5.1 Oftel believes that it is now appropriate to move away from detailed control of charges for all interconnection services in every year, and to rely instead on caps to control network charges. Network charge caps, once set, would last for a specified number of years. Oftel would define the scope and coverage of the controls, which would probably include all conveyance network services. Most network services would be within a basket of services subject to a cap. Oftel would calculate the initial level of interconnection charges for these services and would establish a rule for the minimum average reduction in charges (in real terms) over the control period.
5.2 For call termination services, Oftel would set the level of initial charges and the rules for changes in the charges over time by a sub-cap within the overall network cap. There would be separate arrangements for network services that were judged to be competitive or likely to become so within the control period. Each such service would be subject to a charge cap (or 'lid'), which would be intended to act merely as a safeguard. Oftel also proposes that charges would be subject to a system of floors and ceilings. All the controls on charges would apply to services sold to BT Retail Systems Business as well as to other operators. Network charge controls would cover approximately 15% of BT's total business and about 23% of BT's currently regulated business, assessed by current revenue. These arrangements are discussed in more detail in later sections of this chapter.
5.3 Many features of the current interconnection regime would remain even with a network charge cap in place. The present arrangements for publication of separate, audited accounts for BT's businesses and disaggregated activities and of details of costs would continue, including a detailed explanation of the methodology used to attribute costs. The publication of interconnection agreements and of the charges for Network Components and Parts, and Standard Services, as provided for under Condition 16B of BT's Licence, would continue. As in the current regime, charges for network components would be geographically averaged. There would continue to be a non-discrimination requirement for interconnection, so that BT Retail faced transfer charges from BT Network that were calculated in the same way as for any other operator interconnecting with BT's network. The requirement upon BT not to discriminate between itself and other operators in respect of the quality of service offered would remain in place.
5.4 Network charge caps would, however, imply differences from the current controls of interconnection charges in two major respects. First, the precise level of the charge for an individual interconnection service would not be set by Oftel, but by BT. The overall level of charges that BT could levy on services in the basket would be constrained by Oftel's decision on the initial level of charges and by the operation of the control itself over time. Oftel also proposes that the levels of charges for network components that BT could set would be limited by ceilings set by reference to stand-alone cost, and that there would be guidelines for charge floors set by reference to incremental cost (see paragraphs 5.46-5.49 and Annex D). Charges would in any case be subject to provisions governing anti-competitive behaviour.
5.5 The second major way in which this would differ from current arrangements would be that the charges would not be reset by Oftel in each year to ensure that BT received revenues equal to some measure of costs. Under a network cap, there would be a requirement for the level of charges to decline by RPI-X each year, and charges in any year could therefore be different from costs. If BT Network were to improve its efficiency by more than expected so that its cost base fell by more than was implied by the level of the cap, BT would be able to retain the efficiency gains. Similarly, if BT failed to reduce its network costs by the amount implied by the action of the cap over time, BT would face the prospect of a reduced rate of return.
Oftel would welcome comments on its proposal to introduce a general network charge control on BT's interconnection charges, and on the division of the services into four distinct categories based on the level of competition.
5.6 Interconnection charges for use of BT's network are currently set on the basis of fully allocated costs using the historic cost accounting convention. For the next charge control period Oftel favours basing interconnection charges upon forward looking long run incremental costs, provided that a robust methodology that is acceptable to the industry can be established to calculate incremental costs.
5.7 Incremental costs include only the costs that are caused by the provision of a defined increment of output: in the proposed methodology to calculate long run incremental costs the increments have been defined as conveyance and access within a stand-alone network of Public Switched Telephone Network (PSTN) services and private circuits. The Interconnection and Accounting Separation (ICAS) Task 19 Incremental Cost Groups are developing the methodology by considering two modelling approaches. One, a top-down approach, starts from BT's reported level of costs, while the other is a bottom-up approach based on a fully efficient engineering based model. The robust methodology will be derived by drawing upon and reconciling these two models. Details of the proposed methodology to calculate long run incremental costs are at Annex D.
