optus submission to accc on review of price control arrangements · no price caps on local access...

Optus Submission to

ACCC

on

Review of price control arrangements

August 2004

Page ii

Table of Contents

1. Overview ................................................................................................................. 3

2. Background............................................................................................................. 4 Industry change.................................................................................................................... 5 The access regime ................................................................................................................ 6 RPCs do not necessarily achieve productive efficiencies .................................................... 7

3. Direct impacts of the current price caps on the state of competition................ 8 State of competition in the fixed telephony market ............................................................. 8 The basket 2 price cap is binding on line rental prices ........................................................ 9 The basket 1 price cap on preselect calling services is redundant ..................................... 10

4. Fundamental structural shift in the fixed voice telephony market ................. 14 A mature fixed voice-based telephony market................................................................... 14 Observed shift in demand toward broadband applications ................................................ 15 Supply-side shift ................................................................................................................ 16 Outlook for facilities-based competition............................................................................ 18 Role of price caps and regulation....................................................................................... 21

5. Facilitation of facilities-based competition ........................................................ 22 Effective access to Telstra’s monopoly local loop is essential .......................................... 22 Flexible retail price controls .............................................................................................. 25 Geographic differentiation ................................................................................................. 25

6. Other issues........................................................................................................... 28 Removal of all price controls on fixed telephony is the optimal action............................. 28 No price caps on local access............................................................................................. 30 Social measures.................................................................................................................. 30 A separate, specific Fixed to Mobile services price cap is not warranted ......................... 31

Appendix 1: Answers to ACCC questions.................................................................. 35

1. Overview

1.1 Optus urges caution in applying a retail price control (RPC) regime over the next three years. We believe that in the coming years, a range of new technologies will establish a significant market presence. A poorly constructed price control regime is likely to stifle and distort entry decisions to the detriment of competition and the long-term interest of consumers.

1.2 Overall, Optus believes that during its review, the ACCC should:

(a) Recommend the relaxation of price control on Telstra’s line rental charges in conjunction with improved wholesale arrangements for local call resale.

(b) Recommend no or light touch regulation of call charges.

(c) Consider exemptions from any retail price controls when measures of increased competition are achieved.

(d) Consider more effective instruments to promote competition in rural and remote areas, keeping in mind the Government’s current universal service (USO) arrangements.

(e) Recommend continuation of targeted low-income support schemes.

1.3 Notwithstanding Telstra’s current monopoly ownership of the local loop, competitors entering the market have advanced competition significantly in the Australian telecommunications industry. The type of entry has ranged from:

• Resale – where competitors resell Telstra’s infrastructure.

• Facilities based – where competitors build competing infrastructure to the local loop, including Optus’ HFC and mobile networks.

• Mixed infrastructure – where competitors partly rely on Telstra’s infrastructure but invest in elements which compete with Telstra’s network (for example, this would include the use of Telstra’s unconditioned local loop service - ULLS).

1.4 Clearly resale and mixed infrastructure entry has been facilitated by the access regime. Optus believes that an effective access regime for monopoly infrastructure is essential for competition in downstream markets. Moreover, if effective, the combination of an access regime and likely facilities based entry makes the RPC largely redundant.

1.5 We believe that each of these forms of entry is likely to be important in the future. However, the retail price controls have the potential to put this type of competition at risk and they are likely to be of limited value over the next few years.

1.6 In this light, the structure of any RPC regime needs to take into account the current and evolving state of competition in each of the relevant geographic markets by examining:

• The evolving competitive landscape - an examination of Telstra’s dominance, barriers to entry and technological changes driving the evolution of the market structure.

• Retail price structures and pricing flexibility and how these have been affected by the price controls.

• The effectiveness of the wholesale access regime.

• Costs and other barriers to entry that carriers face with the move toward facilities-based competition in voice and data services across different geographic areas.

• Customers’ evolving profiles and their adaptation to emerging technologies.

1.7 The submission provides the ACCC with Optus’ views on the factors listed above concerning the competitive pathway being created by the industry within the current regulatory bounds. Specifically, the submission discusses the pace with which the industry is moving from a market that is dominated by resale-based competition to one in which facilities-based competition is allowed to develop within current and new technologies.

1.8 Section 3 provides an overview of the main impacts that the current price controls have in the relevant markets.

1.9 Section 4 outlines the change occurring in the market structure due to demand and technological shifts.

1.10 Section 5 examines how policy makers through the price controls and the access regime can facilitate the rate of the demand for technological substitution in the market.

1.11 Section 6 attempts to provide some more detailed responses to some of the ACCC’s questions and some solutions that the ACCC might want to consider in this review.

2. Background

2.1 The retail price controls (RPC) regime have been imposed on Telstra’s retail prices by the Australian Government since 1989, with the underlying intention being to protect particular groups of end-users from excessive prices during the transition toward effective competition.

2.2 There are specific objectives that the price control arrangements are intended to achieve. The main objectives of the price controls, as set out in the Government’s Regulation Impact Statement1, are:

• to allow Telstra greater freedom to rebalance line rentals while protecting consumers from ‘rate shock’ caused by excessively rapid rebalancing;

• to promote efficiency in markets not yet effectively competitive and the passing on of benefits to consumers;

• in accordance with Government policy, to protect low-income consumers from any adverse effects of line rental increases;

• to ensure that consumers in rural and remote areas share in the benefits from greater competition in telecommunications; and

• to meet other equity objectives.

2.3 The stated objectives show clearly that the price controls are expected to achieve a broad range of objectives that in some ways may be conflicting. For example, the objective to maximise allocative efficiency by setting price at cost may be in conflict with the requirement to ‘meet other equity objectives’ which can dictate that prices be set well below cost for some users in some areas.

Industry change

2.4 This current review comes at a time of critical transformation in the telecommunications industry. The industry is undergoing a fundamental structural shift, driven by rapid technological developments and changes in demand preferences toward data services.

2.5 There has also been some impetus provided by Government to promote this shift. For example, there are Government policy measures to promote broadband competition in rural areas. The ACCC has also promoted competition in the voice and data markets by indirectly encouraging the availability of Telstra’s wholesale DSL service and by setting de-averaged ULLS prices in its model terms and conditions.

2.6 Given this structural shift and the mechanisms at the wholesale access level in place to encourage this, it is important that the RPCs be set in a complementary manner. This review of the RPCs will have significant impact on the direction of competition in the industry. Therefore, the Government must be cognisant of the repercussions of decisions with respect to the next period of RPCs on the long-term development of facilities-based competition.

1 Telstra Carrier Charges - Price Control Arrangements, Notification and Disallowance

Determination No. 1 of 2002, Telecommunications (Consumer Protection and Service Standards) Act

1999

The access regime

2.7 For the Government to maintain the status quo on the price control regime at this point in time requires extensive evidence that such a regime will continue to achieve its intended efficiency objectives. It is also important to ascertain whether a price control regime is required at all and whether it is consistent with the efficiency objectives guiding the access regime, that is the long term interests of end users (LTIE) criteria outlined in the Trade Practices Act 1974.

2.8 There is direct conflict between the wholesale access regime and the retail price controls. Whilst the Trade Practices Act does not concern itself with specific equity issues, and the determination of which end users gain or lose, Government policy more generally deals with such issues.

2.9 Optus believes that there is the opportunity in this review for the Government to attempt to align the objectives of the price controls more closely with the Trade Practices Act by giving more weight to the LTIE criteria. Alignment of the access regime with retail price regulation is now more important than ever, during this structural transformation in the industry. A shift in focus from retail outputs in the form of prices to wholesale inputs is essential if the price controls are to work in unison to promote effective competition over the longer term.

2.10 Optus believes that it is not appropriate to continue the price controls in the same manner as those that have applied in the past, nor those that currently apply to Telstra. With the expectation of increasing competitive pressures in fixed telephony markets from facilities-based investment as well as mobile services and data applications, the case for price controls become increasingly weak.

2.11 In contrast, retaining the price controls in their current form carries the risk of over regulation and harming allocative and dynamic efficiencies by distorting both consumers’ consumption decisions and carriers’ (both Telstra’s and competitors’) investment decisions. For example, the retail price control on line rentals, which has held the retail price below cost, reduces dynamic efficiencies by distorting incentives for efficient investment in local loop infrastructure. This has directly inhibited the development of competition through facilities-based entry. Government cannot hope to encourage investment in facilities on the one hand whilst setting prices below cost on the other.

