Submission to the. Ministry of Economic Development. on the. RBI Non-Discrimination Consultation Paper

Transcription

1 Submission to the Ministry of Economic Development on the RBI Non-Discrimination Consultation Paper March 2011

2 Summary Introduction 1. While InternetNZ raises a number of issues and concerns in this submission - aimed at helping optimal achievement of Government s objectives - we applaud the Ministry s consultation following the TCF (Telecommunications Carriers Forum) session earlier this month. We note valuable improvements following that session. We also note the Commission s involvement referred to in the Consultation Paper, which we also welcome. Both public and Commerce Commission involvement at relevant stages will help achieve better outcomes for consumers and for Government s objectives. Open access, Equivalence of Inputs (EOI), Equivalence of Outputs (EOO) and Non-discrimination 2. Open access is used loosely in the debate, as are equivalence and nondiscrimination. Under the operational separation undertakings, EOI is required: supply of the same service at the same price and using the same operational processes. 3. But the Bill does not require EOI. EOO the approach in the Bill allows use of equivalent processes. This is different from the same processes as different systems can be used for internal and external supply. That is exactly what Vodafone (VF) intends. It represents a major shift toward the much weaker non-discrimination standard. This makes it very difficult to monitor and enforce discrimination according to the Commerce Commission (the Commission), leading to competition problems. 4. Respected economics consultancy, Frontier Economics, highlights the need to pay careful attention to the precise terms of the equivalence and non-discrimination obligations: internationally, weak arrangements imposed on vertically integrated operators are fraught with difficulties. The framework being established must impose tight and easily enforceable obligations. Vodafone and EOI 5. VF Retail will sell its own retail product lines separately from the services supplied by the VF wholesale unit. With little retro-fitting, VF can supply on an EOI basis and that should happen. It has publically committed anyway to allow access on equal terms. Any other approach makes it very difficult to monitor and enforce discrimination and would not achieve RFI objectives. Policy and objectives guiding the approach in the undertakings 6. In line with the MED and the Minister s views, we consider that the VF undertakings should be determined in the context of promoting both rural consumer welfare and healthy competition, minimising VF s ability to discriminate in favour of its own retail division. This is one reason why we favour EOI. 2

3 Non-discrimination, non-price service levels and Telecom s position 7. While we are grateful for the TCF Workshop, it was not comprehensive. As such, it appears to be assumed that, because some issues were not raised at the TCF workshop, they are not of significance. That is not the case. Many issues were not raised as there was limited information provided before and during the workshop. The issues largely came up randomly. Here is an example: non-price EOI or service levels is key and would benefit from consultation. There will be other examples, unknown to stakeholders. 8. It may be that, for similar reasons, the hard to-understand exclusion of Telecom s position from the current consultation has been made. Given Telecom s scale and rural retail market dominance, there would be benefit in consulting as to Telecom as well. Price squeeze imputation test 9. This is a valuable way of promoting competition. But the proposed model loses that opportunity. To the contrary, for the reasons we outline, it will be highly unfavourable if not fatal to competition. That view has strong support internationally and from the Commerce Commission. 10. We have outlined the two main price squeeze imputation test models: one based on the access provider s costs (the EEO model) and one based on the hypothetically efficient competitors costs (the REO model). The latter model is more likely to promote competition. The former is damaging to competition in this context, and does not recognise that VF are getting subsidies and should be required to enable greater competition. 11. The MED paper correctly notes the likelihood that the REO model should apply. But then the implementation of that REO model is proposed to be an EEO approach. That is because a retail minus model is proposed. The minus (that is, the access provider s costs not the access seeker s costs) is used. This is a simple percentage calculation. (This confusion between the two models (REO and EEO) indicates that closer analysis is required). 12. There are a number of criticisms of this retail-minus approach (and of the EEO approach generally). On this important issue we have provided some detail. Note that in all material respects, the proposed model replicates the retail-minus construct. (That the wholesale price is fixed by contract does not change this). Our reasons include: 12.1 The retail-minus model does not stop price squeeze. That has been firmly confirmed by both the Commerce Commission and the well-respected Competition Appeal Tribunal ( CAT ) in the UK (including a highly regarded economist and competition/regulatory judge). So, using the retail-minus model (including the minus percentage), as proposed here, does not deal with the problem. 3

