INTRODUCTION
6.1 The provision of universal service imposes a cost on the operator charged with the universal service obligation if its overall financial performance would be improved without the obligation. Oftel has commissioned a number of studies to develop and refine a methodology to identify the costs of universal service in the UK. Reported below are the results of this work to estimate the direct financial costs to the universal service provider of the current level of provision of universal service and of the future costs. Details of the basic costing methodology that has been applied, which is consistent with the approach set out in the EC Costing Guidelines, are explained in Note 1. (A summary of the EC Costing Guidelines is included in Note 4).
6.2 The direct financial costs do not, however, present the whole picture. It is widely agreed that the universal service provider obtains some benefits from holding the obligation, which enhance its financial performance, although little work has so far been done on how large these benefits might be or how they should be quantified. The benefits should be subtracted from the direct financial costs in order to measure the true cost of universal service. Oftel s further work on the valuation of benefits and its conclusions are set out in this Chapter.
6.3 The following terminology is used: the direct financial costs, which are calculated as the difference between revenues foregone and long run avoidable costs, are referred to as universal service costs . The long run avoidable costs include not only operating costs and depreciation but also a reasonable return on capital employed. The costs net of benefits are referred to as universal service net costs .
RESULTS OF Oftel's COSTING ANALYSIS
6.4 Universal service costs (before benefits) exist if the revenues generated by a customer or group of customers are insufficient to cover the costs incurred by the universal service operator in providing service to that customer or group of customers. Costs of universal service might arise for some customers or groups of customers, because the universal service providers are required to offer the same tariffs to all customers in their licensed areas, whilst the costs of service provision differ between different parts of the country (and between customers).
6.5 As explained in Note 1, the appropriate measure of cost is the long run avoidable cost of providing service to an individual customer or group of customers. The appropriate measure of revenue ( revenue foregone ) should take account of incoming calls to the customer, which are billed to other subscribers on the network, as well as the outgoing calls, line rental and connection charges, which are billed to the customer.
6.6 The components of universal service to be costed are:-
6.7 The other components of universal service have not been included in the costing studies, either because they are funded by other means (eg BT s maritime services) or because they are an obligation upon all operators (eg provision of access to the emergency services free of charge). Services to the disabled have not been included in the list above because the Disability Discrimination Act places duties on all providers of service to the public.
The current costs of universal service
6.8 Table 6.1 shows the estimates of the universal service costs
to BT for each of the components indicated above, derived from
a detailed analysis of the disaggregated cost and revenue information
that BT has been able to supply (ie applying the costing methodology
discussed in Note 1). The figures in Table 6.1 are in the form
of estimated ranges for the universal service costs, because the
information provided by BT for the costing work has been inadequate
in a number of respects. Amongst the most serious missing information
is the absence of any detailed data on incoming calls, and the
absence of call data on an areabyarea basis. With
better and more disaggregated information about costs and revenues,
the quality of the estimates of universal service costs would
be improved significantly. A list of data requirements for the
costing methodology, including the most important pieces of information
that are not currently available, is at Note 2.
| Universal service cost (£ million) | Uneconomic lines as proportion of total | |
| Uneconomic areas | 10-15 | less than 0.5% of UK lines |
| Uneconomic customers | 45-55 | 6%-7% of UK lines |
| Uneconomic public call boxes | 10-15 | about 20% of BT public call boxes |
| Total | 65-85 |
Table 6.1 Estimate of universal service costs in 1995/96 for BT,
before efficiency adjustment and before benefits
6.9 BT has been able to provide disaggregated information on the costs and revenues of individual PCBs, but was unable to explain the cost variations between call boxes. There is therefore a lack of understanding of which particular call boxes are uneconomic and why. One particular failing is the lack of precise information about whether or not the call boxes that are identified as currently uneconomic were in existence at the time of privatisation. There were about 75,000 public call boxes at privatisation, but there are more than 132,000 now. Since the new call boxes were installed in the full knowledge of the restrictions in BT s licence concerning removal and resiting, the true universal service cost only arises from call boxes in existence at the time of privatisation that are unprofitable now. BT has been unable to supply detailed data on the call boxes installed since 1984. Since the figure of £10-15m is based on an analysis of all call boxes, it represents an upper bound on the true universal service cost.
Efficiency
6.10 It can be argued that the cost of universal service should be measured using the efficient level of avoidable costs. If the universal service cost were to form the basis of an amount to be recovered from other operators using a funding mechanism, other operators should not be expected to pay for the inefficiency of the universal service provider. This is the approach taken in the EU Costing Guidelines.
