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Vodafone, O2, Orange

Reports on references under section 13 of the Telecommunications Act 1984
on the charges made by Vodafone, O2, Orange and T-Mobile
for terminating calls from fixed and mobile networks
Volume 1: Summary and Conclusions

Vodafone, O2, Orange

and T-Mobile
Reports on references under section 13 of the
Telecommunications Act 1984 on the charges made by
Vodafone, O2, Orange and T-Mobile for terminating calls
from fixed and mobile networks

Volume 1: Summary and Conclusions

Presented to the Director General of Telecommunications
December 2002

© Competition Commission 2003

Web site:

Members of the Competition Commission as at 31 December 2002 Dr D J Morris (Chairman) Professor P A Geroski1 (Deputy Chairman) Mrs D P B Kingsmill CBE (Deputy Chairman) Professor J Baillie Mr R D D Bertram Mrs S E Brown Mr C Clarke Dr J Collings Dr D Coyle Mr C Darke Mr L Elks Dr G G Flower Mr N Garthwaite1 Mr C Goodall Professor C Graham Professor A Gregory Mrs D Guy1 Mr G H Hadley Professor A Hamlin Miss J C Hanratty Professor J E Haskel1 Mr P F Hazell Mr C E Henderson CB Mr R Holroyd Professor B Lyons Professor P Klemperer Dame Barbara Mills QC Professor P Moizer Dr E M Monck Mr R J Munson1 Professor D Parker Mr A J Pryor CB Mr R A Rawlinson Mr T S Richmond MBE Mr J B K Rickford Mr E J Seddon Dame Helena Shovelton DBE Mr C R Smallwood Mr J D S Stark Professor A Steele Mr P Stoddart Mr R Turgoose Professor C Waddams Mr S Walzer Mr M R Webster Professor S Wilks Mr A M Young Mr R Foster (Chief Executive and Secretary) 1 These members formed the Group which was responsible for this report under the chairmanship of Professor P A Geroski. Mr N Garthwaite was selected by the Chairman of the CC under section 13(10A) of the Telecommunications Act 1984. iii .

Note by the Office of Telecommunications Certain material has been excluded from this version of the report following a Direction made by the Secretary of State for Trade and Industry to the Director General of Telecommunications acting in accordance with section 14(6) of the Telecommunications Act 1984 as affected by the requirement of the EC Directive on a common framework for general authorisations and individual licences in the field of telecommunications services in respect of the obligation of professional secrecy and certain business secrets. by the symbol . The omissions are indicated by a note in the text or. iv . where space does not permit.

............................................................................9 v .....................................................Volume 1 contents Page Part I—Summary and Conclusions Chapter 1 Summary...........3 2 Conclusions...........................................................................................

Part I Summary and Conclusions .

not only of O2 and Vodafone. Both references are in similar terms and we therefore decided to investigate the two references in parallel. 1. In May 2002. Our investigation concerned the call termination charges which O2. except where the context otherwise requires. in his view. FNOs’ call termination charges are separately regulated and are much lower than the termination charges levied by the MNOs. Under each reference.1. however. One reference concerned the charges made by Vodafone Limited (Vodafone) and BT Cellnet Limited1 (BT Cellnet). in the absence of a charge control mechanism on them. mmO2. 1. into a stand-alone company. One2One’s parent company. do not attract termination charges). Orange and T-Mobile levy on each other for terminating calls on their respective networks (‘off-net calls’) and on fixed network operators (FNOs). be set at levels which operate. Following a review of the current control of the call termination charges of O2 (UK) Limited (O2) and Vodafone. against the public interest. BT Wireless. of which the largest is BT. whose average charges had been at the maximum level permitted under the cap for the whole period of their existing charge control. mmO2 included BT Cellnet. whether the effects adverse to the public interest could be remedied or prevented by modifications to the licences of one or more of the four mobile network operators (MNOs) concerned. and the DGT therefore referred the matter to us. mmO2 rebranded all its operations under the O2 banner and BT Cellnet became O2 UK Limited. to operators of fixed or mobile public telecommunications systems for the termination of calls to handsets connected to their respective mobile networks. On 7 January 2002 the Director General of Telecommunications (the DGT) made two references to us in exercise of his powers under section 13 of the Telecommunications Act 1984 (the Act).3. and provided nearly all the MNOs’ net revenue from call termination charges in that year. whose unregulated charges had consistently been above those of Vodafone and O2 over the same period. Vodafone. announced that One2One would be renamed T-Mobile UK and the transition took place on 18 April 2002. The full terms of reference are set out in Appendix 1. We refer to this company as O2 throughout this report.2. Call termination charges are incurred by the MNOs and FNOs as costs at the wholesale level. 3 . mobile termination charges were substantially in excess of costs. 2 In September 2001. and that he had proposed charge caps of RPI–12 each year for four years until 31 March 2006 on the call termination rates. we are required to investigate and report on whether these termination charges would. and are taken into account in the retail prices which they set for their own customers. We refer to this company as T-Mobile throughout this report. This is because the MNOs pay out in termination charges to other MNOs (for off-net 1 In 2001. except where the context otherwise requires. with the same Group of CC members. Deutsche Telekom AG.1. or on-net calls. Calls to mobiles from FNOs accounted for a much larger proportion (70 per cent) of termination minutes than off-net calls (about 30 per cent) in 2001/02 (mobile-to-mobile. British Telecommunications plc (BT) demerged its domestic and international wireless subsidiary. for terminating fixed-to-mobile calls on their networks. BT’s UK mobile operator. The four MNOs had objected to the proposed charge controls. and if so.1 Summary 1. and the other reference the charges made by Orange Personal Communications Services Limited (Orange) and Mercury Personal Communications Limited (One2One2). but also of Orange and T-Mobile (UK) Limited (T-Mobile). or may be expected to operate. the DGT announced in a press release dated 12 December 2001 that.

In the light of arguments put to us by the MNOs. There is vigorous competition among the MNOs to attract and sign up subscribers to their networks. hence. mobile) technology. there are formidable problems associated with computing correct Ramsey prices. and we do not believe it would be appropriate for us to attempt to do so. to the extent that callers with both fixed and mobile phones use their fixed lines to call mobiles more than they use their mobile phone. such as calling a fixed line instead. We found that this structure of incentives put in place by the MNOs distorts the volume and direction of traffic on the network. are fixed and common to outgoing and incoming calls.7. we concluded that termination charges should in principle be cost-reflective and that the most appropriate method for determining the costs of termination was long-run incremental costs (LRIC). and we allocated those costs on the basis that. We concluded that competitive pressures at the retail level did not constrain termination charges. Vodafone. with almost no reciprocal benefit. as it would breach the cost-causation principle. The high prices of fixed-to-mobile. this being based on the LRIC of call termination (including fixed and common network costs) and a mark-up for relevant non-network costs. in any case. and low prices of on-net. 1. the only costs that should be allowed should be those costs that the caller himself causes (which we term ‘the cost-causation principle’). leading to a distorted pattern of usage by consumers. Some costs. or forced the MNOs to pass on excess termination revenues to retail customers through lower prices. It was put to us by the MNOs that.4. We concluded that the call termination charges of the MNOs were well in excess of a ‘fair charge’.5. fixed) technology to the higher-cost (that is. with the adverse effects that termination charges in 2002/03 are 4 . Moreover. and should make a contribution to the recruitment and retention of marginal subscribers. The MNOs argued that the costs of call termination should be calculated on a demand-led (‘Ramsey’) basis.calls) broadly what they earn in termination revenue from other MNOs. and. they suffer a detriment due to the high termination charges of the MNOs. 1. a justified addition to the fair charge because the caller benefits from having a large. because most people now have a mobile phone. however. and so the net revenue they receive from other MNOs or the net amount they pay to them is small compared with the call termination revenue they receive from fixed-to-mobile calls. 1. accessible pool of people to call and be called by. the DGT and others. but we rejected such an approach. 1.6. but this is funded by excess returns from termination charges. what consumers lose in paying high termination charges they gain on cheap handsets and competitively priced on-net calls. 1. set neither the correct structure nor the level of retail prices in accordance with Ramsey principles if we were to set termination charges at Ramsey levels. and so subsidize mobile customers through high call termination charges. There are also no ready substitutes for calling a mobile phone at the retail level.8. We found that each MNO has a monopoly of call termination on its own network. Further. and handset subsidies to customers. Some callers to mobiles from fixed-line telephones or from payphones do not themselves own a mobile phone. Orange and T-Mobile operate against the public interest. We conclude that the termination charges of O2. This is because there are currently no practical technological means of terminating a call other than on the network of the MNO to which the called party subscribes and none that seems likely to become commercially viable in the near future. for example through the payment of incentives and discounts to retailers. We considered whether competitive pressures on the MNOs at the retail level constrained call termination charges in any way. implementing Ramsey pricing would require us to set retail prices. calls also tend to skew usage from the lower-cost (that is. because call termination charges are ultimately borne by the caller. in practice. We also concluded that there should be a small mark-up for the network externality. We found less evidence of effective competition in call origination: thus the MNOs appear to display at least some power to set price structures that suit them for on-net and off-net calls. We rejected those arguments. we concluded that the MNOs would.

(d) the excess charges for termination have the further effect that they serve to encourage or facilitate significant distortions in competition because MNOs are not obliged to charge and subscribers are not obliged to pay the economic cost of handsets. because it attributes costs on the basis of who causes them. the termination charges of O2. or who make little use of their mobile phones. (b) consumers who make more fixed-to-mobile or off-net calls than on-net calls. too few such calls are made.30 to 40 per cent in excess of our estimation of the fair charge. (b) the high price of fixed-to-mobile calls discourages such calls and. which could justify their continuation. or that there might be expected to be. will not unfairly subsidize other consumers. it should mean that: (a) consumers do not pay too much for fixed-to-mobile or off-net calls. with the adverse effect that termination charges may be expected to be up to double the level of the fair charge by 2005/06. as a result. was the only remedy likely to address them effectively. (c) consumers who make more fixed-to-mobile or off-net calls than on-net calls unfairly subsidize those who mainly receive calls on their mobile phones or who mainly make on-net calls. and that. It addresses the adverse effects through a methodology that is equitable. if such charges were retained at their current levels in real terms. and concluded that a charge control by way of a price cap. If termination charges are regulated on this basis. this approach is both right and fair. or who make more off-net calls than they receive. plus the appropriate mark-ups as set out in paragraph 1. with the result that consumers pay too much for fixedto-mobile and off-net calls. Orange and T-Mobile may be expected to operate against the public interest. We considered a number of possible remedies to address the adverse effects. in the absence of a charge control on them. based on the relevant LRIC of the call termination service of an MNO with a 20 per cent market share. Vodafone. any offsetting public interest benefits arising from the termination charges set by the four MNOs being in excess of the fair charge.6. This proposal. thereby distorting patterns of telephone use. We did not find that there were.10. would remedy the adverse effects we have identified by removing their root cause. In our view. This leads to the undervaluation of mobile phone handsets by the MNOs’ customers combined with a greater turnover (‘churn’) than would take place if customers paid charges which reflected the proper valuation of such handsets. This leads to yet further distortions in greater expenditure in mobile customer acquisition than would have taken place if termination charges reflected costs more closely and if handset costs reflected the costs of handsets more closely. As a result. 5 . The price cap can be expressed as an RPI–X formula applied to the weighted average termination charge of the MNOs and would take the form of a 15 per cent reduction in their termination charges over the period from 1 April to 25 July 2003 and then a progressive reduction to the fair charge by 31 March 2006. and (e) the higher prices of calls from fixed to mobile phones and the lower price of on-net mobile calls encourage greater use of the higher-cost (mobile) technology at the expense of the lower-cost (fixed) alternative.9. which is proportionate to the detriments and non-discriminatory. 1. 1. the following detriments occur and may be expected over at least the next three years to occur: (a) the costs incurred by the FNOs and the MNOs through paying mobile call termination charges that are in excess of the fair charge are wholly or mainly passed through by them into their customer tariffs.

we used the longer period for the purposes of our analysis of the mobile market and the likely developments in that market. Orange and T-Mobile should each be required to reduce the level of its average termination charge by 15 per cent in real terms before 25 July 2003. However. (d) there should be no displacement from less resource-intensive to more resource-intensive technology. 1. however: (a) We expect welfare gains of between around £325 million and around £700 million over the period of our recommended charge control. which should reduce the rate of replacement of handsets. Accordingly. one regulating termination charges for fixed-to-mobile calls and the other. Even if handset subsidies are reduced. the DGT asked us to state our views on the level at which termination charges should be set for periods beyond July 2003. a period of three years is more suitable for regulatory assessment than the shorter period required by the change of regime. As the result of our recommendations. the analysis we have carried out enables us to take a view of the levels at which charges should be set for the period to March 2006 and. Vodafone. The precise effect of our recommendations on the MNOs and consumers is dependent on the extent to which the MNOs seek to recover the reduction in revenue from capped termination charges by price changes in the retail sector. The MNOs need not increase their retail prices to restore revenue lost through the capping of termination charges. The DGT’s proposed licence modification sought to regulate termination charges within the period to 31 March 2006. In our view. in carrying out our inquiry. 1 April 2004 to 31 March 2005.12. Moreover. and (e) there will be less incentive for the MNOs to subsidize handset acquisition.11. In this way. Vodafone. (d) Orange and T-Mobile should be subject to further reductions in their average termination charges of RPI–14 in each of the periods 25 July 2003 to 31 March 2004. people already owning mobile 6 . and 1 April 2005 to 31 March 2006. (c) As we anticipate no increase in retail prices. we have decided to state our views on the level at which we think call termination charges should be set to 31 March 2006. 1. 1 April 2004 to 31 March 2005 and 1 April 2005 to 31 March 2006. In our view. notwithstanding that such views can have little more than persuasive effect. (b) We do not expect average retail prices to increase. there should be two price caps. Consequently. as their business plans project a continued downward trend in retail prices and they could recoup these revenues by reducing the rate of retail price reductions for a period. the MNOs cannot load charges disproportionately on to one or other call type. termination charges for off-net calls. we recommend that: (a) For each of O2. 1. we expect no significant loss of mobile subscribers. set at the same level. (c) O2 and Vodafone should be subject to further reductions in their average termination charges of RPI–15 in each of the periods 25 July 2003 to 31 March 2004.(c) cost-reflective call charges should minimize distortion in the volumes and patterns of calling.13. Orange and T-Mobile. (b) O2. the falling away of the current framework of telecommunications regulation as the result of the coming into effect of new telecommunications Directives on 25 July 2003 means that any licence modification we recommend will have a very short life.

The MNOs have the option to offer marginal subscribers cheaper packages to induce them to stay on the network once that happens. 7 . (d) No threat is posed to the financial viability of the MNOs. stolen or broken. The MNOs have had notice of the possibility of charge controls on termination charges since at least September 2001 and their business plans all assume some reduction in termination charges over the next three years.phones are unlikely to leave the network unless their handset is lost.

................................................................................................................................................... 29 O2 ....... 39 Customer awareness and behaviour ................................................................................................ 48 Entry .......... 16 Developments since the MMC’s 1998 report ............... 45 Other market definition considerations ............................................................................................................................................................. 26 Jurisdictional and other legal issues............................................................................................ 31 Third parties........................................................................................ 45 Competitive pressures at the retail level .................................................................... 46 Profitability .......................................................................................................................................................................................................... 29 Vodafone................................................. 32 Market definition ............................................. 14 Vodafone............................................................................................................................................................................................................. 32 Supply-side substitution............ 26 Summary of views ................................................................................................................................2 Conclusions Contents Page Introduction................................... 13 Events leading up to the references....................................................................................... 50 Sales and marketing and customer care . 44 Conclusion on market definition..................................................................................................................................................................................................................................................... 21 General features ............................................................................................................................................................................................................................................ 49 Access and call origination issues.................................................................................................................................... 41 Awareness on part of customers of calling a particular mobile network .............................................................................................................................................................................................................................................................................. 27 The DGT .. 41 Sensitivity to the price of incoming calls ... 35 Competitive pressures on termination charges................................................................................................................................... 17 Features of termination charges ......................................................................................................................................................................... 50 Customer acquisition and retention............................... 30 Orange.................... 26 Framework ............................................................................................................................ 15 Orange............................................................................................................................................................................................................................................................................................................................... 47 Market shares ................................................................................. 35 Closed user groups.................................................................................................................................................................................................... 15 T-Mobile ................................................ 22 The public interest .......................................................................................................................................................... 43 Customer behaviour when calling mobile phones ............................................................................................... 21 Sources of termination revenue for the MNOs ....................................... 50 Switching or churn................................................................................................................................................................... 42 Knowledge of relative and actual prices ..................................................................................................................................................................................................................................................................................................................................................................................................................................................... 13 The four MNOs........................................... 12 Background............. 37 On-net and off-net calls................................................................................................................................................................................................................. 15 Summary of the MNOs’ UK performance....................................................................... 49 Access ................................................................................................................................................................. 52 9 ...... 14 O2 ..................................................................................... 33 Demand-side substitution........................................................................................................................................................................................................................................................................................................................... 30 T-Mobile .............................. 28 The MNOs ..................................................................................

....................................................................... 90 Arguments for and against high termination charges................................................................................ 102 Remedies................................................................................................ 58 The risk-free rate... 61 Gearing and taxation ............................. 105 Other possible remedies .................................................................................................................................................................................................................................................. 81 The concept of a network externality................................................................................................................................................................................. 73 Combined 900/1800 MHz vs 1800 MHz costs ............................................... 89 Costs of call termination—conclusion ............................................................................................................................... 61 Debt premium ..................................... 90 Distributional argument ........................................................................................................................... 56 Conclusion on competitive pressures at the retail level ..................................... 73 Operating cost ................................................................................................................................................................................................................................................................................................ 98 Termination charges in the absence of a price control... 67 The level of efficiency ................................................. 84 The effectiveness of a surcharge on call termination in increasing mobile penetration................................................................................... 98 Conclusions on the public interest ................................................................................Conclusion on ‘access’............ 113 10 ...................................................... 58 Introduction................................................................................................................................................................................................................................................................................................................................................................................................................. 109 Yardstick regulation............................................................................................................................................ 86 Estimate of the externality surcharge................................................................................................ 72 Quantity and value of equipment ........................................ 57 Costs of call termination .................................... 111 Technological solutions .................................................................................... 109 Bilateral agreements. 73 Comparison with FAC estimates for 2001..... 82 Measurement of the network externality............................................ 58 Cost of capital .. 77 Externalities ........................................................................................................................ 54 Margins ........................................................................................ 85 Consequences of a reduction in the subsidy.................................... 54 Call origination .................................................................................. 83 Whether the R-G factor changes with penetration levels..................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... 66 The increment ................................................................................................................................................................................................................................................................................................. 81 Introduction............................................................................................................................................................................................................................................................................................................... 70 Concerns over accuracy of the Oftel LRIC model................................................................................................................................................................................................................................................. 55 Conclusion on call origination ..................... 70 Comparison of outputs of the Oftel LRIC model with MNOs’ data ................................. 93 Reduction or removal of the subsidy would be detrimental to mobile sector and benefit FNOs ................................................ 54 Transparency of tariffs .............................. 59 Equity risk premium ............................................................... 96 Distortion of consumer choice ..................................................................................................... 104 The MNOs’ views on a charge control ............................................... 66 Common network costs........................................................................................................................................................... 96 Roll-out of 3G ................................................................................................................................................................................................................................................................. 62 The network cost of call termination ........................................................................................................................................................... 57 The basis of the MNOs’ pricing..................................................................... 76 Non-network costs ...................................................................................................................................................................... 91 Consumer welfare ........... 97 Conclusion on arguments for and against high termination charges........................................................................................................................................................ 62 Overall findings on the cost of capital ..................................................... 84 Funding of the subsidy.............................................................................................................................................. 62 Alternative to CAPM ................... 60 Equity beta .............................................................. 94 Financial position of the MNOs............................................................................................................... 63 Oftel’s LRIC model ................................................... 68 Economic depreciation........................................................................................................................................... 82 Internalization ................ 75 Cost trends 2002 to 2006 ................... 64 The time period ....................................................................... 87 Conclusion on the externality surcharge .......................................................................................................... 104 The DGT’s proposals for charge controls..................................................................................

.........Receiving party pays................................. 118 Implementation of charge control ......................................... 131 Overall conclusion ......................................................................................................... 130 Price impacts for mobile customers ................................................................................................... 125 Other matters relevant to the implementation of a charge control ......................................................................................................................................................................................................................................................................... 126 2G/3G calls ....................... 131 Conclusion on impact on consumers............................................................................................................................................ 115 Further alternative remedies suggested by MNOs .......................................................................................................................... 129 Impact on MNOs....................................................................................................................................................... 126 Target average charge ......................... 131 Proportionality and effectiveness...................................................................................................... 122 One or more charge caps................................. 129 Impact on consumers ................................................................................................................................................................................. 126 Ported numbers ....................................................................................................................................................... 128 Conclusion on welfare ...................... 117 Remedying the adverse effects ............................................................................................................................................................................................................................................................. 127 Impact on welfare ........................................................................................................................................................................................................ 117 Our proposals for a charge control.............................................................................................................. 117 Alternative approaches to calculating a regulated price control ...................... 127 Impact of price cap................................................. 122 Finding on whether the adverse effects identified can be remedied or prevented by a modification of the MNOs’ licences .. 133 11 ............................................................................. 130 Volume impacts of regulation........................................................................................................................................................................................................ 113 ‘Pass-through’ and price transparency measures ............. 114 Non-discrimination ....................................................................................................................... 116 Conclusion on other possible remedies......................................................................................................... 131 Formal recommendations on licence modifications.......

12 to 2. An FNO incurs a wholesale termination charge whenever one of its subscribers is connected to a call recipient who subscribes to any of the mobile networks (a fixedto-mobile call). A termination charge is a wholesale charge made by one telecommunications operator to another for connecting calls to a phone on its network. the DGT is able to modify provisions of a public telecommunications operator’s licence by agreement with that operator or. as the MNOs had objected to the proposed charge controls. The terms of each reference are set out in full in Appendix 1. One reference concerned the charges made by O21 and Vodafone. As both references are couched in similar terms and raise the same issue. We then look at a number of developments in the mobile market over the past four or five years which are of relevance to our inquiry (see paragraphs 2. namely the level of termination charges made by the MNOs in the absence of a charge control on them. We first summarize the events leading up to the references (see paragraphs 2. 2.3. Orange. for terminating calls made to its network. See footnote to paragraph 1. with the possibility of a further six-month extension.Introduction 2. and if so whether the effects adverse to the public interest could be remedied or prevented by modifications to the licences of one or more of the four MNOs. However. or T-Mobile report. an MNO incurs a wholesale termination charge whenever one of its subscribers is connected to a call recipient who subscribes to a different mobile network (a socalled off-net call) or to a fixed-line network. it is fixed-to-mobile and off-net calls that are therefore the focus of our inquiry. following its recent review3 of the charge control on calls to mobiles. we provide relevant background to our inquiry. and that.1. As we are concerned with the level of call termination charges made by the four MNOs. Orange. be set at levels which operated. against the public interest.1. 26 September 2001. and the body of our report addresses the two references together. Review of the charge control on calls to mobiles: A Statement issued by the Director General of Telecommunications on competition in mobile voice call termination and consultation on proposals for a charge control. Before addressing the public interest questions set out in each of our terms of reference.24 to 2. The reference was subsequently made and we were given six months from 7 January 2002 to make our report. failing this. we are required to investigate and report on whether these termination charges would. we have carried out a single investigation by one group of CC members. whether fixed or mobile. we sought and obtained from the DGT a six-month extension of our inquiry until 6 January 2003. Oftel. 2.6 to 2.2 to operators of fixed or mobile public telecommunications systems for the delivery (or termination) of calls to handsets connected to their respective mobile networks. Under the Act. 2. In May 2002. that it had accordingly proposed charge caps on the termination rates of O2. In a press release issued on 12 December 2001. certain of the appendices form a part only of the O2.1.1.2. An MNO does not charge itself a termination charge for handling calls made between two people both of whom subscribe to its network (a so-called on-net call).4. Similarly. as the case may be.42). On 7 January 2002 the DGT made two references to us in exercise of his powers under section 13 of the Act. it had concluded that mobile termination charges were substantially in excess of cost and that there was little incentive for MNOs to reduce them. 2 3 12 . Our investigation concerns charges made by an MNO to other network operators. in the absence of a charge control mechanism on them.5. describe briefly each of the four MNOs involved (see paragraphs 2. 2. Oftel announced that.11). Under each reference. following a reference to the CC that results in an adverse public interest finding and a conclusion that specified licence modifications would remedy the adverse effects identified. or might be expected to operate.21) and provide a summary of their UK performance (see paragraphs 2. and the other reference concerned the charges made by Orange and T-Mobile.23).22 and 2. it intended to refer the matter to the CC early in the new year. T-Mobile and Vodafone of RPI–12 per cent each year for four years until 31 March 2006. Vodafone. We end the 1 See footnote to paragraph 1.

43 to 2. in Oftel’s view.1. become established operators with sizeable market shares. were already subject to licence conditions designed to control the level of the charges they made to FNOs for terminating fixed-to-mobile calls. 2.) These considerations. The controls imposed on O2 and Vodafone had implemented recommendations by the Monopolies and Mergers Commission (MMC) following an investigation1 in 1998 into the termination charges which those two operators levied on FNOs (but not those levied on other MNOs).3). In September 2001.8 pence per minute (ppm). O2 and Vodafone had had the same weighted average termination charge of 14. the proposed licence modifications for all four MNOs were referred to us in January 2002. and Oftel did not include them in its reference to the MMC in that year. (Oftel estimated that Vodafone and O2 each had a share of UK mobile subscriber numbers in June 2001 of 25 per cent. Orange and T-Mobile were less well established in the mobile market than O2 and Vodafone. Oftel began a review of the extent of competition in mobile termination. should it decide that a further period of controls was necessary.8. The MMC had concluded that the level of their termination charges was too high in relation to their costs and that this operated against the public interest. and required the ceiling to be further reduced by RPI–9 per cent for each of the subsequent two years. 2.9). so far as mobile termination charges were concerned.introductory background section by identifying the distinguishing features of mobile termination charges. The outcome of this review was a statement published on 26 September 2001 (see the footnote to paragraph 2. following a period of consultation. together with its conclusion following the review that each MNO had market power in respect of mobile termination to its own network. Between August 1998 and March 1999. This meant a reduction in the ceiling for the weighted average charge to 10. the main sources of termination revenue for the MNOs and trends in mobile termination charges since 1998 (see paragraphs 2. Accordingly.9. Based on the MMC’s recommendations. that T-Mobile had 22 per cent.2 ppm in 2000/2001 and 2001/ 2002 respectively. 1 Cellnet and Vodafone: Reports on references under section 13 of the Telecommunications Act 1984 on the charges made by Cellnet and Vodafone for terminating calls from fixed-line networks. Oftel therefore modified the licences of O2 and Vodafone so as to include ‘rollover’ licence conditions. and Orange 28 per cent. led Oftel to conclude that there was now no justification for setting price caps for O2 and Vodafone alone and not for Orange and TMobile. and for which MNOs. both companies have. Background Events leading up to the references 2. These controls were due to expire in March 2002 (but see paragraph 2. Oftel reduced the weighted average termination charges which O2 and Vodafone were permitted to levy on FNOs to a ceiling of 11. 13 . At the time of Oftel’s review.86 ppm and 10. if not. It formed part of each of the terms of reference made to us on 7 January and is set out in full in Appendix 1. two of the MNOs.6. MMC 1998. RPI–9) for a further year (that is. Before undertaking its review of call termination charges. These controls have accordingly been in effect throughout our investigation. from 1 April 2002 to 31 March 2003). Oftel had recognized the possibility that. In 1998.60). These conditions extend the current controls on O2 and Vodafone at their existing level (that is. there might be insufficient time to implement them before March 2002 when the current controls on O2 and Vodafone expired.7.7 ppm for 1999/2000. Since then. 2. O2 and Vodafone. what further controls would be appropriate. to establish whether competitive pressures were likely to be sufficient to restrain termination charges to a competitive level after 2002 and. This statement included Oftel’s conclusions on the degree of competition in mobile call termination and its final proposals for future controls of termination charges. In July 2000.

Oftel. The termination charges of Orange and T-Mobile have remained formally unregulated. 12. Orange said that its annual price review with BT had focused on Orange’s time of day charges. Germany.1 million were customers of O2 in the UK.11. at the retail level. of these.65 of its competition review) that ‘the structure of on-net and off-net mobile-to-mobile pricing points to the presence of strong interdependencies between operators in an oligopolistic sector when setting retail prices and call termination prices on mobile networks. although in 1999 BT asked Oftel to make a determination as to what they should be.4 billion at the end of November 2002. Oftel said (in paragraph 2. together with Vodafone.10. resulting in an inefficient pricing structure for mobile-to-mobile calls’. Oftel found that.7) that the reference made by the DGT to the MMC in 1998 concerned the level of termination charges for calls to mobiles from fixed lines only. 2. That we are now required to investigate termination charges made not only by each of the four MNOs to FNOs but also by one MNO to another reflects Oftel’s view that the mobile sector as a whole (that is. a common measure of financial performance). off-net calls were on average priced at a much higher level than on-net calls. Cellnet. 14 . A Statement issued by the Director General of Telecommunications.5 million customers in March 2002. but also from one mobile network to another. The group supplies voice and data mobile telecommunications services in the UK. and more than 100 per cent (£0. Following discussions with Orange and T-Mobile. The mmO2 group had a total of 17. Until rebranded as O2 in May 2002.12.8 billion) of the group’s total turnover (£4.7 billion) of its earnings before interest. O2’s importance to the mmO2 group as a whole is shown by the fact that in the year to March 2002. tax. Cellnet.2. BT reached agreement with Orange and T-Mobile over the level of their termination charges. until May 1999. However. which was established in November 2001 following a demerger of the domestic and international wireless businesses of BT. mmO2’s UK mobile subsidiary was called BT Cellnet. 26 September 2001. We have already seen (see paragraph 2.3 billion). depreciation and amortization (EBITDA. T-Mobile told us that it had agreed its weighted average termination charge with BT. O2 is the UK subsidiary of mmO2 plc (mmO2). O2 contributed 64 per cent (£2. Netherlands. was one of the first companies to be granted a licence to operate mobile telecommunications networks in the UK. The four MNOs O2 2. at both the wholesale and the retail level) is not yet effectively competitive. taking the DGT’s view into account. 1 Effective Competition Review: mobile. 11. It was against this background that we were asked to consider termination charges made by the MNOs in relation not only to calls made from fixed networks to mobile networks. and before that.13. 2. mmO2 also operates a fixed network in the Isle of Man. the DGT indicated his preliminary view that the charges of those companies should be set at the ‘public interest benchmark’ level (that is.98 ppm for 1997/98) established by the MMC in 1998 for O2 and Vodafone.1 which it undertook in parallel with its review of the level of termination charges made by the MNOs. Ireland and the Isle of Man. and launched its network in January 1985. adjusted as necessary for cost variations arising from differences in their respective networks. Overall. Its market capitalization was £4. The current termination charges of the four MNOs accordingly reflect the exercise of formal regulation in the case of O2 and Vodafone and informal regulatory pressure in the case of Orange and T-Mobile. Oftel set out its position in a separate review of competition in the (retail) mobile sector. Oftel thought that competition in the retail sector was only ‘prospectively competitive’. before the DGT made the determination.

The group operates or has interests in a large number of countries including the UK. of whom some 12 million were in the UK. in 1999. having peaked at some £230 billion around March 2000. T-Mobile accounts for 25 per cent of TMO’s turnover. 2. a German industrial conglomerate. whose principal operating subsidiaries are Orange. In the UK. had a market capitalization of around £83 billion at the end of November 2002. the Netherlands. Orange’s turnover in the year to December 2001 was £3. Japan and the USA. Vodafone is an important contributor to the Vodafone Group’s business. Vodafone. [ Details omitted. Orange SA had 40 million customers worldwide. while its EBITDA. TMO in turn accounts for about 25 per cent of Deutsche Telekom. France Telecom rebranded almost all its mobile activities as ‘Orange’ and organized them under Orange SA. See note on page iv. Orange 2.16.18. 2. being only 7 per 15 . and a retail subsidiary operating its network of shops. Italy. Its £3. Media One International Incorporated and Cable & Wireless plc. Although Orange was the last mobile operator to join the UK market when it began operations in April 1994. the company was bought by Mannesmann. ] 2. Floated on the London Stock Exchange in 1996.4 billion. France. and its EBITDA was £0. which is the largest MNO in the world. In 2000. a UK listed company. Deutsche Telekom was privatized in 1996. T-Mobile 2. which was required under EC merger regulation to divest itself of Orange.6 billion turnover in the year to March 2002 represented 12 per cent of the group’s proportionate turnover in that year. The Orange business began in the UK in 1991 and launched its mobile network in 1994. Orange plc is the holding company.2 million UK customers in March 2002. T-Mobile’s operations in the UK are small in relation to the group’s activity as a whole.15. Vodafone Group sold Orange to France Telecom in September 2000. although its largest shareholder (43 per cent) is still the German Federal Government. Deutsche Telekom rebranded its mobile subsidiaries and One2One became T-Mobile UK.and shortterm debts which it has signalled its intention of reducing to 50 billion euros by 2003. which represented 40 per cent of that of its parent. which operates the UK Vodafone mobile network. Orange SA was floated on the Paris and London stock exchanges. the established fixed-line operator in Germany.17. Deutsche Telekom has large long.3 billion. is a wholly-owned subsidiary of Vodafone Group Plc (Vodafone Group). T-Mobile was founded in 1993 as One2One Partnership. its turnover for the year to December 2001. when the telecommunications industry was very highly rated by investors worldwide. represented 13 per cent of the £10 billion EBITDA for the group as a whole. with around 100 million customers.8 billion. In February 2001. Mannesmann was acquired by Vodafone Group. a French subsidiary. which are now similar to those of Vodafone at around 12 million.14. It was subsequently sold in 1999 by its parent companies. and later became part of T-Mobile International AG (TMO). 2. with France Telecom retaining a majority interest currently around 86 per cent. Ireland.1 billion.Vodafone 2. at £2. Germany. At the end of 2001. Subsequently.19. it overtook T-Mobile and O2 during 2001 in terms of subscriber numbers.20. Vodafone Group. It had 13. which operates the mobile phone network. Orange SA. which represented 36 per cent of the turnover of its parent company. In May 2002. Orange SA’s market capitalization was around £24 billion at the end of November 2002. owned by Deutsche Telekom AG (Deutsche Telekom). at £1. 8.2 11. §Earnings before interest. depreciation and amortization.1 3.750 670 3.4 3.5 7. T-Mobile’s early strategy was to concentrate on developing its customer base within an area bounded by the M25 motorway.397 771 2.4 1.2 billion.8 8.062 345 30 41 23 22 29 25 17 11 751‡ 202 344 –261 73 19 33 –25 Outgoing call minutes (bn)— including on-net calls 13. which had from the beginning sought to build up its network and customer base across the UK as a whole. tax. 16 .1 Comparison of the UK business activities for the four MNOs* Vodafone T-Mobile† Vodafone Share of total (%) O2 Orange O2 Orange 3. which in 2001/02 comprised the vast majority of the UK activity of the Vodafone Group. Virgin Mobile Telecoms Ltd (Virgin Mobile) had 1.0 8.1 9. we set out the recent performance of each of the four MNOs’ UK businesses in respect of a number of key performance indicators.cent of Deutsche Telekom’s £30 billion total business in terms of assets and turnover. In Table 2. including those using T-Mobile’s network through Virgin. ¤ARPU is the annual average revenue per user calculated as revenue from sales to customers (which is not total revenue which includes for example equipment sales) divided by the average number of customers.8 4.3 billion as against its ultimate parent’s £11.8 11.9 6. ¶The figures given for each MNO’s share of total incoming minutes do not mean that we see all incoming minutes as constituting a single market. whereas Orange and T-Mobile data is for the year ended December 2001. Summary of the MNOs’ UK performance 2. #Average outgoing and incoming minutes per customer are based on the average number of customers.6 10. 2.5 12.7 8.) TABLE 2. T-Mobile had around 10 million customers in the UK.2 5.596‡ 1. By the end of 2001. ‡Vodafone figures given are for Vodafone Ltd.6 28 35 25 24 25 23 26 27 26 22 13 26 Customer type Contract (%) Prepay (%) 38 62 32 68 31 69 18 82 ARPU¤ £ per year £ per month 276 23 231 19 246 21 202 17 Average customer numbers (m) 12.7 31 19 30 20 Incoming call minutes (bn)— excluding on-net calls¶ 6. The figures above are based on the statutory accounts of main UK entity for each of the MNOs.161 925 531 454 568 500 Turnover (£m) EBITDA§ (£m) Profit/loss before interest and tax (£m) Average outgoing call minutes per year per customer# Average incoming call minutes per year per customer# T-Mobile Source: CC based on information from the MNOs.8 10. only then gradually extending its coverage across the UK.3 4.252‡ 2. By contrast with Orange. It had EBITDA in that year of £0. †Figures for customers and minutes for T-Mobile in this table include figures for Virgin and Wholesale Partners.5 12.070 787 1. (The data in this table is for the year to March 2002 in the case of Vodafone and O2 and for the year ending December 2001 in the case of Orange and T-Mobile.4 1.8 8. *Vodafone and O2 data is for the year to March 2002.7 30 22 28 21 Customers (m) Contract Prepay 13.4 million customers at 31 December 2001.

17 . Note: Number of mobile subscribers for 2001D is not comparable with numbers for earlier periods due to O2 and Vodafone revising the basis on which they calculate the number of their subscribers. Its mix of 80 per cent prepay and 20 per cent contract customers yields the lowest ARPU of the four MNOs. Prepay subscriber numbers rose from half a million in March 1998 to 31 million by the end of 2001. Mobile subscriber numbers grew from just over 7 million in March 1997 to just under 45 million in December 2001. The phase of most rapid growth in the market started in 1998 and was attributable in part to subscribers who were for the first time able to buy a mobile phone under prepay arrangements (see paragraph 2. Over the same period there has been a corresponding rise in the number of call minutes from mobile phones. There has been a very marked growth in the number of mobile users over the past five years. usually monthly. Table 2. T-Mobile told us that it did not have a large share of business customers.1. businesses) are on average more valuable to the MNOs (that is. Their 33 billion call minutes in 2001/02 (or an average of around 190 minutes a month) compared with 14 billion minutes (or an average of about 35 minutes a month) for prepay subscribers. as shown by Figure 2. 1997 to 2001* 50 40 Millions Postpay 30 Prepay 20 All 10 Fixed lines 0 1997M 1998M 1999M 2000M 2001M 2001D Source: Oftel. the corresponding prepay and post-pay percentages both for Orange and O2 are approximately 70 and 30 per cent. Post-pay or contract customers (for example. O2 and T-Mobile are shown to have the lowest. Developments since the MMC’s 1998 report 2. by contrast. notwithstanding the more marked growth of prepay subscriber numbers. and that Vodafone and Orange have the largest volume of outgoing call minutes (the measure of call volume used in the industry).24. they generate higher ARPU) than prepay customers.25. T-Mobile. FIGURE 2. 2. *M is year-ending March and D is year-ending December.23). it was post-pay customers who accounted for most of these additional minutes. The four MNOs and their businesses are described more fully in Chapter 5. subscriptions). another factor accounting for its relatively low ARPU.2. from 14 billion in 1998/99 to over 46 billion in 2001/02. at the end of 2001 there were approaching 15 million post-pay subscribers. has the smallest customer base of the four MNOs. About 60 per cent of Vodafone’s customers own their mobile phone on a ‘prepay’ or ‘pay-asyou-go’ basis (where the mobile user pays for call minutes in advance through the purchase of a voucher of a set amount) and about 40 per cent on a post-pay or contractual basis (where the customer enters into contractual arrangements with the MNO to pay periodic. which in 2001 was the only unprofitable UK operator as measured by profit before interest and tax.1 shows that Vodafone has the highest ‘average revenue per user’ (ARPU.1 Growth in the number of mobile subscribers and fixed lines. However. a common measure used in the industry to denote the average revenue derived from each customer).23.

A recent development has been the offer in their tariff packages of inclusive minutes for calling any network at any time of day (instead of merely calling on-net).30. By contrast. the percentage had fallen to 73 per cent in May and August 2002 (see Table 6. They have accordingly directed their marketing efforts over the past year or so primarily to the retention of existing retail customers and the encouragement of as much mobile phone usage as possible by those customers. the first year in which Oftel collected data on the use of text messages. this number had risen to over 13 billion. and growing. over the past couple of years. revenue stream. although on Oftel’s revised sample basis. although the number of minutes from fixed lines did fall slightly between 2000/01 and 2001/02. It appears that there has been no marked slowing of the growth in the number of call minutes from fixed lines either to other fixed lines or to mobiles in the face of the strong growth in the numbers of call minutes from mobile phones.31. The MNOs to a greater or lesser extent use indirect retail sales channels as means of increasing the numbers of customers on their networks.26. O2 and Vodafone were originally prohibited from selling mobile airtime to the public. Thus a customer has a direct contractual relationship with a service provider. 2. such as businesses. to include peak-time calls. prepay users are more likely to be individual rather than corporate customers and to include people who do not expect to use their mobile phone often enough to make a subscription worthwhile. there were around 2 billion such messages. With such a high level of mobile penetration. Very few tariff packages now restrict inclusive minutes to off-peak usage. 2. persons over 15 years of age) who have a mobile phone has risen steeply since the middle of 2000. In recent years the short messaging service (SMS) (also known as text messaging). for example. Some of these users may also be less affluent than post-pay customers (especially as no credit check is required when a mobile phone is purchased on a prepay basis). 2. when 49 per cent of adults in the UK had both a fixed and a mobile phone. rather than as agents for the MNOs. As we have seen. Outgoing minutes from both fixed and mobile phones rose markedly between 1996/ 97 and 2001/02 (see Table 6. This development is a continuation of the move to widen the coverage of inclusive minutes. Prepay call charges being typically more expensive than contract minutes. they had sought to increase revenue by reducing or removing entirely the incentives they had previously offered to acquire prepay customers (for example. they now primarily monitor their performance in terms of ARPU. because the Government wanted to 18 .2. the relatively high price may discourage long phone calls by prepay customers. 2.27.1). There are a number of reasons for this discrepancy between prepay and post-pay usage.29. the MNOs can no longer rely on adding new subscribers to their networks to increase their revenues to the extent they did previously. while total call minutes from fixed to mobile phones grew by an annual average rate of 37 per cent. the subsidy on handsets). has provided the MNOs with an additional. Total call minutes from mobile phones grew by an annual average rate of 47 per cent. The period of rapid growth in the current mobile technology appears to be over and it seems likely that there will be at best only modest further growth in customer numbers. The MNOs told us that. Oftel told us that. It is in such customers’ interests to make periodic subscriptions and obtain the resultant cheaper call charges. Market research carried out for Oftel over recent years shows that the percentage of adults (in this context. who bills the customer for his or her mobile service and handles all customer service issues. The MNOs told us that. Service providers carry on business under their own name and act as principals.28. in line with these developments. prepay customers on average use their mobile phones less than contract customers and individually generate lower ARPU for the MNOs. In 1999/2000.7). Post-pay customers typically include those expecting to make a large number of calls. which allows mobile phone users to send text messages of up to 160 characters. by 2001/02. 2. on the same sample basis. penetration had risen to 76 per cent by August 2002.

MVNOs cannot set termination charges for incoming calls at rates different from those of their host MNO. The onus was put on the original network (that is. At present. 2. which provides mobile services to companies and operates on Orange’s network. the network with which the mobile user’s number was originally registered) to act as an intermediary and route the call on to the recipient network (that is. the network with which the mobile user was subsequently registered).4. which required them to permit subscribers to retain their telephone number if they changed networks. The four MNOs with which we are concerned in this inquiry have. 2. In September 2001. Number porting is not yet widely used. The MNO usually provides the customer support and the billing. Most MVNOs rebrand the MNO’s service. 2. excluding only the radio spectrum and base stations. rolled out their mobile networks using digital technology known as Global System for Mobile communications (GSM). and Energis Mobile.4 million subscribers by the end of 2001.34. they would need to be assigned their own number range by Oftel. operated by the mobile retailer Carphone Warehouse Limited (Carphone Warehouse) on T-Mobile’s network. However. Publication of the MMC’s 1998 report closely preceded the introduction of mobile number portability (MNP) in the UK. A number of major technological developments occurring over the past five years have affected the operation of the mobile networks.33. To do this. when no more spectrum was available at 900 MHz. 19 . The DGT considered this to be a major obstacle to competition both in fixed and mobile telephony. network B receives the termination charge for calls to network A. Orange and T-Mobile.32. Historically. Whilst using the same technology. Orange and T-Mobile. service providers accounted for 3. 2. subscribers had to change their telephone number when transferring their custom from one network to another. Transferring a mobile phone number from one MNO to another has implications for the call termination charges of both MNOs involved. when they accounted for 26 per cent of subscribers. and ports their phone number. which is a 50:50 joint venture between Virgin and T-Mobile. The charges made to those calling the MVNO’s customers could then be billed at a different rate from the charges made to those calling the customers of the operator on whose network the MVNO’s calls were being carried. whose network it uses.stimulate competition and growth at retail level. MVNOs currently operating or due to be launched in the near future in the UK are shown in Table 3.35. since the early 1990s.36. Oftel’s August 2002 survey of residential mobile phone customers found that only 18 per cent of those who had ever changed networks or service providers had ported their number. Oftel therefore introduced new requirements for MNOs on 1 January 1999. This prohibition did not apply to the new entrants. the most complete involving the ownership and operation by the MVNO of a whole network. Some ten MVNOs are currently operating in the UK.5 million subscribers or 8 per cent of all subscribers. Other MVNOs include Fresh. Oftel told us that the number of service providers had declined since March 1998. and their subscribers may not know which MNO acts as the host network. Virgin had 1. who have always for the most part sold direct to customers. For calls from all other networks. given the duopoly at the network level. although they were subsequently allocated additional spectrum around 1800 MHz. the largest at present being Virgin Mobile. 2. in the UK the more typical form is that in which the MVNO operates a mobile service by purchasing wholesale bulk call minutes from an MNO and selling them on at a margin by setting their own retail tariffs. network B receives its standard termination charge only for calls originated on network A. O2 and Vodafone have from the outset used frequencies around 900 MHz. who acquired their licences later. minus a small transit fee which is retained by network A. MVNOs can take a variety of forms. If a subscriber transfers their custom from network A to network B. A more recent development in the UK mobile market has been the emergence of the mobile virtual network operator (MVNO).

that those services were not yet available. as offered by the original GSM specifications.use frequencies around 1800 MHz.37. issued on 1 November 1999. most mobile handsets today are capable of operating on both 900 MHz and 1800 MHz and are known as dual-band handsets.39. The analogue networks have now been switched off. 3G spectrum was made available to the licensees from 1 January 2002. The other MNOs said they would not be launching their services until sometime in 2003.4 billion. that Oftel did not seek to regulate new services or technologies in advance of their launch. other mobile communication technologies are used which are incompatible with GSM handsets (for example. He gave as his reasons.5G. UK licences for UMTS were awarded by Government following an auction during 2000. All four MNOs in the UK now offer GPRS services. 20 . 2. first generation being the analogue service which preceded the current systems. Of the five licences issued. calls will automatically fall back on to existing GSM coverage. The GSM technology is usually referred to as second generation or 2G technology. 2. However. and call recipients are unlikely to know the extent to which their voice calls have been routed over 2G or 3G technology. in Japan and the Americas). it will be possible to carry the majority of calls solely on the 3G network. When 3G networks begin to be rolled out across the UK. enabling callers to contact mobile phones in countries where. despite GSM’s widespread presence. Hutchison 3G told us that it hoped to launch an initial service by the end of 2002. As 2. the European version of which is known as Universal Mobile Telecommunications System or UMTS. the latter in acknowledgement of its functionality which is intermediate between the second and third generation technologies. while a new MNO entrant. secured the fifth. in particular. first. that it was uncertain what services would develop. and third. In the UK. 2. 1 Public mobile telephony was first introduced to the UK in 1985 with the introduction of analogue networks operated by Vodafone (then Racal-Vodafone) and O2 (then Cellnet). has launched 3G services in the Isle of Man.38. The rapid uptake of mobile services and the perceived demand for faster data services have led to the development of a third generation (3G) of mobile service. drew the attention of prospective bidders to the regulatory environment for MNOs and. allowing data facilities such as multimedia services and access to the Internet. the call will be passed back and forth between the 3G and GSM networks in order to maintain continuity. As 3G coverage spreads. second. The main advantage of UMTS is expected to lie in its capacity to offer much faster data transmission speeds than GSM or GPRS. to the cap imposed on 2G termination charges following the MMC’s 1998 investigation. More recently. Very significant sums were paid by each company for its 3G licence. coverage will probably centre initially around major conurbations. UMTS also has the potential to offer other advantages such as wider international roaming. although mmO2’s subsidiary.1 2. amounting in total to £22.5G users are always connected to the network whilst in radio coverage. using GSM and GPRS to provide their voice and data connectivity respectively.40. This packet-switched technology is known as General Packet Radio Service (GPRS) or 2. information can be sent to or from their handsets continuously. When outside these areas of coverage. The Information Memorandum. This service has not yet been launched commercially in the UK. GSM networks have been modified to enable them to transfer packetswitched data and thus deliver Internet-type services in a much more effective and efficient way than using circuit-switched connections. Hutchison 3G (UK) Ltd (Hutchison 3G). the DGT said that he did not intend to bring 3G calls within the ambit of the price control he was proposing. In his September 2001 statement following his review of the charge control on calls to mobiles. Indeed. one was awarded to each of the incumbent MNOs. handsets will need to be capable of operating on either technology. Manx Telecom. if subscribers are on the move during a call and move in and out of 3G coverage.

