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Gaining a competitive edge in the Telecom sector: address to AFR 2nd Annual Telecom Summit, Sydney, 15th November 2004

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AFR 2nd Annual Telecom Summit Sydney

Gaining a Competitive Edge in the Telecom Sector

15th November 2004 Ed Willett, Commissioner

This conference comes at a critical time in the development of communications markets in Australia. We are likely to see, over the next three years, some quite massive changes in the ownership and structure of Australia’s communications sectors.

At the same time we are seeing emerging markets, networks and new technologies that all have the potential to offer some real competition in Australia’s telecommunications markets.

However, it’s likely that regardless of these changes one thing won’t alter much in the immediate future - the dominance of Telstra over the telecommunications sector.

Industry structure

Telstra is one of the most integrated telecommunications companies in the world, continuing to be the major wholesale and retail supplier of telecommunications services including:

• local, national, international and mobile telephony;

• dial-up and broadband internet; and

• pay TV (through its 50 per cent ownership of Foxtel).

Significantly, Telstra owns two of the three major local access networks outside the major capital CBDs - the copper network that connects virtually every household in Australia and the largest HFC network, which passes around 2.5 million homes.

Telstra’s dual ownership of this infrastructure results in it being largely unconstrained by the existence of competitors, particularly in relation to residential consumers where Telstra clearly dominates the customer access networks.

This outcome is in sharp contrast to other jurisdictions where the development of relatively competitive communications markets has been facilitated by the separation of ownership of cable and telecommunications networks.

Canada provides a good example of this form of separation, with telecommunications companies there prohibited from taking over cable companies or offering video services from 1970 until 1995. This restriction enabled the cable industry to develop to the extent that it has become an effective competitor to the incumbent telecommunications firms. Canada now enjoys relatively low broadband prices and one of the highest broadband penetration rates in the world. This experience overseas is not unique.

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Of particular concern is Telstra’s control of inputs essential to providing downstream services. Few of Telstra’s competitors have any real alternative to using Telstra’s network services as an input for providing their own services.

As the OECD has outlined:

‘An integrated firm, in contrast to a separated firm, benefits from any action which delays the provision of, raises the price or lowers the quality of access. An integrated firm will therefore use whatever regulatory, legal, political or economic mechanism in its power to delay, restrict the quality or raise the price of access. Furthermore, the integrated firm has strong incentives to innovate in this area, constantly developing new techniques for delaying access. Although the regulator can address these techniques as they arise, it is likely to always be “catching up” with the incumbent firm. Regulation, despite its best efforts, is unlikely to be able to completely offset the advantage of the incumbent.1

These comments have obvious parallels in Australia’s telecommunications market.

The existence of such extensive market power provides Telstra with both the ability - and, importantly, the incentive - to try and thwart entry into complementary and substitute markets by other companies.

There is a risk therefore that Australia will reap the benefits of competition in telecommunications markets more slowly than other counties under the current regime. Worse, competition may actually decline with digitisation should Telstra use its power in existing markets to leverage into new markets.

This remains the case despite the fact that technological developments offer the prospect of serious challenges to Telstra’s dominance and opportunities for Telstra’s competitors:

• Firstly, by lowering the costs of existing infrastructure, such as telephone exchange switchgear which improves the economic viability of competitive infrastructure; and • Secondly, technology is improving the viability of new communications

modes, such as fixed wireless and satellite.

To date, the development of new technologies has not led to new competitive networks nor enabled a reduction in the scope of regulation. The Commission’s very strong view is that in order to maximise the potential benefits arising from these new developments, we must ensure this serious challenge to Telstra’s current market power is not smothered at an early stage.

In short, these emerging markets, networks and technologies will only survive if they are supported by effective access regulation designed to promote sustainable competition in which competitors are less reliant on Telstra infrastructure.

