TELECOMMUNICATIONS NETWORK

DEVELOPMENT AND INVESTMENT IN

THE EUROPEAN UNION

European Investment Bank

Projects Directorate
Industry II

JACQUES GIRARD
HARALD GRUBER

*^ί^Α

EUROPEAN INVESTMENTBANK
 Telecommunications Network Development and Investment in the European
Union

Principal points

Sector developments

The telecommunications service industry is growing very rapidly, wiith average annual growth rates of
10% during the last five years. These growth rates should continue for the next five years. This increase
of activity is a result of the interaction of technological improvements (micro-electronics, optical fibres)
and institutional changes (liberalisation). Technological advances in micro-electronics and the
development of optical fibre cables have dramatically increased the processing capacity of
telecommunications networks. The Plain Old Telephone System (POTS) is becoming an interconnected
information processing system and the basic building stone of the information society. It has become
evident that only widespread liberalisation (i.e. privatisation and opening up to competition) would carry
the right incentives for modernisation of what used to be profitable but sleepy state monopolies.

The number of lines in the EU fixed telecommunications network reached some 180 million by end 1995,
or 48 lines per 100 inhabitants. In addition, there were 19 million mobile telephone subscribers.
Teledensity, the sum of fixed and mobile lines, has therefore reached 53 access paths per 100
inhabitants. Even though universal service seems to be achieved, i.e. neariy every household is
equipped with a telephone, there are still large differences across EU-countries in terms of penetration
and modernisation of the networks. In any case, the main source of growth in the future will not come
from an increased subscriber base, but from increased services that will be feasible on a modernised
network.

In 1995 the telecommunications service market amounted to ECU 143 billion, of which ECU 17 billion
(12% of the total) came from the mobile sector. The latter is expected to exhibit very high growth i.e.
some 15 to 20% per year, over the next 5 years, and could represent up to 25% of the total revenue by
the year 2000.

Investments

The expansion and modernisation of the fixed network has required huge investments, which have
peaked during the years 1990-1994. In 1995, operators in the EU-countries invested ECU 31 billion, or
some 25% of their turnover. For the years 1996-2000, some ECU 87bn will be invested by télécoms
operators to complete the expansion and modernisation of the fixed network in the EU.

The mobile telephone sector alone is expected to invest about 31 bn ECU for the years 1996-2000. This
would bring the penetration rate of mobile telephones in the EU from 5.6% in 1995 to 17.2% in 2000. In
some countries, investment in the mobile sector would be equivalent to, and may even exceed, the
investment made for the fixed network. Moreover, as more and more players enter this industry and this
sector converges with other sectors (e.g. computer, broadcasting, consumer electronics), the traditional
public operators' investments will represent a declining fraction of the total investment requirements of
the sector. The investment of these players is more dispersed and difficult to assess for the time being,
but it is likely to be large.

Tariffs and regulations

Huge price decreases for telecommunications services have been observed as a result of technological
advances and liberalisation. This has also affected the tariff setting, which used to be based on cross-
subsidisation. Local calls and monthly rentals were cheap compared to the cost of providing these
services. Long distance and international calls provided the subsidies for local calls and line rentals. This
distorted pricing system, where tariffs did not reflect costs, turned out to be inefficient and not sustainable
in a competitive environment. Liberalisation would attract competition in long distance and international
calls, driving down prices. To compensate for this, prices for local calls and rentals have to increase.
Liberalisation therefore means "re-balancing" of tariffs, i.e. bringing them closer to cost. The practice
has shown that even though local tariffs have increased, long distance and international tariffs have
decreased by much more, so that in the end the adjustment led to widespread net benefits to the user.
Cross-country comparison shows that cross-subsidisation is particulariy evident on long distance and
intemational calls. Countries with higher tariffs on these segments include Austria, Italy, Portugal, Spain,
Greece, Germany, Ireland and France. Operators in these countries will be more vulnerable to
competition when the telecommunication markets start to be liberalised in 1998. Countries which have
already opened up to competition (such as the UK and Sweden) are close to re-balancing their tariff
structure and eliminating cross-subsidisation between different types of calls. "Non-competitive"
countries still have to undertake considerable price cuts on long distance and international calls.

Apart from the example of pioneering countries such as the UK and Sweden, the driving force behind
liberalisation and dismantling of state monopolies has been the European Commission. The process is
one of stages, but with accelerating speed. January 1998 is the deadline for complete liberalisation in
most countries, including voice services. For mobile telecommunications, liberalisation already began in
January 1996.

Impact on operators

The direct impact on the profits of incumbent operators as a result of liberalisation is strong, even though
this may sometimes be overstated. Assuming a typical 70% gross margin on lost revenues, potential
loss of profits would lie between 15 to 30% of present operating profits in static terms. The experience of
liberalised markets, shows that a tough regulatory environment may have an effect on the performance
of the incumbent operators that is similar to that of competition. Moreover, full infrastructure liberalisation
will have a dramatic effect on investment cost and the prices of leased lines, and this will amplify the
impact of services competition on the incumbent operators. Last, but not least, technology improvement
in the form of digital transmission, fibre optics, micro-electronics and wireless telephony has lowered the
barriers of entry and is probably the most important factor in challenging the incumbent operator's
monopoly.

To succeed in liberalised markets, public operators have to increase labour productivity. Most European
operators now have labour productivity targets of 350 lines per employee for telephony services, against
current levels of 200 to 250. Because an increase in the number of lines will be limited, this requires in
many cases extensive shedding of staff with public operators, which presents a problem in most
countries. Experience, however, shows that employment generated by the telecommunications sector
through new services, more than outweighs the staff reduction by the public operator.
 Telecommunications Network Development and Investment in the European
Union

Table of Contents

Page

1. Introduction 4

2. The Market S

3. The telecommunications network in Europe 5

3.1. The fixed network 5
3.2. The mobile network 5
3.3. Overall assessment and international comparison 6
3.4. Digitisation 6
3.5. Optical fibre technology 8

4. Investment trends and outlook 1996-2000 8

4.1. Fixed network 9
4.2 Mobile network 9

5. Tariffs 10
5.1. Fixed network tariffs 10
5.2. Mobile network tariffs 11
5.3. Leased lines 11
5.4. Tariff trends and rebalancing in the EU 11

6. Regulatory framework 12
6.1. Community regulations for liberalisation 13
6.2. Implications for tariffs and universal service 13

