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Statement – February 1998 Contents Annex A: Guidelines on the conditional access charges for digital television Annex I: Investment in generic skills: depreciation issues The Guidelines accompanying this Statement set out the approach Oftel would take in carrying out its responsibilities to ensure the prices for conditional access services for digital television are fair, reasonable and non-discriminatory. In making its assessment of whether prices are fair, reasonable and non-discriminatory, Oftel would need to consider:
The Statement considers issues raised by respondents to Oftel’s consultative document The Pricing of Conditional Access Services for Digital Television published in October 1997. A number of respondents voiced concerns over Oftel’s proposed approach of reliance on individual negotiations backed up by regulation. This was linked to concerns over the degree of flexibility conditional access operators would have to price at different levels for different categories of broadcaster, or to adopt different forms of risk-sharing arrangement. The concerns centred on possible complexity and the potential loss of transparency. The Statement outlines Oftel’s conclusion on this issue which is that the approach does not involve an unnecessary degree of complexity when set against the disadvantages of a less flexible framework. It also notes that there are important requirements on the publication of prices. A number of issues were also raised over Oftel’s proposed approach based on ensuring comparability between broadcasters/service providers within a particular category. The Statement sets out how the Guidelines have been revised and clarified to take account of these points. The Statement also considers some more specific issues including the treatment of investment in acquiring generic conditional access skills, costs of smart cards and marketing costs. It also outlines Oftel’s thinking on the approach to the investment in the subsidy of consumer equipment – a subject which will be covered in more depth in a consultative document to be published in March 1998.
1 The Guidelines set out in Annex A to this Statement set out the approach Oftel would take in carrying out its responsibilities under the Conditional Access Services Class Licence which came into force on 7 January 1997 and the Advanced Television Services Regulations 1996 (SI 96/3151) which together implemented the requirements of the EC directive on Advanced TV Standards (95/47/EC). They outline the approach Oftel would take if called upon to assess whether prices were fair, reasonable and non-discriminatory. 2 The publication of this Statement and Guidelines follows the publication in October 1997 of the consultative document The Pricing of Conditional Access Services for Digital Television. Overview 3 The Statement begins with an overview of Oftel’s proposals. It then considers the major general issues raised by the consultation, before moving on to consider some more specific issues. The Oftel proposals 4 The key requirement of the Class Licence for Conditional Access Services is that those who produce and market technical conditional access services should do so on a fair, reasonable and non-discriminatory basis. Oftel does not propose to set a price control as it does for BT’s interconnection prices, nor to mandate a rate card. Instead Oftel would expect prices, terms and conditions to be negotiated; and only intervene in the event of a complaint that a licence condition had been breached. The guidelines set out the principles and approach Oftel would take if called on to assess whether the prices offered for the supply of conditional access services were fair, reasonable and non-discriminatory. 5 In making its assessment, Oftel would need to consider:
General issues 6 A number of respondents voiced concerns over Oftel’s proposed approach of reliance on individual negotiations backed up by regulation. This was linked to concerns over the degree of flexibility conditional access operators would have to price at different levels for different categories of broadcaster, or to adopt different forms of risk-sharing arrangement. The concerns centred on possible complexity and the potential loss of transparency – placing a greater onus on Oftel to monitor the operation of the system This linked with concerns over the principle and practical application of Oftel’s proposed category-based approach 7 The context for this discussion is that the major part of conditional access costs are common costs – whether the fixed system costs (which are common to all services) or the cost of smart cards (which are shared between all the services authorised for that subscriber). Common costs are costs which cannot be attributed with certainty to any one category of service. Where there is a preponderance of common costs, a wide variety of pricing schemes are possible. Indeed there is no right or wrong level for prices for any individual category of service – provided that:
8 In certain circumstances a conditional access operator may want to price close to incremental costs for certain categories of service in order to bring new types of service on to the system. If the conditional access provider were to pitch its prices too high it would risk forgoing any additional revenue from these services – and this in turn would increase the costs to be borne by other users. 9 A practical example of this issue is the pricing of conditional access services to free-to-air broadcasters who require conditional access in order to limit access to satellite transmissions to viewers in specified geographical areas. If the conditional access operator were unable to differentiate between free-to-air and pay broadcasters, then the likelihood would be that the charges would be higher than the free-to-air broadcasters would be willing or able to pay. There would then be a strong likelihood that free-to-air broadcasters would simply be deterred with the effect that charges for other types of user were increased. 10 It is difficult to see that this is an outcome in line with the aims of the directive. Similar arguments could apply to other services which could contribute incremental revenue greater than the incremental cost of providing the service. 11 A further set of issues concern how the pricing framework will adapt to changing circumstances and information. One of the big problems in setting prices at this stage of the development of the market in digital television services is the extent of volume risk. Key uncertainties include:
All of which means that risk management and risk sharing are important issues. 12 The significance of these risks has two main implications. First that the regulatory framework should give conditional access providers and those purchasing conditional access services sufficient flexibility to put in place arrangements for managing and sharing risk. The second implication is that the framework needs to be able to adapt to change over time. Each set of negotiations or renegotiations could take place in the light of new information. In this circumstance there is a danger that a single rate card approach would be insufficiently flexible. At the very least it would need to be subject to frequent revision. This would in turn raise the issue of winners and losers from such revisions – which might in turn require there to be different versions of the rate card in force at any one time. 13 Oftel accepts that there is a degree of risk that flexibility could lead to additional complexity and a potential loss of transparency. The following paragraphs consider the extent of that risk. However it is important to set that risk against the risk that an insufficiently flexible approach might lead to economically inefficient outcomes. Complexity and transparency 14 There was a concern among a number of respondents that the additional complexity could lead to a loss of transparency and make it more difficult for the industry to ‘blow the whistle’ in the event of an abuse. This lead to calls for a ‘rate card’ approach rather than for setting prices through a process of individual bilateral negotiations. 