5.8 The move to incremental costs would distinguish between the costs that vary with the increments of output - the incremental costs - and the costs that are not sensitive to such output changes - the common costs. It has been suggested that if a proper cost attribution method were adopted, such as activity based costing, the common costs of the network would be small, because most overheads could be causally attributed if the analysis were sufficiently detailed. The approach taken by Oftel and the ICAS Task 19 Incremental Cost Groups recognises the validity of this argument, but also notes that common costs of the network arise from economies of scope between conveyance and access. For example, common costs may arise from the sharing of duct between transmission and access - part of such duct cost would not be saved if either conveyance or access were not provided; it would only be saved if both were not provided. Or common costs may arise from costs associated with concentrators, either physical components of the concentrator that serve both customer lines and traffic, or indirect costs of the concentrator, such as buildings.
5.9 Oftel favours the use of equal proportionate mark-ups to apportion the common costs of BT's network between conveyance and access respectively. Subject to the operation of the network cap over time, the incremental costs of conveyance and the share of common costs apportioned to conveyance by equal mark-ups would be recovered by BT Network through interconnection charges to all operators using BT's network, including BT Retail. The incremental costs of access and the share of common costs apportioned to access by equal mark-ups would be recoverable by BT through retail prices to customers.
5.10 Oftel considers that mark-ups over incremental cost are necessary if BT is to be able to recover the common costs that it necessarily incurs in providing its network. It has, however, been suggested to Oftel that there should be no mark-ups over incremental cost when setting interconnection charges, either because zero mark-ups are necessary as a form of entry assistance or because economies of scope (and hence common costs) are not significant. Oftel does not favour using interconnection charges to provide entry assistance but will continue to tackle barriers to entry directly. The extent of economies of scope between conveyance and access is an empirical matter. Table 5.1 gives estimates of the percentage breakdown of the costs of a stand-alone PSTN into the incremental and common costs of conveyance and access, taken from the top-down model.
Table 5.1: Estimated percentage breakdown of the costs of a stand-alone PSTN into the incremental and common costs of conveyance and access
Incremental cost Incremental cost plus
apportioned common costs
Conveyance 30% 33%
Access 61% 67%
Common costs 9% -
Stand-alone PSTN 100% 100%
Source: ICAS Task 19 top-down model
5.11 The figures in Table 5.1 reflect work on the calculation of incremental and common costs that is in progress but not completed. First, the figures reflect the costs of a stand-alone PSTN, rather than a network of PSTN plus private circuits. Second, there are some parts of the top-down model in its current form which require further development and refinement and this might affect the percentage breakdown of costs (see Annex D for further details). Third, the figures reflect costs before any adjustment to asset values, an issue which is discussed later in this chapter.
5.12 Table 5.1, albeit with the caveats above, suggests that there are likely to be some common costs, perhaps of the order of 10% of the costs of the network. Oftel considers that such common costs should not be ignored when designing a sustainable regime and so, in general, favours the use of mark-ups.
5.13 Subject to the controls imposed by Oftel, it is BT that would decide the level of the charge (that is, the size of the mark-up over average incremental cost) for any particular interconnection service covered by the network cap. The charges that BT could set would be restricted by the existence of the network cap, and its action over time through the operation of the X factor, which would constrain the overall level of interconnection charges. Oftel proposes further restrictions on BT's charging flexibility, in that the charge for each network component would be subject to a ceiling and a (guideline) floor. Provisions relating to anti-competitive behaviour and the need for publication of charges would also apply. BT Network would be required to set its charges to interconnecting operators on the same basis as its transfer charges to BT Retail.
5.14 For interconnection services other than call termination, it is Oftel's inclination that BT should have the flexibility, for example, to set different charges for a given interconnection service depending upon the end-use (the retail service for which that interconnection service is used). The flexibility to vary charges for interconnection services depending upon end-use would make it possible, for example, for BT to choose to set reduced or zero mark-ups on interconnection services purchased by operators for use in new retail services. It is possible that the imposition of mark-ups might have undesirable effects on new and innovative services, such as deterring new entry or retarding the growth of such services. This approach would be a significant departure from present arrangements, in which network charges are independent of the retail use of the interconnection service.
5.15 BT's incentives to offer reduced or zero mark-ups would depend upon the treatment of such charges in the network cap. One possibility would be for the interconnection services carrying lower or zero mark-ups to be regarded as separate services outside of the main network basket and perhaps subject to a separate cap. But this would raise complications. The establishment of a separate cap would require a judgement about the X factor for the new cap and there might be a need for the parameters of the main network cap to be revisited. There could also be significant problems of definition about what would be inside or outside of the main network basket at any point in time.