7. Impact of competition on network operators 14

7.1. Fixed network operators 14
7.2. Mobile network operators 16

ANNEXES

Table 1 - Public Telecommunication Investment in the European Union 18

Table 2 - Investment Estimates for Fixed Telecommunications in the EU 1996-2000 18
Table 3 - Penetration and Investment Estimates for Mobile Telecommunications in the EU 1996-2000 19
Table 4 - OECD-PJ Basket of telephone charges, February 1996
19
Table 5 - OECD Basket of Leased Line Charges, 1994 20
Table 6 - EIB Activity in Telecoms 1990-1995 20
 Telecommunications Network Development and Investment in the European
Union

1. Introduction

The Bank has significantly financed the telecommunications sector in the EU. Financing
amounted to some 2bn ECU per year over the period 1990-95, or about 5% of the yeariy 35bn ECU
telecommunications investment in the Union. Up to now, the financing was mainly devoted to
investment programmes by the monopoly operator with good security, occasionally guaranteed by the
public sector. However, as a result of technological changes, widespread liberalisation and the
emergence of new competitors, the sector is undergoing profound changes which will also affect Bank
lending. There will certainly be increased opportunities for lending, but there will also be more risk.

From an eligibility point of view, the Bank's financing of projects in the telecommunications
sector are justified by their contribution in improving communication links within and outside Europe and
in providing the basic infrastructure for an "information society". As a result, the international
competitiveness of the European market would be improved. Support for new, private, initiatives in
particular would strengthen the European-wide process of liberalisation and reduce the non-innovative
role of established monopolies. This is at the very heart of the current EU policy of the sector.

This sector review illustrates the main features of the market and how these are about to change.
It also tries to highlight new financing opportunities that may arise as a result, as well as the increased
risks.

2. The market

The telecommunications service industry is growing very rapidly, with average annual growth
rates of 10% during the last five years. In 1995 the telecommunications service market amounted to
ECU 143 billion, of which ECU 17 billion (12% of the total) came from the mobile sector (Figure 1).
These high growth rates for the industry should continue also for the next five years. In particular mobile
communications is expected to exhibit growth rates in the order of 15 to 20% per year, over the next 5
years, and could represent up to 25% of the total telecommunications service market by the year 2000.

Figure 1. The breakdown of telecommunication services in W-Europe in 1995

Data services Cable TV services

3%

, , Mobile . ..
telecommunications

12%

4-
 This increased growth in the service market is a result of the interaction of technological
improvements (micro-electronics, optical fibres) and institutional changes (liberalisation). Technological
advances in micro-electronics and the development of optical fibre cables have dramatically increased
the processing capacity of telecommunications networks. The Plain Old Telephone System (POTS) is
becoming an interconnected information processing system and the basic building stone of the
information society. It has become evident that only widespread liberalisation (i.e. privatisation and
opening up to competition) would carry the right incentives for modernisation of what used to be
profitable but sleepy state monopolies.

3. The telecommunications network in Europe

3.1 The fixed network
There are several measures of the size of the telecommunication networks. One is the number
of lines per 100 inhabitants or the penetration rate. By 1995, there was an average of 48 mainlines per
100 people in the EU. Even if this appears quite high, it is still some 10 points less than in the United
States. However, there is a considerable heterogeneity across countries (Figure 2). Sweden and
Denmark display outstanding telephone penetration rates of respectively 69 and 61 lines per 100 people.
EU-countries with a much lower penetration rate are Ireland, Portugal and Greece. But these countries
are catching up and recorded the highest growth in mainlines during the last years, along with Germany
whose increase in the number in lines was induced by unification. In general, the EU is approaching the
point where each household is equipped with a telephone. There is only one country, Ireland, with a
connection rate of less than 80 per cent of households and therefore still room for high growth rates for
subscribers. However, this full penetration of households needs not be an absolute limit, as there are
countries such as Denmark, Greece, France, Luxembourg and Sweden where there are more residential
phones than the number of households.

Figure 2. Telephone penetration rates (lines per 100 inhabitants) in the EU in 1995

Source: ITU

3.2. The mobile network

Mobile communications is a new development and has big potential. Between 1989 and 1995
the number of mobile telecommunications subscribers increased at a compound annual growth rate of
42% meaning that by end 1995, there were already more than 19 million mobile subscribers in the EU.
As figure 3 shows, the Nordic countries lead the way in terms of mobile penetration, with Sweden
(22.9%), Finland (20.4%), and, to a lesser extent, Denmark (11.6%) having more than several times the
EU average (5.2). In 1995 more mobile subscribers were added (6.6 million) than fixed mainlines (4
million). In general, one can observe that in most EU-countries, with high fixed network penetration rates
and efficient mobile telecommunication provision more mobile customers are added than fixed line
customers.
 Figure 3. Mobile telephones per 100 inhabitants in the EU in 1995

Source: ITU

3.3. Overall assessment and international comparison

Telecommunication access paths per 100 inhabitants (i.e. the sum of fixed and mobile phone
lines) is a more accurate guide to the ability to access the network. This indicator suggests that the
average tele-density in the EU-countries was more than one line for every two people in 1995. A
comparison with the US situation shows that the EU is still lagging far behind the north Americans, with a
telecom access path ratio in 1995 some 15 points below, due to less mainlines per 100 people (48
against 58%) and less mobile connections (5.2 against 9.8%). To the extent that the US shows the way
for future development in the EU télécoms sector, one could thus assume that a significant growth
potential exists, in terms of the number of customers, both on the fixed and the mobile segments.

3.4. Digitisation
The full benefits of the innovations in the communication and information technologies will only
accrue if all ways to send, receive and manage information are feasible with a single telecommunication
infrastructure. The key condition for these developments, as far as public operators are concerned, is
the digitisation of the network. In 1995, basically three fourths of the EU network was digitised. Since
the late 1980's a number of EU-countries have boosted their rate of digitisation. In 1995 the EU
(weighted) average ratio of digital mainlines was 74 per cent, against 32 per cent in 1989. However,
there is quite a large heterogeneity in digitisation across countries (Figure 4). France and the
Netheriands have been the initial pace setters with digitisation, with the United Kingdom and Sweden
closely behind. These countries have already reached full digitisation, or will have done so within next
year. All other countries are expected to have a fully digitised network within the year 2000, or shortly
afterwards.