6.11 of the review of the retail price control on BT that Oftel carried out last year, it was estimated that BT s unit operating costs were about 5% higher than the costs achieved by the best performing Local Exchange Carriers in the USA. Inefficiency in capital costs was not identified explicitly, but for illustration it is assumed to be the about the same as for operating costs. Therefore, an illustration of universal service costs using the efficient level of avoidable costs can be derived by adjusting the estimates of BT s incurred avoidable costs downwards by 5%.
6.12 The resulting reduction in the universal service cost can
be substantially larger than 5%, because the universal service
cost is calculated as the difference between the revenue foregone
and the avoidable cost. The efficiency adjustment reduces the
avoidable cost, but does not affect the revenue foregone. Table
6.2 shows the estimated ranges for universal service costs after
the efficiency adjustment.
| Universal Service Cost after efficiency adjustment (£ million) | |
| Uneconomic areas | 5-10 |
| Uneconomic customers | 30-40 |
| Uneconomic public call boxes | 10-15 |
| Total | 45-65 |
Table 6.2 Estimate of universal service costs in 1995/96 for BT
after efficiency adjustment, but before benefits
The future costs of universal service
Uneconomic areas
6.13 The universal service cost of areas relates to remote rural areas, which are particularly expensive to serve because of their low density of population and geographical characteristics. Although uneconomic areas include less than 0.5% of UK lines, they may account for as much as 20% of the total land area of the UK. This is illustrated in the map shown in Chapter 7, which shows the areas of the UK found to incur a universal service cost before benefits (under one set of assumptions about the information that BT has been unable to supply). BT currently uses a fixed wire network to provide telephone access to customers in these areas. However, BT has been licensed by the DTI to provide telephony in some rural areas using fixed radio access. Fixed radio access would replace the copper loop currently used to provide the customer s line with a radio link to the customer s house. The importance of this technological development in the context of universal service is that it will allow BT to adopt a technology that is lower cost for low density, rural areas. Since BT has been licensed to provide fixed radio access to many rural areas, this technology could in future be considered the modern equivalent asset in the forward looking valuation of assets as part of the calculation of long run avoidable costs. Oftel s costing work suggests that this might reduce the cost of uneconomic areas by about onehalf.
Uneconomic customers
6.14 The major change to the nature of the universal service cost of uneconomic customers will arise from the introduction of the service packages described in Chapter 3. In summary, it is proposed that:-
a Lifeline scheme (incoming calls only) will be offered by BT in 1997;
the Light User Scheme (LUS) will continue in its current form until replaced within 2-3 years by one or more better targeted, eg limited outgoing calls or cardphone schemes.
6.15 The great majority of the current universal service cost
of uneconomic customers shown in Tables 6.1 and 6.2 relates to
LUS customers (ie approximately 80% or £25-30m after efficiency
adjustment). It should, however, be noted that the majority of
LUS customers are economic for BT to serve - only about 30% of
LUS customers impose a universal service cost (before benefits)
on the provider. In the previous consultative document Oftel proposed
that BT would only be eligible to receive a payment for any net
universal service costs of uneconomic customers arising from LUS
or LUS replacement schemes (ie the new service packages). The
reason given was practical, in terms of simplifying the amount
of detailed, disaggregated information that a universal service
provider would need to supply for the universal service cost of
uneconomic customers to be calculated. For this reason the estimates
below examine only the future universal service costs of the proposed
new service packages and LUS (whilst it remains a licence obligation).
| £ million | Low takeup | High takeup | ||||
| Lifeline | LUS | Total | Lifeline | LUS | Total | |
| 1998/99 | 10 | 30 | 40 | 30 | 30 | 60 |
| 2000/01 | 15 | 30 | 45 | 45 | 30 | 75 |
Table 6.3 Estimate of future universal service costs of uneconomic
customers for BT after efficiency adjustment, but before benefits.
6.16 The universal service cost of uneconomic customers on the Lifeline scheme depends upon the tariff and the takeup assumptions. The tariff is taken to be £6.50 per quarter including VAT, as proposed in Chapter 3. Two takeup scenarios have been analysed consistent with the figures in Table 3.2: the low takeup scenario corresponds to the numbers that the BT research found to be very likely to use the Lifeline scheme (0.3m new customers and 0.2m migrating from LUS); the high takeup scenario corresponds to the numbers that were fairly or very likely to use the scheme (0.7m new customers and 0.5m migrating from LUS). Takeup is assumed to build up over time, as more customers become aware of the scheme. Since customers are unlikely to remain on Lifeline permanently, an allowance has been made for a proportion of customers to leave the scheme each year (and move to LUS). Rather than the maximum possible takeup figures of 0.5m for the low takeup scenario and 1.2m for the high takeup scenario, the stock of customers on Lifeline in 2000/01 has been modelled as approximately 0.3m and 0.8m respectively. The resulting estimates of the future universal service costs of uneconomic customers are shown in Table 6.3.
