11 Views of O2

Contents
Page General view of the DGTs proposals..................................................................................................... 324 Legal and regulatory ............................................................................................................................... 325 Market definition .................................................................................................................................... 325 O2s view on the significance of market definition............................................................................. 325 The mobile market was dynamic and competitive.............................................................................. 326 Current Prices and Regulation ................................................................................................................ 327 Current Charges .................................................................................................................................. 327 Ramsey Pricing ................................................................................................................................... 327 Choice and tariff structures ............................................................................................................ 329 Subsidies ........................................................................................................................................ 329 Competition has led to optimal prices........................................................................................... 330 No unfair subsidy........................................................................................................................... 331 Prices cannot rise and are likely to fall ............................................................................................... 332 Contractual and institutional constraints ........................................................................................ 332 Balanced prices are the key to delivering benefits ......................................................................... 332 Competitive pressures exerted by consumers and retailers............................................................ 333 Consumers alternatives................................................................................................................. 334 Technological changes................................................................................................................... 335 Regulation is unnecessary and potentially dangerous......................................................................... 335 Distributional Issues....................................................................................................................... 336 Comments on DGTs cost model............................................................................................................ 336 Ramsey pricing ................................................................................................................................... 337 Externalities ........................................................................................................................................ 337 Response to hypothetical remedies ......................................................................................................... 338 General................................................................................................................................................ 338 Proposed form of CCs findings ............................................................................................................. 343

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General view of the DGTs proposals

11.1. O2 believed that the DGTs proposed remedy of price regulation for the four major operators was not only intrusive and disproportionate, but, if imposed at or above the level proposed by the DGT, positively dangerous, for, inter alia, the following reasons: (a) First, such a remedy raised a number of serious issues as to mobile operator viability. O2 was concerned that, when three out of the four operators were not excessively profitable (recognized by the CC), operators would be unable to recover the lost revenue contribution of a significant price control from other sources. In the present economic climate in the mobile telecoms sector, this was likely to have highly detrimental effects. If one or more operators failed profitably to increase other prices it might impinge upon their financial viability, which would be contrary to the CCs duty under section 3 of the Act to secure that any person by whom [telecommunication] services fall to be provided is able to finance their functions. (b) Second, such a remedy could severely damage (or even put to an end) the prepaid customer sector, on which many vulnerable members of society, particularly less well off subscribers, relied. Currently, at peak times, an outgoing prepaid call was priced at 35p, an incoming call from BT at 19p. If the gap were to widenas it would under the DGTs proposed remedy (as peak incoming prices would fall to 9p)call-back services similar to those that had been developed in relation to international calls would almost certainly start up (the technology was already available). The call-back operator could offer the customer UK national calls for, say, 15p instead of the 50p or so charged by the mobile operatora saving of 35p a minute. One way in which operators might attempt to recoup lost revenues would be to introduce a scheme such as mandatory time-limited voucher policiesso-called ouch vouchers. If all MNOs were to require a 10 a month mandatory voucher, one-third of prepay customers would see the cost of using a mobile phone more than double. Almost half of prepay customersover 10 million people in the UKwould see their cost of using a mobile increase. This was likely to lead to significant demand responses, potentially resulting in the loss of many millions of existing and potential mobile customers. With so many fewer customers, such a scheme was unlikely to succeed in augmenting revenues. Prepaid services would rapidly be uneconomical. If O2 had to raise outgoing charges for prepay customers, then lower income groups, for example the elderly, who tended to rely on prepay, might no longer find a mobile phone affordable. (c) Third, the remedy proposed could inhibit the development of new technologies, in particular the development of 3G mobile networks. Although the DGT claimed that the remedy proposed would affect only 2G, O2 believed that view to be wrong given the ways in which 2G and 3G would be inextricably linked. First, cost allocation between the two would be virtually impossible. Second, calls to customers were entirely determined by the mobile number called and never by reference to the network called. Third, consumers were technology neutral as to the terminating network. Fourth, consumers would not tolerate (different) prices for voice services which to them were indistinguishable, particularly as they would not know which technology and hence which rate applied when they made a call. 11.2. Therefore, concluded O2, if we were to support the DGTs findings on 2G this would necessarily affect 3G from the point of service launch, jeopardizing decision-making not only by the four operators now under review but also those made by an entirely new market entrant.1 11.3. O2 believed that the DGTs findings relied on each operator having a monopoly in relation to call termination charges on its own network. However, there was an abundance of regulatory provisions should competition not deliver the desired result, not least the process under Chapter II of the Competition Act 1998. These various provisions would allow the DGT to ascertain whether the effects it appeared to fear would materialize and whether the prospective competition would arrive soon enough to act as an additional constraint, if one were needed. 11.4. O2 said that UK consumers received a high quality of service, benefited from a wide range of packages and enjoyed prices that had persistently fallen and were among the lowest in Europe. The high levels of penetration of mobile phones in the UK were a clear expression by consumers of the value of
1

Hutchison 3Gs Response to the DGTs Review of Price Controls on Calls to Mobile, paragraphs 5, 11 and 12.

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the service offered by the operators. The high-quality services and the competitiveness of the UK market had brought about very rapid growth and an exceptionally high level of penetration of mobile phones. This high penetration level provided benefits for all consumers in the UK (whether or not mobile phone owners). O2 said that the MMC had noted in its 1998 report a benefit (ie an option externality) to all consumers with either fixed and/or mobile lines arose when a new subscriber joined a mobile network.

Legal and regulatory

11.5. O2 told us that it accepted the legal position as described in paragraphs 3 to 8 of our remedies letter (see Appendix 2.2), and believes that the legal position described in paragraphs 9 and 10 of our remedies letter is broadly accurate subject to two important provisos: (a) O2 did not share our doubt as to whether we were required to have regard to the provisions of section 3(1) of the Act in reaching our decision. It believed that we had a duty to deal with the matters entrusted to us in the manner which [it] considers is best calculated to secure that all reasonable demands for telecommunications services were met; and to secure that any person by whom such services fall to be provided is able to finance the provision of those services. In O2s view, mobile services were such services and it was to MNOs that it fell to provide such services. (b) O2 believed that we could avoid the problem posed by the uncertainty of the provisions of the new EC requirements and an anomalous decision by devising a remedy that was contingent on their final form. 11.6. Commenting on T-Mobiles legal and regulatory submission (see Chapter 13), O2 told us that it supported T-Mobiles conclusions that we are subject to the duties under sections 3(1) and 3(2) of the Act. O2 also strongly supported the arguments relating to our obligations under the Access and Interconnection Directive, the Framework Directive, particularly Article 8, setting out the principles of regulation to be followed by national regulatory authorities, and the Draft Recommendation on relevant product and services markets to be made under the Framework Directive. O2 said that we were not obliged to implement EC provisions before they came into effect, but were obliged by Article 10 of the EC Treaty and by case law not to act inconsistently with or compromise the provisions of the European regulatory framework. Failure to take the framework into account could jeopardize the worth of our findings post July 2003. 11.7. O2 said that it appeared to be common ground that any licence modification adopted as a consequence of our inquiry would cease to have effect no later than 24 July 2003, and believed that it would be inappropriate to introduce any remedy until after that date, since to do so would violate general legal principles of proportionality and good administration and would be wasteful. O2 agreed that if a fouryear period is seen as the appropriate period for the imposition of controls, the first few months cannot be severed from the rest and stand as a separate and lawful remedy. Nor can regulation for such a short period be expected to remedy any adverse public interest effects. It is a waste of resources for us to impose a remedy intended to last four years, based on findings as to market definition that could change almost immediately after the conclusion of the inquiry. O2 believed that whatever form of regulation we concluded to be appropriate should be expressed as a recommendation to Oftel to be implemented on or after 25 July 2003, contingent upon the European Commission and ourselves having identified identical markets, each MNO having been designated as exercising SMP in the relevant market and us having complied with both section 3 of the Act and Article 8 of the Framework Directive.

