6.1 The retail market for telecoms services in the UK during the period of the next price control will be very different from that at the time of the last review. Then the fixed market was effectively still a duopoly. Now competitors to BT are establishing themselves in nearly all segments of the market and this competition will increase and become more effective in the period ahead. Business customers, particularly large users, already have considerable choice amongst suppliers of telecoms services and, as the cable companies build out their networks and radio-based operators launch services, more and more residential customers will have a choice of two or, in many areas, three suppliers. In addition, both BT and its competitors will be deploying new technology to offer new services and to provide a much greater choice and diversity of service. Competitors will be looking to differentiate themselves on the type of service they offer, as well as on price.
6.2 The first consultative document noted that the key question for Oftel in the current price control review would be to what extent this emerging competition would be effective and would act as a restraint on BT's pricing - would competition be strong enough to allow regulation to withdraw from the role of controlling prices? Oftel proposed in the consultation document that, for the purposes of price control, retail services should be divided into three categories which would be treated differently:
6.3 Oftel has reaffirmed in this document (Chapter 2) that the central objectives for the current review are the protection of customers and the promotion of maximum efficiency in BT and the rest of the UK telecoms industry. The network controls discussed in Chapter 5 will act to promote efficiency at the network level. Transfer charges from BT's Network business to its retail business (the regulatory Retail and Access businesses for price control purposes) amount to 43% of retail costs. Once established, the network control will, therefore, bear down on a large proportion of retail costs. Oftel considers, however, that a retail price control will still be needed to ensure that efficiency gains at the network level are passed through to customers. This chapter discusses the retail price control arrangements in the period ahead.
6.4 Predictably, responses to the first consultative document fell into two camps. The industry argued strongly that effective competition would be in place during the period 1997-2001; that telecoms could no longer be regarded as a utility industry - there would be real choice of suppliers, innovation in service provision and new approaches to bundling and pricing of services. They emphasised that cable companies' build would be substantially completed during the period and that the launch of fixed radio access during 1996 would give further choice to business and, in particular, residential customers. The expected further liberalisation of the international market in 1998 when the European Union liberalises voice telephony would further extend competition. BT took the same view as the rest of the industry on this general issue.
6.5 There were strong arguments from operators that the need for a further period of conventional retail price control was questionable. They considered that there would be sufficient competition to ensure that retail prices would continue to be driven down. Geographic averaging of BT's prices would ensure that as BT responded to competition from other operators in particular geographical areas, the benefit of that competition would extend to all of BT's customers. They proposed that Oftel should therefore move away from conventional retail price cap control to alternative mechanisms focused on protecting those customers who would not have an effective choice and not be able to benefit from the effects of competition. Rigid adherence to a price cap approach would, it was argued, tend to ossify present pricing structures and deny the flexibility that BT and other operators would need if they were to introduce new services. If further detailed regulation of prices went on for too long it would risk stifling prospective investment.
6.6 Several operators suggested that Oftel should move from a price cap to a form of safeguard control on customers' bills. There were several alternatives suggested by different operators: the Median Residential Bill might be capped, there could additionally be other controls on bills of different groups, there could be a "safeguard" tariff package available to any one customer where the bill for a typical residential customer would be frozen in real terms. With these controls in place, the operators argued, there would be sufficient protection for those customers who might not benefit from competition and in other areas of the market competition would be active in driving prices below these levels.
6.7 The industry argued strongly that Oftel's proposals on the cost of capital and on BT's expected efficiency gains would lead to values of X that drove prices down to levels at which competitors' investment plans would be put at risk. Operators maintained that further efficiency should be extracted from BT through the network charge cap arrangements. Competition would carry these efficiency gains forward into retail prices.
6.8 Consumer representatives, on the other hand, were considerably more sceptical. They could appreciate the possibility of increasing competition over the period and its importance in bringing more choice of suppliers and diversity of services. But they questioned whether, in the residential market in particular - where BT will at the start of the period probably still have around 90% of residential lines - competition would be effective. They supported the continuation of a price cap approach and generally urged Oftel to consider whether greater protection could in fact be given to residential customers through a focused price cap on residential prices or consideration of some type of residential bill control in addition to the price cap.
6.9 Oftel anticipated in the first consultative document that there would probably be such a polarisation of responses to it. The industry has a common interest in arguing against price controls and Oftel has to recognise this in weighing the responses. Consumers must be protected until competition is effective. No one disagrees that some form of retail price control is needed for the period beyond July 1997. The issues are what is the best form of control and for how long should it last.
6.10 Oftel believes that the UK telecoms market is genuinely at a turning point in the development of competition. The market is already lively and fast changing, with many new players building businesses. There is real potential for effective competition becoming established during the next price control period. Oftel considers that a conventional price cap control will continue to be needed for the next few years but the dynamics of the future market may mean the control may take a different form to match the developing market. Keeping price controls beyond the point when competition is effective and price control is no longer needed to protect customers could distort the market and freeze pricing structures which should be becoming more flexible to promote the development of new services.
6.11 These concerns have led Oftel to the view that there are two possible alternative approaches to a conventional 4/5 year price cap which might better fit the present state of increasing competition in the UK telecoms market. These possible alternatives are dealt with in paragraphs 6. 42 to 6.47 . The thinking that has led Oftel to consider these options and Oftel's position on the various issues raised with in the first consultative document are set out below.
6.12 BT argued that rather than a conventional retail cap the best theoretical approach to price control was a global price cap covering all prices. Failing this BT argued that a conventional price cap with services being withdrawn from the basket as they became competitive was their preferred approach (this is considered further at paragraph 6.19 below). As noted above, a number of other operators proposed that controls on individual services should be abolished altogether and that Oftel should focus instead on the protection of those residential customers for whom competition was least likely to be effective.