6.17 For simplicity, the replacement of LUS by new service packages, such as a limited outgoing calls scheme, has not been modelled. One might expect that the replacement of LUS by new service packages should lead to a reduction in the universal service cost, because the new schemes will be better targeted than LUS, ie there will be a tendency for customers, who are able to afford higher tariffs that mean that they impose no universal service cost on the provider, to move onto such tariffs.
Future cost of call boxes
6.18 The relaxation of Condition 11, to allow more flexibility for BT to resite public call boxes (see Chapter 5), should reduce the universal service cost of call boxes in the future. BT will have more freedom, for example, to resite call boxes to locations where they are less likely to be vandalised, which will reduce the costs of repair and call box replacement, and are more likely to generate greater revenue.
Summary
6.19 A summary of the estimate of universal service costs in the
future is set out in Table 6.4. These figures build on the estimates
of the current costs of universal service, about which a number
of concerns have already been noted. In addition, a range of assumptions
about uncertain parameters (eg takeup of service packages,
growth in demand, changes in unit costs) is required to produce
these estimates. The figures in Table 6.4 should, therefore, be
treated with a degree of caution. The estimates should only be
interpreted as providing an indication of the likely scale of
universal service costs in the future, before benefits have been
taken into account.
| Universal Service Cost after efficiency adjustment (£ million) | |
| Uneconomic areas | 0-5 |
| Uneconomic customers | 40-60 |
| Uneconomic public call boxes | 0-15 |
| Total | 45-80 |
Table 6.4 Estimate of future universal service costs (in 1998/99) for BT after efficiency adjustment, but before benefits
BENEFITS TO THE UNIVERSAL SERVICE PROVIDER
What are benefits?
6.20 Benefits is the term used to refer to the beneficial effects on the current or future financial performance of the universal service provider o providing universal service, that have not already been taken into account in the costing methodology. The benefit of revenues from outgoing and incoming calls has already been allowed for, since the universal service cost is calculated as the difference between avoidable costs and revenue foregone. Benefits should be subtracted from the universal service cost in order to derive the universal service net cost, the true cost to the universal service provider (USP).
6.21 In principle, the scale of these benefits would be revealed in a competitive auction for the minimum subsidy that an operator would require to take on the responsibility for providing specified elements of universal service obligation (or the maximum price an operator would be prepared to pay for the right to provide specified elements of universal service). Oftel intends to explore the possibility of tenders for parts of universal service, as discussed in chapter 7. In the absence of a competitive auction for all elements of universal service, it is necessary to make an assessment of the scale of benefits. Whilst there are difficulties in arriving at a robust quantification of benefits and a degree of judgement will inevitably be involved, in Oftel s view these benefits are significant.
6.22 The customer base of many commercial organisations contains a proportion of customers that is unprofitable at any point in time (eg banks and building societies). Companies may choose to retain such customers for a variety of reasons. For example, some customers may be expected to become profitable in the near future. Or an attempt to remove service from currently unprofitable customers may result in the loss of other customers who are profitable, due either to imperfect targeting or to insufficient information to identify accurately which customers are unprofitable. Or the retention of service to currently unprofitable customers may enhance brand image and corporate reputation, which encourages other profitable customers to remain with the supplier. In an environment in which the universal service provider is facing increasing competition, these benefits are likely to be especially valuable.
6.23 The precise nature of the benefits may be somewhat different between uneconomic areas and customers, and uneconomic public call boxes. Each of these is discussed in turn below.
The benefits of serving uneconomic areas and customers
6.24 Oftel has made an attempt to judge the value of the following types of benefit which arise from serving uneconomic areas and customers:
6.25 The approach that Oftel has adopted is to attempt to quantify as far as possible the effects that are most amenable to modelling. For other types of benefit, the attempt is to set them in context to inform the judgement about their magnitude. However, it has not been possible to quantify potentially significant benefits, such as the retention of some currently unprofitable customers because of imperfect targeting or information. Nevertheless, these benefits should not be ignored when making the overall judgment about the size of benefits.
