Contents

Summary
Chapter 1 Introduction
Chapter 2 The services considered in this review
Chapter 3 Definition of the relevant market
Chapter 4 Assessment of significant market power
Chapter 5 Options and proposals for remedies for BT
Chapter 6 Options and proposals for remedies for other network providers
Chapter 7 Accounting separation and cost accounting
Chapter 8 Consultation details

Annex A Notification under regulation 6 of the electronic communications (market analysis) regulations 2003
Schedule 1 BT
Schedule 2 Kingston
Schedule 3 Other fixed network providers
Annex B Criteria to assess effective competition
Annex C Cost-benefit analysis of the proposed price control regulation on BT
Annex D List of questions for consultation
Annex E Glossary

Summary

A new regulatory regime

S.1 A new regulatory framework for electronic communications networks and services will enter into force in the UK on 25 July 2003. The basis for the new regulatory framework is five new EU Communications Directives that are designed to create harmonised regulation across Europe and aimed at reducing entry barriers and fostering prospects for effective competition for the benefit of consumers.

S.2 The new Directives require National Regulatory Authorities (NRAs), such as Oftel, to carry out reviews of competition in communications markets, to ensure that regulation remains appropriate in the light of changing market conditions.

Markets considered in this review

S.3 The markets considered in this review are those in which services are sold and purchased by communications providers to complete end-to-end. The public electronic communications network (PECN) provider needs to purchase services to complete end-to-end calls when calls leave its network and are then terminated on another PECN’s network. These are call termination services. This particular review considers local exchange fixed geographic call termination services only.

Initial conclusions on Significant Market Power

S.4 The Director has considered whether Significant Market Power (SMP) is held by any PECN in the relevant markets, taking into account the European Commission [ Commission Guidelines on market analysis and the assessment of significant market power under the Community regulatory framework for
electronic communications networks and services
] and Oftel SMP Guidelines.

S.5 As a result of this, the Director’s initial view is that all fixed PECNs have SMP in the provision of their own network fixed geographic call termination services. This is for a number of reasons one of which is that no one other than the terminating PECN can terminate calls over its own network.

Regulatory remedies

S.6 The Director considers it appropriate to propose a number of remedies on all PECNs that terminate fixed geographic calls. Of these, the Director proposes that BT and Kingston should be subject to more detailed regulation than other PECNs, as the Director believes that they also possess SMP in related, relevant retail markets.

S.7 In summary the Director’s proposals are:

(a) to require all fixed PECNs to provide network access, which in this case means call termination, to all other such PECNs if in receipt of a reasonable request to do so;

(b) that BT’s charges for its call termination services should be subject to a price control and that its charges should be set on the basis of its forward looking long-run incremental costs;

(c) that Kingston should be required to set its charges for its call termination services on the basis of its forward looking long-run incremental costs;

(d) to require all other fixed PECNs to set fair and reasonable terms for their call termination services and that, in the event of a dispute, the Director will decide what constitutes fair and reasonable terms.

S.8 In addition, for BT and Kingston, the Director proposes that they should publish cost-accounting information, separate accounts, a reference offer, and publish changes to their prices in advance of those proposed changes taking place.

S.9 The Director believes that his proposals are consistent with the new regulatory framework and are a proportionate response to all fixed PECNs’ SMP in fixed geographic call termination markets. The overall regulatory framework should not be unfamiliar to any PECN, as it is broadly consistent with the current regime and therefore current requirements.

Consultation

S.10 The Director is seeking comments on his proposals by 30 May 2003. Once he has considered all responses, the Director will publish his final proposals and these will take effect from 25 July 2003. Comments should be sent to Mike Galvin, Oftel, 50 Ludgate Hill, London EC4M 7JJ or sent to mike.galvin@oftel.gov.uk.

S.11 The formal draft notification of the proposed market definition, SMP designation and specific conditions can be found in Annex A.

Chapter 1

Introduction

A new regulatory regime

1.1 A new regulatory framework for electronic communications networks and services will enter into force in the UK on 25 July 2003. The basis for the new regulatory framework is five new EU Communications Directives as follows:

• the Framework Directive - Directive 2002/21/EC on a common regulatory framework for electronic communications networks and services;

• the Access Directive - Directive 2002/19/EC on access to, and interconnection of, electronic communications networks and associated facilities;

• the Authorisation Directive - Directive 2002/20/EC on the authorisation of electronic communications networks and services;

• the Universal Service Directive - Directive 2002/22/EC on universal service and users' rights relating to electronic communications networks and services ; and

• the Privacy Directive - Directive 2002/58/EC concerning the processing of personal data and the protection of privacy in the electronic communications sector.

1.2 The new regulatory framework is designed to create harmonised regulation across Europe and aimed at reducing entry barriers and fostering prospects for effective competition for the benefit of consumers.

1.3 The Framework Directive provides the overall structure for the new regulatory regime and sets out fundamental rules and objectives which read across all the new directives. Article 8 of the Framework Directive sets out three key policy objectives which have been taken into account as relevant in the preparation of this consultation document, namely promotion of competition, development of the internal market and the promotion of the interests of the citizens of the European Union. The Authorisation Directive establishes a new system whereby any person will be generally authorised to provide electronic communications services and/or networks without prior approval. The general authorisation replaces the existing licensing regime. The Universal Service Directive defines a basic set of services that must be provided to end-users. The Access and Interconnection Directive sets out the terms on which providers may access each others’ networks and services with a view to providing publicly available electronic communications services. These four Directives must be implemented in the UK and in other EU Member States on 25 July 2003. The fifth Directive on Privacy establishes users’ rights with regard to the privacy of their communications. This Directive was adopted slightly later than the other four Directives and has an implementation date of 31 October 2003.

Implementation

1.4 In the UK, it is intended to implement the four main Directives through a new Communications Act. The Communications Bill, which precedes this Act, was introduced into the House of Commons on 19 November 2002 and is available at www.communicationsbill.gov.uk. The latest version of the Communications Bill, which was amended in Committee in the House of Commons on 6 February 2003, can be found at that website ( any references to the Communications Bill in this document are references to that version of the Bill). The Bill may continue to be subject to change as it proceeds through Parliament.

1.5 The Communications Bill should receive royal assent by 25 July 2003. However, in the event that the Communications Bill does not receive royal assent by 25 July 2003, the government has acknowledged that implementation will need to occur by Statutory Instruments made under the European Communities Act 1972 for an interim period until the Bill enters into force. Further, if the Communications Bill does receive royal assent by 25 July 2003, it is expected that Ofcom will not be ready by the summer to assume all of its duties foreseen by the Communications Bill. Should that be the case, the Communications Bill makes specific provision to enable Ofcom’s functions to be carried out by the Director or the Secretary of State for a transitional period. For these reasons, this document refers to the Director rather than Ofcom.

1.6 Article 16 of the Framework Directive provides that analysis of the relevant markets for the purpose of the new regime should be carried out as soon as possible after the adoption of the European Commission’s Recommendation on markets ("the EU Recommendation"). The EU Recommendation was adopted on 11 February 2003. This market review is the preparatory work required as to the analysis of markets required by the new regime. In the UK, the Electronic Communications (Market Analysis) Regulations 2003 (SI 2003/330) ("the Regulations") confirm the Director’s ability to carry out this preparatory work. Pursuant to the Regulations, Oftel is consulting on the market identification, designation of SMP (or not) and the SMP conditions proposed to be adopted on or after 25 July 2003. Regulation 8 of the Regulations enables the Director to confirm his proposals before 25 July 2003. They will then be given effect on 25 July 2003 by the new Communications Act or the interim regime introduced by Statutory Instruments.

Market reviews

1.7 The new Directives include the requirement that National Regulatory Authorities (NRAs), such as Oftel, should carry out reviews of competition in communications markets to ensure that regulation remains proportionate in the light of changing market conditions. Oftel already carries out market reviews as part of its long term strategy, focusing on effective competition as the best means to deliver a good deal for consumers.

