Consultation document issued by the Director General of Telecommunications

31 July 2001

Contents

Summary

Chapter 1 Introduction

Chapter 2 Defining the Relevant Markets  

Chapter 3 Key Competition Indicators and Preliminary Views  

Chapter 4 Consultation Details

Glossary

Summary

S1 Oftel’s goal is the best deal for consumers in terms of quality, choice and value for money. Competitive markets are the best
way of achieving this goal. 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 control has taken the form of placing
a ceiling – or a cap – on the extent to which BT can raise prices for selected services.

S2 In February 2001, Oftel published the Statement Proposals for Network Charge and Retail Price Controls from 2001.
Oftel concluded that retail price controls on BT should be extended for the period 1 August 2001 to 31 July 2002. While
recognising that competition was increasing in the provision of basic telephony services, Oftel did not believe that competition
alone would provide protection for all customer groups. The extension of the price control was to allow Oftel time to further review
the extent of competition in basic telephony markets and to assess whether further controls or other measures are needed
beyond July 2002.

S3 The current retail price control 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 and 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

S4 BT is subject to a separate control on its retail retention on calls to BTCellnet and Vodafone (that is, the control applies to the
price net of the outpayment made to the mobile operator). This control is set at RPI-7% and is also set to end on 31 July 2002.

The review process

S5 This document begins the further review of competition in the provision of basic telephony services. In the first instance,
Oftel needs to define the relevant markets. Oftel can then begin to explore whether competition is the main influence on BT’s
pricing behaviour. In this consultative document Oftel has defined the relevant markets and given its preliminary views on
competition in those markets. Oftel plans to issue a consultative document at the end of the year with proposals for future
consumer protection arrangements – if they are needed – and a statement setting out its conclusions and final proposals by
June 2002. This statement will include the licence modifications needed to give effect to Oftel’s proposals.

S6 If the review finds that competition is acting as the overall constraint on the prices of BT’s services, price controls would not be
required. However, if Oftel concludes that competition is not acting as a constraint, further price controls or other measures to
stimulate competition might be required. The measures could include, for example, requiring BT to provide cost-based access to
service providers or reviewing the way in which wholesale services such as calls and access and carrier pre-selection are provided
by BT.

S7 Oftel requires input from stakeholders to help it to assess the competitiveness of basic telephony markets in the UK.
Respondents are encouraged to provide any data that they believe is of relevance to this market review.

Defining the relevant markets

S8 In order to assess whether competition is effective in any market, and is thus protecting consumers, it is necessary to define
what constitutes the relevant markets. Oftel’s view is that the following services are in separate markets:

• Access;
• Local calls;
• National calls;
• International calls by country pair;
• Calls from fixed to mobile; and
• Operator assisted calls.

Key indicators and preliminary views

S9 In Implementing Oftel’s Strategy: Effective Competition Review Guidelines, August 2000, Oftel set out twelve indicators it uses
when assessing whether competition is effective in any market. This document gives Oftel’s initial view on the extent of competition in
the relevant markets using those indicators. The overall picture at this stage is one in which competition is increasing and this is
shown by prices increasingly moving towards costs, and consumers’ views and behaviour. However, it is Oftel’s view that
competition may not be fully effective at present.

S10 To assess whether action is needed beyond July 2002, and if so in what form, Oftel intends to examine and invites views and
evidence on, amongst other things:

• how far customers are benefiting from competition and have access to the information needed to make effective choices
  between operators;
• barriers to entry;
• the extent to which BT’s prices are likely to be constrained by existing and new competition;
• the framework for the competition analysis; and
• how the indicators should be interpreted within the overall market assessment.

Chapter 1

Introduction

Retail Price Controls

1.1 Oftel’s goal is the best deal for consumers in terms of quality, choice and value for money. Competition – rather than regulation
– is likely to ensure that operators increase efficiency by reducing costs whilst still innovating and meeting customers’ requirements.

1.2 Retail price controls should be used only where competition is ineffective and is likely to remain that way. In a competitive
market, competition would act as a pricing constraint on all players in that market. Price controls would not therefore be necessary.
However, price controls may be appropriate if there is insufficient competition to provide a competitive constraint on prices.

1.3 BT is currently subject to retail price controls that are focussed on the bottom 80% of its residential customers by expenditure
and are set at RPI-4.5%. This control is set to end on 31 July 2002. The control is focussed on the bottom 80% of residential
customers by expenditure because when Oftel implemented the controls it believed that these consumers were benefiting the least
from competition. The price controls limit increases that BT can make for the following group of services (the price control "basket"):

• Access (connection, take-over and line rental);
• Local calls;
• National calls;
• International calls; and
• Operator assisted calls

1.4 Within the ‘basket’ control, BT chooses how it wishes to meet the overall control subject to the provisions of normal
competition law.

1.5 In addition, BT’s retention for calls to BTCellnet and Vodafone are subject to controls set at RPI-7%. These controls are also
set to end on 31 July 2002.

Market review

1.6 This document begins Oftel’s review of competition in the provision of basic telephony services. In the first instance, Oftel needs
to define the relevant markets. Once Oftel has defined the relevant markets, it can begin to explore whether competition is the main
influence on BT’s pricing behaviour. This consultative document gives Oftel’s views on the relevant markets (Chapter 2) and its
preliminary thoughts on competition in those markets (Chapter 3).

1.7 Oftel has to decide whether competition is protecting all groups of customers or whether further price controls are required after
the present control ends on 31 July 2002. If competition is protecting all consumers, it will not be necessary for price controls to
continue beyond July 2002. Conversely, if competition is not protecting consumers, Oftel has to identify those groups of consumers
that are not benefiting from competition and decide what the best form of protection for them would be. Oftel could protect consumers
either by proposing that price controls should continue or it could attempt to stimulate competition further by, for instance, opening
up access to BT’s network to systemless service providers. Alternatively, Oftel might find that it is not necessary to increase
regulation in this manner because services such as calls and access and carrier pre-selection provide a strong competitive
constraint. The threat of competitive entry to the market combined with actual entry might, on its own, provide consumers with
adequate protection by constraining BT’s pricing flexibility. On the other hand, it might be necessary to introduce a combination of
price controls and encourage competition still further.

Relationship with other Oftel projects

1.8 This review will also take account of the outcome of other work underway in Oftel.

1.9 In March 2001, BT asked Oftel to review regulatory obligations in relation to all retail international direct dial (IDD) routes
that are not currently deemed to be competitive. BT believes that competition is effective on all retail IDD routes and that the
obligations should be removed. Oftel aims to publish proposals for consultation in September 2001 and complete this review by
December 2001.

1.10 On 28 June 2001, Oftel published the consultative document BT’s regulatory obligations to provide advance notification of
price changes and to maintain a published price list. This document considers whether the requirement for BT to give
twenty-eight days’ notice before it can change any of its retail prices remains appropriate. This requirement allows BT’s
competitors an opportunity to put in competitive responses to BT’s price changes. However, there is some concern that this
might lead to price leading on BT’s part and price following on the part of its competitors; BT’s consequent loss of first mover
advantage may discourage it from attempting to compete on price. In some instances, advance price publication may even
facilitate the maintenance of collusive practices. This would not be in consumers’ interests. Oftel is therefore considering
whether these requirements remain appropriate and are in consumers’ interests.