Market definition O2s view on the significance of market definition

11.8. O2 believed that market definition was an important, but essentially intermediate step in the process; its own position with regard to it having always been that it was not an issue on which it was useful to dwell. O2 believed that a far more meaningful framework for assessing whether price regulation was required in the public interest was on the basis of an evaluation of the competitive restraints faced by MNOs. O2 believed that market definition should not take place in the abstract and must be based on an 325

understanding of how firms competed and how services were offered. O2 noted that the MMC had concluded in its 1998 report that [it] is not in our view useful to dwell on the question of [bottle necks, market definition and monopoly positions] 11.9. O2 believed that termination of calls should not be viewed in isolation and that operators had no ability to charge excessive prices for termination. Mobile operators competed for customers by offering a service bundle including, as a minimum, the ability to make and receive calls and to send and receive SMSs. It said that the majority of costs in providing mobile services were fixed and common. The challenge for mobile operators was therefore to design tariff packages that would encourage use of their network while ensuring (so far as possible) that overall revenues were sufficient to recover such fixed and common costs. Total system prices (including termination charges) for supplying mobile services were constrained by the competitive pressures previously described, while individual service elements (including termination charges) were constrained as a result of demand responses to particular tariff pricing strategies. It was not therefore true that termination charges could, in the absence of price regulation, be set at exploitative levels on the basis that they represented a discrete service that was paid for by a group of ill-informed and/or price-insensitive fixed and off-net callers. 11.10. O2 said that mobile operators offered a bundle of complementary and interdependent services, including subscriptions and calls, both outgoing, incoming and SMS. These were not provided in isolation but were purchased by consumers as a package. Consumers sought and purchased bundles enabling them both to make and receive calls: in fact, they sought the ability to communicate via a mobile phone. O2 believed that any attempt, along the lines put forward by the DGT, to categorize separate markets for incoming and outgoing calls was artificial, given that these were not viable independent activities. O2 gave as an illustration of this point the experience of four Telepoint operators, which had offered one-way voice communication a little over ten years previously. In 1993, all four companies had abandoned the service due to lack of demand and the absence of a commercially viable business case. 11.11. O2 said that MNOs competed to sell a handset, establish a customer relationship, subscription or prepaid, and for the revenue streams that customers would generate. It maintained that termination charges were just one factor in the framing of a competitive offer. The individual elements of the bundle were interdependent and complementary, not discrete services. Mobile operators offered bundles of services that consumers bought as a complete package, and consumers would take their business elsewhere if particular elements of the bundle were too expensive. O2 pointed to the DTI evidence on switching to support this view. As such, the MNOs risked losses not just from particular service elements, but all the incremental revenues from the subscriber. 11.12. O2 told us that the majority of costs of providing mobile phone services, incoming and outgoing calls, sending and receiving SMSs, were fixed and common. Incoming and outgoing calls shared the same technical infrastructure of MSCs, BSCs, BTSs, and HLRs as well as the transmission that linked these elements. O2 said that there was no separate network path for incoming and outgoing calls. SMSs also used the same infrastructure although in a slightly different manner. It was not possible to categorize any part of the technical infrastructure as dealing only with incoming calls.

The mobile market was dynamic and competitive

11.13. As to whether sufficient competitive restraints were being exerted on the MNOs call termination charges O2 said that it believed the UK mobile phone network to be dynamic and competitive, as indicated by the great changes in the market since our previous inquiry. Consumers had engaged in extensive switching between networks and types of service, while retailers had become increasingly sophisticated in providing more detailed information and advice. Nor was the industry excessively profitable: the DGT was in error in relying on Vodafones profitability as an indicator of the market as a whole. 11.14. O2 drew attention to the great changes in market share over the previous years as an indicator of the dynamism of the market. At the time of our last inquiry, two operators, Vodafone and O2 had held 77 per cent of the mobile market by revenue, and 72 per cent by subscriber numbers, while since then two others, Orange and T-Mobile, had entered the market, reducing the share of revenues of the original

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two operators to less than 60 per cent and the share of subscribers to 50 per cent. Orange now had more subscribers than either Vodafone or O2. 11.15. O2 said that these changes in the structure of the market had been accompanied by radical changes in the number of subscribers (increasing almost fivefold), the profile of subscribers and the type of services sought. Most of that growth had been in prepay customers, now twice as numerous as post-pay customers. Mobile telephones were now used by 90 per cent of the addressable population, leading to new demands, such as SMS, which had been scarcely an issue at the time of the previous inquiry. Today, the increase in demand for SMS services far exceeded even the increase in demand for voice services. 11.16. Nor did O2 believe that the market was yet mature. It remained in a state of flux, with constant initiatives in tariff packages and the new 2.5 and 3G technologies and services imminent. The latter offered the prospect of a greatly enhanced ability to send and receive data in various formats, but required very large investments (22,000 million in obtaining licences alone), and an immensely challenging sales effort, probably requiring costly consumer subsidies to encourage the take-up of new and untried services. There was already one new entrant in the 3G market. Over the previous four years, the market had been in constant evolution, with steadily falling prices and in the cases of Vodafone and O2, falling profit margins. The degree of competition, with the introduction of 3G, seemed certain to accelerate, with the increasing convergence of industries such as IT, broadcasting and telecommunications, bringing additional competitive pressures. Hutchison 3G, in proposing a new regulatory authority, OFCOM (Office of Communications), had recognized this change.

Current Prices and Regulation

11.17. O2 set out in considerable detail its belief that: (a) we were in danger of making a serious error if we concluded that charges today are above the optimal level. To make such a conclusion would be to put to one side the acknowledgement by Oftel and its economists that Ramsey pricing is an efficient way to price and to recover fixed and common costs; (b) in the absence of regulation prices could not rise in the future and will in any event be under pressure to fall, due to institutional and competitive constraints; and (c) in light of the above, regulation is inappropriate. The case for taking the risks inherent in regulation needed to be compelling, the cost-benefit analysis conclusive. It was not.

Current Charges
11.18. O2 believed that termination charges were set at the most efficient, optimal level, and not at a level that required regulation.

Ramsey Pricing
11.19. O2 and DotEcon submitted a number of papers containing a model for determining optimal call termination charges in the presence of network externalities. This demonstrated that todays termination charges are at or about the optimal level given any reasonable structure for externalities. 11.20. O2 told us that it believed the establishment of a benchmark optimal call termination rate to be central to our inquiry, but that previous attempts to model one had been inconsistent and contained errors. It had therefore commissioned a study of optimal call termination rates,1 a copy of which it supplied to us, which it hoped would provide a basis for a consistent, error-free framework for Ramsey
1

Optimal Call Termination Rates, DotEcon, June 2002.

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pricing in the presence of network externalities. It had aimed to achieve this by systematically building up a model from the behaviour of individual consumers, using a formulation in which externalities were explicit. This, O2 believed, removed the methodological problems of many previous models. 11.21. There were three key conclusions of the study, as follows: (a) That the DGTs assertion that its original estimated externality surcharge of 2 ppm was an upper bound on the true value was incorrect. The study showed that 2 ppm must be a lower bound on a reasonable externality surcharge, even taking similar assumptions to those of the DGT. (b) The study found that the benchmark optimal call termination rate was similar to (and sometimes even above) existing rates. Even on the DGTs assumptions (which O2 believed led to a significant underestimate) the optimal mark-up, when correctly calculated, was not 2 ppm, but 2.8 ppm, 3.8 ppm and 4.5 ppm at R-G factors of 1.3, 1.5, and 1.7, respectively. This was the range considered by the DGT. (c) The study found that the DGTs assertions that Ramsey pricing approaches were impractical, as they required detailed information about demand conditions, were incorrect. The study showed that the key determinants of optimal call termination were costs and the R-G factor: the results were relatively insensitive to changes in demand elasticities. For example, the model showed that, taking a subscription LRIC of 25 a quarter, fixed costs of 73 a quarter and an R-G factor of 1.3 (which O2 believed to be conservative), socially optimal call termination surcharges would be in the range of 2.3 ppm to 3.6 ppm for a wide range of demand assumptions, compared with a central case of 2.8 ppm. 11.22. O2 said that there was universal agreement across all models that it was appropriate to consider efficient cost recovery and that the DGT had himself acknowledged that Ramsey prices were an economically efficient way of recovering fixed and common costs. O2 believed that Ramsey prices should be considered not only in the context of putting into place a particular remedy, but also when assessing whether or not there was a public interest detriment that needed to be rectified. O2 therefore believed that the CC was wrong in assuming that LRIC plus EPMU represented the competitive price with which to compare the price of individual telecommunications services. O2 believed that existing call termination prices were in line with Ramsey principles and that future prices were not likely to rise above them. 11.23. Operators needed to design a tariff structure which encouraged consumers to subscribe to their network and which ensured that they earned sufficient revenues to cover the fixed and common costs. Cost-based pricing achieved the second of these objectives, but not the first. Demand-based pricing was capable of achieving both objectives provided that operators correctly assessed what consumers wanted. O2 believed that the DGT had recognized this in theory, when it stated that demand-led pricing is an efficient way for firms to recover the fixed and common costs they incur from producing a range of different goods and/or services.1 O2 believed, and the DotEcon paper Optimal Call Termination Rates demonstrated, that there was no reason why this logic should not apply to all constituent parts of a bundle of goods and services. 11.24. O2 said that it set tariffs by reference to consumer demand and market requirements. In doing so, it had regard to the following factors: its assessment of customer lifetime values, taking into account handset subsidies, reseller payments (for example, connection bonuses), the estimated life of the customer and the likely revenues a customer would generate (the last, in particular, clearly depending on the tariffs and their anticipated effect). It also paid attention to feedback from customers, which O2 obtained in a variety of ways. In other words, in the process of seeking to establish tariff rates, it would take account at all times of the need to cover costs and the fact that competition in the sector would force it to compete away any excess profits on one service element. 11.25. O2 believed that consumers attached weight both to the value of being able to make calls and to the value of being called and would accordingly want to be sure that the price structure was such that this could happen without inhibition. O2 drew attention to the NOP survey, the BMRB market research, and the DotEcon paper on mobile customer behaviour. Different consumers would be more or less sensi1 Review of the charge control on calls to mobile, A Statement issued by the Director General of Telecommunications, 26 September 2001, Annex 5, paragraph A5.4.

