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Oftel submission to the Office of Fair Trading’s review of BSkyB’s position in pay TV markets |
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May 2000 Market definition and market power Annex A: Market definition in the broadcasting industry Annex B: Accounting separation Annex C: The assessment of profitability per subscriber Appendix I Glossary 1.1 Oftel welcomes the opportunity to comment on the Office of Fair Trading (OFT) review of BSkyB’s position in pay TV markets. Rather than commenting on all the issues raised in the paper, we would like to focus on certain topics in which Oftel’s knowledge and experience might be particularly helpful. These are:
Market definition and market power 2.1 Oftel’s work is increasingly concerned with convergence. The convergence between the telecoms, broadcasting and information technology industries is blurring the boundaries between existing markets and increasing the scope for competition. 2.2 Changes in the market place since the time of The Director General’s review of BSkyB’s position in the wholesale pay TV market (‘the 1996 Review’) may well have had an impact on the relevant market definitions. For instance, it is possible that basic pay TV and free-to-air TV have become more substitutable since the time of the 1996 Review. The growth in the number and range of free-to-air channels (eg ITV2, BBC News 24, BBC Knowledge) may mean that basic pay TV channels are more substitutable for free-to-air channels than was the case in 1996. In addition, basic pay TV channels are becoming more similar in content to free-to-air offerings. The fact that basic pay TV and free-to-air channels are in many cases competing for the same programme rights is an indication of this. This does not necessarily imply that basic pay TV and free-to-air are in the same market. However, it might be sensible to consider this question as part of the current review, since these developments suggest that the wholesalers and retailers of basic pay TV channels are increasingly constrained in their ability to raise prices by the availability of free-to-air channels. 2.3 Technological change also affects market definitions in premium pay TV markets. The proliferation of channels and the introduction of new broadcasting media - eg digital terrestrial, ADSL - are making it increasingly difficult to make distinctions between different markets. For example, near-video-on-demand (NVOD) and video-on-demand (VOD) did not exist at the time of the 1996 Review. To the extent that NVOD and VOD constrain the ability of premium channel suppliers to raise prices, then any market power enjoyed by the latter will be limited. 2.4 The holders of programming rights are also becoming more sophisticated in their approach to selling programming rights. One example of this comes from the growing practice of splitting a particular set of rights into different ‘windows’ ie different time periods in which broadcasts are made. It may well be the case, therefore, that the holder of programming rights for any particular window is likely to be constrained in the extent of its market power by holders of rights for other windows. 2.5 Oftel would like to offer a conceptual framework which may assist in considering such issues. This is outlined in Annex A. Briefly, the conceptual framework is based on the idea that the closer different windows are to each other, the greater the possibility of demand-side substitution (ie substitution by consumers) from one to another. To the extent that the holder of rights for any one particular window is constrained in its ability to raise prices by the possibility of demand-side substitution to other windows, the market power it possesses will be limited. 3.1 BSkyB might be found to have market power in wholesale pay TV markets as it was in the 1996 review. The OFT’s concern might then be, as it was in 1996, to prevent leverage of that market power into retail markets through the practice of margin squeezing. To achieve this, it is necessary to ensure that BSkyB’s retail arm purchases channels and programmes from its wholesale arm on similar terms to those available to competitors in the retail market. To ensure that BSkyB cannot effectively circumvent this rule, by charging a high price to both its own retailing arm and to other retailers, it is necessary to check whether BSkyB’s retail arm makes a reasonable profit after taking account of the non-discriminatory payments to its wholesale arm. To ensure that these arrangements are working properly, accounting separation of BSkyB’s wholesale and retail operations is necessary. 3.2 Oftel has a great deal of experience in enforcing accounting separation. A number of companies regulated by Oftel are subject to accounting separation provisions under the terms of their licences. Annex B describes in detail current Oftel practice in relation to accounting separation. Oftel would be happy to discuss in detail its accounting separation procedures with the OFT. 4.1 As in the 1996 Review, BSkyB might be found to have market power in the wholesale market for pay TV programming. The issue which would then arise would be how to prevent BSkyB from leveraging market power by margin squeezing competitors in the downstream market. To assess whether BSkyB is behaving anti-competitively it is possible to look at BSkyB’s profitability at the retail level. However, to measure profitability the OFT would require a method to overcome the difficulties which arise when considering such dynamic markets and activity. In particular, a purely accounting approach is not appropriate, since profitability will tend to change considerably from one year to another with the relative growth in the number of subscribers. The Net Present Value approach (NPV) allows the regulator to solve this problem, but others arise, especially the need for a terminal value. 