1.8 Oftel is now conducting a series of market reviews under the Regulations. Oftel aims to have the reviews completed by 25 July 2003 to ensure that any appropriate and proportionate regulation flowing from them is in place for the commencement of the new regime on that date.

1.9 The analysis in each market review consultation document follows three distinct stages and these are the:

• definition of the relevant market or markets;

• assessment of competition in each market, in particular whether any companies have Significant Market Power (SMP) in a given market, and;

• assessment of the options for regulation and proposal of appropriate regulatory obligations where there has been a finding of SMP.

1.10 More detailed requirements and guidance concerning the conduct of market reviews are provided in the Directives, the Communications Bill, the Regulations, and in additional documents issued by the European Commission and Oftel. As required by the new regime, Oftel will take the utmost account of the two European Commission documents discussed in paragraph 1.11 in this market review.

Recommendation on relevant product and service markets

1.11 The EU Recommendation identified a set of product and service markets within the electronic communications sector. These have to be reviewed by NRAs. The EU Recommendation seeks to promote harmonisation across the European Community by ensuring that the same product and service markets are subject to a market analysis in all Member States. However, NRAs are able to regulate markets that differ from those identified in the EU Recommendation where this is justified by national circumstances and where the Commission does not raise any objections. Accordingly, NRAs are to define relevant markets appropriate to national circumstances, taking the utmost account of the product markets listed in the EU Recommendation.

SMP Guidelines

1.12 The European Commission has also issued guidelines on market analysis and the assessment of SMP ("the SMP Guidelines"). Oftel has produced additional guidelines on the criteria to assess effective competition. These supplement the SMP Guidelines and replace Oftel’s effective competition guidelines issued in August 2000.

Regulatory option appraisal

1.13 When considering the appropriate level of regulation if a finding of SMP is found, Oftel will also give consideration to its regulatory option appraisal guidelines published in June 2002.

1.14 As explained in paragraph 1.9, there are three distinct stages to the analysis set out in this consultation document. Firstly, in chapter 3, the Director has defined the relevant markets considered in this review. Secondly, in chapter 4, the Director has assessed whether any public electronic communications network (PECN) provider has SMP in the relevant market or markets. As a result of his provisional conclusions in chapter 4, chapters 5 and 6 consider regulatory options and proposals for remedies for BT and then all other fixed PECNs respectively.

Notification

1.15 Annex A contains the formal notification of the proposals made by the Director as a result of the review, including the markets defined, the designation of SMP and the conditions proposed as a result of the market analysis. This implements the provisions of Regulations 5 and 6 of the Regulations.

1.16 This document, including the formal notification in Annex A, has been made accessible to the European Commission and to the NRAs in other Member States in accordance with the scheme of the Directives.

      Chapter 2

The services considered in this review

Fixed geographic call termination

2.1 Retail customers expect (and demand) to be able to speak with or send data to any other retail customer irrespective of the network to which the called party (or the other retail customer) is connected. PECNs therefore need to interconnect with each other to allow calls to be seamlessly delivered between them. However, there are costs associated with the delivery of calls between and over networks and the recipient PECN expects the requesting (or originating) PECN to pay those delivery costs relevant to termination. This review is considering the final service needed to deliver a call to a called party on a fixed (i.e. not mobile) network. This service is fixed call termination. For reasons explained in chapter 3, this review is considering fixed geographic call termination only.

2.2 If PECNs did not allow calls from other PECNs to be delivered across their networks, retail customers could only speak with or send data to retail customers connected to the same network. This would reduce consumer choice and welfare. It would also restrict competition, as new entrants would automatically be placed at a disadvantage in comparison to PECNs who already have many retail customers connected to their networks.

2.3 In the UK, approximately 82%[Market Information, Fixed Update, Oftel, December 2002] of retail customers who have a fixed phone service are connected to BT’s network. There is therefore a great demand for BT’s fixed geographic call termination services, as other PECNs could not offer viable retail services if they could not offer access to BT’s customers. BT also needs to purchase fixed geographic call termination services from other PECNs so that its customers can call customers on those other networks. However, in the absence of regulation, BT would be in a strong position to negotiate with other PECNs, as its need to connect with other PECNs is less than their need to connect with it.

2.4 There are four main inland wholesale conveyance services or, in other words, services sold and purchased by PECNs to allow calls to cross networks. These are:

• fixed geographic call origination (which is the conveyance of a call from the customer to the local exchange);
• local-tandem conveyance (which conveys a call to or from the local exchange to the tandem or trunk exchange and involves use of the tandem exchange);
• inter-tandem conveyance (which conveys a call between two tandem or trunk exchanges and involves use of one of the tandem exchanges); and
• fixed geographic call termination (which involves conveyance between the local exchange and the called customer).

2.5 An end-to-end BT call from London to Birmingham, for instance, would need to use call origination, local-tandem conveyance, inter-tandem conveyance, local-tandem conveyance (again) and call termination. This consultation is concerned with the wholesale conveyance service fixed geographic call termination only. This service is shown in diagram 2.1. The consultation document entitled the Review of the fixed narrowband wholesale exchange line, call origination, conveyance and transit markets is concerned with the other inland wholesale conveyance services.

Diagram 2.1 - Fixed geographic call termination

The current regulatory framework

2.6 BT (in the UK apart from the Hull area) and Kingston (in the Hull area) were determined to have SMP in the provision of interconnection services under the Interconnection Directive (Directive 97/33/EC). For the purpose of the Interconnection Directive, the relevant market was defined as the provision of fixed networks and services. This definition included the provision of fixed geographic call termination services. As a result of this determination, BT and Kingston were required:

• to offer fixed geographic call termination services;
• to publish a reference interconnection offer;
• to set cost-oriented charges;
• to give 90 days’ notice before changing call termination charges;
• not to unfairly discriminate in the provision of services between operators and their own retail businesses; and
• to publish separate accounts

2.7 In addition, BT has been subject to a price control since October 2001 under which it has been required to reduce its call termination prices on average by RPI-10%. This control was set on the basis that it was to last for four years.

2.8 Kingston’s charges for call termination are set on the basis of a Direction made by the Director in which charges were set on the basis of Kingston’s current cost accounting fully allocated costs (CCA FAC).

2.9 Other PECNs came to a commercial agreement with BT to set their charges on the basis of BT’s costs.

Chapter 3

Approach to definition of the relevant markets

3.1 There are two dimensions to the definition of a relevant market: the relevant products to be included in the same market and the geographic extent of the market. Oftel’s approach to market definition follows that used by UK competition authorities (see Office of Fair Trading Market Definition Guideline, OFT 403, March 1999, and is in line with those used by European and US competition authorities.

3.2 Market boundaries are determined by identifying constraints on the price-setting behaviour of firms. There are two main competitive constraints to consider: how far it is possible for customers to substitute other services for those in question (demand- side substitution) and how far suppliers could switch, or increase, production to supply the relevant products or services (supply-side substitution) following a price increase.

3.3 The concept of the ‘hypothetical monopolist test’ is a useful tool to identify close demand-side and supply-side substitutes. A product is considered to constitute a separate market if a hypothetical monopoly supplier could impose a small but significant, non-transitory price increase (SSNIP) above the competitive level without losing sales to such a degree as to make this unprofitable. If such a price rise would be unprofitable, because consumers would switch to other products, or because suppliers of other products would begin to compete with the monopolist, then the market definition should be expanded to include the substitute products.

Relationship between the wholesale and retail markets

3.4 This consultation document will consider the relevant markets at the retail level and define them at the wholesale level. Consideration of the relevant retail markets logically precedes the analysis of the wholesale markets, since the demand for wholesale services is derived from the demand for retail services.

3.5 The purpose of this exercise is to assess whether a provider has SMP in a wholesale market and to identify appropriate remedies in that market to counter the existence of market power. Given this objective, it is necessary for the consideration of retail markets to be undertaken on the basis of an assumption of no regulation of the wholesale services being considered. To do otherwise would mean that the wholesale market power assessment would depend on a retail market definition that relied on a wholesale remedy arising from the finding of wholesale market power. This would be a circular and incorrect approach to market definition. Therefore, the demand side and supply side substitution possibilities at the retail level will be considered only if they are viable in the absence of regulated wholesale inputs.