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tive to different pricing components. The parent buying a phone for a child partly to be able to call the child from a fixed line to check on its whereabouts would pay more concern to the cost of incoming calls to their childs network than the elderly or highly cost-conscious person who purchased a phone to use only in an emergency or if stranded in a car. 11.26. O2 said that the majority of consumers were concerned about the cost of incoming calls, since, if termination charges were too high, those consumers would lose the utility derived from receiving calls, making the particular MNO, or even the mobile phone itself, unattractive. MNOs therefore had to set termination charges at levels that would not discourage take-up. They needed to recognize the price sensitivity of a significant number of customers (business users, parents, the cautious and cost conscious), as well as the role that retailers played in informing consumers at the point of sale. Again, O2 highlighted the support given to its views by the NOP survey, the BMRB market research and the DotEcon paper on mobile customer behaviour.

Choice and tariff structures

11.27. O2 told us that its extensive range of tariffs did not represent a harmful segmentation of the market: it was incapable of targeting particular customers as there was a continuum of demand in the market as customers sought a wide range of tariff packages to suit their different requirements, the features of these packages overlapping to a significant extent. All O2s tariff packages were open to all actual or potential future subscribers and all subscribers were able technically to migrate from one tariff to another tariff and indeed did so frequently. The market for the provision of mobile services was both competitive and complex and MNOs structured their tariffs to appeal to as many different types of actual and potential subscribers as possible, to boost take-up, growth and incremental traffic. The structuring of these tariffs had to take account of the overall costs incurred and the total revenues generated but was principally demand-led and directly reflected customers actual wants. 11.28. As to whether the number, variety and complexity of pricing packages made comparisons difficult for consumers, O2 said that customers could easily identify a selection of suitable tariffs. This complexity was neither a matter for concern nor was it against the public interest. The high degree of specialization meant that consumer preferences would be met more precisely, and if they experienced any difficulty in finding the best package there were many sources of advice. The combination of product range and sources of information explained the high level of consumer satisfaction. The DGT surveys had shown 78 per cent of consumers as being satisfied with the range and quality of information available to help them. This included specialist retailers, web sites and magazines available to consumers. Also, many consumers would be aware of charges from their monthly bill, the frequency, for prepay with which they topped up their credit and word-of-mouth from other users.

Subsidies
11.29. We asked O2 whether, if insufficient competitive restraints were being exerted on the MNOs call termination charges, the revenue from those charges was being used by the MNOs to reduce the level of prices charged by them to their customers for calls, or to subsidize handset prices or monthly subscriptions. O2 replied that there were sufficient competitive restraints, that, as its Ramsey pricing modelling demonstrated, prices, in aggregate, were not above the competitive level and that the market was not characterized by unfair price reductions or cross-subsidies. Outgoing charges could not be subsidized since they were not set at below incremental cost. 11.30. We asked O2 whether the present level of call termination charges effectively resulted in fixed-line consumers subsidizing customers of the MNOs. O2 replied that there was no evidence to suggest that customers of fixed network operators were subsidizing customers of MNOs. In any event, O2 believed that fixed users and mobile users were largely one and the same group and that a group could not reasonably be said to subsidize itself. To the extent that they were not, any possible detriment was minimal and those fixed callers who did not also have a mobile benefited from the general network externality of being able to call a mobile user on the move.

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11.31. We asked O2 whether the present level of call termination charges of the MNOs enabled them to compete unfairly with the FNOs. O2 reiterated its view that termination charges were set at a competitive level: these were not above stand-alone cost and therefore could not be said to subsidize its on-net charges so as to allow it to compete unfairly with the fixed operators through on-net charges.

Competition has led to optimal prices

11.32. O2 believed that competition for UK mobile phone subscribers was vigorous and effective, having led to many consumer benefits. Each component price or charge within the overall package of services was constrained accordingly. The balance of charges within the package, including termination charges, was such as to promote mobile penetration while providing a strong public interest benefit for all consumers. There was an essential interdependence between the call termination and the other mobile services within the overall bundle of services that consumers received. Consumers would not buy phones that did not deliver a comprehensive package of services, including the ability both to make and receive calls (at rates which were not so high as to discourage either the making or receiving of calls). O2 said that it (and, it imagined, each other operator) calculated its prices for all services that a subscriber might utilize by reference to the total revenues that a subscriber might be expected to generate. In carrying out this calculation, O2 said that it had regard both to the price of originating calls from its network and the price of terminating calls. 11.33. In short, said O2, any margins above a cost base on incoming calls were competed away on other services so that the overall bundle of services was reasonably priced and delivered only normal profits. Therefore, maintained O2, competition for the supply of mobile phone services was effective. 11.34. O2 pointed out that the DGT had accepted that the market was subject to growing competitive pressures and was prospectively competitive; and that conditions of competition were such as to allow it to conclude that Vodafone and O2 no longer had market influence. O2 accepted that the DGT did not believe that it was competitive enough to abandon regulation. 11.35. This was on the basis that one operator was said to be making profits that had persistently and significantly exceeded the cost of capital. The DGT had not suggested that all operators were excessively profitable even on its own measure, making calculations by reference to a single period rather than by reference to a lifetime of assets. 11.36. O2 believed that the DGTs reliance on Vodafones profits (which he considered to have persistently and significantly exceeded the cost of capital1) and prices to show that the market was not yet effectively competitive was unsound for the following reasons: (a) the analysis did not show that Vodafone was persistently earning excessive profits; in fact it showed that Vodafones profits had been declining in immediately past years; and (b) even if the DGTs analysis were to show that Vodafones profits were excessive, that said nothing about the competitiveness of the market or any market distortions: a single operator earning high profits was not in itself inconsistent with a competitive market, as the MMC had acknowledged in its report on soluble coffee.2 O2 said that, in analysing whether a market was competitive in its previous report on termination charges,3 the MMC had consistently reached its conclusions based on a whole range of indicators, not on a single indicator. The DGT, by contrast, seemed to require that a market aspired to a model of perfect competition if it was to be exempt from regulation. O2 believed that few markets, including some found by us to be effectively competitive, would pass that test.4 11.37. In O2s view, the DGT had not supplied enough information to enable O2 to examine the DGTs profitability analysis. O2 questioned whether it was fair and proper for the DGT to reach a conEffective competition review: mobile a Statement issued by the Director General of Telecommunications, 26 September 2001. Soluble Coffee: a report on the supply of soluble coffee for retail sale within the United Kingdom, Cm 1459. 3 O2 and Vodafone: Reports under references under section 13 of the Telecommunications Act 1984 on the charges made by O2 and Vodafone for terminating calls from fixed-line networks, ISBN: 011 5154590, December 1998. 4 Supermarkets: a report on the supply of groceries from multiple stores in the United Kingdom, Cm 4842.
2 1