2.12 The ACCC recognised this risk in its recommendations in the last price control review:

Whilst price control arrangements can help protect consumers during the transition from monopoly to competition, there is also a danger they can inhibit the development of competition, efficient investment and the long-term benefits of consumers – especially if they are not implemented consistently with pro-competitive reforms.2

2 ACCC, Review of price control arrangements: An ACCC report, February 2001, Page viii

Price controls can help provide consumers with some of the benefits of effective competition. However, they do not deal with the underlying reasons for competition being less than effective. In this regard, the preferred course of action is to tackle the factors inhibiting effective competition and use price control arrangements where other pro-competitive reforms cannot be implemented ... Constraining pricing decisions through price control arrangements can distort the pattern and extent of both investment and competition. This has significant consequences for the size and distribution of the long-term gains for consumers. Accordingly care needs to be taken in designing retail price control arrangement to ensure that they facilitate rather than inhibit the pathway to effective competition.3

RPCs do not necessarily achieve productive efficiencies

2.13 The promotion of long-term competitive market structures is preferable to regulation. Regulation is a second-best policy measure to address a market failure, and retail price caps represent a relatively inflexible and stringent form of regulation.

2.14 Regulation should promote facilities-based entry and downstream competition in preference to a narrow focus on one part of the service to the end user, namely the retail price. Retail price controls designed to replicate competitive outcomes prevent those competitive outcomes from emerging over the longer term, whilst also lowering consumer welfare, investment and dynamic efficiencies.

2.15 Price controls do not induce greater productivity efficiency by Telstra; rather they hinder its attainment. RPC regulation, where the CPI-X controls are reset every two to three years, can produce similar effects to traditional rate of return regulation. This is known as the Aversch-Johnson4 effect where the firm does not have economic incentives to make cost reducing investments. This is because the manifestation of such cost-efficiencies in the form of greater profits, directly leads to decisions by the regulator to further tighten the price controls with adjusted X values.

2.16 Further, price controls on Telstra have been reset every two to three years; and X has been set on the basis of Telstra’s past productivity improvements. Any RPC that sets X on the basis of the firm’s actual efficiency improvements undermines the incentives for the firm to be productively efficient. This is because in normal competitive markets, or even markets characterized by unregulated monopoly, the firm retains efficiency improvements in higher profits; this provides the motivation for firms to seek such cost-reducing improvements in production.

3 ACCC, Review of price control arrangements: An ACCC report, February 2001, Page 67

4 See Aversch, H and Johnson, L “Behavior of the firm under regulatory constraint”, American

Economic Review, vol 52 pp 1052–69.

2.17 Available empirical evidence supports the proposition that RPCs undermine productive efficiency and thereby cause higher prices through time, less innovation, and lower consumer welfare. For example, a comprehensive study by Blank, Kaserman and Mayo on the pricing of RBOCs in 1991 in long-distance markets subject to price-caps, and those not subject to price caps, found that prices tended to be higher in the competitive markets subject to price-cap regulation.5 In addition, price-capped markets were characterized by similar pricing, less dynamic vigour and less significant price falls over time. The authors concluded that price caps had no positive impact on pricing in long-distance markets, and, in fact, tend to increase prices and lower consumer welfare.

2.18 Price caps largely act as a mechanism or formula to distribute benefits between monopolists and consumers in the manner dictated by the relative weights given to each objective of the price controls. Price controls cannot promote or create the dynamic incentives that cause monopolists to be efficient through time.

2.19 Price caps change the focus from the enhancement of competition to a tug-of-war over the size of the x factor. As best this is a zero sum game. More usually, price caps act to create significant deadweight loss in society as monopolists have the incentive to engage in various inefficient activities (cost inflation, construction of unrequired capacity, changes in quality) to obtain a lower X factor in future years.

3. Direct impacts of the current price caps on the state of competition

State of competition in the fixed telephony market

Telstra’s monopoly ownership of the local loop

3.1 Telstra is clearly the main beneficiary of its historic monopoly ownership of the local copper loop (or the customer access network – the CAN).

3.2 Optus and other carriers have made investments in competing infrastructure in customer access networks including HFC networks, fibre rings in CBD areas and transmission tails to large business customers. Competition appears to be greatest where facilities based entry in the local loop has occurred successfully.

3.3 Notwithstanding the investment that has occurred to date, the fact remains that Telstra retains its historic monopoly position in local loop. Recent market share data shows that Telstra remains dominant in the local loop with over 87% share in basic access services. It also has high market shares in other fixed voice services, which appear in accounting terms to be highly profitable. This is shown by the fact that Telstra receives approximately 60 percent of industry revenues and 90 percent of total industry profits.

5 Blank, L. Kaserman, D. and Mayo, J. “Dominant Firm Pricing with Competitive Entry and

Regulation: The Case of InterLata Toll’, Journal of Regulatory Economics, vol 14 pp 35–53;

3.4 Competition in the provision of local loop services is weakest in rural areas where costs faced by potential entrants are much higher and where the USO regime maintains Telstra’s dominance in service provision.

3.5 Whilst the industry transitions towards facilities-based competition in the local loop, it will in the interim remain reliant on access to Telstra’s local loop infrastructure. It is therefore vital that the ACCC sets an effective access regime for LCS that encourages competition to flourish. As discussed in section 5, this will require some changes to the current LCS pricing principles.

3.6 Optus considers that the development of competition in the wider telecommunications industry (mobile, data, pay TV) requires a concerted effort from the ACCC and the Government to break Telstra’s leveraging of its local loop market power into these other markets.

The basket 2 price cap is binding on line rental prices

3.7 Optus understands that the line rental price cap is binding on Telstra, in that it forces Telstra to charge below what it would otherwise charge as its cost recovery price for line rental. Without entering into the debate over the level of cost recovery for Telstra, it is important to examine how below-cost charging impacts on access seekers and their ability to compete with Telstra.

3.8 Retail prices that are forced to be below the cost of production distort dynamic efficiencies by reducing the scope for a reasonable rate of return on investments in competing infrastructure. This includes investment both by Telstra and competitors or new market entrants.

Telstra’s rate of rebalancing

3.9 Optus understands from ACCC estimates6 that at a GST-inclusive average price of approximately $32 per SIO per month ($346 per year), Telstra recovers its line costs in full. That is, when retail line rental charges are at this level, then rebalancing by Telstra will have been achieved.

3.10 Based on Optus’ internal estimates, and using Telstra’s reported revenues and volumes, Optus predicts that Telstra will be fully rebalanced by June 2006 at the latest. This is consistent with the ACCC’s expectations in this regard, as announced in its statement on the access deficit in its final indicative prices and also in its price control discussion paper.

3.11 Whilst the RPC should enable Telstra to fully rebalance soon, there is also good reason not to cap line rental prices in the future. Optus believes that emerging competition in the local loop, as discussed later in this submission, will prevent Telstra from monopoly pricing.

3.12 The business market provides a good example of this. In the corporate market there has been traditionally less restraint on Telstra’s ability to price line rental above cost. Even so, it has not chosen to price at above cost levels, because of

6 ACCC, Review of price control arrangements: An ACCC Report, February 2001, page 36

competitive forces driving the price down. The current basic access price Telstra sets in the business market is consistent with cost-based pricing. Headlines prices for business line rental are around $34.95 per month (inc GST), but prices paid by many business customers are at a discount headline rate.

Cost of competing with Telstra for basic access services

3.13 Since line rental prices are currently held below cost, competing carriers charge the market price for line rentals, which in effect is set by Telstra within the line rental sub-cap.

3.14 Revenues are capped for line rental, regardless of the level of discount being offered on other services within the bundle. The difference for competitors is that they face varying line costs depending on the type of access they use. The cost of competing with Telstra is determined by the delivery platform chosen by competitors. The choices available are:

• partial facilities-based access via the ULLS.

• full facilities-based competition via:

i) HFC

ii) WLL

iii) FTTC

iv) Satellite

3.15 Investors will only commit funds where those funds can achieve a reasonable rate of return for the period of the project. Below-cost pricing directly reduces this rate of return and reduces the incentives for investment. This is particularly the case for investments that carry a high risk and thus require a greater level of return on capital invested. An example would be wireless local loop in rural areas.

