REVIEW OF PRICE CONTROLARRANGEMENTS

An ACCC Report

February 2001

CONTENTS

EXECUTIVE SUMMARY I

BACKGROUND ICONDUCT OF THE REVIEW II

ANALYTICAL FRAMEWORK IICONCLUSIONS VIRECOMMENDATIONS XIII

CHAPTER 1 INTRODUCTION 1

CHAPTER 2 BROAD GOALS OF THE PRICE CONTROL ARRANGEMENTS 3

2.1 PREVIOUS GOVERNMENT STATEMENT 32.2 DCITA DISCUSSION PAPER 42.3 THE TERMS OF REFERENCE FOR THIS REVIEW 42.4 COMMISSION VIEW 4

CHAPTER 3 THE PRICE CONTROL ARRANGEMENTS 6

3.1 CURRENT PRICE CONTROL ARRANGEMENTS THAT ARE THE SUBJECT OF THIS REVIEW 63.2 OTHER RELEVANT CONTROLS ON TELSTRA’S PRICING 73.3 HISTORY OF THE PRICE CONTROL ARRANGEMENTS 73.4 PRICE CAP REDUCTIONS 8

CHAPTER 4 STATE OF COMPETITION IN PRICE CONTROLLED MARKETS 11

4.1 INTRODUCTION 114.2 MEASURES OF EFFECTIVE COMPETITION 114.3 THE STATE OF COMPETITION IN THE MARKETS COVERED BY PRICE CONTROL ARRANGEMENTS 164.4 CONCLUSIONS AND IMPLICATIONS FOR PRICE CONTROL ARRANGEMENTS 26

CHAPTER 5 EFFICIENCY – MAKING THE COMMUNITY AS A WHOLE BETTER-OFF 27

5.1 INTRODUCTION 275.2 THE EFFICIENCY RATIONALE FOR PRICE CONTROL ARRANGEMENTS 285.3 THE ALLOCATIVE EFFICIENCY PROPERTIES OF A BROAD CPI – X PER CENT PRICE CAP 305.4 PRINCIPLES IN MEASURING ALLOCATIVE EFFICIENCY GAINS 325.5 ALLOCATIVE EFFICIENCY GAINS UNDER ALTERNATIVE PRICE CONTROL ARRANGEMENTS 355.6 PROBLEMS WITH USING CURRENT -PERIOD (“ANTICIPATED”) REVENUE WEIGHTS 505.7 ALLOCATIVE EFFICIENCY CONSEQUENCES OF THE LOCAL CALL PARITY PRICE CONTROL 515.8 CONCLUSIONS 54

CHAPTER 6 THE APPROPRIATE LEVEL OF “X” 55

6.1 INTRODUCTION 556.2 PRINCIPLES FOR DETERMINING THE VALUE OF X 556.3 ESTIMATES OF WHOLE-OF-TELSTRA TFP GROWTH 576.4 ESTIMATES OF PSTN-SPECIFIC TFP GROWTH 586.5 BENCHMARKING 616.6 COMMISSION’S VIEW ON THE VALUE OF X 626.7 THE PRICE INDEX 636.8 THE PRICE CAP PERIOD 646.9 THE CARRY OVER PROVISIONS 646.10 CONCLUSIONS 65

CHAPTER 7 CONSUMERS, INVESTMENT AND CONSUMERS 66

7.1 FACTORS AFFECTING COMPETITION, INVESTMENT AND CONSUMERS IN THE AUSTRALIANTELECOMMUNICATIONS MARKET 667.2. THE IMPACT OF RETAIL PRICE CONTROL ARRANGEMENTS ON COMPETITION, INVESTMENT ANDCONSUMERS 677.3. LINE RENTAL 747.4. LOCAL CALL PRICE PARITY 88

7.5 CONCLUSIONS 91

CHAPTER 8 DISTRIBUTIONAL IMPACTS OF ALTERNATIVE PRICE CONTROLARRANGEMENTS 92

8.1 INTRODUCTION 928.2 ALTERNATIVE PRICE CONTROL ARRANGEMENTS 928.3 METHODOLOGY FOR DETERMINING DISTRIBUTIONAL IMPACTS OF CHANGES TO THE PRICECONTROL ARRANGEMENTS 938.4 DISTRIBUTIONAL IMPACT OF THE REMOVAL OF SUB-CAP ARRANGEMENTS 968.5 DISTRIBUTIONAL IMPACT OF THE REMOVAL OF THE LOCAL CALL PARITY REQUIREMENT 1068.6 CONCLUSIONS 108

CHAPTER 9 OPTIONS FO R COMPENSATING DISADVANTAGED CONSUMERS 110

9.1 INTRODUCTION 1109.2 SOCIAL OBJECTIVES OF THE PRICE CONTROL ARRANGEMENTS 1109.3 EXISTING POLICIES AIMED AT DISADVANTAGED USERS OF TELECOMMUNICATIONS SERVICES 1119.4 THE ADJUSTMENT PERIOD ALLOWED FOR INCREASES IN RESIDENTIAL LINE RENTALS 1169.5 OPTIONS FOR NEW COMPENSATION ARRANGEMENTS 1189.6 FUNDING INHERENT IN PRICING STRUCTURES 1239.7 FUNDING BY GENERAL TAXATION 1269.8 FUNDING BY INDUSTRY LEVY 1289.9 ADMINISTRATIVE AND TRANSPARENCY ISSUES 1309.10 CONCLUSIONS 131

CHAPTER 10 CONCLUSIONS 133

OBJECTIVES 133INCREASING EFFICIENCY – MAKING THE COMMUNITY AS A WHOLE BETTER OFF 133AMELIORATING THE POTENTIAL ADVERSE IMPACTS OF CHANGES TO THE PRICE CONTROL

ARRANGEMENTS 138

APPENDIX A: SUMMARY OF TERMS OF REFERENCE 143

APPENDIX B: SUMMARY OF RELEVANT PRICE CONTROL ARRANGEMENTS 145

APPENDIX C: LIST OF SUBMISSIONS 147

SUBMISSIONS ON THE DISCUSSION PAPER 147SUBMISSIONS ON THE DRAFT REPORT 147

APPENDIX D PUBLIC HEARINGS 148

HEARING LOCATIONS 148HEARING ATTENDEES 148

APPENDIX E: HISTORY OF THE PRICE CONTROL ARRANGEMENTS 150

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Executive Summary

Background

The Minister for Communications, Information Technology and the Arts has directedthe Commission under Division 3 of Part 25 of the Telecommunications Act 1997 (theAct) to undertake a review of the Telstra price control arrangements which theCommission administers, and to report by 14 February 2001.

The Ministerial direction requires the Commission to hold a public inquiry into:

§ whether there is a need for price control arrangements to continue after theexpiry of the current Determination; 1 and

§ if there is a continuing need for price control arrangements, the nature of suchfuture arrangements, including their duration, means of implementation andmechanisms for review.

In addressing these questions, the terms of reference also require the Commission tohave regard to a series of considerations. These are included, along with the full termsof reference, at Appendix A to this report.

Price control arrangements of the form spelt out in the Determination were firstintroduced in 1989. Since that time, Telstra (or its predecessors, Telecom and theOverseas Telecommunications Corporation (OTC)) has been subject to price controlarrangements on a range of telephony and data services.

Since introduction of the price control arrangements, the Government has conductedperiodic reviews, with the most recent review being in 1998. These reviews haveproven necessary as the telecommunications industry has gone through a number ofchanges since 1989. In particular, the telecommunications market has evolved fromone that was supplied by two government-owned monopolists (i.e. Telecom and OTC),to one that is now serviced by a number of carriage service providers.

Generally, the current set of price control arrangements run from July 1999 to June2001.2 Broadly, the price control arrangements have two major components. The firstcomponent is a CPI – X per cent price cap on a broad range of telecommunicationsservices, including among others, local call, line rental, mobile, STD and IDD services.The “X” factor is currently set at 5.5 per cent per annum. The second component is a

1 The current Determination is the Telstra Carrier Charges – Price Control Arrangements,Notification and Disallowance Determination No. 1 of 2000 made under the Telecommunications(Consumer Protection and Service Standards) Act 1999.

2 Strictly, the current set of price control arrangements were introduced in July 2000, when a numberof amendments were made to the previous set of price control arrangements which had operatedfrom July 1999 to June 2000. However, the broad structure of the current price controlarrangements is similar to that which operated over the July 1999 to June 2000 period.

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number of “sub-caps” on particular services in the broad basket. These include a 22cent price cap on local calls, a CPI – 0 per cent price cap on a basket of local calls andline rentals (with a similar cap for connections), and a requirement for local callcharges to be broadly the same for both metropolitan and non-metropolitan consumers.There are also further sub-caps relating to “low-spend” consumers. A summary of thecurrent price control arrangements that the Commission believes are relevant to thisreview is included in Appendix B.

Conduct of the review

The Commission commenced its inquiry in September 2000, and released a discussionpaper on 29 September 2000.

Submissions on the discussion paper, or any other matter relevant to the price controlarrangements, were sought by 31 October 2000. Fifteen submissions were received.Submissions came from a diverse range of interest groups, includingtelecommunications carriers, telecommunications consumer groups, regional councilsand the general public. A full list of these submissions is provided at Appendix C tothis report.

Following receipt of submissions, the Commission conducted a series of publichearings in early to mid-November 2000. The hearings were held in twelve locationsaround the country, including several regional locations. A list of the hearing locationsand the parties that attended can be found in Appendix D.

In order to facilitate further discussion by interested parties, the Commission issued aDraft Report identifying a set of draft recommendations on 22 December 2000.Submissions on the Draft Report were sought by 15 January 2001. In response to theDraft Report, the Commission received seven submissions from interested parties. Afull list of these submissions can be found at Appendix C of this report.

Analytical framework

In preparing this report, the Commission has sought to answer a number of importantquestions about the price control arrangements. These questions have been derivedfrom the terms of reference and are directed at contributing to an understanding of thebroader questions of whether the price control arrangements should continue, and, if so,in what form. The following outline provides an overview of the questions and howthe Commission has answered them.

Objectives (Chapter 2)

The Commission has sought to gain a detailed understanding of the objectives of theprice control arrangements. This is considered fundamental to answering the initialquestion of whether the price control arrangements should continue. The Commissionconsiders that continuation of the controls would require evidence that the price controlarrangements could continue to achieve, or in the future will achieve, these objectives.

In this regard, the Commission believes it is reasonably clear that the current pricecontrol arrangements are geared towards making the community as a whole better-off

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while ameliorating any adverse impacts on particular groups of consumers.Accordingly, the Commission has considered a number of questions that go towardsdetermining whether future price control arrangements would meet these objectives.

Competition (Chapter 4)

Analysis of the objectives of the price control arrangements suggests that they were, inpart, predicated on the assumption that price control arrangements were needed to helpthe prices of telecommunications services move closer to those expected in competitivemarkets. This suggests that if developments in price-controlled markets result incompetition becoming effective, then an important part of the rationale for continuationof price controls is removed. Consequently, this chapter considers the effectiveness ofcompetition in the price-controlled markets.

In order to assess the current state of competition in each of the price-controlledmarkets, this section of the report:

§ reviews the ways in which the effectiveness of competition intelecommunications markets can be assessed;

§ assesses the state of competition in those markets; and

§ provides conclusions about the state of competition in those markets and theimplications for decisions regarding future price control arrangements.

Increasing efficiency – Making the community as a whole better-off(Chapters 5 - 7)

One of the clear objectives of the price control arrangements is to ensure pricing andproduction of telecommunications services will make the community as a whole better-off. Where this occurs, one could say that the pricing and production oftelecommunications services is more efficient. Consequently, the Commission isdirected in the terms of reference for this review to consider the efficiency gains thatmight occur under alternative sets of price control arrangements. In addition, theCommission must consider the impacts of alternative price control arrangements oncompetition, investment and on the availability, choice and prices of services toconsumers.

The three chapters that deal with this issue consider the following questions:

§ how can price controls be designed such that they generate the greatest benefitto the community as a whole (chapter 5);

§ assuming some form of CPI – X per cent price capping arrangement shouldcontinue in future price control arrangements, what X value is appropriate andfor what time period it should apply (chapter 6); and

§ how the price control arrangements affect competition, investment andconsumer choice, especially in light of the existence of access regulation setout in Part XIC of the Trade Practices Act 1974 (chapter 7).

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In addressing the first question, the Commission is directed to consider, in the terms ofreference, the extent to which efficiency could be achieved with and without the pricecontrol arrangements. In order to assess the impacts of alternative price controlarrangements on the welfare of the community as a whole – and, in particular, howpricing of telecommunications services will allow consumers to consume more of thetelecommunications services that provide them with the greatest overall benefit –possible under alternative price control arrangements, Chapter 5:

§ outlines how price control arrangements improve the welfare of thecommunity as a whole;

§ considers estimates of the extent to which alternative price controlarrangements will improve the welfare of the community as a whole; and

§ considers how the local call parity requirement might impact on the welfare ofthe community as a whole.

In answering what form any future price control arrangements should take, theCommission notes that a CPI – X per cent price cap on a broad range oftelecommunications services has been an important feature of the arrangements sincetheir introduction in 1989. Assuming that a price cap of some form is retained in futureprice control arrangements, Chapter 6 of the report addresses important decisions in theoperation of the price cap, including decisions behind the choice of X. In this regard,Chapter 6 considers a number of different approaches that could be taken to assist indetermining an appropriate level of X. These approaches include estimating expectedproductivity gains for Telstra as whole, and specifically for those services included inthe broad CPI – X per cent price cap, as well as benchmarking against othertelecommunications carriers in other countries. Chapter 6 reaches a number ofconclusions, not just on the level of X, but also on other important aspects of the designof CPI – X per cent price caps.

The terms of reference also direct the Commission to look at how the price controlarrangements affect competition (and the future development of competition),investment, and the availability, choice and prices of services to consumers. Theseissues are examined in Chapter 7 of the report.

The Commission’s approach to developing an understanding of how the retail pricecontrol arrangements impact on these terms of reference is built on exploring how theretail price control arrangements interact with other aspects of regulation, particular theaccess regime under part XIC of the Trade Practices Act.

The first issue considered is identification of the main factors affecting competition,investment and consumers in Australian telecommunications markets. Then the reportconsiders the ways in which the current price control arrangements could harm thedevelopment of competition, efficient investment and consumer welfare in thosemarkets. Detailed analysis is then presented regarding the impact of the retail pricecontrol arrangements on the markets in which two fundamental telecommunicationsservices – line rental and local calls – are supplied.

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Achieving equity - ameliorating potential adverse impacts on particular groups ofconsumers (Chapters 8 - 9)

Previous and existing price control arrangements appear concerned to amelioratepotential adverse impacts of price control arrangements on particular groups ofconsumers. Thus, while changes to the price control arrangements may ensure thataverage price levels fall over time, they also allow flexibility for some prices to risewhile others fall. As a consequence, while consumers on average will benefit, someconsumers could be worse-off.

The terms of reference require consideration of the distributional impacts of changes tothe price control arrangements, and the most appropriate means with which to promoteefficient and equitable pricing outcomes.

Consequently, the important questions that are considered in these sections of the reportare as follows:

§ how will changes to the current price control arrangements impact on differenttypes of consumers (that is, low and high income consumers, metropolitan andnon-metropolitan consumers, and residential and business consumers)(Chapter 8); and

§ what options are available for compensating consumers who may bedisadvantaged under alternative price control arrangements (Chapter 9)?

In order to address the first of these questions, the Commission engaged the NationalCentre for Social and Economic Modelling (NATSEM) to help develop an approachfor estimating the impact of changes to the price control arrangements on differentgroups of consumers. The approach devised involved two stages. The first stage,undertaken by NATSEM, involved estimating current expenditure profiles for differentgroups of consumers of certain telecommunications services. The second stage of thedistributional impact analysis, undertaken by Commission, involves estimating changesin the welfare of different groups of consumers under alternative sets of price controlarrangements.

To assess the different options available for compensating potentially disadvantagedconsumers, the Commission applied the following criteria:

§ the effectiveness of policies in targeting assistance to people in need, andavoiding assistance to those who are not;

§ the achievement of horizontal and vertical equity in the funding of theassistance;3

§ the minimisation of adverse flow-on impacts in other parts of the economy;

§ the minimisation of administrative costs; and

3 see page 111 of the report for a definition of these terms.

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§ the extent to which the assistance is transparent to those who fund and receivethe assistance.

These criteria are applied to the existing controls, and to other more directly targetedpolicies. In this regard, the Commission has also considered a number of alternativepolicies that could be considered for achieving alternative equity policy objectives.

Conclusions

The analysis described above has formed the basis for a number of conclusions on thefuture scope for, and form of, price control arrangements. For the sake of exposition,these conclusions are divided between those that would enhance the welfare of theeconomy as a whole, and those that would help ameliorate the adverse impacts onparticular groups of consumers.

Conclusions regarding making the community as a whole better-off

The Commission’s analysis leads to five broad conclusions:

1. Competition is still not sufficiently developed in all telecommunicationsmarkets to warrant the full removal of price control arrangements.

The Commission has analysed the state of competition in each of theprice-controlled markets in order to determine the effectiveness of current levels ofcompetition for producing efficient market outcomes. Measures of competitioninvolve both market structure and market performance indicators, includingconcentration ratios, firm dominance and consideration of natural monopolyfeatures.

The analysis finds that, although competition has developed to some extent over thepast few years, the majority of the price-controlled markets are still not subject toeffective competition. In this regard, the analysis finds that Telstra still faces littlecompetition in the market in which line rental services are supplied and only limitedcompetition in respect of local calls. Competition for both national long-distanceand international calls remains less effective than a cursory inspection mightindicate, with Telstra retaining a high market share in each and prices stillseemingly well above efficient costs. In this regard, the Commission notes that asimilar conclusion with regard to national long-distance and international calls hasrecently been made by the telecommunications regulator in the United Kingdom(the Office of Telecommunications – Oftel) in deciding to keep these servicessubject to retail price regulation.

While market shares are more dispersed in the market for mobile services, there isstill a concern about market power and high prices in fixed-to-mobile services. TheCommission considers that the markets for leased lines have become morecompetitive in recent times due to rapid technological progress in the transmissionof large amounts of voice and data.

Further, any case for the removal of price control arrangements in the national long-distance and international calls, as supported by some carriers, rests on the strength

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of the access regime in Part XIC of the Trade Practices Act as Telstra still hascontrol over essential inputs to these services. Without a well-developed accessregime, Telstra’s control of the customer access network could weaken competitionin these markets considerably.

2. The welfare of the community as a whole is best improved with a broad pricecap applying to all price controlled services and the removal of a number ofexisting sub-caps from the current price control arrangements

Broad price caps of a CPI – X per cent variety provide incentives for efficiency inthree main ways:

§ they can help ensure Telstra does not price too far in excess of costs inmarkets where it has market power;

§ they can provide firms with an incentive to seek cost savings in excess ofthose needed to reduce the price of services by X per cent per annum; and

§ they give Telstra the freedom to structure its prices so as to recovercommon costs in the most efficient way.

Further, the Commission’s analysis indicates that the welfare of the community as awhole is best achieved by removing any other sub-caps on individual services orgroups of services. This is because sub-caps limit the extent to which Telstra canrebalance its prices towards costs.

In this regard, the Commission believes that whilst the welfare of the community asa whole could be improved under the current set of price control arrangements,further gains would be achieved if the Government removed certain sub-caparrangements such as: the CPI – 0 per cent sub-cap on line rentals and local calls;the CPI – 0 per cent sub-cap on connection services; and the CPI – 1 per cent sub-cap on a basket of services for the lowest 50 per cent spend consumers.

In order to assess the extent to which the community as a whole could be madebetter-off under the set of price controls recommended in this report, theCommission engaged Access Economics to help develop a model for assessinggains under alternative price control arrangements. The Commission has thenapplied this model to estimate the extent to which the community as a whole couldbe better-off under different price control arrangements.

The Commission estimates that if the set of price control arrangementsrecommended in this report were adopted, consumers could potentially experience again in welfare equal to approximately $376 million in the first year of the pricecontrol arrangements, with additional, albeit slightly smaller, gains in followingyears. These calculations assume a CPI – 5 per cent price control on a broad basketof services that the Commission recommends should continue to be subject to pricecontrol arrangements. Whilst Telstra’s profits would be reduced under thisscenario, the community as a whole could still gain by as much as $139 million inthe first year.

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This gain is primarily because the price of national long-distance, internationallong-distance and fixed-to-mobile services will be driven closer to costs, therebyproviding cost savings to those consumers already purchasing these services, andenabling these and other consumers to afford more of these services. While it istrue the price of line rental could rise under the set of price control arrangementsrecommended in this report, the cost to consumers of this price rise is expected, onaverage, to be overwhelmed by the reduction in prices of other services.

Hence, the analysis shows that the community as a whole will be better off byretaining a single broad price cap on all price-controlled services, while removingany other sub-caps on individual services or groups of services. The Commissionnotes, however, that there are also equity objectives that need to be taken intoaccount in deciding whether some of these sub-caps should be retained.

On a related matter, estimates provided to the Commission by Telstra suggest thecost of providing local calls varies substantially according to the geographic area inwhich these calls are made. Whilst the Commission has not conducted a study intothe cost of providing local calls in different geographic areas, the relative costdisparities suggested in Telstra’s analysis are not inconsistent with market inquiriesmade by the Commission in this regard.

Given the disparity between costs in rural and metropolitan areas, removal of thelocal call parity requirement, which requires the price of local calls in rural areas tobe broadly the same as those in metropolitan areas, would be expected to generatebenefits for the community as a whole. Whilst the size of the immediate gains ishard to specify, tentative analysis by the Commission suggests these could bebetween $9 and $19 million per annum. Accordingly, these gains are likely to beconsiderably less than those that would accrue from the removal of the sub-capsoutlined above. The Commission believes, however, that there would potentiallybe substantial additional benefits from the removal of the local call parityrequirement for rural consumers in the form of increased competition, investmentand consumer choice in rural areas. This is discussed in more detail below.

3. The long-term benefit to consumers will be enhanced by the removal of certainprice control arrangements, as current arrangements may be inconsistent withthe development of competition, efficient investment and consumer choice

The Government has implemented a range of pro-competitive structural andregulatory reforms in recent years aimed at increasing competition intelecommunications markets and providing an increase in the choice of servicesavailable to consumers.

While price control arrangements can help protect consumers during the transitionfrom monopoly to competition, there is also a danger they can inhibit thedevelopment of competition, efficient investment and the long-term benefits ofconsumers – especially if they are not implemented consistently withpro-competitive reforms.

In this regard, analysis suggests that the sub-caps, which restrict the ability ofTelstra to raise the price of line rental towards cost, have had significant impacts on

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the development of competition and the efficient operation of the access regime as aresult of the consequent access deficit. For instance, the inclusion of an accessdeficit contribution4 in wholesale charges, which forces the price of someinterconnection services above efficient levels, may be deterring investment thatwould otherwise be economic.

Accordingly, the analysis finds that there is considerable scope for the price controlarrangements to hamper the competitive developments expected to unfold over thenext few years. Changes to the price control arrangements that will allow the priceof services to begin moving closer towards costs are considered to be an extremelyimportant objective for the next period of price control arrangements. Thisconclusion further supports the view that sub-caps should be removed in order togive Telstra the incentive to efficiently restructure its prices for price-controlledservices.

Further, the removal of the local call parity requirement also has the potential tounlock much larger longer-term dynamic efficiency gains for consumers in allregions of Australia. In this regard, the Commission’s analysis finds that theremoval of the local call parity requirement has the potential to enhance thedevelopment of desirable competition and efficient investment in the local callmarket in both rural and metropolitan parts of the country. That is, removal of thelocal call parity requirement, which forces Telstra to price below cost in rural areas,has the potential to increase investment and the development of competition in ruralmarkets. In turn, this has the potential to improve the range of services andtherefore consumer choice available to rural consumers.

The impact of price controls on rural users is considered further below.

4. The appropriate X factor in a price cap needs to consider both Telstra’sexpected productivity growth as well as its existing productivity level

Telstra is expected to continue to achieve considerable gains in productivity – andhence cost savings - over the next few years, and the Commission considers theseshould form the basis of the X factor in the broad price cap. It is also consideredthat some account should be taken of yardsticks for benchmarking cost reductiontargets, including productivity levels achieved by carriers in other countries, and theproductivity growth achieved in the economy as a whole. In this regard, theCommission notes there is a range of methods for estimating TFP growth rates andfor benchmarking Telstra’s productivity against that achieved by carriers in othercountries. This makes estimation of an exact level of X for future price capsparticularly difficult. However, based on a range factors – including an estimate ofthe expected total factor productivity (TFP) growth of the PSTN – the Commissionbelieves that a value of X in the order of 5 per cent per annum is reasonable for thenext period of price control arrangements.

4 The access deficit contribution (ADC) is a wholesale charge levied by Telstra to recover the lossesfrom providing line rental at below cost.

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The Commission also considers that the choice of duration of the price controlarrangements is an important consideration when determining the form a CPI – Xper cent price cap should take. In particular, the longer the period over which aCPI – X per cent price cap will apply, the greater the incentive to reduce costs inexcess of those needed to meet the CPI – X requirement. That said, a shorterduration for the price control arrangements may be needed in light of the speed oftechnological change and advance of competitive forces in telecommunicationsmarkets.

5. Revenue weights used to determine whether Telstra complies with a broadCPI – X per cent price cap should be based on previous period revenue levels.

Under the current price control arrangements, the revenue weights used to measurewhether Telstra has complied with its price control obligations are determined withreference to revenue levels in the current price control period.

The Commission believes, however, that there are strong theoretical and practicalreasons for basing revenue weights on revenue Telstra earns in the previous period.The Commission believes this will provide Telstra with the appropriate incentive torebalance its prices in a way that makes the community as a whole better-off.

Conclusions regarding means to ameliorate the potential adverse impacts ofchanges to the price control arrangements

As indicated above, it is clear that the price controls are also aimed at ameliorating thepotential adverse impacts on particular groups of consumers as a result of changes toprices. In order to determine what form price control arrangements should take if theyare to achieve this, the Commission has had to infer which particular groups ofconsumers should be the focus of analysis. In this regard, the terms of reference askthe Commission to have regard to the impacts of price control changes on low-incomeconsumers, different types of household and business consumers, and those fromdifferent geographic areas. For the purposes of simplicity, therefore, the Commissionhas identified low income and rural consumers as the two main groups to be the focusof these considerations.

The current price control arrangements are then assessed with respect to how well theyachieve these objectives. The Commission’s analysis makes the following sevenconclusions:

1. The current price control arrangements appear to be not well targetedtowards protecting low-income consumers

An important conclusion from the Commission’s analysis is that the targeting ofassistance usually involves the provision of assistance to people who are in needand the avoidance of provision to those who are not. Analysis by the Commissionfinds that the current price control arrangements do not appear to be well targeted –especially with regard to low-income consumers. This is because low-incomeconsumers appear to be targeted by price control arrangements that protect low-usage consumers. Although low-usage does have some correlation with lowerlevels of income, there are many reasons to believe that some wealthier consumersmay also have low usage of those services included in the price control baskets.

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For instance, a wealthy person owning a holiday home is likely to receiveprotection under the current price control arrangements from increases in telephonyprices if s/he spends little time at the holiday home throughout the year. Bycontrast, a poor consumer with relatives inter-state or overseas may use a largenumber of telecommunications services such as STD and IDD calls.

2. There is potential for measures aimed at ameliorating the adverse impacts onparticular groups of consumers to conflict under the current price controlarrangements

Under the current price control arrangements, there is scope for conflict betweenmeasures geared towards assisting low-income and rural consumers. For instance,the local call parity requirement means that low-income metropolitan consumers oflocal calls may cross-subsidise wealthy rural local-call consumers.

