Contents

Summary

Chapter 1 Introduction

Chapter 2 Market definition and assessment of competition

Chapter 3 Policy objectives and proposals

Chapter 4 Implementation issues

Chapter 5 Consultation details

Annex A Responses to consultation

Annex B General price control issues

Annex C Fixed-mobile substitution

Annex D Framework for cost-benefit analysis of price control proposals

Summary

S1 This document sets out Oftel’s proposals to replace the current retail price controls on BT with a package of measures better designed to encourage competition, while still protecting the most vulnerable consumers in a changing marketplace.

The case for change

S2 Oftel first imposed retail price controls on BT in 1984. Since then price controls have provided consumers with protection in markets in which BT has had a monopoly and continues to have market power.

S3 But today’s market place is radically different from that of 1984. Cable operators and suppliers of indirect access (IA) and now carrier pre-selection (CPS) provide greater choice than ever before. In this rapidly changing market, it is no longer self-evident that the traditional model of retail price control is the most effective or proportionate way to develop competition further and to protect residential consumers.

S4 Against this background, Oftel has looked at the markets for calls – the provision of voice and data services – and the market for access – the provision of the exchange line which is paid for through the consumer’s line rental. Oftel’s conclusions are that:

• competition is now increasing in all fixed telephony markets but is not yet effective;
• BT will remain dominant in the provision of access for the foreseeable future;
• the current terms of access to BT’s network may not prevent but certainly deter entry from service providers and hence restrict innovation in pricing and products in the calls market; and
• in particular, the imbalance between BT’s large return on capital employed in relation to calls and low return on access means that rigorous competition in calls markets could put BT into a position where it was unable to recover its costs. The current form of price control does not address this fundamental issue.

S5 In short, Oftel believes that the conclusions of the review show that a new approach is necessary.

S6 The case for regulatory intervention remains powerful. There is an overriding case for action to ensure BT does not exploit its market position unfairly in the calls or access markets. Because of the importance of telephone services for social inclusion, it is also vital that the lowest spending groups of consumers are able to access services at an affordable price. Proportionate regulation is the best policy instrument to achieve these outcomes. Competition, rather than price control, is the best long term protector of the consumer interest, because it offers the customer greater options in terms of price and service. The proposals in this paper are therefore designed both to stimulate competition and to protect consumers where this is needed.

The main proposals

S7 The main proposals are:

• To encourage greater market entry by mandating a ‘wholesale line rental’ product. What this essentially means is that existing operators, telecommunications service providers and new entrants from other sectors wanting to enter the fixed telephony market will be able to buy the wholesale line rental product from BT Network on non-discriminatory terms;

• To give service providers and operators using BT’s network the ability to offer a ‘one bill’ service. This means that the bill from the alternative supplier would cover the cost of both the line rental and the calls made, rather than there being a separate BT line rental bill. A single bill gives operators the ability to charge in wholly different ways – for example, virtually free calls but a high subscription or no explicit line rental at all and all costs recovered from the costs of calls;

• To remove RPI-X control, but only when call prices have fallen sufficiently to signal clearly that competition was now the main determinant of these prices. The removal would be automatic when the trigger was reached, rather than following a further period of regulatory review; and

• To protect low spending customers by maintaining the present Low User Scheme and maintaining a safeguard cap, preventing bills from rising in real terms, after the trigger had been pulled.

S8 Each of these main elements is explained further below.

Improving access

S9 Any withdrawal of retail price regulation only makes sense as a response to competition in the calls market. In turn, this can only happen if the terms of access are reasonable. Oftel therefore proposes to require BT to provide wholesale line rental products, which anyone wishing to offer publicly available telephony services would be able to purchase. The starting price of this product, which will be set by Oftel, will be based on BT’s costs. This would give both existing resellers and potential new entrants from other sectors the opportunity to buy access on the same terms as any other operator. Oftel believes that BT should be subject to a requirement for no unfair discrimination regarding the pricing, product design and quality of service parameters of this new product available to third parties.

‘One bill’

S10 At present, many consumers who have switched to another supplier for making calls continue to pay a line rental charge to BT and thus receive two bills. There is evidence that the existence of two bills deters consumer switching and so reduces competitive pressure on BT. The access product will address this problem and increase the range of choice available. For example, a single bill gives telephone companies the ability to charge in wholly different ways – virtually free calls with a high subscription or, perhaps, no explicit line rental and all costs recovered from call charges. Such products would increase competition and thus place pressure on BT to reduce its call prices and increase the range of choices it offers to customers.

S11 However, some consumers positively welcome separate calls bills and the products which reach that group (IA and CPS) will remain in place

S12 Oftel believes that there are lessons to be learned from experience in the energy industry and from past telephony experience in relation to Calls and Access in particular. Oftel will therefore be looking to work with industry and consumer bodies to deal with issues around the marketing and delivery of new products and the production of transparent, accurate, comprehensive and comprehensible price information for consumers.

Removing the price cap

S13 Oftel proposes to remove the RPI-X control. It has worked well in protecting consumers, but is increasingly inappropriate in a multi-player market place and arguably hinders the resolution of the structural imbalances between the calls and access markets. But this cannot happen immediately. The timing of the removal of the retail price cap is a crucial judgement. If it is done too early – before increased competition has appeared in the calls market – BT might be able to maintain higher call prices than would be expected in a competitive market, whilst also having the ability to increase line rental. If it is left too late, however, after the other elements of the package have had an effect, BT might not be able to recover its costs.

