BT accounts reveal fear of retrospective price adjustments

BT announced its annual results today.

Press comment focused on BT’s profit growth and the reduction in their pension deficit. However, both of those stories are not quite such good news for BT as might be supposed. Profit growth came from BT cutting costs faster than the fall in BT’s revenues – trends which are not exactly going to set the analysts’ models humming when plugged into DCF valuation models. BT’s pension deficit reduction was to a large extent driven by timing – not surprisingly it looks much better now than shortly after the 2008 market crash – and some commentators have suggested that BT has used some rather optimistic inflation assumptions in its deficit valuations modelling.

For me a bigger story was BT’s narrative that revenue growth would come from its (very capital-intensive) roll-out of fibre-optic access and associated services (such as BT Vision). With established competition from Virgin Media, the strong triple-play offering from Sky, potential new entrants such as Fujitsu and continued regulatory scrutiny there would seem to be significant implementation risk around this plan.

However, I always find that the most interesting sections of annual results are buried in the notes to the accounts. In note 11 (risks) BT says this about regulation:

“Communications industry regulation

Some of our activities continue to be subjected to significant price and other regulatory controls which may affect our market share, competitive position, future profitability and cash resources. Many of our wholesale fixed network activities in the UK are subject to significant regulatory controls. The controls regulate, among other things, the prices we can charge for many of our services and the extent to which we have to provide services to other CPs. In recent years the effect of these controls has required us to reduce our prices, although in some recent cases, prices have been allowed to increase in real terms.

Regulatory authorities may increase the severity of the price controls, extend the services to which controls apply or extend the services which we provide to other CPs. These controls may adversely affect our market share, our ability to compete and our future profitability and cash resources. Wholesale customers may also raise disputes with Ofcom, seeking lower prices on wholesale services which are not subject to direct price control.

Impact
In recent years, changes in price controls have required us to reduce our prices and in some instances to make payments in respect of retrospective price adjustments. Additional or more substantial regulatory price reductions could constrain our revenue growth. Regulatory actions may also indirectly affect us. For example, Ofcom has reduced the mobile termination rates that mobile network operators can charge to terminate calls on their network. There will be a stepped reduction in prices over four years starting from April 2011. This regulatory action will have a significant impact on future transit revenues in the UK and Europe.

We may be required to provide new services to wholesale customers on a non-discriminatory basis, increasing our costs and increasing retail competition. Disputes may result either in reduced revenue or increased costs going forward. We may also be required to make retrospective payments to CPs if it is ruled that past charging mechanisms we have applied have overcharged CPs. Appeals may change Ofcom’s decisions, which had originally been concluded in our favour.

Risk mitigation
We continuously monitor and review potential regulatory changes and disputes, and maintain a strategic dialogue with regulators and other key influencers on critical issues.[underlining added].

This is a very interesting statement in the light of BT’s recent loss in the PPC case in the CAT.

Ofcom has wide jurisdiction and discretion to accept and resolve disputes

The CAT today rejected BT’s arguments that Ofcom has a narrow jurisdiction to accept and resolve disputes referred to it by Communications Providers pursuant to Section 185 of the Communications Act 2003.

The CAT joined two cases (one relating to ‘ladder pricing’  and one to charges for ethernet services above DSAC) in both of which BT alleged that Ofcom had no jurisdiction to determine the alleged disputes because:

  1. No dispute existed. BT contended that whilst there remained any scope for resolution of issues through, inter alia, future negotiation, no dispute existed. It relied on (i) the 32nd recital of the Framework Directive as modifying the meaning of ‘dispute’ in article 20 of the Framework Directive and article 5 of the Access Directive so as to require that all negotiations have been exhausted; (ii) Ofcom’s 2004 Disputes and Complaints Guidance; and/or; (iii) a ‘floodgates’ policy argument.  The CAT rejected all BT’s arguments.
  2. Alternative dispute resolution means were available. BT argued that (i) future negotiation constituted alternative means; and/or (ii) Ofcom should have used its Condition enforcement powers. The CAT again rejected both arguments.

The Watcher needs to declare an interest: he represented an intervener in this appeal, so readers should ‘filter’ this post accordingly.

Ofcom consults on reductions in LLU and WLR prices

Ofcom today started a consultation on price controls for local loop unbundling and wholesale line rental products provided by Openreach, the functionally separate local access division of BT.

This consultation follows on from Ofcom’s finding in its wholesale local access and wholesale fixed analogue exchange line market reviews that BT held a position in those markets akin to dominance (in EU telecoms regulatory speak – ‘significant market power’). Each of those market reviews imposed various obligations on BT including an obligation to meet reasonable requests for network access, an obligation to publish a reference offer, cost-orientation requirements and a compliance with charge control requirements – the subject matter of today’s consultation. 

