Contents

Summary
Chapter 1 Introduction
Chapter 2 Market definition
Chapter 3 Assessment of market power in the UK excluding the Hull area
Chapter 4 Options for remedies in the UK excluding the Hull area
Chapter 5 Assessment of market power in the Hull area
Chapter 6 Options for remedies in the Hull area
Chapter 7 Consultation

Annex A Notification and proposed conditions
Annex B Utilisation of FRIACO routes
Annex C List of questions
Annex D 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 to 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 This review considers the market for wholesale unmetered narrowband Internet termination. This is the key wholesale service needed by ISPs wishing to offer unmetered, ie flat rate, narrowband Internet access services to consumers. The review considers separate geographic markets for the UK (excluding the Hull area) and the Hull area. The requirements for FRIACO services are being separately reviewed in Oftel's review of call origination.

S.4 Oftel has considered the market boundaries in the light of a more mature market since its last review of Internet call termination . It considers that separate markets can be identified for unmetered and metered services. In view of the findings of the previous market review, that many of the competitive problems identified were associated with the provision of unmetered Internet termination, Oftel considers it appropriate to review only the market for unmetered narrowband Internet termination but not the metered Internet termination market.

S.5 This market is not identified in the European Commission's Recommendation on relevant markets which was published on 11 February 2003. Oftel considers that national circumstances justify this review and sets out its reasons in more detail in Chapter 4.

Initial conclusions on Significant Market Power

S.6 Oftel has considered whether Significant Market Power (SMP) is held by any providers in the markets, taking into account the European Commission and Oftel SMP Guidelines.

S.7 In the UK (excluding the Hull area) geographic market for wholesale unmetered narrowband Internet termination, the Director General's (the Director) initial view is that no single firm has SMP. The key factors contributing to this view are:

• market shares have changed considerably over the last 12 months and the share of the largest player has declined;
• the higher entry costs for unmetered access have not proven to be insurmountable, and an additional player has entered the market over the last 18 months;
• some competing operators have completed national or near national build out of FRIACO, so that ISPs now have viable alternatives to BT’s unmetered Internet termination services;
• there is evidence of some countervailing buyer power from a major ISP and that operators are competing for that business;
• the risks and cost of entry should be lower following changes to FRIACO to ensure payment can be made monthly in arrears and over the arrangements for refunds of cancelled FRIACO virtual paths; and
• BT does not appear to charge a significant price premium over other operators.

S.8 The Director's initial view, in relation to collective dominance, is that the conditions to prove collective dominance are not met. This is supported by the existence of some countervailing market power, lack of transparency of pricing, and the lack of stability in market shares.

S.9 Oftel has identified a separate geographic market for the provision of wholesale unmetered narrowband Internet termination services for traffic originating in the Hull area. Oftel believes that the competitive conditions there are very different to the rest of the UK. In particular, the Director's initial view is that Kingston Communications has SMP as it is virtually the sole supplier of unmetered wholesale services for Internet traffic originating within the Hull area.

Regulatory remedies

S.10 The current regulation relevant to BT in this market requires it to supply services to any one who makes a reasonable request, prohibits undue preference and undue discrimination, and requires the publication of charges, terms and conditions.

S.11 The Director's initial view is that BT does not have SMP and therefore no regulatory remedies are required in this market under the new regulatory framework. The review does however present the regulatory options that would be relevant if, following consultation, Oftel concluded that BT has SMP. These include a range of remedies, such as obligations relating to charge publication, non-discrimination and publication of a reference offer.

S.12 In the Hull area, the Director proposes that requirements on Kingston to provide network access, publish a Reference Offer, publish charges, publish technical information and not to discriminate unduly would be appropriate regulatory remedies.

Consultation

S.13 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 Justin Moore, Oftel, 50 Ludgate Hill, London EC4M 7JJ. E-mail: justin.moore@oftel.gov.uk. Tel: 020-7634 8859. A full list of the questions to which Oftel is seeking responses is in Annex C.

S.14 The formal notification of the proposed market definition, SMP designation and specific conditions can be found in Annex A. The proposed draft directions and the obligations set out therein can also 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 to 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 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 is that which was amended in Committee in the House of Commons on 6 February 2003. It can be found at that website (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 It is intended that the Communications Bill will 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 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 Each market review has three stages:

• 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 below in this market review.

Recommendation on relevant product and service markets

1.11 The European Commission has identified in its Recommendation on markets, adopted on 11 February 2003 ("the EU Recommendation"), a set of product and service markets within the electronic communications sector, which are to be reviewed by NRAs. The 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 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 Recommendation.

SMP Guidelines

1.12 The European Commission has also issued guidelines on market analysis and the assessment of significant market power ("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. These can be found at: http://www.oftel.gov.uk/publications/about_oftel/2002/roa0602.htm.

Previous review

1.14 Oftel has already carried out effective competition reviews as part of its strategy to obtain the best deal for consumers through promoting effectively competitive electronic communications markets. In particular, Oftel undertook a review of Internet markets which concluded in January 2002.

1.15 One of the markets considered by that review was wholesale Internet call termination. Internet call termination refers to the wholesale conveyance of Internet calls to an Internet Service Provider (ISP) for the purposes of providing retail Internet access.

1.16 The previous review concluded that BT had market power in wholesale Internet call termination and that the market was not effectively competitive. The change, from what had previously been viewed as a competitive market, was linked to the relatively recent move to unmetered Internet access. Unmetered services provide dial-up Internet access on a flat rate basis with no call charges, as compared to metered services for which there are per minute call charges.

1.17 In particular the move to unmetered access had resulted in higher entry barriers for terminating operators and consequently a much more limited choice of suppliers of unmetered services compared to metered services. In addition, BT's share of Internet call termination volumes had increased substantially over the previous two years. The review concluded that the existing regulations, including price publication and non-discrimination, were still appropriate given the existence of market power.

Scope of this review

1.18 Although Oftel's previous review had considered a single market for wholesale Internet call termination, the rapid emergence of unmetered services raises the question of whether metered and unmetered Internet access can continue to be considered as a single market. Oftel has now considered the market boundaries in the light of a more mature market, and concluded that separate markets can be identified for unmetered and metered services (see Chapter 2 for the market definition).