3. The current price control arrangements can create inefficient incentives

As indicated above, sub-caps and the local call parity requirement compromiseefficient pricing of telecommunications services. In turn, this can lead to outcomesthat are not in the interests of those people whom the price control arrangementsseek to protect, such as the local call parity requirement which may limitinvestment in local call services in rural areas. That is, if, as indicated above, thelocal call parity requirement leads to the price of local calls being set below theircost in rural and regional areas, this will deter investors in these areas as they willbe unable both to recover their costs and compete with Telstra’s prices in theseareas. Whilst this may provide a short-term benefit to rural consumers in the formof lower local call prices, it could potentially lead to longer-term losses as it maydeter the development of competition, efficient investment and consumer choice inrural areas.

4. The price control arrangements are administratively simple, although they arenot transparent to consumers

The price control arrangements, by directly restricting the prices that Telstra cancharge, minimise administrative costs compared with a system where shortfalls arefunded through industry or government funded subsidies.

However, the fact that the price control arrangements do not require an explicit “taxand transfer” system means that they are not a very transparent way of achievingequity objectives.

5. Equity objectives would be better served by more targeted assistance packages

The current price control arrangements do not appear to take a direct approach intargeting assistance to those in need. Targeting lower income consumers, forexample, might be more effectively achieved by using a means-tested subsidy, orby extending existing Commonwealth programs for pensioners, the unemployed orthose with health care cards.

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6. Equity objectives are better funded through broad-based measures, and fromservices with low responses to changes in price.

Where taxes or cross-subsidies are levied for funding of redistribution programs,they should be levied on as many services as possible. Under this approach, theimpact in any one market is likely to be kept to a minimum. To illustrate, raising aset amount of revenue to fund a given Government program by levying a small taxon all goods and services will have a smaller adverse impact on consumerbehaviour in any given market than levying a large tax on telecommunicationsservices alone.

In a similar way, measures to ameliorate the adverse impact on particular groups ofconsumers as a result of changes to the price control arrangements are best achievedby taxing, or cross-subsidising from, those services that have a low level ofresponsiveness to changes in their own price. This is because any increases inprices needed to fund a package will have a smaller impact on the final quantities ofthese services consumed. Hence, the impact on consumer behaviour from raisingthe prices of these services will be minimised.

7. The impact of changes to the price control arrangements will affect differentgroups of consumers in different ways.

The removal of certain sub-caps, as recommended in this report, will allow Telstrato increase the price of line rental. However, any increase in the price of line rentalwill be more than offset by falls in the prices of other telecommunications services.

It follows that changes to the relative price of telecommunications services arelikely to affect different groups of consumers in different ways.

Based on analysis of current expenditure patterns, the Commission believes that:

§ consumers in all regions would on average be potentially better-off if therecommendations in this report are implemented. However, given non-metropolitan consumers tend to have higher levels of expenditure on telephonecalls (especially STD), they are likely to benefit more than urban consumers asa result of the decrease in per call charges that could occur if the changesrecommended in this report are adopted;

§ in the longer-term, the changes to the price control arrangements shouldgenerate even greater benefits to consumers. That is, by giving Telstra morefreedom in the way it structures its prices, and by allowing final prices to betterreflect underlying costs, competition, efficient investment and greater consumerchoice can flourish in telecommunications markets;

§ businesses would be expected to benefit relatively more than residentialconsumers as a result of the introduction of the recommendations in this report.This is because business consumers tend to be more intensive users oftelecommunications services per line (ie. they make more calls per line) thanresidential consumers, and because the price of line rental for businessconsumers already covers the costs of line rental for these consumers; and

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§ the impact on low-income consumers is uncertain. However, to the extent thatlow usage is an indication of low income, then high-income consumers willbenefit more from the price changes allowed under the recommendations in thisreport than low-income consumers. In particular, the results of the analysisconducted by the Commission indicate that low-spend residential consumerscould, potentially, be marginally worse-off as a result of the removal of the sub-cap arrangements. Consequently, this indicates there is likely to be a call forpolicy measures to protect low-income consumers from changes to the pricecontrol arrangements.

With regard to the possible distributional impact of removing the local call parityrequirement, the Commission believes metropolitan consumers of local calls will berelatively better-off in the short-term than rural consumers of local calls.

However, rural consumers may not be disadvantaged if the 22 cent price cap onlocal calls is retained (i.e. if the 22 cent price cap is retained, the price of local callswill not rise in rural areas, and will fall in real terms). In the long-term, moreover,rural consumers could be expected to gain as a result of increased competition,investment and greater consumer choice that could follow if prices are given morefreedom to reflect underlying costs. Other Government initiatives such as theUniversal Service Obligation (USO) tendering process and the provision of untimedlocal calls in extended zones should improve the quality, range and affordability ofservices in rural areas.

8. The costs of compensating those residential consumers who do not benefit as aresult of changes to the price control arrangements is likely to be small

The Commission has considered the potential cost of a number of alternativepackages to compensate low-income consumers for losses they may incur as aresult of changes to the price control arrangements. Whilst the cost of the packagewould vary depending on who the Government decided should be compensated andby how much, the Commission estimates the cost of a compensation packagetargeted at needy consumers who suffer a loss as a result of the price controlarrangements could be in the order of between $5 and $15 million dollars in thefirst year of the price control arrangements.

Recommendations

The conclusions in this report lead directly to a number of recommendations as to thefuture scope of the price control arrangements. In making these recommendations, theCommission has attempted to devise an overall package of recommendations thatshould lead consumers as a whole being better-off without significant adverse impactson particular groups of consumers.

Accordingly, the Commission makes the following recommendations in this review:

1. A broad CPI – X per cent price cap should be retained for the next pricecontrol period

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A broad CPI – X per cent price cap is desirable because it should make thecommunity as a whole better-off and has the potential to encourage Telstra toimprove the efficiency with which it produces telecommunications services. Thecommunity as a whole can be made better off by limiting the exercise of monopolypower and by giving Telstra the freedom to restructure prices in a way that allows itto efficiently recover common costs. In turn, this can benefit consumers by leadingto lower prices for national long-distance, international long-distance and fixed-to-mobile services. Further, there is an incentive for Telstra to become more efficientin the production of telecommunications services as a CPI – X per cent price capgives Telstra an incentive to reduce costs.

The composition of the price cap should include those services for which theCommission believes competition has not fully developed. In this regard, theCommission believes competition has not yet developed fully in the markets inwhich local calls, line rentals and connection services are supplied. Further, theCommission is not convinced that competitive forces are sufficiently strong toachieve effectively competitive outcomes in the markets in which STD, IDD andfixed-to-mobile services are supplied.

While the Commission recognises that most of these services are subject to somelevel of wholesale price regulation under the access regime that it administers underPart XIC of the Trade Practices Act, the Commission does not believe that theaccess regime is sufficiently mature with regard to these services such that theyshould be removed from future price control arrangements yet. Whilst it wouldappear that competition is developing in the markets for most of these services –especially with regard to STD and IDD services – the Commission is stillconcerned by the apparent difference between the retail price and efficient cost ofproviding these services. A similar conclusion has recently been made by theOffice of Telecommunications (Oftel) in the United Kingdom when deciding theseservices should continue to be the subject of retail price controls. Hence, untilcompetition has developed further in these markets, the Commission believes theseservices should remain under some level of retail price regulation.

The Commission considers, however, that the markets for the supply of othermobile services and leased lines have become sufficiently competitive such thatthey should both be removed from the existing broad price cap. Further, they donot share the common PSTN costs that apply to the other items that will remain inthe broad CPI – X per cent price cap.

2. The level of X for the broad basket of services should be in the order of 5 percent, and should apply for a period of three years.

As discussed above, the Commission has considered a range of factors in the settingof the X factor. These include Telstra’s projected total factor productivity (TFP),estimates of Telstra’s TFP growth for the PSTN alone, productivity growth for thewhole economy, and overseas benchmarking. Based on this analysis, theCommission believes that 5 per cent represents a reasonable level of TFP growthfor the PSTN services included in the broad cap – and hence cost savings – thatcould be expected to be passed on to consumers in the form of lower prices.

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Further, in order to provide Telstra with an incentive to improve productiveefficiency and reduce costs even further below that required to reduce prices by Xper cent per annum, the Commission believes the period for the next set of pricecontrol arrangements should be longer than the current price control period of twoyears.

However, given the speed of change in telecommunications markets, there is someargument that the duration of the next set of price control arrangements should notbe too long.

After weighing up these two factors, the Commission believes the duration of thenext set of price control arrangements should be three years.

3. All other existing sub-caps in the price control arrangements (other than the22 cent sub-cap on local calls) and the local call parity requirement should beremoved

This would include the CPI – 0 per cent sub-cap on a basket of line rentals and localcalls, the CPI – 0 per cent sub-cap on connections, and the price controlarrangements that target the bottom 10 per cent and 50 per cent of Telstracustomers by bill size. The main reason for this is to give Telstra the ability torebalance its prices to efficient levels.

It is also possible to argue, from the perspective of making the community as awhole better-off, that the local call parity requirement should be removed from theprice control arrangements. As indicated above, the Commission’s analysissuggests that the local call parity requirement, which requires the price of local callsin non-metropolitan areas to be broadly the same as those in metropolitan areas, islikely to be limiting the benefits that could accrue to the community as a whole dueto the divergence between costs and prices.

Further, the Commission’s analysis also suggests that the local call parityrequirement has the potential to have adverse impacts on investment choices in bothmetropolitan and non-metropolitan areas. In turn, this could prevent thedevelopment of long-term sustainable competition in both metropolitan and non-metropolitan areas which could be to the long-term detriment of consumers in bothareas.

That said, the Commission recognises there are equity objectives which aim toensure the benefits of competition are shared more evenly between consumers in allgeographical areas. This would imply, therefore, that there is an argument for theretention of the local call parity requirement.

The Commission believes, however, that other Government initiatives such as theUSO tendering and the provision of untimed local calls in extended zones may besufficient to ensure that the quality, range and affordability of services in rural areasis protected in an environment of increasing competition in telecommunicationsmarkets. In this context, it may be questionable whether the local call parityrequirement should be retained.

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However, the Commission considers that, even in the absence of a local call parityrequirement, rural users will benefit more from the recommendations in this reportthan metropolitan users. This will be the result of their greater use of long-distancecalls, which would be expected to fall in price.

The Commission also believes there may be arguments for retaining the 22 centlocal call price cap in order to protect rural consumers from increases in price thatmight otherwise result from the possible removal of the local call parityrequirement.

Further, the hearings indicated that the main concern for rural consumers regardingany potential removal of the local call parity requirement is the likelihood of asharp increase in the price of local calls. The Commission considers this concerncould be met by the retention of a 22 cent cap on local calls. To the extent that thismay lead to Telstra incurring losses on the provision of local calls in rural areas,such concerns would be addressed through the USO scheme.

4. The revenue weights used to determine whether Telstra has complied with itsprice control arrangements should be based on past year revenue levels

The Commission believes that the current practice of measuring revenue weightsaccording to revenue earned in the current year to which the broad CPI – X per centprice cap applies has the potential to limit the incentives Telstra has to rebalanceprices towards costs.

Further, there is a practical advantage for Telstra in using past year revenueweights, as Telstra will be better able to plan its pricing packages in order to meetits price control obligations, as it knows how it will have to set prices in the year tocome in order to satisfy the CPI – X per cent price cap constraint.

5. Targeting of low-income groups should be based on measures of income ratherthan usage levels for telecommunications services

Analysis suggests that the level of telecommunications spend is a poor indicator ofincome levels. In contrast, the Commission believes the Government could bettertarget compensation packages for low-income consumers by developingcompensation packages that target particular needy groups of consumers. In thisregard, the Commission has presented options in this report that would providecompensation for particular groups of consumers such as Pensioner ConcessionCard holders and Health Care Card holders.

6. Targeted assistance or other equity measures recommended in this reportshould be funded from government or industry-based sources.

Changes to the arrangements, as suggested above, will require additional funding tobe found.

The Commission’s analysis shows that measures to promote the objective of equityare better funded through broad-based measures and from services with low

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responsiveness to changes in price. In this regard, it is found that the losses fromfunding the equity measures under the current price control arrangements aresubstantial in comparison to a government scheme funded from taxation revenue oran industry-funded scheme.

7. There should be an adjustment period over which rebalancing of the price ofline rental is allowed to occur.

One of the central goals of the Commission’s recommended set of price controlarrangements is to give Telstra more freedom to set its prices for line rentalservices, and it therefore recommends the replacement of current price controls thatconstrain Telstra ability to change the price of line rentals with one that providesTelstra with greater pricing flexibility.

However, despite recent increases in the price Telstra charges residential consumersfor line rental, the current price of line rental still lies at around 55 per cent of thefull cost of provision for residential consumers. Hence, the immediate removal ofall price controls on line rental could potentially see Telstra almost double the priceof line rental for residential consumers. The Commission is concerned that thismight have some severe and potentially unwanted distributional consequences.

Hence, whilst Telstra may or may not choose to fully increase the price of linerental to cost if all price controls on line rental prices are removed, the Commissionsees merit in easing-in changes to the price control arrangements that enable Telstrato raise the price of line rentals.

Accordingly, the Commission recommends the introduction of a price control thatlimits the speed with which Telstra can increase the price of residential line rentalto cost. Such a control would have the advantage of minimising possible “rateshock” in the event that Telstra chose to rebalance too quickly.

There is a range of ways in which this could be achieved including a “CPI + X” percent price cap on line rentals or by limiting the increase in monthly line rentalcharge to a specified amount each year.

The Commission believes Telstra should be given the freedom, if it so chooses, toadjust line rentals to cost within 5 years.

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Chapter 1 Introduction

The Minister for Communications, Information Technology and the Arts has directedthe Australian Competition and Consumer Commission (the Commission) underDivision 3 of Part 25 of the Telecommunications Act 1997 (the Act) to undertake areview of the Telstra price control arrangements which the Commission administers,and to report by 14 February 2001.

The Ministerial direction requires the Commission to hold a public inquiry regarding:

(a) the need for price control arrangements under Part 9 of the Telecommunications(Consumer Protection and Service Standards) Act 1999 for carriage services,content services and facilities supplied by Telstra Corporation to continue after theexpiry of the current Determination; 5 and

(b) if there is a continuing need for price control arrangements, the nature of suchfuture arrangements, including their duration, means of implementation andmechanisms for review.

The terms of reference therefore require consideration of not just the future scope ofprice control arrangements, but whether they are necessary at all after 2001 (the expiryof the current Determination).

The Commission is also directed to take into account a number of important matters inconnection with the conduct of the inquiry. These are repeated with the full terms ofreference at Appendix A.

Price control arrangements of the form spelt out in the Determination were firstintroduced in 1989. Since that time, Telstra (or its predecessors, Telecom and theOverseas Telecommunications Corporation (OTC)) has been subject to price controlarrangements for a range of telephony services. In general, the price controlarrangements have aimed to achieve the objectives of efficient and equitable pricing oftelecommunications services. A summary of the price control arrangements since theirintroduction in 1989 is found in Appendix E of this report.

Since introduction of the price control arrangements, the government has conductedperiodic reviews, with the most recent review being in 1998. These reviews haveproven necessary, as the telecommunications industry has gone through a number ofchanges since that time. In particular, the telecommunications market has evolvedfrom one that was supplied by two government-owned monopolists (i.e. Telecom andOTC), to one that is now serviced by a number of carriage service providers.

The Commission commenced the inquiry in September 2000 with the release of adiscussion paper. Submissions on the discussion paper, or any other matter relevant to

5 The current Determination is the Telstra Carrier Charges – Price Control Arrangements,Notification and Disallowance Determination No. 1 of 2000 made under the Telecommunications(Consumer Protection and Service Standards) Act 1999.

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the price control arrangements, were called for by 31 October 2000. A full list ofsubmissions is detailed at Appendix C of this report.

Public hearings were conducted in 12 locations across Australia (including several inregional locations) in early-mid November 2000. A full list of hearing locations, andthe organisations that were represented at the hearings, can be found in Appendix D ofthis Report.

Following consideration of both the submissions to the Discussion Paper and the viewsof interested parties at the public hearings, the Commission released a Draft Report on22 December 2000. The Commission sought submissions from interested parties onthe Draft Report by 15 January 2000. In this regard, the Commission received sevensubmissions from interested parties. A full list of these submissions is included inAppendix C of this report.

After considering all of these sources of information and conducting extensive analysisof the issues raised in the terms of reference, the Commission has reached a number ofconclusions regarding the operation of the current price control arrangements andwhether they should continue after the expiry of the Determination. The Commission’srecommendation, in this regard, is that price control arrangements should continue toapply to Telstra in the future. However, the Commission has also made a number ofrecommendations regarding how the price control arrangements could be changed toimprove their operation in the future.

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Chapter 2 Broad Goals of the Price ControlArrangements

An important consideration when determining whether price control arrangementsshould continue and, if so, in what form, is their underlying objectives. That is, withoutan understanding of what they are intended to achieve, it is difficult to know whetherthe price control arrangements should continue and what form they should take.

Accordingly, this chapter outlines what the Commission understands to be theobjectives underlying the price control arrangements.

In order to determine these objectives, the Commission has looked at three mainsources:

§ Government statements;

§ a discussion paper for the previous price control review by the Department ofCommunications, Information Technology and the Arts (DCITA); and

§ the terms of reference for this review.

Each of these sources is discussed below. The Commission’s interpretation of theunderlying objectives follows this discussion.

2.1 Previous Government statement

Prior to the commencement of the controls in 1989, the Government issued a statementthat provides a basis for an understanding of the price control arrangements.6 Itsuggests four main goals were:

(a) to create pressures for efficiency in monopoly areas of Telecom and OTC’sbusiness;

(b) to provide incentives for Telecom and OTC to efficiently restructure their prices inorder to recover common costs of production in the most efficient fashion;

(c) to induce Telecom and OTC to strive for and pass on cost reductions from greaterproductive efficiency; and

(d) to ensure that the benefits of efficiency changes are equitably shared amongconsumer groups.7

6 Australian Telecommunications Services: A New Framework , Statement by the Minister forTransport and Communications, AGPS, Canberra, 25 May 1988.

7 ibid., p. 147

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2.2 DCITA Discussion Paper

The statement outlined above is consistent with the view of the CommonwealthDepartment of Communications, Information Technology and the Arts (DCITA),which suggested after the most recent review in 1998 that the price controlarrangements have had the following implicit objectives:

(a) technical efficiency: in the absence of significant competition, to maintain pressureon Telstra to improve its productivity;

(b) allocative efficiency: to prevent monopoly pricing behaviour by Telstra, and toensure that Telstra passes on to consumers the benefits of its own productivityimprovements; and

(c) equity: to ensure that the benefits of competition, and productivity improvements inTelstra’s network, are reasonably spread among different groups of consumers,residential and business, metropolitan and rural, and to attempt to ensure that noconsumers are made worse off by rebalancing of Telstra’s charges.

DCITA thought that, arguably, there might be a fourth objective:

(d) dynamic efficiency: that the price control arrangements should not be constructed soas to inhibit technological change.8

2.3 The terms of reference for this review

A third potential source for discerning the objectives underlying the price controlarrangements is the terms of reference for this review. In this regard, the terms ofreference don’t specify the underlying objectives of the price control arrangements.However, they do indicate that efficiency is an important consideration whendetermining recommendations in this review. Further, they identify certain groups ofconsumers to which the Commission should have regard when making itsrecommendations. In particular, the terms of reference direct the Commission to haveregard to the distributional impacts of the price control arrangements on different typesof household and business consumers; consumers from different geographic areas; andconsumers with different income levels.

2.4 Commission view

From these three sources, the Commission believes that the Government is concernedwith broad community welfare, as encompassed in the various efficiency objectives,and is concerned for the welfare of certain groups in the community. From both theDCITA discussion paper and the terms of reference, the Commission interprets thesegroups to be:

§ consumers from rural areas;

8 DCITA, Discussion Paper: Telstra Retail Price Control Arrangements, December 1998, p. 3

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§ consumers on low-income levels; and

§ different types of household and business consumers.

While the Commission is not convinced that targeting the welfare of consumers indifferent geographic locations or with different characteristics (such as being ahousehold or business) is an appropriate basis for achieving equity, it none the lessinterprets this is an important consideration in framing alternative price controlarrangements.

It is important to note that there are likely to be circumstances where measures thatmake the community as a whole better off may be in conflict with the welfare of thoseparticular groups identified in the terms of reference. For instance, where there is anargument for increasing prices on the grounds of making the community as a wholebetter off (if a product was priced below the cost of production, say), it could be shownthat this would have a negative impact on lower-income consumers of Telstra’sservices. Similarly, the benefits from competition, in some circumstances, may accrueonly to certain users of telecommunications, and may not be spread widely among allof residential or business users, or among consumers in rural and metropolitan areas.

Similarly, policies that benefit the welfare of one of the groups identified above may beto the detriment of consumers from one of the other groups. For instance, the local callparity requirement, which requires Telstra to charge broadly similar prices forconsumers of local calls in metropolitan and non-metropolitan areas, can lead tosituations where low-income local call consumers in metropolitan areas cross-subsidisewealthy consumers in regional areas. This kind of issue is discussed further in Chapter9 of this report. Additionally, it is also possible that different types of efficiency canconflict with each other. For instance, prices that achieve efficiency in use maygenerate detrimental investment incentives.

It follows, therefore, that devising a single set of recommendations that consistentlymakes the community as a whole better off, while ameliorating any adverse impacts onparticular groups of consumers is not an easy task. None the less, in determining whatform future price control arrangements should take, the Commission has attempted todevise a set of recommendations that will meet both of the major objectives of the pricecontrol arrangements.

For the purpose of analysis, this report proceeds on the basis of first determining howthe price controls might be improved in order to make the community as a whole betteroff. Having considered this, the analysis then addresses how the price controlarrangements could be designed to ameliorate any potentially adverse impacts thatmight result from the aforementioned changes to the price control arrangements.

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Chapter 3 The Price Control Arrangements

3.1 Current price control arrangements that are the subject of thisreview

At present, Telstra is subject to a number of price control arrangements under variouspieces of legislation. The terms of reference for this review ask the Commission tohold a public inquiry into whether there is a need for price control arrangements tocontinue after the expiry of the Determination at the end of 30 June 2001.

Accordingly, the Commission interprets this as a direction to assess the current pricecontrol arrangements under the Determination, with a view to determining whetherthese, or alternative arrangements, should continue after 30 June 2001. Hence, pricecontrol arrangements that arise under other pieces of legislation will not be the focus ofthis review.

The Commission believes the following price control arrangements from theDetermination are of most relevance to this inquiry:

§ a broad price cap of CPI – 5.5 per cent on a basket of digital cellular mobiletelephone services, fixed-line connections, domestic leased lines, internationalleased lines, line rentals, local calls, trunk calls and international calls;

§ a cap of CPI − 0 per cent on a basket of local calls and line rental services;

§ a cap of CPI − 0 per cent applies to a basket of connection services;

§ a cap of 22 cents per call (GST inclusive) on the provision of basic untimedlocal calls, with a similar cap of 40 cents per call applicable to calls made fromTelstra public payphones; and

§ a low-spending residential price cap of CPI − 1 per cent on a basket of servicescomprising connections, line rentals, local calls, trunk calls and internationalcalls. The revenue weights are based on the average bill size of the bottom(low-spend) 50 per cent of Telstra’s pre-selected customers.

Further, Telstra’s average price charged to residential, charity and business customersin non-metropolitan areas for untimed local calls in 1999-00 must not exceed theaverage price charged by Telstra to residential, charity and business customers inmetropolitan areas for untimed local calls in 1998-99 by more than 0.4 per cent.9 Asimilar price control exists for 2000-01.

9 This requirement applies to residential/charity and business customers separately.

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Finally, should Telstra propose to increase its line rental charge for residentialcustomers by more than the CPI, it must obtain prior consent from the Commission ifthat line rental is to be used by anyone falling within the bottom (low-spend) 10 percent of Telstra’s pre-selected customers. The Commission cannot consent unlessTelstra has made other products available, or made alternative arrangements, such thatcustomers in the bottom (low-spend) 10 per cent would, on average, experience no realincrease in their average telephone bill if they took up these offers.

3.2 Other relevant controls on Telstra’s pricing

It is also possible, under Part XIC of the Trade Practices Act 1974, that Telstra couldbe subject to regulation in respect of the prices it charges other carriage serviceproviders for access to those parts of its infrastructure which they need in order toprovide telecommunications services. There is a question of how these controls onTelstra’s access (or wholesale) prices might interact with the retail price controlarrangements that are the subject of this review. This issue is explored in more detail inChapter 7 below.

Finally, Telstra is also subject to a universal service obligation (USO) under Division 2of Part 2 of the Telecommunications (Consumer Protection and Service Standards)Act 1999. The main requirement of the USO is that standard telephone services,payphones, and prescribed carriage services are reasonably available to all people inAustralia on an equitable basis. There is also an obligation relating to access to digitaldata services. At present, Telstra is the universal service provider (USP). To the extentthat this might generate losses for Telstra (because the provision of services to certaincustomers comes at a high cost) the universal service regime allows for the losses to beshared amongst all carriers in proportion to their revenue. Hence, Telstra is able torecover some of its losses from the USO from other carriers in the telecommunicationsindustry. It should be noted, however, that recent amendments contained in theTelecommunications (Customer Protection and Service Standards) Act open universalservice provision to competitive tendering where successful tenderers become theuniversal service provider in specified zones.

3.3 History of the price control arrangements

The price control arrangements have covered the following four periods:

§ July 1989 – June 1992;

§ July 1992 – June 1995 (extended by six months to December 1995);

§ January 1996 – December 1998 (extended by six months to June 1999); and

§ July 1999 – June 2001 (current period).

Details of price control arrangements from 1989 to 1999 are given in Appendix E.

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3.3.1 Changes to the operation of the price control arrangements 1989-2000

The important changes to the operation of the controls over the previous 11 yearsinclude:

(a) the broadening of controls in 1992;

(b) the introduction of a sub-cap on untimed local calls (at 25 cents fixed) in 1996;

(c) the introduction of the “local call parity” requirement in 1997; and

(d) the 1999 introduction of controls targeted at protecting low-spend consumers ofTelstra’s services.

The coverage of the basket of services controlled by price-caps has increased over theperiod. The major changes occurred in July 1992, when a range of services(connections, leased lines and mobile services) which were previously subject tonotification and disallowance by the Minister were brought into the overall basket.

Untimed local call sub-caps were introduced in the 1996 determination, fixing the priceof this type of service at 25 cents from residential or business phones, and 40 cents forcalls made from a public payphone. In 2000, this sub-cap was reduced to the extentthat the maximum price for an untimed local call is now 22 cents (GST-inclusive) and40 cents (GST inclusive) from payphones.

Further major changes were made in 1997 with the introduction of the “local call parityprovisions.” These provisions aim to ensure that regional users benefit from the impactof price caps on local calls at least as much as metropolitan users. In practice, thismeans that the weighted price average of local calls in regional areas cannot exceed theweighted average price of local calls in metropolitan areas for both residential/charityand business users.

A further change in the 1999 determination was to provide more protection for thebottom (low-spend) consumers of Telstra’s services. Telstra must obtain prior consentfrom the Commission if it proposes to increase its line rental charge by more than CPIand that line rental is to be used by anyone falling within the bottom (low-spend) 10 percent of Telstra’s pre-selected customers. The Commission cannot consent unlessTelstra can ensure that these customers (low-spend) would, on average, experience noreal increase in their average telephone bill.

3.4 Price cap reductions

One of the key features of all the price control arrangements has been the inclusion of aCPI – X per cent price cap on a broad range of telecommunications services. While theservices included in this broad basket have changed over time, the broad structure ofthis price control has stayed the same.