3.6 Throughout this consultation document, markets will be defined first on the demand side. The analysis of demand side substitution will be undertaken by considering if other retail services could be considered as substitutes by consumers, in the event of the hypothetical monopolist introducing a SSNIP above the competitive level.

3.7 Supply side substitution possibilities will then be assessed to consider whether they provide any additional constraints on the pricing behaviour of the hypothetical monopolist which have not been captured in the demand side analysis. In this assessment, supply side substitution will be considered as a low cost form of entry which could take place within a relatively short period of time. [The OFT Guidelines on Market Definition, OFT 403, March 1999, consider the relatively short period to be within a year.]That is, for supply side substitution to be relevant, there would need to be additional competitive constraints arising from entry into the supply of the service in question, from suppliers who are able to enter quickly and at low cost, by virtue of their existing position in the supply of other services. As discussed earlier, only those supply side substitution possibilities that are viable in the absence of unregulated wholesale inputs will be considered as relevant to the analysis.

3.8 There might be suppliers who provide other retail or wholesale services but who might also be materially present in the provision of demand side substitutes to the service for which the hypothetical monopolist has raised its price. However, such suppliers are not relevant to supply side substitution since they supply services already identified as demand side substitutes. As such their entry has already been taken into account and so supply-side substitution cannot provide an additional competitive constraint on the hypothetical monopolist. However, the impact of expansion by such suppliers can be taken into account in the assessment of market power.

3.9 A third factor that is sometimes an additional consideration is whether there exist common pricing constraints across customers, services or areas such that they should be included within the same relevant market even if demand- and supply-side substitution are not present.

Fixed geographic call termination

3.10 Any telephone call to a number prefixed by a geographic code will result in the call being delivered to the specific telephone number within a particular geographic area (unless call-forwarding facilities are in use) and to a particular end-user’s fixed telephone. As that telephone number is unique to one end-user at any time, the caller will generally know where they are calling and whom they are calling. However, it is unlikely that the caller would know the identity of the network provider of the called party or have much, if any, influence over the call recipient’s choice of network.

Demand-side substitution at the retail level

3.11 At the retail level, a customer does not in practice purchase fixed geographic call termination as a separate service. The customer buys the retail end-to-end call from his or her provider and the provider will need to buy call termination if the call is destined for another network. In terms of end-to-end calls, on the demand-side at the retail level, there are no effective substitutes for a caller who wishes to call a given party’s fixed geographic number to making that call. Calling someone other than the desired party (at either a geographic or a non-geographic number) is unlikely to be an adequate demand-side substitute. This means that, on the demand-side at the retail level, the provision of calls to individual parties’ numbers may constitute separate economic markets in which a hypothetical monopolist could profitably increase its prices above the competitive level.

Common pricing constraint

3.12 However, suppliers of retail (end-to-end) calls are unlikely to possess sufficient information regarding the elasticities of demand for calls to individual geographic numbers to allow them profitably to price discriminate according to individual called numbers at the retail level.

3.13 Indeed, such price discrimination does not generally happen in practice due to its impracticality. There is thus a common pricing constraint at the retail level. For this reason, retail calls markets are thus defined more widely and by type, e.g. local calls and national calls.

Calls to mobiles

3.14 An obvious potential retail demand-side substitute to calling a party’s fixed geographic number would be calling the same party’s mobile number (if they have one). However, as the cost of termination on mobile networks is higher than that on fixed networks, the competitive level of retail charges facing a calling party choosing between these two types of calls would reflect this more expensive mobile termination. This would in turn make calls to mobiles a less attractive option than calling the party’s fixed geographic number.

3.15 Mobile network providers’ traffic-sensitive network costs (which are relevant to call termination) are approximately ten times higher than the equivalent fixed network costs. The reasons for this difference in mobile and fixed termination costs relate to the additional functionality of mobile networks and the different characteristics of the two technologies (including the costs of mobility and authentication). For a fuller explanation of these differences in call termination costs and market definitions refer to http://www.oftel.gov.uk/publications/mobile/ctm_2002/term0502.pdf and http://www.oftel.gov.uk/publications/mobile/ctm_2002/market_def0302.pdf respectively.

3.16 Consideration of current market prices shows that, in general, there is still a substantial price premium between calling a mobile phone from a fixed line relative to calling another fixed line. In spite of this, the volume of fixed-to-mobile calls has increased (by approximately 4% between Q4 00/01 and Q4 01/ 02 [Market Information, Fixed Update, Oftel, August 2002]), whereas fixed-to-fixed local and national calls have declined (by 5% and 3% respectively to the nearest one per cent). However, by volume, calls to mobiles constituted only 4% of all calls from fixed lines in the final quarter of 2001/2. This suggests that, whilst some substitution at the margin may be taking place between fixed line calls to fixed lines and mobile phones, it is very small.

3.17 Oftel believes that this coupled with the cited significant termination cost differences between fixed and mobile networks act to illustrate that the two types of retail calls are not effective demand-side substitutes. A hypothetical monopolist in the supply of retail calls to an individual party’s fixed line would not be constrained from pricing above the competitive level by substitution to calls to the same party’s mobile number. However, there could of course be perceived quality differences between calls terminating on fixed and mobile networks. For example, there is a greater probability of immediate contact with calling a mobile rather than a fixed line.

A call to a party’s other fixed geographic line

3.18 Most retail customers have a fixed line with just one network provider.[Consumers' use of fixed telecoms services, Oftel, November 2000, indicated that 11% of UK households had more than one line and usage of the second line was predominantly for non-voice services and where it was used for voice it was used for international calls. Of those polled with more than one fixed line, 68% stated that they used one supplier only. The others would have been using either an indirect access supplier or have an additional fixed service with another operator.] Even where customers have more than one connection to different fixed networks, Oftel’s research suggests that the second connection would be commonly used for a different purpose to that of the first, e.g. one for voice and one for fax or internet usage. It is thus unlikely that second connections provide an effective alternative for callers attempting to call a given party as this line is likely to be being intensively used for non-voice services and its renter will be less inclined to provide this number to potential callers due to wanting the line to remain free for non-voice services. The caller therefore has little alternative but to call the single fixed geographic number on the network to which the party that they wish to call is connected and wishes to receive voice calls on.

Supply-side substitution at the retail level

3.19 Although the calling party may be able to make calls via a variety of providers, (e.g. indirect access), the potential for competition at the retail level (and thus supply-side substitution in providing a given end-to-end call) does not have an effect on the competitive conditions in the wholesale provision of fixed geographic call termination. The terminating provider has a monopoly in the provision of fixed geographic termination and this is the case irrespective of who wishes to buy call termination. Indeed, in order to enable retail supply-side substitution to be competitive, call termination services have to be made available on reasonable terms to providers of retail services.

Demand-side substitution at the wholesale level

Relevance of the calling party pays principle

3.20 For fixed geographic telephone calls, the UK telecommunications industry has a system whereby the calling party (and not the called party) pays the total price of the retail call (unless the called party accepts the responsibility for payment, e.g. reverse charge calls). This means that the call termination charge will be included in the originating network provider’s cost base and is likely to be reflected in the retail price it sets for calls. It therefore follows that increases in the price of wholesale fixed geographic call termination may lead to higher retail call prices. Increases in call termination prices are of less consequence to the called party, as the called party does not bear them, and it is therefore unlikely that a customer would decide to connect to a network on the basis of that network’s call termination charge.

3.21 As the calling party pays, terminating providers naturally have an incentive to raise the charge for termination to maximise their call termination profitability. In providing termination services to rivals in the retail market, a terminating provider has a further incentive to increase its call termination price. Not only does the terminating provider increase its call termination revenues but it also increases its competitors’ end-to-end retail costs, as the terminating provider’s competitors have to buy its call termination service. The effect of this is that a provider with higher call termination prices has a competitive advantage at the retail level over its direct competitors. This perverse cost incentive is known as the ‘termination externality’.