4 12.2 Retail-minus is heavily criticised generally by both the Commission and the CAT. Reasons include that the model does not promote dynamic and static efficiencies. Further, efficient access seekers cannot compete: only superefficient access seekers can do so (and that is unlikely). 13. Our initial view is that MED s likely choice in principle (as opposed to the means of implementation) is to be preferred. That is the REO variant based on access seekers costs. Repeatedly in the literature, and in the Commission material, it is noted that this promotes competition. 14. We give an example from an Ofcom decision on BT wholesale broadband services where the REO model was used. This also included a price squeeze test on a productby-product basis. This is to be preferred to averaging the services for the imputation test as the former in these circumstances would be harmful to competition. 15. A major consideration is bundling: 15.1 For example, VF will bundle retail mobile services with the broadband services. This will be largely impossible for other access seekers to replicate (except Telecom, in duopoly conditions). This in itself will make competition by other access seekers difficult or impossible. (The clothed option is unlikely to solve for this) Price squeeze increasingly raises horizontal issues, and the ability for VF to bundle wireless and broadband services provides cross subsidisation and horizontal squeeze opportunities As well as being relevant to the overall approach, the imputation tests will need to take horizontal bundling into account. 16. The underlying financial and economic modelling will need to be considered, beyond a simple % metric. There is valuable guidance for this, and the Commission is able to assist with its expertise. RBI Co-Location services 17. We welcome the apparent improvements. VF will still have strong incentives to build so that access by new entrants is minimised. In practice that is relatively easy to do. We propose a model by which, if the pre-agreed design cannot be achieved (and approved by landowners and under the RMA), the Commission is notified and can take necessary steps. This is efficient as problems can be managed by exception. Vodafone-Commission undertakings by VF 18. We welcome the Commission s current involvement and the intention to have Vodafone-Commission undertakings. The undertakings can and should extend to issues such as the price squeeze imputation test. Having this regulatory backstop should encourage early resolution. We note with concern however that it may be intended to limit the scope of undertakings to something similar to the draft UFB undertakings. With the two large vertically integrated suppliers winning UFB, with 4

5 their substantial retail customer bases, there is a need for more robust and comprehensive undertakings than apply to UFB. 19. At present the undertakings can only be entered under the Sch 3/3A process: this is a good example of why the special access undertaking regime (SAU), promoted by us and other submitters before the select committee, would be valuable. Answers to MED s questions 20. We note that we have raised a number of other issues, arising out of the paper, for consideration such as the Commission s role, wider consultation including as to Telecom and also non-price service levels, EOI, etc. These are in addition to the questions asked. 21. As to the questions asked we note the following answers but we emphasise that the detail and further issues, not noted in the answers, is in the body of this submission: Q.1 Do you consider the proposed approach to price non-discrimination would be effective in ensuring access seekers of the wholesale broadband service can compete at retail with Vodafone with confidence? If not, what do you consider to be the appropriate approach and why? We consider it would not be effective. Among our proposals outlined below (there are more) we submit VF should be subject to EOI and there should be consultation on wider issues such as non-price service levels. We consider that the proposed price squeeze test will not work and needs substantial change, with Commission input. Full details are set out below. Q.2 What would be a good mechanism for combining and weighting the prices of the different wholesale products to develop a single wholesale price? As we outline below, the price squeeze test should be on a product by product basis and so combining and weighting should not be used. Imputing prices from bundles is problematic and another solution is needed, avoiding retail minus approach. Further the test should encompass bundles such as mobile services with broadband services, given the scope for horizontal squeeze and cross subsidisation. Q.3 Do you consider the proposed approach to co-location would be effective in providing fair access that will promote competition. If not, what do you consider to be the appropriate approach and why? We note the improvements in the approach, but we expect that other submitters will comment on the detailed proposals. As VF has incentives to reduce availability to other providers, we have proposed a Commission monitoring process. The detail is set out below. 5

6 Table of Contents Summary... 2 InternetNZ... 7 Structure of this Submission... 7 Clarity and significance: open access, EOI, EOO and non-discrimination... 8 Policy and objectives guiding the undertakings approach The role of the Commission Vodafone should supply to the EOI standard Non-discrimination and non-price service levels Price Squeeze Imputation Test Applying the price squeeze principles to RBI RBI Co-location services Vodafone-Commission undertakings Telecom Conclusion

7 InternetNZ 1. InternetNZ is a membership-based not-for-profit organisation with the management responsibility for the administration of the.nz domain name registry, a critical component of the Internet infrastructure in New Zealand. 2. Our mission is to protect and promote the Internet for New Zealand. We advocate the on-going development of an open and uncapturable Internet, available to all New Zealanders. 3. The Society is non-partisan and is an advocate for Internet and related telecommunications public and technical policy issues on behalf of the Internet Community in New Zealand both users and the industry as a whole. Structure of this Submission 4. Our submission deals in turn with the following: 4.1 Clarity about, and significance of, open access, EOI, EOO, and Nondiscrimination; 4.2 General Policy guiding the approach to the undertakings; 4.3 The Role of the Commission. (Also, at the end of our submission, we also deal with Vodafone-Commission undertakings, as raised in the MED Consultation Paper); 4.4 Our view that VF should supply on EOI terms; 4.5 Non-discrimination, equivalence and non-price service levels; 4.6 The price squeeze imputation test; 4.7 RBI Co-location services; and 4.8 Questions as to why the Telecom position is out of scope of the Consultation Paper. 5. The answers to MED s questions are covered throughout the submission, and briefly summarised in the summary above. 7

