A New Pricing Framework for Openreach – second consultation

Summary

Summary

Introduction

1.1 BT Group plc ('BT') is subject to SMP conditions including price controls and cost orientation obligations in relation to Wholesale Line Rental (WLR) and Local Loop Unbundling (LLU)

1.2 In 2005, BT offered and Ofcom accepted a set of undertakings ('the Undertakings') pursuant to Section 154 of the Enterprise Act 2002. These Undertakings included the commitment to establish a new organisation, Openreach, which is separate from the rest of BT.

1.3 Openreach is required to provide services to competing providers of telecommunications services (“CPs”). These include:

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

1.4 In May 2008, we published a consultation document, “A New Pricing Framework for Openreach” (the “First Consultation” ). This set out our proposals to review certain aspects of the regulatory regime, including the prices of all of these regulated access network services; certain other access and backhaul services are covered by the separate Leased Line Charge Control review. The scope of this review therefore includes the charges for WLR, MPF and SMPF rentals (the “Core Rental Services”) and related services.

1.5 The First Consultation explained that the review would be held in two stages. The purpose of the First Consultation was 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.

1.6 This, the Second Consultation, sets out a range of proposals for modified price controls. It also describes the key assumptions and parameters which will inform our final conclusions on the charge controls. The latter will be set out in a Statement which we expect to publish in the first quarter of 2009.

1.7 We have also begun a new market review on fixed wholesale narrowband services with a view to publishing a consultation around March 2009. This will consider, amongst other things, whether BT continues to have market power with respect to WLR services. A market review on wholesale local access is also expected to begin in 2009. It will consider the need for any future regulation of the other services to which our proposals relate, including MPF and SMPF.

1.8 However, we consider the current charge ceilings – which are fixed in nominal terms and unlimited in their duration - are no longer appropriate. We remain of the opinion, set out in the First Consultation, that the controls need to be reviewed now.

1.9 To provide the appropriate market context for this review, it is necessary to look ahead several years, which we have done through analysing the appropriate market and financial data to the end of 2012/13. In this document we, therefore, set out specific proposals for the adjustment of the relevant charges over the next 1-2 years, but in the context of the changes we anticipate over a full 4 year period.

1.10 The long term charge controls will be considered further as we complete the relevant market reviews. We would expect to rely on analysis and proposals set out in this consultation, and the Statement which will follow, in the event that we conclude that charge controls continue to be appropriate for the relevant access services.

1.11 There are significant uncertainties surrounding the short term macro-economic outlook and capital markets continue to exhibit unusual levels of volatility. Setting a new set of charge controls in this context is challenging. In particular, we recognise the possibility that certain eventualities (such as general price deflation) may present unforeseen challenges that necessitate review of the controls that we set following the consultation. In light of this we will closely monitor the effectiveness of our new controls, and intervene if such circumstances require.

The first consultation

1.12 In the First Consultation, we explained that the current charge ceilings for the Core Rental Services are fixed in nominal terms and have not changed since they were set in 2005. When they were first set, we indicated that it would be appropriate to review the charge controls within the first few years of operation.

1.13 There have been significant developments since these charges were set. CPs have invested heavily in LLU. Openreach and the CPs are also facing important decisions including those relating to potential investment in unbundling further local exchanges and other new infrastructure.

1.14 In the First Consultation, we also set out the financial evidence presented by Openreach at that time. This indicated that the prevailing level of the regulated charges may not be sustainable, and that there may also be a case for increasing the price of MPF relative to WLR. We invited Stakeholder responses on our initial views that:

• Infrastructure competition has been working well and is delivering substantial benefits to consumers;
• Openreach has been making a reasonable overall rate of return to date 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;
• There appears to be financial 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; and
• 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.

Responses and other developments

1.15 We received 14 responses to our First Consultation. These are listed in Annex 16 and include responses from Openreach, other CPs, and organisations representing the interests of the communications industry and employees, and individuals. Non –confidential responses can be reviewed on our website .

1.16 Stakeholders generally agreed that infrastructure competition has been working well and agreed that this review should aim to promote efficient and sustainable competition in the future.

1.17 However, Stakeholders did not all agree that there is a persuasive case for price increases. Some stakeholders suggested that prices should fall. Stakeholders expressed a range of views on the key assumptions to be taken into account when determining charges, particularly regarding the appropriate rate of return and the potential for efficiency gains.

1.18 Several stakeholders also expressed the view that greater disclosure of the data underlying the case for price changes was necessary. In particular, they considered this to be necessary to ensure that the consultation process is informed and effective. We have drafted this document with this in mind.

1.19 Since these initial responses were received, we have also received further information from Carphone Warehouse and from Openreach. At our request, Openreach has also provided updated financial projections to cover the period to 2012/13. Openreach also revised (upwards) its assessment of the costs it considers should be recovered through the regulated charges. Carphone Warehouse’s additional response is available with the other responses on our website. To the extent it has informed our proposals, we describe the further information provided by Openreach in this document.

1.20 The period since May, when we published the first consultation, has also been characterised by significant volatility in the financial markets. This is pertinent to our consideration of the appropriate cost of capital and is, therefore, a factor we have analysed further in this second consultation.

1.21 We consider that this new information is relevant to our assessment of the pricing framework for Openreach and should, therefore, be taken into consideration. This Consultation sets out this new information and analysis and shows how we have taken it into account in shaping our proposals.

The second consultation

1.22 Informed by the responses to the First Consultation and our own financial and economic analysis, we set out in this consultation our updated views on the underlying assumptions, and our initial views on the modified price controls that will be required as a result.

