Issued by the Director General of Telecommunications

February 2001

Contents

Summary

Chapter 1    Introduction

Chapter 2    Retail Price Controls

Chapter 3    Network Charge Controls for BT and Concert

Chapter 4    Financial modelling: main assumptions

Chapter 5    Consultation details

Annex A      Responses to Consultation

Annex B      Retail Price Control Review: key indicators

Annex C      Discounts, Reference Prices and the Price Control

Annex D      Comment on BT’s note on the competitive price

Annex E      Cost of capital

Annex F      Proposed modifications to BT’s licence

Annex G     Proposed modifications to Concert’s licence

Annex H     Notice under Section 12(2) of the Telecommunications Act 1984

Annex I      Glossary

Summary

S.1 In October 2000, Oftel published a consultative document entitled Price Control Review which set out proposals for future retail price and Network Charge Controls. This was the third round of consultation on the measures to be introduced when the current controls end in mid-2001. This document sets out Oftel’s conclusions and proposals for the future of both types of controls in the light of responses and invites comments on the proposed modifications to BT’s and Concert’s licence to bring these into effect.

Retail Price Controls

S.2 The current retail price control, which expires at the end of July 2001, restricts annual increases in the average price of a group or ‘basket’ of services to the rate of inflation (RPI) minus 4.5%. The services controlled are connections, line rentals, local, national, international calls and operator assistance. Oftel calculates the relative weight of each service within the basket by looking at the expenditure patterns of the lowest 80% of residential customers by spend. This means that the control focuses price changes on services used largely by lower spending customers.

S.3 In the October 2000 consultative document, Oftel recognised that the market is beginning to change quite significantly with increasing competition from both direct and indirect access operators and, in addition, an increasing number of consumers using mobile phones as a substitute for fixed telephony. Reductions in BT’s market shares in the main call markets reflect this increasing competition, although in the residential sector its shares remain around the 60-70% level.

S.4 Oftel noted that prices for basic telephony services had fallen through the period of the price control, partly through the operation of the price cap and partly through the effects of competition for higher spending customers. However, BT’s returns on calls, assessed on the basis of BT’s cost allocation, remained substantially above a reasonable level. These returns were significantly offset by the failure to recover fully through line rental the costs allocated to access under BT’s cost allocation. Nevertheless, the overall level of profitability exceeded what BT requires to cover its full costs and make a reasonable return.

S.5 Oftel also noted that there would be changes in the market in the coming year which would be likely to increase competitive pressures further. Full carrier pre-selection, by which BT customers can elect to have calls delivered by other operators’ networks without needing to dial an access code, will become fully available during 2001. Higher bandwidth technology is being rolled out and BT’s local loop is being made available to other suppliers to offer competing services. Cable operators will continue to expand their telephony activities and calls and access resellers are also expected to provide some competitive stimulus. In view of the considerable uncertainty surrounding the impact of competition on BT in the immediate future, Oftel proposed that the current retail price controls should be extended until the end of July 2002. This would enable Oftel to review the impact on the market of continuing infrastructure competition, carrier pre-selection, indirect access, local loop unbundling and mobile substitution.

S.6 Most responses to the document supported Oftel’s analysis of the market and Oftel’s proposals for the extension of price controls for one year. BT argued that, in view of the current and prospective developments in competition, all formal retail price controls should be removed and that in future competitive market forces would be sufficient and should be relied on to provide protection for consumers. Nevertheless, BT offered to voluntarily ensure that, in real terms, telephone bills did not increase.

S.7 Oftel has concluded that it should proceed with the extension of the current retail control – RPI-4.5% – until 31 July 2002. Oftel also proposes that a further ‘rollover’ provision is needed. This provision would allow for the retail controls to be extended for the period 1 August 2002 to 31 July 2003. It would be invoked only if there were a reference to the Competition Commission following any proposals Oftel put forward in 2002.

S.8 Oftel does not intend to accept BT’s proposal that the control should be implemented through a voluntary commitment on its part. Oftel has concerns about the operation and details of a voluntary commitment and would need to be satisfied that, in the event of a failure by BT to honour the commitment or of a dispute between Oftel and BT on its implementation, Oftel could rapidly reinstate controls through licence conditions. However, Oftel intends to explore the use and enforcement of voluntary commitments in future should the need for further controls exist beyond July 2002. This document sets out the draft licence modifications to implement the extension of the retail controls.

S.9 The extension of controls would enable Oftel to carry out a review during 2001/2002 to assess the level of competition. If the review suggested that competition had not become fully effective, and appeared unlikely to become so in the near future, Oftel would consider whether further price controls or other measures to stimulate competition, such as the introduction of a cost-based access product, were needed. Oftel intends to publish an initial document in May 2001 which will be the formal trigger for the start of the review and will invite contributions from stakeholders. A formal consultative document will follow by December 2001.

Network Charge Controls

S.10 The present Network Charge Control arrangements are set to end on 30 September 2001. In the light of responses to the earlier consultative documents, and market analysis, Oftel has concluded that competition has not increased to the extent that would allow it to remove the controls introduced in 1997. Oftel therefore is to introduce new controls, which will run for the period 1 October 2001 to 30 September 2005. These controls are based on the extent of competition in the relevant interconnection market. Interconnection services will be classified in one of the four following categories of competitiveness:

• Competitive Standard Services;
• New Standard Services;
• Prospectively Competitive Standard Services; or
• Non-Competitive Standard Services

S.11 Controls will not be applied to interconnection services determined to be competitive. In order to ensure that incentives to innovate remain, new services will not generally be subject to charge controls immediately on their introduction. However, Oftel proposes to retain the power to charge control new services before they are introduced or subsequent to their introduction. Prospectively competitive services will be subject to ‘safeguard’ caps set at RPI+0%.

S.12 Non-competitive services are divided into different ‘baskets’ or groups of services. Oftel stated in the October 2000 consultative document that the exact value of ‘X’ for the RPI-X formula applied to each of these baskets would be set in this Statement following additional research. Oftel explained that that the extent of traffic migration away from the switched telephone network would be an important factor in determining BT’s costs and hence the appropriate level of any charge controls. Much of the current data traffic which is being conveyed over the basic telephony network, and which forms much of the expected growth in overall traffic in the future, is going to be migrated off this network onto Internet Protocol (IP) based networks. The extent of this migration will clearly be a very important factor in determining the volume increases on the basic telephony network, which are an important factor in setting charge controls.

S.13 After taking account of comments received, Oftel has concluded that the interconnection services currently classified as non-competitive and subject to charge controls should continue to be subject to charge controls. Oftel proposes that the structure of the controls should be the same as the present structure, with the exception that BT’s charges to other operators for originating calls should be controlled separately from charges for use of the tandem switching layer because of the possible need to adjust charges for the tandem layer. This means that the existing three ‘baskets’ would be replaced by four ‘baskets’ of non-competitive services subject to charge controls: call origination; call termination; tandem layer services; and interconnection specific services.

S.14 Oftel is introducing different values of ‘X’ for each basket of non-competitive services. For the ‘Tandem Layer Basket’, which incorporates single transit and local-tandem conveyance, the value of ‘X’ is proposed to be set at 13. For charges for originating and terminating calls, the value of ‘X’ is proposed to be set at 10 for each basket. For the ‘Interconnect Specific Basket’, covering the charges made to physically connect with BT, the value of ‘X’ is to be set at 8.25. Oftel is proposing to set a starting charge and introduce a charge control for Flat Rate Internet Access Call Origination (FRIACO), covering charges for unmetered Internet access. Oftel proposes the starting charge of £333.04 per circuit – based on revised cost data and revised utilisation factors. Oftel proposes a charge control for each element of the charge to be set at RPI-7.5%.

