EN

Brussels, 13.11.2007

SEC(2007) 1472

COMMISSION STAFF WORKING DOCUMENT

IMPACT ASSESSMENT

Accompanying document to the

Proposal for a

Directive of the European Parliament and the Council

amending European Parliament and Council Directives 2002/19/EC, 2002/20/EC and 202/21/EC

Proposal for a

Directive of the European Parliament and the Council

amending European Parliament and Council Directives 2002/22/EC and 2002/58/EC

Proposal for a

Regulation of the European Parliament and the Council

establishing the European Electronic Communications Markets Authority

{COM(2007) 697 final}

{COM(2007) 698 final}

{COM(2007) 699 final}

{SEC(2007) 1473}

TABLE OF CONTENTS

I INTRODUCTION AND OVERVIEW (...)6

1. The Review of the Regulatory Framework for electronic communications (...)6

2. Consultation and expertise (...)10

3. The Main Objectives in the context of the i2010 Initiative (...)11

4. Setting the scene - The e-Communications market in the EU (...)12

4.1. The overall benefits of telecoms liberalisation (...)12

4.2. Recent market developments: broadband (...)13

4.3. Consumer benefits and digital divide (...)15

I BETTER REGULATION (...)18

5. Competition, investment and innovation (...)18

5.1. Identifying the problem (...)18

5.1.1. Background - Current framework: ensuring a level playing field for all operators (...)18

5.1.2. Deregulation under the current framework (...)20

5.1.3. Challenge: to what extent does the framework encourage investment and innovation? (...)21

5.1.4. Evidence base for the problem (...)23

5.1.5. Summarising the problem (...)26

5.2. The objective (...)28

5.3. Policy options and assessment of impacts (...)28

5.3.1. Option 1 – Adopt 'open access' model for new infrastructure: separate infrastructure from service provision (...)28

5.3.2. Option 2 - No regulation: remove or restrict sector-specific regulation ('regulatory holidays') (...)37

5.3.3. Option 3 - No change to the regulatory framework: maintain the current model (...)39

5.4. Results of the public consultation (...)42

5.5. Comparison of options and impacts (...)43

5.6. Conclusion (...)47

6. Spectrum Management (...)48

6.1. Identifying the problem (...)48

6.1.1. Introduction (...)48

6.1.2. Policy response to the identified problem so far (...)53

6.1.3. Summarising the problem (...)54

6.2. The objective (...)54

6.3. Initial Policy options (June 2006) (...)54

6.4. Results of the public consultation (...)55

6.5. Revised policy options (...)56

6.5.1. Option 1 – adapt the regulatory framework by introducing the principle of technology and service neutrality and co-ordinated spectrum trading (...)56

6.5.2. Option 2 – no change to the regulatory framework (...)58

6.6. Assessment of impacts (...)58

6.6.1. Three spectrum management models (...)59

6.6.2. Quantitative modelling of impacts using scenarios (...)60

6.7. Asessment of options and impacts (...)60

6.8. Conclusion (...)64

III Completing the single market in electronic communications (...)64

7. Regulatory consistency and effectiveness: institutional and procedural issues (...)65

7.1. Identifying the problem (...)65

7.1.1. Institutional design (...)65

7.1.2. Inconsistency in remedies imposed by NRAs (...)66

7.1.3. Barriers to provision of services with pan-European potential, particularly those needing numbers and/or frequencies (...)69

7.1.4. Diverging approaches in National appeal procedures (...)71

7.1.5. Summarising the problem: the internal market is not yet a reality in the sector (...)72

7.2. The Objective (...)72

7.3. Policy options (...)72

7.3.1. Option 1: Single European Regulatory Authority with discretionary decision-making powers in market reviews and in charge of managing EU aspects of spectrum (...)73

7.3.2. Option 2: European Regulatory Authority without discretionary decision-making powers assisting in the implementation of reinforced Community procedures (...)73

7.3.3. Option 3 – Better co-ordination between the Member States (...)77

7.4. Results of the public consultation (...)79

7.5. Comparison of options and impacts (...)79

7.6. Conclusion (...)85

IV CONNECTING WITH CITIZENS (...)86

8. Users' rights and consumer protection (...)86

8.1. Identifying the problem (...)86

8.1.1. Transparency and publication of information (...)87

8.1.2. Users with disabilities (...)88

8.1.3. Emergency services: access to 112 and caller location (...)89

8.1.4. Basic connectivity and quality of service ('network neutrality and freedoms') (...)90

8.2. The Objective (...)93

8.3. Policy options and assessment of impacts (...)93

8.3.1. Option 1 – Encourage more industry self-regulation (...)93

8.3.2. Option 2 – Update and strengthen the current provisions (...)95

8.3.3. Option 3 – No change to the regulatory framework (...)97

8.4. Results of the public consultation (...)98

8.5. Comparison of options and impacts (...)99

8.6. Conclusion (...)102

9. Privacy and security (...)102

9.1. Identifying the problem (...)102

9.1.1. Main issues and challenges (...)102

9.1.2. Divergence of national approaches to network and information security (...)106

9.1.3. Notification of security breaches by network operators and ISPs (...)106

9.1.4. Future-proof network integrity requirements (...)107

9.1.5. Enforcement mechanisms under the ePrivacy Directive (...)107

9.2. The objective (...)107

9.3. Policy options (...)108

9.3.1. Option 1 - No change to the regulatory framework (...)108

9.3.2. Option 2 - Update and strengthen the current provisions (...)108

9.3.3. Option 3 – Introduce a new, detailed instrument dealing with security and integrity (...)108

9.4. Results of the public consultation (...)109

9.5. Assessment of impacts (...)110

9.6. Comparison of options and impacts (...)117

9.7. Conclusion (...)120

V OVERALL IMPACT (...)120

10. Overall effect and synergies of the legislative package (...)120

10.1. Synergies between different areas of analysis (...)120

10.2. Simplification and reduction of administrative burdens (...)121

10.3. Environmental impacts (...)122

10.4. Synthesis of the preferred options (...)123

VI MONITORING AND EVALUATION (...)126

Annex I: Econometric modelling of the impact of spectrum reform (...)128

Annex II: Assessment of Administrative Burdens (...)136

Annex III: Evaluation of costs and benefits of the European Authority with advisory role in Electronic Communications (...)147

Commission Agenda planning number: 2007/INFSO/001

I INTRODUCTION AND OVERVIEW

1. The Review of the Regulatory Framework for electronic communications

Background

The EU’s regulatory framework for electronic communications networks and services (eCommunications) was adopted by the European Parliament and Council in 2002 and became applicable in Member States in 2003. The framework provides a common set of rules for all communications that are transmitted electronically, whether wireless or fixed, data or voice, Internet-based or circuit switched, broadcast or personal [1]. It comprises five Directives: the Framework Directive (2002/21/EC), the Access Directive (2002/19/EC), the Authorisation Directive (2002/22/EC), the Universal Service Directive (2002/22/EC) and e-Privacy Directive (2002/58/EC) [2].

In 2006, the Commission undertook a review of the framework, and this has culminated in the current proposals for its revision. This impact assessment explores alternative policy options that have been considered as part of this review, and analyses the impact of the Commission’s legislative proposals.

The current report builds upon the analysis undertaken in the first impact assessment [3] on the Commission's Communication of 29 June 2006 [4], which outlined the main proposals for changes in the five Directives of the framework. That Communication and its associated documents were subject to a public consultation that ran from June to October 2006. The consultation also covered a proposed revision [5] of the 2003 Commission Recommendation on relevant markets, which is a supplementary measure defining those markets where economic ex ante regulation may be justified in the sector [6].

Purpose of the Review

The purpose of the review was to examine:

– How well the regulatory framework had achieved its objectives, namely promoting competition, contributing to the development of the internal market, and promoting the interests of citizens;

– How the framework could be changed in the light of technological and market developments [7] so that it continues to meet the needs of the sector and consumers over the coming decade.

The review also took into account policy developments that had taken place since the framework was adopted that needed to be incorporated into the EU legal framework.

The population affected by the proposed changes are business, society, government departments, institutions and every consumer and citizen in Europe, since all are users of electronic communications. In particular, the key players who will be affected by the review proposal are:

– Operators, service providers, broadcasters and others who may be directly affected by changes to the framework. This is not a homogeneous group: its members may often have conflicting interests; and

– National regulatory authorities, who have responsibility for applying EU rules at the national level.

Assessment at two stages

The first, initial impact assessment report of June 2006 aimed "to inform stakeholder debate on the main issues and options, and their implications, in a form accessible to a broad public and decision-making constituency." To this end it identified broad policy options for the main issues considered under the review, and provided a preliminary, mostly qualitative set of impacts of the different policy options.

The current impact assessment report deepens and refines the previous analysis, drawing particularly upon the stakeholder inputs and empirical evidence, i.e. studies and surveys conducted by external consultants and the Commission as well as market trend and economic data, which have become available since the first impact assessment was published. This consultation and discussion process has allowed the current report to focus on a more specific set of options covering the key areas.

Areas of analysis – options and impacts

Although, the legislative proposals taken as a whole comprise around 150 changes, many are quite minor updates of the provisions or repeals of obsolete provisions. Thus, this assessment report concentrates on the changes that have the most far-reaching effects (which are largely economic).