8 Clarity and significance: open access, EOI, EOO and nondiscrimination 6. We take this opportunity, as words such as open access can be used loosely in the debate, to clarify the meaning of words such as those noted above. We also expand on the significance of the approach, as background to our view that VF should supply on an EOI basis. 7. Of the four expressions in the heading, all but open access have formal definitions. Those definitions can differ from plain English meanings of the words, so it is necessary to be clear about the approach. Often, open access is claimed when in fact truly open access is not being provided. Similarly, equivalence is claimed when true equivalence is not provided. It is always best to focus on the specific ways in which so-called open access in being implemented. 8. The highest standard is equivalence of inputs (EOI). This is framed slightly differently in different places. 1 However, in all instances, it essentially involves the access provider supplying the same service at the same price and using the same operational processes to all access seekers including itself (typically a downstream retail or wholesale business unit or line). 9. The Bill, at proposed s156ab, alters this approach to equivalence by noting that the supply can be in the same or an equivalent way. Or an equivalent way makes all the difference. This is known as equivalence of outcomes (EOO). This is a critical difference as it can be hard to detect compliance where the access provider is able to use different processes to provide equivalence. 10. The Commission considers that the change from EOI to EOO moves the standard From EOI to one of non-discrimination as the same systems do not have to be used. As the Commission notes in its 2011 Select Committee Submissions: The Proposed section 156AB defines equivalence, in relation to the supply of a relevant service, as equivalence of supply of the service and access to the service provider s network so that third-party access seekers are treated in the same, or an equivalent way, to the service provider s own business operations (Commission emphasis added). 25. This is not the equivalence of inputs standard as specified by the Amended ITP. 26. The inclusion of the phrase or an equivalent way in the definition of equivalence changes the meaning to be no more than non-discrimination. 11. While EOO is a variation on the non-discrimination theme, this illustrates that there can be varying levels of non-discrimination. The Bill defines another variant of nondiscrimination on the basis that access seekers must not be treated differently unless 1 It appears in the Operational Separation Undertaking, the UFB ITP and the draft UFB deeds of undertaking on the CFH website. 2 Para

9 differences are objectively justifiable and do not harm competition Apart from EOI, none of the other variants (EOO and non-discrimination as defined in the Bill) can properly be described as implementing open access. That is because substantial variations in the treatment of access seekers, relative to the providers own downstream customers, are possible. Yet open access is loosely used in the debate. 13. The Commerce Commission explains why the difference between EOI and nondiscrimination (including EOO) is so important: The critical difference between equivalence [of inputs] and non-discrimination is that equivalence [of inputs] requires that the service provider offer the same service using the same operational processes to all Access Seekers including itself. Non-discrimination on the other hand, does not require the same systems be used, provided the service received is an equivalent service. 20. EOI is a more stringent requirement than non-discrimination. 22. This difference is not just technical. It is important because where different systems are used for internal and external supply it becomes very difficult to monitor and enforce discrimination on non-price terms. 23. These non-price terms can be critical for competition; end-users can place a high value on quality of service and will differentiate between service offerings on this basis. Even if such discrimination can be eventually identified and stopped, the harm to competition is not so easily rectified. 14. Respected Australian economics consultancy Frontier Economics provided evidence for the select committee. 5 They conclude that Government should pay careful attention to the precise terms and conditions of non-discrimination and equivalence obligations. As they note in their report: To the extent the New Zealand government intends to rely. only on open access requirements in the form of non-discrimination and equivalence obligations, careful attention must be paid to the precise terms and conditions of these arrangements. The history of access regimes in New Zealand, Australia and many other parts of the world demonstrates that arrangements imposed on vertically-integrated network operators who also compete in downstream retail markets are fraught with difficulties. They tend to be highly contentious, and lead to long drawn-out processes that are the subject of intense regulatory gaming by both access providers and seekers. It is also less than clear that they are adequate at controlling the market power enjoyed by providers of services over natural monopoly infrastructure. To have any chance of being effective, these regimes must be carefully designed; and impose tight and easily enforceable obligations on access providers. 15. As outlined below, deviation for RBI from EOI is problematic. 3 This is the definition of non-discrimination in s156ab. 4 Paras submission to the Select Committee on the Bill and the SOP. 5 They were commissioned by 2degrees. A copy is available at 9