1.11 In its review of the Universal Service Obligation, Oftel has been assessing whether the placing and funding of the obligation
represented an unfair burden on BT. Oftel has explained that, in determining this, it would take into account the extent to
which BT is unable to recover its costs of serving uneconomic customers from the profit it makes from economic customers.
Oftel has indicated that, given BT’s current return on capital for basic services, it is unlikely that any net cost of meeting the
obligation within the range of estimates made to date would be seen as an unfair burden. Oftel will consider the implications
of the outcome of this Market Review for its policy on assessing the net cost of the obligation.

Effective competition indicators and data requests

1.12 At the end of Chapter 2, Oftel has set out the key indicators of effective competition that it is to consider in assessing
whether competition in the provision of retail telephony services is or is not effective. These follow the framework set out
in Implementing Oftel’s Strategy: Effective Competition Review Guidelines, August 2000. This document sets out Oftel’s
initial assessment of competitiveness based on these indicators. It also sets out Oftel’s data requirements.

1.13 Oftel already has a significant amount of data following the earlier review of competition in the provision of retail services.
However, this data need updating. Oftel wishes to receive updated data and other comments on what further information it
requires to accurately gauge the nature and extent of competition in retail telephony markets. Such information will help to
inform Oftel in its view on whether competition in the relevant markets is or is not effective.

Timetable

1.14 The data that Oftel has sought through this document, and on which it will base its proposals, need to be sufficiently
robust to provide an accurate picture of competition in basic telephony markets. Oftel will therefore seek views informally
– through an industry workshop and other meetings – in the autumn on the relevance and accuracy of the data that it receives.
Thereafter the Director General will consult on his proposals for future arrangements – whether this is for further price cap
arrangements or for the end of such controls – by December 2001. Oftel’s final proposals and, if necessary, the draft licence
modifications to give effect to them will be set out in a statement to be published by no later than June 2002.

1.15 In the event that BT objects to the proposed licence modifications, the Director General may make a reference
to the Competition Commission asking it to investigate whether his proposals were in the public interest. The Director
General may express his views in any reference on the adverse impact on the public interest if regulatory action is not taken,
and specify any licence modifications he considers appropriate in order to remedy such adverse impact. Whilst the
Competition Commission was undertaking its investigation, the present controls would continue for one further year
to 31 July 2003. Oftel can extend the controls for the additional year in this way by invoking Condition 74B of BT’s licence
(‘Rollover of General Price Controls’). This condition can be invoked only if BT has not accepted Oftel’s proposals to
modify its licence.

Consultation

1.16 Oftel is seeking views of consumers, their representatives and the industry and data on competitive pressures that
show how far consumers are benefiting from competition. Comments are also welcome on the interpretation of data,
for example on how survey responses can be combined with more quantitative information. Responses to the consultation
are sought by 2 October 2001. Thereafter there will be a further 2-week period in which comments can be made on
responses received following the first period of consultation.

Chapter 2

Defining the Relevant Markets

Market definition

2.1 The extent of competition in the provision of services will decide whether price controls or other action is required to
protect consumers. If competition in the provision of the relevant services is effective price controls will not be required.
However, if competition is not effective, Oftel will need to ensure that consumers are protected against potentially exploitative
pricing.

2.2 Generally, there are two sequential stages involved in competition analysis: an assessment of the relevant market for the
particular product followed by an assessment of the market power held by the supplier(s) of that product. Thus, the assessment
of competitive pressures faced by the suppliers is preceded by the definition of the relevant market. This Chapter is concerned
with market definition.

2.3 Oftel’s approach to market definition follows that used by the UK competition authorities and is in line with those used
by European and US competition authorities. Market boundaries are determined by identifying constraints on the
price-setting behaviour of firms. There are two main competitive constraints to consider: how far it is possible for customers to
substitute other services for those in question (demand-side substitution), and how far suppliers could switch, or increase,
production to supply the relevant products (supply-side substitution) following a price increase.

2.4 The concept of the ‘hypothetical monopolist test’ is a useful tool to identify close demand-side and supply-side substitutes.
A product is considered to constitute a separate market if a hypothetical monopoly supplier could impose a small but significant,
non-transitory price increase without losing sales to such a degree as to make this unprofitable. If such a price rise would be
unprofitable, because consumers would switch to other products, or because suppliers of other products would begin to compete
with the monopolist, then the market definition should be expanded to include the substitute products. However, the relevant
market is not necessarily the smallest which it is possible to define using the hypothetical monopolist test. It may be appropriate
to include, in the relevant market, a number of products, in the supply of which competitive conditions are homogeneous.

2.5 In defining a relevant market, it is usual to begin with a fairly narrow view and then expand that market to include the relevant
substitutes. A natural starting point for an analysis of the need for further retail price controls would be to consider whether
each of the services included in BT’s retail price cap, as well as calls to mobiles, could be considered a separate market.
This would be consistent with the approach taken in the previous review of BT’s retail price controls in 1996 and reaffirmed
in Oftel’s first consultative document of the current review Price Control Review: Future developments in the competitiveness
of UK telecommunications Markets, July 1999. This means that Oftel needs to consider the following services:

• Access;
• Local calls;
• National calls;
• IDD calls (by route);
• Operator assisted calls; and
• Calls to mobiles.

A similar analysis would be necessary for any other service proposed for inclusion in the retail price cap.

2.6 Market definitions may change over time and therefore it is important to consider again whether the above market definitions
remain relevant. In addition, it is important to consider whether competitive conditions in the supply of a service vary by customer
group and so whether separate markets should be defined for different customer groups. A key feature of the current retail price
control is that the weight of each service in the price control basket reflects the expenditure patterns of the lowest-spending
80% of residential customers, on the grounds that these were the group of customers for whom competition was least well
developed. The appropriateness of this segmentation will also be reviewed in the light of competitive developments.

Access

2.7 From the consumer’s point of view, access can be thought of as the ability to make and receive calls. The price of access
is composed of the line rental, connection and take-over fees, for which the customer receives an exchange line connecting
their premises to the operator’s local exchange.

2.8 If a hypothetical monopoly supplier of access increased its price, consumers wishing to use fixed telephony services
would consider switching to available substitutes. The most obvious potential substitute is mobile access. Oftel has considered
whether fixed and mobile telephony are substitutes on a number of occasions, most recently in its Effective competition
Review: Mobile, February 2001.

2.9 In that document it was concluded that fixed lines would not be an adequate substitute for mobile services since the
former are linked to a particular geographic location. The focus of the Effective competition Review: Mobile was on whether the
availability of fixed telephony acted as a constraint on the price of mobile services. The issue here is whether the availability
of mobiles constrains the price of fixed access, though much of the evidence set out there is equally relevant.

