Ofcom’s UK digital communications review: BT can keep Openreach (for now…)

On 25 February 2016 Ofcom published its initial conclusions from its strategic review of the UK’s digital communications market. Whilst much of the headline press coverage has focused on BT being able to retain Openreach, provided its governance is reformed, Ofcom’s review goes much wider than the regulation of Openreach and sets the strategic direction for UK telecoms regulation for the next decade.

However, as someone who has seen successive regulators try alternatives including accounting separation, functional separation and now reformed functional separation whilst technology has moved from cellular telephones that could only be said to be mobile if you drove the car carrying them to modern smart-devices what is striking is the persistency of incumbency, and in particular the ‘last mile’ connection. Whilst Ofcom’s proposals go wider than just addressing this bottleneck, the most interventionist regulation is aimed at this problem, which of course tacitly admits that the last strategic review, done just after Ofcom was formed, failed.

The rest of this post explains how Ofcom reached its conclusions.

What is Ofcom trying to achieve?

Legal Duties

Ofcom is of course a statutory body and the Communications Act 2003 sets out Ofcom’s duties, with Ofcom’s primary duties being:

to further the interests of:

(a) …citizens in relation to communications matters; and

(b) …consumers in relevant markets, where appropriate by promoting competition.

Vision

The challenge for Ofcom is understanding how to turn this duty into something that allows it on a day to basis to take decisions, all of which involve trade-offs. This is where the vision comes in, as Ofcom can then test each of its decisions and see whether they help or hinder it achieving its vision. Ofcom explains that in 2016 its ten-year vision is that:

  • everyone in the UK will enjoy fast, reliable broadband services. Most consumers and businesses will move from ‘superfast’ to ‘ultrafast’ broadband, based increasingly on competing networks, and the latest mobile phone technologies will be rolled out across the UK’s geography;

  • the UK will move towards a new fibre future, with widespread availability of competing ‘fibre to the premise’ and cable networks to homes and businesses. As more consumers and businesses enjoy a greater choice of networks, competition will drive both innovation and affordable prices;

  • people who do not have a choice of providers, do not enjoy even a basic level of service (whether through social circumstance or simply due to where they live), or find it hard to take advantage of offers in the market, will be protected through effective, targeted intervention; and

  • the UK will be a world leader in the availability and capability of its digital networks.

Areas of strategic focus

Ofcom then explains that it will organise its work into five main areas to achieve its vision, with a final sixth theme of seeking to reduce regulation being applied across everything that Ofcom does.

The five areas are:

  1. securing a wide availability of services;
  2. promoting investment and competition;
  3. delivering a step-change in quality of service;
  4. strengthening Openreach’s independence; and
  5. empowering and protecting consumers.

Each of these areas are then examined by Ofcom, and its analysis of the issues to be addressed and form the basis for Ofcom’s proposals. In Ofcom’s own words they are:

Securing a wide availability of services

“From a UK-wide perspective, the availability of fixed and mobile services is good. Most consumers can now access high broadband speeds at home and in their place of work, as well as mobile voice and data services while on the move.

However, some areas of the UK do not have access to an acceptable level of service. The starting point for any future communications strategy must be to ensure that everyone shares in the benefits of a modern digital society.

The Government’s plan for a right to decent, affordable broadband is central to our availability strategy. We will prioritise supporting plans for a 10Mbit/s broadband Universal Service Obligation (USO) to ensure that all people and small businesses have access to decent broadband speeds. Over time, we expect that the USO will need to evolve to ensure all consumers and businesses benefit as technologies and services improve.

We will also secure wide availability of services by:

  • enabling further investment in fixed networks, especially the transition from superfast to ultrafast broadband services, through competitive mechanisms wherever possible;
  • exploring options for extending mobile coverage. We will seek to place new coverage obligations on companies who win new spectrum licences. The 700MHz band is particularly well suited to providing such coverage
  • supporting the UK Government’s reform of the Electronic Communications Code; and
  • providing consumers and businesses with accurate, comparable and accessible coverage information across communications services so that they can make better choices about their services.”

Promoting investment and competition

“Our strategic objective in relation to fixed networks is to encourage the large scale deployment of new fibre networks over the next decade, driving the widespread availability of competing ultrafast broadband services.
To deliver this we will:

  • make it easier for competing providers to build their own fibre networks, across as much of the UK as is practicable, by providing them with access to Openreach’s network of underground ducts and telegraph poles;
  • price access to BT’s network in ways that encourage providers to build their own networks while protecting consumers from excessive pricing;
  • deregulate where network based competition is effective; and
  • continue to promote competition based on other forms of access to Openreach’s network, where effective network competition does not arise.

