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.

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.

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.