1.19 An important feature of the conclusions of the last review was that the changes in the market, which led it to reach the view that BT had market power, were all associated with the supply of unmetered services. In particular, increased entry barriers, economies of scale and greater concentration were all specifically related to unmetered services. In contrast, for metered services, the review identified that there were many suppliers, relatively few barriers to entry and operators had been able to compete effectively.

1.20 Oftel’s concerns are therefore focused on unmetered access as that is where the potential competition issues lie and the area where conditions are most likely to have changed over the relatively short period since its last review. In contrast, metered Internet termination is a mature market that was viewed as being more competitive than unmetered access in the last review. Therefore, this review addresses only the unmetered narrowband Internet termination market.

1.21 There are also close links between the call origination market and the unmetered narrowband Internet termination market and competitive conditions in the downstream termination market are heavily dependent on operators having access to adequate unmetered call origination products. Therefore reviewing this market also enables the effectiveness of the existing unmetered call origination obligations, for example Flat Rate Internet Access Call Origination (FRIACO) to be assessed. Regulation relating to FRIACO is assessed in Oftel's Review of the fixed narrowband wholesale access, call origination, conveyance and transit markets. Figure 1 shows the relationship between unmetered narrowband Internet termination, other markets and typical products.

Figure 1: Relationship between narrowband Internet markets

1.22 Oftel has based its analysis in this review on a wide range of sources, including responses to questionnaires sent to operators, Oftel’s own market research and regular market information collected from industry.

Question 1.1

Do you agree with Oftel's reasons for reviewing the wholesale unmetered narrowband Internet termination market?

Question 1.2

Do you agree that there is a greater concern over competitive conditions in the provision of unmetered compared to metered narrowband Internet termination?

Services considered by this review

1.23 Wholesale unmetered narrowband Internet termination products are communication services provided to ISPs to enable them to provide retail unmetered Internet access. They provide end-to-end wholesale conveyance comprising call origination, termination on a Network Access Server (NAS) and IP conveyance to the ISP (or a location specified by the ISP, such as an Internet exchange). Services are normally provided to the ISP on a port rental basis, where each 64kbps port is capable of supporting a single concurrent dial-up session. Figure 2 illustrates the typical network architectures used to provide unmetered dial-up Internet access services.

1.24 Note that wholesale services may also be provided to other network operators or service providers who then bundle other services in order to provide a package to virtual ISPs, ie ISPs that do not run any of their own infrastructure.

 Figure 2: Unmetered dial-up Internet network architecture

1.25 The two main types of unmetered narrowband Internet termination services provided by operators are dedicated services and shared/managed services.

Dedicated services

1.26 For a dedicated service, an ISP will request specific FRIACO circuits in specific locations. FRIACO circuits allows the conveyance of traffic between end users and the local or tandem exchange for a flat rate charge. These circuits and the modems (also known as Network Access Servers) used to terminate calls are dedicated for use by that ISP. Therefore the ISP needs to manage where it needs network capacity, and when, if it is to maintain the quality of service provided to its customers. Consequently, these types of services are typically used by larger ISPs who have sufficient demand to justify a dedicated network and wish to manage the details of their network capacity.

Managed / shared services

1.27 For a managed or shared service, operators build sufficient capacity to provide a shared service to their ISP customers. In other words, the FRIACO circuits and modems may be used by end users belonging to any ISPs using that service. The operators in this case are responsible for planning and managing network capacity so that quality of service to customers can be maintained. These services are preferred by smaller ISPs that do not carry sufficient traffic to justify a national network and those ISPs that do not wish to undertake their own network planning.

1.28 ISPs will typically order a number of managed ports on a national basis. These ports are virtual in the sense that they do not correspond to physical ports. The number of virtual ports corresponds to the maximum number of concurrent dial-up sessions that the ISP can have.

Current regulation

1.29 The specific obligations currently applying to BT in the unmetered narrowband Internet termination market are the obligation to supply to any person who reasonably requests such services (Condition 43). Linked to this obligation is a prohibition on undue preference and undue discrimination (Condition 57) and the requirement for publication of charges, terms and conditions (Condition 58).

Outline of rest of document

1.30 The rest of the document is structured as follows:

• Chapter 2 defines the relevant market;
• Chapter 3 assesses whether there is SMP in the UK (excluding the Hull area) geographic market;
• Chapter 4 assesses the options for regulatory remedies in the above market if SMP is found;
• Chapter 5 assesses whether there is SMP in the Hull area geographic market;
• Chapter 6 assesses the options for regulatory remedies in the above market if SMP is found;
• Chapter 7 gives details of the consultation process.

Notification

1.31 Annex A contains the formal notification of the proposals made by the Director as a result of the review, including the market(s) 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.

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

Chapter 2

Market definition

Approach used to define markets

2.1 There are two aspects to the definition of a relevant market: the relevant products to be included in the 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, available at: www.oft.gov.uk/html/compact/technical_guidelines/oft403.html) and is in line with those used by European and US competition authorities. 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.

2.2 The concept of the ‘hypothetical monopolist test’ is a tool used to help identify 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 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. A further 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.

2.3 The market relevant to this review is a wholesale market. However this chapter begins with an analysis of market definition at the retail level. This is because the analysis of retail market definitions is logically prior to the definition of the upstream (wholesale) markets as the demand for the upstream service is a derived demand, i.e. the level of demand for the wholesale input (upstream) depends on the demand for the output (retail service). The definition of a retail market is likely to affect the assessment of whether Significant Market Power (SMP) in a related upstream market exists, since the relevant upstream market will generally be as broad as the demand-side substitutes in the relevant retail markets.

Product market

Retail product

2.4 As in previous reviews, Oftel here defines narrowband Internet access to include Internet access at speeds up to 128 kbps. This is also the definition adopted by the European Commission in its Recommendation on relevant product and service markets. There is however no uniquely correct or generally agreed minimum speed for high-speed, higher bandwidth or broadband access. The issue of whether separate markets can be defined for access at speeds above and below this level is considered below.

