189.In regulating BT, given its vertically integrated structure, Ofcom faces the dual task of controlling its monopoly power over essential infrastructure and preventing it from discriminating in its treatment of rival retailers. The regulator therefore has to expend a great deal of time preventing such behaviour happening. Separation would eliminate the opportunity for such discriminatory actions but would not remove Openreach’s potential abuse of its significant market power.
Position in Australia, New Zealand, Singapore and Sweden
Structural separation requirements have been applied in Australia, New Zealand and Singapore. In all three of these countries, the imposition of structural separation was one condition of next-generation broadband network development. We have also set out the arrangement in Sweden.
Australia opted for a model of structural separation based on Telstra’s and Optus’access networks. The government-owned NBNCo has been responsible for rollout of a FTTP network (although this is now based on a mix of technologies). Telstra was forced by legislation to structurally separate. It also de-commissioned its copper and cable networks and leased these assets to NBNCo before migrating its customers to the new NBNCo network. This case in particular illustrated the scale of the practical challenge associated with structural separation. While the superfast broadband initiative was announced in 2009, agreement with Telstra and Optus to separate their networks was only reached in 2014.
In setting up public-private partnerships for the rollout of fibre, the New Zealand government insisted on wholesale-only infrastructure providers and prohibited retailers of broadband and telecoms services from integrating with these. This in turn induced Telecom New Zealand to split itself up into separate infrastructure and service companies, Chorus and Spark respectively.With the owner of the monopoly infrastructure separated from retail activities, regulation became purely a matter of controlling the exercise of market power, i.e. setting cost-based price controls where deemed appropriate. This is the approach used by Ofgem, the energy regulator, for gas and electricity markets in the UK.
In Singapore, the government commissioned the building of a national ‘fibre to the home’ network to 100% of premises.The contract was awarded to a structurally separate ‘NetCo’ which was required to build and maintain the network and offer passive access products. In addition, a separate contract was awarded to an operationally separate regulated active network operator, ‘OpCo’, which provides active access services.
Retail service providers can choose whether to build their own commercial active network operator, or to buy services from the regulated OpCo. Structural separation between the winning bidder for the NetCo, NetLink Trust, and the incumbent, Singtel, has been achieved using a trust structure.
It should be borne in mind that all three of these broadband rollouts given above have received significant injections of public investment.
In Sweden the objective is to provide 90% of all households and businesses with access to connections of 100Mbps by 2020. The aim is to drive user demand with local communities and not-for-profit organisations taking the lead, supported by regional and national Government.
In 2008, TeliaSonera, the former national incumbent, formed a wholly-owned subsidiary called Skanova to sell wholesale network capacity on equal terms to both its own retail arm and competing broadband providers. Skanova operates in similar way to BT’s Openreach. Skanova provides network capacity to 160 operators in Sweden, including local authorities, which have helped deploy fibre to the premises. Given that Skanova is operator neutral, it is able to provide network capacity to local bodies that wish to choose their own local third-party service providers, using its national wholesale network
190.BT extols the strengths of the current arrangement. According to Gavin Patterson, Openreach is able to draw on the balance sheet and know-how of the wider BT Group. For example, Openreach benefits from BT’s capital as well as the £500m a year that BT invests in research and development. In addition, when Openreach invests in new services, it benefits from having BT as an ‘anchor tenant’, which guarantees a route to market and lessens the risk of making investments. Accordingly, the business case for its superfast broadband investment expected to achieve a payback on a BT Group basis of over 10 years when the investment decision was made; yet the payback at the Openreach level would have been nearly 20 years, when the benefit of retail margins were taken out of the case.
191.Ed Vaizey has said “be careful what you wish for” to those pushing for a separate Openreach. He foresees that structural separation would be fraught with difficulties and could take many years to achieve. Moreover, Gavin Patterson, BT’s chief executive, has threatened that he would respond to an attempt to force a sell off of Openreach by cutting investment in the network and warned of ten years of litigation. Based on its experience of functional separation after 2005, BT claims that full separation would take several more years to achieve and estimated the cost of functional separation alone had been in excess of £1bn. Nonetheless, in response to Ofcom’s initial conclusions in the DCR, the Government stated that it agreed with Ofcom’s view that the current relationship between BT and Openreach would not deliver what the country needs for more competition, better innovation and better service. It went on to say:
The Government believes that Ofcom should be firmly focused on taking whatever action is needed to correct the competition problems identified, and to promote growth of the digital economy, however radical a change that might be.