The basket 1 price cap on preselect calling services is redundant

Actual prices are lower than those required by the price caps

3.16 In direct contrast to the cap on line rental, the available evidence suggests that the basket 1 CPI – 4.5% price cap on calling services is largely redundant. As the chart below shows, the price of calling services has fallen well below the price required to comply with the price cap.

Price movements versus price control pathway7

3.17 The above analysis appears to demonstrate that Telstra does not have unfettered market power in the markets for LD, international and fixed to mobile services. Rather, competitive forces have been pushing prices lower than required by the price control regime.

3.18 In its report on “Telecommunications Competitions Regulation: Inquiry Report”, the Productivity Commission noted that for;8

• National long distance – Telstra’s share fell from 100 per cent in 1992 to 90 per cent in 1994, and then fell steadily to be slightly under 80 per cent by June 1999

• International – Telstra’s share fell from 100 per cent in 1992 to 65 per cent by June 1997, since which time is has fallen to around 46 per cent by June 1999.

3.19 These shares are even lower now, as supported by available market share data for call services which indicates that Telstra’s market share has fallen substantially as competition has strengthened.

7 ACCC, Report 2: Changes in prices paid for telecommunications services in Australia 1997-98 to

2002-03

8 Productivity Commission, Telecommunications Competition Regulation: Inquiry Report, September

2001, page 123

Actual prices versus price cap for call services

0

20

40

60

80

100

1998 1999 2000 2001 2002 2003

Index

Call pricesCap on call prices

Market share based on 2002-03 carrier service revenues9

2002-03 Telstra’s revenue share

Optus’ revenue share

Others’ revenue share

Basic access 87% 6% 7%

Local calls 77% 14% 9%

Domestic long distance 71% 17% 12%

International long distance

62% 22% 16%

Fixed to mobile 74% 13% 13%

Total PSTN services 78% 12% 10%

3.20 However, despite the above analysis, the ACCC continues to believe that these markets are less than effectively competitive. In its recent decision on mobile termination the ACCC noted that:

The commission considers that although barriers to entry into the market within which FTM services are provided can be partially mitigated by access to Telstra’s PSTN network ... other indicators suggest that the market is not effectively competitive.

Therefore on the basis of the observed concentration levels, price conduct, the considerable scope and incentive for anti-competitive price-squeeze behaviour and a possible lack of full and effective competition in the preselection NLD, IDD and FTM services market, the Commission considers the market within which FTM services are provided (sic) is not effectively competitive.10

3.21 However, the ACCC has not put forward compelling evidence to support its conclusion that the market is less than effectively competitive. On the contrary, it acknowledges factors which would lead towards the opposite conclusion:

• Barriers to entry are low; and

• Telstra’s market share has been falling.

3.22 If the ACCC does not accept Optus’ arguments on the current state of competition, then it should back its own judgement on the reforms it has made to stimulate further competition. Consistent with its views on competition in

9 ACCC, Telecommunications market indicator report 2002-03, June 2004, page 10

10 ACCC, Mobile services review mobile terminating access service: Final decision on whether or not

the Commission should extend, vary or revoke its existing declaration of the mobile terminating access

service, June 2004, page 109

voice services, the ACCC has made substantial changes to the access regime for upstream services in recent months on the grounds that these will promote competition in the market for call services. These include a substantial reduction in mobile termination rates and the accelerated removal of the access deficit contribution (ADC). These changes should address any concerns that the ACCC may have about the level of competitive intensity in the near future.

3.23 Notwithstanding the ACCC’s views, Optus contends that the low barriers to entry and the demonstrable changes in market shares and reductions in prices are indicative of an effectively competitive market.

3.24 There is no justification for price controls on these services. Firstly, they do not lead to any further efficiency gains, and secondly they are not required to achieve any equity-based objectives.

3.25 It is effective competition in this market for long distance, international and fixed to mobile calls that has created downward pressure on call prices. As evidenced by in the table above, competition in this market is growing due to the large number of competitors competing vigorously for market share. This competitive intensity will be further enhanced by developments in competing technologies, such as mobile calling services, and the emergence of internet protocol (IP) services such as VoIP.

3.26 Consistent with this trend is the fact that Telstra more than complies with the price cap on these services. Telstra has very large carryover credits which it may be able to use in the coming years. A CPI-X% regime on calling services does not appear capable of generating further gains to the community as a whole in the future.

Using the mobile industry as a guide for basket 1 calling services

3.27 A good indicator of the likely result of removing these price controls is to examine what happened when the price controls were removed from the mobile market.

Prices for mobile telephony 1997-98 to 2002-03

Price index for mobile services

0

20

40

60

80

100

120

1998 1999 2000 2001 2002 2003

Price index

3.28 Mobile services were removed from the basket in the last price control review of 2001. Since this date prices have continued to decline. Whilst the rate of decline slowed in 2003 (as shown by the above graph) the level of price competition since the launch of Hutchison’s 3 service is likely to show an acceleration of price reductions through 2004.

3.29 This Government’s decision to remove mobile services from the price controls was presumably based on the following advice provided by the ACCC in its recommendations:

While natural monopoly characteristics are not totally absent from the mobile industry, it appears to have fewer of then than does the fixed-line industry. Perhaps the major difference is that it does not have dedicated access lines as in the wire network, so that customer access is much less costly. Three or four carriers seem to be able to provide mobile services and under such circumstances it appears that prices of mobile services are falling more rapidly that for other telecommunications services. The Commission believes the market is sufficiently competitive to be freed from price controls.11

3.30 The ACCC logic was that, whilst the market was not considered effectively competitive from a purely theoretical perspective, the prices and behaviour in the market did imply competitive outcomes. Optus posits that this is not too dissimilar to the markets in which preselect calling services are provided.

4. Fundamental structural shift in the fixed voice telephony market

A mature fixed voice-based telephony market

4.1 Fixed voice-only telephony, which is the focus of the retail price controls and represents around 39% of total Telstra sales revenue (including wholesale revenue), is in the mature phase of its lifecycle.

4.2 The fixed telephony market has experienced significant structural change over the past several years, as it has moved toward a relatively more open and competitive market. Not only has the number of players increased dramatically, but the array of services offered has increased in line with changing customer preferences and increased service expectations by users. Fixed telephony has shifted from a commodity product to a differentiated service.

4.3 Since 1997 prices for fixed telephony have decreased by over 18% in nominal terms12, reflective of the fact that competition has developed strongly over this period. Whilst the level of competition has not developed as fast, nor to the degree that regulators and consumers may have anticipated, it remains the case

11 ACCC, Review of price control arrangements: An ACCC report, February 2001, page 24

12 ACCC, Changes in the prices paid for telecommunications services in Australia 1997-98 to 2002-03

that consumers’ choices have improved and that Telstra’s market share continues to be eroded in this market.

4.4 Industry profits in the relevant price-controlled markets have also been falling in real terms. In terms of basic telephony revenue, Macquarie Research Equities forecasts a decline in revenue of approximately 3% p.a. from 2005/06 onward.13 This decline is attributed to the fact that other technologies have higher growth potential. In fact, when compared to overall positive industry growth in the table below, the decline in basic telephony is a stark contrast to the industry growth trend.

Forecast industry turnover and growth

Year Turnover (AUD Million) Annual growth %

2004 20,600.0 3.6

2005 21,175.0 2.8

2006 21,700.0 2.5

2007 22,350.0 3.0

2008 22,950.0 2.7

Source: IBISWorld, J7121 - Wired Telecommunications Carriers in Australia

4.5 In terms of growth, fixed voice telephony has declined in relative importance compared to mobile and data services. This is consistent with the fact that fixed telephony penetration rates have reached approximately 97 percent, with a general industry consensus that this basic voice-only market has reached saturation point.

4.6 This explains the tendency toward bundled voice and data offers in recent years, as carriers attempt to add value to their basic voice service.

Observed shift in demand toward broadband applications

4.7 Whilst revenues from basic voice telephony services are flattening and forecast to decline, the size of the total fixed user base continues to remain relatively stable. This is largely driven by the growth in demand for data-based services, namely broadband.

4.8 In contrast to fixed voice telephony, there has been significant growth in data-based applications. The popularity of the internet has stimulated a massive increase in data traffic, and the volume of data-based traffic has now overtaken voice traffic.