5.16 Oftel favours retaining within the main network basket
interconnection services offering reduced or zero mark-ups. Such charges could be treated as discounts off the standard interconnection charges (ie those including mark ups). If the rule were that these discounts would not count as reductions in charges for the purpose of the network cap, BT would be deterred from offering reduced or zero mark-ups for interconnection. Oftel therefore favours allowing such discounts to count as reductions in charges, which would permit particular retail services to benefit from reduced or zero mark-ups on interconnection services purchased from BT, but would allow the common costs of BT's network to be recovered from other services.
5.17 This approach would be consistent with Oftel's desire to take a less interventionist role in the setting of interconnection charges and would allow BT flexibility to set interconnection charges, within the limits identified above and discussed in greater detail in later sections of this chapter. However, Oftel recognises that there could be some practical difficulties, for example, in monitoring BT's compliance with the requirement to set charges to BT Retail on the same basis as to other interconnecting operators. Furthermore, BT might choose to exercise its flexibility by relating the structure of charges for interconnection services to the structure of its retail prices. To the extent that interconnection purchased from BT forms an important element in the costs of other operators, they might find it more difficult to offer a structure of retail prices that was significantly different from that offered by BT. On the other hand, it may be precisely this type of flexibility for BT that is important to ensure compatibility between the proposed network and retail price caps (see the discussion in the final section of this chapter).
Oftel would welcome comments on the scale and range of costs likely to be considered as common costs; on whether BT should be able to vary the degree of recovery of common costs; on the criteria that should be used to assess to which services this flexibility might apply; and on the use of components as the chosen level of disaggregation.
5.18 The key parameters to be set by Oftel for a network cap would include:-
5.19 Oftel's aim would be to set the parameters in such a way that BT would not be expected to earn supernormal profits at the end the control period, assuming an efficient level of costs. The first three of the parameters above are discussed in turn in the sections below; the last two parameters are dealt with in Chapter 4, General Issues in Price Cap Regulation.
5.20 As discussed in Chapter 4, General Issues in Price Cap Regulation, Oftel favours taking BT's actual costs as the starting point for the control of charges and setting X so that the expected rate of return reaches an acceptable level by the end of the control period. The X factor would therefore depend in part upon the current level of BT's efficiency, which is being measured in two ways.
5.21 First, the ICAS Task 19 Incremental Cost Groups are attempting to measure the long run incremental costs of an operator such as BT by considering two approaches to the measurement of incremental costs. The top-down approach will reflect BT's reported level of costs, while the bottom-up approach is based on a fully efficient economic-engineering model. The difference between these two models, once methodological differences and inconsistencies have been reconciled, should give some measure of the degree to which BT falls below best practice.
5.22 The second approach to assessing BT's efficiency consists of a benchmarking study to assess BT's unit costs levels against those of a number of international comparators. This has been carried out by consultants on behalf of Oftel. The study did not focus directly on the costs of BT's network activities, but dealt with BT's total involvement in the provision of access and call services to final customers. If it is assumed that BT's relative efficiency at the network and retail level is approximately the same, the results from this study could be used to assess the efficiency of BT's provision of network services. Preliminary results from this study suggest that BT is of the order of 10% inefficient, in the sense of having costs higher than those incurred by the best performing telecoms operators with similar characteristics to BT. Copies of the efficiency study are available from Oftel.
5.23 The initial level of interconnection charges would be set by Oftel in relation to incremental costs of conveyance plus a mark-up. The size of the mark-up over incremental costs would depend upon the size of the common costs of the network apportioned to conveyance under the equal proportionate mark-up regime. As the estimate in Table 5.1 suggests, this might be of the order of 10%. In subsequent years the operation of the X factor would require an average reduction in charges in real terms.
5.24 Estimates of the size of the average incremental cost of conveyance in pence per minute, broken down into network components are shown in Table 5.2. These estimates were taken from the bottom-up model. For comparison, Table 5.2 also shows figures under the current regime of fully allocated costs (which are based on historic rather than forward looking costs).