3.22 As at the retail level, when purchasing wholesale fixed geographic call termination, the originating network provider will not find termination on a network other than the one its retail customer wishes to call (actually dials) an adequate substitute on the demand-side. A hypothetical monopolist in the supply of wholesale fixed geographic call termination on an individual network would find a price increase (SSNIP) profitable, as those seeking to terminate calls on its network would not find termination on a different network to be a suitable demand-side substitute. This flows from the fact that the demand for wholesale fixed geographic call termination is derived from the demand of retail customers to make end-to-end calls and, as explained, at the retail level there are no effective substitutes for the fixed line end-to-end call desired.

3.23 If the called party were required to pay the retail price for the end-to-end call, then it is unlikely that wholesale call termination on an individual provider’s network would constitute an economic market. In this case, a wholesale terminating provider would be likely to find a price increase (SSNIP) unprofitable. This is because the wholesale terminating provider or its customer would bear the cost of the higher termination rates that result. If the terminating provider charged its own customer for an increase in its termination costs, the increased charge could act to influence that customer’s choice of network provider, as they would be likely to switch away from the network provider who chose to increase the wholesale termination charge. This retail substitution would have the effect of making the wholesale price increase (SSNIP) unprofitable. It is therefore the case that the wholesale markets defined under calling party pays would not exist under a called party pays regime.

Supply-side substitution at the wholesale level

3.24 On the supply-side, competitors cannot offer an equivalent wholesale fixed geographic call termination service because technically they cannot terminate calls over each other’s networks. The terminating fixed network provider supplies the service between its local exchange and the retail customer, and the originating network provider (or an intermediary on its behalf) has to hand-over the call to the terminating network provider for call termination to take place.

3.25 Supply-side substitution would require the entrant to win the customer from the hypothetical monopolist at the retail level. This is because, as already explained, retail customers are not sensitive to termination charges due to the calling party pays principle. Thus supply-side substitution to win customers who were attracted by lower termination charges is not possible or relevant in this context.

Customer versus operator specific markets

3.26 As at the retail level, it could be argued that wholesale fixed geographic call termination to each individual customer number forms separate economic markets. However, it is unlikely that terminating providers would possess sufficient information regarding the elasticities of demand for wholesale termination services by fixed geographic number to allow them profitably to price discriminate by number at the wholesale level. Indeed, such price discrimination does not happen in practice, as there is a common pricing constraint at the wholesale level. For this reason, relevant markets are not limited to each terminating number. The wholesale markets are thus widened to the extent of wholesale fixed geographic termination on each provider’s network.

Fixed non-geographic (NTS) call termination

3.27 This review does not consider the market for non-geographic call termination on number translation services (NTS). In Oftel’s statement entitled Effective competition review of number translation services, which was published in March 2002, Oftel found that the NTS market was effectively competitive such that continued sector-specific regulation in this market was not necessary to secure the best deal for consumers.

Termination on mobile networks

3.28 This review does not consider call termination on mobile networks. As explained, mobile services, including call termination, are not considered to be an effective substitute for fixed services. Any regulatory rules that are considered appropriate in mobile call termination markets will be considered in the forthcoming consultation document that will be entitled Mobile call termination.

The relevant geographic market

3.29 As call termination on each fixed geographic network is a separate market, the geographic extent of each market matches the geographic scope of each fixed geographic terminating provider’s network.

The Director’s initial conclusion

3.30 For the reasons outlined in this chapter, Oftel believes that fixed geographic call termination on each network constitutes a separate market. This is therefore the market defined for the purposes of this review.

3.31 As noted in chapter 1, the Director is required to take utmost account of EU Guidelines in its market analysis, including the Commission’s Recommendation on relevant product and service markets.

3.32 Indeed, the Director has given careful consideration to the markets listed in the Commission’s Recommendation. However, the Director has decided to define the market in this review differently to the Recommendation.

3.33 This market differs from the Commission’s Recommendation because, as explained, the market for non-geographic fixed call termination is competitive in the UK and is subject to competitive pressures. It is not therefore necessary to impose regulatory remedies in the market for non-geographic fixed call termination to secure the best deal for end-users.

Question 1

Do you agree that fixed geographic call termination on each network constitutes a separate market?

Prospects for competition

3.34 Oftel has considered the likelihood of competitive or technical developments that might affect its market definition of network specific fixed geographic call termination services. Oftel’s view is that such developments are not currently in prospect. For calls to a particular geographic number, it is not technically feasible to provide a termination service over a network other than the terminating provider’s and this is not likely to change in the near future. Additionally, Oftel does not consider that any of the retail demand-side substitutes are likely to have any real impact in each fixed geographic call termination market in the foreseeable future. However, Oftel notes that in the longer term retail substitution between fixed and mobile calls may provide an increasing competitive constraint.

Question 2

Do you believe that any effective substitutes for call termination on a given network will emerge before 2005?

Chapter 4

Assessment of significant market power

4.1 Under the new Directives SMP has been newly defined so that it is equivalent to the competition law concept of dominance. Article 14 of the Framework Directive states that:

"An undertaking shall be deemed to have significant market power if, either individually or jointly with others, it enjoys a position equivalent to dominance, that is to say a position of economic strength affording it the power to behave to an appreciable extent independently of competitors, customers and ultimately consumers."

4.2 SMP may be held by one company in a given market (single dominance) or by more than one company (collective dominance). In assessing whether any provider has SMP, this review takes account of the Commission’s Guidelines on SMP [ Commission guidelines on market analysis and the assessment of significant market power under the Community regulatory framework for electronic communications networks and services] as well as Oftel’s equivalent guidelines.

4.3 Clause 42 of the Communications Bill provides that a person to whom an SMP service condition is applied must be a communications provider or person who makes associated facilities available and a person whom Ofcom (or the Director in the interim) have determined to have SMP in a specific market for electronic communications networks, electronic communications services or associated facilities.

Criteria to be used in assessing SMP

4.4 This chapter considers the criteria that Oftel believes are most relevant in determining whether any provider has SMP in the provision of fixed geographic call termination services. The main criteria considered here are market share, the overall size of the undertaking, control of infrastructure not easily duplicated, barriers to entry, and countervailing buyer power. This chapter also explains why the effect of the regulatory environment is an important factor in assessing whether any network provider has SMP in the provision of fixed geographic call termination services. In annex B, Oftel then sets out why it believes that the other criteria are less relevant in this market.

Market shares

4.5 In chapter 3, Oftel explained that for the purpose of this review the relevant market is wholesale fixed geographic call termination on individual networks, as it is only the terminating network provider that can terminate calls over its network (this is an absolute technical entry barrier). Each network provider therefore has 100% of the market for calls terminating on their networks and this means that each is a monopoly. However, as criteria other than market share need to be considered this factor on its own does not necessarily mean that each provider possesses SMP in the provision of fixed geographic call termination.

4.6 As explained in chapter 3, the retail price for calls is very likely to include the charge paid to the terminating network provider for call termination. In the absence of regulation, the terminating network provider as a monopolist would have an incentive to increase its call termination charge in order to increase both its revenues and its competitors’ costs. However, network providers with customers connected to their networks also provide retail services and will also need to buy call termination from their competitors.

4.7 The question of whether a provider has SMP will depend on the extent to which the termination provider’s monopoly position may be counteracted by the size (and therefore countervailing buyer power) of the provider seeking termination. This countervailing buyer power would be relevant when negotiating either bilateral termination rates or one-way termination rates, i.e. the network provider wishing to buy fixed geographic call termination offers indirect access services only.

BT’s position in the provision of its fixed geographic call termination service

4.8 As BT is the largest provider of fixed services in the UK, it is appropriate to consider initially whether its monopoly in termination is offset by the countervailing buyer power of the purchasers of its fixed geographic call termination services. First, Oftel considers BT’s negotiations with other fixed network providers and, second, when it provides fixed geographic call termination to mobile providers.

