March 2000

Contents

Summary

Chapter 1     Introduction

Chapter 2     Price Control Review – results of consultation

Chapter 3     Retail price controls – Initial proposals and coverage

Chapter 4    · Network charge controls   
                    · Interconnection arrangements for Number Translation Services (NTS)
                    · End-use pricing
                    · Two-part interconnection charging
                    · Capacity charging

Chapter 5     Financial modelling and cost of capital

Chapter 6    Form of controls and general issues in price cap regulation

Consultation

Annex A  List of recipients of consultation document

Annex B  Responses to consultation

Annex C  The Consumer Panel and Oftel’s Expert Advisers

Annex D  The setting of X for the residential basket

Annex E The recovery of common costs between network and access

Annex F Glossary

Summary

S1 Oftel’s overall goal is to achieve the best possible deal for consumers in terms of quality, choice and value for money. Oftel believes that competitive markets are the best way of meeting consumer needs and achieving Oftel’s overall goal. An effectively competitive telecommunications market would lead to high quality of service and low prices.

S2 As set out in Oftel strategy statement: Achieving the best deal for telecoms consumers (January 2000) 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. Equally a failure to regulate where it is needed can harm consumers’ interests. As stated in the strategy statement, Oftel believes that price control can be justified to protect consumers in markets where competition is ineffective now and is likely to continue to be ineffective. In such circumstances controlling the prices of the dominant player may be the appropriate regulatory intervention. This is the approach favoured by Oftel in both retail markets and markets for interconnection services.

S3 In July 1999 Oftel published the consultation document Price Control Review: Future developments in the competitiveness of UK telecommunications markets. This document sought comments on the competitiveness of telecommunications markets at present, and views on how competition is likely to develop up to and beyond the ending of the current controls in 2001. Oftel has considered all the responses to the July consultation document, and is now putting forward its initial proposals for future retail price and network charge controls.

Retail price controls

S4 Since 1 August 1997, a price cap has controlled the increases that BT can make to its residential line rental and the prices of local, national and international calls to geographic numbers (excluding payphones). This cap controls the average price for these services, with the average being weighted by reference to the expenditure on these services by the lowest spending 80% of BT’s residential customers. The control is currently set at a level of

RPI-4.5% and the current control period is set to end in July 2001.

S5 While Oftel believes that competition in telecommunications markets has increased since the start of the present controls, it is not convinced that this increase in competitiveness of telecommunications markets is sufficient to protect lower spending customers now or in the period immediately after the expiry of the present controls. Oftel therefore believes that regulation of BT’s retail prices or other measures to constrain them may be needed beyond July 2001. Chapter 2 of this document outlines three possible approaches to constrain BT’s retail prices, the third of which has a number of variants.

S6 Approach 1 consists of the continuation of price controls broadly along the lines of the present controls, with a retail price cap focussed on lower spending residential customers.

S7 Approach 2 reflects the fact that the prices of BT’s services provided to customers outside the current controls have not fallen as far or as fast as Oftel expected when the current controls were set. Under Approach 2 price controls would be extended to cover all BT’s residential and business customers.

S8 Approach 3 is based on the premise that additional competitive pressures would be desirable, and preferable to an extension of price controls. Approach 3 has five variants, all of which involve the introduction of a cost based access product and the extension of interconnection rights to service providers.

S9 The changes envisaged under Approach 3 would be likely to increase competition at the retail level, though lower spending customers might not benefit from this competition. Variant 3 (i) would include the continuation of controls broadly along the lines of the present controls in addition to the introduction of the cost based access product and the extension of interconnection rights to ensure that low users continued to benefit from price reductions. However, Oftel recognises that this combination of arrangements could be inconsistent with BT’s ability to recover its costs. Strong competition in the more profitable sections of the market might make it difficult for BT to comply with price controls on lower spenders and recover its costs at the same time.

S10 In recognition of this potential difficulty, four other variants are considered. Variant 3 (ii) would involve the complete withdrawal of price controls. While this would allow BT to fully recover its costs, it could also result in increases in BT’s residential line rental. A large increase in the residential line rental would be likely to disadvantage low users.

S11 Variant 3 (iii) would address this difficulty, as Oftel would constrain increases in BT’s line rental price for all customers. Under this approach, the difficulty identified under Variant (i), that BT might be unable to cover its costs, would be addressed by allowing BT to recover a greater proportion of common costs through interconnection charges than it is permitted to do at present.

S12 Variant (iii) focuses protection on a service (ie by restricting rises in the line rental) rather than on customers who need protection. Variant (iv) focuses on a protection of the lowest spending residential customers through a control on their bills. The resulting shortfall in cost recovery would be met from a Universal Service Fund. This variant would allow BT to rebalance its tariffs – increase the line rental and decrease call prices – for customers who were not protected.

S13 Variant (iv) might lead to some movements in the line rentals and possibly in the bills of some customers. Variant (v) addresses this concern by allowing gradual increases in BT’s line rental.

S14 Oftel is not committed to any of the approaches outlined above. Each of the approaches has its benefits and disbenefits. It is also possible that some responses will propose different approaches for retail price controls. Oftel would consider the merits of any new approaches proposed by respondents to this consultation document.

Network charge controls

S15 Network charges are the charges levied by BT to other operators for connection to and conveyance over its network. Currently, the charges for some of BT’s interconnection services are subject to charge caps which operate in much the same way as the retail controls. As with the retail price controls, and consistent with Oftel’s overall strategy, the network charge controls only apply to services for which there is not effective competition either now or in the next charge control period.

S16 Oftel does not believe that the market for interconnection services has sufficiently increased in competitiveness to allow Oftel to relax the present controls. Under the current controls, interconnection services are deemed to be competitive, prospectively competitive or non-competitive. BT’s free to set the charges for competitive services; a safeguard cap (RPI+0%) controls prospectively competitive services; and a control of RPI-8% is placed on non competitive services, which are grouped into one of three charge control baskets.

S17 Oftel proposes that, whichever of the retail approaches is favoured, BT’s interconnection services should remain in the same categorisation of competitiveness that they were placed in at the start of the current network charge controls. Oftel also proposes that the non-competitive interconnection services should remain in the same baskets that they were placed in at the start of the current controls. The exact level of the controls has to be decided.

S18 In addition to these proposals Oftel has proposed a possible extension of interconnection rights and that BT should introduce a cost based access interconnection product (see paragraph S8 above).

Consultation

S19 This consultation document contains Oftel’s initial thinking on controls on BT’s retail prices and network (interconnection) charges when the current controls end in 2001. Oftel is seeking comments on these initial views and will will publish a further consultation document in July 2000 setting out firm proposals. Oftel’s final proposals, and licence modifications to give effect to those proposals, will be published in December 2000. Oftel would be grateful for comments on the proposals put forward in this consultation document or would consider suggested alternative arrangements. Comments are sought by 5 May 2000 and comments-on-comments are required by 19 May 2000.