Even by concentrating the evaluation on the main issues, the breadth and complexity of the issues under review is too great for a single set of evaluation options covering the whole package to address the issues at stake in sufficient depth. The report is therefore divided into five main areas of analysis (Chapters 5 to 9) each with its own set of options and impact analysis. These chapters fall under three broad themes: ‘Better regulation’, 'Completing the single market' and ‘Connecting with citizens’, which are reflected in the two proposed Directives amending the current set of Directives [8] and a proposal for a regulation creating a European Communications Authority.

In more detail the structure is as follows:

· Part II addresses ‘Better regulation’ in the context of ex ante regulation, competition and investment (Chapter 5), and better management of radio frequency spectrum in the EU (Chapter 6).

· Part III addresses 'Completing the single market in eCommunications' to create an internal market for consumers and businesses though a more effective regulatory model (Chapter 7).

· Part IV addresses the theme of ‘Connecting with citizens’, and assesses the impact of the changes to strengthen users' rights and consumer protection (Chapter 8), and those dealing with privacy and security (Chapter 9).

The proposals however do also constitute a single regulatory package; thus, whilst each option has to be examined on its own merits, some combinations of measures create important synergies. These synergies are further described in Part V – Overall Impacts.

Alongside its legislative proposals, the Commission is updating the Recommendation on Relevant Markets that defines which markets are susceptible to ex-ante regulation. This Recommendation provides a flexible tool to roll-back ex-ante regulation in areas where competition has successful been established. The evaluation has therefore examined the scope for reducing substantially the number of markets (see Chapter 4) and also the options of restricting, or even entirely removing ex ante regulation (Chapter 5).

The report also contains an annex on the administrative costs following the model of the Commission Impact Assessment Guidelines (Annex II).

Impact assessment steering group

In view of the broad scope and the cross-cutting nature of the subject matter at hand, an inter-service steering group of the Commission services was established for the impact assessment, which met eight times in 2006-2007 [9].

Opinion of the Impact Assessment Board

In its opinion of 26 July 2007, the Impact Assessment Board recommended the following improvements to the draft document:

– 'The IA report needs to explain better the changes in the regulatory environment that the new initiative is to bring. In particular, changes to Commission powers, and/or changes to procedures regarding Commission instruments in the field of privacy and security need to be clarified. Similarly, changes to the current functioning of the national regulatory authorities regarding the infrastructure (section 5 and 7) and the spectrum management (section 6 and 7) could be better explained.

– The relation between the actions proposed in the 5 main problem areas needs to be clarified. Should there be no trade-offs or synergies between them, it must be explained why they are bundled together in one impact assessment report.

– Environmental impacts should be better analysed. Whereas it might not be feasible to assess in detail environmental impacts for all policy options, their analysis should be improved. Discussion about consequences for waste generation and energy consumption on the one hand and replacing transport and travel with e-communication services on the other hand needs to be added to the IA report.

– The simplification resulting from proposed changes requires further clarification. Some of the elements (such as disclosure of security breaches) seem to create additional obligations for operators, whereas others (decrease in the number of markets) seem to aim at their reduction. Since the initiative is part of Simplification Rolling Programme, overall simplification effects need to be made more explicit. The report should state more clearly whether an assessment of the impact on the administrative burden will be carried out at a later stage, during the implementation process.

– The impacts of the various options (in the relevant sections) should be compared to the respective baseline scenario(s), in line with the IA guidelines. Therefore, the baseline scenarios in the comparison tables should not be marked with impact qualifiers (+/-); but only indicate the effect of the proposed changes with the baseline scenario as benchmark.

– A separate ex-ante evaluation of the European Authority needs to be carried out.

In response to these comments, the analysis of options and impacts has been further improved and substantiated with the requested elements. Part V now includes a detailed description of the synergies and links between the five main areas of analysis, more detailed analysis of the environmental impacts as well as an analysis of the key simplification elements of the initiative. As regards the administrative burden related to mandatory breach disclosure, Annex II provides further explanation why quantified measurement is not provided at this stage. Further assessment will be provided at the implementation stage. A summary of the ex-ante evaluation of the European Regulatory Authority satisfying the minimum requirements of the Financial Regulation is included in Annex III. Finally, the impacts of options in each area of analysis are now compared to the “no change” scenarios, which are used as a baseline for this comparison.

2. Consultation and expertise

The Commission's review proposals draw upon an extensive consultation process that was launched by a public call for inputs in November 2005, which resulted in over 150 written submissions and a public hearing of over 440 participants in January 2006. This was followed by several discussions with Member States and regulatory authorities [10] prior to the adoption of the Communication of June 2006 presenting the Commission's initial proposals.

At the second stage of the review, the Commission undertook another set of consultation activities:

– A public consultation that ran four months between June and October 2006. A total of 315 responses in eleven different languages were received from a broad range of stakeholders: Member States, regulators, network operators and service providers, broadcasters, users and consumers. 220 of the submissions concerned the regulatory review of the five directives, and 95 the consultation on the draft Recommendation on relevant markets [11];

– A public workshop was held on 13 July 2006 in which the Commission services presented the initial proposals for the review and responded to questions;

– A public workshop was also held on 10 October 2006 for all interested stakeholders to provide their comments to the Commission. Both of these workshops attracted several hundred participants. A number of national authorities also consulted/discussed with the stakeholders on the review at national level before submitting their response to the Commission's consultation;

– Discussions with Member States in High Level meetings with ministries in September 2005 and in March and November 2006, and June 2007, and in the Communications Committee and the Radio Spectrum Committee; and

– Discussions with the national regulatory authorities and the European Regulators Group (ERG).

In general, the results of the public consultation showed stakeholder views along the lines already expressed in the call for input launched in November 2006. The responses gave overall support for the regulatory approach to this sector, i.e. ex ante, market based and technologically neutral. There was moreover general support for most of the changes put forward by the Commission. These stakeholder views have been taken into account in the Commission's final legislative proposals and in this impact assessment.

The major sources of information for this impact assessment are the annual Commission Reports on Implementation of the Regulatory Package in general [12], and on the market reviews (“Article 7 procedure”) in particular [13]; as well as studies and surveys commissioned from the external consultants for the review [14]. The current report has particularly benefited from a study the Commission commissioned on the issues relating to spectrum management [15]. In addition, the Commission conducted a questionnaire on administrative costs among the national regulatory authorities and markets players, the results of which are given in this document.

3. The Main Objectives in the context of the i2010 Initiative

The Commission’s i2010 initiative [16] stresses the crucial role of information and communication technologies (ICT) in achieving the growth and jobs objectives of the renewed Lisbon strategy. In the area of eCommunications, the i2010 initiative aims to create a Single European Information Space by 2010 that offers affordable and secure high bandwidth communications, rich and diverse content and digital services.

These objectives are underpinned by the current EU's electronic communications regulatory framework, which is designed to drive competition in the market, bringing investment and innovation, with choice, quality and lower prices for the consumer. This review has, accordingly, aimed at enhancing the ability of the framework to deliver on its objectives and supporting the i2010 policy, by proposing adaptations that build on experience to date and anticipate future market and technological changes.

A major aspect of the IA is therefore to assess the extent to which the main objectives of the regulatory framework had been met, i.e.:

1) to create an open and competitive single market for electronic communications services and networks in Europe, and thereby

2) to encourage innovation in communications networks and services, by both new entrants and existing operators, for the benefit of European businesses and citizens.

More specific objectives of the review are to examine:

– the impact of the regulatory framework on investment and growth;

– the scope for more efficient and flexible spectrum management in the EU;

– the possibilities to increase the consistency of regulatory actions in line with the i2010 objective to create a single e-communications market in Europe;

– ways to reduce red-tape and administrative costs associated with market reviews;

– the reinforcement of user rights and consumers protection; and

– ways to improve network security.

4. Setting the scene - The e-Communications market in the EU

4.1. The overall benefits of telecoms liberalisation

This section will show that although a great deal of progress has been made through the current framework, there continues to be structural imperfections in competition which will perpetuate themselves in new markets and services unless appropriate regulatory steps are implemented.

The telecommunications industry in the EU has evolved very far over the past two decades, from state-run telephone monopolies to open competitive services that underpin Europe's capacity for innovation and technological change. Overall, progress has been steady, starting with the freeing up of terminal equipment (1988), extending into network and service markets (1998) [17] and culminating in the harmonised European regulatory framework (2002) [18] that is currently under review.

Price developments give a good indication of the extensive impact of liberalisation of telecommunications [19]. Figure 1 compares the price development telecommunications against other 'network industries' (i.e. electricity, gas, transport and postal services) [20], all of which are characterised by bottleneck networks assets. It shows clearly that the market opening and competition – combined with technological advances - have pushed down telecommunications prices. In 2006, consumers in the EU15 spent around 27 % less for the same telecoms services than 10 years ago - in real terms this represents a 40% decrease [21].

Figure 1. Evolution of network industry price indices relative to the all-items HICP* since 1996, EU-25

(...PICT...)

Note: The telephone and telefax services price index refers to the EU15 only.

