1.1 The main purpose of this document is to start the process of public consultation on arrangements to replace the current controls on BT's retail prices when they expire in July 1997. The review of price controls needs, however, to be set in the context of other regulatory developments which will affect BT's revenues and costs. This document, therefore, also covers, and seeks views on, Oftel's proposals for a new regime for interconnection charging based on incremental costs and a network charge cap. Oftel's proposals for new interconnection arrangements for service providers and new arrangements for defining, funding and delivering universal service also need to be considered alongside proposals for the next price control. A consultative document on both these issues will be published in two weeks time.
1.2 The current controls on BT's retail prices were set in 1993 to run for four years. New arrangements have to be in place in August 1997. In fact, Oftel has to have decided what new arrangements it wants and to put them formally to BT by end-May 1996. If BT does not agree the issue will be referred to the Monopolies and Mergers Commission for consideration. The review timetable, therefore, has to allow a year for such a referral and subsequent further public consultation by Oftel, should that prove necessary.
1.3 The main feature of the price control arrangements is an overall price cap, based on the RPI-X formula, - currently RPI-7.5%. This means that BT has to reduce its retail prices each year so that the average price for the services included in the price cap basket is reduced by RPI-7.5%.
1.4 The price cap mechanism acts to control prices paid by customers while at the same time providing strong incentives for BT to improve the efficiency of its operations. It has, in practice proved a very powerful and effective way of introducing the effects of competition to a market where a single supplier is dominant. Since the first price cap was set in 1984 BT's prices have fallen on average by 40% in real terms and its efficiency has increased overall by an average of 3.5% a year in real terms. The way the price cap works has also allowed customers to share in any greater than anticipated improvements in efficiency. These have been taken into account at each review and reflected in the value of X for the following period. The value of X has increased at each review.
1.5 Besides the overall price cap the price control arrangements also include other rules on how BT can alter its prices. For example, there are sub-caps on nearly all individual services in the basket so that no price can rise in real terms. (The main exception is RPI+2% on exchange line rentals.) There are rules constraining the timing of price changes which contribute to the reductions required by the price cap and rules on the treatment of discounts. Private circuit prices are dealt with separately from the main basket. Overall the revenue from services covered by price caps currently covers over 64% of BT's total revenue. (Background on the detail of the current arrangements is set out in paras 1.39-1.45).
1.6 The price control is Oftel's major instrument for regulating BT's pricing behaviour in the UK market. But it is only one of the instruments and powers Oftel has to fulfil its various statutory duties. The scope of the rules within the price control arrangements could be stretched to cover a number of Oftel's objectives but only at the price of complexity in the way the rules are constructed and the effectiveness with which they will operate. Complexity leads to uncertainty and uncertainty can act to deter investment. Oftel wants to avoid this and to keep the controls as straightforward as possible. It is important, therefore, in this consultation to focus on those outcomes which are best promoted through the price control and not to expect the price control arrangements to cover too many of Oftel's objectives. This is considered further in Chapter 2.
1.7 The price control arrangements apply only to BT. BT is, however, still the dominant player in most segments of the market and controls on its prices will have a significant effect on both the level and structure of prices throughout the rest of the industry. The price control arrangements will thus have a direct impact on the development of competition in the UK telecoms market. The market is very different now from that at the time of previous price control reviews. In the period before 1991 the fixed network market was a duopoly. At the time of the last review in 1991/2 the effects of opening up the market after the duopoly had still to be felt. By contrast, the UK telecoms market today is a number of separate but interlocked markets which are changing fast with the rapid deployment of new technology and the increasing convergence of the telecoms, broadcasting and information technology industries. It is a complicated mosaic with different levels of competition in different segments. There are over 150 licensed public telecoms operators and many other companies offering different sorts of telecoms services. There are competing players in all segments of the market and competition has gained a hold even if, in most markets, penetration by other players is still quite small. But BT remains the only nationally present, vertically-integrated operator active in all sectors of the market.
1.8 Telecoms is the only privatised utility market where there is any significant competition in the provision of underlying infrastructure. In addition to competing with other players in retail markets, BT is, therefore, a competitor and a supplier of services in the network wholesale market. It competes, for example, with other operators offering long distance carriage of calls or the provision of private circuits. And, since BT still has nearly 95% of residential customers' exchange lines, other operators need to pay it for use of its network to deliver calls from their own customers to BT's.