15 It is important to recall that condition 7 of the Class Licence requires the publication of charges, terms and conditions. Guidance on this provision was included in the Oftel Conditional Access Guidelines. This guidance has been expanded and included in the pricing guidelines. 16 Oftel’s approach does not preclude the use of a published rate card. Conditional access operators may well take this approach. The alternative is that the key terms and conditions of each individual deal must be published. This will enable broadcasters to find out the terms and conditions offered to comparable broadcasters. 17 Oftel’s view is that, at least in the early years, there are unlikely to be a very large number of deals. If the number of negotiated deals were larger than expected then would taken together the agreements already made would tend in effect form a rate card – or at least provide a set of benchmarks forming bands within which subsequent negotiations are constrained. 18 Oftel’s conclusion is that it accepts that the proposals do involve a degree of complexity – certainly more than would be involved in a rate card approach – however, it does not involve an unnecessary degree of complexity if the disadvantages of a less flexible approach are taken into account. Oftel’s proposed categories 19 A number of issues were also raised over Oftel’s proposed approach based on ensuring comparability between broadcasters/service providers within a particular category. Respondents’ concerns focussed more on the categories proposed rather than on the principle of allowing differentiation between categories. The major points were that:
Blurring of boundaries 20 There are two points to be made here. First, the consultative document did not draw a sufficiently precise distinction between categories of service and categories of broadcaster. Oftel recognises that a broadcaster may, for example offer both free-to-air services and pay services. Clearly the appropriate point of comparison would differ: where it was purchasing conditional access services for pay television the point of comparison would be with the terms and conditions offered to other pay television broadcasters; where it was purchasing conditional access services for free-to-air service the comparison would be with terms and conditions offered to free-to-air broadcasters. Oftel has sought to clarify the guidelines in this respect. 21 The consultative document also gave rise to a degree of confusion over the significance of the ‘interactive service providers’ category. A number of respondents pointed out that broadcasters would also wish to offer interactive and enhanced television services. The ‘interactive service providers’ category referred solely to the purchase of conditional access services by interactive service providers to enable them to restrict access to broadcasts (ie broadcast video, audio and text) to viewers in a specified geographical area. It did not refer to charges for access control services in respect of interactive services themselves. This is the subject of a separate consultation. Broadcasters wishing to use the additional features and facilities to offer interactive and enhanced television services would need to pay the appropriate charges in respect of these facilities in addition to the conditional access charges for the basic ability to control the scrambling and descrambling of audio and video. Oftel’s initial view in relation to access control charges for interactive and data services is that the distinction between broadcaster and interactive service provider may not necessarily be appropriate and the forthcoming consultative document will seek views on this issue. Distinctions within categories 22 The issue underlying the concern over the breadth of the proposed categories is that premium and basic channels would be counted in the same category. As one respondent pointed out this could, hypothetically, result in a single basic channel having to pay the same charges as a premium channel. Were this to occur this would mean that the basic channel would have a proportionately greater conditional access overhead to pay. This in turn might distort competition between them. It was also argued that:
23 Oftel recognises the importance of the distinction between basic and premium channel. For this reason it had proposed that the basis of comparison should be separable retail offerings – ie so that the units compared might either be ‘bouquets’ of basic channels or stand alone premium channels. 24 For a variety of reasons, basic channels are generally sold as part of a package of services. A basic channel sold on its own would be very much an exception. However, the underlying question is whether the proposed approach might distort pay TV operators decisions about how to package their channels. Oftel’s original intention in making this proposal was to avoid the potential distortion which might result from a pricing framework based on retail revenues. On the other hand, as consultees have pointed out, there is also potential that a pricing framework based on the number of services, or combinations of services might also have a distorting effect. 25 Whichever approach is taken on pricing is likely to involve a degree of risk of distortion. or anomalies. At the same time it is important not to lose sight of the much greater risk that an inflexible approach could result in inefficient pricing strategies. There is also a risk of the distortion of competition were the pricing framework to take no account of the material differences between broadcasters and the services they offer. 26 Oftel has reconsidered and sought to clarify this section of the guidelines, in order to focus on the objective to be achieved – a pricing framework which, so far as is reasonably possible, does not distort competition – while not seeking to constrain conditional access operators to one method as opposed to another. 27 One consultee argued that the problems highlighted in this section lead to the conclusion that regulation should be focussed on vertically-integrated operators and on ensuring comparability between services offered by the vertically-integrated operator and third party competitor services; where the vertically-integrated operator was not involved, comparability between two third-parties should not be an issue of concern. 28 It is right to focus attention on the comparability between a vertically-integrated operator and third-party competitors. However, even if attention is only focussed on areas where third parties directly compete with a vertically-integrated operator the question of how to assess comparability still needs to be addressed. Also, there may be circumstances in which third parties do not compete directly with a vertically-integrated operator but the vertically-integrated operator may have incentives to discriminate – for example because the third party could potentially become a direct competitor at some point in the future. Discrimination between free-to-air broadcasters 29 Responses to the consultation were broadly in agreement with Oftel’s view that the scope for discrimination between different free-to-air broadcasters was limited, and that current universal availability was not an appropriate criterion for discrimination. It should be emphasised that this does not preclude discrimination using cost-related criteria where the conditional access operator could demonstrate that these reflected savings to it in the costs of providing those services. Discrimination between pay-per-view services 30 There was general agreement with Oftel’s preliminary view that it would be fair, reasonable and non-discriminatory for charges to pay-per-view broadcasters to distinguish between continuous and occasional broadcasters.