Table 5.2: Estimated comparison of the average incremental cost of conveyance, broken down into network components, and the fully allocated costs (using data for 1993/94)
Pence per minute Average incremental Fully allocated costs costs Switching: - Local switch 0.22-0.40 0.432 - Main switch 0.06-0.09 0.102 Transmission: - Concentrator to 0.12-0.24 0.276 local switch - Local switch to main 0.09-0.16 0.217 switch - Main switch to main 0.25-0.47 0.574 switch
Note: The figures for average incremental cost are before mark-ups for common cost.
The fully allocated costs of transmission are calculated as combinations of the junction and trunk transmission components using information on routing factors for local exchange, single and double tandem segments.
Source: Oftel from information supplied by the Incremental Cost Working Group.
5.25 The figures for avearge incremental costin Table 5.2 are shown in ranges because they reflect the preliminary efforts of the Incremental Cost Working Group to produce estimates for a network of PSTN and private circuits. Further work will be needed for the Working Group to refine the estimates by improving the bottom-up model, in three areas in particular.
5.26 First, the modelling of transmission will require further development to reflect more accurately the costs of electronics, fibre and duct in a transmission network serving private circuits as well as PSTN. Second, because the bottom-up model builds up costs from the dimensioning of capacity for the busy hour, robust information on the proportion of traffic in the busy hour by network component will need to be collected to allow the output of the bottom-up model to be expressed in terms of pence per minute. Third, there is the question of capturing the appropriate depreciation profile that reflects the economic depreciation of asset values. The Working Group is aware of these issues and work is in hand to develop the bottom-up model further and to refine the generic data with which it is populated.
5.27 The work on establishing a robust methodology for deriving incremental costs will continue under the ICAS Task 19 Groups (see Annex D). This work will cover improvements to the present top-down model, continuing work on the bottom-up model, and the reconciliation of the two approaches. The intention is to have a developed methodology by March 1996 when the draft licence modifications, to give effect to the price control proposals and the modifications to Condition 13 to introduce the new interconnection charging regime, will be published.
Oftel would welcome comments on the proposed methodology to calculate long run incremental costs, which is set out in Annex D.
5.28 Interconnection services will be divided into fourcategories: competitive services, services likely to become competitive within the next control period, call termination, and other services. It is proposed that there will be differences in the arrangements for setting interconnection charges for each category.
5.29 Under Condition 16B of BT's licence, BT or another operator can ask the Director General to examine whether the market for the provision of an interconnection service is competitive. If after investigation the Director General finds this to be the case the charges for the service will no longer be annually determined by Oftel. Oftel will shortly be consulting on non-binding guidelines that will set out how it would assess whether or not the market for a particular service were competitive. At present no interconnection services are considered competitive.
5.30 However, there may be interconnection services that are likely to become competitive within the next control period. These might include interconnect services such as international, if international facilities are liberalised; the Number Translation Service (NTS); Directory Enquiries (DQ) and operator assistance, depending upon the outcome of the current consultation exercise concerning alternative Licensed Database Managers; and the Number Information System (NIS) database.
5.31 The existence of such prospectively competitive services could raise a number of difficulties. If a service were to become competitive between charge cap reviews, should it remain in the basket or be removed? If competitive services were to remain in the charge cap, it could allow BT to reduce significantly the charge of services where it faces competition, which would enable it within the overall cap to keep high the charges for services where it faces relatively little competition. This can, of course, be a more general difficulty with a cap where the degree of competition differs across the services covered, but the problem would be exacerbated if competitive services were to be included in the charge cap basket. On the other hand, if the service were to be removed from the basket when it became competitive, there could be the difficulty that the cap and the X factor might need to be reviewed and perhaps adjusted.
5.32 It is Oftel's view that BT should be free from controls on its charges for competitive services. However, the issue considered here arises from services that are not competitive at the time of the charge cap review, but are expected to become competitive before the next review. Oftel proposes that each such prospectively competitive service should be subject to a separate cap, outside the general control basket, which would act as a safeguard by placing a 'lid' on the charge of each service. It would be the pressure of competition that would be expected to provide the binding constraint on BT's charges for these services rather than the 'lid'. The intention of the 'lid' would therefore be merely to provide a safeguard, should the judgement of the speed of development of competition prove to be optimistic.