*) HICP = Harmonised Index for Consumer Prices

Source: Evaluation of the performance of network industries providing services of general economic interest – 2006 Report Commission Staff Working Paper, SEC(2007) 1024, (Commission calculations based on Eurostat)

4.2. Recent market developments: broadband

Accompanying and driving forward the process of market opening has been a revolution in information and communication technologies that has brought affordable digital communication technologies and services to the vast majority of citizens and businesses. These processes have shifted the emphasis away from fixed voice towards mobile and data, and in particular towards internet and audio visual services.

That is why, in the current review, the focus of the regulatory discussion has been on high-speed (broadband). Affordable broadband communications is now a prime objective both in terms of consumer welfare and digital inclusion, but also economic growth.

European broadband development in the international context

Broadband [22] is the fastest growing segment in the European eCommunications sector in terms of revenue growth, which was estimated at between 7.8% and 8.5% in 2006 [23].

Figure 2 shows that several EU countries are now world-leaders with broadband penetration rate exceeding the 20% [24]. With the rate of reaching 35%, two EU Member States had surpassed Korea, which has traditionally ranked in the top of the league [25]. By July 2007, the average take-up reached 18.2% of the EU population (over 90 million lines), up from 14.9% in the previous year. Between July 2006 and July 2007, more than 21.5 million broadband lines were taken, an increase of over 31% [26].

Figure 2. OECD broadband subscribers per 100 inhabitants (by technology), June 2007

(...PICT...)

Source: OECD

Further examination of these figures assists the analysis of opening up competition in e-communications markets. In short, the highest levels of broadband penetration in the world are where there is effective competition. Both inside and outside the EU, the countries with the highest penetration rates either have a healthy cable television industry that is competing on internet services, (e.g. Netherlands and Denmark, or Switzerland and Canada) or there are new market entrants who have capitalised on easy access to facilities through strict unbundling requirements (UK and France, or South Korea and Japan).

Overall, the EU member states where the pro-competitive EU policy framework has been applied effectively have already achieved high penetration rates and continue to add subscribers much faster than the comparable third countries. In 2006, the EU average annual increase in broadband penetration was 16%, while growth rates were single-digit in comparable third countries (e.g. Australia 3.2 %, Canada 3.2%, Japan, 2.6%, Korea 1.1%, Switzerland 5.8% and US 4.7%) [27]. The expert estimates forecast that by 2012, the EU15 with 66% household rate will near that of Korea's at 69% [28].

As regards competition modes, there is relatively little full infrastructure competition in Europe due to the low and patchy coverage of cable. This compares badly with the USA, South Korea, and Canada, where broadband over cable is well developed. For Europeans, over 80% of broadband connections are DSL running via the fixed telephone line. This means that the vast majority of consumers are using the local access network of the traditional incumbent.

As far as new infrastructures are concerned, fibre-to-the-home (FTTH) networks are very little developed in Europe. This situation contrast strongly with the world leader, Japan, with 8.8 million fibre broadband subscribers in 2006 [29]. The high Japanese take-up of fibre seems to be driven by relatively low costs (overhead cables are permitted) and intense local competition (in particular with electricity utilities). There is also strong evidence of demand for more bandwidth among consumers [30]. The USA also has higher levels of FTTH development in areas where cable and telephone companies are engaged in strong competition for market share.

4.3. Consumer benefits and digital divide

Consumers have gained many benefits from the liberalisation of eCommunications in recent years [31].

Lower communications prices: Competition has more than halved communications prices since liberalisation. On fixed lines, the EU weighted average charge of a 3 minute call has fallen by 65% and the cost of a 10 minute call by 74% since 2000. Prices for mobile services are now starting to fall as well, reducing almost 14% between 2005 and 2006 [32].

Better access and choice: By end 2006, 95% of EU27 households had access to telephone services (fixed and/or mobile). In just eight years (1998–2006), overall mobile penetration grew from 13% to 103% [33]. Around 81% of EU27 households had at least one mobile phone and 72% had fixed lines. Today over one fifth (22%) of EU households have a mobile phone but no fixed line [34] (see Figure 3).

Figure 3. Telephone access, EU25 households, 2006-07

(...PICT...)

Source: Special Eurobarometer – eCommunications household survey, April 2007

Broadband: On average 29% of the EU households used broadband at the end of 2006 compared to 5% in 2002. Around 23% of households have broadband access, against 16% of households with a narrowband access [35]. By comparing the broadband price development worldwide, it can also be observed that, although Japan and Korea have the lowest consumer prices (measured by kbit/s), some EU countries are already among the cheapest, and that the prices in the EU have been generally falling much more rapidly than the global average (Fig 4).

Figure 4. International comparison of broadband prices

(...PICT...)

Source: ITU

Broadband penetration is also slowly transforming voice services. VoIP (voice over Internet Protocol) is a generic term describing voice carried over IP-based networks (such as the Internet) [36]. For consumers, VoIP immediately cuts the cost of voice calls. Although the market is still at an early stage, VoIP on public broadband already accounts for more than 5% of Europe’s fixed telephone traffic, up from 2% in 2005. In some countries VoIP is particularly popular, totalling 18% of fixed telephony traffic in France and 12% in Sweden. Forecasts indicate that VoIP might increase by an average 47% a year, by-passing traditional fixed calls by 2012 with 30% of overall telephony traffic (fixed and mobile) [37].

The Information Society for all: Broadband is now a fundamental indicator of an (information) society that is “universal, ubiquitous, equitable and affordable". The ITU's Digital Opportunity Index (DOI) measures the ability for citizens to benefit from access to information based on 11 internationally agreed indicators (including broadband). The index ranges from 1 (complete digital opportunity) to 0. The average DOI score 2005/06 worldwide was 0.40. Europe's average was 0.58, ahead of the Americas (0.45), Asia Pacific region (0.45) and Africa (0.22) as reported in the The World Information Society Report 2007 [38] (see Figure 5). According to the report, "Europe has achieved the largest overall gain in digital opportunity over the last two years."

Figure 5. Digital Opportunity, top 25 countries, 20005/06

(...PICT...)

Source: The World Information Society Report 2007, ITU

I BETTER REGULATION

Introduction

Better regulation is a central policy objective of the EU under the Lisbon Strategy for growth and jobs. A range of initiatives have been launched to cut-red tape by consolidating, codifying and simplifying existing legislation and improving the quality of new legislation through better ex-ante impact evaluations. The aim is to better define and justified public policy initiatives and to evaluate the costs and benefits of policy actions [39]. The regulatory environment should create incentives for business, cut unnecessary costs, remove obstacles to adaptability and innovation and ensure legal certainty. Better regulation also demands that policy should be applied efficiently at both EU and national level. The overall aim of better regulation therefore is effectiveness and efficiency of outcomes, not just fewer rules or fewer powers for regulators [40].

The existing regulatory framework for e-communications is already the product of a process of better regulation. Already in 2002 it involved the modernisation, consolidation and simplification of rules by replacing 22 legal measures by a streamlined set of five directives. It is also founded on the principles of technological neutrality, thus providing a flexible regulatory tool in the face of the fast technological change in the e-communications sector.

The aim of the current review is to apply again the principles and tools of better regulation in order to achieve a higher level of public policy efficiency and effectiveness of outcomes. Part II of this report therefore focuses on two areas where changes have been identified that could achieve increased efficiency simplification and legal certainty. These are: i) competition, investment and innovation; and ii) spectrum management.

5. Competition, investment and innovation

5.1. Identifying the problem

5.1.1. Background - Current framework: ensuring a level playing field for all operators

The basic concept of the framework is that effective competition and ensuring opportunity and reward for innovative companies is the key to promoting consumer interest and technological advance in today's converged communications environment.

Telecommunications markets are characterised by the concentration of essential networks in the hands of a few powerful operators. Historically, these networks were pure monopoly assets, but with the opening of competition – through application of the regulatory framework - there has been investment in competing infrastructures, particular on the more heavily trafficked core networks. In some cases, full end-to-end competition on fixed line telecommunications has emerged either through the upgrading of legacy cable networks to provide telephone and internet, or through new-build fibre-to-the-home services. The term 'ladder of investment' has been coined to describe how the regulatory model works: having gained access to the network, market entrants start generating revenue, climb up the 'ladder of investment' and in the process, roll out their own infrastructures [41].

The framework is inherently deregulatory because it foresees a progressive rolling back of ex ante regulation, to be replaced by general competition law intervention ('ex post regulation'). However, ex-ante regulation can only be discarded once sustainable competition has been established. For example, for the vast majority of European fixed line subscribers, the traditional copper cable that links their premises to the network is the dominant – if not the only - means of connection. This "local loop" – which in most cases was installed in the days of state run monopoly telephony -represents an essential and often non-replicable asset which is in most cases fully in the hands of the incumbent telecommunications operator. Ex-ante regulation of such bottleneck assets ensures a level playing field for alternative operators [42].

Overview of the regulatory process under the framework

The framework requires the national regulatory authorities (NRAs) to encourage efficient investment and promote competition [43]. NRAs can impose ex ante regulation only after conducting a thorough market review.

Starting point: Recommendation on Relevant Markets

The national regulators must first examine those markets where competitive conditions are likely to be imperfect, starting from a list of markets in the 2003 Commission's Recommendation on Relevant Markets [44]. That Recommendation includes 18 wholesale and retail markets. To identify a market, three criteria must be met: 1) There are structural or regulatory entry barriers in the market; 2) The market has characteristics such that it will not tend towards effective competition; and 3) competition law is not sufficient to address the problem. Only exceptionally may a NRA consider regulating outside the listed markets. It should be noted that even if the Recommendation identifies a market, regulation will not be warranted if there is effective competition on that market. The Recommendation constitutes an important part of the overall design of the framework, because it allows the Commission to adapt ex ante regulation to technological and market trends.