192.Undoubtedly there would be many complexities to overcome in carrying out separation, such as the division of systems and assets, transfer of people and pensions, over two million wayleave agreements to be reassigned, reissuing of bonds, and the tricky situation of determining where Openreach’s boundaries should lie. That said, there could potentially be practical steps taken to ease some of the burden; for example, it is not out of the question that the BT proprietary name could transfer to the new entity so that the need for wayleave and contract amendments was obviated. However, clearly other BT businesses’ holding contracts would need to be taken into consideration too and a judgment made. In practice, Ofcom’s measured approach within the DCR and its current negotiations with BT—with regard to BT developing and publicising its infrastructure map, for example—is treading a path that would be necessary, in any event, if it decided to recommend that Openreach be subject to structural separation.
193.The position of BT’s pension scheme was also raised during our inquiry. BT pointed out that the returns from Openreach contributed to the overall Group profits which themselves funded BT’s historic pension liabilities and that many of these liabilities arose from past Openreach employees. Gavin Patterson told us that BT’s pension fund had a significant pension deficit that ran—depending on how it was valued—into billions of pounds. He argued that if separation were required then the scheme’s trustees would be likely to find the covenant for Openreach would not be as strong as the one currently provided by the BT Group.
194.However, it is uncertain how big a stumbling block the pensions issue would be in reality. BT’s scheme is the largest private pension scheme in the UK in terms of assets and so it would be a significant undertaking to split. But there are examples of other companies separating and so it should not be seen as an unsurmountable task. There could be measures taken to help. Potentially, Government could be invited to extend the Crown guarantee to cover the members of the new Openreach scheme. Such an undertaking would be contentious, but it has been suggested that the issue of BT pensions should certainly not be a “deal breaker”.
195.If BT Openreach were to be separated there is a risk it could undermine the confidence of other investors towards the sector. Liberty Global, Virgin Media’s new US owner, has backed a £3bn investment in network expansion. Tom Mockridge, Virgin Media’s chief executive, made it quite clear to us that if BT were forced to make a divestment of such scale then his parent company would be unlikely to make further network investments in the UK. Clearly, there are further reasons why Virgin Media and other companies would not wish to see Openreach become independent. Gigaclear’s chief executive, Matthew Hare, suggested that a separate Openreach would be a more formidable competitor but while it remained within BT it would maintain its poor performance and underinvestment.
196.In Professor Helm’s opinion, a compromise position, where Openreach is not fully separated from BT, would create a host of unintended problems and regulatory costs, and delay broadband investment. He has called for a separate Openreach with a single management focused entirely on “broadband Britain”, neutral between all the competitors in the retail market and delivering the service at a very low cost of capital—a view shared by several of BT’s rivals.
197.Given all the concerns, Ofcom has firmly stated that continuing the status quo is not an option. Many of the concerns it identified in 2005 still exist today. Ofcom has therefore decided that reform is necessary to give Openreach greater independence and autonomy. Under a new reformed structure, Ofcom concludes that Openreach must have:
198.As well as full structural separation, Ofcom is considering whether a strengthened model of functional separation could work. Ofcom has also found that there is a pressing need for Openreach to consult its customers on strategic decisions regarding its network, so that they can be properly taken into consideration.
Ofcom has set out three models which would strengthen separation
Functional separation with independent governance
Creation of a divisional Board with non-executive members who act independently from the group Board
Upstream business is established as a separate legal entity within the wider group, but remains under the same overall ownership
Split of the vertically-integrated operations into separate legal entities, with no significant common ownership and ‘line-of-business’ restrictions to prevent them re-entering each other’s markets
199.Increased functional separation could involve Openreach becoming a wholly owned subsidiary of the BT Group, with its own board of directors and an independent non-executive Chair and other non-executive directors. Openreach could in effect be an incorporated subsidiary in which the BT Group is a passive investor. The independent Openreach Board would need to have the capability and resource to draw up its own strategy, budget and investment plan, possibly publishing its requests for funding to the main BT board so there was absolute clarity over its determinations and requirements.
200.There would need to be an open dialogue between Openreach and the BT board so that no financial settlement could be unfairly imposed on Openreach. We would see Openreach as having an ability to raise funds within agreed limits potentially applying directly to the capital markets in its own name and by funding certain network developments through co-financing ventures with the communications providers who were the users of the network. This would enable Openreach to spread the risk of such investments with others given the uncertainty over returns. Clearly, Openreach would have fiduciary responsibilities to the BT Board and would need to act within delegated parameters to prevent jeopardy to the wider Group’s credit profile. Openreach would continue to have an explicit responsibility to serve all its customers equally, and as Ofcom has suggested, this could be established through the objectives and purposes of the company in its articles of association.