-6
 Figure 4. Digitisation rates (% of total lines) of the fixed network in the EU in 1995

Digital technology is spreading as well in mobile telecommunications since its introduction in

1992, accelerating the diffusion of mobile phones. The growth observed on the cellular market is now
fully driven by digital technology, and it is expected that this technology will get neariy 70% of the market
by 1997, as against 45% in 1995 (see figure 5). The spread of mobile telecommunications was grossly
underestimated in the past. Digital technology has dramatically increased the potential of available
value added services such as data transmission. Digital technology is, from this point of view, superior
to the analogue technology. This explains the accelerated development of the mobile sector over the last
three years, which is likely to continue for the next few years.

Figure 5. Mobile telecommunication network (analogue and digital) development in the EU

3.5. Optical fibre technology
Transmission technologies in telecommunications are evolving at a very rapid rate. There is a
strong synergy between digital switching and digital transmission. Optical fibre cable, which is ideally
suited to digital transmission is now the dominant technology for inter-exchange connections. The
penetration of optical fibres in telecommunication cable has been gradual. It began on the trunk inter-
exchange network. In several countries, these lines are now completely dominated by optical fibres.
Optical fibre is now beginning to penetrate the local area network particulariy on the primary distribution
cables (from the exchange to the primary distribution cabinets). It is expected that, in the future, optical
fibre will also enter the secondary distribution channels (from the primary distribution cabinets to the
subscribers). As penetration of optical fibres goes down the different layers of the network, demand for
optical fibres expressed in fibre-km terms increases exponentially. However as local area costs are
largely dominated by the costs of civil works (trenching), the replacement of existing copper cables by
optical fibres will only take place when it is economically justified by, for example, the development of a
new business area or the upgrading of a cable TV system.

4. Investment trends and outlook 1996-2000

Public telecommunications operators in the EU-countries invested an estimated ECU 31 billion in

1995. This roughly corresponds, in real terms, to the level observed between 1983 and 1988, but below
the average level 1989-1993 (see annex table 1). One reason for the investment peak observed in
1989-1993 is the very large spending in Germany. After reunification, the country started to expand and
upgrade the telecommunications infrastructure in Eastern Germany.

Another reason for this period of booming investment is the large expenditure for additional
modern (digital) mainlines. About 85 million digital mainlines were added by the 15 EU-countries from
1990 to 1995. Some of these lines were for new customers, but most were upgrading the lines of existing
customers. The EU-countries upgraded the lines of 53 million existing customers between 1990 and
1995, while some 32 million new customers were connected to the network: for every new customer
there were 1.7 digital upgrades for the lines of existing customers. This trend of increasing digitisation
accelerated over the period, with a ratio of 1.2 to 1 over 1990-1992 and of 2.3 to 1 over 1993-1995. This
means that investment is increasingly geared towards modernisation rather than expansion.

The costs associated with installing a fixed telecommunications network are dominated by the
requirement to bury cable in the ground. As a result, the cost for a new digital line is lower when an
existing (analogue) line is replaced compared to adding a new connection which involves additional local
area network costs. This fact is illustrated by figure 6, which shows the cost for a new digital line against
the proportion of replacement in total new lines: there is a trend of the cost to be lower the higher the
proportion of replacement of analogue lines. However, some countries exhibit a bias toward higher or
lower than expected unit cost per line: Germany and Austria are considerably above average, whereas
the United Kingdom is considerably below average. This may well reflect the role that competition
between operators and suppliers has played in stimulating cost effectiveness.

8-
 Figure 6. Cost of an additional digital line and replacement rate in total new lines
(Average 1992-1994)
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40 45 50 55 60 65 70 75 80 85 90 95 100%

Proportion of replacement In total new digitai lines

It should be noted that any resource which allows a company to reduce this investment cost (for
example, existence of easily accessiblerightsof way, ducts, poles or overhead electricity cables which
may make the installation of fibre easier and much less costly) is of strategic relevance when it comes to
becoming a new competitor in the market. For this reason utility companies, such as electricity, gas,
railways and water, are already involved in the preparation of providing alternative local loop
infrastructures.

Total investment in telecommunications is increasingly difficult to measure. As the number of

players rises along with the erosion of public monopoly position in most countries, the well documented
public telecommunications investments represent a declining share of overall investment in
telecommunications. Examples of additional investments, include investment in mobile communication,
or investment by users in equipment such as facsimile or private branch exchange. This trend is
particulariy pronounced in countries where télécoms markets have been fully or partially liberalised such
as the United Kingdom, the Netheriands and the Nordic countries. In the United States, where the
situation is similar, OECD estimated that investment in public telecommunications in 1992 by local and
long distance carriers represented only 60 per cent of overall investment in the telecommunications
sector.

4.1. Fixed network

In preparation for the 1998 "big bang", the liberalisation of the telecommunications sector, more
rapid digitisation is now expected in most EU-countries, even those with a lower penetration rate where
expansion of the network was, until recently, the dominant factor. It is likely that by the year 2000 the
universal service obligation, i.e. each household is in principle equipped with a telephone, is satisfied.
Moreover, most of the countries will also have achieved full digitisation by then. The investment
requirements for full digitisation and universal service is estimated at some 85bn ECU until the year
2000, of which 69bn for digitalisation and 16bn for new lines'·. For the expenditure in the individual
countries see annex table 2.

4.2. Mobile network

Mobile telecommunications have seen a very rapid development in the EU during the last five
years. There has been a mix of technological, regulatory and economic factors that have mutually
reinforced the diffusion path for mobile telecommunications. In the past, the penetration rate for mobile

The underlying assumption is thiat by ttie year 2000 all existing lines should be digitised. Moreover, universal sen/ice entails that
each household should tie supplied with a fixed telephone line. For the cost estimate, an average cost of 3000 ECU Is taken for
the cost of a new line and 1500 ECU for digitisation of an existing line.
telephones has generally been underestimated. As a result of the rapid growth seen over the past two
years, simple extrapolations may however induce overestimation of the potential for mobile
communications. One can try to model penetration rates with a logistic diffusion function (the "S" curve).
In this case the adoption of a mobile phone by the different agents is modelled in a similar way as
diseases spread in biology. In other words, the flow of the adopters is related to the stock of existing
adopters. At the beginning there is an acceleration in the adoption rate and then a decline once the
population approaches saturation point.
The penetration rates according to a logistic function for the different EU countries have thus
been estimated (see annex table 3). One can notice that there is quite a different starting point between
countries. There will also be differences in the year 2000. Total penetration rate in the EU is expected to
increase from 5.6% in 1995 to 17.2% in 2000. This would imply that there are some 44 m new
subscribers to mobile telecommunications. Assuming an average investment cost of 700 ECU per
subscriber, the cumulative investment cost is 31 bn ECU by the year 2000.
In a number of countries, investment in the mobile sector would thus be of neariy the same
magnitude as the investments for the fixed network. In the case of the UK investment in mobiles could
be even higher than for fixed telecommunications.
The results should be interpreted with much caution, given the huge degree of uncertainty which
surrounds the projections by country of the cellular market, as well as the rough methodology used to
estimate the investment cost. In particular for certain small countries (Luxembourg, Greece) the figures
projecting investment in the cellular market are likely to be overestimated. However, on a EU global
level, these projections seem plausible. They show that the mobile sector has a major investment
potential in the near future, not to mention the longer term.

