International Conference

Vertical Separation in Telecoms

Brussels, Belgium, 22 - 23 November 2010

On 22-23 November 2010, WIK hosted an international conference on vertical separation in electronic communications. Following a period of relative quiet on the European telecommunications policy agenda, the topic has the potential to now move towards the forefront. Vertical separation can provide an effective means of preventing anticompetitive discrimination, but the remedy is complex and intrusive. This conference brought together regulators, experts and industry participants to discuss recent experience and likely future developments with vertical separation in Europe, Asia and Oceania. The conference was an international event with speakers and attendees from around the globe.

Most participants were European, but a sizable percentage came from Asia as well. In terms of their affiliation, the participants were about equally balanced between regulators and industry. The remainder came from professional service firms, trade associations, and universities.

Keynote: "Separation under the Revised Framework"

Reinald Krüger, a senior European Commission official who serves as Head of Unit for "Procedures related to National Regulatory Measures", DG Information Society and Media, began the conference with a keynote address outlining how and when separation can be imposed under the Framework Directive as revised in 2009. He explained that the imposition of functional separation as a remedy had been possible in principle under the 2003 Framework Directive; however, there has been no experience with imposition as a remedy under the old Directive. The revised Directive now provides explicit authority to all National Regulatory Authorities (NRAs) to impose functional separation as a remedy where suitable conditions have been met.

The imposition of functional separation is an exceptional measure. Market-based regulation, based in this case on the application of remedies identified in Articles 9-13 of the Access and Interconnection Directive where dominance has been identified in a market susceptible to ex ante remedies, is preferred. Separation may be imposed as an exceptional last resort if market-based remedies have failed to address persistent competition problems or market failures; however, the burden of proof on the NRA is substantial. To date, there is no example of functional separation having been imposed by an NRA under these provisions.

The examples of functional separation in Italy, the UK and Poland have all been voluntary, based on commitments offered by the incumbent operator. Under the revised Directive, such voluntary separations must be transparent, and the Commission must be notified so as to enable scrutiny of the regulatory effects. Competitors should be no worse off than under a pure regulatory approach.

Session I: The European Experience

This session was comprised of three panellists who described the experiences with voluntary separation agreements in Italy, the UK, and Poland. Giovanni Battista Amendola of Telecom Italia described the company’s separation measures designed to technical and economic equivalence. These efforts began in 2002, when AGCOM effectively imposed regulatory provisions concerning the internal-external parity of treatment between Telecom Italia retail and competitive operators. Later, in February 2008, Telecom Italia offered to create the Open Access division, which provides equivalent wholesale access services on a first-come, first-served basis. Twenty-five key performance indicators (KPIs) have been put in place to ensure compliance.

Richard Cadman described BT’s voluntary functional separation in the UK, based on equivalence of input (EOI). BT’s decision came in response to Ofcom’s 2004 Telecoms Strategic Review as an attempt to avoid a protracted and uncertain legal battle. Mr. Cadman explained that prior to the functional separation, BT was required to not unduly discriminate with respect to network access; however, lack of clarity as to the meaning of "undue" was problematic. Ofcom concluded that non-discrimination by itself had proved inadequate to address the competition problems caused by economic bottlenecks, and that a stronger remedy was needed. In 2005, Ofcom and BT signed a set of "Undertakings in Lieu of a Reference under the Enterprise Act 2002". The agreement required: a separate Access Services business unit (Openreach, which is a division, not a subsidiary); an Employee Code of Practice; and an Equality of Access Board (EAB). EOI and functional separation appear to have had no limiting effect on the diffusion of broadband, but they do appear to have improved the nature of competition.

Tomasz Bator, Head of the SMP Division of the UKE, spoke about the separation of Telekomunikacja Polska. Based on Telekomunikacja Polska’s breach of non-discrimination obligations, the UKE pursued a functional separation starting in 2008. The UKE chose to separate Telekomunikacja Polska into a retail unit and a wholesale unit. The wholesale unit has independent management, and a separate incentive scheme for employees based on sales performance at the wholesale level. The President of UKE is continuing a comprehensive assessment of the efficacy of the separation agreement and its implementation.

Session II: European Implementation Issues

The second session looked at the regulatory efforts to accommodate functional separation in Europe. Paolo Lupi of the Economic and Competition Analysis Department of AGCOM spoke on the BEREC document on functional separation. The document provides guidance rather than guidelines. Mr. Lupi discussed the criteria required for functional separation. He noted that Equivalence of Access could constitute either EOI (Equivalence of Input) or EOO (Equivalence of Output). In imposing functional separation, NRAs must document the precise nature and level of separation, must identify the assets of each entity, and must clearly define governance. Under a voluntary separation, later events which affect the commitments (such as a corporate reorganisation) might necessitate a new analysis of the affected markets.