1 OECD, Restructuring Public Utilities for Competition, OECD, Paris, 2001, p.17.

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So, the role of regulation and the ACCC must be, in the short term at least, to ensure new entrants are not unduly prevented from developing a customer base, while at the same time and with the longer term in mind, designing and applying regulatory solutions that best promote competitive infrastructure.

The Commission’s actions have therefore been motivated by the need to promote and protect opportunities and incentives for the development of competitive infrastructure and services, including the deployment of new technologies on existing and refurbished networks.

New entrants need a reasonable opportunity to build new access networks, or to use existing networks to provide new services and technologies. Incumbent operators are likely to resist these developments and it is perfectly reasonable to expect them to compete vigorously in emerging markets.

However, the Commission has a duty to ensure that anti-competitive conduct is not occurring and must be prepared to use its full suite of powers in order to ensure that competitors are dealt with fairly and in a timely manner

Both access regulation and conduct regulation (which prohibits anti-competitive conduct) have an important role in promoting competitive markets. However, given the level of market power that Telstra wields in the industry and the incentives that Telstra has to limit competition, it is arguable whether any access regime will - on its own - deliver fully competitive outcomes.

There are several limitations to access arrangements that prevent them from being an effective substitute for other measures, such as changes within Telstra itself. Access arrangements, independent of such measures, do not change the underlying incentives of a firm to impede fair, timely and non-discriminatory access to its upstream inputs where it also competes in downstream markets.

Note that in that last paragraph I referred to ‘changes within Telstra itself’. I was very careful with those words. A few years ago I would simply have referred to the need for structural reform, intending those words to cover a range of possible measures. But in the current debate, those words tend to attract undue attention because many believe the words inevitably mean breaking Telstra into smaller pieces.

Certainly, ‘structural reform’ can involve breaking one company into smaller companies, but it can also mean a range of other corporate changes. In fact, the introduction of accounting separation and record keeping rules, as well as Telstra’s own creation of a wholesale division (which I will discuss further) have been types of structural reform.

Regardless of the labels that may be applied to reforms to telecommunications markets, we should not give up on looking at ways by which the existing arrangements can be strengthened further to limit as much as possible the ability and incentive of Telstra to leverage its existing market power into new services, technologies and infrastructure.

There are several such enhancements that can be looked at, such as stronger directions and pricing powers, but today I wish to focus on how we can strengthen the existing

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accounting separation provisions to make them more effective tools in monitoring and checking Telstra’s ability to discriminate in favour of its own operations and against those of access seekers and commercial rivals.

Current accounting separation arrangements Given the Commission’s concern at Telstra’s market power across virtually all sectors of the telecommunications markets, the effectiveness of the current accounting separation arrangements in ameliorating these concerns is still a key issue that needs to be resolved.

The accounting separation arrangements are intended to provide greater transparency of Telstra’s operations by ensuring it does not unfairly discriminate against access seekers using its services in favour of its own retail operations.

The purpose of both the original accounting separation arrangements under the Regulatory Accounting Framework (RAF) and the enhanced arrangements introduced by the Government is to provide the Commission and access seekers with greater information about Telstra’s wholesale and retail costs.

It was intended that this information would assist the Commission in investigating specific instances of conduct that may be in breach of Parts IV and XIB of the Trade Practices Act 1974, including:

• predatory pricing; • retail margin squeezing; • cross-subsidisation; • bundling; and • vertical cost shifting.

To date, the Commission has released three rounds of reports regarding the enhanced accounting separation of Telstra, covering:

• current cost financial reports for ‘core’ telecommunications services; • imputation analysis comparing Telstra’s retail prices with the prices of the core telecommunications services provided to access seekers; and • key performance indicators on non-price terms and conditions that compare

performance between Telstra’s retail and wholesale supplied basic access services.

In these reports the Commission concluded that there are no major concerns with how Telstra is providing the specific services covered by the arrangements to access seekers in order to enable them to compete in retail markets.

However, this is far from the clean bill of health that some have interpreted the Commission has provided Telstra in relation to these reports.