Moreover. mobile termination charges are charges made at the wholesale level. Because of BT’s retention.4 ppm for the year 1 April 1999 to 31 March 2000 and that this ceiling should be reduced in each of the following two years by an amount equal to RPI–7 per cent. As we have already noted. 2. they would make it more expensive for their customers to use their phones to call the network which had increased its termination 1 British Telecommunications plc: a report on a reference under section 13 of the Telecommunications Act 1984 on the charges made by British Telecommunications plc for calls made from its subscribers to phones connected to the networks of Cellnet and Vodafone.45. If those other operators were to pass on the increased costs to their customers in the shape of increased retail prices. Oftel. Since 1 August 2002. We end this section and set the scene for our discussion of the public interest issues by identifying. which was due to expire in July 2002. Finally in this section. at least in the short-term. As the result of its investigation. 21 . the salient features of termination charges levied by the MNOs. although such pass-through would not necessarily be into charges for fixedto-mobile calls specifically. and pay termination charges to other operators when their customers make calls from their own to other networks (outgoing calls). they are imposed by an MNO and incurred by another MNO or an FNO. The DGT had referred these charges to the MMC because he considered that the price of fixed-to-mobile calls was too high. that is. 2. this would not only increase its own revenue but also raise the costs of other network operators. the MMC had carried out an investigation1 of the charges levied by BT for calls made by its subscribers to mobile phones on the O2 and Vodafone networks. in turn. the retention should be controlled as part of BT’s general retail basket of prices.43. monthly subscriptions for post-pay customers or the price of mobile handsets.42.2. we note that. The target retention for calls to MNOs from BT for 2000/01 was 3. during the course of our inquiry. MNOs and FNOs take these charges into account in the retail prices which they set for their own customers. Oftel expects that any reduction in termination charges by the MNOs will be fully passed through one way or the other into retail prices to the FNOs’ customers. instead of attracting its own charge control. and for 2001/02. However. the MMC recommended that an RPI–X price control be imposed on that part of the retail charge that BT was allowed to keep when calls originating on BT’s network were terminated on the mobile networks of O2 and Vodafone (termed BT’s ‘retention’).44. the principal sources of termination revenue for the MNOs and the trend in the levels of these charges since 1999. December 1998. In 1998. It is a feature of termination charges that. he determined that. it is clear that such charges represent both a cost and a source of revenue for network operators.08 ppm.41.19 ppm. the DGT reviewed the control on BT’s retention. 3. Features of termination charges General features 2. the retail costs that BT was allocating to fixed-to-mobile calls were excessive. BT was required to ensure that retentions for calls to Orange and T-Mobile were at a similar level. The cap provided that the average net retention should be no higher than 3. in his view. 2. for example through their call tariffs. The outcome of the DGT’s review was the decision that BT’s retention on calls to mobiles should continue to be regulated. As MNOs both receive termination charges from other operators when calls are made to customers on their network (incoming calls). if a network operator could unilaterally raise its own charges. BT’s retail prices have therefore been subject to a so-called ‘RPI– RPI’ control (which has the effect of freezing prices in nominal terms) for four years until 31 July 2006.

little incentive to lower them. It has. while the third is only possible if the MNO which is seeking to retaliate for the increase in termination charges is either not regulated or. Sources of termination revenue for the MNOs 2. when an MNO raises its termination charges. either as a ‘first mover’ tactic or in response to another MNO’s doing so. however. which would rise by a smaller percentage amount than the increase in termination charges. 2. there would appear to be an incentive for MNOs to raise their termination charges and.71. Second. this would. there appears to be no commercial incentive for MNOs to lower their termination charges. it might decide to absorb the increase. Thus.charges. Otherwise. by the same token. An MNO facing an increase in termination charges by another MNO faces. In practice. At the same time.1 However. in the USA and is termed ‘receiving party pays’ (RPP). MNOs may be more inclined to raise their charges (since they individually have a small effect on the average) than they would if most consumers knew the terminating network they were calling and understood clearly the full rise in price that they faced. in mobile telephony in the UK. where the charge is levied on an FNO). assuming no reciprocal action from other MNOs). MNOs derive termination charges mainly from two sources: incoming off-net calls (where the charge is levied on another MNO) and incoming calls from fixed lines (fixed-tomobile calls. Surveys suggest that many consumers do not know the particular mobile network they are calling (see paragraph 2. all other things being equal. Hence.46. (Oftel’s views on the effects of CPP are set out more fully in paragraph 2. has room to raise its termination charges by the required amount without breaching that regulation. once a number has been ported. it could refuse to terminate on its network calls made by the customers of the MNO that had raised its termination charges or. The impact of the level of termination charges on the MNOs’ finances is very different as between the two sources.136). it is no longer possible to identify the network to which it belongs. it is the person who initiates a call to a mobile phone who pays for that call. This is compounded by MNP. thereby suffering a potential fall in profits. an increase in its costs. First. it could pass on the increase to its customers via its retail prices. 10 per cent. improve its competitive position vis-à-vis its MNO rivals. 22 . Oftel has described this feature as the principle of ‘calling party pays’ (CPP). If an individual MNO raised its termination charges by. The normal consequence of a company’s raising its prices is that its customers consider leaving in search of a better deal elsewhere. the customers of the operator that had raised its termination charges would not (at any rate by virtue of that action alone) suffer any increase in their retail prices. it could raise its own termination charges. if one MNO unilaterally raised its termination charges.48. for the following reasons: 1 This is what might be expected to happen if an MNO raised its termination charges under a system where the call recipient pays for the call—such a system exists. Finally. in theory. therefore. refuse to send calls to that MNO. only the first two options would remain open. consumers who did not know which network they were calling would be likely to notice only the effect on average retail charges. both regulatory obligations to connect and commercial necessity would preclude these final options. its own customers are not affected. for that matter. since lowering them would both reduce their own revenues and lower the costs of their competitors. if it is.) It is a consequence of the CPP principle that. There may be an additional consideration for MNOs in deciding whether to raise termination charges. say. 2. To this extent (that is. 2. the following alternative responses. Third.49. Given the characteristics of termination charges that we have been discussing. for example.47.

42). See note on page iv. and (c) each MNO sends calls to other MNOs as well as receiving calls from them. except perhaps at extremes far beyond any level discussed in this report. The volumes of calls sent and received are not equal. that is. there is an effect on the finances of individual MNOs because of the imbalance of trade within the group of four.2. (b) if termination charges levied by MNOs on FNOs for fixed-to-mobile calls are changed. however. 23 .14). Accordingly. the effect of an across the board change in mobile-to-mobile termination charges on an MNO’s financial position (and thus potentially on the retail prices it charges to its customers) is only a fraction of the gross amount of the change. Thus. a change in termination charges levied on FNOs for fixed-to-mobile calls has a far greater impact on the MNOs’ finances than an equivalent change in termination charges levied on other MNOs for off-net calls.50. This applies whether the change results from price-regulation (which may be expected to affect all MNOs in a similar way). This is because FNOs’ termination charges are separately regulated (see paragraphs 2.479. there is in fact an imbalance of trade. although the causal link is not easy to establish and quantify. Thus.51.49(b) were maintained). We refer to the comparison of such calls sent and received as the ‘balance of trade’ (see Table 6. as discussed in sub-paragraph (c) below. the fraction of a change in termination charges that impacts on the MNOs’ profits is by definition zero whenever trade within the MNO sector is exactly balanced. then the finances of the individual MNOs would be unaffected whatever the level of mobile-to-mobile termination charges. increases or decreases in mobile-to-mobile termination charges would necessitate no changes to MNOs’ retail prices so as to preserve their financial position. This would be the case even if there were no reciprocity of mobile-to-mobile charges among MNOs. which shows termination revenue by contributing operator in 2001. For the MNOs taken together (that is. ] 2. If the trade in paragraph 2. As a result.(a) fixed-to-mobile calls account for a much larger proportion of incoming (or termination) minutes than off-net calls—about 70 per cent compared with about 30 per cent (see Table 6. the financial effect would be small. [ Details omitted. Also. Even at the level of imbalance shown in Table 2. or by ‘tit-fortat’ price changes in a completely unregulated environment. there will be no resultant change in termination charges levied by FNOs on MNOs for mobile-to-fixed calls. By contrast.122 to 2.41 and 2.49(c) were exactly balanced (and provided the reciprocity in paragraph 2. by means of bilateral agreements as described in paragraphs 2.8). 2. This would be the case whatever the level (either absolute or comparative) of each MNO’s mobile-to-mobile business.473 to 2. for the mobile industry as a whole).131). and we do not rely on its existence in forming our conclusions. The size of the fraction depends on the balance of trade. and for this reason may prima facie be expected to have no effect on MNOs’ retail prices. There is a possible effect on the balance between on-net and off-net call charges (discussed in paragraphs 2. a change in the mobile-to-mobile termination charges set by all four MNOs will result in any individual MNO’s costs—ie the termination charges it pays—being changed in the same direction (up or down) as its revenue—ie the termination charges it levies. changes in mobile-to-mobile termination charges do not affect the aggregate finances of the industry as a whole. the existence of such reciprocity (see (b) below) together with the effect of the ‘balance of trade’ among the MNOs (see (c) below) magnifies the already large difference in impact.

*Figures for Orange were calculated by the CC on the basis that the proportions of outgoing calls from the different sources was similar to those of the other three MNOs. 2. B Overall net revenue from termination charges Contribution from FNOs (%)† Source: CC calculations on data provided by MNOs. or indeed that the reciprocity of termination charges with the incumbent MNOs would necessarily in all circumstances be as described in paragraph 2. and the 24 .54. Insofar as these claims are valid. †A has been given as a percentage of B.55. In their evidence the MNOs described in detail the effect that a reduction in termination charges would have either on their own finances or on the retail prices they charge their customers. ] 2. because (so far as the MNOs were aware) there was no systematic reason for the pattern shown in Table 2. it is not clear that Hutchison 3G.49(b). See note on page iv. [ Details omitted. See note on page iv. as a new market entrant providing a 3G service only.49(c). We considered whether these comments would cause us to change our conclusion in paragraph 2. and that. 2. with no obvious limit to the increase.52. such a pattern could not be assumed to continue. 2. 2001 £million Vodafone O2 Orange T-Mobile Total Revenue from termination charges—from other MNOs Costs of termination charges—to other MNOs Net revenue Revenue from termination charges—from FNOs Paid to FNOs A Net revenue Figures omitted. However. As a caveat to the above analysis.2.52.2 Termination revenue by contributing operator. ] From this it can be concluded that: (a) all the incumbent MNOs (and/or their customers) would benefit from higher termination charges. the first two comments are not relevant to the conclusion. and (b) [ Details omitted. The MNOs told us that they did not keep records of the balance of trade referred to above. that determining accurate figures would be impeded by the fact that many mobile-tomobile calls were routed via BT. and scarcely at all from changes in termination charges for mobile-to-mobile calls. the benefit being at the cost of the FNOs (and/or their customers).TABLE 2. will exhibit a call ratio similar to that in paragraph 2.49 (a) or a balance of trade with the incumbent MNOs similar to paragraph 2. See note on page iv. the above analysis shows that the effect would derive almost entirely from changes in termination charges to FNOs for fixed-to-mobile calls.53.

Table 2. (O2’s and Vodafone’s actual charges differed slightly from those in the table. O2 and Vodafone chose to reduce their termination charges (in conformity with the charge control—see paragraph 2. 2. See note on page iv. after averaging pluses and minuses over time.3 sets out the average termination charges of the four MNOs (in ppm) for the current price control period.3 MNOs’ average termination charges. these were then corrected in the subsequent year (details are shown in Table 6. However. O2 and Vodafone are permitted to set each of these charges at whatever level they choose.58. for all four MNOs. mobile termination charges make up about two-thirds of the retail price that FNOs charge their customers for calling a mobile phone and about 40 per cent of the retail price of calling from one mobile network to another.57. ¤For the period January to June. as well as the possible distortive effect of excessive mobile-to-mobile termination charges on the balance between on-net and off-net call charges. are shown in Table 6.) TABLE 2.13. as the result of these termination costs being passed through to customers at the retail level.56. 2. The MNOs set different call termination charges by time of day and day of the week. 25 .86 10.4 )¶ 1999 2000 2001 2002 ( Figures omitted.60. See note on page iv. the comments in paragraph 2.13. daytime charges are the highest. )¤ Source: Oftel and CC calculations on data provided by MNOs.2 shows that FNOs accounted for virtually all of the MNOs’ net revenue from termination charges in 2001. 2. See note on page iv. If the imbalance of trade is not systematic.2  2002/03 9. ‡Applicable to standard termination rates only. [ Details omitted. due to mis-estimations during each control period. *Charge under the price cap. We note that. if it fluctuates then.59. 1999/00 to 2002/03 (ppm) Vodafone* O2* T-Mobile†‡ Orange† 1999/00 11. Oftel has calculated that. 2. evening charges generally rather less and weekend rates the lowest. O2 and Vodafone have set their average termination charges at the maximum level permitted under the charge control in each of the four years 1999/2000 to 2002/03.7 11.12). the effect could well be even smaller.7 (  )§ 2000/01 10. ] ¶[ Details omitted.2 10. then it is likely to continue to be relatively small (albeit perhaps fluctuating).4 9. provided the resulting weighted average charge (the weights being based on the previous year’s call minutes) meets the price control. †Average inbound revenue.86 ( 2001/02 10. §February to March 2000. The MNOs’ termination charges by day of week and time of day. Actual charges differed slightly due to mis-estimations but these are corrected in the subsequent year (see Table 6. It follows that the charges shown for O2 and Vodafone in each of those years effectively show the level of the price cap in those years. It will be seen that.51 might appear to indicate that priceregulation of mobile-to-mobile termination charges is inappropriate.12). as shown in Table 6. Orange and T-Mobile have broadly reduced their rates for all time periods. At first sight. ] 2. even if regulation of fixedto-mobile termination charges is justified. Under their current charge control. Table 2. from April 1999 to September 2002. during our inquiry.9) on their evening and weekend rates. the effect of the imbalance of trade on individual MNOs while relatively small is not negligible.third comment reinforces it.

or might be expected to operate. If we found that in either case the level of their termination charges would operate. we are required to have regard to the provisions of the Act and in particular to section 3(1). We also received legal submissions from the DGT.The public interest Framework 2. in the absence of a charge control mechanism on them. purchasers and other users.64. which were also discussed with them at hearings and in a succession of staff meetings. 2. During our inquiry. that the DGT’s process in the current inquiry was an unlawful and unauthorized assertion of jurisdiction and accordingly that we could not act on the references.1). On 22 July we published a Remedies Statement which set out our thinking at that time on the issues and on hypothetical remedies (see Appendix 2.1. We commissioned a market research company. On jurisdiction. Jurisdictional and other legal issues 2. and Orange and T-Mobile. As summarized in paragraph 2. and Oftel published many of its submissions on its web site. In all. T-Mobile argued. we are required by section 14(1)(b) of the Act to specify in our report the effects adverse to the public interest. at such levels. We also held a number of hearings with third parties (as indicated in Appendix 1. 2.65.1). The Act imposes a number of other duties on us. Vodafone.2). The second question put to us by the DGT is whether any adverse effects so specified could be remedied or prevented by modifications of the respective licences of O2. The UK and EC legal and regulatory framework relevant to the current references is described in Chapter 4. All parties put to us a number of points relating to the Competition Commission’s (CC) jurisdiction to determine and impose controls on the level of their termination charges. against the public interest. and our duties under the Act. we are required by section 14(1)(c) to specify the modifications by which those effects could be remedied or prevented. We made site visits to the four MNOs and consulted them and Oftel in writing throughout the inquiry on a range of issues. virtually from the outset of the inquiry. in the light of existing and new EC legislation. BMRB International Limited (BMRB) to conduct two surveys of mobile users on our behalf and took the advice of technical consultants and Leading Counsel. Orange or T-Mobile. which imposes primary duties on us to secure that there are provided throughout the UK such telecommunications services as satisfy all reasonable demands for them and that any person by whom any such services fall to be provided is able to finance the provision of those services. or might be expected to operate. would be set at levels which operated. 26 . We encouraged the main parties to send each other copies of the principal submissions they had made to us. the first of the two questions put to us by the DGT is whether the termination charges of O2 and Vodafone. Oftel and the four MNOs.62. On 1 April 2002 we published a letter which had been sent on 31 March to the main parties setting out a number of public interest issues (see Appendix 2. four hearings with Oftel and with each of the four MNOs were held during the investigation. the greater part of it from the five main parties—that is. We also sought the views of the European Commission on the draft Market Recommendation relating to mobile markets. including a duty to promote the interests of consumers. edited as necessary to exclude confidential material.61. 2.63. we received a substantial volume of written evidence from interested parties. If we found that they could. In carrying out our investigations on these references. We took the advice of Leading Counsel who concluded that the CC was properly seized of the references and acting on this advice we informed T-Mobile of our decision and proceeded with the reference without interruption.

which would expire on 25 July 2003 when the new regime took effect. that the CC was obliged to identify the adverse effects and. 2.70. as a national regulatory authority. The views of the DGT are summarized in Chapter 10. 2. unless they complied with the new EC regime due to be implemented in July 2003. the main parties and third parties. 2. even if the DGT could impose price controls. The regulation of the telecommunications sector is in a state of evolution. and the DGT can exhaust the statutory consultation process before the expiry of the regime. The DGT provided his views. taken together with the provisions of the Act. it said that Oftel. including the FNOs. and that. the CC could state no modification to the current licences for the period beyond 25 July 2003.68. we were satisfied that we could proceed to make our findings and to propose the appropriate licence modification. yet the licence so modified will cease to take effect on 25 July 2003. central to these developments is that the two key Directives most closely related to the regulation of interconnection. had no power to impose price controls under the current Directives.69. Orange also questioned whether Oftel would be able to maintain. the CC was acting in conformity with its existing obligations under the Licensing and Interconnection Directives. A description of the most important aspects of this evolution is found in Chapter 4.67. 1 2002/21/EC. We considered very carefully the views of the parties in this connection. Accordingly.66. We begin by summarizing the general arguments put to us by those parties who submitted evidence to our inquiry. to quantify them. have created a complex framework of regulation within which the current references have to be considered. We arranged for T-Mobile’s views on the legal issues to be disclosed to the other main parties in the inquiry. First. and he believed that they were so remediable. those of the four MNOs in Chapters 11 to 14 and those of third parties in Chapter 15. Second. Part of the complexity of the scheme of regulation is that it is common ground between the parties that the licences which the DGT seeks to modify by these references will be abolished by the new Directives before 25 July 2003.1 The Licensing and Interconnection Directives will cease to have effect as of 25 July 2003. T-Mobile added two further submissions in support of its view that we should terminate the inquiry. his advice. was to terminate the inquiry and await the adoption of the European Commission recommendation on market definition before embarking upon a proper market review which would comply with the new regime. The transition from one scheme of EC regulation to another. In summary. We now turn to our substantive analysis of the level of termination charges. The correct solution. The situation is believed to be unique in that the CC can report and state proposed modifications well before the expiry of the existing regime. have been prospectively repealed by the Framework Directive. if possible. namely the Licensing and Interconnection Directives. any regulatory obligations that might be imposed as a result of our inquiry. Summary of views 2. Arising from this transition. 27 . that is. in stating appropriate licence modifications. that it should satisfy itself that such adverse effects were remediable by a licence condition. according to T-Mobile. over the period from September 2002 to the end of the inquiry assessed the legal views of the parties and offered us advice on the CC’s powers. was that the CC was properly seized of the references and arguments to the contrary were devoid of merit. which was consistent with the advice offered by the CC’s own Legal Advisers.2. However. after 24 July 2003. We took the advice of Leading Counsel who.

of what would happen were there no regulation. who care about the charges paid by other members of the group). a caller had to use a particular network to reach a particular number. access and call origination) at a level to attract and retain them. and those of Orange and T-Mobile above that level. Call termination was different because this service was initiated by. Furthermore. and this had been the case over the four-year period of the price control. The DGT pointed out that the MNOs were setting above-cost termination charges even under conditions of actual (in the case of O2 and Vodafone) and indirect (Orange and T-Mobile) regulation. whereas MNOs had an incentive to keep the price of those services required and paid for directly by their own customers (that is. he said. 2. that the person who initiated a call paid for that call. that is. not the mobile owner. This was because the inbound calls were actually a wholesale service which were then sold on to a retail customer (by definition. The consequence was. Indeed. the DGT told us that central to his analysis of the level of competition in call termination was the principle of CPP. 2. The costs were LRICs. and including the cost of capital—we discuss the issue of how costs should be measured in the mobile sector later (see paragraphs 2. that a network charging high termination charges was unlikely to suffer an erosion in its subscriber base for that reason. closed user groups (that is. such as businesses or families. that high termination charges were unlikely to be subject to normal competitive market disciplines and.The DGT 2. Each MNO had a monopoly over the termination of calls on its network and this meant that it could set termination charges without significant competitive pressure.73.217 to 2. the MNOs would set termination charges at a profit-maximizing level in the absence of regulation. In the DGT’s view. the DGT said. and paid for by.2 ppm against costs of 5. plus mark-ups. even though they were free to levy lower termination charges if they had wished to do so. it could not be assumed that higher profits on incoming calls were competed away and reflected in lower 28 . This was relevant to the question posed in our terms of reference. text messaging.74. not a customer of the MNO making the termination charge) making a call to a mobile. Termination charges that were significantly in excess of costs were not economically efficient. Orange and T-Mobile had consistently set their average charges above the level of the price cap. The DGT said that he had considered whether factors such as consumers’ switching networks. as the broad mobile sector was not yet effectively competitive.6 ppm and Orange and T-Mobile were charging [  ] in relation to costs of 6. He said that this was because callers could not take their business elsewhere if dissatisfied. the overall effect of the CPP principle was that.5 ppm. call-back. and countervailing power from purchasers of mobile termination would have the potential to put competitive pressure on termination charges. for the majority of mobile services.71. nor did they represent a fair distribution of costs and benefits as between those who called mobiles and those who owned them. the caller to the mobile phone (who might be a fixed-line caller or a caller on a different mobile network). the use and supply of the service (for example. In the DGT’s view. in particular. they had less incentive to keep their termination charges low. Indeed. the receiving party also had little incentive to act to reduce charges which he did not pay.387). 2. the evidence showed that O2 and Vodafone were charging 10. the substitution of other kinds of calls. The DGT told us that he rejected the MNOs’ argument that the MNOs were selling a bundle of services. Moreover. to their customers. including incoming calls. He told us that he had found no clear evidence that any of these had forced the MNOs’ termination charges to a competitive level. those of O2 and Vodafone were being set at the maximum level allowed under the price caps. this would be above the current regulated rate and could be as high as 20 ppm. or were likely to do so in the near future. groups of users. the choice of network or tariff package) was initiated and paid for by the mobile owner. The DGT said that.72. As we have already noted. the DGT said.

it was seeking an efficient way in which to recover fixed and common costs across a range of services. But in Oftel’s view there remained some problem areas. Individual service elements. that there was a single market for the provision of all mobile services in the UK. and the fact that O2 and Vodafone had been able persistently to maintain higher prices than Orange and T-Mobile (see Table 6. The DGT therefore considered that caps on charges for the termination of calls to the four MNOs’ networks were appropriate and justified in order to protect consumers. and SMS. Termination charges were just one factor in the framing of a competitive offer. Other main points made by each of the MNOs are summarized in the following paragraphs and set out more fully in Chapters 11 to 14.157 to 2. The proposed ‘cost-based’ price regulation proposed by the DGT would put at risk the consumer benefits already realized and place those to come (especially 29 . so far as possible. that that market was competitive. in aggregate. O2 told us. The four MNOs submitted that it was inappropriate to view call termination as a separate market. Competition in the broad mobile sector was sufficient already to constrain the level at which operators could set their termination charges.78. and that none of the MNOs had the ability to earn excessive profits from call termination because the competitive pressures they all faced in respect of the totality of the services they offered competed away any such profits. including subscriptions and calls.162). the challenge for the MNOs was to design tariff packages that would encourage use of their networks while ensuring. vigorous and effective and had ensured that prices for mobile services in the UK were.11) Oftel said that. There were a number of positive indicators that competition was developing and that competitive pressures would increasingly deliver a good deal for consumers. The MNOs 2. Oftel also drew attention to the high level of profitability of one of the MNOs (Vodafone) (see paragraphs 2. O2 said. Consumer satisfaction with mobile phone services was high. 2. were constrained as the result of demand responses to particular tariff pricing strategies. 2. that overall revenues were sufficient to cover costs.retail prices for outgoing mobile calls. for which the demand varied. as it was just one of the bundle of interconnected services purchased by customers. MNOs competed for customers by offering a bundle of complementary and interdependent services. the market was only ‘prospectively competitive’. Any margins above a cost base on incoming calls were competed away on other services so that the overall bundle of services was reasonably priced and delivered only ‘normal’ profits. In designing the prices for individual elements of the bundle of services it offered.76. the demand for subscription and the demand for incoming and outgoing calls. for services bought by mobile subscribers. relatively high prices for some types of call (international roaming and off-net calls) and barriers to consumers’ switching networks.33). Competition for UK mobile subscribers was. both outgoing and incoming. O2 said that it had regard to the need to balance incoming and outgoing prices. O2 said that it was not useful to dwell on the issue of market definition.75. O2 2. As the majority of costs in providing mobile services were fixed and common. In doing this. a far more meaningful way of assessing whether price regulation was required in the public interest was on the basis of an evaluation of the competitive constraints faced by mobile operators. including termination charges. As we note earlier. among the lowest in Europe. in its review of competition in the retail mobile sector (see paragraph 2. notably a lack of consumer awareness of different prices and tariffs. he said.77.

to ensure that call termination charges on any given network would be set at efficient levels (that is. and encouraging the greatest possible (efficient) usage of the network. Vodafone said that the relevant market was the provision of all mobile services in the UK.those resulting from the development of 3G services) in jeopardy. such intervention should be the minimum needed to bring termination charges to efficient levels. even if call termination charges were set at an inefficiently high level.82. MNOs might well be expected. Over the past four years. that did not mean that MNOs would make excessive profits. assessed by Oftel as generating excessive profits. if an MNO were to raise termination charges to levels which generated revenues in excess of any relevant measure of cost. which would operate against the public interest. competition in the mobile market was about the acquisition and retention of customers. the capped level of termination charges under current regulation. Vodafone 2. levels which would achieve optimal consumption of each service provided via mobile networks). as their ability to reach others by mobile phone would be diminished. In the absence of any form of regulation.81. most notably market shares. that an effectively competitive retail market was not enough. This reflected the fact that. as measured by Oftel. lead to a better attainment of the public interest objectives laid down in the Act than continuation of the status quo. In Vodafone’s view. This was evident in a variety of market outcomes. intervention of some kind (but not necessarily in the form of a charge control) might therefore be necessary to prevent this from happening. in itself. price reductions exceeding cost efficiency gains and massive investment in existing and new services. 2. If the CC was. It said that even Vodafone. switching at a level comparable with other industries. on balance. The mobile market was unusual in that competition to win customers provided greater incentives to reduce charges to mobile customers than to reduce termination charges. Orange invited us to consider whether it was appropriate to contemplate the imposition of price controls on an industry that showed clear evidence of being intensely competitive and no signs (even on Oftel’s own analysis) of generating excessive profits.79. satisfied that some form of intervention was necessary. Vodafone said that the mobile market in the UK was effectively competitive. This would bring about inefficiencies and depress incentives to invest in the sector. was too low. it would be forced. however. 2. O2 said that the result would be a fall in penetration levels and this would damage fixed and mobile customers alike. it said. because any excess would be fed back into competition to win subscribers. In Orange’s view. Customer satisfaction. the industry had brought affordable mobile telephony to 30 million new customers. the CC also needed to be satisfied that such intervention would.3 ppm. Orange submitted that regulation could not be justified in respect of operators which had never made an operating profit (T-Mobile) or which had only just done so for the first time (Orange). It said that the DGT’s proposal that call termination charges should fall to an average of 6 ppm by 2005/06 meant that prices could fall well below costs. 30 . Vodafone argued that. It meant only that the pricing of each separate element of the MNOs’ services might lead to overall allocative inefficiency.80. leading to distortions in the mobile market. Vodafone acknowledged. however. had seen the level of those profits eroded by the forces of competition. to dissipate those additional revenues via lower subscription and outbound call charges. Orange 2. 2. at an average 9. was over 96 per cent. and. moreover.83. to set termination charges above the efficient level. by competition from other MNOs offering services to subscribers.

taking call termination in isolation. it should be able to rely upon the principle of UK and EC law that as a non-dominant firm it could set its prices as it saw fit in a competitive product market. An MNO’s interconnection rates could be set in such a way that the FNO had an incentive to reduce its retail rates. an MNO would offer a discounted call termination charge to an FNO in return for the FNO’s reselling the MNO’s services to the FNO’s customer base. including call termination. 2. Oftel had wrongly inferred from the CPP principle that MNOs could set termination charges independently of their competitors.84. Orange accepted that. It was of course the retail prices charged by the originating MNO which influenced customer behaviour. There was no case for price control through amendment of its licence. That competition in the sector was intense was demonstrated by falling prices. there needed to be a link of some kind between the retail prices charged by FNOs for originating calls and MNOs’ termination charges. given the extra value afforded to the caller by the ability to contact someone personally wherever they were. In due course. Here. the price of such calls had been reduced. T-Mobile told us that the UK mobile market was currently vigorously competitive and that competition would intensify in the period ahead. T-Mobile saw no realistic prospect of any of them raising the prices of any of their services. the MNOs needed the commercial freedom to set the prices for individual components of the bundle of services which they offered in such a way as to recover the significant fixed and common costs of providing termination. Orange thought that a difficulty with exclusive arrangements of these sorts was that they might infringe non-discrimination regulations. if not impossible. tariffs that offered customers increasing value for money. and BT’s systems and ways of working were in Orange’s view very inflexible. However. In T-Mobile’s view. Given the existing intensity of competition between the MNOs. for example. for BT to sign agreements with other operators offering any form of exclusivity.Orange looked at ‘customer lifetime value’ and did not separate out individual service elements in order to evaluate its success. high customer satisfaction and high consumer penetration. So far as fixed-to-mobile calls were concerned. to maintain this dynamism and competitiveness. 2.86. 31 . it told us. T-Mobile maintained that it had not acted against the public interest in the past and that its existing and prospective levels of call termination charges were not against the public interest. if a greater competitive focus were to be generated on calls to mobiles from the fixed market.87. not the MNO’s termination charges. It believed that. regulation of BT made it very hard. Calls from these fixed lines to the Orange customer’s mobile phone would attract a lower termination charge from Orange and a correspondingly lower retail charge from the FNO.85. 2. Another possibility was a ‘reverse friends and family’ concept. There was no reason to think that the MNOs would not want to attract more and longer calls to their networks and to attract them at times of the day when their networks were not being fully utilized. rapid service innovation. T-Mobile said that it was plainly not dominant within any economically relevant product or geographic market. and should not be subject to intrusive regulation. Orange said that. Orange said. Moreover. this should have the effect of increasing the competitive pressure on MNOs to reduce their call termination charges. Orange told us that there had been recent moves by MNOs towards more intense competition for off-net calls. low barriers to consumer switching between networks. T-Mobile 2. substitutes were limited. in Orange’s view. In T-Mobile’s view. However the market was defined. an Orange customer might nominate five or ten fixed-line numbers. through initiatives such as resale partnerships with FNOs where. One way of achieving this was through interconnection incentives. This could be encouraged. By bringing off-net calls within a ‘bundle’ of inclusive minutes offered to mobile subscribers. Orange said.

it said. We begin with the subject of our investigation. Vodafone said that there was anyway no requirement under the Act for the CC to decide on a formal market definition. as proposed by Oftel (and referred to by Oftel as the ‘glide path’). widely used by competition authorities. including BT. Nevertheless. The third. 2. It cited a number of such effects. We discuss access and call origination later (see paragraphs 2. The charge controls would reduce the incentive and ability of firms to invest in existing 2G networks. seeks to establish whether a hypothetical sole supplier of a product would be able to increase its profits 32 . this would reduce the total revenues of the networks. Thus. In order to address the public interest issues raised in our terms of reference. not by the mobile phone customer. Third parties 2. is effected and charged for at the wholesale level by the network operator of the called party.198 respectively) in the context of competition in the retail market. Most of these parties agreed with the DGT’s analysis of the problem and his proposed remedy. have a significant impact on the development of competition in the sector and the levels of investment and innovation in the industry.174 and 2. call termination. The hypothetical monopolist test. competitive pressures operate to keep termination charges at levels consistent with the public interest. the mobile phone customer who makes the choice of network on which the call is to be terminated and hence determines the level of the termination charge. some of whom would no longer be able to afford a mobile phone. it is necessary in the first place to determine what. falling termination rates were likely to lead to increased subscription or outgoing call charges and this would affect the most price-sensitive customers. are instigated and paid for by the mobile phone customer and occur at the retail level. in assisting us to identify competitive constraints in the mobile sector. bodies representing consumers (which included the statutory telecommunications advisory committees) and other interested parties.90. The ability of MNOs to compete with FNOs would be weakened. The first two services. the second is the making of a call. rather than a stepped reduction over four years.2. although a number of the FNOs were in favour of an immediate reduction of termination charges to cost. and the third enables the mobile customer to receive calls (‘call termination’). we consider it helpful. an activity which we term ‘call origination’. at a time when BT continued to dominate fixed telephony.5G and 3G technology. the shareholders of these networks would be forced unreasonably to incur further losses. The DGT’s proposed price control would. however. access and call origination. but is instigated and ultimately paid for by the calling party.88.91. termination charges. the first is gaining access to a mobile network and selecting a call tariff. If the MNOs were unable fully to raise subscription and outgoing call prices to offset the reduction in termination revenues. in the absence of any charge control mechanism on them. this sort of analysis will be required. and in 2. because they would force a greater proportion of the fixed and common costs of the network to be recovered from services that were likely to have a higher price-elasticity of demand than termination. given that three out of four of the MNOs were not even earning their cost of capital. in T-Mobile’s view. it is. We also received evidence from a number of FNOs. to the longer-term detriment of consumers.92.89. which we term ‘access’. The charge controls could be expected to lead to fewer calls being made. if any. Market definition 2. to consider whether separate markets exist for different mobile services and whether any of the MNOs has market power in any such markets. We have already seen from the brief summary of views of the MNOs that in their view call termination on each MNO network cannot be regarded as a separate market. Under the new EC regime. 2. We begin by identifying three distinct activities or services involved in the take-up and use of mobile phones: seen from the point of view of the mobile customer.

The SIM card can also be used to store telephone numbers and text messages. whether they would switch their SIM card to benefit those calling them. this would involve the mobile owner’s being able to use a single mobile handset both for making outbound calls on network A and for receiving inbound calls on network raising prices by a small amount (usually taken as around 5 to 10 per cent)—that is. Moreover. which may be another mobile network or another means of receiving calls. Supply-side substitution 2. the called party would have to be able to switch his handset between connections to different networks. one solution would be for the mobile customer to obtain a mobile phone with an internal dual ‘subscriber identity module’ (SIM1) card holder that would allow the subscriber to take advantage of the network with lower termination prices.135). However. For this to happen. so that placing the SIM in a different GSM handset would transfer any stored numbers and text messages to the new handset.and demand-side substitutes for call termination on the network of the called party.93. 2. due to significant technological and coordination difficulties. 1 A SIM card. as well as the lack of incentives on the part of the called party to make use of a facility to reduce the costs of incoming calls. We considered whether there were any means by which a call to a mobile phone could be terminated on a network other than the network of the MNO to which the called party was a subscriber for the purpose of making outbound calls. for example. either through manual or automatic intervention. that those switching their SIM card would do so to take advantage of differentials in outgoing call charges. as might the installation of special software on the mobile phone of the called party. we consider first the possibilities of supply. when roaming overseas. if they did. we discuss whether there would be any alternatives to terminating a call to a mobile phone on the network of the called party. In particular.141). were an MNO to increase its termination charges by 5 to 10 per cent.96. a small but significant and non-transitory increase in price (SSNIP)—above the competitive level. In practice.95. only switching to the other network to make cheaper outbound calls.133 to 2. other firms switch into the supply of the product whose price has risen. Cooperation by the MNOs in allowing access to their SIM cards might be required. Oftel told us that this was theoretically possible. if this dual SIM card device was to act as a competitive constraint. Supply-side substitution occurs when. those being called would also need to be aware of current termination charges on different networks (a matter we examine later—see paragraphs 2. We pursued the SSNIP test with the parties at hearings with them and carried out a survey of consumers (see Appendix 6.2) in which we explored the possible supply.137 to 2. Oftel told us that it doubted whether called parties would have the incentive to undertake this procedure or.and demand-side substitution of mobile voice call termination by other services at the wholesale and retail levels. in response to a rise in price. 33 . In the case of manual intervention. Oftel thought. 2. Our own survey evidence supports Oftel’s view (see paragraphs 2. 2. which belongs to an individual MNO. So far as automatic intervention to enable the mobile customer to make inbound and outbound calls on different networks is concerned. it was more likely. is an essential component of a GSM handset and contains details of the network on which the phone is to operate. We looked first at supply-side substitution.94. Oftel told us that. we understand that it is not currently possible for a handset to be logged on to two networks simultaneously. mobile customers would have to use the network with cheaper call termination as the ‘default’ network. In order to determine whether a 5 to 10 per cent increase in termination charges would be sustainable. Such a mechanism did not currently exist and in Oftel’s view would be unlikely to develop in the foreseeable future. Oftel told us that some mechanism would need to be found to instruct the called party’s mobile phone to switch networks automatically.

just discussed. which used short-range radio technologies. apart from the significant technical issues to be overcome if any of these technologies were to become a viable option for mobile users. and that the speed with which they are then taken up by consumers is difficult to predict. some of them with the potential to blur the distinction between a voice call and a data message. The developments mentioned above.98. Various suggestions were made in this context (see Appendix 3. the same lack of competitive pressure on the inbound call would still apply because of the CPP principle. 2. We sought the views of the MNOs. told us that these radical new technologies might be expected ‘in the relatively near future’. O2 said that the other important new technology. we therefore believe that it would be wrong to base our public interest findings on expectations about the pace of introduction. IM.2.97. Vodafone told us that it was unlikely that over the next five years. (Similar possibilities exist for the termination of calls on Bluetooth and other short-range wireless technologies. It is true that.100. O2 told us. We note that various technological developments were quoted as likely or possible in the MMC’s 1998 report.5G) networks as well as 3G. so that the MNO would be able to control whether prices and quality were set at a level which would make voice over a packet-switched bearer an effective substitute for voice over the circuit-switched network. of any such new technologies. These were ‘Voice-over-Internet Protocol’ (VoIP) and instant messaging (IM). for example. Oftel. technological or other developments would enable voice calls to an MNO’s customers to be terminated otherwise than on that MNO’s network. 34 . O2. and impact on existing mobile phone use. O2 and TMobile. and some may not involve the levying of a termination charge in its current form. Oftel and other parties involved in our inquiry on whether it was likely that technological developments over the next three or four years would make termination of a call other than on the network of the called party a commercial possibility. 2. have as yet made little impact on voice communication in the UK. It was envisaged that IM would be offered over GPRS (2. however. We have no reason to doubt that important technological developments are in prospect. However. we are required to investigate the public interest effects of an absence of regulation of termination charges on calls to mobiles from the expiry of the current charge controls in March 2003. These various possible technological developments are described more fully in Chapter 3. thus. it was this charging system that made VoIP such a promising technological and commercial option. although one MNO. O2 said that VoIP would allow one person to contact another via their email or Internet Protocol address rather than via their mobile phone number (that is. Nonetheless. see paragraphs 3. Given the comparatively short period for which we are empowered to make recommendations. but that none of them has turned out to be a constraint on termination charges. thought that voice over a packet-switched bearer was unlikely to act as an effective constraint on voice termination charges because the same MNO would set the termination charge and quality of service for both types of call.) However. parties would pay for access and there would be no such principle as CPP or the caller having to bear a termination charge. In O2’s view.1) including the possibilities for either manual or automatic use of multiple SIM cards. there have been significant steps forward in many of the technologies that underlie telecommunications networks. including VoIP and IM. 2. since the last report. allowed for the exchange of voice clips in virtually real time and would be rather like a voice ‘chat line’. thought that in the foreseeable future two new technologies in particular would be important for consumers wishing to communicate with each other.108 and 3. we believe that there can be an appreciable time lag between the appearance of new technologies and their implementation in new commercial products. and this would allow a voice call to take place via the Internet.109).99. T-Mobile said that other possibilities included ‘wireless local area networks’ (WLANs. Oftel told us that. via packet-switched rather than circuit-switched technology). Charging for these calls would be dictated by the mechanisms that currently existed for charging for Internet access.

Another possibility would be to request the called party to call back. Evidence from Vodafone’s survey of mobile phone users. if prices at the retail level are to have a constraining effect on termination charges. they are strategies to reduce the amount paid for calls and create added costs and burdens (in terms of time and trouble) for both caller and call recipient. or perhaps to using a text message (SMS). since an operator wishing to offer calls to customers belonging to a particular mobile network must purchase termination from that network in order to do so. since the operator providing the termination for the text message would be the same operator as was providing termination of voice calls. Oftel’s research showed that text messaging was regarded. the calling party (who paid the charge through his retail price) could switch to calling the person on that person’s fixed line instead. imposed constraints on call termination charges. and that text messages were largely additional to voice calls rather than a substitute for them. not a place. also suggests that most people do not regard text messages as a satisfactory substitute for voice calls to a mobile phone. Call-back and shorter calls are not. At the retail level. and these messages can be delayed. as a mobile-to-fixed call is cheaper than a fixed-to-mobile call. 2. carried out by NOP. Furthermore. this form of communication is nothing like a complete substitute for a telephone conversation in most cases.101. While a mobile phone is associated with an individual.132 to 2. Calling a fixed-line number instead of a mobile number is clearly a possibility. which is precisely when the mobile phone is most valuable. several demand-side substitutes were put to us by the MNOs which.131) before looking at the available evidence of consumer knowledge and awareness of termination charges (see paragraphs 2. however. We consider a number of possible competitive pressures on termination charges in the following paragraphs (see paragraphs 2. A call to a fixed line will therefore be an inadequate substitute whenever the called party is away from the fixed-line telephone or is on the move. On the demand side.105. the MNOs said.101). however. But because it enables parties to exchange only relatively short messages.106 to 2.104. For these reasons. We note that. in our view genuine alternatives to calling a mobile. 2. and who could therefore set termination charges for text messaging at such a level as to prevent its putting pressure on voice termination charges. 2. we consider that neither calling a fixed line nor sending a text message is an adequate substitute for reaching the called party on their mobile phone. if the called party happens to be where the fixed line is located when the call is made and the caller knows this (or does not mind delaying making the call or the call ending in an answering service). text messaging would not necessarily put pressure on call termination charges.103. 23 per cent thought that they were a poor substitute and 36 per cent thought that they were a good substitute for only some such calls (see paragraph 6. Or the caller could keep his call short. 35 . But fixed and mobile telephony clearly have fundamentally different characteristics and in our view a call to a fixed line will rarely be a wholly satisfactory substitute for locating someone on a mobile phone. Text messaging could be a partial substitute for a call to a mobile.102.146). Oftel and all the MNOs agreed that substitution at the wholesale level was not currently feasible. Competitive pressures on termination charges 2. especially by the young. If the price of terminating calls to a mobile phone were raised. Only 30 per cent of those questioned thought that text messages were a good total substitute for calls to a mobile or a good substitute for many such calls. as an activity separate from voice calling. then any changes in the level of termination charges have to be passed through to prices at the retail level.Demand-side substitution 2. if the caller was using a fixed line. rather. they said. fixed-line telephones are associated with a place rather than an individual.

