How RPI-X Works
Price regulation (explained later) and increasing competition have brought substantial benefits to all UK customers since BT was privatised in 1984. These include:
There are a number of changes around the corner, which although they do not arise out of this price control review, we expect will lead to further benefits to customers:
Removal of RPI + 2% control on line rentals and more tariff choice
We have already proposed removing the Retail Price Index (RPI) + 2% control on BT's line rental and draft licence modifications to achieve this are in the pipeline. When this goes, regulation will not limit line rental charges directly. But there will be a lot of pressure on BT not to raise them and BT will still need to comply with the current Price Cap rules which broadly limits overall price increases to 7.5% below the rate of inflation.
Customers on BT's Light User Scheme (LUS), which gives line rental rebates to residential customers whose call bills are low, will be guaranteed no increases above general inflation in charges for the same usage. This protection will last until the end of the current price cap in July 1997. After that, the new universal service arrangements will come into play to secure affordable basic service to any customer who reasonably requests it.
Other operators are already offering more tariff choices: for example, some tariffs now offer a fixed monthly charge to cover line rental and a set volume of calls. BT has said it is willing to introduce new tariff packages but these have yet to be finalised.
BT plans to make "Call Levels" available to new customers by June 1996. Under this scheme, a financial limit is placed on their calls. When reached, the customer must pay the bill before making further calls. (They can still make 999/operator calls and receive incoming calls.) This will avoid the need for deposits for new customers, reduce disconnections and will help to control telephone costs. We want BT to make the service available to all customers as soon as possible. A "Call My Bill" service, which tells customers of the size of their bill at any given time, should also be available next year.
We want to see the number of disconnections fall and are proposing, as part of our universal service definition, an Outgoing Calls Barred service as an alternative to disconnection for existing debt. This would allow the customer to stay on the phone while the debt is repaid gradually and again 999/operator calls would still be possible.
BT is considering enhancements to its fault repair service including extended appointment hours, with specified appointments times at a small extra charge.
A number of new services making use of the most modern telecoms technology are increasingly available. These give access to the Internet, on-line information services, advice services, home shopping and banking, entertainment and new ways of working using E mail and video links.
We believe that competition is the best way to get companies to produce services at least cost, keep prices down and encourage quality improvements. Where competition is not sufficiently well developed, regulation is needed to protect customers from excessive price increases. Regulation of telecommunications in the UK has been designed to mimic a competitive market so that there are pressures to achieve cost reductions and lower prices to customers than would otherwise be the case.
Regulation has worked by using a RPI - X formula to restrict the average prices that BT can charge. This means that prices have to fall after allowing for general inflation. X is now 7.5%, so broadly speaking prices can only rise by 7.5% below the rate of inflation every year. Price Control works by setting the value of X at each review to reflect BT's expected efficiency gains over the next Price Control period. If BT does better than expected, then its profits will be higher than expected - it has a strong incentive to reduce costs. When the Price Control period ends, the value of X is reset for another fixed period. If efficiency has been higher than expected and it looks like this will continue, Oftel will take this into account in resetting X for the next Price Cap period.
The system provides a strong incentive on BT to reduce costs while at the same time allowing customers to share in the benefits of efficiency improvements.
When BT was privatised in 1984, it completely dominated telecoms in the UK. A RPI-3% (ie. X was 3%) Price Cap was set for 5 years. This meant that overall BT's prices fell in real terms. How BT split prices across their various services was down to them, though since 1993 BT had individual Caps on a number of services which prevented their prices rising in real terms. (The main exception was exchange line rentals where a RPI + 2% control applied.) In broad terms, the form of control adopted in 1984 remains in place today although, as a result of later price reviews, the range of services covered has increased and the value of X has increased progressively to the current level of 7.5%, reflecting large gains in efficiency.
The present controls on BT's retail prices end in July 1997. The purpose of the current review is to look at what should replace them.
Our view is that competition is the most effective protection for customers. This gives customers choice, drives down prices and costs and encourages innovation. Competition has increased considerably since 1993 when the last Price Control was set. This is good news for customers.
But the growth of competition has been uneven. It has been strongest in the business sector and competition there is likely to get stronger still. Competition is also growing for residential customers in urban areas as cable companies build their networks, but those in rural areas may not benefit directly. BT still has nearly 95% of residential customers' exchange lines - this strong position will be eroded over the next few years but in some areas this erosion will be slower than others.