5.33 The approach of a safeguard cap or 'lid' for each prospectively competitive service is to be distinguished from a basket of services. Even if there were two or more prospectively competitive services, the charge of each would have to conform to the specified X factor each year, whereas in a basket it is the average change in (real) charges that must conform to X, and individual charges within the basket could fall by more or less than X. Given its purpose to act as a safety net, Oftel is considering a 'lid' on the charge for each prospectively competitive service that is set at RPI+0%. Charges set by BT for such services would continue to be subject to non-discrimination requirements and anti-competitive provisions.
Oftel would welcome comments on its proposal to include safeguards on the charges for each prospectively competitive interconnection service; on the proposals that the 'lid' should be set at RPI+0%; and on the services that should be covered by the safeguards.
5.34 Oftel proposes that the remaining categories of interconnection services, call termination and other services, would form a basket of services and be subject to charge cap control of RPI-X. This would constrain the level of charges for such services in a similar way as the current retail charge cap has constrained retail prices. However, because it would give BT considerable freedom to alter the structure of interconnection charges, Oftel considers that there will be a need for further controls over the charges for call termination services.
5.35 Call termination services would be defined by Oftel to cover call completions to customers on BT's network from the lowest point in the network hierarchy at which operators can practically and economically interconnect. In many instances, call termination would comprise call completion through a digital local exchange (DLE). However, where interconnection at the DLE would not be practical or economical, perhaps because a DLE was situated in a remote rural area, call termination would be defined as call completion from a single digital main switching unit (DMSU). There would therefore be two call termination services on BT's network: call completion through a DLE and, where appropriate, call completion through a DMSU.
5.36 Oftel considers that BT's charges for call termination services will need to be subject to relatively tight regulatory control during the next control period, since BT is likely to retain its dominance in call completion. Therefore, unlike other services within the network basket, it is Oftel's view that BT should not be permitted to vary charges for call termination depending upon the end-use (ie the retail service served by call termination). Oftel further proposes that there be a sub-cap within the overall network cap, governing the charges for call termination services. Oftel is considering setting the X factor for this sub-cap at the same level as the X factor for the overall network cap. Oftel would determine the initial charges for call termination at the start of the period and the average reduction in the charges for call termination services would thereafter be required to fall at the same rate as for all interconnection services within the network basket.
Oftel would welcome comments on its definition of call termination, its proposal for a sub-cap to regulate BT's charges for those services and on their exclusion from the flexibility BT may have in setting other charges.
5.37 The dominance of BT is not, however, the only issue for call termination. There may also be a need for Oftel to set call termination charges for operators other than BT. Over the next five years most customers will have a choice of which operator will provide access to them, but each operator will have 'bottleneck' control of delivery to its own customers. The 'bottleneck' arises because, once a customer has decided to become connected to the access network of a particular operator, any subscriber wishing to call that customer (and the operator conveying the subscriber's call) would have no choice but to terminate the call on that operator's access network. If termination charges were left to be decided in negotiation between network operators, the outcome may be expected not to be sufficiently pro-competitive, economically efficient or fair to other operators, particularly new or smaller operators. There is, therefore, an argument that all access network operators' charges for call termination should be set by Oftel.
5.38 One possibility would be that Oftel would determine on the basis of costs the charges payable to each operator with an access network. Under this approach, if there were cost differences, different charges would be set for call termination on different networks. Oftel considers that such an approach would be extremely difficult to implement, especially for new operators, would be unduly time-consuming and could result in charges being set at economically inefficient levels, and possibly lead to undesirable discrimination among operators.
5.39 A second possibility would be to set standard charges for call termination that would be the same across all access operators. The idea would be that the same charge would be paid for equivalent functionality in all networks of a generic type, so, for example, all fixed wire based network operators would receive the same amount for terminating a call from an equivalent point of interconnect. The basis for these charges would be the charges set by BT under the call termination sub-cap. In effect, the topology and architecture of BT's network would need to be imposed upon other operators' networks. But these networks, even if they are fixed wire networks, might have significant differences in topology from BT's network and so there could be considerable room for debate about whether, for example, equivalent functionality in a particular network suggested the application of the DLE or the DMSU call termination rate.
