Leased Lines Charge Control - Ofcom Statement

Executive Summary

Introduction

1.1 This Statement sets out our conclusions on the charge controls for wholesale traditional and alternative interface leased lines services supplied by BT in markets which it was found to have Significant Market Power (“SMP”) in the Business Connectivity Market Review (“BCMR”) Statement . The BCMR Statement concluded that, in principle, BT should be subject to charge controls in the markets where BT had SMP. This Statement concludes on the detailed design and methodology of these charge controls.

1.2 We set out below our conclusions following consideration of the responses to the consultation document published on 8 December 2008 (the “December Consultation”).

The charge controls are being set in a changing market

1.3 The charge controls are being set in a dynamic and evolving market environment:

• The UK communications market is seeing increased demand for bandwidth in the backhaul network, to support higher speed broadband services and the associated growth of internet traffic.
• The Traditional Interface Symmetric Broadband Origination (“TISBO”) market is going through a period of steady decline. BT is not expecting any significant volumes to remain on the Digital Private Circuit Network (“DPCN”) platform beyond 2012/13 and expects most customers to have migrated to other products such as Ethernet.
• Openreach is continuing to develop its Alternative Interface Symmetric Broadband Origination (“AISBO”) portfolio. It is currently undertaking a significant investment in a national backhaul network based on Wave Division Multiplexing (“WDM”) technology, to support new products such as Ethernet Backhaul Direct (“EBD”), which are designed to meet the growing demand for backhaul capacity. The networked nature of this product will mean greater efficiency and lower costs in backhaul provision.
• BT has recently announced an ambitious Next Generation Access (“NGA”) programme, which is likely to further boost demand for capacity to support high speed broadband services.

1.4 In this context, we have sought to ensure that the charge controls provide appropriate incentives for efficient investment and for efficient migration from old to new products.

Stakeholder responses

1.5 We received twelve responses to our December Consultation. These are listed in Annex 1. We have published non-confidential responses on our website . As set out in this Statement, responses included comments on the following:

• The form and duration of the leased lines charge controls Most stakeholders agreed with our proposals for an RPI-X control for a three year period up to the end of September 2012;
• The adjustments to BT's base years costs Most stakeholders agreed with the principle of our proposed adjustments;
• The one-off adjustments to the starting charges of TISBO and AISBO services stakeholders (other than BT) expressed concerns regarding the one-off increases to the starting charges of some TI terminating services, but welcomed the proposed decreases to 2 Mbit/s trunk charges;
• The underlying assumptions to be used in our cost modelling Most stakeholders agreed with our proposed assumptions, though some also noted some areas where we could take a different approach;
• The appropriate notice period ahead of any price changes Most stakeholders commented on the need to keep the appropriate notification period for price increases that could be imposed as part of the charge controls.

1.6 The responses included comments from the European Commission (“EC”) as part of the community-wide consultation which ran in parallel with the national consultation, received on 19 February 2009. The EC invited us not to exclude the possibility of carrying out a market review before the expiry of the charge controls if changes in market conditions warrant it. We have taken these comments into account in reaching our conclusions on the duration of the charge controls.

1.7 In this Statement we set out the key elements of these responses, which have informed our final decision making process on the design and methodology of the leased lines charge controls.

Summary of our decisions

We are implementing RPI-X charge controls

1.8 We are implementing RPI -X charge controls for most of the services provided by BT in the wholesale markets in which it has been found to have Significant Market Power (“SMP”).

1.9 The leased lines charge controls will apply for the period ending 30 September 2012. This duration will provide stability in the market and maintain incentives on BT to achieve efficiency savings. This is in keeping with other charge controls that have been implemented in the telecommunications sector in the UK.

We are setting price caps and sub-caps for six charge control baskets

1.10 When deciding on the appropriate charge control baskets we have balanced two potentially conflicting requirements: the requirement to give BT enough pricing flexibility to respond to changing market conditions and to manage migration from old to new services; and the need to ensure that this pricing freedom is not used in a way that might harm competition. We believe our baskets strike an appropriate balance between these two objectives.