6.13 In the light of the debate on this issue since the first consultative document, BT has indicated that it considers some form of bill control could be used to protect customers in place of a conventional retail price cap. It does not feel, however, that a single Median Residential Bill control would offer sufficient clarity on reassurance to customers. A single control would protect only customers at that level of bill and BT considers that a broader range of controls would be necessary. It has indicated its willingness to introduce "safeguard" tariffs in August 1997, combining line rental and calls for groups of customers up to the median level for whom competition and choice may prove slower to arrive. These "safeguard" combinations would include the Light User Scheme or its successor. The price of each combination would rise by no more than the rate of inflation during the next control period. Any BT customer would be free to choose either a "safeguard" tariff or one of a range of other pricing options from BT, or from other operators, that would meet their requirements more closer. In BT's view this tariff structure would become the prize "umbrella" below which all operators - including BT - would be offering more attractive options to each customer group in a competitive market.
6.14 Oftel has examined these proposals from the industry very seriously. It remains unconvinced, however, that they would in practice be any less interventionist than a price cap or that they would be simpler in operation.
6.15 It was notable that consumer groups responding to these alternative proposals from operators were very reluctant to see bill controls replace a basket control, although some felt they would be helpful in addition.
6.16 Customers on BT's Light User Scheme (those on the lowest 20% of bills by size) are currently protected from increases of more than RPI in their bills and will continue to receive protection through the replacement for the Scheme which is being discussed in the context of new arrangements for universal service. The bill constraints proposed by the operators would need to be applied to the bills of customers up to and perhaps beyond the median bill.
6.17 It would certainly be straightforward enough just to place an RPI cap on the Median Residential Bill in order to prevent it rising in real terms, or to place a similar control on some other chosen bill or bills. Oftel is, however, looking to use price controls not just to provide a broad safeguard but actually to drive prices down to the level which an efficient operator would offer in a competitive market. A simple 'no real increase' cap on the Median Residential Bill would fall far short of this. In fact, to achieve through bill control the customer protection and efficiency effects of a price cap, Oftel would need to do all the same modelling work needed to establish a price cap in order to arrive at a view of what an appropriate value of X might be for a bill control. Modelling would in fact be more difficult since there are a number of ways in which a Median Residential Bill control could be met and BT's possible tariffing strategies for different components of the controlled bill would have to be taken into account. The resulting X would be subject to wider margins of uncertainty than a conventional price cap.
6.18 Controls on a single bill inevitably provide effective protection only for customers whose bills are at or around the size of that bill. Control of a single bill allows the possibility that changes in other bills could differ markedly from the one controlled and significant rises in bills would be possible. It is, therefore, very unlikely that adequate customer protection would be provided by control on a single bill and a number of bills would need to be controlled. It would be necessary to establish exactly what constraints should be placed on other bills and how these controls would relate to that on the Median Residential Bill. But parallel constraints on bills of differing proportions of common services could mean that pricing flexibility for BT would actually be seriously diminished, rather than being promoted as intended by those suggesting this approach. The choice of precisely which bills to control raises as many issues as deciding on the scope of a conventional cap. It would be difficult to justify why only certain customer groups were being specifically protected. Customer groups above the median would be concerned that their interests were not being protected.
Oftel recognises that forms of bill control could play a useful customer protection role but is not persuaded by the arguments it has heard so far that bill controls should replace a conventional price cap on a basket of services. Oftel remains of the view that this is the best form of price control for the next control period, although it will of course listen to further arguments on this and would be particularly interested to have consumer groups' views on the proposal which operators have put forward and on BT's proposed commitment to a range of 'safeguard tariffs' which would not rise in real terms. Oftel considers that the apparent attractions of bill control - simplicity and customer focus - cannot be realised in practice and do not meet the broad consumer protection and efficiency requirements of price control. Oftel will, however, continue to monitor the bills of customer groups and would consider re-opening the price control, or taking alternative action, if particular groups of customer seemed to be suffering discrimination as a result of BT's pricing strategies.
6.19 There was some support in the responses to consultation for Oftel's proposals that services which were likely to become competitive during the price control period should be subjected to an individual safeguard cap of RPI+0%. But there was no great enthusiasm for the idea. Consumer groups were generally wary of seeing possible price reductions under an RPI-X cap replaced by a requirement simply that there should be no increase.
6.20 BT shared Oftel's view that, once competitive, services should not be in the price cap basket. They proposed the alternative mechanism of the progressive withdrawal - to a pre-set timetable - of specific services when they became competitive (eg the removal of international calls in 1998 when the European Union market is liberalised). In theory, this sounds a sensible proposition. In practice though, every time a service is removed from the basket the value of X needs to be recalculated and it is a difficult matter of judgement how much of the costs in the basket calculation should be removed with any individual service. BT's proposal means effectively a continuous, running price control review. Oftel considers that far from providing certainty, as BT argued, this proposal would create considerable uncertainty and instability, as well as being excessively time-consuming to implement. Customers would be confused about the impact of price control. Moreover, it is difficult to see how Oftel could be committed to a pre-set timetable for removing services without a specific test of whether there would be effective competition in the market.
6.21 Other responses argued that safeguard caps might act as price ceilings and that BT and competitors would act together to keep prices near the prescribed level. Oftel considers that, since only those services which were regarded as having good prospects of effective competition would be capped in this way, there would be little likelihood of this sort of behaviour and that Oftel would anyway be able to use its fair trading powers to deal with any such collusive activity.
6.22 Oftel feels that safeguard caps could have a helpful role to play in a market where several services are likely to become competitive over the price control period. Safeguard caps provide a mechanism through which the price control basket itself could be reduced in scope - prospectively competitive services would be outside it and subject to separate caps. Clearly, the usefulness of safeguard caps depends on the proposed scope of the basket and the period of the price control. They are less likely to be needed if the price cap basket is broad in scope.