S14 Oftel believes that a mechanism is therefore needed to allow the price control to be removed as competition reduces BT’s calls profits. This is a more appropriate approach than attempting to predict now a precise date at which the calls market will become effectively competitive and proposing that the retail price control should be removed at that time. It also provides more certainty than building in a further lengthy process of regulatory scrutiny to establish whether the calls market had become competitive.

S15 Oftel proposes that a safeguard cap, which prevents nominal price increases, should apply to the bottom 80% of residential customers by expenditure. This cap should be removed automatically once call prices have fallen significantly by a pre-set amount.

Protecting low users

S16 Oftel believes that action continues to be essential to protect, in particular, those customers that would not otherwise be able to afford telephony service. Oftel’s statement Universal Service Obligation in August 2001 made clear that the present Light User Scheme (LUS) would be maintained and reviewed again in 2003. This scheme provides protection in the form of lower line rental to the most vulnerable 20% of telecommunications users. In addition to the LUS itself, Oftel proposes to maintain a safeguard cap to prevent the bills of this most vulnerable group of consumers from rising in real terms overall, after the automatic trigger mechanism set out above has been pulled.

S17 If Oftel’s proposals bring about effective competition in the calls market, it would propose to review the means of financing the retail elements of the Universal Service Obligation (USO) when it next reviews the USO as a whole in 2003.

Conclusion

S18 Delivery of this package will require close working between Oftel, all sections of the telecommunications industry and consumer representatives. Oftel considers that the benefits to consumers of this approach make the investment of effort by regulator and industry worthwhile.

S19 Given the scale of change proposed by the document, Oftel is seeking views not just on the issues of principle and overall strategy, but also looking to the consultation to highlight more detailed issues that need to be addressed in implementation, and the best mechanisms and appropriate timescales for doing so.

S20 Oftel will issue its final decisions on the way ahead in the light of consultation in June 2002. That statement will also include the statutory consultation on changes to BT’s licence to implement the final decision.

Chapter 1

Introduction

Best deal for consumers

1.1 Oftel’s goal is the best deal for consumers in terms of quality, choice and value for money. To ensure that consumers have been getting value for money, Oftel has needed to control BT’s ability to increase prices to prevent it from taking advantage of its dominant position in UK telecommunications. However, price controls were always intended to be a transitional measure, because competition was expected to place the longer-term constraints on BT’s pricing freedom. Oftel has therefore been considering whether competition will by 1 August 2002 provide protection for all customers from possible exploitative pricing. If the answer is yes, price controls are not warranted. If it is no, then price controls are required until consumers are protected.

Price controls

1.2 BT has been subject to price controls since it was privatised in 1984. The most recent controls, which were implemented on 1 August 1997, were set for four years and were then extended from 1 August 2001 for one further year. This control required an annual reduction in prices of inflation less 4.5% (RPI-4.5%). This price control has applied to a group of services known as the price control ‘basket’. The services within this basket are as follows:

• connection (of a new service);
• take-over (of a service already installed);
• line rental;
• local calls;
• national calls;
• international calls; and
• operator assisted calls.

1.3 The basket control is focused on the expenditure patterns of the lowest 80% of residential customers because when the controls were implemented Oftel believed that it was this group of customers that needed protection. Other customer groups – high spending residential customers and most businesses – were more likely to be able to benefit from greater competition for their custom, which Oftel believed meant that even if they remained customers of BT their prices would fall because of the effects of competition.

1.4 Oftel has also controlled BT’s retention for calls to BTCellnet and Vodafone since 1 April 1998. These controls were introduced because competition in calls to mobiles was not strong enough to protect consumers. They were set at RPI-7% for three years and were extended for four months to align them with the controls for the other retail services referred to in paragraph 1.2. Oftel has been reviewing separately competition in the provision of mobile call termination to decide whether controls on mobile termination will be needed after the expiry of the current controls. Oftel has referred this issue to the Competition Commission after the mobile operators rejected its proposals. BT’s retention for calls to mobiles is a separate issue from that referred to the Competition Commission. The need for further control of the retention is related to the extent of competition in the retail market for calls to mobiles and is considered in this document.

Market review

1.5 In February 2001 Oftel completed a review of competition in basic telephony markets with the publication of Proposals for Network Charge and Retail Price Controls from 2001. Oftel noted that competition was developing, but it was not clear that competition was fully protecting all consumers. Oftel chose to extend the price controls for one further year while it monitored the development of competition. In June 2001 Oftel began a further review of competition in the fixed retail markets with the publication of a consultative document Competition in the provision of fixed telephony services.

1.6 Oftel has considered carefully the data and representations it has received from all parties in response to the document and subsequently. These are referred to throughout the document and in detail in Annex A. In chapter 2, Oftel defines the relevant markets and outlines the extent of competition within those markets. In chapter 3 Oftel sets out its preliminary conclusions and proposals. Issues related to the implementation of the proposals are set out in chapter 4.

European legislation

1.7 In setting out the proposals outlined in this consultation document, Oftel has taken into account the draft proposals stemming from the European Commission’s review of communications regulation: "Towards a new framework for electronic communications infrastructure and associated services – The 1999 Communications Review". In particular, the draft Framework Directive requires National Regulatory Authorities (NRAs – in the UK this is Oftel) to "define relevant markets appropriate to national circumstances in accordance with the principles of competition law" (Article 14). Article 15 requires the NRAs to assess whether relevant markets are effectively competitive and, if they are not, identify those undertakings that have significant market power before imposing "appropriate specific regulatory obligations" on those undertakings with significant market power.