4.9 This growth in broadband has occurred, despite the fact that Telstra has managed to delay broadband supply in Australia. International comparisons show that Australia is clearly lagging behind the rest of the developed world in

13 Macquarie Research Equities Report, Telstra: the decline of the PSTN, 19 July 2004

broadband take-up rates. OECD research indicates that in December 2001 Australia was ranked 18th in broadband penetration out of 30 OECD countries.14

4.10 However, more players are entering the broadband market and offering a range of broadband applications and innovative technologies. Demand is increasing rapidly with some trends developing in Australia that are consistent with demand preferences that have developed overseas. These include:

• An increasing demand for higher bandwidth and capacity from home computers, as broadband becomes the internet application of choice;

• Bundling of voice and data is becoming increasingly prevalent in the market.

4.11 An examination of broadband uptake shows phenomenal growth in this data platform over the past several years. As at 31 March 2004 total broadband take-up was 829,300 users, representing an increase of 95.8% from the previous year.15 Optus now provides broadband to 200,000 customers, with sales rising sharply since the launch of its residential digital subscriber line service in February 2004.

4.12 Data services are likely to be the revenue drivers of tomorrow and this is already being observed in the market. This evolution is forcing carriers to upgrade their network facilities to cope with the ever-increasing demand for capacity and download speeds, in addition to the peripheral services associated with data products.

4.13 Telstra reported in a media release of 16 August 2004 that its “… ongoing campaign to make broadband more accessible to all Australians saw Telstra’s broadband customers soar by 46% in just five month this year…Telstra has spent well in excess of one billion dollars broadbanding Australia with ADSL networks in the last four years... with a new $28 million campaign bringing Broadband ADSL … available to 90% of premises within the next two years.”

4.14 Customers are generally showing a strong propensity to adopt new technologies in terms of the delivery mechanism for data services. For example, IP services are becoming popular for not only large corporates but also for a number of small businesses and residential customers.

Supply-side shift

4.15 The data market is a particularly competitive market, as shown by the retail market shares for data services.

14 OECD, Broadband Access for Business, May 2002

15 ACCC, Snapshot of broadband deployment as at 31 March 2004

Retail market share of data services: 1999-200316

Year Telstra Optus Fixed SPs

1999 53.2% 6.9% 39.9%

2000 49.8% 8.7% 41.5%

2001 43.7% 12.1% 44.2%

2002 est. 36.5% 11.7% 51.8%

2003 est. 31.9% 11.8% 56.3%

4.16 IBISWorld quotes a recent Ernest and Young study which predicted that;

“revenues derived from fixed wire services will contract at an average rate of roughly one percent per annum over the period 1999 to 2005. In comparison, global revenues from data services are forecast to expand at an average rate of 18 percent per annum over the same time frame. Substitution trends favouring mobile or wireless telephony, and technological innovations in other telecommunications industries which impinge on the activities of this industry such as PC based IP telephony ('e-calling') will also have adverse implications for the wired telecommunications industry.17

4.17 The ACA in its Communications Outlook 2003-200818 points to the gradual development of a "seamless communications world" with a "converged core network capable of supporting multiple access technologies" and no network boundaries. This reflects in part the continued convergence phenomena as the boundaries between communications, information and entertainment and even financial services and commerce become increasingly blurred. According to the ACA the emerging networks are likely to be Internet protocol and packet based using open systems architecture.

4.18 It is the next generation wireless technologies and broadband services that will be the main growth drivers in the telecommunications industry over the next 5 to 10 years. These developments will have far reaching implications for the industry. Broadband has the potential to become the significant revenue stream as voice may become increasingly commoditised. Access to these new revenues will provide both the incentives and funds for carriers to invest in new technologies and applications.

4.19 The supply-side of the market, ie. the technology choices, investment decisions and scale choices by operators are driven by customer preferences (both business and residential) for voice and data applications, as well as service quality and availability.

16 Paul Budde, Telecommunications Industry Australia 2002/03 15th Edition, page 33

17 IBISWorld, J7121 - Wired Telecommunications Carriers in Australia

18 ACA, Special Item: Communications outlook 2003-2008

Outlook for facilities-based competition

Investment in local access networks

4.20 Based on information available to the ACCC in its report on infrastructure investment the ACCC produced the following summary table of investments in different network types in 2001/02:

Investment in local access networks (2001/02)19

Network type Total ($million)

Copper 925.8

Optical fibre 476.5

HFC 246.4

Microwave, LMDS, MMDS, fixed wireless 38.6

ISM spread and modified spread spectrum 0.1

Satellite 78.0

Total 1,765.4

4.21 Of the $1.765 billion invested in that year, one third was by carriers other than Telstra in such infrastructure as optical fibre, HFC and satellite networks.

4.22 The ACCC estimates that since 1997 there has been approximately $19.7 billion invested in telecommunications infrastructure and $3.2 billion of this was in 2002-03.

4.23 The table below provides a good indication on facilities based investments in the local access networks.

Types of local access networks (as at 30 June 2002)20

Network type Carriers Percentage of coverage

Copper Telstra, Airnet Commercial Australia, Victorian Rail Track*, TransACT#

80.33%

Optical fibre Telstra, SingTel Optus, Powercor Australia Telecom, Ipera Communications, Amcom Telecommunications, Flowcom, AARNet*,Uecomm, Powetel, NTT Australia IP, Primus Telecom, Macquarie

1.17%

19 ACCC, Telecommunications Infrastructure in Australia 2002, October 2003, page 20

20 ACCC, Telecommunications Infrastructure in Australia 2002, October 2003, page 8

Corporate Telecommunications, AAPT, MCI Worldcom Australia, Soul Pattinson Telecommunications, Swiftel Communications.

HFC Telstra, SingTel Optus, Neighbourhood Cable, Broadcast Engineering Services, Windytide (AUSTAR)

9.87%

Microwave, LMDS, MMDS and fixed wireless

Telstra, SingTel Optus, OMNIconnect, Ipera Communications, Soul Pattinson Telecommunications, AAPT, Highlands Internet, Windytide (AUSTAR), Alphalink (Australia), Integrated Data Labs, Unwired Australia

0.39%

ISM & modified spread spectrum

Arafura, Airnet Commercial Australia 0.00%

Satellite Telstra, SingTel Optus, PanAmSat Asia Carrier Services

8.24%

* private network; # the TransACT network is a hybrid copper/optical fibre network

4.24 As evidenced in the table above, whilst there has been significant investment to date, copper remains the dominant local loop access technology with HFC and satellite being the next most used technologies.

4.25 In the years since the technology crash investment in new infrastructure has been constrained since available capital has been scarce. In this environment, competing carriers have been forced to focus their efforts on resale based access with limited investment requirements. However, there appear to be signs of a growing appetite for new investment in facilities.

4.26 The most likely form of this investment will be in DSL over ULLS. It is likely that the emerging growth of mass-market data services will drive enhanced facilities based competition for voice service.

4.27 Whilst ULLS utilises Telstra’s existing local loop, this can be considered a form of facilities-based competition, on the basis that investment in infrastructure that directly competes with Telstra is the key to a sustainable competitive position in the market.

4.28 However, facilities-based competition requires a long-term view to be taken by regulators. Investment will not happen over night. In fact, most investment decisions are based on timeframes of at least 3 to 5 years.

4.29 There are high fixed costs associated with facilities-based investment, either by ULLS build, HFC or wireless local loop (WLL). These high fixed costs can act as a significant barrier to entry for most carriers and may act to delay the level of investment. The traditional model of “build it and they will come” has not proven to be viable to date.

4.30 However, if competitors are able to build up their level of market penetration initially through resale the risks associated with the high fixed costs are reduced and the economics of investment in infrastructure not only become more viable but are more compelling than resale. Whereas access-based input costs are directly proportional to penetration, own-infrastructure investment costs will decline per unit as penetration increases. Further, with access to an established revenue stream for voice and data services, the payback period on any investment is dramatically reduced.

4.31 There is increasing evidence that this model will drive changes in the market, with carriers committing to further investment in facilities. The new facilities are likely to allow them to leverage off the availability of new revenue streams provided by data to offer a full suite of voice and data services.

4.32 A number of smaller carriers have recently announced commitments to new investment. For example, Powertel has recently committed to installing its own DSL-based infrastructure in response to the rapidly changing market. Powertel chief executive, Shane Allen, stated:

“I believe our focused, full-service product offering, competitive pricing and personal customer attention position us as a serious contender to Telstra and Optus in the business market … We continue to rollout DSL exchanges with 85 currently in service and we are on track for another 21 by the end of 2004 … We have spent the past few months consolidating our position, further building and refining our infrastructure for voice and data services and refining our sales and marketing strategies”21

4.33 iPrimus is committed to wireless local loop infrastructure investment with iPrimus and partners strategically building Wireless Access Points, known as ‘Hotspots’, across CBD’s and capital cities in Australia enabling customer to access to the iPrimus Broadband Wireless Internet and broadband service.

