Establishing world-class connectivity throughout the UK Contents

6Openreach’s performance since 2005

150.A central question throughout this inquiry has related to the nature of BT Group’s relationship with Openreach and, relatedly, Openreach’s performance in network development and maintenance of telecoms infrastructure.

151.In considering the position of BT and Openreach in the telecoms sector today, it is worth reflecting on the historical context. Having been separated from the Post Office in 1981, BT—then British Telecom—was privatised in 1984, with the sale of over 50% of its shares to the general public. At privatisation all the telecoms access infrastructure transferred with the rest of the business to the new partly privatised British Telecom PLC. A second share issue took place in 1991, and a third issue followed with the Government selling off virtually all of its remaining shares in 1993.189 Since then, aside from changing its name from British Telecom to plain BT, the company has undergone a number of changes.

152.After BT’s privatisation, retail price control was the main regulatory mechanism to prevent high prices. A duopoly review in 1991 shifted the emphasis towards encouraging end-to-end competition, for example from cable. But when its effectiveness was shown to be limited, the emphasis shifted again, to access-based competition. This culminated in the market-by-market analytic approach set out in the 2003 European Telecoms Framework. In recent years these market analyses have taken place on a three-year cycle by Ofcom.190

153.The most striking change came in 2005 during Ofcom’s review of the telecommunications sector.191 At that time, Ofcom’s consultation found that people wanted more choice in telecoms services rather than simply lower prices. Whereas the mobile market was delivering end-to-end competition and choice, this was not happening to any adequate extent in the fixed telecoms sector. Ofcom therefore adopted the principle that, in the interest of increasing competition, its regulation should promote competing infrastructures as deep into the network as was likely to be effective and sustainable.

154.For this to happen, Ofcom concluded that BT needed to make access available to its network on the same terms as it was available to itself. A fundamental question in their review was whether structural or operational separation of BT, i.e. separating out the access network from the rest of the Group, was necessary. In June 2005, as part of the negotiation, BT offered Ofcom a set of undertakings in lieu of Ofcom making a referral to the then Competition Commission for a full market review; Ofcom accepted these and this led to the creation of Openreach.192

155.Functional separation of Openreach involved the establishment of a separate access services division with its own management board, CEO and incentive structure. Openreach is required to provide equality of access to BT’s competitors through ‘equivalence of input’. This allows BT’s wholesale customers (i.e. retail competitors that use BT’s local access network) to purchase the same wholesale products, at the same prices and using the same systems and transactional processes, as BT’s own retail businesses. As well as limiting BT’s ability to engage in price and non-price forms of discrimination it was hoped that, by requiring BT itself to use the same products and systems as its rivals, functional separation and equivalence of input would give BT better incentives to improve the products and quality of service that it provides to its competitors.193

156.The creation of Openreach, along with lowering the regulated access process for local loop unbundling, have been very effective in stimulating service competition in the communications sector, improving customer choice without excessive prices. The UK retail market has seen the emergence of two of the top four broadband providers, Sky and TalkTalk, come from a base of zero subscribers before functional separation to supplying 40% of the market within 10 years.194 Nevertheless, a decade on, the Digital Communications Review (DCR) this year has demonstrated that the present system is not working as well at it should. It had been hoped that the requirement for BT itself to use the same products and services as its rivals would encourage Openreach to improve its quality of service and the provision for all its network customers. However, the evidence presented in the DCR demonstrates that Openreach has:

Quality of service

157.Openreach’s poor quality of service is one of the single biggest issues highlighted as needing urgent attention in the DCR. Although standards of service, specifically customer service, are also problematic in the wider industry, Ofcom has identified Openreach’s quality of service provided at a wholesale level to communications providers, including to BT’s businesses, as being highly unsatisfactory. For instance, there have been:

158.According to Sky, a history of under-investment in Openreach has led to a range of service quality problems which, in addition to the above, have also included jobs that were simply not completed.

