b. How should prices be regulated?

In 1983 the Government commissioned a report on these matters from Professor Stephen Littlechild. On the matter of the scope of price controls, he reported they should be confined to access and local calls, whereas long distance and international calls had enough potential for competition for regulation to be unnecessary. The Government did not, however, fully accept this recommendation, and long distance calls came within the scope of price control.

As for the manner of control, Professor Littlechild considered a number of options, including no explicit constraints, a modified maximum rate of return, which would require the company to share profits above a certain level, an arrangement whereby allowable profits would increase with output (to encourage output growth and limit incentives to set monopoly prices), a simple profit ceiling and a price cap. Littlechild's evaluation of these options in terms of the five criteria he identified is shown in Table 1.4. In the event, the price cap (known as RPI-X) approach was adopted.

The initial price cap was set at RPI-3 for the period 1984 to 1989. Since that period, the cap has been revised on three occasions. A new cap of RPI-4½ was set for 1989 to 1993. In 1991, however, international calls were included within the scope of the cap, at a notional rate of RPI-10, and the overall cap was adjusted to RPI-6¼ to accommodate this change. Then in August 1993, a new price control regime came into force for four years, at RPI-7½. (See Table 1.5)

Thus throughout the period, the price control regime has been significantly tightened. Perhaps more surprisingly, its coverage has also gradually been extended, so that the proportion of BT's revenues covered by the price cap has increased by about 50% (from 48% to 71%) over the 10 year period. This has disappointed the expectation that the regulator would be able to withdraw fairly quickly from the control of retail prices.

One additional feature of the price control regime deserves mention. In 1984, the Government was concerned that BT might use its increased pricing freedom to make a substantial increase in the price of subscribers' access to the network - the connection charge and the quarterly rental charge. In order to allay these fears, the company gave an undertaking not to increase quarterly rental charges by more than 2% in real terms (RPI+2) throughout the first control period. In subsequent periods, the RPI+2 constraint has become a formal condition of the licence and applied to connections - which in 1993 became subject to a ceiling of £99 for single lines, capped at RPI+0.

BT has argued that this restriction places it at a major disadvantage in responding to competitors, because the revenues of its access business fall short of their fully allocated costs (the “access deficit”). It asserts that it has to make up this shortfall through earning returns on calls substantially in excess of their (fully allocated) costs, thus opening up the field to competitors. Data on the so-called access deficit are provided in Section 2.3 below. The access deficit has also played a major role in interconnection arrangements discussed below. Most recently,