FAIR TRADING IN THE MOBILE TELEPHONY MARKET

Conclusions on future competition policy, following Consultation

April 1997

CONTENTS

Chapter 1 Purpose of the Statement

Chapter 2 Summary of conclusions and recommendations

Chapter 3 Background

Chapter 4 Responses to public consultation

Chapter 5 Recent developments in the mobile market

Chapter 6 Assessment of relative market power

Chapter 7 The future regulation of the mobile market

Chapter 8 Effect of changes to the structure of the regulatory regime

Chapter 9 Control of brand promotion

Chapter 10 Enhanced services

Chapter 11 Application of the Oftel formula

Annex A Statistics on the mobile telephony market

Annex B Assessment of market power

Annex C Main licence obligations applying to provision of fixed and mobile services

Cellular telephony in the UK is a fast developing and maturing market. Although it is only twelve years old, there are now four networks, with a total of nearly seven million subscribers. The two newest networks, Orange and One2One, now have more subscribers between them than Cellnet and Vodafone had after their first five years of operation. Rapid growth has been accompanied by innovation, with digital technology opening the door to an expanding range of services. Yet all four mobile networks are still subject to special regulation, in some cases more onerous than that applied to BT as the ubiquitous fixed network operator.

In particular, the freedom of the mobile operators to decide for themselves how best to distribute their products to the public is still constrained by a system of rules devised in 1982, before the two original successful applicants for licences were even selected and three years before they launched. The key features of this system are a mandatory obligation to provide wholesale airtime to any reseller (or ‘service provider’) who requests it, and a requirement that, in doing so, operators should not unfairly cross-subsidise or show undue preference to competing service provision businesses which they themselves may own or control.

Such constraints on an operator’s choice of distribution channel are unique among competitive industries in the private sector, selling to the mass market. In the infant mobile industry of the 1980s the rules may well have played an important part in promoting growth and competition. But the industry has changed enormously and become more competitive. This raises the question: is there any longer any justification for subjecting the players in this industry to rules and obligations not applicable to other competitive sectors of the economy? Above all, do the consumer benefits justify such regulation?

Oftel has been addressing these issues for some time, in the wake of complaints by independent mobile service providers of unfair treatment by the network operators. Monitoring arrangements designed to prevent unfair cross-subsidy of tied service provision businesses (‘TSPs’) have been in place since 1994. In May 1996 I published a Consultative Document, Fair Trading in Mobile Service Provision (‘the CD’), in which I reviewed these arrangements and made a number of proposals for modifying the regulatory regime. In this statement I am announcing my decisions, in the light of the consultative process.

Arriving at these decisions has not been easy. Given a fully competitive market there would be strong economic arguments for freeing the operators not only from their obligations to service providers, but also from licensing constraints relating to pricing, access and cross-subsidy. Competition should ensure a good deal for the consumer, without the need for special rules governing service provision. A market with four players has the potential to function competitively, both at the wholesale and retail level. However, several factors suggest that competition between the mobile telephony networks, though active, is not yet fully effective. It is not clear that prices are cost-oriented, and two of the operators are making persistently high profits. There is no number portability in the mobile market, and a tendency for the terms of consumer contracts to be weighted in favour of the networks and their service providers.

In particular, all four mobile operators remain for the time being protected by an absolute barrier to further market entry – a circumstance not applying to other areas of telephony. This barrier stems from shortage of radio spectrum, and a consequent decision by Government not to award any more mobile licences prior to a competition for third generation mobile systems. Such systems will not be launched until well after the turn of the century. A ring-fenced market of this kind affords considerable opportunity for abnormally high profits (and, indeed, even the temptation to engage in collusive behaviour to restrict competition, whether by formal agreement or not).

Against that background there is a natural inclination to tinker with the detail of the regulatory system, while leaving its main thrust untouched. On balance I believe that the rapid evolution of the mobile market demands a bolder approach. In addition, given the trend towards convergence of the fixed and mobile markets, it is also desirable to bring the rules more closely into line with those applying to fixed network operators, except where the differences between the fixed and mobile markets dictate otherwise.

I have therefore decided to initiate action immediately to remove from the licences of mobile operators without market power (which, at present, Oftel considers to be Orange and One2One) the specific obligation to provide mobile services to service providers for resale. They will retain an obligation to complete the geographical roll-out of their networks by the end of 1999 (as required under current rules), and to enable the provision of mobile services in the specified areas. Other changes (including licence modifications where necessary) will also ensure that these operators will, for so long as they are without market power, be largely freed from constraints with regard to unduly discriminatory pricing, undue preference, and unfair cross-subsidy, and from the requirement for accounting separation. Given the unusual structure of the mobile market, rules on these matters will remain in the licences, but they will only come into play if Oftel determines that an operator is ‘well-established’, ie has market power. I shall be vigilant for any signs of anti-competitive behaviour, and take action against it if it appears.

Vodafone and Cellnet still, in my view, possess market power, and should therefore remain for the time being subject to the present rules and obligations with respect to mobile service provision. This includes the maintenance, with some adjustments, of the current arrangements under which tied service provision businesses submit quarterly returns to demonstrate compliance with the financial criteria I specified in 1994. I intend, however, to keep a watch on the mobile market and will review these arrangements in the light of market developments, though I do not expect this review to be necessary before 1998. If the review establishes that competition is fully effective I will let these monitoring arrangements lapse, and the Cellnet and Vodafone licences will also be modified to substitute for the present rules the regime described above for mobile operators without market power.

Defining whether an operator has market power (or, equivalently, is well-established) is not a straightforward matter, and Section 6 and Annex B of this Statement contain a detailed discussion of the criteria and methodology which Oftel has applied, and the considerations to be taken into account, in deciding whether and when competition has become fully effective. In view of the importance of the market power issue, I shall be monitoring developments in the industry closely over the next two years. Before the controls on Vodafone and Cellnet are relaxed I shall expect to see clear signs that the mobile market is free from conduct which restricts or distorts competition. This will include an openness on the part of these operators to the provision of competing services over their networks, an acceptance of number portability, a willingness to interconnect with other operators and to do so on reasonable terms, keen competition in consumer pricing, a closer relationship between tariffs and costs, and an open and fair commercial relationship with fixed network operators requiring mobile services to package with their own products.

It is my intention to modify all PTO (including the mobile) licences, and most other licences, to include the Fair Trading Condition (‘FTC’) which has already been introduced into BT’s and certain other licences, and Oftel has recently published a consultative document on this matter. This condition will prohibit behaviour which has the effect of preventing, restricting or distorting competition in relation to any commercial activity connected with telecommunications, where either a licensee abuses a dominant position in a relevant market, or makes a restrictive agreement or carries on a concerted practice with such effect. In addition, if any of the four operators, after their licences had been modified, appeared to be party to anti-competitive practices falling within the FTC, this could be grounds to determine that they were well-established, so triggering the dormant controls in their licences referred to above.

The licence modifications referred to above will be published and announced in the press. There will be a period of public consultation on them of at least 28 days, with the opportunity to make representations. The text will be available direct from Oftel and via the Internet.

DON CRUICKSHANK

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CHAPTER 1

Purpose of the Statement

1.1 In May 1996 the Director General published a Consultative Document, Fair Trading in Mobile Service Provision (‘the CD’), about, primarily, the future of the regulatory regime governing the activities of businesses engaged in the retailing of airtime on the mobile telephone networks, and of businesses providing value added or ‘enhanced’ services on those networks. The purpose of this Statement is to set out the conclusions which the Director General has reached, in the light of responses to the CD and recent developments in the mobile market, and his proposals for fair trading in the mobile market.

1.2 The CD complemented two other Consultative Documents published by Oftel in February and June last year (both with the title Promoting Competition in Services over Telecommunication Networks). It also now needs to be considered in relation to a further statement (with the same title) published in February 1997. The last three documents dealt solely with service provision on fixed telecommunication networks, while the CD and present Document are concerned exclusively with mobile service provision. The definition of ‘service provider’ used in the CD and the present document is also slightly different from the definition used in Promoting Competition in Services over Telecommunications Networks. In this document and the CD it refers both to businesses reselling mobile airtime and to businesses providing enhanced services on the mobile networks, and covers service provision on the analogue and digital mobile networks run by Telecom Securicor Cellular Services Ltd (‘Cellnet’), Vodafone Ltd, Orange Personal Communications Services Ltd (‘Orange’), and Mercury Personal Communications Ltd (‘MPCL’, trading as ‘One2One’). (Unless indicated otherwise, references in this statement to ‘Vodafone’ are to Vodafone Ltd, rather than the Vodafone Group.)

