D11.1.1 On 31 March 1995 BT agreed to accept a number of new Conditions to its Licence which among other things established a framework of Accounting Separation.
DII.1.2 Accounting Separation has been introduced to provide the necessary financial and regulatory framework to ensure that the charges which BT makes for interconnection services to other operators and to its own retail services arm are fairly and transparently derived from relevant costs; and to provide a means of checking that BT does not unfairly subsidise (or cross-subsidise) any part of its business or show undue preference to or undue discrimination against other operators.
DII.1.3 This financial framework requires BT to produce regulatory accounts - separate from its statutory accounts - constituting of separate financial reporting for its Access, Network, Retail Systems, Apparatus Supply, Supplemental Services Businesses and Residual Business (these will be reconciled to the statutory accounts). Within this new system of financial reporting BT is required to show in detail how the costs of interconnection services are derived from the underlying costs of the components from which these services are built up.
DII.1.4 In addition to providing this financial reporting framework the package of licence modifications included the following four provisions which gave the Director General new powers.
Condition 16B
DII.1.5 When a standard service provided under Condition 13 is deemed competitive by the Director General the charge for that service will no longer be determined by him but BT will be free to set its own charge.
Condition 17B&C
DII.1.5 This is designed to prevent BT showing undue discrimination in the quality of service provided under Condition 13 to other interconnecting operators.
Condition 20B.15
DII.1.6 The Director General can direct BT to remedy any unfair subsidy or cross-subsidy of a defined set of BT businesses or any part of a business (excluding the Residual Business) where this is having (or may be expected to have) a material effect on competition.
Condition 24F
DII.1.7 In certain circumstances, the Director General can consent to BT reducing some of the prices of retail services which are subject to the price cap control review below (or further below) their fully allocated cost.
DII.2.1 Condition 16B.6 of BT' s licence allows the Director General to decide that one or more standard services, the charges for which would normally be determined by Oftel, are being supplied in a competitive market. The effect of this decision is that BT would be free to set its own price for this service.
DII.2.2 This decision process is triggered by an application from BT or another operator asking Oftel to declare that a specific service (or services) isbeing supplied within a competitive market. These guidelines set out the factors that Oftel is likely to take into consideration in reaching a decision. The principles it sets out draw on, and are intended to be consistent with, those emanating from the OFT and MMC concerning competitive markets.
DII.2.3 There are likely to be two distinct stages in answering the question put to Oftel. The first stage will involve defining the relevant market for the interconnection service (or services) and the second stage will involve gauging the competitiveness of that market once defined.
DII.2.4 Before the competitiveness of a market can be evaluated, it must first be defined. As in competition policy more widely, the principle which will be followed is that services should be included in the definition of the market where their availability significantly constrains the prices of products in a more narrowly defined market.
DII.2.5 This is most likely where products are sufficiently close substitutes that a monopolist supplying just one of a set of products could not impose a significant price increase without losing sales to an unacceptable extent.
DII.2.6 The degree of demand-side substitution varies across the different elements of interconnection services. For instance, connectivity between switching points for any one call can be supplied by more than one network. This service is potentially competitive from other networks supplying direct substitutes for BT's services. A simple example is the use of Mercury's trunk network as a substitute for BT's. Other networks provide similar services.
DII.2.7 For other services the scope for demand-side substitution is much more limited.
DII.2.8 The most likely spread of competition in this market will result in substitutes being available for most, but perhaps not all, calls. How much this lack of complete substitutability matters may itself depend on the application of other regulatory rules. So, for example, where BT is constrained from differentiating its prices for services by geographical location, complete substitutability may not be necessary before declaring that market competitive.
DII.2.9 On the supply side Oftel will consider whether there are any suppliers who are in a position (and are likely) to switch existing production resources to provide a service if the price was raised. In most cases of basic telecommunication interconnect services, the infrastructure will already exist and the service is likely to be already on offer.