Table 3.1 shows the history of weighted price changes and reductions under the pricecontrol arrangements for the period 1989-90 to the first half of 1999. While in the earlyyears of the broad price cap there were nominal increases (as the CPI was greater thanthe X-factor), in more recent times there have been substantial nominal reductions in

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prices for consumers. Since 1989 the value of X for the basket of services hasincreased from 4 per cent from 1989 to 1992, to 5.5 per cent from 1992 to 1995 and7.5 per cent from 1996 to the first half of 1999 and again back to 5.5 per cent for thesecond half of 1999 to the first half of 2001.

ear CPI factor X factor CPI – X Maximumnominalincrease

Actualweightedchange

Allowancecarriedforward

1989-90 7.3% 4.0% 3.3% 3.30% 0.0% 3.30%

1990-91 8.0% 4.0% 4.0% 7.30% 3.5% 3.80%

1991-92 5.3% 4.0% 1.3% 5.10% 5.1% 0.00%

1992-93 1.9% 5.5% -3.6% -3.60% -3.6% -0.04%

1993-94 1.0% 5.5% -4.5% -4.54% -3.7% -0.85%

1994-95 1.8% 5.5% -3.7% -4.54% -5.6% 1.08%

1995* 1.6% 2.75% -1.2% -0.07% -1.4% 0.00%

1996 4.6% 7.5% -2.9% -2.90% -4.3% 1.44%

1997 2.6% 7.5% -4.9% -3.46% -3.9% 0.46%

1998 0.30% 7.5% -7.2% -6.74% -6.8% 0.06%

1999** 0.45% 3.75% -3.3% -3.27% -3.40% 0.13%

Table 3.1 Price capped tariff changes, 1989-90 to 1999

* Year from July only** Year to June only – allowance carried forward is 0.06% / 2 = 0.03%

Source: Access Economics (1998); Telstra carrier charges price control compliance, ACCC, various years.

It should be noted that, as yet, the Commission has not been provided with final figuresto confirm whether or not Telstra has complied with its current price controlarrangements for 1999-00.

An important feature of the broad CPI – X per cent price cap regime is that Telstra isable to “carry forward” price changes where it chooses not to change prices by themaximum allowable under the price cap in any one year. However, this carry-forwarddoes not apply when the price control arrangements have changed. In the last fewyears, Telstra has kept actual price changes close to the maximum allowable pricechange.

In more recent years, reductions in prices under the price caps tend to have focused oninternational and mobile calls. This is illustrated in Table 3.2 which shows Telstra’sthe price reductions for price controlled services over the period 1997 to June 30 1999.

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Service 1997 1998 First half1999

Total 1997-99

Local calls -2.5% -0.7% -1.1% -4.3%

Basic access -0.5% -2.7% -0.6% -3.8%

Trunk calls -11.8% -3.9% -2.5% -17.4%

International calls -5.0% -41.9% -17.5% -54.5%

Mobile services -4.7% -9.8% -6.5% -19.6%

Domestic -8.8% 0.0% -0.7% -9.4%Leasedlines International -10.5% -1.3% -1.1% -12.6%

(Weighted) overall price cap -3.9% -6.8% -3.4%

Table 3.2 Summary of 1997-99 reductions in Telstra’s prices

Source: ACCC, Telstra carrier charges price control compliance, various years

While prices of Telstra’s price-capped services have fallen substantially in real termssince 1989, prices of services used by business customers have generally fallen fasterthan prices of services used by residential customers. Volume discounts have tended tobe focused more on business customers, so that their inclusion in the cap and Telstra’sreliance on them to achieve the requirements of the price-cap has led to a greater shareof the benefits going to business customers.

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Chapter 4 State of Competition in Price ControlledMarkets

4.1 Introduction

The Ministerial direction requires that the Commission have regard to “the current stateof competition in each of the price controlled markets” and that it determine the impactof current and possible alternative price control arrangements on the current level anddevelopment of competition in those markets. The first of these considerations isaddressed in this chapter. While the impacts of price control arrangements oncompetition are treated in Chapter 7, it has been difficult to avoid these completely inthis chapter.

As explained in Chapter 2, the objectives of the price control arrangements were, inpart, to limit the exercise of monopoly power; induce Telecom and OTC to strive forand pass on cost reductions from greater production efficiency, and allow“rebalancing” of the pricing structure such that it was more closely aligned with costs.With respect to the first two of these objectives, there is now an issue of whether theprice control arrangements are still needed. That is, if competition in atelecommunications market has become “effective”, market forces now perform thesetwo original functions and the case for price control arrangements on these grounds isgreatly weakened.

In order to assess the current state of competition in each of the price-controlledmarkets, therefore, this chapter will:

§ review the different ways that the extent of effective competition intelecommunications markets can be assessed;

§ assess the state of competition in the markets subject to price controlarrangements; and

§ provide conclusions about the state of competition in the different markets andthe consequent implications for decisions regarding future price controlarrangements.

The conclusions about the state of competition and the implications for the future of theprice control arrangements will then be “taken through” into the remaining chapters ofthis report.

4.2 Measures of effective competition

At the time retail price control arrangements were first introduced in 1989, nocompetition in telecommunications markets was allowed by statute. The legislationreserved the domestic market for Telecom and the international market for OTC. Sincethen, legal barriers to entry have been progressively relaxed. Following the end of the

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duopoly period in mid-1997, the issuing of carrier licences has become far more liberaland the number of licensed carriers has increased from four to fifty in a little over three-and-a-half years.

While there is essentially legal freedom of entry into all telecommunications markets,this does not necessarily mean that there is effective competition in each of the price-controlled markets. An important task in this section, therefore, is to discuss thedifferent possible approaches to assessing the extent of effective competition.

In submissions received by the Commission after issuing the Discussion Paper, variousapproaches have been suggested for measuring effective competition, includingtraditional “concentration” measures, assessment of whether telecommunications has“natural monopoly” characteristics giving rise to the existence of essential facilities foreffective entry and the examination of market outcomes. These approaches will bereviewed drawing on the appropriate economics and trade practices literature.

Importantly, an assessment of whether effective competition exists intelecommunications markets is far more complex than simply considering theproportion of market shares (e.g. minutes provided) by suppliers other than Telstra. Inparticular, additional measures of competition can be considered which relate either tomarket characteristics (such as the number of producers and natural monopoly features)or to market outcomes (such as price reductions over time and the extent of productinnovation). In essence, therefore, there are a number of indicators that theCommission can refer to in determining whether competition is effective in a givenmarket. These will sometimes give conflicting answers, and none are definitive.Judgement is then required. The various approaches are explained and assessed indetail below.

4.2.1 Market structure

Market structure relates to the cost structure and demand conditions in a particularindustry and is important because it is a major determinant of market outcomes. Fourways of indicating whether market structure is consistent with effective competition areconsidered. These are the extent of the presence of natural monopoly characteristics,measures of dominance, concentration indexes and the Commission’s declarationprocess.

Natural monopoly characteristics and essential facilities10

The primary market structure indicator of effective competition in network industrieslike telecommunications is whether or not a market displays natural monopolycharacteristics over essential inputs in the production chain. Typical features of natural

10 A useful summary of natural monopoly characteristics in telecommunications is found in the paperprepared for Telstra, Janusz Ordover, “Effective Telecommunications Service Competition inAustralia and the Need for Regulatory Reform”, November 26 2000, pp. 16-26.(http://www.telstra.com.au/newsroom/docs/ordover.pdf) Note, however, that Ordover studiouslyavoids using the term “natural monopoly” to describe any telecommunications market.

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monopolies include economies of scale,11 economies of density and economies ofscope. These determine how many producers will efficiently “fit in” to an industry. Inthe presence of natural monopoly characteristics it will be inefficient, uneconomic orboth for entry to occur in at least some parts of the industry.

A component in a production chain to which access is necessary for successful entry isknown as an “essential facility” or “bottleneck facility”. In order to achieve an efficientoutcome it is usually necessary to regulate access to the essential facility. The owner ofthe essential facility has an interest in denying access to the essential facility at anyprice below the monopoly price. This is because any entry at monopoly prices wouldeffectively preserve monopoly power and therefore not achieve the objectives ofcompetition policy. In Australia, the price of access to essential facilities intelecommunications can, under certain conditions, be regulated by the Commissionunder Part XIC of the Trade Practices Act.

Where entrants do purchase access to an essential facility, they can combine otherproduction elements with the essential facility element to produce retail services. Thepresence of successful entrants in downstream markets can result in desirable marketoutcomes, but retention of these may be dependent on the continued availability ofregulated access, and removal of regulated access would result in the disappearance ofthe competition. Issues relating to Part XIC of the Trade Practices Act are consideredfurther below and in Chapter 7.

Market power can also prevail as a result of the advantages of incumbency. In all ofthe service areas covered by the price control arrangements (including in mobiles)Telstra is the incumbent in that it originally occupied each of the markets as the solesupplier.

Dominance

In industries like telecommunications, the dominant firm is usually the incumbent firmthat existed prior to the introduction of competition. Natural monopoly characteristicsmay result in one producer having “dominance” in the market. Dominance is usuallydefined as the ability to act independently of other suppliers, in particular the extent towhich it is able to hold price above cost of provision. The market outcome liessomewhere in-between complete monopoly (where the dominant firm faces or owns themarket demand curve and can set the profit-maximising price) and the other extreme ofcomplete or perfect competition (where all producers are price takers with no price-making ability and must be content with cost recovery in the long run). Oneintermediate case is the dominant firm model where the dominant firm shares themarket with a fringe of competitive firms. This fringe acts as a constraint on the priceit can set and the result is an intermediate price between the fully monopolistic andfully competitive prices.

In telecommunications markets where competition is emerging and sometimes limitedto particular production components, the incumbent often retains some degree of

11 More accurately the reference here should be to “sub-additivity” of the cost function where oneproducer can produce a given quantity at a lower total cost than can two or more producers using thesame technology.

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independence in its pricing. The market outcome is one where price is above the fullattributable cost of production in the long-run. However, as argued below, somedegree of gap between price and cost in at least some markets will be required inindustries like telecommunications.

Concentration measures

Traditional measures of market power and strength of competition have been developedfor use mainly in manufacturing and some service industries such as banking. Underthese measures, industries are more competitive the larger the number of firms and themore even their size. There are several ways of measuring these characteristicsincluding the CR4 – which measures the market share of the four or fewer largestfirms12 – and the Herfindahl index. 13

The Herfindahl index is the most sophisticated of the concentration measures and iscalculated by summing the square of the proportionate market share of each firm in theindustry. 14 A complete monopoly therefore has a score of 1; whilst a textbook perfectlycompetitive industry has a score approaching zero. Hence, the closer the score is tozero, the less the concentration of firms within the market.15 This is because thesquaring of market shares effectively places a greater weight on producers with agreater market share. While this index has strong intuitive appeal, it is not possible tospecify some minimum threshold under which competition can be said to be effective.

In addition to their limitations in analysing the industries for which they were designed,concentration measures are not reliable for network industries like telecommunications.There are two main reasons for this:

§ The presence of many suppliers – even if of fairly even size – may not be consistentwith effective competition where their presence is reliant on regulated access to anessential production component controlled by one producer.

§ On the other hand, the presence of a small number of market participants could stillbe consistent with effective competition under the conditions for “contestability”(low sunk costs, customers not tied to the incumbent, etc.).

12 The Commission uses the CR4 measure as part of its merger test. See Australian Competition andConsumer Commission, Merger Guidelines, Canberra, June 1999, pp. 43-5.

13 Concentration measures have sometimes been applied in telecommunications. See for exampleBureau of Transport and Communications Economics, The Australian Telecommunications Market:When Does Dominance Cease, Working Paper 6, Canberra, 1992.

14 See J. Black, Oxford Dictionary of Economics, Oxford University Press, Oxford and New York,1997, pp. 209-10.

15 Consideration of some intermediate cases between complete monopoly and complete competitionenhances the understanding. Duopolists with equal market share get a score of 0.5, but if one of theduopolists has 0.75 of the market the score is 0.625 (ie 0.752 + 0.252 = 0.625). A triopoly evenlydividing the market scores 0.333, while a triopoly where one firm “dominates” (say the threeproducers have market shares of 0.6, 0.2 and 0.2) scores 0.44 and is thus more concentrated.

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Declaration

A final indication of market structure is whether the market has been “declared” underthe Trade Practices Act. The Commission considers a statutory test under Part XIC ofthe Act for determining whether services should be declared or not, which requires anassessment of the state of competition for the particular telecommunications service.The Commission must assess whether declaration is in the long-term interests of endusers. In this regard, the Commission is required to take into account the followinglegislative objectives:

§ the promotion of competition;

§ the facilitation of any-to-any connectivity; and

§ the efficient use of and investment in telecommunications infrastructure.

Given the Commission is making evaluations using specific statutory criteria, cautionshould be exercised in translating the Commission’s findings of the state of competitionin the context of this report for the purposes of declaration inquiries.

4.2.2 Market outcomes

An alternative means of determining the degree of effective competition in a givenmarket is by examining market outcomes. Examples of relevant market outcomesmight include the change in retail and wholesale prices associated with the introductionof competition, the extent of the gap between price and full attributable long-run cost,international comparisons of pricing and the extent of product differentiation andinnovation. 16

4.2.3 Summary

There are various possible indicators of whether or not competition is effective in amarket. These are based on either structural characteristics such as the degree ofconcentration or on market outcomes. Telecommunications markets, while movingaway from complete monopoly, are never likely to display the characteristics of perfectcompetition in the textbook sense. While imperfection is easy to find, it is difficult toestablish what degree of imperfection constitutes effective competition. For example,Ordover’s definition is that “one or more firms may possess some degree of marketpower yet pose no significant risk to present or future competition” (p. 9). Thisdefinition raises more questions than it answers about “market power”, “significantrisk” and “competition”. In the end some degree of judgement is required based onconflicting bits of evidence, and different analysts can and do reach divergentconclusions about the same market.

16 Detailed accounts of the relevant factors are included in RSL COM Australia Pty Ltd’s (RSLCOM’s) submission (pp. 3-4) and in chapter 2 of the paper by Frontier Economics accompanyingAAPT Limited’s (AAPT’s) submission.

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4.3 The state of competition in the markets covered by price controlarrangements

The service areas subject to retail price control arrangements are described in theDetermination as the “first basket of services” and are listed as line rentals,connections, local calls, trunk calls, international calls, digital cellular mobile services,domestic leased lines and international leased lines. These eight items are treated inthis Report under four categories: local call services (line rental, connections and localcalls); long-distance call services (national long-distance and international calls);mobiles (subscriptions, mobile-to-mobile calls, fixed-to-mobile calls and mobile-to-fixed calls) and leased lines (domestic and international). This categorisation isdifferent from the market definition approach used elsewhere in the Commission.

A diversity of views about the extent of competition in telecommunications marketshas been presented in the submissions on the Discussion Paper and the Draft Report,ranging from the assertion of pervasive effective competition17 to suggestions of veryweak or zero competition in particular areas, especially with regard to local callservices and fixed-to-mobile calls. Many of the submissions contain useful discussionsabout how to evaluate the extent of competition, and apply these to some or all of theareas under price control arrangements. In this section each of the four areas isconsidered individually under the same framework – general description of the market,discussion of the views of the parties and a systematic assessment based on theapproaches outlined above.

4.3.1 Local call services (local calls, line rental and connections)

Local call services are provided by the local network. The local network is comprisedof the customer access network and the inter-exchange network. This provides directcustomer access and local calls. Telstra charges for initial connection to the network, acontinuing line rental or customer access charge (differing for business and residentialsubscribers) and for local calls. All three services are subject to the “first basket” pricecontrol arrangements. Telstra also wholesales local telephony services to serviceproviders and other carriers, so line rentals and local calls can alternatively bepurchased from resellers.

On the surface this appears to be the least competitive of the areas under retail pricecontrol arrangements. Telstra has the only ubiquitous fixed-line network with the fullrange of capabilities, including the provision of line rental and local calls (“localservice” or “local telephony services market”). As noted by Telstra in the 1999-00Annual Report (and in contrast to its submission), “We currently face limitedinfrastructure competition in basic access and local call services” (p. 32). However,

17 Telstra claims effective competition is pervasive across telecommunications markets. It refers to itssubmissions to the Productivity Commission for details of its views. In the first of these, Telstraclaims that the overall telecommunications market in Australia is now “fiercely competitive” (p. 2);although the conclusion is a little weaker later – any market power Telstra may once have had hasbeen “substantially reduced” (p. 5). Telstra also claims that no part of the telecommunicationsindustry can properly be described as a natural monopoly (p. 5).

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while the exclusivity of its ubiquity remains, there are various ways that competitorsare entering the local services market.

Views from the submissions

Cable and Wireless Optus Limited (CWO) in its submission on the Discussion Paperwas concerned about the absence of adequate competition in local service and arguesthat retail price control arrangements deter investment in alternative networks andtherefore stifle competition.

AAPT in its submission on the Discussion Paper argued that there are differences in theintensity of competition by geographical area and argues that retail price controlarrangements should remain in some regional areas where competition is absent.AAPT also argued that if access regulation under Part XIC of the Trade Practices Actwere weakened, the case for retail price control arrangements would be strengthened.

The Australian Telecommunications Users Group (ATUG) also argues there is anabsence of effective competition in local service and that “a level of price control isjustified”. This position was maintained in its submission on the Draft Report.

Several submissions drew attention to the implications for competition from holdingaccess prices below cost, particularly through the access deficit contribution being apart of all access prices for PSTN origination and termination services. This is an issuefor Chapter 7.

Application of the effective competition criteria

Local service has the classic attributes of a natural monopoly and access to Telstra’slocal network remains an “essential facility”. Telstra’s “Ordover Report” mentionedearlier states that it is an exception to those services that are effectively competitive(p. 5) and states that “Local access facilities are an essential input to providing manytelecommunications services” (p. 12). This reflects what appears to be close to aconsensus view.

As measured by the Herfindahl index, the level of concentration in local service iseffectively 1 (complete monopoly) as only Telstra has direct access to every householdand business in Australia. This effectively means that Telstra has dominance in themarket for these services.

The situation with respect to declaration is interesting.18 The Commission has notdeclared line rental, although there is a proposal for declaration from MacquarieCorporate Telecommunications before the Telecommunications Access Forum. Theunconditioned local loop service (ULLS) has been declared and the Commission iscurrently arbitrating on access to ULLS. Local call service (LCS) has also beendeclared and arbitrations are currently in progress.

18 Details of the considerations leading to local service declarations are in Australian Competition andConsumer Commission, Local Telecommunications Services, Canberra, July 1999.

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While these services have the attributes of a natural monopoly, indications of somedegree of competition in local service are emerging from a number of sources:

§ The development of digital subscriber line (DSL) technology allows the fullrange of services (including high-speed data transmission) to be run throughcopper wires. The Commission’s declaration of ULLS is leading to Telstra’scompetitors gaining direct access to households and businesses at a regulatedprice, while avoiding unnecessary duplication of the CAN. However, itscontinuation as a competitive force is dependent on Part XIC of the TradePractices Act remaining.

§ CWO and Telstra have both built substantial HFC cable networks in mostmetropolitan areas in order to offer pay television and, in the case of CWO,telephony services. This means that CWO is able to offer fixed-line line rentaland local calls in the areas covered by its broadband cable network. Othercarriers are establishing customer access networks in the CBDs of the largercities. New fixed-line customer access networks are being produced in anumber of specific areas such as the Australian Capital Territory and Bendigo.In all cases, however, there is a lack of ubiquity in these networks and itremains necessary to interconnect with Telstra’s CAN in order to provide any-to-any connectivity.

§ Wireless technologies provide some competition for fixed-line local service.Possession of mobile access provides access to the fixed-line network as well;albeit at a substantially different pricing structure. For example, making a“local call” from a mobile to a fixed line is priced at an average of 40 cents perminute compared with a flat 22 cents for the untimed call. Further, emergingtechnologies like 3G mobiles will be able to offer the full range of advancedservices now available on fixed-line services.

§ Local calls and line rental can be purchased from resellers, but as in almost allcases Telstra entirely produces the underlying services. Consequently, this initself cannot provide effective competition because there is no competition inthe wholesale part of these services. However, this can lead to competition inthe retailing (lowering the costs of retailing) of local service and it helpspromote competition by allowing new telecommunications firms to provide afull range of services to customers by including its own and other services inbroad packages while they are developing their own production capabilities.

Summary

The Commission believes that competition in local telephone services is limited. Inlocal services there is no effective competitor for Telstra’s ubiquitous local network,although competitors are nibbling away at this monopoly through the building oflocalised access networks, the “regulated” availability of ULLS, wireless access, etc.Local call resale promotes competition in the retailing of local calls and enhances theservice offerings of competitors, but does not represent competition for the productionof local calls.

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4.3.2 National long-distance and international calls

Telstra’s national long-distance (STD) and international (IDD) call services arecurrently subject to retail price control arrangements as part of the first basket.National long-distance calls are produced using long-distance and local networks(using Domestic PSTN originating and terminating access services). International callsare produced using terminating services in the destination country, internationaltransmission components, the long-distance network and local networks. On thesurface there appears to be considerable competition:

§ CWO and AAPT have established alternative long-distance networks on atleast the main inter-capital routes, and others are under construction.

§ As noted previously, non-ubiquitous access networks have been or arecurrently being built in various CBDs, metropolitan areas and regional centres.

§ Mobiles provide some competition, although the price structure is quitedifferent. Making “long-distance calls” using a mobile at one or both endsusually is substantially more expensive than for STD. 19

However, all suppliers of long-distance and international calls are reliant on access toTelstra’s PSTN. Further, the other production components used for these calls displaysome natural monopoly characteristics.

Views from the submissions

Telstra’s position on competition in these services differs between its submission on theDiscussion Paper and the 1999-00 Annual Report. In the submission there is a strongemphasis on the intensity and “vigorous rivalry” of competition, while in the 1999-00Annual Report there is acknowledgment that the pricing of originating and terminatingservices and transmission “influences the development of retail offerings by ourcompetitors” (p. 33). However, Telstra argues that competition “already exists in thewholesale provision of transmission services on major domestic and internationalroutes”.

CWO and AAPT regard these areas as sufficiently competitive as not to require retailprice control arrangements. CWO in its submission on the Discussion Paper adds theproviso that its position is dependent on “fixed line access to the monopoly dominatedPSTN …[being] regulated appropriately” (p. 12). Similarly, Frontier Economics in thepaper accompanying AAPT’s submission cautions about the need for a continuing roleof the access regime “to limit the scope for barriers to entry into the wholesale localservices market to “spillover” into … national long-distance calls” (p. 46). A similarconcern is expressed with respect to international calls.

RSL COM in its submission on the Discussion Paper argues that it is not a “reasonableassumption” that these markets are competitive and that “competition in the national

19 For detailed comparisons of the prices of long-distance calls using mobile and fixed-line services seeAustralian Competition and Consumer Commission, Competition for Long Distance MobileTelecommunications Services: A Report about Declaration of a Long Distance Mobile OriginatingService, January 2000, Appendix 2.

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segment is somewhat limited” (p. 6). This assessment is based on an examination ofmarket share figures and the observation that “Telstra controls the prices for networkinterconnect” (p. 6).

ATUG in its submission on the Draft Report observes “national long-distance andinternational calls markets as having generally effective competition” (p. 1), butprovides no supporting evidence for this claim.

None of the other submissions contain explicit arguments for the continuation of retailprice control arrangements on either national or international calls, although a number(including CTN) implicitly accept their continuation by endorsement of theCommission’s proposed basket.

Application of the criteria

While on the surface there are indications of substantial competition in national long-distance and international calls, there are also factors suggesting that competition maynot be effective.

A small number of entrants (in particular CWO and AAPT) have establishedindependent long-distance transmission facilities on major routes, especially betweencapitals. The potential for further replication is limited because of natural monopolycharacteristics in such facilities. Further, entry into this area has not spread beyond themajor routes, and there is a clear lack of effective competition on those non-majorroutes.

Further, there is no alternative means for rivals to reach the majority of their potentialcustomers without access to Telstra’s local network. If this access were not regulatedunder Part XIC of the Trade Practices Act, there is a strong possibility that accessprices would be substantially higher.

The Herfindahl index for both national long-distance and international calls indicates asubstantial degree of concentration. 20 For national calls the score of 0.59 is quite high,based particularly on Telstra’s retention of 75 per cent of the market (including callssold through service providers). In the case of international calls Telstra’s market shareis only 48 per cent. CWO has 18 per cent, AAPT 6 per cent and OneTel Limited 5 percent. However, the score for international calls is difficult to determine because theremaining 23 per cent of calls are classified as “other”. If “other” is treated as acollection of very small carriers the index has a value of 0.28. The Herfindahl indexprovides less cause for concern for international calls than it does for national long-distance calls.

Taking a behavioural or market outcome approach also is indicative of a degree ofineffectiveness in competition. There are two main ways the issue can be approached –examination of the gap between price and cost of provision, and by tracking pricechanges over time, especially relative to costs.

20 The figures for market shares are from the Australian Competition and Consumer Commission, AReport on the Assessment of Telstra’s Undertaking for the Domestic PSTN Originating andTerminating Access Services, Table 7.11.

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With respect to the price-cost gap, Telstra concedes margins have been high in thepast21 but does not make an observation on the present situation. However, informationon long-distance costs available to the Commission tends to suggest that the fullaverage attributable per-minute cost of providing STD calls (including retail costs) isless than half the average per-minute price. Only a small portion of this gap can beexplained by the access deficit contribution (ADC). The ADC is a component in theprice Telstra charges other carriers for interconnection to the PSTN and that has to beretrieved by Telstra in its retail pricing.

STD prices have continued to fall since the end of the duopoly in 1997. According toinformation in the 1999-00 Annual Report the average revenue per minute of fixed-to-fixed calls was 16.80 cents in 1997-98, 15.84 cents in 1998-99 and 14.83 cents in1999-00. This represents a total fall of nearly 12 per cent or of about 2 cents perminute. However, this is less than the fall in the cost of interconnection that has fallenby more than 3 cents per minute.22

IDD prices have fallen more rapidly than STD prices, but information available to theCommission indicates the presence of a substantial remaining gap between price andcost. This gap is proportionately less than in STD if cost includes the internationalsettlement price, but the weighted average per-minute price is still substantially abovethe full average attributable cost including retail costs.

Summary

While on the surface there is substantial competition in national long-distance andinternational calls, the Commission is not convinced that there is sufficient evidence forthis to be described as effective competition. The problem does not lie with Telstra’scontrol over what is still an essential facility for entry, as long as access is subject toeffective regulation. With respect to market structure, reasons for concern arise fromthe long-distance and international components of the production chain displayingsome natural monopoly characteristics. The amount of facilities-based entry into thesecomponents is limited by these characteristics, especially on other than major routes.Further, the outcomes of competition since the cessation of the duopoly have beenpositive but limited. In particular, Telstra has maintained a high market share in boththe national and international long distance markets, and the price reductions that haveoccurred appear to have been insufficient substantially to reduce the gap between priceand full cost. The Commission notes that Oftel has expressed similar concerns anddrawn the same conclusion with respect to these services.23

21 In its first submission to the Productivity Commission inquiry, Telstra draws attention to how pricedistortions have “made the STD and IDD markets very attractive to potential entrants, since theseare the markets in which margins have been high” (p. 8) and presents historical data showing largegaps between prices and costs of STD and IDD.

22 It has fallen from 7 cents (3.5 cents x 2) to 3.4 cents (1.7 cents x 2) over this period.

23 See “Price Control Review”, October 2000, http://www.oftel.gov.uk/pricing/pcr1000.htm, and“Proposals for Network Charge and Retail Price Controls from 2001”, January 2001,http://www.oftel.gov.uk/pricing/2001/pcr0101.htm.

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4.3.3 Mobiles

Mobile services included in the Determination cover mobile subscriptions, mobile-to-mobile calls and the mobile component (origination or termination) of calls betweenmobile and fixed networks (ie, mobile-to-fixed and fixed-to-mobile calls). There arepresently three carriers with a high degree of national coverage (Telstra, CWO andVodafone). Telstra has the most comprehensive network. The Commissionunderstands that two others are establishing mobile networks. The penetration rate hasreached about 54 per cent which, while quite high by international standards, is belowthe highest levels achieved overseas (for instance, around 70 per cent in theScandinavian countries, Austria and Italy).

