4.1. Chapters 5 and 6 on network and retail price controls deal with specific issues relating to the individual type of price control being considered. In addition to these, there are a number of issues relating to price control regulation generally, on which decisions have to be taken. Responses to the first consultative document indicated a large measure of agreement to the proposals made in Chapter 4 of that document. These responses, including those which disagreed with Oftel's suggestions, have been taken into account in formulating the revised proposals outlined below.
4.2. BT has argued that, instead of a combination of separate retail and network price caps, its prices might be regulated by means of a "global" price cap which would include the prices of interconnection services as well as retail services. Within this cap, BT would be free to set the relative prices of all services subject to some constraints, including a limit on the overall level of charges. It has argued that a global price cap would promote efficient pricing and reduce the incentive on BT to behave anti-competitively.
4.3. Oftel has considered the possibility of introducing a global price cap. Oftel accepts that, under certain assumptions, it is possible to show that a global price cap can be economically efficient without necessarily creating an incentive to behave anti-competitively.
4.4 However, a global price cap would give BT a considerable amount of freedom over relative prices. In markets where it is not possible to trade off lower profits today against higher profits tomorrow, this need not be harmful; indeed it is the basis for the setting of efficient prices. But in practice, Oftel believes that there is a danger that this freedom would be used in ways which would inhibit the development of effective competition as reductions in prices of competitive services could be offset by rises in prices of monopoly services. This was clearly a major concern amongst the many respondents to the first consultative document who opposed adoption of a global price cap.
4.5 It might be argued that the danger of anti-competitive pricing under a global price cap could be mitigated by application of the Efficient Component Pricing Rule (ECPR). Oftel has considered the usefulness of the ECPR in previous consultation exercises (for example in "A Framework for Effective Competition", December 1994). Oftel's view is that the ECPR has some useful properties but that these are outweighed by its disadvantages, notably the possibility that it could, in the present state of the market, discourage the development of effective competition. Thus Oftel does not see the ECPR as a solution to the problems of the global price cap.
4.6. Another difficulty is that the efficiency properties of the global price cap depend on applying the correct fixed weights to the various services in the basket, a difficult task. In addition, the theory of the global price cap suggests that it should include all retail and wholesale services. This would be contrary to Oftel's objective, and indeed BT's preferred approach, of withdrawing services from the price cap where effective competition makes this possible. BT's proposal for a single cap, but one which excludes certain services, does not therefore correspond to the global cap of the theoretical literature.
For these reasons Oftel has decided not to consider further the introduction of a global price cap.
4.7. Hitherto, the control on BT's prices has been based on the all-items RPI. However, concern has been expressed that RPI does not closely reflect BT's costs and that it includes items such as mortgage interest rates and indirect taxes which are irrelevant to BT's costs. This latter means, for example, that BT has in the past derived significant benefit from increases in indirect taxation. The main advantage of the all-items RPI is its public familiarity. In addition, it is never revised, unlike some cost indices and so has the advantage of certainty.
4.8. Oftel has given careful consideration to possible alternatives to the all-items RPI. The main alternatives are:
4.9. Whilst there are alternatives, and RPIY has some merits, the view was expressed very strongly by many respondents that the index needs to be understood by the public. Oftel attaches great weight to transparency and has therefore concluded that the advantages of RPIY do not outweigh the disadvantage that it is less well-known than the all-items index. For this reason also, Oftel is not attracted to the use of averages of RPI and producer price indices which would seem to combine the disadvantages of both with a considerable sacrifice in transparency.
Therefore Oftel agrees with those respondents who argued that it remains appropriate for the price control to be based on the all-items RPI.
4.10. The first consultative document noted that, where innovative services are newly introduced by BT, BT may not face effective competition. It may thus be in a position, at least in the short-term, to exploit the customer. On the other hand, such profits act both as a reward for the introduction of new services which benefit the customer and as a signal for competitors to enter the market. In such cases, control of prices may stifle entry and discourage innovation, to the detriment of the customer in the longer term.