4.2 Oftel suggests that the OFT consider the profitability of BSkyB at a per subscriber level in order to assess the profitability of BSkyB’s retail operation. If the cost of acquiring a new customer exceeds the expected present value of net revenue from that customer over the expected lifetime of the customer’s subscription, then it can reasonably be assumed that cross-subsidisation from the wholesale pay TV market to the retail pay TV market is taking place. This method, which Oftel has used in its own investigations into possible margin squeeze in mobile telephony markets, is described in detail in Annex C. We would be happy to explore how the method outlined may be applied to the pay TV sector in conjunction with the OFT. Annex A: Market definition in the broadcasting industry 1. Defining a market in any industry investigation is a process which raises a number of questions to which the answer is often far from certain. Although this is likely to be the case with most industries, the audiovisual industries present additional difficulties. 2. The relevant product markets often cross the boundaries of more established markets. This is all the more true in the presence of the current developments in communication technologies and the overall convergence process. It would be useful therefore to have a comprehensive and consistent framework to approach product markets in the broadcasting industry (although this paper will be concerned mainly with broadcasting, the same approach for all the audiovisual industries). 3.
Product markets can be distinguished on the basis of the type of
content. The exact nature of any market defined in this way depends
on the extent to which consumers regard one type of content as a substitute
for another. This means that the relevant market could be as wide as
‘sport’ if consumers regarded different types of sporting
coverage as a substitute for each other. Alternatively, the market could
be as narrow as competitive soccer matches involving Manchester
United if a significant number of customers regarded this as a unique
product for which there were no good substitute. 4. However, a key feature of audiovisual products which is particularly relevant to market definition is their durable nature, ie the fact that consumption of these products can take place over a longer time period without the utility they provide being sharply diminished. 5. The other dimension to be considered is therefore the time frame of exploitation of the product, that is, the timing of its consumption during its life. The life of an audiovisual product can be quite long for a durable good (eg feature films, documentaries, educational programs), or relatively short for a perishable one (eg ‘live’ events, news, and also television series to some extent). Although all audiovisual products maintain a degree of utility (thus an economic value) over a virtually infinite period of time for at least a proportion of users, they are usually distributed so as to extract the maximum value from users. This value depends on the incremental utility these products can provide users with. 6. We define incremental utility as the additional amount of utility that a user can benefit from when consuming the product at a point in time. Incremental utility is highest at the time of the first consumption, since normally consumers associate the highest utility level with the first consumption of the product, and decreases with time more or less rapidly, depending on the type of product and on the user’s preferences. The cumulative total utility provided by a product is on the other hand likely to increase over time, as the product is used by increasing numbers of people. 7. From the perspective of their exploitation, audiovisual products can therefore be distinguished on the basis of the age of content. The more mature a product is, the less incremental utility it is likely to provide users with (this is true, at least, when we consider commercial exploitation of audiovisual products, which implies the need to maximise first-time audiences). Firms typically base their decisions on pricing and type of carrier on the basis of the incremental utility of products, and incremental utility will in turn be affected by both the age of the content and the number of ‘passages’ or ‘windows of exploitation’ that the product has been offered for. This concept is well known in business practice in the audiovisual sector: windows of exploitation of any audiovisual product are designed so as to maximise the total value of the product over its lifetime. 8. In defining the market, then, it is appropriate to take into consideration the window of exploitation that the product in question belongs to, as that product is likely to compete more fiercely with other products belonging to the same window, than to similar products belonging to earlier or later windows. The shorter the distance between different windows, the greater the possibility for demand-side substitution. To put things more clearly, it might be useful to consider an example of how market definition might take into account the time dimension of audiovisual products. For example, the standard life of a feature film can be represented as follows: An example of different windows for a film release