1.8 Oftel has carried out its market assessment along these lines. It has identified and defined the relevant markets appropriate to the UK telecommunications market. Oftel will review whether further action is appropriate following adoption of the Framework Directive and the publication of any relevant guidelines by the European Commission.

Timetable

1.9 Oftel intends to publish its final conclusions for the future of price control arrangements in June 2002. This statement will include the necessary licence modifications to give effect to the new arrangements.

Consultation

1.10 Oftel is seeking views on the proposed arrangements set out in the document to increase competition and provide protection for consumers. Oftel requires comments on these proposals by 30 April 2002.

Chapter 2

Market definition and assessment of competition

2.1 In Competition in the provision of fixed telephony services, July 2001, Oftel described its approach to market definition and set out its initial views on the definition of the relevant markets (see www.oftel.gov.uk/publications/pricing/pcr0701.htm). Oftel also outlined its initial assessment of competition in markets for basic telephony services. This was based on the key indicators of effective competition set out in Implementing Oftel's Strategy: Effective Competition Review Guidelines, August 2000.

Market definition

2.2 The approach to market definition is based on identifying constraints on the price-setting behaviour of firms. These constraints may arise from customers substituting other services for those in question (demand-side substitution), or from suppliers switching production to supply the relevant products (supply-side substitution) following a price increase. This approach is widely used by competition authorities.

2.3 Oftel proposed the following as separate markets:

• fixed access;
• local calls;
• national calls;
• international calls by country pair;
• calls from fixed to mobile; and
• operator assisted calls.

Responses to Competition in the provision of fixed telephony services on market definition issues

2.4 The responses to Competition in the provision of fixed telephony services are summarised in Annex A of this document. Click here to view responses in full on Oftel's website. Not all respondents commented on market definition issues. However, of those who did, most broadly agreed with Oftel's proposals for market definitions including general agreement that calls markets were separate from access and that markets were national in scope.

2.5 Most respondents who commented on the issue also agreed that mobile and fixed markets were currently separate. BT, however, argued in its response that fixed-mobile substitution has now developed to such an extent that fixed and mobile telephony are now part of a single market and that Oftel, by regarding them as separate markets, underestimates the extent of competitive pressure on BT. BT submitted a study by .econ suggesting that consumers would switch between fixed and mobiles in response to price changes. This is discussed further in Annex D.

Conclusions on market definition

2.6 In the light of the above, Oftel intends to use the market definitions proposed in Competition in the provision of fixed telephony services, with the exception of IDD calls where the definition used in the recent review of competition in international markets will be adopted (see paragraph 2.32 below). The following separate retail markets will therefore be defined for the purposes of the price control review:

• fixed access;
• local calls;
• national calls;
• international calls in two categories as in the international direct dial (IDD) review;
• calls from fixed to mobile; and
• operator assisted calls.

2.7 Oftel proposes to define separate markets for each of the above for business and residential customers. Some respondents suggested that a further subdivision of residential markets by spend should be considered and this is discussed in paragraphs 2.35 - 2.42 below.

2.8 These markets are national in scope.

Assessment of competition

2.9 In the light of the evidence available in July 2001, Oftel concluded that competition to BT in calls markets was increasing but was not yet effective and was likely to be stronger for some services and for some customer groups than others.

Responses to Competition in the provision of fixed telephony services

2.10 Most respondents agreed that competition is increasing but not fully effective and not yet sufficient, by itself, to adequately protect consumers. However, many felt that lack of effective competition would best be addressed by tackling barriers to competition directly. Several operators identified their inability to offer a total service to the customer, with a single bill, as a factor currently preventing calls markets from being effectively competitive.

Competition indicators

2.11 A number of other sources of data relating to the competitiveness of markets have become available since July 2001. These include results from Oftel's August/September and November surveys, updated (but unpublished and unaudited) financial information from BT and updated market share data. They are summarised in the following paragraphs.

Customer satisfaction

2.12 The August/September survey found that, among small and medium-sized businesses, customer satisfaction remained high. In particular, 95% of small businesses and 84% of medium-sized businesses were satisfied with their fixed telecommunications services overall. This was not significantly different from the results of the May survey. An apparent fall in satisfaction amongst small businesses to 88% in November may be an anomaly; amongst medium-sized businesses satisfaction increased slightly.

2.13 Similarly, both the August and November surveys of residential customers found that 97% of those respondents for whom the home fixed phone was the main method of telephony were satisfied with it. This compares to 95% in May.

Profitability

2.14 Oftel has used financial information for 2000/01 prepared by BT on a fully allocated current cost basis in its competition assessment. This information is not directly extracted from BT's published financial statements and differs from the published data for two main reasons. Firstly, the regulatory businesses and activities contain activities which are not price controlled, such as calls to some non-geographic numbers and ISDN calls and lines. By excluding these services, the latest data reflect the composition of the price control basket but are not directly comparable to the Financial Statement data or the figures published in July 2001 as these included ISDN and some non-geographic calls. Secondly, these figures are calculated on an end-to-end basis and thus include profits earned in BT Network as well as in BT Retail.

2.15 Data on BT's profitability for 2000/01 are shown in Table 2.1. The figures shown below include Oftel’s estimates of profits and capital employed in incoming international calls (which accrue to Concert) which were excluded from BT’s figures. Comparable figures for 1999/2000 are also shown (for comparison purposes the 2000/01 access figures have been adjusted to reflect a consistent treatment of dropwire costs. The unadjusted 2000/01 ROCE for access would be 1.7%).

Table 2.1: BT’s Return on Capital Employed (ROCE)

Source: BT. The full methods of attribution, accounting and valuation have not been disclosed to Oftel. Oftel believes that BT's stated methodology for removing NTS calls, based on call minutes, may underestimate the returns earned on geographic calls.

