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Establishing world-class connectivity throughout the UK Contents

Annex: Specialist Advisers’ advice to the Committee

Investment in superfast broadband: Regulation, competition and the cost of capital

A joint paper to the Committee by Tim Jenkinson,254 Tony Lavender,255 Jim Norton256 and Helen Weeds,257 7 July 2016

I. Introduction

1.We have been asked to assist the Culture, Media and Sport Select Committee of the House of Commons in its inquiry into “Establishing world-class connectivity throughout the UK”. This advice focuses on investment in superfast broadband, especially the impact of regulatory treatment of investment, the role of competition and questions related to the cost of capital.

2.The rest of this report is structured as follows. Section II outlines the need for broadband investment, noting recent demand growth, and describes the available technologies for providing superfast and ultrafast broadband services. Regulatory treatment of investment is explained in Section III, which sets out the RAB model and examines its application to the communications sector. Section IV discusses the role of competition. Section V compares Ofcom’s assessment of Openreach’s cost of capital with the hurdle rate used in Openreach’s capital budgeting and discuss implications of this and Openreach’s structure for investment in local access infrastructure. Section VI concludes.

3.This report was drafted prior to the referendum on the UK’s membership of the European Union held on 23 June 2016. It takes no account of the outcome of the referendum or its implications for the UK communications sector or wider economy.

II. The need for broadband investment

4.Demand for broadband services has increased considerably over the past few years. This appears as both an increase in demand for connections capable of supporting high speed broadband services and an increase in the data traffic demand from these connections. The driver of demand is access to an increasing set of content and applications for both consumer and business purposes. Of these applications the biggest generator of data traffic is increased demand for video (e.g. YouTube, BBC iPlayer and others).

5.Ofcom (2015a) states that:

6.Fixed broadband services are available from a number of suppliers in the UK. The major retail players are BT, Virgin Media, Sky and TalkTalk. Virgin Media provides its services through its own cable network infrastructure. Other major players use wholesale local access services provided by Openreach (e.g. unbundled local loops and VULA258). In addition, there are builders of new fibre infrastructure including CityFibre and Gigaclear.

7.Use of mobile broadband has increased with the introduction of 4G LTE services. According to Ofcom, in Q1 2015, 61% of adults in the UK were using their mobile handset to access the internet. As LTE rollout increases across the UK, mobile becomes capable of supporting a wider range of high bandwidth applications creating a degree of substitutability between fixed and mobile broadband services.

a. What sort of speed and capacity do people require?

8.There is a tendency to focus on speed as the main metric for describing broadband performance. While important, speed does not tell the entire story and there are other aspects of service performance to take into account, particularly the capacity offered to users. This is often represented as a monthly amount of data (e.g. 20 gigabytes) that consumers can use. The consumption of services such as high definition TV can quickly require large amounts of capacity.259

9.Broadband Stakeholder Group (2013), a report on domestic demand for broadband, suggested that a median household would need a speed of 19Mbps by 2023 and that the top one percent of households would need 35–39Mbps. The BSG has also considered business broadband speeds and it suggests that small business connectivity requirements will increase from a median downstream speed of 5Mbps to 8.1Mbps between 2015 and 2025 and the downstream speed required for the 95th percentile of small businesses rises from 12.9Mbps in 2015 to 41.1Mbps in 2025. The BSG also highlights the Importance of upstream speeds for small businesses and that more than 50% of businesses will require an upload speed of more than 1Mbps.

10.Ofcom (2016a) (“the DCR”) paints a similar picture. However, it also notes that there are many residential consumers and business who would like access to superfast broadband services but are currently unable to access them.

11.To address premises with no or poor broadband service the Government announced a consultation on a broadband Universal Service Obligation (USO) in November 2015. Ofcom has been commissioned to provide technical analysis and recommendations to support the design of the broadband USO. The proposed download speed for the broadband USO is 10Mbps.

b. What is the capability of current solutions?

12.Solutions to deliver fixed broadband services could utilise existing copper assets, fibre, wireless or satellite technology. Much of the broadband provision in the UK today is based on use of BT’s legacy copper assets.

Copper

13.There are two main copper based solutions in use:

Note that not all users will achieve the speed shown above as the actual speed achieved is dependent on the loop length and the quality of the loop.

Cable

14.Cable broadband access is based on a technology called DOCSIS3.0260 This technology, as deployed by Virgin Media, is capable of supporting data speeds of up to 200Mbps. It is available where Virgin Media has rolled out cable infrastructure.

Fibre to the premises

15.Fibre to the premises (FTTP) solutions can potentially support very high data speed of 1Gbps or more. For example, Gigaclear offers a number of home broadband packages with speeds ranging from 50Mbps up to 1Gbps download.

Fixed wireless access

16.Fixed Wireless Access (FWA) solutions can provide good broadband access although these systems do have limitations, especially for higher data speeds and high capacity use. An example of FWA deployment is Relish,261 which will support data speeds of up to 50Mbps.