1.9 In the past, price control arrangements have been applied only to retail prices. Oftel has already indicated in Effective Competition:Framework for Action published in July that the idea of a network price cap should be pursued in the current review. A cap operating directly on wholesale prices would encourage efficiency improvements in BT's interconnection costs and charges. It would also be an important step away from detailed regulation - at the moment BT's interconnection charges are each set annually by Oftel. Clearly, if there is to be a network as well as a retail price cap the structure of the caps and the interaction between them is very important. This is considered further in Chapter 5. For both network and retail caps Oftel is proposing a new approach to services which might become competitive during the price control period. They would not be part of the overall basket but instead subject only to a light price cap.
1.10 The price of telecoms services affects everybody in the UK -directly and indirectly. Over 91% of households have a phone and telecoms costs are an increasingly important input cost to the production of all goods and services. Telecoms services comprise some 3% of GDP. The impact of this review will be wide-reaching. It is, therefore, vitally important that there is extensive, informed debate about the choices Oftel needs to make.
1.11 It is not just a matter of deciding how X in the RPI-X formula should be set. Other decisions profoundly affect the impact the new control will have on the market - what services should be included in the basket of controlled prices? how should tariff packages or discounts be treated? should there be detailed rules or sub-caps on movements of individual prices. The review is a complex process and Oftel considers it important that this consultation document and the further ones that will follow should set out as fully as possible the issues to be addressed and the decisions which need to be taken. Oftel proposes to put as much information into the public domain as is consistent with the requirements of commercial confidentiality; and it will also ensure that claims of confidentiality are, if necessary, challenged and not used excessively cautiously to hold back information necessary to allow those consulted to take an informed view of the matters at issue.
1.12 Oftel considers it important that BT, consumers and the rest of the industry should all be aware of the background to, and justifications for, the decisions Oftel will be taking.
1.13 A great deal of the information necessary to conduct the price control review must, obviously, come from BT. Equally clearly, BT will have its own commercial interests to protect. Oftel considers that, wherever possible information provided by BT should be supplemented or validated by input from others. Oftel has already approached other operators (and other interested parties) to get their views on the development of competition in different market sectors over the period up to and through the next price control period. This study will feed into other areas of Oftel's work as well but it is particularly important for the price control where estimates of future market volume growth and market shares are critical variables in the arithmetic. Forecasting is inevitably difficult and Oftel needs to set its own forecasts and BT's against others' best estimates.
1.14 Oftel already has a great deal of information about network costs and likely future changes through information in published regulatory accounts and through its development with the industry of an incremental cost model for interconnection charging (more details are set out in Chapter 5). Oftel has asked the industry for similar details about future movements of retail costs.
1.15 Input and forecasts from others will be particularly important in the second stage of consultation when ranges of X are being considered.
1.16 Oftel needs specialist advice in certain areas of the price control review. Two advisory panels have been set up and involved in the preparation of this document - a consumer panel to advise on the interests of residential users and a panel of expert economics and business advisers (details at Annex A). Oftel has also taken outside advice on its approach to the cost of capital to use in the review and engaged specialist advisers to provide financial and business input.
1.17 Oftel will also be consulting its existing six advisory committees - the Advisory Committees for England, Scotland, Wales, Northern Ireland, Disabled and Elderly People, and Smaller and Medium-Sized Businesses. (These are committees which provide advice to the Director General on general consumer issues within their specific geographic or sector remit.)
1.18 This first consultation document aims to set out the background to the current review and to identify for consultation the main issues which need to be addressed and the key assumptions which Oftel will have to make - with Oftel's initial views where possible. A less detailed document focusing on the implications of the price control for residential consumers will be published in the next few weeks. Responses to this document should be received by Oftel by 2 February 1996. There will then be a two week second stage of consultation to 16 February where respondees can comment on the views which others have provided in the initial period. This is Oftel's standard procedure for allowing wider debate and transparency in the consultation process. A less detailed document focusing on the implications of the price control for residential customers will be published in the next few weeks. Consumer groups will be asked to provide responses by 16 February.