1.12 Along with the main TI and AI price caps we are implementing a number of sub-caps and other safeguards in order to reduce the likelihood of undue price discrimination:

• We have limited any potential increases in the sub-baskets of TISBO terminating segments and BES services to RPI in each year of the control.
• We have limited the maximum increase in any charge in the TI and AI Baskets to RPI + 5% in each year of the controls. As an exception to this individual Point of Handover (“PoH”) charges in the TI Basket will each be subject to a sub-cap of RPI-0%.

We have taken account of the introduction of newer and cheaper products by Openreach

1.13 We have taken account of the introduction of newer and cheaper products by Openreach. Given the levels of migration and the expected average price reduction from moving to the new network, we have calculated the contribution that this migration would make towards meeting the AI Basket charge cap (which we estimated to be 2.26%). The value of X for the AI basket in Table 1.1 above is net of this migration saving.

We have excluded some services from the charge controls

1.14 We are not including Radio Backhaul Station Services (“RBS”), Symmetric Digital Subscriber Lines (“SDSL”) and BT Wholesale Accommodation services (e.g. BT Netlocate) within the scope of the charge controls.

• For RBS, we maintain the requirement on BT to price these services in a manner which is consistent with the pricing of TISBO and trunk services.
• For SDSL, BT has given Ofcom a voluntary price commitment that it will not increase the price of these services faster than the rate of inflation (RPI-0%) for the two years following publication of the BCMR Statement.
• For BT Netlocate, we rely on BT's cost orientation and other ex-ante obligations as well as on its general obligation to comply with competition law.

We are amending the level of some starting charges

BT Wholesale has notified some of the price changes to TISBO services we discussed in our December Consultation

1.15 In our December Consultation, BT Wholesale (“BTW”) had proposed a number of adjustments to the starting charges for some TI terminating and trunk services. The overall effect of these adjustments was to decrease TI Basket revenues in 2006/07 by around 4%, and the proposals were revenue neutral for external sales. BTW has since notified these new charges on 3rd June 2009. We are not introducing any further amendments to these prices with the exception of:

• We are introducing separate PoH rental charges; and
• 64 kbit/s and 2 Mbit/s external local end prices need to be reduced by the amount of the new PoH charges we are imposing.

1.16 In our December Consultation, BTW had also proposed to make one off adjustments to the starting charges of services in the Equipment and Infrastructure Basket. The proposals were revenue neutral for internal and external customers.

1.17 From 1st October 2009 BT will have an obligation to align all relevant TISBO starting charges with those included in Annex D to Conditions G4, GG4, GH4 and H4.

1.18 We discuss our conclusions regarding one of adjustments to the starting charges of TI terminating and trunk services in Section 4 of this Statement.

We have implemented further one off decreases to the price of 1 Gbit/s BES services

1.19 In our December Consultation we proposed not to impose any further one-off reductions to the prices of Ethernet services. We instead proposed that Openreach should be required to bring individual charges within appropriately measured DSAC ceilings and DLRIC floors within 12 months of the implementation of the charge controls. We also noted that Openreach had recently announced substantial decreases to the connection and rental prices of a number of WES/WEES/BES services. These price decreases were fully implemented in February 2009.

1.20 Following stakeholder responses, and to ensure consistency with our approach to the TI basket, we have since amended our position with regards to the starting charges of some Ethernet services. Our analysis indicates that some charges remain too high when compared to the overall level of costs and we are concerned about inefficiencies this could cause. We have therefore decided to require Openreach to decrease the price of 1 Gbit/s BES rental services by a further 17%. We require Openreach to introduce this new charge from 1st August 2009.

1.21 We discuss our conclusions regarding one of adjustments to the starting charges of AISBO services in Section 5 of this Statement.

The structure of the charge controls

1.22 We have concluded on a number of issues relating to the detailed structure of the controls, including the following:

• The weighting of the charge control baskets: For TI and AI services we have determined that prior year revenue weights should be used to check compliance with the charge control.
• Geographic discounts: BT can offer geographic discounts for charge controlled services at the wholesale level, but these will not contribute to BT meeting its charge control obligations;
• Volume discounts: In line with our conclusions in the BCMR Statement BT cannot offer certain volume discounts (i.e. saw-tooth discounts) at the wholesale level; and
• Term discounts: BT can offer term discounts for charge controlled services at the wholesale level, but these will not contribute to BT meeting its charge control obligations.