6.23 The current price cap basket covers about 64% of BT's total revenues. In the first consultative document, Oftel asked for views on whether a number of additional services might be brought within the scope of the price control in some way - either taken into the price cap or otherwise controlled. Clearly, the UK telecoms market in the period ahead is going to be more competitive than at present and Oftel is, on further consideration, extremely reluctant to consider adding to the scope of the present basket. Oftel's position now on those services which it considered might be subject to control is:
Public Payphones: Oftel proposed that public payphone charges might, instead of being brought into the price cap, be tied to the price of, say, a local call. Many consumer bodies favoured some control.
BT has around 130,000 public payphones. Its public payphone business has shown volatile rates of return on capital over the last few years and profits have generally been small. The 94/95 Financial Statements showed only an 8% return, although this is in part because of the provision of 'loss-making' payphones.
As shown in Chapter 3, competition in the public payphone market is increasing. The Italian company, IPM, has taken over Mercury's payphone sites and New World Payphones are also entering the public payphone market. There is also substitutional competition from chargecards and mobile phones and there are around 0.5m private payphones (eg in pubs, railway stations and airports) whose markets overlap with those of public payphones. Geographic averaging of payphone prices means that as BT responds to the competition it faces from other operators in particular areas by reducing prices the benefits of those reductions are passed on to all public payphone customers.
Public payphone prices have not previously been controlled and it would be inappropriate to bring them into the price control now when competitors are just starting up, having based their business plans on what they considered would be free pricing arrangements.
Oftel considers that competition will be the best constraint on prices and with the new players in the market there will be increasing choice very soon. Oftel does not, therefore, propose to extend price control now to public payphones.
Oftel recognises that with keen price competition and geographically averaged tariffs it is possible that more public payphones with low usage could become uneconomic. After 1997 some loss-making public payphones could be funded from the proposed Universal Service Fund if it is demonstrated that these sustain a net cost after benefits are taken into account.
Calls to Mobile: Oftel remains concerned about the high charges for calls to mobile phones, in particular because most customers are not always aware that they are calling a mobile phone and are being charged such high rates. Oftel proposes, however, to pursue this separately from the price control review. The very high out-payments to Vodafone and Cellnet are the main reason for the high prices to those mobile operators. BT is currently discussing with all operators moving to new interconnection agreements based on BT's proposed Standard Contract. New interconnection agreements between BT and mobile operators will be placed in the public domain. Oftel intends to ask the industry generally to ensure that charges for calls to mobile phones and publicity about the dialling codes which indicate that a call is terminating on a mobile are given more prominence; and that the current substantial differential between BT's charges to Orange and Mercury One-2-One on the one hand and Cellnet and Vodafone on the other are made clearer in their price lists. Oftel may also require more detail from BT in the regulatory accounts on its payments to and from mobile operators.
Vision Circuits: As discussed in Chapter 3, Oftel considers that provision of these circuits constitutes a separate product market. There is a choice of suppliers in this market and considerable buyer power which provides a restraint on prices. The market is sufficiently competitive not to warrant price control.
ISDN: The first consultative document highlighted Oftel's concern at the high price of ISDN connection charges. Many of the responses echoed this. It is important at a time when the range of services available over wide/broadband lines is increasing rapidly that any inappropriately high prices charged by a dominant player should not act to deter wider take-up of ISDN by both business and residential customers. The Government recently launched its Information Society Initiative which is seeking to promote greater use of wider band services for the benefit of both industry, customers and the UK economy generally. Responses to Oftel's consultative document, Beyond the Telephone, the Television and the PC, last year argued that a focus on provision of broadband services was premature and that wideband provision was more important in the immediate future. Increased take up of ISDN is, therefore, crucial if greater access to wideband services is to be promoted.
Many of those responding to the consultative document found the high price of connection was a significant deterrent to take-up. Oftel has obtained figures from BT on its ISDN costs and has also looked at international comparisons of life-cycle prices for ISDN provision. It is, of course, important to consider the levels of rental and usage charges as well as initial charges since any customer installing an ISDN line would need to take account of ongoing charges as well as initial ones. Connection charges are high, rentals are higher than for an ordinary line but customers pay only standard call charges for BT's ISDN services.
BT figures indicate it has made a loss on connections for ISDN2. ISDN30 has been profitable overall but shows a loss on connections. BT's costs, however, include a high proportion of overheads and need further detailed examination.
Evidence from benchmarking studies of overseas ISDN provision shows that taking total charges for ISDN the provision in the UK is probably amongst the most competitive anywhere - certainly better than the US, France, Germany and Australia. Connection charges in overseas markets may be cheaper than in the UK but their usage charges are considerably higher. These benchmarking studies are recent and, in Oftel's view, reliable. Moreover, ISDN provision in the UK is set to become much more competitive - some cable companies and regional operators are or are intending to offer an alternative service to ISDN2 and those operators who have recently been licensed to operate in the 10GHz part of the spectrum will also shortly be able to offer competitive alternatives to BT's ISDN services. Mercury, Energis and other operators already offer competitive services to BT's ISDN30. For large users, private circuits provide an alternative to ISDN lines. Oftel is proposing that high capacity private circuits (greater than 64kbit/s) will not be covered by price controls.
With increasing competition in prospect and likely to be a reality at the start of the next price control period, Oftel at present considers it would not be appropriate to subject ISDN connection charges to price control. Oftel is, however, examining further the reasons for BT's high ISDN connection charges in the content of its overall charging arrangements. It will make the results of this investigation public, in due course, together with any proposals for further action by Oftel on ISDN prices. Oftel would welcome views on its proposed position on this and observations from the industry and users on the current level of BT's connection charges in relation to the reasonable costs of providing the connection.
Oftel, therefore, considers that the current scope of the retail basket is the maximum appropriate for the increasingly competitive market in the period ahead.