1.19 During this first consultation period Oftel will be arranging workshops with the industry and consumer groups. Dates for these workshops are set out inside the front cover together with details of how to find out more.
1.20 After the first consultation, Oftel will take account of the views expressed and then set out in mid-March in a second consultation document its proposals for the next price control - both the structure of the control and a provisional range of values for X (for both network and retail price caps). This second consultation document will also have with it draft modifications to BT's licence to put the proposals into effect. Again there will be a separate consultation document focusing on the issues from the residential customers' point of view. Consultation, as before, will be an initial period, this time running to the middle of April 1996, and a second follow-up running to early May. Oftel intends to hold public hearings around the country on the proposals in the second consultative document. (Dates will be notified in the next consultative document in March.)
1.21 Oftel's final proposals will be published as a statement at the end of May which will incorporate final draft licence modifications for formal statutory consultation. Oftel will be asking for responses by the end of June with a second period of consultation to mid-July. BT can then agree the proposals. If not, the issues will be referred to the Monopolies and Mergers Commission. In either case, the new price controls will be effective from August 1997.
1.22 The review process provides for extensive consultation on all aspects of the future control arrangements. Public consultation will extend to over 22 weeks all told. The two main periods of informal consultation will each be less than the three months Oftel usually likes to allow for consultation on major issues. But Oftel considers that separate shorter consultations on, first, form and structure and, subsequently, on the values of X will make responses more focused and consultation more effective.
1.23 As indicated above, the review of the price control arrangements has to be set in the context of other developments affecting BT's revenues, costs or pricing. Chapter 5, therefore, deals with Oftel's proposals for future interconnection charging. The further consultation document to be published shortly deals with the proposed new service providers regime and with universal service arrangements.
1.24 Consultees should also be aware that as a result of an earlier review Oftel has already proposed, and will shortly be consulting formally on, draft modifications to BT's licence to remove the RPI+2% constraint on increases in exchange line rentals. The complex Access Deficit Contribution regime would be abolished as a consequence of this. If the modifications are implemented there will be no regulatory constraint on the level of rental charges. Oftel believes, however, that commercial constraints on BT will prevent any significant increase in bills and the position of customers on the Light User Scheme is specifically protected. (Details were set out in Oftel's July Document Effective Competition: Framework for Action.)
1.25 More broadly Oftel has proposed to introduce into BT's and other operators' licences a new provision prohibiting anti-competitive behaviour. Oftel will shortly be consulting formally on draft licence modifications. The new provision will be supplemented by non-binding guidelines indicating what might or might not be considered anti-competitive.
1.26 Oftel also made clear in the July Statement that it proposes no change to the principle of geographic averaging of BT's prices for basic voice telephony services which are part of universal service. (Definitions of universal service and possible changes for the future will be considered in the consultative document to be issued in two weeks time.)
1.27 Oftel's overall goal is "to obtain the best possible deal for the consumer in terms of quality, choice and value for money". This goal is pursued, primarily, through the promotion of fair, effective, and sustainable competition in provision of services to customers and in provision of network infrastructure.
1.28 Oftel recognises that competition is a better incentive mechanism for restraining prices than price control. Rivalry promotes a search for previously unidentified efficiency gains, ensures they are passed to customers and stimulates innovation and choice in the process of seeking competitive advantage. However, in those markets where competition is not considered to be sufficiently well developed to generate incentives for efficient supply, innovation and cost-related pricing, regulation is necessary to protect the customer from monopolistic price levels. The objective of price control is, therefore, to prevent excessive prices being charged to customers in markets where a monopolist or dominant supplier faces no constraint from competitors on its pricing freedom.
1.29 Ideally any price control arrangement should mimic the effects of competition - by stimulating new services and greater efficiency whilst at the same time protecting the customer both by limiting price increases and ensuring an appropriate distribution of the efficiency gains. In addition, the form of control should allow the firm sufficient freedom to set prices to enable it to meet customer needs effectively and make purchasing decisions reflecting, as far as possible, an efficient allocation of resources. Under the price cap form of price control the regulated firm will, in seeking to maximise its profitability, attempt to take account of customers' willingness to pay for different services. A situation in which firms are able to meet differing customer demands will in general be more reflective of a competitive market.