159.When Sharon White gave evidence, she explained that Ofcom had come fairly reluctantly to setting quality of service standards for Openreach in the provision and repair of copper access lines following its 2014 Fixed Access Market Review.195 Ofcom has also set tougher targets for Openreach in relation to leased lines in its Business Connectivity Review in March 2016.196 Since 2011, however, the average time taken between the customer’s order and the line being ready had not been reduced, but had increased from 40 to 48 working days. Openreach had also failed to complete one in four leased line installations on the initial date it promised a customer. We were told that Ofcom targets represented minimum standards, and that if BT failed to meet them Ofcom could impose a fine on BT of up to 10% of its turnover.197

160.It would appear that Openreach scaled back its resources during the recession but has recruited over 3,000 new engineers in the last two years198 and has committed to hiring 1,000 more.199 We were told that Openreach was now exceeding all 60 of the minimum service level targets Ofcom has put in place—though, as Gavin Patterson admitted, this was not widely understood. In an article in The Telegraph in May 2016, Mr Patterson apologised for Openreach’s poor customer service. He explained that BT was now moving up a gear to ensure it did better, and promised to halve the number of missed appointments where Openreach was at fault within a year.200

161.Openreach’s reputation for poor service has been borne out by the numbers of constituents writing to MPs in frustration over the delays and problems experienced as a result of its work. Given the scale of the problem and the impact delays have had, Members have stepped in, and there have for example been two debates in Westminster Hall this year regarding BT Openreach’s service standards alone. BT’s undertakings stipulate that Openreach should treat all providers equally, a condition that is enforced by the Equality of Access Board.201 Yet Sky told us that the truth of the matter was that all communication providers received very poor service.202

162.Issues with service quality have not related to Openreach alone. For example, it offers enhanced service levels at the wholesale level, but these do not appear to be made available by retail providers. In particular, Openreach’s highest broadband service care level, offering a six-hour fix, is not offered to consumers by many retail providers. Ofcom has noted that this is an example where improved quality requires industry coordination. Where a wholesale service is offered by Openreach, communication providers need to be able to match the new care level within their own systems and resourcing for it to be offered to consumers. This does not appear to be happening sufficiently.

163.The introduction of a USO could be used to set out minimum service standards for holding communications service providers to account. As is common with other utilities, Ofcom is currently consulting on proposals to bring in automatic compensation for residential consumers and smaller businesses if certain service standards are not met. Automating the payment of compensation should help to ensure that consumers are compensated more quickly and easily by their retail provider when they are entitled to payment as a result of service quality issues. Ofcom believes such compensation would introduce incentives for providers to improve service quality and help prevent service quality issues occurring in the first place.

Level of investment

164.According to BT’s annual reports, Openreach is the most profitable business in BT Group. In 2015/16, Openreach revenue was equivalent to 27% of total BT Group revenue. But it had the largest EBITDA—Earnings Before Interest, Tax, Depreciation and Amortization, also thought of as operating cash flow—of the Group at £2.664bn, reflecting the return it earns on its extensive network assets.203 At the same time, as a capital-intensive business Openreach incurs significant capital expenditure and depreciation costs, which are not reflected in its EBITDA contribution. Around 60% of Openreach’s revenue is generated from other BT lines of business, so its contribution to external group revenue is the smallest, at 11%.

BT Financial results for financial year 2015/16

£m

Group summary

Breakdown by business:

Openreach

EE

BT Business

BT Consumer

BT Global Services

BT Wholesale

Revenue

18,909

5,100

1,055

3,130

4,598

6,530

2,086

Operating costs

12,329

2,436

794

2,054

3,561

5,482

1,544

EBITDA

6,580

2,664

261

1,076

1,037

1,048

542

Depreciation and Amortisation

1,301

176

198

206

518

212

Operating profit

†3,473

1,363

85

878

831

530

330

Capital expenditure

2,650

1,447

111

138

206

415

177

Operating cash flow

3,098

1,417

310

819

762

475

404

Net debt

9,845

Source: BT Group Annual Report 2015/16

† Before taxation

Note: Areas such as BT Technology, Service & Operations are not included in this break down