Annegret Groebel of the German BNetzA noted that Germany is currently transposing the provisions of the new Directive into law, and will of course implement the relevant provisions of the 2009 Directive, thus empowering the BNetzA to impose functional separation if needed; however, functional separation is not viewed as a first best option in Germany, where local loop unbundling has proven to be quite effective. Dr. Groebel noted that functional separation is an exceptional access remedy and enforcement measure. Functional separation supplements but does not replace existing remedies. It is an intrusive remedy to the extent that it requires the NRA to get involved in the operational and management functions of the SMP operator; however, it might possibly simplify enforcement. Enforcement of conventional access remedies requires credible and meaningful penalties to sanction noncompliance. Functional separation may also present a disincentive for investment to the extent that the SMP operator loses economic signals which would otherwise steer investment decisions.

Keynote: "The evolving Theory of Separation"

Prof. Martin Cave began the second day of the conference with a keynote address. Prof. Cave looked to the work of Ronald Coase to provide an economic foundation. He discussed the size of firms and markets; markets versus hierarchies; and control versus contract. The relative advantages of each depend on the relative magnitudes of economies of scale and scope versus transaction costs. Prof. Cave explained that functional separation can be examined through the "quadruple lens" of moral hazard: risk; retailer effort; market power; and the cost of monitoring. With respect to telecommunications, the local loop is a very specific investment; when assets are specific, retail-wholesale integration makes sense.

Prof. Cave went on to discuss arguments for and against vertical integration, including the classic hold-out problem (with the GM-Fisher Body case an often cited but perhaps fallacious example), double marginalisation, foreclosure, raising rival’s costs, and strategic delegation and collusion.

In quoting a recent comprehensive study by Lafontaine and Slade, Prof. Cave concluded that in most circumstances, profit maximising vertical integration decisions are efficient both for firms and for consumers. He discussed what he termed "telecommunications exceptionalism," referring to a "Ladder of Separation" (see the figure at the right). Prof. Cave questioned whether it would ever be practical for a regulator to force functional separation against the wishes of the company, and whether functional separation was really a sensible way to address the problem of non-discrimination.

Given that the migration to Next Generation Access (NGA) entails a once-in-a-century reworking of the local loop, one should take seriously the risk that functional separation might reduce the incentives to invest in this infrastructure. Government can, however, overcome delays in making investments in the local loop through direct or indirect public funding. Prof. Cave concluded by noting that while conventional wisdom may be right that functional separation of conventional copper networks is a second best option that could be appropriate under some circumstances, but expressed considerable scepticism as regards the use of functional separation in fibre-based Next Generation Access networks.

Session III: Costs and Benefits of Separation

In this session, Prof. Erik Bohlin from Chalmers University of Technology and Dr. Boaz Moselle from LECG set out the costs and benefits of functional separation. Prof. Bohlin noted that the benefits of functional separation are transparency, reduced incentives to give preferential treatment, limits on non-price discrimination, and incentives for competition in local loop access. The costs include irreversibility, implementation costs, reduced investment incentives, and incentives to provide low quality of service. Prof. Bohlin then went on to describe the voluntary separation in Sweden, which began as a dialogue between the PTS and TeliaSonera in 2007. It applies only to copper network infrastructure. He concluded that since the voluntary separation was only recently put in place, it is too soon to evaluate conclusively its effect.

Dr. Moselle’s talk offered a cross-sectoral analysis, spanning the economics of vertical separation in three distinct infrastructure industries: water, electricity, and telecommunications. He began with a discussion of the economics of natural monopoly and the possibility of competition in different parts of the value chain. Certain industries will see greater benefits than others from vertical separation, depending on the extent of overlap between up- and down-stream markets, and the rate of technological progress and new product development. Vertical separation presents a clear trade-off between reducing discrimination versus irrecoverable efficiencies. The policymaker can address this trade-off by looking at the relative importance of access-based competition versus the efficiency losses associated with vertical separation. This is not a static analysis, because the factors change over time, requiring the regulator to reassess the costs of vertical separation in the future. Vertical separation is a low stakes gamble in water markets (where technology advances glacially), and a medium stakes gamble in electrical markets. In telecommunications, however, vertical separation is a high stakes gamble.

Session IV: The Global Experience

Dr. Ross Patterson, the Telecommunications Commissioner of New Zealand, described that country’s transition from a regime based on competition law rather than ex ante regulation in the early 1990s, to a more conventional system with the adoption of telecommunications reg¬ulation in 2001. In 2006, the still-limited regulatory environment was deemed to be ineffective in dealing with non- price discrimination. The 2006 reforms strengthened regulatory oversight, and provided for the robust operational separation of Telecom New Zealand (TNZ). Details of the operational separation were to be specified in a Ministerial Determination and Separation Plan. TNZ offered an alternative, less restrictive set of arrangements; however, the NZ Commerce Commission (NZCC) rejected this offer because it felt that the proposed arrangements were (1) inconsistent with regulatory best practice; and (2) sought to bypass the independent regulator and public scrutiny by means of a private contract with the Government. Instead, an operational separation was imposed along the lines originally proposed in the 2006 legislation: arms-length separation of retail and wholesale, non-discrimination rules (EOI), information flow restrictions, transparency, and monitoring.