10 16. We understand that the current intention is to have short undertakings similar to the draft UFB undertakings. We consider that more comprehensive and robust undertakings are needed, especially given the challenges arising from vertically integrated operators providing the RBI services and their strong incentives to favour their downstream operations. There is greater need for a robust approach than as to UFB, given these incentives. In our submissions, we have outlined some of the issues that should be the subject of comprehensive undertakings such as information and monitoring obligations involving the Commission, the price squeeze imputation test, co-location obligations, and so on. As to information disclosure by Vodafone and Telecom, it is necessary to go into detail as, unlike the list of matters for the Commission to monitor as to LFCs, as set out in the Bill, no such list applies to RBI. So that needs to be detailed. 17. There are related rules of importance, some of which are identified by the Commission in its Select Committee submissions, such as arm s length rules, for which documented internal trade arrangements, for example, are essential. 6 Policy and objectives guiding the undertakings approach 18. We agree with the general principles and objectives that guide the approach, identified by the Minister and in the MED Consultation Paper. These are valuable as they assist identification of optimal solutions. 19. Last week, the Minister confirmed the importance of the consumer in deciding the approach: in this instance rural communities and businesses. We agree that the consumer is the focus. That is achieved, in the words of the Consultation Document, by the promotion of healthy competition in rural New Zealand. 20. Rural consumer welfare and healthy competition are the benchmarks to measure the best approach in the undertaking regime. 21. As the Consultation Paper notes (and we agree): The Crown s general objective is to ensure that workable competition emerges in the provision of retail broadband services to rural households and enterprises. More specifically, in negotiating the manner in which Vodafone would implement its non-discrimination obligations, the Crown s objective is to minimise Vodafone s incentive and/or ability to discriminate in favour of its retail division The Minister emphasised that contracts would include strict open access rules in order to promote healthy competition in rural New Zealand. 6 Paras of the Commission 2011 Select Committee submission. 7 Paras 2, 8 and 12 Consultation Paper. 10

11 21.3 Vodafone will also be free to compete in the relevant downstream retail market. The fundamental issue is then to ensure that Vodafone makes a robust set of non-discrimination commitments to ensure that there is no favouring of its own retail division, so that its wholesale customers can compete with confidence with Vodafone in the retail market. The Vodafone and Telecom position 22. When selected for RBI commercial negotiations, Vodafone and Telecom released a joint press statement. 8 They stated: An open access approach is at the heart of the Telecom Vodafone bid, which will allow other operators to access the infrastructure on equal terms. This will provide strong retail competition from different technologies and service providers and a real choice of solutions and providers for rural New Zealanders. 23. This continued earlier public statements by Vodafone about providing access on equal terms, and supports equivalence obligations on VF, which should be at the Equivalence of Inputs (EOI) level, beyond non-discrimination including EOO. The role of the Commission 24. The Commission in its Telecommunications role - has backstop regulation powers. We note that the Commission is engaged at least as to price squeeze tests. We welcome this. At the end of this submission, we outline the Commission s actual and potential role in more detail, including as to the Vodafone-Commission undertakings the Consultation Paper notes will be sought by VF. We also raise some questions as to what is proposed, such as the scope of the undertakings, an issue we deal with at Para 16 above. Vodafone should supply to the EOI standard 25. As the Telecommunications Commissioner pointed out in submissions to the Select Committee, anything short of EOI (such as EOO) boils down to a non-discrimination test and compliance (or the lack of it) is very hard if not impossible to detect. Therefore the EOI standard is appropriate. We have outlined this in more detail above. 26. VF is establishing a new line of services and can readily, without undue retro-fitting, apply an EOI standard. Instead, it is choosing to have, as VF stated at the TCF session, retail develop its own products, which will not be supplied by VF s wholesale unit. This is a recipe for gaming the undertakings regime and for minimising the prospect of detecting any price and non-price breach of the undertakings. The implication is that other products, not available to wholesale customers, will be supplied at retail. In any event, bundles including mobile services will be supplied which access seekers cannot economically 8 7 February 2011, 11

12 replicate. 27. Significantly, VF has committed to allowing access on equal terms, a standard at the EOI not the non-discrimination level. When VF makes such a commitment to the public, it should be prepared to stand by it, with an EOI requirement. 28. The importance of having the EOI standard is outlined in more detail in the section in our report above headed, Clarity and Significance: open access, EOI, EOO, and non-discrimination. Non-discrimination and non-price service levels 29. The Consultation Paper does not deal with service levels as, at the TCF Workshop, it is said that there appeared to be little controversy That can only be because, with little detail provided at and before the workshop on this and other issues, the topic was not canvassed in the relatively short time available. Discrimination on non-price issues is a classic, well-known and major problem. It is an easy means for those with dominance to discriminate against their competitors. 31. While service levels can be crafted, the form of those service levels is significant. In any event, given the issues noted in the preceding paragraph as to EOI, a service level regime has limited ability to monitor and control discrimination. Therefore EOI is appropriate. The fact that VF will establish retail services separately from its wholesale unit is further cause for concern in this regard. 32. If EOI is not to be implemented, the service level regime should be strong, and provided for consultation. Price Squeeze Imputation Test Introduction 33. We welcome a price squeeze test as an important method for encouraging healthy competition for rural consumers and businesses. However, we consider that the currently proposed design will not avoid market failure indeed, it may cause it. For example, the endeavour to have a simple model following a retail-minus approach will cause market failure, as we outline below. This is particularly so if the minus component in the retail-minus UBA calculation (currently 18%) is used. 34. This section of our submission is extensive, given the issues involved, and the variety of issues. 9 Para