165.A concern expressed about BT is that Openreach has been “over-earning” substantially in relation to its cost of capital while Openreach’s investments, including in fibre, have not increased since 2009. On BT’s regulated returns, Ofcom estimates that the gap between BT’s returns and the benchmark cost of capital is £4bn over a nine year period up to 2013/14204 and that around two-thirds of the estimated gap was accounted for by factors205 that represented policy choices made by Ofcom when setting charges or through inherent forecasting challenges.206 The remaining third was due to BT’s efficiency against the charge controls put in place.

166.Since publication of the £4bn figure, BT has published its financial statements for 2014/15. Ofcom told us that these show that BT’s regulated products have made returns significantly higher than their estimated weighted average cost of capital (WACC) in BT’s business lines markets.207 On this point, Gavin Patterson said in his testimony that he did not accept that BT made “excess profits”, contrary to Ofcom’s findings.208 On leased lines, he argued that Ofcom had decided to keep prices high to encourage the business market to move to the next generation of technology.209

167.Similarly, Sean Williams, ‎Managing Director, Strategy, Portfolio, Legal and Regulatory Services at BT Group, told us one of the aims of Ofcom’s regulation is to promote efficiency by permitting regulated firms to achieve returns above their cost of capital, if those greater returns can be achieved by reducing costs.210 This works in the national interest, he suggested, by encouraging efficiency in the industry. The savings made by reducing costs are then, under Ofcom’s direction, passed onto broadband retailers in the form of lower Openreach prices, after a period of no more than three years. In the intervening period, Openreach is allowed to hold onto the profits generated by dint of reducing costs. However, this argument appears to conflict with Mr Patterson’s evidence: in effect it concedes Ofcom’s point that BT earns excess profits, but points to other reasons why such profits are acceptable. In any case, it was only in 2014 that Ofcom introduced quality of service standards into their market review process. As is now evident, achieving standards must be a key factor in this price-control determination, otherwise low prices can be achieved at the expense of quality.

168.Openreach has operated under a relatively consistent capital budget of approximately £1bn per annum since its creation. However the mix between different priorities within this budget has changed over time. For the period up to 2014/15, TalkTalk told us that after adjusting for inflation Openreach’s capital expenditure had fallen by around 20% in real terms since 2008/09.211 In its assessment, Openreach’s investment in its copper network, on which superfast broadband and most other providers depended for the links to premises under FTTC solution, had fallen by around 50%.212 A summary of Openreach’s capital expenditure by technology type is given in the following table

Openreach capital expenditure spend by programme categorised by technology type £m

2009/10

2010/11

2011/12

2012/13

2013/14

2014/15

Forecast 2015/16

Ethernet Total

112

124

118

164

177

206

261

Copper Total

464

466

460

444

423

424

500

Fibre Total

128

262

313

360

233

165

217

BDUK/SEP Net

-

2

11

12

56

142

262

Other Total

205

234

175

166

161

146

129

Total

909

1,089

1,077

1,146

1,049

1,083

1,369

Source: BT submission (EWC0097)

169.BT told us that its gross capital expenditure in Openreach had been over £1bn each year for most of the period since Openreach began but that it had grown for each of the past four years. For 2015/16, BT’s actual capital expenditure in Openreach was £1.447bn,213 of which approximately £500m was forecast to be expenditure on copper: both amounts represented significant increases on previous years. Basing its account on the sharply higher peak expenditure in 2015/16, BT pointed out in that year, gross capital expenditure in Openreach was nearly 70% higher (excluding public funding) compared with 2009/10.214 Based on 2014/15, it would be just 19 per cent higher.