The treatment of investment in subsidy of consumer equipment 31 While the consultative document stated that there would be a separate consultation on the treatment of investment in the subsidy of consumer equipment it sought views on the specific proposal from BIB that it would recover 95 per cent of such investment from access charges to those wishing to offer interactive services via the system, and the proportion recoverable from broadcasters would be limited to 5 per cent. 32 Oftel intends to publish a consultative document [shortly] however, it might be helpful in the present context to sketch out the main outlines of proposals it expects to make. 33 There are two issues to be considered here. The first is what proportion of the total investment should be regarded as investment in network infrastructure. The second issue is that of the relationship between charges for different types of service. 34 On the issue of the treatment of the overall investment, Oftel would expect to propose that its approach should be:
35 Once the issue of the total value of the subsidy eligible for recovery had been assessed, the next question would be the apportionment of charges between television and interactive services. It should be emphasised that access control charges in respect of interactive services would apply to broadcasters who wished to use the additional facilities either to offer interactive services, or enhanced television services. 36 Oftel sought views on whether it would be fair and reasonable for broadcasters to contribute towards 5 per cent of the cost of the investment in subsidy. However, a number of respondents have argued that the share to be borne by interactive services is excessive when compared with the cost of including the additional memory and other facilities to make a television-only box capable of receiving interactive services. Oftel understands that on average the unsubsidised retail price of a digital receiver would be around £300 of which the cost of the interactive facilities would be £60. The subsidy required to bring the retail price down to the £200 level would therefore be around £100. (Initial prices and subsidy levels will be higher than these figures). 37 The issue here is how such an apportionment might be made. Discussions with the industry have suggested that without the ability to offer interactive services, pay television operators would commission the production of a receiver with a lower specification – and reduce their investment per receiver by a corresponding amount. If this is correct, there is arguably a ‘willingness to subsidise’ interactive receivers which is equal to the incremental costs of supporting interactivity. This suggests that it would be a reasonable assumption to regard the subsidy as first of all meeting the cost of the additional facilities and whatever proportion is left may be regarded as going to meet the subsidy of the basic receiver. 38 Oftel’s proposed approach would therefore be that:
For example, suppose the cost of an unsubsidised interactive receiver is £300 and the incremental cost of the additional facilities is £60. If the total subsidy were £100, £60 would be regarded as applicable to interactive services and the remaining £40 a common cost between basic television and interactive services. It should be stressed that these figures are purely for illustration. In this example, no adjustment has been made to reflect the value of a consumer tie-in. 39 This approach would mean that:
40 The framework set out in the preceding paragraphs would permit a range of pricing options:
41 There is a possibility that options at the extreme ends of the ranges might be proposed. 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. Oftel would however wish to consider whether extreme disparities in the pricing of different categories of service could have an effect of foreclosing the development of competition in new services. 42 In addition, the requirement that access charges should be ‘fair, reasonable and non-discriminatory’ contains within it the concepts of equity and proportionality. The Director General may therefore take the view that pricing schemes which involved an extreme disparity between different types of service or different categories of user do not meet this requirement. 43 In considering such proposed pricing schemes the Director General would take into account the absolute size of the amount of subsidy to be regarded as a common cost. Where the amount is relatively small then the effects of extreme distributions are likely to be of less concern. In this context, the valuation of the incremental benefit from any consumer tie-in is likely to be of significance. At the time of writing the BiB joint venture was still under consideration by the competition authorities of the European Commission. Part of the Commission’s discussion will be about the acceptability of the proposed subsidy arrangements. Oftel would need to make its assessment of the proposed pricing structure in the light of the European Commission’s decision and the valuation of the incremental benefit to BSkyB of a contractual obligation to subscribe to its services made as a condition of purchase of subsidised receiver. Investment in acquiring generic conditional access skills 44 The consultative document sought views on Oftel’s proposal that it would in principle accept 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 access charges. 45 This was subject to the conditional access operator having a suitable method for identifying whether the costs were indeed generic. It would be neither appropriate nor acceptable to recover from digital conditional access charges costs that have been incurred in acquiring skills or equipment that are specific to analogue conditional access systems. To do so would imply double recovery of costs. It will be necessary, therefore, to identify the proportion of costs incurred during the analogue phase that are generic ie that are also relevant to, and necessary for, the operation of digital conditional access systems. Oftel also proposed that these assets would be subject to an appropriate method of depreciation. 46 Against this, a number of consultees argued that analogue television revenues had been more than sufficient to cover these costs and therefore it would not be appropriate to recover these costs a second time from conditional access charges for digital television. 