1.3 The term ‘mobile networks’ is used in this Statement as a convenient shorthand for the four operators just listed. It must, however, be borne in mind that these operators are now licensed to provide fixed as well as mobile services.

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CHAPTER 2

Summary of conclusions and recommendations

2.1 In considering how the mobile market should be regulated in the future, the Director General is concerned to withdraw from detailed control of how mobile services are distributed to the public, as soon as the development of competition allows, relying instead on general provisions for the control of anti-competitive behaviour and abuse of market power. In deciding how to put this objective into effect, he has had regard to:

2.2 The responses to the CD and recent trends in the mobile market confirm the Director General in his view, expressed in the CD, that competition in the mobile telephony market is now flourishing, but that there is still some way to go before it is fully effective. (Issues concerning market definition and market power are discussed in Section 6 and Annex B.) The Director General’s conclusion is that while neither Cellnet nor Vodafone is necessarily dominant, each does continue to possess market power. The most recent entrants, Orange and MPCL, while able to influence to some extent the marketing decisions and pricing strategies of Vodafone and Cellnet, do not possess market power.

2.3 The main respect in which the proposals in the present Statement differ from those in the CD concerns the rules to be applied to mobile operators without market power. In the Director General’s view the CD proposals applying to such operators (at the present time considered to be Orange and MPCL) need reconsideration in one important respect. It was proposed in the CD that in the case of such operators, while their licences should continue to contain controls against unfair cross-subsidy, any cross-subsidy of related businesses such as tied service provision should not be regarded as unfair for as long as they remained without market power. These operators should, however, continue for the time being to be bound by their other existing licence obligations with respect to service providers, including the obligation to provide airtime to service providers for resale and to avoid undue preference to a tied service provision business.

2.4 The Director General has now concluded that for mobile operators without market power it is inappropriate to continue to require that they sell through service providers in all circumstances, as opposed to allowing them commercial choice in their product distribution. Mandatory requirements to distribute their output in a particular way are inappropriate for operators without market power, and are not imposed on producers in other sectors of the economy. He has also reviewed the obligations applying to mobile operators without market power in the light of the current licence obligations applying to provision of fixed services by network operators without market power. He therefore proposes as soon as practicable, rather than in several years’ time as signalled previously, to introduce modifications to their licences which, with respect to mobile services, will put them on a footing as close as possible to fixed network operators without market power, and leave them free to decide for themselves on their best distribution channels. (The provisions in the mobile licences relating to the running of fixed systems already broadly match those in the standard fixed-service PTO licence.) On certain points the changes can be made within the framework of existing licence conditions, rather than by licence modifications – see below. Table C contains a comparison of the main relevant licence obligations which will apply, once the necessary licence modifications have been made, to provision of both fixed and mobile services, by PTOs with and without market power.

2.5 As soon as possible the Director General will initiate the necessary licence modifications and other changes in the case of Orange and MPCL. These modifications will be published in due course for public consultation, under the normal procedures which include a minimum 28-day consultation period. They will involve, amongst other things:

(a) removing the obligation to provide mobile services to service providers for resale, leaving a simple obligation to install and run systems in such a way as to enable the provision of Mobile Radio Telecommuni-cation Services (‘MRTS’) in areas where 90% of the UK population live. This obligation is stricter than applies to fixed network operators without market power (which have no roll-out obligations regarding provision of voice telephony), and is a consequence of Government policy that networks to which scarce radio spectrum has been allocated must accept a roll-out obligation, in order to ensure that this spectrum is fully and efficiently used for the benefit of the public. A specific obligation to provide mobile services will only come into play, as with fixed services, if the Director General has determined that an operator is ‘well-established’ (ie has market power) and has made a Direction to do so.

(b) the obligation to publish charges, terms and conditions, and the prohibition of undue preference and undue discrimination, will be retained in the licences. However, the publication condition will only apply to services which the licensee is obliged to provide. This means that with respect to provision of airtime it will only apply where the Director General has concluded that the operator in question is ‘well-established’ and has made a Direction, as above (consistent with the policy in enforcing other licences). The prohibition of undue preference and undue discrimination will be enforced on the basis that preference or discrimination will not normally be considered to be undue where the operator is not ‘well-established’.

(c) the unfair cross-subsidy condition and the requirement for accounting separation will be retained in the licences. However, cross-subsidy will not normally be considered to be unfair where the licensee is not well-established, and the licence requirement for accounting separation will be modified so that it only applies if the licensee is well-established. (For full details see paragraph 7.2.1.)

2.6 The Director General has decided that it is appropriate to confirm the proposals in the CD which apply to mobile operators with market power (at the present time Cellnet and Vodafone):

(a) these operators will for the time being remain subject to all their present licence conditions concerning service provision, including the obligation to provide mobile services to service providers, and the existing rules relating to undue preference, publication of wholesale charges, terms and conditions, unfair cross-subsidy and accounting separation. (see paragraph 7.3.1).

(b) their tied service provision businesses will also, for the time being, be asked to continue to make quarterly returns to the Director General demonstrating compliance with certain financial criteria, designed to monitor cross-subsidy and known as ‘the Oftel formula’, though these criteria will be amended in certain respects (see section 11).

(c) The Director General will keep a watch on the mobile market and will review these arrangements in the light of market developments, though he does not expect this review to be necessary before 1998. If the review establishes that competition is fully effective (and he will look to the operators concerned to demonstrate this) he will let these monitoring arrangements lapse, and licence modifications will be introduced which will free Cellnet and Vodafone from these obligations and place them under the same licensing regime with regard to service provision as it is proposed should by then apply to Orange and MPCL (see paragraph 7.3.1). Paragraphs 7.3.2 and 7.3.4 set out the criteria the Director General will have in mind in deciding whether the market has become sufficiently competitive to allow him proceed in this way.

2.7 Following consultation, it is Oftel’s intention that the Fair Trading Condition will be incorporated into all PTO licences, including the four mobile licences, as well as almost all other licences. (see paragraph 7.1.1.)

2.8 The issue of whether measures by operators to increase their control over how their brands are promoted are in conflict with licence obligations has also been raised in the responses to the CD. Oftel believes that in a competitive market it is appropriate that network operators should have the freedom to control and direct the promotion of their brand, as players in other markets are free to do. Therefore, Oftel will not regard inclusion of contractual provisions in the operators’ contracts with service providers which require adherence to strategies designed to promote the operator’s brand as in conflict with licence obligations.

2.9 However, where operators remain subject to an obligation to provide airtime wholesale to service providers for resale (as Cellnet and Vodafone will do, for the time being), outright refusal by such operators to allow service providers to resell airtime under the network brand name would, in Oftel’s view, conflict with this obligation. Accordingly such operators will not be permitted to refuse to do so, so long as the obligation continues in force. Mobile operators without market power (ie Orange and MPCL) will have no specific obligation to provide services to service providers once the relevant modifications to their licences have come into effect. They will be free from that time to attach what terms and conditions they choose to any contracts with service providers (including restrictions on use of the brand name), subject to the general constraints of competition and other legislation.

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CHAPTER 3

Background

3.1 In the CD the Director General noted that the new mobile operators, Orange and MPCL, were still some way from achieving the levels of market power possessed by the two operators first to be licensed, Cellnet and Vodafone, which continued to command positions of market power in the provision of mobile telephony services. Nonetheless, competition between the four operators was now relatively strong and increasing, so that dismantling the special rules regulating mobile service provision seemed to be a real prospect for the relatively near future. Against that background the Director General concluded that for the time being the existing regulatory framework under which mobile service provision was conducted should continue to apply, subject to certain modifications summarised below. However, it would be appropriate to keep it under review, with the general objective of progressively withdrawing, as soon as the development of competition allowed, from detailed control of how mobile services were distributed to the public, and relying instead on general provisions for the control of anti-competitive behaviour and abuse of market power.

3.2 The CD considered possible motives for the cross-subsidisation of TSPs. Five possible explanations for such cross-subsidies were identified. These were that the cross-subsidies:

(i) reflected start-up losses, while the operators established themselves in the market;

(ii) were simply the result of error;

(iii) represented an attempt to establish a position of market power in service provision, despite the fact that entry barriers into service provision appeared to be low;

(iv) represented an attempt to weaken competing network operators, particularly new entrants;

(v) were intended to facilitate the acquisition of independent service providers at reduced prices.