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clusion that affected many parties on the basis of an analysis that was not made available to, and could not therefore be challenged by, the affected parties. 11.38. In the opinion of O2, the evidence showed clearly that the four UK network operators competed aggressively for customers who bought a bundle of mobile phone services. Competitive factors, many noted by the DGT, had ensured low prices. 11.39. O2 concluded that the UK mobile market was dynamic and displayed most of the signs that would be expected of a competitive marketa high level of innovation, shifting market shares, declining prices and reasonable profits. The various components of the mobile service (including termination services) were in reality part of a package of services where the price for the whole was constrained, as evidenced by the normal or below normal profits of the majority of the industry. 11.40. Competition in the UK mobile phone market had delivered substantial benefits to consumers, a fact O2 believed was recognized by the DGT. Prices for mobile phone services had fallen dramatically over time and in particular since we reviewed this sector in 1998. Prices in the UK for the overall bundle of services compared favourably with those in other European countries. UK consumers were offered a wide range of tariffs and packages. UK operators provided a high-quality service to their customers, and UK consumers benefited from a high level of innovation, a fact also recognized by the DGT. 11.41. It was O2s opinion that the high level of investment indicated clearly the degree of competition in innovation and the wide range of new consumer benefits being delivered, including high network quality, extensive network coverage and a high level of customer service, including recently introduced services such as location-based services enabling its customers to seek and obtain information on restaurants, banks, ATMs, petrol stations and the like on an area-by-area basis, as well as Instant Messaging and Multimedia Messaging Services. Increased customer service would follow the launch of 3G, on which operators would be investing [ ] to [ ] on top of licence fees. 3G would enable the efficient delivery of complex information and data packages. 11.42. The fact that 94 per cent of consumers reported a high level of satisfaction with the mobile phone services they received convinced O2 that the factors mentioned were clearly valued by consumers: such a figure was extraordinarily high for any consumer market. Positive consumer response at that level suggested a competitive market, and showed beyond doubt that consumers valued the service that they were receiving. All consumers, whether or not they owned a mobile phone, had the ability to communicate with the vast majority of the population at any time and in almost any place. 11.43. The attractiveness of the mobile offer, including the quality and range of services available was, O2 believed, responsible in part for the high penetration, as were, to an important degree, the pricing strategies of the operators. The strategies adopted in setting termination charges and charges for other services also played a very significant part in encouraging maximum mobile phone use, allowing operators (to the extent permitted by the existing price regulation) to price the different components of the mobile service by reference to the sensitivity of consumers to changes in pricea policy which O2 believed that the DGT accepted, in principle, could be both efficient and in the public interest. 11.44. O2 believed that an analysis of whether the strategies adopted in the UK had produced more efficient results would have shown this policy had been beneficial to consumers in practice, and that prices were set at an optimal level.

No unfair subsidy
11.45. O2 said that there was no unfair subsidy from fixed to mobile. In any event, with a mobile phone ownership penetration rate at almost 75 per cent those who received incoming calls were predominantly the same as those benefiting from lower call charges. There was therefore a close alignment of the interests of fixed/mobile customers and of mobile-only customers. The group of possible

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strong losers (ie those without a mobile but making significant calls to mobiles) was very small indeed.1 11.46. O2 did not believe that the present level of MNOs call termination charges allowed them to compete unfairly against the fixed network operators. In particular, neither the price for the bundle of services provided to consumers nor the price for outgoing calls was below incremental cost. Therefore, O2 did not believe that fixed network customers subsidized mobile customers. Neither the present level of call termination charges nor any other factor identified to O2 had allowed MNOs to compete unfairly against fixed network operators. O2 added that the latter were becoming as innovative in packaging as the MNOs had been and had their own strategies to compete.

Prices cannot rise and are likely to fall

11.47. O2 made clear that, not only are current prices at the optimal level, but thateven in the absence of regulation of termination chargesthey could not rise and would be under pressure to fall. Therefore O2 strongly disagreed with Oftel and Vodafones assertion that termination charges could rise significantly in the absence of regulation, on the basis that this ignores the technological, contractual and institutional constraints faced by operators when setting termination charges. 11.48. O2 said that the conditions of competition on the market today provided an effective constraint on call termination charges. Competition in the UK had ensured the lowest average prices for all mobile services in Europe, and termination charges could not, at the extreme, exceed the level of the package. Operators could not set termination charges at a level that caused the retail prices of calls to mobiles significantly to exceed the price for outgoing calls if arbitrage was to be avoided (to the detriment of the operators). There was a level of price sensitivity among many mobile users today (in particular SMEs which sought to maximize accessibility; and young mobile phone users in particular were both conscious of the cost advantages of SMS as an alternative to voice communication and were willing to use this alternative), which in O2s view constrained prices in a way that was not true when we had looked at this market in 1998.

Contractual and institutional constraints

11.49. O2 believed that we would be wrong to accept Oftels and Vodafones assertion that termination charges could rise significantly, in the absence of regulation, to 20 ppm or more. In addition to the various competitive restraints on prices rising (set out below), this ignored the contractual and institutional constraints faced by MNOs when setting termination charges, which made it impossible for charges to rise. Assuming that MNOs all managed to increase their charges to other MNOs to, say, 15 or 20 ppm, it was inconceivable that BT would agree to such an increase under its interconnection agreement. It would be entirely disadvantageous to do so: BT could not raise its retention, but the price of calls to mobiles would go up. In such a case the MNOs would either back off, in which case termination charges to BT would not increase or the matter would go to Oftel for determination, with the same result. In practice, since no other operator would pay charges higher than BT (as they could avoid such higher charges by transiting traffic via BT, thereby availing themselves of the lower charges), no rational operator would pay an effective termination charge higher than that paid by BT, as it would be commercial folly to do so. The result was that call termination charges could not rise: they could only fall. There was a downward ratchet system in effect.

Balanced prices are the key to delivering benefits

11.50. O2 regarded the question of the balance of incoming and outgoing call prices as being of particular importance and regretted that our provisional conclusions disregarded the fact that it would be commercially irrational for MNOs to let incoming and outgoing prices fall out of balance. O2 pointed out that the average price of a call to O2 was about 16 ppm and that the average price of an outgoing call was the same. The pressure to balance charges had delivered incoming and outgoing retail prices that were

1 This was clearly demonstrated, said O2, by the Lexecon paper Distributional effects of Oftels proposed regulation of call termination charges.

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very similar, competitive prices that responded to consumer demand. If termination charges were to fall out of line with the decline in the price for outgoing calls, it could result in a damaging shift in the balance of traffic. Incoming calls would be replaced by outgoing calls, which would have the effect of: (a) neutralizing any increased margin that an MNO would enjoy on incoming calls; and (b) reducing the benefits enjoyed by mobile subscribers as a result of receiving fewer calls, thereby discouraging mobile phone uses and reducing revenues to MNOs. 11.51. O2 said that tariffs were also constrained by the threat of arbitrage, either through call-back or through a commercial entity offering a service, already technically feasible, involving the switching of the direction of a call. Call-back services were currently available for mobile-originated international calls, exploiting the price difference between outgoing and incoming international calls. O2 said that the technical infrastructure was in place and could be deployed rapidly if incoming and outgoing call charges for UK calls were to diverge systematically and persistently. MNOs needed to maintain a balance of prices to counter these threats.

Competitive pressures exerted by consumers and retailers

11.52. O2 said that consumers typically exerted pressure on suppliers by switching, encouraging competition between suppliers, both between the networks and between the independent service providers. The DGT, (in his September 2001 Review) had stated that 23 per cent of residential mobile consumers had switched mobile networks) and acknowledged this as a positive indicator of effective competition. But the DGT had sought to play down the importance of the level of switching as an effective competitive constraint on the grounds that there were barriers to it and that consumers had a relatively poor idea of comparative costs. O2 challenged this view. It believed that the barriers to switching were low and in some respects diminishing: mobile number portability had made switching easier and SIM locking had not been a significant barrier. O2 said that many consumers were sensitive to the structure of tariffs (and the costs of making calls to mobiles) and operators were unable to treat this group differently from other consumers who might be less price sensitive. Consumers also exerted pressures on operators, as demonstrated by the NOP survey, by switching to cheaper substitute services, especially SMS, or restricting call times. Retailers indirectly exercised competitive pressure on the mobile network operators by advising consumers on optimal networks and packages, including the relevant components. 11.53. As a result of this pressure, O2 said that an MNOhaving set prices in the bundlehad to: (a) monitor them and check that the tariff structure continued to take into account the relative weightings of the elements in the bundle; (b) check that charges remained attractive in the light of other competitive developments. [ Details omitted. See note on page iv. ]; and (c) check network usage, to be sure that it was not losing income by charging at a level which would encourage those calling a network to make shorter calls than they otherwise would or look for some alternative means of communication (for example, by SMS). 11.54. O2 believed that consumers were likely quite regularly to monitor whether a mobile phone was offering the benefits they required at acceptable prices. That regular monitoring did take place was confirmed by the DGTs data on the regular switching that took place and the fact that the average time before a customer churns was two and a half years. O2 said that it offered a service to customers helping them to optimize tariffs by choosing the O2 service which should, based on their history of usage, provide them with the lowest rate. 11.55. In assessing demand responses at the point of sale and subsequently, O2 said that MNOs had to recognize the price sensitivity of many different types of user: First, businesses were likely to be sensitive as to whether their customers could call them. The DGT had provided survey evidence showing 333