5. Tariffs

The market for telecommunications services used to have a highly distorted price system, i.e.
tariffs did not reflect the underiying cost of services provided. Typical international and long distance call
prices were significantly above cost and local tariffs and rental charges below cost; in other words, the
former were cross-subsidising the latter. This system was typically regulated by the government with the
aim of ensuring universal service. This was politically appealing because it shifted the financial burden
mainly to customers with high willingness to pay (i.e. companies and wealthy persons). However, from an
economic point of view, it was inefficient. It became clear that this scenario could not withstand a
competitive environment: the competitors would enter the high price/profit services market and push
down the prices, therefore local tariffs and rental charges would have to increase to cover costs as the
scope for cross-subsidisation would be reduced. A so called tariff re-balancing would therefore set in.
This section outlines the evolution of tariffs in the EU and outlines expected effects of competition.

5.1 Fixed network tariffs

With the progressive liberalisation of the telecommunications market in the European Union, the
analysis of tariff structures and levels is increasingly important in assessing the competitiveness of
operators. Inter-country comparisons, which are a key element of such an analysis, are thus undertaken
by referring to a basket of services. This is to avoid conditions specific to one country as much as
possible. These baskets can determine whether a country's operator is expensive or inexpensive, and to
what extent the introduction of competition is likely to lead to an erosion of its market shares.

For business users, the Northern European countries, including Denmark, Finland, the
Netheriands and Sweden, continue to offer the lowest prices by far, as annex table 4 shows. These
countries have recently significantly liberalised their telecommunications market, while on the other hand
the most expensive countries for business users, such as Austria, Greece, Italy, Spain, Germany, Ireland
and Portugal, have retained monopoly provision of most of the télécoms services: the average annual
spending by a business user in Austria is some three times the amount paid in Sweden or in the
Netheriands. The tariff basket for residential users reflects a similar ranking of the EU-countries to the
business basket.

10
 The tariff baskets for residential and business users are highly correlated and depend to a large
extent on the prevailing market structure. The importance of market structure becomes even stronger
when it comes to international tariff comparisons. Countries which have allowed competition in the sector
are the least expensive countries for an international basket based on a fixed distribution of calls among
adjacent countries and other EU-countries, the USA and Asia. While the OECD generally undertakes
tariff comparisons in terms of purchasing power parity (PPP), we have used current exchange rates,
which provide more accurate information on the cost to the consumer and is also the reference for
competitors such as call-back operators. These call-back services were pioneered in the United States
where suppliers took advantage of competitive rates to offer US prices to overseas customers abroad
where local carriers charge much higher prices.

The trend toward lower international tariffs has thus been further stimulated by call-back
operators. For a business traveller or tourist, the exchange rate with their home country is thus a more
relevant measure of the cost of an international call than the purchasing power parity of the local
currency. Countries like Austria, Italy, Portugal and Spain, with expensive international tariff baskets,
appear to be very vulnerable to competition from call-back services. Also, countries with relatively strong
currencies such as Germany, the Netheriands and France, appear similariy attractive for call-back
customers. On the other hand, countries with relatively inexpensive charges or in some cases weaker
currencies, such as Denmark, Greece, Ireland, Sweden and the UK, would seem to be attractive hubbing
sites for call-back operators.

5.2. Mobile network tariffs

Mobile telecommunication is one of the most dynamic areas of the telecommunications sector
and this is amplified by the reduction in prices over the last few years. The cost of handsets has fallen
dramatically as a result of technological advances, economies of scale and of very vigorous competition
among manufacturers. At the same time, the average cost of joining a mobile network (connection and
rental) in the EU area has fallen by more than 30 per cent since 1992. In 1996 almost all EU-countries
had competitive provision of mobile telecommunications, generally two service providers including the
incumbent public operator. Nevertheless, there is still a large disparity of tariffs across countries. Nordic
countries such as Sweden, Finland and Denmark have typically much lower tariffs than the other.

Lower prices are themselves making mobile services affordable for a greater number of users.
At the same time, there is a trend toward the convergence of fixed and mobile network capabilities in the
form of cordless and cellular telecommunication. The gap between a basket of fixed and mobile services
is narrowing especially in those countries where mobile telecommunications is subject to more
competition and is therefore developing fast.

5.3. Leased lines

Leased lines allow large users (e.g. business) to take advantage of volume discounts and to
have control over their own telecommunication facilities and traffic. At the same time, leased lines
provide a platform for competitors to incumbent public operators to offer a range of value added services
and complement their own networks. As indicated in annex table 5, the OECD basket of leased line
charges shows huge discrepancies among EU countries over different speeds and distances. However,
correct comparisons of similar services in regard to leased lines is difficult, mainly because the sources
generally fail to specify whether the cost of the end links (sometimes called telecommunication tails) to
customer premises are included. In addition, some packages include redundancy in the form of a
second line at a lower price or priority service restoration in the event of a network fault as customer
options.

5.4. Tariff trends and rebalancing in the EU

After the EU-countries decided in the eariy 1990's that télécoms markets should be liberalised in
most member states by 1998, a number of remarkable price trends have followed. For instance, the
average total cost of a basket of telecommunication services either for a business or a residential user
has declined rapidly. Between 1993 and 1995, the average cost in the EU of a basket of
telecommunication services for a business user has declined in real terms from ECU 1 179 to ECU 878,
and for a residential user from ECU 378 to ECU 275. Expressed in per cent, the actual decreases were
respectively 25.5% and 27.3%. For international calls the reduction was even higher, i.e. 30%.