Satellite

17.Satellite systems are capable of providing access to areas where fixed or terrestrial wireless access systems are not available for providing broadband service. They are capable of supporting download speeds in the range 15Mbps to 20Mbps but the current generation of products can be expensive for provision of high capacity service.

c. Future developments for copper based services

18.There are two strands to future development of copper based services:

d. Ultrafast broadband services

19.Ofcom signalled in the DCR that it will make a strategic shift to encourage deployment of new ultrafast networks, including fibre direct to homes and businesses, as an alternative to copper based technologies currently being planned by BT.263 Ofcom believes that the UK is behind some other countries with deployment of such services.264 Ultrafast, which is defined as offering speeds of greater than 300Mbps, is generally taken to mean FTTP. However, it is possible that ultrafast speeds could be delivered by G.Fast technology over very short loop lengths in future. Future upgrades to DOCSIS could also potentially deliver ultrafast speeds.

20.Fibre investments are being made, for example, by Hyperoptic, CityFibre, Gigaclear and Virgin Media (under Project Lightning265). BT has also announced an “ambition” for one million businesses to have ultrafast available by 2020 and for one million homes passed in the same time frame.

III. Regulatory treatment of investment

21.In his written evidence to the Committee, Professor Dieter Helm discusses the steps needed to establish Openreach as “the broadband utility”, separate from the rest of BT Group. Helm’s third step, after a CMA reference to bring about separation and defining a licence for the broadband utility, is that:266

“The duties of the regulator—in particular in respect of the financing of functions—would need to be defined. Again there is lots of experience, and again Ofcom does not address this issue [in its DCR], and the related ones of protecting investors’ investments through its regulated asset base.”

a. The RAB model

22.As Helm explains in a 2009 paper,267 the concept of a regulated asset base (RAB) was introduced into the UK’s “RPI-X” price cap system of utility regulation as a means of protecting capital investments made by the regulated company. Under RPI-X, there is a danger that past investments may be effectively expropriated by the regulator at the next periodic review by re-setting regulated prices at a level that covers operating costs but does not allow a return on these assets. Fearing such treatment, and given that investments are typically sunk (i.e. cannot be reversed and their costs recovered in full), the investment will not be forthcoming in the first place.

23.The RAB provides the regulated company with a form of guarantee reducing the risk of such ex post exploitation of its monopoly network assets.268 Although not mentioned in the statutes governing UK utility regulation, the RAB has a legal underpinning of sorts in the form of the regulator’s financing duty, mentioned by Helm in the quotation above. Regulators have a duty (amongst others) to have regard to the regulated firm’s ability to finance its regulated functions. However, unlike the alternative “rate of return” system of utility regulation traditionally applied in the USA,269 the financing duty does not legally enshrine full cost recovery and a guaranteed rate of return on investment.

24.In each regulated utility sector the methodology for establishing the RAB and adjusting its value over time, as new assets are built and old ones depreciated, has developed through a process of consultations and published principles, giving investors a high degree of certainty over how the company’s assets will be treated. Despite the absence of a statutory basis, the RAB is supported by the regulator’s concern for maintaining its own credibility as well as the companies’ rights of appeal in regulatory reviews.270

b. Applying RAB to the communications sector

25.Turning specifically to regulation of the communications sector, the underpinning of the RAB is a little different from the other UK utilities.271 Ofcom does not have a financing duty as such; however, in carrying out its duties Ofcom is required to have regard to (among other things) the desirability of encouraging investment and innovation in relevant markets.

26.In practice, when setting price controls Ofcom has acted in a similar way to the other utility regulators in its approach to asset valuation and depreciation. Openreach’s pre-1997 copper access network assets are given a “regulatory asset value” (RAV) based on their historic cost accounting (HCA) value.272 For post-1997 assets Ofcom applies current cost accounting (CCA) principles,273 with financial capital maintenance to ensure that there is the opportunity to recover efficiently incurred costs. For example, in the fixed access market reviews setting cost-based price caps for local loop unbundling (LLU) and wholesale line rental (WLR),274 Ofcom uses current cost accounting fully allocated costs (CCA FAC) to assess the cost base, with a “RAV-adjustment” for the HCA value of pre-1997 local access ducts. Ofcom’s cost assessments include an allowance for a return on capital, measured at the firm’s cost of capital (this is discussed further in Section V).

c. New products and services

27.Innovative products and services based on new technology involve high up-front risk of failure. Given the fast pace of technological change in the communications sector, this issue is particularly pressing here. For innovative products Ofcom recognises that, while there is potential for excessively high prices, this concern may be less important for consumers than the need to ensure that the innovation and related infrastructure investment takes place in the first place. Given that a product which fails earns a low or even negative return,275 it may be necessary to allow high returns on new products that turn out to be successful in order to ensure that the ex ante expected return covers the cost of capital and the investment takes place.