2.10 Oftel survey evidence suggests that UK fixed line penetration of residential households may have reached a peak of 95%
between 1997 and 1999 but has since fallen back to 93%. Of the 7% of homes without a fixed telephone, nearly 90% (equating
to about 6% of households) use mobile services as an alternative to the fixed network. However, the rapid rise in numbers of
mobile subscribers has largely been reflected in an increase in the number of households with both fixed and mobile phones.
The number of such households as a proportion of the total rose from 60% to 72% between May 2000 and May 2001 whereas
the proportion of mobile-only households was relatively stable at around 5% - 6%. This suggests that mobiles are seen by most
customers as a complement to the fixed line rather than as a substitute for it. This is supported by evidence from Oftel’s April
2001 survey of adults with both a fixed and a mobile telephone (note that, although Oftel conducts regular surveys, not all
questions are repeated each time, so that the most recent data on a particular issue may not come from the most recent survey).
Some 29% said that they would never completely replace their fixed telephone with a mobile whilst, among the remainder, the
average increase in the quarterly fixed bill which would be required to induce a switch entirely to mobile was 102%.

2.11 One reason may be that, even if access and calls are regarded as separate markets, there is a ‘buy-through’ in that a
customer cannot purchase calls without first purchasing access and, in particular, a customer cannot purchase fixed calls
over a mobile network. A customer who used a mobile telephone instead of a fixed line would therefore pay mobile call charges
and, for most users, these charges would be a major consideration in deciding whether to switch from a fixed line to a mobile.
As noted in Effective Competition Review: Mobile, February 2001, mobile call prices remain significantly above those from
fixed lines, particularly at peak times. Oftel’s analysis suggests that, for comparable packages, mobile prices still exceed BT’s
prices by between 24% and 55%. In addition, mobile calls are dropped more often than fixed calls and the quality of speech
is poorer, though survey evidence suggests that these differences may not be significant for the majority of customers.

2.12 Some customers may wish to have a telephone for incoming calls or emergencies only and, for these customers, a
comparison based on access costs alone may be relevant. BT’s standard line rental is £9.99 per month including VAT.
This also includes £1.80 worth of calls.

2.13 The price of mobile access depends on whether the customer opts for a monthly contract, a pay-up-front annual fee,
or a pre-pay package. The lowest available monthly rental is about £9.99 (including 20 minutes call time). However, customers
who want the ability to receive calls anywhere may favour a pre-pay package, which until recently were widely available for a
one-off fee of about £39.99 (and even this may have been reduced by special offers) subject to a (negligible) minimum usage
requirement. At this price, over a period of a year or so a pre-pay mobile may have worked out cheaper than a fixed line if no
calls were made. However, anecdotal evidence suggests that the main value of low- or no-use mobile pre-pay packages is as
a complement to the fixed line, for customers who value the ability to be contacted or to make emergency calls anywhere,
but who make most of their calls over the fixed line. In addition, recent price rises have reduced the attractiveness of such
packages relative to a fixed line. In any case, the number of BT customers using their BT fixed line for access only is
proportionately very small.

2.14 On the supply-side, the relevant consideration is whether a firm without a fixed local access network could enter the
market and develop its own network. Amongst existing network operators, potential candidates would be mobile operators and
those operators with long-distance transmission networks (who may provide calls using indirect access (IA)). In both cases,
however, the operator would need to incur significant fixed costs to develop a local access network. Given that a large proportion
of these costs are likely to be sunk (not recoverable on exit), entry barriers are likely to be significant. Moreover, the process
of installing local access infrastructure is time consuming and this also suggests that supply-side substitution is unlikely to
be possible within the timescale relevant to the hypothetical monopolist test.

2.15 Retail access provision is also possible for operators without their own networks by means of BT’s Calls and Access
product or Local Loop Unbundling (LLU). For the purposes of this review, Oftel proposes to consider these as examples
of entry into retail markets rather than supply-side substitution. Their impact is discussed further in Chapter 3.

2.16 Oftel believes that fixed access is currently a separate relevant market.

Geographic extent of the access market

2.17 At first sight, it might appear that the access market should be divided into local areas, for example, cable franchise areas.
A consideration of the potential for demand-side and supply-side substitution suggests that the potential for either of these
factors to constrain local line rental or connection charges is limited. On the demand-side, fixed access in another area is
unlikely to be an acceptable substitute for a line at the home address, whilst the entry barriers described above, together with
licence restrictions, are likely to limit the scope for supply-side substitution by an operator in one (franchise) area into another.

2.18 However, whilst there may therefore be differences in competitive conditions between regions, BT’s charges for access
are geographically uniform. This means that any response to competitive pressure in one area in the form of lower prices
would apply throughout the country. This suggests that, for the purposes of the price control review, the geographic extent of
the relevant market should be regarded as being the whole of the UK.

2.19 Oftel believes that the market for access is currently national in scope.

Calls markets

2.20 In the last section, it was concluded that supply-side substitution by providers of calls without their own local access
network (that is, IA and CPS operators) would not constrain the price which a monopoly provider of local access could charge
for access. However, an operator with a local access network will certainly be able to provide at least calls between customers
connected to the same concentrator, i.e. the part of the local exchange which is positioned closest to customers, and typically
such an operator will supply the full range of call types including national and international calls and calls to mobiles,
using interconnection with other networks where necessary.

2.21 However, Oftel believes that calls markets should be regarded as separate from the market for access. This is because
competitive conditions are not homogeneous between calls and access and a single market definition would therefore obscure
the analysis of the extent of competition. In particular, the ability of IA operators to offer calls, including increasingly local calls,
without themselves possessing a local access network means that entry barriers into the provision of calls are much lower than
into the provision of access and suggest that calls markets are likely to be more competitive.

2.22 Oftel believes that calls markets should currently be regarded as separate from access.

Geographic extent of calls markets

2.23. As with access, BT’s retail prices for calls are geographically uniform. Furthermore, some of the suppliers of calls to
customers in one part of the UK would find it relatively easy to supply such services to customers in another area in response
to a price increase in that area. IA operators may use their own long-distance networks and buy in wholesale call origination
and termination from direct access operators. Supply side substitution between areas exists for IA operators, given the
availability of wholesale origination and termination throughout the UK (at geographically uniform charges in the case of BT).
The geographic extent of the relevant market for calls is, therefore, the whole of the UK.

2.24 Oftel believes that calls markets are currently national in scope.

Fixed-Mobile substitution

2.25 In considering whether a call from a mobile to a fixed line or to another mobile is an adequate substitute for a call from a
fixed line, a number of issues arise. Firstly, substitution is more likely if the caller already has a mobile (as noted above some
72% of households have both fixed and mobile phones), and therefore base their decision on the marginal call price. For the
reasons given in paragraphs 2.9-2.11, it may be difficult to persuade customers who have a fixed line to replace it with a mobile,
especially if they wish to use it for data applications. However, it may be relatively easy to persuade customers who have both
a fixed and a mobile to switch between them by price differentials. According to Oftel’s February 2001 survey of residential
consumers (the last in which this question was asked), about two thirds of those with both fixed and mobile phones find
occasions on which they do substitute mobile usage for fixed usage. This means that just less than one third are not substituting
mobile usage for fixed to take advantage of lower prices at certain times, or for convenience. In addition, 21% have a fixed
telephone only. The question then is whether this extent of substitution is sufficient to constrain the prices of fixed calls.

2.26 The size of the price differential depends on a number of factors including whether the caller’s mobile tariff package
provides an allowance of ‘free’ calls in return for a fixed fee. Where the users purchase an allowance of free calls with their
subscription, the marginal call price may be regarded as zero and this may encourage use of the mobile in preference to the
fixed phone. However, the possible scale of substitution of calls from the fixed line may be limited if the allowance of free calls
is small relative to the volume of fixed line calls. In addition, whilst some off-peak mobile tariffs are now comparable to BT’s
charges for calls on the fixed network, in general the price premium for making calls from a mobile suggests that mobile prices
do not constrain the prices of calls from a fixed line to another fixed line.