1.30 When BT was privatised in 1984 the form of price control adopted was the periodic price cap. Under this arrangement the prices of a specified 'basket' of services (consisting mainly of direct dialled calls and exchange line rentals) are controlled such that the weighted average percentage price change in any one year for these services is no greater than the rate of inflation less a given number of percentage points - RPI-X. In this formula X reflects the rate of increase in efficiency that the regulator expects the firm to achieve each year, but it also takes account of the level of profitability at the end of the previous period, expected volume growth in the forthcoming period and the scope the firm has to shift the balance of its tariffs to maximise its revenue. In 1984 X was set at 3%.
1.31 Within the price cap the weights are derived from the previous year's revenues for the relevant services. The RPI, the change in Retail Prices Index, relates to the rate of price change for the preceding year to June. Within the 'basket' of services, BT is able to set prices broadly as it wishes (though there has up to now been a specific constraint on the rate of increase in the exchange line rental and, since 1993, a constraint of RPI+0% on each price). This freedom to set prices was seen as important in encouraging BT to price in a way that reflects evolving costs and best meets customer demands.
1.32 The form of control adopted in 1984 remains in place today, though, as shown in Table 1 of Annex B, both the range of services included in the 'basket' and the period of control have been altered. In 1984, the cap was set for 5 years, but for subsequent periods this has been reduced to 4 years.
1.33 At the time of its introduction in telecoms in 1984, the price cap form of price control time was still rather a novel departure. Up to that time, both in the UK and elsewhere the more conventional form of price control was through control of profits and took the form of a specified rate of return on capital employed for relevant services (a form of cost plus regulation). Under that arrangement the firm is required to earn no more than the specified rate of return in each year, the rate of return being set after assessment of the appropriate level of costs.
1.34 The major attraction of the price cap form of regulation is that it not only provides controls on the level of prices charged to consumers, but also provides very clear incentives to the firm to minimise costs. If the firm can improve its efficiency by reducing its costs base beyond that expected under RPI-X then the firm can retain the increased profits, at least for the period until the cap is reviewed.
1.35 A further attraction of the price cap approach is that it avoids overly intrusive and bureaucratic regulation. Price controls are not set every year according to the rate of return earned in the year, but for a period of years, and they are not revisited until the end of the period. This avoids the burden of regulation and inevitable uncertainty associated with an annual review process.
1.36 The distinction between rate of return regulation and price cap regulation should not, however, be taken too far. In setting the price cap an assessment of the firm's expected efficiency gains has to be taken together with assessments of its investment needs and its likely profitability. On the one hand, the aim is to minimise opportunities for very high profits and to ensure that the expected efficiency gains flow through to the customer. On the other hand, it would ultimately be against the interests of customers to set controls so tight that the firm was unable to attract capital to finance its investment programme.
1.37 Thus, in deciding on the price cap a view has to be taken as to the appropriate rate of return to be earned by the firm. The rate of return is not, however, the explicit constraint, so price cap regulation avoids the deficiencies described above of direct rate of return regulation. The rate of return is nonetheless critical in setting the price cap. But rather than this control being reset each year to take account of actual performance, under the price cap account is taken of the firm's performance and profitability at the end of the price control period. (The issue of profit claw-back is addressed more fully in Chapter 4.)
1.38 The duration of a price cap is clearly an important issue. If a price cap were set for an indefinite period and never reviewed - admittedly an unlikely possibility given its consumer protection role - either excessive profits would build up or the firm would go out of business. On the other hand, too short a period would destroy the important incentive properties. This is also addressed further in Chapter 4.
1.39 Since 1984 price cap regulation has brought very substantial economic benefits to telephone customers in particular and the wider economy in general. Retail prices have on average fallen by about 40% in real terms. Overall, prices have moved more into line with underlying costs, whilst at the same time BT's cost base has been reduced, on average by around 3.5% per annum in real terms, reflecting a substantial increase in efficiency. Moreover, quality of service has improved significantly both in terms of network quality, through substantial investment in new technology, and customer service. At the same time as delivering these benefits BT has continued to earn an adequate return on capital. These are substantial achievements and are of particular significance given the importance of efficient, low cost and high quality communications to consumers and for sustaining the UK's international competitiveness.