S.15 In addition, Oftel proposes to maintain safeguard (RPI+0%) controls on the services that were deemed to be prospectively competitive in 1997. Oftel does not believe that competition has increased sufficiently for it to remove these safeguard controls.

S.16 The draft licence modifications to give effect to these proposals are set out at Annex F. The modifications also make provisions for these controls to rollover for a period until 30 September 2006 in the event of a reference to the Competition Commission concerning future arrangements beyond 2005.

Concert and the Network Charge Controls

S.17 Concert, which is a joint venture between BT and AT&T, runs wholesale international connection and conveyance services on behalf of BT. It has done so since January 2000. The charge controls that were applied to BT were applied to Concert. In the light of increased competition, the only charge controls that Oftel intends to maintain from 1 October 2001 are those limiting increases in the aggregate of charges for wholesale international conveyance (by time of day and route), and product management, policy and planning by RPI+0%.

S.18 The draft licence modifications to give effect to these proposals are set out at Annex G.

Chapter 1

Introduction

Overall approach

1.1 Oftel’s goal is the best deal for consumers in terms of quality, choice and value for money. Oftel believes that competitive markets are the best way of achieving this goal.

1.2 Oftel believes that regulation should be imposed only where it is justified and that regulation should be appropriate to the level of competition in the market – excessive regulation can reduce incentives to invest and innovate. However, Oftel recognises that a failure to regulate where it is needed can harm consumers’ interests.

The Retail Price Controls

1.3 Price control is a means of protecting consumers in retail markets where competition is ineffective now and is likely to continue to be ineffective in the immediate future. Since 1984, price controls have taken the form of placing a ceiling – or a cap – on the extent to which BT can raise its prices.

1.4 The current retail price control, limiting prices to a level below the rate of inflation and expressed as ‘RPI-X’, was set in 1996. It covers ‘access’ – connection to the network and line rental – and the prices of local, national and international calls and of operator assistance. The value of ‘X’ in the current control was set at 4.5%. This means that, for example, if inflation is 2% BT’s prices (for services covered by the control) must fall by 2.5% on average. The control applies to services consumed by residential customers with the weight on each service corresponding to the consumption of that service by the lowest 80% of BT’s residential customers by expenditure.

The Network Charge Controls

1.5 Interconnection charges are the charges BT makes to other operators to connect to and convey calls over its network. The charges for some of BT’s interconnection services are subject to controls that operate in much the same way as the retail controls. Network Charge Controls are applied to interconnection services in markets in which competition is not effective.

Consultation

1.6 The Price Control Review began in July 1999 with the publication of Future developments in the competitiveness of UK telecommunications markets. In this document, Oftel made an assessment of the extent of competition that BT is likely to face over the next price control period. This was followed by a further consultative document in March 2000 entitled Price Control Review – possible approaches for future retail price and network charge controls setting out various options for future controls. In October 2000, Oftel published a third consultative document Price Control Review setting out proposals for future controls.

1.7 With respect to retail controls, Oftel recognised in the October 2000 document that the telecommunications market is beginning to change quite significantly with increasing competition from both direct and indirect access operators and an increasing number of consumers using mobile phones as a substitute for fixed telephony. This increasing competition was reflected in a reduction in BT’s market shares in the main call markets, though in the residential market its share remained around the 60-70%. The increasing competition was also leading to declining profits overall, although BT’s Return on Capital Employed (ROCE) for the main price controlled services remained above 20% with continuing very high returns on calls more than compensating for relatively low returns on access.

1.8 In addition, in the document Oftel recognised that competition to BT was likely to increase over the coming years. Full carrier pre-selection, by which BT customers can elect to have calls delivered by other operators’ networks without needing to dial an access code, will become fully available during 2001. BT’s rollout of higher bandwidth technology and the unbundling of its local loop are expected to provide additional stimulus to competition. Cable operators will continue to expand their networks and calls and access resellers are also expected to provide some competitive stimulus.

1.9 However, Oftel concluded that the impact of these competitive pressures both in terms of their level and timing was not yet clear. In view of this uncertainty, Oftel proposed to extend the current retail price controls until the end of July 2002 and to review the impact on the market of competition during 2001/2002. Oftel indicated that, if additional competition does not emerge to constrain BT’s call prices by late 2001, it would consider whether further price controls or other measures to stimulate competition, such as the introduction of more widely spread cost-based access to BT’s network, were needed.

1.10 In the October 2000 consultative document, Oftel proposed to continue with interconnection charge controls based on the level of competitiveness in each interconnection market. Oftel stated that the value of ‘X’ in the RPI-X% formula was likely to lie in the range 7.5%-11.5% for non-competitive services, but that Oftel would be conducting additional research to inform its final decisions.

Purpose of this Statement

1.11 Oftel received 25 responses to the October 2000 consultative document and three responses commenting on responses. These are summarised in subsequent Chapters and in Annex A. This document sets out Oftel’s conclusions and proposals on the form that controls should take from 2001 on the basis of responses to the consultations and the market analysis carried out since 1999. Annexes F and G to this statement contain proposed draft licence modifications to implement these proposals. Comments are invited on these proposed modifications. Further details of the consultation process are given in Chapter 5.

Chapter 2

Retail Price Controls

October 2000 consultation

2.1 As explained in Chapter 1, Oftel concluded in the October 2000 consultative document that BT’s profitability in the calls market remains higher than would be expected in a competitive market. Oftel proposed that the current retail price controls should be extended for another year until 31 July 2002 and that a review should take place during 2001/2002 to consider developments in the market in order to identify any measures that might be required after July 2002.

2.2 Responses to the consultation are summarised in Annex A. User groups and service providers broadly agreed with Oftel’s analysis that BT’s rates of return remained high and that this indicated that competition was not yet fully effective. BT expressed concern that Oftel was basing its analysis on historic profitability figures and that recent developments in the market suggested that competition was developing more rapidly. BT also pointed out that its returns for the lowest spending 80% of customers by expenditure were below the cost of capital and argued that returns in excess of the cost of capital do not on their own indicate excess profits and should not justify continued price control (details of BT’s argument on this point and Oftel’s response are set out in Annex D).

2.3 On the proposal to extend existing retail controls to July 2002 in order to carry out a further review of the market, consumer groups and many other respondents supported Oftel’s conclusion. BT expressed disappointment that Oftel had not taken a more deregulatory stance which BT believed was justified by the level of actual and prospective competition. However, BT welcomed the fact that the proposed extension was only for one year at this stage. BT proposed that, if Oftel proceeds with its proposals, it should be in the form of a contractual arrangement between BT and its customers instead of a licence condition. Under its counter proposals, BT would give a voluntary commitment to deliver price reductions at least equivalent to those proposed by Oftel until July 2002 and offer direct compensation to its customers should BT break its commitment.