9. Bearing in mind that any definition of a market should be carried out on a case-by-case basis, it is useful to consider that, based on the previous example, a film on pay-per-view (PPV) might be competing more closely with the same film on video cassette sales, rather than with video cassette rentals or pay-TV. A similar exercise can be conducted with less durable goods (ie sports events or live concerts), although the time frame of exploitation will be consequently shorter, and there will be a smaller number of potential candidates, or windows in which the content is displayed. 10. Two dimensions can thus be used when defining a market in the broadcasting and audiovisual industries: the type of content and the time-frame of exploitation. By using this framework of analysis, we can identify the substitutes for the product under observation by looking at the availability of substitutable content and the number of adjacent windows. The most obvious candidates for substitution, and, therefore, the products which can be regarded as being in the same market, will be all those which: a) are shown in the same window and have substitutable content (eg, an action film shown on PPV may be seen as being in the same market as another film on PPV that can appeal to the same type of audience); b) have the same content and are in adjacent windows (eg, the highlights of an European league football match on a basic pay TV channel may be seen as being in the same market as the highlights of the same match on a free to air channel). 11. Such an approach has three main advantages. First, it is a comprehensive approach, since the generality of audiovisual products can be thought of having a specific location in this two-dimensional space, regardless of the specific type of carrier. Second, it builds on the specific economics of the audiovisual products, and it reflects business practice. Third, it is open and technology-neutral, allowing for future market and industry developments, while at the same time providing a sufficiently flexible approach. In particular, this framework provides an economic basis for the consideration of questions such as whether PPV is in the same market as subscription-type pay TV. There are also other questions for which this approach may be helpful: for example, what are the appropriate market definitions for VOD products? The approach defined here allows this question to be answered in terms of the way customers would perceive VOD products to be substitutes for other combinations of content and windows. In particular, the approach allows for a service such as VOD to be assessed as being in a number of possible markets, depending on the age of the specific content and the windows in which that content has been and is currently available. Annex B: Accounting separation 12. If BSkyB is found to have market power in a wholesale pay TV market, Oftel believes that properly-enforced accounting separation is necessary to ensure the effective operation of rules to prevent that market power from being leveraged into the retail pay TV market. 13. Under these circumstances, it is imperative that the preparation of accounts for BSkyB’s wholesale and retail businesses should enable costs and revenues associated with each business, and the transfers between them, to be separately identified and properly allocated. Accounting separation should be undertaken on the basis that the accounts of a particular part of a business would reflect the position as if that business were a separate entity. There should therefore be a clear rationale for the transfer charges used, and each charge should be supportable. The separated accounts should enable a decision to be made as to whether BSkyB’s revenue from its retail business generates an adequate return over its economic lifetime. 14. Oftel believes that accounting separation should be based on the following principles:
15. As a result of the 1996 Review, separated accounts are now being produced on a six monthly basis. At present, however, these separated accounts are only scrutinised by the OFT. Oftel considers that by making these accounts publicly available, the accounting separation procedure would be fully transparent. The separated accounts are now also subject to an independent audit to regulatory standards. The audit of these separated accounts should conform to recognised auditing standards. 16. Clear transfer charges, along with clear ground rules on the attribution of marketing and transmission costs, are of paramount importance. 17. To identify anti-competitive practice, such as cross-subsidisation it is essential that appropriate financial data is available in order that the accounts can be effectively analysed. The issue is analysed in Annex C. Oftel is in broad agreement as to the disaggregated segments that are currently used in the preparation of separated accounts for BSkyB’s wholesale and retail arms. Annex C: The assessment of profitability per subscriber Introduction 18. This issue raises a number of questions, which all relate to the possibility that BSkyB might behave anti-competitively by setting unduly low retail prices in relation to its wholesale prices to other retailers, which would have the effect of restricting competition in the retail pay TV market. Oftel has developed an approach to deal with these issues that can be used comprehensively in all sectors it regulates. This approach is based on the assumption that proper accounting separation takes place, since this would provide an estimate of the profitability of BSkyB’s digital activities on a per subscriber basis. The overall context: assessing profitability 19. If BSkyB were found to have market power in the provision of wholesale pay TV programming, the risk arises that it might margin squeeze competitors at the retail level by cross-subsidising or unduly discriminating in favour of its retail operations. To ensure that BSkyB does not behave anti-competitively, it would be necessary to assess the profitability of its downstream operations, to consider whether the relationship between BSkyB’s wholesale and retail prices does not have an anti-competitive effect. The OFT recognises that accounting separation is a necessary tool in order to ensure that the financial performance of BSkyB’s retail arm, Disco, can be efficiently monitored. 