6.24 Oftel has considered which of the services in the current basket might be taken out - either removed from control completely or made subject to a safeguard cap. Two sets of services were put forward as possible candidates in the first consultative document:
Specially Tariffed Voice Services (0800, 0345, 0990): there was a broad consensus in the responses to consultation that there was potential for effective competition in this market, provided that Oftel took regulatory action to ensure number portability of these non-geographic numbers in order to reduce BT's first mover advantage. Oftel is already consulting on preliminary proposals with a view to putting together a formal work programme geared to commercial roll-out of non-geographic number portability in 1997. Oftel considers that when these steps are in place the market will become competitive and that the current, clearly recognised link between these calls and free, local call and national call charges will act as a restraint on prices. Oftel, therefore, proposes to remove them from the basket. Revenues from these services amount to around £101m a year. Removing them from the basket would reduce coverage of the price cap by about 0.7% of BT's total revenue.
(Premium rate services are not currently in the retail basket. Consultation supported the proposition that this was a market separate from specially tariffed voice services and that it should not be brought within control.)
Directory Enquiries (192)/Operator Assistance (100): In the light of consultation, Oftel intends to regard these as two separate markets. Current revenues are around £132 m and £16m respectively. In the first consultative document Oftel proposed that they should be subject to safeguard caps.
Operator Assistance is currently loss-making. It is a small but integral part of the package of services BT provide and is plainly a monopoly service. BT customers have no real choice of supplier of Operator Assistance as a separate service. Other operators generally use BT's Operator Assistance services rather than providing their own. Oftel considers that, while keeping Operator Assistance within the basket would provide some consumer protection through constraining price increases, it would also act to discourage possible competitive provision by other operators for their own customers. Removing Operator Assistance from the basket could encourage other operators to consider this. Oftel, therefore, proposes to remove it from the basket but would welcome views on this.
Oftel is currently reviewing responses to its separate consultation on the prospects for introducing competition into Directory Information and services, which includes Directory Enquiries. The retail prices for Directory Enquiries are currently about the same level as the cost of the service. Oftel proposes to take Directory Enquiries out of the price control basket given the possibility of competitive provision of Directory Information services. Oftel will, however, be examining the issue further as part of the separate consultation and will make a statement on this at the end of June.
Oftel's view, on which it would welcome comments is that these two groups of services - Specially Tariffed Voice Services, Directory Enquiries and Operator Assistance should be removed from control altogether.
6.25 National/International Direct Dialled Calls: Oftel has considered whether either of these call services could be removed from the basket. Oftel suggested in the first consultative document that it might be appropriate to regard local and national calls as part of a single market for inland switched calls. It proposed that these inland calls should continue to be in the basket while international calls should be subject to safeguard caps.
6.26 There is clear potential for much greater competition in international calls. The European Union will be liberalising its voice telephony markets in 1998 and there may well be substantial liberalisation before that. The DTI has recently issued a consultative document which proposes that there might be facilities liberalisation on European Union routes as early as mid-1996. The document is also consulting about the prospect of unilateral liberalisation on all other routes (subject to safeguards).
6.27 Large business customers who are significant users of international services already have a real choice of supplier for international calls either through direct lines provided by other operators or through indirect access. This choice will extend more widely to other business users as facilities are liberalised and more operators can offer attractive international services to a broader range of business customers.
6.28 But how far will residential customers benefit? For most residential customers international services are not a significant component of their overall bills. International calls comprise about 7% of the total Median Residential Bill and (14% of the call charges in this bill) and less for customers below the median. There are, however, some groups of residential customers for whom international calls are quite a high proportion of their bills - perhaps 3-5m customers for whom changes in international charges could be significant. Some indirect access operators are targeting these groups. International calls account for nearly £1bn of BT's revenues (12.3% of basket revenue).
6.29 Nevertheless, it is true to say that most residential customers would regard the international calls they make as part of a total package of calls provided by their local access operator. The availability for them of choice of international operator is thus restricted to the availability of choice of local access operator and it is unlikely, for most of them that use of indirect access would be a realistic proposition. For the majority of residential customers the impact of increased facilities liberalisation could be fairly small.
6.30 The position is similar for national calls: there is significant competing infrastructure to carry national calls and those business users who spend significant amounts on these calls will benefit either from direct access from competing suppliers or from using indirect access. Some high spending residential customers will also take advantage of lower prices offered by indirect access operators. But residential customers will benefit from competition in the national calls market only indirectly, through the competitive interconnection arrangements their alternative local access providers can make with other operators who are competing with BT (eg. Mercury, Energis or regional operators like Torch, Scottish Telecom). The number of residential customers using indirect access is low and cable companies and other access operators are not required to offer indirect access until they have market power. For the majority of residential customers the availability of competitive provision of national calls, like international calls, is actually delivered through the local access provider. (National calls account for rather less than 20% of the total of the Median Residential Bill and 36% of the call charges in that bill. They account, however, for a significant proportion of the 3-5m top-spending residential customers. BT's revenues from national calls are £1.9 bn, 24.3% of basket revenue.)
6.31 International, national and local call markets may be separate markets but, from the perspective of most residential users, they are all delivered as part of a combined calls package by the local access provider. The issue of effective competition and choice in these markets for residential customers is, therefore, closely tied to the issue of whether the local access market is effectively competitive. Competition in access is clearly increasing but Oftel would not regard the market as likely to be competitive at the start of the next price control period.
6.32 Oftel's clearly stated view is that regulation should pull back as competition takes hold. With increasing competition in international and national markets it would be an option , if it could realistically be argued that these were truly prospectively competitive, to take these services out of the basket and make them subject to individual safeguard caps. This would leave a minimum basket of access and local calls. In the absence of effective competition in the local access market, effective competition in these markets for residential consumers could only be provided by a significant increase in the use of indirect access by these customer groups. This has not been the experience of the past and new indirect access operators are not generally widely targeting the residential market.
6.33 Oftel has recently reviewed the case for extending indirect access through the introduction of 'equal access' arrangements, whereby directly connected customers of public telecoms operators (PTOs) could obtain national and international services from other operators by dialling the same number of digits as for calls made via that PTO. BT's and other operators' licences contain a provision enabling the Director General to direct the licensee to provide such equal access. The licences require Oftel to undertake a cost-benefit analysis showing that there is a positive net case for equal access to be introduced before any such direction can be made. Oftel has conducted and consulted on a cost-benefit analysis. Having assessed the responses to the consultation, the Director General has concluded that there is at present no positive case for introducing equal access as defined in this provision.