that 31 per cent of SMEs indicated that they took the cost of incoming calls into account in reaching their purchasing decisions1 and that 19 per cent of small and medium businesses with mobiles had taken steps to reduce the cost for them to call their own mobiles. Second, consumers within so-called closed user groups who were part of two or more closed user groups could not avoid call termination by joining the same network as members of both groups and so benefiting from low on-net call charges, as the DGT claimed. Since these customers were sensitive to the cost of being called (either from another mobile network or from a fixed line), they might be explicitly influenced in their network choice by termination rates. 11.56. In O2s view the DGT had underestimated the effect of the first and not even considered the second of these types of price sensitivity. 11.57. O2 also regarded repeat calling arrangements as being significant. An analysis of the calling patterns of O2 customers showed that the vast majority were in repeat-calling relationships. The DotEcon paper Mobile Customers Behaviour shows that such consumers had the abilitywhich they exercised to reverse call direction between pairs to take advantage of lower calling rates, thereby exerting pressure on all aspects of pricing, including termination rates, and survey evidence2 showed that they did so in practice. Substitution between incoming and outgoing calls suggested the existence of cross-price effects between incoming and outgoing calls, involving the timing and direction of calls according to relative charges.

Consumers alternatives
11.58. O2 demonstrated, with support from the NOP survey and BMRB market research, that consumers had a number of alternatives to making mobile calls, each of which exerted pressure on prices, as described in the following paragraphs. Although examples were given of the alternatives that might be adopted by a group of customers, O2 emphasized that each customer was free at any time to choose from among the alternatives described. 11.59. Those consumers with a fixed line and a mobile might be able to switch to an on-net or offnet call paid for as part of a package of inclusive call minutes, thereby avoiding termination charges. Onnet and off-net calls provided increasingly strong substitutes for fixed to mobile calls: many subscription packages had for some time included on-net calls so that such calls could be made without further payment. All four MNOs had introduced tariffs including off-net calls within inclusive call minutes in a number of their tariff packages. 11.60. Consumers might be able and prepared to switch from a voice call with a termination charge to an SMS from a mobile, chargeable at a low set fee (typically either 10p or 12p). One of the key changes in the mobile sector since the 1998 MMC report had been the dramatic growth of SMS. For many mobile phone users (the young in particular), data communication, in particular text messaging, was not only an easy, acceptable and cost-effective way of communication, but was regarded as fun. O2 said that the DGT had reported evidence from a MORI survey showing that over 40 per cent of mobile users used text messaging and that of these, 59 per cent sent text messages because they were cheaper than voice calls.3 O2 believed that, as with email and instant messaging, SMS was certain to grow as its convenience, cheapness and acceptability as a means of communication were recognized. O2 recognized that SMS would not be a substitute for all call types, but that was not necessary for the services to have a noticeable impact on call termination. 11.61. A further switching opportunity would be to switch from a voice call to data message in a GPRS or in a 3G environment. Moreover, O2 said that 3G technologies would be capable of providing existing services in different ways as well as completely new services. GPRS was already offering some of the new data services (which had no termination fee element attached). The fact that 3G would offer the same services as the existing 2G technology meant that consumers would perceive 3G to be a substi1 Review of the charge control on calls to mobiles: A Statement issued by the Director General of Telecommunications, 26 September 2001, paragraph 2.11. 2 NOP Survey. 3 Effective Competition Review: Mobile, Issued by the Director General of Telecommunications, February 2001, paragraph A2.35.

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tute for 2G. In addition the new data services on GPRS and 3G would increasingly come to be seen as substitutes for voice services. The introduction of the RIM Blackberry, a GPRS device, made it easier to contact a business colleague via a short email than by a voice call. For emails there was no termination charge. Also available was IM which was being developed to enable virtually real-time voice communication using voice clips. 11.62. O2 believed consumers might simply shorten their calls to mobiles, reducing their costs and operators revenues. O2 believed that fixed to mobile calls were shorter than fixed to fixed calls, and that this might in part be accounted for by the nature of the call (for example, a call checking when a guest was likely to arrive for dinner on a fixed-to-mobile telephone was likely to be shorter than a purely social call to a friend). In part, however, O2 thought that these shorter calls were likely to be accounted for by the fact that callers generally knew that calls to fixed lines were cheaper than calls to mobiles (a fact recognized by the DGT1) and by the fact that consumers with this general level of price awareness might postpone the longer call intentionally in order to save costs. The propensity was for consumers to make shorter calls in response to higher termination charges.

Technological changes
11.63. On the possibility of delivering voice calls to mobile as lower-cost data calls, O2 believed that the introduction of VoIP would effectively blur the distinction between a voice call and data message: receiving a call was the same as downloading a file. Charging systems for the two technologies were different: with VoIP the called party pays for capacity or data throughputthe calling party pays for the same but this was not related to making a particular call to a particular customer. As well as providing communication without call termination, these new services would alter the nature of competition in the market. O2 believed that VoIP provided the most promising alternative to termination on a mobile network by 2004. 11.64. On the possibility that calls to mobile might be delivered to a user-nominated fixed line, O2 said that technologies to achieve this did exist and could provide an alternative to terminating on a particular network, but that these had yet to prove popular with users and would require significant changes in billing arrangements. On the possibility of calls to mobiles being handed over to the mobile network at the BSC nearest to the receiving party, O2 believed that applications could be developed to build on existing technology which could be used to reroute calls to the nearest BSC, but that the costs would be unlikely to result in significant termination charge savings. On the possibility of converting a fixed-to-mobile call to an on-net call, O2 said that it already offered services which provided significant discounts on fixed-to-mobile calls by converting them to on-net mobile calls. As regards the use of alternative, unregulated signals to deliver calls to mobiles, O2 said that it was not familiar with systems capable of doing this, but was aware that developments were in progress. It believed that it was probable that W-LAN technology would be deployed in the UK in the following two years. O2 told us that the use of dual-SIM devices or of multiple network identities on one card was technically possible but likely to be applicable mainly in the international roaming context.

Regulation is unnecessary and potentially dangerous

11.65. O2 concluded that the competitiveness of the market for mobile phone subscribers and the mechanisms that constrained call termination charges meant that regulatory intervention was unnecessary. Termination charges set freely by mobile network operators should not adversely affect the public interest. O2 considered that regulation was not only unnecessary, but that a price cap at or above the level proposed by the DGT was dangerous, had not been fully thought out, would have a negative effect on the use of mobile telephony services, and would act against the public interest. 11.66. In the view of O2, price regulation designed to bring about cost-based termination charges would put at risk the consumer benefits already realized: the more draconian the price control, the greater the risk. In summary, as O2s views in this regard are dealt with in greater depth below, a draconian price controlbe that a P0 cut or a severe RPIX capcould jeopardize the financial viability of
1 See Review of the charge control on calls to mobiles, A Statement issued by the Director General of Telecommunications, 26 September 2001, paragraph 2.21although he indicated that many users do not know the extent of the difference in charge.

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operators by generating a downward spiral of investor confidence, making the cost of borrowing more expensive, and could have particularly deleterious consequences on prepay users, as many prepay users were only marginally profitable to the mobile operators such that losing their termination revenue was likely to make them unprofitable. Any negative impact on prepay would cause significant detriment to the most socially vulnerable. It would also put at risk the development of 3G services, which could not in practice be shielded from 2G regulation (irrespective of the DGTs intentions). This could delay or damage the development of important new broadband services. A further result would be a fall in penetration levels by putting at risk the ability to price different components of the mobile service in such a way as to maintain those levels. A fall in penetration levels would be damaging to owners of fixed and mobile phones alike, as their ability to reach others by mobile phones would be diminished. In short, price regulation was not only unnecessary and disproportionateit was likely adversely to affect the public interest.