13 35. Simplicity - as in the proposed test - does not lead in this instance to healthy competition and benefits for consumers: to the contrary. Getting the price squeeze test right can make all the difference: this is worth doing even if it is significantly more complex than the simpler test currently proposed. 36. That the use of the minus of 18% is an erroneous application of the policy model outlined in the Consultation Paper - as we explain below - demonstrates that the price squeeze imputation test needs to be carefully considered and then implemented. 37. We have provided some ideas as to workable solutions in the few days available to review the approach. But we can do no more than that in the short time. Ultimately, we consider that this is an issue for the Commission to decide when it considers VF s request for Vodafone-Commission undertakings. However, given that regulatory backstop, we hope that the parties can be encouraged to agree now a price squeeze imputation test acceptable to VF, the Commission, access seekers and consumers. 38. At the end of these submissions we outline our understanding of: 38.1 How the Commission process works; and 38.2 How the Commission powers operate as a regulatory backstop, encouraging VF to offer up robust price squeeze RBI undertakings now. 39. The Commission is well resourced and experienced to make the right assessments on price squeeze issues. 40. In this section of our submissions, we first overview the policy objectives behind price squeeze imputation tests and how they might differ according to the specific circumstances. We then apply the policy objectives to this initiative. Finally we deal with specific issues including a major feature of this initiative: the ability of VF (and Telecom) to provide fixed broadband services bundled with other services, particularly mobile phone services. Policy: Price squeeze imputation tests 41. Price squeeze is also often called margin squeeze. However, like the Consultation Paper, we will use price squeeze. There is valuable guidance for the parties in the 2009 European Regulator s Group Report on the Discussion on the application of margin squeeze tests to bundles ( the ERG Bundle Margin Squeeze Report ) That report describes price squeeze as: A margin squeeze (also known as price squeeze) is a situation where a vertically integrated firm with market power in a key upstream market, supplies rival firms in associated 10 Para 1 margin_squeeze_tests_to_bundles.pdf. See also the December 2010 Report by BEREC (the successor to ERG: Body of European Regulators for Electronic Communications), namely, BEREC Report on convergent services. 13

14 downstream markets and sets prices for the input and the downstream service in a way that renders unprofitable the activities of its competitors in the retail market. 43. The key is not the absolute prices (the wholesale or the retail price points). Instead, it is the difference or margin between those two prices. The fact that one price point (the wholesale price) is controlled does not mean that there is no price squeeze. 44. In a competition law context (in New Zealand, under the Commerce Act), price squeeze issues almost invariably are considered ex post (after the event). However, in a regulatory environment (and a quasi-regulatory environment as here where healthy competition is encouraged), the price squeeze test is typically done ex ante (before the event). As we explain below, there are significant policy differences in the position under competition law, such that the competition law position does not determine or necessarily equate with the ex ante regulatory / quasi-regulatory approach. 45. In particular the optimal price squeeze ex ante imputation test methodology is determined by the specific circumstances, especially the objective of promoting competition. Promoting competition is a recurring theme in the literature. The two main price squeeze tests: EEO and REO 46. Over time, two variant models for price squeeze tests have evolved. There is further detail as to how each is implemented such as the underlying methodologies to determine relevant cost. The two models are called: 46.1 The Equally Efficient Operator Test (EEO); and 46.2 The Reasonably Efficient Operator Test (REO). 47. The ERG Bundle Margin Squeeze Report describes each as follows: 27. The first test (called an Equally Efficient Operator test, EEO) involves assessing whether the dominant/smp firm s downstream operations could trade profitably if it had to pay an upstream price that was equivalent to that charged to rival competitors The second test (called a Reasonably Efficient Operator test, REO) involves examining whether the difference between the vertically integrated firm s retail and input prices is sufficient for a reasonably efficient downstream competitor to make a normal profit. 29. The primary difference between the two tests is that the first is based on the relationship between the vertically integrated company s retail price (P) and its own (non-regulated) cost while the latter is based on the relationship between the vertically integrated company s prices and the alternative operator s costs. 30. Although the [competition regulator, the] European Commission mainly refers to the first imputation test, [European regulators] have adopted either one or the other definition according to their needs to test margin squeeze occurrence. 48. In summary, the EEO test (typically applied in a competition law context) utilises the access provider s own imputed saved retail costs, whereas the REO test uses a more access seeker oriented approach: the costs of a reasonably efficient operator. A key difference is likely to flow from the fact that the access provider has larger scale and 14

