Oftel welcomes the Director General of Fair Trading (DGFT)'s decision to hold a more general review of the pay-TV market. The Director General of Telecommunication has a statutory duty to maintain and promote competition in the telecommunications market, and, as the submission argues, the operation of the pay-TV market has a major bearing on the future of the cable industry and in turn on the future prospects for competition in the telecommunications access market (ie between the subscriber and the local exchange). We believe that the implications of the operation of the pay-TV market for the Government's policy of promoting network competition raise important public policy issues which should form part of the public interest dimension to the review.

Competition in telecommunications

The development of competing networks is of strategic importance to the development of competition in telecommunications in the UK - both as part of the Government's clear policy of encouraging the development of alternative infrastructure, especially between the subscriber and the local exchange (the 'access market'), and in terms of facilitating a greater choice of services.

The policy of promoting network competition has begun to bear fruit. In certain parts of the market there is already substantial competition in networks and services. Competition in the access market remains the most substantial challenge - but also the one which has the greatest potential to bring the benefits of competition to consumers (especially residential and small business customers). The cable companies (who can be expected to cover around 80% of the population over the next 10 years as the ITC franchising process continues)remain the most a crucial part of the process of bringing competition into the local access market.

Allowing cable television operators to compete in telephony was a genuinely new, groundbreaking, policy. This is an area where the UK has led the world. The UK cable operators have been pioneers and have had to find solutions to the unprecedented problems involved in integrating cable television and telephony and how to marry very different technologies, cultures, and products. This has in turn given the UK industry opportunities to package and market services in innovative ways to exploit the advantages of more sophisticated subscriber management systems, as well as the fundamental change to the economics of the industry resulting from the ability to combine telephony and cable TV.

The experience of the US cable industry (which spent more than 20 years reaching its mature capacity) suggests that the development of the UK industry will follow an 'S' curve - ie relatively slow progression in the early phase before critical mass is achieved leading to accelerating growth rates. It is obviously difficult to estimate what levels of penetration will be achieved by the mature industry. However in certain franchises operators have achieved penetration rates of over 30% in cable TV, 30% in residential telephony and 20% in business telephony.

These figures have lead some respected industry analysts to predict long term future penetration rates of 42% for cable TV, 38% for residential telephony and 20% for business telephony.

Our concerns centre on Sky's pre-eminent role in the supply of programming together with a significant share of the retail distribution market, and on whether its pricing and other terms and conditions of supply are, or may have an adverse effect on the development of the cable companies. This in turn has implications for the prospects for network competition in the Telecommunications access market.

Competition in television services

We fully recognise Sky's role in bringing greater competition in television services. We would stress that while the promotion of competition in telecommunications networks and services is a key part of Oftel's remit we are not suggesting that regulatory action should be taken to give the cable companies favourable treatment at the expense of Sky in order to further that aim. The objective of regulatory action should in our view be to secure fair, efficient and sustainable competition. We look forward to the future of vigorous competition between cable and satellite (as well as other forms of delivery such as digital terrestrial television) - to the benefit of the customer.

Sky's market position

We believe that it is right to distinguish the pay-TV market (ie the market where televisions services are predominantly paid for by the viewer through subscription or other payment for service) from the general television market. There are a number of significant barriers to entry to this market. The possession of substantial market shares together with the existence of substantial barriers to entry leads us to conclude that there are good grounds for regarding Sky as being dominant in the pay-TV market.

Issues for consideration

We have taken the view that Sky has market power (ie a dominant position). The analysis set out in this paper suggests there are good grounds for considering that its pricing and other practices are tending to hold back the development of the cable companies and therefore is threatening the prospects for competition in pay-TV in both the short and long term, this in turn has threatens the competitive process in the telecommunications market. Consideration also needs to be given to what safeguards need to be put in place to address the use, or ability to use, dominance in one part of the market to leverage or reinforce a dominant position in another. There is also the potential for Sky to build on its dominant position in analogue pay-TV to strengthen its position either in future new markets (eg online gambling) or in new services within the pay-TV market (Near Video on Demand and digital terrestrial television).

A number of issues have been raised on Sky's wholesale pricing and terms and conditions of supply. The main questions appear to concern:

• network access;
• the level of the prices charged by Sky to the cable companies and whether these prices may be discriminatory;
• the pay/basic ratio penalty/discount and other aspects of the rate card;
• security of supply and other contractual issues;
• channel packaging.

Network access

Sky controls the dominant distribution network for pay TV. Access to that network is essential to reach the majority of the UK Pay TV subscriber base. There is a clear potential for dominance in distribution to impact on competition elsewhere in the market. The question to be considered is what safeguards might be necessary to prevent this.We believe that consideration might also be given to making provision in the undertakings for requirements on the provision of encryption and subscriber management services to third parties.

The Rate Card

On the rate card there are three issues, ensuring non-discriminatory pricing, the link between the Sky wholesale price and the DTH retail price, and discounts.