Distributional Issues
11.67. O2 stated that there might be a concern that those people who had not acquired mobile phones or a particular subsection of the population might be considered to be adversely affected by call termination prices, despite the significant benefit to the majority of the UK population. Such concerns should give rise to a public interest issue only if a significant number of consumers were at risk. O2 did not think that this was the case, because there were very few consumers frequently calling mobile phones who did not own one, given that 73 per cent of the population (90 per cent of the addressable population), had mobile phones and a further 6 per cent lived in a household with at least one mobile phone. 11.68. O2 believed that the far more serious concern from a distributional perspective was that the proposed regulation was likely to be socially harmful in its impact on vulnerable members of society. A price control would harm, in particular, those mobile-only customers (who tended to be among the least affluent sections of society). The proposed regulation would result in one clear group of losers: those with only mobile phones. This view was based on the distributional work done by Lexecon in its paper Distributional effects of Oftels proposed regulation of call termination charges.

Comments on DGTs cost model

11.69. Having set out the rationale for why termination charges are not currently excessive, cannot rise and are under considerable pressure to fall, and why regulation is inappropriate, O2 commented more specifically on the DGTs cost model. 11.70. O2 said that it accepted the overall objective of Oftels LRIC model, which was to understand the forward-looking costs that a reasonably efficient new MNO would incur in providing different mobile services at the present time, but that it had deep concerns about the way the task had been carried out and the conclusions which the DGT appeared to draw regarding the link between LRIC and the appropriate benchmark prices. For the outputs of the modelling process to provide a reasonable alternative view the models needed to produce results that were robust and stood up to scrutiny. O2 believed that there were problems with the robustness and reliability of the DGTs LRIC model. 11.71. In particular, the methodology used had primarily been based on importing techniques developed to deal with fixed networks, which were subject to less technological and market change than mobile networks. Nor did they have to cope with the fact that their customers could make calls from any geographical position. These difficulties might invalidate some of the assumptions implicit within the model. 11.72. O2 itself, in the process of establishing tariff rates, considered the potential demand responses of its consumers, at all times taking into account the need to cover costs and the fact that competition in the sector would force it to compete away any excess profits on one service element. 11.73. O2 said that the DGT had rejected such an approach on the basis that the demand-led prices resulting from it did not match up to its competitive benchmark. In calculating the so-called competitive benchmark, O2 maintained that the DGT had failed to take proper account of the fixed and common costs of an operator that were clearly material to the setting of prices for individual elements of the mobile service bundle, for the following reasons: 336

(a) First, the DGTs LRIC model was deeply flawed, implying that only around 5 per cent of network costs were fixed and common across the three services considered: subscriptions, incoming and outgoing calls. O2 believed that this was clearly understated, rendering meaningless the DGTs own conclusions as to the legitimacy of demand-led pricing for the recovery of fixed and common costs in a way that least discouraged take-up. (b) Second, a significant proportion of the costs incurred by operators was excluded from the DGTs model, implying that those calling mobiles should contribute only to the recovery of fixed and common network costs. This ignored the fact that callers to mobile phones obtained significant benefits from investments in boosting penetration: failure to take this into account would produce an economically inefficient result.

Ramsey pricing
11.74. A description of the merits of Ramsey pricing is set out at length above. In brief, O2 could not accept the criticism that Ramsey pricing was not fair. Only in the narrow sense that prices might not be equitably distributed across each and every consumer could this possibly be alleged: Ramsey pricing was a fair system, both socially optimal and efficient, delivering a consumer surplus and public interest benefits.

Externalities
11.75. On externalities, O2 believed that people who did not own mobile phones nevertheless gained from the optional benefit of contacting mobile phone owners. This benefit was paid for by those purchasing mobile phones, and went some way to offset any call termination charges incurred by the nonmobile-phone owner and other mobile owners who gain from an increase in penetration. 11.76. O2 therefore believed that when assessing the public interest it was entirely appropriate to consider external benefits, such as those flowing from an increase in mobile penetration, since all who made or received calls from and who made calls to mobile phones received benefits from greater mobile penetration. These benefits were external to individual decisions (ie whether to acquire a mobile) that affected penetration levels. O2 believed that there were flaws in the DGTs way of calculating optimal prices in the presence of network externalities. O2 had examined both the DGTs model and the models presented by Oftels adviser, Dr Jeffrey Rohlfs, and had concluded that there were fundamental flaws in the methodology of both. In the case of the Rohlfs model, if mobile ownership increased as a result of a decrease in the price of making calls, no network externality at all was applied. In O2s view externalities should be applied regardless of the source of a change in mobile penetration. The flaw implied that since certain externalities had been ignored optimal termination rates had been underestimated. O2 added that a further flaw in the Rohlfs model arose from the definition of net externality factor used in the model. This had the effect, if the R-G factor were sufficiently small, of producing a net externality factor of less than 1. O2 believed that, where there were only positive externalities in the model, this made no sense. O2 said that a similar flaw appeared in the DGTs model, but he had chosen to ignore the impact of crosselasticities in his model. 11.77. O2 said that both the DGTs model and the Rohlfs model largely dismissed the problem of fixed cost recovery by assuming that these amounted to only a tiny proportion of the total. O2 said that at the calibration prices and quantities supplied by the DGT and used by Rohlfs to calibrate his demand system, fixed costs amounted to only about 2.9 per cent of total costs, a proportion O2 believed to be implausibly small. Given the cost assumptions reported by Rohlfs, this would imply apparent industrywide excess profits of more than 1.2 billion a year, which was clearly not the case (as the DGT had accepted). The implication of this was that costs, especially fixed costs, were under-represented in the Rohlfs model, presumably as a result of failing to include any retail costs within either model.

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Response to hypothetical remedies General

11.78. O2 believed that our conclusions and hypothetical remedies were based on a fundamental misunderstanding of the nature of competitive pricing in the mobile telecommunications sector and that it would be an error to conclude that call termination charges were above the efficient level. Such a conclusion could be sustained only by discarding Ramsey pricing and adopting LRIC plus a small EPMU plus some allowances as the benchmark for charges, thereby disregarding the approach advocated by a broad range of economists and the view of Oftel that Ramsey pricing is an efficient way to price and to recover fixed and common costs. Dismissing demand-led pricing in the face of this consensus would be perverse. O2 believed that, in the absence of regulation, there were powerful competitive, contractual and institutional constraints at work to prevent prices from rising in the future and that competitive pressures are far more likely to drive termination charges down, making regulation unnecessary. 11.79. O2 provided evidence of competitive pressures arising from: (a) the increasing relevance of incoming call charges on the network choice of mobile customers; (b) the need to maintain a reasonable balance between incoming and outgoing retail charges in order to avoid slewing of traffic, and to offer an attractive proposition to subscribers; and (c) substitute ways of contacting particular customers (such as SMS, email, delaying calls until a customer can be reached on a fixed line). 11.80. O2 maintained that its DotEcon model, Optimal Call Termination Rates, demonstrated that termination rates at present were at about the optimal level on any reasonable assumptions about elasticities; that there was no evidence of excessive profits being derived from call termination charges; that these were not being used to fund unhealthy competition at the retail level; that symmetry of fixed and mobile regulations is not a necessary outcome; that Ramsey pricing is appropriate; and that the charges were socially optimal. O2 therefore believed that it would be wrong to conclude that call termination prices are excessive and should be regulated. 11.81. O2 believed the revenues lost if the suggested remedies were implemented could not be made up by MNOs other than to an extent that would limit competition for retail services and would be likely to harm the least well off and older members of the community. [ Details omitted. See note on page iv. ] 11.82. [ Details omitted. See note on page iv. ] 11.83. [ Details omitted. See note on page iv. ] 11.84. [ Details omitted. See note on page iv.