There is the appearance of a high and growing level of competition in mobile services,but this does not necessarily constitute effective competition. In particular, in assessingthe state of competition in mobiles, a distinction is drawn between fixed-to-mobileservices and all other services. Competition appears to be much less advanced withrespect to fixed-to-mobile services.

Views from the Submissions

With respect to assessing competition in mobiles there is no substantial difference inthe position of Telstra and the other carriers. All the carriers except MacquarieCorporate Telecommunications Pty Limited (Macquarie) comment on the extent ofcompetition in mobiles, and all except RSL COM submit that there is a high degree ofcompetition. Various indicators are canvassed by the carriers including:

§ low barriers to entry;

§ the growing number of carriers is indicative of a high degree of facilities-basedcompetition;

§ reductions in prices over time with great detail in both CWO’s and Vodafone’ssubmissions;

§ favourable international price comparisons; and

§ the substantial extent of product innovation.

RSL COM and ATUG both perceive a problem because of the inadequate extent ofcompetition in fixed-to-mobile calls. This is considered further below.

Application of the Criteria24

The extent of new entry and the appearance that the two established carriers on whichinformation is available appear to be operating profitably25 does not indicate the

24 The extent of competition in GSM markets is analysed in the Australian Competition and ConsumerCommission, Pricing Methodology for Access Prices of the Domestic GSM Terminating AccessService, December 2000, section 5.

25 No data are available for Vodafone, but those for Telstra and CWO suggest a high level ofprofitability as measured by earnings before interest and taxes (EBIT). Telstra’s 1999-00 AnnualReport (Table 22) reports that the OnAir business unit had EBIT of $832 million on revenue of

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presence of strong natural monopoly characteristics. However, as in every networkindustry there are economies of scale from the greater volume of traffic using thenetwork and the technology of the industry means that some element of networkestablishment costs are sunk. Accordingly, CWO refers to “the incumbent’s economiesof scale, scope and ubiquity”,26 and there are suggestions of possible amalgamation inthe mobile industry. None the less, it appears that size economies level out sufficientlyat volumes allowing three or more carriers to fit into the available market.

With respect to concentration, of the three substantial carriers, Telstra has about 47 percent of the subscriptions, CWO about 33 per cent and Vodafone about 19 per cent.Two much smaller carriers have a little over one per cent between them. TheHerfindahl index for mobiles as a whole is about 0.37. Reflecting Telstra’s highmarket share, this score is above that of equal-sized triopolists. On the surface, thisplaces the mobile market at around the threshold of concern with respect toconcentration.

Origination (in respect of 1800/1300 calls) and termination services in relation to callsbetween fixed-line and mobile services were declared under the deeming arrangements.They had been subject to access regulation prior to mid-1997 under the previouslegislation. The Commission decided in early 2000 not to declare long-distance mobileoriginating services, “in the light of … significant competitive developments”.27

Market outcomes have been consistent with rapidly developing competition. Retailprices for mobile-specific services have fallen at an accelerating rate, and more rapidlythan either fixed-to-mobile or STD prices in the period from 1996-97 to 1999-00, butthe Commission has insufficient information to comment on the relativity of prices tocosts. Each carrier offers an increasing range of innovative pricing packages that allowconsumers to trade off subscription and call charges. The penetration rate hasincreased rapidly.

Fixed-to-mobile services

The manifestation of a possible failing of competition is in the area of fixed-to-mobilecalls. RSL COM believes that as the three mobile networks charge similar prices andthere is no available substitute for this termination service, “no competition can be saidto exist” (p. 7) in fixed-to-mobiles. ATUG also claims an absence of effectivecompetition in fixed-to-mobile calls.

Market outcomes are also a cause for concern. First, while retail prices have beenfalling, this has been at a slower rate for fixed-to-mobile calls than for mobile prices in

$3002 million (27.7 per cent). This is an understatement of the financial position as OnAir revenueexcludes all call termination charges. These are in the region of $1 billion. Adding these in raisesthe EBIT to 45.7 per cent of revenue. CWO had a first half of 2000 EBITDA from mobiles of $435million on revenue of $1.01 billion (43.5 per cent) (Christine Lacy, “TNZ blueprint to list Optusmobile assets”, Australian Financial Review , 14 November 2000).

26 CWO submission, fn. 17, p. 30.

27 Long Distance Mobile Originating Report, op cit, p. 62.

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general. Second, information available to the Commission suggests that both retailprice and the GSM termination element of the wholesale price of fixed-to-mobile callsappear to be high relative to costs. Telstra’s average retail price for fixed-to-mobilecalls in 1999-00 was 40 cents per minute,28 whilst market inquiries indicate that the fullcost appears to be much lower. There is also an indication that the gap between retailprice and cost inclusive of the termination charge is large.

The Commission believes the market for termination is not effectively competitive. Inwork done for the Commission in late 1999 and early 2000, Stephen King and JoshuaGans 29 argue that callers’ difficulties in distinguishing among alternative mobilecarriers gives each carrier a degree of market power in determining the terminationcharge for calls from fixed-line services.30

While there is some substance to this argument, it is not clear that the problem it raisescan be addressed by retail price controls. Approaching it from the other direction,Vodafone argues that it is “unreasonable to ascribe the blame for high retail price onmobile carriers” and that any problem arises from “a lack of “pass through” byretailers”. The Commission believes there is an excessive gap between retail price andfull cost inclusive of the termination charge, and that this can partly be addressed byinclusion of fixed-to-mobile calls in the price cap.

Summary

While natural monopoly characteristics are not totally absent from the mobile industry,it appears to have fewer of them than does the fixed-line industry. Perhaps the majordifference is that it does not have dedicated access lines as in the wire network, so thatcustomer access is much less costly. Three or four carriers seem to be able to providemobile services and under such circumstances it appears that prices of mobile servicesare falling more rapidly than for other telecommunications services. The Commissionbelieves the market is sufficiently competitive to be freed from price controls.

Competition does not appear to be effective in fixed-to-mobile services, whereconcerns have been raised about market power and excessive retail prices.31 Theseobservations, combined with the association of fixed-to-mobile calls with the PSTN,causes the Commission to believe there is a strong case for keeping fixed-to-mobilecalls in the basket of services subject to price control.

28 According to Telstra’s 1999-00 Annual Report it had revenue from fixed-to-mobile calls of $1220million (Table 4) and carried 3035 million minutes (Statistical Data, p. 75), giving an average of40.2 cents per minute.

29 See for example, Gans, J., “An Evaluation of Regulatory Pricing Options for Mobile TerminationServices”, prepared for the ACCC, Melbourne, December 1999.

30 CWO has offered an alternative explanation for this discrepancy. It claims that the high terminationcharges are part of an efficient “cross subsidy” arrangement where surplus revenue from thesecharges is used to hold subscription charges down.

31 There are also high prices in inter-carrier mobile-to-mobile services, although the circumstanceswith respect to origination are different from those for fixed-to-mobile calls.

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4.3.4 Leased Lines

Leased lines are virtual dedicated circuits or dedicated paths within shared lines,usually for the purposes of data transmission, and subject to various degrees of“management” by Telstra. Specific products included under the price controlarrangements are Fastway, Digital Data Services (DDS), Voicelink C and T, Megalink,Tie Lines and LightStream. Leased lines produce a substantial but rapidly decreasingamount of revenue for Telstra. According to data in Telstra’s 1999-00 Annual Report(pp. 91-3), Telstra received revenue of $2,838 million from “data, text and internetservices data”, but only $750 million of this came from “data and leased lines”, and notall of this sub-category is subject to the price control arrangements. Revenue from thissub-category is falling while revenue for all “data services” is increasing. Totalindustry-wide revenue from data services is estimated to be about $5 billion, andTelstra is the only carrier to offer leased line services.

Views from the Submissions

None of the original submissions on the Discussion Paper commented on the extent ofcompetition in leased line markets, but Telstra provided a brief supplementarysubmission addressing this issue on 14 December 2000. Telstra at that time argued thatleased lines represent an “anomaly within the price control regime” because they are ahigh-value business product in what it sees as a consumer protection measure. It alsoargued that there are substantial compliance and administrative costs of including themin the basket. ATUG did not raise the issue of leased lines in its submission on theDiscussion Paper, but reported “very strong feedback … that effective competition isnot widespread throughout the leased line market sector”.

Application of the Competition Criteria

The application of the competition criteria is very difficult in this area. The particularproducts are supplied only by Telstra and this appears on the surface to indicate acomplete lack of competition. On the other hand, the services under control constituteonly a small part (less than 10 per cent) of the total data market. This market isserviced by many other carriers in addition to Telstra. The total data market is growingrapidly at the same time as the market for the services under price control arrangementsfalls. Faster and more efficient data services based on IP, frame relay and ISDN appearto be displacing the price-controlled services. In the 1999-00 Annual Report, Telstraclaims that “we have lowered our prices for … dedicated leased lines, to maintain theircompetitiveness” (p. 92).

The Commission believes it is difficult to make a case for inclusion of just theseproducts and that the case has not been made for the extension of the controls to coverother services in this rapidly changing and growing market area.

Summary

Leased lines are a small and declining product area in a rapidly growing marketexperiencing competitive price reductions. There does not appear to be a strong casefor keeping just these products under price control, and it would be extremely difficultto extend the controls to cover other data products.

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4.4 Conclusions and implications for price control arrangements

The effectiveness of competition varies across the different market areas currentlysubject to price control arrangements, ranging from substantially ineffective in localservices to apparently effective in some mobiles areas.

In local services there is no effective competitor for Telstra’s ubiquitous local network,although competitors are nibbling away at this monopoly through the building oflocalised access networks, the availability of ULLS, wireless access, etc.

While there is a case for retail price control arrangements on local services these appearto have been overly severe, especially in relation to line rental. As further discussed inChapter 7, the impact of the inability for Telstra to cover the cost of the CAN from linerental charges is that an access deficit contribution is included in the prices of all PSTNcarriage services, and this appears to have hindered the development of competition.

While there is the outward appearance of strong competition, the Commission believesthere is sufficient evidence of ineffectiveness of competition in the provision ofnational long-distance and international calls to take a cautious approach with respectto these products. There are natural monopoly characteristics in those parts of theproduction chain where facilities-based entry has occurred and market outcomesindicate that competition has been associated with consistent price falls, but is yet tomake a substantial inroad into the gap between price and cost, especially in STD.Telstra has maintained a high market share in both the national and international long-distance markets. As has Oftel in similar circumstances, the Commission recommendsa cautious approach with respect to these services.

The mobiles market appears to have fewer natural monopoly characteristics than doesthe fixed-line markets, and perhaps three or four carriers seem to be able to fit into themarket. Market outcomes are encouraging with respect to mobile services with theexception of fixed-to-mobile services, where competition does not appear to beeffective. The Commission believes that fixed-to-mobile services should remain underretail price controls, partly because of the lack of effective competition and partly inrecognition of their association with the PSTN and Telstra’s need to cover its commoncosts efficiently.

Leased lines are a small and declining product area in a rapidly growing marketexperiencing competitive price reductions. There does not appear to be a strong casefor keeping just these products under price control, and it would be extremely difficultto extend the controls to cover other data products.

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Chapter 5 Efficiency – Making the Community as aWhole Better-off

5.1 Introduction

As outlined in Appendix A, the terms of reference for this review direct theCommission to consider the extent to which further efficiency gains could be achievedwith and without price control arrangements.

The purpose of this chapter, therefore, is to consider the efficiency gains achievableunder a series of alternative price control arrangements. In order to do this, however,the Commission has to determine what is meant by efficiency. In this regard, theCommission has identified three major types of efficiency that it believes are relevantto the pricing of telecommunications services:

productive efficiency - the ability of firms to produce given quantities ofservices at the lowest possible cost;

allocative efficiency - the deployment of resources to those areas of theeconomy where they are valued most and therefore provide the greatest benefitto society; and

dynamic efficiency - the development of efficient production processes overtime.

As outlined in Chapter 2 of this report, the Government would appear to be concernedwith these various forms of efficiency because, if achieved, they can make thecommunity as a whole better-off. Whether or not these changes make particularindividuals better off is a separate question that is addressed in Chapter 8 of this report.

The focus of this chapter will be primarily on analysing the allocative efficiency gainsachievable under alternative price control arrangements. The next chapter, whichconsiders the appropriate level of X to set in CPI − X per cent price caps, will focusmore intently on aspects of productive efficiency. Chapter 7 – which looks atcompetition, investment and consumers – will raise issues relating to both allocativeand dynamic efficiency.

In order to assess the efficiency gains – and, in particular, the level of allocativeefficiency gains – possible under alternative price control arrangements, the remainderof this chapter will:

§ outline how price control arrangements can lead to efficiency gains;

§ outline the justification for broad CPI – X per cent price caps;

§ consider estimates of the potential allocative efficiency gains that could beachieved under alternative price control arrangements;

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§ outline on what basis revenue weights should be calculated in order todetermine whether Telstra has complied with a broad price cap; and

§ consider the extent to which the community as a whole could be made betteroff by the removal of the local call parity requirement.

5.2 The efficiency rationale for price control arrangements

Appropriately designed, price control arrangements can generate all of allocative,productive and dynamic efficiency gains in the telecommunications industry. Howthey can achieve each type of efficiency is addressed below.

5.2.1 How price control arrangements can improve allocative efficiency

As stated above, allocative efficiency refers to the deployment of resources to thoseareas of the economy where they are valued most and therefore provide the greatestbenefit to society.

In general, the community as a whole will be made better off when the price of a givenservice better reflects the marginal cost of producing it.32 That way, consumers onlypay for a service if they value it at least as much as the marginal cost of producing it.33

In perfectly competitive markets, the forces of competition should ensure that the priceof a service is driven towards the long-run marginal cost of producing it. Hence, inperfectly competitive markets, allocative efficiency should be assured.

In markets where a service provider has monopoly power, the incentive to drive pricestoward marginal cost is removed. Indeed, under normal circumstances, anunconstrained monopolist would price above marginal cost to the extent necessary toextract as many monopoly rents as it could from a given market. Such profitmaximising behaviour is seen to be inefficient from a social welfare perspective as itleads to higher prices for end-users and lower levels of output being consumed.

One of the advantages of price cap arrangements, therefore, is that they can limit theextent to which a monopolist can price in excess of marginal cost. Indeed, a CPI − Xper cent price cap - which forces a firm to reduce the price of a service, or set ofservices, by X per cent in real terms each year - can be designed so as to force a

32 Marginal cost is defined as the additional cost of producing an extra unit of a given service. In thelong run, this comprises the change in both capital and operating costs.

33 That is, if the price of a service lies above its marginal cost, allocative inefficiency can arise as thereare likely to be consumers who value the service at more than the marginal cost of producing it, butless than the price at which it is being sold and will therefore not purchase it.

Similarly, if the price of a service lies below its marginal cost of production, allocative inefficiencycan also arise. This is because there may be some consumers who value the service at less than themarginal cost of producing it, but at more than the price at which it is being sold. Hence, they willpurchase the service despite not valuing it at least as much as its cost of production. Ideally,therefore, one would like the price of a service to reflect the marginal cost of producing it.

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monopolist to push the price of a given service towards marginal cost over time.Hence, to the extent that price control arrangements can lead to the price of a servicebeing driven towards its marginal cost, allocative efficiencies can be gained.

Another way in which price control arrangements can improve allocative efficiency isby allowing a firm to restructure its prices across a number of services in a way thatreduces allocative inefficiencies. That is, under certain circumstances, it may not bepossible for a firm to profitably survive if it sets the price of all services at marginalcost. For instance, in the case of telecommunications, the production of many servicesoften involves a number of common costs. Long-run marginal cost pricing, which doesnot include the recovery of common costs, will therefore leave a firm unable to recoverall of its costs if it is applied to all services. In these circumstances, a producer willneed to price above long-run marginal cost for some, or all, of the services contributingto common costs if it is to recover all of its costs of production. In other words, in suchcircumstances “effective competition” will involve at least some prices above costs.

While pricing above long-run marginal cost will introduce inefficiencies into themarkets in question, one way of limiting the extent of this inefficiency is to use“Ramsey pricing”. This is where the producer raises the price of each service abovelong-run marginal costs in a way that will distort each market in such a way as tominimise the loss in efficiency from raising a given amount of common costcontribution. Under this approach, the producer raises prices proportionately morewhere demand is least sensitive (more inelastic) to changes in price.

A regulator can give a firm the incentive to Ramsey price by including a number ofservices with common costs within the same broad price cap basket. For instance, asindicated in Chapter 3, a central theme of all the price control arrangements since theirinception in 1989 has been the inclusion of a broad CPI − X per cent price cap on abroad basket of services. Under this form of price control, a firm is still required toreduce the prices of a number of its services collectively towards cost, but still has thefreedom to do so in a way which minimises the allocative inefficiency of recoveringcommon costs across these services.

The size of allocative efficiency gains can be estimated using standard measures ofconsumer and producer surplus. These measures are discussed in more detail in section5.4 below. Estimates of allocative efficiency gain under current and alternative pricecontrol arrangements are then assessed in section 5.5.

5.2.2 How price control arrangements can improve productive efficiency

Productive efficiency refers to the ability of firms to produce given quantities ofservices at the lowest possible cost.

One of the advantages of competition is that it provides an incentive for firms to findthe least-cost way of producing services so they can establish a cost advantage overtheir competitors. At the time of the introduction of the 1989 price controlarrangements, however, Telecom and OTC were monopoly providers oftelecommunications services. Accordingly, it was felt they did not have sufficientincentive to find the least-cost way of producing the services they provided.

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In order to redress this situation, the government introduced CPI − X per cent pricecaps on certain services that Telecom and OTC provided. A CPI − X per cent price capworks by forcing a regulated firm to reduce its weighted-average prices for a basket ofservices by X per cent in real terms each year. The value of X is set according to someestimate of the cost savings an efficient telecommunications firm should be able toachieve in the provision of a service, or a set of services in a basket, over a given year.Hence, CPI − X per cent price caps were seen as one way of encouraging Telecom andOTC to strive for productive efficiencies, as they encourage firms to reduce their costsin order to meet their price cap obligations. A further incentive to seek productiveefficiencies is provided because if Telstra reduces its costs by more than X per cent, itcan keep the difference between price and the lower cost until X is re-set.

5.2.3 How price control arrangements can improve dynamic efficiency

Dynamic efficiency refers to the development of efficient production processes overtime. Hence, firms will be dynamically efficient if they have the incentive to invest,innovate, improve the range and quality of services, increase productivity and lowercosts through time.

Again, the use of CPI − X per cent price caps can help a monopolist achieve dynamicefficiencies by providing it with the incentive to continue to seek increased productivityand lower costs over time in order to meet – or exceed – its price control obligations.

In contrast, however, price control arrangements can also hinder dynamic efficiency ifthey stifle a firm’s incentive to efficiently invest in telecommunications services. Thisissue is discussed in more detail in Chapter 7.

5.3 The allocative efficiency properties of a broad CPI – X per centprice cap

As indicated in section 5.2, allocative efficiency is best achieved, in the absence ofexternalities, when the price of a service equals the marginal cost of producing it.However, where common costs arise in the production of a number of services, a firmmay need to price above marginal cost for some or all of these services in order torecover its costs of production. As indicated in section 5.2, this will introduceinefficiencies into the markets in question. One way of minimising this efficiency lossis for the firm to use Ramsey pricing.

One implication of Ramsey pricing is that it may be efficient for a firm to set prices forsome of its services well above their costs of production because they have a low own-price elasticity of demand.34 Accordingly, setting an individual price cap on everyservice may lead to inefficient outcomes. This is because it could push the price of allservices towards cost in a uniform way, rather than encouraging the firm to structure itsprices for all services such that it minimises the efficiency loss of recovering commoncosts.

34 Where own-price elasticity of demand measures the responsiveness of the demand for a service to achange in its price.

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It can be argued, therefore, that if there is a number of services that the governmentdecides should be subject to a price cap, then those services should be included in abroad price cap if they share common costs. Under this approach, the firm would stillbe required to reduce the price of the basket of services as a whole, but will have thefreedom to restructure its prices so that it raises prices proportionately more wheredemand is least sensitive.

In summary, therefore, where common costs exist, efficiency is best served by applyinga price cap to as broad a basket of the services sharing these costs as possible.

A natural implication of this conclusion is that sub-caps, which impose additionalrestrictions on the movement of the price of services within the broader basket, areundesirable from an efficient pricing perspective. Accordingly, the CPI − 0 per centsub-cap on the basket of local calls and residential line rental services; the CPI − 0 percent sub-cap on connection services; the CPI −1 per cent sub-cap on a basket ofservices for the bottom 50 per cent of Telstra’s customers; and the 22 cent price cap onlocal calls are all likely to limit the extent to which Telstra can efficiently structure itsprices. The Commission notes, however, that removal of these sub-caps may haveadverse impacts on particular groups of consumers. In order to ameliorate the potentialfor these adverse impacts, therefore, there may be an argument for retaining of some ofthese sub-caps.

Submissions

In its submission on the Discussion Paper, Telstra agrees that price controlarrangements should be applied to a single broad basket of services. In particular,Telstra states that:

…it is important for the overall price-cap to be applied as broadly as possible. This is primarilybecause a broad basket approach to the overall price-cap provides Telstra with the latitude toallocate common costs more efficiently than if prices were set on accounting rules or if theregulator were to set prices on a service-by-service basis.35

Further, Telstra also states that:

…a broad price-cap allows Telstra to build knowledge of its customers’ demand over timethrough practical application of its pricing policies. Through continued practice of finely tuningpricing for differential market segments (e.g. charging lower price to elastic market segmentsand higher prices to more inelastic segments), Telstra can make welfare enhancing adjustmentsto its prices.36

Accordingly, Telstra argues that:

…the creation of narrow and constrained baskets artificially inhibit Telstra’s ability toimplement an increasing range of price offerings.37

35 Telstra submission, p. 7

36 ibid., p.7

37 ibid., p.8

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And that:

The bottom 50% basket…is over inclusive in its reach, and largely operates to inhibit productpackaging and pricing options for diverse groups of consumers.38

CWO argues that if the Minister is to continue to use broad price caps, they should onlycover those markets that are not competitive. This is because the inclusion of non-competitive services in the broad price cap provides an incentive for Telstra to reduceprices in those markets that are competitive, and push up prices for those services in thebasket where it has market power.

Commission analysis

In summary, therefore, the Commission believes that price caps should be appliedbroadly to all services for which Telstra still continues to have market power and whichshare common costs. Once a broad price cap is in place, sub-caps should not beincluded in the price control regime from an efficient pricing perspective, as they willlimit the extent to which Telstra can efficiently restructure its prices. As indicatedabove, however, there may be equity considerations that need to be taken into accountwhen deciding whether some of these sub-caps should be retained.

5.4 Principles in measuring allocative efficiency gains

As indicated above, improving the allocative efficiency of alternative price controlarrangements can make the community as a whole better off. One way to compare therelative merits of alternative price control arrangements is to consider the extent towhich they make the community as a whole better off.

As indicated above, the gains to the community as a whole can be calculated usingmeasures of consumer and producer surplus. In this regard, consumer surplus isdefined as the difference between a consumer’s valuation of a good, and the price s/hehas to pay for it. In general, therefore, if the price of a given service falls, consumersurplus will increase. Hence, if price control arrangements lead to a reduction in theprice of price-controlled services, consumers will benefit. The extent of this benefitcan be measured by the increase in consumer surplus.

Producer surplus, on the other hand, is defined as the difference between the cost ofproducing a service and the price a producer receives from selling it. Accordingly, aprice fall will normally lead to a reduction in producer surplus.

In order to measure whether society, as a whole, benefits or loses from a change inprices, one must weigh up the changes in both consumer and producer surplus. Inparticular, if a change in prices leads to an increase in one form of surplus, but adecrease in the other, society as a whole can only benefit if the gain outweighs theloss.39 In the absence of externalities, if a change in price means closer alignment with

38 ibid., p.8

39 Hence, if a price fall leads to an increase in consumer surplus, but a decrease in producer surplus,society as a whole will only gain if the increase in consumer surplus is greater than the decrease inproducer surplus.

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cost, society as a whole will gain. Again, the intuition is that by more closely aligningprices with cost, resources will be better directed to those parts of the economy wherethey are more highly valued. A more detailed description of consumer surplus,producer surplus and welfare gains as a result of price moving closer to cost is providedin Box 5.1 below.

Box 5.1 – Consumer surplus, producer surplus and welfare gains

As outlined in the main body of this report, consumer surplus is defined as thedifference between a consumer’s valuation of a good, and the amount s/he has to payfor it. Producer surplus, on the other hand, is defined as the difference between the costof producing a service and the amount received from selling it.

This is illustrated in Figure 5.1 which provides a graphical depiction of consumer andproducer surplus concepts with regard to the market for a given service, X. InFigure 5.1, the quantity of X is measured along the horizontal axis, whilst the price ofX is measured on the vertical axis. Demand for X is shown by the demand curve DX,40

whilst the marginal cost of producing additional units of X is represented by the curveMCX.41

Given a demand curve represents how much consumers are willing to pay forsuccessive units of a service they consume, the demand curve represents the valuationconsumers’ place on successive units of X. Accordingly, the area under the demandcurve represents the total valuation consumers’ place on their consumption of X.Similarly, the area under the marginal cost curve represents the total cost of producinga given amount of X.

It follows, therefore, that if the price of X is originally set at P0, consumers will demandX0 of X. In the absence of price discrimination, therefore, consumers will pay a totalamount for their consumption of P0

.X0. In Figure 5.1, this is represented by the area B+ C. The variable cost of producing X0 is, however, only equal to the area under themarginal cost curve, area C. It follows, therefore, that the producer earns a surplus overits costs equal to the area B.

40 The Commission has a preference for using a “Hicksian” demand curve for estimating welfare gains,as it focuses on how a change in relative prices will influence consumers’ substitution betweendifferent services in response to a change in their relative prices. Whilst such a demand curve doesnot consider the income effect of changes to the price of a particular service (as does a“Marshallian” demand curve), the Commission believes this effect is relatively small in the case oftelecommunications products as any change in expenditure as a result of changes to the price controlarrangements is likely to represent only a small part of the consumer’s overall budget.

41 For the purposes of simplicity, marginal cost is assumed to be constant. Whilst this may not accordwith many telecommunications services, this assumption does not affect this analysis.

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P,C

A

P0

B

MCX

C DX

X0 X

Figure 5.1 – Producer and Consumer Surplus

Consumers, on the other hand, value their consumption of X0 by an amount equal to thearea under the demand curve A + B + C. Given they only pay B + C for theirconsumption, consumers also enjoy a surplus equal to the area A.

In general, therefore, if the price of service falls, consumer surplus will increase, whilstproducer surplus will fall. The reason for the increase in consumer surplus is twofold.Firstly, those consumers who already purchased units of a service will now benefitbecause the price they have to pay for these units has fallen. Secondly, consumers willbe induced to consume more units of the service because its price has fallen. Hence,there will be more units over which their valuation of the service is greater than its costof production.

This is illustrated in Figure 5.2 which demonstrates the change in consumer andproducer surplus as a result of a reduction in price of X. To illustrate, suppose the priceof X falls from P0 to P1. As a result of this, demand for X will increase from X0 to X1,and consumer surplus will increase by an amount equal to the area C + D. Of this, Crepresents the gain for consumers already consuming X0 units of X, while D is the gainfor the extra units of X consumed.

Providing producers are not pricing above profit maximising levels, producer surpluswill decrease as a result of a fall in price. That is, for those units previously sold at P0,producers now receive a lower price. However, this loss will be partially offsetbecause there will now be additional units (i.e. X1 – X0) over which they can earn asurplus. In Figure 5.2, therefore, producers will lose an amount equal to the area C, butgain an amount equal to the area E.

In order to measure whether society, as a whole, benefits or loses from a change inprices, one must weigh up the changes in both consumer and producer surplus.