28.To this end Ofcom has adopted a “fair bet principle”, stating:276

“An investment is a ‘fair bet’ if, at the time of investment, expected return is equal to the cost of capital. This means that, in order to ensure that an investment is a fair bet, the firm should be allowed to enjoy some of the upside risk when demand turns out to be high (i.e. allow returns higher than the cost of capital) to balance the fact that the firm will earn returns below the cost of capital if demand turns out to be low.”

29.While the fair bet principle may allow an apparently high return in instances where risky investments turn out well, the intention is nonetheless that expected returns do not exceed the cost of capital when viewed (properly) at the commencement of the project rather than in its outturn.

30.At the present time Ofcom applies the fair bet principle to superfast broadband. VULA, the local access product used to provide superfast broadband, is not subject to a charge control capping the level of prices set by Openreach (although it is subject to other measures intended to prevent discrimination between BT’s downstream businesses and other Openreach customers). Thus the VULA price is currently not set according to the RAB valuation principles described above. Note that this is in the interests of the regulated firm’s investors as it protects them from asymmetric risk: the “heads I win, tails you lose” effect that arises when the regulator caps prices for successful products.

31.However, regulatory forbearance is unlikely to be open-ended. A cost-based charge control may well be imposed on VULA in the future, perhaps as soon as the next market review in 2017. At this point the RAB principles will come into play for VULA, in the same way as they apply to many other areas of Openreach’s activities.

d. Introduction of competition

32.The introduction of competition may pose a challenge to the RAB model as a means of guaranteeing recovery of investment costs (including a reasonable return on capital). If consumers switch to rival products in sufficient numbers, some of the incumbent’s assets may unexpectedly be rendered obsolete (or “stranded”). As competition grows, the regulator’s ability to ensure full cost recovery may become constrained: if costs are passed on in the form of higher prices elsewhere, this raises the risk of undercutting by competitors in those areas too.

33.Besides, guaranteeing full cost recovery for the incumbent would tilt the competitive playing field against entrants. Even if it were possible to extend a similar guarantee to other players—difficult to envisage since these are unregulated—public underwriting undermines incentives for firms to be efficient or to undertake careful assessments of their investments, making this undesirable.

34.The impact of competition on regulatory commitment under the RAB is not unique to the communications sector. Writing in relation to the proposal by water regulator Ofwat to introduce competition into that sector, Nourse (2009) recognised that the regulator could not guarantee a return in such circumstances:

“Investors do not expect Ofwat to provide a ‘silver bullet’ to take away the risk of regulatory change from the current reviews. It is recognized that Ofwat could not say something like ‘We guarantee that as a result of all this competition stuff, we will not touch £1 of RCV [regulatory capital value].’” [Emphasis in the original.]

35.In the communications sector there is actual and potential competition in the local access network. It is not a natural monopoly. Openreach competes with Virgin Media for nearly half of households, faces emerging fibre-based operators such as CityFibre and Gigaclear in some areas, and there is also the possibility of convergence with mobile data services. BT can and does lose demand to competitors that use their own local access infrastructure, in which case BT and Openreach earn no further revenue from these customers.

36.Regulated incumbents in the communications sector sometimes complain that they are required to grant their competitors a “free option” to use the regulated assets while they wish and then walk away when a new technology comes along or they choose to make their own investments. While incumbents occasionally use this argument to request a higher return on such assets as an “option premium”, regulators have been reluctant to grant up-front remuneration (e.g. via a front-loaded depreciation profile) to offset the risk of stranding.

37.The possibility of licensing a single operator of local access infrastructure—as Helm appears to assume in his written and oral evidence to the Committee—might help to protect the licensee from asset stranding due to competition, but runs contrary to current industry developments which foresee increasing competition from a variety of technologies. Moreover, licensing a monopoly provider would conflict with Ofcom’s stated aim of fostering competition in local access infrastructure. In her evidence to the Committee,277 Ofcom CEO Sharon White stated that the regulator foresees that around 40% of the country could have real network competition, with a minimum of three competing access providers, the shift occurring over the next ten years. Ofcom has stated that it prefers to use competition to drive investment in network upgrades.278 Ofcom’s approach of regulating for competition is discussed next.

