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Consultative Document, October 1997ContentsForeword by the Director General Chapter 1 Introduction Chapter 2 Background Chapter 3 Regulatory mechanisms Chapter 4 access costs Chapter 5 Revenues and cost of capital Chapter 6 Pricing for particular categories of broadcaster Chapter 7 Pricing of services to individual broadcasters Chapter 8 Risk-sharing arrangements and the recovery of fixed costs Annex A Cost of capital Foreword by the Director Generali The launch of digital television serConditionalvices in the UK is now only a matter of months away. The transition to digital offers not only a huge increase in the number of channels and the capacity to offer pay-per-view services, but also new interactive and information services. These new services promise not only to change the broadcasting landscape but also to redefine the way we use the television. ii Much of this explosion of new services will be paid for by subscription and other charges to the viewer. Conditional access – the electronic turnstile in the set top box which makes pay television possible – will be crucial to these developments. For this reason I take very seriously the responsibility I have been given for the regulation of conditional access to ensure that conditional access services are supplied to broadcasters on a fair, reasonable and non-discriminatory basis. iii Those organisations who are preparing to launch digital services next year face a massive task and there are still many technical and commercial issues to resolve. My aim is to ensure, so far as possible, that all parties are clear about the rules and the principles and approach Oftel will seek to apply, so that regulatory uncertainty is not added to the list of uncertainties faced by market players. iv This document is intended to lead to further guidance on the interpretation of the requirement that conditional access services should be offered on a ‘fair, reasonable and non-discriminatory basis’. I believe there are good reasons for giving further guidance:
v This is a consultative document which seeks views on Oftel’s thinking. This reflects Oftel’s normal policies on transparency. It also reflects the fact that conditional access raises issues which would involve breaking new ground. Consultation is helpful to Oftel in bringing a wide range of views and opinions to the problem. I also want to ensure that all interested parties have the opportunity to comment. vi The words ‘fair, reasonable and non-discriminatory basis’ are capable of differing interpretations. In seeking to set out Oftel’s approach I believe I have two basic tasks. The first of these is to establish a framework which makes appropriate allowance for the risks of investment in new services and appropriately rewards investment while at the same time ensuring that new, efficient, operators can enter the market to the benefit of consumer choice. vii The second main task is to strike the right balance between the different types of broadcaster. It is clearly important to ensure that the pricing framework takes due account of the differences both between different pay television services, and between pay television and free-to-air services. viii The interpretation of the non-discrimination requirement is particularly important here. The underlying principle here must be that comparable customers for comparable services should receive comparable terms and conditions and in particular that the charging structure should, as far as possible, be competitively neutral. This document seeks to open the discussion of how this underlying principle should be applied. ix On free-to-air services, I am conscious of the importance which the BBC attaches to its free-to-air services being available to its viewers by all delivery mechanisms. This is clearly an important issue from the viewpoint of the consumer. It is therefore important to ensure that the charges to the BBC and other free-to-air broadcasters properly reflect the costs of offering services to them. The free-to-air broadcasters should not be required to contribute to services and facilities required by pay television broadcasters – but equally neither should pay television broadcasters be expected to subsidise the free-to-air broadcaster. x Oftel has spent twelve years overseeing the framework for regulating interconnection prices in the telecoms market. I hope that this document reflects that experience while taking account of the particular issues raised by conditional access. I am in no doubt as to the central importance of those rules on interconnection in the development of competition in the telephony market. That framework has fostered competition and innovation. I am equally convinced of the importance of the framework for conditional access in the development of a dynamic market in television and interactive services. The issues raised in this document are potentially far reaching and I hope therefore that they will be subject to the broadest possible scrutiny and debate. Don Cruickshank
ConsultationThe initial consultation period will run until 28 November 1997. There will then be a further period until 13 December 1997 during which comments are invited on any submissions made to Oftel during the initial period. Written comments should be submitted to: Lisle Peters Oftel 50 Ludgate Hill London EC4M 7JJ Written comments will be made publicly available in Oftel’s library except where respondents indicate that their response or parts of it are confidential. Respondents are therefore asked to separate out any confidential material into a confidential annex which is clearly marked as such. In the interests of transparency, respondents are requested to avoid confidentiality markings wherever possible. To assist with photocopying respondents are asked not to spiral bind submissions. Comments on this document can also be sent to Oftel on the Internet (if they are relatively short) by using the following e-mail address: intsection.oftel@gtnet.gov.uk Confidential responses should not be sent via the Internet. Oftel intends to set up a link between this document on Oftel’s web pages and any comments placed on respondents’ own internet pages. Please contact Cate McLaurin on 0171 634 8752 or e-mail press.office.oftel@gtnet.gov.uk to organise this. Recorded messages may be left on Oftel’s Comments Hotline: 0645 600 660 (Calls charged at local rate) In addition, Oftel is prepared to discuss the document in more detail with any group with a particular interest in purchasing or supplying conditional access services for digital television.