Other fixed network providers

4.9 BT has approximately 29 million customers connected to its network and this makes it the largest fixed network provider in the UK. [ Viho v Commission Case C-73/95 P [1996] ECR I-5447] Commission guidelines on market analysis and the assessment of significant market power under the Community regulatory framework for electronic communications networks and servicesIn contrast, BT’s two largest direct access competitors (ntl and Telewest) have less than 5.5 million connections between them. Kingston has approximately 220,000 connections in the Hull area.

4.10 One consequence of the fact that the majority of retail customers are connected to BT’s network is that other fixed operators require termination on BT’s network in order to offer a viable service. They thus do not have countervailing buyer power, in the sense of being able credibly to threaten not to purchase termination services from BT. It is the case that the size of BT’s access network is such that it cannot be easily duplicated by competitors and thus the ability to compete with BT in relevant retail calls markets depends upon the ability to acquire termination from it.

4.11 In relation to BT’s ability to exercise countervailing buyer power against other monopoly providers of fixed call termination, BT’s position in the fixed retail local and national calls markets is a key factor.

4.12 In the consultation document entitled Review of the fixed narrowband retail markets, Oftel explained that BT has SMP in the provision of both retail local and national calls. In the absence of regulation, BT’s SMP in these markets would provide BT with countervailing buyer power when negotiating to buy other providers’ fixed termination services. Other fixed providers would have a far greater need to buy BT’s call termination services than it would theirs. If other fixed providers refused to provide their termination services to BT on terms acceptable to BT, it could refuse to buy their termination services. This would not damage BT’s competitiveness as much as it would its competitors. BT could offer a viable retail service even if it did not include termination on other networks. However, other network providers’ retail services would not be viable if they could not receive inbound calls from BT.

4.13 BT could both profitably set its call termination charges above the competitive level and could, as a result of its countervailing buyer power, force other fixed providers to provide termination to it at a charge below their costs. Indeed, in the extreme, again in the absence of regulation, BT might refuse to buy or sell fixed termination services altogether.

4.14 For these reasons, BT possesses SMP in the provision of its own network fixed geographic call termination services to other fixed network providers. However, in the absence of regulation, other fixed network providers would not possess SMP in the provision of their fixed geographic call termination services to BT because of BT’s countervailing buyer power.

Mobile network providers

4.15 The provision of mobile call termination services will be considered in the forthcoming consultation document that will be entitled Wholesale mobile call termination. However, this document considers whether mobile network providers would individually have sufficient countervailing buyer power to offset against BT’s fixed call termination monopoly when buying termination from BT.

4.16 As with the fixed PECNs, mobile PECNs need BT to terminate calls on its network. Their services would be less attractive if their customers could not call customers on BT’s network. Together the mobile providers have more customers than BT and therefore could in theory in combination have countervailing buyer power when dealing with BT. However, the theoretical joint bargaining power could be undermined if BT refused to provide fixed termination services to one or more of them.

4.17 In the absence of regulation, it seems unlikely that mobile network providers would possess sufficient countervailing buyer power to prevent BT from setting call termination charges above the competitive level.

4.18 The Director’s initial view is therefore that BT has SMP in the provision of fixed geographic call termination services to mobile providers.

4.19 For these reasons (those set out in paragraphs 4.10 onwards), the Director proposes to regulate the provision of fixed geographic call termination services by BT to all PECN including mobiles. The level and type of regulation is discussed in chapter 5.

Assessment of potential SMP of other PECNs given the proposed regulation of BT

4.20 As a result of his proposal that BT has SMP in the provision of retail local and national call services, the Director proposes to impose various obligations on BT. Oftel will explain in the forthcoming consultation document that will be entitled End-to-end connectivity that BT should be required to buy call termination from other PECNs. This rule is needed to enable other PECNs to compete in retail markets. If BT refused to buy call termination from other PECNs, other PECNs would be unable to offer their customers the service of receiving calls from BT. Given BT’s position in retail local and national calls markets, this could have serious anti-competitive effects.

4.21 The effect of the proposals to regulate BT in the provision of its call termination services and the proposed obligation on it to buy other PECNs’ call termination services, eradicates any countervailing buyer power that BT would otherwise have when negotiating to buy other PECNs’ call termination services.

4.22 As the proposed regulation would require BT both to sell its own termination service and to purchase call termination from other PECNs, other PECNs could in the absence of regulation exploit their monopoly in the provision of their fixed geographic call termination services when they are sold to BT. Other PECNs therefore possess SMP in the provision of their fixed geographic call termination services when they are provided to BT. In the absence of regulation, they would have an incentive to increase their termination revenues and BT’s costs.

In the absence of regulation, do other fixed PECNs possess SMP when selling termination to each other and to mobile PECNs?

4.23 A further issue for consideration is whether fixed PECNs other than BT possess SMP when providing call termination services to each other or to mobile PECNs. The extent to which any PECN would have countervailing buyer power when dealing with another PECN and the extent to which the countervailing buyer power could be offset against the terminating provider’s monopoly is again relevant.

4.24 For bilateral negotiations between fixed PECNs, it is not clear whether the level of countervailing buyer power in any case would be sufficient to restrict the termination monopolist’s pricing freedom or would be strong enough to drive the terminating PECNs’ prices down. It is also unclear whether this would be the case for fixed PECNs when terminating calls from mobile PECNs.

4.25 To understand fully when or if call termination would be constrained by the possession of countervailing buyer power, Oftel would need to compare the market power of each fixed PECN against the countervailing buyer power of all other PECNs. It would also need to compare the countervailing buyer power of each of the mobile PECNs against each of the fixed PECNs.

4.26 This analysis would be very extensive and, Oftel believes, not very informative. Oftel is of the view that it would be the exception rather than the rule that the level of countervailing buyer power in these negotiations would be of the precise magnitude to ensure that call termination charges were constrained to the competitive level.

4.27 It is the Director’s provisional conclusion that each fixed PECN possesses SMP in the provision of call termination services to all other PECNs. Each relevant PECN is therefore identified in annex A. Those PECNs identified in annex 1 of schedule 3 to annex A are all believed to be active providers of fixed geographic call termination services on the basis of information supplied to Oftel and each has therefore been provisionally notified as having SMP in the relevant market. Nonetheless, the Director would need to consider on their merits any arguments casting doubt on his provisional findings.

4.28 Competitive conditions may differ across the very wide variety of bilateral relationships possible in the telecommunications industry, e.g. BT to another PECN or another large PECN to a smaller PECN and vice versa. Oftel considers that the appropriate way of addressing this is through the discussion of remedies across each of the principal categories of relationship. This is considered in chapters 5 and 6.

Network providers with SMP in the provision of fixed geographic call termination services.

4.29 The analysis set out in this chapter has led Oftel to conclude that all fixed PECNs have SMP under Article 16(4) of the Framework Directive in the provision of their fixed geographic call termination services to all other PECNs. All these providers are identified at Annex A.

Question 3

Do you agree that all providers that terminate fixed geographic calls have significant market power in the provision of call termination over their own networks?

Prospects for competition in the provision of fixed geographic call termination services

4.30 At present, Oftel does not believe that competition is likely to increase in the provision of fixed geographic call termination services because no one other than the terminating PECN can terminate calls over their own network. Oftel is not aware of any opportunities for wholesale or retail substitutability that are going to change this situation over the next two years. Oftel does not therefore propose to review these markets until 2005.

Question 4

Do you agree that there is little likelihood of potential substitutes constraining pricing behaviour in call termination markets or, if you believe that there are potential substitutes, what are they and why are they likely to constrain pricing behaviour?

Definition of the dominant provider

4.31 The Director has proposed that all fixed PECNs have SMP in the their own network markets for fixed geographic call termination.

4.32 The Director considers it appropriate to prevent a person to whom an SMP service condition is applied (i.e. the dominant provider) which is part of a group of companies, exploiting the principle of corporate separation. That is to say, the dominant provider should not use another member of its group to carry out activities or to fail to comply with a condition, which would otherwise render the dominant provider in breach of its obligations.