Oftel’s conclusions

2.4 On the basis of the market analysis set out in the October 2000 consultative document and the responses to consultation, Oftel has concluded that the current retail controls at RPI-4.5% should be extended by one year. The retail price controls, covering access and the prices of local, national and international calls and of operator assistance and applying to the lowest 80% of residential customers by expenditure, would continue until 31 July 2002. Under the extended control, the provisions for discounts and reference prices would remain as for the current period. Details of these are set out in Annex C to this Statement.

2.5 BT suggested that the licence obligation imposing price controls should be replaced by a voluntary commitment on its part. Oftel does not think that this is appropriate at this time. In part, this is because the licence basis for the current price control is in place and an extension is the most straightforward and well understood way forward. In addition, Oftel has concerns about the details of a voluntary commitment, for example how it would work in relation to the treatment of discounts, and how the monitoring process would work. Moreover, Oftel would need to be satisfied that, in the event of a failure by BT to honour the commitment or of a dispute between Oftel and BT on the implementation, Oftel could rapidly reinstate controls through licence conditions without customers experiencing a period when they were not appropriately protected. Oftel proposes instead that the use of voluntary commitments in future should be explored as part of the review process referred to above. This would allow full consultation on the details and operation of any commitments, should Oftel conclude that they are appropriate beyond July 2002.

2.6 Annex F sets out draft licence modifications to implement the proposed extension of retail controls. The modifications also include provisions for the rollover of controls until 31 July 2003, should BT not accept proposals to be made by Oftel in 2002 as a result of the review and Oftel has referred the matter to the Competition Commission for investigation. Comments are invited on the proposed licence modifications.

2.7 As part of the 1995/1996 Price Control Review, BT gave Oftel an assurance known as the Small Business Safeguard. Under this, BT agreed to offer a package to small businesses which was at least as advantageous as one in which call charges were no higher than those of the residential call reference price and in which the line rental increased by no more than RPI each year. Given the overlap between the pattern of usage of some small business customers with that of a moderate spending residential customer, Oftel proposes that BT’s undertaking to provide the Small Business Safeguard should continue until 31 July 2002. Oftel will formally seek BT’s agreement to this as part of the proposals for licence modifications contained in this statement.

2.8 Oftel also believes that the requirement on BT not to increase in nominal terms the rental charge for hardwired phones should be extended for a year to 31 July 2002. Over 300,000 customers have hardwired phones and, given the absence of competition in the provision of hard-wired phones and the costs involved in switching to a plug and socket connection, Oftel believes that they should continue to retain this protection for the period of the extended price control. The draft licence modification required to implement the proposed extension is set out in Annex F. The provision will be considered as part of the 2001/2002 review. Comments are invited on the draft modifications.

Market review

2.9 The extension of controls will enable Oftel to carry out a review during 2001/2002 to assess the level of competition in retail markets. If the review were to conclude that competition had not become fully effective, and appeared unlikely to become so in the near future, Oftel would consider whether further price controls or other measures to stimulate competition were necessary. These might include the introduction of wide spread cost-based access to BT’s network, possibly accompanied by some additional protection for low users over and above current Universal Service Obligations. Furthermore, some form of safeguard control might be necessary.

2.10 In May 2001, Oftel expects to issue a document to start the review. This document will set out Oftel’s initial thoughts on the review:

1. an initial assessment of effective competition indicators likely to be most significant for the segment as a whole;
2. Oftel’s data collection plans and timetable; and
3. information which will be sought from stakeholders.

2.11 This document will form the basis of discussions with stakeholders. The key indicators that Oftel is likely to consider are set out in Annex B to this Statement.

2.12 Oftel will consider initial reactions when drawing up the formal consultative document, which it expects to issue by December 2001. The document will set out an analysis of the market and any measures that should be put in place after July 2002. The document will provide a further opportunity for consultation on the details of a cost-based access product, should Oftel consider that this was an appropriate way forward. A Statement is expected to follow this consultation by May 2002 setting out any appropriate licence modifications to give effect to the proposed policy.

Calls to mobiles

2.13 As a result of a report by the then Monopolies and Mergers Commission in December 1998, controls were placed on the amount BT retains from revenues for fixed-line phone calls on its network to mobile phones on BTCellnet’s and Vodafone’s networks. Under these controls, BT’s weighted average retention for calls to subscribers on BTCellnet’s and Vodafone’s networks was 3.40ppm for the financial year 1999/2000, and had to be reduced by RPI-7% in the following two financial years. These controls are set to expire at the end of March 2002. In the October 2000 consultative document, Oftel proposed that, in order to align the timetables for the retail price controls and the controls on BT’s retention for calls to mobiles, the controls on BT’s retention should continue on the same basis for the period 1 April 2002 to 31 July 2002.

2.14 In its response, BT argued that there were sufficient competitive pressures, for instance through mobile to mobile calls and calls via indirect access operators, for the controls to be removed. However, it accepted that if retail controls were extended for one-year aligning those on the mobile retention would seem sensible. Other respondents were supportive of the proposals for an extension to the cotnrols.

2.15 Oftel concludes that the controls on BT’s mobile retention should be extended to 31 July 2002. The draft licence modification required to implement the proposed extension is set out in Annex F. The controls will be considered as part of the 2001/2002 review. Comments are invited on the proposed modifications.

Leased lines

2.16 As part of Oftel’s consultative document – National leased lines: effective competition review and policy options – issued in August 2000, Oftel reviewed the existing safeguard retail price caps on analogue and digital circuits up to and including 64kbits. Oftel proposed to remove the digital safeguard cap, but to extend the analogue safeguard cap until the end of July 2005. All respondents to the consultative document on these issues supported the policy proposals. Oftel has decided to implement these proposals. The draft licence modifications to implement these proposals are in Annex F.

2.17 As part of the leased line market review process, Oftel is also considering whether price regulation of wholesale part leased lines is necessary to promote further competition in retail leased lines. Oftel plans to publish a further statement on this in spring 2001.

Chapter 3: Network Charge Controls for BT and Concert

Introduction

3.1 Network charges are the charges made by BT for interconnection services, which consist of the physical linking of telecommunications networks and the conveyance of communications across them. These are a necessary input for operators that wish to compete in the UK telecommunications market with BT. BT has a ubiquitous network and a large proportion of subscribers connected to its network. This means that other operators need to purchase from BT physical interconnection and various interconnection conveyance services to provide end-to-end conveyance of communications to their customers.

3.2 For competition to be efficient and effective, charges for BT’s interconnection services should be set at the level at which they would be set in a competitive market, which would reflect efficiently incurred costs. Where competition in interconnection service markets is effective, no regulatory action to achieve this is required. However, where there is not effective competition, it is necessary to place constraints on BT’s ability to set excessive charges.

3.3 In this statement, Oftel sets out its final proposals for Network Charge Controls from 1 October 2001, including the proposed values of ‘X’ for the controls on non-competitive interconnection services. Oftel’s proposals largely represent a rolling forward of the arrangements which currently apply. There are some minor adjustments to the structure of the controls and the proposed values of ‘X’ are slightly higher than the current levels.

Network Charge Controls and the annual determination regime

3.4 The Network Charge Controls were introduced in October 1997 and replaced the old interconnection regime under which Oftel determined annually BT’s charges for interconnection services. The Network Charge Control arrangements had two main differences from the previous regime: charges were to be based on forward looking costs (LRIC), rather than historic costs, and were to be subject to charge controls rather than determined annually. The purpose behind these changes was, first, to bring the charges into line with those that would prevail in a competitive market and, second, to improve the incentives on BT to increase its efficiency. The arrangements were designed to comply with the Interconnection Directive (EC/97/33) which required operators deemed to have significant market power (SMP) in interconnection markets to charge at a level derived from actual costs including a reasonable rate of return.