DII.2.10 Although reasonably straight forward, at least at present, these interconnection service markets are likely to get more complicated in the future as the functionality the networks operators are looking for in their interconnect services becomes more complex (eg intelligent network services) and it becomes possible to provide demand and supply-side substitutes for services using radically different network configurations and/or technology.
DII.2.11 For the present Oftel does not see market definitions as being particularly problematic for the operation of this condition. However, any operator applying to Oftel for a declaration that a service is competitive should address the issue and propose a definition of the relevant market within which they wish to argue that a service (or services) are competitively supplied.
DII.2.12 A more difficult issue will be the assessment of competitiveness within any relevant market.
DII.2.13 There is no unique indicator of the competitiveness of a market. Simple tests, such as looking at market share data or considering the number of firms in a market, have an advantage of clarity and simplicity (and would thus reduce the direct costs associated with regulation) but market share figures on their own are a poor indication of market power or the competitive conditions within the market.
DII.2.14 Therefore, Oftel does not think that it is feasible to lay down hard and fast rules. These Guidelines are designed to give the industry information on the factors which Oftel will take into account in deciding whether a market may be regarded as competitive. This is not to say that all the factors listed are necessary conditions which must be satisfied together for a market to be considered competitive, but they do give an indication of the range of factors that Oftel is likely to take into account. For example, if entry barriers were low, it may not matter that there are few firms in the market whilst, if there are many firms, it may not matter that entry barriers are high.
DII.2.15 The inability to set hard and fast structural criteria which would allow a mechanistic determination of whether or not a market was competitive is partly as a result of the complexity of these markets, but more importantly because a significant test for Oftel of the competitiveness of a market will often be an evaluation of the conduct of firms in the market, and more particularly the likely behaviour of BT if the direct regulation of interconnect charge(s) was removed.
DII.2.16 The analysis is further complicated because with a limited number of possible substitutes (which is likely to characterise the interconnection market generally) the potentially idiosyncratic behaviour of any existing competitors will also have a bearing on the outcome of removing the price determination constraint from BT. If the competitors were, for example, tactically to collude with BT if the price control mechanism was removed then that would increase the risks for Oftel in declaring a particular market competitive.
DII.2.17 There is obviously an element of judgement inherent in analysing the likely conduct of firms in a market and thus there is the risk attached to any decision to declare a market competitive that Oftel has misjudged the competitive situation. However, this Condition provides a quick method of recovering from such a mistake: ie a market can be declared to be uncompetitive. Oftel's Consultative Document Pricing of Telecommunications Services from 1997 also sets out proposals for the inclusion of safeguard caps (of RPI + 0%) for interconnection services that were prospectively competitive.
DII.2.18 Notwithstanding the general difficulties outlined above, the following guidelines indicate the likely way a decision would be taken.
DII.2.19 The market for the main telecommunication and other interconnection services is characterised, at present, by having significant sunk costs in the creation of a network, lower incremental costs of capacity once the network is in place, and very low marginal costs of taking extra traffic within the current capacity constraint. In addition, service enhancement tends (but not always) to be software dependent. This results in a cost characteristic that upgrading the first switch to handle the service is expensive, but upgrading all other switches (of that type) is relatively cheap.
DII.2.20 These economic characteristics suggest that the likely restraint that a potential supplier (ie one not already in the market) would have on BT would be small. Oftel will, therefore, concentrate its analysis on the actual competition available. In addition, given that additional capacity is expensive (and usually sunk) competition analysis would take into account excess capacity in other operators'networks which could be a significant constraint on any attempt by BT to behave anti-competitively.
DII.2.21 The sunk cost characteristics combined with the low marginal cost of carrying traffic within that capacity constraint will pull the analysis in opposite directions as far as the significance of the number of players is concerned. The low marginal cost suggests that competing companies would compete vigorously for market share as a profit maximising strategy. However, the lack of a credible threat of new entry suggests that, at least if there is a small number of players, collusion to keep prices high and to share the market would be an obviously attractive strategy.