5.40 A third possibility would be to apply the principle of reciprocal charging. At its simplest, this would mean that, if an operator were to interconnect with BT at a DLE, the payment that the operator would receive from BT for call termination would be the same that it pays BT, ie the charge for a local exchange segment. Similarly, if an operator were to interconnect at a DMSU, the payment received by the operator would be the same as that paid to BT, ie the single tandem rate. The principle of reciprocity could also be applied where interconnection did not involve BT but was between two other operators. However, some issues of detail would need to be reviewed, such as the recovery of the costs of In-Span Interconnect (ISI) and Customer-Sited Interconnect (CSI) and the costs of transiting the DMSU switch.
5.41 In conclusion, Oftel proposes that BT's charges for call termination should be governed by a sub-cap within the overall network cap. It is Oftel's view that call termination on other operators' networks should be based on standard charges and it sees some attraction in basing these on the charges for call termination on BT's network. It also sees some merit in the principle of reciprocal charging, so that an operator would receive from BT the same rate for conveying calls to customers as it pays to BT.
Oftel would welcome comments on the need for changes to the regulation of call termination charges on the networks of operators other than BT, and on the form that any such charges should take.
5.42 Other services include all interconnection services that are neither call termination services nor prospectively competitive services. These might include transit, interconnection circuits and non-conveyance services such as data management amendments. Given the definition of call termination suggested above, the interconnection service called 'transit' would include conveyance on BT's network to call termination on any network, including BT's.
5.43 The market for other services is not yet competitive and would be judged unlikely to become fully competitive within the next control period. However, there should be an increasing degree of competition in the supply of these services and other operators will generally have some choice of who to buy from. In such circumstances, Oftel does not consider that annual determination of these charges will be necessary to ensure a fair and efficient level and structure of interconnection charges. These objectives could be achieved by placing these interconnection services in a network charge cap basket, with appropriate controls such as ceilings and floors, as discussed below.
Oftel would welcome comments on the range of interconnection services that should be included in the BT network charge cap basket.
5.44 Oftel proposes a classification of BT's interconnection services into four categories: competitive services, prospectively competitive services, call termination services, and other services. As part of the work on accounting separation some 65 standard network services have been identified, which can be grouped into nine different types. Table 5.3 lists those types and for each indicates Oftel's preliminary view of the category into which it might fall over the period of the next control. There are no services currently considered competitive.
Table 5.3: Categories of Standard Services for the Next Control Period
Prospectively Call termination Other
competitive
International; Local exchange; Transit (see 5.42);
NTS; Some single tandem. Interconnection
circuits;
DQ & operator Data management
assistance amendments.
NIS database.
5.45 Oftel's proposals for the three categories of BT's interconnection services are that:
5.46 The network charge cap will constrain the overall level of interconnection charges of a basket of interconnection services. With a basket of services subject to a cap rather than the determination of individual charges by Oftel, BT would have freedom to set the structure of interconnection charges. However, Oftel believes that there will be a need to retain some regulatory controls on the structure of charges, in the form of ceilings and floors. It is proposed that these ceilings and floors would be applied to the charges for network components, whilst it is the charges of interconnection services which would be governed by the network cap. The charge for a service would be calculated as at present by adding up the relevant component charges using primary (as opposed to actual) routing factors.
5.47 The proposed system of ceilings is intended to prevent BT from exploiting a lack of competition on any particular interconnection service by pricing at an excessively high level. Oftel proposes to set a ceiling on the charge for each network component, which would be related to, but normally less than, the stand-alone cost of that component. Further details of the proposed system of ceilings and the methodology to calculate them are at Annex D.
5.48 It is possible that BT might seek to set an excessively low charge for a service, in order to engage in predatory pricing against existing competitors or to deter the entry of potential competitors. Some commentators, drawing upon the theory of contestability, have argued that predatory pricing can be avoided by requiring that the charge of each component is set at least as high as a floor, set at the average incremental cost of that component. However, where there are significant barriers to entry and exit, a floor of average incremental cost may not be sufficient to prevent predatory pricing or entry-deterring behaviour.