3.5 Under the Network Charge Controls, services were put into one of four categories according to the extent of competition in the relevant market. These categories were: competitive services; new services; prospectively competitive services, and non-competitive services. BT was free to set the charges for competitive services and new services, although Oftel retained the power to introduce charge controls if it found that the relevant market was not competitive. Prospectively competitive services were subject to safeguard controls set at RPI+0%, though competition, rather than the safeguard controls, was expected to be the binding constraint on BT’s charges for these services. Non-competitive services were placed into charge control ‘baskets’ subject to controls set at RPI-8%. Table 3.1 below shows the competitive categorisation of services in 1997.

Table 3.1 – Network Charge Controls, 1997

The competitiveness of markets for Interconnection Services currently classified as non-competitive

3.6 The present Network Charge Control arrangements are set to end on 30 September 2001. Oftel has therefore examined whether controls beyond that date will be required. This has included an assessment of whether competition in the provision of each interconnection service has increased to an extent that would justify a reclassification of any of the services. The findings of these assessments are set out in the following paragraphs.

Call origination

3.7 BT retains over 80% of fixed exchange lines in the UK, and this percentage is expected to remain high over the period up to 2005. BT’s large share of lines leads to the majority of fixed calls originating on its network, and this leads Oftel to conclude that BT is dominant in the provision of call origination. Oftel expects this position to be maintained up to and including 2005.

Call termination

3.8 For call termination services, there is a further factor in addition to BT’s share of customers connected to its access network, which affects BT’s market power. This is the effect of the calling party pays principle. The principle of calling party pays which prevails in the charging for telecommunications services in the UK leads to a situation where charges for call termination services are not subject to direct competitive pressures. The charges for these services are faced by the calling party rather than the customer of the network providing the termination service. On fixed networks this has the effect of conferring market power on the providers of call termination services. This can be offset by the buying power of operators purchasing call termination services, but given the relative size of operators in the UK this is not a significant factor constraining BT’s charges for call termination. Oftel concludes from these factors that BT is currently, and is likely to remain, dominant in call termination.

Single Transit

3.9 Single Transit is a conveyance service provided by BT to convey calls from one network to another when the networks are not interconnected to each other. Direct interconnection between the two non BT networks would be justified only if there were sufficient traffic flowing between the two networks. The alternative is generally to use BT as a transit operator: both operators would generally be interconnected with BT, since this is essential in order to be able to access the largest base of customers. BT’s position as the operator with whom all operators are interconnected puts it in a uniquely strong position in providing transit services. No other operator can offer similar services to all operators and other networks often have only the choice of direct interconnection as an alternative to using BT’s transit service. Oftel expects BT to remain dominant in the provision of this service.

Local-tandem conveyance

3.10 Local-tandem conveyance is the conveyance service linking BT’s local exchanges with its main exchanges (at the tandem layer). Many operators rely on interconnection at the tandem layer. New entrants, and even in some cases established operators, are likely to connect at the tandem layer. In such cases, they have to purchase local-tandem conveyance from BT. In principle, they could purchase local tandem conveyance from an operator who was connected to BT’s network at the local exchange level and who offered an interconnection service at the tandem level. In practice, no one other than BT currently is in a position to offer this service, and Oftel considers BT to be dominant in its provisions. Oftel expects BT to remain dominant in the provision of local-tandem conveyance in the foreseeable future. However, other operators are expected to build out data carrying facilities to the level of the local exchange as the growing volumes of traffic make this more economic. Over time, this could lead to alternative suppliers of wholesale local-tandem conveyance becoming established and the service becoming competitively supplied.

Interconnect Specific Services

3.11 The services in this basket include those purchased by other operators to interconnect physically with BT at the tandem layer or local exchange layer. Given the imperative to interconnect with BT, and the inability of any other supplier to provide them, these services are non-competitive.

3.12 Oftel’s conclusion is that competition in the services previously classified as non-competitive has not increased to the extent that would justify the reclassification of those services as prospectively or actually competitive.

Oftel’s proposals for Network Charge Controls from October 2001

3.13 On the basis of the assessment of the competitiveness of services summarised above, Oftel believes there is a need for controls on network charges from October 2001. Oftel proposes that new Network Charge Controls should be introduced to run for the period 1 October 2001 to 30 September 2005. Oftel has also made provisions for these controls to rollover for a period until 30 September 2006 in the event of a reference to the Competition Commission concerning future arrangements beyond 2005. Although Oftel would expect the controls to run for the period specified, it notes that new EC Directives concerning interconnection charges are due to come into force before the end of the proposed period of control. Oftel will naturally ensure that its actions remain consistent with any changes to the European legal framework.

3.14 As before, Oftel proposes that interconnection services should be charge controlled according to the extent of competition in the relevant interconnection market. Interconnection services will continue to be classified in one of the four following categories of competitiveness:

• Competitive Standard Services;
• New Standard Services;
• Prospectively Competitive Standard Services;
• Non-Competitive Standard Services

3.15 Oftel proposes that services should remain in these current categorisations of competitiveness until the Director General determines otherwise. The only exceptions to this are IDD conveyance, which is now provided by Concert (BT offers an IDD service via Concert, but BT’s conveyance services to Concert are controlled separately from Concert’s IDD control) and access to DAS as this service is no longer provided.

3.16 Controls will not be applied to interconnection services determined to be competitive. In order to ensure that incentives to innovate remain, new services will not generally be subject to charge controls on their introduction. However, Oftel will retain the power to charge control new services before they are introduced or subsequent to their introduction. Oftel proposes that prospectively competitive services should continue to be subject to ‘safeguard’ caps that are set at RPI+0%, the controls to be disaggregated by time of day, day of week and distance as necessary. However, the expectation is that competition rather than the safeguard cap will be the binding constraint on the charges for these services. Non-competitive services will be grouped into five ‘baskets’ of services. Table 3.2 below sets out the proposed non-competitive ‘basket’ structure from 1 October 2001. Oftel proposes that the ‘baskets’ of Non-Competitive Standard Services will be subject to RPI-X% controls limiting the increase in the charges for the services within each basket.

Table 3.2 – Non-competitive services, October, 2001

Revised basket structure: creation of a Tandem Layer Basket

3.17 The non-competitive basket structure follows broadly the structure introduced on 1

October 1997. However, Oftel proposes that call origination should be removed from the General Network Basket and placed in a new Call Origination Basket. Oftel has proposed to split local exchange services and tandem services in order to separate interconnection services utilising capacity at different layers of the network. It is necessary to separate services according to utilisation of the network because of the uncertainty surrounding the costs and volumes of tandem usage following Oftel’s proposals for Flat Rate Internet Access Call Origination (FRIACO) at the tandem layer.