It said that competition from other MNOs indeed prevented it from generating excess profits from call termination charges. termination charges on the part of the MNOs’ customers to induce them to take such actions.108. The consistent evidence from surveys is that the reverse is the case (see paragraphs 2. 2. Vodafone took a different approach. by dialling a prefix before dialling the mobile number or based on some preset pattern) or during the call (by the mobile subscriber accepting the charges by pressing keys. Vodafone told us that any such solution would require substantial development work for the network. 36 . Moreover. in the same manner as is adopted to put calls on hold).107. that did not mean that the network in question faced no competitive constraints in delivering termination.133 to 2. They maintained that. called into serious doubt the utility and correctness of regarding call termination on each MNO’s network as a separate market. Vodafone argued that. The four MNOs put it to us that the key question was not whether call termination constituted a separate market on the network of each of the MNOs. though there might be some practical issues and cost implications. each MNO would be subject to pressures to maintain call termination charges for calls from fixed networks above efficient levels (by which it meant levels which would achieve what it regarded as optimal consumption of each service provided via mobile networks) with a view to using the excess revenues earned to fund competition to win subscribers. However. For example. Three of the MNOs. but is passed on as a result of competition to its own customers via lower prices) they would take either action only if they valued the expenditure that others incur to call them on their mobile phone above their own expenditure for their own calls. We discuss these in the following paragraphs and then examine whether the evidence suggests that these are indeed effective to constrain the level of termination charges. when making an outbound call. the level of that network’s termination charges and the effect on their own call charges. BT told us that no major new technological developments were required to implement this solution. Vodafone thought that these features of the market. But. There are a number of possible ways in which customers of the MNOs might put pressure on the level of mobile call termination charges. then their initial choice of network might depend at least partly on the level of termination charges levied by that network.106. They might switch networks for the same reason. 2. Those customers would need to know.110. 2. billing system and handsets. and the context in which the MNOs operated. and concern about. The MNOs cited a number of retail pressures which they said had the effect of constraining the level of termination charges.2. whether or not they were calling a mobile phone (which in practice most of them would know) and if so which network they were calling. We discussed with the industry various mechanisms for increasing pressure on call termination prices based around optional RPP. as well as caring sufficiently about the price of incoming calls. 2. if customers of MNOs valued receiving calls as part of the ‘bundle’ of services they received when they purchased a mobile phone. in a market in which MNOs competed to sell mobile subscriptions and outgoing calls. such behaviour would presuppose a sufficient degree of awareness of. (on the assumption that the benefit of high termination charges is not retained by the MNO making the charges. Orange and T-Mobile. and the nature of competition in the market would lead them to maintain termination charges above an efficient level.109. whereby the calling or called party could trigger a mechanism to transfer the cost of the call to the mobile subscriber either at the outset of the call (for example. submitted that the competitive pressures they faced prevented them from setting termination charges above a competitive rate. even if the CC were to reach the conclusion that there was a separate market for call termination on each MNO’s network. it would be quite wrong to infer that an MNO would be abusing a ‘dominant’ position if it were to set its call termination charges above efficient levels.135). O2. This was because the MNOs were operating in a market in which they competed among themselves to win subscribers and to sell outgoing calls. even if there was no alternative to termination on the network of the called party.

the calling party could leave a voice-message for the mobile subscriber. the call would be diverted straight to that subscriber. the subscriber paying for the mobile element of the call (effectively a form of partial RPP). and a connection was made between the payment of the termination charge and the mobile owner. O2 told us that it thought the term ‘closed user group’ was misleading and preferred the concept of ‘repeat calling relationships’. We note that both Orange and T-Mobile currently offer similar services. if the two prices equalized. In paragraph 2. the calling party not only paid but was also the customer of the called party’s MNO. paying the appropriate rate for outgoing calls. We noted that O2’s suggested approach was similar in concept to the optional RPP approach that we had previously discussed with the industry (see Appendix 3. and largely consisted of loose collections of friends and families. The mobile subscriber could then return the call. and in any case it may be more cost-effective to make a short voice call to request call-back. The first was a narrow group. We note that this can already be done between mobile networks or by a fixed network subscriber using the free Internetbased SMS services to request a call. Again. At a late stage in the inquiry. Closed user groups took advantage of the fact that on-net calls were priced much lower than off-net calls. if the mobile subscriber opts to divert all calls to voice-mail. Orange and T-Mobile argued that the effect of the CPP principle in keeping charges high (as seen by Oftel) was undermined by the growth of closed user groups. Oftel said. They argued that the sensitivity of these groups of mobile phone customers to incoming call charges placed a competitive constraint on the level of termination charges that the MNOs could impose. It said that closed user groups were far less common than repeat calling relationships.111. but he could also call a national rate (087xxx) number. It would. — Failing this. The main objection to optional RPP was that it required action by mobile subscribers. which involved calling pairs who called each other regularly.2. — Alternatively.115. Oftel told us that it distinguished two types of closed user group. we note that there is nothing to stop this taking place at the moment. or a business which chose a single MNO for all its employees and then paid for all the calls made from the business premises or from employees’ mobile phones. typically a family in which the mobile owner was also the person who paid for the calls to their mobile and so had a direct interest in the cost of incoming calls. The calling party could call the mobile directly and thus pay the standard termination charge.504 we consider whether a proposal on these lines could form the basis of a remedy. whether or not they fell into the category of ‘closed user group’.113. who would then be notified of the awaiting message. there would in our view be no incentive to use the alternative mechanism. seem likely to increase the burden on callers to mobiles. at present. However. In these situations. for mobile-to-mobile calls the cost of the SMS may be higher than the savings made. 2. Such calls occurred both 37 . The second type of closed user group was a rather wider circle of people with a mutual financial interest in keeping call costs down. Whilst the price for outgoing calls would remain lower than for incoming calls. 2. the calling party could opt to have a text message sent to the mobile subscriber containing a call-back number. Closed user groups 2. O2 suggested a solution along the following lines. 2. therefore.112. Individuals might be members of more than one such group.1). which would trigger the following options: — If the mobile subscriber had preselected this. the system as described would have the potential to turn incoming traffic into outgoing traffic and. control and implement unless it were introduced for all subscribers. and would be complex to understand.114.

on-net and, very frequently, off-net. It said that analysis of its customer call data showed that a
large proportion of traffic was generated within repeat calling relationships, most people having
such relationships with around five other people. It was easy for a pair of individuals in such a
relationship to exert pressure on charges by deciding jointly to switch call direction on a regular
basis in response to price differences. This ability to switch call direction accordingly constrained the MNOs from introducing any imbalance between incoming and outgoing call
charges, O2 argued. Orange and T-Mobile took the view that closed user groups were widespread and that call recipients were likely to be concerned about the cost of calls to them.
Vodafone, however, told us that in its view closed user groups did not effectively constrain call
termination charges.
2.116. We looked at a number of surveys carried out by the MNOs for evidence of consumer behaviour and attitudes on this matter.
(a) According to Vodafone’s NOP survey, carried out in March/April 2001, 39 per cent of

respondents told NOP that all the mobile phones for which they or the other members of
their families paid were on the same mobile network. But 56 per cent said that this was
not the case. About half of those who were on the same network said that this was
because it reduced the costs of each calling the others, while 22 per cent said that their
being on the same network was coincidental.
(b) A survey commissioned by O2 in February 2002, also carried out by NOP, asked those

owning mobile phones whether the network used by people they were likely to be
communicating with was an important factor when deciding which network to join. For
around one-third of respondents this was important but for over half it was unimportant.
A high percentage of these groups could not say why this factor was, or was not,
important to them.
(c) Vodafone’s NOP survey (see (a) above) also asked respondents whether they took into

consideration when choosing their mobile network those networks of which their
friends, family or other regular contacts were customers. 58 per cent did not consider
this matter.
(d) Another survey, carried out by Martin Hamblin GfK (GfK) for O2, exploring why

people changed their mobile network provider, found that very few respondents said
they had changed network so as to be on the same network as family and friends (see
Table 6.44).
(e) A survey for Oftel carried out by Taylor Nelson Solfres plc (TNS) in November 2001

found that of those who had ever changed network provider (29 per cent), price was
given as the reason by most respondents, with ‘wanting to be on the same network as
family and friends’ being a reason for far fewer respondents.
2.117. This survey evidence (set out in paragraphs 6.210 to 6.217) suggests that the
majority of people do not consider it important for their mobile phone to be connected to the
same network as that of the people they call most often.
2.118. These findings were confirmed in the first of our own surveys (see Appendix 6.2),
which we commissioned from BMRB during the inquiry. 81 per cent of respondents who paid
for a mobile phone told BMRB that they had never chosen, or changed to, a network in order to
be on the same network as someone they spoke to often. Of those who had chosen to do so,
88 per cent said that it was to save money on outbound call charges. This evidence should be
seen in the light of other findings from our survey; these showed that, for a high proportion
(79 per cent) of those who paid for mobile phones, the groups of mobile users that they called
most often on their mobile phone were family, friends or partner and that such calls accounted
for some 60 per cent of all the respondents’ mobile-to-mobile calls. However, of the 79 per cent
who paid for mobile phones, only 9 per cent of their calls were on-net calls.

2.119. While this evidence suggests that a small minority of residential mobile users is
aware of, and interested in, the reduction of call charges among their circle of family or friends,
manifested in behaviour such as the formation of closed user groups (or repeat calling relationships) or tactics such as call-back, we do not consider that it shows a widespread concern on
their part to keep incoming call costs down.
2.120. The position is slightly different for corporate customers. Thus, Oftel’s research in
the business sector showed that about 19 per cent of small and medium-sized enterprises
(SMEs) had taken steps to reduce the cost for them to call mobile phones through methods such
as private wires and adaptations to convert calls from fixed lines into on-net mobile-to-mobile
calls. However, the research found that most SMEs cared more about other considerations, such
as the prices of outgoing calls and network coverage. Large organizations, which are likely to
be a more price-sensitive segment of users, have sufficient negotiating strength and expertise to
secure favourable terms which help to reduce their costs of using mobile phones.
2.121. Before reaching our conclusions on the extent to which closed user groups or repeat
calling relationships constrain termination charges, we need to examine the purpose and effects
of the large differential between on-net and off-net prices, since the MNOs claim that on-net
calls have been a particular focus of competition and are the means by which frequent callers to
each other on mobile phones can minimize the costs of doing so, thereby putting pressure on
call termination charges.

On-net and off-net calls
2.122. In order to obtain a broad comparison of the prices of on-net and off-net calls, we
calculated the average retail revenue per minute (excluding subscription revenue) received by
the four MNOs in 2000/01 (see Table 6.10). Average revenue was about 25 ppm from off-net
calls and about 6 ppm from on-net calls. We noted a corresponding relationship between the
contribution per minute (after network costs and termination charges paid) from these two call
types (see Table 5.22 and also paragraph 2.200).
2.123. Table 6.5 shows the total number of outgoing call minutes from mobile phones for
different call types. In 2001/02, on-net calls accounted for 30 per cent of all outgoing minutes,
off-net calls for 15 per cent and calls from mobiles to fixed lines for 55 per cent. If we compare
the prices of these types of call with the number of call minutes for each, it is clear that, broadly
speaking, off-net calls account for the lowest proportion of traffic (15 per cent) and have the
highest prices (25 ppm), while mobile-to-fixed calls account for the highest proportion of
traffic (55 per cent) and, at 7 ppm, have much lower prices than off-net calls and broadly
similar prices to on-net calls (6 ppm).
2.124. Vodafone and Orange offered commercial explanations for the price differences.
Vodafone said that, as the mobile market had begun to expand dramatically, the MNOs had
started to focus attention on ways in which they could offer attractive new packages to new
subscribers and help to differentiate their offer from those of their competitors. Vodafone told
us that it had accordingly started to offer a category of relatively lower call charges that could
change the widely held perception that all mobile calls were expensive; for new subscribers,
joining one of the established networks would be particularly attractive, because of the large
number of existing subscribers whom they would be able to contact at cheap on-net rates.
Orange told us that lower on-net charges had been its strategy for building share when it had
first entered the market.
2.125. Vodafone gave us two further reasons for the upward pressure on off-net charges:
first, off-net calls incurred higher costs than on-net calls (see paragraph 6.118) and second, the
downward pressure on on-net charges had meant that revenues had to be recovered from other

charges. This ‘rebalancing’ had to bite on off-net calls, Vodafone said, because any adjustment
to other charges would have resulted in a further divergence from what it called the ‘optimal
pricing structure’ and would thereby have placed it at a competitive disadvantage.
2.126. We were concerned to establish whether the price differences indicated that off-net
calls were priced significantly above cost; and, if so, why this should be. We received no evidence that the resource costs of off-net calls were so much higher than those of on-net calls as
to justify the very large price differential between them. In its review of competition in the
mobile sector (see paragraph 2.11), Oftel said that there was no clear competitive pressure on
off-net call prices, and no evident differences in demand for on-net and off-net calls, or in the
costs of each type of call, which might justify the price differences between them. On-net and
off-net calls should incur approximately the same costs.1 In any case, Oftel said, even if there
were some small cost difference, this would not account for the wide price differential between
2.127. We suggested to the MNOs that the price difference might relate to cost-allocation
made by reference to different price-elasticities, as envisaged under demand-led pricing (for
example, Ramsey pricing (see paragraphs 2.212 and 2.213)). Vodafone told us that the differential between on-net and off-net pricing did not reflect Ramsey principles. Orange said that it
had no direct evidence on the relative magnitudes of demand elasticities between on- and offnet calls on which to base an assessment of whether on-net prices were consistent with Ramsey
2.128. Vodafone’s and Orange’s explanations of the commercial rationale for the price
difference are credible. However, Oftel put it to us that on-net calls were in effect another
opportunity which the MNOs offered price-sensitive customers to reduce their bills. It argued
that the on-net/off-net differential was a natural response by the MNOs to the more pricesensitive elements of the mobile phone population. Businesses in particular were attracted to
schemes by which their costs could be kept down; the same would be true within some families, especially where one person was paying for all the calls. In Oftel’s view, the MNOs had
recognized the constraints on their ability to set high prices where there was high pricesensitivity of this kind and had isolated such price-sensitive customers from the generality of
mobile phone users by specifically targeted tariff schemes. Oftel thought that, in this way, the
degree of market power which MNOs exercised over the remaining, less price-sensitive, customers was increased. The Consumers’ Association (CA) told us that it would expect the market to be highly segmented given that the MNOs possessed extremely accurate information
about both consumer usage and pricing sensitivities.
2.129. Vodafone and Orange both told us that the price difference between on-net and offnet calls had recently been declining. Vodafone told us that it was clear that on-net and off-net
charges were gradually being rebalanced, to reflect both consumer demand and the fact that, as
the four UK networks were now of roughly equal size, the impetus for the larger MNOs to
differentiate themselves through low on-net prices had largely disappeared. It said that it had
made no reduction in on-net charges over the past two years, during which period it had
reduced other outgoing call charges. Orange said that its ‘Pay Monthly’ tariffs had increasingly
included both on-net and off-net mobile calls within the bundled inclusive call minutes—an
example was Orange’s ‘Everytime’, which had removed the differentiation except for calls
made outside the bundle. Orange said that, by bringing this type of call within the bundle of
inclusive minutes offered to mobile subscribers, the price of such calls had been reduced and in
due course this should increase the competitive pressure on MNOs to reduce their call termination charges.
Off-net calls of course have to bear termination charges, while on-net calls do not. However, if call terminations are priced at
cost, this fact should not invalidate the comparison. In any event, off-net calls are far more expensive than on-net calls, even after
deducting termination charges paid from the price of off-net calls (see Table 5.22).


131.133. third. then off-net charges at least must be above cost. For the majority of respondents. These levels were similar. We consider first how sensitive the mobile subscriber himself is likely to be to the price of an incoming call when choosing a network.2. and fourth.8 shows the trend in on. 2. Moreover. We examined the available survey evidence in relation to four aspects of customer awareness and behaviour with respect to the use of mobile phones: first. 2. In summary: (a) if there is no difference in the relevant elasticities. 41 .130. second. as explained by the MNOs. Customer awareness and behaviour 2. how aware people were that they were calling a particular mobile network. as will be seen from the call tariffs of the MNOs set out in Table 6. none of which differentiates between on-net and off-net calls in terms of price elasticities. and only 9 per cent had said that this cost had been a significant factor in their choice of one network over another. the price of on-net calls was falling while that of off-net calls was rising. in general. This disparity is not diminished by the inclusion of off-net minutes in inclusive minutes. Even for those respondents who had suggested that incoming call costs were a factor in their choice of network.and off-net prices from 1999 to 2002. Moreover. the trends have been broadly similar. It told us that market research carried out for Oftel in February 2002 had found that only 15 per cent of those surveyed said that they had found out how much it would cost others to call them before choosing their network. the sensitivity of the mobile subscriber to the price of incoming calls. Sensitivity to the price of incoming calls 2. Since then. the Ramsey price models presented by the MNOs.or off-net calls. as prepay customers are not generally offered inclusive minutes either for on. geographical coverage and outgoing call costs were the most significant reasons for choosing a network. (a) The cost of incoming calls (expressed in the survey as ‘the price others pay to call you’) was not a highly rated factor by respondents who paid for the use of a mobile phone. it was costs in general (which were likely to be mostly outgoing costs) that represented the most compelling factor in their choice of one network over another. Oftel said.134. customer behaviour when calling a mobile phone. The commercial rationale for the price differences. on-net and off-net prices offered to prepay customers in May 2002 still show a very significant disparity. Figure 6. and would be likely to understate the proportion of fixed costs to be borne by the relatively inelastic off-net call origination charges and therefore to overstate the proportion to be borne by termination charges. Oftel told us that there was no evidence that. and (b) if on the other hand there is a difference in the relevant elasticities. provided no justification why this should occur and be sustainable in competitive conditions. to those revealed in its corresponding survey in February 2001. then the difference would need to be substantial if it were to explain the price difference in terms of Ramsey principles. could not be relied upon to give an accurate depiction of optimum relative prices even in their own terms. Until the first quarter of 2000/01. mobile customers responded to the high prices charged for inbound calls by switching to another network where the inbound call price was lower. reception quality. how aware mobile customers were of the relative and actual prices of on-net and off-net calls. Three main points emerged from our own BMRB survey on the question of how sensitive mobile phone customers are to the price of incoming calls.32.132.

Hence. 2. much higher percentages of respondents rated as ‘very’ or ‘fairly’ important each of the nine factors that were more important to them overall. 42 . O2’s NOP survey found that it was the cost of making calls from their mobile phone and the overall value for money of the packages available that were more important to respondents than the cost to others of calling them. It will be seen from Table 6. followed in descending order of importance by ‘the quality of the network service’. all these surveys demonstrate that there are low levels of concern on the part of mobile owners about the costs that others incur in making calls to them. In our view. While 57 per cent of those owning both a mobile and a fixed line claimed to know the mobile network they were calling when using their fixed line. Thus.57 that 49 per cent of those surveyed rated ‘the price others pay to call you’ as either ‘very’ or ‘fairly’ important to them. A high proportion (85 per cent) of both categories were unable to say why they took the view they did. However. (b) Over two-thirds of respondents were not concerned about the costs incurred by their main group of phone contacts in calling their (the respondents’) mobile phone. unless they are calling a person with whom they are in a repeat calling relationship. 83 per cent thought that the price they paid to call others was ‘very’ or ‘fairly’ important to them. The survey carried out for O2 by NOP found that.55). in response to the question whether respondents knew which network they were calling when they rang a mobile phone. Our own survey indicated that only 28 per cent of respondents who paid for the use of a mobile phone were likely to know whether they were calling a mobile phone on the same network as themselves. only about 30 per cent of those who did not own a mobile phone were aware of this.135.136. and higher percentages (than 49 per cent) were recorded for the six other factors that respondents ranked above ‘the price you pay to call others’. We note that MNP will make it progressively more difficult for those calling a mobile to know what network they are calling. ‘the ease of understanding of prices’ and ‘the geographic network coverage’ (see Table 6. a similar level of awareness was claimed as that of the owners of both fixed and mobile phones. We looked next at levels of awareness on the part of those mobile customers who called other mobile networks of the particular network they were calling in each case. 84 per cent thought this of the quality of network service they received. If ‘the price others pay to call you’ is regarded as a fair proxy for the level of termination charges. Awareness on part of customers of calling a particular mobile network 2. When NOP put the same question to mobile-only customers.being ranked tenth in a list of 14 factors offered to respondents as likely to be relevant in their choice of MNO. there was a difference in awareness between those who had and those who did not have a mobile phone (see Table 6. Only 9 per cent said that they were more concerned about their contact group’s costs than their own costs and 28 per cent were equally concerned about both sets of costs. These findings are consistent with those of surveys of residential customers commissioned by two of the MNOs. The most important factor for respondents was ‘the price you pay to call others’.57). then the level of those charges is not a factor to which mobile subscribers are sensitive. 72 per cent of mobile users did not know this. (c) Nearly two-thirds (61 per cent) of respondents were more concerned about their own costs of telephoning one of their main contacts than they were about the costs that those contacts incurred in calling them. 76 per cent thought it of the ease of understanding of prices. The results of the NOP survey commissioned by Vodafone showed that the price paid by respondents for making calls and the overall value for money of the packages on offer were much more important to them than the costs that others incurred to make calls to them. many other factors were more important to them. Nearly three-quarters of respondents said that the cost to other people of calling them on their mobile phone was an unimportant factor when they decided which mobile network to join. Under one-fifth said that it was important.

This revealed that about 48 per cent of respondents thought that fixed-to-mobile calls were a lot more expensive than fixed-to-fixed calls (findings which correspond to actual price relationships). Oftel’s February 2002 survey found that only 18 per cent of fixedline customers thought they knew how much it cost to call a mobile from a fixed-line telephone.139. if the arguments advanced by the MNOs that mobile customers put pressure on them to set termination charges at competitive rates are to carry weight. O2 conducted a survey which tested consumers’ knowledge of relative rather than actual prices.) 2. Finally. we considered it preferable to ask respondents what they thought it would cost them to make a fixed-line call to a mobile phone. we thought it would be difficult to elicit reliable responses about mobile-to-mobile prices. About half the respondents to O2’s NOP survey correctly said that on-net prices were lower than off-net prices and roughly the same proportion correctly said that the price of fixed-to-mobile calls varied by time of day. the actual cost of a 2-minute daytime weekday call from a fixed line to a mobile phone would have been between 38 and 47 ppm at full tariff rates.) Thus. 16 per cent said that they did not know and 2 per cent said that ‘it would depend’. In part because of this. 2. 11 per cent did not know. this corresponds with the actual position). (We also note that fewer respondents (36 per cent) thought that off-net calls were a lot more expensive (than fixed-to-fixed) than thought that fixed-to-mobile were a lot more expensive (48 per cent). Vodafone’s survey found that 57 per cent of respondents correctly thought that fixed-to-mobile prices were a lot more expensive than fixed-to-fixed prices. in constructing questions for our own consumer survey about levels of knowledge of relative and actual prices. (These findings are set out in paragraphs 6. than on-net calls. 9 per cent thought they were about the same. Of the remaining 35 per cent. 21 per cent thought they were a little more expensive. only 21 per cent had even an approximate idea of the true cost of such a call. 8 per cent thought they were the same or a little less and 33 per cent did not know. 2 per cent thought they were a bit cheaper and the final 2 per cent thought they were a lot cheaper. 2. 43 . 18 per cent suggested prices that were lower than this and 43 per cent suggested prices that were higher than this.138. We have already noted evidence indicating low levels of awareness and concern on the part of mobile owners about the costs of incoming calls. Mobile phone customers have a large number of different tariffs available to them for outgoing calls. (In the example we put to them. of the remaining 19 per cent.140. the remaining 56 per cent either did not give a view or did not know. We set the ‘correct’ range for responses at between 30 and 50 ppm. 3 per cent thought they were a little cheaper and 3 per cent thought they were a lot cheaper. while 22 per cent did not know.) Given that the difference between fixed-to-fixed and fixed-tomobile is actually smaller than the difference between fixed-to-fixed and off-net prices. 36 per cent said that off-net calls were a lot more expensive than fixed-to-fixed calls (again. while 24 per cent thought that they were a bit more expensive. 7 per cent thought they were anything between the same price and a lot less expensive.226. We found that 77 per cent of customers did not know. 60 per cent correctly said that mobile-to-mobile calls varied by time of day. 21 per cent did not know. of the remaining 64 per cent. 44 per cent correctly said that the price of calling mobile phones from fixed lines varied by the network being called. 4 per cent thought they were about the same. of fixed-to-mobile calls and of calls made to a mobile phone at different times of day. It is also important to consider how knowledgeable mobile phone owners and fixed-line users are about actual costs of calling mobiles and the relative costs of different call types. Instead. It is also important. that enough customers are shown to be broadly aware of the relative prices of on-net and off-net calls. Vodafone’s survey also found that 43 per cent of respondents correctly said that the off-net price of calls was a lot more expensive and 22 per cent a little more expensive. in particular how prices of fixed-to-fixed calls compared with those of other types of call. 22 per cent thought they were a little more expensive.137.Knowledge of relative and actual prices 2.221 to 6. this tends to confirm the finding that there is a lack of widespread awareness of the relative prices of different types of call.

Broadly. they show that a large number of consumers have little knowledge of either. The final aspect of the survey evidence relevant to our consideration of the competitive pressures on termination charges is the behaviour of customers when calling mobile phones. Taken overall. Those (a minority) who knew and cared about the cost of making fixed-to-mobile calls either kept calls short or requested call-back to save money. two-thirds of respondents said that they would not change their behaviour. so far as residential mobile phone users are concerned. 2. who were unaware. then the social value and utility of mobile phone use are lowered. and more tellingly. asked respondents how they would change their pattern of calling mobile phones if the cost of calling fell by 25 per cent. It is significant in our view that price did not feature at all highly in the list of factors suggested to respondents in this survey as reasons why they called mobile phones. (This evidence is set out in paragraphs 6.145 suggests that. In both cases. incoming call charges are a relatively low priority.141. the cumulative evidence set out in paragraphs 2. 2. 2.144.) Vodafone’s survey found that 78 per cent of respondents making fixed-to-mobile calls agreed with the proposition that they tried to keep the length of their calls to a minimum. while one-third said that they would. to call back in order to save money but 62 per cent said that they had not. This reveals a marked lack of price sensitivity among those paying for the use of both fixed and mobile phones. Customer behaviour when calling mobile phones 2.146. Further.142.132 to 2. O2’s NOP survey also found that the main reason by far why respondents called mobile phones (either from a fixed or mobile phone) was because they wanted to contact the person straight away. pay higher charges. Only 8 per cent said that they rang another mobile phone on the same network because it was cheaper and a mere 2 per cent said that they did so because of the ‘free’ minutes offered. In summary. through NOP.241. At the 44 . call-back) and fairly low levels of knowledge of actual prices.143. for most of them. We conclude that there is insufficient knowledge and concern among callers to mobile phones to induce them to change their behaviour to such a degree as to put pressure on call termination charges and force these down to competitive levels. little evidence that many people try to join the same network as those people they call most often. low levels of preparedness to adopt strategies that would save the calling party high charges (for example. The remainder. 38 per cent of mobile customer respondents said that they had offered. we find low awareness among people as regards which mobile network they are calling. We also explored the behaviour of mobile phone customers in our BMRB survey (see Appendix 6. these findings indicate that there is some degree of consumer awareness of relative levels of charges for different types of call.2). 2. to the extent that people are using tactics to keep calls short or avoid charges.145. O2. Over one-quarter of those questioned in NOP’s survey for O2 said that they considered ringing the mobile phone to let the recipient know that they wanted to talk and to request that the recipient call back. The findings in this and the previous paragraph suggest that it is the ability to reach someone straight away that is the most important factor for many people in calling a mobile and that price does not feature highly in their list of priorities. The main finding from this survey was that over 90 per cent of respondents said that they would not change the way they contacted the person they wished to call in response to a 10 per cent price increase in call charges. and that many people’s beliefs as to both relative and absolute prices are significantly mistaken. In our view.2. we consider that these findings reveal a degree of awareness on the part of consumers which is insufficient to enable them to make an appreciable impact on prices or to drive termination charges down to competitive levels. Moreover. or had been asked. But signifycantly more non-mobile owners said this than mobile owners.235 to 6. but that there is a much lower level of knowledge of actual prices.

in his September 2001 statement.147. For all these reasons taken together. usually in the form of differential tariff rates. including particular groups such as large businesses. At the retail level.149. Taking all the evidence set out in paragraphs 2.148. calls 45 . and (b) for calls which are delivered using both GSM and 3G technologies. incoming call charges are a relatively low priority. in the context of market definition. For most mobile users. but neither (c) calls that are carried and terminated using only 3G technology. however. this definition means that we are required to make a public interest finding on voice calls delivered using GSM technology. whether our terms of reference require us to include termination charges in respect of voice calls carried over 3G as well as 2G networks. we consider that for those consumers who are aware of the relatively high cost of making fixed-to-mobile calls and who take steps to reduce the length of their calls. In our view. We also need to consider. the MNOs have been able to sustain higher termination charges for the generality of customers than would otherwise have been the case. In substance. the definition set out in that Annex refers to voice calls ‘intended to terminate on a GSM mobile handset using the GSM air interface for the conveyance of that speech call’. argued that because handsets would be developed with the capacity to handle both 2G and 3G calls and. in our view largely neutralized the pressure which these groups would otherwise have been able to exert on termination charges by offering such users more favourable terms than the generality of mobile customers. we think it is clear that there are currently no adequate substitutes for termination of calls on the network of each operator. As we have already noted (see paragraph 2.146.same time.150. the term ‘call’ has the meaning set out in Annex A of our terms of reference. There is evidence of a degree of price-sensitivity on the part of a minority of mobile users. however. By segmenting the market in this way. there are no ready alternatives to making a call to a mobile (such as calling a fixed line or using SMS) and no adequate consumer strategies (such as call-back) that are easy to use and effective enough to put sufficient pressure on termination charges. nor (d) for calls that are delivered using both GSM and 3G technologies. this definition means that we are required to make a public interest finding on voice calls carried over GSM but not 3G technologies. we conclude that each MNO has a monopoly of call termination on its own network. that proportion of call minutes which is delivered over GSM technology. Conclusion on market definition 2. for three reasons. that proportion of call minutes which is delivered over 3G technology. For the purposes of this report. this reduces the value of their mobile usage. Other market definition considerations 2. This will include: (a) voice calls delivered solely using GSM. The MNOs have. the DGT said that in his view there should be no regulation of voice calls provided using 3G technology and spectrum. in the early years of 3G. 2. 2.94 to 2. In our view. The MNOs and Hutchison 3G.40). There are currently no practical technological means of terminating a call other than on the network of the MNO to which the called party subscribes and none that seems likely to become commercially viable in the near future.

international roaming also falls outside our terms of reference. Oftel said. low and falling prices. The MNOs pointed to a number of factors which. The definition of a ‘call’ in our terms of reference means that we are not required to consider termination charges made in respect of text messaging. because the competitive con46 . operators that were improving their efficiency. the MNOs accounting to Oftel as to the relative proportions. demonstrated the effective competitiveness of the mobile sector. Oftel told us that under its proposals it would be possible for MNOs to set an unregulated charge for 3G and a different regulated charge for 2G. customers with such dual-mode handsets would be unaware of whether their voice calls were being transmitted via the new or existing technology. Competitive pressures at the retail level 2. tariff charges that were offering customers increasing value for money. any excess profit would be competed away in prices at the retail level.102 to 3.545 to 2.would be passed backwards and forwards between the two technologies. As we have already noted. The four MNOs have laid great emphasis on competition between the MNOs at the retail level which. they could not tell. Orange drew our attention to falling prices. 2. This appeared to us. it would in practice be very difficult to regulate only 2G termination. to be feasible (see paragraphs 3. for the same reason. high consumer satisfaction and high consumer penetration as evidence of the intensity of competition in the mobile market. Orange and T-Mobile and that there is a separate market for termination of voice calls on the network of each of these four operators. high consumer satisfaction. Although we acknowledge that these factors are likely to be indicators of competition at the retail level. Oftel considers that the retail market is not yet effectively competitive. even in retrospect. in the context of remedies (see paragraph 2. Oftel envisaged a single charge that would be a weighted average of the 2G and 3G elements of the call. they are not by themselves a guarantee of full competitiveness in the sector. the terminating MNO would know whether the call was 2G or 3G. even if termination charges were excessive. T-Mobile pointed to the long-term decline of mobile prices. a high degree of innovation and some new entry in the shape of Hutchison 3G. a high degree of switching. first. they said. and what might happen to call origination and access charges if termination charges were to change. We conclude that the scope of our inquiry is voice call termination on the GSM networks of O2. Vodafone said that the best evidence of the effectiveness of competition in the market for mobile services was the speed at which Orange and T-Mobile had been able to gain market share. Even if customers were unaware of the network underlying their calls. and second. that it was meaningless to describe a call as ‘2G’ or ‘3G’.105).153. in O2’s submission. Vodafone. based on evidence from the MNOs.151. Indeed. is the source of much of the competitive pressure that leads to the dissipation of any excess profits which may arise from high termination charges.152. These included. rapid service innovation. low barriers to switching. a dynamic market with shifting market shares. Oftel told us that it was reasonable to consider competition in the mobile sector in the context of a single retail market for all outgoing services. They have argued that. It is therefore necessary for us to examine what evidence there is of competitive activity in the retail market. based on engineering estimates at an aggregate level of how much of each type of network was used by calls. saying. The MNOs disputed this. in order to form a view both on the extent to which this competitive activity is likely to be effective in keeping termination charges down. because it could be a mixture of both. or could set up an inter-network or wholesale billing system to enable it to differentiate.155. 2.154. how much of each technology any particular call had used. in their view. 2.547). 2. We address the practical issues surrounding 3G later. competition in quality and lack of evidence of anti-competitive behaviour as evidence that the UK market was extremely dynamic and competitive.

because of the room for improvement in consumer awareness of different prices and tariffs. Thus. In this section. we look first at the profitability of the MNOs (see paragraphs 2. Prices were above the level that would be found in an effectively competitive market. none of these three MNOs was found by Oftel to have profits that persistently and significantly exceeded the cost of capital. it was appropriate to regard prices that reflected a reasonable ROCE as a proxy for the competitive level of prices. Vodafone said that its profit levels should not be regarded as indicating that the mobile sector was not competitive. were likely to be the same.157.169).198 to 2.9 of that review) that supernormal profits were consistent with competitive market conditions under particular circumstances. Judged largely by its high levels of profitability. as an operator with market power could raise prices above the competitive level.162) and then go on to consider market shares (see paragraphs 2. subscription and call tariffs. that the declining trend of retail prices had flattened out.158. 2. 2. T-Mobile was loss-making throughout the period.168 and 2. Vodafone said that the DGT had placed too much weight on its profitability.159. were not as Oftel believed them to be.157 to 2. Vodafone put a number of arguments to us as to why its profitability levels. as regarded overall profits in the mobile businesses.167) and entry conditions (see paragraphs 2. We looked at the profitability of each of the four MNOs.170 to 2.173). These factors might give rise to excess 47 . there had been little movement in mobile prices which (in the early part of 2002) were at about the same level as in May 2001. for example. we give our conclusions on competitive pressures at the retail level (see paragraph 2.174 to 2. and Vodafone’s return on capital employed (ROCE) had consistently.197) and then call origination (paragraphs 2. and proposed various adjustments to Oftel’s calculations.156. Profitability 2. Oftel told us that. however. We then look at indicators of competition in relation to access and call origination issues (paragraphs 2.210). exceeded the cost of capital. 2. not only overstating its return on capital but incorrectly concluding that a high rate of return on capital was evidence of a lack of competition.211). It told us that its return had been achieved because of its advantages over the other MNOs in terms of customer mix and cost efficiency. For example. We discuss access first (paragraphs 2. It told us that. and substantially.160. evidence of the existence of some barriers to customers’ switching networks and poor levels of consumer information. Finally in this section. Oftel said that Vodafone appeared to be pricing above the competitive level. it had placed weight on the long-term trend of declining prices in the mobile market. The sector still fell short of effective competition. Oftel had found that Vodafone’s ROCE was persistently and substantially in excess of the cost of capital over the period 1998 to 2002. since publishing its 26 September 2001 review statement. On that basis. It appeared that Vodafone at least had been making profits in the UK in excess of its cost of capital over the period 1998 to March 2001. Oftel stated in its 26 September 2001 Effective Competition Review (see paragraph A8. adjusted to allow for economies of scale and the costs of a hybrid GSM 900/ 1800 MHz network operator compared with an 1800 MHz operator. high returns might reflect relative efficiency and high levels of innovation by an operator. Also.ditions for particular outgoing retail services. Oftel’s September 2001 Effective Competition Review showed O2’s returns over the same period declining to a level below Oftel’s estimate of cost of capital. This ROCE would relate to an MNO’s efficiently incurred costs.163 to 2. Oftel noted that. and the trend in those levels. 2. it said. this was evidence. in coming to its view that the mobile sector was ‘prospectively competitive’. Oftel put it to us that a finding of effective competition implied an absence of operators with market power. while Orange’s returns available up to December 2000 had not reached Oftel’s estimate of cost of capital. Oftel said.

Oftel said. however. which were derived from data provided by Oftel and those in Table 2. is the right one to examine. it is obvious from its submissions that Vodafone believes that the adjustments it has made to its published accounts are necessary. Each of the four MNOs had broadly the same proportion of subscribers in the year to 2001: Vodafone had 24.8 20.0 7.4. 2. because over time competitors should be able to replicate efficiencies or produce rival innovations. whether they have been declining (as Oftel believed) or remain approximately constant but at a lower level (as Vodafone’s evidence indicates) demonstrate. Whatever our views on the matter. 2.3 per cent.6 per cent. when deciding whether persistently high profit levels are an indicator of ineffective competition. and Oftel will no doubt wish to consider them carefully. Vodafone’s returns have been earned in a period when the mobile phone market has been expanding extremely rapidly. and Orange. which were based on information from the MNOs.8 22. or some other version.2 27.7 19. These conclusions are therefore not affected by whether Oftel’s or Vodafone’s version of Vodafone’s ROCE.profits in any single period. 23. fixed charges and connections earned by each of the MNOs between 1996/97 and 2001/02. 2.163. In the circumstances. we do not conclude that Vodafone’s high profit levels. 27. in both principle and practice.4* Percentage share held by MNOs.1bn Outgoing call minutes 2001/02 30.3bn Source: CC calculations on data provided by Oftel. value of outgoing revenue and the number of outgoing call minutes.6 26. In our view. Vodafone still had the largest share in 2001/02 (34.162. Market shares 2.7 23. the circumstances in which persistently high profits become an indicator of ineffective competition is a matter of judgement.4 16.165.7 per cent.2 100. it is necessary to consider the circumstances in which such returns are earned. for the valid computation of its ROCE.7 100.1 These are set out in Table 2. The picture has changed significantly since 1997 when Vodafone and O2 had nearly 80 per cent of subscriber numbers between them.9m 34. T-Mobile. We broadly concur in this view.6 100.0 44. However.4 (and in more detail in Tables 6. *There are discrepancies between the share figures in Table 2.6 per cent. 24. O2.8 per cent).6 24. about which contrary views may legitimately be held. ineffective competition. We calculated the MNOs’ market shares using the following measures: number of subscribers.0 46.164. in themselves.1. 48 . even though its share fell by some 11 percentage points over the period 1 We also calculated shares according to the number of text messages each MNO sent and received but it is not necessary for us to consider these here. that it was clear that persistent high returns were difficult to reconcile with a competitive sector. 2001/02 Vodafone O2 T-Mobile Orange Total Volume Subscribers year ending 2001 Outgoing revenue 2001/02 24. 6. In terms of revenue from outgoing calls.39. 2.42). TABLE 2.41 and 6.161. as we have decided that text messages do not fall within our terms of reference. Our view is that the profitability of each MNO over the past few years is not critical as an indicator of competition in any particular part or parts of the wholesale or retail market.7 28.

2. 2.168. the degree to which the cost of handsets was recovered upfront or in call prices would also reflect optimal 1 We note that the structure of the GSM sector in the UK is rather different from that of most other EC countries. Hutchison 3G will be unable to offer its customers many other customers to call on an on-net basis. at any rate in mobile voice calls. It said that the existence of subscription charges for a minority of customers reflected a two-part tariff structure where the ‘subscription’ charge provided for a certain block of minutes. T-Mobile told us that it was in the business of selling calls to and from its subscribers. where the pattern is more typically that of a single dominant operator and one or two smaller players. call origination and call termination. The MNOs rejected any analysis of the retail market which separated services for access from the making and receiving of calls. 2. T-Mobile’s share was the lowest at 16.170.171. Access and call origination issues 2. so that broadly speaking a consumer could obtain attractive outgoing rates (that is.7 per cent. Hutchison 3G will want to build up market share rapidly in those limited parts of the country in which it intends initially to concentrate its services.from 1996/97.91) three activities involved in the take-up and use of mobile phones by consumers: access.2 per cent). 2. although some MNOs are clearly stronger than others. and a fifth about to enter the market. No other new entry is expected in the foreseeable future because of a shortage of spectrum. prepay customers) did not pay subscription charges. 49 . each with roughly equal market shares. many ‘free’ minutes) in exchange for a higher subscription charge.8 billion in 1996/97 to 46 billion in 2001/02. to raise their termination charges and lower their on-net charges. the UK has a larger number of MNOs and these more evenly matched than is the norm on the Continent. In addition. beginning with access. We noted that access and call origination are retail activities.166. 2. So far as voice traffic is concerned. although it is always possible that the ownership of particular MNOs may change hands.7 per cent respectively) and T-Mobile the lowest at 19. in the initial phases. and that around 65 per cent of its customers (that is.172. Entry 2. and if they did. but both its and Orange’s shares rose markedly over this period. We now examine the degree of competition at the retail level in the context of each of these activities. For example. Vodafone and Orange had the highest percentage of outgoing call minutes (30. The incumbent MNOs will have the incentive. Total outgoing call minutes rose from 6. We have already concluded that call termination forms a separate market at the wholesale level. this would make it more difficult for Hutchison 3G to establish itself.8 per cent and 28. handsets were of value because they were part of the means (along with the network infrastructure) by which calls were made and received.4 per cent) than that of Orange (26. therefore.169. When Hutchison 3G starts operating. O2 said that subscription charges and outgoing charges were part of a package.167. No single dominant or dominating player in the retail market emerges from these measures of market share. With four established operators.6 per cent. O2’s share also fell and was lower (at 22. Oftel told us that mass market take-up of 3G services was not expected before 2004 at the earliest. The fact that there are currently four more or less evenly-sized businesses is unusual by European standards1 and gives all the MNOs a similar. it will bring the number of MNOs in the UK to five. broadly common interest in events affecting the sector as a whole. So far as its high-speed mobile data transmission is concerned. In 2001/02. We distinguished earlier (see paragraph 2.

and customer service (including customer care and billing services). while average customer care costs per subscriber were £14. We calculated that the average sales and marketing costs per subscriber were a little over £17. ranging from 5. sales and marketing costs. customer care and itemized billing.187). we look at what the MNOs spend on acquiring cus50 .176. Finally.8 per cent. and remain on. and ongoing competition among the MNOs in respect of call charges on the other. nevertheless. As a proportion of total voice and SMS revenue.174.176).174 to 2. and customer care first. The MNOs each spent. 2.50.11). that there is an important distinction to be made between the competitive activity which takes place among the MNOs to acquire and sign up new customers to their networks. Such investment is worthwhile for the MNOs. Orange told us that the monthly payment made by post-pay or contract customers was not a subscription charge (that is.10). Access Sales and marketing and customer care 2.197). on average.two-part tariff considerations.175. The MNOs argued that their sales and marketing expenditure was by no means excessive. 2. a fee paid just for being connected to the network) but a service charge for elements such as inclusive minutes. The MNOs incur various categories of expenditure in attracting customers to their networks and encouraging them to make calls. The main categories are customer acquisition and retention costs. we look at switching (see paragraphs 2. 2.177. reasonable. In this connection. they said. £185 million on selling and marketing their services in 2001. their networks. an average. Within customer acquisition and retention costs we have included net handset costs (ie handset costs less handset revenues).188 to 2. In their last financial year for 2001/02. Our primary concern in this section is to consider the implications of the MNOs’ strategy for acquiring and retaining customers through their expenditure on customer acquisition and retention.6 per cent to 8. in respect of which the MNOs incur various subscriber acquisition costs. on the one hand. An important part of the MNOs’ competitive strategy is the funding of initiatives to encourage customers both to join. and sales and marketing. Average expenditure on customer care for the four MNOs was £154 million in 2001 (see Table 7. their spend was. Vodafone said that there was nothing ‘discretionary’ about its marketing expenditure: it was a sign of how effective competition was that each MNO was forced to incur ever greater costs to win and retain subscribers.196) before reaching our conclusions on access (see paragraph 2.177 to 2. answerphone service. because customers generate the MNOs’ future revenue streams through their subscription and other tariff payments and through the termination charges they generate by receiving calls. up to the point at which any excess profits were competed away. the four MNOs spent. before examining the nature of the subsidies that the MNOs offer customers to induce them to join the network (see paragraphs 2. discounts and incentives to retailers. under the heading of access. We begin with access and look at the sales and marketing of mobile services (see paragraphs 2.173. We believe.178. then go on to consider customer acquisition and retention. We therefore propose to examine access and call origination separately for the purposes of establishing where competitive pressures are felt in the retail market. We discuss sales and marketing. 2. Customer acquisition and retention 2. £682 million on these categories (see Table 7.

customers are given a financial incentive to join or stay on the network.32 illustrate the range of prepay and post-pay tariffs on offer. We accept this. The MNOs told us that it was impossible to know with any precision how much of the sums paid to retailers by way of discounts and incentives went into handset subsidies. O2 said. Customers require a handset. a SIM card and a tariff package before they can make and receive calls. namely the purchase of the mobile handset itself and the establishment (or continuation) of a connection to a network. As some contract customers do not use all their inclusive minutes. at the very least. £122 million on net handset costs. to enable the retailers to sell the handsets to their retail customers at a subsidized price. off-net or mobile-to-fixed. but this would be very unusual (and indeed would be more expensive in the short term than buying a handset with a network connection). All the MNOs incentivize retailers to recruit customers to their networks. 2. 2. A key element in the MNOs’ marketing strategy is the sale of a bundle or package of services which includes. we have been told that some of the funds they make available to retailers are used towards subsidizing handsets.11). often at below cost.182. the MNOs may purchase handsets from manufacturers which they then sell on to retailers. and to what extent. although prepay handsets had been subsidized in the recent past. 51 . O2 told us that post-pay handsets were subsidized (that is. 2. (Tables 6. each MNO spent. The parties stressed the important role that subsidization of the handset played in their marketing of the ‘bundle’ of mobile services to customers. once established. to provide incentives for customers to take up post-pay packages. It added that. Each tariff plan has many different pricing components.179. to make and receive more calls than prepay customers.174 to 2. they sign a contract (typically for 12 months). the latter involving a contractual arrangement between the MNO and the mobile customer under which the customer makes periodic (usually monthly) payments in return for a handset and SIM card (or a SIM card alone if the customer wishes to retain his existing handset) and a specified allowance of call minutes (the number of minutes allowed varying with the amount of the subscription). 2. 2. and whether the call is on-net. They have the choice of either a prepay or post-pay package. They receive a number of inclusive minutes per month and in some cases a number of inclusive text messages.176). Within each of the prepay and post-pay categories there is a choice among various tariff plans. Prices for mobile phone subscribers comprise a number of components. It was still commercially important.tomers and at how. sold below incremental cost) and would remain subsidized for the time being. Some MNOs sell handsets to the retailers at cost and make incentive payments to retailers when the handset is sold as part of a customer joining the network. We have already considered sales and marketing costs and customer care above (see paragraphs 2.) All of these prices may have an effect on the willingness of particular customers to join the different networks. Post-pay customers tended.12). which commits them to paying a periodic (usually monthly) subscription charge.31 and 6. It is possible to purchase a handset without a network connection. on average. When contract (post-pay) customers buy a new mobile handset. These expenditures amounted to some £[  ] per new subscriber to the networks in the year 2001/02 (see Table 7.183. the sale of a SIM card which connects the customer to a particular network. Prepay customers purchase connection to the network outright and also a handset if they need one. at least part of the monthly subscription charge might be thought of by the customer as a way of paying for the mobile handset.181. known as a line rental.180. and £381 million on related discounts and incentives (see Table 7. In their most recent financial year for 2001/02. increasingly the sale of such handsets was making a full contribution to costs. reflecting for example the time of day and day of week when the call is made. we believe that this category of spend can properly be regarded as representing a type of subsidy. In order to encourage retailers to recruit more customers to their networks. Although we were unable to quantify how much of the MNOs’ costs for discounts and incentives was used in this way. The purchase of a mobile phone therefore normally consists of two transactions. However.

52 . All the figures that they provided indicated that the average subsidies per customer were greater for post-pay customers than for prepay customers. however.186. The allocations of subscription revenue to call income by the different MNOs left a residual of between zero and 73 per cent of subscription revenue which we consider should be offset against customer acquisition costs.13). switching mobile networks appears to be quite straightforward and relatively inexpensive. Churn rates therefore need to be treated with caution. 2.567). Switching or churn 2. the subsidy given at the time of sale). we took the view that 50 per cent of subscription revenue should be attributed to calls.2. MNOs were prepared to invest more up-front to attract post-pay customers. later in this chapter (see paragraph 2. The MNOs produced various figures on different bases to quantify the average level of subscription/handset subsidies. 2. for these purposes. 2.190. to £425 million as shown in Table 7. and the extensive loss of their customer base which they said would result if this were to occur. The usual measure of churn is the number of disconnections from an MNO’s network in any period. The MNOs agreed that part of the subscription revenue from contract customers could be regarded as call revenue and that this could be calculated by valuing the bundled free minutes offered as part of those packages.13. or the proportion to be allocated to outgoing call revenues or to offset customer acquisition costs.187. we look at the extent of switching or churn in the mobile sector. and 50 per cent to offsetting customer acquisition costs (see paragraphs 7. Making this adjustment resulted in average customer acquisition costs (ie net handset costs. in those who switch tariff but remain on the same network. Finally. It was clear to us that any consideration of call charges and customer acquisition costs necessitates an allocation of periodic subscriptions between these two elements. To calculate any offset to the subsidy. as such customers tended. The Large Business Users Panel. discounts and incentives and sales and marketing) being reduced in 2001/02 from an average for the MNOs of £682 million. In the absence of any consensus among the MNOs as to either the correct basis of allocation. 2. We discuss the impact which we would expect any reduction in termination charges to have on customer recruitment when we discuss possible remedies. there is no industry standard for calculating churn.156 and 7. They monitor churn rates closely. However. we considered whether some proportion of the contract customer acquisition costs should be offset by part of the periodic subscription revenue that the MNOs receive from those customers.184. to have a higher lifetime value. and to obtain some idea of what proportion of customers are new to the network on the one hand and what proportion are simply churning between networks on the other.185. We are not interested.189. on average. For residential customers and some SMEs. and the term ‘churn’ is sometimes used to describe both disconnection from a network and disconnection from a particular tariff (which does not necessarily mean that the MNO has lost a customer). The figures in the previous paragraph represent the up-front handset subsidy (that is. The MNOs put it to us that switching or churn rates in the mobile market were an indicator of competition among them.157 and Table 7. 2. The MNOs differed in their view as to what proportion of the subscription revenue could reaonably be allocated to call revenue and hence what residual amount was left. Several of the MNOs drew to our attention the reduction in handset subsidies that would be necessitated if termination charges were reduced.188. under ‘access’. expressed as a proportion of the average number of customers in that period. We sought to estimate the extent of churn (by which we mean disconnection from an MNO’s network). We thereby calculated that the average net cost of acquiring a new customer was around £100 for the most recent completed financial year.