15 scope, and can achieve economies of scale, which the access seeker cannot replicate. 49. In the latter model (the REO model) the approach is described as: 11 The margin between the price charged to competitors in the downstream market for the input product and the price which the dominant firm charges in the downstream market [must be] sufficient to allow a reasonably efficient downstream operation to earn a normal profit. The Consultation Paper and the two tests 50. As we explain below, the Consultation Paper: 50.1 Correctly, in our initial view, proposes a REO model (It does this by noting that [the model] is likely to depend on the scale of costs that an access seeker will incur in providing retail broadband services using the Vodafone wholesale broadband service as an input ; 12 and 50.2 Incorrectly suggests implementation of that REO approach by an EEO model (This error occurs by proposing use of the minus (currently 18%) in the retail-minus calculation, which reflects access provider not access seeker cost). Reasons for the different REO and EEO approaches 51. In this section we outline why there are different approaches: REO and EEO. Promotion of competition is at the heart of the approach. 52. The ERG Bundle Margin Squeeze Report briefly summarises the reasons for the different approaches: 13 While competition law is intended to prevent margin squeeze as an exclusionary abuse, ex ante regulation seeks the more ambitious goal of promoting competition by facilitating entry into those markets meeting the three criteria test [equivalent in a European context to our s18 purpose statement in the Act: long term interests of end users, etc]. 53. The ERG Bundle Margin Squeeze Report expands on those reasons including the fact that the access provider cannot be expected to comply with a test based on its rival s costs as it does not know them, and the remedy is ex post not ex ante. 14 Because the regulatory/quasi-regulatory test is ex ante, it is possible to have a test based on access seekers costs. 54. In dealing with the choice between EEO and REO, the Report continues by noting circumstances where the REO approach is preferred: this pivots around markets, as here, with significant economies of scale and scope, learning curve effects and first 11 Para 292 Albion v Water Services Authority and Dwr Cymru [2006] Competition Appeal Tribunal (UK) 23 (and the second judgment at page 36). 12 Para At Para Para

16 mover advantages, where there promotion of competition is a key objective: a number of national competition authorities or national regulatory authorities (inclusive of DG Competition (2005) see paragraph 67 of Discussion Paper) have suggested that where the market exhibits significant economies of scale and scope, learning curve effects or first mover advantages, then there might be a case for using the higher costs of the downstream competitor. 54. In a regulatory context, this reasoning may have merit where promotion of competition is the main regulatory principle. Specifically, regulators might find it justified to promote the entry of relatively inefficient operators in the short term in the expectation that they will become more efficient in the long run. Additionally, there might be efficiency benefits from having competitors in the market that although they might be less efficient may still be able to constrain the pricing of the SMP operator. [highlighting added] The Commerce Commission View on REO versus EEO 55. This is outlined in the Commission s submissions in 2006 to the Finance and Expenditure Committee. 16 As noted in more detail below, the Commission is opposed to the retail-minus regime. One reason is that retail-minus uses the access provider s costs not those of hypothetically efficient competitors (ie it is an EEO not REO-centric model). As the Commission notes, referring to the Irish and Italian experience: 17 In estimating the retail costs to derive the discount applicable, it is also worth noting that countries which use retail-minus are also giving increasing weight to the cost of entrants or hypothetically efficient competitors where scale and scope effects are significant, in recognition of the high threshold imposed by using the incumbent costs or an avoidable cost standard. 56. In New Zealand the retail cost in the minus (i.e. the currently 18%) is solely the access provider s costs without regard to higher hypothetically efficient access seekers costs. 57. The Commission goes on to conclude that the retail-minus model in New Zealand (which in all material respects is being replicated in the proposed price squeeze imputation test) does not prevent price squeezes. The Commission is clearly stating that the proposed test, adopting the retail-minus calculation including the minus will not work to prevent price squeeze. More is required, or something different is required. Yet this is exactly the model that the Consultation Paper proposes to use. As the Commission noted in 2006: 18 The existing retail-minus mechanism in its current format does not prevent potential price squeezes by the incumbent. As explained above, in countries where retail-minus is in place, it is generally complemented by additional safeguards, including imputation requirements, to ensure compliance with the control on an ex ante basis and to prevent gaming by the incumbent. 15 Para 53 and At Para At Para 44 page

17 Example of a REO choice instead of EEO: BT and Ofcom 58. In 2004, Ofcom used the REO approach 19 instead of the EEO approach in relation to BT s wholesale broadband access products. 59. It also did the imputation test at the level of each individual BT product instead of at an aggregated level across all products. The MED proposal in the Consultation Paper has a weighted average (i.e. aggregated) model instead of a per-product imputation test. 60. Ofcom explained its reasons for this REO/per-product approach as follows: 20 [In] terms of margin squeeze analysis ex post competition law would tend to start from a presumption that the appropriate standard against which a dominant firm should be assessed is one of equally efficient competitors i.e. analysing the margin such that an equally (or more) efficient competitor to BT could enter and compete effectively with BT in the relevant downstream services markets. However, the context for the setting of a margin for [wholesale broadband] is one of ex ante regulation which has as its objective the promotion of competition. Given this objective, Ofcom has concluded that a modification of this conceptual approach is warranted. 61. So, recognising promotion of competition, a REO approach was taken, 21 with a test on each individual product (not aggregated). This allowed access seekers to have sufficient margin on each product (not aggregated) to enable them to enter the market and adequately compete at each product level. 62. Significantly, this approach was specifically timed relative to the product, market lifecycle and the objective of promotion of competition. For example, the relevant controls were rolled back by Ofcom in Concerns about the retail-minus approach 63. Before turning to the application of these principles to VF and the RBI initiative, we outline competition problems flowing from the EEO model, particularly in the version proposed to be adopted, namely application of the retail-minus model, and the use of the minus calculation. This in theory reflects VF s avoided costs and so is similar to the EEO model. 64. The proposed model replicates the retail-minus model, which is much maligned internationally and within New Zealand. While the starting point is the contractually agreed wholesale price, the model has the same elements. Conceptually, there is no material difference. 65. This is an important conclusion. In all material respects, the model and its implications are the same as to (a) retail-minus derivation of wholesale price under the UBA price construct, and (b) the proposed price squeeze imputation test using the same 19 Using a Fully Allocated Cost (FAC model). 20 Para 2.4,Ofcom, Direction Setting the Margin between IPStream and ATM Interconnection Prices (August 2004). 21 Based on Fully Allocated Cost. 17