3.18 In its draft Direction concerning FRIACO, Oftel proposed that BT should

meet some of the demand for tandem capacity by migrating some interconnection traffic to the DLE, providing transmission from the DLE to the OLO’s switch at the tandem layer. BT would continue to charge for this service as though the physical point of interconnection continued to be at the tandem switch. It would be a ‘virtual’ tandem interconnection service. Under Oftel’s proposals, the cost of the interconnection arrangements from the DMSU to the DLE would be borne by BT at the time of the rearrangement. If the costs of the ‘virtual’ service turned out to be higher than the costs of the actual local to tandem service – because the costs of the rearrangement and local to tandem transmission exceeded the costs saved through avoiding the use of actual local to tandem conveyance – Oftel believes these costs should be recovered through an addition to charges for services involving use of the tandem layer of BT’s network. This is because the costs arise from the need to expand supply to meet demand for tandem layer services. All users of tandem services contribute to the demand being served, and so it is both equitable and efficient that they should all contribute to the costs of meeting this demand.

3.19 The simplest way of achieving this would be by adjusting downwards the level of ‘X’ for the tandem basket. Oftel intends to obtain the best information it can on the likely cost of such rearrangements before inviting BT to agree to the licence modification formally. If the net cost is significant, it will propose a reduction in the value of ‘X’ for the tandem basket, ie a lower value than is set out in this document. The reduction would be calculated to be sufficient to allow BT to recover the net costs in present value terms over the period of the control remaining when the adjustment took place.

Oftel’s proposals for future regulation of Flat Rate Internet Access Call Origination (FRIACO)

3.20 Flat Rate Internet Access Call Origination (FRIACO) is an unmetered call origination interconnection service which has been available from BT since June 2000. It is to be used in the provision of Internet access over the PSTN. The service provides virtual capacity from the customer through the concentrator up to a port on the network side of the local exchange at a fixed fee, which does not vary with the volume of traffic carried up to and through the port. This service is called Flat Rate Internet Access Call Origination (FRIACO) at the DLE. It is similar to and, is subject to the same level of competitiveness as, call origination. As set out above, BT’s is expected to remain dominant in the call origination market over the next charge control period.

3.21 This implies that, as set out in Oftel’s October 2000 consultative document, there is a need for regulatory control of the charge for FRIACO, because BT is dominant in call origination interconnection services. In that document, Oftel proposed that regulatory control of FRIACO should be taken forward by incorporating the charge for FRIACO into the Network Charge Controls from October 2001.

3.22 In November 2000, Oftel published a draft Direction, ordering BT to provide a flat rate wholesale service between the DLE and BT’s tandem switches, which is where most OLOs have their points of connection with BT’s network. This service is equivalent to FRIACO at the DLE plus unmetered local-tandem conveyance. As set out above, local-tandem conveyance is also considered to be a non-competitive service, so regulatory control of the unmetered local-tandem service is also appropriate. This service (which in total constitutes single tandem FRIACO) has not yet been introduced, though Oftel expects shortly to finalise its views on the requirements which should be placed on BT. Since the decisions have not been finalised, there is currently no single tandem FRIACO service in existence, nor is there any determined charge in place. Should a service be introduced at a determined charge, Oftel believes it would be appropriate for the charge to be subject to an RPI-X charge control. Therefore, it is proposed that any charge for ‘single-tandem FRIACO’ should also be subject to a control of the RPI-X type.

Flat Rate Internet Access Call Origination Basket: FRIACO at the DLE

3.23 The charge for FRIACO at the DLE has three components, as follows:

        A. local exchange call origination (LECO) circuit (excluding FRIACO port at DLE)

        B. FRIACO port at DLE

        C. PPP per FRIACO port

3.24 In calculating the FRIACO charge, the charge for the call origination circuit, A, is

multiplied by an adjustment ratio which reflects the number of call origination circuits required per FRIACO port. The charge for FRIACO at the DLE is then derived as:

        A. x AR(LECO) + B. + C.

        where AR(LECO) is the relevant adjustment ratio

3.25 In October 2000, Oftel set out its view that it would be appropriate to include only the charge for a call origination circuit and not the effects of the adjustment ratio in the Network Charge Controls. Oftel continues to believe that this is appropriate. This is because, for the most part (though not entirely), the influences on the adjustment ratio are not related to greater or lesser efficiency on the part of BT and so would be better addressed outside of the charge cap controls (by periodic review).

3.26 Two further charges would need to be specified for single-tandem FRIACO, as follows:

        D. Local-tandem circuit (excluding FRIACO port at tandem switch)

        E. FRIACO port at tandem switch

3.27 The charge for Single tandem FRIACO would then be derived as:

        A. x AR(LECO) + (B. + D.) x AR(L-T) +E. + C.

where AR(L-T) is again the relevant adjustment ratio reflecting the number of DLE ports and local tandem circuits required per tandem port. Since the adjustment ratios are expected to change over time, A. & B. and D. & E. need to be separately identified.

3.28 The charge control for DLE FRIACO will apply to the individual component charges (that is, the maximum increase for each component will be limited to RPI-X%). Otherwise, BT could gain revenue by increasing the charges for A. and B. matched by declines in the charges for the other ‘components’. It is possible to illustrate this with a simple example. Suppose that the charges for a call origination circuit and a FRIACO port at the DLE are both initially 1 and that the adjustment ratio is 2.2. Then revenue per unit is:

        1 x 2.2 + 1 = 3.2

3.29 However, increasing the circuit charge by 10% and reducing the port charge by 10% yields an increase in revenue per unit because of the adjustment ratio, as follows:

        1.1 x 2.2 + 0.9 = 3.32.

Starting charges

3.30 In October 2000, Oftel proposed that the charge for FRIACO at the start of the next charge control should be based directly on the cost of a call origination circuit, using data on the numbers of such circuits and the costs of providing them. This would be different from the method used in the Determination of May 2000, which was necessitated by deficiencies in the available data. However, Oftel believes that the charges calculated directly from the cost data should be consistent with those implied by the May 2000 methodology, once that is adjusted for the effects of the known data deficiencies. Oftel has therefore attempted to reconcile the charge which would be set using the methodology set out in the Determination, if this were rolled forward to 2001, with the proposed starting charges for the new Control calculated from costs per circuit. This shows that, at the start of the new Control, the charges calculated according to the two methodologies differ by only a relatively insignificant amount.

3.31 Stability in the FRIACO charge is important for operators using this service. For this

reason, Oftel proposed in October 2000 that, if there were a significant difference between the charge calculated from cost data, and the charge derived from the Determination, Oftel would not move immediately to the former at the start of the next charge control period but would smooth the change over time by reflecting the difference in the value of ‘X’. In the event, the consistency between the two methods means that the charges calculated from cost data can be used as the new starting charges.

3.32 Oftel also stated that the charge for FRIACO should be consistent with the metered

pence per minute charges, to avoid artificial incentives for interconnecting operators to use one type of charging structure rather than the other. To achieve such consistency in the starting charge for FRIACO, Oftel has calculated the average circuit cost using BT’s expected rate of return on per minute call origination services at the start of the next charge control period, rather than at the cost of capital. As for other price capped services, the value of X has been set so as to drive out super-normal profits by the end of the control period given projected changes in unit costs.

3.33 The FRIACO charges have been set by projecting 1999/2000 data on costs per circuit forward on the basis of reductions in costs forecast by Oftel’s financial model of BT. They are thus consistent with the projections used to set the values of ‘X’ for the other charge control baskets. An allowance for expected inflation has also been included. The adjustment ratio has been updated to reflect changes in rates of circuit utilisation since the Determination. This is equal to 2, since the Erlangs per Circuit for the Internet ports is estimated to be 0.7, while the equivalent figure for the LECO circuit is 0.35. However, any future revisions will be taken forward outside the charge control and no forecasts of changes in the ratio have been made in the financial modelling.