Chapter 1

Introduction

1.1 This document is the second stage of consultation in the review of controls on BT’s retail prices and network charges. An earlier document was published in July 1999, which focused on competition in telecommunications markets and possible developments which may affect the competitiveness of markets between now and the ending of the next price control period. Oftel received 34 responses to that document and 2 comments on initial responses. Oftel is grateful to respondents for their contributions.

1.2 Responses to the first consultation document confirmed Oftel’s thinking that not all retail and interconnection markets are effectively competitive. Oftel, therefore, believes that further regulation may be required beyond 2001. This document considers what form this regulation might take and includes options for the coverage of new retail price and network charge control arrangements for the period from 2001 to replace the existing controls when they expire. The competitiveness of markets and likely developments in competitiveness are the most important factors in determining the coverage of any new controls, and so responses to the first consultation document have been particularly important in developing these proposals. The document also makes proposals about the form of price and charge controls for the next period, and explains the modelling methodology which Oftel will employ.

Timing of the Review

1.3 Following consultation on this document, a further stage of consultation will be published in July 2000. A Statement containing Oftel’s final proposals for price and charge controls together with licence modifications for statutory consultation will be published in December 2000.

1.4 Whilst this document contains Oftel’s initial proposals for price and charge controls, it is important to emphasise that the review will run throughout 2000. All elements of the review, including consideration of competitiveness of markets and developments thereof, will continue to run until Oftel makes its final proposals in December. Oftel looks forward to discussion and debate with the industry, consumers and their representatives, and other interested parties throughout this process.

Rollover

1.5 The current retail price controls on BT are scheduled to end in July 2001, and the current network charge controls in September 2001. Normally, this would require Oftel to complete the price control review in summer 2000. This is because it is necessary to allow a year between final proposals and implementation of any new controls in case it is necessary for the matter to be referred to the Competition Commission. In this case, Oftel has proposed modifications to BT’s licence to enable rollover of the current controls. This means that, in the event that Oftel and BT do not agree on Oftel’s proposals at the end of the review and there is consequently a referral to the Competition Commission, the current controls will continue after their scheduled end date and until the end of March 2002. The purpose of adding the rollover provisions to BT’s licence is simply to enable the current review to continue until the end of 2000 and thus enable Oftel to take account of more up to date financial and market information. There will be no change to the timing of implementation of any new controls unless there is a reference to the Competition Commission. Oftel consulted on the principles behind rollover in May 1999, and published licence modifications for statutory consultation in December. Oftel will put these modifications to BT to seek its consent on their addition to its licence.

Oftel’s advisers

1.6 Oftel is advised on price and charge control, and other regulatory issues, by a Consumer Panel and by other expert advisers. Details of membership of the Consumer Panel and the other expert advisers are set out in Annex C. Both groups advise Oftel in their own capacity and not as representatives of particular organisations.

1.7 Oftel is also advised by 6 Advisory Committees on Telecommunications (ACTs) – those for England, Scotland, Wales, Northern Ireland, Disabled and Elderly people, and small and medium sized businesses.

1.8 The advice Oftel has received has covered a range of opinions. The proposals set out in this document are Oftel’s own.

Chapter 2

Price Control Review – results of consultation

Introduction

2.1 This chapter sets out Oftel’s preliminary conclusions on the competitiveness of telecommunications markets and hence the need for price controls. The retail price and network charge controls proposed in this consultation document are controls on BT’s basic Public Switched Telecommunications Network (PSTN) services and not a control on retail and network services conveyed over other BT networks using telecommunications technologies such as Internet protocol. The conclusions set out take account of the responses to the July 1999 consultation document and the views expressed at the public hearings and at meetings with operators, service providers, the Consumer Panel and the Large Business User Panel. Oftel has also taken account of data obtained from surveys conducted on its behalf. A longer summary of responses is provided at Annex B.

Retail Price Control Issues

2.2 This section is organised as follows. First, competition to BT from ‘traditional’ fixed network operators in the provision of access to the telephone network is considered. Then, competition to provide calls over fixed networks is discussed. This includes Indirect Access (IA) operators, who do not have their own access networks, as well as competing local network providers. The discussion is then broadened to consider competition from providers of newer types of networks and services, including radio fixed access (RFA), mobile operators, providers of higher bandwidth services and resellers of basic telephony. In principle, all these can compete with BT at the retail level in the provision of access as well as calls although, by definition, the last category does so by reselling BT’s own access and call services.

Retail Competition – Fixed Access

2.3 The main source of competition to BT in the provision of access, particularly for residential customers, is the cable operators. Cable operators now offer alternative direct access services to around 50% of households. Whilst this indicates that direct access competition has increased, at the same time it means that a significant percentage of residential customers still have no alternative access provider. Moreover, the extent of additional cable rollout is uncertain and, although there could be some further increase in coverage in future, cable companies may choose to concentrate their efforts in the area already served.

2.4 BT retains high market shares (over 80%) in both the residential and business fixed access markets and the rate at which its share has been eroded continues to be slow. BT’s share of new connections has fallen, according to its own figures, to just over 50%, but this still suggests that BT’s shares are likely to remain high in 2001 and beyond. Even taking into account BT’s most recent results, it is quite possible that BT will retain more than 70% of access lines in the period immediately after the expiry of the current controls. Indeed, some respondents suggested that retail access was likely to remain a BT/cable duopoly for many residential consumers, and that earlier expectations that there could be multiple access providers were unlikely to be realised. Consumer organisations were also particularly concerned about the lack of alternative access providers or, in rural areas, the realistic prospect of any.

2.5 Oftel accepts that even an access duopoly would not necessarily preclude the operation of strong competition. However, there would clearly be a very serious risk, given the other characteristics of telecommunications markets, in particular the extent of entry barriers and the low propensity of customers to switch operators, that an effectively competitive outcome would not result if customer choice was restricted to only two operators. In addition, a market share of 70% or more, as outlined in paragraph 2.4, is some way above the standard threshold for a firm to be considered dominant. As noted earlier, Oftel believes that price control is likely to be appropriate where BT remains dominant. In the light of this, Oftel does not believe that competition from other local access providers is likely to be sufficient for controls on BT’s prices to be removed after 2001.

2.6 Consumers in areas where BT is the only access provider also benefit indirectly from direct access competition because of the requirement for BT to offer geographically averaged line rental and call prices. BT is not allowed to differentiate in price (and terms and conditions) between areas where there is and is not competition. Oftel believes that there is a need for the continuation of geographically uniform prices, even – or particularly – if other controls are removed, in order to spread the benefits of competition to areas where it is less developed.