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P,C

P0

P1 C D

E MCX

DX

X0 X1 X

Figure 5.2 – Measures of allocative efficiency

As indicated in the main body of the text, a change in price means that the price of agiven service is more closely aligned with cost, society as a whole will gain.

This is illustrated in Figure 5.2 where the gain in consumer surplus is equal to the areaC + D; whilst producer surplus decreases by the area C + E. In sum, therefore, societyas a whole will gain by an amount equal to the area D + E

5.5 Allocative efficiency gains under alternative price controlarrangements

In this section, the Commission applies the principles outlined in section 5.4 to measurethe extent to which alternative price control arrangements might improve allocativeefficiency, and therefore make the community as a whole better off.

In this regard, the Commission has received submissions from Telstra and CWO thatconsider the impact of removing some of the sub-caps currently in place, and modelledwhat it believes could be the impact on allocative efficiency of alternative price controlarrangements. In order to address this issue, this section:

§ Comments on modelling exercises provided in submissions;

§ Outlines the modelling approach performed by the Commission; and

§ Provides estimates from the Commission’s modelling of the efficiency gainsavailable under alternative price control arrangements.

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5.5.1 Submissions on measurement of the efficiency gains possible under futureprice control arrangements

As indicated earlier in this chapter, allocative efficiency gains and losses can bemeasured using standard measures of consumer and producer surplus. Both Telstra andCWO use these approaches to estimate the efficiency cost of certain sub-caparrangements.

The two pieces of analysis, and the Commission’s assessment of them, are providedbelow.

Telstra’s estimate of the efficiency costs of the sub-caps on line rental

In its submission on the Discussion Paper, Telstra estimates the efficiency gains thatwould result if the sub-caps that currently limit the ability of Telstra to raise the price ofline rentals to cost were removed.

That is, in its most recent assessment of Telstra’s charges for providing DomesticPSTN Originating and Terminating Access services, the Commission concluded thatthe cost of customer access including an indirect cost attribution (i.e. line costs) waswell in excess of the revenue that Telstra could earn from line charges under currentprice control arrangements. In particular, the Commission estimated the efficient costof line rentals to be, on average, $336 per line for 1999-00 and $346 per line for2000-01.

In contrast, the price Telstra charged for line rental was, at the time of its submission onthe Discussion Paper, equal to $166.20 per annum (GST exclusive) for residentialcustomers and $300 per annum (GST exclusive) for business customers.42 Clearly,therefore, the prices Telstra charges for line rentals are, on average, below cost. Thisgives rise to what is referred to as an “access deficit”.43

In the Discussion Paper for this review, the Commission noted that whilst there is someroom under the current price control arrangements for Telstra to increase the price ofline rentals each year, the combined effect of a number of those arrangements limit theextent to which Telstra can raise the retail price of line rentals. In this regard, inassessing the charges for Domestic PSTN Originating and Terminating Accessservices, the Commission noted that even if Telstra raised the price of line rentals to thefull amount allowed under the price control arrangements, it would still continue toincur an access deficit of $1,278 million in 1999-00 and $1,180 million in 2000-01.

The implication of this is that if Telstra is to achieve overall cost recovery, it mustrecover the access deficit through other aspects of its business. Generally, this involvesraising the per-unit price of services using Telstra’s network above their efficient cost.For instance, in assessing charges for the Domestic PSTN Originating and TerminatingAccess services, the Commission decided to add an access deficit contribution (ADC)

42 The Commission notes that the price Telstra charges for residential line rentals has subsequentlyincreased to $190.90 per annum (before GST).

43 This term arises because line rental is sometimes referred to as basic access.

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to the conveyance cost in order to estimate a reasonable charge for the service. Thiswas determined at 0.69 cents per minute for 2000-01 which, when combined with anestimate of conveyance costs, led to an overall price of 1.53 cents per minute. Hence,without an ADC, the appropriate charge for Domestic PSTN Originating andTerminating Access services would have been much lower at around 0.84 cents perminute.

In order to estimate the efficiency costs of the sub-caps on line rental, Telstra estimatedthe gains that would accrue to consumers if the price of line rental was allowed to riseto cost and the ADC was removed from the price of a number of services currently inthe broad price cap. Given prices would move closer to cost, one would expect anincrease in allocative efficiency. Based on the price changes it estimated would occurif the price of line rentals were allowed to rise to costs, Telstra estimated the efficiencycost of the sub-caps that prevent Telstra from raising the price of line rental to be$25 million per year.

Whilst the Commission agrees that the efficiency cost of the sub-caps that preventTelstra from raising the price of line rentals is substantial, the Commission does notbelieve that Telstra’s approach gives a true representation of the full efficiency cost ofthe current price control arrangements. The reasons for this are threefold. Firstly,Telstra’s analysis only considers the efficiency gains that would occur from theremoval of the sub-caps that affect the price of line rental. 44 It is important to note,however, that other sub-caps exist which limit the ability of Telstra to structure itsprices efficiently. In particular, the CPI − 0 per cent sub-cap on connections and the22 cent price cap on local calls are both additional sub-caps that limit the ability ofTelstra to restructure its prices.

That said, Telstra’s analysis does not pretend to estimate the full efficiency cost ofremoving all sub-caps on Telstra. However, the Commission believes an analysis ofthe efficiency costs of the current price control arrangements should consider theimpact of all sub-caps on Telstra.

Secondly, Telstra’s analysis assumes that if the price of line rental was allowed to riseto cost, the consequent removal of the ADC from the price of other services currentlysubject to price control arrangements would see the price of these services reduce toTSLRIC. In other words, Telstra’s analysis assumes that the only difference betweenthe current price and the TSLRIC of services currently subject to price controlarrangements is the ADC. This conclusion would appear to rely on the assumption thatthe markets for all services in the price cap are fully competitive already, with the onlydistortion being the access deficit on line rental and the consequent need to recover theaccess deficit through the pricing of other services.

44 Indeed, Telstra’s submission only notes the CPI – 0 per cent sub cap on line rental and local calls aslimiting the extent to which Telstra can raise the price of line rentals to cost. The Commissionassumes, however, that Telstra has in fact considered the impact of removing other sub caps thataffect the price of line rental such as the CPI – 1 per cent sub cap on the basket of services for thelowest 50 per cent of Telstra’s pre-selected customers.

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As indicated in Chapter 4, however, the Commission does not believe that competitionis fully developed in each of the price controlled markets. Accordingly, theCommission believes there is good reason to believe that for many of the pricecontrolled services, the difference between price and TSLRIC+ is greater than theADC.

The implication of this is that the efficiency gain from simply increasing the price ofline rental to cost, and then decreasing the price of other services by their current ADC,is greater than that estimated by Telstra.

To illustrate, suppose the cost of providing a given service is less than its current priceminus its ADC. This is illustrated in Figure 5.3 below, where the current price is P0,the price after the removal of the ADC is P1 and the true underlying cost of the serviceis equal to MCX. Under the approach to estimating efficiency gains in the Telstrasubmission, removal of the ADC would lead to an efficiency gain equal to the shadedtriangle A. However, if – as the Commission believes – the true underlying cost ofmany of these services is actually below the ADC-exclusive price, the efficiency gainfrom removing the ADC should also include the rectangle of producer surplus gainedfrom selling additional units of each service. In Figure 5.3, the area B would measurethis gain in producer surplus. Hence, using the welfare measures outlined in Box 5.1,the true efficiency gain should be equal to the area A + B.

P,C

P0

P1 A

B MCX

X0 X1 X

Figure 5.3 – Efficiency gain from the removal of the ADC

Finally, Telstra’s analysis makes no effort to “rebalance” prices in accordance withRamsey pricing principles. That is, the analysis merely removes the ADC from thecurrent price of each of the price-controlled services (other than line rental) inaccordance with the method used by the Commission for attributing the ADC to otherservices using the customer access network. Whilst this approach may be anadministratively simple method for allocating the ADC, it does not accord with Ramseypricing and therefore will understate the full allocative efficiency gain.

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Hence, when estimating the full allocative efficiency gains achievable if Telstra was torestructure its prices efficiently, an attempt should be made to estimate how priceswould change if Telstra set the price of each service such that it raises proportionatelymore common costs where demand is least sensitive to changes in prices. Under thisapproach, the efficiency gains from the full removal of sub-caps are likely to besubstantially higher than that estimated by Telstra.

CWO’s estimate of the efficiency cost of the sub-caps on line rental

In its submission on the Discussion Paper, CWO also provides an estimate of theefficiency cost of the sub-caps on line rental. CWO estimate the loss at $45 million peryear45 based on a calculation of the welfare cost from the inclusion of the ADC in theprice of long-distance services, international outgoing services, fixed-to-mobileservices and mobile-to-mobile services. This figure estimates both the allocativeefficiency and dynamic efficiency costs of the current set of price control arrangements.

Whilst the Commission agrees that there is a welfare loss arising in the markets CWOconsiders, the Commission believes the size of this loss is much larger than thatestimated by CWO. For reasons similar to those expressed in assessing Telstra’sestimate of the welfare cost of the sub-caps on line rental, the Commission believes theCWO measure of welfare loss under-estimates the full extent of the welfare loss in thelong-distance market (and other markets). That is, like Telstra, CWO assumes theremoval of the ADC would see the price of long-distance services fall to underlyingcost so that the only difference between the current price and marginal cost of long-distance services is the 1.38 cents per minute of ADC.46 The Commission believes,however, that given competition is still developing in the long-distance market, price isstill well in excess of marginal cost plus ADC.

Finally, like Telstra, CWO makes no attempt to consider the efficient price forlong-distance services if Telstra was to base its prices on Ramsey pricing principles.

5.5.2 The Commission’s approach to modelling allocative efficiency gains underalternative price control arrangements

In order to identify the possible allocative efficiency gains under alternative pricecontrol arrangements, the Commission engaged Access Economics to help it develop aset of models to estimate the prices Telstra might charge under alternative price controlarrangements. In this regard, the Commission has considered two broad types ofmodel:

1. A full rebalancing model that estimates what prices would provide thegreatest benefit to the community as a whole whilst ensuring Telstracontinued to make the same contribution to indirect costs and profits; and

45 CWO presents the efficiency gain as a present value of a perpetual stream of gains discounted at 10per cent and therefore has the appearance of a much greater gain.

46 Based on an ADC estimate of 0.69 cents per minute for 2000-01 multiplied by 2 to account for bothorigination and termination of a long-distance call.

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2. A model that estimates how Telstra might set prices for each of the pricecontrol services if it sought to increase its profits to the greatest extentpossible under different price control scenarios.

The first model is useful as it indicates the extent to which Telstra’s current pricingstructure reduces the welfare of the community as a whole. The second model is usefulas it indicates how the welfare of the community as a whole could be improved underalternative price control arrangements. By considering the benefit to the community asa whole under a range of alternative price control arrangements, the Commission canbegin to make recommendations regarding which set of price controls would best meetthe objectives of the price control arrangements.

The methodology, data sources and results for both of these two models are outlinedbelow.

The full rebalancing model

Methodology

As indicated above, the full rebalancing model attempts to estimate the full extent towhich the community as a whole could be made better off if Telstra changed its pricingstructure for the price controlled services. In order to estimate this, the model askswhat prices would, in the absence of any price controls, maximise the overall gains tothe community as a whole whilst ensuring Telstra still received enough revenue tomake the same contribution towards profits and common costs.

Under the full rebalancing model, the benefit for the community as a whole ismaximised - as discussed in section 5.3 – when Telstra raises proportionately more ofits contribution to indirect costs and profits through the prices of those services wheredemand is least sensitive (more inelastic) to changes in price.

Viewed from another perspective, the model provides an estimate of how the currentprice controls inhibit the development of efficient pricing structures by showing howprices could alternatively be set such that overall consumer welfare was improvedwithout harming Telstra’s overall level of profit.

The basis of this model is similar to that devised by Albon47 – variants of which havebeen used in previous studies of price control arrangements by the IndustryCommission and Access Economics.48

47 Albon, R.P., “The Welfare Costs of Australian Telecommunications Pricing”, Economic Record , 64,June 1988, pp.102-12.

48 Productivity Commission, Telecommunications Economics and Policy Issues, Staff InformationPaper, Canberra, March 1997 and Access Economics, Review of Price Control Arrangements onTelstra , August 1998 represent the two most recent attempts to quantify the efficiency costs ofabove-cost pricing of telecommunications services.

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Data sources

In order to perform this modelling, the Commission collected data to provide indicativeestimates of the:

§ current prices being charged by Telstra for each of the price-controlledservices;

§ current quantities of each of these services being consumed;

§ elasticity of demand for each of these services; and

§ long-run incremental cost of most of the services that are currently subject toprice control arrangements.

These estimates were based on a combination of data provided by Telstra (both interms of price control compliance information and Chart of Accounts/Cost AllocationManual (COA/CAM)); industry data and results from the n/e/r/a model used by theCommission to estimate the costs of the PSTN. Most of this data is commercial-in-confidence. Further, the data are based on estimates for the 1999-00 financial year.

Given the Commission has recommended that certain services be removed from theprice control arrangements in Chapter 4 of this report, the Commission did not attemptto estimate how the prices of these excluded services might change under alternativeprice control arrangements. Hence, mobile services and leased lines have not beenincluded in this analysis. Further, the Commission has made no attempt to model theimpact of changes to the price control arrangements on the price of connection services.Accordingly, the modelling undertaken only looks at the impact on the consumption ofbusiness and residential line rentals, local calls, national long-distance (STD),international long-distance (IDD) and fixed-to-mobile (F2M) services.

The Commission also notes that estimates of current prices are aggregate in nature (asare the prices used to determine whether Telstra currently complies its price controlobligations), and therefore the model can not estimate for the impact within certain sub-markets within the broader product categories.

Updating the data for changes since 1999-00

In order to estimate the current price of those services included in the Commission’smodelling, the Commission was provided with aggregate revenue and quantity data forthe 1999-00 financial year. The Commission notes, however, that any changes to thecurrent price control arrangements would be likely to take effect from July 2001.Hence, in order to estimate how Telstra’s prices might change under alternative futureprice control arrangements, the Commission must either:

§ Model how Telstra would have set its prices in 1999-00 if alternative pricecontrol arrangements had been in place at that time; or

§ Update 1999-00 data to reflect current price levels, and then ask how theseprices would change in the future under alternative price control arrangements.

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Given the price of many of the services modelled have changed significantly since1999-00, the Commission thought the second approach would give a better indicationof potential price changes under alternative price control arrangements. For instance,the Commission notes that the price of both line rentals and local calls are significantlydifferent to their average levels for the whole of 1999-00. In particular, the price of linerental is now at $190.90 per annum before GST, whilst the maximum amount Telstracan charge for a local call is 20 cents per call before GST.

Hence, in order to improve the relevance of its modelling, the Commission hasattempted to update the average prices for each of the services it models to reflect thosethat are likely to exist today. Accordingly, the Commission has adjusted its startingprice for line rental to $190.90 per line for residential consumers; and decreased thestarting price for local calls to 20 cents per call.

Further, the Commission believes that the prices for STD, IDD and F2M services arelikely to have decreased since 1999-00. At the time of this report, reliable estimates ofthe average prices Telstra charges for each of these services was not available to theCommission. Hence, in order to estimate the likely price falls for each of theseservices, the Commission considered trends in the movement of these prices over thelast five years.49 This showed that over this period, the average price had fallen forSTD, IDD and F2M services by 2.8 per cent per annum, 12.2 per cent per annum and1.6 per cent per annum respectively. Market inquiries indicate that these price trendsare broadly consistent with those experienced over the past six months. Accordingly,the Commission applied these price trends to provide an indicative estimate of what theaverage prices for each of these services is likely to be for the purposes of theCommission’s modelling of alternative price control arrangements.

Finally, in order to make these price changes consistent with quantity and revenueestimates, the Commission estimated how revenue and quantity levels for each of theservices would change in response to the updated price estimates. The Commission didthis with reference to its elasticity of demand estimates for each of the services.

Estimating TSLRIC for each of the price controlled services

The Commission’s preferred approach to identifying efficiency gains from the pricecontrol arrangements would be to base estimates of cost on TSLRIC. TSLRIC is thecost that an efficient firm would incur in providing that service in the long run. This isthe pricing approach favoured by the Commission in relation to the pricing of access todeclared telecommunications services.50

In order to provide indicative estimates of the TSLRIC of most of these services, theCommission considered TSLRIC estimates of the cost components. These estimateswere based on COA/CAM data, data from the n/e/r/a report into the costs of the PSTN,data from industry participants and estimates of international settlement rates from the

49 ACCC, Telecommunications charges in Australia, 1995-99, Canberra, 2000.

50 ACCC, Pricing Principles for Telecommunications: A Guide, Canberra, 1999.

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Productivity Commission. 51 Again, most of these data are commercial-in-confidence.The Commission also notes that these estimates may not be precise, but none-the-lessbelieves they are indicative of the TSLRIC costs of providing these services.

Summary of inputs to the model

In summary, therefore, Table 5.1 outlines the price, quantity, elasticity of demand andTSLRIC estimates the Commission used in estimating the benefits to the community asa whole that might result under alternative sets of price control arrangements.

Service Average price Quantityconsumed

TSLRIC(indicativeestimate)

Elasticity ofdemand

STD c-i-c cpm c-i-c b min c-i-c cpm -0.55

IDD c-i-c cpm c-i-c b min c-i-c cpm -0.90

F2M c-i-c cpm c-i-c b min c-i-c cpm -0.30

Line rental (res.) $190.9 per line c-i-c m c-i-c per line -0.04

Line rental (bus.) $300 per line c-i-c m c-i-c per line -0.01

Local 20c per call c-i-c b c-i-c c percall52

-0.06

Table 5.1 Input data for both models [c-i-c]

Results

Based on the inputs outlined in Table 5.1, the Commission, estimates that if Telstra wasallowed to fully rebalance its prices subject to the constraint of not changing its overalllevel of profits, the welfare of the community as a whole could increase by as much as$232 million in the first year under these changes.

The results of this analysis indicate that the pricing outcomes under the current pricecontrol arrangements are different from those that would generate the greatest overallbenefit for the community as a whole. The reason for this is that under the currentprice control arrangements, Telstra is constrained in the way it can price the servicesthat fall under price controls – especially with regard to the price of line rentals. As a

51 Productivity Commission, International Telecommunications Market Regulation , Report no. 7,Ausinfo, 1999, Canberra .

52 The Commission notes that it has not undertaken a TSLRIC study regarding the cost of a local call.In order to estimate this figure, the Commission relied on Telstra’s submission to the ProductivityCommission Inquiry into Telecommunications Specific Regulation (p. 8). In this regard, Telstraestimated the TSLRIC cost of a local call to be 14.85 cents per call. Subtracting an estimate ofindirect costs and adding a figure for retail costs provides a figure of c-i-c cents per call. TheCommission’s use of this estimate should not be taken to imply that the Commission believes thisrepresents the true cost of a local call. However, for the purposes of this exercise, the Commissionbelieves the estimate provides a conservative proxy measure as it is based on Telstra estimates of thecost components of a local call.

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result of these constraints, Telstra is unable to structure its prices in a way that wouldprovide the greatest benefit to the community as a whole. 53

In particular, the price controls have the effect of preventing Telstra from recovering itsindirect costs and profits from those services where demand is least sensitive tochanges in prices. For example, one service with a particularly low demand responseto price changes is line rental. Accordingly, in order to generate the greatest benefit forthe community as a whole, Telstra should be recovering more of its indirect andcommon costs from this service. However, one impact of the current price controlarrangements is to limit the extent to which Telstra can raise the price of line rental inorder to do this.

In summary, therefore, the major conclusion from the full rebalancing model is that thecurrent price control arrangements are preventing Telstra from structuring its prices in away that provides the greatest benefit to the community as a whole. Accordingly, thereis a strong argument to change the current price control arrangements in order to giveTelstra more flexibility in the way it prices the telecommunications services currentlysubject to price control arrangements.

The impact of alternative price control arrangements

Methodology

While the full rebalancing model indicates the inefficiency of Telstra’s current pricingstructure, and the gains that could potentially accrue to the community as a whole underan alternative pricing structure, the model is limited in the sense that it doesn’tnecessarily indicate how Telstra would structure its prices if all price controls wereremoved. This is because the model assumes Telstra keeps its contribution to profitsand indirect costs constant in the absence of price control arrangements. In reality,however, Telstra would be more likely to structure its prices in a way that will increaseits profits to the greatest extent possible if all price controls were removed, andtherefore is unlikely to structure its prices in the way the full rebalancing modelsuggests.

In order to determine how prices might change under different price controlarrangements, and the impact these changes might have on the welfare of thecommunity as a whole, a different type of model is required. Accordingly, theCommission, in consultation with Access Economics, has sought to develop a modelthat will estimate how Telstra might be expected to set its prices in the presence ofalternative price control arrangements.

53 Note that this modelling overlooks complicating factors including the likelihood that there is somesubstitutability between services, particularly between (fixed) line-rental and mobile services, STDand F2M services, and the complementary nature of line rental and call services. Increases in theprice of line rental, for example, could influence the take-up of mobile services and hence this maycause the model to overestimate the gains from increasing line rental prices. On the other hand, afall in call prices may cause an increase in the take-up of line rental, causing the model tounderestimate the gains from falling call prices. These factors are considered sufficiently small inmagnitude that, while they would enrich the analysis, they would not fundamentally alter the resultsreported.

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In this regard, the Commission considered three alternative sets of price controlarrangements, and estimated how it thought each of these arrangements might influencethe way in which Telstra might restructure its prices. A description of each of thesescenarios is provided below.

a) Scenario 1 – A broad CPI – 5 per cent price cap only

In the first scenario, Telstra is only subject to a broad CPI – X per cent price capon the basket of the services recommended in Chapter 4, with no additional sub-cap arrangements in place. In line with the analysis provided in Chapter 6, X isassumed to be set at 5 per cent per annum.

b) Scenario 2 – The set of price control arrangements recommended in thisreport

In the second scenario, the Commission has attempted to model how Telstramight structure its prices if the Government choses to adopt the full set ofrecommendations outlined in this report. In particular, scenario two models forthe following set of price control arrangements:

§ A broad CPI – 5 per cent price cap on the services the Commissionrecommends should remain subject to price control arrangements;

§ A 22 cent (GST inclusive) sub-cap on the price of local calls;54

§ A CPI + 10 per cent sub-cap on the price of line rentals.55

c) Scenario 3 – A CPI - 0 per cent broad price combined with the otherrecommendations made in this report

This scenario is the same as scenario 2, except that the Commission assumesthat X is set at zero in the broad CPI – X per cent price cap rather than five.

The data sources for all three models are the same as those used in the full rebalancingmodel.

Results

Table 5.2 provides a summary of the modelling results for all three scenarios. Finalprices and price changes are indicated, as well as the gain to the community as a wholeas a result of these changes.56 The initial price values in this table are commercial-in-confidence.

54 For modelling purposes, this is translated into a CPI – 0 per cent price cap on local calls.

55 The Commission notes that this report recommends that there should be an adjustment period overwhich rebalancing of the price of line rental is allowed to occur. Further, the Commissionrecommends that this period should not exceed 5 years. For modelling purposes, the Commissioninterprets this as a CPI + 10 per cent price cap on both business and residential line rentals.

56 For simplicity, the CPI factor has been assumed to be zero in these models.

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Initial values Broad Caponly

CPI – 0Broad Cap

ACCC-preferred

Nominal price changesSTD c-i-c c per min -29.8% -11.2% -20.1%IDD c-i-c c per min -21.2% -9.8% -15.3%F2M c-i-c c per min -23.9% 0.2% -16.2%Line rental – res $190.9 per line 27.4% 10.0% 10.0%Line rental – bus $300.0 per line 25.2% 10.0% 10.0%Local calls 20c per call -3.8% 0.0% 0.0%

Weighted price change -5.0% 0% -5.0%

Welfare effects ($m)Contribution to profit +common costs

$1,829.1 $1,611.3 $1,886.1 $1,592.9

Deadweight loss $276.0 $87.5 $211.9 $136.6Change in deadweight loss -$188.5 -$64.1 -$139.4Change in consumersurplus57

$406.5 $7.0 $376.4

Change in producer surplus -$218.0 $57.1 -$236.0Table 5.2 Price changes under alternative scenarios

The Commission emphasises these are not prices the Commission recommends Telstraset in response to alternative price control arrangements. Rather, they are indicative ofthe prices Telstra may choose to set in response to alternative price controlarrangements.

The Commission also notes that the specific results are reliant on the inputs used in thismodel. To the extent that some of these inputs may not be precise, the final pricechanges are likely to be slightly different.

The strength of this model, however, is that it provides a good indication of thedirection in which the price of the price controlled services will move under alternativeprice control arrangements, and the relative benefits these changes will make to thewelfare of consumers and the community in general.

Interpretation of results

Examination of Table 5.2 indicates that a simple broad CPI – 5 per cent price cap willprovide the greatest benefit for the community as a whole. This result is not surprising

57 The Commission notes that the Australian Communications Authority has recently released a studythat includes estimates of consumer surplus changes for 1999-00 (Australian CommunicationsAuthority, Telecommunications Performance Report 1999-00 , Melbourne, 2000). The Commissionnotes, however, that this study calculates consumer surplus using a different methodology from thatemployed by the Commission. In particular, the ACA estimate includes estimates of demand growthover time when measuring an increase in consumer surplus. The Commission believes thisoverstates the gain in consumer welfare from a given change in price. Accordingly, the Commissionestimates of future changes in consumer surplus are likely to lie below those estimated by the ACAin the past.

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given the theoretical superiority of a broad cap with no additional sub-caps, as outlinedin section 5.3. That is, with no sub-caps, Telstra has a high degree of flexibility whenstructuring its prices, and hence has more freedom to recover indirect costs in a waythat will provide the most benefit to the community as a whole.

It is noteworthy, however, that Table 5.2 indicates the prices of the price controlledservices would be expected to change quite sharply in a situation where all sub-capconstraints were removed from Telstra. In particular, if Telstra were to increase profitsto the greatest extent possible under this scenario, one might expect that it would seekto significantly raise the price of both residential and business line rentals, with largeoffsetting decreases in the price of STD, IDD and F2M services. This is because thedemand for line rental services is relatively less sensitive to changes in price than STD,IDD and F2M services and because residential line rental charges are below cost.Hence, one would expect Telstra recover more indirect costs and profits from linerental services.

Whilst the community as a whole would benefit most under this set of price controlarrangements, the Commission is concerned that the size of the associated pricechanges could have the potential to significantly disadvantage certain groups in thecommunity. This is especially the case for those consumers that make relatively fewcalls, as they would experience sharp increases in the price of line rentals that couldpotentially overwhelm any cost savings they might receive from the small number ofcalls they make.

Accordingly, the Commission believes, in the interests of ameliorating the potentialadverse impact on certain groups of consumers, that there may an argument forintroducing a limited range of sub-caps into the price control arrangements. This isdespite the impact this may have on the welfare of the community as a whole.

In particular, the Commission believes there may be a strong argument for limiting thespeed with which Telstra can rebalance the price of line rentals – especially forresidential consumers. As indicated in Chapter 9 of this report, the Commissionbelieves it would be appropriate to introduce a price control that limits the speed withwhich Telstra would be able to rebalance the price of line rentals to a maximum of fiveyears.

Whilst the Commission does not specify in this report what form that price controlshould take, one option may be to introduce a CPI + X per cent price cap on line rentalservices. As discussed further in Chapter 9 of this report, Telstra could, based oncurrent estimates, raise the price of residential line rentals to cost over five years if itincreased the price of line rental by around 10 per cent each year.

Hence, in order to measure the impact of a price control that limits the speed withwhich Telstra can rebalance residential line rental prices to five years, the Commissionhas assumed that a CPI + 10 per cent price cap is applied to line rental services.