2.16 There seems to be no tendency for BT's rates of return on calls, with the exception of calls to mobiles where BT's retention is capped, to decline. They remain extremely high. The fall in the overall ROCE seems to be due to declining call volumes relative to access lines. (These returns are expressed in terms of fully allocated cost (FAC). However, in assessing BT’s line rental in relation to cost to establish if BT makes or loses money on the provision of lines, a different assessment, based on incremental cost, is more relevant. In such an approach, the question is not so much whether BT makes or loses money on PSTN lines, but rather how different services contribute to the recovery of BT’s common costs, both costs within the access business – intra access costs – and costs common between access network common costs. For the purposes of simplicity, the discussion here concerns returns on a current cost accounting (CCA) FAC basis.)

2.17 The impact of loss of market share and falling prices is also reflected in a decline over time in the absolute values of BT’s profits on calls.

Table 2.2 BT end-to-end profits at current prices £M

Source: BT. The basis of the figures changes in 1999/2000, (see headings) hence there are two sets of figures for that year. The discontinuity reflects the transfer of customers and assets to Concert in January 2000 (the figure marked * includes an Oftel estimate of full year profits on incoming calls). The full methods of attribution, accounting and valuation have not been disclosed to Oftel. Oftel believes that BT's stated methodology for removing NTS calls, based on call minutes, may underestimate the returns earned on geographic calls. Profits are shown before subtracting cost of capital

Awareness of information sources

2.18 Awareness of the ‘Phonebills’ and comparable performance indicators websites has increased over the last year. Oftel's November 2001 residential survey found that 11% of respondents were aware of each of these sites compared to 7% and 5% respectively in March 2001.

Awareness and take-up of indirect access

2.19 Oftel's August surveys yield updated information on consumers' awareness and use of IA. BT also provided some survey evidence of customer awareness in its response. Table 2.3 compares the results of BT's survey with evidence from Oftel's August/September and November surveys.

Table 2.3: Survey data

2.20 BT's assertion that customer awareness of IA is rising appears to be based on a comparison of its own surveys for June and July 2001 with earlier Oftel surveys (from February and May 2001). This comparison may not be valid as the higher level of awareness found in BT's surveys may reflect differences in the sample or in the form of the questions rather than a change over time. Indeed, the form of the question on awareness in Oftel's survey changed in May 2001. Oftel's August 2001 residential customer survey found no change in awareness compared with the previous quarter and the November survey found only a small increase. Evidence from the November survey suggests that, on a comparable (ie pre-May) basis, the figure for customer awareness would now be 40%, compared to 33% in February 2001.

2.21 Similarly, there appears to have been no significant change since May in the proportion of residential customers using IA. However, there is evidence of a decline in the proportion using IA for all of their calls. Use of IA by business customers seems to be increasing.

2.22 The November survey confirmed that billing issues are a barrier to using IA for about 10% of residential customers. Some 6% quoted the "hassle of two bills" as a reason for not using IA whilst 5% mentioned complicated billing. This is comparable to numbers referring to the need to dial extra digits (6%). In addition, 7% of businesses in the November survey said that billing issues were a reason for not using an IA operator.

Customer switching

2.23 The August survey found that 8% of residential fixed telephone users had switched supplier in the last year compared to 9% in the February survey (the question was not asked in May). There appears to have been little change in rates of switching since March 2000 (the November survey in fact suggests a slight fall but this may be anomalous and will be checked in future surveys). Of those that switched, 92% found the process easy and use of number portability appears to be increasing: 58% of customers who switched in the last year kept their number compared to 35% of those who switched more than a year ago.

2.24 In August/September, 10% of small and medium-sized businesses had switched operator in the last year, of which 90% had ported all their numbers. In the November survey, 7% of businesses had switched in the last year. In both surveys, about 90% of switchers had found the process easy.

Market shares - retail access

2.25 Table 2.4 shows trends in BT's market shares to June 2001.

Table 2.4: Market shares (number of lines)

Source: Oftel Market Information

2.26 BT's share of residential lines increased between September 2000 and June 2001 at the expense of cable operators. There appears to have been a small fall in its share of business lines but this remains around 90%.

Market shares - retail calls

2.27 Table 2.5 shows trends in BT's shares of calls markets to June 2001. BT's shares are declining at a faster rate than in access. There have been particularly significant reductions in BT's share of residential national and international calls since September 2000. Combined with the data on share of lines, this suggests that IA may be having increasing impact. However, BT's revenue shares are still over 50% in all markets except international calls for business customers, which suggests that it is likely to be dominant in most calls markets.

Table 2.5: Market shares (calls)

Source: Oftel Market Information. Market shares have been adjusted to allow for the fact that some operators do not provide separate data for business and residential customers. In addition, Worldcom’s submitted national minutes and revenues have been apportioned among local calls, national calls and calls to mobile. BT includes Concert for these purposes.

Entry by broadband and other operators

2.28 There has been significant growth in take-up of broadband service using ADSL and cable modems but from a low base. Demand for LLU has continued to be much lower than originally expected. In total, even allowing for the rapid pace of growth in the last two quarters, fewer than 1% of homes and businesses are thought to be using broadband Internet access.

2.29 Fixed Wireless Access is still only available in limited areas. Moreover, Atlantic, which provided a narrowband service mainly to customers in Scotland, has recently entered into administration.