170.In May 2016, BT announced new investment plans in fibre, 4G and customer service. This was the first investment announcement following BT’s acquisition of EE, earlier in the year. Together the Openreach and EE businesses plan to spend around £6bn in capital expenditure over the next three years.215 Given that Openreach’s capital expenditure last year was £1.447bn and EE’s had been running at £500m per annum, this appears to us to represent a continuation of last year’s spending levels, rather than any substantial increase. Yet even so, BT emphasised that its new investment plan was “subject to regulatory certainty,” indicating that it could only make big investments in infrastructure if it knew that its business would not face interference.216

171.BT has failed to improve already poor quality levels at Openreach in recent years, while overall investment has remained flat until very recently. For its part, Ofcom was slow to introduce minimum standards of service with financial penalties for Openreach, happening some nine years after its creation. Ofcom regulates for competition, and its charge control regime has kept a downward pressure on prices, so that the UK’s communications prices are among the lowest compared with similar EU countries. But this mechanism has not been successful in holding Openreach to an adequate quality of service; and it is an open question how effective overall it has been in stimulating investment in Openreach’s infrastructure.


189 The Government then relinquished its Special Share in 1997, retained at the time of flotation which had allowed it to block a take-over of the company and appoint two non-executive directors to the board.

190 See: Strategic Review of Digital Communications, Discussion document, Ofcom, 16 July 2015.

191 In April 2004, Ofcom published a consultation of its Strategic Review of Telecommunications. The review was designed to set out a strategic direction for Ofcom’s activities in relation to telecoms, and to create a new settlement between the regulator, the companies it regulated and consumers.

192 Ofcom has the power to make a reference to the Competition and Markets Authority under Section 131 of the Enterprise Act 2002. These references can be made where there are “reasonable grounds for suspecting that any feature, or combination of features, of a market in the United Kingdom for goods or services prevents, restricts or distorts competition in connection with the supply or acquisition of any goods or services in the United Kingdom or a part of the United Kingdom.”

193 See Ofcom, Strategic Review of Telecommunications, Phase 2 consultation document, 18 November 2004, paragraph 6.13.

194 NB: In 2009, Tiscali sold its UK subsidiary to Carphone Warehouse following regulatory approval from the European Commission and the service was rebranded as TalkTalk in January 2010. Easynet was owned by British Sky Broadcasting, from 2006 to 2010.

195 Under the targets, the majority of phone lines must be repaired within two working days, while most of those requiring a new line must receive an appointment within 10 working days.

196 ‘Ofcom demand better business services from BT’, Ofcom Press Release, 22 March 2016.

197 Q984

198 Communication Workers Union (CWU) (EWC0032), para 27.

199 BT to invest billions more on fibre, 4G and customer service, BT Press Release, 5 May 2016.

200 ‘I know BT broadband can be infuriating and I’m the boss of BT’, The Telegraph, 23 May 2016.

201 The Equality of Access Board is a committee of the BT Group plc Board. It is supported by the EAB Secretary and the Equality of Access Office.

202 Q110

203 BT Group Annual Report 2015/16, p58

204 Over the same period BT’s revenues in these markets were around £56bn.

205 Factors include: incentive effects; balancing policy objectives; price control design; and changes in the way costs are recorded.

206 Strategic Review of Digital Communications, Discussion document, Ofcom, published 16 July 2015, para 4.52.

207 The weighted average cost of capital (WACC) is the cost of funds used for financing a business, given by the weighted average across all sources of capital such as equity and debt. To calculate the WACC the cost of each source of funds (e.g. the interest rate paid on debt) is multiplied by its share of the total market value of the firm’s financing.

208 Ofcom (EWC0125)

209 Q793

210 BT (EWC0123)

211 TalkTalk (EWC0056), para 6.2. Period between financial years 2008/09 and 2014/15.

212 FTTC and Superfast Broadband does involves replacing some of the copper with fibre.

213 BT Group Annual Report, page 89

214 BT (EWC0123)

215 BT to invest billions more on fibre, 4G and customer service, BT Press Release 5 May 2016

216 Following the merger, there should be opportunity in the next few years for BT to achieve significant operating cost and capex synergies through integration of some parts of the business and network sharing.




© Parliamentary copyright 2015

18 July 2016