DII.2.22 Oftel s experience to date is that, for these market types, two players tends to result in behaviour more to the collusion end of the spectrum rather than the competitive end. Four players in the market of the provision of mobile networks, (for example) has produced more competition, at least in the retail market. But this market has the characteristic that all four networks are committed to producing more or less complete coverage of the UK - so each would be a complete substitute for any other.
DII.2.23 This suggests that for the fixed market, in terms of number of players, two is too few, and even four may not be enough. It also suggests that the total capacity of the non-BT players should be a significant part of the total demand, in order to make independent behaviour an attractive proposition to the competitors.
DII.2.24 For transmission connectivity there are significant barriers to entry in the form of fixed and sunk costs (see above). However, for other interconnection services and in the future, more intelligent network type services, this problem may be reduced. It is, however, difficult at this stage to give any guidance as these services are still rather novel, and the way in which they are likely to be provided is not yet clear.
DII 2.25 Although this is usually a consideration in this type of analysis, for the operation of Condition 16B.6 this is unlikely to be an issue. The reason is that the rules on unbundling will still apply as it is only the price control mechanism that will be relaxed if a service is declared competitive.
DII 2.26 Even within the limited framework of Condition 16B.6 it is impossible to provide any mechanistic guidance on when an application for an interconnect service (or services) to be declared competitive would be successful. However, the important dimensions on which Oftel is likely to carry out its analysis (at least for telecommunications transmission services) would include:
(a) The capacity of non-BT providers to carry a significant proportion of available demand.
(b) Market share, number and size of competitors.
(c) Barriers to entry/exit and the history of entry (and exit) into a market.
(d) The conduct of firms in the market and their likely response if BT were to be given pricing freedom.
(e) The powers available to Oftel if the decision turns out to be wrong
DII.3.1 Conditions 17B & 17C are designed to ensure that BT does not show undue preference or undue discrimination in respect of the quality of provision of interconnection services in relation to interconnecting operators. Condition 17B provides that undue discrimination should not take place, while Condition 17C sets up the system to measure the quality of service delivered (for specific services) in order to assess whether or not there is a difference between the quality of service delivered by BT to itself and other operators, or the quality of service delivered by BT to different operators.
DII.3.2 In practice the quality of the delivery of interconnection services will vary between operators. This will arise as a result of the random occurrence of faults, because services required are slightly different and for a variety of other reasons. Therefore, the simple fact of a difference in quality of service will not, in itself, result in a finding that undue preference or undue discrimination has taken place.
DII.3.3 For these reasons the objectives of these guidelines are to:
(i) indicate the cases where it is likely that a difference in quality of service actually delivered will, or will not, lead to a finding of undue discrimination;
(ii) indicate to what magnitude, or cause, of difference in quality of service would be necessary before it is likely that Oftel would take any action under this condition;
(iii) to indicate what kinds of information are likely to be required to underpin a request to Oftel for action, or to underpin the arguments that no action is appropriate. Oftel would expect that operators will endeavour to ensure that they capture the relevant kinds of information to either sustain, or refute, a request for regulatory intervention.
Circumstances where a direction would be likely
DII.3.4 Where there is a persistent and material difference between the quality of service provided to one or more operators when compared to other operators or to the equivalent service provided by BT to itself, unless there is an objective, and demonstratable, cause for this difference.
Example, a direction would be likely if over a three month period BT achieves 99.5% call completions for calls arriving at the destination DMSU from the BT network, but only 94% for calls arriving at that DMSU from non-BT networks.
Circumstances where a direction would be unlikely
DII.3.5 Where there is no objective evidence of a persistant and material difference in the quality of the service supplied, provided that the lack of information is not due to the deliberate action, or inaction, of the Licensee. (However, where no objective information is available, the Director General may take action to ensure that such information is obtained for the future.)
Example a direction would be unlikely if an interconnecting operator complains that BT updates its DQ service with BT s customers numbers faster than it does for its own customers without providing any supporting evidence. However Oftel would be likely to request information from BT to measure updating times of its own and others customers which might support (or not) the complaint.
