A New Pricing Framework for Openreach

Summary

Summary

Introduction

1.1 On 22nd September 2005, BT Group plc ('BT') ^(-1-) offered and Ofcom accepted a set of undertakings ('the Undertakings') pursuant to Section 154 of the Enterprise Act 2002 in lieu of a reference of certain markets to the Competition Commission.

1.2 The Undertakings included the commitment to establish a new organisation, Openreach , which is separate from the rest of BT. Openreach is required to provide:

• Wholesale Line Rental (“WLR”);
• Local Loop Unbundling (“LLU”) which includes fully unbundled lines (Metallic Path Facility or “MPF”) and shared unbundled lines (Shared MPF or “SMPF”); and
• Ethernet services.

1.3 These services are provided under Significant Market Power (“SMP”) conditions.

1.4 The current charge ceilings for WLR and LLU services were set as follows:

• For WLR, in the 24 January 2006 Statement, “Wholesale Line Rental: Reviewing and setting charge ceilings for WLR services “ ^(-2-) (the “WLR Statement”);
• For MPF, in the 30 November 2005 Statement, “Local loop unbundling: setting the fully unbundled rental charge ceiling and minor amendment to SMP conditions FA6 and FB6” ^(-3-) (the “LLU Statement”); and
• For SMPF, in the 16 December 2004 Statement “Review of the Wholesale Local Access Market ” ^(-4-) (the “WLA Statement”).

1.5 The current charge ceilings for the WLR, MPF and SMPF rentals are set out in Table 1.1.

 

Table 1.1

Service	Current charge ceilings for annual rental
Residential WLR	£100.68
Business WLR	£110.00
MPF	£81.69
SMPF	£15.60

1.6 These charge ceilings are fixed in nominal terms and do not change over time. When they were set, we explained that it would probably be appropriate to review the charges within the first few years of operation ^(-5-). Since then, BT has held the charges at the ceilings, with the exception of the MPF Rental which BT has priced at £80. However, BT announced on 29 April that, with effect from 1 August 2008, it would be setting the MPF charge at the ceiling of £81.69.

1.7 Since these charges were set, there have been significant developments in the relevant markets. Communication Providers have invested heavily in LLU and there are now more than four million unbundled lines. Meanwhile, Openreach and other Communication Providers are facing important decisions including those relating to potential investment in unbundling further local exchanges and other new infrastructure investment.

1.8 Openreach has also presented evidence to Ofcom which indicates that, due to cost pressures, the prevailing level of the regulated charges may not be sustainable, and that there may be a case for increasing the price of MPF relative to WLR.

1.9 In light of these we have decided to review certain aspects of the current regulatory regime. The purpose of the review is to determine whether there is a need to change the existing level and structure of charges for the regulated wholesale access services and, if so, to put in place a new, forward looking, price control framework for those services.

1.10 The review will consider all regulated access network prices other than those backhaul services covered by the separate Business Connectivity Market Review ^(-6-), which will be addressed in the upcoming Business Connectivity Charge Control review. We are conscious of the need to consider the total impact of both reviews on BT and the Communications Providers and we are coordinating the reviews such that Stakeholders will be able to comment on the overall implications of any changes.

1.11 This consultation will be held in two stages, followed by a Statement which we plan to issue before the end of 2008. The purpose of this, the First Consultation, is to obtain Stakeholder views on a range of issues relating to the review, including the objectives, our proposed approach and the potential implications of different outcomes. The Second Consultation will set out a range of proposals for new price controls. These proposals will be informed by responses to the First Consultation and further financial and economic analysis.

Approach to the review

1.12 The new framework should continue to encourage efficient, sustainable competition in access services. It should also provide appropriate incentives for future improvements in the quality, innovation and investment in existing and next generation services. It should enable Openreach to charge prices which reflect costs, promote efficient competition, and provide Openreach with the opportunity to cover efficiently incurred costs, including the cost of capital ^(-7-). In conducting the review we will therefore need to:

• Analyse and, where relevant, benchmark Openreach’s cost structure and efficiency levels and assess aspects of Openreach’s service costing methodology;
• Develop cost projections for Openreach – overall and at the the level of individual services;
• Consider how price controls for the regulated services should be determined given the overall, and service specific, cost projections for Openreach; and
• Consider if and how the contribution made by other services to the total cost base should be taken into account.

1.13 This will require detailed cost modelling similar to that used to set price controls in the past. It will also require a decision on the appropriate scope of the review.

1.14 The modelling will draw on a range of evidence, including that generated by Ofcom and received in response to this consultation. It will also take account of cost projections provided by BT, described in more detail in this document. This will be balanced by other evidence on costs and pricing, including international benchmarking data.