4.34 Unwired, a new entrant in the wireless broadband market, now offers a wireless broadband service to more than one million people in Sydney’s greater west. This wireless network is estimated to have involved investment of $33 million over the past year with the wireless network expected to reach up to 95% of all Sydney homes and flats.22 Areas covered include Parramatta, North Rocks, Penrith, Campbelltown, Fairfield and surrounding suburbs. Over 700 square kilometres of Sydney is now unwired.23

4.35 Further signs that infrastructure competition is likely to increase in the near term is provided by Telstra’s investment plans. In its media release of 22 July 2004, Telstra confirmed that it would maintain a domestic capex spend in the

21 Powertel Media Release, Powertel steps up into another league, 10 August 2004

22 Coverage to units and flats is important, particularly since providing fibre or cable to units has

proved to be uneconomic.

23 http://www.unwired.com.au/index.php

2005 financial year of about $3 billion, excluding any possible accelerated commitment to 3G investment.

Emerging technologies as a driver of effective competition

4.36 To date there have been significant barriers to entry for the use of both wireless and DSL based technologies to serve the mass market. However, in both cases recent trends in prices have reduced these barriers.

4.37 In the case of wireless there are significant fixed costs, relating to the acquisition of spectrum and CPE which has traditionally been expensive. However, prices for wireless based equipment (CPE and transceivers) have declined to the extent that wireless is becoming an increasing viable service. There are a number of wireless vendors already in the market, these include IP Wireless; iBurst and Motorola.

4.38 The costs of DSLAMS and customer modems have declined significantly over the past few years.

4.39 The need to adopt new technologies within existing and new infrastructures is essential to meet the increasing demand pressures placed on telecommunication networks. Product differentiation and value added services is of growing importance, therefore carriers need to offer bundles across integrated communications, information and entertainment packages.

4.40 To be able to respond in this environment carriers will need financial flexibility and access to ready capital for investment in infrastructure and new services. However, investors will require certainty of a return on their investment, not in 10 to 15 years but in 2 to 3 years.

Role of price caps and regulation

4.41 Optus considers that the industry is on the brink of a period of significant change within telecommunications, which is likely to see a significant assault on Telstra’s dominance of the local loop. The actions of the Government in setting price controls can and will impact the pace and level of this change.

4.42 Whether to allow margins to remain in voice services in order to promote investment is the key trade-off the ACCC and Government need to contemplate in this review. That is the choice essentially becomes one where:

• Tight price controls on voice services may be justified as a means to extinguishing any economic rents and improving allocative efficiency in the short term; however

• Tight price controls on voice services will reduce the gains from facilities-based entry and therefore reduce dynamic efficiency in the medium term.

4.43 Optus believes that tightening the retail price controls can only have a detrimental impact on investment. Investment decisions are based on longer term criteria, therefore tight price controls will send out the wrong signals to

potential investors and could risk reversing a trend that is well underway in the current market.

4.44 The result of such action would be to reduce revenues available in the local and long distance market in the short-term compared to the scenarios where no such action is taken. This will mean that carriers will have less resources available to fund new investment and the returns on that investment are likely to be reduced. That is, simply redistributing long distance profits back to consumers will not ensure that local access competition will take off across Australia.

4.45 In contrast, forbearance in the setting of price controls is likely to stimulate new investment. Carriers will have better flexibility to set pricing to meet both their short and medium term needs. As competition intensifies through facilities based competition it will provide constraints on retail pricing. The advancement of competition is likely to ensure that reductions in prices will outstrip those enforced through government mandate in the longer-term. Further, the resulting quality of services ensuing in the market is likely to be far superior to those that arise when prices are prescriptively controlled by Government.

5. Facilitation of facilities-based competition

Effective access to Telstra’s monopoly local loop is essential

5.1 Ideally, achievement of an effective wholesale pricing access regime will negate the need for retail price controls altogether. Optus believes that this is where regulation, both access-based regulation and retail price regulation, needs to be focused in the current market conditions. To the extent that access regulations cannot address all likely concerns of government, then regulations at the retail level need to be specific and targeted.

5.2 Tardiff and Taylor24 quote the FCC’s chief economist Joseph Farrell to demonstrate the strong link between retail price regulation and competition. Simply, whilst competition can be promoted by an effective wholesale access regime, retaining price controls under these circumstances can be detrimental; it is a fine balance of the two:

Smoothly functioning wholesale regulation…permits and indeed almost demands retail deregulation. If multiple providers can compete for a customer’s business and promptly supply it at reasonable overall cost, even if they do so by leasing the incumbent’s facilities, then it would seem that prompt deregulation of all charges to the provider’s end-users will be appropriate…Indeed if regulators continue to regulate the incumbent’s retail prices, and don’t happen to replicate the solution that the incumbent and the customer find jointly most beneficial, it puts the incumbent at an artificial competitive disadvantage.

24 Tardiff T. J and Taylor W. E, “Aligning Price Regulation with Telecommunications Competition”,

in Review of Network Economics Vol. 2, Issue 4 – December 2003, page 347-348

Thus, while economic theory has evolved, especially in its application to telecommunications markets, the pattern is clear: the opening of local exchange markets to competition (facilities-based or that made available by the provision of wholesale services) makes continued regulation of retail markets increasingly problematic. By implication, any retrogression towards traditional regulation would be especially counterproductive. And, …practice is advancing with theory: regulators in other states have recently revised incentive regulation plans consistently with these advancements in economic theory.

5.3 Whilst access-based competition can only achieve a certain degree of competition in the market, an access regime that promotes dynamic efficiencies will inevitably lead to effective competition, thereby negating the need for further retail price controls.

5.4 The ACCC has made some significant progress in setting an access regime that facilitates the development of competition. It has declared and set prices for Local Call Resale and ULLS, it has reduced prices for PSTN access and has recently taken action under Part XIB to address anti-competitive conduct in respect of wholesale DSL access.

5.5 However, further changes to the regime are necessitated to remove some lingering obstacles to the development of effective competition. The most significant of these issues relates to the ACCC’s regulation of Local Call Resale and its interaction with the retail price control arrangements.

Addressing the problems with the LCS pricing principles

5.6 Under the present local call resale arrangements the LCS price is set on the basis of a Retail Minus Avoidable Cost methodology (RMAC) by reference to Telstra’s unbundled price. This creates the incentive for Telstra to price discriminate, which it does by offering lower prices for local calls in bundled retail offers to those available for unbundled services. The impact of this is that access seekers effectively have to pay higher input costs for LCS than Telstra Retail. This has the effect of diminishing the ability of resellers to compete with Telstra, in turn meaning that prices for some calling services may be higher than would otherwise be the case.

5.7 A second problem is that as Telstra rebalances under the current price control arrangements, the full cost of any increase in line rental prices is passed on to access seekers, with the result that their costs increase and margins are reduced. However, these are the very margins that are required to help fund investment in additional scale and investment in new infrastructure. The combination of the current RPCs and the LCS pricing principles actually act to cushion Telstra from competitive entry.

5.8 There are a number of possible policy solutions to this issue. One is for the ACCC to move to a TSLRIC pricing of both local calls and line rental at the point that TSLRIC yields lower prices than those based on RMAC. Under this arrangement wholesale line rental would formally need to be declared and prices set at cost (i.e. network cost based on TSLRIC). The line rental prices would effectively be capped at the rebalanced level. The local call price would also be reduced from its current level.

5.9 These changes would have a number of advantages:

• Resellers’ costs are likely to be reduced so enhancing their ability to compete and gain scale;

• Competitive neutrality will be achieved. This will enable both Telstra and resellers to create bundled offers to match customers’ range of preferences in a competitively neutral manner; and

• Whilst Telstra remains dominant in the provision of local loop access, a wholesale line rental price based on cost will act as a constraint on its ability in the retail market to set retail line rental prices at monopoly levels.