IV. The role of competition

38.In contrast with other regulated utilities, the communications sector has no clear dividing line between “natural monopoly” and “potentially competitive” activities. Competing infrastructure is present in many parts of the industry. Even the “last mile” between the customer premises and BT’s exchange—traditionally viewed as monopolistic—faces existing and growing competition in parts of the UK: Virgin Media’s network currently passes 44% of UK premises279 and is set to expand to around 60% of premises, and new providers such as Gigaclear and CityFibre are laying fibre access lines in some areas of the country.

a. Regulation for competition

39.Ofcom’s approach to regulating the sector balances two objectives: preventing the exploitation of market power and promoting competition where this is feasible and desirable. Ofcom’s approach of regulating for competition has two distinct elements. First, with BT being a vertically integrated firm combining inputs that confer significant market power (mostly operated by Openreach) with wholesale and retail divisions that operate in competitive markets, Ofcom polices the essential inputs that are used by BT’s competitors as well as its own downstream divisions. Secondly, Ofcom aims to promote the expansion of competition into parts of the network that previously were monopolised. For example, local loop unbundling (LLU) helped to stimulate investments by alternative operators (primarily TalkTalk, Sky and Vodafone) in infrastructure connecting up to BT exchanges.

40.However, there is a difficult balancing act to be performed between the two objectives. In facilitating third party access at one point in the network—e.g. at the BT exchange—in order to promote competition in markets downstream of this stage, there is a danger that investments which go deeper into the network—in local access infrastructure itself—are discouraged. The “make or buy” decisions of rival operators are profoundly affected by regulatory decisions.

b. Functional separation

41.Functional separation of Openreach in 2005 was intended to achieve two main aims. By allowing BT’s rivals to purchase the same products, using the same processes and systems, as BT’s own businesses, “equivalence of input” extended the principle of non-discrimination to non-price aspects of service. Secondly, it was hoped that by requiring BT itself to use the same products and processes as its rivals, this would generate internal pressure for Openreach to improve their quality, delivery times and reliability.280

42.The first aim has been achieved, albeit with the loss of some vertical efficiencies. Alongside a cut in the wholesale price for LLU in 2005,281 functional separation helped drive uptake of LLU by BT’s retail competitors (especially Sky, which acquired broadband provider Easynet the same year, and TalkTalk), thus stimulating their infrastructure investments to connect to the exchange.

43.However, the evidence presented in the DCR demonstrates that the second aim has failed. Despite serving BT itself as a major customer, Openreach has failed to improve its quality of service. Openreach appears instead to have adopted the well-established strategy of a price-regulated monopolist of raising its profits by compromising quality.282

44.Ofcom is now adopting explicit quality of service regulation. Ofcom has powers under the Communications Act 2003 to impose financial penalties on BT should it fail to meet its regulatory obligations, and has recently published updated penalty guidelines.283 In the past two years Ofcom has adopted the approach of including minimum performance standards as part of its market reviews.284 In the DCR Ofcom sets out its intention to impose tougher minimum quality of service standards on Openreach, with substantial fines for failure to meet these standards.

c. Access to ducts and poles

45.Ofcom is now looking to extend its approach of regulation for competition to the local access network itself. As part of its measures to encourage fibre investment and increase availability of competing ultrafast broadband services, Ofcom’s DCR proposes to facilitate rivals’ access to BT’s ducts and poles, known as physical infrastructure access (PIA). Although BT has been required since 2011 to publish a reference offer for PIA and meet reasonable requests on cost-oriented and non-discriminatory terms, evidence submitted to the Committee indicates that uptake has been negligible. Many details remain to be fleshed out, and international experience of PIA is somewhat mixed.

46.Improved access to BT’s ducts and poles should reduce the costs of fibre investment for BT’s rivals,285 stimulating competitor investment in local access infrastructure. The heightened threat of competitor investments should also prompt BT to expand its own investment programme: rather than sweating its copper assets, which will become redundant in any case, BT will have a greater incentive to invest in fibre. If the PIA regime can be made effective, it could promote widespread, competing fibre networks.

d. Regulatory approaches to fibre

47.In its regulatory decision-making, Ofcom frequently faces a trade-off between conflicting effects on BT’s and its competitors’ investment incentives, or towards investment in different parts of the network. High prices for fibre relative to copper access products—as is seen currently with regulatory forbearance towards VULA while LLU is subject to cost-based charge controls—stimulates fibre investment at the local access level by BT and other providers, but dampens competing retailers’ efforts to promote superfast relative to standard broadband products.

48.BT’s vertically integrated structure generates another trade-off. BT argues that having its own retail division as an “anchor tenant” enables it to make risky fibre investments. However, the counterpart to this is that competing fibre providers—such as CityFibre and Gigaclear—find it harder to invest as they can access only 40–50% of superfast broadband customers through wholesale contracts with retailers (presuming that the vertically integrated BT and Virgin Media retail divisions will not sign up with them).286

49.If successful, fibre rollout will raise further issues. Will BT be permitted to remove its copper, and if so when? In the long run it is inefficient to maintain both copper and fibre networks, but removal of copper will eliminate the backstop from competing (albeit lower quality) copper-based products which place some constraint on the pricing of superfast broadband. Ofcom states in the DCR that where network based competition is effective it will deregulate downstream forms of network access:287 how many competing access providers will this require? On these and other questions, Ofcom will need to make its intentions clearer in time.