1.23 Our current views can be summarised as follows:

• The impact of general price inflation has - and will continue to - put upward pressure on the costs of providing the regulated services;
• Further, due to the fixed nature of some of Openreach’s costs, the expected decline in demand for fixed lines, and the projected shift from WLR services to MPF, will create additional upward pressure on costs and the structure of charges;
• The impact on costs will be offset to some extent by efficiency gains, but it is unlikely to be mitigated entirely;
• We consider that Openreach’s assessment overstates the need for price increases. Specifically, we consider that Openreach’s analysis overstates the costs of providing the regulated services, and understates the scope for efficiency improvements; and
• Recent developments in the capital markets since May are likely to have implications for Openreach’s cost of capital.

1.24 In conclusion, we believe that the evidence on Openreach’s costs supports a general case for increases in the charges for the regulated access services. Further, we now consider that there is relatively greater need for an increase in the price of MPF rentals. The MPF rental price is currently less closely aligned with underlying costs than other Openreach services. We also consider that prices of other related services, such as migrations and provisions, may need to change, probably at around the rate of inflation.

1.25 This Consultation sets out our view on the direct evidence on the need for changes to the current regulated charges – including volume projections, cost levels, cost allocation, efficiency trends and the cost of capital. It also sets out our view on the other evidence that should be taken into account when determining if and how prices need to change. This includes international benchmarking and the impact price changes might have on competition, consumers and investment.

1.26 We also consider the impact of the possible outcome of this consultation on Openreach and other CPs in the context of the outcome of other related Ofcom projects, such as the Leased Line Charge Control review.

Proposals

1.27 Our final decision on the future charge controls will take account of responses to this consultation, including those relating to the assumptions to be taken into consideration when determining the cost of providing the regulated services.

1.28 To inform this consultation, we have therefore constructed what we consider to represent reasonable “high” and “low” estimates of Openreach’s future costs. These define the basis from which our proposed charge controls are derived. Having made our assessment of the likely range for costs in 2012/13, we have considered the rate at which the current charges should move towards these projections of costs over the next one or two years.

1.29 On this basis, our proposed ranges for the major new controls are set out in Table 1.1. These comprise two elements: the proposed price ceilings for 2009/10, and the proposed indexation of this ceiling into 2010/11 (in the case of MPF and SMPF).

Table 1.1 Proposed price changes

Service	Current price cap	Proposed charge from 2009/10		Proposed control from 2010/11
MPF rental	£81.69	£85.00 to £91.00	RPI + 0.0% to RPI + 5.0%
SMPF rental	£15.60	£15.60 to £16.20	RPI - 2.5% to RPI + 1.5%
WLR residential line	£100.68	£100.68 to £104.40	See paragraph 1.7
WLR business line	£110.00	£106.00 to £110.00	See paragraph 1.7

1.30 In summary we propose regulated charges as follows:

• MPF: an increase from £81.69 to between £85.00 and £91.00 on 1 April 2009, followed by an adjustment of between RPI + 0.0% and + 5.0% on 1 April 2010;
• SMPF: an increase from £15.60 to between £15.60 and £16.20 on 1 April 2009, followed by an adjustment of between RPI - 2.5% and + 1.5% on 1 April 2010;
• Residential WLR: an increase from £100.68 to between £100.68 and £104.40 on 1 April 2009;
• Business WLR: a reduction from £110.00 to between £110.00 and £106.00 on 1 April 2009.

1.31 The final combination of 2009/10 charge and subsequent indexation will be determined such that – if an equivalent annual indexation were to apply until 2012/13 - it would deliver a price that equals our final assessment of the projected efficient fully allocated cost of each service in the final year.

1.32 For the purposes of illustration, in calculating the proposed indexation ranges for 2010/11 indexation shown in the table above, we have assumed that these start from the mid-point of the respective range for the proposed 2009/10 charges. The indexation ranges shown would, if applied to this mid-point starting charge, allow prices to approach fully allocated costs by 2012/13.

1.33 To the extent that the final set of assumptions supports prices towards the high or low end of the range for one service, it is likely to support a similar outcome for all services. We therefore expect to see MPF prices increasing relative to WLR prices.

1.34 The Wholesale Narrowband Market Review which we are undertaking will consider the potential requirement for the continuation of the WLR remedy in the longer term and any associated charge control in the longer term.

1.35 Our current assessment in the context of this review of the costs of WLR indicates that – if we were to set 2009/10 WLR charges at the mid-point of the ranges shown in table 1.1, any future control on combined WLR rentals (business and residential) would, on average, need to allow prices to change at a rate of between RPI-3% and RPI+3%.

1.36 As set out in the First Consultation, Openreach provides a range of other services, related to the provision of rental services. These are currently subject to price control and/or cost orientation obligations. We propose that these services should be subject to price controls applied to appropriately defined baskets.

1.37 Our decision on the definition of these baskets will be informed by responses to this Consultation. However, we consider that the baskets should be designed to be straightforward to understand and implement, while minimising the risk of inappropriate incentives or disruption to the markets.

1.38 In broad terms, we intend to group these services into three baskets based on the underlying services – WLR services, MPF services and SMPF services – plus a fourth basket for services relating to the occupation of space in BT buildings. One-off price changes for some services within those baskets remain an option, although we do not consider there to be a case for significant changes to average prices within each basket. We currently expect to apply a similar control to each basket, with prices being allowed to increase at a rate similar to, or just above, inflation.

Next steps

1.39 Stakeholders are invited to comment on the methodology employed and assumptions used in arriving at these proposals and the potential implications of these proposals. Responses should be submitted by 20 February 2009.

1.40 We intend to publish our statement before the end of March 2009 with an expectation that any new controls will take effect from 1 April 2009.