Retail Competition – Calls over Fixed Networks

2.7 In addition to competition from the cable companies and other access providers, BT faces competition to provide calls from around 150 Indirect Access (IA) operators and resellers – some with established brands – who provide call services nationwide but do not compete with BT in the provision of exchange lines. IA customers retain their BT line but send calls via the IA operator by dialling an (four digit) access code or a freephone number. The volume of IA calls is increasing and IA operators are now offering local as well as national and international call services. Competition from IA operators has meant that BT’s share of call minutes has fallen faster than its share of exchange lines, as the table below shows. This is particularly true for international calls.

2.8 BT’s prices and market share have fallen during the present price control period as the competition it faces has increased. However, neither BT’s retail call prices nor its market share have declined as quickly as expected at the beginning of the current price control and embodied as assumptions in the financial modelling undertaken in setting the value of X (in the RPI-X formula) which governs the required reduction in BT’s prices. It was assumed then that competitive pressure, in particular from IA operators, would force BT to reduce call prices to higher-spending residential and business customers outside the main focus of the price control basket relatively quickly. As it has turned out, BT has made smaller reductions than expected in call prices to customers both within and outside the price control basket. Within the basket, these have been offset by smaller than expected increases in the line rental. Further details of the price reductions received under the current control by different groups of customers are given in Chapter 3. The combination of higher than expected prices and market share in the first two years of the price cap suggests that competition has not developed as quickly as anticipated and partly accounts for the higher than expected profits earned in this period.

2.9 On February 2, BT published its financial results for the third quarter and nine months to 31 December 1999. The results were considered disappointing by the stock market and BT’s share price fell in consequence. In its press release, BT placed some emphasis on increasing competition as a factor behind the reduction in operating profit compared to the same period in the previous year. The above table includes some estimates by BT illustrating the decline in its share of the market over the first three quarters of 1999/2000 which underlies the financial results. BT believes that much of the decline reflects increased competition from IA operators and estimates that the volume of IA traffic increased by 58% in the year to December 1999, with residential IA calls growing by 96%. Oftel has therefore considered whether markets are now showing signs of becoming increasingly competitive, to an extent that was not apparent when Oftel undertook its public consultation last year.

2.10 Oftel considers that the data do not clearly indicate that a fundamental change in the competitive conditions facing BT has occurred. Although BT’s market shares of all price-controlled services have continued to decline, they still remain at high levels. The impact on BT’s rate of return on basic services is not yet clear, but Oftel has estimated that the effect is likely to be a small but significant reduction. It would be roughly in line with the annual reductions expected when the price control was set. At this stage in the price control period, this would imply that BT’s rate of return in the final year is still likely to be significantly above the cost of capital. Nonetheless, the likelihood that some increase in competition is now occurring is reflected in the discussion of options for future price controls in Chapter 3.

2.11 Some future developments will also tend to increase the competitiveness of call markets. The introduction of Carrier Pre-Selection (CPS), which will enable Indirect Access operators to provide call services to customers without the need to dial an access (four digit) code is one example. However, it is difficult to say how great an impact this will have. At least one operator is currently offering an IA service using autodiallers, even before CPS becomes available and indications from the take-up of this service suggest that CPS operators may well have some success. In addition, CPS may well provide a marketing stimulus for IA operators. However, many IA customers may already use memory button phones or PBXs which remove the need manually to dial the additional digits on every call and hence reduce the advantage of CPS over traditional IA.

2.12 Oftel has also noted the concern that IA, even with CPS, is more suitable for large users, or is not understood by the majority of customers. Until now, Indirect Access has not been a realistic alternative for customers who make few national or international calls. These customers, concentrated in the lower 80% of residential customers by spend, generally purchase calls as a package from their access provider. Whilst the recent increases in the use of IA noted above suggest that IA is now viable for a greater number of customers than previously, it is likely that IA appeals mainly to those with above average levels of call spend, not least because these are the most profitable customers and therefore the natural target market for IA operators.

2.13 Call markets are, and are likely to remain, more competitive than access provision. However, Oftel believes that the analysis underlying the structure of the current controls is still relevant and that IA competition is unlikely to be sufficient to protect lower users. Oftel believes that price controls will still be needed to protect lower users and there could be a case for extending their coverage or introduce other measures to increase competition to BT. Alternative options for doing so are discussed in Chapter 3.

New Network Operators – Radio Fixed Access

2.14 Like cable operators, Radio Fixed Access (RFA) operators have the potential to compete with BT both in the provision of the connection to the network and calls over it. RFA may spread basic access competition to smaller towns not served by cable. For example, Atlantic Telecom plans to cover Scotland and around 50% of the English population using RFA. It will also offer IA in areas not covered by RFA. Tele2, currently providing service in Reading, is said to aim to cover 60% of UK population by 2003.

2.15 However, Atlantic’s network is likely to be based on main urban areas and targeted at small and medium sized businesses and above average spending residential customers. Reports suggest that Atlantic aims to reach 10% penetration in ten years. Therefore its impact on competition to serve lower spending residential customers may be small, particularly in more rural areas. In addition, high-speed data services aimed at business users such as those offered by Tele2 may have little impact on the prices of basic services for residential customers. Technical constraints also limit the practical use of RFA to certain areas and terrains.

2.16 In the light of this, Oftel does not believe that RFA will provide sufficient competition to BT for price controls to be removed after 2001.

Competition from Providers of Other Telecommunications Services

2.17 The July 1999 document asked whether BT’s prices for basic fixed link services would be constrained by competition from other telecommunications companies providing services apparently of a different type, particularly mobile telephony, Internet services and higher speed telecommunications services. Paragraphs 2.18 to 2.23 address these issues.

Fixed-Mobile Substitution

2.18 In principle, mobile operators are able to compete with BT in the provision of both access and calls. It seems likely that any impact from mobile competition will be felt first in calls. It is now usual for mobile customers to be offered tariffs in which the regular subscription entitles the customer to make a certain number of call minutes at low or even zero marginal prices. For those already with a mobile, the low marginal price of unused bundled minutes is likely to encourage some substitution of fixed calls. However, in general, the monthly charges for these bundles suggest that, taking total costs into account, they are only likely to be competitive to BT’s charges for higher users, that is, the part of the market which is already relatively competitive.

2.19 Oftel’s analysis of mobile price trends also suggests that the fixed/mobile price gap is still significant when all charges are taken into account. In addition, this situation is likely to continue because mobile network costs and hence retail prices are likely to remain above those of the fixed networks. Whilst customers may be prepared to pay a premium for the extra convenience of mobile, large-scale substitution may also require the mobile operators to be able to match BT for coverage and quality of service. Mobile networks coverage does not extend to some more remote areas.