V. Openreach’s cost of capital and investment

50.As part of the RAB model described in Section III, an important element is the cost of capital that the regulator includes as part of the regulated firm’s costs when setting price controls. The market cost of capital, the rate allowed by the regulator and the regulated firm’s approach to capital budgeting are important influences on the firm’s investment behaviour. This is discussed next.

a. Ofcom’s assessment of Openreach’s cost of capital

51.In setting price controls the regulator has to estimate an appropriate cost of capital that allows investors an expected rate of return that is commensurate with the risks of the business. In the case of BT, Ofcom estimates the weighted average cost of capital (WACC)288 for the overall group using market data, and also provides disaggregated estimates of the cost of capital applicable to Openreach and the “rest of BT”.289 The cost of capital is periodically reviewed to reflect changes in financial markets: Ofcom’s latest estimates are 9.9% for BT Group, 8.8% for Openreach and 12.4% for the rest of BT.290 The lower cost of capital for Openreach reflects the relatively stable, non-cyclical nature of the access network business compared with BT Group’s other activities.

52.The estimates produced by Ofcom for the disaggregated cost of capital appear to us reasonable and in line with those estimated by other regulators and private companies. In evidence submitted to the Committee Ofcom compares its estimate of Openreach’s WACC on a like-for-like “real vanilla” basis (4.0%) with those estimated by Ofgem (3.8%) and Ofwat (3.7%) for the energy and water sectors respectively.291

b. Openreach’s capital budgeting approach

53.One of the more surprising pieces of evidence heard by the Committee was that BT does not internally mimic the Ofcom approach in requiring different rates of return on investments in different parts of its business. BT uses its estimate of a 10.4% group cost of capital for all investment projects, even though the risks involved will differ markedly between Openreach and other parts of the group. In evidence to the Committee, BT justified this approach as follows:292

“Openreach does not have its own capital structure or debt. Financing is raised at BT Group level rather than at the Openreach level. As such, it is not possible to calculate a specific cost of capital for Openreach alone. This would involve having to make subjective assumptions such as how much Group debt should be allocated to Openreach and what ‘beta’ to apply in the Capital Access [sic] Pricing Model.”

54.Many businesses face such issues in varying degrees, and it is normal practice to estimate the relative riskiness of the different activities and use a lower required return for the less risky investments relative to the riskier investments. Failing to allocate capital on this basis is likely to reduce shareholder value.

55.It is certainly the case that measuring relative risk, and required return, at the business level within an integrated group faces certain measurement and conceptual issues. But these are not insurmountable. Ofcom produces such estimates (for instance, assuming that the debt raised by BT is spread pro-rata across Openreach and the rest of BT), and it is unclear why BT eschews this approach in its internal capital allocation decisions.

56.By requiring a higher rate of return (10.4%) than the estimated cost of capital for Openreach (8.8%) BT will, inevitably, reduce investment in Openreach to below optimal levels in this part of the business. Profitable projects whose expected return falls between these rates will not be pursued. Ironically, shareholders, as well as BT’s customers, should welcome higher levels of investment in the local access network.

57.When the rate of return allowed by the regulator is below the cost of capital considered by the firm, the situation may be worse still. In the reverse of the “Averch-Johnson effect” found in US utilities subject to rate of return regulation,293 the firm may be expected to under-invest in capital assets, preferring instead to make greater use of other inputs that are fully compensated by the regulator. On this view, Openreach would wish to invest as little as possible in its network, or at least to invest only in projects where it believes it can make efficiency gains not anticipated by the regulator (and hence achieve the 10.4% hurdle rate despite Ofcom’s expected 8.8% return).

58.This decision by BT to allocate capital between its various businesses on the basis of a single group-wide hurdle rate is bound to lead to sub-optimal investment in (relatively low-risk) Openreach. Estimating the magnitude of this investment shortfall would require additional analysis, with considerable data requirements concerning the investment opportunities available to BT and their associated costs, but is likely to be substantial and could perhaps even run into the hundreds of millions of pounds. By adopting this approach BT is likely to be sacrificing shareholder value and, with this, the public benefits that would flow from these investments.

c. How can Ofcom encourage Openreach to invest?

59.It is challenging for Ofcom to regulate investment in the access network. The investment programme is made up of a large number of relatively small capital projects, and the regulator is not in a position to micro-manage this programme. Ofcom could encourage BT to “invest more”, but the ultimate goal is not investment per se but a better outcome for customers in terms of quality, speed, resilience, service levels, etc. Regulating inputs (capital expenditures) is generally less effective than giving incentives on outputs (the customer experience).