We noted that the information provided by Telstra is highly aggregated in nature and could mask specific instances of conduct requiring more detailed analysis.

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It is also noteworthy that the Commission has only relied on the existing accounting separation arrangements to a very limited extent in relation to its imputation testing analysis of specific cases.

Imputation analysis Imputation analysis played a part in the ACCC’s competition notice in broadband. This analysis has been contentious between the ACCC and Telstra, to the point of providing little, if any, assistance to resolving the dispute.

In the view of the ACCC our imputation analysis clearly demonstrated an anti-competitive price squeeze in the prices being offered by Telstra to its retail competitors to access its broadband network.

According to Telstra, this was merely vigorous competition.

Imputation analysis is designed to impute appropriate wholesale prices from Telstra’s retail prices and its retail costs. This suggests (or at least implies) that the concept of a Telstra wholesale business can be constructed, at least in concept if not in reality. But Telstra is not structured to engage in this way - despite the recent very positive step of creating a separate division for selling services to its wholesale customers.

From the point of view of senior management, Telstra’s wholesale and resale operations are closely integrated and decisions are taken on a whole of business point of view. The fact that retail competitors are surviving and taking market share from Telstra is the over-riding consideration. It is difficult, if not impossible, to engage with Telstra senior management on issues that go exclusively to the concept of a ‘wholesale business’.

This is not a criticism of Telstra senior management, who are doing no more than their jobs in maximising shareholder value by protecting their markets. Rather, it is a criticism of the existing combination of Telstra’s market power, ubiquity and internal structure - as well as the current regulatory arrangements that are intended to deal with competition problems only as they arise.

These regulatory issues are unlikely to diminish in the near future; in fact, they are likely to escalate. As Telstra’s competitors seek to commit capital to making more inroads into Telstra’s dominant position, Telstra will merely see these as competitive threats demanding a ‘competitive response’.

This in turn is a serious disincentive to large capital commitments by competitors, since the more they invest, the more they are vulnerable to Telstra ‘competitive responses’. For example, it took a very long time for Optus to recover from Telstra’s ‘competitive response’ to the roll-out of HFC cable. Of course, from the point of view of Telstra’s competitors and the ACCC, Telstra’s ‘competitive responses’ in these circumstances are likely to constitute predation. But again the great imponderable rears its head: what is the appropriate starting point wholesale price for the supply of essential inputs for Telstra’s competitors and how do we distinguish between vigorous downstream competition and predation?

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Need for change within Telstra It is difficult to design a solution to this problem that does not involve some change within Telstra itself. The ACCC and Telstra have explored the possibility of reaching some agreement on the use of imputation analysis, but it will be some time and considerable work, I think, before the two parties can reach a constructive agreement. Even then, questions will remain about whether the agreed approaches will be binding on the parties and whether other service providers can have confidence in these arrangements.

Like behavioural access regulation, simple accounting separation does not alter a carrier’s underlying incentive to favour its own downstream retail provider.

More specifically, however, the current form of accounting separation is nominal in that it only requires Telstra to collect and report information. It does not require the carrier to reorganise its internal affairs to operate as if it were running two or more discrete businesses, or to introduce internal transfer pricing.

While still of a nominal nature, stronger internal separation along these lines would offer a superior means of both detecting and rectifying discriminatory and other types of anti-competitive behaviour.

Such an approach could take the form of operational or legal separation and would require further changes to Telstra’s organisational structure in addition to accounting separation arrangements. For example, a clearer separation of Telstra’s wholesale and retail businesses would enable the costs and revenues associated with each business (as well as transfers between them) to be identified and allocated more clearly.

The integrity of this approach could be further reinforced by requiring the discrete businesses to maintain separate management teams in different physical locations, with restrictions on information that can be transferred between them.

