DotEcon considers the impact of Ofcom’s proposed price controls on legacy services

On 21 September 2015, Ofcom published responses to its 2015 Leased Lines Charge Control (LLCC) consultation as part of its Business Connectivity Market Review. The 2015 LLCC consultation included Ofcom’s provisional views on the form and duration of the charge controls for leased lines.  The market for leased lines includes Traditional Interface (TI) services, which are a legacy technology with rapidly declining volumes as customers migrate to newer Ethernet technologies.

Ofcom has previously adopted a positive X (RPI+2.25%) in the charge control for TI services which, as acknowledged by Ofcom, is “what we might expect in a declining market”.  However, in the 2015 LLCC consultation, Ofcom proposes a significant negative X (CPI-12.25%) and negative starting price adjustment for the TI basket, which represents a substantial step change.  Ofcom’s decision to impose a negative X and starting price adjustment is based on its assessment of BT’s profitability (using ROCE figures).

BT asked us to consider the impact of Ofcom’s proposed changes to the charge control in the TI market.  In our report, submitted as an Annex to BT’s LLCC response, we argue that where assets are almost fully depreciated (as in the TI market) one cannot credibly rely on ROCE figures.   Adjustments, such as Hypothetical On-Going Network (HON) adjustments, should be made to increase asset lives to ‘steady state’ levels .

Ofcom has concluded in its consultation that a HON adjustment for BT’s TI services would not be appropriate in this case, as it considers that there are insufficient benefits to warrant the higher prices. In particular, Ofcom considers that customer migration away from TI services would be unlikely to be undermined by lower prices.  However, we argue that Ofcom is understating the likely impacts of its proposals and explain that there are good reasons – which Ofcom have not considered – to expect large price reductions of the scale proposed to significantly slow migration of customers away from legacy services TI to alternatives such as Ethernet services and other competitive alternatives.

The impact of Ofcom’s proposals on investment incentives could be wide reaching:

  • declining TI prices will have an impact on BT’s investment incentives and ability to recover its efficiently incurred costs
  • slowing migration to alternative services can have longer-term impacts on incentives to invest (by BT and alternative operators) in non-TI services such as Ethernet and other competitive alternatives
  • expectations of future policy (for example the misapplication of profitability metrics towards the end of an assets’ life) may undermine investment incentives of both BT and alternative operators in other markets

Overall, given the significant potential downsides, Ofcom’s proposals for a radical change in X needs an appropriate degree of justification, which has not been provided in the 2015 LLCC consultation. Simple accounting ratios, such as ROCE, are arguably not sufficient to support of themselves such considerable changes.

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