In common with other UK telecoms charge controls, the proposal is that the charge controls will take the form of an RPI-X% control (where RPI = retail price index and X is set at a level to ensure that BT’s expected rate of return reaches an ‘acceptable’ level by the end of the charge control period), although somewhat unusually a two year, rather than the more normal four year, period is proposed for the charge control.

The charge control has been structured as:

  • an individual control for metallic path facility (or MPF – the copper wire to the home);
  • an individual control for shared metallic path facility (or SMPF – the high frequency part of the copper wire to the home, used to provide broadband, rather than voice);
  • separate baskets for (i) MPF ancillary services, (ii) SMPF ancillary services; and (iii) co-mingling services;
  • an individual control for wholesale line (WLR) rental;
  • an individual control for WLR new connection; and
  • an individual control for WLR transfer.

Prior charge controls were reviewed by the Competition Commission (see here for LLU and here for WLR), and those determinations have been taken into account in this consultation as well as BT’s revaluation of its duct network. This consultation uses a WACC for BT of 8.6%, although this is subject to another consultation on the appropriate WACC.

Responses are due by 9 June.

Ofcom proposes prohibition of evergreen customer contracts

Earlier this week I discussed the changes Ofcom are proposing to the General Conditions of Entitlement to implement the revised European Regulatory Framework. It now seems that Ofcom are also taking the opportunity to look at other changes to the General Conditions, yesterday publishing proposals to amend General Condition 9 to prohibit providers of fixed voice and broadband services to the consumer and SME (for these purposes, businesses with less than ten employees) markets having contracts which automatically renew at the end of their initial contract term for subsequent fixed contract term(s). Early termination charges would be payable if contracts are terminated before the end of any particular contract term.

Readers will recall that Ofcom’s earlier consultation already included proposals restricting Communications Providers’ freedom to contract with their customers including a maximum contract period of two years and the requirement to offer a twelve month contract option where a longer contract period is offered, as a well as a general requirement to ensure that conditions or procedures for contract termination do not act as disincentives for end-users against switching.

The additional proposed restriction would prohibit relevant Communications Providers from having opt-out processes for minimum contract term renewals.

Ofcom is clearly anticipating significant industry resistance, as they have commissioned an array of research to justify their proposals, including:

  • Empirical Analysis of BT’s Automatically Renewable Contracts, August 2010 – an econometric study analysing the impact of BT’s automatically renewing contract on its customers decisions to switch to another CP.
  • Mystery shopping survey summary by E-Digital, September 2009 – to see whether BT promotes ARCs ahead of other options, and whether consumers are given all facts about ARCs in order to facilitate effective purchasing decisions.
  • BT Renewable Contracts – a Report by Spring Research, August 2009 – to assess the knowledge and understanding of ARCs terms and conditions among BT customers.
  • Analysis of Call Recordings by Mott MacDonald, October 2009 – to understand the accuracy of information that BT call centre advisors provide to consumers in relation to ARCs at point of sale, and whether advisors verify that customers understand the ARC prior to agreement.

Ofcom identify two types of potential harm:

  1. direct effects  from the exposure to switching costs in the form of early termination charges; and
  2. indirect effects  from the lessening of competitive intensity in the market.

Responses are due by 12 May with implementation proposed to be at the same time as the other changes to general conditions.

The watcher has mixed views on the proposals. Whilst on their face they appear positive for consumers and competition, from a policy perspective it is not clear that Ofcom have identified a market failure that requires regulatory intervention and interference with the freedom to contract.  Some communications providers already compete in the market by making a virtue of their lack of contract term (e.g. see Post Office Home Phone) and there is not a convincing cost-benefit analysis of the proposals. I await responses with interest.

DSAC an appropriate test for assessing LRIC cost-orientation

Today’s CAT judgment confirmed that Ofcom’s use of distributed stand-alone cost (“DSAC“) was an appropriate method to assess whether a regulated Communications Provider who had been found to possess Significant Market Power in a particular market was charging in a way that was ‘reasonably derived from the costs of provision based on a forward-looking long run incremental cost approach, allowing an appropriate mark-up for the recovery of common costs and an appropriate return on capital.’ The judgment went on to confirm that where charges had not been compliant with the cost-orientation obligation that Ofcom had correctly exercised its discretion by ordering repayment of the amount of the overcharge.