2.20 Another relevant factor is the likely increase in the importance of higher bandwidth services in future. Although the ability of mobiles to deliver higher bandwidth services will increase, particularly with the advent of third generation technology, the greater capacity of fixed lines means that they are likely, in Oftel’s view, to remain the primary means of accessing higher bandwidth services.

2.21 Oftel therefore believes that, whilst it is likely that mobiles will substitute for fixed calls and perhaps lines to an increasing extent in the period immediately after the expiry of the current controls, they are unlikely to provide sufficient competition to BT for price controls to be removed.

Internet and Higher Bandwidth Services

2.22 Voice over Internet is likely to increase in importance in the period immediately after the expiry of the current controls, with expanding numbers of suppliers and Internet subscribers. New partnerships of broadcasters and phone companies may also emerge in competition with cable. At least one operator has begun to offer IA telephony combined with completely free Internet calls and this is an example of the packaging together of new and basic services in ways which could increase competition in the supply of the latter.

2.23 On the other hand, the impact of new technologies and services on competition for basic services is currently difficult to predict. For example, BT is now rolling out ADSL over its network and plans to begin taking orders from the end of April, with service to end users starting at the end of June 2000. Initially it will cover 25% of homes and business addresses, but further roll-out depends on take-up. In addition, whilst Oftel’s proposals for access to BT’s local loop will facilitate the provision of new higher bandwidth services, the extent of demand for them is still essentially unknown. In many areas, few homes may currently have a computer, leading to the comment that the market there is ‘unformed’ and will take some time to develop. New competing networks might never be extended to more remote areas. Oftel believes that the impact of competition to provide advanced services in the period immediately after the expiry of the current controls is as yet unclear and that therefore it would be premature to rely on it as an alternative to price controls for basic services.

Resale

2.24 The document also asked about the impact of competition from resellers of BT’s services. The competitive impact of resale depends to a large extent on the terms on which resellers are able to gain access to BT’s network. At present, ‘Annex II’ operators (essentially those with some network infrastructure, including IA operators) purchase network interconnection services from BT at charges based on BT’s costs whereas resellers, not deemed to have Annex II status, purchase services from BT at charges based on BT’s retail prices. The difference between the prices offered to Annex II operators and resellers essentially represents BT’s profit margin and can be significant.

2.25 Oftel believes that resale of BT’s network would offer greater competitive opportunities if charges to resellers were not based on BT’s retail prices. In particular, cost-based charges similar to those enjoyed by Annex II operators would significantly increase the scope for resale competition by reducing the charges paid by resellers for the use of BT’s network.

2.26 Use of BT’s network at cost would enable resellers to place increased competitive pressure on the retail prices of access and calls, although they would not place downward pressure on the cost of the network as this would be purchased from BT. Downward pressure on network costs would be provided by the wholesale charge control. Oftel believes that extending the right to cost-based use of BT’s network may well have merit as a means of placing increased competitive pressure on BT’s prices for basic telephony services. A proposal along these lines is discussed in Chapter 3.

Barriers to Switching

2.27 The July consultative document asked a number of questions about whether there were significant barriers to switching which prevented telecommunications customers changing suppliers to take advantage of competing offers of basic telephony services. In addition, Oftel asked for views on whether these barriers could be tackled directly and whether this could be sufficient to protect consumers without the need for retail price controls.

2.28 Many respondents agreed that the factors identified by Oftel in the July consultative document were important barriers to switching. In particular, the perceived quality of service and reputation of alternative suppliers was seen as a potentially enduring barrier to switching. Experimentation with alternatives is sometimes perceived as risky and this can give rise to switching costs where customers are not well informed about the service quality of rival operators. To some extent this is supported by the findings of a Consumer Awareness Survey carried out by Oftel in September 1999. In general, respondents did not expect the market alone to overcome barriers to switching or believe that any measures addressed directly to these barriers would be sufficient to enable price controls to be removed.

2.29 Oftel will continue its efforts to reduce barriers to switching by, for example, encouraging the publication of comparative price and quality information. Oftel is currently undertaking a survey of switching behaviour together with the Consumers’ Association (CA) and has endorsed the creation of an industry website which will help customers to find the cheapest telephony deal in their area. At present, Oftel does not believe that the industry’s endeavours to provide comparative price information will on their own provide sufficient stimulus to competition to be an adequate substitute for price controls.

Conclusion on the Need for Retail Controls

2.30 Oftel considers, in the light of the evidence presented in response to the consultation, that for many customers there is little choice of access provider, and for lower residential users this also means little effective competition for calls. This in turn suggests that some form of regulation to restrain BT’s retail prices for at least some consumers will be required after 2001. Oftel also believes that geographically uniform prices should continue in the period immediately after the expiry of the current controls in order to ensure that all customers benefit from price reductions resulting from competition where it exists and to ensure that BT customers in areas where competition is less developed are not exploited.

Private Circuits

2.31 Oftel has launched a review of the state of competition in the provision of leased lines and issued a Statement in November 1999. Rather than take forward its proposals for private circuits as part of the price control review, Oftel plans to complete its review of the regulatory framework and publish a Statement by October 2000. The review will cover all issues related to the pricing of private circuits raised in the context of the price control review.

Network Charge Control Issues

2.32 The July 1999 consultative document described how, under the current network charge control regime, network (interconnection) services were split into three categories of competitiveness:

• Services, including new services, which were deemed to be competitive during the period of the present controls;

• Services which were deemed to be prospectively competitive during the period of the controls; and

• Services which were deemed to be non-competitive during the period of the controls.

2.33 Table 2.1 of that document, reproduced below, shows the view taken in 1997 of the correct category for each interconnection service. Respondents were asked for their views on how competition for each of these services had changed and how it would be likely to evolve in the light of future developments.

Table 2.1: Interconnection services and the category of competitiveness, price control 1997/2001

2.34 Services that were deemed to be non-competitive were put into one of three baskets, each of which has been controlled by the formula RPI-8%. As shown in the table below, non-competitive interconnection services are included in one of the following baskets: the Call Termination basket; the Interconnect Specific basket; or the General Network Services basket. Interconnect specific services are those required physically to connect another network to BT’s and have to be purchased from BT in order to interconnect with its network.

The Call Termination basket and the Interconnect Specific basket

2.35 Oftel’s view remains as set out in the July consultative document, that is, that competition to provide call termination is intrinsically limited by the fact that the calling customer will generally not have a choice as to which network to use. Where the called customer has both a fixed and a mobile phone, an element of choice may exist. However, as noted above, Oftel believes that mobile costs are unlikely to come down to fixed network levels and therefore are unlikely to constrain BT’s charges for call termination.