2.27 Another consideration arises in the case of substitution by mobile to mobile calls. This is most relevant for fixed to mobile
calls, though not necessarily exclusively so. The size of the price differential then depends on whether the alternative mobile
to mobile call is on the same network (‘on-net’) or on a different network (‘off-net’). Off-net mobile to mobile calls are often
excluded from inclusive call allowances (ICAs). In general, the strategy of the mobile network operators is to maintain relatively
high prices for off-net calls but to offer low prices for on-net calls. Indeed, prices for the latter can be comparable to fixed to fixed
prices even outside of call allowances. Substitution is therefore more likely if the potential alternative mobile to mobile call is
on-net. The likelihood that a call will remain on-net will reflect the market share of the mobile operator in question, which will
currently lie between 20% and 30% depending on the operator. However, it is likely to be higher if the caller is a member of a
‘closed user group’. A closed used group can be defined as an identifiable group of people who have an interest in how much
it costs to call each other. At present, Oftel does not have sufficient information to draw conclusions on the importance of
closed user groups.

2.28 As Oftel argued, in its July 1999 consultative document Price control review: Future developments in the competitiveness
of UK telecommunications markets, the extent of substitution may increase as the mobile networks expand and evolve to cater
for more advanced forms of data transmission and as costs fall. These developments will significantly increase the overall traffic
capacity of GSM networks, particularly for voice which will be able to match the fixed networks for quality. Improved quality and
lower off peak mobile tariffs may mean that the fixed line will be used increasingly for data traffic while the mobile will increasingly
be regarded by some customers as the principal voice communication medium, although enhanced mobile networks will
increasingly be able to provide data as well. However, mobile operators’ traffic-sensitive costs are expected to remain above
those of fixed networks. Consumers may well be prepared to pay some premium for the additional convenience of mobiles
but full substitutability of residential fixed lines by GSM is unlikely as long as a significant price premium remains.

2.29 Oftel’s May 2001 survey of residential consumers found that 79% of respondents still consider the home fixed telephone
as their main method of making and receiving calls. About 15% regard the mobile as their main telephone (the remaining 6%
use other methods such as a fixed telephone at work or a payphone). Whilst this was similar to the findings of the February
2001 survey, the proportion of customers regarding their mobile as their main telephone has increased significantly over the last
year and Oftel intends to monitor future trends in this figure. Some 70% of these consumers also have a fixed telephone at home.

2.30 Oftel believes that, in general, calls from fixed lines are not currently in the same market as calls from mobiles.

Customer type

2.31 It may be possible to define separate markets for different groups of customers, for example, by distinguishing between
business and residential customers, or on the basis of spend levels. This would be consistent with the structure of the current
retail price cap, which is focused on the lowest-spending 80% of residential customers (with a safeguard arrangement for small
businesses). These are the groups which, in 1996, were considered to have the least access to competition, and the price control
was designed to ensure that it benefited those that benefited least from competition and were most in need of protection. However,
the 1996 price control review was not always explicit on the question of whether they constituted a distinct market.

2.32 It is, however, clear that competitive conditions were not seen as homogeneous across all customers. The chosen
categorisation reflected the fact that the highest spending residential customers had very different usage patterns to the rest
of BT’s customers. A much larger proportion of the top-spending 20% of residential customers’ bills was (and is) spent on
international, ‘other’ (for example, premium rate services) and, to a lesser extent, national call services than for other residential
customers. BT made higher returns on these services than for local calls and rental so the high spending residential customers
were attractive and profitable both to BT and its IA competitors, and were therefore already benefiting from competition. In addition,
it was noted that if their spending were included in the revenue weights used to calculate compliance with the price control, they
would increase the attractiveness to BT of reducing national and international call charges and decrease the attractiveness of
reducing local call and rental charges which constitute a large proportion of the bills of low and moderate use customers. This
would have resulted in most of the benefits of the price control going to those customers who were least in need of protection.

2.33 The choice of the 80% threshold was also informed by BT’s discounting behaviour, which indicated where it considered it 
faced the greatest threat of competition.  In 1995/1996 the threshold at which BT’s main discount packages became worthwhile 
for customers was a call spend approximating to the borderline between the 20% of highest users and the rest of BT’s customers.

2.34 In the Decision published in May 2001 following Oftel’s Competition Act investigation into the pricing of BT’s ‘Surf’ product
within the BT Surf Together and BT Talk & Surf Together tariff packages, it was noted that an argument could be made that
residential access is in a separate market from business access, because residential and business customers tend to be in
distinct geographical locations. This will reduce the extent of supply side substitution because a supplier of access to business
customers would need to incur significant sunk costs and take the time to build out its network in order to compete against a
supplier of access to residential customers. Although smaller businesses in particular may be more likely to locate close to their
customers, the fact that charges for business and residential access are different would suggest that they do in fact constitute
separate markets.

2.35 The argument is slightly less clear-cut in the case of retail calls. For direct access operators supply side substitution
appears not to be present, because of the costs and time required to build out networks to the areas in which residential
customers are located. Also, like access, different prices tend to be charged to business and residential customers. IA operators
and resellers do not face these constraints, because they use existing exchange lines rather than building their own. However,
it was argued that the characteristics of residential customers are sufficiently different from business customers to limit the
extent of supply side substitution because a supplier of calls to business customers would be likely to need to develop different
tariff packages that would appeal to residential customers and because such a supplier might also need to incur significant costs
in order to create sufficient awareness and brand recognition in residential customers.

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

2.37 The precise boundary between the markets by customer type is open to debate. For example, the highest spending
residential customers have call expenditure as high or higher than small business customers; and some small businesses
are located in residential areas. Nevertheless, for the purposes of the Surf inquiry, it was concluded that distinguishing residential
from business customers is a reasonable approach.

2.38 In the price control review, Oftel will consider the appropriate segmentation by customer group in the light of current
and expected future competitive conditions. These findings may also have wider implications. For example, a finding that
markets for the provision of basic telephony services to businesses were effectively competitive could mean that other aspects
of regulation which apply to BT in these markets could also be relaxed.

Call type

2.39 The next question is whether it is appropriate to treat all call types as part of a single calls market or instead to
define separate markets for individual call types, for example along the lines set out in paragraph 2.5. A consideration only
of the scope for demand-side substitution suggests that markets might be quite narrowly defined. Indeed, in the limit, it might
be possible to define calls to particular individuals as separate markets since, with some exceptions, a call to one person
will not be a good substitute for a call to someone else.