SummaryBackground Conditional access systems are used by broadcasters of pay-television service to ensure that only authorised viewers – either those who have paid to receive the service or those for whom the broadcaster has purchased rights – are able to receive services. In this respect conditional access systems may be likened to an electronic turnstile. Conditional access services have been pivotal in the development of pay-television. Oftel has been given the remit of ensuring that digital conditional access services are supplied on a fair, reasonable and non-discriminatory basis. This consultative document is intended to lead to further guidance on pricing issues. Oftel’s approach Oftel’s approach to pricing issues will be to establish whether the framework used for setting prices is one which gives outcomes that are fair, reasonable and non-discriminatory. Oftel does not intend to mandate a single set of prices – individual broadcasters should be free to negotiate agreements which meet their individual needs providing these are consistent with the overall framework. In making its assessment, Oftel will have regard to: (a) whether costs associated with the provision of conditional access services have been properly identified; (b) whether their level is reasonable – ie whether they have been efficiently incurred; (c) the relationship between expected total revenues and expected total costs. The document considers whether it would be appropriate to recover certain costs from conditional access charges to broadcasters. Having assessed the total level of costs attributable to conditional access services, the next issue would be to consider the relationship between those costs and expected revenues. Oftel would consider in advance whether the pricing framework is such that the conditional access operator may be expected on average to make a return on its investment that is neither inadequate nor excessive, taking into account risk and uncertainty. The document considers issues raised in assessing the appropriate level of cost of capital. Having considered the overall framework Oftel will then consider the prices offered to particular categories of broadcaster and to individual broadcasters. The key principles are that:
Conditional access costs and pricing of conditional access services Conditional access costs predominantly involve common costs which are not directly caused by any individual set of activities. This raises a number of issues. The first of these concerns the relationship between costs and prices. The fact that costs are not directly caused by any individual broadcaster does not mean that all broadcasters and all services are equally responsible for costs. Different types of broadcaster require different types of service. The level of the incremental and stand alone costs for will vary depending on, for example, the need for security measures and the level of sophistication of the services supported by the system. The large share of costs which are common means that there is likely to be a significant difference between incremental and stand alone costs. This leaves the potential for a wide range of pricing options. Oftel’s approach to the interpretation of fair, reasonable and non-discriminatory will be informed by the need to allow conditional access operators sufficient flexibility to pursue economically efficient pricing strategies which maximise the usage of the system, whilst at the same time ensuring that these strategies do not have adverse effects on downstream markets. This approach implies two things: (a) the prices paid by comparable broadcasters for comparable services should be comparable; (b) where broadcasters are not competing against one another (ie when they are not comparable) then differentiation in pricing is unlikely to have an adverse impact on competition and should not be prohibited. For the purpose of assessing whether different broadcasters are or are not competing against one another, Oftel would group broadcasters requiring the use of conditional access under four main headings:
These headings reflect Oftel’s market analysis based on the differing demand conditions as well as the different facilities required by different types of service. In line with this analysis, Oftel would start from the presumption that there would not be a material effect on competition were a conditional access provider to offer different prices for the same or similar services to different categories of broadcaster. This approach could potentially give rise to the possibility of pricing schemes with extreme variations in prices with some categories of broadcaster being charged at incremental cost and others at stand alone cost. Oftel would not wish to preclude from the outset charges for any particular category of broadcaster at or around incremental cost. In certain circumstances such charging arrangements may be economically efficient. Nevertheless Oftel also recognises that concepts of equity and proportionality are implicit within the term ‘fair, reasonable and non-discriminatory’ and these could be relevant if pricing schemes were to involve extreme disparities between different categories of broadcaster. Comparability of treatment between comparable broadcasters Within categories there is a need to ensure comparable treatment for comparable broadcasters. This of course raises the issue of what is the appropriate comparator. This is of particular importance for subscription television services. Oftel’s initial view on its approach to assessing whether the services offered to different subscription broadcasters are similar is that the most appropriate units of comparison are:
Spreading fixed costs over a number of years In the early years of operation of conditional access systems for digital television fixed system costs will be a significant element, while the number of subscribers will be comparatively small. This raises issues concerned with how these fixed costs might be spread, as well as how risks resulting from uncertainties over subscriber numbers and other volumes might be handled. Oftel’s preliminary view is that:
Arrangements for risk-sharing Given the importance of fixed costs, the eventual unit costs (ie costs per subscriber) could vary significantly depending on the number of subscribers taking digital services. This means that the handling of this risk is an important issue. Oftel’s approach would be to interpret the criteria on ‘fair, reasonable and non-discriminatory’ in a way that permitted a variety of risk-sharing arrangements. A useful analogy can be drawn between such pricing options and fixed and variable rate mortgages. Such arrangements might would mean that some customers would be operating under different deals from the conditional access operator at any point in time. Oftel’s preliminary view is that provided that the same set of deals was available to all customers seeking to enter an agreement at any particular point in time, this would appear to meet the non-discrimination requirement.
Chapter 1IntroductionBackground 1.1 Oftel’s responsibilities in relation to the pricing of conditional access services for digital television stem from the Advanced TV Services Regulations 1996 (SI 1996 No 3151) and the Class Licence for Conditional Access Services issued under the Telecommunications Act 1984 on 7 January 1997. The Regulations place a duty on conditional access operators who produce and market access services to offer technical conditional access services on a ‘fair and reasonable, non-discriminatory basis’. This duty is mirrored in the class licence for Conditional Access Services. (The Regulations and Class Licence implement the European Union directive on Advanced TV Standards – 95/47/EC). 1.2 The Oftel guidelines on the regulation of conditional access for digital television services (The Regulation of Conditional Access for Digital Television Services – Statement, March 1997) give initial guidance on the principles and approach which the Director General might apply if called on to consider representations as to whether the charges, terms and conditions for such services are fair, reasonable and non-discriminatory. What the document covers 1.3 In line with the scope of the Directive and the Regulations, this document covers pricing of technical services for conditional access for digital television services. While the term technical services was not defined in the directive, the DTI and Oftel have taken the view that technical services does not include customer management services ie the taking of subscribers’ orders and processing of subscriptions. For ease of reference the term conditional access services is used throughout this document. Unless otherwise stated this should be taken to mean technical conditional access services. 1.4 The Oftel guidelines also contain extensive discussion of non-price terms and conditions for the supply of digital conditional access. Negotiations between the different parties have not as yet revealed a need for further guidance or clarification on this. 1.5 This document does not cover the terms for carriage of programme data and listing within Electronic Programme Guides (EPGs) and other associated issues. These would be the subject of a separate consultation exercise in conjunction with the ITC. Investment in subsidy of consumer equipment 1.6 BSkyB and BT have announced plans for a joint venture to be called British Interactive Broadcasting (BiB). BiB will provide subsidy for set top boxes. At the same time in the Broadcasting Act 1996, the provision of subsidy for consumer equipment was one of the criteria set down by for the award of the digital terrestrial television multiplex licences. The Oftel guidelines on conditional access contains a preliminary discussion on Oftel’s general approach to question of the recovery of set top box subsidies from third parties. Oftel intends to consult in more detail on these issues later this year. 1.7 However, this is an issue which is of relevance to the pricing of conditional access services to broadcasters. This document therefore outlines the potential implications for charges to broadcasters of the initial proposals from BiB and BSkyB. Oftel would also need to consider this issue in relation to digital terrestrial transmission and any proposals on subsidy recovery from British Digital Broadcasting. 1.8 The BiB joint venture has sought clearance to proceed from the European Commission Directorate General IV (DGIV) under Article 85 of the Treaty of Rome. The Office of Fair Trading is coordinating the views of the UK authorities for submission to the European Commission, and Oftel is contributing to OFT’s assessment. In the meantime, Oftel is considering the specific issues raised in relation to the recovery of investment in set top box subsidy in the event that the joint venture as a whole is approved by the European Commission. Terminology 1.9 In line with the wording of the Directive and the Regulations this document is phrased in terms of ‘broadcasters’ and ‘television services’. Both terms are left undefined in the Directive and the Regulations. The interpretation of these terms should not therefore necessarily be taken as being limited to traditional television services and broadcasters. 1.10 Oftel and the DTI are presently considering responses to the joint consultation document Extending the Regulatory Regime for Conditional Access Services published in July 1997. In the light of the outcome of this consultation Oftel may need to give further and more detailed consideration to the issues involved in the pricing of conditional access services for interactive services such as online verification of interactive applications.