-11
 However, these gains for the users were not evenly spread throughout the EU. Hereafter we
differentiate countries according to the status competition, and we distinguish a group of "competitive"
countries with effective competition among operators (i.e. Denmark, Finland, the Netheriands, Sweden
and the United Kingdom) and another group of "non-competitive" countries (i.e. the remaining countries
of the EU) where competition among operators is weak or non existent. Several key trends emerge:
• The cost of average baskets decreased in competitive countries by an amount equivalent or greater
than the decrease observed in non-competitive markets. This trend affects both the business and
residential baskets, in contrast to eariier fears that residential customers could be penalised by the
liberalisation of the sector. Moreover, the average tariff level of the baskets in competitive countries
remains much lower than in non-competitive countries. This indicates that further drastic price cuts
are likely to occur in non-competitive countries.
• Re-balancing between usage charges and fixed charges is occurring at a much faster rate in
competitive countries. In other words, these countries have been lowering the contribution of usage
charges relative to fixed charges such as rental and connection fees.
• While fixed charges are higher on average in competitive countries, usage charges are much lower
and are reduced at a faster rate than in non-competitive countries. This suggests that non-
competitive countries are very far from having significantly re-balanced their tariff structures.
• Concerning the pricing of geographical distance in calls, one can observe that public operators in
competitive markets have reduced tariffs at a relatively faster rate than in non-competitive markets,
and implementing the greatest reductions (in relative terms) over shorter distances (see figure 7). As
a result, the proportion between local and long distance rates is in the order of 1 to 3 in competitive
countries, while it is of 1 to around 10 in non-competitive countries: this gives an idea of the order of
magnitude for the future price cuts, especially on long distance calls, that one may expect after
liberalisation in 1998.

Figure 7. Tariff structure by distance of calls in competitive and non-competitive countries *

IO
o>
3
u
UJ

Local 5 0 km 10 0 k m 25 0km

* "Competitive countries": Denmark, Finland, the Netheriands, Sweden and the United Kingdom.
"Non-competitive countries": all other EU countries.

6. Regulatory framework

In most Western European countries, telecommunications services used to be provided by a

single organisation, on a regulated monopoly basis, at least until the late 1980's. In almost every case,
the organisations were departments of the public sector administration, providing postal services as well
as telecommunications services, where the latter cross-subsidised the former. The argument for
monopoly provision of telecommunication services was mainly that of economies of scale due to the high
set-up costs of networks, avoidance of duplication of networks, together with the social obligation to
provide universal service at the same price throughout the country.

12
 However, over the last 15 years, advances in technology, which have reduced the cost and
increased the functionality of telecom networks and services, and the realisation through experience of
liberalised mari^ets that monopoly provision could be an inefficient way to serve users, have called into
question the relevance of the prevailing regulatory regime. The experience made with liberalisation of
telecommunications in a few countries (such as the US, the UK and Sweden) has demonstrated that
competition is feasible and could produce a demand-led and market-driven telecommunications sector.
At the same time this would also lead to more innovation in services, a broadening customer choice, an
increase in investment and a reduction of costs and prices. These potential benefits led individual
governments and the European Commission to initiate wide-ranging reform programmes with the
objective of ending the monopoly provision of telecommunications services.

6.1. Community regulations for liberalisation

The main direction of EU telecommunications policy was set in 1987 with the publication of the
Green Paper on the development of the common market for telecommunications services and
equipment. The Commission proposed the introduction of more competition combined with a higher
degree of harmonisation, in orderte maximise the opportunities offered by the single EU market.
On the basis of the favourable reaction from all market participants to the Green Paper, the
Commission prepared an action programme supported by the Council and the other European
Institutions. This programme included :
• Rapid full opening of the technical equipment market to competition;
• Full mutual recognition of type-approval for technical equipment;
• Progressive opening of the telecommunications services market to competition;
• Clear separation of regulatory and operational activities;
• Establishment of open access conditions to networks and services through the Open Network
Provision (ONP) programme;
• Establishment of the European Telecommunications Standards Institute (ETSI), in order to stimulate
European standardisation (which started in 1988);
• Full application of the Community's competition rules to the telecommunications sector.
These actions have subsequently been implemented to a large extent through the adoption of a
series of legislative measures, among which are:
• Open Network Provision Directive of 1990 (90/987): it harmonises the methods and conditions of
public access to the network according to the principles of objectivity, transparency and non-
discrimination.
• Services Directive of 1990 (90/388): it provides for the gradual removal of special and exclusive
rights granted by Member states to telecommunication operators for supply of value added (by end
1990) and data services (by 1.1.1993).
• Public Voice Telephony and Infrastructure Directive of 1996 (96/19); calls on member states to
liberalise the provision of public voice telephony services throughout the Union by 1 January 1998,
while maintaining universal service. Additional transition periods of up to five years could be granted
to Spain, Ireland, Greece and Portugal to allow for necessary adjustments, particulariy of tariffs, and
a possible additional period of two years could apply to countries with very small networks (e.g.
Luxembourg), if justified. In view of these deadlines, restrictions on the use of alternative
infrastructure should be lifted by 1996 and licensing and interconnection rules should be set down by
1997.
• Mobile Communications Directive of 1996 (96/2); it abolishes the special and exclusive rights in
mobile communications, which was previously excluded from the Services Directive. It also aims at
an eariy liberalisation (by 1997) of infrastructures and the right for mobile operators to directly
interconnect. It also explicitly requests Member States not to refuse licences for the operation of
alternative DCS 1800 mobile systems.

6.2. Implications for tariffs and universal service

The opening up of telecommunications service markets to competition, as well as the regulatory
requirements on pricing and the availability of new technologies, requires European operators to
undertake major tariff reviews to correct historical imbalances and allow development of new services.
In the Communication on tariffs of 1992 (SEC (92) 1050), the Commission set out guidelines for
cost orientation and adjustment of pricing structures. This builds on the principles set out in the Open
Network Provision Directive, that tariffs should be cost-oriented and that national regulatory authorities
should ensure that cost accounting systems are put in place by the operators to provide transparent

13
information. In orderte meet the 1998 liberalisation deadline, most Member States have already started
to re-balance national tariffs, involving lower prices for international and long-distance calls and
consequently higher charges for local calls and basic connections. This tariff re-balancing is as such
closely linked to the issue of universal service.
The Commission's Communication (COM (93) 543) establishes the key elements of the policy of
providing universal service for telecommunication in the Union. This defines the scope of universal
service (i.e. a basic voice telephony service and a network access supporting it, as well as fax and low
speed data access), the methodology to be followed for costing universal service (i.e. a "net cost"
approach), and the possible funding mechanisms to share any identifiable burden associated with the
provision of universal service (i.e. compensations may not be required for minimal burden; a national
universal service fund may be established; a system of supplementary charges may be requested from
market players by the incumbent operator). The document recognises that competition would improve
service quality, bring down prices and extend penetration. However, at the same time affordability is
essential to ensure that service will be genuinely universal. Flexible and targeted tariffs should play an
important role, as concerns affordability for all users.