60.In this regard, the approach adopted by Ofcom to date has been to hope that functional separation would encourage Openreach to invest to improve quality of service. As discussed in Section IV, this approach has not had the desired effect and Ofcom is now adopting explicit quality of service regulation, with the threat of substantial fines. By increasing the penalties for poor quality of service, lowering BT’s profit if it fails to improve, the relative returns to investments in the access network will be increased. Thus the impact of an enhanced quality of service regulation regime would be to increase the return earned by BT on investments undertaken by Openreach, stimulating investment.

d. Financing of investment

61.Increased investment in the local access network needs to be financed. This additional funding could come from shareholders or lenders. BT’s ability to raise debt and equity finance to help fund its acquisition of EE suggests that financial resources and flexibility are readily available to it. While BT will of course be mindful of its credit rating, its relatively low gearing suggests that it might be able to finance an increased level of investment in the local access network simply by taking on some additional borrowing.

62.BT’s current policy is to raise financing at the group level. However, other options exist: it should be possible, even without legal separation, to raise debt against the revenues earned by specific assets (such as the access network). While Openreach remains part of BT, however, it forms part of the group’s equity: it cannot issues shares itself and its borrowing will affect the cost of group equity.

e. Separation of Openreach and the cost of capital

63.The question of the impact of structural separation on Openreach’s cost of capital generates mixed opinions: BT claims that separation would increase the cost of capital, while Dieter Helm argues that separation would facilitate a licensed utility structure that would benefit from a low cost of capital.

64.In his oral evidence to the Committee294 BT CEO Gavin Patterson claimed that, as part of BT Group, Openreach benefits from access to the balance sheet of the wider group. With its substantial capital assets and large, stable cashflow the financial position of a separate Openreach would in any case be strong. Besides, the disclosure that BT uses a common hurdle rate across all of its businesses suggests instead that it is BT’s riskier lines of business that gain from group operation at the expense of relatively low-risk Openreach. The mismatch between the hurdle rate and the actual cost of capital for each business area has the effect of misdirecting capital away from lower risk activities (e.g. Openreach) and towards riskier ones.

65.BT provided a recent (April 2016) survey of institutional investors295 in support of its view that a separate Openreach would experience a higher cost of capital than an integrated BT. Of the 26 respondents who gave an opinion, 15 thought that a separated Openreach would have a higher cost of capital, six thought the cost of capital would be lower, and five thought it would be unchanged. We do not view this survey as decisive evidence: we note both the relatively small sample size and the fact that all of those surveyed were against structural separation, perhaps because of its other implications,296 which may have influenced their responses to individual questions. Of all the potential reasons to oppose structural separation the claim that the cost of capital will be higher is, in our view, among the least plausible.

66.Since Ofcom already disaggregates its estimate of the cost of capital between Openreach and the rest of BT, it is unclear that structural separation would necessarily reduce Openreach’s cost of capital relative to that estimated by Ofcom: the risks associated with the Openreach business will be largely unchanged whether or not BT owns the business. The 8.8% estimate of the cost of capital produced by Ofcom would change only to the extent that more direct market evidence on required returns was available and deviated from Ofcom’s current assumptions.

67.Helm’s assessment that a separate Openreach would benefit from a lower cost of capital appears to come from his view of a changed regulatory regime for Openreach. We note that in setting price controls Ofcom already effectively applies a RAB model in its treatment of Openreach’s assets (as discussed in Section III). The fact that, when compared on a like-for-like basis, Ofcom’s estimate of Openreach’s cost of capital is not much higher than those estimated by Ofgem and Ofwat suggests that Openreach investors do not perceive the regulatory regime facing Openreach to be significantly riskier than those applying to the energy and water sectors.

68.In common with other UK sectoral regulators, Ofcom does not guarantee the regulated company absolute protection against the possibility of asset stranding. Given the greater extent of competition in the communications sector compared with other utilities, this might be considered a more significant risk; yet, on the basis of Ofcom’s estimates it appears that Openreach’s cost of capital is not significantly affected.

69.Of course, if the regulator were somehow able to provide a cast-iron guarantee—notwithstanding the difficulties discussed in Section III—then the cost of capital might be expected to be lower. However, the investment risks would not have disappeared: they would instead be borne by consumers who could end up continuing to pay for redundant networks. Moreover, the licensed utility approach advocated by Helm would appear to come at the cost of sacrificing competition in local access infrastructure itself, in contrast with Ofcom’s stated aim. A regulatory approach—such as that developed by Ofcom over many years—that encourages innovation, competition and entry in local access networks has many advantages in the long term.

VI. Conclusion

70.The report has discussed a number of factors that affect investment in superfast broadband: providing regulatory certainty for investment via the RAB, competition in local access infrastructure and Openreach’s cost of capital. It has highlighted a number of features that influence the extent of investment by Openreach and competing providers of superfast broadband networks.