Chapter 2Background2.1 Conditional access systems are used by broadcasters of pay television service to ensure that only authorised viewers – either those who have paid to receive the service or those for whom the broadcaster has purchased rights – are able to receive services. In this respect conditional access systems may be likened to an electronic turnstile. Conditional access services have been pivotal in the development of pay television. Broadcasters are now able to charge viewers to watch their services whereas previously any viewer with the appropriate reception equipment would have been able to watch them without charge. Previously the broadcaster would have been reliant on other forms of income, such as advertising revenue or television licence payments, to fund its programmes. 2.2 Oftel has been given the remit of ensuring that digital conditional access services are supplied on a fair, reasonable and non-discriminatory basis. This Chapter sets out the particular issues raised by conditional access which have led to the decision to put in place special rules for its regulation. 2.3 The equipment in most viewers’ homes will only give access to pay television services using the particular conditional access system incorporated into the set top box. Conditional Access System B is therefore not a substitute for Conditional Access System A for a broadcaster wishing to reach the population of boxes equipped with Conditional Access System A. Since set top boxes will, at least initially, be relatively expensive, there are likely to be significant switching costs for households wishing to change to a different conditional access system requiring the use of a different set top box. 2.4 Because of the importance of switching costs, consumers are likely to adopt the system which provides access to the widest range of content. Content providers are likely in turn to use the system giving access to the greatest number of subscribers. This position is therefore likely to be one which is self-reinforcing and which rival systems are likely to find difficult to break. 2.5 There is therefore a substantial risk that the first conditional access system to be widely adopted will constitute a bottleneck. Other service providers wishing to use conditional access to sell subscription services into the market would have to use this system. 2.6 Control of the dominant conditional access system in a market is likely to confer a powerful gatekeeper role. Where this gatekeeper role is held by an vertically-integrated organisation which is also active in the retail market for subscription television (or other paid-for content) there may well be incentives to use control of the conditional access system to keep other providers of subscription television out of the retail market. 2.7 There has been considerable discussion about whether future market developments might reduce the importance of this barrier to entry. For example, new generations of TV receivers may be equipped either with the circuitry to support more than one conditional access system, or the common interface which would allow the conditional access circuitry to be incorporated on a plug-in module (a PCMCIA card as used with a laptop computers). 2.8 This ‘multicrypt’ approach, if adopted, might facilitate network competition by enabling consumers to switch between competing networks without having to replace all their equipment. However, enabling consumers to switch easily between channels using different conditional access systems would require provision for more than one conditional access system to be incorporated in the box at the same time. This does not at the present moment appear to be a likely outcome in the near to medium term future. Even if, at some point in the future, such receivers were to become widespread, a new entrant, or potential new entrant, would still be left with the problem of how to gain access to the population of single system receivers. 2.9 For these reasons Oftel’s view is that it is unlikely that in the foreseeable future there will be effective competition among conditional access systems using the same delivery mechanism in the UK market. The launch of digital television services in the UK 2.10 Oftel has been given the remit to regulate the terms and conditions of supply of conditional access for digital services and of ensuring that such digital conditional access services are supplied on a fair, reasonable and non-discriminatory basis. Oftel’s understanding of the likely picture for the provision of conditional access services with the launch of digital TV services in the UK is as follows. 2.11 The large majority of English-language services broadcast by satellite to the UK will be broadcast from the Astra 2A satellite which is to be launched later this year. Organisations which have leased, or taken options on transponders on Astra 2A include, BSkyB, Flextech, the BBC for its free-to-air channels, as well as other broadcasters such as CNN. 2.12 It is anticipated that with the exception of services broadcast ‘in the clear’, these services will use the conditional access system operated by Sky Subscribers Services Ltd (SSSL)using the VideoGuard technology developed by News Digital Systems. SSSL is a wholly-owned subsidiary of BSkyB Limited. It will provide conditional access services to BSkyB in respect of pay television services which are part of the BSkyB bouquet as well as for services provided by third-party broadcasters. ( this document refers to ‘BSkyB’ except where it is necessary to distinguish between different elements within the overall BSkyB group). 2.13 Certain free-to-air satellite broadcasters may also require conditional access services. Such a broadcaster might need to scramble its satellite broadcasts for two reasons:
This question is not raised for digital terrestrial transmission as reception of these transmissions should be largely limited to the UK. 2.14 Interactive service providers using satellite transmission (such as BiB) may require a similar facility to limit reception of pictures and data to the UK. 2.15 Cable and Wireless Communications, Telewest and General Cable have announced their intention to launch digital services. Oftel understands that each company will operate its own conditional access system separately from the others. 2.16 British Digital Broadcasting has been awarded the licence for three digital terrestrial television multiplexes. It will require a conditional access system for its pay services. Of the remaining three multiplexes the BBC will have one and the ITV and Channel 4 will share another. Channel 5 and S4C will share part of the third multiplex. The ITC has awarded a licence to the SDN consortium for the remainder of the third multiplex. Although most of capacity on the non-BDB multiplexes will be used for simulcasting of existing analogue services and new free-to-air services, there may also be new subscription services. These will require the use of a conditional access system, most probably BDB’s. The requirements that terms offered to third party broadcasters should be fair, reasonable and non-discriminatory will apply equally to digital terrestrial.