3.3 It was noted that the third to fifth explanations could only be relevant to operators with market power at the network level, whilst in no cases could an operator without market power gain advantage by cross-subsidising retail sales. Therefore it was proposed to confine the requirement to comply with the Oftel formula to TSPs linked to operators with market power.

3.4 In detail the Director General proposed that:

(a) subject to the regime being kept under review as mentioned above, all four mobile network operators should continue for the time being to be bound by obligations to provide wholesale airtime to service providers on request, and to do so on a basis which avoided any undue preference to their tied service provision businesses, if they had them (eg in terms of charges, terms and conditions, access to network features, etc). (Tied service provision businesses (‘TSPs’) are mobile airtime retailing businesses owned either by the mobile network operators or their parent Groups, or in which they have significant shareholdings.) These obligations would continue to be accompanied by an obligation to publish the charges, terms and conditions on which the Licensee provided mobile services to service providers (ie its wholesale prices, etc), and not depart from such published charges, terms and conditions, and a requirement for accounting separation;

(b) a prohibition of unfair cross-subsidy to TSPs should continue to apply to operators with market power (deemed at the present time to be Vodafone and Cellnet), but not to other operators (ie Orange and MPCL) until such time as they might acquire market power.

3.5 This regime was envisaged as applying to both airtime reselling and to the provision of enhanced services. The CD also proposed that TSPs should for the time being continue to comply with certain financial criteria (‘the Oftel formula’) and monitoring arrangements introduced in 1994 to eliminate unfair cross-subsidies. However, it suggested that a number of modifications might appropriately be made to these financial criteria, and that all the operators could now be allowed greater flexibility in deciding how their products are brought to the market.

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CHAPTER 4

Responses to public consultation

4.1 In reaching conclusions on whether the CD proposals should be implemented as they stand or in some other form, the Director General has taken into account both the responses to the CD, and of the further developments in the mobile telephony market which have occurred since it was published.

4.2 Responses to the CD were received from, respectively, BT, the four mobile network operators, six service providers (some of which made a single collective response), Scottish Telecom, and the TMA.

4.3 Cellnet (supported by BT) and Vodafone argued strongly that they no longer possessed market power because (for example) they could not price their products independently, and because they were achieving shares of new connections no greater than those of the newer networks. They pointed to large resources behind MPCL and Orange and the heavy spending by those operators on advertising and promotion. They also, for the same reason, argued that it was not correct to view mobile telephony as a single market, but that the digital market should be treated as a separate market in its own right. (On this basis Orange and MPCL obviously have much larger market shares than they do of the total mobile market.) In their view, a regime favouring MPCL and Orange would unfairly accelerate the progress of these networks towards market equality, and this would be a distortion.

4.4 To rectify this perceived imbalance Cellnet and BT preferred that the established operators should be released from the existing controls relating to service provision (including the obligation to supply to service providers). Vodafone’s preference was that all the controls (including the prohibition on unfair cross-subsidy) should continue to apply and be enforced equally on all four operators. However, if they were not to be applied to Orange and MPCL, they should not be applied to Cellnet or Vodafone either.

4.5 MPCL and Orange supported the wider definition of the mobile market and argued from it that they were non-dominant while Cellnet and Vodafone remained dominant. They therefore sought a regime reflecting this imbalance.

4.6 Independent service providers argued that network operation would never become fully competitive unless new licences were granted, and that both Orange and MPCL, as well as the older operators, had market power. They believed that all four operators should be subject to the full range of controls on unfair cross-subsidy, undue preference, etc.

4.7 In view of the polarisation of views among the respondents it is difficult to conclude that there is a consensus supporting a shift towards either more or less relaxation of the regulatory regime than was proposed in the CD. What can fairly be said is that they highlight the importance of competition between the networks. If and when fully effective competition is achieved, it would be reasonable to rely on this to produce the keenest possible retail prices and the best possible levels of service to users. It would therefore be appropriate to withdraw from detailed regulation of the basis on which they select their distributors and contract with them to resell their services, even at the price of some loss of diversity in the range of retail airtime propositions on offer. But, until effective competition can be relied on to deliver the best deal for the customer, it would be unwise to dismantle entirely the provisions governing the access of independent service providers to wholesale airtime.

4.8 Judging whether and when fully effective competition has been, or is likely to be, reached is thus a key issue in deciding what changes should be made to the regime. Oftel has therefore considered not only the responses to the CD but also further market developments since it was published.

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CHAPTER 5

Recent developments in the mobile market

5.1 At the beginning of January 1997 a total of 6.8 million mobiles were connected to all four networks. 3.4 million of these, or 50.4% of the total, were connected to one of the four digital networks, compared with 1.4 million (38.7% of the total) at the beginning of the year. Table 1 of Annex A shows the size of the market and the market shares of the four mobile operators at quarterly intervals over the last year, and Table 2 their respective quarterly net connections. Table 3 shows market growth over the last five years. (Data source: Financial Times Mobile Communications Newsletter).

5.2 In the months following publication of the CD in May the overall growth rate of the mobile market continued to slow down, though it picked up somewhat during the last quarter of 1996. Reductions in tariffs for digital airtime by Vodafone and Cellnet, coupled with their introduction of per second billing for new digital customers, have helped these operators to arrest their overall loss of market share. Indeed, their share (particularly Vodafone’s) of total connections to the four digital networks has increased, though this may be due in part to the availability of financial incentives from the networks to encourage their customers to migrate from the analogue to the digital networks.

5.3 The networks have continued to compete strongly through handset subsidies and promotions of various kinds. An important result has been the progressive shaving of digital handset prices, so that a typical street price for many models is now £9.99, comparable to the cheaper analogue phones. However, outright price competition in airtime services has been less strong than might appear at first sight, perhaps because of a desire to maintain airtime revenue in order to recover rising handset subsidies. The true effect of price changes is hard to judge because of the proliferation of tariff options and the fact that the benefits to the customer depend critically on his or her usage patterns.

5.4 Orange has not changed its retail tariffs since they were introduced in April 1994, and has always offered per second billing and cheaper messaging services than Cellnet and Vodafone. Overall its tariffs remain below those of the established networks, though by less of a margin than formerly. MPCL has repackaged its retail tariffs several times since it launched, introducing in the process several reductions but also several increases (including the restriction to weekends of its initial offering of free off-peak local calls). MPCL switched to per second billing in September 1995 and now offers free messaging. Its tariffs overall also remain below those of the established networks and are in some cases lower than those of Orange.

5.5 Vodafone and Cellnet have introduced a variety of new tariff options and made several cuts in recommended retail charges over the last four years (normally reflected in their wholesale tariffs). The most notable of these changes have been:

5.6 Thus, while the new tariff options can clearly be beneficial given appropriate usage, the only really significant outright price reductions by Cellnet and Vodafone in recent years seem to have been those of Autumn 1993 and April 1996. The networks’ recommended retail tariffs are closely followed by almost all service providers. The only two service providers (Cellcom and Peoples Phone) whose tariffs diverge significantly vary them by repackaging rather than by cutting charges.

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CHAPTER 6

Assessment of relative market power

6.1 The present position

6.1.1 Trends in recommended retail prices, and market shares, are not the only determinants of market power. However, the evidence overall is that competition, while in sight, is not yet fully effective in the mobile market. Oftel continues to hold the view that the relevant market is the total market for mobile telephony services, both analogue and digital. (This is because, as discussed in Section 3 of the CD, consumers are primarily interested in buying mobile services, rather than technologies, and regard analogue and digital services, despite the enhanced facilities available on the latter, as effective substitutes.) At their present relatively low shares of the total mobile market Orange and MPCL, while their marketing decisions and pricing strategies certainly influence those of the established operators, cannot yet be said to possess market power.

6.1.2 Cellnet and Vodafone have argued they no longer possess market power, and in Annex B Oftel assesses this claim, using a method which is set out at the beginning of that Annex. In particular it considers the positions of Cellnet and Vodafone in terms of the summary indicators in paragraph 15 of Annex B. The conclusion reached is that while neither Cellnet nor Vodafone is necessarily dominant, each does continue to possess market power. The reasons for this view, which are discussed in full in Annex B, may be summarised as follows:

(i) the high shares – around 40% each – of the mobile market currently accounted for by Cellnet and Vodafone;

(ii) the effective entry barrier resulting from the decision by the Government not to award any more mobile licences before the competition for third generation systems to come into operation after the turn of the century;

(iii) the first-mover advantages enjoyed by Cellnet and Vodafone as a result of having already rolled-out their networks;

(iv) the expense to a consumer of switching between networks, including the absence of number portability, which makes it more difficult to persuade customers to change networks;

(v) the slow rate of decline in the overall market shares of Cellnet and Vodafone, and their increasing market shares in the digital segment;

(vi) the ability of Cellnet and Vodafone to maintain a price premium without large losses of market share;

(vii) the contrast between the financial performances of Cellnet and Vodafone and those of Orange and MPCL.