1.40 Table 1 of Annex B provides a summary of the history of price controls in terms of the coverage of services included in the 'basket' and the value of X. The coverage of the basket of services controlled by price caps has increased in the period since 1984. The major changes occurred in 1989, when private circuits prices were subject to a price cap for the first time, though as a separate basket from PSTN Services, and in 1991 when international calls were included in the basket. The inclusion of international calls occurred midway through the 1989-1993 price control period. Although an adjustment was made to the value of X to reflect the very high levels of profit on international calls, this was not a mid-term review of the existing controls, but a broadening of coverage. In 1984 the value of services covered by price controls accounted for 48% of BT's group turnover; coverage of current controls accounts for over 64% of BT's turnover. The annual revenue from the public switched services covered by the current basket stands at £7.9 billion.
1.41 Over the period from 1984 the value of X for the basket of public switched services has increased from 3% to the current level of 7.5%. Over the period there has generally been a decline in the level of price inflation. This has meant that whereas ten years ago BT's prices were able to rise each year and BT was thus able to increase prices in nominal terms, this is no longer the case and significant nominal price reductions each year are now required. In this situation BT could potentially minimise the impact on its revenues by choosing to introduce the price reductions at the end of the price control year. To ensure the customer receives the full benefit of these price reductions, BT's licence has been modified to ensure that the price changes take place on average no later than three months after the start of the price control year.
1.42 Table 2 of Annex B sets out the history of BT's price changes going back to 1984. On average the decrease in prices in real terms has been 40%. However, the decrease varies significantly according to type of call and by type of bill. Price comparison over the whole period is difficult because of changes in BT's retail tariff structure since 1984. Nevertheless, it is generally true to say that the prices of the services most used by business customers fell by the greatest amount. It is important, however, to recognise that the starting point for these calculations was, to some extent, arbitrary. Some prices were well out of line with costs at the start of the period. Rental charges to residential customers, for example, were well below costs and BT has since been constrained by price control rules on how far it has been able to increase exchange line rentals.
1.43 Prior to the Duopoly Review in 1991, there was competition to BT from Mercury only (for fixed, switched services). Since the Review, competition has intensified in many sections of the market, and BT has targeted price reductions at a larger group of customers. Table 3 of Annex B shows how price changes in more recent years have benefited business and residential customers (reliable statistics are not available for earlier periods). The "total" column shows the overall change necessary to comply with RPI-X. Thus from 1990/91 to 1994/95 the total of price changes implemented by BT was -10.2%. The reductions within this total which benefited business and residential customers differed significantly, with the former benefitting by reductions of 20% whilst residential customers received reductions amounting to only 1%. (Residential consumers do, of course, also benefit indirectly from lower business rates as these feed through to lower prices of goods and services in the economy. And, as noted above, they have benefitted from below-cost rental charges.)
1.44 The degree of variation between benefits to residential and business customers has, however, reduced significantly during the 1993-1997 price control period. As can be seen from the figures in Table 3 the major cause of the variation occurred during the previous price control period. This was partly the result of the inclusion of volume discounts as qualifying price reductions (i.e. they were 'in the basket') at the time when international prices were brought into the basket of controlled services in 1991. While volume discounts were in the basket, BT was keen to make substantial use of them to achieve the necessary price reductions. As volume discounts have tended to be focused more on business customers, their inclusion in the basket and BT's reliance on them to achieve the requirements of the price cap led to a greater share of the benefits going to business customers. Under the price control arrangements in operation since 1993, those discounts have been excluded from the basket. Residential customers are now seeing a similar share of benefits to those available to business customers. A second reason for the more balanced distribution of price cuts is the growth of, and prospects for, competition from cable companies for the direct connection of residential customers.
1.45 Table 4 of Annex B describes how the quality of BT's services has changed for a number of key indicators which were set a decade ago. Service quality for these indicators, which gave rise to consumer concern in the past, is now relatively high. For example, very few calls now fail and network reliability consistently stands at well over 99%. Just as BT's focus has shifted over this period from being an engineering-oriented company to a customer service-oriented company, so consumer concerns tend to focus less on network based issues (such as faults and call failures) and more on softer service issues (such as complaint handling and responsiveness).
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