2.5 Oftel therefore includes the termination of Internet calls originating on ISDN lines in the narrowband market. Oftel also includes NTL’s 128 kbit/s offering in the narrowband market. Although this is marketed as "broadband", it has only some, not all, of the key characteristics of broadband. It is always on and allows use of the telephone at the same time but is not as fast as other services marketed as broadband. Oftel's latest residential survey found that the main reason for getting broadband was faster access, mentioned by 57% of respondents compared to only 8% who mentioned simultaneous voice calls and 6% who mentioned permanent connection. Oftel believes that for this reason these services should be regarded as narrowband rather than broadband for the purposes of this review. The residential survey, which was conducted in November 2002, can be found at http://www.oftel.gov.uk/publications/research/2003/q11intr0103.htm

Wholesale product

2.6 "Internet termination" services provide wholesale end-to-end conveyance of Internet calls between the end user and the Internet Service Provider (ISP). Specific types of wholesale unmetered narrowband Internet termination products, dedicated and managed services, are described in chapter 1. A retail ISP typically purchases this end-to-end product and adds wholesale Internet connectivity and other services in order to provide a retail Internet access product.

2.7 However, an alternative model is possible using BT's Surftime service. With Surftime, BT retails the unmetered call origination portion of the service direct to the end user. The wholesale service provided by the terminating operator in this case therefore does not include wholesale call origination.

Retail markets

Metered versus unmetered

Demand-side substitution

2.8 The hypothetical monopolist test can be used to consider whether separate markets can be defined for metered and unmetered retail Internet access. If a monopoly supplier of unmetered Internet access raised the price by a small but significant amount for a non-transitory period, would consumers switch to the use of metered Internet access in sufficient numbers to make this unprofitable?

2.9 This may depend on what is hypothesised about the range of metered tariffs available. For example, at one extreme there might be an almost infinite variety of metered tariffs with varying levels of fixed and usage-related charges, including some which could approximate closely to an unmetered tariff that is, with a very low usage-based charge. In such circumstances it might be argued that there was a chain of substitution with unmetered access at one end of the chain and pure metered access at the other. Substitution between adjacent elements of the chain might then be sufficient to impose a common pricing constraint on metered and unmetered tariffs, with the implication that it would then be appropriate to consider them as part of the same market.

2.10 In practice however, the range of metered tariffs available is more limited than this (this is likely to reflect the structure of the wholesale tariffs available). Whilst clearly there may be levels of usage at which the costs of metered and unmetered access are comparable, many consumers are unlikely to find the available range of metered tariffs an adequate substitute for unmetered access. In other words, the chain of substitution hypothesised above is broken. It would then follow that demand-side substitution from metered access would not be sufficient to constrain the price of unmetered access and vice versa.

2.11 This appears to be supported by results from recent Oftel surveys which suggest that substitution between metered and unmetered access is limited. According to the November 2002 survey, 82% of residential metered Internet customers have only ever used this mode of connection and 75% of unmetered Internet customers have only ever used this type of connection. Switching from metered to unmetered tariffs has occurred to a greater extent than from unmetered to metered, no doubt reflecting the later introduction of unmetered access. As would be expected, heavier Internet users are more likely to use unmetered packages and these are less likely to find a metered alternative an acceptable substitute. Similarly, metered access users are likely to be low-volume users who might find that the premium that they had to pay for unmetered access did not justify the level of their use. Again, it appears unlikely that the proportion of consumers who would switch is high enough to constrain the prices of such services.

2.12 There may also be a significant proportion of consumers for whom non-price factors affect their decision to use metered or unmetered Internet access and which therefore restricts substitutability between the two. In the case of metered, these non-price factors might include the desire to maintain flexibility in their expenditure on Internet usage, perhaps to reflect variations in the funds available from month to month, and the perception of greater value for money compared to unmetered. In the case of unmetered, users are more likely to value the security of a constant monthly payment and the freedom to access the Internet at any time.

2.13 Oftel therefore believes that demand-side substitution from unmetered access is not likely to constrain the price of metered Internet access and vice versa.

Supply side substitution

2.14 Supply-side substitution would be a relevant constraint if, when a monopoly supplier of unmetered Internet access raised the price by a small but significant amount for a non-transitory period, suppliers of metered access began to provide unmetered Internet access in sufficient numbers to make this unprofitable.

2.15 At the retail level, the ability of ISPs to switch from supplying metered access to supplying unmetered access in response to an increase in the price of the latter depends on their ability to obtain the appropriate wholesale inputs. In particular, it is unlikely to be feasible to offer an unmetered retail offering on the basis of a metered wholesale product. This is because a service provider attempting to do so would then be exposed to all the volume risk associated with uncertain levels of usage. Its revenues would be fixed but its costs would vary with the volume of usage made by its customers. This being the case, this switching is reliant on access to appropriate unmetered inputs and the possibility of supply-side substitution at the retail level cannot then act as a constraint on the pricing of such inputs. In practice, the ability of ISPs to offer unmetered access depends on the availability of unmetered call origination (FRIACO) on regulated terms, which is then incorporated into wholesale unmetered narrowband Internet termination services. In addition, in switching to providing unmetered access, ISPs would need to develop a billing relationship with the consumer and this would impose certain costs. Supply-side substitution by retail ISPs is unlikely to be a relevant constraint therefore.

2.16 Operators may also offer partially unmetered services. For example, BT's Anytime service has a cap on its unmetered usage – consumers can use the service for 150 hours a month on an unmetered basis. However, the average unmetered user is unlikely to spend more time connected than that (Oftel's November 2002 research shows that narrowband unmetered users spend an average of 11 hours a week online), so that these products are in effect likely to be perceived as unmetered by the customer. Similarly, Surftime services allow consumers to access the Internet for up to 120 hours per month during off-peak hours. In both these cases, the unmetered component is significant and so it is likely that these products could only be offered on the basis of unmetered wholesale offerings. These are therefore regarded as part of the unmetered market.

Initial conclusion

2.17 The Director's initial view is that there are therefore separate retail markets for metered and unmetered narrowband Internet access.

Question 2.1

Do you agree that separate retail markets can be identified for metered and unmetered narrowband Internet access?

Relationship to other definitions

2.18 In Oftel's last review that considered narrowband Internet termination, Oftel defined the market to include both metered and unmetered products. Similarly, the European Commission in its recommendation on relevant product and service markets, includes metered and unmetered access in the same market. A key factor in this conclusion was however the availability of unmetered wholesale products on regulated terms which enables supply-side substitution at the retail level. Provided both metered and unmetered wholesale Internet termination are available, it is straightforward for a retail ISP to switch from the supply of retail metered access to retail unmetered access and vice versa. However, as noted above, because supply-side substitution at the retail level is dependent on the availability of both metered and unmetered wholesale inputs, it cannot constrain the prices of the wholesale inputs themselves. As Oftel here is concerned with the competitiveness of wholesale markets, it seems more appropriate for the purposes of the current review to regard metered and unmetered access as separate markets.