6.2 Future development of the mobile market

6.2.1 Contention for market share is already strong and the relative positions of the four networks in a year or two from now may well look different. Important influences on the further development of competition will be the impact of MPCL, following its recent ‘relaunch’ and decision to achieve full national coverage by the end of 1997, and the outcome of a number of matters currently with Oftel concerning interconnection arrangements.

6.2.2 Also significant in determining the effectiveness of competition will be the rate of progress towards the achievement of mobile number portability. Number portability is a facility whereby customers are able to retain their phone numbers when changing from one operator or service provider to another. While some of the benefits of number portability can be obtained through the various personal numbering services now on offer, not everyone wanting to change his/her mobile network necessarily wants the features, or the charging arrangements, associated with a personal numbering service. Therefore these services do not directly meet the needs of people who simply want to retain their mobile number while changing network or service provider.

6.2.3 Oftel is committed to the introduction of number portability for all services. Changing number can be a major inconvenience for customers and a barrier which prevents them from exercising choice and taking advantage of competition in the telecoms market. Number portability is currently being introduced for geographic (01) numbers and will be extended to freephone and other specially tariffed services later this year. In August 1996 Oftel published a consultative document on the National Numbering Scheme, which invited comments on whether and when to introduce mobile number portability. The responses to this consultation showed strong support from business and user groups for the early introduction of mobile number portability.

6.2.4 Oftel considers that the achievement of full competition in the mobile market will remain inhibited until consumers have the ability to retain their mobile numbers when they change operators. Work on mobile number portability is already underway. A joint industry/Oftel working group has been examining the technical options. This has not found any fundamental technical barriers to the introduction of mobile portability and has identified a number of possible methods of implementation. Another working group has been established to examine commercial and process issues in co-operation with representatives of the mobile service providers. A number of these questions have already been resolved in the context of geographic and freephone number portability, and it should be possible to translate some of the solutions to mobile portability.

6.2.5 Once an appropriate method of implementation has been identified, Oftel will expect operators to undertake the necessary system developments as quickly as possible. Oftel considers that modifications to mobile operators’ licences will be required in order to ensure the efficient and effective introduction of portability. It will publish proposals for appropriate modifications to mobile operators’ licences in May 1997. These will include a requirement to provide portability on a reciprocal basis to any other mobile operator, set a timetable for the introduction of portability, and establish charging principles. A modification will also be proposed to address the issue of portability between service providers, as well as between network operators.

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CHAPTER 7

The future regulation of the mobile market

7.0.1 The factors just discussed will affect the rate of progress towards effective competition, but, for the reasons set out in the CD and summarised in paragraph 3.2, Oftel believes that the conclusions and recommendations of the CD regarding the framework, content and structure of the regulatory controls remain appropriate with respect to mobile operators with market power, while they remain in that position. However, telecommunications operators without market power should as a general principle be subject to the minimum of regulation, and it is also desirable that regulation of the mobile market should be as consistent as possible with regulation of the fixed services market. Against this background there is a case for moving more quickly than was envisaged in the CD towards giving mobile operators without market power the same degree of freedom from regulation as fixed network operators without market power. The Director General has therefore reached the following conclusions. (Note: These conclusions all relate to the requirements of the mobile licences which concern the provision of MRTS, as defined, not to the rather different requirements which these licences also now contain concerning the provision of fixed services. This document does not propose any changes to the latter provisions, though they may be subject to changes in consequence of policies announced in other Oftel statements or consultative documents.)

7.1 Fair Trading Condition

7.1.1 As has already been proposed in the Oftel Consultative Documents Fair Trading in Telecommunications (December 1995) and Pricing of Telecommunications Services from 1997 (June 1996), it is Oftel’s intention to introduce into other licences, including the mobile licences, the Fair Trading Condition which has already been introduced into BT’s and certain other licences. Oftel has recently published a consultative document, Fair Trading Condition: Incorporation into Existing Telecommunications Licences, proposing that the FTC should be introduced into over 300 current licences (including all PTOs), by means of a single ‘mass modification’ to take place in the summer of 1997. This condition will prohibit behaviour which has the object or effect of preventing, restricting or distorting competition in relation to any commercial activity connected with telecommunications, where either a licensee abuses a dominant position in a relevant market, or makes a restrictive agreement or carries on a concerted practice with such effect.

7.2 Modifications to licences of Orange and MPCL

7.2.1 As soon as possible, the Director General will initiate the following amendments to the licences of Orange and MPCL. (As noted above, these modifications will be published for statutory consultation under normal procedures (which include a consultation period of at least 28 days), and are likely to come into effect approximately six months following publication of this statement.) At the same time the conditions on undue preference and unfair cross-subsidy will be applied, with respect to mobile services, as set out below:

(a) the obligation on the licensee to provide wholesale airtime for resale to any service provider requesting it will be abolished. Instead there will be a simple obligation to install and run systems in such a way as to enable provision of MRTS in an area where 90% of the UK population live. For both operators the obligation to install and run systems so as to enable provision of MRTS will apply immediately, but, as under the existing licence, the 90% coverage obligation will not apply until the end of 1999. These obligations are stricter than those applying to fixed service PTOs, which only become subject to roll-out obligations where the Director General has concluded that they have become ‘well-established’ and has directed them to provide services. However, it is Government policy that networks to which scarce radio spectrum has been allocated must accept a roll-out obligation, in order to ensure that this spectrum is fully and efficiently used for the benefit of the public;

(b) A specific obligation to provide MRTS will only come into play, as with fixed services, where the Director General has concluded that an operator is well-established (ie has market power) and has made a Direction to do so. A licensee will not normally be considered to be well-established and be directed to provide services unless it has 25% or more of the relevant market. However, the Director General will have power, where circumstances warrant it, to determine that a licensee with less than 25% of the market is well-established; this is particularly important having regard to the fact that in an industry where further market entry is for the time being precluded by the non-availability of new mobile licences an operator with less than a 25% market share may have market power;

(c) the Orange and MPCL licences will continue to contain conditions prohibiting undue preference and undue discrimination, and requiring publication of charges and other terms and conditions. applicable to provision of such services. However, with respect to provision of MRTS these conditions will be applied in the following way (which corresponds to the manner in which they are applied to provision of fixed services):

• preference or discrimination on the part of the licensee as regards the provision of mobile services or the connection of mobile phones to its systems will not normally be treated as ‘undue’ where the licensee in question is not well-established, except in those cases where the discrimination has the effect in practice of nullifying the obligation to provide services;

• only if the Director General has determined that a licensee is well-established will it be required to publish its charges and other terms and conditions relating to the provision of MRTS (ie airtime).

(d) the unfair cross-subsidy condition and the requirement for accounting separation will be retained in the licences. However, cross-subsidy will not normally be considered to be unfair where the licensee is not well-established, and the licence requirement for accounting separation will be modified so that it only applies if the licensee is well-established (ie has market power).

(e) provision of MRTS will remain subject to existing licence requirements regarding provision of services by others over the licensee’s network, interconnection, connection of other systems and apparatus, codes of practice on consumer affairs and customer confidentiality, and agreed procedures for network alterations which make it necessary for customers to change or modify their handsets.

7.3 Modification to the licences of Cellnet and Vodafone

7.3.1 For so long as Vodafone and Cellnet continue to possess market power, their licences will remain unmodified with respect to the provision of mobile services. They will therefore continue to contain:

(a) an obligation on the licensee to provide wholesale airtime for resale to any service provider requesting it, subject only to a right to refuse to do so where there is reasonable cause to doubt the ability of the service provider to provide services to others “in a proper and efficient manner” or to finance the provision of those services, or where the service provider is unwilling to sign a standard contract. (In Cellnet’s licence the relevant provisions are in Conditions 1.1, 37, and 41.5. Vodafone’s licence has analogous provisions.)