47 This approach is in direct counter-position to the depreciation-based approach in that the depreciation period is based on the useful life of the asset and not upon the profits made by the enterprise. Oftel believes that it would be inappropriate to take the former approach. There is first of all the problem of how to determine whether the level of profits has been sufficient. Second, even if it there were a satisfactory method to determine whether sufficient profits had been earned during the analogue phase against which all such costs could be offset, to apply such a system retrospectively would be unfair. This could also introduce a disincentive to undertake future investments of this kind because of perceived ’regulatory risk’, with the result that a sub-optimal level of investment would take place in the future. 48 Oftel believes that a better approach is to identify the life of the generic assets and then to recover the costs of the assets over the relevant time period. Smart cards 49 Oftel sought views on the its approach where inputs such as smart cards are purchased from an associated company. It also sought views on whether 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. 50 On the issue of input costs, a number of respondents made the point that the cost of smart cards should be stated as part of any offer for conditional access services so that industry players could make open market comparisons. Oftel has made this point explicit in the guidelines. 51 On the scrutiny of input costs, a number of respondents suggested that the independent scrutiny data should be made available to Oftel and that the conclusions drawn from that data should then be made available to third party broadcasters. Oftel’s view is that it would seek this information if it were investigating a complaint but it would not call for it automatically. Similarly while Oftel is a firm advocate of transparency, it also needs to be take account off legitimate business confidentiality: Section 48 of the Telecommunications Act governs publication of information relating to the affairs of particular business. The Director General would take a view based on the circumstances of the case as to whether publication would be appropriate. 52 Some respondents agreed that charging for smart cards through a monthly fee was the most workable solution to the replacement card charge issue, but there were other suggestions. An alternative proposal was a “sinking fund” arrangement whereby a periodic flat rate would be charged to service providers on account of the estimated general expenses which would be incurred in replacing smart cards. The flat rate would then be supplemented by a top-up charge where the costs of any particular card replacement exceeded the relevant proportion of the flat rate charge. It was also argued that the price of cards should be specified, and the replacement events negotiated with all parties, and actual costs charged. 53 Oftel would emphasise that it does not regard a set monthly fee based on an assumed average replacement cycle as the only acceptable way to charge for replacement smart cards. Oftel takes the view that the payment of a monthly fee is fair and reasonable providing that the assumed replacement cycle does not involve an excessively frequent replacement of cards. 54 Oftel also sought views on the appropriateness of a direct charge to the consumer for the cost of the smart card. It was argued by one respondent that, given that the costs of smart cards make up a large proportion of the common costs, a direct charge to the consumer would take a large element of the costs out of the remit of regulation and greatly reduce the need for regulation of prices in the medium to long term. 55 However, a number of other respondents argued that smart cards are required by broadcasters for security, charging and other purposes and therefore the principle of cost causation would correctly result in broadcasters paying for the initial and replacement cards. 56 There was also concern from the BBC that where customers only wished to receive the automatically-entitled broadcasts a direct charge to the customer could be perceived as a charge satellite customers had to pay additional to the licence fee. 57 While the arguments for a direct charge – that it would remove costs from the scope of regulation – are attractive from a regulatory point of view, it is not the only reasonable method of recovering smart card costs. Oftel’s view is that it could not therefore mandate a direct charge and preclude other methods of cost recovery. In any event, the results of the consultation do not suggest that there is a consensus in favour of such a move. Marketing costs 58 Oftel sought 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. Responses on this issue revealed that some clarification was needed on what ‘wholesale marketing expenditure’ was intended to cover. The guidelines have therefore been amended to make clear that ‘wholesale marketing’ means marketing expenditure which is purely employed to promote the digital platform generally and which does not refer to the offerings of any particular broadcaster.
59 Oftel sought comments on differing forms of discount structure aimed at reducing the per subscriber price in the early years. There was general agreement with Oftel’s view that spreading the fixed system costs over a number of years in order to reduce the per subscriber charges in the early years would not be discriminatory provided that comparable prices were available to comparable broadcasters at any given point in time. 60 However, concerns were raised over the issue of whether early entrant discounts should be permitted. These discounts would give such entrants an ongoing discount against the level prevailing for other broadcasters at any point in time. The major concern was that such discounts should not be subsidised by prices paid by later entrants. 61 The proposal put forward by Oftel was that such discounts would be regarded as non-discriminatory to the extent that the conditional access operator was able to demonstrate that they reflected savings in costs to the conditional access operator as a result of a reduction in risk. The conditional access operator would also need to be able to demonstrate that the extent and duration of the discount was commensurate with the cost savings. It would not therefore be open to the conditional access operator to offer discounts to one group of customers at the expense of others. 62 Concern was expressed that the eligibility dates for such discounts might be restricted in a way which had a discriminatory effect. If this were to occur, Oftel would clearly consider whether the obligation to offer services on a fair, reasonable and non-discriminatory basis had been complied with. 63 Finally, Oftel sought views on its proposed approach to different risk-sharing arrangements and in particular its view that it would be permissible to offer different types of arrangement provided that at any point in time all comparable customers were offered the same set of options. In general this approach was endorsed. However, this was tempered by the concerns, discussed earlier, over the potential for complexity and loss of transparency.