1.15 Financial modelling provides only part of the overall evidence to be taken into account in determining how the existing pricing framework should evolve. Other evidence, including, for example, the impact price changes might have on demand, competition, consumers and future investment decisions must also be taken into account.

Seeking Stakeholders’ views

1.16 Stakeholders’ responses are invited on our early views that:

• Infrastructure competition has been working well and is delivering substantial benefits to consumers;
• Openreach overall has to date made a reasonable rate of return based on the prevailing regulated access prices;
• This is likely to change if the impact of cost inflation cannot be mitigated, thus potentially bringing into question the sustainability of the current price ceilings (which are fixed in nominal terms);
• There is evidence to support a case for increases in the prices of the current regulated services;
• The strength of this evidence is critically dependent on a number of key assumptions which will be subject to further analysis during the course of this review, including
  
  
  • The potential for efficiency gains within Openreach;
  • The consistent treatment of costs in line with previous regulatory reviews ;
  • Openreach’s cost of capital;
  • The scope of services which should be encompassed by the review;
  • Future demand for services; and
  • How Openreach’s fixed and common costs should be recovered through individual service charges.
• The foregoing must be considered alongside other evidence, including international benchmarking and the impact price changes might have on infrastructure competition, consumers and future investment decisions.

Preliminary Conclusions

1.17 BT has provided evidence that the current, regulated prices for wholesale access services (WLR, MPF and SMPF) are out of balance with the underlying costs. BT has also provided projections which suggest that the costs of these services will increase over the next few years, even after allowance is made for improvements in efficiency levels. The implications of these projections are that the charges for these services overall may need to rise and, potentially, that the price of MPF in particular may need to increase relative to the price of WLR.

1.18 As we set out in this document, we consider that Openreach may have adopted a conservative approach in projecting future costs. We also believe that there is a need to look at Openreach’s current efficiency levels (given the evidence on comparative MPF price levels across Europe) and at a range of other cost related factors which will have a bearing on the need to raise prices overall, and on the appropriate balance of those prices – these include the scope of services which should be encompassed by the review, potential adjustments to the cost base, the cost of capital, and the appropriate method for recovering Openreach’s fixed and common costs. Besides the evidence on costs we will also need to consider the impact of any changes on competition and on consumers, particularly bearing in the mind the benefits that the current regime has brought to consumers over the past two years in terms of new services, choice and reduced retail prices.

1.19 Our conclusions will be based on the evidence received, and the analysis we will undertake, during the course of the review. Nonetheless, the evidence we have reviewed to date suggests that there is likely to be a case for some increases in the charges for the regulated access services – prices fixed in nominal terms do not appear to be sustainable indefinitely. However, we do not currently believe that the increases need to be as significant as is implied by the projections provided by BT. We have not yet formed a view on the case for an increase in the price of MPF relative to WLR; however, the analysis of this issue will be a core element of the preparation for the next consultation.

Structure of this document

1.20 This document is set out as follows:

• Section 2 sets out the background to this review, including a summary of relevant regulation, and an explanation of our powers to review and make changes to the current regime, where appropriate;
• Section 3 provides some context for this review by considering recent market developments;
• Section 4 provides further context by considering Openreach’s recent financial performance;
• Section 5 sets out our overall approach to this review;
• Section 6 summarises the evidence provided by BT to support the case for changing the current level of charges, our views on this evidence and other factors that will need to be taken into account in establishing a new pricing framework;
• Section 7 considers the relationship of the Pricing Framework to Openreach performance and quality of service; and
• Section 8 looks at how a new framework might be implemented.

Footnotes:

1.- Openreach is a division of BT. All legal obligations are placed on BT, including regulatory remedies for significant market power determinations, and BT is the legal entity in any contracts with third parties. Throughout this document, we refer to BT when discussing legal obligations and the provision of financial information to Ofcom. We refer to Openreach when discussing the operational activity and performance of the division.

2.-http://www.ofcom.org.uk/consult/condocs/wlrcharge/statement/statement.pdf

3.-http://www.ofcom.org.uk/consult/condocs/llu/statement/llu_statement.pdf

4.-http://www.ofcom.org.uk/consult/condocs/rwlam/statement/

5.- See paragraph 1.16 of the WLR statement and paragraph 3.17 of the LLU statement.

6.-http://www.ofcom.org.uk/consult/condocs/bcmr/

7.- Throughout the document references to Openreach’s cost of capital refer to the cost of capital for the main existing Openreach business.

The full document is available below