(b) an obligation to connect the customers of service providers to its network and not discontinue connections lawfully made (cf Cellnet licence c.6.1);

(c) an obligation to publish charges and other conditions (in effect wholesale charges, etc) and not to depart from the published terms (cf Cellnet licence c.8);

(d) an outright prohibition of undue preference and undue discrimination in relation to the provision of MRTS or the connection of mobile apparatus. This will continue to be accompanied by a provision deeming such preference or discrimination to arise if the licensee unfairly favours to a material extent a business carried on by it so as to place others at a significant competitive disadvantage (cf Cellnet licence c.9);

(e) a power for the Director General to require action to remedy unfair cross-subsidies provided by a Licensee’s Systems Business to other businesses it may run, including airtime retailing businesses and the provision of enhanced services (cf Cellnet licence, c.40);

(f) a requirement for accounting separation of the following Businesses of a Licensee:

• Apparatus Supply Business
• Apparatus Production Business
• Direct Business (ie retailing direct to the end-user)
• Systems Business
• Supplemental Services Business
• Any other distinct commercial business connected with telecommunications

7.3.2 The Director General will keep a watch on the mobile market and will review these arrangements in the light of market developments, though he does not expect this review to be necessary before 1998. If the review establishes that competition is effective (and he will look to the operators concerned to demonstrate this) he will let these monitoring arrangements lapse, and licence modifications will be introduced which will relax these obligations (in particular by removing the obligation to provide services to service providers for resale), and place Vodafone and Cellnet under the same licensing requirements with regard to mobile service provision as it is proposed should by then apply to Orange and MPCL (see paragraph 7.2.1 above). The Director will expect to see clear indications of active competition and no evidence of anti-competitive practices. Such signs would include an openness on the part of these operators to provision of competing enhanced services over their networks, an acceptance of number portability, a willingness to interconnect with other operators and to do so on reasonable terms, keen competition in consumer pricing, a closer relationship between tariffs and costs, and an open and fair commercial relationship with fixed network operators requiring mobile services to package with their own products.

7.3.3 So long as Cellnet and Vodafone are still deemed to have market power they should continue to be subject to controls on cross-subsidy of tied service provision businesses by means of the Oftel formula for TSPs, though there is a case for modifying particular parameters of the formula. Proposed changes to the formula are discussed below in Section 11 of this statement.

7.3.4 In judging whether and when competition has become fully effective, the Director General will have regard, among other factors, to:

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CHAPTER 8

Effect of changes to the structure of the regulatory regime

8.1 The regime proposed (for Orange and MPCL when licence modifications come into effect in approximately six months’ time, and for Cellnet and Vodafone somewhat later, dependent on the outcome of an effective competition review by the Director General – see above) will significantly increase the freedom of the mobile networks to decide how they distribute their products to the market. Although geographical coverage obligations will remain there will no longer be a specific obligation to provide services to service providers. Market processes will determine when and where independent service providers can add value, and the extent to which they are used. Competition, if it is fully effective, should ensure the lowest possible retail prices and a sufficient variety of tariff packages to meet all reasonable needs.

8.2 It is perhaps not surprising that the role of a particular form of market intermediation – independent service provision – devised in 1982 to promote competition in an infant industry not yet launched and restricted to two players (one being controlled by the fixed-line monopoly), should come under strain in a more mature market of four players where competition is strong and increasing. Over time the role of service providers has changed, with the growing importance of high street retail chains in arranging airtime contracts, and the introduction of freedom for networks to sell airtime direct to the public. Despite the pressures on them, independent mobile service providers play a useful part in the market, and Oftel expects them to continue to do so in the future, through their ability to identify particular market needs and offer retail products tailored to them. That is why Oftel regards it as important to signal ahead what its response to these market developments is going to be.

8.3 The proposals may lead to some change in market structure. However, all four mobile operators will be subject to the Fair Trading Condition. In addition, if any of them, after their licences had been modified, appeared to be party to anti-competitive practices, this could be grounds to determine that they were well-established, so triggering the dormant controls in their licences referred to above. Oftel will be especially vigilant to ensure that any anti-competitive practices are quickly identified and the appropriate action taken.

8.4 The proposals will also bring the licensing regime applying to provision of mobile services more closely into line with the regime applying to provision of fixed services. The differences which remain, such as the roll-out obligation, are mainly attributable to the special circumstances of the mobile market, in particular the constraints on entry to the mobile market and the fact that the operation of a mobile network is dependent on use of scarce radio spectrum. Annex C compares in tabular form the relevant provisions of the licences of fixed and mobile operators, both with and without market power, as they will apply after the licences of mobile operators without market power have been modified.

8.5 The main respects in which the licensing regime for provision of fixed services will differ from the regime for mobile services are as follows. For fixed services, in contrast to the post-modification regime for mobile services described in paragraph 7.2.1, operators with market power (ie BT, and Kingston (in Hull)) are obliged to provide telecommunication services to any person in their respective licensed areas, except to the extent that the Director General is satisfied that reasonable demand can be met by other means, whilst operators without market power (eg MFS, Energis and Racal) are subject to no service obligation unless and until the Director General considers they are well established and requires them to provide particular services on reasonable demand. Fixed operators without market power have no licence obligations requiring them to keep separate regulatory accounts or prohibiting cross-subsidy; they would only be required to publish charges and abide by them if they were well established; and they are not required to publish consumer codes of practice, although some have chosen to produce their own codes.

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CHAPTER 9

Control of brand promotion

9.1 The CD argued that there was a case for enabling the network operators to exercise greater control over how their products are presented in the marketplace. To facilitate this, it was proposed that the inclusion of contractual provisions in an operator’s contracts with service providers which required adherence to strategies (including pricing strategies) designed to promote the operator’s brand should not be regarded as in conflict with the obligation to provide services.

9.2 Not unexpectedly, this proposal was generally supported by network operators, though opposed by some service providers. However, Orange and MPCL submitted that the scope for new operators to protect their brands should go further than this. They argued that they have invested heavily in complete and integrated retail propositions, comprising not only availability of their service from them direct, but also other features such as the brand identity, per second billing, 14-day trial periods, particular airtime contract terms, bundled insurance, 24-hour customer support, and so forth. A key aspect of their marketing is that the brand signals a direct relationship with the customer, and that this relationship is diluted, and customers confused, if their branded airtime can be obtained from other suppliers.

9.3 These operators have therefore proposed that they should not be obliged to offer branded airtime to service providers at all. They are willing to offer them unbranded airtime on their networks, to be re-packaged under whatever label they wish, and free of many of the contractual restrictions contained in the contracts they have offered to service providers up to now.

9.4 Oftel believes that for an operator without market power this is a reasonable and defensible commercial strategy. In the case of Orange and MPCL the proposals in the present Statement, once they have come into force, will make it possible for them to pursue such a policy, since these operators will no longer be under an obligation to provide services to service providers (other than in consequence of existing contracts) and, where they do, will be free to attach what terms and conditions they choose, within the normal constraints of competition and other legislation. (However, until the relevant licence modifications have come into effect they will remain under the same obligations as operators with market power – see paragraph 9.6 below.)

9.5 On the other hand, a policy of denying service providers use of and access to the network brand name would raise different considerations, if implemented by an operator which in consequence of possessing market power continues to be subject to the obligation to provide services to service providers for resale. It would result in a degree of preference being shown to the TSPs or DSBs of these operators, which would continue to have access to the brand name while independent service providers did not. This would put competing service providers at a significant competitive disadvantage, and as a result many might conclude it was not worth while to apply to become, or continue to act as, service providers of the network in question. Thus denying service providers use of the network service marks would be tantamount in effect to refusing to meet the obligation to supply service providers, and hence contravene the relevant licence condition.

9.6 Vodafone and Cellnet are judged at present to have market power, and it is intended that for the time being the licences of both operators should continue to contain an obligation to provide mobile services to service providers on request which is absolute: the network operators may only refuse to do so on specified grounds, such as reasonable doubt about a service provider’s ability to provide a proper and efficient service or to finance resale services. For so long as the obligation remains in force, denying service providers use of the network brand name would effectively contravene it. Therefore, until such time as the obligation to supply service providers with airtime is lifted (which is subject to a review, in due course, of the effectiveness of competition – see paragraph 7.3.2), Oftel will continue to regard any proposal by Vodafone or Cellnet to deny service providers use of the brand name by which they identify and promote their networks as in conflict with the obligation to provide services to service providers, and take action, if necessary, to prevent this.