Guidelines on the conditional access charges for digital television Introduction Background A1 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). A2 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. A3 These guidelines replace section 4 (paragraphs A60–A106 inclusive) of the Guidelines to the Regulation of the Provision of Conditional Access for Digital Television Services published in March 1997 which dealt with the pricing issues. A4 These guidelines represent Oftel’s current view of the way it would interpret its responsibilities and exercise its discretion under current legislation. Oftel will keep them under review in the light of market developments and further information, and to issuing a revised version if it should appear necessary to do so. A5 These guidelines do not form part of the Licence or the Regulations, and they do not affect the legal scope of either. The Director General will take the guidelines into account in applying the Licence and in his role in relation to the Regulations. He would normally expect to follow them and to give his reasons if he departed from them. The Director General cannot legally fetter his discretion in advance and therefore he retains the ability to depart from the guidelines where the circumstances warrant it. The guidelines are therefore not binding on the Director General and will be reviewed from time to time as the market develops and experience is gained. Scope of the guidelines A6 In line with the scope of the Directive and the Regulations, these guidelines cover 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. A7 The guidelines follow the Directive and the Regulations in using the terms ‘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. A8 The guidelines apply to the terms and conditions for the supply of technical conditional access services to interactive service providers where those service providers wish to broadcast sound and video in scrambled form. They do not apply to the charges for the use of the additional facilities needed to provide interactive and data services, these issues are addressed in a separate consultative document to be published shortly. This consultation will also cover the issue of the recovery of investment in consumer equipment. Oftel’s intention is to publish further guidance on this issue in the Spring of 1998. A9 The 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. Regulatory mechanisms A10 There are three possible mechanisms which might be used to ensure that prices of digital conditional access services are fair, reasonable and non-discriminatory. These are:
A11 The Conditional Access Class Licence has been framed with the third of these methods in mind. 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 propose such an approach unless absolutely necessary. Nor does it start from a presumption that a price control of the form RPI–X is the best approach in the circumstances. In any event, this would still leave the issue of where to set the prices which would be used as the baseline. A12 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. Oftel does not intend to mandate a single set of prices but would also seek to establish whether the framework used for setting prices is one which gives outcomes that are fair, reasonable and non-discriminatory leaving individual broadcasters free to negotiate agreements which meet their individual needs within the overall framework. 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 RPI–X approach, or even to determine individual prices. A13 Oftel would normally only expect to make an assessment of whether the price offered for the supply of conditional access services to a broadcaster was fair, reasonable and non-discriminatory if a complaint were made to it. It should be noted that neither the Directive, the Regulations or the Class Licence preclude a broadcaster from making a complaint to Oftel about the prices charged under an existing agreement between it and the conditional access operator. A14 In the event that the Director General took the view that the prices offered were not fair, reasonable and non-discriminatory, he would then take any necessary enforcement action under Section 16 of the Telecommunications Act 1984 for the purpose of securing that it complies with the terms of the Class Licence. Interaction of licence conditions A15 Condition 1 of the Class Licence requires that the conditional access operator supplies technical conditional access services on fair, reasonable and non-discriminatory basis. The Licence also includes Condition 3 (Fair Trading) and Condition 6 (Prohibition on Undue Discrimination and Undue Preference). There is an established body of experience of the approaches embodied in both of these conditions, and Oftel would normally expect to base its interpretation of the provisions of the Licence on established practice. However, is should be noted that Condition 1 directly reflects the words of the Directive and it is not open to Oftel to set limits on the interpretation of the Directive. Conditions 3 and 6 while providing established reference points are without prejudice to Condition 1. None of these conditions should be interpreted as placing limits upon the interpretation of the others. Overview of the process of assessing conditional access prices A16 The process Oftel would undertake to assess whether the framework for conditional access pricing is fair, reasonable and non-discriminatory has three main steps. A17 First Oftel would consider the nature and level of the costs to be recovered from conditional access charges and the relationship between total costs and total expected revenues. A18 The second step would be to consider the pricing framework for particular types of service. In this part of the process Oftel would be primarily concerned to establish that there was no cross-subsidy between different categories of service. A19 The third step would be to examine the prices offered to individual broadcasters, or categories of broadcaster. In this part of the process Oftel would be concerned to establish that comparable broadcasters requiring comparable services were being offered comparable prices. A20 These steps are described in more detail in the remainder of this document. Conditional access costs A21 The general principle Oftel would take in assessing whether the nature of the costs to be recovered from conditional access charges is that the conditional access operator should not seek to recover costs which should properly be recovered elsewhere. This applies in particular where the conditional access operator is part of a company, or group of companies which is also involved in providing television services to retail customers. Investment in acquiring generic conditional access skills A22 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. A23 Only costs that are truly generic to conditional access should be recovered in this way. It would be neither appropriate nor acceptable to recover from digital conditional access charges costs that have been incurred in acquiring skills or equipment that are specific to analogue CA systems. A24 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. A25 These investments would also need to be subject to an appropriate method of depreciation. It may be that some assets acquired during the analogue phase of operations may have reached the end of their life. In such circumstances, it would not be appropriate to recover this proportion of generic costs again from the conditional access for digital television. Depreciation issues are discussed in more detail in Annex I. Marketing expenditure A26 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 which are purely to promote the digital platform generally and which do not refer to the offerings of any particular broadcaster and where the method of recovery is competitively neutral between different service providers. Investment in subsidy of consumer equipment A27 The issue of the recovery of investment in subsidy of consumer equipment is to be covered in a forthcoming consultative document with the aim of publishing guidance on this in the Spring of 1998. The level of input costs A28 In assessing whether the final charges are fair and reasonable Oftel may need to consider whether the input costs are efficiently incurred. A29 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. Where payment takes the form of a monthly management fee based on an assumed replacement cycle the assumed replacement cycle should not involve an excessively frequent replacement of cards. For the avoidance of doubt, it should be noted