7. Impact of competition on network operators

In the rapidly changing technological and regulatory environment, many opportunities are arising
for new and existing companies as well as many threats to existing companies and, for all operators,
increased uncertainties and risks. The incumbent operators of fixed telephony networks and services,
who until recently felt sure of their continued domination due to the "natural monopoly" in transmission
and distribution, have to adapt to the changing environment and the emerging competition.
The threat of competition has already started to induce a response in terms of improved quality,
business customer focus, new products and efficiency programmes. The mere fact of simply becoming a
"contestable" market, even before new competitors have actually started operations, induces the
telecommunications sector to register huge efficiency gains and dramatic improvements for the
customers in terms of service quality and range of products.
The customary design of POTS public investments is challenged by the opening up of the
sector. Competition vyill arise not only on the network, but also between communication networks. This is
already happening at a large scale in certain countries, such as the UK where cable TV companies are
also offering telephone services. A further challenge is mobile communications, whose potential still has
to be fully exploited.

7.1. Fixed network operators

The incumbent operators are facing a situation where significant tariff reductions on the most
profitable segments, international and long-distance, have to accompany increased investments for
modernisation and/or upgrading of their networks. At the same time, experience of competition in more
advanced countries has shown that an erosion of market shares is unavoidable at least in specific
segments. As a result, most European télécoms incumbent operators will sooner or later face a decline in
profitability, depending on the time scales of market share losses which may, in some cases, take more
than a couple of years. Efficiency gains and overall market growth may also be able to offset part of the
loss of revenues, but this is likely to be insufficient.

As an example, a simplified model of telecommunications investment shows that under

optimistic assumptions (the investment cost per line is ECU 1000 - 1500, operational costs are 15% of
the investment cost, and a payback period of 15 years), break-even at a 10% discount rate would require
an average revenue per line of some ECU 400 to 600 in real terms over a 15-year period. This can be
compared with the actual range of values of the average revenue per line in the EU : from some ECU
400, in the most liberalised countries, to neariy ECU 1000, the other extreme which could thus be
expected to reach the lower figure some years after liberalisation.

Against this background it is clear that, unless radical efficiency gains and growth of value added
services are achieved, public companies could face financial problems. They therefore have to adopt
consistent investment strategies along with new managerial and commercial practices, while they need
to accelerate their tariff re-balancing to minimise the impact of competition.

14
 Liberalisation cannot be considered alone. All operators face challenges in their home markets
from a combination of liberalisation, regulation and technology. In liberalised countries, regulators control
prices to protect customers from undue price increases. The experience from the UK and Swedish
markets shows that a tough regulatory environment for prices had a similar impact on the performance of
the incumbent operators than competition, even at a relatively late stage of competitive entry. Price
caps2, now in place in almost all EU countries thus constitute an important signal of the speed at which
the operators are forced to re-balance their tariffs: this is low in already liberalised countries, where costs
are close to tariffs, with a CPI minus 0 to 3% per year up to 1998 in Netheriands, Sweden and Denmark,
but as high as CPI minus 5 to 8% in France, Gemriany, Italy or Spain.

While price caps are determined domestically, price comparisons with other European countries
are becoming an increasingly important factor for service providers. It is worth here insisting again on the
difference between competition on the network and competition between networks. With competition on
the network the new entrants have to lease transmission capacity from the incumbent. With competition
between networi^s, new entrants may choose either to use existing alternative networks, those owned by
utilities or cable television companies, or completely new infrastructure construction. In the first case, it is
obvious that high rental charges for leased lines will limit the effectiveness of competition in services.

It was shown eariier in the less liberalised countries (in particular Austria, Italy, Germany, France
and Spain) that the average tariff for a leased line from the incumbent is some 2 to 3 times higher than in
the liberalised countries of the EU, and neariy 10 times the corresponding US tariff. Full infrastructure
liberalisation, as expected by the Commission, would have a dramatic effect not only on the prices of
leased lines, but more importantly would eventually amplify the impact of service competition on the
incumbent operators.

Last but not least, technology in the form of digital transmission, fibre optics, micro-electronics
and wireless telephony, is probably the most effective factor undermining the position of the incumbent
monopoly operator. It makes it not only cheaper for new competitors to enter the market, it also reduces
the profit margin in liberalised markets. Something similar has happened in the computer industry, where
large companies like IBM and Digital Equipment were forced into restructuring as prices fell faster than
overheads. To the extent that telecom switches are now simply large computers, they are subject to the
same price decline, with eventually similar effects on the télécoms sector.

To succeed in liberalised markets, operators have started to adopt strategies aiming at

increasing productivity, while expanding domestically and abroad in fast growing segments. Actually, the
economic significance of the télécoms industry is increasing rapidly all over the worid: the evidence from
already liberalised countries is that the industry is losing its narrow product characteristics of a utility and
is becoming a mixed market of consumer and business products open to branding, variety and choice.
Stimulated by tariff decreases and opening of the economies, long distance and international traffic in
liberalised markets are growing at rates ranging from 10% to 12% per annum. Direct spending on
telecommunications has increased from some 2% to more than 3% of GDP. As well as stimulating a
wider range of new products and services, competition acts as a very strong incentive to improve service
quality. Efficiency improvement is however key in this process, and this requires drastic manpower
reductions: most European operators are now implementing labour productivity targets of 350 lines per
employee for telephony services, against the current levels of 150 to 250. The important conclusion to
draw is that all European operators have room for considerable efficiency gains, implementing the
benefit of technology and lower equipment costs.