9.7 Oftel does, however, believe that in a competitive market it is not reasonable to deny network operators all ability to control and direct the promotion of their brand, as players in other markets are free to do. So long, therefore, as Cellnet and Vodafone do not go as far as to refuse to allow service providers use of their brand names, Oftel will not regard inclusion of contractual provisions in the operator’s contracts with them which require adherence to strategies designed to protect the operator’s brand as necessarily in conflict with the obligation to provide services to service providers.

CHAPTER 10

Enhanced services

10.1 The strategy set out above for airtime retailing will also be applied to provision of enhanced services on the mobile networks. This in practice at present mainly affects voice messaging services, which are much used by mobile subscribers, though in future there is likely to be increasing interesting the provision of other enhanced services. (Such services may include on-line information services, Internet access, electronic mail and other services (such as data download and transfer) involving plugging a mobile phone into a laptop or PC, and services based on GSM.) Thus, Cellnet and Vodafone will continue for the time being to be obliged to allow access to their networks, and on fair and non-discriminatory terms, to service providers wishing to provide voice messaging and other enhanced services. They will also continue to be precluded from unfairly cross-subsidising provision of enhanced services, either in-house or by associated companies. Subject to the effective competition review by the Director General referred to above, licence modifications will then be introduced which will free them from specific obligations and restrictions in this regard.

10.2 Orange and MPCL will be free of any specific obligation to grant enhanced service providers access to their networks as soon as the licence modifications proposed for them in this Statement have been put into effect, and, where they do, will be free to decide the terms and charges on which such access is granted.

10.3 These relaxations should not, however, be regarded by the operators as a green light to deny all access to their networks to independent providers of enhanced services, or act anti-competitively towards them. As noted earlier in this Statement, their policies and practice respecting the provision of enhanced services will be subject to the Fair Trading condition, which applies to anti-competitive behaviour in consequence of operators carrying on a concerted practice in a relevant market, as well as to such behaviour in consequence of abuse of a dominant position. In addition (as already noted), if any of the four operators, after their licences had been modified, appeared to be party to anti-competitive practices, this could be grounds to determine that they were well-established, so triggering the dormant controls in their licences referred to above, and providing a basis on which cross-subsidies might be considered to be unfair, and preference or discrimination considered to be undue.

CHAPTER 11

Application of the Oftel formula

11.1General

11.1.1 The unfair cross-subsidy rules will continue for the time being to apply to Cellnet and Vodafone. The means of enforcing them since May 1994 in relation to service provision has been through the financial criteria and quarterly reporting arrangements for TSPs introduced at that time. Respondents to the CD, apart from those who believe that all regulation of service provision should cease immediately, are generally agreed that the formula is an appropriate instrument for the purpose, but varying views have been put forward about whether and how individual components (such as the assumed average life of a subscriber contract) might be amended.

11.1.2 Oftel’s view is that the formula and reporting arrangements should continue to apply to the TSPs of Cellnet and Vodafone, as operators with market power, until the Director General has reviewed their position in two years’ time (as proposed in paragraph 7.3.2) and, if appropriate, modified their licences. (The arrangements would then lapse.) A number of changes, however, should be made to the way in which the formula is applied, and these are discussed below. Revised Guidance will be sent to affected operators and TSPs to indicate any changes in the way the quarterly financial returns are to be completed. The first returns to be completed according to the revised formula will be those for the second quarter of 1997. In addition to TSPs already covered by the arrangements, returns will be required from Q2/1997 from TSPs newly acquired by Cellnet or Vodafone, such as Talkland International and Peoples’ Phone.

11.1.3 Orange and MPCL will not be asked to comply with the formula during the remaining period before their licences are modified.

11.2 Incentive payments made direct to retailers

11.2.1 The first, and perhaps most important, change will be to bring within the scope of the formula all incentive payments made by the two network operators direct to dealers or other distributors, and which are not channelled through service providers or currently covered by the returns. This will require both Cellnet and Vodafone to record and monitor such payments, and make quarterly returns to Oftel indicating the amounts directly or indirectly associated with, conditional on, or otherwise linked to airtime contracts arranged by retailers with TSPs.

11.2.2 Most respondents commented on the principle of taking such payments into account rather than on how it should be done. Oftel’s main concern is that the payments appear to be potentially discriminatory. Since in practice most high street retailers receiving them arrange network connections through a TSP (whether or not they are obliged to) the payments can be seen as an additional subsidy to customers signing to the TSP rather than to an independent service provider not operating through a dealer. Oftel believes that it is therefore appropriate to treat the payments as if they had in fact been made by the TSP and to incorporate them in monitoring returns on this basis. It will be asking the TSPs concerned to do so.

11.2.3 High street dealers may well offer the products of several networks. But given that dealer chains generally seem to operate through the networks’ TSPs, the existence of alternative network offerings in high street stores would not invalidate the argument for modifying the formula which is concerned with fair competition among service providers.

11.3 Parameters of the formula

11.3.1 The Consultative Document also proposed a number of changes to the parameters of the formula. Oftel has considered the responses to the Consultative Document on these points and, in the light of these, believes that a number of modifications are appropriate.

11.4 New and Existing Subscribers

11.4.1 In the Consultative Document, Oftel suggested that it would be desirable to modify the monitoring formula the better to reflect differences between new and existing subscribers. It was suggested that this could be done on the basis of the length of time that customers have been in place, or by tariff type.

11.4.2 Many respondents agreed that account should be taken of the changing subscriber mix. However, there appeared to be little support for monitoring by tariff type and some strong objections were raised. In particular, it was felt that it would be difficult to monitor consistently by tariff type across operators. It would also be difficult to incorporate new tariffs and the withdrawal of existing tariffs.

11.4.3 Monitoring by age of a subscriber’s contract appears likely to be more acceptable. However, responses suggest that it would be difficult to choose an appropriate cut-off date balancing the desire to increase the relevance of the formula with the need to avoid distortions caused by atypical calling patterns amongst new subscribers, although it seems likely that an appropriate cut-off date would lie between one and two years after acquisition. Concerns about the difficulty of allocating costs and the difficulty of reconciling disaggregated data back to accounts were also raised.

11.4.4 Oftel’s view is that, since detailed monitoring is unlikely to continue beyond a relatively short time, the case for increasing the burden of complying with the formula in this respect is not compelling. It does not, therefore, intend to modify the formula to provide for monitoring by tariff type or length of a subscriber’s contract.

11.5 Subscriber Lives

11.5.1 In the consultative document, Oftel proposed to re-estimate average subscriber lives, based on recent evidence and (possibly) broken down by tariff type. This reflected concern that average subscriber lives were now shorter than at the time of the Direction and that this should be reflected in the monitoring formula.

11.5.2 This question elicited rather little hard information. However, on the basis of the information provided there could be a case for reducing the average subscriber life to around 27 months, equivalent to a monthly churn rate of 2.5% or 26.2% per annum. In the absence of more complete information from operators and TSPs Oftel intends to adopt a figure of 27 months.

11.6 Required Rate of Return

11.6.1 In the Consultative Document, Oftel proposed to estimate service providers’ cost of capital using the Capital Asset Pricing Model (CAPM). This would represent a departure from the current approach which uses a required rate of return based on actual rates earned by the network operators prior to the 1994 Direction. Most respondents supported use of the CAPM and comments generally focused on the value of the cost of capital and hence the appropriate required rate of return.

11.6.2 The Consultative Document noted that estimation of the cost of capital using the CAPM relies on share price data. However, many service providers are not quoted companies or are part of larger groups whose share prices reflect the performance of a number of diverse activities. It was therefore suggested that a sector or company average beta might be used. It was also noted that estimates of the cost of capital published in connection with the flotations of Orange and People’s Phone suggested a beta of 1.3 and a nominal cost of capital of 14–15% (presumably after tax).

11.6.3 BT commented at some length on the appropriate required rate of return, revisiting many of the arguments from the review of BT’s price cap to apply from 1997. These are not reconsidered here. However, BT went on to suggest, on the basis of work by Professor Grout, that the cost of capital should be 1.5%–4% above the figure for BT’s regulated activities (currently 12.5% pre-tax), reflecting Oftel’s suggested range for beta of 1.0–1.4. BT argued for a figure at the bottom of the range on the grounds that service providers have low risk relative to network operators because a much lower proportion of their costs are fixed.