Complaints and quality of service

2.30 At the time of the publication of Competition in the Provision of Fixed Telephony Services, there appeared to be a decline in some aspects of BT's quality of service. This trend was reflected in the number of complaints to Oftel concerning faults and the time taken to repair them.

2.31 More recent data suggest that this decline may have been temporary and performance in April - June 2001 (the latest period for which data are available) appears to have been restored to early 2000 levels. This has similarly been reflected in a fall in the number of complaints to Oftel. The number of complaints to Oftel about BT per 1000 BT customers is slightly below the average figure for all providers of fixed telephony (see Consumer complaints to Oftel). Generally, comparable performance indicators also suggest that BT's quality of service compares favourably with that of other operators.

Competition in international markets: International direct dial (IDD) review

2.32 In November 2001, Oftel published the results of its review of competition in IDD markets at both the wholesale and retail levels. The main conclusions regarding market definition and competition at the retail level are summarised below. These will be adopted for the price control review.

2.33 Oftel defined a single retail market for all those routes where competition at the wholesale level was effective. On routes which were not effectively competitive at the wholesale level, retail markets were defined on a route by route basis. Oftel also defined separate markets for calls by business and residential customers on the grounds that widespread price discrimination suggested that competitive conditions differed between them.

2.34 Oftel found residential retail IDD markets to be increasingly competitive, rather than effectively competitive, on all routes. Oftel also concluded that, on routes which are effectively competitive at the wholesale level, the business retail IDD market is effectively competitive. On routes where the corresponding wholesale route is not effectively competitive, the business retail IDD market is increasingly, but not yet effectively, competitive.

Customer segmentation

2.35 Several respondents to Competition in the Provision of Fixed Telephony Services commented that Oftel should, in its competition analysis, differentiate to a greater extent among residential customers on the basis of usage. In response to this, Oftel examined a number of indicators from its surveys of residential customers in which separate customer groups are identified according to the level of expenditure on telecommunications services.

2.36 The survey results suggest that, as might be expected, awareness of IA is higher amongst higher spenders and there is a tendency towards higher use of IA amongst higher spenders.

2.37 Similarly, higher spenders tend to be more likely to have switched supplier within the last 12 months, although the relationship between switching and spend in general is by no means clear cut, with relatively high rates of switching more than twelve months ago found amongst the lowest spenders. The reasons given for not switching supplier do not vary markedly by spend. Satisfaction with the fixed phone as the main method of calling is consistently slightly lower amongst heavier spenders.

2.38 It is perhaps slightly surprising that the survey data do not show a stronger decline in awareness and use of IA as spend declines. IA might be expected to appeal mainly to high spenders, with almost no use amongst lower spenders, but this expectation is not borne out by the survey data. Even amongst those spending less than £30 per quarter, 7% in the November survey and 10% in the August survey said that they were using IA. It is not readily possible to identify a spend level below which IA has little or no impact.

2.39 It may therefore be that low-spenders' use of IA is simply very infrequent, as might be expected given that those low spenders who benefit from the LUS are not entitled to use IA. The survey does not indicate how often respondents use their IA operator, although it excludes former users who no longer use IA.

2.40 Differences in prices and profitability may also indicate differences in market competitiveness for different groups of customers. It would generally be expected that prices and profits would be highest where competition is least effective. However, as noted above, business and higher spending residential customers are likely to be BT's most profitable, whilst the revenue from the lowest spenders does not cover (fully allocated) costs. This reflects the fact that the line rental does not cover the (fully allocated) costs of providing the line and is a much greater proportion of the bill of lower spenders. High spenders are profitable because of the high profitability of calls. This is shown in Table 2.6. Note that in this document, the term ‘line rental’ or ‘rental charge’ is used for convenience even though at present BT's quarterly fixed charge also includes an allowance of free calls (ie an inclusive call allowance).

Table 2.6: Profitability of BT residential customers by spending deciles

Source: BT The full methods of attribution, accounting and valuation have not been disclosed to Oftel.

2.41 A more relevant question might be whether call prices differ depending on call spend. BT has provided information to Oftel on how the value of inclusive call allowances (ICAs) and discounts, as a proportion of customer bills, varies by spend level (although this has not been reconciled to the Financial Statements and Oftel has previously noted some concerns about the methods used by BT to calculate and attribute discounts). BT's ICAs offer proportionately greater savings for lower spenders. On the other hand, BT offers discount packages which allow the user to benefit from reduced call charges in return for payment of a fixed fee, some of which also feature enhanced ICAs. These are therefore most attractive to higher users. Taking into account both ICAs and discounts, the differences between average prices paid by low spending and high spending residential customers appear likely to be relatively small.

2.42 It is difficult to draw firm conclusions from this because the design of BT's ICAs and discount packages reflects not just the impact of competition but also regulation, in particular the retail price control. However, the profile of average call prices by spend, taking account of discounts and free calls provided in the form of ICAs, appears broadly consistent with the survey results outlined above. Both suggest that competitive pressure tends to increase with spend but that there is no obvious threshold of spend at which calls markets become competitive.

Price of operator assisted calls (‘OA’ calls)

2.43 A number of respondents felt that the market for OA calls was at least potentially competitive. They argued that OA could feasibly be provided by operators other than the access line provider but that at present the costs of billing made such competition uneconomic. Until competition becomes fully effective, Oftel believes that OA prices should continue to be subject to price control. It does not however propose a separate control for OA services.

Price of calls to mobiles

2.44 BT is currently subject to a separate control on its retail retention on calls to BTCellnet and Vodafone. The retention is subject to a cap set at RPI-7% per annum.

