Contents

Introduction

The Surf Product

Suspected abuse of a dominant position

Compeition Assessment

Conclusion: Non-Infringement

INTRODUCTION

1. On 2 November 2000, British Telecommunications plc ("BT") provided formal notification to the Director General of Telecommunications ("the Director"), under Condition 58 (publication of charges, terms and conditions) of the Licence granted to it to run a public telecommunication system under section 7 of the Telecommunications Act 1984, of a number of price changes and new tariff packages for residential customers that came into effect on 1 December 2000. These included two new packages offering off-peak (see footnote 1) internet access calls on an unmetered basis. BT Surf Together, priced at £14.99 (including VAT) per month, provides the lower voice call prices associated with the BT Together package and unmetered off-peak internet access calls. BT Talk & Surf Together, priced at £19.99 (including VAT) per month, also provides the lower voice call prices of the BT Together package with both unmetered off-peak internet access calls and unmetered off-peak local voice calls.

2. The Director was satisfied that it was more appropriate for his investigation to be carried out using his concurrent powers under the Competition Act 1998 ("the Act") (see Section III below).

3. The investigation under the Act examined the pricing of the Surf (see footnote 2) element within the BT Surf Together and BT Talk & Surf Together packages ("the Packages"). The Director was concerned this was being provided below cost and that BT was funding the shortfall from profits on local and national residential voice calls in which it appears to the Director that BT is dominant, or wholesale call origination (see footnote 3) in which BT is dominant (see Section IV below). Such behaviour could be an attempt to leverage market power horizontally (from residential voice calls) and/or vertically (from wholesale call origination) into retail internet access or wholesale termination of calls to Internet Service Providers (ISPs). The Director suspected that this could have materially anti-competitive effects.

4. The Director has now decided not to pursue the investigation further and to close the case with a finding that, in the current circumstances, BT’s introduction of the Packages does not constitute an infringement of the Act.

Footnotes

footnote 1 - BT's off-peak period consists of evenings and night-time (Monday to Friday before 8.00am and after 6.00pm) and weekend (all day Saturday and Sunday).

footnote 2 - See product description in paragraphs 5 and 6.

footnote 3 - Interconnection service consisting of the traffic-sensitive network components between the customer and the point where the call exits the local switch (digital local exchange). This interconnection service enables operators to offer call services to the originating operator's customer.

THE SURF PRODUCT

5. BT’s product, Surf, is part of an unmetered tariff for off-peak internet access. Surf does not provide internet access on its own since it relates only to internet access calls and not internet service provision. Surf provides call origination up to the Digital Local Exchange (DLE) (see footnote 4) but does not include call termination. BT offers Surf from ‘enabled’ DLEs at which it has installed the functionality to ‘groom’ internet traffic off the Public Switched Telephony Network (PSTN), that is to separate internet traffic from other traffic (eg voice calls) and hand it over to ISPs through terminating operators for termination. Since June 2000, BT has been offering this same service as a stand-alone product called SurfTime. Two variants of SurfTime are currently available: SurfTime Evenings and Weekends offers unmetered off-peak internet access calls for £5.99 (including VAT) per month and SurfTime Anytime offers unmetered internet access calls 24 hours a day, 7 days a week ("24/7") for £19.99 (including VAT) per month.

6. A customer needs, in addition to purchasing Surf from BT, to contract with an Internet Service Provider (ISP) that has decided to offer its services in conjunction with Surf. This ISP will purchase call termination from a network operator and will set a price to the consumer for call termination and internet service provision.

footnote 4 - The telephone exchange to which customers are directly connected.

SUSPECTED ABUSE OF A DOMINANT POSITION

7. After conducting an initial examination of the Packages, the Director was concerned about how BT planned to recover its costs of providing the Surf element included in the Packages. On the information available to him at the time, the Director suspected that this would be likely to have materially anti-competitive effects.

8. The Director suspected that BT’s behaviour in pricing the Packages could infringe the Chapter II prohibition of the Act. This prohibits the abuse by one or more undertakings of a dominant position (see footnote 5) in a market where this may affect trade within the United Kingdom or part of the United Kingdom (see footnote 6). Under section 25 of the Act, the Director may conduct an investigation if there are reasonable grounds for suspecting that the Chapter II prohibition has been infringed. On 24 November 2000, the Director issued a notice to BT under section 16 (5) of the Telecommunications Act 1984 stating his intention to conduct an investigation into the Packages.