2.19 In general, it should always be recognised that market definition is a means to an end, the analysis of market competitiveness, rather than an end in itself. Moreover, Oftel has always emphasised that market definitions in rapidly developing Internet markets are likely to be particularly subject to change over time as markets adapt to the introduction of new products. Unmetered access was a relatively recent innovation at the time of Oftel's last review and there have been some indications that competitive conditions differ between metered and unmetered access provision, a fact noted by the European Commission which recognises the need for greater build out of networks to terminate dial-up calls under unmetered arrangements. Both these factors suggest that it may be appropriate to regard metered and unmetered access as separate markets. The need for flexibility to respond to new product developments means that the possibility that market definitions may need to be revised in future should be borne in mind.

Narrowband versus broadband

2.20 Since the launch of broadband products in 2001, the number of broadband subscribers has been growing rapidly, more than doubling during 2002. Broadband Internet access via DSL copper enabled lines, or through cable, has four distinguishing features which are not available in practice using narrowband Internet access:

• It allows use of the telephone for voice calls at the same time as the subscriber is connected to the Internet (the exception to this is if a narrowband subscriber rents a dedicated line for Internet access).
• It is fast, because of higher bandwidth.
• It is always-on, ie no dial-up is required.
• It allows content which is not practically available with narrowband access (for example real-time video content).

Metered narrowband versus broadband

2.21 Are metered narrowband and broadband Internet access part of the same market?

Demand-side substitution

2.22 Metered Internet access users are distinguished from other types of Internet access users by the fact that they tend to be relatively low volume users of the Internet. The benefits of a broadband access service are therefore unlikely to outweigh the price premium for broadband access for these types of consumers given current price differentials. Therefore, if a hypothetical monopolist raised the price of narrowband metered Internet access by 10%, it is unlikely that a sufficient number of consumers would switch to broadband to make this price rise unprofitable. Therefore demand side substitution is unlikely to provide a constraint on metered narrowband access.

Supply-side substitution

2.23 At the retail level, it would not appear to be difficult for an ISP to switch from the supply of broadband Internet access to the provision of metered narrowband Internet access and vice versa provided they can obtain the appropriate wholesale inputs. However, as noted in the discussion of supply-side substitution possibilities between metered and unmetered narrowband access, where this switching is reliant on access to an input over which the hypothetical monopolist has control, the possibility of supply-side substitution at the retail level could not act as a constraint on the pricing of such inputs. Supply-side substitution by retail ISPs is unlikely to be a relevant constraint therefore.

Unmetered narrowband versus broadband

2.24 Are unmetered narrowband and broadband Internet access part of the same market?

2.25 Unmetered narrowband and broadband share the feature of unlimited access to the Internet. It is possible therefore that customers may perceive unmetered narrowband as a closer substitute for broadband access than metered narrowband access.

2.26 It is useful to distinguish two types of narrowband users here. Typical narrowband unmetered access users are those with a single telephone line connected to the Internet by a modem, paying a flat fee per month. The other type of narrowband users are those on an unmetered package, but who have a second telephone line that is dedicated to the Internet connection. In addition to the unlimited access, such users would value the ability to use the telephone for voice calls while connected to the Internet that the second line provides. In that sense, the narrowband connection offers them one of the features of broadband.

Demand-side substitution

2.27 It is useful to consider price differentials between narrowband unmetered access, with both a single line and with two lines, and broadband access. Some examples of current prices are provided in the table below; it assumes that the customer already possesses an analogue telephony access line.

Table 1 : Example narrowband and broadband prices

Source: suppliers’ web-sites; if not stated otherwise all prices include VAT.

2.28 If the hypothetical monopolist of unmetered narrowband access raised the price by 10%, would there be demand side substitution to broadband?

2.29 The above table illustrates that monthly rates for a (single line) unmetered package are much lower than a broadband package and hence even if prices increased by 10%, prices would not be comparable. Hence it is unlikely that this would constrain a hypothetical monopolist of one service.

2.30 Prices for an unmetered package with a second line are closer to those of the cheaper broadband packages taking into account connection fees and modem costs. It could be argued that even at current price levels there is an incentive for consumers with a second line to move to some broadband packages due to the additional features that broadband can offer at similar prices. Those who still choose to use a narrowband connection with a second line may not place a higher value on the additional features of broadband. It seems likely that this may represent a relatively small proportion of customers and therefore would be unlikely to constrain the hypothetical monopolist. Oftel is currently undertaking market research in order to verify this view. In addition, there may be customers who do not have access to broadband and are not likely to have access in the near future. Faced with a price rise, such customers would not be able to switch and therefore could not constrain the monopolist's ability to raise prices profitably.

2.31 It therefore appears unlikely that there would be sufficient demand side substitution between narrowband unmetered access and broadband access for these services to be subject to a common pricing constraint. This is consistent with the fact that broadband Internet access prices fell by approximately 25% in April 2002 without any apparent impact on the price of unmetered narrowband Internet access.

Supply-side substitution

2.32 Supply-side substitution is unlikely to be a relevant constraint on unmetered narrowband access prices, for similar reasons to those applying to metered narrowband access.

Initial conclusion on unmetered narrowband vs. broadband

2.33 The Director's initial view is that unmetered narrowband Internet access is in a separate market to broadband Internet access.

Question 2.2

Do you agree that unmetered narrowband Internet access is in a separate market to broadband Internet access?

Wholesale markets

Metered versus unmetered

Demand-side substitution

2.34 The demand for Internet termination is derived from the demand for retail Internet access. As noted earlier, the relevant wholesale market will typically be as broad as the retail market. Therefore, as there is considered to be insufficient demand side substitution at the retail level between metered and unmetered access for these to be regarded as a single market, this would imply limited demand side substitution at the wholesale level too.

Supply-side substitution

2.35 In the event of a price rise imposed by a hypothetical monopolist of unmetered termination, could an operator providing metered termination switch to unmetered termination sufficiently easily and cheaply to make the price rise unprofitable? It is useful to consider this in both an unregulated environment and in an environment in which regulated unmetered call origination products are available.

2.36 In an unregulated environment, an operator providing metered termination could only switch into the provision of unmetered termination if it had a network capable of providing an unmetered service. An unmetered service is likely to carry much greater traffic volumes than a metered service, and therefore a much more extensive network is likely to be required. As discussed below, an efficient network is likely to require interconnection at local exchanges, requiring considerable investment and time. Supply-side substitution would be unlikely to constrain the price of unmetered termination in this environment therefore.