Since in many areas competition is not yet firmly established and is unlikely to become so by 1997 we must keep Price Control on BT to protect customers from excessive prices and pass on to them the benefits of BT's improved efficiency.
We need to propose new arrangements by July 1996 because, if BT disagrees, we will need to refer the matter to the MMC. This may take 12 months to resolve.
In carrying out the review of price control, Oftel's main objective is to seek "the best deal for the customer in terms of quality, choice and value for money". We believe that this is best achieved in a fully competitive market, so we promote competition. Where competition is effective, regulation can be reduced to a minimum because from the customer's viewpoint it is safe to do so. We do not want regulation to restrict the choices available to customers.
However, where competition is not yet fully effective, the new system of price controls will aim to squeeze down prices to those which efficient operators in a competitive market would offer while maintaining measures to encourage BT to improve quality of service. Oftel considers that consumer protection is a prime objective of the review.
We also want to make sure that everyone benefits from competition. Easy-to-serve customers are likely to benefit but we want to protect those living in remote areas and people who through age, income and disability need special consideration. BT must offer the same prices in all areas of the country so that all customers benefit from any price reductions that it introduces. We use these rules governing BT's behaviour to prevent BT from making price reductions only in areas where competition exists. The new universal service arrangements will also benefit many customers. Price Control is one of several ways of achieving Oftel's fair shares of benefits objective.
There are three other objectives of the review:
Fair Trading - ensuring that market dominance is contained and that anti-competitive practices are deterred, or dealt with, to the benefit of consumers.
Promoting Network Competition - competing networks that interconnect with each other give customers a choice of companies for telephone service and companies some choice when deciding which network to use to carry their customers' calls. Oftel is considering separate retail and network caps to help here. The network cap could be important for reducing the costs to other companies for using BT's network: they could reflect these reductions in prices to their own customers.
Promoting Services Competition - customers benefit from a range of telephone services offered by a number of suppliers. A Consultative Document proposing new arrangements for Service Providers will be published soon and will address a number of changes which are aimed at encouraging the development of new services and expanding customers' choices.
As part of the new Price Control system, we are consulting on whether the retail Price Cap (which currently controls BT's charges to business and residential customers) should be modified and joined by a network Price Cap, which would control the charges which BT can make to other operators when they use BT's network to carry their calls. This would replace the current arrangements where Oftel has to rule on the charges for these services on an individual basis.
At this stage, we are not consulting on the values of "X" in either Price Cap. The second Consultation Document to be published in March will propose ranges of values for X.
We want these controls to encourage maximum efficiency. Oftel wants to see the greatest possible long term benefits for customers.
The detailed issues surrounding the network price cap and the interaction with the retail Price Cap are not covered in this Guide but if, after reading the main Consultative document, you have views we would like to hear them.
The main issues on which Oftel is seeking consumers' views are:
We believe that services which are sold in competitive markets should not be price controlled, but services which are not competitive should be price controlled. In practice, not all services fall into these two groups: some are in an intermediate group which are thought likely to be competitive after 1997, but we cannot yet be confident enough about the prospects for competition to remove them from price control altogether. We are consulting on a proposal to apply a restriction limiting increases in charges for these services to the rate of inflation (a safeguard cap equal to RPI).
So, any service can be (i) in the price control which will mean average prices will fall in real terms; (ii) in the safeguard cap which restricts price increases to the level of inflation; or (iii) outside price control altogether.
The aim is to classify services as set out below:
Price Cap (RPI-X) Safeguard cap (RPI-0) Outside Price Cap Uncompetitive market Becoming competitive Competitive market
The table below sets out Oftel's proposals on the coverage of the cap of interest to residential customers:
Market Segment In Price Cap Safeguard cap Outside Price Cap Connection and line X rental Local and trunk calls X International Direct X Dialled calls Operator assisted X calls/Directory Enquiries Special tariff voice X services (eg. 0345 lo-call, premium rate) Payphones X* Integrated Switched X Digital Network Calls (ISDN) End user equipment X Mobiles X Telex X
*Note : We are looking at public payphones: this is discussed below
We would particularly welcome comments on:
Whether International Direct Dialled calls should be taken out of the Price Cap and be made subject to a safeguard cap of RPI only.
These calls were put into the cap in 1991 because the market was dominated by BT and Mercury and very high profits were being earned. Since then there have been many changes which are making the market much more competitive for residential customers.
Whether operator assisted calls/directory enquiries and specially tariffed services should be taken out of the Price Cap and included in the safeguard cap of RPI only.