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] 11.85. O2 had already given its views on many of the possible remedies, but added the following points: (a) As regards the market definition adopted by us, O2 maintained with the support of empirical evidence that the requirements set by the European Commission in the Draft Recommendation in order to consider the call termination market to be part of a bundled market were met in this instance and that we were therefore wrong to define the market narrowly in terms of call termination on each mobile operators network. Regarding each of the tests proposed by the European Commission, O2 provided evidence that: (i) technical possibilities exist as substitutes for a fixed-to-mobile call such as its Cellular Exchange line which substitutes an on-net call for a fixed-to-mobile call; consumers would readily change calling patterns to save money (O2 provided survey evidence that 34 per cent of fixed-line callers will change the time they call, 61 per cent will call a fixed line instead and 41 per cent will send a text); and

(ii)

(iii) subscribers subscribe on the basis of what it costs to be called (O2 pointed to our own survey that showed of those who have chosen or changed network to be on the same network as someone they speak to often, 88 per cent did so to save money on call charges). (b) On the question whether the relevant market included voice calls using 3G technology, O2 believed that it did and that to regulate 2G voice calls and not those using 3G technology or regulate without regard to 3G costs would be illogical, inconsistent and contrary to both our and the European Commissions findings on market definition. But to regulate 3G within a costbased price control would eliminate the switching necessary to build a new generation service and would be contrary to the European Commission recommendation that 3G should not be hindered by regulation. O2 believes that if 2G cannot be regulated without adversely affecting 3G the correct approach would be to regulate neither. (c) O2 did not believe that the market was segmented to the extent of limiting the ability of priceconscious customers to force down prices. The wide variety of tariff packages had been designed to appeal to as many types of consumers as possible, and price-conscious customers influenced the creation of new packages as MNOs responded to migration among the packages. However, there are no groups of customers that can be picked off. There was no more segmentation than in any other market where differentiated services were offered. Nor did O2 believe that there was any evidence that the variety of packages made price comparison difficult: consumers were adapting behaviour in response to price and were not making ill-informed pricing decisions. The recent introduction of off-net minutes in the bundle was an example of price conscious customers driving down prices for the market as a whole. (d) O2 did not accept that the present level of call termination charges resulted in customers of FNOs effectively subsidizing customers of the MNOs. With mobile penetration at some 75 per cent, fixed and mobile users were largely one and the same, while to the extent that there were any serious losers (ie those making significant calls to mobiles but not making calls from mobiles) the total public disbenefit was very small (an estimated 13.4 million across all users). Also, fixed customers benefited from the externality of being able to call a mobile and communicate with someone on the move. O2 believed that any distributional concern was more serious with the proposed charge caps, which would result in disproportionate losses to prepay users from lowincome groups and the older members of society. O2 identified three pieces of evidence to highlight the effect on vulnerable members of society: (i) a report by Lexecon entitled Distributional Effects of OFTELs Proposed Regulation of Call Termination Charges which showed that the largest losers from a price cap on termin-

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ation charges would be those with a mobile and no fixed line, who tend to be the poorest members of society; (ii) our survey that showed whereas 58 per cent of those in social category AB are prepay, this rises to 88 per cent in social grade E; and

(iii) omnibus survey evidence which showed that in the event that mobile operators were forced to introduce a mandatory time-expired voucher of 10 (which O2 believed would be an inevitable consequence of the proposed control), this would have the effect of increasing the monthly bill for around half of all prepay consumers, and more than doubling the bill for about one-third. (e) O2 said that an assessment of whether the present level of call termination charges allowed the MNOs to compete unfairly against the FNOs depended in part upon whether they were in the same market, which the DGT and we had provisionally decided was not the case. O2 said that our conclusion seems to imply that there is insufficient competition between fixed and mobile networks thereby preventing a finding that there is a broader market than terminating calls to a particular network. However, given that conclusion, it would be incongruous to find that there was unfair competition between the different networks (as there could only be unfair competition among parties that compete). For its part, O2 believed it implausible that if FNOs and MNOs competed for calls that did not constrain MNOs in their approach to pricing. (f) As to whether the differences between on-net and off-net call termination charges reflected the cost differences between them, O2, said that in a competitive market prices for different services did not necessarily equate to the costs of providing them and that the competitive significance of on-net rates was in any event overstated. The majority of calls took place in repeat-calling relationships, the substantial majority of which crossed network boundaries, only 24 per cent being on-net. Favourable on-net rates need to be offered alongside favourable off-net rates in view of the ease of switching between tariff packages. Tariffs were now moving in the direction of bundling free off-net minutes. (g) Finally, as to whether, if call termination charges were reduced as a result of regulatory action, MNOs were likely to increase their prices for other services, O2 believed that they would have to try to compensate for any drastic reduction in revenues. O2 did not believe that a waterbed effect was inevitable, since there was no certainty that MNOs could raise subscriptions, handset prices or outgoing call prices without damaging effects on overall revenues, the loss of customers and a generally reduced mobile phone penetration. Nor was it necessarily the case that MNOs could raise prices to the extent needed to ensure continued viability: it would be irresponsible to regulate on the assumption that they would be. 11.86. As to our hypothetical remedies, O2 believed that neither a significant RPIX nor an immediate P0 adjustment to the final level, ie no glide-path, met the legal tests that had to be satisfied before we could propose a licence modification. O2 believed that any such remedy would be both unnecessary and unlawful, since there was no evidence that O2s present termination charges operated against the public interest: they were set in a competitive environment and were likely to be at or close to the socially optimal level. Significant competitive and institutional constraints were likely to keep such charges at the socially optimal level in the future. 11.87. In O2s opinion the proposed remedy failed to meet the following legal tests: (a) that it should be consistent with our statutory duties under sections 3(1) and 3(2) of the Act; (b) that it should be proportionate, as required by European law, human rights legislation and general legal and regulatory principles. This means that any remedy must do no more than address the problem identified; (c) that it should not threaten the viability of those regulated;

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(d) that it should satisfy a cost benefit analysis; (e) that it should do no more than produce the outcome expected of competition. Specifically this means imagining a situation where termination is subject to similar competitive constraints as other parts of the service bundle purchased by mobile customers; and (f) that it should be consistent with European law. 11.88. In O2s opinion a remedy involving the absence of a glide path would be highly unusual, dangerous, disproportionate and inappropriate: it would amount to clawback of the fruits of part investment in damaging revenue receipts from existing customers already invested in, [ Details omitted. See note on page iv. ]. Analysts including Goldman Sachs share concerns over the impact of a P0 adjustment. It would also have a serious impact on prepay customers (a significant proportion of which were older and poorer members of society, and which formed two-thirds of its customer base), with the likely outcome that these customers as a group would become uneconomic for MNOs. This would impact particularly negatively on low-income users who tend to favour prepay. Finally, it would have a detrimental effect on the development of 3G since O2 would be obliged to make cuts in capital spending, [ Details omitted. See note on page iv. ]. 11.89. As to the RPIX remedy, O2 believed that this would give rise to effects similar to those of the no-glide-path scenario, dependent upon the level of X. O2 had factored a remedy of RPI12 into its business plans, as a remedy which it envisaged should not significantly damage its financial viability or significantly delay the rollout of 3G, and believed that any remedy more severe would move progressively and unacceptably towards a draconian outcome. O2 pointed out that it had not been provided with the levels of any price controls under consideration and that failure to provide such information had limited its ability to comment on remedies in any meaningful way, or on the figures that underpinned a particular level of control. It could therefore comment only generically on particular forms of remedy that might be imposed. Regardless of the level of X, RPIX as a regulatory principle is incapable of satisfying the test that any remedy must come as close as possible to the competitive outcome. The remedy is a blunt and inflexible instrument. Although it serves artificially to lower termination charges, it is not market driven. As a consequence it necessarily has a finite life. This will lead to the administrative expense and inconvenience of a further inquiry in four years time. 11.90. As to the inclusion of 3G services in any remedy, O2 drew attention to the European Commissions recommendation that 3G should not be hindered by regulation, but said that any control on 2G call termination services would amount to control of 3G voice termination since voice termination on the two services could not be separated. O2 believed, therefore, that the correct decision was to regulate neither. 11.91. As to a retail benchmarking remedy as favoured by the ACCC, O2 believed that this passed all the legal tests for an appropriate remedy, provided that it were not coupled with an immediate downward adjustment. O2 believed that the remedy would have all the benefits of CPP without its disadvantages. Contrary to objections, O2 maintained that there was no risk of distortion of outgoing services, and noted that the ACCC experience provides an example that a retail benchmarking approach was workable. 11.92. O2 submitted a proposed remedy which it believed would provide a viable alternative to a price cap. Rather than seeking to address the symptom of the perceived problem (high charges for calls to mobiles) through a price control, O2 considered that the remedy sought to address any underlying regulatory problem arising from there being insufficient competitive pressure on call termination charges because those paying termination charges had no choice but to terminate their call on a particular network; and the fact that it was the calling party that paid termination charges but the receiving party that made the phone purchasing decision. Under the remedy, callers to a mobile would be given the option to reach the mobile subscriber in the normal way and to pay termination charges or to leave a voicemail 341