In addition to this, the Commission believes there may be strong arguments forretaining a 22 cent (GST inclusive) price cap on local calls on the grounds ofameliorating the impact of changes to the price control arrangements on particulargroups of consumers. This is especially the case if, as discussed in section 5.5 below,

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the Government chose to remove the local call parity requirement from future pricecontrol arrangements.

From Table 5.2, the Commission estimates that the impact of these additional sub-capscould be to limit the extent to which Telstra raises the price of line rentals to 10 percent in the first year of the price control arrangements. As compared to the broadCPI – 5 per cent only price control scenario, this would be associated with smallerdecreases in the price of STD, IDD and F2M services. In total, this would decrease theextent to which Telstra could rebalance, and hence decrease the gain to the communityas a whole from around $188 million in the first year of the price control arrangementsto approximately $139 million.

In essence, therefore, the difference in the welfare for the community as a wholebetween the “broad cap only” case and the Commission’s preferred set of price controlarrangements may be interpreted as the efficiency costs of sub-caps. That is, in theabsence of these sub-caps, there are additional welfare gains that could be enjoyed bythe community as a whole in the first year of future price control arrangements.However, the Commission believes it is important to balance these additional gainsagainst the need to ameliorate the potential adverse effects this may cause for certaingroups in the community. Hence, the retention of a limited number of sub-caps may beuseful in balancing the welfare of the community as a whole with the potentiallyadverse impact on particular groups in the community.

In the third scenario, the Commission has modelled how these results would change ifX was set at zero in the broad CPI – X per cent price cap in combination with the otherprice controls recommended in this report. This is in response to submissions fromCWO and Telstra on the Discussion Paper that argue that X should be set at zero in anyfuture price control arrangements.

From Table 5.2, it is evident that under this type of scenario, the overall benefits to thecommunity would be significantly reduced. More specifically, the Commissionestimates that the gain to the community as a whole under this set of price controlarrangements would reduce to $64 million in the first year of the price controlarrangements. Perhaps more importantly, close examination of Table 5.2 indicates thatmost of these benefits are likely to be in the form of increased profits for Telstra ($57million) with little increase in the benefit for consumers (around $7 million in the firstyear of the price control arrangements). This is because consumers would experiencethe full 10 per cent increase in the price of line rentals, with much smaller offsettingreductions in the price of STD, IDD and F2M services.

5.5.3 Can Telstra profitably meet the price control arrangements recommendedin this review?

In submissions received on the Draft Report, two parties indicated a concern thatTelstra may not be able to meet its price cap obligations if X is set too high in aCPI – X per cent price cap without it decreasing the price of some services below theircost of provision. The basis for this argument is on the assertion that, in order forTelstra both to increase the price of line rentals and meet a CPI – X per cent price cap,it must substantially reduce the price of STD, IDD and F2M services. One party hasindicated that it believes there are limited margins available on these services.

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Accordingly, this party believes that Telstra may be unable to raise the price of linerental and meet its price control obligations without forcing the price of STD, IDD andF2M services below cost. On this basis, this party believes a value of X of 5 per centwould be too high, and that X should alternatively be set at zero.

Commission view

The Commission is not concerned by this argument, however, as it believes:

§ Estimates of TSLRIC and current prices for STD, IDD and F2M services, asoutlined in Table 5.2, indicate that Telstra is earning larger margins on theseservices than some parties suggest;

§ Telstra is currently earning profit on the whole PSTN such that it should beable to rebalance prices and still continue to make economic profits; and

§ The value of X is determined, in part, with reference to how the costs of thePSTN would be expected to fall over time. Hence, if costs are, on a weightedaverage basis, estimated to fall at X per cent per annum, then Telstra should beable to reduce prices on a weighted-average basis by X per cent per annum aswell. The Commission’s estimate of X is provided in Chapter 6 of this report.

Hence, if Telstra is currently earning economic profits across the whole of the PSTN,and it is expected that the weighted-average cost of the PSTN will fall somewhere inthe order of 5 per cent per annum in the future, the Commission is confident thatTelstra should be able to start to rebalance (if it so chooses) and decrease the weighted-average prices of those services in the broad price cap by 5 per cent each year.

This conclusion is supported by the Commission’s analysis in Table 5.2 that indicatesthat Telstra will be able to begin rebalancing, and decrease the prices of STD, IDD andF2M services, whilst still continuing to make a contribution to indirect costs and profitsin the first year of the price control arrangements. Further, this analysis understates theextent to which Telstra can recover its costs, as it makes no allowance for the decreasesin the underlying cost of the PSTN during the first year of the price controlarrangements. That is, cost estimates used to derive the results in Table 5.2 are basedon 2000-01 levels. If cost reductions of X had been included in the modelling, theresults would have shown that Telstra could recover its costs under a CPI -–5 per centprice cap even more comfortably.

Moreover, the Commission notes that the analysis in Table 5.2 shows that if X was setat zero per cent per annum, the major beneficiary would be Telstra, as consumers as awhole would gain only $7 million in the first year of the price control arrangements.Further, as indicated in Chapter 8, this would also increase the number of residentialconsumers that would be made worse-off under changes to the price controlarrangements. The major reason for this is, as indicated above, that while residentialline rental prices would continue to increase under a CPI – 0 per cent price cap, therewould be much smaller decreases in the price of STD, IDD and F2M services.

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5.5.4 Summary

In summary, the removal of all sub-cap arrangements would provide the greatestbenefit to the community as a whole. However, it is likely that this would come at thecost of potentially adverse impacts for certain groups in the community. Hence, theCommission believes it may be important to retain a limited number of sub-caps inorder to help ameliorate the potential adverse impacts on certain groups in thecommunity.

In this regard, the Commission believes a set of price control arrangements thatincludes a limit on the speed with which Telstra can rebalance the price of line rentals,and a 22 cent (GST inclusive) price cap on local calls, would serve both to providesignificant benefits to the community as a whole, whilst limiting the adverse impacts onparticular groups in the community.

Whilst this set of price controls is likely to still have adverse impacts for some groupsin the community, the Commission believes these impacts are likely to be much smallerthan under a scenario where no sub-caps were retained in the price controlarrangements.

The distributional impacts of the Commission’s preferred set of price controlarrangements on different groups in the community are discussed in detail in Chapter 8of this report. Chapter 9 provides further consideration of targeted assistance packagesthat can be directed to compensating disadvantaged consumers (however defined) thatare made worse off as a result of these proposed changes.

5.6 Problems with using current-period (“anticipated”) revenueweights

The existing price control arrangements require that the weighted average price changeallowed under a CPI – X per cent price cap be assessed using revenue weights from theyear in which the price changes occur (ie. current-year weights). An alternative is touse revenue weights from the year prior to when the price changes occurred (ieprevious-year weights). Previous-year weights were used in the first triennium of theprice controls (1989 to 1992), but the arrangements were changed to require the use ofcurrent-year weights in 1992. The change was part of a number of changes (includingnew sub caps) that made the price controls more restrictive. The Commission believes,however, there are efficiency and administrative reasons for the price controlarrangements to be amended to use previous-year weights for determining whetherTelstra has complied with it price control obligations.

The Commission believes the use of current-year revenue weights would be moreefficient as current-year weights overly constrains the extent to which both pricedecreases and price increases can occur, and hence the amount of price rebalancing andconsequent efficiency gains that can occur. To illustrate, consider first a decrease inprice for a service subject to inelastic demand. As the price is decreased, the revenuegenerated decreases and this reduces the credit that can be attained for any given pricedecrease. Similarly, as price is increased, revenue increases and this increases thepenalty from any given price increase. The consequent regulatory resistance to price

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rebalancing reduces the amount of it that occurs and deprives society of potentialefficiency gains.

In addition to this, the Commission believes that using current-year revenue weightsgenerates higher compliance costs because revenue weights are not known with anycertainty during the period of the price controls. This means that Telstra must forecastthe anticipated revenue for all services in order to determine how it should set prices tomeet its price control obligations.

Further, the Commission notes the use of current-year revenue weights is common inother regulated industries facing broad-based price caps here in Australia, such asFederal Airports.

The Commission therefore believes that the basis of calculation of the revenue weightsrevert to the previous-year approach. This will ensure that Telstra is given morefreedom in the way it structures its prices for price controlled services with resultinggreater community benefit.

5.7 Allocative efficiency consequences of the local call parity pricecontrol

Under local call parity arrangements, Telstra is required to charge effectively the sameamount for local calls in non-metropolitan areas as it does in metropolitan areas. Thisrequirement would be expected to have adverse efficiency implications of two kinds.First, in circumstances where costs of provision differ between the two geographicareas, it would lead to divergences between price and costs and consequent losses forthe community as a whole. This is considered in this section. Second, it would belikely to have negative effects on competition, investment incentives and consumerchoice - especially when combined with the effects of wholesale price controlarrangements. This is considered in Chapter 7. Social objectives relating to local callparity are discussed in Chapter 9.

Submissions

AAPT in its submission to the Discussion Paper argues that untimed local call prices innon-metropolitan areas (excluding selected regional centres) should be capped inaccordance with the corresponding cost, and “local call parity would be no longerrelevant and therefore could be removed” (p. 3).

RSL COM sees no overall efficiency advantage in removing the local call parityrequirement, arguing that it would result in price increases in non-metropolitan areasand “little, if any” price reduction in metropolitan areas. It would also result in othertypes of costs – such as billing and marketing – increasing.

ATUG in its submission on the Draft Report strongly supports local call parity,claiming the cost differential is not clear.

Commission’s Analysis

A model of direct cost-recovering uniform geographical pricing acts as a basis forconsidering the allocative efficiency effects of local call parity. Suppose that thetelecommunications carrier is required to offer a uniform geographical price whilerecovering costs in the context where per-unit direct costs in non-metropolitan areas

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exceed per-unit direct costs in metropolitan areas. The discussion revolves aroundFigure 5.4.

P,C

MCb

B

PU

A

MCC Db

Dc

Qc Qb

Figure 5.4 – the allocative inefficiency of the local call parity requirement

The long-run marginal cost of providing the service in metropolitan areas (MCc) is lessthan in non-metropolitan areas (MCb); there are no unallocable costs, metropolitandemand is Dc and non-metropolitan demand is Db. Effectively, the uniform pricerequirement necessitates that the utility operate a cross-subsidy arrangement wherenon-metropolitan users are subsidised (given a concessional price) and this is paid forby setting price above cost for metropolitan users. It is assumed it is possible to find auniform price (Pu) where the “revenue” from pricing above cost in metropolitan areas isequal to the subsidy payment to bush users.58

Based on the presumption that the divergence between price and cost will lead toallocative inefficiencies, it can be shown that adverse efficiency effects should beexpected at both ends of the arrangement. In metropolitan areas, there is a deadweightloss equal to the excess of the value to users over the cost to produce the units forgone.In Figure 5.4, this is represented by the area A.

In non-metropolitan areas there is a deadweight loss equal to the excess of the cost toproduce the additional units consumed over their value to users. In Figure 5.4, this isrepresented by the area B.

In principle these efficiency effects of the local call parity arrangement can beestimated using estimates of the long-run marginal costs, quantities demanded andelasticities of demand for both the metro and non-metro areas. In practice this presentsmany difficulties:

§ While it would be sensible to base the analysis on 1999-00 for which quantitydata are available, the price in that year (a weighted average of about 23 cents)

58 This will be less likely the larger is non-metropolitan areas’ quantity relative to metropolitan areas’quantity and the greater is non-metropolitan areas’ cost relative to metropolitan areas’ cost.

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is substantially greater than in 2000-01 when it is likely to be about 20.6 cents(GST inclusive) and 18.75 cents (before GST).

§ Commercial-in-confidence TSLRIC cost data from Telstra are available forfour zones (CBD, metro, provincial and rural), but insufficient data areavailable to find weighted averages for the broader “metro” and “non-metro”areas.

§ For 1999-00, weighted average price is above TSLRIC plus retail, indicatingcontributions to indirect costs and to the access deficit. Given this excess, it isnot possible to de-average on a cost recovery basis and the allocativeefficiency analysis is complicated.

§ Own-price elasticities are likely to differ both between metropolitan areas andnon-metropolitan areas and between different types of users. Data on thisbasis are not available.

While there are slightly different possible ways of progressing the analysis, that withperhaps the closest proximity to the actual situation is based on the following:

§ A weighted average price of 19 cents (approximately the 2000-01GST-inclusive price).

§ A metropolitan cost of c-i-c cents and a non-metropolitan cost of c-i-c centsbased approximately on TSLRIC plus retail costs.

§ Quantities of c-i-c metropolitan calls and c-i-c non-metropolitan callsprovided by Telstra.

§ Overall elasticity estimates are used, with a lower bound elasticity of c-i-c andan upper bound of c-i-c (supplied by Telstra).

Using these figures results in recovery of direct costs at the original price andquantities. De-averaging price to costs raises metro quantity and reduces non-metroquantity, but sacrifices full cost recovery as the loss in net revenue from reducing themetro price is greater than the gain in net revenue from increasing the non-metro price.However, cost recovery can be achieved with prices of c-i-c cents in the metro areaand c-i-c cents in the non-metro area. This results in an allocative efficiency gain ofabout $9.5m with an elasticity of c-i-c, and about $19million with an elasticity of c-i-c.

Discussion

While it is difficult to frame the analysis, it is clear that there are allocative efficiencycosts from the local call parity arrangement as it holds the price constant in differentgeographic areas in the face of substantial differences in costs. The way chosen toestimate these allocative efficiency costs for illustrative purposes is based on numbersthat are not too far removed from reality, and while the estimated allocative efficiencygains from removing the local call parity arrangement are small, they are not trivial.However, in comparison with the allocative efficiency gains from the broaderrebalancing discussed earlier in this chapter, removal of local call parity is not asubstantial allocative efficiency issue.

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The Commission believes, however, that there would potentially be substantialadditional benefits from the removal of the local call parity requirement for ruralconsumers in the form of increased competition, investment and consumer choice inrural areas. This is discussed in more detail in Chapter 7 below.

The Commission also notes that there may be equity concerns that would suggest theretention of the local call parity requirement.

5.8 Conclusions

This chapter has a number of conclusions about the ways in which the benefit to thecommunity as whole could be improved under alternative price control arrangements.It finds that:

§ a broad CPI – X per cent price cap appears capable of generating further gainsfor the community as a whole in the future;

§ the retention of such a cap should include services which share common costs,and are in markets which are not, as yet, fully competitive;

§ the retardation of price rebalancing that would result in broad communitybenefits would be avoided by using previous-year revenue weights rather thancurrent-year ones;

§ allocative efficiency would, however, be maximised if all existing sub-capsremoved such that Telstra had the freedom to efficiently restructure prices.However, for the purposes of ameliorating potential adverse impacts onparticular groups in the community, there is a justification for retaining alimited number of sub-cap arrangements; and

§ the removal of the local call parity requirement has the potential to generategains for the community as a whole, although the full extent of these gains isdifficult to estimate. The Commission discusses further gains – in terms ofincreased competition, investment and consumer choice in rural areas in thatcould result from the removal of the local call parity requirement in Chapter 7of this report.

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Chapter 6 The Appropriate Level of “X”

6.1 Introduction

In determining the form of any future price control arrangements, the terms of referencefor this review require the Commission to consider the most appropriate means ofpromoting economically efficient and equitable pricing outcomes. This chapter focuseson issues of productive efficiency and the distribution of productivity gains to endusers, and investigates how price control arrangements can be designed to achievethem.

Historically, a CPI – X per cent price cap has been applied to Telstra. Assuming, asrecommended in this review, the Government was to continue with this form of pricecontrol arrangement, it is important to consider the following issues:

§ the principles to be used for determining the value of X;

§ the methods that can be applied to estimate the value of X;

§ the appropriate level of X to apply to the Commission’s recommended basketof services under the cap;

§ the price index to be used;

§ the duration of the next set of price control arrangements; and

§ the carry over provisions for over or under-achieving required pricereductions.

Determination of the value of X in a CPI – X per cent price cap formula is aparticularly complex task. Where the value of X is set too low, too little productivitygrowth will be passed on and the regulated carrier will be under little pressure toimprove efficiency. As a result, both short-run and long-run consumer benefits will belessened. On the other hand, where the value is set too high, the viability of theregulated carrier may be threatened. In determining the value of X for a broad basket,the Commission believes that the X value should reflect the overall cost reductions thatare feasible and provide Telstra with an incentive to reduce its costs of productionfurther.

6.2 Principles for determining the value of X

Determination of the value of X requires consideration of a range of factors. Theseinclude:

§ past and potential productivity growth of the regulated carrier, includingconsideration of economies of scale and economies of scope;

§ past and potential growth of economy-wide productivity;

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§ business plans of the operator;

§ investment requirements and the economic and required rates of return oninvestments; and

§ forecasts of traffic growth.

The Industry Commission considered total factor productivity (TFP) fundamental to thedesign and monitoring of improved price capping arrangements as well as for anassessment of operational efficiencies.59 Evaluation of TFP involves construction of anaggregate output index and an aggregate input index. The ratio of the two indicesprovides the TFP measure that includes the impact of technical progress, economies ofscale or of scope and managerial improvements. Unlike partial productivity measuressuch as labour productivity and capital productivity, the TFP approach provides themost comprehensive summary of a carrier’s productivity.

An important issue in determining the appropriate value of X is whether an aggregateTFP measure for a carrier is relevant to the X factor applicable to a basket or sub-baskets of its products. In the Draft Report the Commission presented an estimate ofTelstra-wide TFP growth (∆TFPTELSTRA) potential and then attempted to adjust this forthe narrower PSTN-based basket of services recommended. This procedure wascriticised in the submissions by some parties. Accordingly, the Commission hasdirected attention to assessment of PSTN-specific TFP in the Final Report.

In determining the appropriate value of X, the Productivity Commission is of the viewthat “it should be equal to the difference between the productivity of the incumbentcarrier and the economy as a whole”.60 CWO supports this view and quotes fromAccess Economics that the X factor adopted by the Federal CommunicationsCommission (FCC) in the US includes only the excess of telecommunications TFPover the economy-wide average TFP growth. 61

The rationale for the TFP minus rule (∆TFPTELSTRA − ∆TFPECO) is that, everything elsebeing equal, the TFP growth in the economy as a whole will reduce the CPI by acommensurate amount. Therefore, the requirement of Telstra to reduce its prices inreal terms should be based on the extent to which its productivity growth exceeds thatof the economy as a whole.62

59 See Industry Commission, Government (Non-Tax) Charges, Report No. 422, Vol. 3 EfficiencyIssues and Public Enterprises, AGPS, 1989, p. 134.

60 Productivity Commission, op. cit., p. 47.

61 Access Economics, Review of Price Control Arrangements on Telstra , a report prepared for DCITA,August 1998, p. 15.

62 CWO, in its submission on the Discussion Paper, argued that if the economy-wide TFP is notsubtracted from the incumbent’s TFP, the rate of return for the incumbent would fall below itseconomic cost of capital. This will attract lower future investment in the industry leading to a lossof consumer welfare in the long-run.

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The Commission believes that in setting X it is appropriate to make an allowance forthe expected TFP growth in the economy as a whole.

6.3 Estimates of whole-of-Telstra TFP growth

Estimates of Telstra’s TFP growth rates have varied widely in the past. For instance,Swan Consultants and Tasman Asia Pacific estimated the average annual growth ratefor the period 1987-88 to 1993-94 as c-i-c per cent and c-i-c per cent respectively.63 Incontrast, the Bureau of Industry Economics (BIE) estimated the average growth for thesame period as 8.43 per cent per annum. 64 Further, using the BIE methodology withupdated data, the Commission has estimated the TFP growth rate at 7.97 per cent perannum over the same period.

The Commission and Tasman Asia Pacific have also estimated the growth rate for theperiod, 1994-95 to 1999-00. While Tasman Asia Pacific has used forecast data for theyears 1998-99 and 1999-00, the Commission has used the publicly-available actualdata. The estimated growth rates are c-i-c per cent and 9.6 per cent per annum,respectively, by Tasman and the Commission. The TFP estimates are presented inTable 6.1.

Studies 1987-88 to 1993-94 1994-95 to 1999-00

Swan Consultants (1995) c-i-c -

Tasman Asia Pacific (1998) c-i-c c-i-c (projected data)

BIE (1995) 8.43 -

ACCC (2000) 7.97 9.60 (actual data)

Table 6.1 Average annual TFP growth rates for Telstra

The Commission conducted sensitivity tests to assess the impact of changes in capitalprices, asset valuation and the opportunity cost of holding capital and found that theresults are insensitive to these changes.65

The Commission could not make formal projections of Telstra’s TFP growth ratesbeyond June 2000 due primarily to a lack of data. In particular, a robust econometric

63 Swan Consultants Canberra Pty Ltd, “Calculating the Total Factor Productivity of Telstra”,Technical Note, Draft Final Report, unpublished, March 1995 and Tasman Asia Pacific, “Enterpriseand Product Total Factor Productivity Estimates for Telstra”, April 1998. Telstra commissionedboth of these reports.

64 BIE, International Performance Indicators: Telecommunications, Research Report 65, AGPS,Canberra, 1995.

65 ACCC, “Sensitivity of TFP Measures to Changes in Price Variables”, internal paper, December2000.

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forecasting technique would require specific data on the variables that have beenidentified as the determining factors for changes in TFP measures in the past. TheCommission has reason to believe, however, that Telstra’s output is likely to increase ata faster rate in forthcoming years, while its labour and capital inputs will increase onlymoderately and may even decline. For instance, an extensive cost reduction program isalready being implemented.66 These prospective growth rates are discussed in moredetail below in relation to the PSTN-specific TFP estimates.

Consistent with Tasman Asia Pacific, the Commission study found that Telstra’s TFPgrowth rate has increased over time. For the period 1979-80 to 1987-88 the averagegrowth rate was 5 per cent per annum. This was followed by an annual rate of almost 8per cent for the seven years to 1993-94 and 9.6 per cent thereafter to 1999-00. Basedon this experience and a belief that output will continue to increase, labour input willcontinue to decline and capital utilisation will improve, it appears likely that Telstra’soverall TFP has the potential to grow at a similar rate over the next three years.

6.4 Estimates of PSTN-specific TFP growth

The submissions received on the Draft Report varied in their positions with respect toX. While AAPT and ATUG were supportive of the approach taken, some othercarriers were critical of both the approach and the resulting X factor of 5.5 per cent. Inparticular, the Commission was interested in the following points regarding PSTN-specific TFP growth:

§ Certain parties were critical of the means of getting from whole-of-TelstraTFP (∆TFPTELSTRA) to ∆TFPPSTN, describing it as “arbitrary”. While theCommission believes its allowance for the difference was reasonable,67 thiscriticism highlighted the need to focus more directly on productivity growth inthe PSTN itself rather than that for the whole of Telstra.

§ The Commission’s n/e/r/a model implies that per-line costs in nominal termsare increasing slightly over time, and this indicates an absence of productivitygrowth. While in real terms this translates into a fall in line rental costs ofabout 2 per cent per annum, it was evident that, for this substantial part of thePSTN, productivity growth is much less than that estimated for the whole ofTelstra.

§ The existence of a lock-in effect on productivity growth of local calls. Whilethere are substantial cost reductions in the per-unit production of minutes, thisdoes not actually result in cost reductions that can be passed on to end-users inthe case of local calls. That is, n/e/r/a-based costs indicate that the cost per

66 “Telstra on the rise as cost cuts kick in”, The Sydney Morning Herald, 8 December 2000. The paperalso reported in its issue of 18 November 2000 that as many as 10,000 staff will leave thecorporation within the next 12 months.

67 For example, the specification of the rate of growth of PSTN-specific TFP growth implied a veryhigh growth rate for the rest of Telstra, and some preliminary work suggested this was not beingattained.

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minute of PSTN use is falling rapidly. However, most of the additionalminutes are embodied in local calls, with the number of local calls growingslowly but their average length increasing rapidly. Because of the cap on theuntimed local call charge, productivity growth is already passed on in the formof “free” extra minutes in the case of local calls. Hence, Telstra’s ability topass on lower costs is tied to the increase in the number of calls, and thisnumber has been growing slowly. Again, therefore, there is prima facieevidence of a substantial part of the PSTN experiencing only slow effectiveproductivity growth.

In order to address these concerns, the Commission has estimated the change in TFPspecifically for the PSTN using COA/CAM revenue and cost data for the period from1996-97 to 1999-00. The results of this analysis are supplemented by a considerationof the likely future course of PSTN costs and outputs, with an emphasis on estimatingthe PSTN cost savings Telstra will be able to pass on to end users.

In the Commission’s study, PSTN output is measured by total PSTN revenue fromCOA/CAM deflated by the increase in CPI minus the actual revenue-weighted pricereduction. In effect this creates a Laspeyres output index with a moving base (ie, achain index) measuring physical changes in PSTN outputs weighted by (moving) base-period prices. Consider how this index interprets the various causes of a change inrevenue.

§ If revenue increases purely from PSTN service prices rising with inflation of pricesin general, then the illusory output increase is removed by indexing for CPI.

§ If revenue declines purely from the CPI − X per cent price cap, then the illusory fallin output is removed by indexing for the weighted average overall price capapplied.

§ If revenue increases because physical output has gone up (eg, the number of accesslines increases or the number of IDD minutes increases), this will be registered infull as an output increase with appropriate weighting. Note also that this methodwill not register the increase in local call minutes arising from longer call holdingtimes as an increase in output. Only the increase in local call numbers will beregistered.

§ Because of the overall constraint on weighted-average price, any apparent increasein output from raising the price of one service will be offset by the apparent fall inoutput from the fall in price of another.

Inputs are measured by the sum of total operating costs (deflated by the CPI) and totalcapital costs (deflated by a capital price index) of the PSTN, as derived fromCOA/CAM. The broad COA/CAM cost definitions were used, inclusive of indirectcosts. This is in recognition that Telstra traditionally requires all of its product areas tocontribute to indirect costs, and this can therefore be considered as a cost that the PSTNhas to bear. Savings in indirect costs are cost savings that Telstra can pass on to otherusers.

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The estimated growth rate for PSTN-specific TFP from 1996-97 to 1999-00 is 7.1per cent. Several factors should, however, be kept in mind when considering whetherPSTN TFP can be expected to grow at this rate in the future.

First, given a portion of indirect costs is charged to the PSTN, and Telstra’s cost cuttingprogram is particularly focused on these unattributable central costs, the Commissionexpects the indirect cost contribution required from the PSTN to fall rapidly. Thiscontribution is currently $967million from the n/e/r/a model. If these fall at 7.6 percent,68 this will translate to a reduced contribution of around 1.2 per cent of PSTN costsper annum. However, it is possible that indirect costs will fall more rapidly than this ascurrent specific cost-cutting programs target central areas such as service supportactivities, rationalisation of management layers, and rationalisation of shared supportfunctions.69

Second, two substantial PSTN cost elements are in the form of payments fortermination – FTM termination and IDD international settlement rates. Futurereductions in these rates are likely, but rates of decline are uncertain. In the case ofFTM termination, the charge is likely to fall by 7.6 per cent per annum if tied toTelstra’s overall underlying cost reduction, and at a similar rate if tied to the fall inmobile retail prices. In the case of IDD termination, international initiatives are leadingto reductions in the rate, but the Commission was unable to form a firm view on thelikely actual rate of decline. However, reductions in these termination rates are likelyto result in cost savings equivalent to over one per cent of PSTN cost.

Third, from 1997-98 to 1999-00, the total number of Telstra’s basic access linesincreased at a rate of 2.6 per cent only, while the number of call minutes increased at arate of more than 21 per cent per annum. These statistics suggest that although thenumber of access lines may continue to increase at a low rate in forthcoming years dueto higher penetration rates already achieved and substitution of mobile for fixed lines,the lines are likely to be used more intensively, leading to a higher TFP growth rate. Aparticular reason for this could be the continued growth in per capita income andsubstitution of telecommunications services for other services.70

Fourth, some caution is required as productivity growth is sensitive to circumstancesbeyond the control of Telstra managers, such as Telstra's majority governmentownership, and because its cost saving measures are under more severe public scrutinythan other operators in the private sector.