5.49 While floors related to average incremental cost may often give an indication of when charges might or might not deter entry or be predatory, Oftel does not favour a mechanistic implementation of floors. Oftel's proposal is that there should be a system of floors on the charges of components with the status of guidelines. Using the current methodology to calculate incremental costs, the (guideline) floor would be related to, but normally higher than, the average incremental cost of the component (see Annex D for further details). If they believed any charge to be anti-competitive, it would be open to others to complain. If a charge were set above the floor, the burden of proof would lie with the complainant to show that the charge could be expected to be anti-competitive. If a charge were set below the charge floor, the burden of proof would lie with BT to demonstrate that the charge was not anti-competitive.
Oftel would welcome comments on its proposal to use ceilings and (guideline) floors to restrict BT's charges for network components and on Oftel's proposals on the burden of proof.
5.50 Quality of service is an important issue at both the wholesale and retail level. The question of how quality safeguards are to be maintained at the retail level is dealt with in Chapter 6, the Form and Structure of Retail Price Control. This section deals with the issues which are relevant to the network cap.
5.51 It is clear that there is a relationship between quality and charges, in the sense that a reduction in the quality of service that is provided represents a hidden increase in the effective charge. In principle, it would be possible to allow for this by specifying a relationship between quality and the charges that BT was allowed to set. In theory, it would be possible to calculate the efficient level of a penalty to be imposed on BT in the form of reductions in charges for failing to achieve quality targets. If the penalties were set optimally, BT would be induced to provide the economically appropriate quality level. This would be the level of quality at which the marginal addition to consumer welfare associated with a small improvement in quality would be exactly equal to the marginal cost of achieving that improvement.
5.52 In the case of network services, the customer is the interconnecting operator and it is possible that such operators would be able to form judgements about this trade-off. Different operators might require different charge/quality mixes and Oftel believes that BT should be encouraged to offer alternative levels of quality at different charges. Nevertheless, Oftel would have to ensure that the basic offering included an appropriate quality level. It would expect to do this through enforcement of Condition 17C in BT's licence, which requires BT not to discriminate between itself and other operators in terms of the quality of service provided. It would also be made clear to BT that any deterioration in quality overall would constitute grounds for revisiting the charge cap.
Oftel would welcome comments on how far and in what ways charge controls should cover the quality aspects of BT's network services.
5.53 Oftel believes that forward looking costs are the correct basis for setting charges, because they provide more efficient signals for pricing, investment and entry than historic costs (see Annex D). Current cost accounting (CCA) would reflect forward looking costs more accurately than historic cost accounting (HCA), which has in the past been used when setting the terms of regulation for BT. However, a change in the regulatory regime from HCA to CCA should ensure that no windfall gains or losses accrue to the shareholders of BT through the impact that a change in asset values might have on the setting of the network cap and future interconnection charges. The choice of CCA rather than HCA as the basis for regulation should also be taken into account when estimating the appropriate cost of capital (see Chapter 7 and Annex E for further details).
5.54 The need for an adjustment to avoid windfall gains or losses arises if there is a large difference between asset valuations under the desired basis for future regulation (as represented by CCA), and under the basis used to set the terms of regulation in the past (namely, HCA). Although the adjustment would be relevant in principle to all assets, in practice it may not be especially important for conveyance assets, since BT's conveyance costs under CCA could be as little as 4% lower than under HCA. The replacement costs of switching and transmission equipment are significantly below their historic cost, but this is largely offset because the replacement cost of transmission duct is substantially above its historic cost. Given that the CCA and HCA values of conveyance assets appear to be quite similar in aggregate, there would be no significant problem of windfall gain or loss when changing the regime. Basing the valuation of conveyance assets on a CCA basis would be desirable, because it would induce a more efficient mix of charges between switching and transmission that reflected their respective forward looking costs.
5.55 The cost of access assets, however, might be as much as one-third higher under CCA than under HCA. The value of access assets is relevant to the network cap, because it would affect the size of the common costs of the network that would be apportioned to conveyance at the start of the cap under the equal proportionate mark-up regime. The value of access assets would also be relevant when setting the terms of the retail price cap. The valuation of access assets under CCA is higher primarily because the replacement cost of duct is approximately twice as large as the historic cost of BT's duct. There would therefore need to be appropriate adjustments to ensure that no windfall gain or loss accrues to BT's shareholders.