11.6.4 On the other hand, Cellnet argued for a relatively high beta on the grounds of the reliance of service providers on connection bonuses which are highly responsive to market conditions, especially in the consumer market. Cellnet also noted that consumer goods markets tend to be volatile, with Dixons having a beta of 1.35 (although this obviously reflects primarily Dixons’ other activities). Cellnet concluded that an appropriate cost of capital was in the range 14.9%–16.3% post tax or (in their view of the appropriate tax adjustment) 22.2%–24.4% pre-tax, though this also reflected a view that the equity premium was above the level suggested by Oftel.

11.6.5 Both BT’s and Cellnet’s arguments concerning the relative riskiness of service providers may have some validity although they work in opposite directions. In addition, to the extent that network operators have market power this may tend to reduce their betas, though they would clearly be above the figure for BT’s regulated activities. On balance, the arguments do not appear to point strongly to service providers’ costs of capital being either above or below the relevant group figures.

11.6.6 Oftel considers therefore that it would be appropriate to base the required rate of return on the CAPM approach and that its value should lie in the range 15–20% (pre-tax). The arguments underlying the choice of rate in 1994 would point to a figure towards the top of the range. Therefore Oftel intends to reduce the required rate of return to 1.5% per month (equivalent to just under 20% per annum).

11.7 Connection Bonuses

11.7.1 In the Consultative Document, Oftel stated its belief that it is appropriate to continue to exclude airtime bonuses which benefit large service providers and proposed to do so. However, it asked for comments on the level above which they should be excluded from the calculation of cross-subsidy.

11.7.2 Some respondents argued that the ceiling should be removed entirely or should be increased in line with growth in the mobile market. Another argued that volume bonuses were justified on the basis of costs and therefore supported removal of the ceiling. However, there was also support for retention of the 50,000 limit on the grounds that payments above this level would in practice apply only to TSPs.

11.7.3 Oftel believes that arguments related to cost savings are not really relevant because they apply at the network operator level. It seems unlikely that economies of scale or fixed costs are significant at the service provider level. Thus the effect on a network operator’s fixed costs will be the same whether say 100,000 subscribers are all signed to one service provider or to ten of 10,000 subscribers each.

11.7.4 Oftel accepts that the typical size of independent service providers may have increased since the measures of May 1994. However, it is concerned that there are a large number of small service providers and, possibly, new entrants (who would presumably start small) who would be disadvantaged by an increase in the threshold. Therefore it does not intend to change the level above which airtime bonuses should be excluded which remains at 50,000 subscribers.

11.8 Cost Basis

11.8.1 Oftel does not intend to change the basis for calculating costs in the monitoring returns.

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ANNEX A

Statistics on the mobile telephony market

Table 1 Mobile telephony market: total number of subscribers (thousands) Source: Fintech Mobile Communications

Table 2 Net new subscriber growth, 1996 (all subscribers, thousands)

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ANNEX B

Assessment of market power

1 General: criteria and methodology

1 The purpose of this Annex is to consider whether, and to what extent, Vodafone and Cellnet can be said to possess market power. First, the relevant market or markets are defined. Then, a method for determining whether an operator could be said to possess market power in any of these markets is proposed. Paragraphs 16 onwards of Annex B then apply this method to the positions of Vodafone and Cellnet in the markets identified.

1.1 Market definitions

2 Oftel set out its approach to market definition in its second consultative document on the Pricing of Telecommunications Services from 1997. The approach follows that used by the UK competition authorities (and is broadly similar to that of the European and US authorities) and focuses on the existence of constraints on firms’ ability to set prices. These constraints may be provided by the possibility of demand-side substitution, that is the ability of customers to respond to a price increase by switching to products which are good alternatives from their point of view, or supply-side substitution which occurs when firms producing other products switch resources into producing a product whose price has increased.

3 In the Consultative Document of May 1996 (‘the CD’) and using this methodology, it was considered that mobile telephony represented a distinct market from fixed telephony but that there was a single market for mobile telephony including both digital and analogue systems. It was considered that customers are primarily interested in services rather than technologies and that from the customer’s perspective analogue and digital systems were effectively substitutes.

4 Several respondents questioned this view. At least one argued that fixed and mobile telephony are already part of a unified market whilst others suggested that even analogue and digital systems represented separate markets. Oftel does not believe that fixed and mobile systems are yet effective substitutes. The differences in functionality and price levels strongly suggest that they are separate markets. Nonetheless this may change as fixed and mobile technologies converge.

5 There are also differences in functionality between analogue and digital mobile systems, as was recognised in the CD. A case can be made on this basis for regarding them as separate markets. Customers differ widely in their willingness to pay for different attributes of mobile service and operators offer a number of different pricing packages to appeal to different customer groups. However, these packages are not set in isolation from each other but as part of a wider marketing strategy and it is clear that the relativities between the packages are very important. Indeed, the network operators have consciously used the design of these packages to affect the rate of migration from analogue to digital systems. Oftel’s view therefore is that the prices of analogue and digital systems do constrain each other sufficiently for them to be regarded as part of the same market.

6 The points were also made by some respondents that competition is more or less entirely for digital subscribers and that indeed there is a target date for the switching of all analogue subscribers to digital networks. The fact that competition appears to be most intense for digital subscribers is consistent with analogue subscribers being either a separate market or part of a wider market including all subscribers. In either case, however, the existence of a large base of analogue subscribers in which Vodafone and Cellnet have dominant shares continues to be relevant. Thus the precise market definition would not necessarily affect Oftel’s conclusion regarding market power. The existence of the target date for switching seems likely, if anything, to increase substitutability; indeed the fact that such switching is possible could be seen as evidence of this. Thus Oftel continues to believe it is appropriate to regard digital and analogue subscribers as part of the same market, although in what follows the implications of the alternative treatment are also considered.

1.2 Market power

7 A firm is said to possess market power if it is able to raise prices above the competitive level for a non-transitory period without losing sales to such a degree as to make this unprofitable. This is a weaker test than that for dominance, which is the ability to act to a substantial degree independently (in terms of pricing behaviour or output decisions) of other firms in the market or potential entrants, and ultimately of consumers. A dominant firm will certainly possess market power but firms which are not by themselves dominant may also have market power. Any test for market power or dominance will therefore involve examination of the same indicators.

8 There is no unique indicator of market power. A number of factors are important, although they may be related. For example, if entry barriers are low, it may not matter that there are few firms in an industry whilst, if there are many firms, it may not matter that entry barriers are high.

1.2.1 Number of firms

9 The number of firms in a market gives some idea of the state of competition. The most extreme form of market power (except in the very special circumstances of a contestable market) is an unregulated monopolist. Experience suggests that firms in a duopoly will also possess significant power because, with only two firms, (tacit) collusion is relatively easy. Such firms may be said to be ‘jointly dominant’. In general, the larger the number of firms, the less likely it is that any individual firm will possess market power.

1.2.2 Market shares

10 The number of competitors needs to be supplemented by some consideration of their relative sizes. Market shares are the obvious measure but are also only a highly imperfect indicator of market power. A market share of 25% is required for investigation under the Fair Trading Act and this can be used as a rule of thumb below which firms are unlikely to possess market power.

1.2.3 Entry barriers

11 An entry barrier allows an incumbent firm to earn additional profit as a sole consequence of being established in an industry. If entry barriers are low or non-existent, then the possibility that new competitors may enter may provide an effective constraint on behaviour. A firm is unlikely to possess market power if entry barriers are low.

1.2.4 Vertical integration

12 Vertical integration is particularly relevant in telecommunications where one firm has a significant share of both calls and the provision of network services. If one firm has market power at the network level then, in the absence of regulation such as measures to bring about transparency in the relationship between costs and charges through accounting separation and the introduction of non-discrimination rules, the firm could exert considerable market power over operators who need to interconnect with it in order to deliver calls to final customers. In that situation, a measure simply of the number of operators competing in the retail calls market or of their market shares would understate the extent of the integrated firm’s market power.

1.2.5 Countervailing power

13 The market power of a producer may be offset by the countervailing power of buyers. Countervailing power is likely to be important where the buyer purchases a large volume relative to the producer’s total output, where the buyer’s purchases represent a large proportion of the buyer’s total costs, where the buyer can switch between suppliers easily but the seller perhaps has some customer specific investment and where the buyer has alternative sources of supply, perhaps by in-house production. Large telecommunications users, for example, are likely to be well-informed about competitive offerings and telecommuni-cations may form an important part of their own costs. Multinational companies may have the ability to choose between telecoms operators located in different countries.