2.37 In practice, operators currently operate in a regulated environment in which wholesale unmetered call origination products such as DLE FRIACO and Single Tandem (ST) FRIACO are available from BT. Oftel is consulting separately on its proposals for FRIACO. To provide metered Internet termination alone, connection to BT's network at the tandem layer is likely to be sufficient. However, although ST FRIACO is available, operators have typically used the DLE FRIACO wholesale product to be able to terminate unmetered originating calls. ST FRIACO has proved less popular for a number of reasons, one of which is that DLE FRIACO is likely to be a more efficient option for an operator wishing to serve a large market with significant volumes of traffic. This issue is discussed more fully under the heading economies of scale in the market analysis in Chapter 3. In addition, the provision of wholesale Internet termination in conjunction with Surftime requires interconnection with the DLE.

2.38 In order to provide a national level unmetered service therefore, it is likely to be necessary to connect to BT's network at most of BT's local exchanges, so that calls originating from customers connected to the these exchanges can be groomed off directly on to the operator’s IP network. As discussed in Chapter 3 under " Ease of market entry ", it is likely to take at least one year to interconnect with a sufficient number of BT's DLEs to offer a commercial unmetered Internet call termination service. It is more appropriate to regard this as market entry rather than supply-side substitution therefore. This being the case, supply-side substitution is unlikely to constrain the prices of a hypothetical monopolist of unmetered termination.

2.39 If a hypothetical monopolist of metered termination products raised its prices, could an operator supplying unmetered termination products easily switch to the supply of metered termination? An operator which is already supplying unmetered termination products will normally have connections at BT's local exchanges. It is likely therefore that such an operator would be able to switch to supplying metered termination without incurring additional significant costs associated with network build out. This however is a theoretical possibility. In practice, metered products were developed first and suppliers of these later built out their networks to provide unmetered products

Initial conclusion on wholesale narrowband Internet termination markets

2.40 Since the demand for Internet termination is a derived demand from retail demand, there are different markets on the demand side between metered and unmetered termination. There is, in theory, a possible asymmetry in supply side substitution between metered and unmetered termination. However, neither demand-side nor supply-side substitution are likely to constrain the prices of a hypothetical monopolist of unmetered termination. Therefore the Director's initial view is that there is a separate market for unmetered Internet termination.

Question 2.3

Do you agree that wholesale unmetered narrowband Internet termination is in a separate market to metered narrowband Internet termination?

Broadband versus narrowband

2.41 Is wholesale broadband access in the same market as unmetered narrowband termination?

Demand side substitution

2.42 The demand for Internet termination is derived from the demand for retail Internet access. As noted earlier, the relevant wholesale market will typically be as broad as the retail market. Therefore, as there is considered to be insufficient demand side substitution at the retail level between unmetered narrowband access and broadband access for these to be regarded as a single market, this would imply limited demand side substitution at the wholesale level too.

Supply-side substitution

2.43 If a monopoly supplier of narrowband Internet termination were to raise its prices, could an operator supplying wholesale broadband access supply-side substitute? There are two possible methods of supply-side substitution from broadband to narrowband. Firstly, a broadband operator could use the broadband network (cable modem/DSL) but at a lower bandwidth. However, the higher costs of a broadband network would make it uneconomic to use this to supply narrowband service except possibly as a marginal activity.

2.44 A second possible method would be for the broadband operator to buy FRIACO and install equipment (Network Access Servers) for terminating dial-up Internet calls. An operator providing wholesale broadband access may already be interconnected at one or several of BT's ATM switches, thereby allowing them to pick up FRIACO traffic at that location. However, this is likely to be a small number of locations compared to the number of local exchange sites required for DLE FRIACO. Therefore, an operator would incur significant expense in installing equipment and reaching the exchanges they were not already present at. Moreover, this possibility rests on the availability of a regulated wholesale DSL product.

2.45 In practice there does not appear to be a common pricing constraint covering both broadband and narrowband termination. The likely strategy of broadband suppliers might be to attempt to migrate customers from narrowband rather than to begin offering narrowband themselves, that is to attempt to increase demand-side substitution rather than supply-side substitution.

Initial conclusion

2.46 The Director's initial view is that wholesale unmetered narrowband termination is a separate market to wholesale broadband access.

Question 2.4

Do you agree that wholesale unmetered narrowband Internet termination is in a separate market to wholesale broadband access?

Geographical market

2.47 The geographic boundary of the relevant market is defined using the same approach as the product market definition, i.e. using the hypothetical monopolist test. The geographical market is the area within which the demand-side and/or supply-side substitution can take place. Oftel considers whether a price increase by a hypothetical monopolist in the narrowly defined area would encourage operators outside the area to begin to offer services to customers in the area and whether customers could switch to suppliers located outside the area. If supply and/or demand-side substitution is feasible then it is appropriate to expand the geographic market boundary.

2.48 With the exception of the Hull area (see below), Oftel believes that there is a single UK wide market. This is on the grounds that charges are uniform nationally and most suppliers operate nationally. Given this, operators would find it easy to switch to supplying customers in one area in response to a price rise. Competitive conditions therefore appear to be homogeneous in the UK outside Hull.

2.49 In addition, it is important to consider whether a separate geographic market exists for wholesale unmetered narrowband Internet termination services for Internet traffic originating within the Hull area (see Annex D for definition of the Hull area). End users in this area are served by Kingston Communications (Hull) plc (Kingston), not BT, and the competitive conditions there may differ from the rest of the UK.

Demand side substitution

2.50 It is initially assumed then that there is a separate market for wholesale Internet access of traffic originating within the Hull area. If customers (ISPs) find operators supplying termination of Internet traffic originating outside the Hull area adequate substitutes, or if other suppliers of wholesale Internet access can readily switch resources to offer termination of traffic originating in the Hull area, then the initial scope of the geographic market needs to be expanded.

2.51 On the demand side it seems clear that an ISP would not switch to operators terminating traffic originating outside Hull in response to an increase in price of Internet access by the hypothetical monopolist since their services are not substitutable for the termination of Hull-originated traffic. Therefore demand side factors would not constrain the price rise.