We are taking steps to encourage competition in these markets. We believe there are good prospects for the development of competition, and Price Control is not needed.
Whether public payphone prices should be outside the scope of price control as at present or whether they should be linked to the price of other calls - if so, proposals on the best means of doing this are invited.
We recognise that concern has been expressed by some about payphone charges. While users of payphones pay higher call charges than domestic customers, they do not pay rental charges. We are taking steps to introduce competition into the payphone market and expect that the emergence of competition will result in operators charging prices which are affordable to customers. Reasonable geographic access to Public Call Boxes will be included in the universal service requirements. For these reasons, we do not intend to include payphone charges within the Price Cap but think that the way forward may be to link payphone charge rates to local or national call charge rates.
Whether the services below should be brought within the Cap and on how best to achieve this:
(i) calls to mobile phones
When you make a call from BT's network to a mobile phone it is much more expensive than making a call to a fixed phone. Including calls to mobiles in Price Control is difficult because the bulk of the price you pay is a payment to the mobile operator, which is outside BT's direct control. On the other hand, BT should be in a strong position to negotiate the level of charges to the mobile operator and Price Control would give it a bigger incentive to do so. Another option would be to have Price Control apply to charges excluding the payment to the mobile operator, but this would only give BT an incentive to reduce a small proportion of the total cost.
(ii) Integrated Switched Digital Networks (ISDN)
ISDN offers faster data transfer than the conventional access service to households which is via the Public Switched Telephone Network (PSTN). It is therefore particularly useful for home working, faster data transmission and using the Internet, although it may also be used for ordinary telephone services. There has been some concern about the prices for ISDN. Oftel is considering bringing ISDN into Price Control because BT is the only supplier of "basic rate" ISDN even though it has been in existence for several years, connection costs are high relative to other countries and, in a competitive market, Oftel would have expected prices to fall.
(iii) "Superhighway" services
These broadband switched mass market (BSM) services have the potential to provide significant consumer benefits such as improved on-line information services, distance learning and remote teaching, home shopping or banking, entertainment on demand, video based healthcare or professional advice and new ways of working and learning. In our August Consultation Document, "Beyond the Telephone, the Television and the Personal Computer", we considered that price control was not advisable at the moment. Too much regulation at this stage could slow the growth of these important services.
Should new services be excluded from the Cap?
Where new services are introduced, BT may have some short term market power, but high profits are a reward for innovation and attract competitors into the market who drive prices and profits down. We believe that new services should not be included in the Price Cap as this may discourage innovation and new entry.
Oftel also invites views on the methods of :
Should there be restrictions within the price control that prevent BT focusing cuts on business users to ensure that residential customers get a specified share of the benefits? If so, how should the shares be ascribed ? Should there be separate business and residential price caps ?
BT currently decides how to split the price cuts required under the Cap between the residential and business sectors (subject to limits on volume discounts). Separate business and residential Price Caps would force BT to make specific price reductions to the two sectors.
In the first few years after privatisation, business customers (particularly in the City of London) received more significant price cuts than residential customers. Competition was more intense in the business sector. Also, BT started from a pre-privatisation position where business customers were subsidising residential customers. Residential rental and connection charges were historically low and did not cover their costs. It was therefore reasonable to expect greater benefits for business customers following privatisation as BT moved prices more into line with costs.
The outlook for residential customers is now better. As cable networks expand, more residential customers will have a real choice. Cable companies are very competitive with BT on price (and cable operators have a choice of operator with whom they can link up to offer long-distance call services). Radio based telecoms operators will be starting to offer service to residential customers very soon.
BT is responding to these developments with new tariff packages for residential customers and by introducing discounts. In the last two years, residential customers have seen significant price reductions, of over 6% p.a., almost on a par with business customers.
This was helped by the Price Cap rules, introduced in 1993, which prevented discounts to high spending customers from counting as price reductions under the Cap. Discounts to low usage residential customers however did count. We propose that this treatment should continue but welcome views on this.
Overall, Oftel doubts the need for separate Price Caps but would like to hear your views.
We currently monitor changes in the bill size of a typical domestic customer - known as the median residential bill. We will closely monitor the spread of benefits under the new Price Control arrangements. We have grouped residential customers according to telecoms spend and income as follows:
Estimated average Estimated number of
telecom spend per households
quarter
Comfortable residential
High spenders more than £70 3.5 - 4.5m
Medium Spenders £35 - 70 8.5 - 9.5m
Low spenders less than £35 2.5 - 3.5m
Less comfortable
residential
Just affordable £35 - 70 2.5 - 3.5m
Hard up low users less than £35 1.5 - 2.5m
The unphoned 2 - 2.5m
Note: The table only covers fixed phones, not mobiles.