Chapter 3Regulatory mechanisms3.1 This chapter considers the regulatory mechanisms available to Oftel in ensuring that the pricing of digital conditional access services is fair, reasonable and non-discriminatory. 3.2 The possible mechanisms Oftel could use are:
3.3 For a number of years interconnection prices in telecommunications have been set by Oftel through annual determinations. This has meant that Oftel in effect has set an annual list of prices for wholesale services. The system of annual determinations has recently been replaced by a network price control for BT which applies an PRI–X formula control to a basket of wholesale services supplied by BT’s systems business. 3.4 Oftel’s view is that a system of determinations for conditional access charges would be unduly intrusive, as well as administratively burdensome, and it would not wish to adopt such an approach unless absolutely necessary. Nor does it start from a presumption that a price control of the form PRI–X is the best approach in the circumstances. It is arguable that, at this stage of the development of the market, a fully-fledged price control regime may be unduly interventionist. 3.5 There would also be considerable technical difficulties in setting a price control. For example, in setting a price control of an PRI–X form the regulator has to make predictions/ assumptions about likely business volumes. In doing so the regulator is able to take account of past performance. While the range of possible outcomes may be large in absolute terms they are relatively small compared to the size of the initial base. A problem in implementing such an approach in the context of conditional access services for digital television is that the major services have not yet been launched. There is considerable uncertainty over likely numbers of viewers. Variations in volumes are likely to be large both in absolute terms and compared to the initial base. An PRI–X price control would therefore need to involve some mechanism for dealing with this volume-related uncertainty or there would be a danger of imposing an unacceptably high-level of risk on the conditional access operator. 3.6 For these reasons Oftel’s initial presumption is that it would seek to facilitate the setting of prices through negotiation by giving guidance on the charging principles which would meet the test of ‘fair, reasonable and non-discriminatory basis’ – and conversely those which would not. However, should the proposed approach be unsuccessful in delivering fair reasonable and non-discriminatory prices without the need for ongoing intervention by Oftel then it might be necessary to adopt an PRI–X approach, or even to determine individual prices. 3.7 Oftel’s preferred approach is to establish whether the framework used for setting prices is one which gives outcomes that are fair, reasonable and non-discriminatory. Oftel does not intend to mandate a single set of prices – individual broadcasters should be free to negotiate agreements which meet their individual needs providing these are consistent with the overall framework.
Chapter 4Conditional access costs4.1 In assessing whether the overall level of charges for conditional access services are fair and reasonable, Oftel will need to have regard to: (a) whether costs associated with the provision of conditional access services have been properly identified ; (b) whether their level is reasonable – ie whether they have been efficiently incurred; (c) the relationship between expected total revenues and expected total costs. 4.2 Within this framework, in considering the prices offered to individual broadcasters or types of broadcasters for a given service, Oftel would also need to take into account the relationship between these prices and the costs of providing that service. 4.3 This chapter considers issues concerning whether it would be appropriate to recover certain costs from conditional access charges. These concern:
4.4 The chapter then goes on to consider issues involved in assessing whether the level of input costs is fair and reasonable. Investment in acquiring generic conditional access skills 4.5 An issue which has been raised is whether a proportion of the costs incurred in the development of conditional access services for analogue transmission may be considered to be an investment in generic conditional access skills. 4.6 Oftel accepts that it would be artificial to consider the specific investment incurred in offering digital conditional access in isolation from investment in the conditional access business as a whole. This investment equips the conditional access operator with the generic skills applicable to all conditional access services – in this respect the difference between analogue and digital conditional access is simply the mode of transmission involved. 4.7 On this basis Oftel accepts that it would be appropriate to regard certain previously-incurred costs as an investment in the generic conditional access business and that the conditional access operator should be able if it wishes, to recover a proportion of these costs from digital conditional access charges. 4.8 The conditional access operator would need to demonstrate that it had a proper methodology for establishing whether it was appropriate to regard particular costs as investments in generic skills. These investments would also need to be subject to an appropriate method of depreciation. Subject to these requirements Oftel proposes to allow such historically-incurred costs to be recovered from charges for digital conditional access. Oftel would welcome comments on its initial conclusion that subject to an appropriate method of depreciation being applied, costs appropriately incurred in developing generic skills should be recoverable from charges for digital conditional access services. Marketing expenditure 4.9 Oftel has been asked to consider whether there are circumstances under which it would be legitimate to include marketing or other similar expenditure which increased the overall number of subscribers to digital services. 4.10 Oftel’s approach here is informed by a distinction between wholesale and retail markets. Conditional access services are wholesale services which are sold to broadcasters who then sell television services in the retail market. This distinction is of particular importance where the conditional access operator is part of a group which also sells television services in the retail market. It is important in such a case to ensure that third party broadcasters are not asked to contribute via conditional access charges to costs which should properly be recovered from the pay-television operator’s retail charges. If this were to occur the likely result would to be a loss to consumers through higher than necessary retail prices due to inflated wholesale prices charged to third party retailers. Oftel’s approach would be to require that only costs which can be demonstrated to be proper to the wholesale conditional access business should be recoverable from conditional access charges. 