Life cycle effects
6.26 By serving a customer now when unprofitable, the operator may increase its probability of obtaining that customer when s/he becomes profitable in the future. In previous work on life cycle effects it had been assumed that, if a customer were expected to become profitable within 5 years it would be worthwhile for the operator to serve that customer now. However, the true gain to the operator of serving the customer now is the improved probability of being chosen by the customer when s/he becomes profitable. This has three implications which make the size of the benefit relatively small: first, the base of customers is only currently uneconomic customers in areas where there is (or will be) a choice of competing supplier; second, only a subset of that customer base can be expected to be profitable for the universal service provider (over the chosen time horizon of five to ten years); third, the gain in terms of obtaining a profitable customer in the future needs to be weighted by the change in probability. An analysis along these lines suggests that BT might, for purely commercial reasons, choose to serve up to 0.8m of the lines that are currently unprofitable, because of the prospect of obtaining future profits from such customers. This leads to a reduction in the universal service cost (ie value of this type of benefit) of about £1m-£10m per annum.
Ubiquity
6.27 BT has accepted that it obtains an advantage from ubiquity: that new households to an area will be aware of the presence of BT, because BT is known to be ubiquitous, but may not be aware of the existence of competing suppliers (See Annex 3 to Effective Universal Service Provision, BT, 22 September 1995). However, Oftel considers that the illustrative calculation that has been provided by BT, showing a benefit per annum of about £3m, represents a serious understatement of the size of this benefit. The Oftel model and the reasons for the difference in results from BT s illustrative calculation are described in Note 3.
6.28 The benefit arises because a proportion of households new to an area in which there are competing suppliers, will choose to take service from BT only because they are unaware of the presence of suppliers other than BT, ie such customers would have chosen a supplier other than BT if they had been fully informed. Over time, as these customers find out about competing suppliers, they will tend to switch away from BT. The benefit to BT is the profit obtained from those customers in the period before they switch to the competing supplier. Whilst a number of assumptions about the values of parameters are quite difficult to ascertain, Oftel considers that a reasonable estimate of the size of the benefit from ubiquity is £40m-£80m per annum. Details of the derivation of this estimate are set out in Note 3.
6.29 It may be argued that it would be inappropriate to ascribe the whole of the value of this benefit to universal service. Some benefit of informational advantage would be likely to accrue to a large, wellestablished national operator, even if that operator were not the universal service provider. Nevertheless it seems likely that much of the benefit derives from being the national universal service provider, because only in these circumstances is it guaranteed that the operator will serve every class of customer in every part of the UK.
Brand enhancement and corporate reputation
6.30 Significant benefits are likely to accrue to the universal service provider from the effect that serving uneconomic areas and customers has upon the operator s brand image and corporate reputation generally and hence upon its overall current and future profitability. The universal service provider s branding is enhanced through fulfilling the universal service obligation. The perception of the operator by all of its customers, and by the customers of other operators, is affected.
6.31 One perspective on brand enhancement is that the benefit to the universal service provider is that it gains or retains more profitable customers than it otherwise would, because of customers perception of the universal service provider s brand. In the case of BT, which is expected to experience a reduction in its market share because of increased competition, the effect of being the universal service provider can be thought of as leading to a slower rate of loss of market share to competitors. However, BT s higher market share, with the obligation to provide universal service, has been taken into account when setting the value of X (ie the market share analysis carried out as part of the financial modelling for the price control review was by default on the basis that BT continues to be the universal service provider). It would, therefore, be inappropriate to net this benefit off the universal service cost, since it would amount to double counting. But, this type of benefit would become relevant if the retail price control on BT is removed, eg at the end of the current control period in 2001.
6.32 More generally the brand enhancement can be thought of as being worth an amount of money each year to the universal service provider, in terms of the cost of advertising and marketing that it would otherwise have to undertake to achieve the same effect. BT already undertakes substantial expenditure on advertising and marketing. BT Group s marketing and sales expenditure in 1994/95 was £438m (BT Retail s expenditure was £276m). The brand enhancement caused by universal service is likely to encourage existing customers to remain with BT and new customers to take service from BT rather than competitors. This is a complementary form of advertising to the general advertising undertaken by BT to stimulate call growth (eg advertising campaigns highlighting the price of calls). If the brand enhancement were worth 20% of BT Retail s marketing expenditure, the value of this benefit would be about £50m.