1.2.6 Competitive behaviour

14 The above measures have focused on the structure of the market. However, there is no deterministic relationship between the structure of a market and the behaviour of firms in it. Market power could therefore be seen as a behavioural concept. The history of entry, prices and profits may also be a useful guide to the existence of market power.

1.2.7 Summary

15 Evidence that a firm has market power might include:

(i) the firm has less than two active competitors;

(ii) the firm has a market share above 25%;

(iii) entry barriers are significant;

(iv) the firm has control of a vital input which its rivals must use;

(v) buyers have no countervailing power, for example because they are typically small and diffuse (such as domestic telecoms users);

(vi) lack of new entry or entrants which remain small or rapidly exit the market;

(vii) a market share which is static or which shows a tendency to increased concentration;

(viii)evidence of collusion or price leadership (when non-dominant firms simply follow the price set by the dominant firm);

(ix) high profits. However, high profits may result from efficiency or innovation as well as market power.

2 Market Power in the mobile market: Position of Cellnet and Vodafone

2.1 Number of firms

16 Whilst the number of competitors is not on its own a measure of competition, the existence of four firms has the potential to generate more effective competition than was the case when there were only two licensees. However, if the analogue market were treated as separate, it would be a duopoly, with the implication that it is likely to be less competitive.

2.2 Market shares

17 At the beginning of 1997 Vodafone had 41.1% of all subscribers and Cellnet 39.4%. Shares of this magnitude are suggestive of market power, and are considerably above the 25% benchmark used in many PTO licences as a trigger to look at whether an operator is ‘well-established’. Vodafone has 35% of digital subscribers, which is also above the 25% threshold referred to above, whilst Cellnet has 25.7%. However, even if their shares of the digital sector were to fall below 25%, it would also be necessary to take into account the two companies’ roughly 50% shares of analogue subscribers, both because of the advantage which this gives them in switching subscribers to digital systems and as a source of profits to finance the acquisition of new subscribers.

2.3 Entry barriers

18 At present there is an effective barrier to market entry by new mobile operators, since the Government has announced that no more mobile licences will be issued before the licensing competition for third generation mobile phone services due to enter service following the turn of the century. This makes a collusive outcome between the four operators more likely to be sustainable. There is no current evidence, or complaint, of collusion, but in the circumstances Oftel must be especially alive to the risk that it may take place. Whether or not such evidence emerges, the pattern of price changes as the market matures will be a factor to be taken into account when reviewing the relative market power of the operators in two years’ time.

19 Scarcity of radio spectrum also needs to be considered, since the privileged access of mobile operators with regard to scarce spectrum is sometimes argued as a reason justifying a unique regime for service provision. Access to this scarce resource may indeed justify the imposition of general service obligations of some kind, and of roll-out obligations, not applicable to fixed operators without market power, but that is a rather different perspective. In the service provision context it is significant because it affects the degree of market power a mobile operator enjoys, rather than because it merits special treatment in its own right. The prime argument for protecting service provision remains whether or not such protection is necessary in order to counteract or ameliorate the adverse effects of network market power. If a network operator lacks market power, there is no obvious reason why the fact that his system relies on allocations of spectrum should in itself make necessary special rules with respect to service provision.

20 A number of other constraints exist which continue to hinder the progress of Orange and MPCL. One of these is the high cost of building a mobile network (which unlike a new fixed network needs to have full national coverage before it can compete effectively) and the long period before it can be expected to yield a profit. The demands on investors by these operators for funding to complete the rollout of their networks is currently at its peak, while revenues remain low. It follows that Vodafone and Cellnet derive a first mover advantage from having their networks already rolled out. The size or reliability of a network can be considered as an example of ‘vertical product differentiation’ or, more simply, quality. Where products are vertically differentiated, all consumers will rank the products in the same order of preference if their prices are the same. In other words, for the same price, all consumers will prefer the larger, more reliable network. Given the smaller and less dense geographic coverage of the Orange and MPCL networks, they must price some way below Cellnet and Vodafone in order to attract customers – and may still find it difficult to do so.

21 Further entry barriers result from the existence of switching costs which are faced by customers changing networks. Contracts typically last twelve months with penalties for early termination, the purchase of a new phone and (currently) a change of number. Here Cellnet and Vodafone have an advantage because they can migrate subscribers from analogue to digital services on their own networks without a change of number. The planned advent of mobile number portability will eliminate this latter advantage, however. In addition, the need to migrate all subscribers to digital networks by 2005 may itself stimulate competition to the extent that subscribers are more likely to change networks if they are anyway changing equipment.

2.4 Vertical integration

22 Interconnection is of less importance than in the fixed network where BT’s ubiquity as the incumbent provider in the local loop is a major entry barrier. Interconnection between mobile operators has generally up to now been effected via BT. However, direct interconnection is now becoming more common, and there is some concern that Cellnet and Vodafone are unwilling to offer such interconnection, without which, for example, short messaging services cannot be offered. In addition, termination rates for calls to Cellnet and Vodafone from fixed networks may be high and also above rates for termination on DCS 1800 networks, though these are shortly to increase.

23 There may, however, be an entry barrier related to the use by Cellnet and Vodafone of tied service providers. The potential for the use of tied service providers as an entry deterring device was considered in the Consultative Document.

2.5 Countervailing power

24 The increasing importance of high street retailers as channels of distribution means that some buyers have countervailing power. Dixons, for example, is well placed to achieve favourable deals from network operators.

2.6 History of entry

25 Two entrants – MPCL and Orange – have entered the market and have clearly had a significant impact on it. However, as noted above, they are, after some years, still some way behind the two established operators in terms of subscriber numbers and profitability.

2.7 Trends in market shares

26 The entry of MPCL and Orange has reduced the market shares of Vodafone and Cellnet, indicating the increasing competitiveness of the market. However, the trend decline in the shares of the latter is fairly slow. Vodafone’s share of all subscribers declined from 43.1% on 1 January 1996 to 41.1% on 1 January 1997, whilst Cellnet’s declined from 42.5% to 39.4% over the same period. Moreover, here it is interesting to consider the analogue and digital segments separately. In the analogue segment, the shares of Vodafone and Cellnet are fairly stable at around 50% each. In the digital segment, however, both have increased their shares in 1996, from 27.9% to 35.5% in the case of Vodafone and from 17.9% to 25.7% in the case of Cellnet. The overall decline in market share results from the declining importance of the analogue segment, where they have a high but static share, in favour of the digital segment, where their shares are lower but rising.

2.8 Trends in prices

27 The clearest impact of the development of competition is in the development of prices. Until 1993, prices were high and stable, aimed at business users. For the six years prior to that date both Cellnet and Vodafone charged an identical and unchanging £25/month rental for all users, with peak-period call charges of 33p/minute intra-M25 motorway and 25p/minute outside the M25. The pattern of prices is at least consistent with muted competition during the duopoly period. Even before the entry of Orange and MPCL actually occurred, however, Vodafone and Cellnet responded by introducing innovative tariff packages aimed at attracting different categories of user, and selective price cuts. Evidence of price competition has continued, typically with the two incumbents following the innovations of the entrants – Orange’s introduction of per second billing being perhaps the best known example.

28 It is clear that Vodafone and Cellnet are not dominant in the sense that they can price independently of the two entrants or each other. However, they have been able to maintain a price premium: Cellnet and Vodafone are generally the most expensive networks whilst MPCL is the cheapest. The ability to maintain a price differential without dramatic losses of market share suggests market power. (For tariffing history see paragraphs 5.4-5.6 of the main text.)

2.9 Relation of prices to costs

29 In a competitive market, it is to be expected that prices should be cost-oriented. Competitive pressure tends to eliminate supernormal profits, bringing prices into line with costs.

30 In the case of mobile telephony, the relation of prices to costs is complicated by the way in which mobile services are usually marketed. As described in paragraph 5.3 of the statement, handsets are typically supplied at prices well below cost, with the cost being covered by airtime prices and other charges associated with an airtime contract which are well above the cost of provision. However, this by itself is not incompatible with a competitive market in which handsets and airtime are sold as a package. One would, however, expect charges for the package to approximate to the costs of the provision of the package, taken as a whole.

31 The Director General said in the June 1996 Price Control Review Statement that he was concerned at the level of BT’s charges for calling mobiles. The main component of the retail charge for calling a mobile phone from a fixed phone is the mobile network’s charge for interconnect, and Oftel noted in that statement that such charges seemed high. Oftel has since considered in more detail the level of Cellnet’s and Vodafone’s costs (as well as