4.33 Article 16 of the Framework Directive requires that, where a national regulatory authority determines that a relevant market is not effectively competitive, it shall identify "undertakings" with significant market power on that market and shall on such "undertakings" impose appropriate specific regulatory obligations. For the purposes of EC competition law, "undertaking" includes companies within the same corporate group, for example, where a company within that group is not independent in its decision making.

4.34 Accordingly, the Director considers it appropriate that the obligations detailed in this consultation document and draft notification shall apply to all fixed network providers and any subsidiaries or holding companies, or any subsidiaries of that holding company, all as defined by Section 736 of the Companies Act 1985 as amended by the Companies Act 1989.

The relationship between the market reviews and Competition Act 1998 and Enterprise Act 2002 investigations

4.35 Economic analysis carried out in this consultation document is for the purposes of determining whether an undertaking or undertakings have significant market power in relation to this market review. It is without prejudice to any economic analysis that may be carried out in relation to any investigation or decision pursuant to the Competition Act 1998 or the Enterprise Act 2002.

4.36 The fact that economic analysis carried out for a market review is without prejudice to future competition law investigations and decisions is recognised in Article 15(1) of the Framework Directive which provides that:

4.37 This intention is further evidenced in the European Commission’s SMP guidelines which state:

4.38 In addition, it is up to all operators to ensure that they comply with their legal obligations under all the laws applicable to the carrying out of their businesses. It is incumbent upon all operators to keep abreast of changes in the markets in which they operate, and in their position in such markets, which may result in legal obligations under the Competition Act 1998 or Enterprise Act 2002 applying to their conduct.

Chapter 5

Options and proposals for remedies for BT

Introduction

5.1 This chapter assesses options for regulatory remedies in the market for wholesale fixed geographic call termination on BT’s network.

5.2 As explained in Chapter 4, the Director’s initial view is that BT has SMP in the provision of fixed geographic call termination services. To reflect this, in this chapter, the Director has set out regulatory remedies to deal with BT’s SMP. However, the preliminary conclusions set out in this chapter are relevant only if the Director finds, after consultation, that BT does indeed have SMP in the provision of its fixed geographic call termination services. The Director will reach his final conclusions in the light of responses to this consultation document.

5.3 Clause 83(1) of the Communications Bill provides that where Ofcom (or the Director in the interim period) has made a determination that a person is dominant in the market reviewed, they shall set such SMP conditions as they consider appropriate and as are authorised in the Bill. This implements Article 8 of the Access Directive.

5.4 Paragraphs 21 and 114 of the European Commission’s Guidelines on market analysis and SMP state that this means that Oftel must impose one or more SMP conditions on a dominant provider. Furthermore, the European Commission states that the imposition of no SMP conditions on a dominant provider would be inconsistent with the new regime. Thus, Ofcom (or the Director in the interim period) is under an obligation to impose at least one appropriate SMP condition on BT if SMP is confirmed.

5.5 The Communications Bill (clauses 41-46 and 74-85) sets out what obligations the Director can impose if he finds that any undertaking has SMP. Those obligations relevant to this review are:

• the provision of network access;
• no undue discrimination;
• transparency;
• cost recovery, including price controls; and
• cost accounting and accounting separation.

5.6 Oftel has set out its intention to consider the appropriateness of SMP conditions on their merits in its regulatory option appraisal guidelines.. Oftel also notes that Recital 27 of the Framework Directive provides that ex-ante regulation should only be imposed where there is not effective competition and where competition law remedies are not sufficient to address the problem. In order to provide a full analysis, Oftel has, therefore, also considered the option of no ex- ante regulation, and whether it would be sufficient to rely on competition law alone, while noting the obligation referred to in paragraph 5.4.

Aims of regulation and conditions that may be imposed

5.7 Clause 4 of the Communications Bill sets out the Community requirements for regulation. The Director in considering whether to propose any conditions has considered all of these requirements. In particular, the Director has considered the requirement to promote competition and to secure efficient and sustainable competition. Therefore, the Director has particularly considered whether conditions are required to prevent SMP in this market being used to distort competition in downstream markets.

5.8 Any SMP conditions to be imposed must comply with the tests set out in the Communications Bill. The Director must also bear in mind the duties set out in clause 4 of the Communications Bill.

5.9 In particular, each SMP condition must be appropriate (see clause 83(1)) and satisfy the test set out in clause 43 of the Communications Bill, namely that each condition must be:

a. objectively justifiable in relation to the networks, services or facilities to which it relates;
b. not such as to discriminate unduly against particular persons or a particular description of persons;
c. proportionate to what the condition is intended to achieve; and
d. in relation to what it is intended to achieve, transparent.

5.10 It is the Director’s initial view that the option proposed in this chapter satisfies the relevant requirements specified in the Communications Bill, as discussed in detail in the following paragraphs.

Options for remedies

What are the options for regulation?

5.11 Oftel has considered three different options for levels of regulation on BT in this market. These are:

• Option A

No ex-ante regulation;

• Option B

To provide fixed geographic call termination on fair and reasonable terms; not to unduly discriminate in the provision of this service; to secure transparency through price publication; a requirement to set prices on the basis of forward looking long-run incremental costs; and requirements for separate accounting and appropriate cost-accounting systems.

• Option C

As option B plus price controls

5.12 The Director's initial view is that Option C is the preferred option for regulation.

Option A

No ex-ante regulation

5.13 As an effectively competitive market will produce a more efficient outcome than a regulated market, the promotion of competition is central to Oftel’s goal of securing the best deal for the consumer in terms of quality, choice and value for money.

5.14 Where markets are effectively competitive, ex-post competition law is sufficient to deal with any competition abuses that may arise. However, without the imposition of ex-ante regulations to promote actively the development of competition in markets in which competition is not effective, it is unlikely that ex-post general competition law powers would be sufficient to ensure that effective competition became established in markets such as those found in telecommunications. For example, ex-post powers prohibit abuse of dominance rather than the holding of a dominant position. Ex-ante powers can be utilised to reduce the level of market power and thereby encourage effective competition to become established.

5.15 Telecommunications markets are also often characterised by features that can complicate the assessment of behaviour under ex-post powers. For example, the existence of significant common costs and economies of scope and scale can complicate matters, as it may be difficult to establish that prices in any one market are excessive until the extent of common cost recovery in other markets has been considered. The complexities that would be involved in dealing with ex-post regulation could result in uncertainty and this would result in additional costs for providers in the relevant markets. This is likely to impair fair and effective competition, and thereby disadvantage consumers.

5.16 However, in some circumstances use of some ex-ante measures can themselves limit the development of competition. In such cases, Oftel would remove regulation if it were hampering competition.

5.17 In relation to the provision of fixed geographic call termination, Oftel does not believe that it can rely on ex-post measures. BT has SMP in the provision of its own network fixed geographic call termination services and, in the absence of regulation, there is a risk that it could be leverage its dominance to distort competition in other markets. As well as this, it is not technically feasible to terminate a call over another network provider’s network. SMP in this market is therefore persistent.

5.18 The Director’s view therefore is that, even if he did not have to impose an obligation on BT, as a result of an SMP finding, it would not be appropriate to do without ex-ante regulation. This reflects the risks to fair and effective competition in the absence of regulation, the risks to the welfare of retail customers, and the strength of BT’s dominance. The Director therefore rejects Option A.

Option B

To provide fixed geographic call termination on fair and reasonable terms; not to unduly discriminate in the provision of this service; to secure transparency through price publication; a requirement to set prices on the basis of forward looking long-run incremental costs; and requirements for separate accounting and appropriate cost-accounting systems

• Obligation to meet reasonable requests for fixed geographic call termination on fair and reasonable terms

5.19 In the absence of an obligation on BT to provide fixed geographic call termination on fair and reasonable terms, it could severely impede competition in downstream markets, by refusing to supply or by doing so on unreasonable terms. Retail customers could, for example, find that if they were connected to a non-BT network they could not call customers connected to BT’s network. As BT has by far the largest fixed access network, this would be likely to have a severe effect on its competitors, and on consumer choice. In the long term, this is likely to result in fewer competitors and therefore less choice.