Customers informing their MNOs that they intend to move to other operators may well be offered incentives to stay and this might be thought to lower switching rates.53). The MNO figures suggest that an individual MNO is losing up to one-quarter of its customers to other networks every year. Customers also incur a charge to purchase a new SIM card and some customers have to pay to have their SIM cards unlocked. 2. 2. existing customers. we estimated that. 10 per cent were genuine new subscribers to mobile telephony during 2001/02. A number of surveys carried out by Oftel and the MNOs have sought to establish the rate of churn between networks (inter-network churn) in the sector (see paragraphs 6. its August 2002 survey of residential customers found that only 18 per cent of respondents who had ever changed networks had ported their existing number. family and friends about a change of number. 2. The proportion of new to existing subscribers rose up to March 2000. and then fell sharply to March 2002 (see Table 6. However. Number portability (see paragraph 2. this time using survey data.182).203).192. however. We estimated that the percentage of genuinely new subscribers (that is. The MNOs submitted that a high rate of inter-network churn would normally be regarded as an indication of intense competition in a sector and that this was indeed the case in the mobile sector. the percentage of people saying that they had changed networks or service provider at some time in the past ranging from 22 to 29 per cent.194. The MNOs’ own surveys produced annual inter-network churn figures of [] to [] per cent for O2.199).34) provides a way for mobile customers to switch networks without the associated costs of changing stationery or business signage.5 million. or about 5 per cent of all mobile customers (see Table 6. The true rate of churn between networks appears to be less than 20 per cent.204). Three surveys—by Oftel in February 2002. Oftel’s November 2001 survey found that there was an appreciable level of awareness among consumers that it was possible for them to switch networks by changing their SIM card (63 per cent of mobile customers were aware of this) (see paragraph 6. of the total number of subscribers in March 2002 (as measured by handset sales). We also sought to estimate the proportion of new residential customers. Oftel found.191. as a result of retailers receiving higher rewards from the MNOs for signing up new customers than from switching. The latest survey data (for August 2002) shows a year-on-year increase in new mobile customers of 1. or of contacting colleagues.195. [] to [] per cent for Vodafone and [] to [] per cent for T-Mobile. 2. first-time subscribers who have not previously owned a mobile phone before signing up) is a modest fraction of the total number of customers who churn between networks. They said that we were therefore inconsistent in appearing in our Remedies 53 . or upgrading the handsets of. These findings indicate a sharp drop in the rate of new customers over a comparatively short period. Contract customers seeking to leave a network before the end of the contractual period will normally be obliged to pay all outstanding monthly subscriptions. that number porting was not widely used (see paragraph 6.178 to 6.193. Previous survey data (for February 2002) had shown the proportion of new to existing customers as being 9 per cent (see paragraph 6. the churn figures may be higher than they otherwise would have been. Using Oftel and MNO data.196.52). 82 per cent had changed their number. while 11 per cent of them had switched networks while keeping their original handset. 2. However. 2. only 6 per cent of these ‘aware’ customers claimed to telephone on more than one network by using more than one SIM card in their mobile handset.told us that large customers found switching more difficult as there could be logistical problems in getting new handsets or SIM cards to employees. This means that the MNOs are very largely taking customers from each other. GfK for O2 and TNS for Oftel in November 2001—all found broadly similar churn rates.

2. This tends to encourage frequent changes of network and upgrading of handsets by mobile users rather than the expansion of call activity. Call origination 2. and expressed our view that this difference threw doubt on the MNOs’ claim that their pricing approximated to a Ramsey structure of prices.199 to 2.200. the degree of churn in this sector is symptomatic of the structure of retail incentives that the MNOs have adopted. O2 offers nine such packages. the number depending on how tariffs were classified (see paragraph 6. compared with just 3. Very few packages now restrict inclusive minutes to off-peak usage.133).and off-net calls earlier. Moreover. ranging from £10–£15 to over £75. Table 5.202 to 2. in our view. calls) and at any time of day. We now turn to consider evidence of the degree of competition at the retail level in respect of call origination. To a large extent. We examined the margins that the MNOs make on different call types. a range of retailers compete to sign up customers.131. We then reach our conclusions on call origination in paragraph 2.197.201. involving the subsidization of customer acquisition. the greater the number of ‘free’ inclusive minutes in the subscription price and the lower the call charges. although some still exclude off-net calls.211. Conclusion on ‘access’ 2. However.22 shows that the average contribution across the four MNOs (including a proportion of subscription revenue) made by this type of call in the year 2001/02 was 11.2) to regard a high level of churn as ‘excessive’. T-Mobile six. Although the MNOs have begun to offer pricing packages which allow their customers a certain number of either free on-net or free on-net and off-net call minutes.4 ppm for mobile-to-fixed calls. We discuss the margins that the MNOs make on their outbound calls (see paragraphs 2. these margins help to meet non-network costs not recovered in termination charges or subscription revenues.198.Statement (see Appendix 2. we think the mobile market is competitive.7 ppm. Margins 2. We accept that the movement of customers between the different MNOs is indicative of competition between them.199. 2. Orange four and Vodafone two. However in our view.210. the largest unit contribution is made by off-net calls. including the number of minutes that remain ‘unused’ in mobile packages (see paragraphs 2. for off-net. Most packages are configured so that the higher the monthly subscription charge. the nature of the competition between the MNOs at the access level. We conclude that competition among the MNOs to attract and sign up subscribers to their networks is vigorous. Each of the MNOs offers contract customers a wide variety of monthly subscriptions.122 to 2.209). For all the MNOs. as well as on-net and mobile-to-fixed.1 This is a further development of the move by MNOs to widen the coverage of inclusive minutes on their networks. in paragraphs 2. MNOs have recently begun to offer packages with inclusive minutes which can be used on any network (that is. We discussed the difference between the prices of on. 54 . To that extent. we consider that the marked differences in average contribution made on these two call types indicate a less than fully competi1 Vodafone told us that it had seven ‘any network’ tariffs. has led to a structure of retail incentives that leads to a higher degree of churn between networks and a lower level of call activity by consumers than would otherwise have been the case.201) and the transparency of tariffs.4 ppm for on-net calls and 5. and our overall conclusion on competitive pressures at the retail level in paragraph 2.

2. Nevertheless. Oftel put it to us that the proliferation of tariff structures offered by the MNOs had evolved to appeal to distinct user profiles or market segments. Price discrimination could be welfare-enhancing if it had the effect of increasing the number of mobile customers who used mobile services.206. MVNOs and service providers all competed to offer attractively-tailored tariffs designed to suit every kind of customer. heavy or light users. It is significant. Moreover. we might have expected to see the net price differential between on-net and off-net call prices (that is.7 ppm for the four MNOs for off-net. ]. so that the average contribution of 11. or their usage of mobile phones. Other sub-segments related to particular customer characteristics. despite the considerable amount of information on offer. Equally.205. We asked the MNOs whether the number and variety of pricing packages available to customers made comparisons between the prices of one MNO and another more difficult for mobile customers than they needed to be. the many different tariff structures might have the effect of confusing consumers and result in prices being less transparent and hence more difficult to compare.204. in a fully competitive market. this might involve changing tariff or selecting an option such as an off-net bundle to be added to the existing tariff. Moreover. 2. for example. The welfare outcome of this was. Oftel also submitted that the range of tariff structures and tariffs was a form of price discrimination.202. contribution after taking termination charges into account) competed away across the board. 55 . MNOs. These differentials vary considerably from one MNO to another [ Details omitted. ambiguous. there were numerous sources of information for consumers and as they became more experienced in using mobile phones. calls disguises very high contribution relative to on-net calls in the case of two of the MNOs. See note on page iv. compared with 3. 2.4 ppm for on-net. O2 told us that it was aware of no evidence that competition was muted by virtue of the MNOs’ multiple tariff offers. O2 and Orange made very similar points. in which products were designed in such a way that customers could self-select themselves on to the relevant tariff structure according to their demand characteristics. consumers had difficulty in making effective choices between the wide range of tariff packages available to them. We acknowledge that the MNOs are offering more of these packages. and could readily make price comparisons among the tariffs available. the most obvious split being between business and residential consumers.203. in Oftel’s view.tive market in call origination. in our view. Indeed. rather than bringing the prices of these calls closer to each other (although Vodafone told us that its on-net and off-net prices had moved closer together by virtue of a reduction in its off-net price). Vodafone drew our attention in this connection to the fact that some [] per cent of its subscribers could be expected to switch to a different plan each year. it could reduce welfare if the result was that overall volumes of purchases were reduced or resulted in consumers making wrong choices. consumers could predict their own usage better and hence make a better-informed choice of tariffs. that the MNOs choose to offer tariff packages that include on-net and off-net minutes. Vodafone agreed that there was a wide range of tariffs available to customers and argued that this was the consequence of having a competitive market. This might lead to higher switching costs for mobile customers. each consumer readily identified a small number of tariffs likely to be suitable for his usage pattern. That did not mean that consumers made confused or bad choices. Oftel said that its research showed that there was evidence of low consumer awareness of the prices of different kinds of call and it was reasonable to conclude that. Transparency of tariffs 2. In Oftel’s view. the range of tariffs on offer meant that customers’ preferences would be met more precisely. 2. Vodafone said that survey findings had shown that the majority of customers found it easy or fairly easy to find the best package.

therefore. The validity of the benefits to customers claimed by the MNOs for the proliferation of tariffs depends. Survey evidence showed that consumers were adapting their behaviour in response to price and were not making ill-informed decisions. and the bundling and complexity of call tariffs. such packages represent a type of segmentation of the market that facilitates price discrimination and localizes price competition in a few groups of consumers. O2 told us that over [] per cent of its call minutes were unused. These figures (set out in paragraph 6.there were numerous sources of consumer advice from the MNOs themselves. Orange’s unused call minutes for all but one of its tariffs (Everyday 50) amounted to less than [] per cent. This is evidenced in high margins for off-net calls.217 to 2. in our view the bundled features of the packages on offer may make it more difficult for consumers to get what they want than if the features were unbundled. there is a lack of transparency in the pricing of mobile packages which makes it difficult for mobile customers to compare different packages. on three factors: first. second. O2 said that consumers became more knowledgeable about prices with repeat purchases and would be aware of charges from their monthly bill or.333). number of inclusive minutes or monthly subscription charge). with a weighted average of [] per cent for 2000/01.132 to 2. the degree to which customers are either aware of or concerned about the existence of the tariffs that would best suit them. In our view. and to set prices for at least some calls well above any reasonable estimate of the incremental costs involved in making those calls (we discuss costs in paragraphs 2. High proportions of unused minutes such as these could be evidence of a lack of competition between the MNOs. 2. further simplifying the choice. in our view. the frequency with which they topped up their credit.207. it said. as Vodafone said. We accept that there is information available to help consumers choose the best package and that mobile phone users are likely to become more knowledgeable the more they use their phones. specialist web sites and specialist magazines.208. Orange told us that. since if competition were intense. Indeed.135) indicate a substantial proportion of unused minutes in inclusive packages. only a small proportion of tariffs were relevant to their personal usage. The high proportion of unused ‘free’ minutes indicates to us that at least one of these factors is likely to be absent. so that comparisons were relatively easy to make. Persistent unused call minutes would seem to represent overpayment by customers for the services they purchase. while Vodafone had between just over [  ] and [  ] of unused minutes for individual tariffs. specialist retailers. to the extent that.210. T-Mobile had just under [] per cent of unused minutes. the unused minutes on Everyday 50 were [] to [] per cent. Moreover. 2. in the case of prepay. make the right choices and bring downward pressure to bear on prices. the existence of tariffs reflecting such usage patterns and third. For most consumers. a substantial level of unused free minutes in mobile packages. the MNOs offer attractively tailored packages designed to suit every customer. We asked the MNOs what proportion of inclusive call minutes in their subscription packages were unused. We believe that this knowledge and awareness are at lower levels than would be effective fully to constrain mobile prices. 56 . we would expect mobile customers’ actual usage to correspond more closely with the packages they acquire.209. while there were certainly a large number of tariffs. The MNOs appear to display at least some power to set call origination price structures that suit them. 2. Conclusion on call origination 2. the extent to which consumers make the right choices from among the numerous packages on offer should be seen in the light of the evidence of consumer knowledge and awareness that we discussed earlier (see paragraphs 2. We conclude that competition in call origination is less intense than competition for access.146). the ability and willingness of customers to forecast their usage patterns. however. However. all fell into common patterns (for example.

economic theory recognizes that. less than effective competition at the retail level.212. to bear a greater proportion of the common costs.147). against the public interest. prices need to rise above marginal costs and one approach is to require less price-sensitive customers. We were told that the levels of the MNOs’ two main categories of retail prices. We have concluded that each of the MNOs has a monopoly of call termination on its own network (see paragraph 2. Other payments are also part of that investment. was therefore to price broadly in line with Ramsey principles. the MNOs told us that their pricing was in effect demand-led rather than cost-plus. The right way to maximize the revenue stream.214. or products for which demand is more elastic. they had greater incentives to reduce charges to mobile customers than to reduce call termination rates (in line with cost reductions).217 to 2. when they acquire new customers. The handset subsidy which the MNOs give their customers (formerly both prepay and post-pay. or might be expected to operate. were broadly consistent with Ramsey pricing. (We consider costs in paragraphs 2. in some circumstances. The MNOs told us that. there is less effective competition in call origination (see paragraph 2. This is described as cost-reflective pricing and is generally regarded as the method by which overall economic efficiency is best achieved. As we have already noted. However. or which disadvantage entrants. We have further concluded that. including that from subscriptions. The basis of the MNOs’ pricing 2. or products for which demand is less elastic. This structure of pricing is sometimes referred to as Ramsey pricing. but not necessarily all. All this indicates. So far as pricing is concerned. they said. Ramsey pricing is a structure of pricing and in the mobile 57 . in competitive markets. subscription prices and overall call prices.333). but since last year predominantly post-pay. customers) may be thought of as part of the MNOs’ investment in this revenue stream. in our view. to bear a smaller proportion of those costs. from call charges when their customers make outbound calls and from termination charges when other people call customers on their networks. where there are fixed or common costs to be recovered. it is first necessary to describe what the MNOs have put to us as their approach to pricing and the allocation of costs in the mobile sector. of the MNOs’ payments to retailers may be seen as an indirect way of granting handset subsidies.211. and it is widely accepted as being conducive to the recovery of costs in a way that minimizes distortions. while there is intense competition among the MNOs to attract and sign up subscribers to their networks (see paragraph 2. the revenue they expect to derive from customers. they regard themselves as effectively buying a revenue stream—that is. but handset subsidies represent the most significant element. a substantial level of unused free minutes in mobile packages. and reflected the need to recover the substantial fixed and common costs which they incurred. Ramsey pricing may. To cover these costs. Part. 2. in the absence of a charge control mechanism on them. where no excess profits are made). and the bundling and complexity of call tariffs. The MNOs told us that. which would result in lower charges for call origination and higher termination charges.197). prices will be set equal to marginal cost.213.Conclusion on competitive pressures at the retail level 2. Ramsey pricing may be expected to produce a more efficient outcome than cost-reflective pricing only if it is applied in conditions where revenue overall is cost-reflective (that is. 2. and more price-sensitive customers. They said that this was a fundamental aspect of the case that they were putting before us. lead to outcomes which seem inequitable. Economic theory states that. and where either demand for some services is more price-sensitive than for others or where some customers are more price-sensitive than others. our terms of reference require us to investigate and report on whether termination charges would.210). in competing to win new mobile customers. However. Further. setting price equal to marginal cost will leave firms making losses. be set at levels which operated. Before we can reach a conclusion on that question. as evidenced by high margins for off-net calls.

333).215.252 to 7. they said. The MNOs also adopted this approach. Oftel told us that the appropriate cost of capital for the purposes of our inquiry was the cost of capital for 2G termination. by themselves. such as access. We then turn to the network costs of call termination (see paragraphs 2. we address the question of what the charges for call termination would be if they were cost-reflective. in the absence of a charge control on termination charges. If prices in the mobile sector were to be set by Oftel at Ramsey levels.217. which adds together the cost of debt and equity finance. We now turn to a consideration of the MNOs’ costs. Vodafone. We next examine whether certain non-network costs should also be included in the costs of call termination (see paragraphs 2. Ramsey prices may be set across different services.258). 2.218. He estimated the cost of equity of the MNOs by using the Capital Asset Pricing Model (CAPM). Costs of call termination Introduction 2. these being set at different levels at different times of day or for different days of the week. We received a considerable volume of econometric and other evidence on this topic.446).320 to 2.244 to 2. but told us that it had seen no evidence to suggest that any sufficiently robust estimates of demand elasticities existed. Cost of capital 2.334 to 2. We consider the questions whether the MNOs currently set Ramsey prices. Oftel did not produce its own econometric elasticity estimates. call origination and call termination.201). be inappropriate to use cost-reflective termination charges as the basis for determining whether those charges were set at levels that operated against the public interest. Alternatively. In the following section. Orange and T-Mobile operate against the public interest. There are a number of other matters we need to consider in deciding this question.387).386). which is also discussed fully in Chapter 8. 2.429 to 2. we consider whether any allowance should be made for externalities (see paragraphs 2. We look first at the appropriate rate of return for the termination of incoming calls with particular reference to the cost of capital (see paragraphs 2. and certainly none that could be relied upon. each weighted by the proportion of debt and equity respectively in the MNOs’ financial structures. then the relative price elasticities of these services would need to be established. Ramsey prices may occur within call termination.319).218 to 2. Oftel used Vodafone’s cost of capital as a benchmark for the other MNOs. 58 . Some of the MNOs produced their own estimates of elasticities for this inquiry and these are discussed in Chapter 8. The DGT estimated the weighted average cost of capital (WACC).216. answer the question whether the termination charges of O2. although certain aspects of its calculation utilized data relating to other operators (see paragraph 7. as this would result in overall losses. later in this chapter (see paragraphs 2. The CAPM in effect generates a measure of how much investors need to be rewarded for holding the risky equity of the particular company rather than of shares generally. Finally. The MNOs put it to us that their pricing had to reflect the need fully to recover fixed and common costs. although T-Mobile made use of a two-factor risk model as well (see paragraphs 7.243). that is.sector may occur within a single service or across different services. in particular the costs involved in call termination. at levels which reflect customers’ price sensitivity to different products or services. set Ramsey prices. Thus. and whether they would. It would. which were significant in the mobile sector. Our findings on the market and on the competitive pressures felt at the retail level do not. before reaching our overall conclusions on costs (see paragraph 2.

2 per cent while the yields for medium-term (ten years) and short-term (five years) index-linked gilts were both about 2.8 per cent (also in nominal terms).235 to 2. We begin with the risk-free rate (see paragraphs 2.9 per cent. Towards the end of our inquiry. This is because the different components (or ‘inputs’) that contribute to the WACC (discussed in the following paragraphs) are subject to change—not only because of movements in financial markets but because of evolving work and views by financial and academic analysts on interpreting data— and there can be considerable uncertainty over the appropriate level for some inputs. 2. 2. we use and discuss both nominal and real rates.2. and to take as our base case the mid-point of each component. The risk-free rate 2. 2 59 . which is to identify. then look at equity risk premium (see paragraphs 2.222.238) and an alternative pricing theory model to CAPM (see paragraphs 2.220. equity beta (see paragraphs 2. which they said seriously understated their costs of capital. the MMC and CC. However.230). 2.5 per cent) but above the long-run real return on government securities (about 1. As will be seen from Table 7. before setting out our overall findings in paragraphs 2. We assessed the real risk-free rate by looking at the redemption yield on index-linked gilts.3 and 16. based their ranges for the risk-free rate on both recent 1 See footnote 4. August 2000.219.234). Oftel and the MNOs agreed that the nominal risk-free rate was 5. Sutton and East Surrey Water plc: a report on the references under sections 12 and 14 of the Water Industry Act. The MNOs told us that they disagreed with many aspects of our cost of capital estimations. in respect of each of its components. Mid-Kent Water plc: a report on the references under sections 12 and 14 of the Water Industry Act. for example the introduction of the minimum funding requirement for pension schemes. We refer to pre-tax rather than post-tax rates.21. All these figures are below their averages for the whole period (about 3. There appears to be widespread recognition that gilt yields have been reduced by special factors. 2.239 and 2. The MMC’s and CC’s published reports in the last four years which considered the cost of capital were those on Cellnet and Vodafone1 and on two water companies. rather than simply adopting the mid-point in the range in each case. CC reports.3 per cent from 1900 to 2000). In this section of the chapter.3). In estimating the cost of capital a degree of judgement is required. while the MNOs estimated their cost of capital as ranging from an average of 16.231 to 2.223.225. debt premium (see paragraphs 2. respectively. Oftel used a real cost of capital in its forward-looking LRIC model.226). which are generally considered as having negligible default risk and inflation risk. we have adopted our normal procedure in calculating the cost of capital. The cost of capital can be expressed in real terms (that is. what we consider to be reasonable ranges. gearing and taxation (see paragraph 2.224.243. Index-linked gilt yields have been on a downward trend since the early 1990s (as shown by Figure 7. the CC’s reports on two airports inquiries were published.2 per cent. averaging 15 per cent. The Competitive Operators Group (COG) estimated a cost of capital for the MNOs of 9 per cent. Oftel estimated the MNOs’ nominal cost of capital as between 13. the real yield for long-dated (20 years) index-linked gilts was 2. Oftel and most of the MNOs estimated the nominal cost of capital.221. The MNOs told us that they disagreed with this approach and said that we should exercise judgement to decide the value of each component. 2.2 In those reports.224 to 2. after adjusting for inflation) or in nominal terms.3 per cent.237). In the light of these uncertainties. At June 2002.227 to 2. August 2000. We now examine each of the elements or inputs in turn.3 per cent to an average of 26.240).241 to 2.

2.5 per cent. We turn now to the equity risk premium. and reflecting the continuing downward trend in the underlying rates.230.229.6 per cent.5 to 4.5 per cent.5 to 3. Dimson. Equity risk premium 2. Our view is the premium lies in the range 2. the main methods used to estimate the equity risk premium are first.6 per cent.5 per cent.220). Vodafone and Orange all estimated an equity risk premium of 5 per cent.75 per cent. Bearing all these factors in mind. these showed estimates of the equity risk premium ranging from 2 to just under 3 per cent. It is clear that no certainty can attach to any equity risk premium figure and we believe that a best estimate must draw both on the historical evidence and the evidence of market expectations.5 to 5 per cent used in the earlier Cellnet and Vodafone reports. While this is below the range of 2.1 per cent. Our real rate is 2. the CC noted that its best estimate of 4 per cent for the equity risk premium was somewhat below the historical average but above current estimates of market expectations. Using a rate of inflation of 2. but this was at an early stage in the decline in yields on index-linked gilts. Both we and the MNOs have made broadly the same estimates but ours is based on nominal rates. As the future returns from equities are uncertain.25 per cent used by the CC in the water inquiries.231) cite a number of surveys of UK investors. to use surveys and other evidence of investors’ current expectations over the short term.15.226. compared with 3 per cent for the main parties. In its report on the water companies. In the water inquiries in 2000 the CC took account of more recent evidence of the failure of yields to recover to their earlier levels and a risk-free rate of 3 per cent was used in both inquiries.213) estimated expected equity risk premia ranging from 2. while T-Mobile suggested a range of 5. A major disadvantage of using historical estimates is that they vary markedly depending on the period used. and below the mid-point (4. we have used a range for the real risk-free rate of 2. In the Cellnet and Vodafone inquiry in 1998. its estimate being more heavily influenced by the long-run average of the equity risk premium. We noted that the CC’s 2000 water reports (see footnote to paragraph 2.227. some of which showed higher estimates. it is above the current spot rates. We considered whether a possible indicator of the right level of the equity risk premium might be the longterm rate of return on equities for companies’ defined benefit pension schemes. The mid-point of that range.5 per cent or less. which gave or implied premium levels of 4.1 to 5.5 per cent.6 to 6.3 per cent.228.25 per cent) of the range 3. which represents the additional return that investors require to compensate them for the higher risk associated with investing in equities rather than risk-free securities. 60 . is below the 4 per cent adopted by the CC in its water reports to which we have referred. The range 2.and longer-term evidence. we noted the objections which Vodafone and T-Mobile put forward to the use of these estimates. This level for the risk-free rate was above the rates then current for index-linked gilts of around 2 per cent.2 per cent from their level in 2000 of around 2 per cent.5 to 2. Marsh and Staunton (see footnote to paragraph 7. at 3. and other similar evidence.5 per cent would reflect both the continuing downward trend in historical data and recent academic opinion. 2. but took account of the downward trend in these gilts. 2. our range in nominal terms is 5. which have recovered slightly to around 2. 2. Using various assumptions (see paragraph 7. Vodafone and T-Mobile supplied us with details of other surveys.5 to 4. O2.8 per cent was used. a range of 3.4 to 4 per cent.6 to 4. to take historical averages of realized equity returns over the risk-free rate and second. Using an inflation rate of 2. as shown in Table 7. which companies are required to publish.75 to 3. our range in nominal terms is 2. using different inflation factors. However. However. We also considered forward-looking estimates of the equity risk premium.

2. Charles Rivers Associates (CRA) told us that a higher rate should be applied to T-Mobile and Orange. notwithstanding that it is a fixed line rather than a mobile network operator. 2. statistical estimates are made by regression analysis (in which total returns from holding a particular share are regressed against total returns from the market portfolio). as less well-established MNOs.19). second. derives the biggest proportion of its turnover from the UK. The COG told us that there were strong a priori reasons to expect the beta for the MNOs’ 2G business to have declined as the market approached saturation and as mobile phones became a basic necessity of business and social life rather than a discretionary purchase. and a lower rate to Vodafone and O2. Again. The range of beta that we have chosen necessarily involves a degree of judgement. It will be seen that the range of estimates is wide: at gearing of 10 per cent. 2.224). or 2G access and origination activities. The lower end of the range is based on monthly data and takes account of the fact that the operations with which we are concerned would be regulated. how this should be done. whether there is any need to adjust betas to take account of overseas activities of companies or business mix and if so. NAO. disputed by the parties.235. Oftel’s estimated range is 1. this is not observable. we have concluded that the range of beta should be 1 to 1. COG thought that the debt premium should be 0.232. it is necessary to decide first.81 per cent for the MNOs. Equity beta measures the risk of investing in a particular company’s shares relative to the average for all equities.45 (based on 40 per cent gearing) (see paragraph 7. as part of its operations are regulated by Oftel. however. Oftel estimated a beta for BT ranging from 1.236. ranging from 1. T-Mobile and The Brattle Group (consultants commissioned by Oftel). Debt premium 2. Taking into account all the uncertainties. To avoid the difficulties caused by overseas ownership. In carrying out such analyses.Equity beta 2. Vodafone.16 (based on 20 per cent gearing) to 1. COG thought that we should be concerned with estimating betas for the 2G operations of the MNOs.22. might be regarded as a suitable proxy for the MNOs in estimating beta. of all the parent companies of the MNOs.58 (see paragraph 7. Table 7. or overseas activities.231.5 per cent. We now consider the equity beta of the MNOs’ UK operations.20. The range is our estimate of the beta of the 2G termination business. termination services) that are the subject of our investigation. Oftel said (and we agree) that theoretically we should be estimating the beta of 2G call termination. 2. O2. We thought this 61 . Oftel’s and the MNOs’ percentage estimates of the debt premium are set out in Table 7. This view was.233. while the upper end of the range is based on daily data for the UK activities of the MNOs. whether estimates of beta should be based on daily or monthly returns.75. We have therefore measured the beta of the MNOs’ UK operations overall and then considered whether any adjustment was necessary to represent the beta of 2G termination.61 (electricity) and 1. Orange. which is the interest that an MNO would have to pay over and above the risk-free rate when borrowing. We nevertheless considered whether BT. while T-Mobile’s is 2. A further consideration was the practicability of assessing betas for the operations of the MNOs (that is. and it estimated beta at 0.0 to 1.2 to 5. which time period should be used and third.17 sets out the estimates of equity beta made by Oftel. 2002).236). our upper estimate is based on mmO2 rather than Vodafone. As beta is not measurable directly from market data. Based on recent debt premia for water and electricity companies (2007 to 2010). However.1 (gas) (see Table 7. because mmO2. It is similar to the beta of a quoted 2G MNO because on balance we did not find enough evidence indicating how far the beta of the quoted company should be adjusted to exclude non-2G activities. We now turn to the question of debt premium.234.6.32. We also estimated equity beta for UK utilities based on a National Audit Office report (Pipes and Wires. This showed equity betas of between 0. the range of estimates among the MNOs is wide. Oftel’s average estimate is 1.

CRA. as low as practically possible. The MNOs provided us with gearing figures ranging from 10 to 30 per cent. So far as tax is concerned. that is. We noted. but we concluded that there was insufficient evidence of the superiority and greater reliability of the two-factor model to cause us to depart from use of the CAPM for the purposes of this inquiry. at 10 per cent. Orange put it to us that it would be inappropriate to apply a single cost of capital to all MNOs. CRA estimated the impact of the value component using mmO2 as a proxy for T-Mobile. that the CAPM was used by four of the five main parties to our inquiry and that it is widely used across the private sector. Overall findings on the cost of capital 2. 2. We considered whether we should adopt the CRA’s suggested model. we have taken account of various estimates of company-specific inputs. Oftel and Vodafone told us that in their view the same cost of capital should be used for all the MNOs. We were aware of the debate that was taking place on the relative merits of CAPM and multi-factor models.0. As T-Mobile is not listed on any stock market. We do not believe that the variation in these inputs is sufficient to justify our using different costs of capital for different MNOs.239. we have adopted the standard 30 per cent rate of corporate tax.237. and have therefore adopted a figure for gearing of 10 per cent as opposed to choosing the mid-point between 10 and 30 per cent.2 and 2 per cent a year higher than the estimate from the CAPM. to 4 per cent (the average of the premium incurred by O2 and Orange). Indeed.241. CRA estimated that mmO2 had a post-tax cost of equity of between 1. T-Mobile argued that the CAPM was not empirically robust and did not provide a reliable estimate of the cost of capital. finance institutions and utility regulators. it said that mmO2 was likely to be a more realistic comparator for T-Mobile than Vodafone because mmO2 is a quoted MNO which derives the biggest proportion of its turnover from the UK. moreover. We considered it right to give more weight to these actual figures (as opposed to estimates). and O2 (10 to 13 per cent). because of its lack of predictive power. In reaching our view on the appropriate cost of capital. some experts believe that the two-factor model has no foundation in finance theory and is merely a statistical model that summarizes the empirical regularities that have been observed in US stock returns. particularly when used for forecasting purposes or for an assessment of actual outcomes. Gearing and taxation 2.240. 62 . Taking all relevant factors into account. Oftel took the view that this should be based on an MNO whose financing costs were ‘efficient’. in T-Mobile’s view. This model added a so-called value component to the CAPM and was in CRA’s view accordingly more appropriate for a company such as T-Mobile which was susceptible to ‘distress’ and likely to perform less well in recession. Vodafone believed that the efficient cost of capital did not vary among the different MNOs and that the CC should not take account of differences that arose from individual MNOs having an inappropriate capital structure. our range for the debt premium is 1. 2. We therefore adopted the CAPM to estimate the cost of capital. Alternative to CAPM 2. was a two-factor risk model used by its consultants.estimate was too low.238. as each had different funding and risk profiles. were based on their actual financial positions. based on Oftel’s low estimate. A more appropriate model. Those of Vodafone. as we believed that the MNOs would be considered as somewhat more risky than the utility companies.

and therefore provide a more reliable measure of the 63 . In our view.0 9. TABLE 2.5 per cent (in real terms). In view of this uncertainty. the trend could change.245.5 Illustrative range of the cost of capital per cent Risk-free rate ERP Equity beta Cost of equity Debt premium Cost of debt Gearing Taxation Pre-tax WACC Pre-tax WACC (real) Low case High Case 5. 2. Call termination would not. Stand-alone cost includes costs that would otherwise be shared or common across a larger group of services.6 1 7. We acknowledge that these are much lower than the estimates of either Oftel or the MNOs.6 1 6. or (b) to determine the overall cost of the mobile network and then to find a way to allocate part of this cost to the termination service.3 14. We set out our own ranges of each of the elements that make up the cost of capital in Table 2. The sum of the stand-alone costs of all services exceeds the total cost of the operator whenever economies of scope may be achieved in providing a larger group of services. it is necessary either: (a) to determine the ‘stand-alone’ cost of operating only a call termination service.3 10 30 17. The mid-point of our estimates is just under 14 per cent in nominal terms and 11 per cent in real terms.4 7. We did not consider the stand-alone cost to be the most appropriate way to estimate the cost of this service.5. Determining the overall cost of the mobile network can be done using either bottom-up or top-down cost analysis.2.7 4.243. but it can be difficult to check whether the underlying assumptions are realistic. if market conditions altered. We consider that a degree of smoothing of the downward trend in the equity risk premium would be appropriate. in practice. to which we add 0. The network cost of call termination 2. because it would take no account of economies of scope. the most appropriate way of recognizing this factor is not by modifying our judgement of the range for the equity risk premium. an approach which would also help to prevent volatility in the short term. Bottom-up models aim to estimate the cost of building an efficient network from its component parts using engineering.5 to 4.25 per cent (in real terms).7 5. we would wish to be cautious over implementing in full the decline represented by our range of 2.6 1. 2. We conclude that the cost of capital figure we should use is 11 per cent.4 Source: CC. giving a final figure of 11.6 12.244.242. The exact extent to which the appropriate level for the equity risk premium has been moving downwards in recent years is uncertain and. 2. Top-down models are based on the cost of a complete network derived from existing operators’ accounts.25 per cent. Bottom-up models are useful when there is limited data available on operators’ actual costs or where one wants to know the costs that a hypothetical efficient entrant could be expected to incur.1 2. be provided in isolation.246. economic and accounting principles and assumptions.3 4. but by an increase of 0.1 10 30 10. To estimate the cost of call termination.25 per cent in the overall level of the WACC for the MNOs.

250. Most equipment in a GSM network is used by more than one service. at each stage of development of the model. 2. as this provided a cost base for future pricing that mimicked the effects of a competitive market. 2. 2. Oftel’s LRIC model 2. he told us that 64 .249. allocates all of the costs between the various services. alongside outgoing voice.247. incoming and outgoing data. and they were not given an opportunity to review the final version of the model. There are two main approaches for determining the cost of an individual service: (a) A fully allocated cost (FAC) approach. 2. Beyond the choice of the basis for estimating costs. Given the advantages and disadvantages of the two approaches. 2. Depending on how the costing systems are designed. sometimes also referred to as fully distributed cost. and the versions of the models supplied to them were difficult to use with inadequate documentation. The DGT used a bottom-up LRIC model that estimated the cost of building what he called a ‘reasonably efficient’ 2G mobile network. in February 2001 concluded that LRIC could be used to determine a regulated rate for termination on a mobile network if it included an appropriate share of the network operator’s joint and common costs. The MNOs told us that the process of the development of the Oftel model.248. in order to derive the cost of incoming calls alone. having determined the overall cost of the mobile network some basis then has to be found for dividing the cost of the network among the individual services. with shared costs usually being allocated to services based on the factor that causes the cost to vary. An industry working group chaired by Oftel. however. and then allocates the costs that are not incremental to any individual services in an appropriate way. 2.252. Termination of incoming voice calls is only one of a number of services provided by MNOs. therefore. We agreed with the DGT that LRIC was the appropriate basis for estimating costs because it identifies costs that are directly caused by a particular service. The DGT told us that the most appropriate and economically efficient basis for regulatory charges was LRIC. and SMS. The DGT told us that he had consulted the MNOs when developing his LRIC model. in particular their involvement in that process through the Working Group. or very different from. which included the MNOs and several fixed-line operators. It can be easier to confirm the accuracy of top-down numbers. and that he had seriously considered comments and had taken these into account where the arguments and data provided had seemed valid. 2. an economic consulting company.253. it is important to consider the detailed methodology behind the LRIC model. to reach a reliable estimate of the cost of an efficient mobile network it is useful to compare the results of bottom-up and top-down analyses. as the proposed regulation only covers 2G. A report for the four MNOs by LECG. a LRIC model can be very similar to. provide any information on whether existing operators are efficient. first met in July 2000 and the group considered a number of versions of the model during 2000 and 2001. The DGT told us that. an FAC model. They told us that concerns over costing principles were ignored or discounted with little feedback from Oftel.costs at existing levels of activity and efficiency. We also agreed that the LRIC should be based on a 2G-only network. the cost that the firm would avoid in the long run if it decided not to provide a service).251. and (b) LRIC considers the additional cost that the firm incurs in the long run by providing a service (alternatively.254. However. a draft had been circulated to the MNOs. was not satisfactory. They do not.

256.65 4.35 –0. and that in removing the data service from the model it would be more difficult to compare the overall results of the model to the actual networks. and thus modelled a hypothetical voice-only network. resulted in lower costs of terminating calls in every year. However.41 5. (c) the definition of the increment. In designing the April 2002 Oftel LRIC model. (b) the definition of common costs and how these should be recovered.68 4.58 –0. These changes. 2. (d) the level of efficiency to be assumed. 2.257. The model also included corrections to some minor errors identified by the MNOs.51 4.03 –0.98 –0.51 4. we decided that our main focus should be on the output of the process rather than on the problems encountered in the process leading to its release.74 4. These were: (a) the length of the time period over which cost behaviour would be was only during our inquiry that the MNOs had made detailed and constructive comments on the LRIC model. Because we wanted to take into account all new evidence put to us. We recognized that it was inconvenient for the MNOs to have to consider another version of the model. He said that he had made Oftel’s consultants available to MNO staff to assist them with explanations of how the model worked and to help deal with any problems running the model. 65 . We noted the issues raised by the MNOs in relation to how Oftel’s LRIC model was developed. the DGT made important decisions in five areas.60 –0.36 6. The cost per minute of terminating calls from the two versions of Oftel’s LRIC model is summarized in Table 2. in April 2002.40 4. and that there had been only one material change to the model since the versions previously released to the members of the working group. we based our analysis on the April 2002 version of the LRIC model.99 5. We considered.38 3.8% by 2005/06 and 20% by 2009/10 Model 2000/ 01 2001/ 02 2002/ 03 2003/ 04 2004/ 05 2005/ 06 Combined 900/1800 MHz Sept 01 Apr 02 Change 5.58 5.95 4.17 –0. taken together.08 4. and (e) the depreciation method to be used.41 4.33 5.83 –0. It was apparent to us that the parties had found little common ground at the meetings of the industry working group.82 6.18 3.6 Comparison of Cost per Minute for Terminating Calls in Oftel’s Sept 01 and April 02 models (LRIC cost including mark-up for common cost) 2001 prices Pence per minute for average operator with 25% market share in 2000/01 falling to 21. The later version of the model excluded data services. whereas the September 2001 model had covered all services. 2.07 –0.42 1800 MHz Sept 01 Apr 02 Change 6. He said that he had believed it appropriate to issue the final version of the model at the same time as his proposals.14 4.85 4.96 –0.88 –0.16 Source: CC based on data from Oftel.20 –0. however. We reviewed each of these decisions in the light of views submitted by the MNOs.255. During our inquiry. TABLE 2.20 4.77 –0. that there was sufficient time for parties to consider the new version and that it would be possible to uplift the results of the voice-only April LRIC model to make it comparable to the MNOs’ networks.89 6.6. the DGT made available a new version of the LRIC model. There were changes to the way that depreciation was calculated which the DGT described as improvements to the methodology.00 3.

because they would be unlikely to promote efficient decisions by consumers.260. and because they might not allow the operators to recover their costs. the network reconfiguration should be technically feasible). included the cost of building a national network with the capability to make a single call to or from any location in the network. and from an economic viewpoint (that is. The DGT told us that using short-run costs was impractical because of their volatility. which he defined as the period over which all assets are replaced. such apparently common costs 66 . T-Mobile told us that the economic definition of the long run focused on the ability to change inputs. 2. The only time when all costs could be altered in most businesses. together with the cost of the network management system.263. even with very low volumes of traffic. T-Mobile told us that the cost of providing this single call was much greater than just the cost of the network management system and site costs. if one service ceased.258. In addition to the equipment on the minimum number of base stations needed to provide coverage across the UK. and did not imply that all costs could be varied in the long run. the MNOs told us that other equipment that was shared between services over and above the minimum network was also common cost. By long run. With regard to T-Mobile’s point that the only time that all costs could be altered was prior to entry. we mean the period over which the MNO has complete flexibility with respect to how it configures its network. using Ramsey pricing (see paragraph 2. when (almost) all costs could be avoided.The time period 2. the fact that equipment is shared between services now does not necessarily mean that the cost of the equipment is common among services in the long run because. there would be a need for equipment on all base stations. We believe that this definition is broadly consistent with that of the DGT.214). was prior to entry. 2. The total common cost should be recovered. in our view. However. 2. even if such shared equipment was found to be common.259. 2.262.264. Vodafone told us that it considered Oftel’s approach to be theoretically unsound because. He called this the cost of minimum coverage presence. 2. and this demonstrated that fixed and common costs were substantial. We agreed with the DGT that over a shorter time period costs could be volatile as capacity constraints were reached and extra equipment was put in place. T-Mobile told us that the relevant time period for the model should be the period of regulation rather than the long run. including their cost of capital). the amount of equipment needed could—and would—be scaled down to the level needed to run the other activity. Shared equipment that is deployed on the sites that are needed for coverage could be defined either as common or as incremental. the MNOs have considerable flexibility to redesign their networks over a period of several years. Common network costs 2. He said that these costs should be recovered by equi-proportional mark-up. the MNOs told us. We therefore think it is reasonable to assume that an MNO has complete flexibility with respect to how it configures its network in the long run. The MNOs told us that the starting point for a consideration of common network cost was the equipment needed to allow a call to be made anywhere on the network. MNOs should be able to achieve and recover an efficient level of cost. In our view the long run is the appropriate period for considering costs. Flexibility here is from both an operational viewpoint (that is.261. The DGT told us that the relevant time period for LRIC was the long run. it said. Common network costs. Selecting any period less than the long run would therefore be arbitrary and unsatisfactory. T-Mobile told us. The DGT told us that the only common costs in a mobile network were site acquisition and lease costs of the minimum number of base station sites needed to provide coverage across the UK. In any case. In our view.

This could be achieved in one or other of two main ways: (a) define the increment as the terminating calls service and calculate the long-run cost of the service in isolation. Within the Oftel LRIC model. if a service were removed.267. Vodafone told us that the relevant increment was the termination of all incoming calls.265. As we stated in paragraph 2. This could lead to a conclusion that. the difference between the sum of the two separate stand-alone networks and the cost of the combined origination and termination network) being treated as a common cost. Vodafone argued that. 2. any equipment cost should be treated as variable. the marginal cost of the service. or (b) define the increment as the traffic on all services and then. with the remainder of costs being allocated according to Ramsey pricing principles. because that was the service whose price we were seeking to determine. it was not necessary to define the increment as a single service because the choice of the increment should not significantly affect the cost calculation. therefore. That might be the case in the short to medium run.260. Costs that would not be avoided in either of these cases were to be regarded as common costs. as closely as was practical. using Ramsey pricing. the cost of the increment. we recognize that most equipment in a mobile network is shared among services.can be allocated across the services in a reasonable manner on the basis of the extent to which each service makes use of the equipment. as a second step.247. The MNOs told us that the choice of increment was important and that it did matter whether the increment was defined as a single service or total volume. on this basis. even if equipment was shared between services in the short run. the change in the total cost of the network would be small. with the full overlap between the cost of the hypothetical stand-alone ‘termination only’ and ‘origination only’ networks (that is. less equipment would need to be deployed. However. were strictly speaking common costs. we should consider what costs would be avoided if Vodafone were not to offer an incoming call service at all. We considered the MNOs’ arguments on the definition of the increment.258 to 2. we are basing our analysis on the long run and we consider it reasonable to assume that in the long run all equipment costs can be varied. 2. the full costs incurred in providing a network with the capability to make or receive a call anywhere within the coverage area should be treated as common costs. and should be marked up on top of LRIC. We therefore agreed with the DGT’s view that the choice of whether to define the increment as all traffic (and then allocate a share of this to terminating calls on a cost causation basis) or just as the terminating call service was not important. Orange told us that the increment should be the voice termination service. We agreed with the DGT that site acquisition and lease costs for the coverage network. for the reasons given in paragraphs 2. 2. These are measures of the relative use that each service makes of each type of network equipment. 2. and starting from current traffic volumes. if a service did not exist. This was because.266. allocate some of the cost of the increment to the call termination service. Similarly. T-Mobile told us that the increment should be less than the whole service so as to estimate. we should look at costs which would be avoided if Vodafone were not to offer outgoing calls at all. 67 . In order to identify and calculate the LRIC of call termination. In the long run.269. and the network management system. That is. The service that we need to cost is that of terminating calls.268. because these costs could not be scaled down in the event that one service ceased. the quantity of equipment required was related to the demand for particular services. being the cost of all traffic. is allocated to the different services using what the DGT described as routing factors. The increment 2. The DGT told us that in the long run.

The DGT told us that the cost of location updates was driven exclusively by the number of active subscribers within a mobile network. With regard to the routing factors.273. the DGT based his recommendations on the costs of an average operator with a 25 per cent market share of call minutes in 2001 declining to 20 per cent by 2010 with the entrance of the fifth operator. We agreed with the DGT that the costs should ideally be based on a reasonably efficient operator. This has important implications because the costs per minute of the two operators with above-average market shares (Orange and Vodafone) would be expected to be lower than the average LRIC output cost. Therefore incoming calls are also a cost driver. zMarket share 2. Hence. It has also necessarily been developed without access to all the data that the DGT would have wished to take account of. a real risk that the model had created a hypothetical network that could be unrealistic.270. the MNOs challenged the DGT’s position that the cost of the home location register (HLR) should not be allocated to terminating calls. the cost of the HLR and updating it is not incremental to the volume of incoming calls. The DGT based his bottom-up model on a ‘reasonably efficient’ operator. Hutchison 3G. Therefore he considered that the most economically efficient way to cover these costs was by means of a per subscriber charge. rather than by the volume of incoming calls. In that sense.271. Vodafone argued that location updates were needed because it was necessary to locate customers only for the purposes of call termination. We were told by MNOs that the Oftel LRIC model assumed a level of efficiency that was unrealistic. but in the absence of evidence to the contrary.275.2.274. There was. groundbreaking as it was probably the most complex model of its type that had been developed for a mobile operator anywhere. 2. therefore. On balance. and the costs of the two operators with below-average market shares (O2 and T-Mobile) would be expected 68 . we concluded that the DGT’s case for excluding the cost from terminating calls was not wholly persuasive: in the absence of call termination there would be no need for location updates. 2. For example. they could be expected to suffer practical difficulties in rolling out their networks similar to those that had been experienced by existing operators. the fairer approach would be to allocate the cost across terminating calls including on-net calls. Vodafone told us that assumptions made in the model did not accurately reflect the reality of providing mobile services in the UK. The level of efficiency z‘Real-world’ efficiency 2. Whilst the DGT had not had access to financial and operating information from the MNOs to enable him to do so. we recognized that the Oftel LRIC model was. whether or not any incoming calls are actually received by that handset or any other. We noted that HLR updates take place all the time that a handset is switched on. He told us that this was based on the network investment that a hypothetical new entrant would incur. in a sense. On the other hand. the purpose of HLR updates is to enable an incoming call to reach the intended mobile handset more economically than if the whole network had to be paged each time a call arrived. New entrants would not have to recreate the design of an existing operator’s network if that were less than fully efficient. However. and Orange told us that the optimal network assumed in the model was unachievable in practice. The cost of the HLR is around 1 per cent of total network cost. Although the Oftel LRIC model is capable of calculating costs for operators with various traffic volumes. we were in a position to compare this information with the outputs of the LRIC model and so identify whether efficiency assumptions appeared unrealistic. 2.272.

in the short term. 2. However. The April 2002 Oftel LRIC model assumes that an MNO with a 20 per cent share of traffic would need a smaller network as compared to an MNO with a 25 per cent share but. and hence the greater importance of economies of scale to those operators. In principle. the appropriate cost for all operators would be based on the DGT’s original estimate of the share for that year of an average existing MNO following the launch of Hutchison 3G.8p is due to the higher initial cost of the coverage network for 1800 MHz operators. This indicated to us that the Oftel LRIC model might be overstating the degree to which network size varies with traffic volume at volumes below 25 per cent of total traffic in the UK at present.3p and 0. we did not see such a clear relationship between market share and network size. The difference between 0. By 2006. so far.5 per cent. but has since then invested heavily in its network to improve quality. Using the April 2002 Oftel LRIC model. being a 22 per cent market share.7p for an 1800 MHz operator at a real cost of capital of 11. 2. This may be an area where further LRIC modelling work is needed. 69 . there are only very limited remaining economies of scale. before any adjustments. in the short term. should be based on a 20 per cent market share. This should ensure that even a relatively small MNO receives enough income to finance its termination business. in order for an operator to be able to maintain or grow its market 1 This economy of scale is more significant at lower traffic volumes. take into account the extra cost of an MNO with a market share of total traffic lower than the average. Therefore.8p for an 1800 MHz operator. 2. for an operator with a lower than average market share is the cost of an efficient operator with that actual market share.25 per cent. to penalize an MNO with a greater than average traffic market share for its success in winning customers. looking at the units of equipment in use by the MNOs. The appropriate cost. Rather than taking into account market share only for T-Mobile and O2 and basing our cost calculations for Orange and Vodafone on the cost of an operator with a 25 per cent market share. We considered two alternative ways of calculating the cost of terminating calls at 20 per cent traffic market share: (a) Assume that the network was designed to support only a 20 per cent market share.3p for a combined 900/1800 MHz operator or 0. once an MNO has captured between 20 and 25 per cent of the current total market volume. we therefore decided that the appropriate cost for all operators.1 2. and the extent to which any extra cost would be relevant in the earlier years of any price control would depend on decisions taken on the glide path between current prices and the cost projection for 2006. over a period of two to three years we think that an MNO with a lower than average market share has the opportunity to capture at least an average share of the market. T-Mobile told us that not accounting for variations in market share would punish it for its small size relative to the larger networks.4p for a combined 900/1800 MHz operator and by 1. It would be wrong. This increases the ppm for terminating calls in 2001 relative to an operator with a 25 per cent market share by 1. we would expect there to be no need for any extra cost due to low market share.277. This would involve taking the network cost of a 25 per cent operator and dividing by the volume of a 20 per cent operator. however. (b) Estimate the cost of a network that could support a 25 per cent market share but. 2. by 2006. being the approximate share of T-Mobile and O2 in 2002. using the DGT’s estimate of real cost of capital at 12. we agreed with T-Mobile that the cost of terminating calls should. the greater the potential to handle volume using the sites and equipment needed to provide coverage.278. actually handles only 20 per cent of total market traffic.276. [  ] had less equipment and less traffic in 2001 than the other MNOs. In addition. We found this a difficult be higher than the average LRIC output cost because the higher the volume.280.279. in the short term. this increased the ppm for terminating calls in 2001 relative to an operator with a 25 per cent market share by 0.