DSAC is  a test that distributes the stand-alone costs of a broad increment of services pro rata amongst each of the services within that increment. DSAC is not widely used outside UK telecoms regulation – during the trial BT quoted contestable market theory in support of the proposition that combinatorial tests were the appropriate method of assessing compliance, and in the original dispute the complainants argued that fully allocated cost (or FAC) was the right test. However, the court found that DSAC was well-known and understood in the context of UK telecoms regulation (appearing, by way of example, as a price ‘ceiling’ within BT’s published regulatory accounts). The court considered these various tests, as well as alternatives including international benchmarking, and found that in this instance that there was ‘no satisfactory alternative’ to the use of DSAC, albeit that it should not be used in a mechanistic way.

The background to the case was that on 14 October 2009 Ofcom resolved a dispute between (i) Cable and Wireless UK, COLT, Global Crossing, Verizon and Virgin Media; and (ii) BT, by finding that BT had overcharged by more than £40 million for particular regulated wholesale leased lines (known in the UK as partial private circuits or PPCs) and ordered BT to repay to BT the amount of the overcharge.

BT appealed Ofcom’s decision in December 2009, with a six day trial heard in October 2010. The trial involved witnesses of fact and significant expert economic evidence. BT’s appeal had a numbers of grounds:

  1. Ofcom misused their dispute resolution powers 
  2. Ofcom failed to give proper regard to economic harm
  3. Ofcom’s refusal to consider trunk and terminating segments in aggregate was flawed and improper
  4. Ofcom made an error of law and appreciation in the approach to cost orientation and their use of DSAC
  5. Ofcom misused their power under s190(2)(d) of the Communications Act 2003 to order repayment of the overcharges.

The Court unanimously found against BT on all grounds.

BT may apply for permission to appeal – I await their decision with interest.

The Watcher needs to declare an interest: he represented the overcharged companies in the dispute before Ofcom and subsequent appeal, so readers should ‘filter’ this post accordingly.

‘Illegal state aid’ challenge to tax levied on BT’s UK fibre network fails in European Court

In a decision dated 21 January, but only released this week, the EU’s General Court in Luxembourg has dismissed Vtesse’s appeal against a decision of the European Commission that rates (a UK land use tax) levied on BT’s UK fibre network did not constitute state aid.

Vtesse originally complained to the Commission in 2004, but the Commission closed its case in December 2006 on the following basis:

In conclusion, it should be recalled that business rates are a tax on the value of the property concerned. They are not a tax on profits or revenues. They are normally applied on all non-domestic properties, and consequently are applied to all telecommunications networks. According to British case-law all telecommunications networks are valued as a whole. There are several methods for valuing such property. When all methods can be applied, they should result in the same valuation. The use of a specific valuation method depends on the circumstances of the case.

It now appears that the VOA has applied to BT and Kingston the general rules concerning business rates as laid down in the legislation and case-law. It is clear that the valuation of BT’s and Kingston’s hereditaments as well as the revisions of these rateable values, are carried out on the basis of a different method than in the case of their competitors. However, the Commission can conclude that there is no evidence that the use of this different method is not justified by the objective differences between those firms and their competitors and by the extent of the evidence available to the VOA.

There is no evidence that the application of a different valuation method to BT and to Kingston has resulted in an advantage to these firms in comparison with their competitors. Since there is no evidence of an advantage, the Commission can conclude that the non-domestic rates system has not provided State aid to BT and/or Kingston within the meaning of Article 87(1) EC during the period considered by the Commission i.e. 1995-2005.

Vitesse appealed on the basis that the Commission didn’t carry out a full and proper investigation before closing the case. It appears from reports of the General Court’s judgement that the court did not engage with this substantive ground of appeal, instead dismissing the appeal on the basis that Vtesse was unable to demonstrate that it was individually concerned by the action. The court apparently observed that Vtesse would have needed to establish causality between the contested state aid and any change in Vtesse’s market position.

Against the backdrop of a government policy objective to encourage competitive roll-out of fibre networks this decision will clearly disappoint BT’s competitors.

UK wholesale broadband access proposed charge control: Ofcom estimates BT’s weighted average cost of capital downwards to between 8.5% and 10%

Ten days ago Ofcom published a lengthy consultation on charge control for Wholesale Broadband Access, accompanied by a report from the Brattle Group on BT’s equity beta.

Wholesale broadband access is the ‘current generation’ (i.e. primarily DSL) wholesale broadband access products sold by BT to its retail competitors. Ofcom’s most recent review of this market geographically segmented the UK into four distinct regions:

  • local exchanges where only BT is present (“Market 1”);
  • local exchanges where in addition to BT, two of BT’s material competitors are present or forecast, or where three of  BT’s material competitors are present or forecast but BT’s market share exceeds 50% (“Market 2”);
  • other local exchanges where BT is present that are not in Market 1 or 2; and
  • Hull (where only Kingston Communications is present).