that Oftel does not have any presumption for or against any one method of payment for smart cards. Revenues and cost of capital A30 Having assessed the nature and level of costs to be recovered from charges for conditional access services, Oftel would then 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. A31 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. The existence of high returns ex post, if the investment turns out to be successful, would not necessarily be regarded as evidence of excessively high prices. A32 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. A33 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 II for a more detailed technical discussion of these methodological issues). A34 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 into account the degree of risk that forecast outturns may not be achieved. Oftel would take these into account in assessing whether the level of the projected cashflows were fair and reasonable having regard to probability of the investment succeeding or failing. A35 The probability of an unsuccessful outcome is likely to reduce over time and subsequent tranches of investment would be expected to be rewarded in a way that reflected this reduced level of uncertainty. A36 The precise way in which uncertainty should be factored into prices would require further consideration, given the relatively subjective nature of risk assessment. Pricing for particular categories of services A37 In assessing the relationship between costs and prices of services to different categories of service, Oftel would be concerned to ensure that there was no cross-subsidy between different categories of service. 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). A38 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. 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. Estimating incremental and stand alone costs A39 The level of the floors and ceilings will vary depending on the type of service and would reflect among other things:
This would mean for example that:
A40 The prices for conditional access services to all categories of broadcaster would be expected to cover their costs. If there are common costs which are incurred by a sub-group of services then the prices for this group of services would have to cover these common costs. A41 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. Ability to discriminate between different categories of broadcaster A42 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. A43 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 significant adverse effects on downstream markets. A44 The general principles Oftel would seek to apply in achieving this aim are that:
A45 For the purpose of assessing whether different broadcasters are, or are not, comparable against one another, Oftel would group broadcasters requiring the use of conditional access under three main headings:
A46 Oftel’s view is that pay-per-view services may well develop as competitors to subscription channels and both would fall into the same category. However, pay-per-view services are likely to involve different costs and have a different cost structure – there are not only the costs of maintaining the capability to offer pay-per-view services but also the transaction-related costs. It is important that the charging framework takes proper account of these cost differences and that the charges for to pay-per-view providers cover the incremental costs of maintaining the pay-per-view capability as well as the transaction-related costs. A47 Oftel would use these categories only in examining the framework for conditional access services for digital television. These categories would not necessarily be appropriate for interactive and data services. The application to interactive service providers is solely to those requiring the ability to broadcast sound and video in scrambled form. This issue is to be considered in an Oftel consultative document to be published in March 1998. A48 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 free-to-air broadcasters from those offered to subscription broadcasters. A49 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. Pricing of services to individual broadcasters A50 In assessing the prices offered to individual broadcasters within the same category, Oftel would be concerned to establish whether or not comparable terms and conditions were available to comparable broadcasters requiring the same or similar services. For the avoidance of doubt, where there are differences in the services required by broadcasters within the same category Oftel would expect the prices to reflect any differences in the cost of providing those services. A51 Oftel would, in principle, presume that the terms and conditions offered to one broadcaster would be available to any other similarly-situated broadcaster. If this was not the case then it would consider that there were grounds for further investigation and would require the conditional access operator to justify the difference in approach. Discrimination between free-to-air broadcasters A52 Oftel’s general presumption would be that discrimination in favour of public service broadcasters or channels simply by virtue of their public service remit, or in favour of licence-fee funded services as compared with advertising funded, would not be consistent with the non-discrimination requirement. However, this should not be taken as preventing the conditional access operator offering discounts where it could demonstrate that these reflected savings to it in the costs of providing those services. A53 Oftel’s presumption would also be that it would not be permissible to discriminate in favour of free-to-air television services which are already universally available (ie in the UK analogue terrestrial services) as opposed to those which were not (eg those available on DTH satellite and cable but not analogue terrestrial). Existing universally available broadcasters already enjoy an advantage vis-a-vis other free-to-air broadcasters, and that the use of this discriminant would further reinforce that advantage to the possible detriment of competition. Discrimination between subscription-TV services A54 The general principle which Oftel would adopt here is that discrimination in pricing would be permissible provided that:
A55 Oftel would regard a pricing structure as unduly favouring a related pay television operator were it to fail to take account of differences which were relevant to competition between it and competing companies. An example of such circumstances would be where a pay television operator offering a single separable retail service (either a premium channel or a bouquet of basic channels) was charged the same per subscriber fees as a provider offering several services or groups of services. A56 Examples of the kind of characteristics which Oftel would be likely to view as acceptable in differentiating the prices offered to different broadcasters include:
This list is not intended to be exhaustive. Oftel recognises that other characteristics may also give outcomes which are fair, reasonable and non-discriminatory. A57 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. A58 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 below). A59 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 fixed fee based on a forecast of subscribers which was independent of the actual subscriber numbers. Pay-per-view broadcasters A60 Oftel’s approach would be to consider whether charges for pay-per-view services covered the cost of maintaining the capability to offer these services, as well as the costs incurred in each transaction. Such costs might be covered by standing charges, or transaction-related charges – or a combination of both. A61 Oftel’s view is that it would be fair, reasonable and non-discriminatory for charges to pay-per-view broadcasters to distinguish between continuous and occasional broadcasters. This should not be taken as precluding charging on a common basis eg per-transaction charges. Risk-sharing arrangements and the recovery of fixed costs A62 As noted earlier, as the number of subscribers increases, the cost of providing smart cards and other subscriber-related costs will be the most significant element of the total costs. However, in the early years, while the number of subscribers will be comparatively small, fixed system costs (the development and set up costs together with the operating and other ongoing costs) will be a significant element. This raises issues concerned with these costs might be spread, as well as how risks resulting from uncertainties