18 components; the fact that the wholesale price is set by contract makes no material difference. 66. There are a number of criticisms of this retail-minus approach: 66.1 As noted above, the Commerce Commission has expressed firm opposition to the use of retail-minus. See the Commission s 2006 submissions to the Finance and Expenditure Select Committee in relation to the Telecommunications Amendment Bill The Commission concluded, as noted above that The existing retail minus mechanism in its current format does not prevent potential price squeezes by the incumbent. 23 Yet this is exactly the model that MED proposed to use including the minus component (currently 18%). The model does not solve for price squeeze Further, as the Commission notes, the model entrenches the EEO model, 24 when other jurisdictions are applying the REO model in retail-minus context Imputing the Layer 2 wholesale component from the VF retail bundles - as the Consultation Paper suggests - is fraught with difficulty (a point that is also noted generally in the Commission s criticism of retail-minus 25 ). The current Commission review of the application of the methodology in relation to UBA is ample evidence of that (as is the Commission s critique in its 2006 Select Committee submission). 26 There are multiple contentious issues This problem is increasingly more difficult including as to the VF services. A key example is that VF will certainly bundle mobile phone services with the fixed/nomadic wireless broadband services. This will be a major bundling feature. While this raises horizontal bundling issues, and issues around crosssubsidisation, dealt with below, it also indicates that imputing the value of the broadband component in VF retail bundles will be increasingly difficult and unreliable. Imputing the retail value of the broadband component solely from broadband-only bundles will be inadequate and misleading (the Consultation Paper appears to propose this: that would not be a valid approach). Again the Commerce Commission 2006 Select Committee submissions dwell on the 27 challenges involved in these issues What is seemingly simple on the surface - a simple % calculation - in fact is significantly more unreliable and complicated than alternatives This price squeeze approach involves going back to retail-minus methodologies at the point when the approach is moving away from this 22 See in particular Paras 39 to 50 and Appendix A at 23 Para Para 44 of the 2006 Select Committee submissions by the Commerce Commission. 25 Para of the 2006 Select Committee submissions by the Commerce Commission. 26 Para of the 2006 Select Committee submissions by the Commerce Commission. 27 Para of the 2006 Select Committee submissions by the Commerce. 18

19 maligned methodology. For example, the comparable fixed line product (UBA) moves from retail-minus to cost based, while the VF fixed/wireless product retains a retail-minus approach, even though the wholesale price is set by contract. That is flowing against the trend The UK Competition Appeal Tribunal has been heavily critical, on numerous grounds, of the retail-minus approach. The Tribunal consisted of a distinguished panel including an economist and a highly respected competition/regulatory judge. It relied on evidence from expert economists. The decision is Dŵr Cymru v Water Services Regulation Authority and Albion. 28 The case and the relevant decisions are comprehensively summarised in the Wigley & Company articles, Retail-Minus Pricing (aka ECPR) panned by UK s Competition Appeal Tribunal 29 and Margin (Price) Squeeze: a landmark December 2006 UK Judgment By way of overview, the Tribunal noted its concerns as to why retail-minus is not compatible with the introduction of effective competition: 31 [T]here appeared to the Tribunal to be some five features of [retail-minus] based approach which gave rise to concern as to whether [a retail-minus] approach is compatible with the introduction of effective competition: (i) the risk of entrenching monopoly rents or inefficiencies in the retail price; (ii) the possible lack of the dynamic effect of competition, resulting from the fact that, as the Director recognises, the dominant incumbent is indifferent as to who supplies the customer; (iii) the raising of barriers to entry; (iv) the risk of a price squeeze; and (v) difficulties in properly identifying the minus element in the retail-minus calculation The Tribunal concluded, among other things (with observations equally applicable to the retail-minus price squeeze construct): The retail-minus model does not solve for price squeeze (the Commerce Commission came to the same conclusion; The model only works where the retail price is regulated (it is not regulated in New Zealand) and/or there is sufficient competition at retail level (there is not such competition in New Zealand) There is little incentive for dominant access providers to compete as they make a margin regardless. Yet, out of the margin created by the incumbent s avoidable cost, the new entrant has to meet its own costs. As the Tribunal stated: [2006] CAT 36The case went on appeal to the Court of Appeal but the appeal was dismissed, and the finding noted in this paper was not disturbed Para Dwr Cymru at para