Ofcom’s market review found BT to have market power in Markets 1 and 2 and Kingston Communications to have market power in Hull. In addition to various other remedies imposed by that review, Ofcom proposed a charge control on BT in Market 1 – hence this most recent consultation.

The consultation proposes to control the charge for BT’s 8 MBits/s IPStream Connect product only, on the basis that this comprises 86% of the product actually sold and that it will act as both a direct control and indirect constraint.  Ofcom proposes a three year RPI-X control, with X set so that by the end of the charge control period, BT is expected to be able to earn a level of return on the basket of services that is equal to its weighted average cost of capital. This objective of course requires Ofcom to form a view on BT’s cost of capital – hence the Brattle report.

The Brattle report contains both:

  • an analysis of BT’s equity beta based on a regression of daily returns for holding stock in BT and from holding a broad market index; and 
  • comparisons against two control groups, being other UK regulated utilities and publicly traded US telecoms stocks.

The Brattle analysis identifies BT’s one-year equity beta to be 0.96 and two-year equity beta to be 0.84.  This is higher than other UK regulated utilities and the report speculates that BT is not considered quite as ‘safe a haven’ as UK utilities.  By contrast, BT’s beta is in-line with the estimates for the US stocks considered. 

Section 6 of the Ofcom consultation then take into account both the Brattle analysis and other factors (primarily lower interest rate and corporation taxes and a reduction in the perceived riskiness of BT) to come up with revised estimates for BT’s cost of capital. These estimates are lower than those made previously in May 2009 as can be seen:

  • Openreach: May 2009 mid-point WACC 10.1% , proposed 2011 mid-point WACC 8.6%;
  • BT Group: May 2009 mid-point WACC 10.6% , proposed 2011 mid-point WACC 8.9%;
  • Rest of BT: May 2009 mid-point WACC 11% , proposed 2011 mid-point WACC 9.3%.

BT sets prices for passive access to ducts and poles

Before Christmas, this blog flagged that last-mile fibre access (also know as next generation access, or NGA) was a commercial and regulatory issue that would be high on the agenda over the coming years.  On Friday, BT announced its draft pricing and product proposals for ‘passive access’ to its ducts and poles in the UK.  (In the NGA world passive access is used to describe access to physical infrastructure, whereas active access means access to some form of wholesale service).

BT is careful to position the new draft product proposals as complementary to its existing (active) Generic Ethernet Access products which it ‘expects … will form the basis of most [of BT’s competitors’ offerings]’. However, BT’s competitors may of course have a different view.  In reality, the impact and usage of BT’s new products will depend on their pricing, both in absolute terms as well as relative to active products and the underlying technology used by its competitors.

In terms of pricing, BT is proposing that duct access will start from £0.95 per metre per year, with various additional charges for ancillary services, whilst pole sharing access will be around £21 per pole, per year.   In BT’s view the duct access is around 15% less than international comparables, although I haven’t seen any underlying analysis to support that contention.  Going beneath BT’s headline figures, the list of ancillary services is extensive and it looks like the level of the charges will be material for most purchasers, so the detail is well worth looking at.

So far as the regulatory background is concerned, the position is somewhat complex, with regulators in Europe and the UK both having taken an interest and the waters muddied even further by the interplay between traditional electronic communications regulation of markets in which players hold significant market power and BT’s Enterprise Act undertakings.  Regulation in the UK is of course subject to EU thinking, in particular the Commission’s  recommendation on NGA which takes into account views of the European Regulators’ Group (BEREC) .

The Commission’s recommendation makes clear in outline that the regulatory requirements on BT in relation to ducts and poles  should include:

  1. duct access on an equivalent basis (para 13 of Recommendation);
  2. cost-orientated pricing for access to existing civil engineering infrastructure (para 14);
  3. mandated reference offer (para 15);
  4. requirement to install capacity for other operators when undertaking future civil engineering works (para 16); and
  5. provision of information to a central database (para 17).

Some of this was picked up by Ofcom in its October 2010 Review of the Wholesale Local Access Market, where following a finding that BT had significant market power in the UK (except Hull)  in the market for wholesale local access services (being those based on copper loops, cable networks and optical fibre at a fixed location), it imposed a range of remedies relating to local loop unbundling (LLU), sub-loop unbundling (SLU), virtual unbundled local access (VULA) and physical infrastructure access (PIA) – with the last relating to ducts and poles.