4.11 An argument which could be made for the inclusion of such expenditure in the cost base is that marketing expenditure by a pay-television operator which persuades a customer to purchase the equipment needed to receive pay-television services subsequently gives other suppliers of those services the opportunity to sell to that customer. 4.12 The argument has been made that this ‘externality’ benefit to other content suppliers means that they should contribute towards the marketing costs of the first pay-television operator. There are circumstances when the existence of significant external costs and benefits (ie costs and benefits to third parties) can lead to ‘market failure’ because prices do not reflect the costs or benefits of consumption and do not send the appropriate messages to producers and consumers. This can lead to under- or over-investment, or to under- or over-consumption. 4.13 In this context, the existence of externalities would present a problem if it were the case that they would lead pay-television operators to under-invest in marketing. Oftel’s preliminary view is that this does not appear to be the case; where a pay-television operator undertakes marketing expenditure to promote its own services it can reasonably be expected to recoup its marketing expenditure from its retail revenues for those services. The fact that these expenditures may also benefit third parties is an incidental effect which does not appear to be a convincing argument for requiring them to contribute towards those costs. On the contrary, it would appear unreasonable to impose an obligation on third parties that they should reimburse marketing expenditure that is primarily aimed at increasing the take up of another operator’s retail services. 4.14 In any event the estimation of this benefit to other broadcasters would be extremely subjective. Third party broadcasters might also argue that their presence, and indeed their own marketing expenditure, on the platform brought an offsetting benefit to other users of the platform. 4.15 Oftel would however, accept that it would in principle be legitimate to recover marketing expenditure from conditional access charges where it can be clearly demonstrated that the expenditure relates to wholesale activities and where the method of recovery is competitively neutral between different service providers. Oftel would welcome comments on its preliminary view that any marketing expenditure recoverable from conditional access charges should be limited to those expenditures which can be clearly demonstrated to relate to wholesale activities. Investment in subsidy of consumer equipment 4.16 As stated in the introduction to this document, an issue which remains to be considered is the appropriateness of recovery from third-party broadcasters of investment in any subsidy of consumer equipment. 4.17 The initial indicative proposals from BSkyB and BiB suggest that, assuming the BiB joint venture receives the necessary approval from the European Commission and becomes operational, 95 percent of the subsidy would be attributed to interactive services and would be recoverable from interactive service providers. Assuming, for instance, a £200 per box subsidy, this would leave £10 per subscriber to recover from broadcasters. Oftel’s preliminary view of this specific proposal is that the recovery of 5 percent of the investment in subsidy of consumer equipment by means of charges for conditional access charges to broadcasters would not be unreasonable or unfair to broadcasters provided that it was recovered in a way which was competitively neutral. This conclusion is without prejudice to the outcomes of the further consultation on recovery of subsidy from providers of interactive services, or to the view Oftel might take in response to revised proposals from BiB or otherwise. 4.18 In considering whether it would be appropriate to recover this proportion of the investment, Oftel would have regard to any condition placed on consumers requiring them to take services from particular broadcasters. Where the provision of subsidy is tied in this way, then Oftel would not consider it appropriate to recover the subsidy from other broadcasters who did not benefit from such restrictions. 4.19 The question of the recovery of investment in subsidy of consumer equipment from broadcasters and/or providers of interactive services will also need to be addressed in the context of digital terrestrial television. Oftel would need to consider any proposals from British Digital Broadcasting when its plans are further developed. Oftel would welcome comments on its preliminary view of this specific proposal from BiB that the recovery of 5 percent of the investment in the subsidy of consumer equipment by means of conditional access charges to broadcasters would not appear to be unfair or unreasonable provided that it was recovered in a way which was competitively neutral. The level of input costs 4.20 In assessing whether the final charges are fair and reasonable Oftel may need to consider whether the input costs are efficiently incurred. This issue has been raised in connection with the supply of smart cards because the smart cards used by BSkyB for its system will be supplied by News Digital Systems a subsidiary of News Corporation the parent company of News International which owns 40 per cent of BSkyB Group plc. Third party broadcasters have raised the issue of what assurance there will be that the costs which are being passed on to them via conditional access charges are not excessive. 4.21 Oftel’s view is that where the conditional access operator is purchasing inputs, such as smart cards, from an associated company the conditional access operator will need to demonstrate that the input costs are not excessive and that it had appropriate arrangements for the independent scrutiny of charges for services from related companies. Oftel would welcome views on its proposed approach where inputs such as smart cards are purchased from an associated company. 4.22 The cost of the first card for a subscriber will fall due when that subscriber signs up. There will then need to be periodic replacements. One method would be to pay for these as and when cards are replaced. Another method is to charge a monthly fee based on an assumption of an average replacement cycle. Arguably the advantage of the monthly management fee, rather than a payment for replacement cards as and when necessary, is that costs are spread and predictable. The risks that an early card swap-out will be necessary are borne by the card-provider – this provides an incentive to ensure system security. Depending on the length of the assumed replacement cycle, this method would appear to be fair and reasonable, but this is not to preclude other methods. Oftel would welcome views on its conclusion that it would be fair and reasonable to charge for replacement cards by means of a set monthly fee based on an assumed average replacement cycle.