5.10 A better option would be to cap the wholesale line rental price at its current level, while leaving retail line rental prices uncapped. This option has a number of policy benefits. Firstly, it is likely to cap costs for resellers, so providing them with increased ability to compete with Telstra and fund investment in new infrastructure. In essence this would represent a form of industry dividend to stimulate the growth of competitive broadband services in Australia. Secondly, the cap on wholesale line rental will act as an effective constraint on Telstra’s ability to set retail prices for line rental above efficient levels.

5.11 Each of the above changes require a shift in focus from the ACCC. It needs to see resale not as a deterrent to investment, but as the “ladder of opportunity” to further investment in technologies that can deliver viable voice and broadband services to the mass market. If the ACCC remains concerned with the trade-off between improved LCS arrangements and facilities-based investment then it can sunset or link any changes to specific achievement in competition levels.

The burden of the ULLS surcharge

5.12 A further concern related to this review is the ACCC’s decision to enable Telstra to discriminate in its pricing of activation between ULLS and its Retail DSL service. In its proposed model price terms and conditions the ACCC has allowed Telstra to include a hefty surcharge in ULLS prices to recover Telstra’s costs associated with the churn of a ULLS service. The current proposal requires a carrier using ULLS to make real cash payments to Telstra of between $120 and $198 annually simply to process a churn request. However, no surcharge is built into the price of Telstra’s own Retail and Wholesale DSL services.

5.13 Such an anomaly has the potential to discourage and delay investment in ULLS. Optus encourages the ACCC to revisit the issue of the ULLS specific charges in the context of its review of the retail price controls and more specifically Telstra’s undertaking for ULLS and to remove the current inequity in ULLS pricing. Such a step would have a significant positive benefit on incentives for facilities based investment in ULLS to deliver voice and data services to the mass market.

5.14 Optus believes that the incremental changes to the access regime, as outlined above, will provide a further catalyst for the prospective investment in facilities based access technologies. This in turn will drive competition in

voice and local loop services which will obviate the need for price controls on these services.

Flexible retail price controls

5.15 However, changes to the access regime need to be combined with forbearance at the retail level. As noted in section 4, retail prices act as a signal for entry and investment decisions, both for Telstra and other carriers.

5.16 Pricing flexibility, which allows Telstra to set efficient prices and price discriminate, is essential for efficient consumption (allocative efficiency) and investment decisions (productive efficiency). Pricing flexibility allows, amongst other things:

• price structures that most closely reflect costs as they are incurred by the carrier;

• efficient price discrimination which maximises societal welfare levels eg. incorporating all you can eat bundles for high volume users versus low fixed cost/high usage charge bundles for low volume users;

• bundling in order to achieve efficiencies; and

• product differentiation to suit different consumer tastes, for example higher quality services and service availability.

5.17 Whilst pricing flexibility and the achievement of allocative and dynamic efficiencies does not necessarily promote the government’s social policy objectives, it is clearly within the LTIE criteria of the Trade Practices Act. To the extent that these equity objectives need to be prioritised for social policy reasons, Optus believes this should be done by means of measures targeted at specific problems or low income users, in order to minimise distortions.

Price versus quality of service

5.18 Product differentiation and service enhancement is becoming increasingly important in the telecommunications industry. Customers want a greater range of choices and varying mixes of availability and service quality. Yet this provides an example of how price controls remove carriers’ flexibility to respond to customers needs.

5.19 Even though price controls are claimed to be a form of incentive based regulation, there is no mechanism within the controls to encourage Telstra to provide a higher quality of service or to differentiate itself by offering a slightly different type of service when the price is restricted by prescriptive price controls.

Geographic differentiation

5.20 Whilst Optus believes that investment in infrastructure will challenge Telstra’s dominance of the local loop in the next 2 to 3 years, this is likely to occur largely in the broader metropolitan areas. Telstra’s dominance in rural areas is significant and the likelihood of facilities-based competition developing in

many of the more remote areas (away from major regional centres) is less than in metropolitan areas. Rural customers may therefore not share in the benefits of competition. The case for relaxing the price controls in these areas is not, therefore, as clear cut as that in rural areas. But again caution is required to ensure short term policy gains do not simply entrench Telstra’s dominance.

5.21 The lower prospects for competition in rural areas is one of the reasons the Government has implemented local call parity requirements in the price controls. This explicitly sacrifices the efficiency for the equity objective. Loss in efficiency arises because it may create a difficulty in Telstra being able to respond in its local call pricing when competitors enter the market.

5.22 However, Optus’ own analysis suggests that the cost of carrying a call in metropolitan and rural areas may not be as disparate as indicated by Telstra in its undertakings. For example, taking the PSTN undertaking costs, Telstra’s modelling estimates that the cost in rural areas is approximately 892% greater than in metro areas. However this is entirely inconsistent with NERA modelling and international cost differences as shown in the graph below.

Rural versus metropolitan PSTN rates25

5.23 The geographic charging in PIE II is substantially out of line with that in US states that have similar demographic and geographic features. Where rural conveyance costs in PIE II are up to 892% greater than metro charges – the US states show a difference of less than 100%. Further, the ACCC-n/e/r/a model rates are more closely in line with US rates.

25 US rates taken from New Zealand Commerce Commission (NZCC), International Benchmarking

Report: A Comparative Review of Interconnection Pricing, September 2002.

Rural vs Metropolitan rates

22% 29%11% 20%

49%26%

82%93%

68% 73%

250%

177%

0%

50%

100%

150%

200%

250%

300%

Kansas Arkansas Oklahoma Missouri PIE II NERA

PS

TN rt

aes

% ru

ral v

s m

etro

Suburban/ProvincialRural

5.24 Therefore it appears that the local call parity requirement may not be as big a constraint as Telstra may indicate.

5.25 In respect of line rental, Telstra has discretion to price its line rentals on a geographic basis, but has chosen not to do so. This is presumably either for profit maximising reasons or more likely because lower line rental discourages investment and any losses it incurs in rural areas are funded by competitors and, as a direct consequence of this policy, by all callers via the USO levy.

5.26 The USO levy has the effect of raising the cost of entry. Competitors entering the market must recover this from call charges and pass this on to Telstra. As such, Telstra is indifferent to its losses in rural areas.

5.27 Optus understands – contrary to the advice of DCITA in its report on the USO that is referenced by the ACCC in its discussion paper – that the Government intends to maintain the inefficient USO levy arrangements. The Hon Darryl Williams stated in a press release of 17 June 2004 that:

Although the report shows these safeguards overall are meeting legislative objectives, the report has identified some problems with the way the current subsidy setting arrangements for the USO have operated in the past.

At this stage, the Government does not intend to change the broad legislative framework, but it will consider ways to respond to these concerns.26

5.28 Optus considers that the changes we have proposed to the access regime in section this section will help to improve competitive intensity in rural areas. Whilst direct investment may be some way off at cost based access price, resale offers a viable opportunity to compete. As with the broader market Government should avoid creating distortions through RPCs that limit the prospects for investment occurring.

5.29 Nevertheless, it is likely that any distortions normally associated with price controls will have less of an impact in rural areas in the shorter term. To the extent that the Government may want to maintain safeguards for rural customers, then it might consider linking the relaxation of controls to the emergence of competition.

5.30 For example, it might be appropriate to maintain price controls on line rental and the local calling parity measures until there is evidence of competition emerging in rural areas. The development of competition could be measured in terms of the achievement of specific targets, such as defined changes in Telstra’s market share for specific services and classes of consumers in specific locations.

5.31 To achieve to such targets, and the relaxation of controls, Telstra will have strong incentives to make available improved wholesale arrangements to encourage competition. This could make the take the form of improved wholesale prices for LCS, DSL and transmission capacity within regional and

26 Hon Darryl Williams, News Release: Key Telecommunications Consumer Safeguards Working, 17

June 2004 (http://www.dcita.gov.au/Article/0,,0_7-2_4011-4_119246,00.html)

rural areas. Such improvements to wholesale arrangements will encourage competition in rural areas and deliver benefits to consumers in those areas.

6. Other issues

Removal of all price controls on fixed telephony is the optimal action

6.1 Optus has argued in this submission for the removal of RPCs on all fixed line services. Removal of all price controls will promote the LTIE by maximising allocative efficiencies and removing the distortion that exists with respect to dynamic efficiencies. No price cap required for competitive (mobile, voice and data) services.

6.2 As demonstrated in this submission there are good reasons to dispense with the controls on call services as these are already subject to an intense level of competition. Recent changes made by the ACCC to the access regime have been designed to further enhance the level of competition across these services.