2.40 How far supply-side substitution would undermine this very narrow definition depends on whether a potential competing
provider of retail calls to a particular person is able to purchase termination of calls to that customer as a wholesale service.
Suppose there is a monopolist of retail (end-to-end) calls to one individual, but calls to other individuals are competitively
provided. If the hypothetical monopolist of retail (end-to-end) calls to that customer refuses to terminate calls to that customer
originating on other networks then supply-side substitution is unlikely. As has been well documented elsewhere, the calling
party pays principle means that the called party is unlikely to switch networks if the price of calling him increases, as he will
not (usually) bear the cost. However, if other operators are able to purchase termination of calls to the monopolist’s
customers, then they will be able to offer competing retail end-to-end calls, using their own networks for origination and
conveyance as far as the terminating segment. In practice, call termination is available as a wholesale service and therefore
a hypothetical monopolist provider of retail calls to one individual would face the prospect of competition from providers of calls
to other individuals if it attempted to raise its prices. Hence the possibility of supply-side substitution suggests that a broader
market definition is likely to be appropriate. This could be along the lines set out in paragraph 2.5 since, for example, an
operator with a local network could be able to offer local calls terminating with all customers in its local area.

2.41 The principle that the extent of the market is determined by the area and services in which competitive conditions
are homogeneous is again useful. In practice, operators do not price discriminate on the basis of the identity of the called
party. However, differentiation between the prices for local, national, international calls, calls to mobiles etc is however usual.
This suggests that a sensible set of market definitions for fixed calls would be those set out in paragraph 2.5. Note however
that a distinction between local and national calls has not been drawn in the case of mobile calls, since mobile call prices
are generally uniform within the UK and do not vary with distance.

2.42 In the 1996 price control review, Oftel considered whether local and national calls should be regarded as a single
market. The main argument advanced in favour of this treatment was the increasing irrelevance of distance as a
determinant of the costs of providing call services. However, Oftel decided in the light of responses to the consultation
to accept the distinction between local and national calls.

2.43 It could be argued that the case for making this distinction might have been stronger in 1996 than now. IA operators
did not then offer local calls because the margin between local call prices and network charges was insufficient to cover the
additional switching costs of IA operators and allow an adequate profit. This meant that there was a significant difference
in competitive conditions between local and national calls. IA operators are now able to offer local calls profitably and indeed
there has been rapid growth in this traffic. There may therefore now be greater homogeneity in competitive conditions than at
the time of the last review. This could be reinforced when the ‘all calls’ option for carrier pre-selection (discussed further in
paragraphs 3.75-3.76) becomes available from 2002. However, whilst margins between retail prices for local calls and
network charges are currently sufficient for IA operators to offer local calls profitably, this might not be so at the competitive
level of prices. The relevant question, then, is whether the threat of re-entry by IA operators would constrain local call prices
to the competitive level.

2.44 Oftel believes that local calls and national calls should currently be regarded as separate markets. This market
definition is consistent with Oftel’s conclusion in its investigation into BT’s pricing of ‘Surf’ within the BT Surf Together and
BT Talk & Surf Together tariff packages. It was also noted there that it is unlikely to be critical as BT’s market share
and profitability in local and national calls are broadly similar.

International calls

2.45 In January 2001, Oftel published the results of its Review of whether Cable and Wireless has Market Influence on
international routes (the C&W review). In the C&W review, Oftel looked separately at markets for international retail services
on a route-by-route basis. Oftel defined that these markets consisted of international retail calls (retail international direct
dial and retail calls delivered via international simple voice resale) and, for large corporate customers, international private
leased circuits (normally considered part of the market for international services to other operators) insofar as they represent
a substitute for international retail calls for such customers.

2.46 The main issue in the case of international calls concerns the geographical definition of the markets at both the
wholesale and retail levels. In the C&W review, Oftel considered it appropriate to treat paired country routes as separate
markets at both levels, as it has done in previous analysis of international markets. On the demand side, substitution between
different country routes is not possible as a call to one country is not a good alternative for a call to another country. Oftel
accepts that a degree of wholesale supply side substitution is possible by means of ‘hubbing’ (the routing of traffic via
an intermediate third country), and other forms of indirect transmission such as ‘transit’, ‘re-origination’ and the use of ‘ring’
systems. However, for the purposes of the C&W review, Oftel considered it appropriate to examine all individual wholesale
routes separately given the difficulty in establishing the extent of indirect routing. Whilst the C&W review also considered it
appropriate to analyse retail routes separately, the growing importance of IA operators and re-sellers in retail IDD competition
and their potential to offer conveyance services to a wide range of international routes raises the potential for a retail supply
side market definition wider than route-by-route. This issue is being considered further in the reviews of competition in retail
and wholesale IDD markets requested by BT and Concert. Oftel believes that it should adopt a set of market definitions
for the price control review which are consistent with those derived from these reviews.

2.47 Oftel believes that it is currently appropriate to consider country pair routes as individual markets. However, the
market definition for the price control review will be consistent with the view that Oftel takes in relation to its review
of competition in retail IDD markets, and could therefore evolve.

Operator assisted calls

2.48 The services charged for and currently included in the retail price control are duration charges for operator-controlled
calls and facility fees for operator-controlled calls other than when the caller experiences difficulty in obtaining a connection
and reverse charge calls (other than from a public telephone box). It is important to distinguish between operator assistance
supplied to retail customers and the wholesale operator assistance service supplied by BT to other operators. The latter
market is deemed to be competitive since there are no major barriers to an operator self-providing or using other operators’
services. Here we are concerned with operator assistance (OA) supplied to retail customers.

2.49 In the last price control review, Oftel took the view that retail OA is an integral part of the telephone service provided by
an operator when an exchange line is supplied. It was considered that entry by an independent service provider was unlikely
given the costs it would face and the difficulty it would have in persuading customers to switch supplier of a service which
was typically a very small part of telecommunications spend. On this basis, it could be argued that operator assisted calls
should be treated as part of the market for access, given the likely homogeneity of competitive conditions between the two
services.

2.50 Notwithstanding the likelihood that competition to provide OA on a given network may be small, prices for operator
assisted calls could be constrained by prices for direct-dialled calls if the latter were seen as good substitutes. However,
the significant additional cost (up to £2 per call) involved in making an OA call suggests that calls will only be made via the
operator as a last resort, for example to some international destinations where direct dialling is not available, and this is
consistent with the low revenue from OA calls. Moreover, the charge for OA has recently increased after a number of years
of stability, during which time call prices have fallen significantly. This suggests that the charge for OA is not constrained
by the availability of direct-dialled calls and that therefore OA calls should be treated as a separate market or as part of
the access market.

2.51 Oftel would be grateful for views on whether operator assisted calls should be regarded as a separate
market, as part of the access market or as part of the market for calls.

Calls to mobiles

2.52 Oftel considered the possible markets for calls to mobiles in its Review of the Price Control on Calls to Mobiles
. However, that document focuses on the position of the mobile operator terminating the call. The issue here is whether
there are competitive constraints on the price the originating operator can charge for a call to a mobile phone. The position
of the originating (fixed network) operator was also considered by the Monopolies and Mergers Commission (now the
Competition Commission) in 1998, as a result of which a price control was imposed on the amount which BT could
retain from supplying calls to BTCellnet and Vodafone mobiles at the retail level.

2.53 The most likely demand-side substitutes for a call from a fixed line to a mobile are a call from a fixed line to
another fixed line or a call from a mobile to another mobile. The substitution possibilities in the latter case are considered
in paragraphs 2.25-2.30.

2.54 It seems unlikely that fixed to fixed calls are a sufficiently good substitute for fixed to mobile calls to constrain
the prices of the latter. In general, there is still a substantial price premium for calling a mobile number from a fixed line
compared to the price for calling another fixed line, particularly at peak periods. This suggests that the two are not subject
to a common pricing constraint.