201.We have considered the case made by Professor Helm for establishing a standalone broadband utility provider using a regulatory asset base model. While the concept of having a single system operator could be conducive to the management of a universal service obligation for broadband, we believe the differences between the communications market and other traditional utility markets are too great. There is already a wide level of competition in the communications access infrastructure market, and real potential for this to grow. It is not clear to us how the presence of a utility-style operator would be compatible with promoting competition or would work successfully alongside current market players such as Virgin Media, to say nothing of the many other smaller providers of broadband access infrastructure, without stifling competition and the growth of alternative networks. We also consider that there is a significant risk of disruption to investment in and by Openreach, were BT forced into a structural separation.
202.Ofcom set out a very cogent case in its Digital Communications Review for full separation of Openreach from BT Group, yet it stopped short of making an outright recommendation for such action at that stage given concerns over difficulties of implementation, possible disruption to investment and likely response by BT. It is a very difficult judgment call as to whether the benefits of full structural separation would outweigh the likely significant disruption and fall-out to the wider industry and consumers. However, there is good reason to suggest that a more independent Openreach might increase infrastructure investment significantly.
203.We consider Ofcom has been right not to rule out full separation; that option should be kept firmly on the table. Ofcom has said that the proposals BT has made to date on governance, performance, status and other arrangements of Openreach have not gone far enough. In our judgment Ofcom must remain resolute in its negotiations with BT to ensure the reform necessary to establish the quality and availability of communications services needed for UK consumers and businesses is delivered. If the regulator were to place more emphasis on Openreach’s quality of service—an area which Sharon White admitted has been comparatively ignored until now—BT would voluntarily invest more in the infrastructure to avoid significant penalties. Should BT fail to offer the reforms and investment assurances necessary to satisfy Ofcom’s and our own concerns, then the regulator will need to set in train the steps to enforce full separation of the Openreach business.
204.In any event, in order to cement Openreach’s independence, we recommend that in future Openreach should be required to set out and publish a five-year strategic investment plan for comment and agreement with the BT Group Board. This would enable it to set out its financial needs, in a transparent and comprehensive manner. Should Openreach remain part of the BT Group under a strengthened model of functional separation, BT should be obliged to allow Openreach to raise finance independently in the capital markets in its own right, and to make investments that meet the business’s own cost of capital. We have every reason to believe that Openreach would be a very attractive investment vehicle to longer-term institutional investors, who could in turn facilitate increased investment in infrastructure.
205.Throughout this inquiry, it has been very clear that the communications sector is characterised by bad internal relations between its main players. With the exception of areas such as technical standards and disaster recovery there has been little co-operation between competitors. This is regrettable because there are other areas—such as training and skills—where more open discussion and co-ordination would benefit the whole industry and its customers. We understand that the industry will continue to be driven by competition, but we are disappointed by companies’ frequent recourse to litigation and failure to adopt a more cohesive approach.
235 Vertical integration is an arrangement in which a single company controls the entire supply chain, e.g. BT controls the local access infrastructure (Openreach), other network infrastructure (BT Wholesale and Ventures) and its retail businesses (BT Consumer and BT Business and Public Sector) and so provides end-to-end services to consumers.
236 See report completed for Ofcom by Analysys Mason
237 Telstra is Australia’s largest telecoms company, previously publicly owned. Optus is Australia’s second largest telecoms company, a wholly owned subsidiary of Singtel.
238 Chorus became New Zealand’s largest fixed communications utility business and Spark remained New Zealand’s largest provider of communications and IT services.
239 Fibre to the Home, hereafter abbreviated as FTTH. NB: Singapore is one of the most densely populated countries in the world, which makes 100% FTTH coverage economic where it has not been elsewhere.
240 BT ()
242 ‘Ed Vaizey delivers blow to rivals’ hopes of BT broadband split’, Financial Times, 30 September 2015.
243 ‘BT chief warns of legal quagmire over proposal to split company’, The Telegraph, 8 July 2015.
244 BT ()
245 Government sets out its response to Ofcom’s Strategic Review of Digital Communications and Business Connectivity Market reviews, DCMS, 30 March 2016.
247 See article by John Ralfe, an independent pension consultant and expert witness for the Competition Commission in its 2012 inquiry into BT pensions. ‘BT’s mountainous pension liabilities hampers spin-off’, Financial Times, 30 March 2016.
251 Professor Dieter Helm, New College, Oxford ()
252 See Sky UK (); TalkTalk ()
253 Digital Communications Review – Initial Conclusions, Section 6
18 July 2016