Example On the other hand, an instance where a direction would be likely is if an interconnecting operator were to complain that BT updates its DQ service with BT's customers numbers in around 2 days (based on some limited evidence) but for its customers the average time was 5 days; and where BT did not have the information available within a reasonable time to prove or disprove the allegation, then a direction would be likely.
DII.3.6 Where the measured difference in performance is not statistically significant.
Example A direction would be unlikely if, over a sample of 1,000,000 calls BT successfully terminate 99.8% of BT originated calls compared with 99.75% of calls originating on interconnecting networks.
DII.3.7 Where the difference in quality of service did not, and will not in the future, place the interconnecting operator(s) at a competitive disadvantage.
Example A direction would be unlikely if,
over a sample of 100,000,000 calls, BT were successfully to terminate 99.8% of BT originated calls compared with 99.75% of calls originating on interconnecting networks.
DII.3.8 Where the difference in quality of service is wholly, or largely, the result of actions, or inactions, of the interconnecting operator(s).
Example A direction would be unlikely if:
because:
DII.3.9 Where the difference in quality is as a result of the request of the operator(s) involved and this difference in quality is available to other operators on a non-discriminatory basis.
Example A direction would be unlikely if, in order to meet the requirements of a special, time limited event, BT provide additional capacity in half the usual lead time for company X. Under similar circumstances BT would do the same for Company Y, but under normal circumstances provision for both company X and Y take the standard lead times.
DII.3.10 Where the difference in quality results from the actions of the DG in exercising his proper functions. For example, as a result of an Order on BT or where BT voluntarily accepts conditions at the request of the DG in lieu of an Order or other formal regulatory decision.
DII.3.11 Where the discrimination is, in the opinion of the DG, consistent with his duties.
Example a direction would be unlikely were BT to provide higher quality interconnection links to Company X using an experimental technology but BT did not offer this service to other companies until the technology is proven.
DII.4.1 The telecommunications market is developing rapidly, and is becoming increasingly competitive. However, in those markets where BT is active the market structure is such that BT is often the dominant firm. Under these circumstances unfair or anti-competitive behaviour may occur, leading to a reduction in competition and reinforcing BT's position, possibly in both the market in question and neighbouring markets. A major factor in this equation is BT's vertical integration allied to its dominant market position in the supply of basic telecommunication services. This could give rise to strategic behaviour across the relevant markets.
DII.4.2 A major concern is that BT will cross subsidise between markets to reduce competition in the markets where it faces significant competition (i.e. use profits earned in a market in which it has market power to cross-subsidise losses made in other markets in order to undercut and drive out or damage competition or prevent entry). Condition 20B.15 addresses that issue as it gives the Director General the power to issue a direction requiring BT to take action to eliminate unfair subsidies or cross-subsidies. These guidelines describe how Oftel is likely to approach the definition of subsidy or cross subsidy and the definition of unfair for the purposes of applying the Condition.
DII.4.3 Condition 20B.15(ii) (subsidy of part of a BT Business)only comes into effect where there is a material effect on competition. Where a case is investigated under C20B.15(ii), a finding of unfair subsidy or cross subsidy (i.e. one that is more than trivial) will raise a presumption (which may be rebutted) that that subsidy will have a material effect on competition in the relevant market in the United Kingdom. Such effect may be shown by, for example, significant movements in market share over a period of time (say, 3 years or over); price depression which cannot be explained by technical developments and is not paralleled e.g. in other markets outside the United Kingdom; evidence that particular significant major contracts have been lost to BT (e.g. in the case of a long term contract of 5 years or over, generating significant revenues).
DII.4.4 There are various ways of assessing subsidy using both economic and accountancy concepts. In general terms Oftel is primarily interested in the economic definition of subsidy, rather than the accounting definition. The relevant base economic concepts are the incremental costs of doing things or the discounted cash flow that arises from providing some goods or services. However, the information that Oftel is likely to have available to it, and the criteria by which, in practice, any subsidy can be measured, is likely to be accounting information rather than any directly available information relevant to the economic concepts. Therefore, the means by which Oftel both discovers and measures subsidy or cross-subsidy in any particular instance is likely to be through accounting type information. In order to translate this accounting type data into an evaluation of what is, or is not, a fair price will require require that the test(s) against which this accounting data will be evaluated will be a proxy for the economic test(s). The result is that Oftel will not apply some simple accounting test to determine if, in a particular instance, there is, or is not, subsidy or cross-subsidy.