9. The European Court has stated that dominance can be presumed, in the absence of evidence to the contrary, if an undertaking has a market share persistently over 50% (see footnote 7). In the United Kingdom BT holds a dominant position in the market for wholesale call origination on fixed telecommunications networks and it also appears to the Director that BT is currently dominant in the markets for local and national retail voice calls for residential customers on fixed telecommunications networks. A detailed assessment of dominance is contained in Section IV below.

10. On information available to the Director before he commenced this investigation he suspected that the Surf element of the Packages was being offered below the cost of provision and that BT would fund the shortfall from profits made on residential voice calls or from wholesale call origination. The Director therefore suspected that the Chapter II prohibition might be infringed by the introduction of the Packages.

11. One possible type of anti-competitive behaviour assessed in the investigation was the potential distortion of competition in internet access markets by BT’s introduction of the Packages, which bundle retail internet access together with retail voice calls, including local and national calls, in which it appears to the Director that BT is dominant. This type of practice would be a form of horizontal leveraging, by which a firm attempts to extend a position of market power from one retail market into another retail market. In this case, the existence of a bundle containing both retail voice calls and retail internet access would not, on its own, be anti-competitive, because BT also offers tariff packages which do not bundle these services together, ie tariffs are offered which include voice calls but not Surf (BT Together and BT Talk Together). But, as set out in Oftel’s Competition Act Guidelines, The Application in the Telecommunications Sector, the issue in this case is the price at which the Surf element is being offered in the two Packages which were investigated. The Guidelines (paragraph 7.51) state that:

12. BT is a vertically integrated supplier in internet access, ie it provides wholesale call

origination, wholesale call termination, retail internet access calls (eg Surf) and internet service provision (via such wholly owned ISPs as BT Internet and BT Connect). A second possible type of anti-competitive behaviour assessed in the investigation relates to BT’s dominant position in the market for wholesale call origination on fixed telecommunications networks in the United Kingdom. This provides BT with the potential to restrict or distort competition in retail internet access markets and wholesale call termination of internet calls through the control of the margin available to competitors between the prices for its retail unmetered tariffs and the charges for wholesale call origination. This type of practice would be a form of vertical leveraging, by which a firm attempts to extend a position of market power from an upstream (ie input) market into a downstream (eg retail) market.

13. In summary, the Director suspected that BT’s behaviour might have the effect of distorting competition in the markets for retail internet access and wholesale termination of internet calls through horizontal and/or vertical leveraging.

• The horizontal leveraging would be from BT’s apparent dominance in the markets for local and national retail voice calls for residential customers on fixed telecommunications networks in the United Kingdom, into internet access markets by means of bundling. Specifically the Surf element would be offered in a bundle together with voice calls at a marginal price below cost.

• The vertical leveraging would be from BT’s dominance in the market for wholesale call origination on fixed telecommunications networks in the United Kingdom into internet access markets by means of a margin squeeze.

14. Either or both of these practices could lead to a detrimental effect on consumers through a restricted choice of unmetered internet access packages and possible higher prices, lower quality of service, less innovation etc resulting from a less than effectively competitive market.

footnotes

footnote 5 - The European Court has defined a dominant position as: 'a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, customers and ultimately of consumers'. Case C27/76 United Brands v. EC Commission, [1978] ECR 207; [1978] 1 CMLR 429.

footnote 6 - The packages relate to the prices charged for telecommunication services supplied in the United Kingdom and therefore affect trade in the United Kingdom

footnote 7 - Case C62/86 AKZO Chemie BV v Commission [1991] ECR I-3359; [1993] 5 CMLR 215.

COMPETITION ASSESSMENT

(a) Relevant internet access markets

Retail market
15. There are two main components of the internet access product that is purchased by residential consumers using dial-up connection over a fixed telephone line:-

• Internet Service Provision, linking the consumer into the Internet, which is provided by an ISP.
• Internet access calls for the consumer to establish a connection between their telephone line and the chosen ISP, which is provided by a telecommunications operator.

16. Sometimes these two components are sold together by the same company, and sometimes they are sold separately, as with internet access using Surf (see footnote 8). However, whether they are sold together or separately, the consumer must purchase both, and in fixed proportions, in order to obtain internet access. That is, in order to consume a minute of internet access, the consumer requires a minute of internet access calls and a minute of internet service provision. For this reason, the Director considers that the retail market includes both of the components.