2.55 The ability to maintain this price premium might stem from the greater probability of immediate contact that comes
with calling a mobile compared to a fixed line. There are circumstances in which the difference in the likelihood of obtaining
immediate contact is relatively low, for example, when the called party is known to be at home. In this case, the caller may
well call the fixed line. On the other hand, if the called party is known not to be at home, the caller will have no choice but
to call the mobile if immediate contact is required. The existence of a substantial price premium for calling a mobile suggests
that the former circumstances are not sufficiently widespread to make calls from fixed lines to other fixed lines a good
substitute for calls from fixed lines to mobiles.

2.56 A further issue is whether at the retail level (ie from the point of view of the BT customer) calls to different mobile
networks are in the same or separate markets. Consideration only of demand side substitution suggests that calls to
each network seem likely to be in separate markets since, if the called party chooses, for example, Vodafone as his
mobile network, the caller has to call Vodafone: a call to BTCellnet is not a substitute. However, as described in paragraphs
2.39 and 2.40, this logic could lead to a very narrow market definition, since a call to any other individual, even if they are
on the same network, is unlikely to be a substitute for a call to another. Oftel has concluded, in the context of its review
of the regulation of mobile termination rates, that it is reasonable to aggregate the market definition on the demand side
at the level of each operator. This is because of the inability of each operator to price discriminate between calls to
particular individuals. The competitive constraints are generalised across the customers of a network.

2.57 Consideration of supply-side substitution may suggest a broader market at the retail level. The mobile operators’
general provision of wholesale call termination would suggest that, if an operator supplied its customers with calls to
Vodafone, say, they would also be able to supply them with calls to the other networks. A hypothetical monopolist
supplier of calls to one network would then not be able to raise prices significantly above the competitive level without
attracting supply-side substitution by operators initially providing calls to other networks. A further argument in favour
of a single market for all calls to mobiles is that competitive conditions at the retail level are likely to be homogeneous
between them. Although BT charges different retail prices for calls to the different networks, this may reflect differences
in the underlying termination rates paid to the mobile operator.

2.58 Oftel believes that calls from a fixed line to a mobile telephone currently constitute a separate market.

 Quantitative analysis

2.59 A number of quantitative techniques exist which, in principle can be used to aid market definition. The simpler tests
are based on analysis of price trends whilst more complex analyses are based on fitting demand equations.
The latter in particular have quite substantial data requirements which may make them difficult to apply in practice.

2.60 A statistical analysis of price correlation can be used to test whether two products are in the same economic market.
The underlying rationale is that the prices of products which are in the same market should be closely correlated with each
other since they will be subject to the same changes in demand (and possibly costs) and as customers shift between them
in response to any price differentials which emerge.

2.61 However, there is no uniquely correct level of correlation which is sufficient for two products to be regarded as part of
the same market. In addition, there is the danger of spurious correlation if prices show common trends for reasons
unconnected with substitutability. For example, the prices of telecommunications services generally have tended to fall in
recent years, reflecting partly declines in the underlying costs of network equipment. In addition, the prices of services which
are subject to price control may also tend to move together, reflecting the downward pressure of the control. Any analysis
would therefore have to account for these and other common factors influencing the prices of telecommunications services.

2.62 An alternative is to test for ‘Granger causality’ between price series. Despite its name, this is a purely statistical test
of association and cannot be used to establish the existence of an economic relationship between two variables. A lengthy
time series of data is needed to use the test. As with correlation tests, the effect of common factors must be removed from
the data to avoid spurious association. In addition, the methodology is subject to a number of technical problems that can
make the statistical test for significance of the association unreliable or hard to interpret.

2.63 More sophisticated analysis attempts to establish whether there is a long-term equilibrium in the relative prices of
products that are re-established after a change to the price of one. Again, adjustment for common factors and a long time
series of data are likely to be necessary.

2.64 A further drawback with all these techniques is that they rely on an analysis of actual prices, rather than those that
would exist if markets were competitive. Actual prices will already reflect any market power possessed by firms in the market
and this can lead to excessively broad market definitions by a process sometimes known as the ‘Cellophane fallacy’.
This occurs when the price for one good is above the competitive level, because of the exploitation of market power, by a
margin sufficient to induce consumers to switch to other products which would not be considered substitutes if the first good
were priced at the competitive level (in the eponymous case, the price of Cellophane was raised to a level where other
packaging products appeared to be substitutes). An analysis of actual prices can then lead to these other products erroneously
being included in the market.

2.65 Oftel believes that the use of quantitative techniques is unlikely to be of significant practical help in defining
telecommunications markets.

Retail Price Control review: key indicators

Chapter 3

Key Competition Indicators and Preliminary Views

Initial Assessment of Competition

3.1 In Chapter 2, Oftel set out the market definitions which it considers are most appropriate for the analysis of the
extent of competition facing BT in the provision of retail fixed telephony services. In this chapter, Oftel outlines its initial
assessment of the state of competition in these markets. It must be emphasised, however, that this is only a preliminary
examination, based on the information currently available to Oftel, and the primary aim of this document is to invite the views
of interested parties. These, and further information as it becomes available, will inform Oftel’s decision on the need for further
retail price controls after the expiry of the current (extended) control on 31 July 2002.

3.2 The following sections are structured according to the key indicators of effective competition set out at the end of Chapter 2.
These follow the framework set out in Implementing Oftel’s Strategy: Effective Competition Review Guidelines, August 2000.
The indicators are a mix of quantitative data, for example on market structure and profitability, and qualitative data, for
example on customer awareness of alternative operators. Oftel will take both into account in its assessment of market
competitiveness. In particular, the more qualitative information may help in the interpretation of the quantitative results.

Consumer outcomes

Whether UK consumers enjoy ‘best or near best deal’ in comparison with consumers in similar
economies

3.3 Competition places pressure on firms to price at levels closely related to costs and to keep such costs to a minimum.
But it is not always easy to observe costs directly or to discover if they are being minimised. An alternative source of evidence
on whether prices in the UK are as low as they would be in competitive markets is by comparing them to prices for the
equivalent services in overseas markets. If UK fixed telephony markets are competitive, one would expect UK consumers to
be getting a deal which is as good as or better than that available to customers in similar economies overseas. For this reason,
Oftel has undertaken a series of surveys to compare UK prices and trends with those in other comparable countries. However,
such comparisons are subject to caveats because international comparisons are themselves prone to a number of difficulties.
These are outlined below along with the way in which Oftel has sought to address these.

3.4 Firstly, the results may be vulnerable to exchange rate fluctuations. This is usually addressed, as in the Oftel survey, by
converting to a single currency at ‘purchasing power parity’ exchange rates. Comparisons may also depend on the interaction
of the pattern of use assumed with the tariff structure used for the comparison. Usage patterns tend to adapt to the structure
of prices, with customers naturally tending to make more calls when the prices they face are relatively low. This means that
comparisons tend to favour the country whose traffic profile is used as the basis of the comparison. Results may also differ
as between large and small users, or depend on the mix of peak and off-peak, or local and long-distance calls. Oftel has
sought to address this by using a range of different usage profiles and by reflecting the variety of packages and discount
schemes offered by operators in each country. The usage profiles cover different levels and patterns of usage and are not
specific to the UK. Unit-based charges may still be used by some overseas operators, which can disadvantage operators who
use per-second pricing unless adjusted for in the comparison. However, after investigation, Oftel has concluded that unit based
charges (or other details such as minimum call charges etc) do not have a significant effect on the results. In addition, the
quality of service and the extent of network coverage may not be readily comparable between countries. It has not been
possible to draw any meaningful conclusions regarding quality of service because of the absence of comparable data between
countries, although network coverage is comprehensive in all the survey countries. Lastly, overseas markets may themselves
not be effectively competitive and prices in them may therefore be above competitive levels.