Supply side substitution

2.52 On the supply side, in the absence of an appropriately priced wholesale unmetered call origination product, for example, the equivalent of FRIACO, operators would have to rely on purchasing metered wholesale call origination as an input to their unmetered termination products. Consequently they would be exposed to forecasting risks as they would have no certainty about the extent to which their unmetered retail products would be used. The monopolist would not be exposed to such risk because its marginal costs of providing additional call volumes would be significantly lower than the metered charges that operators would be required to pay (which would be based on the average cost). This would allow the monopolist to effectively squeeze the margins of the terminating operator (see paragraph 2.17 above). Therefore an alternative supplier of unmetered Internet termination could not profitably enter the market and undermine the hypothetical monopolist’s price increase.

2.53 If an alternative supplier had access to an appropriately priced wholesale call origination product then supply-substitutability may be feasible, and it is possible that Oftel might define a national market for Internet termination. If this were the case it is possible that alternative suppliers of termination services could switch into terminating Internet traffic which originates in the Hull area. However, such an unmetered wholesale product is not currently available. Therefore supply side substitution is not currently a constraint on prices. As a result, the Director's initial view is that a separate geographic market can be identified for unmetered narrowband Internet termination for Internet traffic originating in the Hull area.

Question 2.5

Do you agree that a separate geographic market can be identified for the termination of Internet calls that originate within the Hull area?

Initial conclusions on the relevant markets

2.54 The Director's initial conclusion is that the relevant markets for the purpose of this review are:

• Wholesale unmetered narrowband Internet termination for Internet traffic originating within in the UK, excluding the Hull area.
• Wholesale unmetered narrowband Internet termination for Internet traffic originating within the Hull area.

Forward look

2.55 The provision of Internet access in the UK has changed very rapidly over the last 2 years, with the very fast growth of unmetered dial-up access, some decline in metered dial-up access and the introduction of broadband access. In looking ahead over the next 2 years, it is difficult to predict what changes might emerge over time as the industry and consumers adapt to the introduction of new products. However, Oftel believes it is likely that there would still be a substantial proportion of Internet users using unmetered narrowband packages.

Relationship between this market definition and the Commission’s Recommendation

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

2.57 The Commission's Recommendation on relevant markets does not include unmetered narrowband Internet termination or any other any wholesale Internet termination markets. Oftel has given careful consideration to the markets listed in the Commission’s Recommendation. However, Oftel proposes in this document a market outside those listed in the Recommendation.

2.58 Oftel believes that national circumstances, which may be specific to the UK, justify carrying out a review of this market. In particular, Oftel has taken account of the conclusion of its previous review of the UK market, the issues that it identified in relation to wholesale unmetered services and the rapid development of unmetered services in the UK over the last two years. Oftel believes that these national circumstances justify a market review to assess whether there are any undertakings with Significant Market Power (SMP) in this market and, if so, what ex ante regulatory remedies would be appropriate.

2.59 In addition, the Commission's Recommendation concludes that unmetered and metered Internet access can be considered as part of the same market. However, the Director's initial view, for the reasons set out in this chapter, is that there are separate markets for metered and unmetered narrowband Internet termination.

 Chapter 3

Assessment of market power in the UK excluding the Hull area

Introduction

3.1 This chapter considers if there are undertakings that have SMP in the UK wholesale narrowband Internet termination market, excluding the Hull area.

3.2 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:

Regulation 5 incorporates this requirement into UK Law for the purposes of this market review.

3.3 SMP may be held by only one company in the market (single dominance) or by more than one company (collective dominance). In assessing whether SMP exists, this review takes account of the European Commission and Oftel SMP Guidelines set out in Chapter 1.

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

3.4 The economic analysis carried out in this consultation document is for the purposes of determining whether an undertaking or undertakings have SMP 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.

3.5 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:

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

• Paragraph 25 "… Article 15(1) of the Framework Directive makes clear that the market to be defined by NRAs for the purpose of ex ante regulation are without prejudice to those defined by NCAs and by the Commission in the exercise of their respective powers under competition law in specific cases." (This is repeated in paragraph 37.)
• Paragraph 27: "…Although NRAs and competition authorities, when examining the same issues in the same circumstances and with the same objectives, should in principle reach the same conclusions, it cannot be excluded that, given the differences outlined above, and in particular the broader focus of the NRAs’ assessment, markets defined for the purposes of competition law and markets defined for the purpose of sector-specific regulation may not always be identical".
• Paragraph 28: "…market definitions under the new regulatory framework, even in similar areas, may in some cases, be different from those markets defined by competition authorities."

3.7 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.

Criteria for assessing significant market power

3.8 The most important criteria that appear to be relevant for the assessment of SMP in the unmetered narrowband Internet call termination market are:

• market share;
• overall size of undertaking and access to capital markets
• countervailing buyer power;
• economies of scale;
• east of market entry and potential competition;
• vertical integration;
• barriers to switching; and
• excess pricing & profitability.

Assessment of SMP against relevant criteria

3.9 The analysis provides an assessment of SMP in wholesale unmetered narrowband Internet call termination against Oftel’s published SMP criteria and the European Commission's guidelines. It initially focuses on assessing whether there is single firm dominance in this market.

Market share

3.10 Figure 3 sets out the estimated market shares of major players in wholesale unmetered Internet termination on a quarterly basis from April 01 to September 02. This is based on the revenues of the major players providing wholesale unmetered services.

3.11 Oftel believes that revenue figures are likely to be the best methodology for comparing market shares in unmetered termination. These more accurately represent the value being added by operators than measures such as number of ports or volume of minutes. This is because there is some differentiation between value of managed and dedicated unmetered termination services (see Chapter 1 for a description of these services).

3.12 However, Oftel would like to emphasise that the market shares are estimates due to the following limitations on the information available for the purposes of this review:

• revenues from two smaller unmetered players are not included. Based on the information available, Oftel estimates that their inclusion might reduce the market shares of the other operators by 1-4%;
• revenues attributable to 128kbit/s cable modem services are not included;
• an element of retail revenues are included for one vertically integrated operator where a split between wholesale and retail revenues was not available. In addition, annual revenues for this operator have been projected on a quarterly basis; and
• revenues associated with terminating unmetered Surftime traffic have been estimated for one operator.

3.13 Therefore, Oftel's view is that the market shares presented in Figure 3 are likely to slightly overstate the market shares of the four operators considered because of revenues, outlined above, that have not been included in the analysis.