This matches the cost of equipment to its actual and forecast usage over the long term. The depreciation approach selected by the DGT for the LRIC model was economic depreciation. As a consequence. We considered that it would be unfair to expect callers to mobiles to have to pay for a higher level of quality above a reasonable level. In parallel to this process we collected the information which we would need in order to carry out a comparison between the calculations of the Oftel LRIC model and the MNOs’ actual data.share. to be reasonable insofar as the suggested amendment to the Oftel LRIC model might make it more relevant to a particular MNO’s network.281.285. Economic depreciation 2. therefore. By contrast. and we considered that a 2 per cent blocking probability as assumed in the Oftel LRIC model was suitable. at face value.283. that the second approach was more appropriate.284. In our view economic depreciation is the appropriate method to use because it most accurately matches the costs incurred in order to carry traffic to the periods in which that traffic is carried.4p to the per minute cost of terminating calls. as they had designed their networks to a higher specification than that assumed in the Oftel LRIC model. We asked the DGT to consider all of the proposed amendments. there is relatively little depreciation in years where utilization is low and relatively high depreciation in years of full equipment utilization.62p and 2.282. economic depreciation would have resulted in lower ppm costs compared to an equivalent calculation based on accounting straight-line depreciation. During the course of the inquiry we received a great deal of information concerning Oftel’s LRIC model. The timing of cost recovery under economic depreciation varies from that under accounting depreciation. In years prior to 2001. we do not see the fact that the operators with smaller market shares have similar amounts of equipment to the larger operators as necessarily reflecting inefficiency. then the MNO could expect to benefit in any case through longer calls or higher traffic levels. We concluded. and between 2001 and 2006 the use of economic depreciation by the DGT added between 0. taking the actual price paid for equipment (or its replacement cost) and dividing by the expected equipment life to reach a depreciation charge for the year. If callers enjoyed a higher QoS. We considered carefully each one of the issues raised. 2. and our staff met Oftel on several occasions to explore how the amendments could be incorporated into a revised version of the model. Two MNOs told us that we should take into account their costs of providing a high quality of service (QoS) on their networks. The DGT responded on a point-by-point basis to the MNOs’ concerns and proposed amendments. including suggested amendments to that model as well as alternative models from Orange and Vodafone. zQuality of service 2. Some appeared to reflect a misunderstanding of the Oftel LRIC model (or to apply to the September 2001 version but not to the April 2002 version of the Oftel LRIC model). Concerns over accuracy of the Oftel LRIC model 2. most forms of accounting depreciation are relatively simple. immaterial (because the changes were small or because proposed changes cancelled each other 70 . it would be reasonable that that operator would design its network to provide a level of coverage and quality of service commensurate with its competitors. As such. but the large majority appeared. He argued that most of the proposed amendments were either wrong in principle. as there was a risk that relying on the Oftel LRIC model could lead to an understatement of the extra cost per minute of an MNO with a 20 per cent market share. 2.

The small number of calculation errors that were identified by the MNOs (and their specialist consultants) in their use of the model were not sufficient to persuade us that our use of the LRIC model was inappropriate. 2. or reflected inefficiency in an existing MNO network. We also decided that attempting to develop our own LRIC model was wholly impractical given that many experts in the industry had already been working on the model for over two years and had failed to reach agreement. Vodafone. flawed and wholly inadequate and that a thorough review of its critique of the Oftel LRIC model was needed. detailed study of the Oftel LRIC model to gauge its suitability. We considered whether there were any suitable alternative models that could be used to help determine the cost of terminating calls for a reasonably efficient operator. There is a risk of formula errors in large models. We took steps to ascertain that the DGT’s testing of the model had been significantly stringent. Both companies argued that their models were more accurate than the unadjusted Oftel LRIC model. Further. It said that the DGT’s response was in danger of suffering from systematic bias by recognizing only some of Vodafone’s suggested amendments as improvements to the model.out). while the MNOs would not provide him with accounting data that might form a basis for such evidence. and then to adjust the results of the Oftel LRIC model if appropriate. It became clear to us that the MNOs and Oftel could not reach agreement on a LRIC model. Other points. In focusing on the outputs of the model.287. 2. prepare a revised LRIC model that was acceptable to the MNOs. The DGT told us that the effect of the suggested model amendments. these models have represented a single operator only. We satisfied ourselves that it was. he said.288. to test whether the results of the model were consistent with top-down FAC estimates and other data on actual network equipment and value. 2. 2. Instead we decided to start with the April 2002 version of the Oftel LRIC model. However. Vodafone told us that our approach was superficial. but rather simply produced a broad estimate of the gap between the model outputs for a particular year and actual figures. and Orange had submitted its own model. therefore. 71 . but that the overall picture was that Oftel had underestimated costs. taken together. He did not. At best. O2 welcomed our approach of testing the accuracy of Oftel’s LRIC model by comparing it with actual data from the operators. rather than undertaking a thorough. and said that the tests that we had carried out on the model were reasonable. would lead to lower costs for incoming calls. we deal with the effects of the detailed issues raised by the MNOs in an objective and comprehensive manner. He suggested that the MNOs might be ‘cherry picking’ by focusing only on changes that would increase costs. and using them would have led to different models for each operator. Vodafone had submitted an amended version of the September version of Oftel’s LRIC model to us. each developed based on different assumptions and methodologies. We considered using these models. Orange expressed its concern at our approach and said that it appeared that. and by continuing to err on the side of over-optimization and cost omission. We did not test every part of the model ourselves. T-Mobile told us that our approach did not test the validity of the Oftel LRIC model. Three MNOs told us that our approach was wrong. should only be accepted if they could be demonstrated to improve the overall accuracy of the results. the Oftel LRIC model had the important advantage of providing an estimate of the cost of an efficient operator to compare with the MNOs’ costs. but we decided that they were less suitable than the Oftel LRIC model because they were designed to reflect these operators’ specific individual network configurations and so would not enable us to compare different operators on a like-forlike basis. over and above any issues regarding the underlying logic in the model.286. we had merely performed a high level review of a limited number of parameters. The MNOs rejected the DGT’s responses. we did not identify any significant problems in the course of our use of the model. not least because the DGT wanted evidence to show that suggested changes would improve the overall accuracy of the model. for example. The April 2002 version of the Oftel LRIC model was less complex than the September 2001 version but it was still a large model by any standards. told us that it believed it had carried out a thorough analysis and that Oftel had overestimated some costs and underestimated others.289.

Comparing the two sets of numbers is the only way of gaining confidence that the numbers that will be relied upon reflect both a reasonable degree of efficiency and are achievable.2.293. but we found no reliable basis for resting our data uplift on anything other than the existing network configurations. MNOs’ estimates of the proportion of cell site capacity that was dedicated to data in 2001 varied from zero to 14 per cent. As we said above. It was possible that the MNOs had originally invested in equipment with a view to using it for data traffic. We also compared the FAC ppm for terminating calls with the LRIC equivalent as a check that the LRIC outputs were broadly accurate. however. We noted that the data uplift assumption was critical to the comparison of top-down FAC costs to the costs calculated by the April 2002 voice-only Oftel LRIC model. Before making comparisons between the outputs of the Oftel LRIC model and the data from the MNOs. The comparisons that we made were based on September 2001 for units and value of equipment. The comparisons were based on the size of the network in terms of overall quantity and value of key items of equipment (base stations. We then went on to examine the differences between the costs of combined 900/1800 MHz operators and 1800 MHz operators.291. 2. (This would. in turn. The aim of this was to achieve a like-for-like comparison. tell us that it believed around 5 per cent of its network cost should be allocated to data. and overall operating costs. for example by excluding nonnetwork costs and 3G costs.333). rather than the DGT’s estimate. We decided to base our comparisons on a data uplift factor of 5 per cent. A higher uplift factor would explain a greater difference between the size of the network that was estimated by the model and the MNOs’ actual networks. and the cost trends beyond 2001. We adjusted these calculations to ensure as far as possible that they were comparable with the Oftel LRIC model. which was based on what had turned out to be a very high forecast of data traffic. 2. reduce the discrepancy between the output of the Oftel LRIC and the MNOs’ actual equipment. and any subsequent adjustment that we might make to the outputs of the Oftel LRIC model. 2.320 to 2. and the financial year ending in 2001 for operating costs. We consider that basing our conclusions on both a bottom-up LRIC model and topdown FAC costs and operational data is entirely logical and fair. Comparison of outputs of the Oftel LRIC model with MNOs’ data 2. First. it was necessary to take account of two important differences between the two sets of data. we considered that taking a figure slightly below the average was reasonable because it would be unlikely to lead to an eventual understatement of the ppm of terminating calls.292.294. 72 . The DGT told us that the data uplift should be much higher than 14 per cent to take into account the need to deploy equipment in advance of the expected future growth in data traffic. we consider non-network costs later (see paragraphs 2. to avoid including substantial investment in 3G. but had since decided to use it for voice. when looking at the size of the network the April 2002 Oftel LRIC model considered a hypothetical voice-only network whereas the information submitted by the MNOs was for their total network and included both voice and data services. It was clear there was a fairly wide possible range of values for the uplift needed to reconcile the voice-only network in Oftel’s LRIC model to a real voice and data network. 2.290. We also decided that the impact of SMS on equipment requirements was minimal. in considering the areas of disagreement we decided that it was important to compare the key results of the Oftel LRIC model with the actual costs of the operators in order to reach a view on the overall accuracy of the model. base station controllers and mobile switching centres). We asked the MNOs to calculate their cost per incoming voice call minute for their financial years ending in March or December 2001 based on their published financial results. The operator that had no capacity dedicated to data did.) We considered that the more reliable basis for the uplift was the operating data from the MNOs.295. In the light of a range of estimates of equipment that was dedicated to data.

297. because it was based on a modelled network that.87p or 1.4 per cent.1 per cent.32p for 1800 MHz operators.01p to the LRIC cost per minute of terminating calls for a combined 900/1800 MHz operator and an 1800 MHz operator respectively at 11. This MNO argued that using its data from September 2001 was misleading because since then it had invested heavily in extra equipment in order to improve its quality of service. On the operating cost of running a network. Adjusting for this would deduct around 0. (b) whether the Oftel LRIC model might have incorrectly estimated the annual cost of run- ning a network. and (c) whether the Oftel LRIC model might have incorrectly estimated the cost differential between combined 900/1800 MHz operators and 1800 MHz operators. We considered that the adjustment was reasonable.298. 2. used straight-line accounting depreciation. had quantities of equipment lower than that shown in the LRIC model.16p to the FAC ppm cost of terminating calls for combined 900/1800 MHz operators and 1800 MHz operators respectively. Only one MNO.299. We also compared the total gross historical cost asset values of the MNOs with those suggested by Oftel’s LRIC and this also showed an understatement of equipment of around 24. the Oftel LRIC model used economic depreciation whereas the MNOs’ FAC estimates.1 per cent. we then reviewed the differences between the two sets of ppm results and the factors that could explain these differences. being based on their financial results.300. 2. [  ]. The Oftel LRIC model calculated lower costs for a combined 900/1800 MHz operator (as exemplified by O2 and Vodafone) compared with an 1800 MHz operator (as 73 . and based on this we added 0. Second (see paragraph 2.25 per cent real cost of capital. Operating cost 2. Orange told us that this economic depreciation adjustment was understated.2. or £645 million per operator in 2001/02.1 per cent.62p and 2. We calculated that correcting this understatement of quantity and value of equipment would add around 0.296. and the DGT told us that this adjustment might have been overstated. transceivers by 24.299). we found that the Oftel LRIC model overstated operating costs for 2001 by 13. Quantity and value of equipment 2. On the quantity and value of equipment needed to operate a network. Further.24p from the LRIC cost per minute of terminating calls for combined 900/1800 MHz operators. Having identified the adjustments that could be made to ensure that the outputs of the Oftel LRIC model were broadly comparable to the information from the MNOs.301. Combined 900/1800 MHz vs 1800 MHz costs 2. our tests showed that the Oftel LRIC model had underestimated cell site capacity by 20. at least up to 2000/01.0 per cent and number of cell sites by 12. and 0. we noted that the effect of economic depreciation was particularly high in the year in which we made our comparison and this made it very unlikely that the adjustment had been understated. The differences between historical cost accounting depreciation and economic depreciation were calculated using an adapted version of the Oftel LRIC model. was broadly in line with the actual size of the two MNOs for which the DGT had been able to use publicly available data. The areas that we considered were: (a) whether the Oftel LRIC model might have incorrectly estimated the quantity and value of equipment needed to operate a network.

As a result. Vodafone told us that its amended version of the Oftel LRIC model showed a much smaller difference between the costs of the two networks than the DGT’s version. the higher prices for termination that the 1800 MHz operators had charged over the previous regulatory period. T-Mobile said. The DGT told us that Orange had more cell sites in place between 1996 and 1999 than Vodafone but less traffic for those years. 2. because the 1800 MHz operators had lower utilization than combined operators in earlier years. it did not agree that differing profiles of economic depreciation that were based on cost differences in the past was a justification for maintaining a cost difference between the two types of network in the future. we agree that an average 1800 MHz MNO’s costs can be expected to be higher than a combined 900/1800 MHz MNO’s costs for the years to 2006. under economic depreciation. We need to ensure that future revenues compensate the operators for their relevant costs. calculated using economic depreciation.303.289.exemplified by Orange and T-Mobile). We did not accept O2’s view that the economic depreciation calculations should take into account the fact that the 1800 MHz operators had been able to charge higher termination charges in the past few years. T-Mobile told us that early deployment of 1800 MHz technology had resulted in higher network equipment costs and more expensive handsets. 1800 MHz operators had enjoyed lower earnings to repay their initial investment. 2. It was clear that the two types of network had a similar amount of equipment by 2001. 2. The DGT told us that the main driver of the difference in LRIC costs between the two types of network was not the different amounts of equipment in use in 2001 but rather the low utilization (that is. He said that the available data strongly supported his view that 1800 MHz operators had experienced lower equipment utilization. Historic levels of revenue and return are not relevant to this calculation. whereas the Oftel LRIC model assumed that some differences still existed in that year. As described in paragraph 2.306. It also said that 1800 MHz operators had suffered significant disadvantages in terms of their ability to offer roaming services. Although there is some controversy over the exact advantages and disadvantages of combined 900/1800 MHz networks as compared to 1800 MHz networks. O2 said that the impact of moving to economic depreciation would require extensive backwards reconciliation in order to identify the degree of cost recovery that each operator had already achieved. 74 . volume of traffic carried compared with equipment in place) achieved by 1800 MHz operators in previous years. they need to recover more cost in later years when volumes are higher. based on publicly available data for these companies. Hence. we believe that the 1800 MHz operators faced cost disadvantages in earlier years due to higher equipment prices and lower equipment utilization (although the costs of the two types of operators had more or less converged by 2001). and that the prices of new equipment were now very similar. with costs very similar at current volumes. We should also take into account. The 1800 MHz operators agreed with the DGT that it was important to consider the higher costs they had experienced in earlier years. We concluded that the two types of network were broadly similar in terms of both the quantity and gross book value of network equipment by September 2001.305. O2 told us that it considered that the Oftel LRIC model overstated the difference between combined 900/1800 MHz operators and 1800 MHz operators.307. O2 told us. 2. However. However. Orange told us that the cost differential between the two types of network equipment had fallen in recent years. for the technical reasons described in Chapter 3. Orange said that the 1800 MHz operators had an installed base of more expensive equipment that should lead to higher depreciation charges compared with the combined operators. and that this explained the higher costs in the years to 2006 of the 1800 MHz operators under economic depreciation.302. we chose economic depreciation because it most accurately matches the costs incurred in order to carry traffic to the periods in which the traffic is carried. In addition. 2. 2. We reviewed whether the evidence from the MNOs supported the differences between the costs of the two types of network.304.

The effect of increasing the number of cell sites for the combined 900/1800 MHz operators in
2001 to the same level as the 1800 MHz operators added 0.2p to the outputs of the Oftel LRIC
model. As we had already adjusted the outputs of the Oftel LRIC model to reflect the amount
of equipment needed by the average MNO in 2001, we decided that an upward adjustment of
0.1p for combined 900/1800 MHz operators, and a downward adjustment of 0.1p for
1800 MHz operators in each year was appropriate.

Comparison with FAC estimates for 2001
2.308. Having made the relevant adjustments to the Oftel LRIC model costs and to the topdown FAC cost estimates, the result of our comparison is shown in Table 2.7.

Comparison of incoming calls network cost per minute 2001 at 11.25 per cent real
cost of capital
900/1800 1800 MHz

Network cost
Cost of capital
Economic depreciation adjustment
Adjusted FAC


Comparison with LRIC results for incoming minutes
Oftel LRIC outputs 2000/01
Add: Market share adjustment (see paragraph 2.286)
Add: Equipment adjustment (see paragraph 2.304)
Deduct: Operating cost adjustment (see paragraph 2.306)
Add/deduct: 900 MHz adjustment (see paragraph 2.313)
Adjusted Oftel LRIC
Percentage difference between adjusted FAC and adjusted LRIC
Percentage difference between adjusted FAC and adjusted LRIC
excluding the market share adjustment






Source: CC based on information from the MNOs.

Note: Totals may not add due to rounding.

2.309. Table 2.7 shows that the average MNO had an FAC cost per minute for incoming
calls in 2001/02 that was 15 per cent lower than the adjusted Oftel LRIC model after our market share adjustment and at 11.25 per cent real cost of capital. All the MNOs’ FAC costs were,
on this basis, lower than the adjusted LRIC, with the smallest difference being 3 per cent.
Before the market share adjustment, the average MNO’s FAC was 7 per cent above the
adjusted LRIC. One operator’s cost was 3 per cent below adjusted LRIC and three were above.
Details of these results are shown in Table 7.8. We regard the lowest of the differences between
FAC and adjusted LRIC as being well within the range of variations that might be caused by
slight differences in methods of calculation, timing, measurement error or approximations in
the calculations.
2.310. From our comparisons between the results of Oftel’s LRIC model and the MNOs’
FAC estimates, we are satisfied that the Oftel LRIC model outputs for 2001/02, as adjusted in
the ways that we have described, form a suitable starting point for estimating costs in the period
from 2002/03 to 2005/06. We believe there is very little risk that the adjusted results underestimate the cost of a reasonably efficient operator. If anything, the adjusted LRIC result for
2001/02 may overstate costs, first, because of the low data uplift factor that we used (if we had
used a higher data uplift, we would have needed a lower adjustment to the LRIC outputs, and
this would have given a lower adjusted LRIC result); second, because of the market share

adjustment that has been applied to all four MNOs; and third, because of the relatively large
economic depreciation adjustment in our base year as compared to other years, which the DGT
told us could have been overstated.

Cost trends 2002 to 2006
2.311. Having decided that the Oftel LRIC model results in 2001/02 should be adjusted to
reflect more closely the actual results of the MNOs, we turned to consider the estimates of costs
for terminating calls in the following years up to 2006. We found that the most significant factor affecting the estimates was the DGT’s expectation that the cost of new equipment would
continue to decrease. The forecast changes in traffic volumes, which for a single MNO were
small due to the market growth being offset by the introduction of Hutchison 3G, had very little
impact on the cost of calls. We therefore decided to focus on whether the equipment cost trends
forecast by the DGT appeared to be reasonable.
2.312. Vodafone said that, if the Oftel LRIC model had been unable to replicate what had
already happened, it was astonishing that we believed that the model would be able to predict
what was still unknown. We considered this view but decided that, provided we had confidence
in an adjusted cost for 2001, and were in a position to assess why the cost changed in the years
after 2001, there was no reason not to use the Oftel LRIC model as our starting point for
reviewing the cost trends between 2002 and 2006.
2.313. The outputs of the Oftel LRIC model from 2002 onwards depend, therefore, on the
assumptions made about decreasing prices of equipment in the future. For most types of network equipment in the LRIC model, unit costs were assumed to decrease by 10 per cent a year,
whereas the cost of site acquisition and preparation was held constant, and site rental and lease
costs were assumed to [ 

] a year in real terms.
2.314. Vodafone told us that some costs were escalating, including site rentals and infrastructure support costs. Vodafone also provided details of its own forecast of equipment price
trends for the equipment in the Oftel LRIC model. T-Mobile also told us that its costs might
increase rather than fall, due to the need to improve network quality and to roll out 3G. The
DGT told us that the cost trend in the Oftel LRIC model for 2001/02 to 2005/06 of –7.2 per
cent a year was within normal bounds of forecasting sensitivity when compared to –5.7 per cent
a year which he calculated using Vodafone’s suggestions for modern equivalent asset (MEA)
prices for the period until 2010. The DGT told us that this suggested to him that the forecast of
–7.2 per cent was reasonable.
2.315. We considered that the DGT’s forecast, which reflected general industry trends for
a reasonably efficient operator without being specific to the equipment that had been selected
by any particular MNO, formed a reasonable basis for our view of costs looking forward. Much
of the recent increase in site costs, we believe, is due to the high number of sites needed for 3G
and in our view the increasing site rental and lease costs in the Oftel LRIC model adequately
reflect more general property cost trends. As the decreasing trend in equipment prices is the
most significant driver of the cost trend of terminating calls in Oftel’s April 2002 LRIC model,
we therefore concluded that this trend appeared reasonable.
2.316. Vodafone also argued that cost trends of equipment should continue beyond 2010,
rather than being assumed to be flat from 2010. The DGT told us that Vodafone’s suggestion
that equipment prices would continue to decline beyond 2010 was less plausible than his
assumption that prices would fall until 2010 and then would remain constant in real terms.
2.317. Clearly, equipment prices beyond 2010 are difficult to forecast, but given that by
2010 the forecast will have been for up to 20 straight year-on-year cost reductions, we believed
it more reasonable and conservative to assume that equipment prices would remain constant in
real terms rather than carry on falling.

2.318. The MNOs expressed general concerns about the use of volume forecasts in the
LRIC model. For the existing operators, annual traffic volume is assumed to increase by less
than 5 per cent a year in the period to 2006, because most of the growth in voice calls overall is
assumed to be offset by a decreasing market share for each of the existing MNOs as Hutchison
3G enters. We think this is a reasonable forecast, although we recognize that these matters are
very uncertain.
2.319. Starting with the result for 2001, we estimated the cost trend from 2002 to 2006. As
shown in Table 2.8, we first adjusted the 2001/02 Oftel LRIC cost of terminating calls for the
equipment understatement (see paragraph 2.298) and the operating cost overstatement (see
paragraph 2.300). We projected this total forwards using the cost trend in the April 2002 Oftel
LRIC model. We then made our 900 MHz adjustment (see paragraph 2.307) that was fixed
across all years. Finally, we multiplied the total by the market share adjustment (see paragraph 2.280) that was based on the market share of one MNO as set out in the Oftel LRIC
model, divided by the market share of one MNO as defined by us.
TABLE 2.8 Derivation of CC-adjusted LRIC of terminating calls by year at 11.25 per cent cost of
capital at 2000/01 prices
Year ending
Mar 02
Combined April 02 Oftel LRIC
Equipment adjustment
1800 MHz (31% × 0.57 × Oftel LRIC)
Operating cost adjustment
(–11.0% × 0.43)
900 MHz adjustment
Market share adjustment
CC-adjusted LRIC
1800 MHz April 02 Oftel LRIC
Equipment adjustment
(31% × 0.53 × Oftel LRIC)
Operating cost adjustment
(–11.0% × 0.47)
900 MHz adjustment
Market share adjustment
CC-adjusted LRIC

Mar 03

Mar 04

Mar 05

Mar 06






























per cent


Market share of one MNO—Oftel
LRIC model
Market share of one MNO—CC











Source: CC based on data from MNOs and Oftel.

Non-network costs
2.320. In order to reach the total cost of the incoming calls service it is necessary to add
any appropriate share of non-network costs to the network cost that has been calculated. Nonnetwork costs are the costs of all activities that are not directly associated with enabling calls to
be made. The main types of cost that we considered in this category were incurred for the purposes of:

(a) acquiring customers, including a share of the costs of the MNOs’ own high-street shops

and telephone sales centres, commissions paid to third party retailers, and discounts on
handsets provided to new customers;
(b) retaining customers, including a share of the costs of the MNOs’ own high-street stops

and telephone sales centres, commissions paid to third party retailers, and discounts on
handsets provided as upgrades to existing customers;
(c) providing services to existing customers, typically including call centres to deal with

any questions or problems that the subscriber may experience;
(d) charging customers for calls, including billing, credit control, sales ledger and debt

collection for customers on contracts;
(e) encouraging higher call levels, including advertising, product development and market-

ing new services; and
(f) managing the business, including head office support functions such as human

resources, building costs and rent, and general IT costs, which can be grouped together
as administration costs.
2.321. We grouped the various types of non-network costs into three broad categories so as
to provide the information necessary for our purposes on a reasonably comparable basis:

Customer acquisition, retention and service costs (CARS)—comprising advertising
and marketing, handset costs, discounts and incentives; customer care; billing; and bad


Administration costs—to include general overheads, which MNOs could not allocate
more directly to cost categories such as network, or CARS.


Other costs requiring separate consideration, such as 3G amortization costs.

2.322. Table 2.9 summarizes the non-network costs in the three categories noted above,
based on the average across the four MNOs (details are shown in the tables in Appendices 7.2
to 7.5). The CARS costs shown are before taking account of offsetting revenue, such as the
proceeds of handset sales and any part of periodic subscriptions from contract customers. Cost
of capital on non-network assets is not shown, because we found that the MNOs had negative
working capital which was roughly equal to the level of their non-network assets.
TABLE 2.9 The four MNOs: summary of non-network costs for 2001*
£ million
CARS costs†
Administration costs


Source: CC based on information from the MNOs.
*Years to 31 March 2001 for Vodafone and O2, and years to 31 December 2001 for Orange and
T-Mobile. Appendix 7.15 shows the full table with confidential information from the MNOs.
†Before taking account of offsetting revenue.
‡Comprises costs that were irrelevant to a consideration of the costs of incoming calls. These do not
include 3G amortization costs, which were identified, as appropriate, in Appendices 7.2 to 7.5 for the
respective MNOs.


2.323. On this basis, non-network costs were between 51 per cent and 66 per cent of the
total accounting costs of MNOs and between 64 per cent and 77 per cent of total cost less interconnect and roaming costs.
2.324. None of these costs was clearly incremental to terminating calls. In deciding which,
if any, non-network costs should be allocated to the cost of terminating calls, we therefore considered the following criteria:
(a) Is the cost common to two or more services in the long run? If so, on what basis should

it be allocated to services?
(b) If not common, should it be allocated to terminating calls for either of the following


callers to mobiles cause the MNOs to incur the cost; or


callers to mobiles benefit from the cost incurred by MNOs?

2.325. The MNOs argued that most non-network costs should be recovered in part from
terminating calls because they were common, although in many cases they also benefited
callers to mobiles. O2, T-Mobile and Orange all said that most non-network costs should be
treated as common and recovered on Ramsey principles from all services. Vodafone told us that
customer care and billing should be treated as fixed common costs and recovered from
incoming calls on Ramsey principles. Vodafone considered that the customer acquisition and
retention costs were specific or incremental to acquiring and retaining subscribers. Further
details of the MNOs’ views are set out in paragraph 7.190.
2.326. The DGT told us that he did not believe that any customer acquisition costs were
incremental to the terminating calls service. The operators chose to acquire customers, he said,
and the fact that calls were then made to those customers did not result in any additional customer acquisition costs. The number of subscribers, the DGT told us, drove customer acquisition costs. Similarly, other non-network costs including marketing and advertising costs and
customer service were caused by services other than call termination.

zCommon cost
2.327. On the question of whether non-network costs should be considered a common cost
in the long run, we looked first at customer acquisition and retention costs. In our view, the
level of customer acquisition and retention costs was closely linked to the expected revenue
that the subscriber would generate: more money is spent attracting and retaining those
customers that generate the greatest revenue (see paragraph 7.154 and 7.155). Although we
received no evidence that more money was spent attracting customers who received the most
calls, we would accept that there is probably some correlation between the intensity of call
making and that of call receiving. However, if, in the long run, expected call revenues from any
service decreased then MNOs would be expected to scale back their expenditure. Therefore, we
did not consider that customer acquisition and retention expenditure was common to termination and other services in the long run.
2.328. We then examined whether customer service costs could be considered as a common cost in the long run, including the cost of resolving problems, billing, bad debts, and distribution of prepay cards. We decided that a very small element of this cost could be described

and usually do not. we saw little if any direct benefit to the caller. To the extent that customer acquisition and retention costs led to a mobile user either changing network or staying on a particular network for longer than they might otherwise have done. and property costs. and the element attributed to CARS was then considered alongside other CARS costs as described below. On this basis. over and above the non-network cost that we considered common. suggesting a difference in how costs had been allocated or an inefficiency). we considered the extent to which non-network costs led to benefits to callers.333. We separately considered the question of whether handset subsidies to encourage the introduction of new technologies may have led to lower network expenditures. the customer call centre to the extent that staff help to resolve technical problems that affect incoming calls). because we considered the purpose of the administration overhead to be to support all areas of the business. including network functions and customer acquisition. Most of this investment in handsets had taken place by 2001 and needs to be considered against the investment in handset subsidies that would have been given regardless of the operational benefits (which. zCaller benefits 2. To reach this figure we allocated the administration overhead across the different areas of the MNOs’ business in proportion to the direct cost of each area.195). in some cases when the receiving party has switched networks the caller might benefit from a cheaper on-net call. The element attributed to the network was then allocated by traffic volumes to individual services. and thus to a greater volume of calls. we calculated an addition to the LRIC ppm of terminating calls of 0. However. We concluded that it would not be appropriate to add any non-network cost to LRIC on the basis that callers either caused or benefited from the expenditure. It was apparent that little. For a caller from a mobile. Finally. human resources. 80 . To the extent that customer acquisition costs led to a new mobile phone subscriber (a small minority of customer acquisitions—see paragraph 2.3p in each year.331. if any. This included the costs of head office functions. Callers cannot be expected to. non-network cost was directly caused by callers to mobiles. including corporate IT. 2. 2. most customer service costs varied with either traffic volume or number of common across traffic services (specifically. we have seen. 2. retention and service functions. is not relevant to call termination). and so were not common. Callers to mobiles might contact a customer service centre of a mobile network if they experienced a problem.332. and assuming a reasonably efficient administration overhead of £130 million a year based on the average of three MNOs (we excluded one MNO’s cost figure from our average because it was significantly higher than the other three. zCaller causes cost 2. we believe that this is better captured by means of an externality adjustment. We then considered the extent to which non-network costs were caused by callers.329. The caller from a fixed line is unlikely to know what network the receiving party is on before or after switching network. we looked at administration overhead. but it is equally likely that the caller would suffer because a previously on-net call could have become an off-net call. We decided that it would not be appropriate to increase the LRIC of call termination to include this expenditure.330. Finally. know the telephone number of other networks’ service centres. For many off-net callers (those subscribing to networks other than the winner and the loser involved in the switch) the switch would make no difference. but we were told that this was unusual. We decided that this was a common cost that should be allocated across all areas of the business. nor would the caller care if the termination rates were the same.

The DGT told us that. Existing subscribers benefit when new customers make the decision to become subscribers because there is then a larger number of people whom they can call and from whom they can receive calls. the benefit would mainly relate to the ability to call or be called at times when this would not otherwise be possible (rather than at all). funding of the subsidy (see paragraphs 2.5 ppm externality surcharge.336. All the MNOs and Oftel told us that call termination charges should include an allowance to reflect the network externality. However. we begin by considering how the network externality might be defined (see paragraphs 2. the effectiveness of the surcharge in increasing mobile penetration (see paragraphs 2. and the consequences of a reduction in the subsidy 81 . but the principle remains the same. 2. a network. 2.06 ppm and 0. was more appropriate. which is the focus of our interest. which estimated the externality mark-up for fixed-to-mobile calls at between 0. The network externality was also the only kind of externality that we were confident of being able. A number of different types of externality have been identified in mobile networks.354). the nuisance caused by mobile phones ringing. at most.351 to 2. These types of externality are generally regarded as positive. This would be consistent with current regulation established following the MMC’s report in 1998.358 to 2. more people than they were before. described in the previous paragraph. BT told us that it agreed in principle with the proposition that we had canvassed in our Remedies Statement. and be contacted by.363).357).347 to 2. and people using mobile phones. Closely related to the network externality is the ‘option externality’. Other types of externality are described in Chapter 8. because these were either agreed to be small (for example. to measure.25 ppm.338. The principal type is the so-called ‘network externality’. as follows: internalization (see paragraphs 2. and he now took the view that 2 ppm was more likely to overstate than understate the appropriate externality surcharge. 2. BT said that it also agreed with the modelling work carried out on behalf of Oftel. In the following paragraphs. the DGT said that a figure of 0. 2. the option externality) or were not clearly related to the volume of subscribers. he had added a mark-up of 2 ppm to take account of network externalities. we are concentrating here on the network externality and it is not necessary for our purposes to consider the other types. which refers to the benefit to existing subscribers from having the ability to contact the new subscriber. however. there are network effects: the more people who join a particular network.350) and whether the R-G factor changes with penetration levels (see paragraphs 2.334. which recommended a 0.355 to 2.Externalities Introduction 2. the more valuable membership becomes. he told us that Oftel had undertaken further analysis since the start of our inquiry. or stay on.5 ppm. for example. In the case of mobile phones. which was that any subsidy justified by economic theory should relate to the benefit to existing mobile phone users.340 and 2.346). We then address in turn a number of related issues concerning externalities. broadly.341) and measured (the Rohlfs-Griffin (R-G) factor) (see paragraphs 2. 2. but negative externalities also exist. because people on the network are able to contact. at least some of the expenditure by MNOs to stimulate growth in the number of subscribers is also of benefit to existing subscribers of all interconnected networks. The benefit is an externality because it does not generally enter into the decision-making of the customer deciding whether or not to become a subscriber at a particular price.339. even if they do not do so.335. Later in our inquiry. both fixed and mobile. when he was considering the target average termination charge in the proposed charge control for the four MNOs. In telecommunications.342 to 2. brought about by marginal customers being induced thereby to join.337. For this reason. in public places.

Finally. In other words.372 to 2.386). (c) how effective the resulting subsidy would be likely to be in increasing mobile penetra- tion and maintaining current levels of mobile phone use. but regard must be had to costs. That society as a whole generally benefits from each new take-up of a mobile phone. and.371). how we might establish the extent of the external benefit that someone joining the network generates in relation to their own benefits from joining. 2. The concept of a network externality 2.(see paragraphs 2. for these people. The R-G factor is generally thought of as having a lower bound of one and an upper bound of 2. Finally.343. (d) what the benefits and detriments are of a subsidy funded by a surcharge on call termina- tion. that is.364 to 2. The marginal social benefit is defined as the sum of (a) the private benefits obtained by an additional subscriber and (b) the external benefits which existing fixed and mobile subscribers obtain from the addition of that subscriber.384) and our conclusions on the externality surcharge (see paragraphs 2. For people who are not willing to pay the marginal cost of joining. is consistent with section 3(1)(a) of the Act. we give our estimate of the externality mark-up that should be allowed (see paragraphs 2. the value they themselves would derive from joining is ‘not worth the price’. Thus. The R-G factor (sometimes also referred to as the ‘gross externality factor’) is defined as the ratio of the marginal social benefit of an additional mobile subscriber to the marginal private benefit. In considering whether an externality surcharge is justified in the context of the allowable call termination costs of the MNOs. because this enlarges the pool of people who can contact each other and be contacted in turn. Central to the notion of a network externality is the relationship between the private benefits that new subscribers obtain by joining the mobile network on the one hand and the external benefits which existing fixed and mobile subscribers obtain by virtue of that new subscriber’s joining. the questions for us are: (a) how the size of any surcharge should properly be measured. which imposes a duty on the Secretary of State and the DGT ‘to secure that there are provided throughout the UK such telecommunication services as satisfy all reasonable demands for them’. 2. on the other.385 and 2. The purpose of an externality surcharge is to provide a subsidy to encourage marginal non-subscribers on to the mobile network and to encourage marginal existing subscribers to remain there.341. The DGT put it to us that the external benefit generated by additional subscribers could be quantified using the so-called R-G factor. (b) how any surcharge should be funded. All new subscribers willing to join are deemed to derive a private benefit from joining at least as great as the private cost of joining. The R-G factor is then the ratio of (a) plus (b) to (a).340. it is assumed that the private benefit to them of joining is less than the cost of doing so. the benefit would not be much above one for a person who valued making 82 . and so these people do not subscribe.342. in the light of the answer to those questions (e) whether the benefits of an externality surcharge would outweigh the detriments in public interest terms. We considered how the network externality might be measured. Measurement of the network externality 2. we give our estimate of what the externality surcharge should be.

(These models are described and analysed in Chapter 9 and Appendix 9.7. For example. It meant. for Orange. Examples are people paying for children’s or parents’ mobile phone services.) We arranged for these models to be disclosed to the other main parties and to Oftel. 2. T-Mobile. and thus doubted that uninternalized externalities could mean an R-G factor as large as 1. as suggested by Oftel. Many submissions were made. and at the effects of various levels of call termination charges on consumers. and businesses acquiring mobile phones for their employees. In these cases.116 and Appendix 9.346. The more that the external benefits to others are taken into account in someone’s decision to join.and receiving calls but whom existing subscribers did not much value contact with. As a result of changed assumptions. and invited the main parties’ views on them. exchanged and commented on as the result of this initiative but no sort of consensus on the models was reached among the parties. 2.1. Dr Rohlfs said. The MNOs. Internalization 2. The R-G factor is reduced if the benefits accruing to others by virtue of someone joining the network are taken into account in that decision to join.106 to 9. these are set out in detail in paragraphs 9. The MNOs constructed systems of demand equations during our inquiry and. two or more subscribers might choose to subscribe to mobile networks primarily and explicitly to communicate with each other by mobile phone. 2. however. We looked carefully at the various methods of modelling the call termination charge. 83 . but Dr Rohlfs told us that that figure was not much more credible. An upper limit of two is proposed on the grounds that it is unlikely that existing members of the network would generally benefit by a greater amount in aggregate than the new subscriber when the latter joins a network. 2. mounted a number of arguments attacking the robustness of Rohlfs’s1 model. 1 Dr Jeffrey Rohlfs. which were presented to us in connection with estimating the mark-up on fixed and common costs. These arguments are discussed further in Chapter 8.348. Lexecon. the fewer are the external benefits that are not taken into account. through their consultants.7. Dr Rohlfs told us that the value of the gross externality factor implied by the initial estimates of Frontier Economics (commissioned by Vodafone) was over 7. An academic economist whose work led to the establishment of the R-G factor and who was engaged by Oftel as a consultant in relation to this inquiry. for example.1.344. and which it is the purpose of the surcharge and subsidy to stimulate. Or subscribers might contribute towards the cost of telephone services (both subscriptions and calls) for others with whom they have a substantial community of interest. Frontier Economics subsequently produced an implied R-G factor of 2. 2. and that such an extreme outcome was not credible. the network externalities are said to be to a greater or lesser extent ‘internalized’ and there is accordingly less justification for a surcharge. said that the argument underlying Dr Rohlfs’s assumption that network externalities benefiting mobile subscribers were largely internalized by MNOs was both empirically inaccurate and internally inconsistent. argued that the derivation of a low termination mark-up value in Dr Rohlfs’s work was driven by unrealistic assumptions about the degree of internalization of network externalities and cost levels in the industry.349. questioned the levels of internalization. BT put it to us that it was implausible to suppose that many users would not take the benefits to their family and friends of being contactable into account in their decision whether or not to buy a mobile phone.347. The R-G factor may be estimated either by a priori reasoning or by inference from a system of demand equations.345. that other fixed and mobile customers derived an implausible six or seven times as much value from communicating with mobile subscribers as mobile subscribers derived from communicating with them.

then the appropriate externality allowance would be correspondingly lower. The relevant survey evidence is set out in paragraphs 8. as most people now had a mobile phone. Hence. and consists partly of research by Oftel. it is clear that the higher the surcharge. To the extent that this is so. during the period when the mobile network had been growing. 2. Given. and partly of evidence from our own August 2002 survey (the August 2002 survey results being set out in Appendix 8. we take the view that the R-G factor is likely at most to have remained fairly constant over time and may have declined somewhat. To the extent that the MNOs were to be permitted a mark-up on their allowed costs of call termination. any such justification had now largely disappeared. although there will inevitably be individual exceptions to the general pattern.355. leaving the R-G factor constant. Some of the FNOs put it to us that we should take into account the disbenefits as well as the benefits of a surcharge. T-Mobile argued that there was no reason why late joiners to the mobile network should bring lower benefits to existing subscribers than early joiners. The survey evidence in our view shows that a significant proportion of network externalities have been internalized. Whether the R-G factor changes with penetration levels 2.354.2. we see no reason why it should have increased in recent years. Funding of the subsidy 2.5).116 and 8. Thus BT told us that high termination charges discouraged calls from fixed telephones and that. Although the evidence as to the extent of internalization is mixed. 2. compared with longer-standing subscribers who make many calls on a regular basis. In a market in which most people who want to make and receive mobile calls already have a mobile phone.351.113 to 2. we believe it suggests that the R-G factor is below 2. in order to fund a subsidy to encourage new subscribers on to the mobile network. BT argued that.117. it said. they are likely also to generate little additional benefit to existing subscribers. For that reason. This is also consistent with all the evidence presented by the MNOs on closed user groups and repeat calling relationships (see paragraphs 2. we would need to consider how such a subsidy should be funded. when subscribers who joined were keen to communicate. Overall. that the mobile market would be virtually saturated by the end of the period of the proposed price cap. BT believed that the externality surcharge represented little more than a tax on callers from fixed lines to mobiles. there had perhaps been justification for an imbalance in the charges paid respectively by fixed and mobile customers. both the social benefit and the new subscriber’s private benefit from joining should increase. partly of research by Vodafone. This is because new marginal subscribers will tend on average to make fewer calls to mobiles themselves and generate fewer incoming calls from others.352.350. especially for their highest-spending customers.121). 84 . the value which new subscribers place on calling and being called and the additional value which existing subscribers will place on calling and being called by each new marginal subscriber are both likely to be lower than was previously the case.353. 2.356. We considered whether there was any relationship between the R-G factor and the extent of mobile phone penetration. it said. The MNOs have some incentive to subsidize subscriptions. the public interest would be better served by encouraging customers to make full use of networks that most customers had already joined. With additional existing (fixed and mobile) subscribers. 2. at any rate. the more the MNOs have the incentive to make subsidies available.

We are not persuaded that the MNOs could not direct any subsidy specifically at marginal subscribers. for example. the MNOs may not consider it to be in their interests to do so. this means that some fixed-to-mobile calls which would otherwise have been made are not in fact made and all calls from fixed lines to mobiles cost more than they otherwise would. However. Vodafone said that it was not possible to introduce new tariffs targeted at the marginal subscriber. to persuade them to stay on the network. subsidies had to be offered to all subscribers. they represented a significant part of the market and were very diverse. then it is the FNOs’ customers who bear the greatest part of the funding of the subsidy. 2. It was not possible. or receive calls from. if a class of consumer is to bear the cost of a subsidy. Vodafone appeared to be making the untenable argument that absolutely no targeting was possible. clearly not the case. to the benefit of others who might call. to induce them to upgrade their handsets. change tariffs or make more calls. potential marginal customers derive less benefit from mobile ownership than those who have already joined the network. it remains the case that marginal subscribers. then those consumers’ interests might be prejudiced if they do not benefit from the existence of the subsidy. they said. Oftel said that the MNOs offered different tariffs appealing to different types of customer.362.361. As we have already seen. the value of each additional customer to the MNOs is likely to diminish. to non-marginal subscribers who do not need them. The effectiveness of a surcharge on call termination in increasing mobile penetration 2. some of it (and. As BT and Oftel put it to us. Commenting on Vodafone’s view that. however. who by definition are not so profitable for the MNOs.358. to become mobile subscribers.359. but in Oftel’s view. Some of the surcharge has been competed away in other ways than subsidy. But the reality is that the MNOs have (as we have seen earlier) a wide variety of pricing schemes which allow price discrimination by 85 . to identify marginal subscribers individually. in part. At the same time. it is the FNOs who contribute by far the largest share of the MNOs’ net revenues from call termination. and so require a higher level of subsidy to induce them to join. In this instance. obtain a smaller proportion of that subsidy than non-marginal subscribers. the sole purpose of the subsidy (the network externality allowance) is to induce people. most of it—see paragraphs 2. It is true that customers of the FNOs obtain some benefit from the expanded network brought about by the externality surcharge. Perfect targeting might not be feasible. which would not also be available and attractive to the non-marginal subscriber. them on the mobile phone they thus acquire. In our view. for example. in Oftel’s view. Subsidies go. or those new to the UK) these customers tend to be lighter users of phones and hence to be less profitable. who would otherwise not do so. in sales and marketing spend. in terms of the effect. Marginal customers did not comprise a homogeneous group with distinguishing characteristics. both the FE and DotEcon models have assumed constant per unit pricing.357.2. as we have seen. because it is spent on encouraging mobile customers to churn between networks. While it is true that some part of the subsidy funded by call termination charges currently finds its way to all subscribers. To the extent that.196 on churn) is also directed at existing subscribers. so as to target subsidies on them.188 to 2. in order to provide subsidies to marginal subscribers. 2. Although some of this spend is directed at potential new subscribers. because (other than those reaching an age when they begin to have sufficient use for a mobile. In so far as the subsidy does not have its intended effect.360. or to encourage or discourage churn. The MNOs told us that there were severe limits on the extent to which they could price-discriminate effectively between ‘marginal’ and ‘non-marginal’ subscribers. That was. There is another reason which tends to weaken the MNOs’ argument that they cannot target subsidy at marginal subscribers. 2. As penetration increases. then the FNOs’ customers who bear the cost of it cannot benefit from its existence. 2.

the utility of mobile ownership. 2. told us that. Another possible package could offer an initial tranche of calls at relatively low prices but successive calls at relatively high prices. The MNOs argued that reduced levels of subsidy would increase this risk. if they chose. and would expect them to replace their handsets in the ordinary way only every four years on average. BT suggested to us that the more disaggregated the MNOs’ approach to pricing. which represented the cost of maintaining them on the HLR. told us that. while a Ramseyadjusted externality approach would achieve optimal use of the network and of the number of subscribers. we estimate the total number of marginal subscribers to be around 12 million. stolen or broken. it would in our view be disproportionate to allow an externality adjustment if we thought that there was no ability to target on the MNOs’ part. 2. [  ] told us that MNOs could reintroduce time-limited vouchers for prepay customers to compensate them for reduced call termination revenues. target individuals who thought it worthwhile to have a mobile phone but did not use it very much. the lower the optimal mark-up on termination would need to be. We note that the incremental cost to MNOs of maintaining low users on their networks is very small—[  ] told us that it amounted to a few pence a month. and the perceived disadvantages of giving up a mobile phone after having used one would militate against subscribers leaving the network if subsidies were reduced.363. From our consumer survey (see Appendix 8. We considered the likelihood of substantial numbers of marginal existing subscribers leaving the mobile network if the subsidy for the externality surcharge was reduced. 86 . Whatever the precise position.virtue of subscribers’ self-selecting themselves on to alternative tariffs. this fall in subscriber numbers would result in underutilization of the network. Oftel said that the MNOs’ ability to price discriminate implied that to some extent the MNOs were able to internalize external benefits which accrued to the population of mobile subscribers and was a further reason for a reduction in the size of the surcharge on mobile termination from the 2 ppm it had previously recommended. too. in the maximization of the aggregate number of minutes on telecommunications networks. 2. The most appropriate package would be one offering a basic inexpensive handset and high call charges. Such a package would be attractive to marginal subscribers but not to high-volume users. In assessing the likelihood of existing subscribers leaving the network in response to reductions in handset subsidies.5).364. again making the package unattractive to high-volume users.367. Another important determinant of whether marginal current subscribers would leave the network if call termination revenue to MNOs was reduced is the willingness of the MNOs to retain such customers. we believe that the MNOs could. Vodafone.209). but it is harder for them to identify and target people who are not on any network. The level of handset subsidy would generally be expected to affect a marginal existing subscriber’s decision whether or not to continue his subscription only when his handset was lost. Orange.366. if prepay handset prices rose by £20. Consistent with our conclusion that the MNOs already effectively segment the retail market and price-discriminate in their offers to customers (see paragraph 2. we think that factors such as the high levels of mobile usage. The MNOs can identify and target marginal subscribers already on their networks (since they know their usage pattern). In Vodafone’s view. in its view. an economically inefficient outcome because efficiency consisted. Consequences of a reduction in the subsidy 2. 2. and the more non-linear the tariff systems. and who were concerned above all to minimize the amount they spent on it.365. a reduction of the subsidy would lower efficiency and welfare. for example. as many as 10 million to 15 million customers could leave the network over a matter of a few years.