Assessing competition in each market

After defining the relevant markets, NRA must assess competition in each market and particularly whether any firms in those markets have significant market power (SMP, i.e. a dominant market position that would allow them to operate independently of their competitors). If the markets are found not to be competitive - and when national and Community competition law is not sufficient to address the problem - then the operators with SMP are subject to ex ante regulatory obligations (remedies), in order to stimulate competition. These remedies must be based on the nature of the problem identified, proportionate and justified [45]. Furthermore, ex ante access and price regulation must be set up in such a way that it does not negatively influence investment incentives for market players and encourages companies to 'ascend the investment ladder' [46].

Remedies: flexible 'toolbox' for national regulators

The EU framework provides the NRAs with a ‘toolbox’ of remedies, allowing for the flexibility to design appropriate measures to tackle market failures and achieve intended regulatory objectives in each Member State. These market failures might include excessive pricing, denial of access, delay for subscribers switching to alternative operators, limitations on providing wholesale service and other discriminatory treatment. If, however, the market is found to be competitive, then the NRA must remove existing SMP designations and any accompanying regulatory requirements [47].

Local loop unbundling

An important means of the market opening and competition in the sector is the unbundling of the local loop (LLU) [48], which requires incumbent operators to offer third parties access to their local loop at a cost-orientated price. This physical wire connection between customer and operators is normally in the hands of the incumbent. LLU allows the use of this bottleneck asset by multiple operators in a way that allows them considerably greater flexibility in configuring their service offer than if they have to use the configuration offered by the incumbent.

5.1.2. Deregulation under the current framework

As already noted, the Recommendation on Relevant Markets is an inherent instrument of better regulation as it allows the Commission to adapt ex ante regulation in response to technological and market changes (without the need to change the underlying EU legislation).

Indeed, in the consultation documents of June 2006, the Commission indicated its intention to take such a deregulatory step by removing a number of retail markets from the list of markets susceptible to ex ante regulation on the grounds that once there is effective wholesale regulation, retail regulation becomes unnecessary.

The system of defining markets in a Recommendation provides further scope for deregulatory flexibility in that, although it provides common guidelines, it does not prevent national regulators from making (well substantiated) departures from the list of markets. For example, geographical markets can be defined at a sub-national scale if justified by normal competition law assessment. Depending on the precise competitive conditions, this could result in rolling back regulation in some sub-national zones whilst continuing regulation in others. The existing consultation mechanism in Article 7 Framework Directive gives the Commission the necessary instruments to give guidance and to ensure consistency of the regulatory approach.

5.1.3. Challenge: to what extent does the framework encourage investment and innovation?

Investment in ICT is now the key driver of growth in an advanced economy because it increases productivity, generates new consumer services and creates jobs. There is strong statistical evidence that the overall performance gap between the USA and the EU in the past ten years has been due to lower investments and less efficient use of ICT in Europe. This is clearly illustrated by those countries that have achieved the fastest growth in per capita GDP over last ten years (Finland, Ireland, Sweden and the UK), which have all recorded considerably high growth rates in information technology investment and productivity [49]. Investment in ICT and its greater use have also clearly helped new EU Member States to catch up with the ‘EU-15’ [50].

Communications networks and services have meanwhile become the nervous system of the economy, which is why it so important that an open, competitive and innovative eCommunications market should be the centrepiece of EU regulatory policy [51]. Moreover, broadband penetration and investment in ICT infrastructure are nowadays generally seen as part of the structural factors necessary for innovation to take place [52].

eCommunications and growth

ICT represents over 5% of the total GDP driving about 40% of productivity growth and one quarter of overall growth in the EU. Of ICT sector revenues of approximately €649 billion in 2006, €289 billion were derived from eCommunications (fixed telephony, mobile telephony, fixed data services and cable), accounting for 44.5% of the total value [53].

Competition and innovation in eCommunications

Competition in communications infrastructure can be measured both at the infrastructure and at the service level (see further in Chapter 5.3.3). Service-based competition has brought lower prices over the short term but infrastructure competition offers a more sustainable basis for long term competition and innovation [54]. Investments in competing infrastructures are more easily justified for business clients than for residential subscribers, because they spend more on communications services.

The opening up of competition has encouraged the emergence of new players not only new operators but also service providers such as internet companies providing IP-based telephony, which are leveraging their rapidly growing customer bases to gain competitive advantages. The increased competitive pressure constitutes a challenge for traditional operators to continue to increase revenues and maintain profitability. They are meeting this challenge through cost-cutting measures and efforts to retain customers through innovative flat rate pricing models. Both objectives are being achieved through substantial new investments in Next Generation Networks (NGN), that involves modernisation of both the 'core' network (i.e. moving to an all IP architecture), and the 'access' components of the network (i.e. rolling out optical fibre all or part of the way to the customers premises).

NGN core networks

The move to IP architectures in core networks increases flexibility and efficiency of network operation, since it allows multiple services to be offered over a single infrastructure. Subscribers will not only receive upgraded versions of existing services but also new content rich services [55].

For example, BT estimates that the reduced cost of upgrading its core network to a full-IP will bring around one billion pounds savings a year by 2008 / 2009 against an investment of £10 billion. Next generation access networks also bring financial advantages in the long term through greater reliability and lower maintenance costs. This is an especially important efficiency gain for incumbent operators, which had developed a variety of networks dedicated to the provision of different services, and which are still dependent for approximately 60% of their earnings [56] on their 'traditional' voice and access businesses [57]. In general new entrants have more modern core networks and many are already IP based.

NGN access networks

Most existing local access lines in Europe are copper (or metallic) loops from the operator's central office that connects the core network to the local access network. The cost of modernising these legacy copper networks by fibre links is very high in Europe. Generally, European planning rules require cables to run underground. Thus re-cabling the local access network calls for substantial civil engineering works, not least because only around half of the existing copper cables are in ducts, with the other half being buried in the ground [58]. These civil works can amount to 50%-80% of the total cost per customer, depending on the fibre solution selected and local characteristics (such as population density, existence and space capacity in the ducts, labour cost and digging conditions).

Construction costs appear to be higher in Europe than in other major regions as it is not usually possible to use aerial fibre (unlike the US and Japan) [59]. For a new entrant, the economics of rolling out fibre to either the cabinet or the home are challenging, in particular where it is not possible to make use of existing underground duct space.

As a way to reduce the costs of upgrading to access networks, several incumbents are implementing plans to extend fibre only as far as the street cabinet and then to deploy VDSL over the existing copper sub-loop between the street cabinet and the customer premises. In this way, fibre is brought closer to the subscribers allowing a higher speed service, whilst the costs of the upgrade are spread across all subscribers served by the street cabinet. Estimates indicate that the costs for incumbents to roll out VDSL would be around € 200 per household and for FTTH between € 500 and 2000 per household in the European metropolitan areas. This approach however is not viable where the local loop is long, which is the case in some European markets, and in those countries Next Generation Access can only proceed via a full deployment of FTTH (fibre to the home).

Competition has clearly been the main driver of investment in the sector in recent times. However, particularly as regards the large investments required to upgrade to high bandwidth and all-IP networks, regulation has to balance the immediate gains for consumers of fierce price competition (that keeps margins in the sector very sharp), and the long term stability of revenue that investors seek when making large commitments to infrastructural renewal.

More precisely, the question for this review is whether in this sector where technologies develop quickly and demands for higher speed and capacity of networks are always on the rise, the current EU framework has found the right balance between encouraging investment and innovation and promoting price-orientated service competition.

5.1.4. Evidence base for the problem

Chapter 4 has already described how broadband development in the EU measures up against other major regions in the world. This section discusses further the available evidence concerning the impact of regulation, competition and investment on broadband networks. It considers first, the situation regarding ex ante regulation and competition in the eCommunications markets, followed by an overview of investments in the sector.

EU framework as a factor for investment

The literature on regulation, investment and innovation has not yet been able to confirm an unambiguous empirical relationship between the current framework and investment. This would require a longer timeframe over which to conduct the analysis [60]. Nevertheless, an econometric study, commissioned to support this impact assessment, has been able to provide estimates of the level of eCommunications investment in the EU and to examine its main drivers [61]. The study covered the period for which investment data was available, i.e. 2001-2004. Although, given the short time over which the empirical observations run, its findings might be considered as preliminary [62], the results suggest that effective national regulation under the EU framework is associated with higher levels of investment in the sector alongside other positively correlated factors such as GDP per capita, market scale and population density. It is worth noting that larger firms tend to invest more due to their ability to spread investments across a number of markets, and that incumbents generally remain the largest players on the market.

1) Competition and ex ante regulation: situation in markets

Based on NRA analyses of national markets (as notified to the Commission under the Article 7 procedure), it is possible to compile an overview of the current situation of ex ante regulation and competition in eCommunications markets across the EU (Figure 6). 'No effective competition' means that NRAs are imposing obligations on operators with significant market power, whereas 'effective competition' means that no ex ante regulation is in place.