2.36 Oftel’s view is that the need for other operators to interconnect with BT, arising from the ubiquity of BT’s network and its share of direct connections, means that interconnect specific services are unlikely to become competitive in the period immediately after the expiry of the current controls. The asymmetry in scale and market share between BT and other operators means that reciprocity of charges is unlikely to be a sufficient constraint on BT’s charges. Moreover, it is possible to show that, even where firms are symmetrically situated, and can agree on a common charge for call termination, there is an incentive on them to agree to a high charge in excess of costs.

General Network Services

2.37 The contents of the General Network Services basket are shown in the table in paragraph 2.34. Oftel noted in the July document that the prospects for competition in general network services depended on the continued development of alternative access networks. As described in paragraphs 2.3 – 2.5, Oftel believes that BT is likely to retain a position of dominance in the provision of exchange lines in the period immediately after the expiry of the current controls. This implies that call origination is also unlikely to become competitive in the period immediately after the expiry of the current controls. Whilst competition from mobile call origination is possible in principle, few operators, apart from BT, are currently interconnected to the mobile operators and, as noted above, mobile costs are likely to remain above fixed levels. In addition, few operators have points of connection at the local exchange level and therefore require BT to provide local-tandem conveyance.

2.38 In a competitive market, charges should tend towards costs including the cost of capital. This was the basis on which the starting charges for BT’s network services were set at the commencement of the current network charge control. In fact, BT’s returns on services in the general network basket are now in excess of the cost of capital, which would suggest that competitive pressure has not driven down the charges for services in this basket as far as might have been expected. In the light of this, and the responses received, Oftel does not believe that the competitiveness of services in the general network basket has increased to an extent sufficient to change the competitive category of these services. Oftel would not, therefore, propose to do so.

Safeguard Caps

2.39 At the start of the network charge controls, prospectively competitive interconnection services were made subject to safeguard caps (RPI+0%). The safeguard caps were not expected to be binding because competitive pressures were expected to be an effective constraint on BT’s charges for services subject to safeguard caps.

2.40 Oftel has considered whether movements in BT’s network charges under the current cap provide evidence of the degree of competitiveness of network service markets. Analysis suggests that, in general, the safeguard cap has not been binding for these services. In many cases it appears that BT has not actively reduced prices, but has simply not raised them by the allowable percentage with the result that charges are below ceilings. However, charges remain above floors. The latest accounting data from BT suggests that supernormal profits are being made in essentially all network services, including those in safeguard caps. This does not suggest that there is effective competition for most prospectively competitive services, although both the level of charges relative to floors and the rate of return figures suggest that competition is greater for longer distance transit and conveyance than for short-distance.

2.41 Oftel published a consultation document in November – Competition in International Markets – that proposed that certain controls on international direct dial (IDD) retail prices and network charges should be lifted. This document was published in response to a determination request made by BT to lift controls on 26 international routes, which it believed were competitive. Oftel proposes that, when BT believes that other international routes are competitive, it should put in a similar determination request which Oftel would then consider. Oftel does not believe that it would be appropriate to determine that all international routes are now effectively competitive.

Directory Information Services

2.42 The main potential concerns identified in the July consultative document related to access to BT’s directory information database, known as ‘Pathfinder’, and to the supply of phonebooks. Pathfinder is the database used by BT to provide its voice directory enquiry services. Operators can purchase a wholesale equivalent if they want BT to provide the voice directory enquiry service on their network. This wholesale service is not currently subject to charge control. This reflects measures taken after Oftel’s September 1998 Statement Provision of Directory Information Services and Products to open up the market for product databases such as Pathfinder to competition. However, it was noted that the appropriate treatment of Pathfinder in future would depend how quickly competition developed in the provision of product databases.

2.43 The development of competition in the wholesale database market may well depend on the development of competition in the retail market. At the moment, BT customers have little realistic alternative to BT’s directory enquiry service. Since BT’s retail service inevitably uses Pathfinder as its input, this reduces the potential customer base for any database wishing to compete with Pathfinder. The main barrier to entry faced by prospective entrants into the retail directory enquiry services market is the fact that BT’s own service uses the familiar 192 code. It is possible to level the playing field by changing access codes in order to remove inequalities in the codes used to access competing voice directory enquiry services. Oftel is currently undertaking a cost-benefit study to help identify whether or not the benefits arising from such a change would outweigh the costs. Oftel believes that the measures recently taken to remove barriers to entry to the directory enquiry market should be allowed time to work before a charge control on Pathfinder is considered.

2.44 Oftel suggested that the bundling of phonebooks with BT’s line rental meant that competition was unlikely to emerge in phonebook provision and hence there was a case for considering whether the charge made to OLOs for provision of books should be capped. Given that competition is not now expected in phone book provision it may appear appropriate to introduce a price cap for this service. However, in some cases prices appear to be below cost floors which weakens the case for a cap. On balance Oftel is minded not to cap the supply of phonebooks at present.

Number portability

2.45 Oftel intends to publish a draft determination establishing charges for BT’s geographic and non-geographic number portability services on a long run incremental cost basis – they are currently charged on a fully allocated cost basis. Oftel would welcome comments on the competitiveness of geographic and non-geographic number portability services, and the need for future charge controls.

Conclusion on the Need for Network Controls

2.46 Charges for BT’s interconnection services are a major cost for other operators. High interconnection charges could reduce retail competition. Oftel has to give careful consideration to the competitiveness of interconnection services before it could safely relax controls on BT. Oftel does not presently believe that competitiveness for the interconnection services in the three non-competitive interconnection baskets has increased sufficiently, or is likely to do so in the period immediately after the expiry of the current controls, to enable Oftel to remove the services from their respective baskets. Oftel therefore proposes that the services deemed to be non-competitive services at the start of the network charge controls should still be deemed non-competitive. Oftel also proposes that the non-competitive services should remain in the same baskets as at present.

2.47 Oftel does not intend to re-categorise any of the prospectively competitive services. BT’s charge movements and returns do not indicate that services deemed prospectively competitive at the onset of the network charge control regime have become effectively competitive. Oftel therefore proposes that services subject to a safeguard cap should continue to be subject to a safeguard cap.

2.48 The network charge control regime allows the competitiveness of interconnection services to be re-categorised should the level of competitiveness change. Oftel would propose that this should remain the case. BT can submit details to Oftel at any stage about the relative competitiveness of an interconnection service and, should Oftel’s investigations find in favour of BT, this could result in the re-classification of the competitiveness of the service. Equally, where other operators have concerns about the competitive category of any interconnection services, they can bring forward a detailed case to Oftel, using the procedures already in place.