Oftel believes that it should monitor the effect of price changes on all the categories of customer shown above. If you have views on whether and how the segmentation above could be used to monitor BT's price changes, we would like to hear them.
We are also aware that there are between 0.3 - 0.5m hearing impaired people who are unable to use a standard phone even when adapted for hearing aid wearers. Special measures to help these people are proposed by Oftel in the universal service section of this Guide.
Service quality may, in certain circumstances, be as or more important to some customers than price. Our current approach to service quality has three main strands:
Oftel believes that these approaches, along with increasing competition, are likely to be the most effective in improving quality of service. Your comments are invited.
As we have already said, there are a number of more complicated issues addressed in the Consultative Documents. We have not tried to deal with them all in this Guide. Nevertheless, the following are issues on which you may wish to comment. For more detail you should go to the Consultative Document.
We believe that Price Cap regulation is better than rate of return regulation. Under rate of return regulation, prices are adjusted annually to keep profits at an acceptable level, and there is very little incentive to control costs. There has been considerable public discussion of a type of regulation which is a cross between rate of return regulation and price capping known as profit sharing. Under profit sharing, the Price Cap would stay but when a certain profit threshold is reached further price reductions would have to be made. For the consumer, there is a chance of more price reductions in the short term than under the pure Price Cap. However, we think that in the long run this would not benefit consumers because BT's incentive to cut costs would be reduced. Over time, this would reduce BT's ability to lower prices. We believe that the benefits of greater efficiency under Price Caps which are then passed on to the customer at the next review when X is reset outweigh any short term gain from lower prices during the period of the Price Control. The Price Cap system has proved to be a very good way of controlling prices and encouraging efficiency and we would be unwise to throw this away in favour of an untried alternative with potentially unwelcome effects.
The advantage of RPI is that it is widely known and used, including by other regulators and is widely accepted as a measure of inflation. An alternative could be to use an index based on BT's costs but this would reduce BT's incentive to reduce the costs of items included in the index. We continue to believe that RPI is the best index but would welcome your views on possible alternatives.
A long Price Cap period increases the incentive on BT to reduce costs. But the telecoms market is moving very fast. Because forecasting is more difficult for a longer period, this runs the risk that BT's profits will depart significantly from what was expected. We are considering a five year cap.
If BT cuts its prices more than the Price Cap needs in a year, then it is allowed to count the extra price reductions towards the cuts that it must make in the next year. We believe that this should continue as it means that BT is not penalised for speeding-up price reductions to benefit customers.
When setting the new price controls, the Director General of Telecommunications has a duty under law to ensure that an efficient BT can make a reasonable return on the assets in the price controlled businesses. This is what would happen if BT was operating these businesses efficiently in a fully competitive market. In a competitive market, a firm would expect to earn a rate of return that was on average equal to its cost of capital - this is the return that investors require for investing in companies of similar risk. If BT does not earn its cost of capital then investors will not supply capital to the company and it won't be able to finance its activities. Eventually it would go bust.
The cost of capital is usually estimated as an average of the cost of equity (ie. return required by shareholders in the company) and the cost of debt (ie. the cost of long term borrowing). The economic models that are generally used to estimate the cost of capital, particularly the Capital Asset Pricing Model and the Dividend Growth Model, are explained in the main document. These models start from the assumption that in a competitive stock market, investors demand a higher return for more risky investments. The models develop ways of measuring this relationship. Our initial view is that the appropriate range for BT's pre-tax cost of capital is between 5.2 and 8.8% in real terms.
The cost of capital cannot be considered in isolation - we also need to decide the value of the assets on which the return should be earned. For the next Price Control period, we intend to move to forward looking current cost asset valuations, since current cost accounting reflects the true economic value of assets better than historic cost accounting. When doing this, Oftel needs to make sure that this change in the basis of regulation does not lead to windfall gains or losses for shareholders in BT.
We also need to take a view on growth in BT's markets, BT's likely shares of these markets, and on the scope for efficiency improvements before reaching a conclusion on the value of X. These factors, along with the cost of capital and asset value, are used as inputs in financial models to give BT's revenue requirements into the future.
If you have any views on these issues Oftel would like to hear them.
We have set out below the questions on which we would particularly welcome your comments. At the back of this Guide you will find a further set of questions about universal service which we would also like you to respond to.
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