2.45 Competitive conditions in the provision of retail calls to mobile are broadly similar to those for other call types. The calling party is able to respond to increases in the retail price of calls to mobiles by switching his (originating) network. Whilst returns on calls to mobiles are lower than on other call types and this may have discouraged some IA operators from offering them, BT's share of calls to mobile minutes is similar to its shares of local calls and national calls. IA allows BT’s customers to choose to have their outgoing calls routed by alternative operators through the use of short access codes. In addition, calls to mobiles are available from Carrier Pre-Selection (‘CPS’) operators under the all calls option. CPS allows BT’s customers to choose to have their outgoing calls routed by alternative operators without the need for the customer to dial additional initial digits directly or via an auto-dialler as is the case with IA. Oftel therefore proposes to include the retail retention on calls to all four mobile networks in the new retail basket, rather than make it subject to a separate control.

2.46 It should be noted that competitive conditions in the retail provision of calls to mobiles are intrinsically different from those in the provision of mobile call termination. The latter largely reflect the fact that, under the calling-party pays principle there is little incentive for the called party to change his or her mobile network in response to an increase in call termination charges. Oftel's proposal for the retail control on calls to mobile prices is therefore entirely consistent with its proposals for individual controls on mobile call termination charges.

Conclusions on competitiveness

2.47 In the light of responses to Competition in the Provision of Fixed Telephony Services and other new information, Oftel believes that access and calls markets are not effectively competitive (with the exception of the competitive business IDD markets identified in the IDD review). However, competition is increasing and there are good prospects for effective competition in retail calls markets if the remaining barriers are addressed. Existing policies address these problems to some extent, although there is currently no policy to address one of the main barriers identified: the current need for IA and CPS customers to pay two bills.

Chapter 3

Policy objectives and proposals

3.1 As set out in chapter 2, Oftel believes that BT remains dominant in the access market. In addition, despite a slow decline in its market share of residential national and local call volumes (BT’s share is now 61% and 71% respectively), Oftel believes that BT retains a position of dominance in calls.

3.2 BT’s market power in the calls market has resulted in call prices being above the competitive level, as can be inferred from the high returns made by BT on all types of calls.

3.3 Oftel has constrained BT’s pricing behaviour since it was privatised in 1984 because of BT’s market power. If Oftel had not taken such action BT would have been able to exploit its dominant market position by raising prices. So Oftel has imposed price controls limiting BT’s freedom to increase prices for a group of services, notably access (connection and line rental) and calls.

3.4 Price controls and increasing competition have been successful in bringing benefits to consumers: prices are now over 50% lower in real terms than they were in 1984. However, there remains an imbalance between BT’s high profits on calls and low returns on access, and this is not a sustainable pricing structure in the face of fully effective competition in calls markets. Competition in calls markets is not yet effective, but it is growing and can be expected to continue to grow. If competition in calls markets can be made fully effective, the movement towards a more balanced tariff structure will benefit most customers in terms of lower prices overall and greater choice of product and provider. Oftel therefore intends to stimulate competition in calls markets and to allow BT to increase its rental charge to the extent that this is necessary for it to be able to recover its overall costs in the face of falling call profitability.

Promoting effective competition in calls markets

3.5 The competition that has been delivered through IA is being enhanced by the full introduction of CPS from December 2001. In the case of ‘all calls CPS’, BT’s customers can choose to have an alternative supplier route all their local, national and international calls and calls to mobiles. In these circumstances, BT would bill the customer only for the line rental.

3.6 A number of respondents to the consultation argued that these developments by themselves will not lead to effective competition as customer inertia, resistance to receiving two bills and the customer’s ongoing relationship with BT will limit progress. They argued that a new product should be available which enables them effectively to lease BT’s exchange line and so include the charge for BT’s line rental on their bill. The provider would decide how best to route the customer’s calls and how the line rental costs should be recovered, for example through call charges or though a monthly/quarterly rental charge or both. From the customer’s perspective the sole relationship for the provision of service would be with the alternative provider. Providers of IA and CPS argue that a new access product would encourage new players into the market with established and trusted brands.

3.7 BT's current Calls and Access tariff is aimed at the resale market. However, the competitive impact of resale depends to a large extent on the terms on which resellers gain access to BT's network. IA and CPS providers argue that the terms on which access to BT's exchange line has so far been provided have significantly limited the extent to which competition to BT can develop. However, since November 2001, the price of the line rental under Calls and Access has been reduced to £31.37 per quarter before VAT bringing it closer to cost (on a CCA FAC basis).

3.8 Oftel therefore believes that many of the conditions necessary for an expansion of retail competition are already largely in place, although their full effect has not yet been felt. CPS has eliminated the need to dial extra digits in order to send calls via an alternative operator. Calls and Access permits the customer to use a CPS operator without the need to pay two bills and the price of that product has moved closer to cost in recent months. Awareness of price comparison aids such as the Phonebills website is increasing.

3.9 But Oftel believes that action is needed to accelerate this welcome trend. In particular, what remains to be done is to formalise the requirement to provide a suitable cost-based access product by making its provision a requirement of BT's licence, ensuring that adequate and non-discriminatory prices and quality are maintained and making its price subject to an appropriate level of control, if a control is necessary. The charge for the wholesale access product will be geographically uniform.

3.10 Oftel believes that the introduction of a new wholesale line rental product could provide an additional stimulus to competition and encourage new players into the market. In addition, by allowing providers to offer both calls and access, innovative approaches to tariffing could develop changing the ‘balance’ between the line rental and call charges. It may lead to similar packages to those now available in the mobile market, for example to a greater availability of ‘free’ calls within line rental charges or the replacement of or reduction in rental charges with some part of rental costs being recovered through call tariffs.