Chapter 3

Retail Price Controls – initial proposals and coverage

Introduction

3.1 This chapter contains the detail of Oftel’s proposals for retail price control. Following consultation on the competitiveness of markets in the July consultation document, Oftel is considering a number of possible approaches to retail price controls. Some are based on continuation of controls of a similar form to the controls currently in operation and some involve a move away from that form of control. The chapter explains the approaches and considers the likely impact of each of them on different customer groups. It also identifies some characteristics of the current controls and explains the reasons for some of their key features in order to aid understanding of the options.

Oftel’s objectives

3.2 Oftel has identified two key objectives for its review of price controls. They are:

3.3 Each of the approaches discussed in this chapter is assessed against these objectives. Oftel will ensure that the outcome of the price control review is consistent with its objectives and, in assessing alternative options, will also concentrate on the need to minimise distortions in the market.

Current retail price controls

3.4 Before discussing the options for price controls from 2001, it is helpful to explain the current controls and the impacts they have had on the pricing of services.

Focus of the controls

3.5 A requirement to reduce retail prices by RPI-4.5% currently applies to a basket of BT’s retail services comprising connection charges, line rental, direct dialled calls to geographic numbers (excluding calls from public call boxes) and operator controlled calls. Because these controls only apply to services supplied over the public switched telephone network (PSTN), they are referred to as the PSTN controls. A note on the methodology for setting the current controls is at Annex D. Safeguard caps set at RPI+0% also apply to baskets of analogue and low capacity digital private circuits at 64kbt/s and below. The pricing of private circuits is the subject of a separate review by Oftel and so is not considered in this document.

3.6 The price cap applied to the basket of services controls the average price for the services, with the average being weighted by reference to the expenditure on these services by the lowest spending 80% of BT’s residential customers. This ensures that price reductions are delivered to lower spending customers rather than being focussed on high spending residential and business customers for whose custom competitive pressures are greater. Table 3.1 below shows the average effective value of X for 1997/8 and 1998/9 delivered in price reductions to customers within the focus of the current controls (ie the bottom 80% by spend) and those outside it. This shows that BT has met the requirements of the price cap for low spending customers. The effective value of X is roughly equal for each individual decile (within a range RPI-4.4% to RPI-4.9%). This is a contrast to price reductions made during previous price controls when reductions were heavily focussed on higher spending customers (between 1990 and 1997, high spending customers enjoyed average reductions each year of RPI-6.7% whereas the bottom 80% of BT’s customers by spend received average reductions of RPI-2.9%). The focus of controls on the bottom 80% of customers by spend has therefore had a positive impact on the distribution of price control benefits amongst customers.

Table 3.1 – Price reductions to BT’s customers for 1997/98 and 1998/99.

Price reductions made against the broad basket during the current control period

3.7 When the current price controls were set, Oftel forecast that price reductions to all of BT’s customers (ie the bottom 80% of domestic customers plus higher spending domestic and business customers – sometimes referred to as the ‘broad basket’) would be equivalent to about RPI-7.5%. This forecast was based on the requirements of the control on prices for low users plus the impact on prices of competition in other sectors of the market. Oftel anticipated that bills would fall in line with about RPI-11% for high spending residential customers (ie deciles 9 and 10) and about RPI-8.5% for business customers.

3.8 Table 3.1 shows that price reductions made to these customers under the current controls have not been as large as this and therefore that competitive forces have not impacted on prices for these customers to the extent expected by Oftel. The level of profitability achieved by BT during the controls to date is also consistent with this – Oftel anticipated that BT’s returns would fall to a level equal to the cost of capital (12.5%) at the ending of the controls, and that for the financial year 1998/99 BT’s rate of return on capital would be around 16%. BT’s accounts for 1998/99 in fact report a rate of return on capital of 23.6%.

3.9 However, it should be noted that BT’s third quarter results for 1999/2000, released at the beginning of February, are indicative of a decline in profitability and this may be consistent with an acceleration of competitive pressure. The level of price reductions to high spending residential and business customers along with BT’s profitability during the current controls are key points in assessing the suitability of the possible future approaches to price control discussed below.

The current review

3.10 In developing its proposals for price control, Oftel will apply the principles of its long term strategy. It will therefore seek to apply regulation only where customers do not benefit from the operation of effective competition. Where competition is not yet sufficiently effective, it will consider whether measures to further liberalise the market are more appropriate than the imposition of regulation. The preceding section contains details of BT’s performance under the current retail price controls to date. These suggest that the current controls have been effective in distributing the benefits of price control amongst the lower spending customers on which the current price cap is focussed, but that prices have not fallen so fast as was expected by Oftel for others. BT’s profitability (measured by return on capital employed) has been higher during the control period than expected, but there are indications that this may be declining with the increasing strength of competition. Oftel will not reach conclusions on its proposals for any new price controls until further financial information is available – notably the full year results for 1999/2000. The alternative approaches to price control presented in this chapter should be read with this in mind.

Geographic averaging of prices

3.11 BT’s prices for PSTN services are currently required to be averaged geographically. This means that such services are priced the same throughout the UK even when there are regional differences in the cost of provision. There are good reasons for this. In particular, geographic averaging has delivered the benefits of competitive price levels nationally, rather than just in geographic areas where competition is strongest. Also, geographic averaging ensures that telephony is affordable in areas where the high costs of provision would otherwise disadvantage certain groups of customers. Oftel does not intend to remove current requirements for geographic averaging of BT’s prices for basic telephony.

Options for retail price control

3.12 Oftel has identified 3 possible approaches to the control of retail prices from 2001. They can be summarised as follows:

(i) continuation of controls of a similar type to the current ones;

3.13 This section discusses the merits of each approach. Each approach is also assessed against Oftel’s objectives, which are set out in paragraph 3.2 – this assessment is presented in tabular form at the end of the chapter. Oftel invites views on the approaches, and in particular on the specific questions included in the text.

3.14 All of the options are based on the continued geographic averaging of prices.

Approach 1 Continuation of controls on the current basket of services and covering the same customers (ie the bottom 80% of BT’s customers by spend)

3.15 Oftel’s analysis of likely developments in competition (the results of which are explained in Chapter 2) indicates that, unless further steps are taken to liberalise the market, competitive pressure on BT during the next price control period is unlikely to be sufficient for Oftel to reduce the coverage of retail price controls from their current level. One approach is therefore to continue after 2001 with a similar structure for retail price controls as operates now. The current controls are focussed on the bottom 80% of BT’s customers by spend. This focus, which was not a feature of previous controls, was designed to ensure that price reductions are delivered to those customers who are least able to take services from competing providers.

3.16 With a broad basket approach – covering services to all BT’s customers as applied before the current controls – price reductions tended to be focussed on those parts of the market where BT faced the most competitive pressure. The current controls have been effective in ensuring that price reductions are delivered to lower spending customers. Continuation of the current controls would therefore ensure that this continues to be so and would also have the benefit of minimising disruption and enabling customers and market players to deal with a system with which they are familiar. Customers could expect to see steady reductions in their bills.