over subscriber numbers and other volumes might be handled. A63 Oftel would accept that it would be legitimate for conditional access operators to adopt pricing strategies which avoided very high per subscriber prices in the early years as these could act as a deterrent to the introduction of new services and the development of the platform. This is of course subject to the condition that at any given time comparable prices should be available to comparable broadcasters for comparable services. Subject to this condition conditional access operators could spread the fixed system cost over a period of years in order to reduce per subscriber costs in the early years of digital services. A64 This condition would also apply to ongoing ‘early entrant’ discounts offered to broadcasters prior to the launch of digital television services, or in their early years. Normally, Oftel only would regard such discounts as non-discriminatory where the conditional access operator was able to demonstrate that any discounts reflected savings in costs to the conditional access operator as a result of a reduction in risk. The conditional access operator would also need to be able to demonstrate that the extent and duration of the discount was commensurate with the cost savings. Volume-related risk A65 Given the importance of fixed costs in the early years, 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. This risk has to be borne by one or other parties or shared among them. A66 There may be a similar risk – due to the relatively small number of broadcasters – that changes in the number of broadcasters in any category, or using the system as a whole could potentially have impact on the level of charges. A67 Oftel’s approach would be to interpret the criteria on ‘fair, reasonable and non-discriminatory’ in a way that permitted a mix of options to be offered. A68 One approach would be to share the fixed costs between broadcasters in a way which was independent of the number of subscribers – for example a flat fee or an agreed percentage of costs. A69 While such an approach might have advantages for some types of broadcaster, other broadcasters (whose income is related to subscriber numbers) might prefer a fee related to the number of subscribers. The options appear to include:
These options are not exclusive – a conditional access operator might offer more than one option or some permutation of these approaches. A70 Different combinations of flat fees and per subscriber charges might also be possible. Options appear to include:
A71 Each method offers a different apportionment of risk between the conditional access operator and the broadcaster. For example:
A72 The corollary of this is that when the conditional access operator accepts the risk (as it would in offering a fixed rate per subscriber) it would reap the benefits if actual volumes exceeded projections. A73 Oftel would take a similar approach to different arrangements for handling the risk resulting from possible uncertainties over the number of broadcasters and other users of the system. These options would include basing the charge on forward estimates of the number of broadcasters using the system or falling within a given category, to a retrospective adjustment of charges in the light of actual performance. A74 The general principle of Oftel’s approach would be that, provided that the full set of offerings was available to all customers seeking conditional access services at any given point in time, conditional access operator would be free to offer differentiated ‘fixed’ and ‘variable rate’ options. A75 Such arrangements might would mean that some customers would be operating under different deals from the conditional access operator at any point in time. However, provided that the same set of deals was available to all customers seeking to enter an agreement at any particular point in time, Oftel would be likely to take the view that the non-discrimination requirement had been fulfilled. A76 Where the conditional access operator takes on most of this risk there is, given the uncertainty of forecasts, the possibility that it could make a large profit or make a loss on a ‘fixed rate’ deal. Such profits or losses should not be taken forward into future charges or spread across the charges made to other operators. They should be ‘ring fenced,’ in keeping with the principle that conditional access operator would be bearing the risk. Condition 4: Fair trading A77 It should be noted that there are separate guidelines to the Fair Trading condition which were published by Oftel in June 1996 as Annex F to the document Pricing of telecommunications services from 1997. Condition 7: Publication of charges terms and conditions A78 The primary purpose of Condition 7 is to ensure transparency in pricing and terms of conditions so that broadcasters and other third parties are able to gain information to judge whether the terms and conditions being offered to them were non-discriminatory. The condition does not require a single rate card; it simply requires that the terms of all offers are published. The conditional access operator may offer a rate card with more than one option – or, indeed, in the extreme, publish the terms and conditions individual offers. A79 The publication of individual agreements should be at a sufficient level of detail to enable other broadcasters and third parties to make meaningful comparisons and should contain a general description of the methodology used such that comparable broadcasters may make a reasonable estimate the charges of the charges to which they might be liable. These details are likely to include:
Generic assets – depreciation issues 1 Generic assets could include intangible assets such as the investment in acquiring the knowledge for developing conditional access systems, as well as tangible assets such as some of the conditional access equipment itself. This mix between intangible and tangible will have implications for asset life and the appropriate method of depreciation to be adopted. Intangible assets will tend to have relatively short lives and to suffer relatively high early depreciation due to their perishable nature. For example, as the knowledge required to develop conditional access systems is disseminated so the value of that knowledge diminishes. It would not be sustainable within a competitive market environment to continue to recover the sunk costs of acquiring these intangible assets over a long period of time. Tangible generic assets will tend to be more durable and will probably have longer asset lives, but they may still depreciate faster at the start of their lives. Overall, then, the nature of generic assets suggests a relatively short life and one where most of the depreciation occurs in the early years. 2 There is, however, a factor working in the opposite direction that means it may be more appropriate to recover a greater proportion of generic costs in later years. In the early years of conditional access the customer base from whom the costs could be recovered would be quite small. This means that, if depreciation charges were calculated with no reference to sales volumes, the depreciation costs that each customer would have to bear would be relatively high in the early years. In later years, with a larger customer base, the costs per customer would be lower, although the total depreciation charge recovered over time would be the same. In order to avoid changes in unit costs over time, it may be more appropriate, therefore, to profile depreciation costs so that a greater proportion of these costs are recovered towards the end of the asset life when volumes are higher. 3 The mix of intangible and tangible generic assets with differing asset lives will complicate the choice of depreciation method. The perishable nature of some of the assets suggests that a depreciation methodology which allows a greater proportion of costs to be recovered in the early years may be appropriate. The effect of profiling, however, will tend to work in the opposite direction in that it points towards a depreciation method that recovers a greater proportion of costs in the later years. On balance, it might be appropriate as well as simpler, to apply a straight line depreciation method. If conditional access operators have been involved in the development of analogue conditional access systems from the start, then some assets may have reached the end of their life during the analogue phase. In such circumstances, it would not be appropriate to recover this proportion of generic costs again from the digital conditional access systems.