In mobile, there is no change to our existing strategy. We want the UK to continue benefiting from competition between four national network providers, and a range of resellers. We will work to ensure that the necessary wireless spectrum is made available. If we see takeovers or mergers leading to fewer, bigger network operators, and consumers are worse off as a result, this could lead us fundamentally to rethink our approach to competition and investment in mobile services.”

Delivering a step-change in quality of service

“Widely available networks and services alone are not enough. Consumers and businesses also need these networks and services to be reliable and of a high quality. While most consumers report that they are satisfied with telecoms services, their expectations of quality are rising. The sector needs to deliver significantly better quality of service than it does today.

Our concerns include Openreach’s performance, but extend beyond it to all providers. For example, not only are we concerned about the volume of faults on Openreach’s copper network and about how quickly Openreach repairs them; but also about the customer service that retail providers offer when something goes wrong.

For Openreach, we intend to:

  • set more demanding minimum standards, extending them to new areas as necessary; and
  • set wholesale pricing controls that strengthen Openreach’s incentives to make long term investments in service quality.

For the wider sector, we will:

  • drive improvements to service quality by making more information accessible to consumers and businesses; and
  • publish an annual Service Quality Report showing how telecoms companies compare. Well-informed consumers who are able to make informed decisions are better able to hold providers to account for the service quality they deliver.

In addition, we intend to work with industry to improve coordination between providers where this is affecting service quality: for example, to reduce missed appointments and solve consumers’ in-home problems. Finally, we will look to introduce automatic compensation for consumers and small businesses when something does go wrong”

Strengthening Openreach’s independence

“BT has a crucial role to play in ensuring that consumers and businesses enjoy good communications services, given its market position and the continued reliance competitors will have on its network.

However, we are concerned that the current model of functional separation fails to remove sufficiently BT’s ability to discriminate against competitors. Therefore risks to competition remain.

Given the concerns identified, continuing the status quo is not an option. We have decided to reform the relationship between Openreach and BT Group to give the former greater independence and autonomy. Under this new structure, Openreach should have:

  • more independent governance structures and processes, with a responsibility to serve all wholesale customers equally;
  • independent technical and operational capabilities;
  • greater autonomy over its budget, and over its strategic and operational decision making; and
  • an ongoing responsibility to consult with all customers in the same way.

One option that might achieve this is structural separation, but we recognise that this would entail significant disruption. We will therefore consider whether a strengthened model of functional separation could deliver the greater independence and autonomy for Openreach that we believe is necessary. If functional separation cannot be strengthened, we reserve the right to take forward structural separation.

We are now developing detailed proposals, which we will discuss with the European Commission later this year.”

Empowering and protecting consumers

“Even when choices are available, people need practical information and tools to take advantage of what the market can offer. This need becomes increasingly important as communications services increase in diversity and complexity.

To help people make informed choices, we will:

  • publish more detailed information, including on: service quality and customer response; fixed and mobile service availability; and broadband speeds;
  • work to introduce a standard cost comparison measure, such as average monthly cost of the core elements of a service over the contract period, so consumers can more easily compare different products;
  • closely monitor the impact of providers’ adherence to the Advertising Standards Authority’s broadband price advertising rules;
  • work with third parties, such as price-comparison websites, to improve information consumers have to hand before they buy; and
  • identify what more can be done for consumers who are not responsive to this information, for example, through stronger triggers to consider other deals when contracts expire.

We will follow up our work on Openreach network switching with proposals to make mobile switching easier. We will also complete our review of switching triple-play services (i.e., phone line, TV and broadband).

Some consumers will find it difficult to engage effectively with the market regardless of the information available them. We will therefore take more direct action to help protect such consumers, for example, by tracking market prices more closely and intervening directly to provide protections for the most vulnerable.

Finally, we will continue to protect consumers when things go wrong, from issues such as nuisance calls to various forms of fraud.”

 

Regulatory uncertainty casts shadow over otherwise positive results from BT and Vodafone

Positive results out yesterday from both Vodafone and BT.

One fact that caught my eye was the news from BT that (for the first time I can remember), BT had a net increase in connections. It’s is very old news that voice has migrated to mobile (if your fixed line rings, chances are it is your mum calling), but it appears that demand for fixed broadband is more resilient than some had predicted. Regular readers will recall my report from a conference earlier in the week where the speakers suggested that increasing smartphone and tablet penetration was, somewhat counter-intuitively, driving demand for fixed networks that were used for wifi and femtocell hand-off in residential markets. BT’s results, whilst not confirming this effect, are at least consistent with that hypothesis.

Meanwhile, both sets of result highlight the continued impact of government and regulators on the sector, with Ofcom’s refusal to let BT recover pension deficit contributions from its competitors and uncertainty over potential retrospective spectrum fees casting a shadow over Vodafone.

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%.