The responses available to the incumbent operators to the threat of competition are a mix of the
basic strategies:
(i) to become a global service provider, focusing primarily on large and multinational customers to
protect the domestic market and grow abroad (e.g. BT);
(ii) to expand in multimedia, focusing primarily on residential customers, with a view to developing in
cable television and new interactive services (Deutsche Telekom and Teledanmark have particular
opportunities given their cable-TV ownership);
(iii) to become a developing country operator, taking stakes in Eastern Europe (Telia, Teledanmark,
Deutsche Telekom) or Latin America (Telefonica, France Telecom);

Price caps formula imposed a celling on the evolution of a télécoms teriff basket, by reference to the Consumer Price Index
(CPI), reduced by an efficiency factor of X%, i.e. "CPI minus X%".

15
(iv) to establish mobile businesses domestically and abroad, building up a portfolio of stakes in
developed and developing countries.

All these strategies are expensive, putting pressure on the strong cash-flow generation of
existing operators' businesses, not only in the short term but also in the medium term: BT and the
Scandinavian télécoms operators are already sustaining start-up losses abroad on an upward trend.
These strategies have also resulted in a web of international cross-holdings and alliances. The forces
driving companies towards partnerships are the perception that no operator has all the skills in-house to
tackle the new market-place; that it is now a necessity to operate on a pan-European level and that risks
are better mitigated through diversification.

7.2. Mobile network operators

The table below summarises the main competitive features for mobile communications in the EU
countries. This shows quite a heterogeneous picture. The number of operators can vary from 1 to 4.
However, there is a trend for all countries to increase the number of different operators as the benefits of
competition are very clear. The dominant operator is normally the incumbent fixed network operator, as
this is generally also the first to have entered the mobile phone market.

Mobile network operators in the EU

Country Operators (Owner) Market shares Year of

(Dec. 95) competitor's
entry
Austria Mobilkom (State) 100%
Maxmobil (Deutsche Telecom, Siemens) end 1996
Belgium Belgacom Mobile (Belgacom, Airtouch) 100%
Mobistar (France Telecom, Telifa) end 1996
Denmark Teledanmark (State) 69%
Sonophon 31% 1992
Finland Telecom Finland (State) 88%
Radiolinja (Regional telcos) 12% 1992
France France Telecom Mobile (State) 68%
SFR (Générale des Eaux, Vodafone) 32% 1989
Bouygues 1996
Germany DeTeMobil (Deutsche Telekom) 56%
Mannesmann Mobilfunk (Mannesmann, AirTouch) 39% 1991
E-Plus (Veba, Thyssen, Bell South, Vodaphone) 6% 1995
Ireland Telcom Eireann (State) 100%
Esat Digiphone (Telenor, Communicor) 1996
Italy TIM (STET) 97%
Omnitel (Olivetti, Bell Atlantic, AirTouch) 3% 1995
Luxembourg Luxmobil (State) 100%
Portugal TMN (State) 40%
Telecel 60% 1992
Spain Telefonica (State) 98%
Airtel (AirTouch, BT) 2% 1995
Sweden Telia (State) 63%
Comvik (Kinnevik, Millicom) 21% 1981
Nordic Tel (AirTouch, Vodafone) 6% 1992
UK Cellnet (BT, Securicor) 43%
Mercury (Cabla and Wireless, US West) 7% 1991
Vodafone 43% 1984
Orange (Hutchinson) 7% 1991

16-
 Infrastructure costs, which used to constitute the higher percentage of total costs for mobile
communication costs, are becoming proportionally much less with the introduction of large up-front
licence payments. Operators are also under regulatory pressure to build out rapidly after the high up-front
investment of infrastructure purchases. At the same time mobile switches are becoming more 'intelligent'
and modular in design and, as a result, contribute to reducing long-term replacement costs, since
switches can be upgraded rather than changed out, thus keeping costs to the minimum. Such changes
have radically transformed network economics in the mobile industry to the extent that national networks
are being built in months rather than decades, offering a level of expansion and interconnection of
networks never met before, with phenomenal social and economic implications.

The risks of mobile operations depend on the prospect for future growth of the market, and the
ability of the company to maintain its projected share. Market growth has, up to now, been systematically
underestimated. But one should bear in mind that penetration rates have not reached a level supposed to
correspond to a "mass market" size in most countries. This is estimated to be in the order of 10-12%,
which corresponds to the 'professional' share of the market. Only in a few countries, notably Sweden,
Finland and Denmark, are those rates now significantly above this level. In other words, while the speed
at which the market develops may be underestimated, it remains to be seen whether conditions are met
in a specific country for the penetration rate to reach the mass market threshold. Given higher and higher
up-front fees, this situation is associated with very significant risks for new mobile projects.

Licence fees for mobile phones in the EU - 1992-1995

Country GPD /head Mobile phones/ Licence fee Fee/inh.

($) 100 inhabitants (m$) ($)
Austria 27300 4.7 397 50
Belgium 20500 1.9 294 29
Spain 12200 1.1 648 17
Greece 7120 - 164 16
Italy 17150 2.3 460 8
Ireland 12760 3.0 24 7

17
 ANNEX

TABLE 1

PUBLIC TELECOMMUNICATION INVESTMENT IN THE EUROPEAN UNION

(in ECU millions, at constant 1995 prices & exchange rates)

83-85 86-88 89-91 1992 1993 1994(e) 1995(p)

Belgium 728 603 767 667 1214 891 755
Luxembourg 19 36 53 77 64 55 45
Denmark 422 567 486 392 337 390 302
Germany 9556 10759 12128 16459 13632 12026 11325
Greece 395 216 380 600 648 624 529
Spain 1837 2114 4499 3117 2454 2714 2265
France 6015 5556 5090 5024 5309 5521 4530
Ireland 280 207 223 210 194 204 215
Italy 4081 4407 6875 6433 5581 5117 4153
Netheriands 759 904 1406 1455 1288 1643 1284
Portugal 340 439 809 816 469 484 453
United Kingdom 2643 3291 3455 2835 2987 2953 3230
Austria 1007 1030 1139 1214 1108 1083 982
Sweden 756 886 858 782 899 999 798
Finland 404 468 492 487 414 432 378
EU 15 29242 31483 38661 40570 36599 35136 31241
United States 16232 18496 18033 19414 n.a. n.a. n.a.
Source : OECD, ITU, PTO annual reports & PJ calculations