Ensuring non-discriminatory pricing: The question seems to be whether Sky's retail business could cover its costs and make an appropriate rate of return if it had to pay the same price for its programming obtained from Sky's wholesale business as the cable companies. This question hinges on the attribution of costs and revenues between the wholesale and retail parts of Sky's business.

In our view, given Sky's position in both the market for the wholesale supply of programming and the retail-distribution market, non-discriminatory pricing based on accounting separation is a key safeguard against abuse and should be a central part any undertakings.

Linkage between wholesale price and DTH price: we are not convinced that the linking of the wholesale price to the Sky DTH retail price is a protection for the cable operators. Our view is that non-discriminatory wholesale prices per channel (based on a proper distribution of costs) provides the right basis to go forward. This would also provide a baseline against which issues of predatory pricing might be judged should they ever arise.

Discounts: our view is that at the very least the incentive arrangements should not involve a penalty for promoting the sale of basic-only services. We would suggest that consideration be given to discounts relating to the levels of premium subscribers - expressed either in absolute terms or as a percentage of homes marketed (as distinct from basic sales). We believe that a discount per channel would be most in line with the objective of preventing channel bundling - we would not support the continuation of a channel carriage discount.

Pay/basic ratio penalty/discount. We have no objections to the principle of Sky offering incentives for the take-up of its premium channels. We have however two principal objections to the pay/basic ratio. First, that it could penalise companies offering independent premium channels in competition with Sky's own offerings. There is a clear penalty if cable companies offer alternative premium programming which competes with Sky's own premium programming - not only does the cable operator have to bear the cost of the programming but also the negative effect on the pay/basic ratio where that programming substitutes for Sky's programming. Secondly that it could act as a penalty against any company which opted for a strategy focusing on low cost 'basic' services in order to achieve higher levels of penetration.

The first of these is of importance for the potential for competition in the wholesale programme supply market. The second is of immediate relevance to the ability of the cable companies to achieve higher levels of penetration. On the basis of the experience of the US cable industry and data for the UK industry, there are good grounds for believing that if cable companies are constrained into marketing strategies based on the pursuit of high pay/basic ratios this will damage their ability to achieve significant long term improvements in penetration levels.

Our view is that the pay/basic ratio penalty/discount is discriminatory in that it is intended to constrain cable companies into a following a strategy based on achieving high pay/basic ratios: a strategy which reinforces the advantages enjoyed by Sky's DTH retail business while hampering the cable companies ability to increase penetration rates and minimising the scope for the cable companies to devise strategies appropriate to the capital-intensive nature of their businesses.

Cable networks are highly capital-intensive and the operators therefore need to find strategies to maximise the use of the network together with revenue per customer. There are differing views among cable companies about the most appropriate marketing strategies to deal with the problems of churn and low penetration. Cable companies are starting to experiment with different pricing and packaging options and the next few years will see probably see greater experimentation. It is clearly important that they should not be artificially constrained in their ability to devise such strategies.

We recognise that the severity of the effects of the pay/basic penalty/discount were reduced. However, in our view they still remain significant. We are not convinced that the penetration and volume discounts in the rate card counteract these effects may to any substantial extent. The cumulative effect of the concerns over the effect of the rate card as a whole highlights the need for a fundamental reconsideration.

Our view is that at the very least any new incentive arrangements should not involve a penalty for promoting the sale of basic-only services. We would suggest that consideration be given to discounts relating to the levels of premium subscribers - expressed either in absolute terms or as a percentage of homes marketed (as distinct from basic sales). We believe that a discount per channel would be most in line with the objective of preventing channel bundling - we would not support the continuation of a channel carriage discount.

Stability of supply and other contractual issues

Cable operators generally, where they have contracts, have short fixed term agreements and the pricing and content of the programming are subject to change at short notice. There are two aspects to the concern:

• that uncertainty over continuity of supply of an essential input is a significant additional risk for projects involving considerable long term investments with large uncertainties and sunk costs;
• uncertainty over pricing and other terms and conditions means that cable companies are vulnerable to disruption by unexpected changes.

There is concern also that, in contrast to standard industry practice Sky does not allow the cable operators 'ad avails' to sell advertising on Sky channels.

We believe the following remedies should be considered:

Length of contract: we suggest that the undertaking provide for a minimum contract length or even a rolling contract;

Price review and consistency of supply: the undertakings should make provision to secure a degree of predictability as to the timing and amount of price increases and a degree of predictability and consistency of channel content. This should not inhibit Sky's ability to offer genuinely additional services;

Independent arbitration: the suggestions on length of contract and price review etc. will depend on appropriate arrangements for independent arbitration.

Advertising: our view would be that Sky should provide ad avails in line with standard industry practice. Arrangements for independent technical assessment could be put in place to deal with any questions as to the technical capability of the cable operator to make the necessary insertions.

Channel packaging

On channel packaging the key issues seem to be bundling of premium with other channels, cross-advertising, the terms of supply of Sky News and Sky One, the restrictions on the ability to sell premium channels on a stand-alone basis, and the exclusive wholesale distribution arrangements for third party channels.We suggest the following measures might be considered:

Bundling: the contract with the cable companies should explicitly provide for separate purchase of individual channels or for certain channels not to be carried.