6.3 Optus does not believe there are any efficiency gains by bundling effectively competitive and monopoly-based services into a broad-based cap. A broad-based cap on Telstra that encompasses competitive and monopoly markets motivates the firm to predate in the competitive market and price at monopoly levels in the monopoly market. This is because the demand curve faced by the incumbent in the competitive market (the firm’s demand curve) will be highly price elastic at the competitive level of pricing. By contrast, the industry demand curve in the competitive market (which measures changes in consumer demand where all firms change their prices) may be highly inelastic. Pricing in this way is consistent with Ramsey efficient pricing which is based on maximization of consumer surplus under industry demand curves, not the demand curve for the individual firm. Whilst a broad-based price cap motivates the incumbent to maximize profits according to this latter demand curve, it is the industry demand curve that is the relevant variable upon which Ramsey efficient pricing is based.27

6.4 Thus a broad-based price control, encompassing markets of differing competitive intensity, is in direct contradiction to the promotion of competition and the intended outcomes for the price control. In particular, such a control:

27 This is also consistent with the economic response predicted by Access Economic Report “Review

of Price Controls on Telstra”, at pg 8. The paper demonstrates that if Telstra has a retail price cap on

both monopoly and competitive services, the incumbent’s profit-maximising strategy is unambiguously

to raise price in the monopoly market, whilst dropping prices to meet competition in the competitive

market. This response is not “efficient” from society’s point of view because the incumbent is

‘Ramsey’ pricing according to the demand curve for the firm, rather than the industry demand curve,

the latter being the relevant variable for calculating consumer welfare.

• encourages prices that are too low from an efficiency perspective in competitive markets;

• undermines otherwise efficient entry, investment and competition in these markets;

• motivates prices that are too high in monopoly markets (such as LCS).

6.5 The inefficiencies associated with a broad-based price control, when competitive and monopoly services are lumped together in that control, has also been acknowledged by the Government. The Department of Communications in its consultation paper on Price Controls in 199928, and consistent with its decision in 2002 on the current price controls, commented:

“If competition is effective in a market, it is arguable that not only is a price control unnecessary, but potentially harmful to competition. By mixing competitive services with non-competitive services in the same basket, the price cap would risk creating a regulatory incentive for Telstra to channel price reductions to competitive services, whilst charging monopoly prices for the uncompetitive services in a manner which could permit anti-competitive cross-subsidies.”

6.6 The Productivity Commission29 has expressed a similar view:

“... another problem with price capping may arise from the pricing flexibility that it is partly designed to promote.... the scope that a multi-product incumbent has to change price and service levels over a range of products in a number of markets also provides it with scope to use its market power against an entrant”.

6.7 The Productivity Commission also noted in its report that this had been borne out in the UK:

“In the UK, British Telecom (the incumbent), operating under a price cap, aggressively countered entry into its long distance market by lowering its prices while raising prices in its uncontested markets (King and Maddock 1996, Vickers and Yarrow 1988, and Armstrong, Cowan and Vickers 1994)”.

6.8 Individual caps are applied in order to achieve more targeted equity issues – but this can be at the expense of efficiency and other competitive outcomes. For example, Telstra has the ability to leverage its market power in LCS into the more competitive markets and circumvent the specific individual caps. This simply harms competition in the competitive mobile and data markets.

28 Department of Communications and Arts Discussion Paper on Retail Price Controls, March 1999.

29 Productivity Commission, “International Benchmarking of Telecommunications Services” March,

1999, p. 247

No price caps on local access

6.9 With respect to local access, whilst Telstra currently retains its dominant position, there are strong prospects that competitive investment in new infrastructure will see significant in roads being made into Telstra’s market share. Government and regulators need to set policy that encourages such investment. In the context of the RPC this means that Telstra should be allowed to re-balance line rental prices to cost and that caps on line rental prices should be removed.

6.10 To provide a safety valve in the system whilst facilities based competition develops, the ACCC should make some important yet incremental changes to the current access regulations. This requires wholesale prices on LCS services to be capped either at their current levels or at cost based levels. Such a measure will help to facilitate the investment in infrastructure by ensuring competitors can compete on a level playing field and attain the scale required to invest. In those areas where investment is less likely to eventuate, capped wholesale LCS prices will act as a constraint on Telstra’s ability to raise prices to monopoly levels.

6.11 If some form of price controls are required to be maintained, these should be targeted to rural and regional areas where competition is less intense. To provide appropriate incentives for competition to develop in these areas, the relaxation of controls should be linked to improvements in competition against defined targets.

Social measures

6.12 If there is concern over equity issues or the welfare of rural or low income users then Optus would urge the government to consider specific targeted measures to address these objectives. This can be done through limited price control measures or through alternate welfare schemes.

6.13 An example of the successfully targeted measures is the requirement for Telstra to have in place low-income packages that are approved by low-income advocacy groups. Consistent with this requirement Telstra currently offers packages targeted at holders of Pensioner Concession cards, Health Care cards and Low-income health care cards. Since holders of these concession cards are likely to have lower than average incomes, this scheme is successful in meeting the government’s objection of directing social benefits to those who should receive those benefits. Optus would support the maintenance of the current Telstra funded low-user requirement.

6.14 Whilst Optus does not believe there is a case for price controls to be retained at a broader level, to the extent that political expediency deems this to be necessary then the controls should be either be targeted to those areas facilities-based competition is less likely to develop, such as rural or remote areas. In this instance the controls could be linked to developments in competition such that it is relaxed as certain competition thresholds are met.

A separate, specific Fixed to Mobile services price cap is not warranted

6.15 Optus expects that the ACCC will come under some pressure to recommend a specific sub-cap on Fixed to Mobile services (FTM) to ensure that any reductions in termination rates resulting form its recent decision on mobile termination prices are passed through in retail prices (known as the “pass-through” mechanism).

6.16 Optus does not support the imposition of a separate sub-cap on FTM services. There are adequate market forces to ensure an efficient pass-through of any reductions in mobile termination rates. As indicated in this submission there are numerous carriers and providers competing for long distance services, including the fixed to mobile component.

6.17 The market for fixed-to-mobile calls is competitive, and the fixed-to-mobile call prices reflect this. Consistent with this fact, Optus observes that retail fixed-to-mobile prices have generally fallen in line with lower termination rates.

6.18 According to the ACCC’s Division 12 reports the price of fixed-to-mobile services have fallen substantially for at least the past three years. Between 1997/8 and 2002/03 retail prices of fixed-to-mobile services have fallen by 22.7%. Whilst the level of price reductions has varied between customer groups, nevertheless all consumers have benefited from significant reductions in prices. The reduction in retail prices is consistent with trends in mobile termination, which have also declined significantly over recent years.

6.19 This evidence suggest that the market operates efficiently to ensure that any reductions in the wholesale mobile termination rates are passed on in charges to end-users. This can be in the form of direct reductions in fixed to mobile prices or alternatively in prices for related long distance services. As fixed to mobile services are sold in a bundle with other preselect services carriers have the flexibility to target cost reductions to different services within that bundle.

6.20 The fact that Fixed-to-mobile calls can be “preselected” by customers in a bundle of long distance and international calls provides an effective avenue for resellers and carriers to compete for these services. As noted previously, Optus, AAPT, Primus and other players have made substantial inroads into Telstra’s incumbent market share for these services and prices have fallen substantially across all these services. Further changes to the wholesale arrangements recommended in this document will add to the level of competitive intensity for fixed to mobile services. Reductions to LCS call charges and capping wholesale line rental charges will provide resellers with enhanced flexibility to compete with Telstra, which will deliver benefits to end-users.

6.21 For the above reasons it should be unnecessary for the ACCC to introduce a pass through mechanism. Moreover, such a pass through mechanism may create distortions by reducing fixed operators’ pricing flexibility in downstream retail fixed-to-mobile services. A pass through mechanism is likely to influence not only how retail fixed-to-mobile rates are structured but also how other prices that are sold within the preselect bundle are structured. Such changes may have distributional consequences in terms of which

customer groups receive the greatest price reductions – this would necessarily raise equity issues that the ACCC and Government should avoid.