4.11. Oftel believes that it is essential that appropriate incentives are given for the introduction of new services. The great majority of respondents to the first consultative document agreed with this view. However, some concern was raised about possible anti-competitive practices and examples where BT has delayed the availability of the relevant interfaces to enable interconnection to new services were cited. Concern was also expressed that market power in new services may derive from BT's dominance in other areas rather than innovation.
4.12 For this reason, care will be taken by Oftel to ensure that new services are genuinely novel and not simply an attempt to evade the price control. Oftel is also currently considering in an Oftel/industry Focus Group the regulatory framework for the introduction of new retail services requiring interconnection between operators for end-to-end delivery. This work will tackle timetables for the availability of interface specifications. Oftel considers that the inclusion of new services in the price control basket should be reconsidered when the price cap is reviewed at the end of the control period.
Therefore, Oftel has concluded that new services should not be included in price control. However, it will take appropriate action to deal with any anti-competitive behaviour which might be identified in relation to such services.
4.13. A related issue is the contribution which new and other non-regulated services should be expected to make to common costs. Oftel is aware that part of the incentive to introduce new services derives from the exploitation of economies of scope. This incentive would be maximised by recovering all common costs from price-capped services. At the other extreme, all non-regulated business revenues could be considered as contributions to common costs. This, however, could seriously weaken the incentive on BT to realise economies of scope.
4.14 Oftel is concerned that there should be no weakening of the incentive on BT to introduce new services. However, Oftel also believes it is reasonable that customers of BT's price-capped services should benefit from BT's exploitation of its economies of scope. As, by their very nature, it is difficult to forecast the benefit which BT is likely to derive from new services, Oftel does not propose to attempt an explicit allocation of common costs to new and existing services. Rather it believes that the best approach is to reflect the expected contribution from the introduction and growth of new services in the forecasts for the volume of use of BT's network which will therefore be higher as a result. This allows new services to share in bearing the burden of common costs. Oftel believes that this method offers the best means of balancing fairness with incentive.
Therefore, Oftel intends to set the value of X on the basis of a reasonable forecast of the benefits which BT might derive from shared use of common assets.
4.15. The first consultative document discussed at some length the merits and drawbacks of explicit profit-sharing. One of the possible merits of profit-sharing is that it may prevent prices getting significantly out of line with costs during the price cap period by automatically triggering a price reduction if profits exceed a certain threshold. This may have both real and presentational advantages. The main disadvantages are the dilution of incentives to productive efficiency which profit-sharing would entail, the complexity of any profit-sharing system and the likelihood that it would encourage "gaming" by the regulated company.
4.16. Moreover, the mechanism by which X is reset at the start of a new price control period ensures that the benefits of efficiency gains are shared progressively with consumers. A further and crucial consideration is that, in various parts of the UK telecoms market, there is strong and growing competition to BT, a point emphasised in many responses to the first consultative document. This is a key difference from other markets where recently privatised companies are dominant and where competition is at a much earlier stage of development. Increasing competition will help to ensure that customers enjoy the benefits of greater efficiency and lower costs, reducing the need for price controls and profit sharing. Moreover, if, in recognition of this, the next price control is set to last for only two years as one of Oftel's options proposes, the case for profit sharing is even further weakened.
4.17. There was very little support among the respondents to the first consultative document for explicit profit-sharing. A helpful contribution from OFWAT pointed out the essential differences between the mechanisms for sharing benefits which they are discussing with the water companies and formal profit sharing arrangements. OFWAT's discussions concern the way (for example, lower prices, rebates or discretionary investment) in which the benefits of higher than expected efficiency gains are to be passed to customers at the next review. OFWAT agreed that formal profit sharing would be inappropriate for the telecoms market.