3.5 Oftel’s survey attempts, as far as possible, to make fair comparisons between prices for fixed telephony services in
France, Germany, Sweden, the UK and the USA. A range of usage profiles, reflecting consumption by residential customers
and small and medium-sized (but not large) businesses, was used for the comparisons, which focused on both the lowest
prices available in each country and the spread of prices.

3.6 The 2001 survey found that PSTN price levels for UK residential consumers generally compared favourably with prices
elsewhere. However, they were found to be on average about 10% above the cheapest country (Sweden). France and Germany
were more expensive than the UK as were the two US states in the survey (though California was very close to the UK average).

3.7 Price dispersion can be seen as an indication of the extent to which some operators are able to maintain prices above
others and hence of market competitiveness, although it may also reflect other factors such as variations in quality of service.
All the Swedish operators in the sample tended to have relatively low prices, whilst this was normally true of only 2 or 3 of the
UK operators. The range of prices available was therefore narrower in Sweden than in the UK. France also displayed smaller
variation in prices whilst dispersion in the US was higher than in the UK.

3.8 Price levels for UK business customers were about average for the sample. They were on average about one-third greater
than those in Sweden and 6% higher than in Germany. On average they were similar to those in France and California
(although this varied with usage). The range of prices available in the UK appeared similar to that in France and Germany
but greater than that in Sweden and the USA.

3.9 The results of the 2001 survey enable trends in prices since the previous survey in 2000 to be compared between
countries. UK prices for residential consumers have fallen by about 4% over the year which is broadly similar to the rate
of price reduction in Sweden and Germany. Prices fell more rapidly in the US, but increased in France. For UK business
customers, the survey suggested that prices had fallen slightly faster than in California, France and Sweden, but not as fast
as in Germany and Ohio. Generally, the UK’s relative position for both residential and business customers was little changed
compared to 2000.

3.10 Because of the approach taken, which was to construct a range of ‘baskets’ representing different usage profiles and
then to price these according to the tariffs available in the survey countries, it is not possible to use the survey to shed light
on competition in the individual service markets set out in the previous chapter. However, the basket approach could in
principle provide some information on the degree of competition facing different customer segments. Sweden is significantly
cheaper than the UK for all baskets, though less so for some high usage residential customers. Germany and France also
appear to be more expensive than the UK by a relatively larger amount for some higher usage residential customers. The
UK also appears to do relatively better for medium businesses than for small businesses.

3.11 The existence of a significant price gap between the UK and Sweden suggests that UK fixed telecommunications
markets may not yet be effectively competitive, although there is some suggestion that the UK tends to do relatively well in
those segments which, a priori, would be expected to be the more competitive. However, it is not possible to draw firm
inferences in the absence of an analysis of the reasons for the good performance of the Swedish operators. Summary
statistics do not suggest that the structure of the Swedish market is significantly more competitive, with incumbent
operators retaining high market shares. Indeed, the UK has by some way the most developed competition in local
access provision. Given the relatively short history of competition in France and Germany, it was perhaps to be expected
that UK operators would fare better when compared with counterparts in these countries.

Whether consumers are satisfied with prices and the quality of service they receive

3.12 In February and March 2000, a survey was conducted for Oftel to establish the proportion of homes that had switched
their fixed telecommunications supplier. The survey attempted to obtain information on the reasons why customers switched,
or did not switch, supplier. Respondents were also asked about their satisfaction with their telecommunications supplier
or suppliers.

3.13 The survey found that overall satisfaction with the main telecommunications supplier was high. Some 95% of
non-switchers were satisfied overall with their main supplier, as were 92% of those who had switched main supplier,
though this proportion fell to 88% among partial switchers (such as IA users). It is interesting that changing supplier
does not appear to result in higher levels of satisfaction. However, this does not imply poorer service by the suppliers to
which customers have switched, since it is likely to reflect customer expectations. Customers tended to be most satisfied
with quality/reliability of service and least satisfied with price. Partial switchers were least likely to be satisfied with the
prices charged by their main supplier. These results are supported by similar findings in the small/medium business sector.

3.14 Approximately one quarter of the sample had changed their supplier at some time. The main reason given was cost,
followed by wish to take up cable TV. Dissatisfaction with former supplier was the primary reason for switching in only 12%
of cases. However, there was some variation by operator and dissatisfaction with former supplier was the main reason
among those who had switched to BT. In addition, one of the main reasons given for not switching was satisfaction with
current supplier; some 60% of those who had not considered switching gave this as the main reason. This is consistent
with findings from other Oftel research.

3.15 Oftel also conducts quarterly surveys of fixed telecommunications usage among residential customers and small and
medium-sized businesses. The most recent survey of businesses was in May/June 2001. This also found that overall
satisfaction was high at 95%. Again, satisfaction was highest with reliability of service whilst value for money was less highly
rated – though still 80% of respondents expressed satisfaction with these aspects of service. Small businesses were more
satisfied overall than medium businesses.

3.16 A survey of residential customers in April 2001 also found high levels of satisfaction. Some 90% of fixed line
customers rated their service as good, very good or excellent, somewhat above ratings for mobile and Internet services.
About 70% of customers thought their fixed telephone service good, very good or excellent value for money. Similarly,
95% of those respondents to Oftel’s May 2001 survey of residential customers for whom the fixed telephone was the main
method of telephony, were satisfied with it.

3.17 The high levels of satisfaction found do not suggest that any lack of competition is harming quality of service.
However, equally, it must be borne in mind that the prices and quality of service received by at least some customers reflect
the fact that the market is regulated. BT’s retail price control has borne down on prices since 1984 and, whilst quality of
service is not explicitly regulated, Oftel has introduced measures, for example, publication of comparable performance
indicators, to ensure that high quality is maintained. Nonetheless it is interesting that price was the least satisfactory
aspect of main supplier service, and dissatisfaction tended to be higher amongst high-spending customers.

Whether prices broadly reflect underlying costs (i.e. absence of persistent excessive profits)

3.18 As noted earlier, competition puts pressure on firms to set prices close to cost. A firm that tried to increase profits by
raising prices above costs in a competitive market would find that it would be undercut by rivals and would lose sales as a
consequence. In a competitive market, therefore, one would not expect to observe persistent excess profits above the level
needed to attract investment to the industry (this minimum level is given by the cost of capital). Of course, profits may
temporarily be above this minimum level, if there is innovation or if there are unexpected changes in demand. But the
competitive process would tend to eliminate any excess profits over time.

3.19 In the October 2000 price control review consultative document, Oftel reported a comparison of BT’s rate of
return on capital employed (ROCE) with its cost of capital for the last three years. The difference between the ROCE
and the cost of capital can be used as an indicator of the extent of any excess profits and hence of the degree of
competition in the markets in which BT operates. Table 3.1 was included in the October 2000 document.