DII.4.5 Generally, at a minimum, the financial performance of the BT activities in question should be such that it could be carried on by a commercial undertaking that was not BT. This suggests that the business or activity in question is sustainable, at least in the medium to long term. This translates into economic tests that the activity in question has a positive net present value and/or that it at least covers its incremental costs. What the appropriate accounting test will be will depend on the nature of the business or activities in question.
DII.4.6 Under all accounting tests there are a number of different elements:
DII.4.7 Even within these definitions, there are different ways of measuring appropriate input costs. For example, if the use of the network is an input cost this could be measured at one extreme as the marginal cost to BT of that usage, and at the other, the standard retail price of the use of the network. The economic definition of subsidy outlined above indicates that Oftel will tend to look at the input price for the use of BT provided facilities which would be faced by a non-BT enterprise operating in the same market. In terms of use of the network this is reasonably straight forward as prices for third parties are published by BT. It is not so straight forward where an activity has access to other, internal, BT resources.
DII.4.8 The approach to date has been to base the test of "unfair" subsdidy on BT's fully allocated costs and, in the absence of reliable accounting data on a different basis, it is Oftel's intention to start the analysis on this basis. However, Oftel recognises that this may not always be the appropriate basis on which the rest of the investigation should be conducted. Therefore, failure to meet a subsidy test based on FAC may not always be unfair. The fairness or otherwise of the subsidy will depend, at least in part, on any resultant anti-competitive effect.
DII.4.9 In view of the complexity of the definition of subsidy or cross-subsidy the following guidance is arranged as a series of tests. The more tests that are failed, the more likely it is that a subsidy or cross subsidy would be found and the greater would be the onus on BT to show that the activity was in some sense special and that in fact no subsidy was present and/or that even if there was a subsidy the special features of that market meant that it was not unfair.
Tests for capital intensive activities
DII.4.10 Oftel would expect BT to enter a market only on the basis that, realistically, it could earn such a satisfactory return over the life of the relevant assets. Therefore an activity that persistently failed to earn such a satisfactory rate of return on its assets would be in receipt of an unfair subsidy. For mainstream BT activities the appropriate rate of return is likely to be that of the cost of capital of BT itself, and this is at present judged to be 15% in nominal terms, although this is currently being looked at as part of the price cap review. For significantly more risky activities a higher rate of return might be appropriate (for example, the direction relating to mobile service providers used 2% per month as the appropriate test rate).
DII.4.11 In the case of a persistent failure to cover costs (including the costs of capital) a finding of unfair subsidy is likely if future recovery of such costs is dependent on:
Tests for non-capital intensive activities and activities with negative capital employed.
DII.4.12 Ideally the test would be based on discounted cash flow, taking into account the same analysis of the future as indicated above. However, in the absence of robust data the test is likely to be specified as a positive margin on sales replacing the rate of return criteria. The necessary positive rate would depend on the activity in question, and is likely to be related to the normal rate for that activity. For the supply of equipment Oftel has used a 5% test rate (Oftel Direction of 22 September 1995).
Tests for activities where income and expenditure occur over different timescales and are known in advance (e.g long term contracts)
DII.4.13 The appropriate test is likely to be an internal rate of return (a weighted average in the case of a series of contracts). The appropriate IIR rate is likely to be the cost of capital of that activity.
Acceptable subsidies
DII.4.14 However, subsidies as defined in the above tests may still be acceptable in the circumstances outlined in the following paragraphs.
DII.4.15 In the initial period following the introduction of a new service, or entering a new market, providing that such early losses would be consistent with full cost recovery over the lifetime of the service on the basis of discounted cash flow.