17. Since retail internet access packages are often offered on a UK-wide basis, the Director considers that the relevant market is national.

Wholesale markets
18. The second component of retail internet access set out above, internet access calls, comprises two distinct wholesale services:-

• call origination, from the consumer's telephone line over the PSTN up to the point of hand-over; and
• internet call termination, from the point of hand-over up to the ISP.

19. Origination and termination are distinct wholesale products. Origination of dial-up internet access is provided over the PSTN, involving circuit switched networks. Termination includes the use of IP networks, which are generally more efficient at transporting data traffic (which is sent in ‘bursts’, rather than the regular stream used for two-way voice telephony and does not need to be synchronised in the same end-to-end, two-way manner needed for voice telephony).

20. There is no demand substitutability between origination and termination. They are strict complements, since both are required to provide an end-to-end internet access call. Neither does supply substitutability exist, because of the different types of networks that are used in each case, so that sunk cost investment would need to be incurred by a supplier of origination to enter termination, or vice versa. Therefore, there are separate wholesale markets for call origination and call termination. A common arrangement is for wholesale call origination to be purchased by terminating operators who then provide end-to-end internet access calls to ISPs.

(b) Wholesale call origination

(i) Market definition

21. Oftel’s approach to market definition follows that used by the UK competition authorities 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 (supply-side substitution) following a price increase (see footnote 9).

Fixed versus mobile
22. Call origination on mobile networks is not an effective demand side substitute for call origination for internet access on fixed networks. Internet access on a mobile phone currently offers considerably less functionality than using a fixed network. For example, only a fraction of the internet is accessible over a mobile telephone and only part of this fraction is delivered because of the constraints of screen size on mobile telephones, and interactivity is constrained because of the lack of a full-size keyboard. The prices for using internet access over mobile networks are also generally high relative to internet access over fixed lines. The extent of substitutability might need to be reviewed in future following the take-up of new mobile technologies offering packet switched services (see footnote 10), such as General Packet Radio Service (GPRS) and Universal Mobile Telecommunications System (UMTS, also known as 3^rd Generation Communications System).

Call types
23. Wholesale call origination is provided by direct access fixed network operators. Such fixed networks provide origination for both voice telephony and internet access. Hence, supply side substitution could exist between origination for both types of call, ie an excessive charge for wholesale call origination for internet access would lead any competing suppliers of origination for voice telephony to enter and undercut that charge.

Residential versus business
24. An argument could be made that call origination for residential customers is in a separate market from origination for business customers, because they tend to be in distinct geographical locations (although this is not always the case). This reduces the extent of supply side substitution, because a supplier of origination to business customers would need to incur significant sunk costs and take the time to build out its network to (more numerous) residential customers in order to compete against a supplier of origination to residential customers. However, the fact that there are the same charges for origination for business as for residential customers would suggest that wholesale call origination to both sets of customers is in the same market. In the discussion of dominance below, market share information is presented on call origination both for residential and for all customers. As discussed below, the Director does not consider that this aspect of the market definition makes a material difference to the existence of dominance in this case. For the purposes of this investigation, the relevant market is defined as a single market including both residential and business customers.

Geographic scope
25. BT’s wholesale call origination charges are geographically uniform (and regulated). This suggests that the geographic extent of the relevant market should be regarded as being the whole of the United Kingdom.

Conclusion
26. The Director defines the relevant market as wholesale call origination on fixed telecommunications networks in the United Kingdom.

(ii) Assessment of dominance

27. BT faces competition in wholesale call origination from other providers of direct access (ie exchange lines), in particular cable operators. BT's market share in wholesale call origination is greatly in excess of its competitors and has been persistently high. Oftel's best estimate of BT's current market share of wholesale call origination by volume is 73% across all customers, or 81% for residential customers. This is derived from call minute data collected for Oftel's Market Information publication for July-September 2000 (Q2 2000/01). Market shares by revenue are not available.

28. A time trend for the market share derived in this way is not available, because of the absence of a consistent series of data on volume supplied to indirect access operators (suppliers of voice calls who do not own their own access networks). But, since customers with lines from BT are constrained to use BT for wholesale call origination a proxy for BT's share of wholesale call origination over time is provided by its share of exchange lines, which is shown in Table 1.