3.34 Oftel’s proposals for the revised FRIACO starting charges to apply from October 2001, are:

3.35 The charges set in the May 2000 Determination will be rolled forward in April 2001. The value of ‘X’ set out in this Statement will then apply to the new starting charges which will apply from 1 October 2001.

Separate baskets for metered and unmetered call origination

3.36 In the October 2000 consultative document, Oftel noted that there were both advantages and disadvantages to incorporating the charge for FRIACO into the General Network Basket alongside metered call origination. This would have the advantage of giving BT some flexibility to alter their relative prices. As long as BT’s incentives in setting the charges for metered and unmetered call origination services were undistorted, it would be able to set such charges to provide appropriate relative price signals to interconnecting operators.

3.37 However, it is necessary to guard against potential anti-competitive behaviour. One possibility was that the use of prior year revenue weights could have given BT an excessive incentive to increase the charge for FRIACO, whose volume is likely to be increasing quickly, relative to the charge for other slower-growing services in the General Network Basket. On balance, Oftel believes that the risk of such distortions outweighs the advantage of flexibility and that the charges for FRIACO should be under a separate cap.

3.38 As noted above, Oftel now proposes that there should be two FRIACO services with connection at the DLE and at the tandem switch respectively. This raises the question of whether there should be just one basket covering both. Oftel believes that there are grounds for placing them in separate baskets in order to mirror the revised arrangements for metered services. Therefore, the charge for single-tandem FRIACO, once set, will be subject to a separate control.

Intelligent Network (IN) services for FRIACO

3.39 In order to make use of the FRIACO product, operators must pay an additional charge for provision of grooming services (Intelligent Network (IN) services). As stated in the FRIACO determination, May 2000, the IN charge is classed as a new service under the Network Charge Controls. As such, IN charges are not immediately regulated.

3.40 However, under the Network Charge Controls, operators are free to make representations about the competitive categorisation of services. If Oftel receives a representation in this regard, it will consider it in the normal manner.

Values of ‘X’ for the non-competitive baskets

3.41 Decisions on the value of ‘X’ are based on the outputs of Oftel’s financial model of BT and depend on assumptions made about the key variables in the model. These variables include anticipated future market growth, BT’s anticipated market share, the scope for efficiency improvements, expected asset price changes and Oftel’s view of BT’s cost of capital in providing these services. Greater detail regarding the modelling underlying the values of ‘X’ can be found in Chapter 4, where the assumptions and forecasts used in setting the values of ‘X’ for the charge controls to take effect from 1 October 2001 are set out. Oftel’s calculation of BT’s cost of capital is set out at Annex E.

3.42 In the October consultative document, Oftel set out preliminary ranges for the value of ‘X’ for period 2001 to 2005. The range of ‘X’ outlined in that document received broad support from operators other than BT. They suggested that the values of ‘X’ should be towards the higher end of the range. BT suggested that the values of ‘X’ should be slightly below the range outlined by Oftel. Oftel has considered all of the responses and has now finalised its view on the appropriate value of ‘X’ for each non-competitive interconnection basket.

3.43 Oftel proposes the following values of ‘X’:

• For call origination and call termination it will be 10;

• For Tandem Layer Basket it will be 13;

• For the Interconnect Specific Basket it will be 8.25; and

• For the Flat Rate Internet Access Call Origination Basket it will be 7.5.

Services currently classified as Prospectively Competitive Standard Services

3.44 The services currently categorised as Prospectively Competitive Standard Services are:

• Inter-Tandem Conveyance;
• Inter-Tandem Transit;
• Non-Conveyance element of Directory Enquiries;
• Non-Conveyance element of International Directory Enquiries;
• Entries onto BT’s Operator Services Information System (OSIS) Database;
• Supply of Phonebooks; and
• Supply of Customised Phonebooks

These services are currently subject to safeguard controls of RPI+0%. In the case of each of these services, there has been insufficient evidence of vigorous competition to warrant a reclassification of the services as effectively rather than prospectively competitive. While charges have been maintained at levels below the safeguard caps in most cases, this has been largely a consequence of BT’s choosing not to raise charges in line with RPI, rather than because BT has been forced to respond to competition.

3.45 Oftel proposes that these services should continue to be classified as Prospectively Competitive Standard Services and that the charges for these services be subject to individual safeguard controls set at RPI+0% disaggregated by time of day, day of week and distance where necessary (eg daytime, Inter-Tandem Conveyance Short <100km is subject to an individual safeguard cap). Oftel believes that these services could be subject to competitive pressure in the period 2001 to 2005.

Competitive Standard Services and New Standard Services

3.46 BT will be free to set the charges for Competitive Standard Services and New Standard Services subject to normal competition rules. However, Oftel retains the power to introduce charge controls should it find that BT is dominant in the provision of the relevant service.

Other Network Charge Control Related Issues

Network Charge Change Notifications (NCCNs)

3.47 Network Charge Change Notifications (NCCNs) are notifications sent by BT to interconnecting operators and Oftel to pre-advise of changes to the charges or the structure of the charges of interconnection services. The notification period is intended to allow other operators to introduce a competitive response to a BT charge change. From October 2001, Oftel proposes that BT should continue to meet this pre-notification requirement. These pre-notification requirements are the same as those under the present Network Charge Controls. The notification requirements are as follows:

• Non-Competitive Standard Services – BT will be required to publish the NCCN for charge changes or changes to the structure of the charge ninety days before the change to the charge can become effective.

• Prospectively Competitive Standard Services – BT will be required to publish the NCCN for charge changes or changes to the structure of the charge twenty-eight days before the change to the charge can become effective.

• New Standard Services – BT will be required to publish the NCCN for charge changes or changes to the structure of the charge twenty-eight days before the change to the charge can become effective.

• Competitive Standard Services – BT will be required to publish the NCCN for charge changes or changes to the structure of the charge one day before the change to the charge can become effective.

Reciprocal charges for call termination

3.48 Since 1 October 1997, charges for fixed call termination on OLOs’ networks have been set according to an agreement between OLOs and BT, which reflects the principle of reciprocity. Broadly, OLOs have received per minute payments from BT given by a weighted average of the charges paid to BT for local exchange and single tandem call termination on its network. Whether this has resulted in receipts or outpayments has been dependent on the level of traffic heading in both directions (and other details in the calculation, such as lags in the weights). This agreement is due to expire on 30 September 2001.

3.49 Oftel believes that it remains appropriate for the industry to reach agreement on the specifics of the agreement for call termination based upon reciprocity to take effect from October 2001. Responses were supportive of the continuation of reciprocal charging arrangements. Oftel expects that the industry will lead on this and agree principles in line with those agreed at the outset of the agreement on reciprocal charges for call termination.

Call origination charges: indirect access and Number Translation Services

3.50 In the October consultative document, Oftel set out its provisional views on the question of whether call origination charges for indirect access and Number Translation Services (NTS) should be aligned. It stated that it believed that there were legitimate reasons for call origination charges for indirect access services and number translation services (NTS) to differ, and so it did not propose to align the charges.