This shows that while a number of markets have already become effectively competitive, the overall picture is of market failures (especially dominance) across most markets. It is especially noteworthy that NRAs in all Member States have found that there is no effective competition in relation to retail fixed access services (markets 1 and 2). This reflects the lack of infrastructure competition over the 'last mile' (see further discussion below) [63].

Figure 6. Overview of market analysis under the framework, June 2007*

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Source: European Commission [64]

*) In the table, 1 to 7 inclusive relate to fixed retail market, and markets 8 to 18 are wholesale markets, which comprise fixed services market (markets 8 to 14), mobile services (markets 15 to 17), and broadcasting (market 18).

2) Investment trends in eCommunications

The current EU framework became applicable in 2003, when the sector was just starting to recover from the financial crisis caused by the burst of the "internet bubble". From 1997 to 2001, increases in investments in the sector in Europe have been estimated as ranging from 50% to 100%. In the following years investment declined, levelling off in 2003 and rising in 2004 to slightly above the investment level in 1997 [65].

In fact, 2006 was the fourth consecutive year of increased year-on-year investments levels in the European communications sector. Aggregate investment – measured in terms of capital expenditure – is estimated to have risen to more than € 47 billion in 2006, representing an increase of 5% over 2005 [66]. The 2005 investment figure of € 45 billion ($ 65 billion) exceeded that of other major regions (Asia Pacific: $ 63 billion and North America: $ 62 billion) [67].

The typical incumbent firm in the fixed or mobile sector invested approximately 13% of its revenues in 2006. This percentage is slightly below the levels seen in the late 1990s, although they are in line with long-run historical averages for the sector. As noted above, incumbents being larger and present in a wider range of markets continue to outspend their competitors in absolute (though not always in relative) terms.

The EU average telecommunications expenditure as percentage of GDP was 3.03 % in 2006. The highest figures are witnessed in fast growing EU Member States whose infrastructures have been undergoing a major renewal, such as Latvia (7.55%), Bulgaria (7.11%) and Estonia (6.8%). The average in the EU15 was 2.92%, moderately ahead of the USA (2.14%) but well behind Japans (4.2%) [68].

As for telecommunications expenditure per capita in 2006, the EU25 average was € 709 (EU15 € 826), with the highest expenditures in Sweden (€ 1.196), Denmark (€ 1.155) and Ireland (€ 990) followed by the Netherlands (€ 984) the UK (€ 990). This is again comparable with the USA (€ 769) but well behind Japan (€ 1.228) [69].

Investments in next generation networks

Both incumbents and alternative operators have on-going or announced investments in new generation core and access networks (NGAs). In absolute terms, according to publicly available data, the largest investment in next generation core networks in the EU is the €15 billion investment in the UK by the incumbent. As for access networks, the largest investment announcements have been by the Italian and German incumbents, € 6.5 billion and € 3 billion respectively. In the Netherlands and Belgium the incumbents are to invest around € 900 million and € 300 million, respectively.

As regards new entrant investments, announcements include: a German city network operator planning to invest € 250 million in fibre; three French DSL operators (with announcements summing to €1.6 billion) plus the cable operators with large scale fibre deployments. The French incumbent has yet to make major announcements. Cable companies elsewhere in the EU including Belgium and the Netherlands have also announced fibre deployment projects.

Besides private projects, there are also several public and public-private partnership projects, often backed by EU funding. For example, in Greece a major public-private partnership project of € 210 million is co-financed by the European Fund for Regional Development [70].

5.1.5. Summarising the problem

Regulatory action over the coming years will have a strong bearing on the pace and the manner of Europe's transition to a high-speed and full IP-based telecommunication infrastructure. Prima facie, the strong comparative position of the EU in terms of broadband penetration rates provides empirical evidence that the regulatory framework is encouraging innovation in new Information Society services.

However, it still needs to be verified whether the right balance between flexibility for the operators and predictability of regulation has been found, and to what extent the current framework contributes to investment and innovation. In particular, there is concern that if insufficient investments are made in new generation networks offering bandwidths several times faster than those currently available in Europe, the EU risks being outperformed by other major economies (such as Japan, Korea and the US) where such developments are already well underway. There is a potential risk here to Europe's competitiveness, as well as having detrimental effects to innovation, consumer benefits, digital inclusion and creation of a more sustainable knowledge-based economy.

In policy terms, the issue is to strike a regulatory balance between, on the one hand, allowing incentives for investors in new core and access networks – in the face of considerable uncertainty over the evolution of demand for these services – and, on the other hand, avoiding the immediate foreclosure of new markets by sanctioning the reassertion of monopoly privileges by the dominant market players over these new infrastructures [71].

A particular focus of debate has been the extent to which new generation networks in themselves constitute new markets [72]. Recital 27 of the Framework Directive notes that in newly emerging markets the market leader is de facto likely to have a substantial market share, and thus should not be subjected to inappropriate ex ante obligations. As already noted, however, new generation networks provide a technological platform for both more efficient delivery of existing services as well as the addition of new services. Thus, a new infrastructure cannot be considered, a priori, as equivalent to a new market. Indeed, new infrastructure investments can even be used to reinforce the dominance of the lead player in existing markets.

Nevertheless, the large investments involved in high-speed networks do require regulators to take into account the risks involved in making these investments and permit adequate returns on investments. Incumbents, in particular, criticise mandated access to their infrastructure and the price at which this is imposed (which they usually consider to be too low) arguing that it provides disincentives to investment, especially the major investments needed for next generation access. On this basis, some incumbents have called for a firm date to be set for the withdrawal of sector-specific ex ante regulation; whilst others for 'regulatory holidays' for major new investments. By contrast, alternative operators fear that the removal of access obligations – in particular the obligation to unbundle local loops and to provide backhaul connections to the alternative operators' network - would inhibit the emergence of infrastructural competition by undermining their growing investments in core networks. They argue therefore for their part that ex ante regulation and open access provisions on incumbents' networks are strongly correlated with increased investment and innovation.

The regulatory challenge is therefore to balance the conflicting interests of economic operators, all of whom need legal certainty about the future course of regulatory practice in order to make investment decisions. This means that ex ante regulation should be targeted on those areas where there are enduring bottlenecks that determine access to the marketplace, and that the regulatory measures should be effective and proportionate in order to make market entry possible for operators that are willing to invest in providing services, whilst safeguarding the long-term economic sustainability of the dominant network providers.

5.2. The objective

The overall objective is to ensure that the EU's regulatory environment promotes competition, investment and innovation in electronic communications, so that user needs are met and consumer interests are protected.

The specific aims within this overall objective are:

– Ensure effective competition which brings tangible benefits to consumers in particular through greater choice of services and lower prices; and

– Promote investment and innovation in high-speed communications infrastructures and new services.

5.3. Policy options and assessment of impacts

Three main policy options [73] are explored:

Option 1: Adopt an ‘open access’ model for new network infrastructure (i.e. separating infrastructure provision from service provision to a greater or lesser extent);

Option 2: No regulation: remove or restrict sector-specific regulation ('regulatory holidays'); and

Option 3: Maintain the current model of the framework.

5.3.1. Option 1 – Adopt 'open access' model for new infrastructure: separate infrastructure from service provision

This option addresses the problem of trying to ensure fair competition in a market where some operators are vertically integrated, owning the network infrastructure and providing services, and others are not.

Network industries require a specific regulatory approach because the dominant players control access to infrastructures that are essential for competitors to provide services in the market place. These facilities are described as "non replicable assets" both because the costs of duplicating cannot be justified by any reasonable business case and also in may cases because there is no public will to see multiple physical networks serving the same purpose. They are therefore often described as "natural monopolies" and as such are subject to ex ante regulation in order to make sure that access to them is maintained on an equal footing in order to encourage competition.

The application of behavioural ex ante remedies (wholesale price caps, obligations to provide reference offers, cost orientation, etc) does not always lead to equivalent access to the bottleneck assets. Thus, alternative service providers often report problems of achieving equivalent treatment to the service provider of the incumbent operator. In short, the incumbent has both the motive and the means, through control of these bottleneck assets, to discriminate in favour of their vertically integrated subsidiaries.

Where such access problems have a significant and enduring impact on competition, further regulatory intervention may be justified to require a transparent separation between the parts of the incumbent controlling the bottleneck assets and the other divisions. These interventions can be carried in a graduated way, which can be presented in simplified form as:

– Accounting separation means the keeping of separate revenue and cost accounts for different activities, in order to achieve a detailed and accurate statement of the cost and profits made by an operator for a specific activity.

– Functional Separation means the establishment of an operationally separated entities, the ownership of which remains with the parent company. The separate entities have separate accounts but they are not legally independent entities.

– Structural separation or 'ownership unbundling' or 'divestiture' means that some or the entire network is placed in a separate legal entity and is placed under different ownership.

Accounting separation can be seen as a complement to behavioural remedies in that it permits more accurate application of price control measures, in order to avoid price discrimination. However, it does not address non-price discrimination, such as delays in switching over customers to competitors, limits on wholesale product offers, differential service quality, etc. In addition, policing obligations for non-discrimination in vertically integrated undertakings are notoriously difficult [74]. For example, operators with obligations of accounting separation have incentives to obscure any anti-competitive behaviour in the accounts.