20 An important feature of [retail-minus] is that the incumbent makes the same profit irrespective of whether the new entrant enters the market or not. In effect, the entrant pays the incumbent in perpetuity for all the revenues (including profits) that the incumbent had previously received, less the costs which the incumbent has avoided as a result of the fact that it is the new entrant, rather than the incumbent, which is now supplying the customer. A further feature of [retail-minus] is that the margin within which the new entrant has to operate is never higher than the incumbent s avoidable cost of supplying the customer in question. Out of the margin created by the incumbent s avoidable cost, the new entrant has to meet his own total costs, including any fixed costs As a consequence, retail-minus does not allow efficient competitors to compete: 33 Often, only a super-efficient competitor (a rare beast) could succeed (and a merely efficient competitor could not). Thus, [retail-minus] often has the effect of shutting out real competition (as the Tribunal said, it throws the baby out with the bathwater)..the need for the competitor to meet all its fixed and direct costs out the margin created by the incumbent s assumed margin for avoidable costs is a heavy burden, frequently requiring super-efficiency. The CAT noted this can have the following effect: Having, as it were, given with the one hand by opening the market to competition, there is a risk of taking away with the other hand if the conditions of entry are drawn so tightly that competition never occurs. In such circumstances, the benefit of competition would never be realised The retail-minus model fosters monopoly rents, deters competition, and is very far from normal competitive conditions as the Tribunal notes. It states: Quite apart from the problem of passing through monopoly profits or inefficiencies in the access price, and the prevention of market entry, [retail-minus] bankrolls all the incumbent s costs and insulates the latter from the disciplines of the market indefinitely. This creates a one-sided market in which the incumbent does not compete, but the new entrant bears all the risks. We share [the access seeker s economist s] view that those are very far from normal competitive conditions The model achieves neither static nor dynamic efficiencies in the absence of regulated retail prices or a competitive market As to static efficiencies, the Tribunal stated: 34 It does not seem to be disputed in this case that [a retail-minus] approach to access prices needs to be accompanied by a system for the regulation of retail prices which ensures a reasonable relationship between those prices and the costs of supply.the essential reason is that if the retail price which forms the basis for the retail-minus calculation already contains excessive profits, or reflects inefficiencies, or reflects costs that have been misallocated, the risk with [a retail-minus] approach is that all those 33 Page 2 and 9, Wigley & Company, Retail-Minus Pricing (aka ECPR) panned by UK s Competition Appeal Tribunal. 34 Para

21 monopolistic consequences are simply embedded in the access price and passed on to the new entrant in that price. As Dr Marshall [expert for the access seeker] points out, and we accept, if such is the case even the productive efficiency theoretically sought by [retail-minus] will be compromised by the continuing misallocation of resources implicit in the retail price used in the [retail-minus] calculation.professor Armstrong [expert for the incumbent] also accepted Dr Marshall s position that, in practice, [retail-minus] must be accompanied by effective price regulation. He expressly accepted that [retail-minus] is only a partial rule As to dynamic efficiencies, the Tribunal said that retail-minus does not aim to produce the dynamic efficiency benefits normally associated with the competitive process : It was not disputed on behalf of the Authority that [retail-minus] does not aim to produce the dynamic efficiency benefits normally associated with the competitive process. The Authority [that is, the regulator whose decision was under appeal] accepted that [retail-minus] does not expose the incumbent to any loss of profit, and does not give the incumbent the possibility of responding to competition. Ultimately the incumbent is indifferent as to who gets the business. As Professor Armstrong saw it, the incumbent remained passive, and was not particularly active participant in the competitive process It was not disputed by the Authority that under [retail-minus] there was no parity between the entrant and the incumbent, the latter being insulated from the risk of competition in perpetuity. Applying the price squeeze principles to RBI 67. Within the few days available to review the approach, our initial view about the price squeeze model is that we broadly agree with MED s initial indication of the model, although we consider that healthy competition and rural consumers are optimally served by an amended formulation and implementation of the model. We consider the model is critically important to achieving Government s RBI objectives and calls for further review, consultation, and, ultimately, formal review by the Commission. 68. The model considered likely, in the Consultation Paper, is as follows: 35 The setting of the X% margin is still under discussion. It is likely to depend on the scale of costs that an access seeker will incur in providing retail broadband services using the Vodafone wholesale broadband service as an input. 69. This is consistent with the Ofcom approach, designed to encourage competition, and designed for the market conditions. As those market conditions changed, as they will change here, it was possible to remove the REO imputation test. 70. The likely MED model also applies the principles noted above, especially the approach expressly designed to encourage competition. 35 Para 26 Consultation Paper. 21