3.11 Oftel’s research The Importance of Brands in the Telecoms Market: Qualitative Report published in November 2001 confirms the importance that telecoms customers place on well established brands. It also suggests that customers’ views differed on the benefits of having one bill rather than separate bills for rental and calls. Some favoured a single bill for convenience; others preferred separate bills so that expenditure could be monitored more closely. The new access product would allow competitors to provide single bills. Both existing and potential competitors to BT would be able to offer a choice to their customers of single billing or of separate bills with either IA or CPS.

3.12 Oftel proposes that BT should be required to provide the wholesale line rental product (and related products such as connection and takeover) and this allows competitors to offer single bills to end-users for all telecommunications services. These products would enable the purchaser to take on the retail relationship with the customer so that all interactions would be with the reseller and not BT. This would be in contrast to IA under which the retail customer retains a contractual relationship with BT through the provision of the line. Oftel proposes to modify BT’s licence specifically to require it to provide this product and other related products such as connection and take over. The modification would be made in a way that required BT to provide the product to anyone wishing to offer telecommunications services to end-users. Oftel's initial view is that this would not be an interconnection product as it would in large part be an enhanced replacement for the current Calls and Access product with a firmer regulatory base, rather than an interconnection product as commonly understood. This product would be subject to the same provisions as Standard Services.

3.13 Oftel believes that the price of this product should be based on BT’s costs in providing the service, including the contribution to common costs deemed to be recovered from the access service in the setting of interconnection charges under the Network Charge Control. At present BT’s residential PSTN line rental is set below this level, and the common costs deemed to be recovered from access are in fact recovered through profits on calls. As calls markets become more competitive, it will be increasingly difficult for BT to recover costs in this way. In addition, in respect of customers taking calls and access from a reseller, BT would receive no retail revenue. A wholesale charge based on BT’s retail line rental could therefore be unsustainable against a background of increasing competition in calls markets, unless BT were to raise the line rental at an unacceptably rapid rate.

3.14 Oftel therefore proposes that the charge for this service should be based on BT’s costs rather than its retail price. To ensure competitive neutrality, Oftel believes that the pricing, product and quality of service parameters of this new product should be available on non-discriminatory terms. A consequence of the provision of this service is that Oftel might need to change the definition of certain of BT's Businesses. There would therefore be a case for separating BT Access into network and retail Businesses for accounting purposes in order to monitor this.

3.15 In relation to conveyance services, Oftel proposes to leave the current position unchanged in line with its initial view that the new product is not an interconnection service. Condition 69 conveyance will therefore remain available only to those telecommunications providers that interconnect with BT. Those that do not interconnect can purchase conveyance services from other suppliers.

3.16 It is recognised that the introduction of a wholesale line rental product could lead to reseller marketing activities (such as doorstep selling) similar to those experienced in the energy markets. These issues are explored further in chapter 4.

3.17 Oftel proposes that these requirements shall take effect as soon as possible. chapter 4 discusses the development of the new product in more detail.

Oftel invites views on:

• the introduction of a wholesale line rental product; and
• the extent to which service delivery procedures agreed for Call & Access are appropriate for the new product, the extent to which they need to be extended and improved and how far this improvement could and should be achieved through formal regulatory action as opposed to a co-regulatory route

Protecting customers as call prices fall

3.18 Oftel believes that another retail price control similar to the current one is not appropriate in the current circumstances, with the expectation of increasing competitive pressures in calls markets. The current cap relies on the continuation of excess profits from business and high-spending residential customers to finance losses (measured on a consistent basis) on lower spending customers (see table 2.6). This would not be sustainable in a world where increased competition is expected to eliminate persistent excess profits.

3.19 However, the impact on the market of IA, CPS and a new wholesale access product is difficult to predict with any certainty. Competitors to BT may take time to emerge and may seek to compete on tariff structure and quality as much as price. Given this uncertainty, Oftel believes that consumers would not be protected adequately if all price controls were removed immediately.

3.20 As explained above, Oftel believes it would be appropriate to allow BT to cover the costs of the provision of a line and to raise the line rental to some extent to offset call price reductions provided that those reductions were driven by competition. However, Oftel does not wish BT to be able to raise the line rental unless and until competition brings down call prices. Oftel believes that it is appropriate for changes in rentals and call prices to be linked within a price control basket. If such a basket were ‘broad’, containing all services supplied to all customers, there would be a danger that BT would have an incentive to raise rentals and cut call prices in the absence of competitive pressures. Oftel therefore prefers a ‘narrow’ basket including services supplied only to some groups of lower spending customers. Because of the high weight of the line rental in such a basket, BT would have to cut call prices very substantially to offset rental increases, and so would not wish to change the structure of its prices unless competitive pressures forced it to do so.

3.21 As noted above in 3.18, with competition becoming increasingly effective, especially in respect of services to higher spending customers, a cap set on the same basis as the current control would not be sustainable. Nevertheless BT remains dominant in the provision of access and, for the time being, calls. It continues to be necessary to prevent BT from exploiting its market power to the detriment of consumers. Given the modest level of profitability of the lowest spending 80% of residential customers, Oftel believes that a safeguard control which would allow no nominal price increases (ie it would be set at RPI-RPI) would provide the appropriate level of protection for customers, while allowing BT to respond to increased competitive pressure in calls markets. Thus Oftel proposes a control under which the overall level of prices in the basket would be held constant in nominal terms, but BT would be free to adjust the balance of charges within the control. Oftel proposes that the safeguard controls should be:

• applied to the spending patterns of the lowest 80% of residential customers; and
• based on the same basket of services – access, local, national and IDD calls and calls to operator assistance – but with the addition of BT’s retention for calls to mobiles.