Thus, where discrimination is found to be a continuing impediment to competition, more fundamental separation measures might be warranted that not only increase the transparency of prices but also remove incentives to discriminate or deny access or use cross-subsidisation to compete unfairly by addressing the underlying motive for discrimination - the internal profit motive of the firm. In theory, both structural and functional separation of bottleneck network assets and network services would give the access provider an incentive to grant all access seekers (service providers) non-discriminatory terms and conditions. This is the fundamental aim of functional and structural separation in network industries [75]. And in so doing it should, in principle, create a level playing field for all service providers, promote competition in service provision and lead to better services at lower costs for consumers.

In network industries, vertical separation is being implemented in one form or another in most OECD countries (see figure 7). However, experience over recent years reveals that the vertical separation model is more likely to be successful in some sectors and countries than in others [76].

Figure 7. Vertical separation cases and projects in main OECD countries

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Source: IDATE, 2007 [77].

A detailed analysis undertaken for the recent proposals for unbundling the energy sector in the EU concludes that "the option of full ownership unbundling has a number of positive impacts on the market, in particular by stimulating investment in particular in interconnectors, reducing market concentration and bringing down prices". At the same time, there is no indication that ownership unbundling would harm credit ratings, share prices, R&D activity or the relationship with external suppliers. The proposals for ownership unbundling ensure that EU energy networks cannot be owned by non-EU supply companies, or by EU supplier [78].

At an overall level in sectors such as telecoms, water, electricity and gas, the benefits of preventing foreclosure and the scope for innovation if competition is strong seem to be relatively high, whereas the costs in these sectors in terms of dis-economies of coordination and the costs of the split can be seen as moderate to low [79]. This goes someway to explain the problems that have been experienced in the case of structural separation of railways, where the net benefits of separation can be expected to be rather low [80].

Recent analysis of experiences in separation in different infrastructure sectors indicate that some of the theoretical disadvantages - particularly tendencies to over or under invest in the infrastructure and problems of coordination due to the rupture of the vertical integration or double marginalisation - can be overcome through effective regulatory and private contracting arrangements [81].

Assessment of impacts of Option 1

a) General

It is evident from the above that not all sectors are the same as regards the application of vertical separation and that therefore the benefits and drawbacks of the two basic forms of vertical separation must be further analysed in the context of the specific techno-economic characteristics of the eCommunications sector.

Under the current framework, NRAs can already impose accounting separation and cost accounting in order to calculate appropriate wholesale access charges and to avoid price discrimination to operators designated having significant market power [82].

Structural separation cannot be imposed under the legal basis of the regulatory framework, but could in principle be imposed under competition law instruments (Council Regulation (EC) No 1/2003 permits the break-up of a company found to have infringed competition law, if it can be shown that no alternative behavioural remedy is equally effective) [83].

Techno-economic characteristics of eCommunications vs. other network industries

Although the eCommunications and other network industries share many similar characteristics, there are also a number of differences. The energy sector, for instance, is not as technologically dynamic as telecommunications networks, the services transmitted can be considered as commodities and there are fewer examples of competing network infrastructures because liberalisation and competition has not been achieved to the same degree. In energy networks the main bottleneck is long distance transmission networks rather than the local access networks that form the key remaining bottlenecks in telecommunications. Nevertheless, telecommunication networks are still characterised by strong market dominance which is based upon direct ownership of bottleneck assets by vertically integrated incumbents. Thus whilst the problems of discrimination are endemic to all network industries, the remedies cannot a priori assumed to be the same.

It should be noted that vertical separation does not remove the need for regulatory oversight of the dominant entity. If implemented effectively it resolves the problem of discrimination but it raises new demands for regulatory oversight such as controlling a tendency for excessive pricing by the infrastructure provider and ensuring that investment in the network infrastructure is adequate. These problems can be rather difficult to tackle, and some have argued outweigh the potential benefits of non-discrimination, especially in telecommunications given the high rate of technological change and the potential loss of economies of scope in the coordination of investments in services and infrastructures. That is why, as noted in the Impact Assessment of June 2006, it is essential that a careful cost benefit analysis is carried out in any serious consideration of vertical separation [84].

Regulatory developments in energy sectors and the issue of ownership separation

The Commission has recently proposed changes to the legal framework for the energy sectors. Its sector inquiry into competition in gas and electricity markets published at the beginning of 2007 found that despite the EU liberalisation directives, there are several sector-specific problems such as high levels of market concentration, vertical integration of supply, generation and infrastructure leading to a lack of equal access to, and insufficient investment in infrastructure [85].

The expert study commissioned for the regulatory review found stakeholder support for the notion that ownership separation ('full TSO [86] ownership unbundling') "could remove the fundamental conflict of interest in a network owner affiliates and would contribute to ensuring non-discriminatory access. It was also felt that the creation of network-only businesses probably would make regulation easier. However, many respondents pointed out that there would be strong opposition to full ownership unbundling and that the benefits were not self-evident or possible to qualify" [87].

Following these findings, the Commission has proposed ownership unbundling (i.e. structural separation) as the most effective means to ensure choice for energy users and to encourage investment [88]. In certain cases, where ownership unbundling is not practicable, a second option establishing an independent system operator (ISO) to carry out the operational management of the transmission has also been tabled, but under strict conditions. These conditions include, inter alia, that the candidate operator has at its disposal the required financial, technical and human resources to carry out its tasks; that it has committed to complying with a ten year network development plan proposed by the regulatory authority; and that it has demonstrated its ability to comply with its obligations on conditions for access to the network for cross-border exchanges in electricity [89].

b) Structural Separation

Structural separation has the advantage of providing a clear-cut regulatory response to serious competition problems in network industries. There are practical examples of structural separation being successfully implemented in telecommunications.

Structural separation of AT&T in the USA

The most famous example of divestiture in telecommunications – and which is also generally considered a success - is the separation of AT&T from the Regional Bell Operating Companies (RBOCs) in the United States in 1984 [90]. With the divestiture, not only were the local operations of AT&T structurally separated from its long distance and international operations, but ownership of the two groups of companies was separated by means of a share swap. With their ownership separate from AT&T, the RBOCs (or “Baby Bells”) no longer had an incentive to favour AT&T over its long distance competitors. Therefore, all long distance competitors obtained access to local telecommunications services from RBOCs on similar, non-discriminatory terms. The divestiture also eliminated concerns about anti-competitive cross-subsidies between AT&T's local and long distance operations.

However, structural separation also carries with it a number of significant regulatory difficulties. First, it makes it difficult to coordinate infrastructure investment with service development, which is particularly acute in the communications industry, where technological change is rapid. Furthermore, the pressing demands for investments in next generation networks (NGN) blur the split between competitive and bottleneck assets. As fibre is extended out from the central office to the street cabinet or to the home to enable fast broadband access (see Chapter 5.1.3), investment coordination is likely to become more important, not least due to the uncertainty of demand for new services and higher bandwidths.

Secondly, it is difficult to define the best way to split the operation into its component parts. The coming of next generation networks has been seen by some as creating a logical separation between the infrastructure that carries electronic communications and the services that that they comprise [91]. Indeed, next generation networks can in principle be completely blind as to the types of services and content that they carry, which is the ultimate commodification of telecommunications traffic.

However, a perfect split between the transport and the service layers may by no means as straightforward as it appears in theory. Rather, it is argued, networks will continue to be hybrids of different legacy systems which makes it difficult to identify an appropriate boundary at which to apply structural separation, given the uncertainties surrounding new network architectures. Moreover, once implemented, such separation is not easy to adapt afterwards. There is therefore a risk of an inappropriate market structure being imposed and becoming entrenched [92].

Thirdly, there are substantial one-off implementation costs associated with the break-up of the integrated firm (see Box). Structural separation of ownership may have a considerable impact on the share value of the regulated company Having said this there is evidence that voluntary divestiture of network assets from the service layer may actually create rather than destroy shareholder value, as is seen in the interest of the Irish incumbent to voluntarily separate its network from its service operations (see below).

Examples of estimated implementation costs of structural separation in telecoms

The implementation costs of structural separation include several components: branding (stationary, vehicles etc.), buildings, communications, and advertising (PR/media relations, website etc.), financial and management reporting systems, hardware and software, information systems, legal, office equipment, recruitment and transition planning [93]. Publicly reported estimates of structural separation of the last years include for instance the following (note that these estimates should be treated with caution, as they cannot be confirmed):

Australia: In 2003, Telstra (Australian incumbent operator) estimated that its full structural separation would cost AUD 2 billion in 2003 (around € 1.23 billion), and would require an annual incremental operating cost of AUD 80 million (around € 49 million) per year [94].

USA (Florida): In 2001, it was estimated that total economic costs of the proposed structural separation of BellSouth in Florida would have been USD 1.2 billion, including an estimate for additional costs of structural separation. The study concluded that: "Thus, the cost of structural separation exceeds the supposed benefit of local competition (in Florida, estimated to be as high as USD 248 million per year)" [95].

In summary, an OECD study on structural separation in telecoms notes that "The impact on end-user consumers is uncertain. If competition strengthens significantly, it is possible that prices could fall, with innovation and quality of service improving. But there is inadequate evidence to generate confidence that this would necessarily happen. Prices could also rise significantly" [96].