On balance, the Commission believes that continuation of PSTN-specific TFP growthof around seven per cent is a reasonable expectation for the next three years.

68 This expected cost reduction is based on the Commission’s estimate of the rate at which Telstra’soverall costs will fall based on its estimate of ∆TFPTELSTRA corrected for economy-wide TFP growth.

69 See ABN-AMRO, “Telstra Corporation: A Business in Transition … still”, 8 March 2000.

70 See Australian Telecommunications Authority, Telecommunications Performance Report, Canberra,2000, for an analysis of demand growth for important telecommunications services.

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6.5 Benchmarking

In the Draft Report the Commission reported on international benchmarking work doneby various researchers, including the Commission. This was used to indicate there wasevidence that Telstra had “room to catch up” to the productivity levels of carriers inmany other countries appearing to have higher overall productivity. Some concern wasexpressed in submissions regarding the analysis, particularly relating to the importanceof other factors that may explain the differences observed.

The Bureau of Industry Economics (BIE) in 1992 and 1995 estimated productivitylevels across OECD countries applying the Data Envelopment Analysis (DEA) andMultilateral Productivity (MLP) approaches. Results of these studies indicated thatAustralia could improve its labour productivity by 90 per cent and capital productivityby 30 per cent to reach the efficiency level of Sweden, and that Australia ranked onlyeighth out of 11 OECD countries included in the study.

The Commission updated the BIE studies using the ITU input-output data for the year1998-99.71 In all, 25 countries were included in the sample including those reported bythe BIE in 1992 and 1995. The DEA results provide efficiency levels compared to thebest practice country. The results showed that, on this measure, Iceland is 2.68 times asproductive as Australia, followed by Norway (2.62 times), Sweden (2.52 times) andLuxembourg (2.51 times). France, Greece, New Zealand and Spain appear to be lessefficient than Australia. The results also suggest that Canada is about 36 per cent moreefficient than Australia, while the USA is 62 per cent more efficient and the UK is 98per cent more efficient.

An important issue in comparing Telstra with overseas operators is whether operatingconditions in Australia are comparable with those overseas. That is, the best performerin the world may not be the best model for Australia because of differences in operatingconditions such as subscriber density and distance between populated areas.

In a recent paper, the Productivity Commission finds that the low population density inAustralia is an important reason why the cost of providing local services is higher.72

Earlier, however, the BIE concluded that population densities in the inhabited parts ofAustralia were not significantly lower than those in the inhabited parts of Canada andthe United States.73

The benchmarking results presented in the Draft Report were estimated using a robustmethodology, but there is a contentious issue of comparable operating conditionsbetween Telstra and overseas operators. These include the low population and linedensity in Australia compared with the OECD countries and the dissimilar ownership

71 Details of this study are contained in an internal paper titled “DEA and MLP analysis of Telstra’sProductivity”, February 2001.

72 Productivity Commission, Population Distribution and Telecommunications Costs, Staff ResearchPaper, Auinfo, Canberra, August 2000.

73 Bureau of Industry Economics, International Performance Indicators: Telecommunications,Research Report 48, AGPS, Canberra, 1992, p. 48.

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patterns between Telstra and many overseas carriers. Empirical studies of thecorrelation between population density and TFP are mixed. None the less, there isstrong prima facie evidence that, at least on a whole-of-Telstra basis, there isconsiderable room to catch up.

6.6 Commission’s view on the value of X

The key variables on which the Commission has had to make assumptions for settingthe value of X have been set out in section 6.2, and the quantitative analyses are set outin sections 6.3 to 6.5. These results include estimates of actual and expectedproductivity gains for both the whole of Telstra and the PSTN, and a “moving target”of productivity gains to reach the productivity level of some model performers.

Whole-of-Telstra TFP

The Commission’s estimates suggest that the whole of Telstra has the potential toachieve a TFP growth rate of 10 per cent per annum over the next three years. Theanalysis performed for Telstra by Swan Consultants indicates that the growth rateswould be lower than this. TFP estimates by Telstra’s consultant, Tasman Asia Pacific,for the period from 1987-88 to 1999-00, are also lower than those calculated by theCommission.

In applying these results to the recommended basket of price-controlled services,however, care must be exercised as there are good reasons to believe the TFP forTelstra as a whole could be in excess of that for the price-controlled services. This isbecause these are more “traditional” services where technological advances thatimprove TFP may not be as prominent. Hence, the Commission believes ten per cent isan upper bound to the TFP growth rate that could be projected.

PSTN-specific TFP

Estimates by the Commission indicate that PSTN-specific TFP growth has been at arate of 7.1 per cent over the period from 1996-97 to 1999-00. The Commissionbelieves that this rate of growth is likely to continue over the next three years. Theprocedure used to estimate this growth rate allows for the lock-in effect on local calls.

Economy-wide TFP

The economy-wide TFP measures are not available for recent years. Accordingly, theABS estimates of the economy-wide multi-factor productivity (MFP) are taken torepresent TFP growth rates for the economy as a whole. Table 6.2 shows that, over theperiod from 1996-97 to 1999-00, the annual average growth rate of the economy-wideMFP was 1.78 per cent.

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Year Productivity index Growth Rates1995-96 94.21996-97 95.2 1.061997-98 97.6 2.521998-99 100.0 2.461999-00 101.1 1.10Average 1.78

Table 6.2 Economy-wide multi-factor productivity, 1995-96 to 1999-00Source: ABS Cat. Number 5204.0, November 2000, Table 17.

Benchmarking

The benchmarking results suggest that, on a whole-of-Telstra basis, there isconsiderable scope for Telstra to catch up with the productivity levels of carriers inother countries. For example, the Commission’s estimates suggest Telstra’s TFP wouldhave to grow at 10.8 per cent per annum for three years just to catch up with Canada’spresent TFP level.

Commission’s view

The Commission’s analysis suggests the TFP for Telstra as a whole has the potential togrow at 10 per cent per annum over the next three years, and that PSTN-specific TFP islikely to grow at over 7 per cent per annum. The Commission believes that this latterTFP is particularly relevant given the PSTN-based composition of the basket it isrecommending.

As indicated earlier, there are good arguments to believe target TFP levels should becalculated according to the “TFP minus” rule. Under this rule, the target TFP level iscalculated by subtracting the TFP for the economy as a whole from Telstra’s TFPgrowth. Subtracting economy-wide TFP growth rate for the same period of 1.8 percent from PSTN-specific TFP growth results in a “net” PSTN-specific TFP growth of5.3 per cent per annum over the coming three years.

On balance, estimating the appropriate level of X must take into account a range offactors, and can be estimated with reference to a wide variety of alternativeconsiderations. This makes estimation of a precise level of X particularly difficult.However, based on the considerations discussed above, the Commission believes that itis reasonable to propose an X in order of 5 per cent to apply to the broad basket ofPSTN services it recommends remain under the price control arrangements.

6.7 The price index

Regulators in most countries including Australia, New Zealand and the UnitedKingdom prefer the use of the Consumer Price Index (CPI). The CPI element of theprice cap formula may be specified either in terms of expected price inflation in thecurrent period or inflation in the previous period. The latter is certain and easier toapply but may delay the producer’s compensation for rising costs at times of increasinginflation. The opposite will happen at times of declining inflation. The current pricecap applied to Telstra uses the historical eight-capital-average CPI recorded in the year

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to the previous March quarter. The Commission received no advice on this issue in thesubmissions and considers it appropriate to continue with the index currently in use.

6.8 The price cap period

The regulatory period for price control arrangements in various industries ranges fromthree to five years. In the case of Telstra, the government has generally adopted a threeyear period since the cap was first introduced in 1989. However, the price capcurrently in use is only for two years, mid-1999 to mid 2001, while the third triennium(1996 to 1998) was extended by six months to mid-1999.

The Commission also notes that the duration of the price cap in the British electricityindustry and airports is five years. Oftel has adopted a four years period for the pricecap applied to British Telecom. In Australia, the cap period is five years for energyindustries and privatised airports.

In deciding the appropriate duration of the price control arrangements, the Commissionbelieves there are several issues that should be considered. These include:

§ A major objective of price cap regulation is to provide appropriate incentivesto the regulated carrier to seek cost productive efficiency improvements. Indetermining the period of the price cap’s duration, care must be taken to assurethe regulated carrier that any productivity gains within the period will not beimmediately passed on to consumers by annual review of the cap, suggestingthat the price cap period should be longer rather than shorter.

§ A longer price cap duration will reduce the regulatory burden and uncertaintyassociated with a shorter review period. In this regard, ATUG’s submissionon the Draft Report recommended a four-year regulatory period on this basis.

§ If, however, the price cap period is set too long, there is a danger that the pricecap may be too far out of line with current conditions with respect tocompetitiveness of services included, underlying cost conditions, etc.

Commission’s View

In the case of telecommunications, the Commission places greater weight on theargument that conditions are changing rapidly than on the arguments that favour longerprice cap periods. The assumptions underlying the determination of X, and theassessment of the extent of competition, strongly suggest no departure from the pastpractice of a three-year regulatory period.

6.9 The carry over provisions

In practice it is difficult for a regulated carrier to judge exactly the price changesnecessary to satisfy the CPI – X per cent price cap requirement, and both under andovershooting are possible. This is particularly a problem where the satisfaction of theconstraint is based on current-period weights and where the CPI change is based onforecast inflation. An adjustment factor (sometimes known as the “K” factor)compensates for over or under-recovery of prices.

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The price caps applied to Telstra, AGL gas companies, GPU PowerNet and privatisedairports all have an adjustment factor. In the UK, the airports, gas companies and theNational Grid Company have a correction factor while British Telecom does not have acorrection factor. In a tariff basket approach using actual CPI (as is the case withTelstra), there is no scope for forecasting error on the CPI element, but there is aproblem in determining the price changes because the weights used are endogenous.This issue was discussed in Chapter 5.

Commission’s View

The Commission considers it appropriate to continue with the correction factor builtinto the price cap formula. This will be consistent with incentive regulation and willprovide greater certainty to Telstra. However, the Commission considers that theunder-recovered amount of one three-year cap period should not be carried forward tothe next three-year period.

6.10 Conclusions

This chapter discusses a number of issues relevant to the CPI – X per cent price capformula should the Government decide to continue with the price control arrangementsapplied to Telstra. In summary, the following conclusions and recommendations aremade:

§ the value of X in the CPI – X formula should be determined with reference topast and prospective growth of TFP, as well as with reference to internationalbenchmarks;

§ based primarily on a range of factors – especially with regard to PSTN-specific TFP - the Commission believes that a level for X of in the order of 5.0per cent per annum is reasonable;74

§ a price-cap period of three years would be appropriate;

§ the preferred option for the Commission is to continue with the historical eightcapital average CPI recorded in the year to the previous March quarter;

§ it is appropriate to continue with the carry over factor built into the price capformula. The Commission also recommends continuing with the presentpractice of not permitting the under-recovered amount of one cap period to becarried over to the next period.

74 The Commission notes that Oftel has determined an X of 4.5 per cent for the next price controlperiod, but believes that caution should be exercised in drawing conclusions for Australia fromvalues of X determined in the United Kingdom or any other country.

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Chapter 7 Consumers, Investment and Consumers

The terms of reference for this review include a requirement for the Commission toreport on the impact of the current price control arrangements on:

§ competition and the future development of competition;

§ the availability, choice and prices of services to consumers (and any otherimpacts on consumers); and

§ the telecommunications industry, including on economically efficientinvestment decisions.

This chapter contains the Commission’s consideration of these questions. In particular,the Commission explores and illustrates how retail price control arrangementsoperating concurrently with pro-competitive measures and with other regulation canactually have an antagonistic, rather than a synergistic, effect on the success of thosemeasures.

This chapter is structured as follows.

§ The first part of the chapter provides an overview of the main factors affectingcompetition, investment and consumers in Australian telecommunicationsmarkets.

§ The second part contains a discussion of the ways in which the current retailprice control arrangements influence competition, investment and consumers.

§ In the third and fourth parts, detailed analysis is presented of the impact ofparticular price control arrangements – the line rental price controlarrangements and local call parity requirement.

7.1 Factors affecting competition, investment and consumers in theAustralian telecommunications market

Where markets are not subject to effective competition, firms may be able to chargeprices that are above efficient levels. As a result, consumers pay more fortelecommunications services than is warranted by underlying costs, reducing their levelof consumption and thereby distorting the allocation of resources within the economy.This is the concept of allocative efficiency raised in Chapter 5. Moreover, the absenceof effective competition also means that firms face reduced pressure to increase theefficiency of their operations.

In such a situation, controls on retail pricing behaviour can be a useful means ofminimising these negative effects. Not only do they limit the extent to which firms canraise prices, but they can also be used to improve the efficiency of their operationsthrough CPI – X per cent price cap regulation.

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That said, retail price controls are only part of the solution for improving efficientpricing in telecommunications markets. That is, price controls can help provideconsumers with some of the benefits of effective competition. However, they do notdeal with the underlying reasons for competition being less than effective. In thisregard, the preferred course of action is to tackle the factors inhibiting effectivecompetition and use price control arrangements where other pro-competitive reformscannot be implemented.

To this end, the telecommunications industry has undergone significant structural andregulatory reform over the past decade. The over-riding objective of the reforms hasbeen to use the forces of competition to deliver lower prices, improved efficiency andinnovation.

Key reforms have involved the opening of telecommunications markets to entry andestablishing regimes for access to “essential” infrastructure used to supplytelecommunications services; i.e. Part XIC of the Trade Practices Act 1974 andSchedule 1 of the Telecommunications Act 1997. Coupled with this has beenconsiderable growth in demand, which has increased the ability of the industry viablyto support a range of service providers.

The resulting changes in the competitive environment are, in turn, affecting the amountand type of investment in telecommunications and the outcomes for consumers.

Implementation of pro-competitive reform is not, however, an instantaneous process.Immediate removal of the protection afforded by the price control arrangements couldhave resulted in significant harm to consumers while competition develops. With thisin mind, the operation of retail price control arrangements was intended to reinforce theemerging competitive pressures on Telstra to raise productivity and lower retail pricesduring the transition from monopoly to effective competition.

That said, retail price control arrangements operating concurrently with pro-competitive measures and with other regulation can hinder the emergence of effectivecompetition. This is because the development of competition, and its continuedeffectiveness, relies on using prices of telecommunications services as a signal for entryand investment decisions.

Constraining pricing decisions through price control arrangements can distort thepattern and extent of both investment and competition. This has significantconsequences for the size and distribution of the long-term gains for consumers.Accordingly, care needs to be taken in designing retail price control arrangements toensure that they facilitate rather than inhibit the pathway to effective competition.

7.2. The impact of retail price control arrangements on competition,investment and consumers

7.2.1. The retail price control arrangements and market outcomes

The retail price control arrangements, both by themselves and through their interactionwith other regulation, appear to alter retail prices and consumer choice in thetelecommunications market in five main ways. These include the pricing of some

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services below cost, the averaging of charges for local calls across geographic areas,constraints on regulated access charges, constraints on the extent to which Telstra canmake quality-price trade-offs, and constraints on Telstra’s ability to offer unmeteredservice bundles75 to customers. Each of these is likely to have both direct and indirecteffects on the evolution of competition, investment incentives and consumer outcomes.

Below-cost pricing

The operation of the price control arrangements has meant that Telstra is required toprovide some services to some consumers at prices which do not enable recovery of thefull cost of that provision. Line rental services, for example, are currently provided toboth business and residential consumers at standard charges ($330 per annum includingGST for business lines and $210 per annum including GST for residential lines) whichfall short of Commission estimates of line-related costs (see Section 7.3 below). Threeseparate price caps limit the extent to which Telstra can realign those charges with itsestimated costs.76 The resulting “access deficit” is then recovered from other retail andwholesale services.

Below-cost pricing implies losses on the services to which it applies. Unless thoselosses are compensated from an external source (such as direct government subsidy orcontributions from other operators), the prices of other services will need to be raisedabove cost to ensure that aggregate revenues are sufficient to cover aggregate costs. Inthe case of line rentals, the access deficit is recovered both from above-cost retailcharges for other Telstra call services, and through the inclusion of an access deficitcontribution in the interconnection charge for PSTN services. These arrangementsdissociate prices from costs, distort consumption and investment signals and,depending on their magnitude, may distort final consumption and investment decisions.

To the extent that Telstra’s charges affect the charges made by other operators in themarket, the effects of these arrangements will extend beyond Telstra itself and beyondTelstra customers alone.

Geographic averaging

The cost of providing telecommunications services differs according to, among otherthings, the location of consumers. The requirement to charge similar rates in differentareas, regardless of differentials in the cost of supply (“averaging”), consequently islikely to result in a further dissociation between costs and prices.

Under the local call parity arrangements, the average price charged by Telstra toresidential, charity and business customers in non-metropolitan areas for untimed localcalls in 1999-00 must not exceed the average price charged by Telstra to residential,

75 That is, service bundles in which individual services, such as line rental, local calls and other calls,are neither separately recorded nor separately charged, such as in “all you can eat” packages.

76 They are: the cap of CPI – 0 per cent on a basket of local calls and line rental services; the cap of 22cents per call (GST inclusive) on the provision of basic untimed local calls, with a similar cap of 40cents per call applicable to calls made from Telstra payphones; and a low-spending residential pricecap of CPI – 1 per cent on a basket of services comprising connections, line rentals, local calls, trunkcalls and international calls.

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charity and business customers in metropolitan areas for untimed local calls in 1998-99by more than 0.4 per cent. A similar price control exists for 2000-01.

The Commission has been provided with estimates suggesting differences in thewholesale cost of local calls in different geographic areas are substantial. If this is, infact, the case, then the local call parity arrangements are likely to produce regionalprice-cost disparities which, like those for line rental and call services referred toabove, may be expected to affect final consumption and investment decisions.

Averaging requirements do not apply to operators other than Telstra.

Constraints on wholesale prices

In unconstrained markets, wholesale and retail charges are linked in straightforwardways. In order for a service to be worth producing, its value in the retail market mustbe expected to cover both its wholesale and retail costs (that is, the wholesale chargemust be no lower than the retail charge, on average). When retail charges areconstrained by price control arrangements, wholesale charges are likely to reflect thoseconstraints.

Where wholesale charges are determined by the Commission in its arbitral role, theCommission will take into account the relevant retail charges in order to ensure that itsdeterminations satisfy the criteria laid down in Part XIC of the Trade Practices Act. Insome cases, the retail price control arrangements have resulted in the Commissionsetting wholesale charges on a basis other than efficient costs. This has resulted, forexample, in the inclusion in wholesale PSTN (access) charges of an access deficitcontribution. It has also resulted in the wholesale charge for local calls being set byreference to retail prices rather than underlying wholesale costs. These examples areconsidered in detail in Section 7.3.

Where wholesale charges are unregulated, two effects are possible. If competitionexists in the retail market, but not in the wholesale market, the wholesaler may haveboth the opportunity and the incentive to “squeeze” the margins of its competitors bymaintaining high wholesale charges. If, on the other hand, competition exists in bothmarkets, the existence of the price control arrangements may affect the price that asupplier of wholesale services will be able to sustain for the service. Services whoseretail prices are below-cost as a result of the price control arrangements are likely toexperience downward pressure on their respective wholesale prices, and vice versa.

Bundling

The retail price control arrangements specify price caps for particular, limited groups ofservices. Assessing compliance with the controls implies a need for price and revenueinformation calibrated into similar categories. The prices and revenues of individualservices within the baskets must be transparent.

For example, line rental and local calls are currently subject to a cap of CPI – 0. Thisarrangement appears likely to preclude Telstra from combining these services into awider basket of services and marketing them as a standard offering, unless its meteringand charging arrangements were able to support separate identification of the line rentaland local call revenue. To the extent that this restricts Telstra’s ability to respond to the

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initiatives of its competitors in its standard offerings, and because it applies only toTelstra, it has the potential to exert a discernible anti-competitive effect in the market.

Price-quality trade-offs

While the price control arrangements affect the rate at which Telstra may increase itscharges for price-controlled services, other legislation affects other aspects of serviceprovision. The interaction between the various regulations may produce conflictsand/or unintended consequences.

Under the Customer Service Guarantee (CSG), Telstra is obliged to meet certainperformance and quality standards for a number of services, and to compensateconsumers for failure to meet those standards unless that failure was demonstrablybeyond its control and/or the customer agreed to a waiver of the standard.77

The operation of simultaneous restrictions on pricing and quality limits Telstra’s abilityto make price-quality trade-offs in response to normal commercial incentives. Forexample, some consumers may demand premium services, but Telstra may have littlescope to respond to that demand if the resulting premium price would jeopardisecompliance with the price control arrangements. (Again, Telstra’s competitors may beless constrained.) Similarly, a “cut down” or minimal version of a particular servicemay be acceptable to many consumers if a corresponding price reduction was offered.However, unless customers agree to waive their entitlements under the CSG, Telstraagain may have no commercial incentive to respond to the demand.

7.2.2 Impacts on competition, investment and consumers

Retail charges and service attributes are critical determinants of both consumption andinvestment. These outcomes therefore can be expected to affect competition,investment and consumers in a variety of ways.

Competition

New entrants are attracted to a market by the prospect of financial return. To the extentthat the outcomes discussed above influence the quantum, the timing and the certaintyof that return, they will also influence the attractiveness of the market to new entrants.

Below-cost pricing for some services will discourage entry (and may even trigger exit)unless the entrant expects to be able to recover projected losses from other services orrevenue sources. Similarly, the geographic averaging of charges, where it results inbelow-cost pricing in some areas and above-cost pricing in others, will encourage entryin regions where the prevailing charges for the services involved are in excess of costs,and discourage entry where losses are likely. The consequence is likely to be aflourishing of competitive activity in low-cost or high-revenue-yield regions, and littlecompetition in others. The opportunity for “cream skimming” of this sort is aninevitable consequence of the price-cost disparity.

77 Australian Communications Authority, Guide to the Telecommunications (Customer ServiceGuarantee) Standard 2000 (No. 2), paras 47-52, 64-65. Exemptions are also made in certain othercircumstances, documented in the paper.

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The type of competition that develops is also likely to be affected. If potential newentrants view regulated access charges as low relative to the cost of building andoperating new infrastructure, then facilities-based competition is unlikely to emerge asearly or as extensively as might otherwise be warranted and access-based arrangementswill be the preferred means of competition. A number of submissions referred to thispossibility and to its likely effects.78

The extent to which the price control arrangements have affected the development ofcompetition in practice is difficult to assess. The greater the cost-price disparity, thegreater the potential for consequent competitive distortion. Competition in CBD andremote areas, for example, may be developing at somewhat different rates than mightotherwise be the case as a result of these effects. However, competition in the marketsfor affected services as a whole (e.g. line rental) may be less affected if the decisions ofentrants are based less on price-cost disparities for individual services than on theexpected costs and revenues of all the services which they expect to offer.

Controls which apply asymmetrically in the market – for example, to Telstra but not toTelstra’s competitors – clearly have the potential to place Telstra at a competitivedisadvantage by reducing the range of pricing and service options which it can offer.Both the reporting requirements of the price control arrangements, which may precludeTelstra from bundling certain price-controlled services in particular ways, and theinteraction of the price control arrangements with the customer service guarantee,appear to introduce such asymmetries. While the extent of any resulting competitivedistortion is unclear, it may be considered undesirable in principle to imposerestrictions with a potentially anti-competitive effect on a single competitor in a market.

Investment

Allied with the effects of the price control arrangements on the nature and extent ofcompetition in the telecommunications market are their effects on investment in thatmarket.

Just as new entrants are attracted to a market by the prospect of financial return,investors commit funds in the expectation of achieving a reasonable return over the lifeof the investment. Telecommunications operators obtain returns on their investment ininfrastructure through the sale of both wholesale and retail services. Investors will notcommission infrastructure with a view to providing wholesale services unless theexpected return on those services is at least sufficient to cover their expected costs.Similarly, operators will not voluntarily enter markets in which they expect to incurwholesale or other costs in excess of their expected retail revenues.

Below-cost pricing reduces the expectation of return and so reduces incentives for themaintenance and expansion of the infrastructure used to produce the services involved.In particular, it has been claimed that the extent to which operators are prepared toinvest in infrastructure upgrades to support services such as digital broadband services(particularly in regional areas) may be limited if constraints on pricing limit the

78 See, for example, C&W Optus submission, p 50, Telstra submission p 14, AAPT submission p 4,RSL COM submission, p. 5.

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prospect of recovering their investment and/or increase the risks associated with suchrecovery. 79

Where markets can be geographically segmented, so that firms can choose to operate insome segments but not others, the geographic averaging of charges has the potential toinfluence the regional distribution of both competitive activity and new infrastructureinvestment. Firms will have an incentive to invest in regions where net revenues areexpected to be positive, and to avoid regions where losses are expected.

Any distortion in wholesale charges may also be expected to affect investment. Bycreating a differential between wholesale charges and wholesale costs, such distortionscan influence the “build-buy” decision of potential entrants to a market and hence thetype and extent of infrastructure investment which results. For example, wherewholesale charges are perceived as low relative to costs, infrastructure investment maybe discouraged and any competition is more likely to be access-based rather thanfacilities-based. If the differential itself varies along geographic lines, then theresulting distortion may be greatest in rural and remote areas. As noted earlier, anumber of submissions referred to this possibility.

It is difficult to estimate the extent of such effects. In an environment where the rangeof services which can be delivered by telecommunications infrastructure is growing,and where the demand for those services also appears strong, new entrants andinvestors may be more likely to make decisions on the basis of the projected revenuesfrom all the services and geographic areas in which they operate than on a service-by-service or region-by-region basis. However, any distortion in wholesale charges maybe expected to exact a cost in terms of allocative efficiency at the margin.

Consumers

Prices also influence the decisions consumers make. When prices are high, consumersare likely to consume smaller volumes of a service than when prices are lower. Theyforego consumption which will require an outlay in excess of the amount they areprepared to pay for the services in question. When the underlying costs are lower thanthe price, that decision to reduce consumption may be unnecessary and inefficient. Thehigh price discourages consumption which may have yielded value to the consumer inexcess of the cost of its provision and hence represented a potential welfare gain for thecommunity in general.

When retail prices are lower than costs, the reverse applies.

Below-cost pricing has the potential to directly reduce economic welfare in two ways:first, by increasing consumption of services above the level warranted by consumers’own valuations, with consequent diversion of resources from other, more-highly valuedservices, and second, to the extent that it requires the prices of other services to beraised above cost, by reducing the consumption of those services relative to the valuethey generate to consumers.

79 For example, see Telstra, Submission to the Telecommunications Service Inquiry (May 2000), pp 17,118 (among others).

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Estimates on the extent of these effects were presented in Chapter 5.

Below-cost pricing, and any compensating above-cost pricing on other services, is alsolikely to have distributional consequences. Consumers purchasing services pricedbelow cost will benefit from an effective “supplement” to their income, equal to thedifference between the charge which would be made in the absence of the price controlarrangements and the price-controlled charge. Following the same logic, consumerspurchasing services priced above cost will lose. If patterns of telecommunicationsexpenditure differ among different consumer groups, then this may result in theeffective cross-subsidy of one group of consumers by another.

Where there are geographic differences in the price-cost differential, similar effects arelikely to occur. Charges which are geographically-averaged will tend to result inunder-charging of service relative to cost for some consumers and over-charging forothers, resulting in an effective cross-subsidy of consumers in one region by consumersin another. The distributional consequences are likely to favour consumers in high-costareas and to disadvantage those in lower-cost areas. Other consequences of below-costpricing are also likely to apply in the case of averaged charges, including distortion ofincentives relating to new infrastructure investment, service quality and new services.To the extent that competition (particularly facilities-based competition) is less likely todevelop in higher-cost areas, consumers in such areas are also less likely to experiencethe lower prices, extended choice and service innovation which typically accompanycompetition.