371. given. The second approach involves capping the surcharge at a level that corresponds to the amount of subsidy which. considering leaving the network and some of whom are high spenders on mobile calls. that we regard an R-G factor significantly above 2 as implausible. More fundamentally. first. thus distorting the volume and pattern of network use. as the MNOs contend. attributable to the externality. we do not accept that. Therefore. and addressing the view that reducing levels of subsidy would be economically inefficient and would reduce welfare. and third. we take the view that there should be an externality mark-up on LRIC but that it should be very modest. if it were used for the purposes of bringing marginal customers on to the network and helping to retain them there. These detriments are higher charges for all callers to mobile phones from other networks. or the retention of existing. Rather. we take the view that the MNOs could.2. We now turn to consider how we might calculate the amount of the surcharge which would. We considered two alternative methods.368. 2. second. Most of the models also distribute the mark-up over termination and other services. 2. It follows from this that.373. that we do not believe that the MNOs would set their other prices on the basis of Ramsey pricing if the termination charge alone were regulated at Ramsey levels. The first approach involves the construction of a system of simultaneous demand equations and calibration using estimates of various price elasticities. The subsidy also encourages the replacement of handsets at the expense of network use. Having considered all these matters. who are ultimately providing the subsidy by funding the surcharge on call termination. High termination charges (embodying high levels of surcharge) make fixed-tomobile and off-net calls more expensive and tend to result in fewer and shorter calls. Estimate of the externality surcharge 2. in principle. are very largely funding an ineffective subsidy. The evidence. suggests that. be effective in generating external benefits. that we have reservations regarding the estimates of the elasticities used in the models (which in many of the models are the way in which the externality is encapsulated). fewer and shorter calls to mobiles from other networks and enforced subsidization by FNOs’ customers of a form of competition which is becoming less and less effective in bringing more subscribers on to the mobile network. however. As we show in that chapter. it is either encouraging switching of existing subscribers between the different mobile networks or simply funding upgrades of handsets for subscribers who are not. marginal subscribers. in any event. Finally. 2. any externality mark-up should be either very small or not allowed at all. targeted at marginal customers for whom it would make the 87 .369.372. we do not view such models as an effective means of calculating the mark-up over termination attributable to the externality. 2. On the grounds that a targeted subsidy could have the effect of bringing marginal customers on to the network and helping to retain marginal customers.370. the claimed overall efficiency brought about by the subsidy at its present level more than outweighs the detriments resulting from it. The problems associated with these models are discussed fully in Chapter 9. on the basis of Ramsey pricing. target with a broad degree of accuracy any subsidy funded through a surcharge on call termination to existing marginal subscribers and potential new subscribers. many of the results derived from the MNOs’ models imply an R-G factor of over 2 (in some cases significantly greater than 2). this is having a limited impact on the recruitment of new. unnecessary upgrading and switching of handsets and of customers between one network and another. we believe that there are efficiency losses associated with subsidization of marginal customers by way of surcharges on mobile call termination and that these have to be set against the benefits of increased overall mobile membership. This means that the customers of the FNOs. if required to do so. to the extent that the surcharge is currently being used to subsidize handsets.

we think that 1. as estimated on the basis of the results of our first BMRB survey (see Appendix 6.99) incorporated subsidy which would be put at risk by reduced termination charges. presents some problems but we decided to adopt it.11 ppm) is the surcharge required to provide the level of subsidy sufficient to induce on to the network all those marginal existing and non-subscribers for whom the external benefits that would thereby be generated exceed this subsidy.378. it would not require perfect price discrimination (that is.11 ppm surcharge would be required—that is.1. For example. in that they would need some inducement to remain on the network were their handset to be lost. The MNOs objected that the minimum handset price (taken by us to be £69. In doing so.374. 2. Oftel thought that each provided a useful cross-check on the results of the other. Their comments are set out in paragraphs 8.14 (see paragraph 8. 0.5.214 to 8. 88 . 2.99 (see paragraphs 8. Our survey results suggested that 12 per cent of non-marginal subscribers would purchase their own handset in any event (although they would not be prevented from receiving the subsidy).2). the £23. precise targeting of the subsidy).199 to 8. if each marginal customer paid an amount exactly equal to his valuation of network membership—only half the 0. based on the proportion of those people aged 12 or over who are currently without a mobile phone (around 16 million) and who would consider getting one. This approach.1. but we have decided that we should err on the side of caution with respect to the MNOs’ finances by allowing an R-G factor as high as 1.223).210) shows the estimated surcharge under a range of different input assumptions.224. on the assumption that marginal subscribers’ valuations of network membership are evenly distributed from zero to £70. because it avoids reliance on elasticity estimates. which all the MNOs challenged. described in paragraphs 8.375. stolen or broken. We estimated that the externality surcharge that would be justified according to the external benefits it would generate—were the MNOs able to target these customers and were they to have the incentive to do so—was 0.242 are set out in Appendix 8. However. including a survey carried out for us by BMRB (see Appendix 8.11 ppm.5. It should be noted that.difference between joining and not joining a mobile network. although a subsidy of £23.33 per marginal subscriber (see paragraph 8. for a value of the R-G factor of 1. brings about at least as much external benefit as the amount of the subsidy. 2. The calculations also employed an estimate (of four years) for the length of time that handsets of marginal customers last before being lost. stolen or broken. Orange told us that the commission on its most basic handset was a little over £[].05 ppm. The MNOs made a number of criticisms of the methodology we had adopted in arriving at these estimates. As Dr Rohlfs’s and our methodologies were somewhat different.33 uniform subsidy would be sufficient to attract 33 per cent of all remaining marginal subscribers (both current and non-current) on to the network or induce them to stay on the network. too.5 is likely to be an upper estimate of the R-G factor. These included an estimate of the mobile saturation level.376.33 would need to be targeted at marginal customers. If perfect targeting were possible—that is. our estimate of the numbers of such customers was made using data from our second BMRB survey (see Appendix 8. in particular the assumptions that they were able to target marginal customers and had the incentive to do so.) This (0.5). we note that the minimum handset price is currently £49. (In fact. The range of assumptions and calculations we used. set out in Appendix 8.377. Table 8. and adopts a more plausible R-G factor than the first approach. 2. we used various survey and other published data. Oftel told us that work commissioned from Dr Rohlfs had obtained similar levels of surcharge when he had modelled substantial targeting of subsidies. Underlying the calculations were a number of assumptions. and an estimate of the minimum price of a handset (with SIM card).1 for the calculation). The calculations also included an estimate of the number of customers already on the network who might be considered as marginal.220 to 8. We calculated that this level of subsidy was £23.5). 2.208 and Appendix 8.

03 0.386) Extra subsidy to existing subscribers for whom Subsidy to non-current subscribers is more attractive (see paragraph 2.236). this would induce 41 per cent of all marginal non-subscribers to join the network. Finally.33 might be more influenced by the offer to non-subscribers.380.11 ppm as we discussed earlier in paragraph 2.45 ppm.385. 2. because this lies mid-way between 0. Oftel objected to the amended calculation of the externality surcharge because it involved directing a subsidy at marginal existing subscribers for whom the marginal external benefit was less than the marginal resource cost (ie the subsidy). stolen or broken might require a discount of almost the full price of a handset if his or her spend was very low.03 ppm to the surcharge (see paragraph 8. which adds 0.381.41 Source: CC. we investigated the sensitivity of this result to changes in some of the parameters used to calculate it. As before. on the other hand. Thus.380 to 2.379.34 0.235). As noted in paragraph 2.34 ppm (see paragraph 8.33 should be offered (as described in paragraph 2. 2. Conclusion on the externality surcharge 2. However.382 can be varied to take account of the amount of targeting of subsidy that might actually be possible. customers with very high spend might require little or no subsidy.387) Total 0.33. Oftel said that the correct amount of surcharge was 0. Those marginal current subscribers who would receive a subsidy of less than £23. The calculations in paragraphs 2. Assuming as before that marginal customers are evenly distributed between £0 and £70 according to their personal valuations of network membership. This is derived from the amounts referred to in the previous three paragraphs as shown in Table 2.10 Externality surcharge justified according to the amount of targeted subsidy (ppm) Subsidy to existing subscribers (see paragraph 2.04 ppm to the amount which must be raised by the surcharge (this calculation is shown in paragraph 8. We conclude that the mark-up on the termination charge that should be allowed in order to take account of externalities is 0. 2. a customer whose handset was lost. marginal existing subscribers would be offered an average subsidy of £35.385) Subsidy to non-current subscribers (see paragraph 2. 89 . We considered the effect of reducing handset life for marginal current subscribers from four to three and a half years and increasing the price of the cheapest handset to £75. Thus the total surcharge justified on the basis that some targeting is possible is 0. stolen or broken would require a surcharge of 0. so could effectively target the marginal customers individually because their level of spend can be taken as an indicator of their private valuation of mobile subscription.5 ppm. from 0.234).380.380) which would add a further 0. Changing these assumptions would take the total surcharge.5. So far as marginal current non-subscribers are concerned. Provision of a £35 (average) discount to the 3 million current subscribers who would be marginal every year because their handset was lost.41 ppm.41 and 0.384. 2. we estimated (on the same basis as before) that a uniform subsidy of £23.2. In the case of current subscribers we note that MNOs know the level of spend of all their customers. This effectively means that the minimum subsidy that could be offered to existing subscribers is £23.10: TABLE 2.41 ppm to 0.04 0. the average discount that the MNOs would have to offer is £35.385. on our estimation.382. 2.383.

2.30 0.59 Source: CC.45 5.73 1800 MHz Adjusted LRIC* Non-network costs Externalities Total 6. Table 2.73 8.390 to 2.45 5.45 4.82 6. that would not produce adverse effects because.59 1800 MHz (2000/01 prices) RPI–9 RPI–12 9.96 7.8.57‡ 9.45 7.30 0.41 0.01 6.0p a minute. TABLE 2. As a cross-check on our externalities calculation. they would still be above our estimate of total costs in each year to 2006.35 0.20 7.01 5. we compared the result with the amount which the MNOs are currently spending to acquire each new mobile customer.30 0. non-network common cost. ppm Mar 03 Year ending Mar 04 Mar 05 Mar 06 Combined 900/1800 MHz Adjusted LRIC* Non-network costs Externalities Total 5.25% cost of capital.45 5.25 per cent.11 Summary of cost of call termination (at 200/01 prices) 11.99† 8.45 7. whatever they lose in above-cost termination charges they gain whenever they make a call as a mobile customer.30 0. These are calculated at our cost of capital of 11.45 5. Because the various components of our calculation of spend on acquiring new customers were necessarily imprecise (for example.45 6. 90 .99† 8.388. These arguments were as follows: (a) Even if the MNOs were.26 0. Arguments for and against high termination charges 2.83 0. We now draw together all our findings on costs.4). Costs of call termination—conclusion 2.54 0.400.10 3.48 7.5p and 3.98 0.30 0.58 4.29 4. the amount which retailers spend on acquiring customers out of the incentive payments made to them by the MNOs is impossible to ascertain with precision) we sought to estimate a range rather than a single figure. in the absence of a price control.41 ppm to acquire each customer that was new to the mobile network altogether (see Appendix 8.30 ppm and 0.71 4.45 6. We now turn to consider a number of arguments concerning whether high termination charges have beneficial or detrimental effects in terms of the public interest.57‡ 8.16 4.386.51 0. since access is subsidized and some outbound charges are low.30 0.46 7.26 2002/03 2003/04 2004/05 2005/06 900/1800 MHz (2000/01 prices) RPI–9 RPI–12 8. as most people have a mobile phone. These results show that termination charges are currently above total costs of call termination by between 2. *As per Table 2. †Provided by Vodafone.93 7.11 brings together our estimates of network cost LRIC.30 0. We note that if future termination charges were set at either RPI–9 or RPI–12. to set high termination charges in order to subsidize customer acquisition at the retail level. We calculated that the MNOs were spending between 0. ‡CC estimate.96 0. and externalities. We consider this distributional argument in paragraphs 2.30 0.387.26 6.

for example. Distributional argument 2. were those without a mobile phone—roughly 15 per cent of the population—as these people called mobile phones but did not themselves own one.422). (f) High fixed-to-mobile termination charges distort consumers’ choices (see para- graphs 2. 2. in that position. we discuss this possibility in paragraphs 2.423 to 2. in the absence of a price control. This group had a disproportionate number of elderly and lowincome people in it. We obtained from Oftel estimates of the number of people who had a fixed-line telephone but were without a mobile phone. ownership of their home). (c) A reduction in termination charges as proposed by the DGT would have a detrimental impact on other businesses in the mobile sector.413 to 2.416). Of the 8 million. We consider each of these arguments in turn.392. while benefiting the FNOs. 10 per cent. There were few ‘losers’: the number of fixed-line customers who subsidized 91 . Oftel said that the distributional issue was one of fairness. the termination charge could be much higher than at present and that would exacerbate the distributional problem brought about by an undue subsidy. Oftel believed. retailers. those receiving incoming calls were predominantly the same as those benefiting from lower call charges. Oftel said that. because most people had a mobile phone. beginning with the distributional argument. and there was a close alignment of the interests of customers who had both a fixed line and a mobile phone.500.393.427). there was a significant number for whom the effect could be important. We address these consumer welfare issues in paragraphs 2. because mobile subscribers.412.401 and 2.417 to 2. The MNOs advanced the argument that.390. It was quite true that. Individuals with both types of phone who used them in approximately equal measure could not be said to be subsidizing themselves. that was a large number of people—around 5 million. Oftel told us that (according to results from a survey taken in February 2002) there were some 3 million households. with a high UK mobile ownership penetration rate. The vast majority of customers of fixed-line networks were also themselves customers of mobile networks. 2. these were the same people. about 2 million made at least one-quarter of their total fixed calls to mobiles. O2 put it to us that. for example. 2.402. Oftel told us that its research showed that two-thirds of fixedline-only households earned less than £11.391.403 to 2. 2. (e) A reduction in termination charges as proposed by the DGT would have a detrimental impact on 3G services (see paragraphs 2. (d) A reduction in termination charges as proposed by the DGT would prejudice the MNOs’ ability to finance their businesses (see paragraphs 2. compared with just over half of mobile-only households (although the older retired fixed-line-only households might have more assets—for example.389.(b) The MNOs’ use of revenue from termination charges to fund (or subsidize) customer acquisition at the retail level is beneficial to consumers and society at large and its removal would be detrimental to consumer welfare. who both value calling and receiving calls and whom others (including fixed-line customers) value calling and receiving calls from. representing some 8 million people. what they lost in high termination charges they gained in low access and outgoing call charges. in some cases. The people most adversely affected. It was not fair that callers to mobiles should unduly subsidize mobile customers. and customers with only a mobile phone. Further. even if the proportion of the population affected adversely was quite modest. However. would leave the network.

falling. that approximately 60 per cent of fixed-line-only subscribers made no more than one call a week to a mobile phone. We consider that all these comparisons need to be treated with caution. if termination charges were price-capped and subsidies had to be reduced or removed. Its NOP research indicated. 2. it would be mobile-only customers. to be from lower income groups. moreover. Lexecon. Oftel said. high. This was because Orange had.396. If mobile subscriptions were efficiently priced (according to Ramsey principles). 50 per cent used payphones to call mobiles and of this 50 per cent. challenged Oftel’s data on the relative sizes of the fixed. Orange said that the mobile-only group was in fact the poorest group of customers.25 million people. Oftel’s market research (from November 2000) into users of payphones showed that at least 12 per cent of British adults used payphones at least once a month. in Oftel’s view. T-Mobile made similar points. It would be wrong for the CC to conclude that mobile call termination charges should generally be set at inefficiently low levels to protect these consumers. as a consequence. on behalf of Orange.397. although about half of the mobile-only group were among the most disadvantaged in society. the fixed-line-only households. thus in Oftel’s view paying an excessive termination charge without any benefit from lower prices at the retail level. it said. if mobile termination charges were too low and access charges were. in contrast with approximately 30 per cent of people who were mobile subscribers. Oftel in turn submitted evidence to us that the group of mobile-only customers represented only 5 per cent of households or about 1. moreover. No agreement was reached between Oftel and Orange on these matters during our inquiry and we were unable to establish to our satisfaction precisely which group—the fixedline-only or the mobile-only households—was the more disadvantaged financially. Second. smaller group. Of these. Its research showed that. 31 per cent did not own a mobile phone. Frequent payphone users tended to be younger than the general population profile.398. but that would simply be the consequence of having efficiently-priced termination charges. rather than fixedline-only customers. Orange. This equated to 850. to live in rented accommodation and to have no fixed line at home. O2 and T-Mobile argued that. it would be better to allow mobile call termination charges to be set at efficient levels and make special provision for the groups adversely affected. it could well be that these consumers would be ‘losers’ if mobile call termination charges were to be efficiently priced. but who make calls to mobiles. Vodafone made several points. the other half were significantly more wealthy and had chosen not to have a fixed-line telephone because of their lifestyle rather than because of financial constraints. however. failed to recognize that the retail mobile market was imperfectly competitive and because it had also ignored possible increases in fixed-to-mobile call volumes following price reductions for those calls as the result of the regulation of mobile termination charges. that Orange had overstated the loss to mobile-only consumers in terms of the higher outbound charges that would arise from a reduction in termination charges. who would be disadvantaged.and mobile-only constituencies and on the income of mobileonly households. some of the 3 million homes could be expected to take up mobile subscriptions over the next few years. Oftel considered. 2.395.394. and the total level of ‘subsidy’ that they provided was also very small and not sufficient to justify public interest concerns. First. There is phone users was very small and declining. in relation to those who were unlikely to take up a mobile subscription but did make calls to mobile phones. Third. 2. who were significantly worse off than the main beneficiaries. It said that the proposed regulation of termination charges would be to the detriment of the mobile-only households. Vodafone said that. Vodafone said that the evidence clearly showed that fixed-line-only households made fewer calls to mobiles than did those who also had a mobile subscription. although we are satisfied that the fixed-line-only group is the larger of the two. then these 3 million fixed-line-only homes were much less likely to take up mobile subscriptions.000 adults who frequently used payphones to call mobiles but did not own one. 2. which contains people who do not own a mobile phone. 92 . and that this number was. 2. it said that.

For these reasons. 2. All those who have both a fixed line and a mobile phone will suffer a detriment to the extent that they use their fixed line instead of their mobile phone to call a mobile phone. Vodafone said that the MNOs were not profligate in offering subsidies to mobile customers. This structure of pricing may. Vodafone said.2. for example. the MNOs had no incentive to offer subsidized handsets to an unnecessary extent. the subsidy maximized aggregate consumer welfare. The availability of lower-priced handsets in the period 1998 to 2001 had allowed millions of consumers to acquire mobile phones. All the MNOs had begun by charging high prices for handsets (O2 and Vodafone in 1985 and Orange and T-Mobile in 1993/94). Beyond that surcharge. the appropriate extent to which that benefit should be reflected in the termination charge is the externality surcharge (see paragraphs 2. we reject the argument that high termination charges used to subsidize customer acquisition costs and the price of outbound mobile phone calls do not produce adverse distributional effects. and whether it encourages patterns of behaviour which are undesirable.401. In particular. because each MNO has a monopoly on call termination on its network. consumer welfare is maximized only through the current structure of prices prevailing in the mobile sector. We believe that the structure which has existed over the past four years has produced an inequitable outcome so far as the customers of the FNOs are concerned. or too little use of handsets in relation to the investment made in them. These customers bear (through their call charges to mobile phones) the costs of high termination charges (above those appropriate to correct for network externalities) that are used to fund mobile customer acquisition and retention. in particular. In our view. such as over-frequent upgrading of handsets. in effect. It is not only these groups that suffer loss by virtue of high termination charges on calls to mobile phones. in theory. be an efficient way to recover fixed and common costs. whether that pricing structure is equitable as among different telecommunications users. We do not accept the MNOs’ arguments that. costs are loaded (via high termination charges for fixedto-mobile and off-net calls) on to consumers who are not customers of the MNOs who. 93 . bringing benefits to them and society as a whole. But in our view. Consumer welfare 2. and had found that customers were particularly sensitive to handset prices. We believe that the group of payphone users who call mobiles but do not themselves own a mobile phone also unfairly contributes to funding the MNOs’ customers through high termination charges. whether it encourages or impedes competition. are able to impose excessive charges on them. It is not. These other considerations include. we do not accept that it is fair that fixed-line customers who call mobiles should subsidize mobile phone subscribers. it said.334 to 2. typically. in our view. this was not surprising for a young technological industry where product innovation had led to rapid technological development and significant improvements in call quality. in Vodafone’s submission. Vodafone told us that. 2. or who make more off-net calls to mobile than they receive. The MNOs said that the funding of subsidies for customer acquisition from termination charges was justified because it brought about the maximization of aggregate consumer benefit.400. this is not only a distortion that particularly disadvantages certain groups of fixed-line-only and payphone customers but also operates as a detriment to all customers who use fixed-line telephones more than mobile phones when making calls to mobiles. necessary to decide whether fixed line-only or mobile-only customers would be the more advantaged or disadvantaged by a price control on termination charges. Moreover. as a result of this they had reduced their prices.402.399. consumers replaced their handset every three years (other MNOs thought every 18 months or two years).386). In short. We acknowledge that fixed-to-mobile callers benefit from there being as many people with mobile phones whom they can call as possible. This has encouraged a frequent replacement of handsets while at the same time distorting the volume and pattern of use of fixed and mobile telephony. by discouraging fixed-to-mobile calls. but there are other considerations which we believe should be taken into account in assessing whether a particular pricing structure operates in the public interest. The other MNOs made much the same points. or make more off-net calls to mobile than they receive.

In particular. then they would be worse off. In any event. albeit not necessarily proportionately to the extent to which its customers make fixed-to-mobile calls (see also paragraphs 2. or the volume of calls involving mobiles. This objection was advanced in the strongest terms by Orange. Orange implied. for which we make allowance) and we note that there is no universal service obligation on the MNOs. BT’s retention would be regulated as part of a basket of retail prices. once people have acquired a mobile phone. It would be for Oftel to intervene if it appeared that a lack of competition was enabling the unregulated FNOs to benefit from the removal of the subsidy to the MNOs instead of passing it on to their customers. To the extent that retailers currently use the funding provided by the MNOs not to offer subsidies to customers but to improve their own margins. We have received no evidence that mobile phone use is an activity particularly deserving of subsidy (other than to the extent of the network externality. BT. In so far as the largest FNO. the FNOs would gain a windfall. 2. We must take account of the fixed sector as well. if that brings significant disbenefits to fixed-line customers. are obliged by commercial pressures to pass on the benefit to their customers. 2.474 to 2. this outcome might be regarded as a reasonable price to pay for a more equitable price structure overall. in a saturated market. in the absence of subsidy. would be to reduce somewhat the demand for their services and products. unlike BT. the benefit must be passed to BT’s customers rather than being retained by BT itself. The MNOs argued that reduction of their subsidies aimed at customer acquisition would have a detrimental impact on others in the mobile sector while benefiting the FNOs. We do not accept this argument. We discuss later (see paragraph 2. is regulated by reference to a basket of retail prices. To the extent that the other FNOs which. as people would be likely to keep their handsets for longer. Orange said that its concern arose particularly from the recent decision of the DGT that. we conclude that we do not expect any significant reduction in the number of subscribers. However. 2. There may well be some small fall-off in subscriptions but we believe that such falloff is likely to be rather less than the MNOs have suggested because. to some extent compensate for any falloff in business which the removal of the subsidy on 2G handsets might bring about.407. handsets would be upgraded less often and would be kept for longer. However. in particular retailers selling mobile packages and handset manufacturers. are not regulated.403. if there is sufficient consumer demand for it.573) whether a reduction in termination charges might bring about a reduction in mobile phone subscriptions. which argued that a price cap on mobile call termination charges should be accompanied by a pass-through requirement. either directly or indirectly. 94 . the reduction would deter the take-up and use of mobile phones. The effect on others in the industry who benefit from the current subsidy. and it would unjustly benefit the FNOs. it would prejudice the financial position of the MNOs and the handset manufacturers and retailers. we think that the effect of a reduction of the subsidy on mobile subscription is less clear-cut than the MNOs have represented it to us. However. as it had been previously. and hence not against the public interest. We consider it likely that. rather than individually regulated. That is indeed our view. with effect from 1 August 2002. We therefore expect all customers to benefit from a reduction in termination charges. The MNOs also put it to us that removal of the subsidy would enrich the FNOs at the expense of the MNOs. 2. Otherwise. they will not readily give it up. the introduction of 3G will.404.477).Reduction or removal of the subsidy would be detrimental to mobile sector and benefit FNOs 2.405. where much of the retailers’ and handset manufacturers’ business is concerned with handset upgrading rather than with servicing new subscribers.406. then they too could not become unfairly enriched. we do not accept the MNOs’ arguments that our objective should be to maximize the number of mobile subscribers. whereby the reduction in mobile termination charges would have to be passed through directly by the FNOs into fixed-to-mobile charges.

found it very difficult to compete in this area.412. Finally. this reduces the overall level of competition for telecommunications services and hence. There was evidence that fixed and mobile operators did compete for at least a part of the consumer demand for telecommunications services. as its NOP survey showed. Vodafone said that there was no evidence that mobile customers were making more on-net calls at times of day when such calls were cheaper than fixed-to-mobile calls. it said. a matter which the CC had not. which derived from the artificially high termination rates they had been charged by the MNOs. with mobile networks still in the process of establishing themselves (despite increasing penetration). Vodafone submitted that fixed and mobile subscriptions did not compete in the same market. that consumers purchased a mobile subscription to complement a fixed subscription. 2. Orange told us that the argument that FNOs were adversely affected depended critically upon the presumption that MNOs and FNOs competed in the same market. even if they are not formally in the same market. 2. consumers would be expected to use up more of their bundled minutes. Moreover. some degree of competition existed between fixedto-mobile and on-net calls. The underlying situation of the two sectors was very different. But. that would not lead to any appreciable distortion of competition between FNOs and MNOs in selling subscriptions. indirectly.410. All in all. mobile technology was more expensive than fixed technology and this fact was widely recognized. to the extent that fixed subscribers contributed to subsidizing mobile subscriptions. and the difficulties that the FNOs experienced as a result in securing call business. 2. We think that there is at least a degree of substitution at the level of call origination between fixed and mobile calls. the FNOs found it difficult to increase their call volumes. it said.409. Oftel said that. Vodafone said that. the evidence did not support an argument that there was appreciable on-net substitution for fixed-to-mobile calls. the existence of the subsidy extended to mobile phone customers would still tend to skew usage from the inherently lowercost (fixed line) to the higher-cost (mobile) technology. not as a substitute for a fixed subscription. a user on a ‘Leisure’ tariff would use [] per cent of available minutes. so far as the impact of high termination charges on other operators was concerned. and were seen by their customers as responsible for the high prices they charged. the public interest would not be prejudiced by asymmetric regulation of the fixed and mobile markets.2. to the detriment of consumers both individually and in the aggregate. Vodafone said. and the effect of not allowing recovery from general revenues was much more serious for the MNOs than for the FNOs.411. We do not accept the MNOs’ arguments. Oftel said. in any event.408. established. according to the evidence. even if every fixed and mobile phone customer used both products in the same ratio. results in an uneven playing field. To the extent that the high termination charges levied by the MNOs limit the degree of competition that the FNOs can present to the MNOs. 2. As to call origination. As noted above. O2 said that it was implausible to believe that fixed and mobile operators competed for calls and yet that this did not somehow constrain mobile operators in their approach to pricing. The FNOs. however. This meant that subscribers tended to use mobile phones only when they could not use a fixed telephone. made by people on the move. BT drew our attention to the adverse effect which the current price structure had on competition between the FNOs and the MNOs. Vodafone also drew our attention to the fact that mobile customers did not fully use up their bundles of ‘free’ minutes. The evidence suggested. 95 . Accordingly. typically. at least to any appreciable extent. high termination charges for fixed-to-mobile calls skew customers’ choices towards making on-net rather than fixed-line calls (whenever they are able to do so and are aware of the price differences). 75 per cent of mobile-originated calls were. If mobile subscribers were tending to make mobile-originated calls in place of fixed-originated calls. Therefore.

it said. Vodafone asserted that any reduction in call termination rates in the next 12 months would coincide with the launch of 3G. as there was no reason to think that the MNOs would bear all of the reduction themselves. at least. leaving the MNOs with stranded 2G assets. If there was spare 2G capacity. Vodafone.417. if call termination charges were required to be brought closer to costs. T-Mobile drew our attention to what it called the clear obligation of the DGT and the CC under section 3(1) of the Act to ensure that the MNOs’ ability to finance their activities was given primary weight in relation to price controls. The inquiry was not.416. The issue was whether the financial profile of mmO2.413.569). See note on page iv. See note on page iv. To that extent. its improving cash-flow trend would be reversed [ Details omitted. 2. was such as to enable the company to attract investment that would allow it to continue to compete effectively in the mobile market. 2. T-Mobile said that it would be forced to cut back on investment plans. said that if termination charges were set below efficient levels. Other operators. told us that it was not a question of whether voice callers to 2G mobile phones would fund the roll-out of 3G.414. then the benefits of the subsidy have been enjoyed not by the MNOs themselves but by their customers.] undermining the future level of competitiveness in the industry. Vodafone said that it would have the incentive to use it and delay the installation of 3G coverage. the impact that any regulatory action applied at the wholesale level might have at the retail level. and over such a period. it said. The MNOs told us that high termination charges were needed to finance 3G. Roll-out of 3G 2. as the MNOs have been arguing that it is. We were also told that the financial viability of one or more MNOs would be put at risk by an enforced reduction in termination charges. O2’s parent company. MNOs would need to reduce handset subsidies as a result of lower incoming revenue streams. BT argued that our inquiry concerned the structure of prices levied by the MNOs.415. The sale of these handsets would accordingly be slower than would otherwise have been the case and the widespread availability of 3G services would be retarded. for example. it said. there might well be an impact on other prices charged by the MNOs and possibly on commissions for retailers. to the extent that competition has been effective in the sector. to drop their mobile subscriptions and total call volumes would be likely to fall. [Details omitted. and consumers facing higher charges for subscription and voice calls would be less likely to be prepared further to increase their monthly mobile expenditure on 3G services. the removal of the subsidy should not adversely affect the financial standing of the MNOs. 2. had more flexibility in responding to the revenue losses that would result from a reduction in termination charges. Here. mmO2 plc. through 2G and shortly through 3G services. Marginal customers would be likely. about controlling or capping the MNOs’ overall profitability or driving down their total revenues. This would apply to the new and relatively expensive multimode 2G/3G handsets. we note that.418. T-Mobile told us that a price control involving a reduction in termination charges would have the effect of reducing directly the required level of its cash flow and hence limiting 96 . taking into account all revenues and costs. BT said it expected that. Any price control should therefore be set at such a level. that is.Financial position of the MNOs 2. 2. ]. in particular Vodafone and to a lesser degree Orange. 2.565 to 2. We discuss the financial impact of a price cap on each of the MNOs more fully later (see paragraphs 2.419. as to ensure that 2G and 3G licensees remained able to finance investment sufficient to enable them to compete effectively in the mobile market. It told us that if Oftel’s proposals for price control of termination charges were implemented.

O2’s and Vodafone’s by 80 per cent and Orange’s and TMobile’s by almost 70 per cent.424. 2. in addition to inefficient resource allocation. 3G was an incremental investment from which a degree of profitability was anticipated.422. 2. a crucial opportunity for T-Mobile [ Details omitted see note on page iv. Oftel took the view that a loss of subscribers in these circumstances would be an efficient outcome.423. This could lead to an inefficient allocation of resources. in 97 . We broadly share Oftel’s and BT’s views on this matter. as such customers would be valuing the existing service at below its resource cost. 2. Oftel said. because the call would most efficiently be provided over the fixed line. The result was economic inefficiency. However. then 3G should be capable of attracting funding. This. BT also submitted that the new EC Directives (see Chapter 4) did not permit a subsidy to be raised on interconnection charges paid by interconnecting operators simply to encourage MNOs to take on more customers than they would otherwise choose to do. if such profitability was sufficient to cover its expected cost of capital. however.425. in the sense of maximizing consumer utility relative to the resource costs involved in providing the service. with the result that some people left the mobile network and subscriber numbers fell. fixed-line customers with a demand only for voice call termination to mobile would be contributing to the cost of a new service for which they had no demand. Oftel told us that it did not think 3G should be subsidized but should stand or fall on its own merits. this distortion might lead. While the choice between fixed-to-mobile and off-net calls was not distorted. We put it to Oftel that if the lowering of termination charges brought about a reduction in (2G) handset subsidies or increased call prices. the effect of excessive termination charges for fixed-to-mobile calls was to deter consumers artificially from using a fixed line to call a mobile when they could make an on-net call instead. Oftel said that current regulated termination charges were already significantly above the costs of termination. it said. if this were to be the case. See note on page iv.420. to a distortion in competition. We believe as a matter of principle that the MNOs’ wish to invest in 3G does not justify termination charges that are in excess of a reasonable estimate of their cost.421.the extent of roll-out of the 2G and 3G network. required cash which T-Mobile said it simply would not have under the proposed price control. ]. particularly if those charges are ultimately derived from customers of FNOs. Whether or not this was the case was unclear to Oftel. 2. Indeed. since the price signals would induce consumers to use the higher cost service (mobile-to-mobile). We considered the argument put to us by Oftel that excessive termination charges for fixed-to-mobile calls distorted consumers’ choice between fixed-to-mobile and on-net calls. there would be fewer people able or willing to take up 3G services and that could affect the roll-out of 3G. ] and to create a new level playing field between all the mobile operators. since both reflected the same excessive termination charge. It was generally acknowledged that mobile technology used more resources than fixed technology. There was no linkage between that and any reduction in 2G termination charges. Oftel added that. existing technology. [ Details omitted. Distortion of consumer choice 2. 2. it should not depend on excessive charges being permitted on voice call termination using another. if mobile-originated and fixed-originated calls to mobiles were in the same market. with 3G investment being dependent on excessive 2G interconnection charges. BT also told us that the investment case for 3G should stand or fall on the basis of the functionality of the services provided. 3G was.

be likely to bring about a different and less distorted pricing structure. So far as the distributional arguments are concerned (see paragraphs 2.564 to 2. We have a duty to consider the distributional and other arguments discussed in the previous paragraphs in the context of section 3(2) of the Act. Orange said that it was incumbent on the CC to provide an economic analysis of the socially optimal prices before it could conclude that there was a price distortion. Our terms of reference require us to consider whether the termination charges of the four MNOs that are the subject of our inquiry would. Termination charges in the absence of a price control 2.566). particularly between fixed-to-mobile and on-net calls.429. For all the reasons we have set out in the preceding discussion.426. 2. we do not accept that the current structure of prices set by the MNOs is either economically efficient or operates to the benefit of consumers or society at large. or reflecting. However. and we note that Oftel said in its review statement of September 2001 that distribution arguments by themselves did not justify intervention. there was certainly the potential for the current level of termination charges to distort competition as well as to impair economic efficiency. The MNOs challenged the notion that the use of high termination charges to fund mobile customer acquisition brought about a distortion of the structure of prices. in our view. and also to provide evidence that such a price distortion was giving rise to significant consumer detriment. Indeed. this would not necessarily in our view be against the public interest. A pricing structure based on.147) that each MNO has a monopoly of call termination on its own network and that insufficient constraints exist at either the wholesale or retail levels to keep call termination charges down to cost (see paragraph 2. outgoing and inbound call charges would be achieved.428. We have also concluded that call termination 98 . the data is insufficiently robust by itself to support conclusions leading to action.406). We do not. Reductions in termination charges would. and this is an important element of our argument that action should be taken to reduce termination charges. Ramsey principles brought about a pattern of selling prices that maximized aggregate consumer welfare. and have adverse distributional effects of the kind already considered (see paragraphs 2. in the absence of a charge control on them. The whole concept of subsidy was inappropriate where a consumer was buying a bundle of services. Even if the retail market were fully competitive. T-Mobile also said that there were good efficiency reasons for the current vertically integrated structure of pricing. It distorts consumer choice by encouraging consumers to choose a higher cost service than they otherwise would. where there were externalities and where there were fixed and common costs to be recovered. be likely to operate against the public interest. we have found that the FNOs’ customers unfairly bear the costs of the distorted pricing structure that we have identified. believe that reductions in termination changes will be fully recovered by the MNOs by offsetting access or call origination charges. the setting of high termination charges in order to fund low access and call origination prices would produce a heavily skewed structure of tariffs which would both distort consumer choices. O2 said that. 2. We have already concluded (see paragraph 2.390 and 2. we think that reductions in termination charges might induce a temporary pause in the general decline of those other prices (see paragraphs 2.396 to 2. which would provide fewer incentives for consumers to acquire new handsets and greater incentives for them to make calls. Conclusion on arguments for and against high termination charges 2. far from being a distorted price structure.Oftel’s view.211). the current structure was consistent with principles of efficient recovery of fixed and common costs across a number of services. Vodafone argued that termination charges were not above the level at which an economically efficient balance of subscription.400). If a reduction in termination charges meant higher handset prices and subscriptions for mobile customers.427. however.

we now consider the MNOs’ arguments that they would have the incentive to set Ramsey prices in the absence of regulatory control and. The objection to Ramsey pricing which we mention earlier does not apply so strongly here (on equity. we conclude that the MNOs do not currently set Ramsey prices.433 into account. Vodafone. as these were put to us by the MNOs.431.432. in the absence of regulation. 2.211). Taking the considerations in paragraphs 2. so the question of possible entry is irrelevant). this price disparity would disappear. as we have already concluded (see paragraph 2. the retail market is not fully competitive. 2. we were not satisfied that there was any way of establishing reliable estimates of elasticities of demand in the mobiles sector with enough precision to inform pricing decisions. or the cost of. the withdrawal or reduction of handset subsidies on prepay phones over the past year or 18 months. except possibly for the time-of-day variations around the regulated (or quasi-regulated) average termination charge. then the MNOs would have the incentive to keep termination charges above cost in order to fund subsidies designed to bring new customers on to the network and retain existing customers. agreed that the differential between on-net and off-net prices was not Ramseybased. Second. moreover. We accept that the MNOs’ decisions on the day. that 99 . In the light of our finding. because the market for the supply of mobile services was generally competitive. Moreover. or are not Ramsey-reflective now. we began by considering whether the MNOs’ current pricing strategies were either based on Ramsey principles or were not dissimilar in structure to prices that had been set according to Ramsey principles.433. indicates that those subsidies were either not Ramsey-reflective before the withdrawal or reduction. on entry. while arguing that the Ramsey structure of prices broadly prevails now and would prevail in the absence of regulation. we accept that charging more for calls made at peak times is in principle desirable on cost grounds.430.434. In effect.387). We have already seen that the MNOs expend considerable sums in acquiring and retaining customers and that the structure of their prices reflects the importance they attach to increasing the size of their respective customer bases. Third. If they were based on Ramsey principles. in the absence of any evidence of changes in demand for.435. 2. We considered three aspects of the MNOs’ businesses. We would therefore not expect Ramsey prices to exist in that market. are based on at least an informal understanding of the respective price-elasticities and are therefore fairly similar to Ramsey prices (they would be true Ramsey prices only if the average termination charge had been set at a level which ensured that termination profits were no higher than a normal level). There is therefore no reason to believe that.122 to 2. we believe that there are problems in calculating reliable Ramsey prices—we discuss this issue in more detail in Chapter 8. We sought to establish whether these features would persist in the absence of any regulation of termination charges. given the target average charge. Further. Hence. and levels of handset subsidies. This confirms our view that competitive pressures are not as strong as they need to be to curb the MNOs’ market power in call termination. leading to above-cost off-net and fixed-to-mobile prices. These were: the reliability of elasticities of demand in the mobiles sector. we have already said that each MNO has a monopoly of termination on its own network. 2. we consider that the wide disparity in retail pricing between on-net and offnet calls (see paragraphs 2. the wide differences between on-net and off-net prices in the context of a retail market that was not fully competitive.charges are substantially above a reasonable estimate of their costs (see paragraph 2.131) cannot obviously or easily be accounted for by demand or cost differences for each of these types of call. the MNOs are prepared to subsidize customers to bring them on to the network and to fund such subsidization through above-cost termination charges.431 to 2. 2. First. 2. providing the subsidy. the MNOs have largely removed handset subsidies from that part of the market where they say that consumers are the most price-sensitive. To help us answer this question. or it may be that in neither case have the prices been Ramsey-optimal. evening and weekend rates to set.

Ramsey prices would produce maximum allocative efficiency and maximum consumer welfare in the mobile sector. not a single price. 100 . Oftel said. (We discuss the question of whether any regulated price for termination should be derived from Ramsey principles later. the relationship between the firm-specific and the market elasticities in the retail market cannot be the same as that in the termination market. we have also established that there is active competition in access to mobile services and. Oftel told us that in its view the incentives faced by the MNOs would lead them. if they reflected the market elasticities of demand rather than the elasticities faced by the MNOs as individual operators (which are referred to as ‘firm-specific elasticities’). the MNOs would have the incentive to set a profit-maximizing price and it was quite possible that the profit-maximizing price would be substantially above the current level. that prices were only Ramsey prices. Oftel said that. to depart substantially from the structure of Ramsey prices. other mobile prices would be similar to Ramsey prices in that they maximized subscriber numbers. 2. however. the MNOs regard their customers as revenue streams and they compete with each other to capture these streams by offering discounts and incentives to retailers and handset subsidies to potential subscribers to encourage them to join their networks. Even if O2’s argument were valid. Having acquired customers. A second key point. it is not clear to us that the maximization of subscriber numbers is the only factor relevant to welfare maximization or a sufficient condition for its achievement. We have already established that each of the MNOs has a monopoly of termination on its own network. It was important to understand.510 to 2.423 to 2.) 2. O2 argued that. This was because there was a disparity in the degrees of competition which the MNOs faced in the two main markets in which they operated. for a given level of termination charge. We asked Oftel and the four MNOs what they thought would happen to the level of termination charges if there were no charge controls after March 2003. Therefore. Given that each MNO was a monopolist in its own termination market. As we noted above. and that therefore the firm-specific and market elasticities would be similar.438.437.439. Oftel stressed that the termination charges currently set by O2 and Vodafone were already at the absolute maximum allowed under the price cap and indeed had been at that level during the whole of the current charge control period. possibly exceeding 20 ppm. the termination market and the retail market. the degree of competition between them might be expected to be similar in each case. We do not accept this argument. It therefore faces the same market and firm-specific elasticities in respect of that service. a corollary of the fact that Ramsey pricing described a structure of prices. although to a lesser extent. because the relative values of their individual firm-specific elasticities were different from the relative values of the market elasticities for the different services they sold. 2. retail competition (albeit not fully efficient competition) drove a substantial wedge between the firm-specific elasticity faced by each MNO and the market elasticity. There are other matters to be taken into account in assessing welfare maximization. because the MNOs competed across a range of mobile services. in the retail market. if the MNOs were to set their retail prices on the basis of their individual firmspecific elasticities in the retail market—as they would if they wished to maximize their profits—they would not set Ramsey prices. In the retail market. the MNOs had no incentive to set a structure of Ramsey prices.519). Orange put it to us that. if unregulated. first.427). In Oftel’s view. in call origination. in the absence of a price control. in the context of our discussion of remedies (see paragraphs 2. including considerations of fairness among different groups of consumers and efficiency in the use of the network. so that calling patterns are not distorted (see paragraphs 2.436. which maximized economic efficiency. was that the size of the mark-up on each service under Ramsey pricing reflected its elasticity of demand relative to the elasticities of the other services. 2. but. the MNOs price call origination and call termination so as to maximize their revenues. Therefore.440. 2. it faced the market demand and the market elasticity in termination.

And even if they tried to raise termination charges. This provided further evidence. The MNOs justify the raising of termination charges on grounds of 1 See paragraph 2. As we have seen. and possibly even up to. the MNOs would have the incentive to raise termination charges above their current levels. each MNO would be subject to pressures to maintain termination charges for calls from FNOs above efficient levels. The ‘optimal’ price. at such levels. It said that. owing to the constraints. 101 . 20 ppm. that termination charges were too low and would need to be higher to bring new subscribers on to the network and retain existing subscribers. Vodafone told us that. in Vodafone’s view.3 ppm. in our view the evidence suggests that it would be no more successful than Orange had been. The recent withdrawal or reduction of subsidies had brought about a reduction in the overall level of mobile subscription. In considering the commercial incentives of the MNOs to increase or decrease termination charges. by which Vodafone meant the price that reflected the maximum consumer benefit. we note that Orange had set its termination charges substantially below those of O2 and Vodafone up to February 1997 as a competitive strategy.1 If the new fifth operator attempted the same strategy. the mobile subscriber (the so-called network externality).444. But it believed that insensitivity to termination charges might no longer be so widespread and might not apply to certain user groups. 2. Vodafone suggested that that level was 17 ppm. since it had become clear that the subsidies needed to bring new subscribers on to the network could not be justified by reference to the revenues which those subscribers could be expected to generate.2. nor would. Vodafone told us that the optimal level of call termination charges was calculated taking into account the fact that society generally benefited from a customer’s decision to take up or retain a mobile subscription. from other services. 2. it had become increasingly clear that significantly undercutting other networks’ termination charges would not provide incentives to most customer groups to select Orange over other operators. 2. that it would be efficient to generate more subscriptions for the benefit of society at large. in the absence of any price control. they believed that BT or another MNO would complain to the DGT. During the MMC’s inquiry into the termination charges of O2 and Vodafone in 1998 (see paragraph 2. including outbound call charges. but no higher than. in a market where the MNOs competed to sell mobile subscriptions and outgoing calls. 2. and receiving calls from. yet it was widely recognized. The other MNOs did not agree with Vodafone. Vodafone told us that the MNOs had recently had to withdraw or reduce handset and other subscription subsidies.443. raise termination charges in the absence of a charge control because of the competitive environment in which they operated. who would intervene and determine a termination charge which would certainly be no higher than current levels.442. We think it is clear that.91 of MMC 1998 report. seeking to gain subscribers by setting lower termination charges than the incumbent MNOs. They said that they neither could. at a weighted average of 9. would lie in a range of 11 to 15 ppm. Vodafone said. Vodafone believed that the MNOs could be expected to set termination charges above efficient levels. current termination charges were capped at too low a level to deliver optimal allocative efficiency. Oftel told us that termination charges might rise to more than 20 ppm in the absence of regulation. with a view to using the excess revenues thereby earned to fund competition to win subscribers. In the absence of regulation. However.441.445. but without success. Vodafone thought that charges could rise to up to 20 ppm compared to an efficient level in the range 11 to 15 ppm.7) Orange had said that: through analysis around that time of call volumes and market research. because other members of society valued making calls to. there was a level above which MNOs would be unlikely to raise termination charges.