Advertising: we would suggest that the undertakings require Sky not to cross-promote channels if the cable operator does not have the ability to opt out from them. These opt-outs could provide the ad avails suggested above. the same provision should apply to offers restricted to Sky DTH subscribers.

Obligation to provide Sky One and Sky News to all basic subscribers: it may be that this issue can be simply addressed by unbundling ie specifically providing for the cable operators to be able not to take specific channels if they do not wish to do so (this assumes that the real strength of Sky's bargaining position lies in its premium programming). There may well however be a need for the undertakings to make provision for independent arbitration where this cannot be resolved (this might for example settle that the proportion of guaranteed subscribers be in line with standard industry practice);

Wholesale distribution of third party channels: we support the OFT's effort to require that Disney should not be supplied in the wholesale market exclusively through Sky. There must however be a question mark over the effectiveness of this without a requirement on Sky to unbundle.

Conclusion

We believe that there are a number of public interest issues which need to be taken into account in considering whether further regulatory action is required: of these we would argue a key consideration is that of local network competition in telecommunications.

There are good grounds for believing that without intervention the prospects for a competitive market will not improve, and Sky will continue to retain a substantial degree of market power. This has four aspects:

1. no one knows for certain when digital services will be launched in this country or how quickly the 'migration' of existing analogue satellite and cable subscribers to digital will take place. It may well be that that transition will continue into the early years of the next decade. Reliance on an early or rapid transition might prove unwise;
2. the transition to digital services will open up the greater opportunities for new entrants - whether this translates into effective competition will depend in part on perceptions of the robustness of the regulatory framework;
3. while cable companies are gaining a growing share of the UK pay-TV subscriber base, whether and when they overtake Sky as the majority network will depend on their success in achieving penetration (as well as on the growth rate of Sky's DTH business). If the cable companies are constrained into following Sky's pricing strategy and are unable to devise more appropriate marketing strategies to achieve higher penetration this could substantially delay the point at which they achieve parity;
4. the cable companies' growing subscriber base will undoubtedly increase their bargaining power as customers in the wholesale market for premium and other channels - this is not however a guarantee of greater competition in that market. It is possible that the market could take the form of a very few large customers with a single dominant supplier. The safeguards to ensure that opportunities for entry by rival channel suppliers are not forestalled will remain a critical issue.

In our view, appropriate action is essential to maintain the prospect of a competitive market in the future.Undertakings along the lines suggested would:

• demonstrate to investors and potential investors in the UK telecommunications and pay-TV markets that the framework exists to ensure fair competition. This is important not just to investors in cable, but also to those considering investment in digital terrestrial television and other future services;
• set out for Sky a clear framework in which it can operate.
• provide the basis for a durable settlement between the cable companies and Sky which would avoid the necessity for continuing ad-hoc regulatory intervention and allow both sides to concentrate on improving services and growing their businesses;
• improve the prospects for the development of competition in all parts of the market.

We appreciate these proposals imply a degree of continuing regulatory oversight however the intention is that they should be effective while minimising the degree of day-to-day regulatory intrusion - once the framework had been put in place the regulator could stand back. We would also note that the existing undertakings and rate card have neither succeeded in enabling the regulator to disengage or in improving the prospects for future competition. The proposals could lay the basis for the regulator to reduce the scope of the undertakings in the medium term (in say 3 to 4 years), but even if this proves not to be the case, a degree of regulatory intervention now, could in our view avoid the need for drastic action later. The transition to digital and other developments offer the potential for greater competition in the future but without action now that potential may not be realised.

Preface

I. Oftel welcomes the DGFT's decision to hold a more general review of the pay-TV market. There has been growing disquiet about the role of BSkyB ('Sky') in the pay-TV market and the review will provide an opportunity for both sides to be heard. We hope that in view of the important public policy questions and the wider interest in this inquiry that there will be a published report and that evidence (other than that which is submitted in confidence) will be publicly available in due course.

II. We would stress that in making this submission Oftel is very much aware that it is not for it to prejudge the outcome of this investigation. We have set out what seem to us to be the issues and concerns, and in doing so we have posed some tough and searching questions, but we recognise that the issues are complex and require further investigation and debate.

Oftel's interest

III. The duties of the Director-General of Telecommunications as set out in Section 3(2) of the Telecommunications Act, include the duties to exercise his functions in a manner best calculated:

(a) to promote the interests of consumers, purchasers, and other users in the United Kingdom... in respect of the prices charged for, and the quality and variety of, telecommunications services provided and telecommunications apparatus supplied;

(b) to maintain and promote effective competition between persons engaged in commercial activities connected with the telecommunications in the United Kingdom.

We hope the review will take into account the Director General's duty to promote competition in the telecommunications market. While the Fair Trading Act does not specifically place a duty on the DGFT in the same terms, the Director has recently stated that his broad responsibility is to encourage and maintain the process of competition in the UK. We believe that the implications of the operation of the pay-TV market for the Government's policy of promoting network competition raise important public policy issues which should form part of the public interest dimension to the review.

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