3.17 It might be appropriate for there to be additional price controls covering customers outside the current controls. These controls could be set at a level that would not be binding on BT in the event that competitive pressure bites on call prices. Such a control would provide a protection to customers prior to the impact of competition or in the event that the expected level of competition does not occur, but would not deter efficient operators from entering the market.

Oftel would be grateful for comments on the advantages and disadvantages of Approach 1 – continuation of the current system of retail price controls after 2001. Should additional price caps be applied to protect customers outside the current focus of the controls in the event that competition does not have the expected impact on prices?

Approach 2 Broadening of controls

3.18 Concern has been expressed that BT is earning higher profits during the current price control period than were forecast when the controls were set. Some of these higher than forecast profits have been earned from customers who are outside the price control baskets and this may indicate that competitive pressures in the unregulated part of the market are less than was anticipated. This is consistent with the fact that price reductions in the current price control period to high spending residential and business customers have not been as large as Oftel expected.

3.19 This suggests that there may be a case for broadening current price control arrangements so that they include the customers from whom BT is currently able to earn excess profits. However, BT’s recently announced financial results for the 3^rd quarter of 1999/2000 may be indicative that competitive pressure is beginning to reduce BT’s profitability. On the face of it, the data does not clearly indicate that a major change in the competitive conditions facing BT has occurred, and more information is needed before it is possible to make a judgement on this. Oftel will make its final proposals to BT on new price control arrangements in December 2000. Analysis of BT’s financial performance and market share data between now and December will be important in determining whether broader price controls would be appropriate. In the meantime, it is useful to consider in principle some of the advantages and disadvantages of introducing broader controls than operate at present.

3.20 Broadening of price controls would guarantee price reductions for more customers than at present. However, as stated in its objectives for price control, Oftel believes that, where possible, customer benefits should be delivered through effective competition. Competition provides customers with choice and spurs market players to innovation in ways which price control cannot. In particular, the impact of regulation is limited to those aspects of service controlled by it (usually just price and some aspects of service quality). Competitive pressure, on the other hand, has an impact on all the firm’s dealings with its customers and so the supplier customer relationship under competition is likely to be better for customers than it is under regulation. Furthermore, whilst price control is a good proxy for competition where it cannot deliver benefits to customers, it can also act as a disincentive to market entry.

3.21 Broadening of the controls could also result in price reductions being focussed at the higher end of the market – precisely the effect which Oftel has avoided in the current controls through their focus on the bottom 80% of customers by spend. Oftel therefore proposes that any broadening of controls would be achieved by establishing a separate basket or baskets covering high spending residential and business customers rather than extension of the current basket.

Oftel would be grateful for comments on the advantages and disadvantages of Approach 2 – setting controls so that they provide direct protection to all BT’s customers.

Approach 3 Increase in competitive pressure through the availability of cost based access and the extension of interconnection rights.

3.22 As Oftel has made clear in its long term strategy and through the objectives for the price control review, consumers are best served by the operation of effective competition, and regulation should only be imposed where effective competition is not sufficiently strong to protect customers. Oftel therefore believes that, if possible, it may be preferable to take measures to liberalise telecommunications markets further after 2001 rather than to impose further price controls.

3.23 Operators and service providers can only purchase interconnection services at cost-based charges if they have been granted Annex II status, that is, they have rights and obligations to interconnect with each other under Article 4(1) of the Interconnection Directive for the purpose of providing publicly available telecommunications services. In general, Annex II status is only held by operators who have made some investment in their own fixed network infrastructure. This can restrict the ability of operators without Annex II status to enter the market, because they will have to pay higher charges based on BT’s retail prices in order to use BT’s network.

3.24 The policy that cost-based interconnection should generally be available only to operators making some investment in infrastructure was followed in order to encourage the development of competing networks. Given the substantial costs of constructing a network and the dominant position of BT, this was appropriate when network operators were trying to enter the market and become established. Now that competing infrastructure providers have had an opportunity to become established, it is more difficult to justify such a restriction on the extent of choice and competition in retail services from which customers are able to benefit. This is particularly true at a time of rapid innovation when the variety of services, which can be provided over telephone networks, is growing rapidly.

3.25 Oftel believes that there would be potential benefit to customers from increased competition in retail services if the restriction on eligibility for Annex II status were removed. Incentives for efficient investment in networks would remain as the charges for use of BT’s network would be based on long run incremental costs (LRIC) including an appropriate contribution to the costs of providing the access network. This is equivalent to the costs which an efficient new entrant would face in building its own network and so provides appropriate ‘make or buy’ incentives. Approach 3 involves removal of the current restriction on the availability of cost-based charges for the use of BT’s network by other operators and services providers.

3.26 However, none of BT’s current interconnection services include provision of the access line. Hence, even with the removal of the limitation on cost based interconnection, competing operators and service providers would be unable to compete with BT at cost based rates for provision of access unless they provided alternative access infrastructure (eg as cable operators do). BT does provide a wholesale service which includes the access line, called ‘Calls and Access’. Calls and Access is priced at retail minus (ie BT’s retail price minus retail costs not incurred by BT in providing the wholesale service) and so its impact in providing a competitive option for access for other operators and service providers is limited.

3.27 Oftel is considering whether, as part of new charge control arrangements, BT should be required to provide on request an access service at cost based rates. Such a service would need to be accompanied by the ability to convey calls across the network at cost based rates, either through current interconnection arrangements or through a cost based equivalent of the current Calls and Access. This would be a radical departure – for the first time enabling resale of the access line with an underlying cost base equal to that faced by BT’s own retail operation. This capability would be available to all operators and service providers to which BT’s service provider products are available, and so would involve a broadening of Annex II status potentially to include all providers which currently qualify to buy BT’s service provider products (providers would of course have to go through the existing application procedure in order to qualify for Annex II). Oftel proposes that charges for a cost based access product should be geographically averaged.

3.28 Oftel considers that the availability of a cost based access service would be likely to intensify competition significantly at the retail level by enabling existing operators and new players to compete with BT across the full range of services. One of the barriers to switching which may currently constrain competition at the retail level is concern about quality of service available from market entrants with no established brand name nor reputation familiar to customers. New entrants might include big established players from other markets capable of adding value through the strength of their brand or existing customer relationships. Oftel anticipates that this development would encourage firms with established consumer brands to enter the market and hence provide customers with a choice of providers, with established reputations for customer service.

3.29 The detail of what a cost based access product would comprise and how it would work would require detailed work and Oftel would welcome views from operators and service providers on this. It is important to note that the provision of a cost based access service is not the same as local loop unbundling (LLU). With LLU, operators will be able to disconnect the access line from BT’s core network and connect it to an alternative network (for detail see Access to Bandwidth: Delivering competition for the Information Age, November 1999) whereas cost based access would enable resale of the BT line.