3.22 A control set at RPI-RPI has the potential to become unduly onerous for BT if inflation turns out to be unexpectedly high. In order to avoid this, the control will be limited to RPI-5% if inflation is greater than 5% per year.

Oftel invites views on the introduction of a RPI-RPI safeguard control to maintain a linkage between line rental and call prices until competition becomes the determinant of call prices.

Trigger to remove controls

3.23 Oftel has to consider the implications for this new price RPI-RPI price control if and when competition develops as intended. The further competition develops, the greater the risk that such a control could prevent BT from recovering its costs. The returns from the lowest spending 80% of residential customers are below the cost of capital, as shown in Table 2.6. Profits from other higher spending customers allow BT to recover its costs overall. If competition develops as intended, the profits that BT makes outside the basket on calls will be competed away and the control may eventually not be sustainable for BT.

3.24 Therefore, it is necessary to introduce an arrangement to remove the RPI-RPI control as competition reduces BT’s call profits. Oftel proposes that there should be a trigger that would remove the control. The trigger could be expressed in terms of market share, return on capital employed or prices. Using return on capital employed or market shares as the point when triggers would be activated would give BT perverse incentives. If return on capital employed were used, BT would have an incentive to become less efficient and thus reduce profitability. If market shares were used, there would be an incentive for BT to lose customers which would be in complete contrast to the desirable incentive properties of competitive markets where companies strive to retain and gain customers. Oftel therefore believes that basing the trigger on prices would be preferable since it would have the correct incentives and be more meaningful to consumers.

3.25 It is proposed that removal of the price control would be triggered once call prices had fallen by a significant amount. The level of the trigger would be set taking into account the impact of reduced call prices (for business and residential customers from an agreed date) on BT’s returns. For example, a 50% reduction in BT’s call prices would reduce BT's end-to-end rates of return on calls to around 25%. To provide certainty to BT, Oftel believes that the trigger should be measurable and automatic, ie not subject to discretionary checks by Oftel. There would nevertheless be provisions for the reinstatement of controls if prices rose significantly again above the trigger level. If the trigger had not been activated within two years of the introduction of the control, the continuation of the control would be reviewed as part of the regular review process required under EC Directives.

3.26 It is important to emphasise that the activation of the trigger would not be equivalent to a judgement that the market was effectively competitive. That assessment will be made through regular market reviews required by the Framework Directive. It would, however, reflect a judgement that competition in the market had reached the level whereby an RPI-RPI control was no longer appropriate. There would still, however, be a case for some less intrusive regulatory action on the basis described below.

Oftel invites views on:

• the principle of a non discretionary trigger to remove the control when call prices are competitively determined;
• the proposed use of call prices for the trigger;
• possible levels of a trigger.

3.27 In addition to the price control, Oftel proposes that there should be a bill constraint of RPI+0% on the amount by which the bills of customers in deciles 3, 4 and 5 could increase. This is an important provision, because increases in the line rental, even combined with reductions in call prices, are likely to increase the bills of some of the lowest-spending residential customers in the absence of measures to prevent this.

3.28 The RPI+0% safeguard could apply either as a separate constraint on each decile 3-5 or across deciles 3-5 effectively as a ‘basket’. The latter would give BT greater freedom to recover a greater share of common costs from the line rental. The former would provide a greater level of protection for lower spending customers in respect of the line rental but could restrict the rate at which BT could adjust its prices in response to greater call price competition. An alternative approach to a control on separate deciles could be to extend the Light User Scheme, which provides for reductions in the line rental for BT customers in deciles 1 and 2 who make few calls (see paragraphs 3.34), to customers in decile 3.

3.29 BT has argued that such a control is not necessary, as the RPI-RPI control could be based instead on the spending patterns of customers in the third to fifth deciles.

3.30 Oftel believes that two separate measures are required because they address two distinct objectives. The purpose of the RPI-RPI control is to prevent BT from exploiting its market power before competition is effective. It is designed to allow BT to offset reductions in call prices made in response to competition by increases in the line rental, but not to give BT an incentive to pre-empt competition by raising the line rental in advance of competition forcing call prices down. This incentive is provided by weighting the basket towards the spending patterns of the lowest spending 80% of customers.

3.31 The objective of the RPI+0% constraint, by contrast, is primarily to make sure that vulnerable customers are not made worse off. Oftel believes that this will remain necessary even after the removal of the price control has been triggered by the development of competition in order to prevent increases in the bills of the lowest-spending residential customers.

3.32 The danger, therefore, of trying to use a single measure to address both objectives is that neither is achieved. In particular, a cap focused on deciles 3, 4 and 5, collectively or individually, could be satisfied without general reductions in call prices. For example, it could be satisfied by call price reductions targeted at decile 3, 4 and 5 that might not benefit customers outside this narrow group.

Oftel invites views on whether the RPI+0% control to safeguard customers from increases in bills should be applied as a ‘basket’ control including deciles 3 to 5 or applied to each individual decile.

Ongoing protection for low spending customers

3.33 Existing Universal Service measures would remain in place to ensure that vulnerable customers do not experience significant increases in their bills.

3.34 Under the Light User Scheme (LUS) users receive a rebate on the rental if call charges are less than £15.95 per quarter (excluding VAT). For every 1.0p that the call charge falls below this amount, the customer receives a rebate of 1.078p (excluding