3.51 In particular, Oftel noted that indirect access call origination is a wholesale interconnection service whereas NTS call origination is a hybrid between a wholesale interconnection service and a retail service. Oftel stated that it was therefore legitimate for NTS call origination services to include a contribution towards the retail functions, such as billing, carried out by the originating operator. However, Oftel noted that indirect access operators should not have to contribute towards the originating network’s retail costs since they carry out a comparable function at the retail level and incur their own retail costs. Having considered the responses to the consultative document on these issues, Oftel proposes to follow the approach it set out in the October consultative document, that is not to align the charges.

Geographic averaging of interconnection charges

3.52 BT has to charge the same for interconnection services throughout the UK. It cannot charge less on routes where competition is greatest in comparison to routes in which there is less competition. It also has to charge the same amount for interconnection in remote areas as it does in urban areas even though the costs differ. Oftel proposed in the October consultative document that these rules should remain.

3.53 In its response to the consultative document, BT argued that:

1. geographic de-averaging of wholesale conveyance would give it flexibility to raise charges where there is excess demand for capacity and reduce them where capacity is spare;
2. the tariff gradient should be allowed to vary geographically to reflect different patterns of demand by time of day in different areas; and
3. wholesale and retail de-averaging should not be linked.

3.54 In connection with the first point, BT asserts that rural customers are subsidising urban investment. But this does not seem sustainable. Investment in new switches in urban areas should lead to lower rather than higher average costs as they should be at least as efficient as existing assets and economies of scale in call conveyance mean that average costs should fall as traffic volumes increase.

3.55 De-averaging wholesale charges without also de-averaging retail prices would seem to give scope for an anti-competitive margin squeeze, since wholesale charges could be raised in some areas while retail prices remained geographically arranged. Oftel’s conclusion is that wholesale charges should continue to be averaged geographically.

Guidelines on the Operation of the Network Charge Controls

3.56 The Guidelines on the Operation of the Network Charge Controls were published in October 1997. Oftel will update the Guidelines on the Operation of the Network Charge Controls for the new charge controls arrangements, which are due to take effect in October 2001. Oftel aims to consult on the updated version of the guidelines before Easter 2001.

Rollover of the Network Charge Controls

3.57 The proposal set out in this document is that Network Charge Controls should apply for the four-year period from 1 October 2001 to 30 September 2005. Before the end of this period, Oftel will consider whether there is a need for further controls beyond October 2005. If Oftel concludes there is such a need, it will put its proposals to BT in time for agreement to be reached before the expiry of the controls proposed in this document (ie before October 2005). If BT does not accept those proposals, Oftel may refer the issues to the Competition Commission. In order that controls would continue to apply while the Commission conducted its Inquiry, Oftel proposes that the charge controls currently proposed should be rolled forward for a year in the event that a reference to the Commission is necessary in 2005.

Modifications to BT’s licence

3.58 The proposed modifications to give effect to the proposals outlined in this Chapter can be found at Annex F. Oftel is formally consulting on the proposed modifications.

The controls set out in this Chapter will commence on 1 October 2001, if BT agrees to them. If not, the Director General may refer the matter to the Competition Commission for investigation. Should a reference to the Competition Commission be needed, the Director General would determine that the present controls should rollover whilst the Competition Commission was undertaking its investigation.

Network Charge Controls and NetCo

3.59 The effect of any changes to BT’s corporate structure in relation to the Network Charge Controls will be considered as, when and if they take place.

Concert and the Network Charge Controls

3.60 In January 2000, Concert, a joint venture between BT and AT&T, took over all of BT’s international network facilities. At that time, the joint venture started to provide all international interconnection services to BT’s retail arm and other operators. These services were controlled under the Network Charge Control regime. Oftel stated in a consultative document published in June 1999 – BT/AT&T proposed joint venture – that it would maintain continuity in the regulatory regime that was applied to BT and that that would be applied to Concert. Therefore, certain obligations that had been applied to BT before the transfer of the international network facilities and associated activities to Concert have applied to the joint venture. These obligations include elements of the Network Charge Control regime.

Connection at Concert’s international switches

3.61 At present, the charges for physical connection at Concert’s international switches (DISCs) are subject to controls set at RPI-8%. These controls replicate the controls that are applied to connection at BT’s inland network. However, Oftel believes that connection at Concert’s international switches is subject to some competitive pressure from other operators offering alternative international facilities and indirectly from BT’s inland network. BT’s inland network provides an indirect constraint because operators can deliver calls bound for international destinations to BT, which would then convey the calls to Concert’s international facility for onward conveyance. Oftel has proposed that BT’s inland services should be subject to further charge controls.

3.62 Oftel proposed, in the October 2000 consultative document, that Concert should be free to set charges for connection to its international switches. After considering responses to the consultative document, Oftel continues to hold this view. Fifteen operators presently interconnect at Concert’s international switches, but all purchase the international link to the international switch from BT so no operator currently purchases interconnection to Concert’s Digital International Switching Centre. The charge control on this service is therefore effectively redundant. In the light of this, Oftel therefore proposes that with effect 1 October 2001, Concert will be free to set charges for connection at its international switches. Concert will be obliged to give one day’s notice should it change the charges or the structure of the charges for these services.

International conveyance and product management, policy and planning

3.63 International interconnection conveyance services are either competitive or prospectively competitive. All of the prospectively competitive routes have the potential to become competitive, and in the longer-term Oftel expects to be able to withdraw from controls for international conveyance services. Indeed, in its statement Competition in International Markets, March 2000, Oftel found that twenty-six wholesale international conveyance routes were effectively competitive. In the interim, however, other routes have been subject to safeguard controls set at RPI+0%.

3.64 Product management, policy and planning (PPP) is a surcharge levied on each international outgoing conveyance minute. It contributes to interconnect specific costs such as billing. It is currently controlled within the Interconnect Specific Basket with connection at Concert’s international switches. This basket is subject to RPI-8% controls.

3.65 From 1 October 2001, Oftel proposes that the safeguard controls should apply to the total charge for international interconnection services including the PPP element. This control will be set at RPI+0% and will apply to all prospectively competitive conveyance international interconnection services. Oftel does not expect that this control will be binding in practice as competition should provide the longer-term constraint on charges.

3.66 Oftel proposes that Concert should give twenty-eight days’ notice before changing the aggregated charge for the product IDD and PPP. The NCCN should refer to the total charge including IDD and PPP and the effect – either negative or positive – of the charge change on the aggregated charge.

Modifications to Concert’s licence

3.67 The proposed modifications to give effect to the proposals outlined in this section can be found at Annex G. Oftel is formally consulting on the proposed modifications.

Chapter 4: Financial modelling – main assumptions

Introduction

4.1 Annex B to the October 2000 consultative document proposed a range for the values of ‘X’ for interconnection charges of 7.5 – 11.5. It set out the key assumptions underlying this range. However, it stated that Oftel had not yet reached a final view as to appropriate values for these assumptions and asked for views. This Chapter sets out the conclusions which Oftel has reached on these underlying assumptions, in the light of responses to the October 2000 document, and proposes values of ‘X’ for the network charge control baskets.

Key modelling assumptions

4.2 The main modelling assumptions concern: cost of capital; the appropriate cost basis to use; efficiency; market growth; market share; cost- and asset-volume elasticities; investment; changes in asset and other input prices; routing factors; the number of baskets; and the treatment of FRIACO costs.