Table 1: BT’s share of exchange lines at end of period

Source: Derived from Oftel Market Information publications

29. For residential customers BT's share of lines provides a very good proxy for its share of origination minutes, as indicated by the similarity in shares for Q2 2000/01 (80% share of lines and 81% share of minutes). Although BT's share of origination for residential customers by volume is declining, the rate of decline is not rapid, eg 3 percentage points over the latest available year (from 83% to 80%), and the current level is still very high at about 80%.

30. The data available on BT's share over time across all customers may be less accurate. For business customers the share of lines shown in Table 1 will tend to overstate BT's share of origination minutes, because competitors are likely to have a greater than average share of the business customers with the highest calling rates. This means that BT's share of total lines will tend to overstate its share of total wholesale call origination minutes (eg 82% of lines in Q2 2000/01 compared to 73% of minutes). Nevertheless, the rate of decline in BT's share, eg 3 percentage points over the latest available year, should be a reasonable indicator of the rate of decline in its share of minutes. This rate of decline is not rapid and the level of BT's share of minutes is still very high, in excess of 70%.

31. The market share information creates a presumption that BT has a dominant position in the wholesale call origination market. The existence of a dominant position is confirmed by consideration of the limited number of competitors that exist and the extent of barriers to entry faced by potential entrants.

32. For residential customers there is typically just a single competitor to BT in each area, the relevant cable operator. Cable operators have been competing against BT over the whole of the period shown in Table 1, but in those six years have only taken about 13% of all lines or 16% of residential lines from BT. Competitors to BT face various barriers to competition, such as consumer switching costs and inertia (discussed further below in the assessment of dominance in retail voice calls). Substantial barriers to entry are faced by new entrants, because of the large sunk costs required to build direct access networks, especially for residential customers.

Conclusion
33. The Director concludes that BT is dominant in the market for wholesale call origination on fixed telecommunications networks in the United Kingdom.

34. This is consistent with the Director's conclusion in a dispute between BT and MCI Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product (FRIACO) (see footnote 11 & 12) and also in the recent review of the network charge controls on BT. The Director proposed licence modifications which included a charge cap of RPI-10% on BT's charges for wholesale call origination for the next four years (after the expiry of the current cap of RPI-8% in September). BT has accepted these licence modifications.

(c) Retail inland voice calls

(i) Market definition

35. The Surf packages are available to residential customers and include all types of voice calls. For the purposes of this investigation, the Director has considered in detail only the relevant markets for the main types of inland calls on fixed networks, ie local and national calls. The underlying purpose of this aspect of the analysis is to consider whether BT is dominant in at least some of the relevant markets for retail voice calls. If so, then abuse of a dominant position by horizontal leveraging is feasible. It is not necessary, therefore, to consider all of the retail voice call markets, eg covering calls to mobile or international calls to all destination countries and, for this investigation, the Director has so restricted his analysis.

Calls versus access
36. Calls are in separate markets from access (the provision of the exchange line). They are complements, not substitutes and they can be purchased by consumers from different suppliers, since retail calls can be obtained from indirect access operators (who purchase wholesale call origination from the access provider) or other resellers.

Residential versus business
37. The Director has considered whether providers of retail calls to business customers constrain to competitive levels the prices of calls to residential customers. For direct access operators supply side substitution appears not to be present, because of the costs and time required to build out networks to the areas in which residential customers are located. Also, and unlike wholesale call origination, different prices tend to be charged to business and residential customers. Indirect access operators and resellers do not face these constraints, because they use existing exchange lines rather than building their own. However, it appears that the characteristics of residential customers are sufficiently different from business customers greatly to limit the extent of supply side substitution. A supplier of calls to business customers would be likely to need to develop different tariff packages that would appeal to residential customers. Such a supplier might also need to incur significant costs in order to create sufficient awareness and brand recognition among residential customers.

38. In addition, there are often fixed subscriber acquisition costs incurred by suppliers to win customers. This might mean that supply side substitution was not present for customers with lower call expenditure, because indirect access operators currently supplying calls to higher spending customers might not be attracted to provide calls to the lower spending customers by a small but significant non-transitory increase in price.