6.22 Optus notes that the ACCC has previously accepted a number of the arguments posited above. In its recommendation on price control arrangements in 2001, the ACCC stated that there was no need for a FTM separate price cap in order to ensure FTM retail pass-through and that it has a strong preference for broad-based price caps rather than specific price caps:

The welfare of the community as a whole is best improved with a broad price cap applying to all price controlled services and the removal of a number of existing sub-caps from the current price control arrangements…Broad price caps of a CPI-X per cent variety provide incentives for efficiency in three main ways:

• they can help ensure Telstra does not price too far in excess of costs in markets where it has market power;

• they can provide firms with an incentive to seek cost savings in excess of those needed to reduce the price of services by X per cent per annum; and

• they give Telstra the freedom to structure its prices so as to recover common costs in the most efficient way.30

6.23 In its most recent report on the Mobile services review, the ACCC maintained its view that a specific pass-through mechanism on fixed to mobile prices is unnecessary as competition will drive reductions in prices either for fixed to mobile services or related services;

While some parties are currently concerned that reductions in mobile termination rates may not be “passed- through” to FTM consumers in the form of lower prices for FTM services, the Commission expects that increased competition in the market within which FTM services are provided would create pressures on all providers of this service to pass-through reductions in the price of the MTAS to end-users. If a provider of FTM chooses not to pass-through reductions in the price of the MTAS, it runs the risk of losing market share to competitors who do. The Commission notes, however, that such pass-through may come in many forms other than simply reductions in the prices of FTM call services. For instance, it could also come in the form of reductions in the per call prices of other services sold in the same pre-selected bundle of fixed-line services that also includes national long-distance and international long-distance calls. Further, pass-through may not be uniform across all classes of consumers.31

6.24 The ACCC’s June 2004 decision setting out pricing principles for mobile termination represents an unprecedented level of regulatory intervention in the

30 ACCC, Review of Price Control Arrangements: An ACCC Report, February 2001, page vii

31 ACCC, Mobile services review mobile terminating access service: Final decision on whether or not

the Commission should extend, vary or revoke its existing declaration of the mobile terminating access

service, June 2004, page x

fixed to mobile market. The ACCC has applied a very powerful regulatory instrument, and has consciously decided to do so notwithstanding the strong advice from Optus and other market participants about the detrimental effects of doing so.

6.25 With the ACCC having used such a strong and intrusive instrument to achieve the policy target of reduced fixed to mobile retail prices, it is difficult to see any justification for imposing yet another regulatory measure targeted to the fixed to mobile market. It would effectively be a vote of no confidence by the ACCC in the approach it has only just adopted in setting mobile termination pricing principles – and would in turn raise the very real question of how the ACCC could in any intellectually coherent way justify its approach to mobile termination.

Mobile services should not be subject to price controls

6.26 The ACCC has canvassed views on whether mobile services should remain outside the price control arrangements. Optus considers that mobile services should not be subject to price controls given that the mobile services market is highly competitive.

6.27 This intense level of competition within the mobile services markets is evidenced by the structure, conduct and performance of the industry.

6.28 The market structure is characterised by the existence of multiple market players competing not only for new customers, but also for customers from other networks. The level of customer churn between networks is high, which reflects the recognition by consumers of the mature state of competition. Each carrier’s market share is also threatened by the potential for new market entry, and consumer usage of substitutes to mobile telephony.

6.29 Market conduct is largely driven by competition for consumers, and also for customer retention. Carriers offer multiple tariff structures and pricing options, enabling consumers to pick the package that best meets their needs. Handset subsidies have played an important role for carriers in attracting consumers to their networks, and in promoting mobile penetration in general and increasingly for new services.

6.30 Bundling is also becoming an increasingly prevalent tool for product differentiation. Indicative of the level of competition and carrier responses to competition, prices for mobile services continue to fall, both at the wholesale and retail level.

6.31 The pricing of mobile-to-mobile calls is subject to intense competition. Pricing is characterised by the existence of a wide range of pricing plans and special promotions, which is indicative of the dynamic and highly competitive state of the market. Between 1997/8 and 2002/03 prices for GSM services have fallen by 23.9%.32

32 ACCC Report: Changes in the prices paid for telecommunications services in Australia 1997-8 to

2002-03.

6.32 The performance of the industry is also consistent with competitive outcomes. Although penetration levels continue to rise (albeit at a slowing rate), industry-wide profitability is modest.

6.33 All of the above factors support the conclusion that mobile services should remain outside the retail price control mechanism.

Appendix 1: Answers to ACCC questions

Are any of the current price controlled markets now sufficiently competitive to warrant the removal of price controls on the relevant telecommunications service?

The long distance, international and fixed to mobile markets are sufficiently competitive to warrant the removal of price controls.

With respect to local access, new investment is likely to erode Telstra’s dominance. Effective regulation requires changes at the access end to set fair and reasonable LCS prices rather than controls at the retail level which distort investment decisions abd hamper the development of competition.

Having regard to the level of competition, are there any telecommunications services that should be subject to price controls that are not within the scope of the current arrangements?

Optus considers that the RPCs should be removed, with the potential exception of services to low income users and those services in rural and remote areas. In respect of these exceptions, the range of services subject to the cap must be carefully defined.

Should mobile services remain outside the retail price controls?

Refer to section 6. Optus considers that Mobile services are subject to vigorous competition and should remain outside the scope of price controls.

Do FTM services need to be subject to their own specific price cap?

Refer to section 6. FTM services should not be subject to a separate cap.

What impact, if any, do the current price control arrangements have on the development of facilities-based competition in telecommunications markets?

The current price control on line rentals has a significant adverse impact on investment in local access infrastructure. Refer to section 4.

What impact, if any, do the current price control arrangements have on the operation, and development, of access-based competition in telecommunications markets?

Refer section 4 and 5.

Are there any other important ways in which the current price controls affect competition in telecommunications markets?

Optus has addressed this question throughout its submission.

What impact do price controls have on the operation of Parts XIB and XIC of the Act which are administered by the Commission?

The price controls can act in opposition to access regulation because in a number of circumstances efficiency and the LTIE can be undermined. To some degree, price controls target specific users groups from an equity perspective, but the manner in which this is administered can harm allocative efficiency.

How important are the price control arrangements to the development of competition in markets other than those directly regulated by the retail price control arrangements?

Markets that are not directly regulated by the retail price control arrangements can, nevertheless, be the controls especially as services increasingly offered as a bundle to the customer. For example a cap on line rental prices may restrict flexibility in pricing competitive services.

What affect do the current price control arrangements have on the availability and/or choice of telecommunications services?

The price controls can act to restrict quality, availability and choice of service offerings because they can restrict the development of access-based or infrastructure based competition.

Using a CPI-X% price control to set retail prices at some measure of cost is likely to reduce product differentiation and service quality enhancements.

What impact, if any, do the current price control arrangements have on economically efficient investment in telecommunications markets?

Evidence of costs of investment in the CAN, PSTN, transmission and anticipated return leading to certain price levels.

What role, if any, do the restrictions on line rental charges have on investment in telecommunications markets? Has this changed over the course of the price control arrangements as line rental and call charges have been rebalanced?

CAN costs have been directly recovered by increasing line rentals. Recovery of the fixed CAN costs from line rental charges is more efficient. Are there any other important ways in which the current price controls impact on economically investment in the telecommunications market?

Refer to section 4.

What changes to the arrangements should be considered in order to promote the long-term interests of residential and business end-users respectively?

Refer to section 5.

Removal of the geographical uniformity in prices – this should be left entirely to the USO arrangements.

Refer to section 5.

Are there currently any telecommunications services delivered by Telstra via means of a new or emerging technology that should be subject to retail price controls?

What is the potential for new and emerging technologies to increase the need for price controls on particular telecommunications services?

Are there currently any new or emerging technologies that reduce the need for retail price controls on certain telecommunications services?

Do the current price control arrangements have any effect on the emergence of new technologies in telecommunications markets? If so, which technologies in particular and what it’s the likely affect?

Do the current price control arrangements have an impact on the incentive of potential entrants to invest in new and emerging technologies? If so, how?

Will the price control arrangements that interested parties suggest should be implemented affect the emergence of new technologies in telecommunications markets? If so, how?

Refer to section 4 for discussion relating to these questions.

How should targeted assistance (and other equity measures) be funded?

Optus recommends that the current requirement for Telstra to have in place low-income packages that are approved by low-income advocacy groups should be maintained. Such arrangements should continue to be funded by Telstra.

optus submission to accc on review of price control arrangements · no price caps on local access...

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