TABLE 2

INVESTMENT ESTIMATES FOR FIXED TELECOMMUNICATIONS IN THE EU 1996-2000

lines to be digitised
(In m lines)
lines for universal service
(in m lines)
cost for digitalisation cost for new lines
(ECU bn) (ECU bn) ^^U
Austria 1.69 0.06 2.53 0.19 2.72
Belgium 1.50 0.36 2.25 1.07 3.33
Denmark 1.31 0.00 1.96 0.00 1.96
Finland 0.57 0.00 0.85 0.00 0.85
France 1.60 0.00 2.40 0.00 2.40
Germany 18.77 1.83 28.15 5.50 33.66
Greece 3.42 0.15 5.12 0.44 5.56
Ireland 0.26 0.26 0.39 0.78 1.17
Italy 5.70 0.59 8.56 1.78 10.34
Luxembourg 0.02 0.00 0.02 0.00 0.02
Netheriands 0.00 0.39 0.00 1.17 1.17
Portugal 1.16 0.40 1.73 1.20 2.93
Spain 6.27 0.63 9.40 1.90 11.30
Sweden 0.72 0.00 1.08 0.00 1.08
United kingdom 2.94 0.67 4.42 2.01 6.43
TOTAL EU 15 45.91 5.35 68.87 16.05 84.91
Source: PJ estimates

18
 ANNEX

TABLE 3

PENETRATION AND INVESTMENT ESTIMATES FOR MOBILE TELECOMMUNICATIONS IN THE EU

1996-2000

e s t i m a t e d p e n e t r a t i o n * (%) new sultscriber total cost

(in million) (ECUbn)
1995 1996 1997 1998 1999 2000 (1996-2000) (1996-2000)
Austria 4.8 6.5 8.3 10.1 12.0 13.7 0.70 0.49
Belgium 2.3 2.9 4.1 5.6 7.3 9.3 0.71 0.50
ÌDenmark 15.1 16.7 18.3 20.0 21.6 23.2 0.45 0.32
Finland 19.7 20.5 21.3 22.0 22.8 23.5 0.22 0.15
France 2.4 4.4 6.4 8.9 11.7 14.7 7.32 5.12
\Germany 4.6 8.8 11.4 13.5 14.9 15.7 9.43 6.60
Greece 2.7 6.5 8.9 9.7 9.9 10.0 0.78 0.55
Ireland 3.4 6.9 9.3 11.4 13.2 14.5 0.41 0.29
Italy 6.9 10.5 13.9 16.4 18.1 19.0 6.61 4.63
Luxembourg 7.2 8.6 10.0 11.4 12.8 14.2 0.03 0.02
Netherlands 3.5 4.9 6.8 9.0 11.6 14.2 1.72 1.20
Portugal 2.9 5.3 7.6 9.2 10.2 10.7 1.07 0.75
Spain 2.4 4.4 6.9 9.7 12.2 14.1 4.56 3.19
Sweden 22.5 23.9 25.2 26.6 27.9 29.3 0.68 0.48
UK 8.7 11.7 15.1 18.5 21.8 24.8 9.39 6.57
total EU 5.6 8.4 11.0 13.4 15.5 17.2 44.07 30.85

* using a logistic diffusion function

Source: PJ estimates

TABLE 4

OECD-PJ BASKET OF TELEPHONE CHARGES, FEBRUARY 1996

(Values express the average annual spending by user, in ECU at current exchange rates)

Business user Residential user Weighted average International

Fixed Usage Fixed Usage Fixed Usage Business &
charges charges Total charges charges Total charges charges Total Residential
Austria 150 1409 1559 150 351 501 150 594 744 84
Belgium 147 655 802 147 168 315 147 280 427 59
Denmark 150 469 619 150 133 283 150 210 360 55
Finland 194 578 773 194 165 359 194 260 454 64
France 83 881 964 83 217 300 83 370 452 65
Germany 134 947 1081 134 233 367 134 397 531 64
Greece 97 1380 1477 97 304 401 97 551 649 53
Ireland 170 870 1040 170 223 393 170 371 542 58
Italy 121 1284 1405 121 316 437 121 538 659 74
Netherlands 138 383 522 138 105 244 138 169 308 65
Portugal 95 958 1053 95 216 311 95 387 482 89
Spain 113 994 1108 113 232 346 113 408 521 92
Sweden 189 381 570 189 103 292 189 167 356 45
UK 190 625 815 190 173 363 190 277 467 52
E U average 141 844 985 141 210 351 141 358 497 68

-19
 ANNEX
TABLE 5

OECD BASKET OF LEASED LINE CHARGES, 1994

(values express the average annual spending by user, in 1994 ECU)

9.6 kbit/s 64 kbit/s 1.5/2 Mbit/s

Austria 38951 128719 709021
Belgium 16687 133691 486104
Denmark 28520 49677 374990
Finland 40161 52993 n.a.
France 48048 72347 439187
Gennany 75733 86216 457552
Greece 22961 58357 231980
Ireland 26926 38757 235145
Italy 40919 91644 799721
Netheriands 34036 64811 339766
Portugal 29879 31809 198377
Spain 71442 144322 947682
Sweden 39077 52809 n.a.
UK (BT) 32801 35885 175347
EU average 38939 74431 n.a.

TABLE 6

EIB ACTIVITY IN TELECOMS 1990 - 1995

EIB TELECOM LOANS (M ECUs)

1990 1991 1992 1993 1994 1995 TOTAL % of loans % of inv. Total Inv.
Belgium 0 0% 0.0% 4609
Denmark 114 116 61 107 50 46 494 5% 22.1% 2230
Germany 49 98 492 521 1160 11% 1.5% 74857
Greece 51 237 53 341 3% 11.0% 3099
Spain 401 577 660 294 6 539 2477 23% 11.4% 21738
France 0 0% 0.0% 27825
Ireland 46 33 46 31 32 188 2% 14.8% 1258
Italy 723 590 738 768 628 247 3694 35% 11.1% 33363
Luxembourg 29 31 60 1% 18.0% 330
Netheriands 0 0% 0.0% 8420
Portugal 83 173 268 200 724 7% 18.9% 3828
United Kingdom 148 127 152 609 1036 10% 4.9% 20943
Austria 74 74 1% 1.1% 6765
Finland 0 0% 0.0% 2863
Sweden 0 0% 0.0% 5588
Other 135 203 89 427 4% 0.0% 0
Total 1650 1897 1991 2095 2157 885 10675 100% 4.9% 217716

20-
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