39. The precise boundary between the markets by customer type is open to debate. For example, the highest-spending residential customers have call expenditure as high or higher than small business customers; and some small businesses are located in residential areas. Nevertheless, the Director considers that distinguishing residential from business customers is a reasonable approach. It can also be noted that defining the residential market as all residential customers rather than a number of markets distinguished by call spend is likely, if anything, to understate BT's market share and market position in the market(s) for lower-spending customers, because Indirect Access competitors are likely to have a greater than average share of the higher-spending customers.

Mobile versus fixed
40. At the margins there is likely to be some demand side substitution of calls from mobile phones for calls from fixed networks. Mobile tariffs often include a certain number of call minutes at low or even zero marginal prices. However, beyond this volume, there is still generally a significant price gap between calls from mobiles and calls from fixed lines. This situation exists and is likely to continue because traffic-sensitive mobile network costs are much higher than on fixed networks. Whilst customers may be prepared to pay a premium for the extra convenience of calls from mobiles, large-scale substitution may also require the mobile operators to be able to match fixed networks for coverage and quality of service. At present this is not the case. Therefore, the Director believes that, whilst mobiles will substitute for fixed calls to an increasing extent in the future, they are unlikely to be sufficiently substitutable at present to constrain the prices of fixed network calls to competitive levels. Calls from fixed and mobile networks are consequently defined as being in separate markets.

Local and national
41. It might be argued that local and national calls should be defined within the same market on grounds of supply side substitution. For example, if a hypothetical monopoly supplier of local calls were to raise its price, it would be possible for an indirect access operator or reseller that was supplying national calls to a customer to supply that customer also with local calls. A development in recent years has been that indirect access operators have been able to offer local calls profitably and indeed there has been rapid growth in this traffic. However, the ability to provide local calls profitably could be temporary, if competition causes margins between retail prices for local calls and wholesale charges to shrink. Indirect access operators may then withdraw from offering local calls and concentrate on national and international calls once again. Therefore, because competitive conditions in the supply of local and national calls could differ materially, the Director considers it reasonable to define separate markets. Note, however, that, as discussed below, BT's market share and profitability is similar whether separate markets are defined for each of local and national calls or a single market for inland calls is defined. This question is not, therefore, critical to the assessment of dominance in this case.

42. For similar reasons, the competitive conditions for the supply of international calls may also differ. Moreover, there is a significant number of suppliers which provide only international and not local or national calls. Therefore, it is appropriate to define international calls as falling within separate markets from local and national calls.

Geographic scope
43. In general, suppliers’ prices for each of local and national calls are geographically uniform. Furthermore, Indirect Access suppliers of inland calls to customers in one part of the United Kingdom would be able relatively easily to supply such services to customers in another area in response to a price increase in that area. Indirect access operators use their own long-distance networks and buy in wholesale call origination and termination from direct access operators. Supply side substitution between areas exists for indirect access operators, given the availability of wholesale origination and termination throughout the United Kingdom (at geographically uniform charges in the case of BT). The geographic extent of the relevant markets for local and national calls is, therefore, the whole of the United Kingdom.

Conclusion
44. For the purpose of this investigation the Director defines separate markets for local and national retail voice calls by residential customers on fixed telecommunications networks in the United Kingdom.

(ii) Assessment of dominance

45. BT faces competition in the markets for local and national retail voice calls from direct access providers, such as cable operators, suppliers using indirect access and Carrier Pre-Selection, and resellers. BT's market shares by revenue and by volume of call minutes are shown in Table 2. BT's shares are declining at a faster rate than in wholesale call origination, by 4 to 5 percentage points in the latest available year. However, its shares are still high at 73-77%, which suggests that it is likely to be dominant in both markets.

Table 2: BT’s shares of local and national retail voice calls by residential customers

Source: Derived from Oftel Market Information publications

46. Another indicator of dominance is the relationship between prices and costs. In particular, rates of return persistently in excess of the cost of capital provide direct evidence of BT's ability to set prices above the competitive level. As shown in Table 3, BT's profitability on inland calls is very substantially in excess of its cost of capital, which Oftel has estimated at 13.5% (for details, see Annex E of Oftel document ‘Proposals for Network Charge and Retail Price Controls from 2001, February 2001). The rates of return in Table 3 are for calls by both residential and business customers (information is not available separately for residential customers), but it is likely that BT’s rate of return on calls by residential customers is at least as high as for all customers.