4.18. On the other hand, the Consumers' Association favoured profit sharing and drew Oftel's attention to recent work which claims to show that, in principle, profit sharing need entail no loss of efficiency compared to price cap regulation. However, this work depends crucially on the assumption that the regulated firm would continue to maximise overall profits (and hence minimise costs) as long as it retains any share of profit above the threshold, no matter how small this share might be rendered by the profit sharing scheme. This seems inherently implausible because shareholder control over management and employees, who in the absence of suitable rewards might prefer to relax their cost minimisation efforts, is imperfect due to the absence of full information. Therefore enforcing profit maximisation is costly. Oftel continues to believe that profit sharing would reduce incentives to productive efficiency.
Therefore Oftel has decided that the present system of price control should not be modified to introduce an explicit profit sharing element.
4.19. Of the exogenous factors which could potentially affect profitability, unanticipated growth in Gross Domestic Product (GDP) has particular significance for performance in the telecoms industry.
4.20. When X is set, account is taken of the expected impact of economic growth on BT's profits over the period of the price cap. However, BT's cost structure is such that profitability is very sensitive to the level of BT's output and unanticipated volume growth can lead to profits significantly above the levels expected at the time of the price control review. It is arguable that increased profits resulting from exogenous changes should be redistributed to customers as they do not reflect any enhanced efficiency on the part of BT and, as they are by definition outside BT's control, there would be no reduction in the incentive on BT to lower costs. This would also spread the risk of errors in forecasting which at present falls on BT.
4.21. The main difficulty is that allowing for GDP growth would require reliable knowledge of the relationship between GDP and telecoms growth, which is not available and would be particularly difficult to discover at this stage of the transition to a competitive market. Most respondents to the first consultative document, including BT, have indicated that they do not support allowance for exogenous factors. BT is thus prepared to bear any risk associated with forecasting errors and indeed may be better placed to do so than customers. BT has also pointed out that the relationship between GDP and telecoms traffic may not be truly exogenous but may in fact be influenced, for example by BT's marketing efforts, and may therefore be unstable.
Therefore Oftel has decided not to make any allowance for unanticipated growth in GDP or other exogenous factors in the price cap.
4.22. The period of the price cap in the conventional incentive regulation model needs to balance two opposing pressures. On the one hand, the longer the period between reviews, the longer the time in which BT may benefit from efficiency gains not taken into account in the price cap and thus the greater the incentive to reduce costs. On the other hand, a longer interval between reviews adds to the uncertainty surrounding the profits which BT will actually achieve and increases the possible divergence between prices and costs. In addition, with a four year cap, there may be only 2 years' data on performance under the existing cap when work on the new one begins.
4.23. Many respondents to the first consultative document commented that a duration of more than four years would be too long given the pace of change in telecoms markets. Some even favoured a three year duration. Some of those who supported a five-year cap argued that there should be provision for interim reviews.
4.24. Oftel believes that a conventional price cap (that is, one in which X is set so that BT's return is expected to equal its cost of capital at the end of the price control period) of less than four years duration would contain insufficient incentives for efficiency. On the other hand, change is occurring at a rapid and accelerating rate in telecoms markets and, in these circumstances it would be perverse to increase the duration of the cap.
Therefore Oftel's view is that the appropriate duration of a conventional price control is four years.
4.25. In the first consultative document, Oftel proposed to introduce a 'roll-over' provision into the next price control arrangements on the assumption that this would be a conventional price cap of four or five years duration. Then, if a further control were needed from 2001/2 and it proved impossible to agree this with BT before the existing control expired, the existing price control would continue in force in the interim until a new control was agreed. This would have the advantage that reviews could be carried out later with better information. However, this would raise some practical issues, for example, whether a new control should operate retrospectively if it was agreed after the formal end of the old control and, if so, how.