6.34 However, Oftel intends to keep the case for introducing equal access under review, and will in particular examine the case for altering the scope of the services to which equal access might apply and which categories of operator or service provide might be covered.
6.35 In addition, Oftel intends to review the existing 'easy access' procedures, and other issues relating to indirect access to services, such as availability of suitable numbers, with a view to strengthening these existing provisions. Oftel remains of the view that indirect access will make a significant contribution to a competitive market for a substantial number of residential and small business customers.
6.36 In future the great majority of residential customers will be offered effective choice for national and international services only where there is effective competition in the choice of local access provider. There is, therefore, in Oftel's view no strong case for splitting off national and international calls as prospectively competitive while leaving local and access charges as non-competitive and subject to the basket control. Oftel considers that for the period immediately ahead all call services should remain in the basket.
Oftel's preference is to stick to the present basket, removing only Specially Tariffed Voice Services, Directory Enquiries and Operator Assisted Calls for the next price control period. With a broad basket coverage like this there would be no services which might fall into the safeguard category and this mechanism would not be needed at the retail level for the PSTN basket. Oftel would, nevertheless, welcome views on whether a minimum basket of just local calls and access could be a realistic option.
6.37 At the moment, any discounts BT offers are not counted towards the basket but count instead towards the total volume of discounts which BT is required to maintain each year. In earlier price control arrangements discounts were included in the basket but BT, at that time, chose to use this flexibility to focus its price cuts on business customers and to offer few price reductions to residential customers. Discounts were, therefore, removed from the basket. In recent years, this pricing policy has changed as BT has faced increasing competition for residential customers from cable operators.
6.38 BT has indicated that in future it wants to move away from a single standard call tariff for residential customers and to introduce a family of call/rental tariff packages which will provide greater choice for customers in how they pay for their telecoms services (low users may choose to opt for a low rental charge with higher call charges whereas high users would favour a high rental and low call charges). Under the recent licence modifications to remove the RPI+2% exchange line rental constraint, call or rental charges under these packages which differ from the reference tariff (the tariff used to calculate compliance with the overall price control) would also count towards the required volume of discounts.
6.39 Whether in the future discounts should be counted towards the price cap control depends to a large extent on the coverage of the basket itself. If there is a broad basket, as in Oftel's preferred option, and discounts were allowed to count towards the price cap control, then there would be considerable scope for offsetting reductions in one of the services in the basket against increases in another. There could be competition concerns if increased discounts on, say, national calls were offset by keeping local call charges - which are the main concern of residential customers - higher than they might have been. For these reasons, Oftel proposes that if the broad basket option is adopted discounts should not count towards the basket and should remain covered by the current rules. The current rules would continue to apply to price changes on elements of call/rental packages. If BT were to move to a family of call/rental packages, it would still need to specify a reference tariff as the basis for calculating compliance with the price control and for calculating the value of the contribution which packages make to the required volume of discounts.
6.40 If a narrow basket of just access and local calls were considered an option there would clearly be no scope for using discounts on one type of call to keep charges on other types of call higher. There would, however, remain the possibility that, even within the local call service, BT could focus price reductions on business customers through large volume discounts on local calls or by concentrating reductions on day-time (rather than evening or week-end) rates.
6.41 Oftel nevertheless considers that discounts or elements of call/rental packages which are not regarded as unfair or undue in competition terms ought to be allowed to count towards the price control requirements. On a narrow basket, Oftel would propose to include in the price control calculations all discounts or contributions from call/rental packages relating to access or local call charges. Oftel considers that in the increasingly competitive domestic market BT is unlikely to want to be seen to disadvantage residential users and figures in the first consultative document showed that in recent years residential customers have received a more equitable share of price reductions.
6.42 Price controls have the greatest incentive effect in improving the efficiency of the regulated firm when they are set, and left, for a long period. On the other hand, there is no doubt that the UK telecoms market will change significantly over the next few years. New competitors will be consolidating their businesses and technology will be driving new developments, products and service choices. The changes in the market, increasing competition from local access players, increased international liberalisation etc - make forecasting very difficult and the basis on which a price control is set may prove to be a long way adrift over a long control period. Given such prospective change the case for prolonging the price control period to 5 years is weakened. The need for continued retail price controls will need to be re-considered before then. On the other hand, setting a price cap calculated on the basis of a short period has poor incentive properties, in terms of improving efficiency, and would mean a price control review in almost continuous session.
Oftel, therefore considers that a price cap under conventional incentive regulation should be set on the basis of a 4 year control period, as at present.
6.43 The analysis above leaves Oftel with an apparent paradox: the market is plainly becoming increasingly competitive but it is not yet sufficiently competitive to allow Oftel to feel confident about moving away from conventional retail price cap control or reducing significantly the scope of the basket. The option emerging from the analysis above is to introduce a further 4-year cap on broadly the current basket. This is hardly de-regulatory and does not reflect the current state of transition in the market towards effective competition.
6.44 Oftel has, therefore, considered whether there are alternative approaches, based on a broad conventional cap which might better match the market in the years ahead. Oftel sees two possibilities.
6.45 Consumer groups have urged Oftel to ensure that residential consumers are given full protection in the period ahead before effective competition takes hold. And while Oftel remains unpersuaded by operators' arguments for replacing a price cap approach with a bill control, it agrees that the next price control needs to secure protection for the most vulnerable groups of customers. Oftel has therefore considered whether, given that it does not feel able to reduce the coverage of the basket in terms of services, it might nevertheless reduce it in terms of the groups of customers for whom those services are provided. It has looked at how to focus coverage of the control on those customers who are unlikely to benefit significantly from competition over the period to 2001.