Table 3: BT's Return on Capital Employed for Local and National Calls

Source: BT (reported in Table 2.4 of Oftel's Consultative Document Proposals for Future Retail and Network Charge Controls, October 2000)

47. The barriers to entry into retail voice calls by indirect access operators and resellers are significantly lower than for wholesale call origination, because such suppliers do not need to incur the large sunk costs of building direct access networks. Furthermore, indirect access operators are able to obtain wholesale call origination and termination from BT at regulated, cost oriented charges.

48. However, there is some evidence that significant barriers to switching exist, which prevent customers changing suppliers to take advantage of competing offers (see, for example, Chapter 2 of Oftel's Consultative Document, Possible Approaches for Retail and Network Charge Controls, March 2000). A potentially enduring barrier to switching is provided by the perceived quality of service and reputation of alternative suppliers. Experimentation with alternatives is sometimes perceived as risky and this can give rise to switching costs where customers are not well informed about the service quality of rival operators. Survey evidence suggests that lack of awareness and information remain barriers for some customers (see Consumers’ Switching Behaviour in the Telecoms Market, August 2000).

Conclusion
49. In light of BT's continuing large market share, its high rates of return and the likely barriers to switching, it appears to the Director that BT is currently dominant in the markets for local and national retail voice calls by residential customers on fixed telecommunications networks in the United Kingdom.

50. As part of the review of retail price controls on BT, the Director will be carrying out a review in 2001/02 of the level of competition in these markets in forthcoming years. This will take into account the impact of future developments.

(d) Further issues assessed

51. In addition to consideration of issues of market definition and dominance, the investigation focussed on two key issues: (i) determining whether the Surf element of the Packages is being offered below cost; and (ii) if so, determining the likely effects of this behaviour on competition and consumers in potentially affected markets, retail internet access and wholesale call termination of internet calls. The Director sought information from both BT and a number of other licensed operators ("OLOs") and ISPs during the course of the investigation.

(e) Analysis of whether Surf is being offered below cost in the Packages

The relevant test
52. The purpose of the test comparing prices and costs is to assess whether an equally efficient competitor (incurring the same relevant costs as BT) could at least match BT’s price for Surf. For this investigation, the Director would not consider BT’s behaviour to be abusive if this test was passed, ie that, on this basis, BT’s price covers the cost of Surf provision.

53. In order to test for the possible existence of horizontal leveraging (from retail voice calls into retail internet access), it is necessary to consider whether the marginal price of Surf in the Packages is sufficiently high to cover the long run incremental costs (LRIC) of providing Surf. BT disputed that LRIC was the correct measure of cost to be assessed in the investigation but Oftel’s Competition Act Guidelines set out why the Director holds the view that LRIC is the appropriate cost measure.( See Chapter 7 of Oftel's Competition Act Guidelines, The Application in the Telecommunications Sector). The marginal price is relevant, because it is the price against which a competitor would be competing as a supplier of a substitute for Surf. BT argued that competing suppliers of internet access calls derive revenues from a range of services including retail voice calls, internet access, call termination, subscriptions, content and advertising. BT is therefore of the view that the profitability of the Packages should be assessed on the revenue received from all of the services provided within the Packages including voice calls. However, given BT’s apparent dominant position in local and national calls, this is inappropriate because it would allow and not test for horizontal leveraging from retail calls markets into retail internet access.

54. For the BT Surf Together package, the marginal price is the additional price that a customer would pay, when making a decision to buy the Surf service as well as the BT Together package. Therefore, the marginal price for Surf on BT Surf Together is £5.40 (including VAT) per month. This is the difference between the fixed charges on BT Surf Together (£14.99 including VAT per month) and on BT Together (£11.99 including VAT per month), plus the value of the inclusive call allowance on BT Together (£2.40 including VAT per month), which is foregone on BT Surf Together (the only differences between these two packages are the availability of Surf and the loss of the BT Together call allowance on BT Surf Together).

55. For the BT Talk & Surf Together package, the marginal price is the additional price that a customer would pay, when making a decision to buy the Surf service as well as the BT Talk Together package. The marginal price for Surf on BT Talk & Surf Together is £5.00 (including VAT) per month. This is the difference in fixed charges between BT Talk & Surf Together (£19.99 including VAT per month) and BT Talk Together (£14.99 including VAT per month).