Moreover, a recent US study examined the issues of separation and monopoly in telecoms by using data from 67 countries that privatised the dominant telephone firm in the period 1984-2003. It found that mandatory vertical separation reduces international telephony usage and the number of fixed lines in service. The study concludes that "monopoly and vertical separation harm those consumers that they were precisely designed to help: the downstream (business) users of international telephony and the upstream users of residential local telephony" [97].

Given this experience and the high level and non revocable intervention involved, very significant benefits of mandated structural separation in terms of gains from achieving equal would have to be demonstrated for it to be a suitable remedy in the telecommunications sector.

c) Functional separation

The risks associated with structural separation in the e-communications sector encourage a search for alternatives ways of correcting persistent discriminatory behaviour. Functional separation would be a less radical intervention but still hold out the prospect of the creating new incentives for access to be supplied on an equal basis to all services operators. Functional separation within an operator entails changes to its organisation and incentive structure, including setting up information barriers between the access and services part of the business, but it does not force the operator to sell off assets.

Functional separation has several advantages: Because it impacts several access markets at the same time, functional separation could address in a single remedy some of the difficulties that arise from compartmentalised analysis of individual markets. It also reduces needs for detailed enforcement of remedies and therefore contributes to better regulation. It has been seen therefore to give greater legal certainty to both incumbent and new market entrants, which can encourage investment in the market.

Functional separation can also help to unblock the problem whereby dominant carriers can delay investments in access upgrades to avoid cannibalising existing downstream revenues, as is the case, for example, with broadband in countries where local loop unbundling is not available on a non-discriminatory basis.

On the other hand, there are risks associated with functional separation: it may reduce incentives for new entrants to invest in alternative local loop infrastructures, and thereby inhibit infrastructure based competition in the access network as all market players would share the same infrastructures under exactly the same conditions. It is not necessarily the case however that functional separation will in itself lead to an under spend on next generation access. In a market driven situation, operators make investment choices based on their evaluation of the evolution of demand on the market. With functional separation, it is the regulator, through controlling the rate of return allowed to the incumbent's access division, who has to balance incentives for investment in new infrastructures against keeping wholesale prices at a competitive level. This means that, depending on the skill of the regulator and the cooperation of the incumbent, functional separation could as easily lead to over as under investment in the infrastructure.

And as in case of structural separation, functional separation may reduce economies of scope or make difficult to coordinate investments.

In the EU, functional separation has been already implemented in the UK, in 2006. BT agreed to implement a functional separation remedy under threat of the UK Competition Commission referral seeking full structural separation through divestiture of the network assets of the BT business. The UK situation, whereby the NRA also acts as NCA (national competition authority) for the sector - with appeal to the Competition Commission – is only present in five EU Member States.

Functional separation in the UK

To implement functional separation, BT set up a division called Openreach charged with freeing up access to BT's local exchanges. This separated the access and non-access (core and retail) services offered by BT without requiring BT to sell its infrastructure to third parties.

The undertakings given by BT [98] to the NRA (Ofcom) devise in particular managerial incentives, which should guarantee non-discriminatory separation of the new division. For example, the management team running Openreach has to be in a separate building from the rest of BT; managerial incentives depend only upon the performance of Openreach, not of BT Group as a whole. There are a number of rules and procedures to prevent the flow of sensitive information from BT Wholesale (including Openreach) to BT Retail. Openreach must provide separate financial statements and regulatory reports, and use the Openreach brand, which must be separated from the rest of BT. These arrangements are monitored by a complaints body called the Equality of Access Board (comprising five members, two from the BT Group and three independent members) [99].

As for costs, BT has reported that the one-off costs of setting up Openreach in 2006 were £ 70 million (around € 103 million) [100], which are an order of magnitude lower than the estimated costs of structural separation cited above. In addition, the Openreach decision is thought to have increased confidence in BT corporation as a whole that has lifted its stock market valuation substantially in the past 2 years. Some analysts suggest that this is because investors are now valuing BT shares in the same terms as utility stocks, which typically trade at much high ratios than mixed service and infrastructure firms.

The UK experience with Openreach is still rather recent and it is too early to assess its final outcome. However, it has been reported that when Openreach went into operation at the beginning of 2006, only 200,000 phone lines had been unbundled in the UK over the years. The number of unbundled lines has grown to over 3.3 million by October 2007 [101].

The functional separation model has lately attracted attention in the other Member States. The Italian NRA (Agcom) is studying the possibility of Telecom Italia separating Telecom Italia’s retail and network operation (Telecom Italia’s network business would be placed into a new unit similar to Openreach). Also the Swedish regulator NRA (PTS) has indicated that in order to increase access to TeliaSonera’s (a Swedish-Finnish incumbent) access network, it sees that ‘”the most suitable model is one based on TeliaSonera being functionally separated” following the Openreach example [102].

Despite these positive early signs from the UK situation, the drawbacks in terms of the level of intervention and the scale of costs involved indicate that it should be reserved for situations where there is an enduring problem of non-price discrimination that cannot be otherwise resolved. This clearly requires a thorough cost benefit assessment. In places such as the Netherlands, where infrastructure competition is highly developed, imposing functional separation on KPN could be disproportionate and could possibly harm infrastructure competition [103]. Similarly, in France where accounting separation and other behavioural remedies backed by effective sanctions seem to have resolved many of the problems of discrimination, functional separation may not even be a consideration [104].

d) Voluntary arrangements of separation

For the operators, there are potential advantages for undergoing some form of ownership separation. For example, it is reported that the Irish incumbent, eircom (which was recently purchased by a private equity fund) is currently considering a voluntary structural separation between retail division (which would be taken over by eircom's employee share ownership trust) and network infrastructure (which would be placed in the equity fund) [105]. This move is expected to increase the overall value of the entity (by better matching assets with investors) as the potentially high-growth retail division would be separated from the more stable and cash-generating wholesale division.

Another example comes outside Europe: in August 2006, Telecom Corp. of New Zealand announced plans to separate its wholesale and retail businesses [106]. However, in September 2007, the New Zealand government ordered Telecom Corp. of New Zealand to split into three operating divisions ( wholesale, retail and network ) [107].

Voluntary arrangements by operators, or between operators and government agencies, are not dependent on the EU framework for implementation. Nevertheless, there is an obligation on the Member States not to act against the provisions of the framework, and so it would be necessary for the Member State to ensure that any undertakings accepted are compatible with the framework.

5.3.2. Option 2 - No regulation: remove or restrict sector-specific regulation ('regulatory holidays')

Option 2 captures two related arguments in favour of the lifting of ex ante regulation in the eCommunications markets. The first argument is based on the inherently deregulatory character of the current framework in that it requires ex ante regulation of markets to be lifted when effective competition has been established. Some stakeholders, particularly incumbents, have argued that the level of competition on the market is now sufficiently stable for a fixed date to be set for the removal of ex ante regulation. This, it is argued, will provide greater regulatory predictability and thus give network operators a clearer financial incentive for investing in new infrastructures.

A second, distinct but parallel argument concerns new generation infrastructures, which are seen as introducing new markets in which first movers have a de facto dominance as a direct result of their investments. This argument, which pleads in favour of "regulatory holidays", argues that such ground-breaking investors should not be disincentivised by being immediately subjected to ex ante regulation.

Assessment of impacts of Option 2

This option sets a clear deadline for the removal of ex ante regulation or exempts certain investments from regulation (at least temporarily). The supporters of this option are mainly incumbent operators who claim that they need a certain period of time without ex ante regulation of next generation infrastructures in order to be able to exploit the 'first mover advantage', which would enable them to recover the high and risky capital expenditure.

It is important to note that removing ex-ante EU telecoms regulation would not mean "no regulation". Investment projects would still be subject to national sector-specific rules, and EU and national competition law, i.e. ex post regulation, would be still applicable.

Instead of progressive deregulation based on how far sustainable competition has been established, the first variant of the option proposes a fixed date for total deregulation. The problem with this approach is that it essentially undermines the pro-competitive intent of the existing regulatory system. Experience shows that competition progresses at different rates in different markets, thus a blanket removal of regulation introduces a strong risk of the reassertion of monopolistic behaviour in those market where an incumbent operator retains its dominant position. This would have a considerable potential impact on the development of sustainable competition and consumer welfare.

As far as the second option – regulatory holidays on new fibre investments - is concerned, there is both empirical and theoretical evidence to call upon. As regards empirical evidence, some market players have supported their claim for 'regulatory holidays' by referring to the US broadband market where regulated access to new fibre investment by telecom operators is the exception, and where – according to this claim – the companies are therefore investing more and there is a faster roll out of high-speed fibre networks (see results from the public consultation in Chapter 5.5).

However, as regards penetration rates, it has already been demonstrated above that broadband take-up in the EU - especially in the best performing Member States - is now faster than in the USA. As regards speed, the US market dynamics are different mainly due to the widespread infrastructural competition between cable and telecommunications networks which is driving fibre investment figures above that of the EU.

As already noted in the first IA report of June 2006, relatively few US subscribers use DSL (Digital Subscriber Line) technology and the telecommunication companies are the minority player in the broadband market, which is dominated by cable (TV) companies (Figure 8). The greater local loop length in the US means that the copper telecommunications network cannot support very high speeds, and therefore the US telecom companies are forced to invest in fibre if they want to catch-up with a strong cable sector, which has been offering high bandwidth in the big cities for several years.