Sobee Shinohara from KDDI in Japan described broadband adoption in Japan and selected other countries. Mr. Shinohara highlighted some of the factors such as unbundling policies which have shaped the Japanese market. He talked about the status of facilities based competition in rural and urban areas of Japan. Competition from electric companies is a noteworthy feature in urban areas. Mr. Shinohara then explained the regulatory history of NTT, and its reorganisation in 1999. He compared BT’s functional separation to that now being discussed for NTT, concluding that a functional separation of NTT might not allow competitors to offer fully competitive products. A review of NTT’s organizational structure is on-going and a report looking at possible separation models is due out shortly.

Keynote: Francesco Caio, Vice Chairman, Investment Banking, EMEA, Nomura International plc, London, UK

Francesco Caio, the Vice Chairman for Investment Banking at Nomura International, gave the luncheon keynote address. He provided a high-level view of functional separation, and of the sweeping changes in the telecommunications industry, from a capital markets perspective. Mr. Caio proposed that, given the economic and social importance of NGNs, politicians should adopt a vision for the rapid transition to advanced networks. Such a vision would speed this transition as a self-fulfilling expectation. In this transition, investors are most concerned about the stability of cash flows generated by the demand for NGNs. At the same time, the industry is witnessing the rise of "Stupid Networks" as envisioned by David Isenberg in 1997. This presents a tension between value-added services and pure capacity. Mr. Caio also pointed to the increasing importance of NGNs to economic and social development. Recognising that this migration is increasingly central to the economy, more resources should be devoted to NGNs, warranting a price rise for services and applications. He acknowledged that higher prices to consumers might be at odds with other public policy objectives. The transition to NGNs will entail lower levels of labour needed for their operation, driving down the need for employment in the sector. This will necessitate a public commitment to those workers who are made redundant, who must transition to new roles in the economy. If the question of excess employment is not properly addressed, policies which support NGNs might not be politically sustainable. Finally, he asked whether network operators would choose to separate themselves and cooperate in the construction of physical networks in order to satisfy the risk versus reward demands of investors.

Panel: The Industry Speaks

This panel consisted of short presentations from four industry participants, followed by a lively discussion and question and answer session. FastWeb’s Head of Regulatory Affairs, Tiziana Talevi, posited the notion that the Telecom Italia separation is in fact not a true functional separation, but rather an internal reorganization. She supported this claim by noting that Telecom Italia’s Open Access division does not have its own P&L statement, or a separate incentive structure. Ms. Talevi said that, in the end, functional separation is not the objective, but rather a means to the end of real non-discrimination.

Victoria Gerus from ETNO argued that functional separation is inconsistent with the Framework, because it could lead to re-monopolisation, and could provide a disincentive for facilities-based competition. On balance, she said, the literature shows that separation reduces efficiency and harms welfare, unlike investment-oriented regulation. ETNO calls for forbearance from the imposition of separation in order to prevent regulatory failure.

Ilsa Godlovitch from ECTA noted that the UK had reduced the cost of unbundled local loops at the same that it introduced functional separation in 2005. Both factors contributed to a "speed war" that provided significant public benefits, and to creating incentives to upgrade the network.

Vianney Hennes from Orange France Telecom Group emphasised that access is essential. If the right tools are in place, the scope for discrimination is reduced. This supposes a regulatory authority’s willingness to intervene in real time to prevent the negative effects of discrimination. Functional separation puts infrastructure competition at risk, and could create a new monopoly in access. Such an outcome could cause operators to "climb down the ladder of investment".

Panel: The Regulators Speak

Mr. Krüger and Dr. Patterson returned for the last panel to provide a closing regulatory perspective. Mr. Krüger said that the European Commission will be providing guidance on how to implement a non-discrimination obligation, and how to measure whether it is functioning correctly. He noted that the procedures to impose functional separation are complex, and that the Commission stands ready to work with NRAs through pre-notification meetings. From the Commission’s point of view, what is important is that the right and appropriate remedies – those which are necessary to address competition problems – are imposed. It is imperative that there be private investment in NGA. Proper policies will balance supply side and demand side approaches. They must take account of the details of the competitive situation.

Dr. Patterson’s noted that the New Zealand separation, unlike those in Europe, was imposed by legislation. It was similar in effect to BT’s voluntary separation, but the process was quite different. Dr. Patterson explained that New Zealand is also taking steps, by means of public-private partnership, to deliver FTTH to 75% of all New Zealand homes within 10 years. The government provides a financial advance to the selected Local Fibre Company (LFC) in each area of New Zealand to fund roll-out past houses. Private parties connect each household. It will be an open network. The LFC that provides the lower layers is not allowed to offer retail services.

WIK’s Scott Marcus, the conference organizer and panel chair, questioned the interaction between NGA and wholesale. For example, Australia considers separation, but it is intertwined with its National Broadband Network. Krüger stated that the Commission’s NGA Recommendation postulates the right remedies for regulators to impose so that Functional Separation might not be necessary. He concluded by stating the Commission can learn from New Zealand and other parts of the world facing similar problems.

Availability of presentations

All presentations that were made at the Conference are available for download.

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J. Scott Marcus
Phone: +49 2224 9225-92
Fax:     +49 2224 9225-2292

Dr. Jutta Jung
Phone: +49 2224 9225-28
Fax:     +49 2224 9225-68