71.Ofcom’s treatment of Openreach’s investments is very similar to the RAB model employed by other UK utility regulators. This approach appears to be successful in providing regulatory certainty to BT’s investors: when presented on a comparable basis, Ofcom’s estimate of Openreach’s cost of capital is very close to those estimated by the energy and water regulators. On this basis there does not appear to be an easy win to be had by changing Openreach’s regulation to a RAB model. While a licensed utility approach might be able to confer a higher degree of certainty on Openreach investment by granting it a monopoly position, this would come at the expense of sacrificing Ofcom’s aim to promote competition in local access infrastructure.

72.Competition plays a key role in Ofcom’s approach to stimulating investment in superfast broadband. Ofcom’s Digital Communications Review promises an improved access regime for BT’s ducts and poles, facilitating rivals’ fibre investments by reducing their cost of rollout. The prospect of competing fibre investment, which would limit BT’s ability to sweat its copper assets, should also prompt BT to expand its own fibre rollout.

73.Ofcom hoped in 2005 that functional separation would prompt Openreach to improve its quality of service. As the DCR shows, this hope has not been borne out by reality. Ofcom is now turning to minimum performance standards, with significant financial penalties for failure, as a means to compel BT to raise its game in service quality. By widening the gap between BT’s profit from investing and that from not investing, this approach should also incentivise investment in broadband infrastructure.

74.Ofcom’s treatment of the cost of capital recognises the lower riskiness of Openreach’s business as compared with BT as a whole and disaggregates the group cost of capital accordingly. BT’s capital budgeting approach, by contrast, applies the same group cost of capital across all business areas. As a result, the hurdle rate for Openreach’s investment exceeds its cost of capital. This gap implies that investment in Openreach is below optimal levels, perhaps by a substantial amount. Both BT’s shareholders and its wholesale and retail customers should benefit from greater investment in Openreach.

75.BT’s relatively low gearing compared with other regulated utilities suggests that it might be able to finance investment in the local access network by taking on some additional borrowing. Even without structural separation, it might be possible to raise debt against the revenues earned by Openreach’s assets.

76.The committee heard conflicting evidence concerning the effects of structural separation of Openreach from the rest of BT Group. Of all the potential reasons to oppose structural separation we consider the claim by BT that this would increase its cost of capital and reduce investment to be among the least plausible. Rather, under current operation the mismatch between the hurdle rate and the cost of capital for each business area has the effect of misdirecting capital away from Openreach and towards riskier activities. While structural separation may go beyond what is needed to improve this situation and increase investment in Openreach, the issue should be considered in any proposed reform of its governance arrangements.

References

Alexander, Ian, Colin Mayer and Helen Weeds (1996). Regulatory Structure and Risk and Infrastructure Firms: An International Comparison. World Bank Policy Research Working Paper 1698, December 1996.

Averch, Harvey, and Leland L. Johnson (1962). Behavior of the Firm Under Regulatory Constraint. American Economic Review, Vol. 52(5), pp. 1052–1069, December 1962.

Broadband Stakeholder Group (2013). Domestic demand for broadband. 5 November 2013.

Brunswick Insight (2016). BT investor audit, Full and final results. 8 April 2016.

BT (2016). Supplementary written evidence submitted by BT. 12 April 2016 (EWC0116).

Helm, Dieter (2009). Utility regulation, the RAB and the cost of capital. Lecture given to the UK Competition Commission, 6 May 2009.

Helm, Dieter (2016). The case for structurally separating Openreach and Ofcom’s response. February 2016 (EWC0102).

ISP Review (2016). BT prep trial of Long Reach VDSL Broadband to hit 10Mbps USO. 16 April 2016.

Joint Regulators Group (2013). Cost of capital and financeability. March 2013.

Nourse, Richard (2009). Competition proposals and financing issues: A report for Ofwat.

Ofcom (2004). Strategic Review of Telecommunications, Phase 2 consultation document. 18 November 2004.

Ofcom (2005a). Valuing copper access, Final statement. 18 August 2005.

Ofcom (2005b). Local loop unbundling: Setting the fully unbundled rental charge ceiling and minor amendment to SMP conditions FA6 and FB6, Statement. 30 November 2005.

Ofcom (2013). Cost orientation review, Consultation. 5 June 2013.

Ofcom (2014). Fixed access market reviews: wholesale local access, wholesale fixed analogue exchange lines, ISDN2 and ISDN30, Statement. 26 June 2014.

Ofcom (2015a). Communications market report 2015. 6 August 2015.

Ofcom (2015b). Penalty guidelines. 3 December 2015.

Ofcom (2016a). Making communications work for everyone, Initial conclusions from the Strategic Review of Digital Communications. 25 February 2016 (“DCR”).

Ofcom (2016b). Supplementary written evidence submitted by Ofcom. May 2016 (EWC0125).

Stern, Jon (2014). The Role of the Regulatory Asset Base as an Instrument of Regulatory Commitment. European Networks Law and Regulation Quarterly, Vol. 2(1), pp. 15–27.