Conclusion on the net costs of areas and customers
6.33 In a competitive environment the universal service provider obtains a variety of benefits from the provision of universal service. Some benefits arise from life cycle effects. The benefits of ubiquity are large - if the whole of these benefits were attributed to being the universal service provider, they could be sufficient to offset the universal cost of areas and customers on their own. The universal service provider also obtains a significant benefit in terms of brand enhancement and corporate reputation. Furthermore, many commercial organisations choose voluntarily to retain a proportion of customers that are unprofitable at any point in time for a variety of reasons, including lack of perfect information about the identity of the unprofitable customers and imperfect targeting (ie actions to remove service from unprofitable customers may inadvertently lead to the loss of profitable customers). In Oftel s view, the size of the benefits in aggregate is likely to be sufficiently large to offset the estimated universal service costs. Oftel concludes, therefore, that the case that there are significant universal service net costs of areas and customers to BT is unproven.
The benefits of serving uneconomic call boxes
6.34 Life cycle effects are one source of benefits to the universal service provider of public call boxes. There is significant variability in revenues from individual call boxes over time. The costs of individual call boxes might also vary from year to year. Therefore, the universal service provider would wish to retain a proportion of the call boxes which happen to be uneconomic at any point in time for purely commercial reasons - a reasonable estimate is that this affects about 25% of uneconomic call boxes.
6.35 A further benefit to the universal service provider of public call boxes is the value of advertising of the company s logo on call boxes and the consequent enhancement to corporate reputation. An indication of the likely scale of his effect is provided by the following rough calculation. Reduce the number of uneconomic public call boxes from 25,000 (see Table 6.1) by 25% to take account of the life cycle effect discussed above, leaving 18,750 call boxes. Assume (conservatively) that onehalf of these call boxes yields no advertising benefit, and that the other half is each worth £100 per month in advertising (for comparison, an equivalent advertising presence at a London bus stop would cost around £200 per month). With these assumptions the value of the advertising benefit from uneconomic call boxes would be about £11m per annum.
6.36 The scale of the benefits derived from the life cycle effect and the advertising benefit taken together appear to be sufficiently large fully to offset the universal service cost of public call boxes. Furthermore, as discussed earlier in this chapter, the universal service cost represents an upper bound estimate, because it may include call boxes that BT has added since privatisation and which were therefore installed in the full knowledge of the restrictions on resiting. Moreover, it is expected that the future universal service cost will fall from its current level, because of the proposal to give BT greater flexibility to resite call boxes. These points reinforce Oftel s conclusion that BT will incur no undue financial burden from the provision of public call boxes.
CONCLUSION
6.37 Some doubts remain about the size of the current and future universal service costs, primarily because of deficiencies in the information provided by BT. Precise quantification of the benefits to the universal service provider is not easy, but in Oftel s view the benefits to BT, especially in a competitive environment, are large. Given the available evidence on costs and benefits, Oftel concludes that there is no proven case that there is an undue financial burden on BT that would justify setting in place new universal service funding arrangements. In Oftel s view it is unlikely that there are any customer segments or areas in the UK that BT as a nationally branded operator would choose not to serve. Oftel also considers that it is unlikely that any such undue financial burden will be created in the near future, eg by the introduction of the Lifeline scheme.
6.38 If BT were to disagree with Oftel s conclusion and considers that it faces an undue financial burden from provision of universal service, then as a necessary first step, in accordance with the EU Costing Guidelines, it would need to announce publicly the areas, customers and call boxes that it would not be prepared to serve at the current level of prices in the absence of funding, were it not for the licence obligation. This would need to be followed by a formal request from BT to the Director General that its licence be amended accordingly. For those areas, customers and call boxes, BT would need to provide more complete information than that provided for the costing studies so far, in order that truly robust estimates of their universal service cost could be produced. BT would also need to demonstrate that these universal service costs were not offset by the benefits that it recoups from being the universal service provider, as discussed in the previous section of this chapter. One possible way that a universal service net cost might then be tested would be through the result of a competitive tender between operators for the universal service responsibilities for a particular area or service, as discussed in the next chapter.
6.39 To ensure that information on the costs of universal service are kept uptodate and to ensure that BT is not unduly disadvantaged, Oftel proposes to conduct a full review of universal service net costs during 1999. This will provide an opportunity to check whether universal service costs have turned out to be higher or lower than expected and to reevaluate the size of the benefits to the universal service provider. At that time Oftel will expect BT to be able to provide the information that has been missing from the costing studies conducted so far and which has adversely affected the quality of the resulting estimates of universal service costs.
Questions:
8 How do respondents consider that the size of the benefits to the universal service provider should be estimated?
9 Do respondents agree with Oftel s judgement that the size of
the benefits to the universal service provider are likely to be
sufficiently large to offset the universal service costs of uneconomic
areas, uneconomic customers and uneconomic public call boxes?