4.26. Response to the proposal has been mixed. Some thought that roll-over would increase regulatory uncertainty and some doubted that a new control could practically be applied retrospectively. On the other hand, some regarded retrospective adjustment as a necessary condition for roll-over to avoid giving BT an incentive to delay introduction of a tighter price cap. Although some respondents supported roll-over as an alternative to a longer period between reviews, there was little support for roll-over in combination with a four year duration or indication, on the basis of past experience, that there was a compelling need for roll-over in such circumstances. In addition, the fact that there are likely to be dramatic changes in the competitiveness of markets over the next price control period makes roll-over unlikely to be appropriate.
In the light of the lack of strong support for Oftel's proposal in the responses received Oftel has decided not to introduce formal 'roll-over' arrangements into the next price cap.
4.27. In the first consultative document, Oftel asked for views on the way in which the constituent services in the price cap baskets would be weighted in the overall price change calculation. Hitherto, the basket weights for BT's price controls have been set equal to the proportions of basket revenue accruing to the relevant services in the prior year to that in which the price change takes place.
4.28. An alternative method would be to base the weights on the proportion of revenues derived from the service in question in the current year, equivalent to a constraint on average revenue. One drawback with this approach is that forecasts of the relevant weights are required, with the complication that there is a need for retrospective adjustment.
4.29. Most of those who responded to this question supported continuation of the current system, referring to the difficulty of forecasting and retrospective adjustment. However, some respondents advocated rather different methods of regulation in which there would be no basket but, for example, a constraint on the rate of increase in the median bill or some other representative tariff. However, Oftel is not attracted by this approach. This issue is considered further in Chapter 6.
Oftel intends to continue with the prior year revenue weighting system for the price control basket.
4.30. If BT reduces its prices by more than is required in a particular price control year then it is allowed to count the excess price reductions towards its obligations in the following year. This gives BT an incentive not to delay price reductions such as those accompanying the introduction of Per Second Pricing in June 1995. The current controls limit BT's ability to carry over price reductions into the fourth year of a price control, depending on the extent to which BT has used this facility in previous years. In the event that the next price control is set to last only two years, Oftel does however intend to allow BT to carry-over price reductions into the second year.
4.31. Whilst some reservations were expressed, most respondents to the first consultative document agreed that carry-over was of net benefit to customers. Any attempt to use the carryover provisions to make predatory price reductions may be addressed under the relevant conditions of BT's licence.
In the light of this, Oftel intends to continue present arrangements for carry over in future price control rules.
4.32. One of the features of price cap regulation is that profits may diverge from the level expected at the time when X was set. Any such divergence may be taken into account when X is reset in the next price control review.
4.33. The first consultative document set out three ways in which this could be done. One possibility would be by a one-off adjustment to prices which would bring BT's expected rate of return to an acceptable level in the first year of the new cap. A second option would be to set X so that, taking the price control period as a whole, BT was expected to earn, on average, an acceptable rate of return, but without a sharp adjustment to prices. A third approach would be for the new control to be set so that the expected rate of return reaches an acceptable level by the end of the price control period.
4.34. The third was Oftel's preferred approach. Its main advantages are that it approximates more closely than the other two methods to the workings of a competitive market and has greater incentives for efficiency as it allows the firm to retain the benefits of cost reductions for longer. It also avoids the particular disincentive to increased efficiency which one-off adjustments would create near the end of a price control period.
4.35. There was no support from respondents to the first consultative document for one-off adjustment. One respondent thought that, in a competitive market, adjustment of prices and profits to deviations from their expected level might be rather faster than implied by Oftel's proposal and might occur within the same price control period. Oftel agrees that any system of regulation is only an imperfect proxy for competition. However, it is fundamental to the efficiency properties of RPI-X regulation that X should not be reset within the life of the price control and that the regulated firm should benefit from efficiency gains above the level implicit in X. Therefore Oftel does not believe that any of the alternatives to its proposal would provide a better combination of incentives for efficiency and benefits to customers.