Figure 8. DSL and cable markets shares in the USA and the EU

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Source: OECD, European Commission

The above figure also illustrates the reason why the regulatory approaches to broadband are different in the EU and US. The advanced infrastructural competition in the US led the Federal Communications Committee (FCC) to decide not to apply the unbundling provisions of the US Communication Act of 1996 to the broadband markets, relying predominately on inter platform competition between the telecom (xDSL) and the TV-cable networks [108].

The US experience does lend some plausibility to the argument that a "regulatory holiday" where there is infrastructural competition will stimulate investment in new networks. However, in the EU given the different network geographies, it cannot be assumed that this will result directly in massive fibre investments. Moreover, there are indications that the US regulatory approach to rely solely on infrastructure competition might be detrimental to consumer choice. The lack of access competition on the 'last mile' means that consumers are only offered what the "cable and telephone broadband duopoly" provide [109]. This issue is closely linked to the US debate on "net neutrality", which is further discussed in Chapter 7.

5.3.3. Option 3 - No change to the regulatory framework: maintain the current model

As described above, the current framework is based on regulation of markets. This market based approach is a response to convergence; it allows inter-platform competition to be fully taken into account, and avoids technology-specific regulation. The same regulatory principles apply regardless of which kind of existing or potentially new technology is involved. Regulation must be lifted when there is effective competition.

This option therefore implies that ex ante regulation should not be removed “en bloc” but progressively as an outcome of market analysis by the NRAs and revision of the list of relevant markets (of the Commission Recommendation) by the Commission, as competition becomes effective in these markets.

Assessment of impacts of Option 3

Maintaining the current regulatory framework (Option 3) provides continuity and the opportunity to build on existing achievements. The attraction of the current system is that it provides a consistent regulatory framework, but national regulators still have sufficient flexibility and possibility to design their interventions to suit the realities of the markets - including unbundling and wholesale broadband access markets - in each Member State. In essence, the NRAs have the flexibility to introduce measures to foster both infrastructure and service-based competition.

The recent market data provides evidence on the effects of option 3, by examining the results achieved so far under the current framework. As noted above, competition in broadband can be measured both at the infrastructure (local loop unbundling + other technologies, mainly cable modem) and at the service level (bitstream and resale of DSL lines). Take-up in the EU has been particularly strong in those countries where infrastructure-based competition has been effective, which allows consumers to choose between different modes of broadband access.

Thus, all leading Member States in terms of penetration, notably the Netherlands, Denmark, Finland and Sweden (see below figure), have also a high roll-out of cable and have arrangements in place which allow alternative operators to gain access to the existing telecoms networks [110].

Figure 9. Broadband penetration rate in the EU, July 2006-2007

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Source: Communications Committee Working Document, COCOM07-50 FINAL, 15 October 2007

Effective market regulation permitting access to the incumbent's infrastructure also stimulates competition, and decisive regulatory action for example in France and the United Kingdom, has clearly been important. As a consequence, France has now one of the highest broadband penetration rates based on service-based competition. Also other Member States have significant service-based competition, generally based on full or shared local loop unbundling. In these countries alternative operators hold significant parts of the ADSL market (e.g. UK, Germany, Sweden, Finland and Austria) [111].

As can be seen from the figure below, there has been also a move from resale to local loop unbundling and shared access, which are crucial for the competitive supply of triple play services.

Figure 10. New entrants' DSL lines by access type, Jan 2004 – Jan 2007, EU 25

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Source: Commission services

In January 2007 there were more than 5.6 million unbundled local loops (LLU) lines compared to January 2006. This can be seen as a positive structural change as the alternative operators are replacing bitstream wholesale access with fully unbundled or shared access lines. Successful wholesale access regulation has also contributed to the strong growth of resale, which grew by 3.5 million lines in 2006, as low entry barriers allow potential market players (who usually have low investment incentive) to enter the market.

It can therefore be observed that that from 2003 to early 2007, there has been a gradual but steady development of infrastructure-based competition. In 2006 alternative providers continued to 'climb the ladder of investment' with more than 4.1 million new fully unbundled local loops (up by 79% from 2005), investing in the process several billion euros into new infrastructure. On average, new entrants now have 52% of the EU market (if resale products are excluded, new entrants have market share of 40.7%). In some countries (e.g. Italy, UK and Spain), the rollout of own networks by the alternative operators has started to emerge [112].

As regards next generation network investments, guidance provided by the ERG could help to provide operators contemplating new investments to know how NRAs will apply the framework and which obligations they might apply in specific circumstances [113]. For example, NRAs can adapt the remedies to take account of the main costs of upgrading the local access network, which are usually not the costs of the fibre itself, but the costs associated with civil engineering works, i.e. the time it takes to be granted rights of way and to dig up roads and pavements to lay ducts.

In this regard, it is worth noting that duct sharing or joint duct usage would drastically reduce the costs for the roll out of parallel cable or fibre networks, thereby facilitating infrastructure based competition. It is already the case that NRAs can under the framework adapt remedies to facilitate sharing of passive infrastructures (ducts, inspection chambers, street cabinets, etc). Indeed, in one Member State duct sharing has been already imposed on the incumbent. The practical feasibility of this approach, however, varies considerably from place to place. For example, duct sharing appears to be feasible in greenfield situations where ducts have been installed relatively recently and are not congested [114].

As regards existing ducts there is no overall picture of the level of congestion and the physical condition in the EU, although it can be assumed from their age that many will be in poor shape and it is estimated that about 50% of local loops are buried directly in the ground. Passive infrastructure sharing in the EU therefore, while attractive in principle, requires a detailed local mapping of local loop networks to gauge its practicability.

5.4. Results of the public consultation

In general, the public consultation showed support for the current model of the framework that was seen to promote competition and investment. Especially new entrants saw that effective pro-competitive ex ante regulation and open access provisions on incumbents' networks are strongly correlated with increased investment and innovation [115].

As for the alternative options, only a limited number of stakeholders expressed their views. The new entrants and the European Regulatory Group as well as couple of Member States supported 'open access model' in its more limited form, i.e. functional separation. However, operators generally saw that this should be based on voluntary action. Several Member States preferred no change, whereas incumbents were clearly against forced structural or functional separation.

Critics of the current approach, in most cases the incumbent operators, argued that the framework does not promote future investment and innovation. Reference was made specifically to the NGNs, which in their opinion merit regulatory forbearance, as they should be considered new investments and therefore be treated as new and emerging markets. The argument is based on the fact that developing new consumer applications and video services will require more bandwidth than ADSL can provide and investment in high speed NGN access technologies of the FTTx [116] type is therefore necessary if Europe does not want to be left behind [117]. Deregulation of the US broadband market was brought up as an argument against the EU regulatory approach, and predictions of faster fibre roll out in the US were presented as evidence supporting the claim for 'regulatory holidays' [118]. Alternative operators were strongly against such approaches as they fear that their investments in core networks will be threatened if incumbents re-exert their monopoly power over local access.

5.5. Comparison of options and impacts

Option 1

Option 1 ('open access model') implies mandated vertical separation between infrastructure provision and service provision, and represents a major intervention into the property rights of firms

The evidence examined above suggests that in the telecommunication sector, the benefits of structural separation - in terms of a once-and-for-all regulatory solution to access discrimination - would be quite difficult to justify against the costs, in view of the high one-off costs to implement the split, the loss of economies of scope and increased difficulties of coordinating investment and innovations between services and the unbundled network operations.

In addition, as regards investments in next generation networks, the largest part of the potential reward for taking the risk of investing in these new networks would accrue to external service providers rather than an internal services division. Only direct regulatory incentives for the network operator (in the form of guaranteed rates of return) might overcome the reluctance of a separated access provider to make such investments, which then puts the burden of determining the pace of innovation onto the regulator rather than the market.

This problem is mitigated under the functional separation model. By maintaining common ownership of the two business divisions, the investment incentives and market signals are preserved to a large extent - even though co-ordination problems may still arise - whilst also increasing the incentive to behave in a non-discriminatory manner. Moreover, regulatory action can be taken to incentivise investments in the local loop. This is functional separation's biggest advantage over structural separation, and the primary reason why the stakeholders in the public consultation has suggested functional separation as a possible remedy and not divestiture.

Functional separation could serve to make competition more effective in a service-based competition environment where infrastructure-based competition is not expected to develop in a reasonable period. As a regulatory measure, it might be warranted when there are systematic market power problems identified across a number of markets (rather than on an individual market). It could therefore be considered when all other regulatory tools have proved inadequate to address market and competition failures.

However, there is a risk that different national approaches to functional separation could fragment the internal market and hinder both competition and investment. Setting common EU criteria for the implementation of functional separation would therefore improve legal consistency and certainty in the sector, thereby contributing to better regulation (note that regulatory consistency is further discussed in Chapter 7). In particular, the common conditions should not prevent appropriate investment co-ordination mechanisms between the different separate business entities in order to ensure that the economic and management supervision rights of the parent company are protected.

Moreover, the costs and benefits of functional separation, and therefore the desirability of imposing such a solution, depend on national circumstances. Before implementing this remedy, the national regulatory authority would need to undertake a detailed cost-benefit analysis and demonstrate that the proposed measure met the set criteria.

The remaining risk is that access infrastructure competition is weakened under functional separation (since competi