Conclusions on the public interest 2. we think it likely that the MNOs would not adopt Ramsey prices whatever the degree of control of termination charges. but we have already said that we do not accept that this is necessarily an efficient outcome. In these circumstances.0 ppm for Orange and T-Mobile. enable subscription prices to be kept at levels capable of attracting and retaining subscribers.both economic efficiency and benefit to society at large. Therefore. where each operator has a monopoly of termination and faces the market elasticity. defined by the continued willingness of fixed-line customers to call mobile phones). in the absence of a charge control. They have the incentive to set prices very much lower than Ramsey levels in the retail market (which is not fully competitive). termination charges exceed the fair charge by between 30 and 40 per cent. or may be expected to operate. 2. Vodafone. the termination charges of O2 and Vodafone may be expected to operate against the public interest. be set at levels in excess of the fair charge arises because: (a) there is a relevant market in the termination of calls on mobile networks and O2. The termination charges of O2 and Vodafone are currently subject to a charge control. 2.147).2 ppm for O2 and Vodafone and 7. against the public interest. in December 2002. The MNOs have the incentive to set very high termination charges in the call termination market.11. were the charge controls to be removed.446. However. For all the reasons set out above. Accordingly. if retained at their current real levels. This is because of the different degrees of competition that they face in the call termination and retail markets respectively. the charges made by O2. if the mobile sector approached saturation and new subscribers required even larger subsidies to induce them to become mobile subscribers. we find that. Orange and T-Mobile operate. Orange and T-Mobile each has a monopoly on the termination of calls on its network (see paragraph 2. In the references. if there were no regulation in place to contain them. Orange and T-Mobile respectively to operators of fixed or mobile public telecommunications systems for calls to GSM handsets connected to the public telecommunications systems of O2.7 ppm for O2 and Vodafone and 5. 4. We find that these termination charges operate against the public interest and that. Vodafone. the termination charges of Orange and T-Mobile may be expected to operate against the public interest. in accordance with their pricing strategies. in the absence of any charge control on them. By raising termination charges the MNOs would. plus an allowance for externalities. The fair charge for the year to March 2006 (in 2001 prices) will be. The current average termination charges in 2001 prices are between 9 ppm and 10 ppm . a reasonable estimate of their costs is LRIC.447. 102 . the DGT has asked us whether.3 ppm for Orange and TMobile. including allowances for relevant network and non-network fixed and common costs. As shown in Table 2. the MNOs’ call termination charges would need to be increased commensurately (although clearly subject to some upper limit. We find that these termination charges operate against the public interest and that. used for example to subsidize handsets. The termination charges of Orange and T-Mobile are currently subject to no charge control. particularly those relating to customer acquisition. we estimate. It seems to us more likely that they would price above the Ramsey level on call termination while setting some retail prices.448. since higher termination charges. at prices below the Ramsey level. where competition for subscribers is strongest. we believe that termination charges will be set above levels that reflect a reasonable estimate of their costs. We make these findings because. termination charges could be up to double the fair charge by 2006. Vodafone. in the absence of a charge control. We term the level of termination charges that reflects such costs ‘the fair charge’. particularly the access market. it is possible that termination charges could exceed the 20 ppm maximum level suggested by Vodafone. The fair charge in the year to March 2003 (in 2001 prices) is 6. generate more subscribers for mobile networks. in the absence of charge control mechanisms. Our expectation that termination charges will.

This leads to the undervaluation of mobile phone handsets by the MNOs’ customers combined with a greater turnover (churn) than would take place if customers paid charges which reflected the proper valuation of such handsets. in the absence of a price control on them.428).146). This is because termination charges at the wholesale level are reflected in the level of charges incurred by consumers who make fixed-to-mobile and off-net calls.(b) there are no adequate demand-side substitutes for call termination on the network of the called party at the retail level.449. too few such calls are made. and each has an incentive to increase its termination charges from their present levels (especially if another MNO had done so). or who make little use of their mobile phones (see paragraphs 2. and thus. (c) termination charges are already set at levels substantially above the fair charge (see paragraph 2. 103 .428). Vodafone.390 to 2. thereby distorting patterns of telephone use (see paragraphs 2.147). or to the fair charge. and (e) there is insufficient knowledge of. and no adequate consumer strategies that are easy to use and effective enough to constrain the level of termination charges (see paragraph 2. the amount by which termination charges will. (d) the excess charges for termination have the further effect that they serve to encourage or facilitate significant distortions in competition because MNOs are not obliged to charge and subscribers are not obliged to pay the economic cost of handsets. In our view. or at all. 2.174 to 2. (c) consumers who make more fixed-to-mobile or off-net calls than on-net calls unfairly subsidize those who mainly receive calls on their mobile phones or who mainly make on-net calls. This leads to yet further distortions in greater expenditure on mobile customer acquisition than would have taken place if termination charges reflected costs more closely and if handset prices reflected the costs of handsets more closely (see paragraphs 2. incoming call charges and the prices of calls to mobiles on the part of consumers to induce them to change their behaviour to such a degree as to put pressure on call termination charges and force these down to the level of the fair charge (see paragraph 2. given that current termination charges exceed the fair charge. exceed the fair charge will be contrary to the interests of consumers in the UK in respect of the prices charged for telecommunication services. as a result. each has an incentive to maintain termination charges above the level of the fair charge (see paragraph 2. Orange and T-Mobile has a strong disincentive to reduce its termination charges from their present levels to rates that are lower than those of its competitors. and may be expected to be.390 to 2.390 to 2. with the result that consumers pay too much for fixedto-mobile and off-net calls (see paragraph 2. (b) the high price of fixed-to-mobile calls discourages such calls and. (d) each of O2.387).210). The adverse effects that result from this excess of termination charges over the fair charge are.197). and concern about.428). that: (a) the costs incurred by the FNOs and the MNOs through paying mobile call termination charges that are in excess of the fair charge are wholly or mainly passed through by them into their customer tariffs. In reaching our finding on the public interest we are required by section 13(8) of the Act to have regard to the matters in respect of which duties are imposed on the Secretary of State by section 3 of the Act. and (e) the higher prices of calls from fixed to mobile phones and the lower price of on-net mobile calls encourage greater use of the higher-cost (mobile) technology at the expense of the lower-cost (fixed) alternative (see paragraphs 2. no ready alternatives to making a call to a mobile (such as calling a fixed line or using text messaging). in summary.52).

505 to 2.449.2.8 ppm for 1800 MHz operators. by way of modifications of the conditions of each of the MNO’s licences (see paragraphs 2. We next examine the financial impact of our proposals on. This would have involved an initial step change (known as a ‘P0 adjustment’) in the level of the average termination charge from 2001/02 to 2002/03 and. he said.509) and an alternative (Ramsey) approach suggested by the MNOs (see paragraphs 2. any offsetting public interest benefit arising from termination charges set by the four MNOs’ being in excess of the fair charge which could justify their continuation. However.471) and then discuss some other possible remedies.523).524 to 2. This target charge produced a range of ‘X’ of between 11 and 13. In the absence of a charge control on them. We therefore believe that the interests of consumers within the UK.578 to 2. such charges are 30 to 40 per cent in excess of the fair charge. We next consider the MNOs’ objections to regulation (see paragraphs 2. In order to arrive at the appropriate charge control. The DGT’s proposals for charge controls 2. The target charge was based on the LRIC of termination. the first an equal proportionate mark-up (EPMU) for the recovery of any common costs and the second an allowance for the value of the network externality. or that there may be expected to be.453.547).451. on the grounds that the current level of termination charge was substantially above cost. 2. as a consequence.3 ppm for combined 900/1800 MHz operators and between 6.8 ppm and 6.577). to which he added two mark-ups.456). consumers and the MNOs (see paragraphs 2.450.454.1 to this report).2 ppm and 6.457 to 2.504). in respect of the prices that they pay for telecommunications services. we expect that termination charges could be up to double the fair charge by 31 March 2006. 2. 2. The DGT told us that he had considered the possibility of setting a new starting charge for the controls. We then turn to issues surrounding implementation of a charge control (see paragraphs 2. In his terms of reference to us. the DGT identified a target charge in the final year of the control (2005/06) of between 5. currently (year to March 2003). we give our formal conclusions on licence modifications (see paragraphs 2. Orange or T-Mobile. In this section.548 to 2. We conclude that the adverse effects that have to be remedied are those set out in paragraph 2.510 to 2.455. the value of X would have been lower. namely of 12. The DGT proposed an X in the middle of that range.580). Finally. respectively.454 to 2.452. In view of the conclusions set out above. He proposed licence modifications which would require the four MNOs to reduce their termination charges by RPI–12 per cent each year for four years until March 2006. we first set out the DGT’s proposals for a remedy in the shape of an RPI–X charge control on the MNOs’ termination charges. including those which we canvassed in our Remedies Statement (see paragraphs 2. Vodafone.472 to 2. the DGT took the view that bringing prices down to cost over the period of the price control (which 104 . As already noted. We do not find that there is. rather than initiating the controls from the existing levels. we are required to answer the question whether the adverse effects that we have identified could be remedied or prevented by modifications to the licences granted to O2. the DGT set out proposals for remedying the adverse effects he had identified (see Annex B of the terms of reference in Appendix 1. are prejudiced. A one-off adjustment might have been considered appropriate. Remedies 2. We then turn to our own proposals for a price cap on the termination charges of the MNOs (see paragraphs 2. which flow from termination charges being in excess of the fair charge.

if one or more operators decided not to adjust any of their outgoing call or subscription charges (including handset subsidies) O2 would not be in a position to make such changes without seriously jeopardizing its commercial position. clearly. 2. The MNOs’ views on a charge control 2. involved a cost-benefit analysis. O2 proposed an alternative remedy (call-back). involving an estimation of the set of charges that maximized the welfare of consumers. Investment in new services would therefore be retarded. regulation would put at risk both the existing benefits of huge increases in mobile penetration levels and future benefits. but a significant structural change in the mobile market. since the benefits identified in the cost benefit analysis were those associated with a better balance and structure of prices. it provided greater incentives for cost reduction. Among other things. the first that current charges were not at socially optimal levels because they were above cost. O2 said that the MNOs would look for ways to cut costs. Oftel’s approach to the assessment of the appropriate level of call termination charges had. it said that this readjustment would be unable to absorb the major shock that a sharp reduction in the level of termination charges would bring about. as the cost of such new investment. There were indeed strong reasons for MNOs to reduce termination charges in line with and in response to competitive pressures. it said. In Vodafone’s view.459.456. Although it would seek ways in which to rebalance its tariffs by raising prices for other services. On the contrary. This assessment took account of the benefits to all customers. subject to ensuring that suppliers were able to earn a reasonable return on their investment. and did not include the benefits associated with the driving out of excess profits or increases in efficiency.458. This had generated a conservative estimate of the overall benefits of the control.500 to 2. this would not be a minor price adjustment around a set of balanced tariffs. it said. Savings might also be sought by cut-backs in innovation and product development. as the result 105 . it said. The DGT said that he recognized that regulatory intervention was appropriate only when there was a reasonable expectation that its benefits would exceed its costs. O2 told us that the DGT’s proposal for a control mechanism on call termination charges was based on two mistaken views. which we discuss in paragraphs 2. This would be very damaging to the public interest in the long term. most significantly the roll-out of 3G services. but competitive pressures had already forced them to cut as many costs as possible. 2. rather than lower overall prices. he said. the reduction in handset subsidies.he termed a ‘glide path’) was a more appropriate route.457. how it adjusted its other tariffs depended on how other mobile operators responded to a termination revenue shortfall. O2 also said that the proposal for regulation of termination charges raised serious issues about its capacity to remain viable. 2. Vodafone told us that any significant intervention in the regulation of mobile call termination rates would be seen by the capital markets as a sign of heightened regulatory risk. The DGT said that he had made conservative assumptions in his cost-benefit analysis. For example. thereby contributing to an increase in the MNOs’ cost of capital. O2 had considered how it would respond to a reduction in termination charges as the result of regulatory intervention.503. because none of the carriers with whom it interconnected would agree to pay a higher price. and the second that termination charges could rise in the absence of regulation. in order to preserve a balance between incoming and outgoing call prices. increased. termination charges would not rise in the absence of regulation and would be likely to remain at socially optimal levels. the DGT said. since the regulated company would be able to keep the benefits of efficiency gains for a period before consumers captured these benefits through lower prices. including those calling mobile phones as well as mobile phone customers themselves. More generally. and the returns required to be earned from it. Apart from the implications for the tariff structure.

It should take account of all relevant non-network costs and be based on the costs of an efficient operator. could not take effect immediately. by removing subsidies or increasing outgoing call charges. Orange said. Orange told us that it did not favour a price cap on mobile termination charges because this would fail to address any of the adverse effects that the CC had purported to find in the mobiles sector. while the financially strongest MNO.473 to 2. However. pass-through had been achieved through specific regulation of BT’s retention on fixed-to-mobile calls. that it might be appropriate for the CC to propose an RPI–X charge control on fixed-to-mobile call termination charges. and the widespread availability of 3G services would be retarded. As the CC appeared to believe that such price-sensitivity was low. to reassure callers to mobiles that the bilateral agreements would make them no worse off. but might increase to between 17 and 20 ppm in the absence of a price control. as marginal customers dropped their mobile subscriptions and total call volumes fell. however. Orange also submitted that any rebalancing by the MNOs to offset the effects of regulated reductions in termination charges. would slow the sales of multimode 2G/3G handsets. Vodafone said that termination charges were currently too low and for optimum efficiency should be in the region of 11 to 15 ppm. 2. Vodafone thought the charge should be set so as to allow each MNO to recover LRIC. thus increasing its market share and over time its relative financial strength. to the adverse impact of a one-off reduction in 106 . but it was to be expected that the rates arrived at in bilateral agreements would be below a mobile-to-mobile cap set at the fixed-to-mobile level. 2. yet any delay would have a significant impact on the MNOs’ overall revenues and levels of return.463. 2. in addition. the recent decision by Oftel to remove this specific regulation from BT with effect from 1 August 2002 would allow BT to redirect the additional profits it could make on fixed-to-mobile calls (in the circumstances of a price control) to other retail services within the broad retail price basket now allowed by Oftel.479. Hence a one-off reduction would significantly reduce the intensity of competition in the mobile market. This would be especially damaging to the financially weaker MNOs. the MNOs could well be left with stranded assets. The reduction in termination charges would also. an RPI–X price control for mobile-to-mobile termination charges could be justified as a safeguard.of lower incoming revenue streams. then price control would only be effective if coupled with pass-through of any changes in termination charges to the prices charged by FNOs to their customers. as a result of which BT was obliged to pass on any reduction in mobile termination charges to its customers in the form of reduced retail prices. would be better able to delay rebalancing. Vodafone told us that it was unnecessary for the CC to resort to an RPI–X charge control to regulate mobile-to-mobile termination charges.460. depend on the price-sensitivity of fixed customers in calling mobile phones. Vodafone said. since these could be constrained by the imposition on MNOs of a requirement to conclude bilateral agreements for such charges. therefore.462. outweighing the positive social benefits of higher mobile penetration. We discuss this proposal in paragraphs 2. the result would be a massive regulation-driven transfer of funds from the MNOs to the FNOs. Other FNOs were to some extent constrained to accept the BT price. The extent to which FNOs would pass through any reductions in the mobile termination rate to their retail fixed-to-mobile prices would in future. Until recently. If there was indeed a detriment of high consumer prices for fixed-tomobile calls. Vodafone said. Vodafone. plus a Ramsey mark-up to recover common costs plus the network externality.461. At present. and the only function of such a charge control would be to ensure that future efficiency gains were passed on through charge reductions. coincide with the launch of 3G services but customers were unlikely to be prepared to increase their monthly mobile expenditure on 3G services if subscriptions and call charges had increased. A reduction in call termination charges by itself would not guarantee any commensurate reduction in the retail prices charged by the FNOs. Vodafone said that. 2. At most. Vodafone accepted. charges were not excessive. Orange pointed.

We asked T-Mobile whether it would maintain that position even if Vodafone were to raise its termination charges to 17 ppm in an unregulated environment. We considered carefully each of the matters put to us by the MNOs (as set out in the previous paragraphs) in response to the proposal for a price control and reduction in termination charges. we took note of the business plans of each of the four MNOs. He had also proposed a glide path for four years. in its view. A substantial increase in handset prices would reduce mobile affordability and hinder the provision of new 3G phones and services to UK consumers. for example.466. consisting of the cost of providing termination. then a prohibition on handset subsidies might also be appropriate. there was no possibility that Vodafone would act in this way and so it was quite willing to give us its undertaking. Therefore. Any resulting increase in call origination charges coupled with a decrease in call termination charges would reduce overall call volumes. driven by the availability of prepay packages which had provided access to mobile services by socioeconomic groups that were previously unable to take advantage of them.464.467. An increase in subscription charges would be likely to reverse the subscriber growth of the last few years. See note on page iv ]. it would be willing to give an undertaking to continue to reduce its interconnection charges by RPI–9. to seek a remedy that enhanced the impact of market forces on call termination and which did not need constant review and replication. T-Mobile also told us that charge controls would be likely to plunge loss-making operators into further losses. in the case of O2 and Vodafone. Finally. and on future investment in mobile network infrastructure and 3G services in the UK. it said. He said that he had calculated a target charge for the MNOs.465. The DGT told us that he had considered the impact of any regulation on the financial viability of the MNOs before deciding on his proposed price cap. the cost of capital. for the period to 31 December 2005. the period to 31 December 2006. particularly Vodafone. Apart from price control with a pass-through obligation. Orange thought that non-discrimination provisions and greater price transparency were remedies (both of which we consider in the next section) that would address the detriments we had identified. leading to excessive focus on subsidies and excessive churn. T-Mobile said that regulation of termination charges. and in the case of T-Mobile. T-Mobile told us that. 2. although in its view no price control was justified. upon which the control was based. capping charges could not be the reason behind any financial difficulties of the MNOs. Other MNOs. had more flexibility in how they responded to the revenue losses from reduced termination charges. In doing so. If Orange were permitted to reduce its termination charges by RPI–9 each year. there was no guarantee that charge controls would deliver the savings to consumers that regulation was intended to secure. At a late stage in our inquiry. if the FNOs’ retention was not directly regulated. Towards the end of our inquiry. that would. As to the detriments to the customers of the FNOs. given the relatively more price-elastic nature of call origination. would be likely to lead to an inefficient and highly distorted price structure with fewer calls being made and dramatic imbalances in traffic. We noted that these strategy documents have to varying degrees anticipated the impact of Oftel’s proposals for a charge control. in the case of Orange. so that the regulated charge was substantially above cost until the last year of the cap. they assume that retail prices will continue 107 . If there was inefficient competition in the mobiles sector. 2. Orange told us that. for the period to the end of March 2006. It was surely preferable. Orange told us that the proposed remedy of a charge control tended to foreclose the prospect of competition in call termination and relied instead on perpetual regulation. and it would not expect to see the need for further rebalancing [ Details omitted. threatening their long-term viability. termination rates on the stability of traffic patterns and costs (as fixed-to-mobile retail prices decreased and outgoing call rates from mobiles increased). 2. a mark-up for common costs and an externality surcharge. alleviate the problems associated with rebalancing its various charges and prices. it suggested. if on the lines proposed by Oftel. T-Mobile told us that it would be prepared to hold its termination charges at their current levels.

573 and 2. There is scope for the MNOs to offset the reduction in revenue from termination charges by maintaining retail prices at their current levels rather than decreasing them at the same rate as has occurred over recent years (we discuss this matter in paragraphs 2. We have already discussed this possibility in paragraphs 2. and (h) that any reduction in termination charges needs to be coupled with a requirement on BT to pass through such reductions to its retail prices. along with BT. (b) that a price cap will result in perpetual regulation. There has been widespread discussion of the possibility of a control on termination charges and the evidence suggests that investors have already taken account of this possibility (for example. we believe that a charge control by way of an RPI–X price cap is the only effective method of remedying the adverse public interest effects and that none of the other remedies discussed would be adequate for this purpose. We considered the concern (see paragraph 2.422. We discussed this matter earlier—see paragraphs 2. that a cap on the MNOs’ call termination charges would be effective only if coupled with pass-through by the FNOs of charge reductions into the prices they charge their own customers.240). (e) that the capital markets will see any reduction in termination charges as a heightened regulatory risk. would be threatened. (g) that the other MNOs will suffer disproportionately in relation to Vodafone. We discuss this matter in the following paragraphs. There is also the possibility that the gradual move to 3G technology will produce a similar result. and that this will leave the MNOs with stranded assets. (c) that a reduction in termination charges will lead to an upward adjustment of other tariffs and therefore a decline in subscriber numbers.564 to 2. it said.468. that termination charges will be reduced and that there will be a significant levelling off of new subscriber numbers. (f) that a reduction in handset subsidies will slow the sales of dual 2G/3G handsets and put in jeopardy the roll-out of 3G. in connection with the effects of the removal of excessive termination charges on the mobile sector. Both types of competitor would benefit.574.422—and concluded that there is no justification for existing customers of the FNOs to pay for new services through above-cost 2G termination charges.417 to 2. (d) that the roll-out of 3G. We address this matter when considering our calculation of the impact of our price cap proposals on the MNOs (see paragraph 2. In the meantime.100) the possibility of technological developments that might at some time in the future obviate the need for regulation of termination charges. BT told us that it currently faced two main types of competition in the provision of calls to mobile phones: cable companies and Indirect Access Suppliers. We also discuss the effect of regulated termination charges on the financial position of the MNOs later in this chapter (see paragraphs 2. expressed in particular by Orange. 2. and BT would therefore need to pass through the vast bulk of the reductions in those charges in order not to get out of step with 108 .548 to 2.563).417 to 2. We address this matter in paragraphs 2. We have rehearsed earlier in this chapter (see paragraphs 2.94 to 2.467(h). from a reduction in termination charges.566). We think this is fall. see paragraph 15. the latter using BT’s lines but routeing their calls through another network. The MNOs’ business plans project a continued downward trend in retail prices.567). as the strongest MNO. We set out below the main issues raised by the MNOs and our response: (a) that any increase in subscription charges as the result of a reduction in termination charges would reverse the subscriber growth of the past few years. and the investment in other new services.

We now consider each of these possibilities. when mobile call termination call rates fell.473. In the increasingly competitive market in which it operated. In view of the inherently intrusive nature of charge controls and bearing in mind our duty to consider the proportionality of any remedy we might recommend in relation to the detriment to be removed or prevented.472. it had not hitherto taken the opportunity to reduce its retention below the cap. Even if it did not pass through the reductions in termination charges penny-forpenny. Even if the reduction in mobile termination charges was not wholly reflected in lower fixed-to-mobile prices. although not necessarily in the price of fixed-tomobile calls. and thus a matter which it had every incentive to address.470. although it had more flexibility under the current arrangements than formerly. if termination charges came down. the prices of calls to mobiles were a major source of dissatisfaction among its customers. in our Remedies Statement. if BT brought down its retention from 3 ppm to 2 ppm. BT said that. In short.its competitors and risk losing its competitive position. 2. BT said. This was because. Vodafone proposed that. customers would still not lose out. BT made two points in response. Moreover.471. in addition to the remedy of a charge control through an RPI–X type price cap.469. Accordingly. First. BT had to lower other prices by an amount equal to any failure to pass through call termination reductions on a penny-for-penny basis. 2. BT’s retention element on these calls increased unless BT cut the prices of calls to mobile phones penny-for-penny. we explored other possible ways in which the public interest detriments we had identified could be addressed. 2. the cost of a daytime fixed-tomobile call would be reduced only from 30 ppm to 29 ppm. so its cap was by no means a floor price. BT said. Bilateral agreements 2. then there would be much more incentive to focus on the price of fixed-to-mobile calls and bring those prices down. This is because of the competitive pressure that would be brought on BT by the other FNOs and the incentive of all the FNOs to increase their call volumes by offering more attractive prices. towards the end of our inquiry. BT had thus to reflect in its prices the totality of the cost savings from lower call termination rates to customers. for example. BT said. Second. customers of the FNOs would benefit from price reduction in other areas. Orange and T-Mobile suggested further alternative remedies. beginning with bilateral agreements between MNOs. Under its current price control. BT said that there was currently very little incentive for it to reduce the prices of fixed-tomobile calls or its own retention. We are satisfied that the reduction in the call termination charges of the MNOs that would follow a charge control on them would be substantially if not wholly passed through by BT and the other FNOs to their customers. O2. Other possible remedies 2. In addition. as there would be no incentive for MNOs to maintain termination charges for mobile-to-mobile calls above efficient levels if they could be sure that no 109 . we canvassed a number of other possible remedies. it had a competitive incentive to pass through the vast bulk of reductions in termination charges to its fixed-to-mobile prices. it said that other FNOs competing with it for fixed-tomobile calls would be receiving any reduction in termination charges to the same extent as BT. because the size of the termination charge in relation to the total cost of the call was such that any reduction would hardly be noticed by customers. and could not appropriate any of the reductions if it did not do so. A retention increase was treated as a price increase in the basket of prices. We put it to BT that. BT would be forced to pass the reduction through in its prices to its own customers or lose out to those competitors. even though its retention was capped.

it should disclose the origin of such traffic to the other MNO and pay. The DGT commented that. This could be 110 . by allowing MNOs effectively to maintain separate call termination charges for mobile-to-mobile calls. be lower than the optimal fixed-to-mobile call termination charge because of the higher super-elasiticity of demand for mobile-to-mobile calls) where they transited traffic across another mobile network. In reply to concerns raised by other MNOs. Vodafone submitted that the bilateral agreements should provide that. Vodafone suggested that we should make clear in our findings that the inclusion of such provisions in bilateral agreements would promote the public interest. Vodafone further submitted that our recommendation should reflect the fact that MNOs could continue to have recourse to Oftel if they were unable to reach agreement. compared with the MNOs’ customers’ calls. then the very fact of that arbitrage would ensure that. each being set at its efficient level. in Vodafone’s view. in setting its rate to other MNOs. Vodafone also argued that such bilateral agreements could contain provisions to prevent FNOs from benefiting from the mobile-tomobile call termination rate (the optimal level of which would. said Vodafone. Vodafone subsequently suggested that. In addition. and fixed-tomobile calls. there could also be a ‘safeguard’ charge control under which each MNO would be prohibited from charging more for mobile-to-mobile termination than it was permitted to charge for fixed-to-mobile termination under a separate fixed-to-mobile termination charge control. so as to maximize consumption of its total services. if MNOs could not prevent FNOs from benefiting from the mobile-to-mobile call termination rate . Such an arrangement would prevent either MNO from ‘stealing a march’ on the other by raising its call termination charges to a higher level. under which each MNO agreed a specified. each MNO would be constrained to set its mobile-to-mobile termination rate by reference to the applicable fixed-tomobile rate.477. 2. in respect of such traffic.476. in his view. mobile-to-mobile termination charges could be constrained by way of bilateral agreements. 2. in the early stages of Hutchison 3G’s operation a much larger proportion of its customers’ mobile-to-mobile calls would be off-net (rather than on-net). given that. and not to alter that rate without giving the counterparty MNO an opportunity to do so at the same time. Each MNO would instead have an incentive to set its own charges at the efficient level. Vodafone submitted that our recommendation should expressly acknowledge that it should not be regarded as being unduly discriminatory for MNOs to agree lower mobile-tomobile termination rates than they offered to FNOs. however. the relevant FNO’s termination charge. MNOs might find it mutually beneficial to keep off-net termination charges high in order to create an entry barrier for Hutchison 3G. Moreover. Vodafone argued. The incentive to price above efficient levels could be ‘neutralized’. Conversely. if all MNOs were required by regulation to negotiate and conclude bilateral interconnection agreements. noting that both Vodafone and O2. being presently designated as having significant market power (SMP) for the purposes of the Interconnection Directive. if one MNO delivered fixed-originated traffic to the other. reciprocal call termination rate.competitor could do so. because (as between two MNOs potentially entering into a bilateral agreement) the MNO with the balance of inbound traffic in its favour would prefer the status quo of high termination charges. and noted that Vodafone itself (by proposing a safeguard cap) apparently recognized this. the argument that bilateral agreements would avoid the need to regulate mobile-to-mobile termination charges was not robust.474. Traffic imbalances would be likely to inhibit a downward movement of prices. The MNOs’ incentives were to set charges for mobile-to-mobile calls in a way that would act to weaken retail competition and this was not conducive to the public interest. were subject to non-discrimination obligations (which would. 2. 2. if the CC thought it was necessary. be removed with the implementation of the new EC Directives). The DGT considered that the termination charges for mobile-to-mobile calls should be regulated so that they were no higher than those for fixed-to-mobile calls.475.

but at the same level as. mandated bilateral interconnection agreements were neither required nor appropriate. by including both fixed-to-mobile and mobile-to-mobile termination charges in the same charge cap but. Yardstick regulation 2. passed all the legal tests for an appropriate remedy in our inquiry. to the extent that MNOs set a lower weighted average level of charges for mobile-to-mobile compared with fixed-to-mobile termination. None of the other MNOs lent positive support to Vodafone’s proposals for bilateral agreements. We consider below the question of whether there should be separate caps. they would lead to inefficient pricing since net purchasers of call termination services would have the incentive of opting for an inefficiently low price. for Vodafone’s proposals for a system of mandated bilateral interconnection agreements represent a fair reflection of their lack of merit as a possible remedy for excessive mobile-to-mobile termination charges. On the basis that the MNOs were able to distinguish the origin of calls that they terminated (between fixed-originated and mobile-originated). who might come into the market with a more transparent pricing structure. the cap on termination charges for fixedto-mobile calls. In our view.2. this was what was recently implemented in Australia. The DGT also argued that. Another possible remedy that we canvassed in our Remedies Statement was to tie year-on-year changes in termination charges to average price changes in more competitive markets. If the argument put forward by the MNOs was correct. and paragraph 15. even from the other MNOs. provided that it was not coupled with an 111 . there could be a distinct safeguard cap on termination charges for mobile-tomobile calls. Broadly speaking.481. however). for mobile-to-mobile and for fixed-to-mobile call termination charges. then the safeguard cap would be a non-binding constraint. T-Mobile believed they might in theory deliver efficient termination charges. The International Telecommunications User Group (INTUG) did not see bilateral agreements as a viable solution. but feared that. First. paragraph 14(c). 2. respectively. such as the market for retail mobile services. Alternatively. covering only network costs. but it would provide protection against the incentives that the MNOs might have to set excessive termination charges for mobile-to-mobile calls. O2 considered that bilateral negotiation of agreements did not differ from the current institutional constraints already operating as an insurmountable bar on increased termination charges. this would not count towards compliance with the cap (the converse would apply. 2. with or without an accompanying safeguard cap. Telewest Communications plc (Telewest) expressed concern that bilateral agreements could lead to collusive behaviour. as overseen by Oftel. by the Australian Competition and Consumer Commission (ACCC) (see Appendix 2. since they did not address what it regarded as the fundamental issue of calls from fixed lines to mobiles. the CA believing that MNOs would have an incentive to act against new entrants. Of the FNOs. O2 believed that a yardstick remedy. whilst both the CA and the National Consumer Council (NCC) worried about the potential for bilateral agreements between MNOs to have anti-competitive effects. the DGT considered the two-cap solution more appropriate because the weights in each cap would reflect the traffic mix of the relevant call type.480. with a safeguard cap in place. as favoured by the ACCC. or remove the need for a price cap on termination charges. 2. and the COG did not believe that subjecting the MNOs to an obligation to negotiate and enter into bilateral interconnection agreements would lead to efficient pricing. rather than reach a commercial agreement.235). BT emphasized that binding bilateral agreements could not be used to set fixed-to-mobile termination charges if one of the parties (the regulated FNO) was not free to depart from preagreed termination rates for its services.479. separate from.achieved in one of two ways. the concerns expressed by interested third parties and the lack of support.478. nor did Orange see the proposals as an effective remedy.

and we stand by that view. furthermore. voicemail remedy would be inappropriate or ineffective (contrary to O2’s belief). moreover.482. a necessary condition for any remedy was that it should reduce termination charges by more than that. there was no risk of distortion of the competitive outgoing sector. difficult to specify accurately and leading to distortions in the setting of the comparator retail prices. 2. Orange believed there would be a distorting effect in relation to mobile retail services. Hence. the remedy would reduce termination charges by as much as mobile retail prices but. Second. an MNO that lowers its on-net price gains more customers directly. T-Mobile believed this remedy would be less intrusive than a one-off adjustment to call termination charges. However. Thus the mechanism should effectively introduce competition into the termination market without distorting competitive markets. and that we should seek remedies that were more clearly targeted at the relevant public interest issue. believing it attractive in principle but. requiring reductions in termination charges at the same rate as the decline in the rate of mobile retail prices. Another possible method of yardstick regulation might be to tie termination charges of each MNO to the average price of originating calls of all the other MNOs.485. for some reason. reducing termination charges on rival networks and so 112 . and since termination is set as the average of all other MNOs’ on-net prices. At best. 2. and the NCC thought that such a remedy made little sense and would distort other markets. MNOs with cheaper networks can charge lower origination charges.immediate downward P0 adjustment. Thus. Contrary to objections. proportionate and potentially permanent solution without the need to revisit the issues periodically. This mechanism has a number of the desirable properties. Vodafone told us that it did not favour a remedy whereby charges for call termination were regulated by reference to movements in retail prices. a further possibility might be to tie the termination charge of each MNO to the average price of on-net calls of the other MNOs (times an engineering-based fraction to reflect the share of an on-net call accounted for by the termination leg). and hence gains the termination revenue from these new customers.484. and this will also lower all termination charges. In our Remedies Statement. this is problematic in network markets. such a remedy would provide all the benefits of switching from CPP to RPP with none of the detriments. provide a market-driven. but would be complex to implement and would still have a significant financial impact on T-Mobile. said O2. we gave it as our current view that it would be inappropriate for call termination charges to be tied to (retail) competitive services because of the risk of distorting a more competitive market. in practice. First. it does not lower its termination charge. MNOs would be constrained from making competitive reductions by the effect that such reductions would also have in the (less competitive) termination market.483. The COG argued that the tying of call termination to call origination charges would not be effective in the absence of a fully competitive call origination market and. given the complexity of tariff packages and the practice of tying ‘free’ origination minutes to the line rental charge. then the CC should recommend a retail benchmarking remedy along ACCC lines. the ACCC experience showed that a retail benchmarking approach was workable. 2. that it would not be a viable remedy even if call origination was fully competitive. all MNOs have an incentive to lower their origination prices. since the termination charge of each MNO affects the outgoing prices of the other MNOs. When making pricing decisions for call origination. it was in practice very difficult to calculate an ‘average’ origination charge to be used as a benchmark. The CA commented that it would be concerned if a solution more complex than capping were proposed. as this would make an unintended impact more likely. Moreover. In any case. the COG believed. If. given the public interest detriment identified. The DGT maintained that the ACCC remedy was defective because it did nothing to redress the distorted pricing structure perceived as the key adverse public interest effect. or of fostering collusion among operators. A yardstick remedy would. the CC were to conclude that O2’s preferred. 2. said O2.

there would be adequate incentives for the MNOs to introduce any such potential solutions. we were not satisfied that. However. Technological solutions 2. 2. as people would turn off their phones to avoid paying for incoming calls. which the scheme attempts to avoid. and that its success would be far from certain. Given that any solution would need time to be developed. and about the consequential requirement to deal with that. in the absence of regulation. We did not see satisfactory evidence that any of these possibilities would be likely to deal with the adverse public interest effects brought about by an absence of regulation of termination charges in the period to 2006. We considered whether a system of RPP whereby the billing systems of the MNOs would be modified so that called parties paid for the termination leg (but not the outbound leg) of an inbound call might represent an alternative to the regulation of termination charges for remedying the adverse public interest effects that we had identified.487. estimating something like a LRIC model. none has yet been implemented. the scheme is simple and does away with the need for building a LRIC model and allocating fixed and common costs. Such a system could be expected to bring about a greater concern on the part of mobile customers about call termination charges and encourage competition between the MNOs in the setting of termination charges in order to gain customers. Vodafone believed that a system of RPP would lead to a sub-optimal usage of mobile services and fail to secure the regulatory objectives of section 3 of the Act. therefore. this was evident from the fact that. and how technical solutions based around optional RPP might lead to an increase in competitive pressure on call termination charges. O2 expressed similar views and identified. delivery of calls via other wireless technologies and VoIP might lead to supply-side substitution. and the initial costs of implementation. Moreover. but he considered that the benefits of RPP were likely to be outweighed by adverse effects on economic efficiency. Orange strongly disagreed that RPP would be in 113 . Receiving party pays 2. and hence constitutes very light regulation. 2.489. The DGT told us that he accepted that a system of RPP was likely to remove the competition problems associated with CPP.providing an incentive for all parties to lower termination charges. We also considered whether there was a practical form of regulatory intervention to encourage the MNOs to implement technological solutions that might either lead to supply-side substitution or increased competitive pressure. we were concerned at the scope for conscious parallelism (even if not other forms of collusion) if such a scheme were to be implemented. The DGT’s view. in particular. In sum. We return to these matters below. 2. was that the case for the introduction of RPP in the UK was weak. so that the MNOs would not lose termination business. in a market with a small number of players interacting repeatedly even if not collusively.490. might be considered essential for monitoring purposes. although a number have been and continue to appear feasible. and also in terms of consumer resistance. a significant risk that under RPP there would be detrimental effects (particularly on low-income members of society). we concluded that we could not rely on such a measure within the timescale considered in this inquiry. We considered earlier how technological solutions including dual SIM cards. by increasing competitive pressure on prices for inbound calls. An additional incentive to the MNOs to keep termination charges low would be the desirability of encouraging customers to keep their mobiles switched on. Third.486.488.

and included specific proposals among its suggested alternative remedies (see paragraph 2. We have seen (see paragraph 2. it would be insufficient by itself to remedy the adverse effects we had identified. indeed. Orange therefore thought it essential that passthrough regulations were imposed on FNOs (or at least on BT). at least) were required to show on their customers’ retail bills a breakdown between the termination charge and the amount of the FNOs’ retail retention. severely undermining the network benefits offered by all MNOs. Orange argued that pass-through regulation and improved price transparency offered significant possibilities of improvements in the competitive dynamics of call termination. however. similar effects could be achieved.the public interest.467(h)) that Orange believed a price control on fixed-tomobile calls would only be effective if conjoined with pass-through of reduced termination charges into FNOs’ retail prices for such calls. 114 . but it appears that neither has experienced more than modest demand for these services to date. provided that they were extended to the fixed retail market. The INTUG believed that the introduction of RPP would be disruptive. The CA and the NCC argued that both improved transparency and a price cap on termination charges were required. while improved transparency was desirable in bringing about increased consumer awareness. O2 disputed that insufficient information was available to enable customers to make rational purchasing decisions. arguing that it would have significant distorting effects. pointing to our first BMRB survey showing that only 18 per cent of respondents underestimated the price of a 2-minute call to a mobile. although going to the root cause—CPP—of the lack of competitive constraints on termination charges. make available. Orange already offer tariff options whereby customers may pay to receive incoming calls if they so choose.492. T-Mobile believed compulsory RPP would be highly disruptive to the continued development of the mobile industry but requested us to recommend that MNOs should develop. said Orange. 2. since it would remedy the underlying cause—CPP—of the problem. T-Mobile. We also note that both T-Mobile and. a mandatory system of RPP would entail too many significant disadvantages for consumers for us to recommend it as an appropriate and proportionate remedy for the adverse public interest effects that we have identified. such as the USA. 2. however. Alternatively. where RPP had constrained market growth through encouraging consumers not to keep their phones on. it accepted that RPP might be costly to implement and might lead to mobile phone users turning off their phones to avoid paying for unwanted incoming calls. In our Remedies Statement we mentioned that we shared Oftel’s view that. make call termination charge control unnecessary. if FNOs (or BT.493. The CA said that the benefits of RPP had to be balanced against the evidence from other markets.491.494. The evidence we received suggested that the MNOs might be able to change their systems to RPP at reasonable cost.503). Orange considered that the incentive for MNOs to compete on fixed-to-mobile calls by reducing their termination charges was critically weakened by the fact that the FNOs set the retail price and this was no longer required to reflect the mobile termination rate. The NCC believed that reversing the CPP principle would be hugely disruptive both to consumers and operators. O2 said that. and promote. we consider that. 2. for its part. would be exceptionally disruptive for consumers and MNOs and would be totally unjustified. More generally. or in addition. confusing and expensive. ‘Pass-through’ and price transparency measures 2. optional tariff package(s) for mobile customers that would enable customers of fixed networks to call those mobile consumers using a freephone and/or local rate number. favoured additional transparency measures. We return to these matters below. if we were concerned about price transparency. it was prepared to work with Oftel and retailers to develop greater transparency. not least because it might lead to significant numbers of users switching off their mobile phones. BT considered that RPP would. if it could be introduced. However.

this problem was becoming increasingly significant. 2. cost or practicality. The COG considered it a matter of urgency that we should deal with this situation and. the MNOs operated a classic ‘price squeeze’ which effectively excluded all FNOs from a significant part of the UK market for calls-to-mobiles in the corporate sector. In Telewest’s view.89). The COG believed that the fact that the MNOs were apparently able to offer 5 ppm retail charges on MVPNs was one indication of market failure in mobile call termination.496.497. in its view. the DGT suggested that.498. Energis asked us to investigate and to recommend a nondiscrimination requirement or other effective solution for any anti-competitive practices discovered. along with a price cap. 2.495. paragraph 14(h)) was required. in particular. if termination charges were reduced as proposed. Nor did Vodafone believe that a non-discrimination requirement. O2 commented that a non-discrimination remedy would fail to address any concern about the underlying level of termination charges. in that it led to distortion of demand and resulted in a reduction in public welfare and a sub-optimal allocation of economic resources. this would enable the FNOs better to compete in this area. Commenting on our Remedies Statement. In circumstances where the majority of calls crossed network boundaries. In offering MVPN retail rates at less than 50 per cent of the fixed-to-mobile termination charge. operators simply could not ‘capture’ consumers on to their network with the allure of cheap on-net calls. The DGT believed that. Nor would a price-squeeze test for fixed-tomobile services be justified: MNOs competed with FNOs in a competitive market where each offered an attractive proposition to consumers. and also pointed out that the present situation resulted in duplication of infrastructure and hence inefficiency costs.7 and paragraph 3. which would require a separate investigation.Non-discrimination 2. expressed scepticism that non-discrimination and price squeeze tests could offer much in terms of effectiveness. if we were to consider the FNOs’ case to warrant early assistance. and that no remedy concerned with addressing the balance of charges at the retail level was justified. however. The DGT had not previously examined this situation. THUS plc wrote in support of the COG’s proposal for a non-discrimination condition along with a price cap. The COG believed this market failure operated against the public interest. A number of FNOs put it to us that a non-discrimination provision (possibly supported by a specific price-squeeze test along the lines referred to in Appendix 2. As the volume of calls-to-mobiles as a proportion of all calls had risen. a one-off reduction (as opposed to a glide path) would be preferable to suggesting that the DGT should consider extending the scope of the inquiry into peripheral areas of the retail mobile market. the only solution was a non-discrimination condition allied with a price-squeeze test. In addition. the COG believed we should recommend a one-off reduction to the daytime termination rate (see Chapter 15). the DGT said that the FNOs’ main concern appeared to relate to the MNOs’ private wire tariffs. in cases where the MNOs provided retail fixed-to-mobile services using mobile virtual private networks (MVPN) (see Figure 3. since the 115 . because MNOs had not reduced daytime charging rates (as would have been expected following recent reductions in weekend and evening rates). BT. was relevant.2. reflecting their respective advantages. This should apply. the use by MNOs of their market power in call termination as a basis to build market power in call origination was the key competition issue: Telewest therefore believed there were strong grounds for both a price cap and a non-discrimination rule. implicitly to charge themselves the same amount for terminating on-net calls as they charged to terminate incoming calls-to-mobiles from other operators. on the grounds that the FNOs were at present unable to compete with the low charges made available by the MNOs to corporate customers with large numbers of handsets. However. they said. resulting in sub-optimal reductions in the relative price of evening calls. apparently intended to apply to MVPNs. in order to prevent competitive distortions brought about by the MNOs’ termination charges: the MNOs should be required. whether or not accompanied by a price-squeeze test. 2. and FNOs could always offer private wire products as service providers of the MNOs if they so chose.

callers to a mobile would be given the option either to reach the mobile subscriber in the normal way and to pay termination charges. sustainable and. that. therefore.92). that it could also be combined with certain RPP options. O2 believed. proportionate and potentially permanent solution without the need to revisit the issues periodically. 116 . Orange told us that it would be willing to undertake to continue to reduce its termination charges by RPI–9 per cent: a step which it envisaged might be accompanied by transparency measures. amounting to only a tiny percentage of Vodafone’s revenues. In short. from the currently high level of the MNOs’ termination charges. Consequently. As already noted.501.481). unjustified and would be unduly onerous. T-Mobile said that it did not favour non-discrimination remedies since they would lead to unnecessary distortions in pricing. it said.incidence of the charges generated was de minimis. Under the remedy. 2. and that the remedy would prove attractive enough to consumers to act as a significant constraint on the setting of termination charges (see paragraph 11. relatively easy to use and to implement. 2. as the wider the disparity between those charges and fixed-line rates. viable. it would be open to complainants to pursue appropriate action under the Competition Act 1998. O2 highlighted that the remedy operated within the competitive dynamic by giving callers an option to pay a termination rate or to request call-back. O2 shared with us the results of a survey demonstrating. see paragraphs 2.502. the more likely the caller was to use the voicemail option. so that those mobile subscribers who wanted incoming calls to be routed to them directly could pay a premium for this facility. Our inquiry has focused on the level of termination charges for calls-to-mobiles in the wholesale market and we have not. Further alternative remedies suggested by MNOs 2. we should recommend a retail benchmarking remedy along ACCC lines (see paragraph 2. arising from unregulated termination charges (which Orange disputed). it may well be that no specific measures to address the FNOs’ complaints will be required. O2.500. towards the end of our inquiry. investigated in detail the FNOs’ specific complaints of discrimination against them in the corporate sector of the mobile retail market. if these charges are brought down to the levels considered below. said O2. including the provision of additional information on customers’ bills. 2. if we were not prepared to recommend such a solution. and that it would provide a market-driven.112). and believed a price squeeze remedy would have similar disadvantages.499. were we to find an imbalance in the competitive position between FNOs and MNOs which was an adverse public interest effect. that it would be practical. O2 also pointed out that callers were familiar with the concept from BT’s voice messaging service. O2 believed there was only one remedy that addressed the identified failures in competition and went no further than was necessary to achieve that objective: the introduction of voicemail access at fixed-line rates as an alternative means for callers to mobiles to communicate with those whom they were calling (O2’s voicemail remedy. at least partially. or to the DGT to launch an investigation into the issue. Orange believed a price-squeeze test was unnecessary. 2. we think that such complaints (to the extent justified) are likely to result. but thought that a non-discrimination provision could be an effective remedy. Should that not prove to be the case.503. However. Rather than seeking to address the symptom of the perceived problem through a price control. most importantly. this remedy would provide a new and strong incentive on MNOs to ensure that incoming and outgoing retail charges were balanced and would therefore provide an effective constraint on termination charges. however.111 to 2. Orange and T-Mobile suggested further alternative remedies. that callers would welcome the option to pay the termination charge or request a call-back. O2 considered that this remedy sought to address any underlying regulatory problem arising from there being insufficient competitive pressure on call termination charges. or to leave a voicemail message at a fixed national rate: this would bring more pressure on termination charges the more it was used.