5.20 For these reasons, the Director’s initial view is that it is necessary to require BT to meet all reasonable requests to provide its fixed geographic call termination services.

• Obligation not to unduly discriminate in the provision of such access

5.21 A requirement not to unduly discriminate would help potential competitors that wish to compete with BT’s retail activities to enter or remain in the relevant retail markets, as BT could not unduly discriminate in favour of its retail activities.

5.22 Where providers with SMP in upstream markets are vertically integrated, like BT, they may have an incentive to provide wholesale services on terms and conditions that discriminate in favour of their own retail activities in a way that would have a material adverse effect on competition. In particular, they may have incentives to charge competing providers a high price for wholesale services to increase competing providers’ costs and give themselves an unfair competitive advantage at the retail level. They might also provide services on different terms and conditions – for example with different delivery timescales – which would disadvantage their retail competitors and hence consumers. A prohibition on undue discrimination is particularly appropriate in BT’s case, as the size of its access market gives it greater opportunity than other network providers to leverage market power from fixed geographic call termination.

5.23 For these reasons, the Director’s initial view is that it is necessary to prevent BT from unduly discriminating in the provision of its fixed geographic call termination services.

• Obligation to publish a reference offer

5.24 A requirement on communications providers with SMP to publish a reference offer (RO) has two main purposes: (a) to assist transparency for the monitoring of potential anti-competitive behaviour (if charges have to be published); and (b) to give visibility to the terms and conditions on which other providers can purchase services. A RO helps to ensure stability in markets and maintains incentives to invest that might otherwise be undermined and thus discourage market entry.

5.25 In addition, the publication of a RO would potentially enable negotiations to be completed more quickly, help to avoid possible disputes, and give confidence to those purchasing wholesale access services that those services are being provided on non-discriminatory terms. In the absence of a published RO, market entry might be deterred to the detriment of the long-term development of competition and consumers. Publication of a RO is particularly important in BT’s case, as all PECNs – either directly or indirectly – have to buy termination services from BT.

5.26 For these reasons, the Director’s initial view is that it is necessary to require BT to publish a RO for fixed geographic call termination services.

• Obligation to publish proposed changes to charges in advance of them taking place

5.27 As with the requirement to publish a RO, the publication of changes to charges in advance has two main purposes: (a) to assist transparency for the monitoring of potential anti-competitive behaviour; and (b) to give advanced warning of charge changes to competing providers purchasing wholesale access services. The latter is important to ensure that competing providers have sufficient time to plan for such changes, as they may wish to restructure retail prices in response to charge changes at the wholesale level. Advance publication would therefore help to ensure stability in markets or, without it, incentives to invest might be undermined and market entry discouraged.

5.28 Advance publication of charges can have some disadvantages, particularly in markets where there is some competition, as it could discourage active price competition. For instance, competitors could see the published prices of the dominant provider and may choose to follow those prices rather than compete with them. Advance notification of price changes could result in price replication and therefore weaken competition. However, in the fixed geographic call termination market, in which SMP is persistent, these disadvantages are of little relevance. Publication of charge changes in advance is particularly important in BT’s case, as all PECNs – either directly or indirectly – have to buy termination services from BT.

5.29 For these reasons, the Director’s initial view is that it is necessary to require BT to publish proposed changes to charges for fixed geographic call termination services in advance of those changes being permitted to take place.

• Obligation to set charges on the basis of forward looking long-run incremental costs

5.30 In effectively competitive markets, the price of services would be driven down to competitive levels by commercial pressures and the entry and exit of firms, i.e. the competitive process. However, where competition does not provide sufficient pricing constraints, it can be necessary to apply ex-ante regulation in order to ensure that prices reflect costs and are therefore not excessive.

5.31 In the absence of a pricing constraint, SMP providers would have strong incentives to set excessive prices, as this would increase their revenues and, in this context, competitors’ retail costs. A requirement not to unduly discriminate would exert downward pressure on charges, to the extent that the SMP provider’s retail activities may seek lower charges and the wholesale activity would be required to charge the same to all PECNs. However, the wholesale SMP provider would still have incentives to set its charges at an excessive level to maximise its overall profitability. Indirectly this could result in higher (i.e. excessive) retail prices. In the long-term this could result in market exit.

5.32 For these reasons, the Director’s initial view is that BT should be required to set cost-oriented charges for fixed geographic call termination. As the telecommunications industry is characterised by economies of scope and scale, the Director proposes that prices should be set on the basis of forward-looking long-run incremental costs.

• Obligation to publish separate accounts for its network and retail activities for the provision of these services and maintain appropriate cost-accounting systems

5.33 In order to ensure that network providers with SMP meet other regulatory obligations, such as requirements to set cost-oriented prices, price controls and non-discrimination, it may be necessary to impose financial reporting requirements to monitor compliance with these obligations. In the absence of suitable financial reporting requirements, it may be difficult or impossible to demonstrate that there is compliance with other obligations.

5.34 As this option would require BT to set cost-oriented prices, the Director’s initial view is that it would also be necessary to impose a requirement for BT to maintain appropriate cost accounting. In addition, as BT would be required not to discriminate unduly, the Director considers that it would also be necessary to require BT to maintain separately account for call termination services.

Option C

To provide fixed geographic call termination on fair and reasonable terms; not to unduly discriminate in the provision of this service; to secure transparency through price publication; a requirement to set prices on the basis of forward looking long-run incremental costs; requirements for separate accounting and appropriate cost-accounting systems; and price controls

5.35 This option is as Option B, plus an obligation on BT under which its charges would be subject to price controls.

• Obligation under which its charges would be subject to price controls

5.36 The price control would be designed to ensure that prices reflected efficiently incurred costs in the provision of these services. The case for this additional obligation is discussed below, under a comparison of Options A, B and C.

Comparison of Options A, B, and C

5.37 Oftel has considered three different options for levels of regulation on BT in the provision of its fixed geographic call termination services. Of these, the Director has already discounted Option A, as this would not address BT’s SMP in the provision of fixed geographic call termination.

5.38 The combination of obligations included within Option B would ensure that BT had to provide fixed geographic call termination services on fair, reasonable, transparent, and cost-oriented terms, and would be unable to discriminate unduly between wholesale customers. Option B would therefore address many of the problems associated with markets in which there was a firm with SMP. This option would allow other network providers to compete with BT in downstream markets on a fair and even basis.

5.39 However, under Option B, there would be less incentive for BT to ensure that the costs of providing fixed geographic call termination services were efficiently incurred, as it would in any case receive its incurred costs plus an appropriate return on capital employed. The obligation to ensure that prices were cost-oriented (being set on the basis of forward-looking long-run incremental costs) would not therefore constrain the level of costs that BT could incur to the efficient level, as it would maintain its profitability whether or not costs were efficiently incurred.

5.40 If costs were above the efficient level, consumer welfare and economic efficiency would be reduced, as prices would be higher than necessary and correspondingly output would be lower. Option B might not therefore fully address the effects of BT’s SMP in fixed geographic call termination and this could have adverse consequences for retail end-users.

5.41 Option C would address these concerns through the introduction of a charge control. In the Director’s view, a price control if appropriately designed is a proportionate response where competitive pressures and other regulation is not otherwise sufficient to ensure that prices are reflective of efficient costs. Charge controls (in particular RPI-X controls) create incentives for the charge-controlled firm to increase its efficiency and they thereby imitate the effect of a competitive market. The Director considers that (the continuation) of charge controls would create the incentives for BT to reduce costs. In BT’s case, the charge control would address BT’s SMP and the lack of competitive pressures to reduce costs; the risks of excessive costs and pricing that result; and the material adverse effects this would have on end-users.

5.42 A price control would ensure that all network providers (including BT) would be able to reduce their retail prices to reflect BT’s increasingly efficiently incurred costs of providing termination services, as technology and efficiency improves. This would therefore increase consumer welfare, as the control would be aimed to reduce prices to the competitive level.