20. Oftel believes that to prevent a vertically-integrated operator with market power from leveraging that market power into other markets it is necessary to make sure it complies with the rules that require that it cannot discriminate between service providers in downstream markets. It is also necessary to ensure that it cannot cross-subsidise its tied retail activity through profits generated in the upstream segment. Accounting separation allows the regulator to check that such an operator is actually complying with these rules. However, once accounting separation is in place, it is still necessary to devise an approach to measure the profitability of the downstream operations. A purely accounting approach does not seem to be very useful, since profitability will tend to change considerably from one year to the following one depending on the relative growth in the number of subscribers. Such an approach would require the system to be in a steady state condition, which is very atypical. The Net Present Value approach (NPV) allows the regulator to solve this problem, but others arise, especially the need for a terminal value. 21. Oftel has devised a way of assessing profitability with a view to detecting anti-competitive practices. This approach has been developed in the context of an investigation on margin squeezing by mobile telephony network operators found to have market influence. Oftel considers that the most appropriate way to assess whether upstream network operations are cross-subsidising their vertically integrated downstream retail operations is to use an NPV approach at the subscriber level. Considering costs and revenues per subscriber helps avoid the problems that commonly arise with the NPV approach. If the cost of acquiring a new customer exceeds the value that the company expects the customer to have in the future, then there is a prima facie case that cross-subsidisation is taking place. This approach thus entails the comparison between the ‘average’ cost and the ‘average’ revenue of a subscriber over the lifetime of the average subscription. Variables used and methodology 22. To assess profitability at the subscriber level, it is necessary to compare figures for revenues per subscriber to those for costs of subscriber acquisition. If Disco were incurring a cost of subscriber acquisition greater than the revenue associated to that subscriber’s life, then we could be reasonably certain that Disco is behaving anti-competitively. This type of analysis requires the following information: a) Cost of acquiring a subscriber (ie, up-front subsidies, operating costs attributable to subscriber acquisition, and other items relevant to acquisition of new subscribers). b) Average periodic profit per subscriber (ie, operating profits, after common costs, divided by the total number of subscribers, normally on a monthly basis). c) A value for the average life of a subscriber, which can be computed from the churn rate (ie, rate at which customers leave the network). d) A value for the cost of capital in the sector to be used as a discount factor. 23. Oftel does not consider that the cost of acquiring this information would be very great, considering that variables a) and b) would be available from Disco’s accounts, once the proper derivation is agreed on, the parameter c) can be computed from a figure for gross deletions, and the parameter d) requires a standard CAPM calculation. More specifically, a) and b) will be reliable and meaningful provided that BSkyB accounting separation is thoroughly performed and monitored. The parameters c) and d) are used in the discounting procedure to obtain the net present value of the future profits per subscriber. This is done by means of a standard discount formula. 24. This approach requires assumptions on the behavioural pattern of subscribers. The assumption that Oftel uses is that by taking a fixed amount of the population of subscribers at any point in time, its number of subscribers will decrease at a decreasing rate. This assumption has been verified empirically for mobile markets and can be approximated by an inverse exponential function. Given this type of function, it is possible to uniquely estimate the average life of a subscriber, the parameter c) above, by taking the reciprocal of the churn rate, that is:
where n indicates the average life of a subscriber and k is the churn rate that indicates the rate at which subscribers leave the network every period. 25. The method proposed essentially requires the comparison between the cost of subscriber acquisition on one side, and the NPV of the profits per subscriber on the other side. This latter term is computed by multiplying the profits per subscriber (normally, monthly profits) by the following standard discount term:
where i is the cost of capital (or any appropriate discount factor), and n is the average life of a subscriber. The left-hand side of the equation is straightforward, and merely requires accounting derivations. The right-hand side is a forward-looking measure taking account of the expected profits of an additional subscriber over the expected life of that subscriber and the principle of discounting (that the value of the monthly profit from a subscriber diminishes the more remote it is from the date of acquisition). This is a standard actuarial formula for the present value of an earnings stream of finite duration. The monthly profits per subscriber used in the calculation incorporate, by definition, information on the firm’s common costs, and are derived again from the firm’s accounts. The discounting formula requires only the definition of the two parameters introduced above. This equation makes it possible to assess whether the net present value of the profits linked to a subscriber is greater or smaller than the average costs borne in order to acquire that subscriber. If the economic value of the subscriber is lower than the acquisition costs, there is evidence that the firm is cross-subsidising, covering the remaining portion of the costs through revenues coming from elsewhere within the company group. Migrations 26. Migrations of customers from and to different technologies raise a question of how the costs of such migrations should be captured in the calculation. In the case of BSkyB it is important to adopt clear rules as regards subscriber migration from analogue to digital. Two approaches might be feasible when using this method. First, the migrations could be treated as a cessation of analogue service and contemporaneous starting of digital service. In this case, adjustment to the churn rate would be all that would be necessary, since this is equivalent to reducing the subscription life: the digital contract is treated as a new subscription and the up-front subsidies are taken into account within the costs of acquisition. 27. The second approach is to treat the migration as an extra cost incurred by the firm in order to upgrade its customer base. In this case the churn rate will not be affected, and the costs of acquisition will be higher (or the profits per subscriber lower, depending on where the cost of upgrading is allocated). Oftel has chosen the first approach when considering mobile operators. Whatever the choice between the two, it is important to maintain consistency between churn rate calculation and allocation of acquisition costs. Accounting Separation – the preparation of separate accounts for different businesses and parts of businesses run by the same company or group of companies, so that the costs and revenues associated with each business and part of a business (and transfers between them) can be separately identified and properly allocated. Basic channels – traditionally these were the channels which all TV subscribers received as part of the basic package. The term is increasingly being used to describe non-premium channels. These are predominantly general news and entertainment channels. See also premium channels Capital Asset Pricing Model or CAPM – an economic model for assessing the cost of equity in the calculation of the cost of capital. According to the CAPM, the cost of equity is equal to the sum of the risk free rate of interest and a risk premium which is multiplied by a factor (called the beta) reflecting the riskiness of the firm relative to the riskiness of the stock market as a whole. Cost Attribution - allocation and apportionment of costs to relevant businesses and activities. Dominance – a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, customers and ultimately consumers. Free-to-air television service – a television service which can be received in a given area without charge to the viewer. Some free-to-air services may be broadcast in scrambled form in order to limit access to viewers in a specific geographic area. Other free-to-air services may be broadcast in the clear – ie unscrambled. Market power – the ability of an undertaking or undertakings consistently and profitably to charge prices higher than if it or they faced effective competition. Near video on-demand - a service which broadcasts films or programmes at short-time intervals, thereby offering customers a choice of viewing times. Net present value (NPV) – the net present value of a stream of costs and revenues is the sum of those costs and revenues when they are all expressed on a common basis, taking account of the time value of money. The value of money depends on the point in time when it is received - because of the opportunity to earn interest when money is received earlier. An NPV calculation takes account of this factor by adjusting the value of money according to the time when it is received or spent. Terminal value – the value of an asset at the end of its life. Terminal values are used in NPV calculations. Vertical integration – where a single company is active in more than one stage in the production and supply of a good or service eg where a network operator also provides enhanced services which are carried over the network or supplies the consumer equipment needed to access services it provides. Video on-demand - A programme or film sent independently to a customer in response to his or her individual request. This contrasts with broadcast television which is sent simultaneously to all customers able to receive it.
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