message at a fixed national rate. O2 shared with us the results of an Omnibus survey to test whether the remedy would prove attractive enough to consumers to act as a significant constraint on the setting of termination charges. The survey showed that 50.7 per cent of all respondents said that they would use the option of leaving a voicemail for a mobile owner at fixed-line national rates, a figure which became 66.3 per cent among those aged 16 to 22. Of the 50.7 per cent, 60.8 per cent said that they would use it five times or more out of every ten calls, while of the 16 to 22 group 74.5 per cent said that they would use it this often. O2 pointed out that callers were familiar with the concept from BTs voice messaging service. O2 demonstrated that callers would welcome the option to pay the termination charge or request a call-back, as the Omnibus survey showed that half of respondents (rising to 62.4 per cent of the 23 to 29 group) thought that it would be a helpful if incoming callers were given the voicemail option, compared with only 13 per cent who thought it would be unhelpful. O2 highlighted what it considered a number of advantages, as follows: (a) It operated within the competitive dynamic. It introduced a system whereby callers had an option to pay a termination rate or to request call-back. This would provide a new and even stronger incentive to MNOs to ensure that incoming and outgoing retail charges were balanced and would thereby provide a new and strong incentive on MNOs to ensure that incoming and outgoing retail charges were balanced and would therefore provide an effective constraint on termination charges. (b) It could be combined with certain RPP options, so that those mobile subscribers who wanted incoming calls to be routed to them directly could pay a premium for this facility. This would achieve all the benefits of RPP in increasing pressure on termination charges. The cost of incoming calls would assume greater importance in a mobile subscribers purchasing decision, without the downside in terms of consumer hostility and encouraging mobile phone owners to switch off their phones, as the RPP option would be voluntary. (c) It would be practical, viable and sustainable. Most important, it would be relatively easy to use and to implement. (d) It would provide a proportionate and potentially permanent solution without the need to revisit the issues at the end of a four-yearly price cap, in contrast to RPIX and P0 regulation, which were, by their nature, finite. 11.93. O2 did not believe that other possible remedies would have any significant impact on competition in call termination charges. It made the following main points: (a) O2 did not consider that encouraging developments such as MVNOs would create different pricing incentives from those that already exist. (b) O2 disputed the view that there is insufficient information available to enable customers to make rational purchasing decisions, pointing to our survey which showed that only 18 per cent of respondents underestimated the price of a 2-minute call to a mobile. However, if we were concerned about price transparency O2 was prepared to work with Oftel and with retailers to develop greater transparency. (c) O2 considered that any benefits of RPP (for example, that customers could be expected to take greater account of costs of calling them when choosing a network) would be outweighed by the adverse effects in terms of customer resistance, costs of implementation and economic efficiency. It identified a significant risk that under RPP there would be detrimental effects (particularly on low-income members of society) as people would turn off their phones to avoid paying for incoming calls. (d) O2 did not consider that bilateral negotiation of interconnection agreements differed from the current institutional constraints which it believed already operated as an insurmountable bar on any operator increasing their termination charges. (e) O2 considered that a non-discrimination remedy would not address any concern about the underlying level of termination charges (which it believed were at a level consistent with the public interest). It considered that any remedy concerned with addressing the balance of charges at the

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retail level was not justified. All services were subject to the competitive constraints it had identified. Where the majority of calls cross network boundaries (only 24 per cent according to O2s evidence were on-net), it believed that operators simply could not capture consumers on to their network with the allure of cheap on-net calls. (f) O2 believed that a price-squeeze test for fixed-to-mobile services was not justified. It believed that there was a competitive market where both mobile and fixed operators compete and each offer a proposition that is attractive to consumers, reflecting their respective advantages. In any event, fixed operators were in no way disadvantaged by the current arrangements as they could offer MVPN products as service providers. (g) In response to our raising the question of excessive churn, O2 objected that the topic was not raised as a public interest issue, nor did we seek to define or analyse what level of churn was considered desirable or undesirable, nor did we present evidence as to why churn or any element of it was considered undesirable and not a sign of a competitive market. O2 said that no attempt had been made to measure how much of discretionary marketing costs were supposed to be linked to the creation of churn, and hence how much was supposedly available to fund a reduction in termination rates. O2 strongly disagreed with our assertion that it would not be fruitful to quantify what we meant by excessive, and believed that any conclusion that there was an undesirable level of churn could not be maintained in the absence of clear evidence. 11.94. O2 believed that neither the two business argument nor the allocation of costs argument in favour of excluding so-called non-network costs was valid. In the case of the first, it could not accept that a true MVNO with its own physical infrastructure would adopt any different structure of prices from an MNO, and that the MVNOs desire to stimulate network usage would ensure that incoming calls bore their fair share of the costs of attracting and retaining subscribers in much the same way as prevails in the current market environment. In the case of the second, O2 agreed that callers should bear the costs caused by the caller or those from which the caller benefited. This should, by definition, include the costs of the acquisition and retention of customers and their handsets, without which callers would have nobody to call. 11.95. O2 therefore maintained its view that even where such costs were judged to be incremental costs and not fixed costs it would still, under a wide range of assumptions, be reasonable to recover at least some of these costs from incoming calls. Similarly, O2 did not accept that customer care and billing did not benefit the caller as these were all part of the services available to mobile subscribersthe very subscribers that callers were communicating with. O2s view was that a conservative measure of topdown costs that are appropriately recovered from incoming calls should be [ ] to [ ] ppm.

Proposed form of CCs findings

11.96. O2 summed up its opinion as to the appropriate form that our findings should take, as follows. 11.97. As to the question whether termination charges were, in the absence of regulation, likely to operate against the public interest, O2 believed that such charges were at present close to the socially optimal level; that there was no unfair distribution as a result of the present balancing of pricing in the mobile sector; that termination charges could not rise in the future; and that, on the contrary, they would be bound to fall as a number of competitive pressures took effect. Indeed, O2s business plan predicted that termination charges would fall at a rate broadly commensurate with RPI12. 11.98. In O2s view, therefore, we should find that there was no public interest detriment to be remedied. 11.99. If, however, as appeared from our Remedies Statement, we were minded to reach another conclusion, then O2 believed that there was only one remedy that identified failures in competition and went no further that was necessary to achieve this objective, and that this was the introduction of voicemail access at fixed-line rates as an alternative means for callers to mobile to communicate with those whom they were calling. 11.100. O2 believed that such a remedy would: 343

(a) provide callers to mobiles with an alternative means of reaching a mobile subscriber at a fixedline price that was subject to normal competitive pressures, which would bring more pressure on termination rates the more it was used (as the wider the disparity between fixed-line rates and mobile-termination rates the more likely the caller to mobile was to use the voicemail option); (b) be practical, viable and sustainable; and (c) would provide a market-driven, proportionate and potentially permanent solution without the need to revisit the issues periodically. 11.101. O2 believed that if we were not prepared to recommend such a solution, then we should recommend a retail benchmarking remedy along the lines discussed above. This would mimic the constraints in a market considered competitive by us, would be practical as shown by experience in Australia, would not risk distortion of the competitive outgoing mobile call sector and would provide a market-driven, proportionate and potentially permanent solution. 11.102. O2 believed that we should conclude by rejecting price control on the grounds that it: (a) went beyond the level of intervention required to address the public interest detriment arising from there being insufficient competitive pressure on termination charges; (b) could at best be based on predictions of what would happen in a fast developing and uncertain market, when such predictions would be almost bound to turn out to be wide of the mark; (c) was inflexible; (d) required constant revisiting at great expense to the industry, consumers and the taxpayer; and (e) risked long-term damage to MNOs ability to finance their operations. 11.103. O2 said that if we nevertheless concluded that a price control was necessary it should: (a) include a moderate glide path of four years; (b) set the X factor at a level that did no more than deliver socially optimal changes (in this context O2 indicated that an X of 12 without a P0 adjustment would not risk serious harm to its financial viability but that anything more severe came close to a draconian outcome compromising O2s long-term future); (c) regulate all MNOs in the same manner and from the same starting point; and (d) avoid placing any reliance on the Oftel LRIC model. 11.104. Finally, O2 said that it was common ground that any licence modification adopted pursuant to the current inquiry must fall away no later than 24 July 2003 due to the implementation of the new European regime. O2 suggested therefore that, due to the complications of implementing any form of price control regulation prior to this date, the CC should express any proposed regulation as a recommendation to the DGT, to implement on or after 25 July 2002, subject to the realization of certain contingencies. These contingencies were the CCs and the European Commissions finding identical markets for call termination, and each MNO being designated as having SMP in the market defined.

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