6.46 As discussed above in paragraphs 6.xx to 6.xx there is a good deal of evidence to suggest that competition is relatively strong for higher volume users, primarily business customers. This is not surprising because the costs of fixed network operators are such that profitability increases with increases in volume. Inevitably, therefore, as competition emerges operators are likely to target these markets and it is the business customers who are likely to benefit most from the range of suppliers offering service. In addition business customers are able to take advantage of alternative services such as private circuits as opposed to switched services; they are more likely to use indirect access to get more competitive provision of services; and those with especially large volumes have the choice of some form of self provision.
6.47 For the residential customer as a whole, however, the availability of competing service provision although developing, is not strong and is unlikely to be so for some time. It is likely therefore, that in contrast to the business sector, competition will not be sufficient to constrain prices.
6.48 In seeking to focus controls on those customers with limited competition there is, therefore, a good case for limiting the retail basket to residential customers and possibly also to small business customers whose usage is broadly similar to that of residential customers and who face similar levels of competition.
6.49 Medium and large volume business customers will be offered an effectively competitive level of service from 1997 and Oftel would propose that services to them would not be included in the price cap. Services to these customers would be outside the basket and there would be no controls at all on their prices. Discounts would remain outside the basket since most discounts are targeted at high volume users who would not be covered by price controls.
6.50 Removing price controls on business customers would, in principle, allow BT greater freedom to meet customer needs. How far BT would wish to take advantage of this is uncertain. Currently BT does so through volume related discounts but there may be a need to allow BT greater freedom than has hitherto been the case to discriminate in its tariffs between residential and business users.
6.51 The impact of withdrawing controls from business customers would reduce the basket of controlled revenues by about £3bn per annum and lower revenues from services covered by the basket from the 64% of BT Group revenues currently to around [ ]%.
6.52 If the basket coverage was limited to residential and small business customers it is likely that the value of 'X' would be lower than with a broader basket. This arises because these customers tend to be less profitable than business customers. Evidence from calling patterns indicate that on average residential customers make relatively less national and international calls, which are particularly profitable, than do business customers. On this basis, there would be less supernormal profits to be recovered in the setting of 'X' for a basket containing only residential and small business customers. In setting a value for 'X' there would be difficulties in deciding how costs of primary services should be allocated between these customers and the rest of BT's customers. One way to approach this would be to adjust the value of 'X' from the wider basket by making a forecast of likely changes in service prices consistent with a given value of 'X' for the wider basket. The overall effect of these price changes for customers covered by the proposed price control could then be computed on the basis of the consumption pattern of this group. The value of 'X' would then be adjusted to be consistent with this calculation. In making such adjustments it may also be appropriate to take account of the advantages that BT could obtain from greater price flexibility for large business customers.
6.53 Effective competition certainly will not, in Oftel's view, be established by August 1997. A conventional and broad-based price cap will be, therefore, necessary for a number of years beyond that. If, however, the industry is right and effective competition is a reality in only a few years' time, then this proposed price control would cease to be a real constraint since competition would have driven prices below it. Continued price regulation would be inappropriate in these circumstances. And while a conventional 4-year price cap set now - with X and the coverage of the basket clearly specified - may be appropriate for the early part of the period but may well not be the best option in the latter years.
6.54 As a possible alternative to a conventional price cap and as a different form of incentive regulation, Oftel proposes that it might instead set the new price cap on the basis that BT's expected rate of return would fall to the level of its cost of capital over a four year period (ie on exactly the same basis and with the same X as a four year conventional control) but the control would in fact end on 31 July 1999. Oftel would review in early 1998, in the light of market developments, what - if any - retail price controls would be necessary thereafter. Oftel's intention would, however, be that if certain specified conditions were met and the markets for capped services were shown to be effectively competitive, there would be no further retail price control at all. If this were not the case, Oftel would reconsider in the light of likely market prospects at the time what form of price control would continue to be needed. By that time the market, even if not fully competitive might justify moving to a narrow basket or considering the alternative of a form of bill control. Nothing would be pre-judged. The nature of a continuing control would be determined by the prospective market.
6.55 If price controls were to end in 1999 there would clearly need to be confidence that the competitive conditions in the market were such that there remained at least the same degree of downward pressure on BT's retail prices as existed with the controls. The first consultative document addressed the issue of how effective competition might be assessed and it suggested that a range of factors would need to be taken into account. These related to structural conditions such as the number of entrants, the market shares of competitors, whether and to what extent these changed over time and the existence and size of entry barriers in the market facing aspiring competitors. In addition, the conduct of the firms in the market would need to be assessed, especially in regard to their price behaviour and how far price itself was a key element in the competitive dynamic of the market.
6.56 The consultation document pointed out that no one indicator could be relied upon to assess the extent of competition and this remains Oftel's view. Oftel considers at the moment that none of the services in the broad basket will with certainty be competitive over a 4 year period. If price controls were to end in 1999 there would need to be significant developments in a number of critical areas:
Clearly there would need to be a choice of operators for a substantial proportion of telephone customers. It is not practically possible to prescribe how many operators would be deemed to be sufficient but there would need to be evidence that the choice was sufficient to constrain the pricing behaviour of any one firm and that there was vigorous price competition for customers.
There would also need to be consideration of the range of services offered by competitors, the extent of innovation in service offerings, the quality of service and movements in relative prices.
There would need to be clear evidence not only that choice was available but also that customers were actually exercising that choice. Clear market information would need to be available to promote informed choice. The market should be an active one and with significant movement of customers between operators.
The development of competition will also necessarily depend on a number of critical issues being resolved at an early stage. One factor that will be important in moving to a competitive market is the liberalisation of the provision of international facilities. Once this had occurred, there would need to be evidence that competition was sufficiently vigorous to be exerting strong downward pressure on the prices of international services.
A further critical factor necessary to encourage competition is the reduction of barriers to entry. At the present time there are a number of structural and operational features which are likely to inhibit entry and which will need to be addressed in order to bring about an effectively competitive market place. In particular Oftel and the industry must have established and put in place agreed arrangements for interconnection of new services between BT and other operators. This would include appropriate processes for agreeing access and interconnection standards.