Under this approach, the wholesale business would be under a specific obligation to treat both its internal (including retail counterpart) and external third-party retailers on an arms-length and non-discriminatory basis. I would envisage that such a wholesale division would report direct to the CEO and take ‘ownership’ of, and management responsibilities for, Telstra’s core communications infrastructure.

While underlying incentives may not change significantly, it is likely any discriminatory behaviour would be more easily identified than is currently possible.

Of course, this approach would also potentially be open to manipulation under a single management through profit and cost shifting between internal businesses, and would therefore require ongoing vigilance from the regulator.

However, in my view, a more independent wholesale business within Telstra with transparent internal pricing arrangements between wholesale and retail operations would be a substantial improvement.

This raises an obvious question: what services should a separate wholesale division in Telstra focus on selling? Another way of putting this question is to ask: what constitutes Telstra’s core communications infrastructure? As little as five years ago,

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the answer probably would have included the Customer Access Network (CAN). But technological developments appear to have rendered switching equipment (such as DSLAMs) contestable - indeed several of Telstra’s competitors currently have plans, or have started, to roll out their own switch equipment in exchanges outside CBDs (where this was done a few years ago). In fact, as outlined above, the ACCC sees this as a critical important development which needs to be protected and promoted.

So the core infrastructure now probably includes not much more than the twisted copper pair of wires that traverses the ‘last mile’ between the exchange and the customer premises - generally referred to as the unconditioned local loop (ULL). It can be debated whether the core infrastructure should also include the exchange premises and/or Telstra’s HFC cable network; or indeed, any future fibre to the home infrastructure.

The importance of such a change within Telstra is twofold.

First, it would increase the confidence of service providers investing in their own networks that they will be provided access to core infrastructure on similar terms to Telstra retail operations. Thus, Telstra’s competitors would be more confident that Telstra would not be able to use its control of core infrastructure to predate on new network investments.

Second, it would render telecommunications regulation more simple, transparent and effective. It would also, I believe, signal the ‘high water mark’ in telecommunications regulation. I would envisage the phase-out of significant areas of current regulation, possibly including many retail price controls, access regulation of retail services (such as local call resale - LCS) and access regulation of ‘intermediate’ services (such as PSTN originating and terminating services) as competitive markets develop. During the phase-out period, I would envisage that Telstra Wholesale would purchase these services from Telstra Retail and resell them to Telstra competitors.

In the absence of more fundamental structural reform, therefore, and despite these limitations, further consideration should still be given to further operational or legal separation of Telstra’s network or wholesale and retail activities. Such measures would improve transparency in dealings between upstream and downstream internal and external businesses and relieve pressure on and improve the effectiveness of the existing regulatory regime.

Structural reform versus intrusive regulation It is important to stress the close relationship between the current industry structure and the need for an interventionist regulatory regime. Without some changes to Telstra itself, it is foreseeable that the extent of the future regulation of Telstra is more likely to grow than decline.

Since 1997, various measures have been adopted to strengthen the legislative access regime and to try to improve its effectiveness and address some of the limitations.

Most recently these measures have included: removing the possibility of merits review for arbitration determinations; and publishing indicative prices for Telstra’s

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copper access services (in addition to the introduction of the current enhanced accounting separation arrangements).

This strengthening of the access regime is noteworthy as it is contrary to the expectations held when telecommunications competition regulation was introduced - that less rather than more regulation would be required over time.

We need to turn this trend around. We need to find and implement measures that would not only protect and promote emerging competition but also reduce regulatory intervention and increase certainty. This is desirable not only from the point of view of industry and the community as a whole, but ultimately the unshackling of Telstra will best ensure maximum value to shareholders. The political and economic reality is that regulation will continue to constrain Telstra to the extent necessary and for so long as Telstra retains or strengthens its ability to leverage off its control of core infrastructure services to the detriment of competition and competitors in downstream markets.

The choice is, it seems to me, between increasing regulation of Telstra or changes within Telstra to render its wholesale dealings more transparent, reliable and credible. In this presentation, I have attempted to make the case for the latter.

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