4.36. Some respondents questioned whether Oftel's objective should be to set X with regard to an acceptable rate of return at all, suggesting, for example, that X might be set to generate a particular pattern of market shares. However, even if this could be done with any accuracy, it would be inconsistent with Oftel's objectives for the price control review which are discussed in Chapter 2.
4.37. Oftel has suggested as a possible option that the next price control might be needed for as little as two years. However, if X were set so as to eliminate all excess profits in only two years, this would be perilously close to one-off adjustment and would have similar disincentive effects. Therefore, Oftel would, if it adopted this option, set X as if the duration of the cap were to be the full four years.
Oftel intends to set X so that BT's expected rate of return on controlled activities reaches an acceptable level by the end of the four years from 1997.
4.38. The first consultative document noted that a key consideration in setting a price control is the level of investment that is implicit in the financial forecasts underlying the price cap. However, it is not necessarily appropriate to require that the forecast amounts of investment are undertaken. Instead, the aim of regulation should be to ensure that the quality of service and other benefits to customers which were implicit in the calculation are realised. The first consultative document asked for views on the best way of doing so.
4.39. Oftel is firmly of the view that regulation should focus on outputs, not inputs such as investment. However, one possibility would be to introduce a licence condition obliging BT to meet certain output requirements. But this has not proved necessary in the past. For the present price controls, BT undertook to report back to Oftel once a year on the progress of key programmes whose investment consequences were included in the calculation of X. The programmes chosen were those aiming to modernise BT's systems and hence improve the quality and range of services to customers across the board: the expansion of access to digital switches and the extension of fibre optic transmission in the core and local networks. BT has largely met the first and is well advanced on the second, halfway through the price control period. There did not seem to be strong support for the idea of formal output requirement from respondents to the first consultative document. The possibility remains that, if there were a significant divergence between the outputs achieved by BT and those implicit in the price control, the price control could be reopened.
Oftel does not intend to introduce formal controls on BT's investment.
4.40. A second issue raised in the first consultative document concerned the possibility that much of any investment proposed by BT might relate to services other than basic telephony, for example to BT's plans for broadband switched mass-market services. Oftel stated its intention to take a critical view of BT's plans for investment in the forthcoming review, and, in particular, to press BT to justify its plans by giving explicit details of the consequences for customers of network services of alternative levels of investment. This is intended to ensure that basic telephony customers, either at wholesale or retail level, pay only for network upgrades which are necessary to provide them with the appropriate level of service. Investment to provide more sophisticated services should be financed from retained profits or borrowing.
4.41. The first consultative document suggested that one way of ensuring that new investment allowed for in BT's prices relates to basic network services would be to compare the level of its gross capital expenditure with its Current Cost Accounting (CCA) depreciation, taking account of volume growth. It would then be for BT to justify any additional capital expenditure over and above that identified as necessary. BT would have to demonstrate that the expenditure was necessary to bring identifiable benefits to basic voice telephony customers through an enhancement of services supplied by BT Network for that investment to be taken into account in the setting of the price cap.
4.42. Most respondents who commented agreed with Oftel's suggestion. However, BT and another respondent questioned whether it was meaningful or practical, with today's increasingly integrated technology, to seek to allocate investment to basic and advanced services. It was also suggested that this would represent a step in the direction of more detailed regulation.
4.43. It is in fact one of the merits of Oftel's proposal to base allowable investment on CCA depreciation that it avoids the need to allocate investment in this way. Indeed, a case could be made for attempting such an allocation in order to allow for the benefit of economies of scope in investment (for example in switching) which serves both basic and advanced services. Oftel believes that it would be unacceptable for basic telephony customers to be required to finance BT's investment in advanced services. Oftel believes therefore that it must take a critical approach to BT's plans for investment in the next price control period and intends to adopt the approach set out in paragraph 4.41.
Investment relating to non-price controlled markets will not be included in BT's investment plans for the purposes of setting the price controls.
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