56. In order to test for the possible existence of a margin squeeze or vertical leveraging (from wholesale call origination into internet access), it is necessary to consider whether the marginal price of Surf in the Packages is sufficiently high to cover the LRIC incurred by BT’s retail arm. The LRIC incurred by BT’s retail arm comprise the charges for network services, which are purchased from BT Network at published rates, and LRIC retail costs. These are the costs that would be incurred by an equally efficient competitor to Surf in the retail market, purchasing wholesale call origination from BT.

The ‘cost stack’
57. A ‘cost stack’ can be constructed to assess whether BT is pricing below cost. The stack identifies the costs incurred by BT’s retail arm in providing a service (the sum of network charges and retail LRIC). However, assessing BT’s actual costs of Surf provision is subject to a number of sensitivities. A key consideration is the level of actual usage by subscribers (as costs, such as call origination, increase with usage but in products priced at a flat rate such as Surf, revenue does not). As part of the investigation the Director obtained actual usage data for the Packages from BT for the period December 2000 to February 2001.

Network costs
58. Most of the network-related costs faced by BT’s retail arm in providing Surf relate to the interconnection charges for metered (see footnote 13) wholesale call origination. Such charges are set by BT Network, subject to regulation in the general network basket of the network charge controls. They are paid on the same basis by all interconnecting operators purchasing metered call origination from BT. The charges differ by time of day. The relevant charges in pence per minute were as follows when Surf was launched: 0.2015 ppm during the Evening period and 0.1690 ppm during the Weekend period. However, during the course of the investigation, on 27 December 2000, BT notified the Director of, respectively, 15% and 20% reductions to these charges from 1 April 2001 to: 0.1718 ppm and 0.1353 ppm respectively. This has a significant downward impact on the costs of call origination in the provision of Surf.

Retail costs
59. During the investigation, the Director considered a number of possible ways of calculating the relevant retail LRIC for the Surf element of the two Packages and obtained a significant amount of information from BT to assist with this. BT supplied data using both revenue as the relevant driver of Surf's retail costs (producing a cost figure per customer that does not vary with individual customer usage) and also on the basis that Surf was assumed to have similar retail costs per minute to local calls. The cost stack is sensitive to which of these methodologies is employed. The true retail cost drivers of Surf are likely to be complex and it is not clear which of these proxy cost drivers (revenue or local call usage) is the more appropriate.

Conclusion
60. While it is clear that the network-related costs incurred by BT’s retail arm for use of BT Network’s facilities are quite sensitive to the level of usage, the position is less clear in respect of retail costs. The retail costs estimated to be incurred by BT’s retail arm in providing Surf are sensitive to the assumption made about the underlying driver of the costs. The information relating to retail costs supplied to the Director during the investigation was not sufficient to support a conclusion that Surf, at the current prices, is being offered below cost in the Packages. In the light of the Director’s conclusion on effects on competition set out below, he concluded that it was not necessary to investigate this issue further.

(f) Effect on competition in the retail internet access and wholesale internet call termination markets

61. In view of the Director’s suspicion that Surf was being offered below cost in the Packages, the investigation also considered what effect this behaviour was having, or might have, on BT’s competitors in the retail internet access and wholesale call termination markets.

62. The Director considers that, in the relevant market for retail internet access, Surf, which is an off-peak unmetered package, faces competition from 24/7 unmetered packages ie allowing unmetered internet access all the time. Off-peak unmetered packages tend to give rise to lower costs than 24/7 unmetered packages and so are generally offered at lower prices.(see footnote 14) But consumers will typically be willing to pay more for a package that offers unmetered usage during the daytime as well as evenings and weekends. It follows that 24/7 packages will constrain the prices charged for off-peak unmetered packages to the competitive level if consumers value the extra opportunity for unmetered usage at or above the differential between the competitive prices for 24/7 and off-peak unmetered packages. The price of a typical off-peak unmetered package using Surf is about £9-10 per customer per month, including the ISP’s charges as well as retail call origination sold by BT. There is a range of prices for 24/7 unmetered packages, but a typical offering would be priced at about £13-15 per customer per month. The price differential between off-peak and 24/7 unmetered packages is, therefore, as low as £3-4, or even lower if 24/7 packages fall in price following the decline in FRIACO charges determined by the Director earlier this year (see footnote 15).

