile' product designed to allow competition from alternative infrastructure providers absent any interest on their part in LLU, wasn't really working at all to meet this need.

The problems associated with Datastream were essentially threefold - the pricing, in particular the effective margin between Datastream and IPStream, simply wasn't viable; migration was both technically problematic and expensive, and there were a host of quality and provisioning issues.

The first thing we sought to do was approach this array of issues from a strategic standpoint: namely that the regulator's job is not to create short-term arbitrage opportunities for alternative businesses, but to encourage sustainable competition at the deepest points of interconnection with the BT network- that is, true facilities-based competition which allows a wide range of innovation and differentiation in the retail and service markets.

We have done the easy bit: that is to set wholesale prices at a level where alternative operators can turn an honest penny with LLU investment in the more densely populated areas and Data-stream in the market towns and rural areas.

But now we are into the harder bit: working with BT to develop and deliver processes for provisioning that wholesale supply, right first time, that work at industrial scale. We have adapted an experience from the television advertising sales market sector- namely an independent adjudicator who is as much facilitator as a quasi-judicial disputes resolver. And- so far- it seems to be working. Regulators must not be soft touches or be captured by the incumbent. Equally, I believe it is counterproductive if they are always in an adversarial relationship with the incumbent and are never prepared to believe good of them. I may be wrong, but I do not think so. I genuinely believe that Ben Verwaayen and his senior team want to make a competitive broadband market work. A smaller slice of a much larger market is more in the interests of BT's shareholders than a larger slice of a stalled market. At this stage, I am prepared to believe that what we have seen in process terms is occasional human error allied to serious organisational commitment.

A commitment from BT, from the cable industry, from the ISPs, from the Regulator that has got us to north of 5 million broadband connections with 60,000 new additions a week - difficult to give the credit for this to one person but Ben Verwaayen deserves his fair share. However retail take up is one thing, wholesale activity is another, and infrastructure commitment is altogether different and that is why Peter Black, the Telecoms Adjudicator, is working with the industry both to resolve the practical problems associated with LLU but also to develop some robust mechanisms to ensure that the process works consistently going forward - past the point where it's a headline story on the financial pages or in the top of BT executives' in-tray.

Key to this will be to develop robust agreed Key Performance Indicators, and mechanisms for enforcing compliance with these. Peter tells me that the work thus far has identified two Key KPIs:

- First, 'Right First Time' measures whether a working loop is delivered in time to meet the end customer's expectation of the completion date set at point of sale - key to that customer's perception of LLU can work to deliver an on-time, quality product.

- Second, 'Throughput' measures the capability of the end to end systems to process and deliver orders; milestone capabilities have been set.

Increased competition in the LLU space will lead to interesting commercial decisions for the incumbent. For instance, BT could respond to aggressive LLU-based competition by geographically de-averaging the prices it charges for Datastream, thus changing the margin between Datastream and LLU.

In time, a move towards cost-orientated pricing by broad- exchange band (i.e urban/rural) will probably come into being. We have allowed BT to set its Datastream prices at retail-minus in relation to IPStream, the last bit in the wholesale value chain. Thus, in principle, the Datastream price is a movable feast. That is consistent with our recognition that Datastream is a transitional broadband product.

We recognise however that this is a new market. With an incumbent in place. Thus an odd market. Inevitably there will be some arbitrage opportunity, if only because of the time lags between price changes and regulatory decisions. We appreciate the ability of an incumbent to disrupt a nascent market by announcing robust pricing plans. And the ability to reverse-cherry pick (i.e. to set prices to target competitors with laser-like precision).

As the broadband market develops, inevitably public focus will shift to the question of how to accelerate the transition to next generation access networks.

We are clear that political and stakeholder interest in next generation broadband access is not going to go away. Indeed, we understand that some public authorities are so convinced of the need for next generation access networks that they are actively investigating building such networks with public money in the absence of private sector interest. Ofcom intends to invest significant time and effort this year in looking holistically at the next generation access question - looking at commercial and regulatory barriers to its deployment. My guess is this will take us into some interesting areas.

We are also looking at universal service rules. We are doing this in two parts. First, we are consulting on how the existing USO obligations in relation to voice are working, and whether they could be made to work better. But secondly, as part of the strategic review we are considering the likely evolution of USO over time - both in terms of the scope of the services which need to be included and the likely funding mechanisms which will be required.

On scope, many commentators are now urging us to examine the case for a broadband USO. It is not in Ofcom's gift to mandate a new broadband USO - that is a matter for Government.

A broadband USO could take two forms, as does the current voice USO. First, an obligation to ensure that broadband is available to all, essentially through a subsidy for the less well off or the vulnerable who otherwise would be priced out of the broadband market. In our view, there will not be a justification for a broadband USO of this kind until broadband - like telephony - is key to consumers and citizens playing a full and active part in society. Clearly we are some way away from this situation today given that broadband penetration is still below 20%.

Three years ago Broadband, or more accurately Broadband enabled exchanges and therefore BT Broadband coverage was a hot political issue. The achievements I described earlier and the personal commitment of Ben Verwaayen and the BT Board, combined with effective competition from Cable, many ISPs and others have successfully taken the political heat out of this issue. However, my plea to the politicians of all parties, is that it would a critical mistake to believe that new universal coverage by BT exchanges, 20% penetration, Broadband speeds of less than 512k is the answer to this country's Broadband needs. A bit more focus and passion about Broadband and less on Broadcasting might be a post-election resolution we would all welcome.

Ends.

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