Oftel would welcome comments on the advantages and disadvantages of Approach 3 – availability of cost based access and broadening of Annex II status potentially to include all providers which currently qualify to buy BT’s service provider products.

Oftel would welcome the views of operators and service providers on the composition of wholesale access services from BT – what functions (eg billing capability) would need to be available from BT to make it viable, and to what extent would these functions need to be unbundled?

Approach 3, variant (i) – Approach 3 combined with continuation of price controls of the same type as apply currently

3.30 Oftel would expect extension of the availability of cost based wholesale products to increase competitive pressure on prices significantly. However, because there could be no guarantee of this, and because lower spending customers might not benefit from the increased level of competition, it may be appropriate to retain some form of regulatory control of prices. Under Approach 3, variant (i) the availability of cost based access together with the extension of interconnection rights would be combined with the continuation of controls of the type which currently apply, which would continue to protect lower spending residential customers.

Oftel would welcome comments on the advantages and disadvantages of Approach 3, variant (i) – the combination of Approach 3 with continuation of price controls of the type which currently apply.

3.31 The intensification of competition which could be expected to result from the availability of cost based access together with the extension of interconnection rights would clearly be beneficial to customers. It would facilitate competitive pressure on call prices and Oftel would therefore expect to see the removal of supernormal profits earned through the setting of prices above the competitive level. This could mean that call prices would be driven down to a level below that necessary for BT to be able to recover all of its costs. (This depends on the way in which costs, including those costs common to access and calls, are recovered. Annex E explains issues associated with the recovery of common costs in detail.) The basic problem is that, under a price control set in a way similar to how the current control was set, BT would recover less than a full contribution to costs from price capped customers. In these circumstances, the erosion of profits from customers outside the controls could result in BT being unable to recover all of its efficiently incurred costs. Variant (i) of Approach 3 might therefore result in BT being put into an unsustainable position.

Approach 3, variant (ii) – Approach 3 combined with the relaxing or ending of retail price controls

3.32 As explained above, the availability of cost based access together with the extension of interconnection rights could be expected to bring about an intensification of competition in retail markets. Call prices would be likely to be driven down and supernormal profits currently earned on calls reduced or even eliminated. There would be pressure for an accompanying rise in BT’s line rental charge to enable it to recover common costs which it could no longer recover through call prices (see Annex E for explanation of the reason for this). Variant (ii) of Approach 3 would allow such a rise, thus changing substantially the relationship between rental and call prices.

3.33 This would benefit high users who could expect reductions in their overall bills because of falling call prices. Low users, however, would be likely to see increases in their bills because they do not make enough calls to offset the effect of line rental increases. Very low users would continue to be protected as at present through the availability of the Light User Scheme (LUS) or a similar scheme, which incorporates a low line rental. But this may not be sufficient to ensure that affordable access is available to genuinely needy customers because the usage of many needy customers is above the level which currently qualifies for LUS.

3.34 Oftel has therefore considered how to ensure that affordable line rental remains available to those who need it. The remaining approaches address this issue in different ways.

Oftel would welcome comments on the advantages and disadvantages of Approach 3, variant (ii) – relaxing of current controls combined with the availability of cost based access and the extension of interconnection rights.

Approach 3, variant (iii) – Approach 3 combined with a constraint on line rental increases and the ability to recover common costs through wholesale and interconnection charges

3.35 With this approach, there would be a constraint on increases in the line rental to ensure that price changes do not lead to increases in the bills of any group of customers. As noted above, such a constraint on line rental charges would mean that BT might not be able to cover the full costs of providing service since its ability to recover common costs from call prices would be undermined by the pressure of competition.

3.36 Under variant (iii), BT would be permitted to recover an appropriate share of common costs through charges for wholesale and interconnection services provided over the line (including transfer charges between BT’s own Retail and Network Businesses). It seems appropriate that all such services – ie broadband as well as narrowband PSTN – should contribute to these costs. This would mean that the charges for interconnection and wholesale services provided over BT access lines would be slightly higher than they would have been if BT were prevented from recovering common costs in this way. It is possible that the recovery of additional common costs through charges for interconnection and wholesale services provided over the access line would result in prices at the retail level being slightly higher than they would have been under Approach 3 without the increases in interconnection charges. However, under Approach 3(iii), competitive pressure could be expected to bear down on call prices so that they would fall below their level under Approaches 1 and 2.

3.37 Oftel has calculated that the increase to charges for interconnection and wholesale services provided across the access line would be between 0.1 and 0.2 pence per minute. (This figure has been calculated on the basis of PSTN traffic. Were broadband minutes to contribute as well the amount would be smaller).

Oftel would welcome comments on the advantages and disadvantages of Approach 3, variant (iii) – availability of cost based access and extension of interconnection rights together with controls to prevent increases in line rental. Increases in charges for interconnection and wholesale services provided over BT exchange lines to cover the costs to BT of line rental constraints.

Approach 3, variant (iv) – Approach 3 combined with bill protection for low users funded through the universal service mechanism.

3.38 With this approach, controls would apply to the bills of low users to ensure that no BT customer’s bill would rise in the event that call prices were reduced with offsetting rises in line rentals to recover common costs. The cost of these controls would be considered as a cost of universal service, and hence if they were found to be material they could be funded through universal service funding mechanisms rather than through increases in wholesale and interconnection access charges. There would be a considerable administrative cost in establishing a universal service fund, which may be a disadvantage with this approach. Such a mechanism would of course need to be compliant with EU requirements.

3.39 The Universal Service Obligation relates to the basic level of telecommunications service, which should be available to all customers. BT is required to provide universal service in its licensed area. Oftel has calculated that the present cost to BT of universal service is not material when associated benefits are taken into account and so no mechanism for the recovery of universal service costs currently exists. Oftel has stated that it will consider the setting up of a Universal Service Fund (USF) in the event that the costs of universal service are material after benefits have been netted off. The inclusion in this calculation of costs incurred through controls on the bills of low users could therefore result in the establishment of a USF, though the calculation would also have to take account of associated benefits. It is relevant to note that the costs of universal service already calculated include the cost of the LUS.

3.40 The costs which would be included would be those incurred in providing service to customers who do not generate sufficient revenue to cover costs. Oftel estimates that these costs would total around £68 million in the first year and this would decline overtime as fewer customers require protection.

3.41 Operators and service providers that do not provide direct connections to uneconomic customers would contribute to the USF. Operators that do provide connections to uneconomic customers would recover those costs from the USF. If a USF were established as a result of including the costs of serving low users, BT would be able to recover its costs in providing service to low users from the USF. Some other direct access operators might also provide services to low users and Oftel wou