Chapter 5Revenues and cost of capital5.1 Having assessed the total level of costs attributable to conditional access services, the next issue would be to consider the relationship between those costs and expected revenues. Oftel’s approach would be to consider whether the pricing framework is such that the conditional access services provider may be expected on average to make a return on its investment in them that is neither inadequate nor excessive, with proper account being taken of risk and uncertainty. 5.2 It should be clear that Oftel would apply this test in advance and not retrospectively. The conditional access operator would therefore be able to keep any gains in the event that its business is more successful than anticipated as well as bearing any losses if it is not. 5.3 Oftel would need to consider whether the expected rate of return used by the conditional access operator in calculating prices equalled the appropriate cost of capital. 5.4 The methods used by Oftel and other regulators for assessing the cost of capital take into account the riskiness of investment of the firm as compared with the stock market as a whole. This in turn is used to calculate the premium investors would require in comparison with a risk-free investment. (See Annex A for a more detailed technical discussion of these methodological issues). 5.5 In the case of conditional access there are the additional risks that revenues may be either substantially above or substantially below the forecasts upon which investment decisions where made. Oftel recognises that it will be necessary to take the probability of forecast outturns not being achieved risks into account in assessing whether the level of prices is fair and reasonable. This approach would reflect the methodology investors would apply when assessing whether a particular investment was worthwhile. Oftel’s approach would be to assess whether the pricing framework was such that the conditional access operator had a reasonable probability of achieving a rate of return on its investment which was not excessive having regard to the risks involved. The precise way in which uncertainty should be factored into prices requires further consideration, given the relatively subjective nature of risk assessment. Nevertheless, Oftel’s general approach should be clear, and the existence of high returns ex post, if the investment turns out to be successful, would not necessarily be regarded as evidence of excess returns.
Chapter 6Pricing for particular categories of broadcasterIntroduction 6.1 In assessing the relationship between costs and prices of services to different categories of broadcaster Oftel would be concerned to ensure that there was no cross-subsidy between different categories of user. The primary test of this is whether the prices cover the incremental costs of providing that service – that is the extra costs incurred in providing that service which would not otherwise be incurred. Where there is more than one service using a common system there will be common costs shared between the services In these cases there would be no cross-subsidy if the price were at least equal to the incremental cost and did not exceed the stand alone cost (the stand alone cost is the cost which would be incurred if only that service were being provided). 6.2 As this chapter explains, a relatively large element of the costs of running a conditional access system are common costs which are not directly caused by any individual set of activities. This chapter considers three sets of issues raised by this. The first set of issues relate to estimating stand alone and incremental costs of providing services to particular categories of broadcaster. The second set of issues stem from the fact that the difference between incremental and stand alone costs may be relatively substantial. It is therefore necessary to consider the degree of flexibility the conditional access provider may have to pursue pricing strategies which involve setting prices for different categories of user at different points between incremental and stand alone costs. Finally the chapter discusses some questions on the handling of the costs of the smart card. Common costs involved in the provision of conditional access services 6.3 There are a number of common costs involved in providing conditional access services which are not directly caused by any individual set of activities. These fall under two main headings:
Fixed system costs 6.4 The fixed system costs include the costs of:
6.5 The set up and development costs are are fixed at the launch of the system and are independent of either the number of broadcasters and services using the system or the number of subscribers. A certain fixed minimum level of operating expenditure is required which is also independent of the number of broadcasters, services, or subscribers, although additional expenditure may be needed for expansion once a certain point is reached. 6.6 In the early years of operation of the system these fixed costs could account for more than 90 per cent of costs. In subsequent years smart card costs will become the major element of total costs rising to over 70 per cent or more depending on numbers of subscribers. Smart card costs 6.7 The cost of different designs of card may vary depending on the amount of memory in the card, the processing power of the microchip, and the features programmed into it. Once the design has been set the cost of the card is largely fixed. The total cost of supplying smart cards will clearly vary with the number of subscribers but it does not vary with the number of broadcasters or the number of services using the card. Activity-related costs 6.8 Activity-related costs are those costs which are directly caused by the activities of individual broadcasters and thus should be recoverable from them. The major activity-related costs connected with conditional access for subscription television services are dealt with separately. These are:
Activity-related costs for interactive pay-per-view are likely to be more significant. Issues 6.9 The fact that the conditional access costs are predominantly common costs, and activity-related costs account for a relatively small proportion of costs raises a number of issues. The first of these concerns the relationship between costs and prices. The relatively very small share directly caused by the activities of particular individual broadcasters means that there is no mechanistic relationship between underlying costs and prices. 6.10 The broad principle is that prices to for a particular service should cover the incremental costs of providing that service. Where there are common costs for providing more than one service then the price for each service should lie between the incremental cost of providing that service and the stand alone cost – that is the cost if it were simply being provided on its own and had to recover all of the common costs. 6.11 The following paragraphs discuss the issues involved in estimating the incremental and stand costs for conditional access services. 6.12 As common costs are a significant element of conditional access costs there is likely to be a significant difference between incremental and stand alone costs. This leaves the potential for a wide range of pricing options. This leads to the second major set of issues considered by this chapter which is the extent of the ability of conditional access providers to differentiate the prices for services to different categories of user. 6.13 A further issue which is discussed in Chapter 8 of this document is the question of the timing of recovery of the fixed system costs and the extent to which this can be spread over a period of years to avoid high per subscriber charges in the early years when the number of subscribers is low. Estimating incremental and stand alone costs 6.14 The fact that common costs make up a considerable proportion of the total costs of conditional access services does not mean that all broadcasters and all services are equally responsible for costs. Different types of broadcaster require different types of service, for example:
6.15 The introduction of impulse pay-per-view services gives rise to a series of new demands upon the conditional access system. Impulse pay-per-view will enable the subscriber to select and pay for a film simply using their remote control. The new features and facilities it requires might include:
6.16 Oftel would expect prices for services to be set between the incremental costs and stand alone costs of providing only these services. This applies to both the fixed costs and to the costs of the smart card. The level of the floors and ceilings will vary depending on the type of service and would reflect among other things:
6.17 This would mean for example that: (a) the stand alone costs to a broadcaster requiring only restriction to viewers in the UK, would need to be based on an estimate of the costs of setting up and operating a conditional access system with the sole purpose of restricting access to a specified geographical area. The incremental costs would be based on an estimate of the difference in total costs incurred with and without the free-to-air broadcaster, assuming the other services were already being provided; (b) the stand-alone costs for conditional access services for impulse pay-per-view would be the costs of setting up and operating the system and of providing the cards complete with all the necessary features and facilities to provide only those facilities. The incremental costs would be based on the costs of providing the additional facilities to support the demands of these services. 6.18 Oftel recognises that in all these cases cost estimates will be approximate and subject to a degree of uncertainty. However the alternative would be a pricing structure which did not take account of differences in the level of sophistication of services required by different broadcasters. There would be a much greater risk that such a pricing structure did not meet the criteria of fair, reasonable or non-discriminatory. Oftel would welcome comments on its view that it would expect prices to different categories of user to be set between incremental and stand alone costs and that there would be different floors and ceilings for different categories of user depending on the sophistication and complexity of the services they require. Ability to differentiate between different categories of broadcaster 6.19 Oftel recognises that the high fixed costs and low levels of activity-related costs might result in a large difference between incremental and stand alone costs. There would then be many sets of prices which would fall within this range. This means that the interpretation of the requirement on non-discrimination will be of considerable importance. 6.20 Oftel’s approach to the interpretation of fair, reasonable and non-discriminatory will be informed by the need to allow conditional access operators sufficient flexibility to pursue economically efficient pricing strategies which maximise the usage of the system, whilst at the same time ensuring that these strategies do not have adverse effects on downstream markets. 6.21 Economic efficiency would be served providers of conditional access services were able to set prices in a way which reflected customers’ willingness to pay. Ideally, all users would be able to obtain conditional access services at prices equal to the marginal costs of their usage. However, because of the existence of economies of scale and common costs such prices would not allow the provider of conditional access services to recover its costs. Mark-ups above marginal costs would be necessary to achieve this, and such mark-ups would generally involve a reduction in output. This would be inefficient because demand would be deterred even though customers would be willing to pay the additional costs caused by their consumption. Pricing structures which minimised these inefficiencies, by taking account of consumers’ willingness to pay in setting the mark-ups above marginal costs, would be economically desirable. This would probably entail pricing structures which differentiated between different types of broadcaster, and possibly between different broadcasters within these categories. The issue of the scope for differentiation between types of broadcaster and between individual broadcasters is discussed in the remainder of this chapter. 6.22 The aim of interpreting the requirement on non-discrimination in a way which allowed for flexible pricing strategies whilst at the same time ensuring that there is no distortion of downstream markets implies two things:
6.23 For the purpose of assessing whether different broadcasters are, or are not, competing against one another, Oftel would group broadcasters requiring the use of conditional access under four main headings:
These headings reflect Oftel’s market analysis based on the differing demand conditions as well as the different facilities required by different types of service. 6.24 In line with this analysis Oftel would start from the presumption that there would not be a material effect on competition were a conditional access provider to offer different prices for the same or similar services to different categories of broadcaster. For example it would be able to offer different terms and conditions to:
6.25 Oftel’s normal presumption would be that within these categories the requirement to offer comparable terms and conditions in respect of similar services would apply. The issues involved in ensuring comparable treatment within categories are discussed in the next chapter. Oftel would welcome comments on:
6.26 This approach could potentially give rise to the possibility of pricing schemes with extreme variations in prices with some categories of broadcaster being charged at incremental cost and others at stand alone cost. Oftel would not wish to preclude from the outset charges for any particular category of broadcaster at or around incremental cost. In certain circumstances such charging arrangements may be economically efficient. Nevertheless Oftel also recognises that concepts of equity and proportionality are implicit within the term’ fair, reasonable and non-discriminatory’ and these could be relevant if pricing schemes were to involve extreme disparities between different categories of broadcaster. Oftel would welcome views on its proposed approach to assessing whether the prices for particular services or services to particular categories of broadcaster are fair and reasonable. Handling of smart card costs 6.27 The smart card is an important common cost and an issue releveant to this discussion is the question of the handling of this cost. 6.28 Where there is only one broadcaster, or other service provider, using a card, the costs of that card and the ongoing management fee will clearly all fall to that broadcaster. Where more than one broadcaster or other service provider wishes to use the card there will need to be appropriate arrangements for sharing these costs. 6.29 In economic terms, the approach which is most consistent with the principle that charges should reflect cost causation would be to charge viewers directly for the card. This would have the effect of taking this element of cost out of the total to be recovered from broadcasters and other service providers. While this approach has much to recommend it from an economic point of view, it would not be appropriate for Oftel to make this approach a requirement because other approaches might also be fair reasonable and non-discriminatory. Oftel would welcome views on its conclusion that while there are arguments to recommend a direct charge to the consumer for the cost of the smart card it would not be appropriate for it to mandate this approach to the exclusion of others which might also be fair and reasonable.