5.43 Option C is therefore the Director’s preferred option for regulation in the provision of BT’s fixed geographic call termination services. In annex C, Oftel provides illustrative results of a cost-benefit analysis conducted with respect to the aggregated effect of the forward looking long-run incremental costs and price control elements of Option C using BT’s termination charges under the current charge control baskets. Although the results can only be illustrative because they are based on certain parameter assumptions, they are an indication of the very significant benefits that this regulation can bring to consumers. These benefits do not vary by a significant degree even when sensitivities within a broad range are carried out on the assumptions.

5.44 In terms of clause 4(3)(a) of the Communications Bill, this option would give the appropriate signals for entry at the network level and should promote competition in the provision of electronic communications services, as a result of the charge control and the prohibition on undue discrimination.

5.45 In terms of clause 4(7), this option would ensure that fixed geographic call termination and interoperability of services were available, as BT would be required to meet reasonable requests to provide services and do so on reasonable terms. In addition, as BT’s charges for fixed geographic call termination would be based on increasingly efficient costs, this option would discourage inefficient competition and encourage sustainable competition as described in clause 8(a). These factors should ensure that customers enjoyed the maximum benefit as described in clause 8(b).

5.46 The Director also believes that this option would meet the tests set out in clause 43(2). It would be proportionate, as it reflects BT’s proposed SMP in the provision of fixed geographic call termination and its proposed SMP status in the provision of relevant retail calls. It would not discriminate unduly, as it would reflect the circumstances of BT and its greater ability to leverage its SMP into retail calls markets. It would be objectively justifiable, given the benefits in greater certainty that it would provide to the industry and thereby to consumers. It would be transparent in relation to the effect it is intended to achieve given the explanation in this document.

Question 5

Do you agree that Option C is the most appropriate and proportionate response to BT's SMP in the provision of its fixed geographic call termination services?

Detail of the proposed remedies for BT

Requirement to provide network access (proposed Condition BA1)

5.47 As explained in the option appraisal, the Director’s initial view is that BT should be required to meet all reasonable requests for fixed geographic call termination. Oftel also believes that fixed geographic call termination should be provided on fair and reasonable terms, conditions and charges and on such terms, conditions and charges as the Director may from time to time direct. These obligations are reflected in proposed Condition BA1 included at Schedule 1 to Annex A of this consultation document.

5.48 The Director considers that the proposed condition meets the tests set out in the Communications Bill. The Director in proposing this condition has considered all the Community requirements set out in Clause 4 and in particular the requirement to promote competition, to further the interests of consumers, and to promote effective and sustainable competition.

5.49 Clause 43 requires conditions to be justifiable, non-discriminatory, proportionate and transparent. The proposed condition is objectively justifiable, in that it relates to the need to ensure that competition develops to the benefit of consumers. It does not discriminate unduly, in that it is imposed on BT and, as explained in chapter 6, all other fixed network providers that terminate fixed geographic calls. It is proportionate, since it does not require BT to provide access if the request is unreasonable. It is transparent as to the effect that it is intended to achieve given the explanation in this document.

5.50 The Director also believes that the proposal to require BT to provide access meets the tests set out in Clause 83(4) of the Communications Bill in that, amongst other things, it is feasible for BT to provide such network access and the absence of such access would have a serious harmful effect on long term retail competition. Additionally, the Director believes his proposal will help to secure effective competition in the long term.

Requirement not to unduly discriminate (proposed Condition BA2)

5.51 As explained in the option appraisal, the Director’s initial view is that BT should be prevented from unduly discriminating in the provision of fixed geographic call termination. The Director considers that BT would be unduly discriminating if such discrimination had a material adverse effect on competition and there was no objective justification for the discrimination. This is reflected in proposed Condition BA2.

5.52 An obligation of non-discrimination might have disadvantages if it prevented discrimination that was economically efficient or justified. However, the proposed condition provides that there should be no undue discrimination. Oftel has considered how it might treat undue discrimination in its statement Imposing access obligations under the new EU Directives, September 2002. This statement notes that any obligation with respect to undue discrimination has the objective of preventing behaviour that has a material adverse effect on competition. This does not mean that there should not be any differences in treatment between undertakings, rather that any differences should be objectively justifiable, for example, by differences in underlying costs of supplying different undertakings. The statement also notes that in the Director’s view there is a rebuttable presumption that a vertically integrated SMP provider discriminating in favour of its own retail activities or between its own different activities would have a material adverse effect on competition. This view would also apply to discrimination in relation to the underlying components of services provided to competing providers if it would have a material adverse effect on competition.

5.53 The Director considers that the proposed condition meets the tests set out in the Communications Bill. The Director in proposing this condition has considered all the Community requirements set out in Clause 4 and in particular the requirement to promote competition and to secure efficient and sustainable competition.

5.54 Clause 43 requires conditions to be justifiable, non-discriminatory, proportionate and transparent. The Director considers that this proposed condition is objectively justifiable, in that it provides safeguards to ensure that competitors, and hence consumers, are not disadvantaged by BT discriminating in favour of its own retail business or between its own different activities. It does not discriminate unduly against BT, in that it reflects BT’s proposed SMP in relevant retail calls markets as well as its proposed SMP in fixed geographic call termination markets, and therefore its potential for using SMP to distort competition in other markets. It is proportionate in that discrimination is only prohibited if it is ‘undue’. Finally, it is transparent as to the effect that it is intended to achieve given the explanation in this document.

Basis of charges (proposed Condition BA3)

5.55 As explained in the option appraisal, the Director’s initial view is that BT should be required to set its prices for fixed geographic call termination on the basis of its forward looking long-run incremental costs and allow for the recovery of common costs through an appropriate mark-up. This basis for charging would allow BT to make an appropriate return on capital employed. This is reflected in proposed Condition BA3.

5.56 Oftel believes that in many communications markets ex-ante regulation should require charges to be set on the basis of long-run incremental costs (LRIC), with appropriate mark-ups for costs which are common across products, and for the recovery of the cost of capital. Economies of scope and scale combined with high sunk costs pose particular issues for assessing competitive prices in the communications industry. Under normal competition principles, a price as low as short-run marginal cost might be considered not to be anti-competitive. However, in communications markets, short run marginal costs can be very low or even zero. An incumbent’s price based on short-run marginal costs could then deter entry as it would not reflect the price that potential entrants would need to charge to cover fixed sunk costs. LRIC is therefore preferred as the cost floor in communications markets as this includes directly relevant fixed costs. This is the case whether regulation is ex-ante or ex-post. This was explained in The Application of the Competition Act in the Telecommunications Sector, which was published by Oftel in January 2000.

5.57 The Director considers that the proposed conditions meet the tests set out in the Communications Bill. The Director has considered all the Community requirements set out in clause 4 including, in particular, the requirement to promote competition and to secure efficient and sustainable competition.

5.58 Clause 43 requires conditions to be justifiable, non-discriminatory, proportionate and transparent. The Director considers that the proposed conditions are an objectively justifiable and proportionate response to the extent of competition in the markets analysed, as they enable competitors to purchase services at charges that will enable them to develop competitive retail services to the benefit of consumers, whilst at the same time allowing BT a rate of return commensurate with that which it would expect in competitive markets. It does not discriminate against BT, in that it reflects the circumstances of BT, and its potential for using market power in termination to distort competition in other markets. Finally, it is transparent as to the effect that it is intended to achieve given the explanation in this document.

5.59 The Director considers that the tests in Clause 84 have been met. As noted above, there is a risk that, in situations where SMP is persistent, pricing will be distorted and not at competitive levels. The proposed conditions are necessary in order to provide benefits to end users by enabling competing providers to buy wholesale services at levels that might be expected in a competitive market. The Director also considers that his proposals promote efficiency and sustainable competition, as, under his proposals, BT would be permitted to earn a reasonable return on its investment.

5.60 The extent of investment of the dominant operator has been taken into account as set out in Clause 84(2) and the pr