 Figure 3: Estimated market shares by revenue (April 01 to September 02)

 (Source: Operator revenue figures)

3.14 The figure suggests that although the market is fairly concentrated it has been quite dynamic with market shares changing significantly over the period examined. In particular, over the last year operator 2 has experienced strong growth in its market share, another operator has entered the market, and there has been a corresponding drop in market share for the other major suppliers.

3.15 Figure 4 shows the growth in revenue over the same period and indicates that the market has grown rapidly to June 02, with growth of existing operators and new entrants contributing this. The most recent quarter seems to indicate slower growth in the overall market.

Figure 4: Revenue growth April 01 to September 02 (Q1 2001/02 = 100)

(Source: Operator revenue figures)

Overall size of undertaking and access to capital markets

3.16 BT's larger overall size and relatively strong balance sheet may give it some advantage when it comes to funding new network infrastructure. A number of other operators have recently faced financial pressures that may have constrained their willingness to invest in new areas. For example, some operators might be more reliant on securing orders from ISPs before investing in network infrastructure, or may face a greater cost of capital.

3.17 In addition, ISPs may be inclined to favour BT because they perceive it as being very secure and financially stable, particularly at a time when financial markets are volatile and investors risk-averse. These conditions may prove to be transient, but Oftel would not attempt to predict future conditions in financial markets.

3.18 However, some operators are undergoing, or have completed, financial restructuring which might reduce the advantage BT has in this respect in the future. The changes that Oftel has made to FRIACO terms over the last 12 months, to ensure monthly payment in arrears and allow refunds for cancelled capacity, should also reduce the up front costs and risks for operators investing in FRIACO capacity.

Absence of or low countervailing buyer power

3.19 The major customers of wholesale unmetered narrowband Internet termination are the large retail ISPs. Table 2 and Table 3 are based on combined data from Oftel’s consumer research in August and November 2002. This indicates that there are three major ISPs with over 10% share of the retail market for unmetered Internet access.

Table 2 : ISP share of UK residential homes with unmetered dial-up Internet access (based on ISPs used) (Weighted base: 670)

(Source: Oftel consumer research)

Table 3 : ISP share of UK business users with unmetered dial-up Internet access (based on ISPs used) (Weighted base: 282)

(Source: Oftel consumer research)

3.20 BT is vertically integrated and its ISP would not exert countervailing buyer power in the wholesale unmetered narrowband Internet termination market. However, AOL, and to a lesser extent Freeserve, are likely to be able to exert some countervailing buyer power over suppliers of unmetered wholesale products because the loss of them as a customer would lead to a significant reduction in revenues for the supplier.

Economies of scale

3.21 The two major sources of economies of scale relating to the provision of unmetered narrowband services arise from packet network efficiencies and route utilisation.

Packet network efficiencies

3.22 Packet networks are much more efficient for carrying Internet traffic than circuit switched networks. Greater use of packet networks compared to circuit switched networks can be achieved by connecting modems to local exchanges rather than tandem exchanges.

Utilisation of circuit switched routes

3.23 Higher utilisation of circuit switched networks can be achieved due to trunking efficiencies and route granularity as the size of the circuit switched route grows.

3.24 Trunking efficiencies. Additional FRIACO circuits at an exchange increases the achievable route utilisation for a given grade of service due to trunking efficiencies. The effect is quite pronounced for the thin routes typical at local exchanges. For example, maximum possible utilisation increases from 67% (for 1 circuit per DLE) to 86% (for 4 circuits per DLE) assuming 1% Grade of Service (see Annex B).

3.25 Route granularity. Operators need to order the minimum number of circuits in order to meet an acceptable grade of service. However, this minimum number can involve over-provisioning because of the requirement to order 2Mbit circuits. This effect is amplified due to uncertainty over demand, both volumes and location, and the lead times for delivering capacity. The affect of this over provisioning, however, reduces significantly, as the route grows thicker.

3.26 For smaller scale deployments, tandem interconnection is a more efficient architecture than local exchange interconnection because local routes would be far too inefficiently utilised. At higher volumes the benefits of early conversion to a packet network outweigh lower utilisation and interconnection at the local exchange becomes a more efficient option. The vast majority of unmetered traffic is now carried by interconnection at the local exchange using DLE FRIACO, although this may also be related to the availability and restrictions that were initially placed on the use of ST FRIACO. (Until 31 January 2003 (Stage 1) there was a limit of 40 x 2Mbit/s ST FRIACO ports that each operator could purchase at any given tandem switch and BT’s obligation to supply was subject to reasonably required traffic re-arrangements being carried out. From 1 February 2003 (Stage 2), BT’s obligation to supply ST FRIACO has been unqualified. However, if it had been necessary for BT to purchase one or more additional switches in order to meet demand for ST FRIACO in stage 2, Oftel’s view at the time was that all users of ST FRIACO must bear the risk of the additional investment being ‘stranded’ before the full costs have been recovered. Oftel is now separately consulting on the future requirements for ST FRIACO.)

3.27 Based on information provided by industry, and its own analysis (see Annex B), Oftel believes that the factors above give rise to significant scale economies up to at least 45,000 64kbps ports. This corresponds to at least 2 DLE FRIACO circuits for each of BT’s local exchanges. The implications of this for market entry are discussed below.

3.28 Beyond this scale there are still likely to be further economies of scale due to increasing utilisation of DLE routes. However, Oftel's analysis suggests that economies of scale beyond 90,000 ports are likely to be limited. The total market size is currently estimated to be 6-7 times larger than this, therefore suggesting that there is room for a number of competing operators in the market. This also implies that any one operator is unlikely to be able to maintain an advantage over others due to economies of scale.

Ease of market entry and potential competition

3.29 Ease of market entry follows closely from the economies of scale present in the market, although there is some degree of variation according to the type of service supplied.

3.30 As discussed above, economies of scale mean that efficient entry with a national level service would require a deployment of at least 45,000 64kbit/s ports. Based on a number of assumptions this corresponds to approximately 8% of the total market (see Annex B). Evidence from operators indicates that a concerted network rollout could achieve full coverage to this scale in approximately one year.

3.31 Although operators have primarily used DLE FRIACO, market entry using a mix of DLE and ST FRIACO may enable full coverage to be efficiently achieved by a smaller entrant. This approach may become more common if the terms on which ST FRIACO is supplied become less restrictive.