Chapter 7Pricing of services to individual broadcastersIntroduction 7.1 The previous chapter has considered the scope for differentiation in the prices offered for particular types of services required by different types of broadcaster. That chapter argued that where broadcasters were not competing against one another differentiation in the prices offered for the same or similar services would be unlikely to have an impact on competition. However, within categories there is a need to ensure comparable treatment for comparable broadcasters. This of course raises the issue of what is the appropriate comparator. This is the subject of this chapter. Differentiation between free-to-air broadcasters 7.2 Even though they are broadcast in scrambled form, every viewer with a smart card will be entitled to receive all the free-to-air services in a given area. (It should be recalled that ‘free-to-air’ is used to describe services which are broadcast in scrambled form but for which the viewer is not charged, as opposed to ‘in-the-clear’ services which do not require conditional access services). Free-to-air broadcasters may well differ in the extent to which they require regional blackouts of their services, with this aside their service requirements are likely to be broadly similar ie to automatically enable every cardholder within a given area. This chapter considers whether there would be scope for differentiation on grounds other than the level of service required. 7.3 The first issue to be considered here is whether the fair, reasonable and non-discriminatory criteria preclude discrimination in favour of public service broadcasters or channels simply by virtue or their public service remit. 7.4 It must be borne in mind is that neither the Directive, the implementing regulations nor the Class licence make any distinction between public service and other free-to-air broadcasters. Oftel’s primary objective therefore has to be to ensure that the charging structure as a whole is fair, reasonable and non-discriminatory. Oftel would look first and foremost at ensuring that the charging structure led to charges that were fair and reasonable for all free-to-air broadcasters. Only once this criterion had been fulfilled would the question of special terms for particular free-to-air broadcaster arise. 7.5 However, while Oftel could not require special terms for public service free-to-air broadcasters, circumstances might arise when Oftel was asked to make a ruling on whether a particular agreement giving preferential terms to a public service broadcaster or broadcasters would be in breach of the non-discrimination requirement. This chapter seeks to air some of the issues involved in order to seek comment from interested parties. 7.6 In considering such an agreement, Oftel would have regard in particular to whether such discrimination would have the effect of distorting competition. In this context it is arguable that different free-to-air broadcasters already operate under vastly different funding arrangements. Advertising-funded channels might have the ability to generate additional revenue from the digital platform by offering advertisers access to additional or enhanced services on the digital network (such as interactive advertising). On the other hand, the BBC, as a licence-fee funded broadcaster, would not, in the short term at least, have the opportunity to increase its income from free-to-air services, since its income is largely determined by the level of the licence fee. 7.7 In this context it is arguable that differences in conditional access charges are unlikely to have a material effect on competition given the distortions that already exist in this market. Against this it could be argued that further distortion of the market would be undesirable. Oftel’s preliminary view is that the scope for differentiation in the charges for conditional access based on whether the services were licence fee or advertising funded would be likely to be limited. Oftel would welcome comments on its preliminary view that the scope for differentiation in the charges between free-to-air broadcasters on the basis of whether they are licence-fee and advertising-funded free-to-air broadcasters would be limited. 7.8 Another potential approach which has been suggested is that a distinction could be made between channels which were already universally available, and those which were not. Television services which did not already have universal coverage could potentially benefit from greater audiences and advertising revenue as the number of viewers with (for example) digital satellite receivers increased. Services which were already universally available would not stand to benefit from greater audiences. It could be argued therefore that it would be legitimate to offer the latter group of broadcasters preferential terms which did not include any contribution to the cost of expanding the digital platform. 7.9 The issue of whether it is appropriate to include marketing costs in the cost base at all has been considered earlier in this document in Chapter 4. Oftel’s view set out in that chapter was that it would only be permissible to recover such costs by means of conditional access charges where it had been demonstrated that the expenditures were of a wholesale nature and not retail costs. 7.10 In any event it appears to Oftel that existing universally available broadcasters already enjoy an advantage vis-a-vis other broadcasters, and that the use of this discriminant would further reinforce that advantage to the possible detriment of competition. Oftel’s preliminary view would therefore be that universal availability would not be an appropriate criterion to differentiate between different free-to-air broadcasters. Oftel would welcome views on its preliminary conclusion that universal availability would not be an appropriate criterion to differentiate between different free-to-air broadcasters. Differentiation between subscription-TV services 7.11 As the previous chapter noted, while free-to-air broadcasters may differ in their target areas and the level of regionalisation of their services, the category is otherwise relatively homogenous in its service requirements ie every card is automatically-enabled to receive their services. There is likely to be a greater degree of variation between subscription broadcasters who may be offering single stand alone channels or packages of basic channels together with the option to add-on further premium channels in different combinations. The broadcasters will differ in the number of subscribers and the number of different combinations of service offered to their subscribers. 7.12 Oftel’s initial view on its approach to assessing whether the services offered to different subscription broadcasters are similar is that the most appropriate units of comparison are:
Number of subscribers 7.13 Oftel would normally expect the charges for smart cards or shared use of smart cards to be based on the number of cards used by the broadcaster. This is not however to preclude options such as the payment of a fixed fee (as discussed in Chapter 8). 7.14 In Oftel’s view it would be reasonable for other charges – ie those which relate to the fixed costs of the system to take into account the numbers of subscribers. Indeed there might be circumstances where charges which did not take account of differences in subscriber numbers could be deemed to have an adverse impact on competition. For example if the charging structure resulted in a channel with a small number of subscribers paying the same total charge as a comparable channel with a large number of subscribers, the latter would enjoy lower unit costs and competition would be distorted. Again this would not preclude an option to pay a fee which was independent of subscriber numbers (see discussion in Chapter 8 below). Number of different services or combinations of service 7.15 A pay television operator might offer stand alone channels, a ‘bouquet’ of basic channels, or premium channels available as an add-on to a basic bouquet. This measure take into account therefore the number of different services combinations of services which would be available to the consumer – which in turn reflects the level of sophistication of the system and the facilities of the card. 7.16 Where a pay-television operator offers a number of retail offerings (either stand alone or combinations of services) there would be the possibility for it to qualify for discounts in respect of its subscribers who take a combination of services resulting in a saving of incremental costs where the services are purchased together. 7.17 It is arguable that this is a fairly crude measure. A further factor which might be taken into account would be the retail revenues (or price per subscriber of the service or package of services). On the one hand, it is arguable that if two broadcasters have to pay the same level of charges per subscriber then this could mean a greater burden on the broadcasters with lower retail prices. On the other hand there could be a risk that the pricing system for conditional access could distort retail pricing – further analysis would be necessary to assess the significance of this risk. 7.18 In any event, introducing revenue or retail price as an element in the pricing structure at this stage could simply add an unnecessary degree of complexity. The approach and ‘units of comparison’ set out in the preceding paragraphs may not pick up all differences between broadcasters but may nevertheless be fit for the purpose and more readily operable. Oftel would welcome comments on:
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