Table 3.1 – BT’s Return on Capital Employed

Source: BT

Footnote

Outgoing and incoming traffic is included in the definition of International used above. International call products (e.g. operator
assisted dialling, payphones and PCs) are excluded.

3.20 Oftel estimates that BT’s cost of capital is about 13.5% (before tax and in nominal terms). Table 3.1 indicates that BT’s
actual return on capital had fallen between 1998/1999 and 1999/2000 but remained well above the cost of capital with continuing
very high returns on calls more than compensating for relatively low returns on access. The persistence of such high rates
of return suggested that calls markets were not effectively competitive. Rates of return were similar across the main call types.
Comparable data for international calls broken down by route were not available, though some variation is to be expected.

3.21 BT provided Oftel, in confidence, with a more detailed analysis of profitability, separating business and residential
customers and breaking down the latter by decile of spend. Given the high rates of return on calls and the low rates of return
on access it is not surprising that this shows that the most profitable customer segments are businesses and, in particular,
higher spending residential customers. The returns on these customers were significantly above the cost of capital. This is
slightly paradoxical since these segments are the most competitive areas of the market and indeed the current structure of the
retail price control, with its concentration on the lowest-spending 80% of residential customers, reflects this. This suggests
that competition may not yet be effective even for higher spending residential and all business customers.

3.22 It should also be borne in mind that BT’s overall rate of return reflects the effects of successive price controls which
have been set with the intention of reducing BT’s ROCE to the cost of capital by the end of each price control period, except
to the extent that BT is able to reduce costs faster than forecast. An observation that BT no longer made excess profits on
residential customers as a whole, for example, would not then necessarily imply that the market for supply to such customers
was competitive. If controls were removed, it is possible that prices, particularly to lower users, could rise.

3.23 The trend in profitability may give an indication of whether competition is intensifying. The figures in Table 3.1 reflect
performance in the year as a whole and do not allow trends within each year to be identified. Comparable figures for 2000/2001
are not yet available. However, some indication of likely trends in profitability can be gained from BT’s preliminary fourth quarter
and annual results for 2000/01 which were published on 10 May 2001 and from those for the first quarter of 2001/02 which were
published on 26 July 2001. The ‘financial highlights’ of BT’s 10 May press release stated that underlying group earnings before
interest, tax, depreciation and amortisation (EBITDA) were broadly maintained in the fourth quarter and the full year 2000/01,
with ‘satisfactory’ performance from the UK business. Group EBITDA in 2001/02 Q1 was also maintained at the same level as
in the corresponding quarter of 2000/01 whilst EBITDA in BT Retail, which includes retail price capped services, increased, as
did EBITDA in Future BT which includes both BT Retail and BT Wholesale. Press reports suggested that the 2000/01 results
had been slightly worse than market expectations, with shares falling 7%. However, it was reported that this reflected news
of more problems in Concert as well as cancellation of the dividend, uncertainty over future restructuring plans and the apparently
unexpected write-down of goodwill in Viag (which resulted in a paper loss for BT). BT’s share price hardly moved on the
announcement of the 2001/02 Q1 results. This does not, on the face of it, suggest that competition is biting very hard at the
moment in the areas covered by the retail price control. On the other hand, BT’s press releases suggest that the volume
of BT retail local, national and international calls is falling. As a result, Oftel would expect a significant reduction in BT’s
end to end ROCE by the end of the current price control period. However, it also seems likely that it will remain above the
cost of capital.

3.24 Oftel intends to examine, and would be grateful to receive, evidence of how far customers are benefiting
from competition. This could include price comparisons with competitive markets overseas, evidence of
customer satisfaction and evidence of how prices relate to costs.

Consumer Behaviour

Whether consumers are able to access information to help make effective choices

3.25 If a market is to operate effectively, consumers must be able to exercise choice between operators on the basis of
reliable information about prices and other aspects of service. For example, if consumers do not know that lower prices are
available elsewhere, they may be unlikely to switch away from their current operator, and that operator may as a result
be able to maintain prices above the competitive level.

3.26 A survey of residential customers in May 2000 found that only 18% of respondents felt they had sufficient information
to decide the best telecommunications supplier and tariff for them. The March 2000 survey (see paragraph 3.12) found
that better information sources were the main factors that consumers said would make switching easier. Over half of those
who had changed their telecommunications supplier said that easier and more independent price comparisons would have
made the process easier.

3.27 Concern that customers did not have the information necessary to make informed choices led to the setting up in
December 1999 of the ‘Phonebills’ website (www.phonebills.org.uk) by a group of operators (BT, Cable & Wireless,
Eurobell, NTL and Telewest, though others have since joined), with the support of Oftel and consumer groups. The
website helps users to find the cheapest operator for them, by selecting from a wide range of ‘typical’ telecommunications
usage levels and given the area in which they live.

3.28 The impact of the availability of ‘Phonebills’ on competition will depend on how far customers are aware of its existence
and make use of it. Oftel has therefore sought survey evidence on consumer awareness of ‘Phonebills’. However, it is worth
noting that customers do not necessarily have to use it themselves to benefit; it may be that the site allows better informed
price comparisons to appear in magazines and other publications. In addition, switching by a relatively small ‘informed’
proportion of customers may be sufficient to provide a competitive constraint on prices, which then benefits informed and
uninformed consumers alike.

3.29 A survey of households conducted at the beginning of March 2001 found that 7% of respondents had heard of or seen the
‘Phonebills’ website. At first sight, this may appear to be a rather small proportion, especially as not all of those aware of the
site may actually use the information. However, given that the website was set up only relatively recently, it is probably in
line with or better than expectations. It is comparable to awareness levels for other similar sites or publications; for example,
the same survey found that only 5% of respondents were aware of the existence of Comparable Performance Indicators
(quality of service statistics for various operators) which have been published for rather longer. It is also broadly in line with
other survey findings. For example, a third of mobile customers surveyed by Oftel in August and September 2000 did not
use any information sources to help them select their mobile. Amongst those who did take advice, by some way the most
popular source of information (used by 28% of respondents) was family or friends, as an earlier survey of fixed
telecommunications also found.

3.30 The availability of sources of comparative information such as ‘Phonebills’ at least means that customers now have the
ability to make well-informed choices between operators. However, survey evidence suggests that customers generally still
feel that they do not have adequate information available to them and that only a minority of customers are likely to make use
of ‘Phonebills’. Whether this minority is substantial enough materially to increase competition between operators is not
clear. This and other qualitative information from surveys can however help to interpret other more quantitative indicators in
order to establish the competitiveness of markets. Oftel is continuing to investigate the scope for action to make
‘Phonebills’ more effective. It is also considering whether any regulatory action is appropriate in relation to supporting the
further development of third party price comparison services.

Whether consumers are confident/knowledgeable in using information and in taking advantage of
market opportunities

3.31 Customers must know of alternatives to their main supplier of telecommunications if competition is to be effective. Respondents to the Oftel surveys referred to above were asked to indicate their awareness of alternative telecommunications providers, particularly IA operators.

3.32 Oftel’s May 2001 survey of residential consumers found that 55% of fixed line customers were aware of IA operators. This was a higher proportion than in previous surveys, which suggested that only around a third of respondents were