Virgin Media (2016). Virgin Media announces largest UK fibre broadband rollout. 27 April 2016.

254 Professor Tim Jenkinson, Saïd Business School, University of Oxford.

255 Tony Lavender, Plum Consulting, London.

256 Professor Jim Norton, Visiting Professor – University of Sheffield.

257 Dr Helen Weeds, University of Essex and Multimedia Economics Ltd.

258 Virtual unbundled local access (VULA) is the local access product used to provide superfast broadband.

259 A high definition (HD) film of two hours duration can require up to 4.5 gigabytes of download.

260 DOCSIS refers to a technical standard called Data Over Cable Service Interface Specification.

261 Relish is currently deployed in Central London. Figures refer to Relish’s home unlimited product. Relish is operated by UK Broadband, which is part of Hong Kong-based telecoms group PCCW.

262 Openreach presentation at BT Capital Markets Day held on 5 May 2016. http://www.btplc.com/
Sharesandperformance/Quarterlyresults/2015–2016/Q4/Downloads/Slides/CapitalMarketsDay-Session2.pdf

263 Ofcom (2016a), Section 4.

264 Ofcom (2016a) states that FTTP was forecast to reach around 2% of UK premises at the end of 2015 and that global leaders such as South Korea and Japan had reached 63% and 70% respectively at the end of 2015.

265 Virgin Media (2016).

266 Helm (2016), paragraph 20.

267 Helm (2009), Section 2.3.

268 The role of the RAB as a regulatory commitment device is discussed in greater depth in Stern (2014).

269 In US-style rate of return regulation the regulated firm has a legally-enshrined right to recover its costs, including an allowed rate of return on capital, which is enforceable through the courts. There is some evidence that the cost of capital is lower under rate of return regulation than under price caps: see Alexander, Mayer and Weeds (1996).

270 Under the relevant legislation the regulated companies have a right of appeal against regulatory price reviews to, variously, the Competition and Markets Authority or the Competition Appeal Tribunal.

271 Joint Regulators Group (2013), Section 2. Ofcom’s statutory duties are set out in the Communications Act 2003.

272 Ofcom (2005a).

273 See, for example, Ofcom (2013).

274 Ofcom (2014), Volume 2: LLU and WLR Charge Controls. See also Annexes 11–13 (cost modelling).

275 This presumes that the regulator cannot provide full cost recovery (including a reasonable return on investment) for innovative investments that do not succeed.

276 Ofcom (2013), paragraph 2.39.

277 Sharon White, Oral evidence, 12 April 2016, responses to Q946 and Q947.

278 Ofcom (2016b).

279 Ofcom (2015a).

280 Ofcom (2004). In paragraph 6.13 Ofcom lists among the advantages of equivalence of input that “[i]t generates better incentives to BT to improve the products it offers to its competitors”.

281 Ofcom (2005b).

282 In belated recognition of this incentive, the Competition and Service (Utilities) Act 1992 gave the telecoms and gas regulators powers to set minimum performance standards, collect and publish quality of service data and set up customer compensation schemes. Sections of the Act relating to telecommunications have since been repealed by the Communications Act 2003.

283 Ofcom (2015b).

284 In written evidence to the Committee (Ofcom, 2016b), Ofcom states that in June 2014, in its Fixed Access Market Review Statement (Ofcom, 2014), it for the first time imposed a range of minimum performance standards on Openreach, and adopted a similar approach in its Business Connectivity Market Review Statement in April 2016.

285 In her evidence to the Committee, Ofcom CEO Sharon White stated that, based on the experience of Portugal and Spain, duct and pole access can reduce the cost of getting to the premises by about 40% (Sharon White, Oral evidence, 12 April 2016, response to Q943).

286 In a pilot project in York, CityFibre has teamed up with Sky and TalkTalk as investment partners.

287 Ofcom (2016a), paragraph 8.19.

288 The WACC incorporates the costs of different categories of capital, primarily debt and equity.

289 See, for example, Ofcom (2014), Annex 14 (cost of capital) and Annex 15 (Brattle Group report estimating BT’s equity beta).

290 Ofcom (2016b). All these cost of capital estimates are on a pre-tax, nominal (i.e. including inflation) basis.

291 Ofcom (2016b).

292 BT (2016).

293 Averch and Johnson (1962). According to Averch and Johnson, utilities whose allowed rate of return exceeds their cost of capital over-invest in capital, resulting in “gold-plating” of assets.

294 BT, Oral evidence, 15 March 2016 (HC407), response to Q801.

295 Brunswick Insight (2016).

296 Notwithstanding Ofcom’s efforts to constrain this, BT’s control over key inputs that are also used by its competitors gives it some ability to favour its own downstream businesses. This discrimination benefit of vertical integration, as well as potential vertical efficiencies, may explain why BT and its investors are keen to retain Openreach as part of BT Group.



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18 July 2016