Cost of capital

4.3 The cost of capital is the minimum rate of return which investors require in order to be persuaded to invest in BT. In a competitive market, one would expect competitive pressure on prices and profits to reduce returns approximately to the cost of capital. Whilst actual returns in any year might differ from the cost of capital, for example, if a firm introduced an innovative product, one would not expect to see returns persistently above (or below) the cost of capital in a competitive market.

4.4 Oftel’s practice is to set ‘X’ so that the value of BT’s rate of return projected by the financial model for the last year of the price control is equal to the cost of capital. This approximates to the workings of a competitive market in which excess profits are gradually eroded by competition.

4.5 The way in which Oftel has estimated BT’s cost of capital is described in detail in Annex E to this Statement. Oftel has used a number of methodologies but has placed most emphasis on the Capital Asset Pricing Model (CAPM). Under the CAPM, BT’s cost of equity (which is combined with the cost of debt to yield the weighted average cost of capital) depends on three parameters: the risk free rate; the equity risk premium; and the company’s beta (the parameter in the cost of capital formula which reflects the riskiness of BT shares relative to the market as a whole).

4.6 Oftel’s views on appropriate values for these parameters are also set out in Annex E. However, it is worth noting here that Oftel’s estimate of the equity risk premium is somewhat higher than that used by some other regulators. Oftel considers that the available evidence supports its estimate. It should also be borne in mind that telecommunications markets are very different to the more stable environments enjoyed by the traditional utilities. In particular, there is a large amount of discretionary investment at stake, and the consequences of underestimating the cost of capital are that this investment could be deterred, with inevitable effects on quality of service and innovation.

4.7 The range of ‘X’ reported in Annex B to the October 2000 document was based on a cost of capital of 12.5% before tax in nominal terms. However, Oftel has accepted that account should be taken of updated estimates of beta and of BT’s plans to reduce its level of gearing in response to financial market concerns that its debt levels are too high. However, these adjustments are partly offset by a fall in the risk free rate of return. The combined effect of these changes is to raise the cost of capital to approximately 13.5%.

4.8 Oftel believes that the higher cost of capital is justified because, as noted above, BT’s network business is increasingly unlike a traditional, stable utility business. In particular, growth in the Internet means that demand for network services is likely to grow rapidly, but to be subject to considerable uncertainty. Considerable investment will be required to meet this demand. Yet, at the same time, the degree of uncertainty means that BT’s capacity to assume debt may be limited. Given the relatively high traffic growth assumptions which underlie the values of ‘X’, it would be inconsistent also to assume a cost of capital more appropriate to a stable utility-type business which could readily assume large amounts of debt.

4.9 Oftel has based its modelling on a cost of capital of 13.5%.

Cost basis for the Network Charge Controls

4.10 The value of ‘X’ in the current Network Charge Controls and the starting charges applied at the beginning of the control in 1997 were set at a level which would allow BT to recover, from network charges, the incremental costs of providing network services and, in addition, a reasonable contribution to the common costs of providing access and conveyance. Oftel deemed that a reasonable contribution would be made by allowing an equal proportionate mark-up (EPMU) over long-run incremental costs (LRIC). The incremental costs of access and a similar equal proportionate share of common costs were deemed to be recoverable from BT’s retail customers.

4.11 Prior to this, BT’s network charges had been based on fully allocated historic costs (FAC HCA). Oftel argued that the change in the cost basis was necessary because LRIC "better reflects the basis on which commercial businesses in competitive markets make investment decisions and thus provides the industry with more appropriate price signals" (Network Charges from 1997, July 1997). However, the most important change made at the last review was the switch from historic cost (HCA) to current cost (CCA), and CCA FAC and LRIC + EPMU data may not be very different.

4.12 Since 1997, BT has changed the way costs are attributed in its LRIC model. Specifically, as a corollary of the removal of the local ends of private circuits from the access business to the network business, the cost of duct has been treated as a common cost of access and the core network. Oftel believes that this change is not economically justified and that the cost of duct should continue to be regarded as part of the incremental costs of the access network since it is clearly associated with the provision of local lines. This change also results in an inconsistency with the way the charge control was set in 1997 and with the way the charge for LLU has been set.

4.13 Oftel believes that, more important than strict consistency with the way charges were set in 1997, is the consistency of the network charge control and the LLU charge. This is necessary in order to avoid the double recovery of some costs, firstly in the charge for LLU and secondly in the charges for network services which could result from inconsistent treatments of common costs. Oftel has therefore produced a reconciliation of the allocation of Access/Network common costs in the LLU exercise and the Network charge control.

4.14 In order to produce an appropriate estimate of LRIC+EPMU for charge control purposes, it is necessary to adjust the allocation of costs made by BT’s LRIC model by moving duct assets out of access-network common costs into the incremental costs of access. By this means, it has been possible to produce estimates of costs on a LRIC+EPMU basis for the Network Charge Controls which are consistent with the LLU charges.

4.15 For the purposes of the charge control review, BT has provided base year cost data on the basis of both fully allocated costs on the current cost (CCA) convention and LRIC+EPMU, consistent with LLU. As with LLU, the total costs of inland conveyance on a LRIC+EPMU basis are not significantly different from CCA FAC.

4.16 The cost data underlying the Network Charge Controls are consistent with those used for setting the LLU charges.

Efficiency

4.17 The model runs underlying Annex B to the October 2000 consultative document were based on the assumption that BT would be able to achieve the same underlying rate of real unit cost reduction (ie before volume effects and catch-up) over the period 2001-2005 as it had over the period 1995/1996-1998/1999, in other words, the time since the last review of BT’s comparative efficiency. The method used to estimate the underlying rate of unit cost reduction was as follows. First, the actual rate of reduction of BT’s real unit costs over the period 1995/1996-1998/1999 was calculated. This was then decomposed into parts representing the contributions of volume growth (with a cost-volume elasticity of significantly less than one, volume growth leads to falls in average costs), catch-up of inefficiency existing at the start of the period, changes in real input prices and underlying efficiency gains.

4.18 As in the last price control review, Oftel has commissioned from NERA a study of BT’s efficiency relative to that of appropriate comparator companies, principally the US LECs. At the time of the October 2000 consultative document, NERA estimated that BT was still about 2%-4% less efficient than the best performing LECs in 1998/1999. It is reasonable to expect inefficiency existing at the start of the charge control period to be eliminated over the life of the control, just as competitive pressure would force companies to become efficient in a competitive market. The underlying rate of reduction expected over the period 2001-2005 is therefore adjusted to reflect expected catch-up of current inefficiency. On this basis, Oftel stated that it is reasonable to expect reductions in real unit costs of about 1.7% – 2.6% per annum over the next price control period, including the effects of expected catch-up but before real input price changes and volume effects.

4.19 In fact, all the runs underlying the range of ‘X’ given in October 2000 were based on the middle of the above range, that is 3% inefficiency, and the central cost-volume elasticity assumption. The underlying rate of real unit cost reduction implied by this combination of assumptions was 2.15% per annum.

4.20 NERA has now updated the study of BT’s efficiency using 1999/2000 data. This enables the next charge control to reflect the most up-to-date data on relative costs. NERA estimate that BT is between 1.2% and 4% less efficient than best practice, the upper and lower figures reflecting different methodologies used. Oftel has therefore assumed 2.5% inefficiency in 1999/2000, approximately the mid-point of the range suggested by NERA’s estimates. The data from which the underlying rate of unit cost reduct