Cost of capital Introduction 1 A firm's cost of capital can be defined as the rate of return that could be earned in the capital market on securities of equivalent risk. In general, the higher the riskiness of the firm's activities, the higher its cost of capital, since investors typically require compensation for greater risk. For a firm financed by debt and equity, the cost of capital will be a weighted average of its cost of capital from both sources. The following paragraphs describe the general techniques used to derive the cost of equity and debt. Cost of equity 2 Two main methods are typically used to establish a firm's cost of equity. The most widely used model for estimating the equity cost of capital is the Capital Asset Pricing Model (CAPM). The basic premise of this model is that investors require a higher expected rate of return on any investment in order to compensate them for a higher risk of returns on that investment (as measured by the variability of those returns). 3 Investors are assumed to be able to reduce risks by holding diversified portfolios of equities. However, there is a degree of systematic risk inherent in even the most diversified portfolio of shares, since the value of the whole stock market can rise or fall, reflecting the risk inherent in the general economy. 4 This non-diversifiable risk cannot be eliminated by holding shares in a large number of companies, and is therefore a component of the cost of equity. If the risk-free rate is that rate of return which investors would be able to earn with certainty, the market risk premium is that additional return that investors would require in order to compensate them for holding a share whose returns moved in line with those of the stock market as a whole. 5 Returns on shares in some companies will fluctuate in step with, but more widely than, returns to the stock market as a whole. Returns on other types of shares will fluctuate in step with, but less widely than, the stock market as a whole. Others still could move against the market. The degree of correlation between returns on shares in one company and returns on the stock market as a whole can be estimated using dividend and share price data and is captured in a coefficient known as the company's Beta. A company showing higher than average non-diversifiable risk will have a Beta coefficient in excess of one, while a company showing lower than average non-diversifiable risk will have a Beta less than one. 6 The cost of equity to the firm can then be calculated according to the basic CAPM formula below: Re = Rf + Beta.[E(Rm) – Rf], where Re is the cost of equity finance, Rf is the risk-free rate of return, Beta is the degree of correlation between returns on the company’s shares and returns on the stock market as a whole, E(Rm) is the expected return on the market and E(Rm) – Rf is the expected market risk premium or excess return to equities. 7 This calculation can be done in real or nominal terms. The two should have identical implications for measuring the financial performance of the enterprise, provided that the inflation rate assumed in the financial forecasts is the same as that implied by the difference between the estimated real and nominal cost of capital. 8 One criticism often levelled at the CAPM is that the calculation of the equity premium is based on historic excess returns on equities rather than the returns that investors expected to achieve. Since investors base their decisions today on expectations of returns and their variability in the future, it would appear preferable to look at expectations directly. This is particularly important in the light of evidence that suggests that the risk premium varies over time, so that estimates of historic excess returns may not be a reliable guide to excess returns required in the near future. Cost of debt 9 In the absence of specific information on the interest rates being paid by the firm in question, the pre-tax cost of debt is typically calculated by adding a small corporate risk premium to an estimate of the risk-free rate of return, as proxied by the return on government debt used in the CAPM calculation. Specific risk 10 In the case of conditional access, there are additional risks that are not reflected in the Beta coefficient. Oftel recognises that it will be necessary to take these risks into account in assessing whether the level of the projected cashflows are fair and reasonable having regard to probability of the investment succeeding or failing. If a group of investors are investing in a series of projects of which they estimate that a given proportion will be failures, then the successful projects will need to earn sufficient revenues not only to cover their own costs but also to cover the costs of the failures. Examples of such projects would include oil exploration, and film production where it is usually expected that some projects will fail.. 11 The approach Oftel proposes to take to take account of these additional project-specific risks is, to calculate the expected revenues which would result in the project representing a ‘fair bet’ for investors rather than to adjust the cost of capital derived from the CAPM methodology. A ‘fair bet’ is one where, if the bet were repeated a sufficient number of times the gamblers would get their stake back. Suppose that the bet was made on the toss of a ,1 coin: if successful the players would make ,2 and if unsuccessful they would lose their stake. A single successful bet would result in the player making a 100% return on their investment. Taken in isolation, a return of 100% to the successful player might seem very attractive, but given the 50% probability of losing the investment altogether, this return if averaged over a number of bets would simply mean that gamblers retained their stake. 12 In the context of project investment, the notion of a ‘fair bet’ would be that, averaged over a number of projects, investors would cover their costs including the cost of capital.
Beta The co-efficient which measures the degree of correlation between the returns on shares in a particular company and returns on the stock market as a whole. In the Capital Asset Pricing Model, the higher a firm’s Beta, the greater the systematic riskiness of an investment in that firm’s shares (a Beta coefficient of one implying that the firm is of average risk). Common costs Costs that are incurred in the supply of all or a group of services provided by the firm and cannot be directly attributed to any one service. Cost of capital A firm’s cost of capital can be defined as the rate of return that could be earned in the capital market on securities of equivalent risk. In general, the higher the riskiness of the firm’s activities, the higher its cost of capital, since investors typically require compensation for greater risk. For a firm financed by debt and eq | |||||||