Clear progress on the implementation of number portability on fair and reasonable terms for all categories of numbers (both geographic and non-geographic) is required.
Service providers and other operators should be able to purchase conveyance services, especially from dominant operators, unbundled to an appropriate degree to avoid the purchase of elements not needed.
There would also need to be clear evidence that the asymmetries benefitting dominant operators in terms of service and information availability had been substantially reduced and that competition in the supply of Directory Enquiries services would be in place.
An absolutely crucial factor is that Oftel must be able to police anti-competitive behaviour speedily and effectively. It needs to have new powers soon to enable it to do this. And these powers must be seen to be working effectively. Oftel has made proposals to achieve this in its recent consultative document 'Fair Trading in Telecommunications'. Effective fair trading powers would be required in order to facilitate the development of a competitive market by allowing quick and effective action against anti-competitive behaviour. This would remain the case even with markets deemed to be competitive as the dynamics of the market and the behaviour of participants are unlikely to rule out the need for quick and effective intervention to ensure that the markets continue to work freely.
6.57 These conditions are not specifically for any particular operator to deliver but rather will need to be addressed by all operators in varying degrees. The conditions are necessary to allow the development of effective competition but do not themselves guarantee that effective competition will be attained. They would not necessarily all have the same weight in the review. Oftel would not want to weigh heavily those factors over which BT has significant influence which it might use to distort the outcome of the review.
6.58 Moreover, Oftel would not wish to encourage operators to meet specific targets merely to give the impression that effective competition was in place when in fact this was not so. More generally, Oftel is aware that in the context of setting 'X' at the retail level there may be incentives for operators to behave in terms of market share objectives in a way designed to minimise the value of 'X' and therefore the impact of price controls. Oftel would need to monitor such behaviour very carefully to ensure that there was no strategic gaming designed to meet targets without necessarily providing effective competition.
6.59 The assessment of effective competition is not straightforward and does not depend solely on particular structural conditions being achieved. The review Oftel would undertake for early 1998 would, therefore, need to be a wide ranging one taking in all appropriate factors. There would be full consultation with industry and customers. If this alternative option is to be pursued Oftel will consult further on and subsequently set out in a Statement the conditions it would be using as the basis for the 1998 review.
6.60 If the conditions for effective competition were not met, Oftel would set in hand a full price control review and would arrange to have in place a new price control (for whatever further period seemed appropriate) to carry on from 1 August 1999. As noted above, the scope and nature of continuing price control would be decided in the light of market developments at that time.
Oftel's preferred basket coverage is the broad basket discussed in paragraph 6.xx above. Yet a continued price control on the basis of a conventional 4-year cap and with a broad basket does not reflect the potential for developing competition in the UK market. Oftel sees three options for the next retail price control and would welcome views on these:
POSSIBLE VALUES OF X
6.61 The composition of the price control basket is a key factor in determining the value of X. The reason for this is that different types of services currently have different levels of supernormal profit (profit in excess of the cost of capital) at the start of the price control period. The price cap acts to squeeze out supernormal profit over the control period. A basket covering services like international calls, which have high levels of supernormal profits, will therefore be consistent with a higher X than a basket with only local calls where the level of supernormal profits at the start of the period is low.
6.62 The coverage of the price control basket is primarily an issue of policy and Oftel has set out above what it sees as the options and its preferred coverage. The other main variables, besides the basket coverage, which have a significant effect on X are:
6.63 The values or forecasts Oftel has taken for these parameters involve considerable measures of judgement. The nature of the judgement on the first two is, however, qualitatively different from that for the other two. The first two are a matter of taking the best forecast of what the future market will be, based on a mixture of BT, industry and outside estimates as well as Oftel's own views. The latter two are less a matter of forecasting and more in the nature of seeking the best available evidence about more objective factors. Oftel has taken the external evidence of current and future efficiency levels in other telecoms operators to reach a view on BT's likely productivity improvements and objective evidence from the financial markets to determine the cost of capital. The approach Oftel has taken is set out in detail in Chapter 7.
6.64 The table 6.1 below sets out for consultation a range of values of X (assuming coverage of all customers) for the 2 baskets Oftel has proposed - the minimum basket (local calls and access) and the preferred, broad basket. Oftel has examined a range of possible values of the four main variables set out above and the values of X they produce. Its analysis will be further refined over the next few weeks and, in the light of this and responses to this consultation, Oftel will reach a final view on the value of X for statutory consultation at the end of May. The figures presented here should not be taken as precise values of X for a particular value of the key variable. Rather, they show the centre of gravity of a number of values for X produced for different values of the key variables. Nevertheless Oftel considers that the values of X set out here probably span the likely range.
6.65 BT's volume growth (the product of forecast market share and growth in market volume) is the variable having the most impact on X. It is the most difficult to get right. The table sets out 3 alternatives:
6.66 The table shows values of X for the three cases, taking central assumptions for efficiency and for the cost of capital.
Table 6.1
BT Volume Growth
Basket Accelerated Historic BT
Minimum
Discounts in 3 1.00 -1.5
Broad 9 7 5
Discounts out
[6.70] Values of X for the narrow basket are small because BT makes a loss on its access business and because there is comparatively little supernormal profit on local calls to squeeze out over the price control period. Chapter 7 explains that taking international calls out of the basket reduces X by around 2 percentage points and taking national calls out entails a further reduction of 4.5 to 5.4 percentage points. X will also change if the price cap is focused on residential and small business customers, explained in paragraph 6.52 above.
6.67 X will obviously change as different estimates for the other two key variables are considered. Broadly, a 1 percentage point increase in the assumed rate of reduction of BT's real input costs would increase X by about 1 to 1.25 percentage points; a 1 percentage point increase in the cost of capital value used reduces X by 0.5 percentage points.