The obligations imposed on BT pursuant to that market review specifically relating to PIA (i.e. ducts and poles) are to:

  1. produce a draft reference offer by mid-January (i.e. the latest announcement) – although this need not support leased line services at this stage;
  2. launch the product by the ‘middle’ of the year (which translated from Ofcom-speak,  I would take to mean that BT need to have something in play by September);
  3. pricing should be cost-orientated (which means argument is likely);
  4. provide network access, to not discriminate unduly, to keep separate accounts and to publish certain information.

Although not referenced in Ofcom’s market review, the various requirements under BT’s undertakings in relation to NGA and equivalence are also relevant (although, Ofcom has expressly decided to not implement a para 13 equivalence requirement), as is Ofcom’s separate consideration of industry-wide mandation of infrastructure sharing.  As can be seen, last week’s announcement is the start of a process that will play out over the rest of this year (and beyond).  Challenge at this stage is unlikely, but the experience of the launch of almost any new product (interconnection in 1984, LLU in 2000) suggests that disputes may well be on the horizon.

Is BT’s wholesale content connect the end of the world?

There has been a lot of discussion this week of BT’s wholesale content connect product, so I thought it would be helpful to unpack the story and explore exactly what BT’s product is (and is not), and what the views are of those objecting.

BT’s View

Let’s start with BT’s side of the story. BT has a dedicated microsite, explaining the product as they see it. 

Their ‘How’ animation explains that the product consists of local caches for video content, with delivery to the caches via links which guarantee end to end quality of service – this new infrastructure bypasses the internet, which doesn’t prioritise video packets.  Although not stated by BT these caches and associated delivery network clearly have required BT to incur both incremental capital and operational costs.

BT explains their rationale in their ‘Why’ animation as the increasing growth of ‘over the top’ video, particularly to TV screens (as opposed to PC screens).

In terms of benefits, BT explain these for different groups as follows:

  • for users a guaranteed broadcast quality viewing experience with no buffering;
  • for content owners a better user experience, customer interactions and new advertising revenue; and
  • for ISPs more cost-effective delivery of video and the opportunity to provide new digital media services.

What BT don’t explain in their published materials (although it is implicitly alluded to in the description of benefits for content owners and ISPs above) is the commercial model.  For content owners in particular, it is unclear why they would want to either pay directly, or indirectly, for use of BT’s product.  A key issue to watch is whether use of this wholesale product can be used to either increase ISP end-user revenues or content owner advertising / subscription revenues, and if either is true how the cake gets shared between the content owners, ISPs and BT. 

Open Rights Group comments

By contrast (although not surprisingly given relative resources and also as a reaction) the Open Rights Group comments are quite brief, so worth quoting in full:

“We are talking about ISPs competing with the Internet for content delivery. Whether films, music or gaming services, the idea is that ISPs will deliver content better and more reliably than the Internet. That says a lot about the state of investment in our Internet.

The result could be a fundamental shift away from buying services from the Internet to bundled services from ISPs: which would reduce competition and take investment away from Internet companies. That would be bad for everyone.”

Whilst they clearly don’t like BT’s proposal, it is not clear exactly what they are positively advocating.  Is it that BT shouldn’t offer this product at all, which wouldn’t help to enable over the top video viewing, or that BT shouldn’t charge for this service / enable ISPs to cut content deals with content owners?  The former seems like a bad consumer outcome and the latter a decision that would be in direct conflict with BT’s directors’ duty to act in the interests of their shareholders (i.e. only invest capital where a return is likely).

Their objection to ISPs bundling content with access is also worth unpicking.  I can see how this might be objectionable where there is no choice of access provider (which I understand to be driving the net neutrality debate in the US), but where there is effective retail competition between ISPs, underpinned by effective wholesale regulation of BT (as is the case in the UK), it seems to me that bundling and resultant multi-dimensional product competition is a good outcome in terms of driving product innovation and delivering consumer choice.

End to net neutrality?

The first point to make is that BT’s product is not about ‘internet’ traffic management or prioritisation at all – it is a separate content delivery network sitting alongside the internet.  Both ISPs and content owners are able to use the internet for content delivery.

If BT’s product is assessed against Ofcom’s current view of applicable net neutrality rules, provided that BT doesn’t degrade or block video traffic passing over the internet, then from the information available it wouldn’t appear to breach current rules.

Another related development is the proposed traffic light system for the BBC iPlayer, which will enable users to see how ISPs are managing video traffic – this type of user transparency could be turned against the ISPs by the content owners. 

However, this debate will clearly run and run, so I will no doubt return to the issue in future posts.  (With thanks to @mattjphillips for his input – mistakes are all my own).