504. told us that it was confident that its prices for termination would not rise even in the absence of regulation and that it was therefore willing to commit itself to cap its rates at current levels for a period of three years.505. We term this ‘the cost-causation principle’. as a way of addressing any continued concern on our part about potential increases in termination rates in an unregulated environment. O2’s voicemail remedy or T-Mobile’s suggested alternative remedies. however.67). That said. If and to the extent that they do so. In considering the possible alternative remedies described above. discounted rates for calls to mobiles for socially disadvantaged fixed-line-only customers. Remedying the adverse effects Our proposals for a charge control 2. with or without O2’s voicemail remedy. These could include a public education campaign to increase awareness of retail prices of fixed-to-mobile calls. which we consider to be the only remedy likely to address adequately the adverse effects we have identified. price transparency measures. we have carefully weighed the obligations on us to ensure that our recommended remedy is proportionate to the nature and severity of the detriments we have identified. the level of a reasonable estimate of LRIC. and those of Orange and T-Mobile persistently slightly above those levels. the most effective licence modification to prevent the adverse effects that we have identified is one imposing a price cap on termination charges. This proposal would directly remedy the adverse effects we have identified by addressing their root cause. and the offer and promotion of optional freephone/local rate tariff packages for fixed-to-mobile calls (see paragraphs 13. We therefore now turn to the proposals for a charge control by way of a price cap. O2’s voicemail remedy would address the root cause of the perceived problem by imposing additional constraints on termination rates. The purpose of a cap on the level of call termination charges would be to bring termination charges down to the fair charge. 2. namely that termination charges are currently excessive in relation to cost. then he has to avail himself of the service of termination 117 . The design of the cap would be an RPI–X formula applied to the weighted average termination charge of the MNOs. that the MNOs have the incentive to raise them above current levels. T-Mobile agreed that. plus an allowance for network fixed and common costs and relevant non-network costs. The MNOs put it to us that some of these remedies would be more effective and might even reduce prices below the cap that we propose below. Conclusion on other possible remedies 2. we see no prospect that any of the above alternative remedies (whether individually or in combination) would be sufficient to bring about a reduction of termination charges to acceptable levels over the period to April 2006. T-Mobile added that it would. We note that a charge cap would not pre-empt bilateral agreements. should they choose to do so. Given that the termination charges of O2 and Vodafone have persistently been at the maximum permitted levels since the current charge controls were imposed. that they are not subject to sufficient competitive constraints. In our judgement. then future regulatory reviews will usefully be informed by hard evidence. plus a mark-up for the network externality. Fundamental to our approach to assessing the costs of call termination has been the principle that the party calling a mobile phone should incur only those costs that he himself causes in making that call.65 to 13. In our view. none of these remedies properly addresses the central issues which we have identified. that they are unlikely to be driven down towards a more cost-reflective level in the absence of a charge control on them and that the matter is important enough to warrant considering recommending such a control. be happy to see one or more further alternative proportionate remedies adopted. We are sceptical of these claims but note that nothing in our proposals would prevent the MNOs from putting their preferred remedies into practice. We now turn to our own proposal for a charge control.506. for its part. If a consumer wants to make a fixed-to-mobile or off-net call. that is.T-Mobile.

Our estimate of the relevant LRIC cost per minute of call termination of a combined 900/1800 MHz MNO is 5.333) that this is better captured by way of the externality adjustment than the cost-causation principle. which starts from LRIC.4p in 2002/03 and 4. 6. because the caller benefits from having a large pool of subscribers to call and be called by. and retention on.429 to 2. which should reduce the rate of replacement of handsets. Ramsey pricing dictated that the recovery of fixed and common costs would reflect what the MNOs said was the lower elasticity of inbound calls compared with the elasticity of other mobile services. or benefits from. We have described our approach to the LRIC of call termination. in the absence of any charge control on them. To the extent that customer acquisition costs lead to new mobile subscribers coming onto the network. we have not identified any better or fairer approach. Alternative approaches to calculating a regulated price control 2. and of an 1800 MHz MNO. because it attributes costs on the basis of who causes.3 ppm throughout the period concerned.11). and for externalities. They argued that we ought to concern ourselves with efficient solutions to the problem of allocating common costs.244 to 2.506).446) whether it was likely that. In particular. To the LRIC of call termination. (c) cost-reflective call charges should minimize distortion in the volumes and patterns of calling. and having regard to the adverse effects set out at paragraph 2. which we have calculated in accordance with the cost-causation principle. but we consider that this should be reflected in the externality adjustment. we have already concluded (see paragraph 2. the mobile network as a whole. 2.3p in 2002/03 and 4. them. As we have already seen. (d) there should be no displacement from less resource-intensive to more resource-intensive technology. this also to apply throughout the period. and (e) there will be less incentive for the MNOs to subsidize handset acquisition. This is a justified addition in arriving at the fair charge.508. The issue of who benefits from the call can also be relevant. in our view. and fairness ought to be a secondary consideration. is both right and fair. the MNOs told us that this approach was an unacceptable alternative to the correct approach. it should mean that: (a) consumers do not pay too much for fixed-to-mobile or off-net calls. (b) consumers who make more fixed-to-mobile or off-net calls than on-net calls. the call termination charges of the MNOs would be 118 . So far as the network externality is concerned.333 and paragraph 2. or who make more off-net calls than they receive. 2. namely Ramsey. After long and careful consideration of the alternatives. In our view. thus generating a greater overall volume of calls.provided by the operator of the network whose customer he wishes to call and it is fair that such a consumer should bear the appropriate cost of doing so. They put it to us that the optimal level of call termination charges would be achieved by applying Ramsey principles.449. not via the cost causation principle. will not unfairly subsidize other consumers. and hence should contribute to their recruitment on to. 2. earlier in this chapter (see paragraphs 2.5p in 2005/06 (see Table 2.509.507.45 ppm should be allowed.385) that a mark-up of 0. We discussed earlier (see paragraphs 2. we then add allowances for network fixed and common costs and relevant non-network common costs. The cost-causation approach has been an important part of our identification of the public interest issues and of the adverse effects.0p in 2005/06. or any reason not to pursue the same cost-causation approach in the selection of a remedy. We decided that the mark-up for nonnetwork (that is. we have said (see paragraph 2.510. this approach.331 to 2. administration) costs should be 0.

and also because this would be the efficient outcome which was. and should not jeopardize the attainment of an optimal level of consumption for the benefit of users generally in order to protect a small group suffering some limited detriment. 2. it would elevate the section 3(2) duties above the section 3(1) duties. Telewest put it to us that the Ramsey pricing analyses that had been presented to the CC (and disclosed to the main parties and some FNOs) were based upon incomplete models. which was often difficult to obtain. Vodafone argued. Vodafone said that there was no objection in principle to applying a Ramsey mark-up and an externality mark-up to call termination charges. for the CC to decide that.set at Ramsey levels. Orange said that the work that had been carried out on its behalf showed that the results for termination charges were relatively insensitive to changes in the demand elasticities. In Vodafone’s view. Vodafone and T-Mobile submitted that the duties imposed on us under section 3 of the Act were such that Ramsey pricing. so far as we are aware. 2. The right way for the CC to protect the interests of any such small group was not to distort the telecommunications market generally by imposing the wrong structure of prices but by requiring some specific assistance to be provided to that group.513. in the interests of some particular class of consumer.511. because this was the means by which to ensure that all reasonable demands for mobile services were met. no telecommunications regulator in any other country has fixed prices on Ramsey principles. required by the words ‘best calculated’. but rather that they would have the incentive to set call termination charges that were significantly above Ramsey levels. prima facie. in its judgement. in particular a class of fixed-line-only users.514. Vodafone argued. We concluded that the MNOs would set neither the structure nor the level of prices in accordance with Ramsey principles. this meant that the CC was not justified in abandoning what would be the most efficient method of pricing for the benefit of consumers generally. such that they were probably unusable for any practical regulatory purpose. flawed modelling assumptions and questionable empirical estimates of key parameters. would pay prices for mobile call termination well in excess of the costs which their calling activity causes the MNOs to incur. It was not. Thus. although in theory Ramsey pricing would minimize distortion in the recovery of common costs. Even if the CC were justified in favouring a particular class of consumer. it would be obliged to pay only a proportionate regard to that class of consumer. what was important was that the relativities were correct. and O2 said that precise estimates of elasticities were not essential to determining an appropriate structure of prices. the only correct way to proceed. whose demand is thought to be relatively price-inelastic. if that was the best way to attain the optimal level of consumption of mobile services. T-Mobile told us that we should not prefer an approach just because it appeared to offer simplicity if the Ramsey approach was the best available. while setting prices in the retail market (particularly those related to customer acquisition) that were significantly different from (and probably below) the Ramsey level.400) that a Ramsey-based approach to pricing might be thought to lead to distributional unfairness. Vodafone’s arguments in relation to the operation of section 3 and to Ramsey pricing are not supported by the wording of the relevant statutory provisions. of which Oftel is a member) said that. although regulators typically allow regulated companies to use Ramsey principles to set the prices of individual services where a basket of regulated services is subject to an overall price cap. The Independent Regulators Group (the group of EC telecommunications regulators. certain demands for services which could be met at Ramsey prices were unreasonable and should not be met. with a network externality was. Vodafone said. 2. in that fixed-to-mobile and off-net callers. We received widely differing views on the use of Ramsey from parties who submitted evidence to us.388 and 2. 2. In our view. If the CC were to do so. the method required robust and detailed information on elasticities. which would be contrary to the provisions of the Act. We note that. We also concluded earlier (see paragraphs 2. O2 said that the absolute size of the elasticities did not matter.512. albeit based on estimates. We do not accept that we are putting the section 3(2) duty above the section 3(1) duty or that the section 3(1) principle (that all reasonable demands for services should be met) necessitates a 119 .

Moreover. subject to the recovery of fixed and common costs. Our second objection to Ramsey pricing arises from the formidable problems associated with obtaining reliable estimates of the elasticities of demand which are the basis of the Ramsey approach. which compounds the problems inherent in obtaining a reliable set of estimates. It said that. Oftel also rejected Vodafone’s argument. a Ramsey approach is not consistent with the costcausation principle. as a result. of which efficiency may be one. But.515. We have set out above our conclusion on the correct approach to establishing the costs of call termination. there would. A regulated Ramsey-based termination charge would be likely to ensure an efficient. however. as profitmaximizing firms. the MNOs will set prices using firm-specific elasticities of demand and their relative levels. we would have to be confident that other relevant prices would also be set at Ramsey levels. as arbiter of the means by which to ensure that all reasonable demands for mobile services were met. First. This means that. We have. which we set out in the following paragraphs. origination and termination. It is clear from the evidence submitted to us during our inquiry (discussed in detail in Chapter 8) that no unanimity—indeed. taking all the relevant factors into account. In our view. we do not believe it would be appropriate for us to try to set levels for all the relevant prices. we would nevertheless find it impossible to recommend Ramsey pricing on this occasion. Ramsey-type outcome in the mobile sector as a whole only if competition at the retail level was sufficient to constrain the MNOs to set their overall structure of prices at Ramsey levels. in our view. and that once we are satisfied that we have. Further. in addition. that callers to mobile phones should pay only those costs that they cause by virtue of making calls. if Ramsey were to be used as the basis of a regulated price. However. Moreover. but may be expected to fulfil the duties in section 3(1) while bringing about a more equitable distribution of benefits among fixed and mobile callers than would be attained under a Ramsey system of pricing. already concluded that the retail market is not fully competitive and. the DGT had rejected Ramsey pricing as the best means to the desired end. not least because the retail market is not fully competitive.517. 2. Nor do we accept Vodafone’s view that ‘best calculated’ means that we have to elevate efficiency considerations above those of equity. Furthermore. we identified three further objections to the Ramsey approach. we would have to be confident either that it would be appropriate for us to intervene to set not just termination charges but all other relevant prices. We are satisfied that our own recommendation not only satisfies all the requirements of section 3. we can consider the section 3(2) duties. we believe that if we were to set a Ramsey-based termination charge. we believe that the DGT would experience considerable difficulty in achieving consensus on 120 . for example. In other words. if termination charges were set at the level commensurate with Ramsey pricing. or that if we set termination charges at Ramsey levels those other relevant prices would be set at Ramsey levels by the MNOs. It told us that. Ramsey pricing is about a structure of pricing. to set some prices at levels different from those of Ramsey in that market. the MNOs would both wish. subscription. 2. Consequently. there were no proper reasons to support Vodafone’s argument that the section 3 duties implied that Ramsey pricing was the only correct way to proceed. In other words. and be able. be no guarantee that the MNOs would set their different retail prices at Ramsey levels which maximized overall consumer surplus. even if (which is not the case) we thought that Ramsey pricing was in principle superior to the ‘fair charge’ approach which we advocate. 2. on-net and off-net calls) are even now not set at levels consistent with a Ramsey pattern of prices. This is because the Ramsey approach is concerned with the relativities between different prices. in its view. a large number of elasticity estimates are required to establish Ramsey prices in the mobile sector as a whole (including those for text messaging and mobile internet). We think these will clearly differ from the analogous market elasticities. it is clear that at least some prices at the retail level (for example. considerable disagreement—exists among the main parties and their economic advisers as to the correct values for the various different elasticities that are involved.516. It is clear that the Act requires us to pursue the primary duties laid down in section 3(1) in whatever rational way we see fit.Ramsey approach.

the MNOs would be free to vary termination charges by time of day. Oftel. In summary. if they wished to do so.210 and 2. told us that the informational requirements were too onerous for Ramsey pricing to provide a reliable basis for regulated termination charges. No consensus was reached among the parties submitting evidence on this matter during our inquiry. Third. if our pro- posals for regulation relate to one element only.122 to 2. having regard to the difficulty of allocat- ing subscription charges between handsets and calls (see paragraphs 2. We should say that the price cap that we advocate is based on an average of termination charges.400) and which result in some consumers unfairly subsidizing other consumers. our own proposals for regulation of termination charges would allow the MNOs. The considerations set out in paragraphs 2.520. determination of which is also necessary for the computation of Ramsey prices (see Chapter 7). Further. It is not our recommendation that all termination charges should be set at the same rate irrespective of. subject to an overall average charge cap that will keep the MNOs from earning excessive profits on call termination. giving rise to prolonged disputes between the DGT and the MNOs and resulting in an increase in the overall costs of regulation and delay in the realization of the regulatory benefits to consumers.516). 2. callers will pay the costs they cause the MNOs to incur.518. they are: (a) the absence of consensus regarding absolute and relative price-elasticities. determination of which is necessary for the computation of Ramsey prices (see Chapters 8 and 9).177 to 2.131). neither do we seek to set individual differentiated prices by time of day or week.211). and (g) our inability. together with evidence discussed earlier in this chapter and in Chapters 6 and 8. we believe that to impose individual time of day charges would be unduly intrusive. in accordance with Ramsey principles. (b) the extreme disagreement among the parties as to the nature and extent of fixed and common costs. 2. 2. The cap effectively ensures that. we believe that a regulated price based on Ramsey principles would lead to the sort of distributional inequities which we have discussed earlier in this chapter (see paragraphs 2. from competition in the absence of regulatory constraint (see paragraphs 2. (c) the implausible outputs of some of the models claiming to compute Ramsey prices (see Chapter 9 and Appendix 9. Consequently. lead us to believe that the objections to using Ramsey principles to set an average regulated mobile termination charge are conclusive. for example. to recommend Ramsey prices in the retail market.reliable estimates of the relevant elasticities forming the basis of the Ramsey price structure. indeed.518. day of the week etc. time of day.510 to 2. Thus. on average. This approach is consistent with that taken by the DGT in his proposed licence modification. to set Ramsey-type prices in the wholesale (termination) market.519. namely termination charges (see paragraph 2.187).388 to 2. (e) the uncertainty as to the actual level of prices. according to the various relevant elasticities. in any event. There would in our view be considerable scope for disagreement if these exercises were to become part of the regulatory process. 121 . (d) the inconsistency between actual retail price patterns observed and the retail price patterns claimed as naturally resulting. (f) our doubts as to the complete effectiveness of retail competition necessary for the emergence of Ramsey pricing patterns even in theory (see paragraphs 2.1).

525. EPMU is equivalent to the special case of Ramsey pricing when all the superelasticities of the goods or services in question are equal. the DGT has in effect allocated network fixed and common costs to termination charges using routing factors and we have done so explicitly. because. which was best suited to achieving efficient prices and to ensuring that all reasonable demands for mobile services were met. the costcausation principle yields a very similar answer to that which results from the application of Oftel’s EPMU proposal. Vodafone said that the Act required us to propose a form of regulation. We also note that EPMU is not consistent with our preferred approach (that is. as proposed by the DGT. we have already concluded that the value of the elasticities cannot be reliably established and we could not. they said. whether there should be one or more price caps governing off-net and fixed-tomobile termination charges. albeit that those caps are at levels that we consider to be above the fair charge. That this modification can be effected is demonstrated by the feasibility of the caps currently in force in the licences of Vodafone and O2. if any were necessary. The MNOs argued strongly that use of EPMU would lead to a less efficient outcome than the application of Ramsey principles. Orange warned of the detrimental impact on the industry when regulation was inappropriately applied or wrongly set. since EPMU and Ramsey would then give the same results. We also considered EPMU as an alternative basis on which to allocate the fixed and common costs of the MNOs. establish that they were not different from each other. this question requires us to consider whether a licence modification can remedy or address the adverse effects both as a matter of fact and as a question of law. the error in using EPMU rather than in choosing Ramsey prices would appear to be small. The modification in question is one which caps termination charges. However. In our view. however. in this sense.522. that all regulation was costly. particularly if. therefore. and as a matter of fact. and second. that in this particular case. We note. as we believe. ought to carry a lower proportion of fixed and common costs. mobile services at the retail level were more price-elastic than call termination and. if the evidence on the elasticities of the various mobile services in this case does not show large differences. Therefore.523.2. 122 . prices are set so as to recover fixed and common costs by marking up the fixed and common costs in equal proportion to the LRICs of each service.524. sub-optimal pricing would. the excess of termination charges over costs can be prevented by a licence modification. we have to consider the following: whether we should recommend that termination charges be reduced immediately to the fair charge or whether there should be a glide path. for that reason. Implementation of charge control 2. fixed and common costs are small. it seems to us to be somewhat arbitrary. In principle. Before we can reach a formal conclusion on licence modifications. 2. All these matters must be considered in the light of our existing legal obligations and with the evolving legal framework within which we are operating in mind. 2. that termination charges should reflect the costs caused by the calling party) and. it said. give rise to both allocative and dynamic inefficiency. Under EPMU. the DGT has allocated no customer acquisition costs to termination charges. and whether the same controls should apply to all the four MNOs equally.521. the period of our proposed price control. as investment might be inhibited or distorted. There are two reasons for this: first. They said that there was no indication that LRIC plus EPMU would represent any less of a regulatory burden than a Ramsey approach. Finding on whether the adverse effects identified can be remedied or prevented by a modification of the MNOs’ licences 2. but arbitrary and unnecessary regulation would produce welfare consequences that damaged rather than benefited consumers. and nor have we.

527. One possible solution to the adverse effect identified is the immediate and complete reduction of termination charges to the level of the fair charge. It would. In reaching this conclusion we have paid careful regard to the effect of the new EC Directives1 and to the obligation of member states in the period for implementation of those directives. non-discriminatory.528.2. Under the Licensing and Interconnection Directives. This market disruption would not be in the interests of consumers. in our view. the difficulty is made more acute by legal circumstance. we note that many of our findings are consistent with the structure of price regulation under the new EC regime. Indeed. The model licence modification presented by the DGT sought to regulate termination charges within the period to 31 March 2006. The risk is that such a remedy would not provide the greatest advantage to consumers and that in effect some of the adverse effects we have identified would not be remedied. each MNO has significant market power as understood under the new regime. we have to state whether we believe that the adverse effects can be remedied or prevented. other conditions have to be satisfied. and having regard to the facts that we have found. or. 2. and this sort of price regulation is expressly envisaged by Article 13 of the Access Directive. if it were attempted. We have found the question of the actual design of the licence modifications difficult. 2. we also acknowledge that there is likely to be a process of revenue adjustment from termination charges to other sources of MNO revenue and that this is unlikely to be achieved overnight. Indeed. we are concerned about the probable effects that such an immediate and complete adjustment might have on the mobiles sector. However. as stated above. In discharging our responsibilities under section 14 of the Act. it is likely to have effect for a few months at best. Nonetheless. it is our view that a licence modification which lasts but a few months could remedy the problem of excess termination charges for the period of the duration of the licence and that the sums involved are sufficiently material to warrant such a modification. We recognize that there may be some licence modifications that are not open to us. it would lead to significant disruption. Although this is a difficult question generally. and must in addition be objectively justified in relation to the services concerned. In short an immediate and complete reduction of 1 For a general description of the new directives. Because each MNO is a monopolist on its own network. At the same time we recognize that. any licence modification that we are able to recommend will have a very short life. see Chapter 4. There remains then the question of whether a suitable licence modification can be designed and given effect as a matter of fact and law. In particular. In our view there is a risk in moving immediately to the level of the fair charge.529. However. Our approach to remedying the problem of excess termination charges is cost-oriented price regulation. Our view. 2. During the course of the inquiry it has become clear that the current licences of the MNOs will be abolished by 25 July 2003. We acknowledge that the MNOs have embarked upon contracts with third parties based upon the continuation of a particular level (albeit excessive) of termination charges. and therefore on consumers. be disruptive and create an unacceptable range of adjustment costs to consumers and the MNOs. We do not believe that there are any objections in principle to such an approach. proportionate and transparent.530. But we do not think that the new EC Directives rule out a price cap having effect for the period to 25 July 2003. We do not say that our conclusions in this report can determine whether there will be price regulation of termination charges after 25 July 2003. is that a cap on termination charges imposed on the MNOs through licence conditions which must fall away is not prohibited by virtue of the new directives. 123 . 2. we have identified wholesale mobile termination as four separate markets.526. any modification that we propose must be within the range of modifications specifically permitted in relation to individual licences. we do not believe that there is any legal rule which must prevent any licence modification at all from being introduced in the period to 25 July 2003. before ex ante regulation can be imposed under the Access Directive. Consequently.

BT proposed a middle course. we have continued to use a longer period for the purposes of our analysis of the mobile market and the likely developments in that market. We noted Oftel’s view in the September 2001 review that a glide path provided greater incentives to the MNOs to reduce costs than an immediate reduction of charges to costs.534. 2. We believe that the analysis that we have carried out enables us to take a view of the levels at which charges should be set for the period to 2006. in carrying out our inquiry. and in view of the side effects that we believe would be brought about by an immediate reduction in termination charges to the fair charge (see paragraph 2. it believed that the MNOs were earning well in excess of costs. 2.536. BT therefore proposed an initial reduction to a level which was 50 per cent between current charges and the cost of termination. it only became the case that any licence modification we propose would fall away by 25 July 2003 once the inquiry was under way. we have decided to state our views on the levels at which we think termination charges should be set to 2006. followed by a glide path. It said that it did not anticipate any material change in competitive constraints on mobile termination over the next four years. brought about by efficiency gains but also by the generosity of the current price cap. In summary. and notwithstanding that any modification that we propose for the period beginning 25 July 2003 can have little more than persuasive effect.530). As we noted in paragraph 2. were unanticipated developments with major competitive effects to occur in the intervening period. In our view. We have considered all these matters very carefully.532. the threat to their finances and the revenue effect of a one-off price cut. (c) fixed network users and mobile network users were by no means identical and it was inequitable that the former should continue to subsidize the latter. these were that (a) the MNOs had been setting call termination charges above cost for some time and it was therefore appropriate that price distortions in call termination should be corrected with immediate effect. As we stated in that paragraph. and believed that incentives would be diminished following a one-off reduction down to cost. It would not. 2. it said.526. Oftel told us that a price control should be set for the longest period for which it was possible sensibly to forecast market conditions. It acknowledged the view that regulation should not undermine incentives for operators. a period to 31 March 2006 is a more suitable period for regulatory assessment than a shorter period such as that to 25 July 2003. 124 . 2.531. 2. Consequently. even on a highly conservative estimate. (d) mobile termination did not need to be above cost in order to drive penetration.termination charges would have undesirable side-effects which we are entitled to take into account in forming a judgment as to whether a licence modification would be capable of remedying the adverse effects found. At the same time. when the references were made. Oftel also thought that a glide path would produce less disruption in the markets. we propose an immediate licence modification which takes full account of those adverse effects which can be remedied and prevented within the existing regime. the DGT envisaged that licence modifications would be in effect for the period until 31 March 2006.535. Consequently. and (e) the MNOs should be given no incentive for delay in implementing charge cuts. since the regulated MNOs were then able to keep the benefits of efficiency gains for a period before consumers captured these gains through lower prices. The MNOs expressed concerns about the disruption to the capital markets and the retail mobile market. in the light of this risk.533. 2. Accordingly. be precluded from launching a market review at an early stage and possibly modifying obligations on the MNOs in the light of its analysis. (b) any market disruption would be minimal: any increase in the retail price that was justified as a result of the loss of revenue from termination charges should not be significant. We think that the scheme of domestic and EC legislation is sufficiently wide to allow us to take these side effects into account in recommending a remedy. Some of the FNOs submitted views to us on this matter.

Moreover. and third.5 7. We believe that this approach is not inconsistent with the specific provisions and general requirements of applicable domestic and EC law.5 9. However.6 10.241. as already noted. We accordingly recommend that two charge caps be set (in each case.537.275 to 2.1 2005/06 Unrounded 14. to take effect within the period 1 April to 25 July 2003. or according to where the call originates. Such an arrangement would provide reassurance to consumers. We discussed these matters earlier (see paragraphs 2.539. because of the different market shares of the MNOs. 2. Consequently.307) and have decided that the only differences we should allow are those that are absolutely outside the companies’ control: that is. it would not prevent the MNOs 125 . The first is whether we should set individual caps for each of the four MNOs or whether they should all be subject to the same cap.538. one for O2 and Vodafone and another for Orange and T-Mobile. at different levels for 900/1800 MHz operators and for 1800 MHz operators). The effect of these reductions will be to bring termination charges down to the level of the fair charge by the end of the period.6 4. 2. the price control we are recommending does not seek to regulate the level at which the MNOs set call termination charges according to the time of day or day of the week. As we have already noted. respectively.7 Unrounded 13.0 9. because of the different costs of capital of the MNOs.5 6.12 The CC’s proposals for termination charges to 2005/06 2002/03 2003/04 Apr-July 2003/04 July-Mar 2003/04 Full year Initial cut of 15% and RPI–15 for the remaining 3 periods 900/1800 MHz 2000/01 prices Out-turn prices 9.9 7. one to control fixed-tomobile.3 6. the differences due to the allocation of spectrum.12. We considered a number of reasons why there should be different caps: first. through most of the charges being loaded on to one or other type of call). second.301 to 2. albeit that the average charge lay within the constraints of an overall price ceiling. which allows adjustments to limit the impact of undesirable side effects.6 6. Accordingly.4 7. and then further reductions of RPI–15 for O2 and Vodafone. call termination charges. the modification that we propose for the period to 25 July 2003 is. for fixed-to-mobile and off-net calls (for example.3 Source: CC. in each of the years 1 April 2004 to 31 March 2005 and 1 April 2005 to 31 March 2006. The modification is a 15 per cent reduction in real terms in the level of the average termination charges of each of the four MNOs. effectively. and RPI–14 for Orange and T-Mobile. we considered that it was desirable to preclude the possibility that very different termination charges would be set. There are two aspects to the question of how many price caps we should set. a partial elimination of the adverse effects identified.2. TABLE 2.280 and 2. as shown in Table 2. The other aspect of the question relates to whether we should set separate caps on termination charges for fixed-to-mobile and off-net calls.1 5. and RPI–14 for Orange and T-Mobile for the period from 25 July 2003 to 31 March 2004. we set two price caps.540. and the other to control off-net.8 Initial cut of 15% and RPI–14 for the remaining 3 periods 1800 MHz 2000/01 prices Out-turn prices 2004/05 5.0 7. One or more charge caps 2. because of the different costs of the combined 900/1800 MHz and the 1800 MHz operators. This is to be followed by a reduction in the average termination charge equivalent to RPI–15 for O2 and Vodafone. 2.

543. it may actually receive more for a ported-in call than its standard termination rate. Other matters relevant to the implementation of a charge control Ported numbers 2. at all times. it will receive the lower termination rate. the recipient MNO receives the termination charge of the original MNO minus a small transit charge. minus the transit charge. The first matter concerns the handling of ported numbers in a price control. Given that the price cap for 1800 MHz operators is higher than that for combined 900/1800 MHz operators. O2 and Vodafone have excluded ported calls from the calculation of the termination charge on the grounds that they have no control over them. There are a number of possible mechanisms for taking ported calls into account as part of a price cap. For an MNO with a lower termination rate than another.542. for a new method of calculating the target average charge. This is the current regime. the DGT has an opportunity to re-examine the matter in that context and that we do not need to reach a conclusion on this matter here. set out in Annex 6 to the DGT’s review Statement of 26 September 2001. We do not believe that the MNOs could reasonably object to a separate off-net cap. 2.544. Oftel told us that it had concerns about maintaining the current charge control mechanism. if the termination charge of the original MNO was more than its own termination rate plus the transit charge. but with the option for the DGT to impose (b) if he found evidence of manipulation.541. the revenue that the MNOs would receive from ported-in calls would be. the donor MNO should charge no more for termination of such a call than it would charge for a similar call to a customer who has not ported. O2 said that ported numbers should be excluded. there will be a systematic bias against the 1800 MHz operators if the current regime of counting only calls delivered to a particular MNO is continued. The second matter concerns a proposal. If the termination charges of all the networks were the same. Oftel told us that there were practical difficulties with option (b) above. since such a cap places no pressure on them over and above the fixed-to-mobile cap. For an MNO with a higher termination rate than another MNO. leaving them with higher revenue than is allowed in the cap whenever calls are ported in from an MNO with higher charges. Two further matters were raised by Oftel. as is the current practice. Vodafone made the point in paragraph 2.542(b). For numbers ported into a network from another operator. which it said provided scope for the MNOs to avoid charge reductions. but if they did so. although not implemented by O2 and Vodafone. and (b) that where any MNO sets a termination charge for calls to a former customer of the MNO who has ported to another MNO. 2. The MNOs however 126 .from entering into bilateral agreements with each other to set lower prices. for some ported-in calls. given the change of regulatory regime that must come into effect as from 25 July 2003. Target average charge 2. and proposed that the current position be formalized. less than the standard termination rate. Orange told us that it saw no valid reason to exclude terminating calls to ported numbers from a termination charge control. those prices would be beneath an overall price ceiling. We take the view that. it is further disadvantaged in that. The two of most relevance for our purposes in this inquiry are: (a) that all calls ported out to another MNO’s network should be included in the calculation of the average termination rate.

To the extent that mobile numbers are ported into Hutchison 3G. Oftel told us that it did not have sufficient information about 3G costs to enable 3G calls to be included in its charge control proposals for 2G. based on the actual volumes of each type of call termination. because voice calls over 2G technology will be indistinguishable from those over 3G.548.550 to 2. Vodafone. then Hutchison 3G will inevitably be subject to price limitations imposed by 2G regulation. then it would investigate. summarized below. if accepted. We asked Oftel whether the proposal to regulate 2G calls but not 3G calls would enable the MNOs to levy very high charges on 3G voice calls which.563. Hutchison 3G expressed concern about the possibility that its charges would become subject to control. any charge control which de facto regulated 3G termination charges would be unlawful. so the number of voice calls over 3G in the period to 25 July 2003 is likely to be small). Impact of price cap 2. Oftel told us that it expected O2. we consider the impact on MNOs.148 and 2. It was put to us by the MNOs that our recommendations for a price cap would result both in financial loss for them and higher retail prices for consumers. We discuss the exercises we carried out to assess the likely impact of a reduction in termination charges on these two groups before reaching our conclusions on licence modifications.told us that their flexibility would be reduced if it was changed. 127 . we discuss the welfare impact. as with ported numbers. 2. the four incumbent MNOs have announced a delay to the launch of their 3G services. we look at the impact on consumers. As we have already noted (see paragraph 2. and which are described in detail in Chapter 9. we are limited by our terms of reference to making recommendations concerning only 2G call termination charges. we have come to the view that.547. which we note that these MNOs said they could estimate. thereby undermining the purpose of the charge control. In paragraphs 2. We now turn to the impact which our recommendations for a price cap might have on welfare generally and on consumers and the MNOs.149. Therefore.546. During the period of some three months in which our recommended licence modifications.40). 2G/3G calls 2. Oftel announced in its September 2001 Statement that it did not intend to include 3G voice calls in its current proposals for regulation. 2. Orange and T-Mobile to charge a melded rate.559 to 2. any charge controls on 2G termination charges would necessarily regulate 3G pricing. and in paragraphs 2. As discussed in paragraphs 2. we note that Hutchison 3G will have a monopoly over the termination of voice calls to its network.549. The DGT has the option of reviewing his stance on 3G voice call termination during that period and considering whether any regulation of termination charges for voice calls to 3G would be desirable or feasible. would have effect. 2. with the regulated charges on 2G calls. The four MNOs and Hutchison 3G expressed concern to us that. We do not regard that as a serious impediment to Hutchison 3G’s roll-out.558. Our overall conclusion is at paragraph 2. T-Mobile argued that regulation of 3G pricing was not permitted under EC law and was not even contemplated by the EC draft Recommendation on markets. (in any event. this matter should be left to Oftel to consider further when the current licence modifications expire in July 2003. would result in an average price well above the capped 2G termination charge. Having considered this matter. we would not expect them to have any significant detrimental effects on the MNOs.545. This involved two separate sets of calculations.569. notwithstanding that 3G calls were not formally included in such controls. but that if the level of charges for 3G call termination raised concerns.568. However. in paragraphs 2.564 to 2.

555.12).550.1. we used the parties’ models under a set of ‘base case’ assumptions. DotEcon. as we said earlier. Second. (b) second. our analysis using this approach shows that.36 and 9. over and above what they pay for that good. however. if a price cap were imposed). However.553. while CRA. we looked at two scenarios for unregulated termination charges. in both these situations (regulated and unregulated) the models effectively set retail prices according to Ramsey principles. First. 2. using the models of DotEcon. 2. We analysed what the level of welfare would be if the termination charge were regulated (that is. 2.61. Consumer surplus is a measure of how much consumers value the consumption of a good. Broadly speaking. Frontier Economics and Rohlfs models all calculate the optimal fixed-to-mobile termination mark-up as being below current levels (see Table 9. where the costs of termination are allocated to those users that generate the costs. For these reasons. as we have already stated. the models make use of elasticity estimates which we believe are unreliable. unlike the MNOs’ models which allocate the costs of the MNOs’ operations on the basis that they are mostly fixed and common costs. Third. as they compared the optimum derived from their models with a constrained situation (see paragraphs 9. we believe that 1. A discussion of these models and their results is set out in full in Chapter 9 and Appendix 9. Frontier Economics and 128 .44). they are based on Ramsey prices at the retail level and we have already noted that we do not believe that such prices occur or would occur. we looked at the effects of using the termination charge as calculated by Rohlfs’s Ramsey-based model against Rohlfs’s model of an unregulated industry. we believe that results from the MNOs’ models should be viewed only as approximations of changes in welfare. because only Dr Rohlfs provided a model of how MNOs might be expected to operate in a completely unregulated industry. We noted that the analyses carried out by DotEcon and Frontier Economics must result in a welfare loss. Overall. which are set out in paragraphs 9. we ensured that the R-G factor implied by the models was around 1. we used the parties’ models to compare the results from a regulated termination charge with the results from two possible unregulated situations. In our first approach. Any change in welfare would be the net effect of the change in consumer surplus and the change in producer surplus. Producer surplus is effectively the difference between total revenue and total costs.60 and 9. when a regulated scenario is compared with an unregulated one. In summary. have a number of reservations about using the models referred to in the previous paragraph. Dr Rohlfs (on behalf of Oftel) found welfare gains from reducing termination charges. and. 2. To do this. We noted that the way in which the CRA model was set up and the way in which it incorporated the effects of externalities made it more likely than not that there would be a loss in welfare as a result of a reduction in the termination charge. We consider the more relevant scenario to be where unregulated termination charges remain at current levels in nominal terms. and compared this with the level of welfare that would result with no such price cap. we believe that costs should be allocated on the cost-causation principle.551.Impact on welfare 2. DotEcon and Frontier Economics (each working for an MNO) found that departures from Ramsey-optimal termination charges (which they claimed were at or above current levels) resulted in welfare losses. CRA.554.5 (although.5 is probably something of an overestimate) and we note that under these assumptions the DotEcon. 2.42 to 9.33 to 9. In this latter comparison we used Rohlfs’s models only.552. where prices in the unregulated situation are not necessarily Ramsey-based. with the exception of Rohlfs’s unregulated model. We analysed the effect on welfare of a regulated termination charge in two ways: (a) first. Frontier Economics and Dr Rohlfs provided us with models which investigated the effect on welfare of the imposition of a cap on termination charges as compared with various alternatives. We do.

Some of the MNOs suggested that we should follow the methodology employed by DotEcon and Frontier Economics in their welfare analyses. For the CRA model.86. In order to assess the financial consequences of a price cap for MNOs and consumers. For the vast majority of the simulations that we ran. Many of the criticisms concerned the methodology we employed. We do. however. However. that termination charges rise to 17 ppm.48 to 9. Our second approach was to use Rohlfs’s model of regulated and unregulated behaviour to carry out the same comparative exercise. The MNOs criticized the approach described above. and in most cases this gain was large. 2. While acknowledging that this simulation cannot be regarded as precise. It is clear that the magnitude of the gain depends very much on the comparison made and the model (and assumptions) used. Conclusion on welfare 2. use of the DotEcon and Frontier Economics methodology would result in a gain in welfare from regulation because the fixed-to-mobile prices used in our welfare analysis (as shown in Table 9.558. therefore. Impact on MNOs 2. Regulating termination charges from current levels produces welfare gains (in net present value (NPV) terms) of around £700 million (with an immediate reduction in charges) and around £325 million (with a progressive reduction in charges) over the three-year control period. that is.12) are optimal (under our base case assumptions) and moving to the higher prices considered in the unregulated scenario must. that there will be gains not losses from regulating termination charges.Rohlfs. comparing the unconstrained optimum with the outcome derived by constraining the fixed-to-mobile termination charge at the ‘unregulated scenario’ level.4 billion from a progressive reduction in charges). the result is an increase in welfare as a consequence of regulation. Their criticisms are summarized fully in Chapter 9. By using the MNOs’ models with our preferred assumptions. we consider that the fact that most of the models produce large welfare gains under various assumptions lends strong support to the argument that termination charges should be regulated. We believe that these gains are probably overestimates because we do not expect that. we and other parties have reservations about CRA’s model and these are set out in paragraphs 9. The 129 .559.50 and 9. We begin with the financial impacts on the MNOs of charge controls on termination charges. we have compared what would happen were a price cap to be imposed with what might happen otherwise. that is. welfare gains are shown of between around £325 million and around £700 million over a three-year period. by construction. termination charges would rise to levels projected by Rohlfs’s unregulated model. on the changes in the prices likely to be charged to mobile customers (in the form of changes to average bills) and on subscriber numbers. as noted earlier. 2. the unconstrained situation must. We have considered two counter-factuals: first. Given this. a move from the unregulated to the regulated termination charges results in a loss in welfare. We turn next to consider the effects of price caps on the finances of the MNOs. it was the case that there was a welfare gain from regulation of termination charges. However.557.556.85 to 9. and second. in the absence of regulation. 2. reduce welfare (as we are moving away from the optimum). This showed large gains over the control period from regulating termination charges (in NPV terms. that termination charges remain constant at their current levels. £3 billion from an immediate reduction in termination charges and about £1. believe that the basic conclusion from the Rohlfs’s model analysis is correct.560. produce a greater level of welfare than the constrained situation.

This showed expected real price reductions of 5. and of course there would be no impacts on the prices to mobile customers with no waterbed effect. obviously.564. and hence we have decided to concentrate on that option for our comparison. according to Oftel and Vodafone. (These calculations. 2. if any. where the MNOs did not recover lost revenue from a fall in termination charges by increasing retail prices to mobile customers. we expect that the waterbed effect may not be a full 100 per cent. and are discussed in paragraph 9. taking account of Orange’s view. Orange did not provide comparable figures but it told us that it expected outbound prices to fall in real terms.565.27.561. these reductions in revenue are overestimates.5 billion and £2 billion (in 2001/02 prices). We consider this possibility more fully in the following paragraphs. that is. We start by estimating the size of retail price changes which would occur if there were a full waterbed effect. We have found it convenient to refer to this rebalancing of the loss of revenue from capping termination charges with its retrieval through raising prices in the retail sector as the ‘waterbed effect’. we regard the scenario of prices remaining constant as more realistic. there are no financial impacts on the MNOs with a full waterbed effect. ie most of the reductions in revenue from termination charges being capped will be recovered from the retail market. With a 50 per cent waterbed effect. We have done this by comparing them with the price changes projected by the MNOs in their business plans. the nature and extent of the rebalancing will depend on the amount of revenue to be recouped (and. However.26 and 9.563. prices would rise between 4 and 7 per cent in 2003/04. which projected real reductions in outbound calling prices. Our calculations suggest that. This view is consistent with the other MNOs’ business plans. or to try to recover the revenue in other ways.5 per cent a year. We also express the price increases as a compound percentage change over three years. together with others positing different glide paths.124. and second because. With a full waterbed effect and unregulated termination charges at current levels. in NPV terms.562. that is. first because they assume that the MNOs’ turnover will remain constant at 2001/02 levels. there will be a waterbed effect. 2. calculated as a simple average for all the MNOs. These possible price rises need to be set in context. Comparing this reduction with our estimate of the price increases that would (assuming a full waterbed) follow a termination charge reduction implies that average retail prices would still fall but by. We calculated the annual average real price reductions in the MNOs’ business plans for the period 2004 to 2006. as discussed earlier in this chapter. about half of the rate as shown in the MNOs’ business plans.) These reductions in revenue account for about 6 per cent of the NPV of the MNOs’ aggregate turnover.latter reflects a level of charges that could be reached in an unregulated environment. with no waterbed effect. We estimate that it would be possible for the MNOs to recover much. It is difficult to be precise about the size of this effect but. to which the reduction in revenue resulting from the imposition of a price cap on termination charges would oblige them to rebalance their other retail prices in the ways they have described. in our view. are shown in Tables 9. Bearing in mind the views of the MNOs (set out in Chapter 9). This method gives an annual average increase in prices of less than 3 per cent. the degree of competition in the retail market). 2. it is important to ascertain the extent. the combined reductions in revenue of the four MNOs. or perhaps all of. these price increases would be halved. 130 . We believe that. 2. Naturally. in practice. incurred as a result of capping termination charges would be between £1. the lost revenue which arises from capping termination charges by delaying price cuts at the retail level. The MNOs’ reductions in revenue are halved with a 50 per cent waterbed effect and. as we have found that the retail market is not fully competitive. on average. by about 3 per cent a year. Impact on consumers Price impacts for mobile customers 2.

Conclusion on impact on consumers 2. They stated that this would enable the impact of the regulation itself to be assessed.570. we do not expect a price cap to lead to any significant reduction in the number of subscribers. Thus. however. and not the result of our recommendations.566.567. 131 . Proportionality and effectiveness 2. most marginal subscribers would not replace their handsets so often. even if handset subsidies were reduced. we believe that any increase in retail prices following the implementation of our recommendations would be a commercial decision on the part of one or more of the MNOs. We also believe that the acquired habit of using mobile phones means that such subscribers are now less marginal than they were when they first signed on to the network and that people already owning mobile phones are unlikely to leave the network unless their handset is lost. This is because we believe that the theoretical increase in retail prices ostensibly necessitated by the reductions in termination charges that we are proposing will be more than offset by reductions in other prices as set out in the MNOs’ business plans.2. without instituting average retail prices increases. absent the regulation. we conclude that a price cap on termination charges to bring them down to the fair charge will benefit consumers by reducing the price of fixed-to-mobile and offnet calls and. overall. As we believe that. stolen or broken. for example. we do not expect a large reduction in the number of subscribers on the four networks. depending on how the MNOs respond. We do not accept this. Volume impacts of regulation 2. against the counterfactual of what would otherwise occur. Thus. In summary. They said that the possible rebalancing effects on outbound call prices should be assessed on a stand-alone basis. it is sufficient that the MNOs slow the decline of retail prices in order to recover the revenue loss from reduced termination charges that we are recommending. We conclude that it will be possible in principle for the MNOs to more or less fully rebalance their prices.568. we believe that. The MNOs have the option to offer marginal subscribers cheaper packages to induce them to stay on the network once that happens. Overall conclusion 2. so that a decision could be made as to whether the regulation would lead to greater benefits than costs. Orange and T-Mobile told us that it was irrelevant to the issue of whether termination charge controls were warranted that outbound price rises resulting from regulation of termination might or might not be offset by planned outbound price falls. there will be a reduction in average retail prices. Some of the MNOs submitted that our proposed charge cap remedy was disproportionate in relation to the alleged detriment. We are obliged by virtue of various provisions of the Licensing and Interconnection Directives1 to act in accordance with the principle of proportionality. following our proposed reduction in termination charges. This is closely related to our duty to decide whether the 1 See. but average retail prices should still fall.569. It follows that we believe that our decision to regulate termination charges will have no major impact on the number of mobile phone customers. If. in the first instance. As their own business plans indicate. could be broadly neutral so far as concerns the effect on the MNOs’ financial viability. handset subsidies were reduced or removed. Article 3(2) of the Licensing Directive.

576. In contrast to the outcome of other regulatory inquiries involving monopoly considerations. Orange or T-Mobile in relation to Vodafone. It would have been open to us to have assessed that the element of excess we identified was so small as to render any intervention disproportionate and thus the continuation of the licences unamended would not operate or be expected to operate contrary to the public interest. maintain its retail prices at current levels at a time when the other MNOs were forced. accept that our proposals for bringing termination charges down to the fair charge will adversely affect the competitive position of O2. and that the detriments if we capped call termination charges at too low a level would be much greater than if we capped them at too high a level. the concerns of the MNOs are misconceived. or on their profits. We do not. we place no constraints on the prices that the MNOs charge to their customers. any recommended modification. Proportionality arises again when assessing the appropriate licence modification to recommend to the DGT. that is. as noted in paragraph 2. 2. while ensuring that the matters to which we are to have regard under section 3(1) have been secured. Such modification can go no further than that statutory objective. 2. with both a greater capacity to absorb the effects of the reductions in revenue brought about by the price cap than the other three MNOs and the incentive to exploit that advantage at those companies’ expense. if left unamended. it must be the least intrusive means of preventing or modifying the adverse effects. In our view. whether alone or in combination. only a price cap on termination charges is adequate for this purpose. In our view neither claim is valid. must accord with the principle of proportionality. by virtue of the reduction in termination revenue. because of the continuing decline in retail prices that is observed in the recent past and planned for in the future. they suggested.572. 2. we do not believe that any re-balancing of prices consequent on our proposals will necessitate increases in average retail prices. therefore. Vodafone might. Vodafone could have exploited this strength with a view to gaining a competitive advantage at any time.571.559 to 2. The object of such a proposed modification is to prevent or remedy the adverse effects identified by the CC. 2.existing licences. 2.574. however.565. We note also that the two more recent entrants have succeeded in gaining market share at the expense of the established operators and we would expect that. Further. the reduction in termination charges we recommend will necessitate little or no increase in the MNOs’ retail prices in order to preserve their 132 . O2. We accept that Vodafone may be in a more advantageous competitive position. albeit only advisory. whom they considered to be the strongest player. to the extent that it is already the strongest player on a number of measures. Orange and T-Mobile put it to us that our recommendations would prejudice them in relation to Vodafone. As we have shown in the discussion of the impact of our proposals on consumers and the MNOs in paragraphs 2. Further. we have not observed that it has chosen to do so. in a fairly competitive market. We believe that none of the other proposed remedies. to raise theirs. On this. We considered this very carefully in our choice of modification and in relation to the extent and timing of the reductions in charges we proposed and their likely impact upon each party. The MNOs have also claimed that the commercial effects of our conclusions and remedies in this inquiry are particularly far-reaching.573. would have been effective to remedy the adverse effects associated with above-cost termination charges. For example. we are satisfied that the element of excess we identified is sufficiently high to warrant a licence modification requiring an initial reduction in charges. operate or may be expected to operate contrary to the public interest. 2. we have fulfilled our obligations under section 3(2) of the Act by addressing the detriment to consumers which above-cost termination charges have brought about. each MNO would continue to find ways to win (and retain) customers at the expense of its competitors.568.575. on this basis.

Thus. 2. the effect would be to create an unjustified subsidy in the reverse direction. Formal recommendations on licence modifications 2. RPI–15 from 1 April 2004 to 31 March 2005.12) that the GSM call termination charges of Orange and T-Mobile: (a) be reduced by 15 per cent in real terms before 25 July 2003.12) that the GSM call termination charges of O2 and Vodafone: (a) be reduced by 15 per cent in real terms before 25 July 2003. and (b) be subject to further reductions of RPI–15 from 25 July 2003 to 31 March 2004. and RPI–15 from 1 April 2005 to 31 March 2006. the effects of our conclusions and remedies are much less far-reaching than in other inquiries. 133 . and RPI–14 from 1 April 2005 to 31 March 2006. 2. And our conclusions and remedies do not cover the 3G business. neither do we believe we have done so. As noted.578. set at the same level. and (b) be subject to further reductions of RPI–14 from 25 July 2003 to 31 March 2004. We recommend (see Table 2. We recommend (see Table 2.580. all or part of this subsidy would continue.579. If we were to cap them at too low a level (which we do not believe we have done). which all the MNOs have told us is where their long-term future lies. We recommend that the four MNOs should each be subject to two termination charge caps.577. one to control the level of GSM call termination charges for fixed-to-mobile calls and the other to control the level of GSM call termination charges for offnet calls. 2. If we were to cap termination charges at too high a level. we do not seek to do this. RPI–14 from 1 April 2004 to 31 March 2005. The main effect and purpose of our remedy is to remove an unjustified subsidy currently paid by FNOs or their customers to the benefit of the MNOs or their position.