63. The Director considers that 24/7 unmetered packages are likely to constrain off-peak packages from being priced above the competitive level. However, it is not the case that off-peak unmetered packages will constrain 24/7 package prices to the competitive level. A significant number of customers of 24/7 will attach a significant value to the peak time availability of unmetered access. The Director notes that a large number of customers have joined or remained on 24/7 packages after the launch of the Surf packages by BT. Accordingly, it is improbable that providers of 24/7 will be driven out of the market, or even substantially weakened as competitors to BT’s SurfTime products at the current set of prices for Surf. This suggests that an attempt by BT in future to raise the price of Surf is unlikely to damage consumers, who could choose to switch to the available 24/7 packages. Therefore, it appears to the Director that there is no distortion in the overall level of competition in retail internet access.

64. The Director has also considered the sustainability of 24/7 packages. Suppliers of retail unmetered packages who purchase metered call origination face the problem that costs increase with usage, whereas revenue does not. Errors in forecasting the level of usage and variation in usage over time could, therefore, undermine the viability of a package. But, compared to other competitors, BT is in a favourable position because of its vertical integration and dominance in the market for wholesale call origination on fixed telecommunications networks in the United Kingdom. BT would face the marginal cost of the additional volume of call origination caused by greater customer usage, but other operators would have to pay the interconnection charge (reflecting the higher average cost). The Director’s Direction of 26 May 2000 (see footnote 16) required BT to provide a 24/7 unmetered wholesale call origination product known as "FRIACO". The Director’s further Direction of 15 February 2001 (see footnote 17) has improved the range and cost effectiveness of FRIACO products. The Director considers that the availability of FRIACO products will support the sustainability of 24/7 packages.

Conclusion
65. The Director is of the view that even if BT’s SurfTime products were to become the primary or sole, sustainable off-peak unmetered package, competition with 24/7 unmetered packages would remain. Therefore, the Director considers it unlikely that the Packages, as currently priced, will have a material anti-competitive effect in the relevant internet access markets.

Footnotes

footnote 8 - As noted in paragraphs 5 and 6, Surf only provides the origination end of internet access calls.

footnote 9 - See also Office of Fair Trading Market Definition Guideline (OFT 403 of March 1999) Available at: http://www.oft.gov.uk/html/comp-act/technical_guidelines/oft403.html

footnote 10 - A service involving the transmission of data in the form of discrete blocks (packets) of information and, if necessary, the assembly and disassembly of data in this form.

footnote 11 - Determination of a dispute between BT and MCI Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product (FRIACO). Published on 26 May 2000.

footnote 12 - Determination relating to a dispute between British Telecommunications and Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product ("FRIACO"). Published on 15 February 2001.

footnote 13 - A competitor to Surf could use one of two wholesale products: metered call origination or Flat Rate Internet Access Call Origination (FRIACO). BT has argued that Surf uses metered wholesale call origination as an input. It can also be noted that FRIACO is not necessarily best suited to an off-peak retail unmetered product like Surf. FRIACO involves the purchase of (virtual) capacity throughout the whole day, so to generate calls only at evenings and weekends would not represent an efficient use of FRIACO which is better suited as an input to 24/7 retail unmetered products. For further details on FRIACO see the references in footnotes 13 and 14 above.

footnote 14 - There are exceptions - some 24/7 unmetered packages are available to the consumer at no charge (or at no charge if a minimum amount is spent on charges for voice calls with that supplier).

footnote 15 - Determination relating to a dispute between British Telecommunications and Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product ("FRIACO"). Published on 15 February 2001.

footnote 16 - Determination of a dispute between BT and MCI Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product (FRIACO). Published on 26 May 2000.

footnote 17 - Determination relating to a dispute between British Telecommunications and Worldcom concerning the provision of a Flat Rate Internet Access Call Origination product ("FRIACO"). Published on 15 February 2001.

CONCLUSION: NON-INFRINGEMENT

66. The Director has now completed his investigation. On the basis of the information available to him at present, the Director has concluded that it is not clear that, at the current prices, BT is or will price Surf below cost in the Packages. Furthermore, the Director considers it unlikely that, even if the price were below cost, a material anti-competitive effect would result on current prices, because of the availability of sustainable 24/7 packages. In these circumstances, the Director does not therefore consider that BT’s current pricing of the Packages constitutes an infringement of the Act.

Anne Lambert

Director of Operations

A person duly authorised by the Director General pursuant to paragraph 8 of Schedule 1 to the Telecommunications Act 1984