3.32 Differences between market entry for the two main types of services, managed ports and dedicated ports is considered below (see Chapter 2 for an overview of these services).

National managed unmetered port service (eg BT SurfPort24)

3.33 There are some risks of entry using a managed port service. Operators incur substantial ongoing costs, related to rental of a large number of FRIACO ports regardless of how much capacity has been sold. Therefore, achieving efficient utilisation of the platform is very important, and highly dependent on ISP orders and getting capacity installed at the right time at the right location. Consequently, operators face the risk that they will be left with unutilised capacity, particularly where capacity is ‘pre-built’, if expected demand fails to materialise.

3.34 To minimise risk of entry, operators may need sufficient commitment from ISPs to justify the initial build (this is also discussed above in relation to access to capital markets).

Dedicated port service (eg BT SurfNet)

3.35 There are a number of characteristics of dedicated port services that suggest that market entry is likely to be a little easier than for managed port services.

3.36 Utilisation risk. If an operator is building a dedicated FRIACO service for an ISP, then, depending on the commercial terms, the risk of utilisation is likely to be passed onto the ISP. In addition, if the ISP knows the location of its customers, it may be able to achieve better network utilisation for a given network size, than an operator running a shared managed network with little knowledge of end users.

3.37 Less than national coverage. If the ISP is able to use intelligent dialler software, then an initial commitment to 100% rollout is not a necessity. For example, the ISP may be able to program the dialler to use 0800 metered capacity for the those areas where the operator does not yet have FRIACO capacity and then modify their dial plans as additional capacity is brought online. Note that whilst intelligent diallers are not in universal use, this approach is probably not appropriate for a managed service.

3.38 Therefore, given the existence of large ISPs who wish to take some responsibility for managing the network, entering the market with a dedicated service appears a little easier than a managed one, and might explain why there has been greater market entry with dedicated services than managed ones. However, there is of course less value to be added by the terminating operator by entering the market in this way.

Changes to FRIACO

3.39 The risks and costs to operators entering the market using FRIACO should have reduced following Oftel directions on:

• making the payment terms for FRIACO equivalent to metered interconnection, ie monthly in arrears (May 2002);
• the arrangements that apply over refunds for cancelled FRIACO virtual paths (July 2002).

Evidence of entry

3.40 When Oftel last reviewed this market, only BT was offering a managed port product that had national coverage (SurfPort24). Since then two operators have extended their FRIACO capacity to cover most mainland DLEs. Another player has also entered the market and now provides a national FRIACO based service.

Vertical integration

3.41 The Director's initial view in its review of the wholesale call origination market is that BT has SMP in that market. BT's unmetered Internet termination business is vertically integrated with its call origination operations and therefore there is a risk of leverage of market power into unmetered Internet termination.

3.42 The purpose of FRIACO access products is to prevent leverage of market power from call origination to unmetered Internet termination. Although they reduce the risk of leverage, on their own they will not necessarily be able to fully eliminate it. There is still a risk that leverage could occur, for example through a margin squeeze, discriminatory service levels or availability of related call origination services.

3.43 In addition, BT's vertical integration means that it faces lower risks in ordering FRIACO capacity than competing operators. If BT's unmetered Internet termination business purchases FRIACO capacity which it does not use, ie it does not carry traffic, then the actual costs to BT as a whole would be much lower than if a competing operator did the same. This is because although BT’s unmetered Internet termination business would pay for FRIACO on the same terms as other operators, the actual cost of an unused FRIACO circuit relates primarily to the FRIACO port which is small component of the overall FRIACO charge.

3.44 However, Oftel is not aware of any evidence or formal complaints to suggest that BT has previously or is currently leveraging its market power in this way. Oftel is considering appropriate remedies to prevent leverage of market power from the call origination market into the unmetered narrowband Internet termination market in its call origination review.

Barriers to switching

3.45 Potential barriers for ISPs switching supplier within this market are issues associated with a change of access number, and, in some cases, contract terms.

3.46 When an ISP switches supplier there may be a need to change the telephone number used to access the service. There are three main approaches, with varying costs, that an ISP may use to deal with this issue. The advantages and disadvantages of these approaches are discussed below.

3.47 Number portability. Number portability may allow an ISP to keep the same access number when switching supplier therefore avoiding the need for end users to reconfigure their Internet browser software. However, current number portability arrangements involve ported numbers being routed by the donor operator. This incurs a pence per minute charge which makes number portability a less attractive option for porting unmetered services. Note that Oftel's June 2002 consultation on number portability discusses one possible alternative using an Intelligent Network dip at the originating local exchange, but the cost effectiveness of this solution is still under review.

3.48 Emailing customers. Customers can be emailed requesting them to change the number they dial for Internet access. Although the process of updating their software can be somewhat automated, customers still need to manually invoke this process. This approach requires a long parallel running period whilst waiting for customers change their settings. It can also lead to the loss of customers who do not change their settings.

3.49 Intelligent dialler software. Some ISPs install intelligent dialler software on their customers’ PCs. This could have been on the ISP’s original CD-ROM or downloaded from the ISP’s website. It enables the ISP to remotely update the number dialled by their customer with little, or no, customer action required. Therefore it offers a way for ISPs to switch supplier without the drawbacks of the other two approaches. It also provides an efficient method for an ISP to manage multiple suppliers and access products, particularly where the most efficient access method depends on the users location. However, for established ISPs without this software there may be significant costs and/or delays in ensuring that customers install dialler software on their PCs, as well as some ongoing maintenance and support costs.

3.50 An additional switching cost / barrier relates to the length of the contract that the ISP has entered into with their existing supplier. For unmetered services, contract lengths appear to be typically between 1 and 3 years. Although this might limit ISPs ability to switch frequently, it does not form an absolute barrier to switching.

3.51 In conclusion, for ISPs without dialler software there are some switching barriers, but for those with this software switching costs are low. At least one major ISP uses this technology already and there is some evidence that ISPs are looking into its adoption, possibly driven by the competitive pressures in the retail market to reduce costs and improve customer experience. Oftel believes that the further adoption of this technology would continue to lower the switching barriers in the unmetered termination market.

3.52 Where Internet termination is bundled with other Internet services, for example email and hosting, as typically supplied to Virtual ISP customers, switching can be significantly more complex. This is because all ISP functions, not just access, have to be migrated from one supplier to another. However, the details of these are not discussed here as they relate to services that fall outside the immediate concern of