6.68 The impact of the value of X on the bills of different groups of residential customers will depend on how BT changes prices for its various services and on any new tariff packages BT may introduce. Taking, for the sake of illustration, the neutral assumptions that rentals stay constant in real terms and that call reductions are applied equally to local, national and international calls, it is possible to indicate ranges of cumulative reductions for residential customers over a four year control period. These ranges are shown below for customers with bills above and below the Median Residential Bill.
Table 6.2 Possible effects on residential bills of different values of X
% Change in bill in real terms
Value of X Call spend less than MRB* Call spend more than MRB
9 -17% to -27% -27% to -41%
7 -14% to -23% -23% to -34%
5 -9% to -14% -14% to -22%
6.69 The present basket has sub-caps of RPI+0% on each price, apart from exchange line rentals. These prevent BT moving prices down and then back up again in order to de-stabilise the market or making big increases in one price to offset reductions in another. Oftel considers that such anti-competitive pricing action would be dealt with under the new anti-competitive practices provision it is proposing. Sub-cap controls can also act as a significant constraint on the overall increases in customers' bills. In the broad basket large reductions in international call charges could for example be offset against increases in local charges if there were no sub-caps. BT could in this way focus price reductions on business customers. Oftel believes, however, that increasing competitive pressure in the residential market will act to prevent this. But more significantly, there are limits on how far call charges can fall without being regarded as anti-competitive and, with values of X set in the range of values discussed above, it is very unlikely that sub-caps of RPI+0 would prove a real constraint. All call charges would have to fall to meet the overall cap.
Of course, if the option of focussing the price control on residential and small business customers were pursued this would itself to a large extent meet concerns about customer protection. Oftel does not, therefore, believe that sub-caps will continue to be necessary as part of a future price control. Removing them would simplify the controls and be de-regulatory.
6.70 There are currently price controls on BT's charges for rental of hard-wired telephones. During the investigation leading to the 'Telephone Equipment' Direction (22 September 1995) it became clear that BT is making very large profits from the rental of hard-wired telephones. In accordance with the Director General's statement of 25 September 1995 on 'Anti-competitive behaviour by BT in the telephone equipment market' Oftel is currently examining this and other related issues to decide what action, if any, should be taken.
6.71 Oftel may want to take this issue further as part of future price control arrangements. A significant one-off adjustment to BT's rental charges may be appropriate. Oftel will set out its position on this in the next consultative document in May.
6.72 There was general support for Oftel's view that it is very difficult to incorporate quality requirements in a quantative way into price controls. One of the main consumer bodies thought otherwise but did not address Oftel's concerns about how the particular quality factors to go into the control would be chosen and how Oftel could be sure that such factors were indeed the ones to which consumers attached most importance.
6.73 In the light of the consultation, Oftel proposes not to incorporate quality requirements into the controls but instead to promote quality improvements through continued monitoring and publication of comparative performance statistics.
6.74 BT is the only supplier of analogue private circuits and is dominant in the market for digital circuits below 64kbit/s - although some competition is expected to emerge from radio-based services in future. BT thus has considerable market power in both these markets.
Oftel proposes that, for the next price control, analogue private circuits should be in a basket subject to an RPI+0% cap (as at present) and digital circuits up to and including 64kbit/s should be in a separate basket with an RPI+0% cap (currently all digital circuits are subject to such a cap). Oftel proposes to continue to impose separate sub-caps on individual private circuit prices ( RPI+2% and RPI+1% respectively for those analogue and digital circuits in the baskets.) Oftel considers this remains necessary to prevent BT imposing large increases on particular circuits. Oftel would welcome views on this.
6.75 Responses to consultation generally agreed that high capacity circuits were a competitive market and that 64kbit/s was an appropriate break point. Oftel proposes that these high capacity circuits should be removed altogether from the price control (and contrary to the proposal in the first consultative document, that they should be subject to safeguard caps).
Oftel proposes to remove both the main links and the terminating ends of private circuits above 64kbit/s from price control. There may be a case for arguing that the digital ends could be significantly less competitive than the main links but BT is currently trialling provision of a partial private circuit interconnection service and this should further contribute to the development of effective competition. In some areas, such as the City of London, there may be particular practical problems for customers that limit their choice of supplier of terminating ends, such as insufficient space in their communications rooms. Oftel would welcome views on whether terminating ends of high capacity circuits should be included in the digital basket.
6.76 If international facilities are liberalised shortly there could be greatly increased competitive provision of international private circuits by the start of the new price control period, certainly on some routes.
Oftel proposes that international private circuits prices should not be controlled. Alternatively, given inevitable uncertainties about the speed at which effective competition would develop, there are arguments that they should be subject instead to safeguard caps - a separate cap for each route. Oftel would welcome views on this.
6.77 As discussed in Chapter 5, Oftel is proposing separate caps on BT's network charges. Transfer payments of network charges account for over 43% of BT's retail costs and there are grounds for arguing that the retail price control should apply only to the margin between retail prices and network charges. All this is explained in more detail in paragraphs 5.xx - 5xx. Applying price control to the margin would mean that the impact of the control on the retail prices which customers actually pay would be unclear. For this reason, Oftel does not propose to take this route but will continue to impose price controls on retail prices themselves. Oftel considers this is a far more transparent and easily understood approach.
6.78 In the first consultative document Oftel asked for views on whether a secondary objective for the price control should be to choose price control structures, which, where appropriate, further Oftel's fair trading objectives. There was little comment on this in the responses and those who did comment felt that promoting this objective would be inherent in the controls chosen rather than being something to be pushed as an independent objective.
6.79 Oftel also stated that it proposed to keep the next price controls as simple as possible. This is not easy. The proposals in this document are inevitably detailed and to some extent complex. But Oftel's preferred option of the broad basket at least continues with arrangements which, if not simple, are familiar. There are some simplifications proposed here - no sub-caps within the main basket - but substantial simplification will be possible only when there is effective competition and services can be removed from controls altogether.
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