We have made a number of key assumptions to model the value of X for the main charge control baskets

1.23 X for the TI and AI basket of services. We based this model on a number of key assumptions which include the volume forecasts for the services covered by the controls, the underlying base year costs and assumptions about BT's future efficiency gains and cost of capital. We discuss our conclusions regarding these matters in the relevant parts of Section 4 and Section 5 of this Statement.
We have amended BT's base year costs

1.24 We introduced some amendments to BT's base year costs for 2007/08 in order to determine the level of costs which are relevant for charge control and forecasting purposes. The impact of these adjustments is to decrease the base year costs for the TI Basket by 137m and for the AI Basket by 12m.

Efficiency

1.25 The objective of the charge controls is to bring BT's current charges in line with an efficient level of costs at the end of the control period. As part of this process it is important to understand the efficiency levels that BT can be expected to achieve during the charge control period.

1.26 Taking into consideration the work undertaken by NERA and our internal work on efficiency, we have concluded that the appropriate assumption in respect of efficiency gains for services in the TI Basket is 2.5% p.a.

1.27 We have concluded that the appropriate assumption in respect of the efficiency gains for services in the AI Basket is 2.8% p.a. This aligns with our decision in the Statement entitled A New Pricing Framework for Openreach (the “OFFR Statement”), with some exceptions which we explain in our Statement.

Cost of Capital

1.28 In deriving the values of X, the aim of the financial modelling exercise is to estimate charging constraints such that in the final year of the charge control period, BT is forecast to earn a rate of return on the basket of services that is equal to its weighted average cost of capital (“WACC”).

1.29 In the OFFR Statement we set Openreach's WACC to 10.1% (pre-tax nominal). On a consistent basis, the value for the WACC for the rest of BT (including core) is 11% (pre-tax nominal).

1.30 We are of the view that TI and AI services should not be classified within BT's access network for the purposes of an assessment of risk levels. We have therefore used the value for the WACC for the rest of BT as determined in the OFFR Statement, i.e. 11%.

We decided not to impose a charge control on Kingston Communications but we accepted its voluntary pricing commitments

1.31 We concluded in the BCMR Statement that Kingston Communications (“KCOM”) has SMP in the wholesale market for low bandwidth AISBO in Hull. KCOM offered us a draft voluntary undertaking to decrease the prices of WES/WEES circuits each year by around RPI-16% over the period to 2012. In our December Consultation we consulted on KCOM's proposals. We decided not to impose a charge control on KCOM but instead to accept KCOM's voluntary pricing commitment on the basis of the considerations set out in Section 6.

Ongoing review

1.32 We explained in our December Consultation that, in light of the ongoing economic uncertainty, we recognise the possibility that certain eventualities may present unforeseen challenges that necessitate a review of the controls before the end of the planned charge control period. As proposed in our December Consultation, we will closely monitor the effectiveness of our new controls, and intervene if circumstances require it. At the same time, we recognise that such intervention is not without risk and potentially introduces an additional level of uncertainty. On this basis, such intervention will be at our discretion and will not be based on any automatic trigger mechanism.

1.33 In addition, we are required by our legal duties to keep developments in leased lines markets under review . As such, we will continue to take a wider view of market developments in leased lines markets. If, at the time of the next review, we conclude that BT continues to have SMP we would have to decide whether or not to impose a charge control as a remedy once the current control expires in 2012. This would provide an opportunity to evaluate the operation of this LLCC and to assess whether any changes would be necessary at that time in light of experience and any other market developments.

1.34 We consider that our ongoing review of the charge controls will address the point of the EC in its response letter to our draft notification, as set out above in paragraph 1.6.

1.35 Also as explained in this Statement, our cost calculations exclude BT Wholesale's and Openreach's share of annual payments made by BT to address the funding shortfall in its pension scheme. While this approach is consistent with our historic treatment of pension deficits and surpluses, we consider that this issue is of increasing importance to the companies we regulate. Accordingly, we propose to undertake a separate review of our treatment of pension costs which will inform our future approach.

View more Ofcom Statements »