5.56 One possible adjustment would be to move to CCA assett valuations and to create a a revaluation surplus for access assets. If this surplus were taken through the profit and loss account, it would be regarded as an element of shareholders' income. When setting the terms of regulation, all elements of shareholder income would be taken into account, so a windfall gain or loss for BT's shareholders would be avoided.
5.57 A second approach to asset values would be to use unadjusted HCA values for existing assets and in the future, after the change in regime, use CCA depreciation for all assets. This would imply no change in the value or earning power of existing assets at the point at which the regime is changed, but better economic signals in the future.
5.58 Oftel considers that the move to CCA as the basis for setting the terms of regulation will require some adjustments to some asset values to avoid windfall gains or losses. For conveyance assets, however, windfall gains or losses should not be a significant problem. For access assets, where the difference between costs under CCA and under HCA could be substantial, there would be a cxhoice between the two approaches outlined above.
5.59 Where the resulting initial and terminal asset values and intermediate profits do not reflect economic values and associated intermediate cash flows, an adjustment to the cost of capital may be necessary as discussed in Annex E.
Oftel would welcome comments on whether adjustments to asset values should be part of the network and retail price control calculations and on the two approaches suggested by Oftel, or other possible approaches.
5.60 Since Oftel is proposing to retain controls over some of BT's retail prices as well as interconnection charges, it will be necessary to ensure that the arrangements for controlling network charges and retail prices are compatible. One danger would be that the retail price cap were set in a way that was too tight in relation to the network cap, which would create a squeeze on margins at the retail level. This could have the effect of deterring effective competition in the retail market, which would not be consistent with Oftel's objectives.
5.61 On the other hand, if the retail price control were set in a way that was loose in comparison with the network control, there would be the opportunity for BT to make supernormal profits at the retail level that did not result from greater than expected improvements in efficiency. However, competition in the retail market might be sufficient to limit the extent of supernormal profits made or retained by BT. If this were considered to be the case, it would be appropriate to set the relationship between the two price caps in a way that gave greater weight to the dangers of retail margin squeeze than to the possibility of excessive retail profitability.
5.62 A further consideration is that the structure, as well as the respective levels, of retail prices and network charges should be compatible. This would require either that Oftel were to set network and retail pricing structures which were mutually compatible, or that BT had enough freedom in setting the structure of prices to ensure compatibility, if a particular pricing structure at network or retail level were imposed upon it. For example, if Oftel wished to control individual retail prices (for example, by maintaining the existing RPI+0% ceilings on individual prices within the basket of retail services), it would be necessary to ensure that BT had sufficient flexibility to choose a structure of interconnection charges that was consistent with this retail pricing structure. Oftel considers that the proposed arrangements for BT to set interconnection charges within the network cap and other limits, such as ceilings and (guideline) floors, could provide sufficient flexibility to ensure compatibility.
5.63 Existing rules on non-discrimination and transfer charges, as laid down in Condition 16B of BT's licence, would remain in place. BT Retail would face transfer charges from BT Network which were set on the same basis as the charges to any other interconnecting operator. In addition, the requirement would remain for BT Retail to demonstrate that its retail tariffs covered costs after taking account of the transfer charges from BT Network.
5.64 One other way to alleviate the potential problem of compatibility between retail and network caps would be for the retail cap to apply to the value added over the network charge, rather than the absolute retail price. More generally there is the question of the appropriate extent of cost pass-through that should be allowed from network charges to retail prices. The greater the cost pass-through, the closer that the regulation of retail prices would be to value added. In general, a high degree of cost pass-through is considered undesirable because it would reduce the incentive to control costs. However, this may not present a significant problem in this context, because the existence of a network cap would provide the incentive to control network costs. One possibility, therefore, might be to allow for some pass-through of network charges in the retail cap.
5.65 Oftel notes the potential tensions that might arise between the level and the structure of network and retail price caps. It considers that it should be possible to ensure compatibility between the levels of the two caps by exercising care in the financial modelling and in setting the X factors for each cap. Furthermore, the flexibility that Oftel proposes to allow BT under the network cap could be sufficient to ensure compatibility between the respective structures of the two caps. Another possible mechanism that could be adopted would be a retail cap that permitted some cost pass-through from network charges.
Oftel would welcome comments on the interaction between network and retail price caps and on mechanisms to ensure compatibility.
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