DII.4.6 Where markets, products and/or services are usually bundled and can not be completely unbundled and the bundled result is not, in total, being subsidised. However, the Director General will take into account whether it is normal market practice to bundle those products/services in that way, and may decide that the subsidy is unfair where the bundling has a material effect. Again, Oftel will need to be convinced that exceptional circumstances apply
Example An example of this is the current bundling of mobile phone handsets with calls. The price of handsets is kept low and they are bundled together with the calls as one package.
DII.4.17 Where markets, products and/or services are usually bundled and:
(i) the bundled result covers the fully allocated costs involved, and;
(ii) no element within the bundle is priced below long run average incremental costs; or
(iii)where the Director General is satisfied that the bundling does not have an anti-competitive effect.
DII.4.18 Where the subsidy arises in a geographical sub-market and BT is required to charge nationally averaged prices or is otherwise constrained not to price discriminate to reflect the variations in costs.
Example An example of this is the cost of services in the remote regions of the UK (such as the Highlands and Islands of Scotland). BT subsidises those services to keep them at nationally averaged prices.
DII.4.19 Where prices are uniform between customers and the variations in costs between serving different customers (as a result of geography, demand characteristics or otherwise) are small relative to the gap between long run average costs and long run incremental costs of serving individual customers.
DII.4.20 Where the apparent subsidy arises as a result of imposed changes in the accounting rules, whether by Oftel or other government body, or the Accounting Standards Board. However, such subsidy would be expected to be time limited.
DII.4.21 Where the subsidy results from the actions of the Director General in execising his proper functions, or where BT has given binding undertakings to the Director General, or is required to subsidise the activity as a result of a licence condition or as a result of compliance with any other law.
DII.4.22 Where the subsidy arose as a result of compliance with a licence condition which has now ceased, subject to the subsidy decreasing at a reasonable rate over time.
DII.4.23 Where the subsidy has no material effect on competition.
DII.4.24 The above guidance describe how Oftel is likely to deal with a question of unfair subsidy. In order for Oftel to do this it is obvious that information to underpin the analysis will need to be available from BT s accounting system. The information requirements implicit in the analysis and approach outlined above will be an integral part of the application of this Condition. Oftel would expect BT to have available to it information that would demonstrate that the tests outlined above would be satisfied in order to assure itself that it was compliant. Therefore, Oftel would also expect BT be able to meet such an information request in relation to this condition in a timely manner (within two weeks for most requests) as part of BT's compliance with its licence.
DII.5.1 Condition 24F requires BT to obtain consent from the Director General before it introduces retail prices, for a number of different call types, that are below the aggregated costs of a number of defined elements, which are costed under current arrangements at fully allocated costs (FAC) of that call type, or reduces further a retail price that is already below FAC.
DII.5.2 Nevertheless, there are some circumstances where prices below FAC would be in the long term interests of customers. These guidelines describe some of these circumstances where this is likely to be the case.
DII.5.3 However, please note that notwithstanding the above, it is unlikely that the Director General would consent to prices below long run incremental costs.
DII.5.4 How far proposed prices are below FAC will be an important factor in the evaluation of whether or not consent should be given. The further below FAC the less likely consent will be given.
DII.5.5 Where BT was unable to meet its price control obligations without one or more relevant prices being below FAC, subject to prices below FAC not being targeted in an anti-competitive way.
DII.5.6 Where there has been significant cost reduction in supplying the product as a result of technical change, and the proposed price is above the predicted fully allocated cost of using the new technology; provided that it does not have anti-competitive effects - for instance by hindering the development of new technology or by being used to exclude new entrants from the market.
DII.5.7 Where BT no longer has market power in that product market, and the market is likely to remain competitive, and BT is adequately constrained (by market characteristics or other means) from re-establishing such power. In assessing whether BT still has such market power the Director General will take those factors into account which are set out in the guidelines on competitive markets.
DII.5.8 Where BT can demonstrate that it is responding to a sustained competitive price, subject to the proviso that prices (expressed in real terms) cannot be raised subsequently.
Return to this document's table of contents