Pricing at levels which are dissociated from costs can also affect consumers in moreindirect ways. It can reduce the incentive for providers of the service to offer serviceenhancements or quality improvements. Where quality standards are a concern, furtherregulation which substitutes compulsion for normal commercial incentives may then berequired. This may reduce the longer-term incentives of operators to produce and offerthe service.

As wholesale charges are inevitably a component of the retail charge, consumers areunlikely to be immune from distortions to wholesale prices resulting from the pricecontrol arrangements. However, the effects are likely to be indirect. Any reducedincentives for entry into the markets for affected services, for investment in newinfrastructure or maintenance of existing infrastructure, will ultimately be deleterious toconsumers by reducing the rate and extent of productivity improvement, price fall andservice innovation, as noted earlier in this chapter.

7.2.3 The relationship between wholesale and retail price regulation

The prospect of an incumbent operator being able to adopt monopoly pricing practicesbecause of a lack of effective competition in telecommunications service markets is thesingle major reason for implementing retail price control arrangements. As discussedearlier in this report, the controls act as a direct limitation on the ability of Telstra toexact monopoly rents through its retail prices and so reduce the efficiency costsassociated with such pricing.

Consequently, and as noted earlier, the development of effective competition is a primafacie indication that the need for such controls may have passed.

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However, if competition fails to develop at the wholesale level, wholesale serviceswhich are essential inputs to retail services may be priced at monopoly levels in theabsence of regulatory intervention. In these circumstances, retail prices whichincorporate a wholesale component may persist at high levels even in the presence ofretail competition. In telecommunications networks, where some network elementsretain natural monopoly characteristics, lack of wholesale competition may be acontinuing (and efficient) feature of the market. Regulation at the wholesale level – atthe point where the market power resides – would then appear to be the appropriatesolution.

In Australia, this has been done since 1997 by opening telecommunications markets tonew entry and by ensuring, through Part XIC of the Trade Practices Act, that newentrants can access essential network facilities in order to compete in the provision ofretail services and ensure any-to-any connectivity. The accompanying accessarrangements provide for the terms and conditions of network access to be arbitrated bythe Commission when access providers and access seekers are unable to reachagreement and when no undertaking is in place.

The use of different legislative vehicles for retail and wholesale price regulation meansthat there is, at best, overlap, and, at worst, conflict, between the two regulatoryarrangements. As indicated earlier, the existence of the retail price controlarrangements has occasionally resulted in the setting of wholesale charges on otherthan strictly cost-based (TSLRIC+) grounds and may, in any event, prevent bothcharges from converging on efficient levels.

In this regard, one party submitted that the combination of access price regulation andsubstantial retail competition from efficient competitors, means that retail priceregulation is now irrelevant. That is, if wholesale prices are set at effectivelycompetitive levels, and competition is effective in downstream markets, retail pricesthemselves should be at effectively competitive levels. Hence, there should be no needfor retail price controls to continue in the presence of an effective access regime.

As argued in Chapter 4, however, the Commission does not believe that competition isfully effective in all markets currently subject to price control arrangements. This isdespite the fact that some aspects of the provision of these services have been declaredby the Commission under Part XIC of the Trade Practices Act. Hence, whilst theaccess regime is still maturing, the Commission believes many of these services arestill not effectively competitive, and that there is room – for the time being – for bothwholesale and retail regulation of these services.

In the next section, the most significant example of such an interaction – below-costpricing of line rental – is analysed in detail.

7.3. Line rental

In this section, the Commission examines the impact on the price control arrangementsrestricting the extent to which Telstra can increase line rental charges. Particularly, theCommission examines the pervasive effect of the current restrictions on charges forother services, including both local call retail charges and wholesale charges, and theconsequential impact on competition, investment and consumers.

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7.3.1. Access deficit

An access deficit arises when the revenue from line related charges (e.g. connectionsand line rental) is insufficient to recover line costs. To cover this shortfall, acontribution (the access deficit contribution) is made by revenue obtained from callsusing Telstra’s fixed line network.

In a recent assessment of Telstra’s proposed wholesale charge for services involvinginterconnection with its fixed line network, the Commission estimated the annual linecosts which would be incurred by an efficient operator.80 These estimates are set out inTable 7.1.

Category Efficient line costs2000-2001

CBD 156

Metropolitan 348

Provincial 310

Rural/ remote 473

National average 346

Table 7.1. – Efficient annual line costs ($)81

Revenue from line rental forms the major component of line revenue. Currently,Telstra’s annual charges for line rental are:

§ $210 (including GST) for standard line rental supplied to residentialconsumers82; and

§ $330 (including GST) for standard line rental supplied to business consumers.

In addition, Telstra offers a number of packages where higher line rental charges arepaid in return for lower call charges (e.g. lower local call charges). While line costs

80 The cost methodology used to estimate these costs is known as Total Service Long Run IncrementalCost (TSLRIC). It is used to estimate the costs that an efficient operator would incur over the longrun in supplying the service in question. In applying this methodology, the Commission includes aportion of attributable common costs, and indirect costs, in calculating the TSLRIC+. Furtherdetails can be found in Australian Competition and Consumer Commission, A report on theassessment of Telstra’s Undertaking for the Domestic PSTN Originating and Terminating AccessServices, July 2000 (the Undertaking Report) and Australian Competition and ConsumerCommission, Access Pricing Principles: Telecommunications – A Guide, July 1997.

81 Undertaking Report, op cit, p. 65.

82 Residential customers pre-selected to Telstra who are among the 10 per cent of customers with thelowest telephone bills have the option of paying a lower effective annual rental charge.

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differ across geographic regions, the Commission understands that Telstra does notdifferentiate between end-user location in its line rental charges.

In some instances, line rental charges exceed the Commission’s estimate of annual linecosts (i.e. charges for services supplied to consumers in CBD locations). Overall,however, line rental revenue would appear to be insufficient to recover efficient costs,and this shortfall is not made up with other sources of line revenue. The Commission’sestimate of the resulting access deficit, calculated for the purpose of assessing Telstra’sproposed charges for certain wholesale services, is set out in Table 7.2.

Annual line costs (A) 3 522

Subtract line connection and other revenues (B) 338

Subtract net universal service funding (C) 279

Retail costs (D) 468

Remainder – to be recovered from line rentalcharges

(E = A – B – C + D) 3 374

Deduct line rental revenue (F) 2 194

Access deficit (G) 1 180

Table 7.2. – Calculation of the access deficit for 2000-01 ($m)83

Line rental charges are subject to control as part of a general basket oftelecommunications services. The extent to which Telstra can raise line rental chargesin order to reduce the access deficit, however, is constrained by three specific sub-caps:

§ the sum on the weighted change in line rental and local call charges (for bothresidential and business customers) cannot increase by more than CPI;

§ the sum of the weighted change in connection, line rental, local call, and longdistance call charges for residential customers pre-selected to Telstra who areamong the 50 per cent with the lowest telephone bills must not increase bymore than CPI – 1 per cent; and

§ line rental charges for residential customers pre-selected to Telstra who areamong the 10 per cent of customers with the lowest telephone bills cannotincrease by more than CPI unless the Commission consents to this occurring.The Commission can only grant its consent if satisfied that there are otherproducts/ arrangements available to these customers which will ensure that theaverage telephone bill does not increase by more than CPI.

83 Undertaking Report, op cit, p. 59. Calculation of the access deficit is based on the assumption thatTelstra raises line rental charges to the maximum extent permitted by the retail price controlarrangements. Where Telstra does not do this, then the actual deficit is likely to be higher thanshown in Table 7.2.

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These sub-caps, and in particular the local call/line rental sub-cap, provide a limitedrange of products for which price decreases can be used to “fund” line rental increases.

In its submission on the Discussion Paper, Telstra states:

Currently, the sub-cap affecting basic access is a cap of CPI – 0 applied to local calls and linerental services. This means that under the current price control arrangements, Telstra can onlyincrease basic access charges in real terms if it decreases (real) local call charges. Given thatlocal call charges are already capped below the efficient cost of provision by a separate pricecap [i.e. the local call price cap of 22 cents (including GST)], Telstra is restricted fromincreasing basic access rentals without incurring an increased loss on the provision of localcalls. Therefore, the CPI – 0 cap currently applying to local calls and line rental serviceseffectively acts as a sub-cap on line rental charges.84

The price control arrangements in respect of the 10 per cent of residential customerswith the lowest telephone bills further restricts the extent to which Telstra can raise linerental charges. On the other hand, the price control arrangements in respect of the50 per cent of residential customers with the lowest telephone bills would appear toprovide greater latitude to increase line rental charges. This is because there are agreater number of products over which price reductions can be used to fund increasesin line rental charges – international calls, national long distance calls, local calls andconnections. That said, because this sub-cap applies to a sub-group of consumers anddoes not capture all services, it still restricts the extent to which Telstra can increaseline rental charges.

The Commission is not aware of the precise manner in which Telstra recovers theaccess deficit from all of its call products under the various constraints, althoughmargins between prices and full attributable long-run costs vary over the call services.AAPT in its submission on the Draft Report85 argues for the retention of the sub-cap online rentals and local calls, while removing the broad first basket cap. AAPT suggeststhat Telstra has an opportunity under existing regulation to rebalance between linerentals and local calls by separating local calls into calls to Internet Service Providers(ISPs) (which, AAPT claims, could be charged on a timed basis) and all other calls(that must be untimed and are subject to the sub-cap on line rentals and local calls).AAPT estimates that, because these other calls on average are much shorter thanInternet calls, the average cost of these other calls is only a little over 10 cents based onthe Commission’s n/e/r/a model. 86 If their price were reduced to cost, this would leavesubstantial room within the existing sub-cap for Telstra to increase line rentals. Whilethe Commission finds this argument interesting, it does not believe that it provides acase for deviating from its recommendation to remove this sub-cap. The Commission’sanalysis in Chapter 5 suggests that there will be substantial gains for the community asa whole from encouraging rebalancing across the range of PSTN services. However,the analysis would tend to suggest that the gains from AAPT’s proposal to rebalanceonly between line rentals and local calls are likely to be modest. Further, AAPT’s

84 Telstra submission, p. 9.

85 AAPT’s submission appends a “Review of Line Rental Analysis” written for AAPT by NeilTuckwell.

86 Note that the Commission does not use the n/e/r/a model to estimate the cost of local calls.

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proposal does not provide any amelioration from the “rate shock” that would arise ifTelstra chose to rebalance too rapidly.

The Commission has considered the manner in which it is reasonable for a share of thedeficit to be recovered from charges for certain wholesale services supplied by Telstrato its competitors (i.e. Domestic PSTN Originating and Terminating Access services).

7.3.2. Wholesale pricing and efficient investment

Under Part XIC of the Trade Practices Act, certain services can be “declared”. Theseservices are generally inputs used by service providers to supply telecommunicationsservices to end-users and other service providers.

Declaration means that when there is a dispute in relation to the terms and conditionson which the (wholesale) service is supplied, the Commission can (if requested)arbitrate and set the terms and conditions of supply. In addition, to avoid arbitrations,the supplier can offer the Commission an “undertaking” setting our proposed terms andconditions of supply, which the Commission can accept if it considers that the termsand conditions are reasonable.

In arbitrating a dispute and setting the terms and conditions of supply, or assessing anundertaking, the Commission must consider a number of factors. Particularly, it mustconsider the impact of the terms and conditions or supply, or the undertaking, on:

§ the long-term interests of end-users;

§ the legitimate business interests of the supplier, including the supplier’sinvestment in facilities used to supply the (declared) service;

§ the interests of all persons who have rights to used the (declared) service;

§ the direct costs of supplying the (declared) service;

§ the operational and technical requirements necessary for the safe and reliableoperation of a carriage service, a telecommunications network or facility; and

§ the economically efficient operation of a carriage service, atelecommunications network or facility. 87

In cases where the Commission has considered and balanced these factors, theCommission has formed the view that it reasonable to permit the inclusion of an accessdeficit contribution in wholesale charges.88

87 Sections 152AH and 152CR of the Trade Practices Act. In arbitrating an access dispute, theCommission must also consider the value of extensions to, or capability enhancement of, facilitieswhen the cost of the extension/ enhancement is borne by someone else (paragraph 152CR(1)(e)).

88 Undertaking Report, op cit, pp. 36-37 and 42.

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The approach adopted by the Commission involves allocating a specific portion of thetotal access deficit to the Domestic PSTN Originating and Terminating Access servicesand then including a contribution in the charges for those services, which is sufficientto enable that portion of the access deficit to be recovered. This is shown inDiagram 7.1.

111

1069

Domestic PSTN Originating and Terminating Access services

Other PSTN call products

Figure 7.1. – Allocation of the 2000-01 PSTN access deficit toDomestic PSTN Originating and Terminating Access services ($m)89

The Commission has previously expressed the view that the $111 million allocated tothe Domestic PSTN Originating and Terminating Access services should be recoveredas both a per call (i.e. flagfall) and per minute contribution. 90

Including an access deficit in wholesale (and retail) call charges, distorts demand forthose services. Estimates by the Commission indicate that the access deficitcontribution accounts for approximately 45 per cent of the 2000-01 wholesale chargewhich would be levied by an efficient operator. Consequently, where prices are basedon efficient costs (as estimated by the Commission) charges are likely to be almosttwice as high as would be the case in the absence of an access deficit contribution.

This can create significant distortions in the level of demand for those services withconsequent efficiency losses as described in Chapter 5.

89 Undertaking Report, op cit, pp. 24-26.

90 Undertaking Report, op cit, pp. 37-39.

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Inclusion of the access deficit in wholesale prices distorts demand (and thereby theallocation of resources). Where the contribution is passed through to retail call charges,consumers pay more for their calls than would otherwise be the case in the absence ofthe access deficit contribution. Also, there are likely to be distributional consequences.End-users who make large numbers of calls and/or have a high traffic volumes (interms of minutes of traffic) will make a greater contribution towards the access deficitthan lower volume end-users. This means that, in many cases, there will be a transferfrom high volume users to lower volume users.

Moreover, the access deficit distorts the investment and entry decisions of Telstra’scompetitors. For instance, charges for call services provided to consumers in centralbusiness district locations may be expected to include an access deficit contribution,even though line revenue is likely to exceed line costs in those areas. Such charges arelikely to be above the cost of serving those customers, providing Telstra’s competitorswith incentives to build their own networks in those areas in order to avoid paying theaccess deficit contribution. This may result in a level of investment greater than wouldbe economically efficient – economic efficiency may be better served by competitorsusing Telstra’s network rather than building out their own.

Levels of investment in excess of that which is economically efficient reduces theextent to which firms can take advantage of economies of scale and scope. As a result,overall, costs are likely to be higher than would be the case in the absence of the accessdeficit contribution. Consequently, while the installation of infrastructure may enablefirms to supply services to consumers at prices that are lower than current prices, futureprices may be unlikely to fall to the levels which could occur in the absence of theaccess deficit contribution.

7.3.3. Local call prices and costs

Other controls on retail prices, notably those for local calls, limit the extent to whichthe access deficit can be recovered from local calls.

Currently, the retail price control arrangements establish a maximum charge foruntimed local calls. Prior to 21 June 2000, this was 25 cents per call. At that time,the retail price control arrangements were amended to establish a new maximumprice of 22 cents per call which, after 1 July 2000, was to be inclusive of GST.

These controls appear to have established a benchmark from which prices withinthe marketplace have been set. In many cases, prices are below the maximum pricepermitted by the price cap. For instance, as part of its standard charges, Telstraoffers “neighbourhood” local calls at 16.5 cents. Telstra also offers particularproduct packages, under which local calls are priced below 22 cents in return forhigher line rental charges, or in return for the customer agreeing to pre-selectTelstra for long distance and fixed to mobile calls. Other service providers alsooffer local calls at prices below 22 cents per call, generally as part of call packagescovering local, long distance and fixed-to-mobile calls.

Telstra asserts that the current level of pricing involves local calls being pricedbelow cost.

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In its submission, Cable & Wireless Optus also appears to claim that local call pricesare below efficient costs:

5.2. The effects of the government’s price capping arrangements has been to reduce thenominal price of local calls from 25 to 20 cents per call (20 % decrease), or 23.5 per centin real terms over the 1999/2000 calendar year given 3 % real inflation.

5.3. Cable & Wireless Optus disagrees with this policy. It undermines competition and theincentives to undertake facilities-based investment...

5.7. ...the effective retail price reduction in local calls, caused by the tightening of the untimedlocal call cap, has reduced the incentives to undertake facilities-based investment orcompetition...

5.8 As noted by the Productivity Commission:

“Price control arrangements may be hindering the competitive process in somecountries including Australia...price caps on local service may be reducing returns inthis market, making entry unattractive.”

5.9. Cable & Wireless Optus recommends, given the requirement of untimed local calls islikely to be maintained post July 2001, the untimed cap should be set at 25 cents per calland able to be increased by the CPI each year. 91

Broadly, a local call consists of three cost components and an access deficitcontribution. The cost components are conveyance costs, indirect costs and retail costs.These components are shown in Diagram 7.2.

Conveyance costs

Indirect costs

Retail costs

Access deficitcontribution

TSLRIC+

Figure 7.2. – Local calls: cost components and the PSTN access deficit

contribution

91 Cable & Wireless Optus submission on the Discussion Paper, pp.51-52.

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Telstra claims that its assertion about local calls being priced below cost is supportedby the Commission’s estimate of local call costs.92 In this regard, it appears that Telstrais referring to the Commission’s estimate of conveyance and indirect costs, and theaccess deficit, undertaken for the purposes of assessing Telstra’s proposed charges forthe Domestic PSTN Originating and Terminating Access services.93 The Commissionhas not, however, undertaken a study of local call costs and accordingly, is unable toverify or refute Telstra’s claim.

That said, for the purposes of analysing Telstra’s submission, it is useful to presentTelstra’s estimate of call costs, without endorsing the correctness (or otherwise) ofthose estimates. In this regard, for local calls of average duration (i.e. eight minutes)during 2000-01, Telstra has estimated that:

§ the average TSLRIC+94 is 14.85 cents per call;

§ the access deficit contribution is 7.26 cents per call; and

§ this results in an average local call cost of 22.11 cents per call (excluding retailcosts),95 which exceeds the maximum revenue that Telstra can earn fromuntimed local calls under the retail price control arrangements – 20 cents percall. 96

Using these estimates, it can be seen that the access deficit contribution isapproximately 50 per cent of local call conveyance plus indirect costs. That said, itshould be noted that Telstra’s estimate of local call conveyance and indirect costs is anaverage cost estimate. Accordingly, where costs are lower than average costs (which islikely to be the case in CBD locations) the access deficit contribution will be a greaterproportion of these costs.

If the access deficit were removed (e.g. through increases in line rental charges) thenaverage costs for local calls of average duration would, based on Telstra’s calculationsfor 2000-01, be approximately 15 cents per call plus average retail costs. Dependingon the quantum of retail costs, removal of the access deficit could result in local callcosts for 2000-01 being at or below the maximum revenue that Telstra can earn under

92 Telstra submission on the Discussion Paper, p.16.

93 This assessment is set out in the Undertaking Report.

94 TSLRIC represents an estimate of the costs that an efficient operator would incur over the long runin supplying the service in question (in this case, local calls). In applying this methodology, theCommission understands that Telstra has included attributable common costs and indirect costs(i.e. TSLRIC+).

95 Telstra submission to the Productivity Commission Inquiry into Telecommunications SpecificCompetition Regulation, 30 August 2000, p. 8. Telstra provided similar, although slightly lowerfigures, to the Commission in a confidential submission.

96 While the maximum price prescribed by the retail price control arrangements is 22 cents per call,this includes GST (2 cents per call) which must be remitted by Telstra to the Commonwealth.Hence, the maximum revenue that Telstra can earn from untimed local calls is 20 cents per call.

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the current retail price control arrangements. The Commission would not expect retailcosts to be more than 25 per cent of call costs (i.e. around 5 cents per call) and hence,based on Telstra’s estimates, the average retail cost of a local call would appear to beless than 20 cents per call.

Consequently, removal of the access deficit contribution from local calls is likely toresult in the removal of significant distortions affecting competition and investment,and ultimately the benefits to end-users, in the local telephony services market.

7.3.4. Wholesale local call charges

The interaction of the access deficit contribution and the retail price controlarrangements also affects wholesale local call charges.

Telstra supplies wholesale local calls (known as the local carriage service) to itscompetitors who then resells those calls to end-users. As noted in the Commission’sinquiry into competition for local telecommunications services, re-supply of local callsis currently the main form of local call competition and enables competition in respectof the retail dimensions of local calls (e.g. customer support, marketing and billing).97

The local carriage service is a “declared” service under Part XIC of the Trade PracticesAct. As such, where Telstra and a wholesale customer disagree over the price for thisservice, one of them can request the Commission to arbitrate and set the price. ByDecember 2000, the Commission was arbitrating six disputes involving this service.

To price the service, two methodologies have been suggested to the Commission –TSLRIC++ and “retail minus”. With the TSLRIC++ approach the wholesale price isequal to the sum of the local call conveyance costs, indirect costs and the access deficitcontribution, whereas with the “retail minus” approach the wholesale price is equal toTelstra’s retail local call price minus average retail costs.

The Commission has indicated its preference for setting prices based on efficient,forward-looking costs (i.e. TSLRIC+ or TSLRIC++). However, the existence of theretail price control arrangements and pricing behaviour within the market has produceda number of complicating considerations.

97 Australian Competition and Consumer Commission, Declaration of Local TelecommunicationsServices: A Report on the Declaration of an Unconditioned Local Loop Service, Local PSTNOriginating and Terminating Services, and a Local Carriage Service under Part XIC of the TradePractices Act 1974, July 1999.

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If Telstra’s claim about local call costs is correct, then a wholesale price based on theTSLRIC++ could result in a price for the local carriage service of approximately22 cents per call; i.e. a price in excess of Telstra’s current retail price. With such aprice, the Commission was of the view that service providers:

...who were as efficient as, or more efficient than, Telstra at the retailing of local calls would notbe able to compete with Telstra unless they price local calls below the cost to them of acquiringthose calls. This is unlikely to promote retail competition for the resale of local calls.98

Consequently, with a view to promoting local call retail competition, the Commissionhas proposed to use a “retail minus” approach in pricing the local carriage service.99

This would enable service providers who were equally or more efficient than Telstra atretailing to enter the market and compete. In other words, the retail price controlarrangements (and resulting retail prices in the market as a consequence of thosecontrols) have altered the level and structure of wholesale charges which mightotherwise prevail in the market.

7.3.5. Investment in the local loop

Investment in alternative fixed line telecommunications infrastructure has tended tofollow a pattern of significant deployment of infrastructure in central business districtlocations by carriers such as Cable & Wireless Optus, MCI WorldCom, AAPT andPrimus, and more limited deployment in regional areas. In suburban areas, installationof alternative infrastructure has been predominantly limited to the Cable & WirelessHFC network.100

As noted by the Commission in its inquiry in competition for local telecommunicationsservices, there are a number of factors influencing the extent of network deployment.These include the need to obtain regulatory approvals (e.g. from local government andenvironmental agencies), access to existing infrastructure (such as ducts), economies ofscale, and the sunk nature of the investment.101

Retail price control arrangements can also influence the pattern of investment. Wherethey result in prices which are below the costs of supply in particular areas, they can beexpected to deter entry and investment in those areas (unless mechanisms exist tocompensate suppliers for serving customers in those areas). In other areas where theyresult in prices that are above cost (e.g. due to inclusion of an access deficit

98 Australian Competition and Consumer Commission, Access Pricing Paper – Local CarriageService: Final Report, November 2000, p. 13.

99 ibid., p. 26.

100 An exception is the ACT where TransAct plans to construct a telecommunications network in theCanberra region.

101 Australian Competition and Consumer Commission, Declaration of Local TelecommunicationsServices: A Report on the Declaration of an Unconditioned Local Loop Service, Local PSTNOriginating and Terminating Services, and a Local Carriage Service under Part XIC of the TradePractices Act 1974, July 1999 (the “Local Telecommunications Services Report”).

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contribution in charges for services supplied in central business districts), then theymay encourage investment beyond levels that could be considered efficient.

In this regard, Telstra submits that:

...line rental rebalancing also has the potential to encourage efficient investment in networkinfrastructure and hence deliver substantial productive and dynamic efficiency gains toconsumers. Under the current price control arrangements, new entrants have little incentive tocompete with Telstra by building their own infrastructure because the price controlarrangements require Telstra to retail local services below cost. Hence it would be extremelydifficult, outside of CBD areas, to compete with the prices that Telstra is required to offer...102

Cable & Wireless Optus, in its submission, claims that as well as discouraging localloop deployment, the retail price control arrangements also distort consumer demandwhich has flow on consequences for infrastructure investment:

4.5. ...because current Price control arrangements cause Telstra to price monthly access belowcost, economically efficient facilities based investment by other carriers is diminished.Other carriers, even if they are able to build and provide local loops more efficiently thanTelstra, are deterred from investing in such infrastructure because of Retail Controls.

4.6. Facilities based investment by rivals to Telstra is very important for the economy as awhole because it unlocks powerful dynamic competitive forces. In particular, currentfacilities-based competition between Telstra and Optus in telephony is leap-frogging intoother important information economy services such as high speed internet access andsubscription television services – innovative services that are producing new and importantbenefits to consumers.

4.7 Investment in broadband infrastructure is particularly critical if Australia is to not fallbehind in terms of new information economy services. Current Price control arrangements,in contrast, encourage uneconomic substitution into narrow-band telecommunicationsservices because of government mandated below cost pricing...103

By deploying their own networks where this is efficient, competitors are able to takeadvantage of the latest technology. This provides competitors with a greater range ofproduct attributes over which they can compete, because they are no longer reliant onthe attributes of Telstra’s network. This then produces a positive cycle of innovationand investment because Telstra then faces increased pressure to innovate in order toprevent loss of customers to those competitors.

Sub-optimal levels of investment have important consequences for consumers. First, itmeans that the level of competition may be less vigorous than it might otherwise be(because competitors are more dependent on access to Telstra’s network than would bethe case if they had deployed their own networks). Secondly, and perhaps moreimportantly, it means that the level of innovation may be below the levels that could beotherwise achieved.

102 Telstra submission, p. 14.

103 Cable & Wireless Optus submission, p. 49.

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7.3.6. Universal service costs

A further consequence of below-cost line rental charges is that there are likely to be agreater number of geographic areas in which the additional costs of supplyingtelecommunications services to end-users exceeds the additional revenue generated(i.e. ”net cost areas”). This increases the size of the net universal service cost. Becausethat cost is currently funded by a levy imposed on service providers, this ultimatelyaffects the quantum of the levy payable by Telstra’s competitors.

7.3.7. Incentives to rebalance

Telstra also claims that the current approach used by the Commission in pricingwholesale services (such as the Domestic PSTN Originating and Terminating Accessservices – see section 7.3.2.), coupled with the retail price control arrangements, affectsits ability to raise line rental charges:

... under the current price control arrangements, the only manner in which Telstra can rebalanceline rental charges is by selling local calls further below cost. That is, the only way that thedeficit on basic access [i.e. line rental] can be reduced is by increasing the deficit on localcalls.104 Unlike the deficit on basic access, the Commission has refused to recognise the deficiton local calls in setting access charges and hence any revenue shortfall on local calls created bythe price control arrangements must be fully funded by Telstra. Clearly, the current pricecontrol arrangements together with the ACCC’s refusal to recognise the local call deficit insetting access charges provide no incentive for Telstra to rebalance line rental charges.105

In the Commission’s view, any disincentive to “rebalance” is more likely to be due tothe local call/line rental sub-cap than its pricing of wholesale services. The example inBox 7.1 demonstrates the point.

As shown by that example, an increase in line rental charges results in a reduction inthe overall access deficit and consequently, a reduction in the per-call access deficitcontribution. This means that less revenue is needed from call products (i.e. local, longdistance and fixed-to-mobile calls, as well as from wholesale charge for the DomesticPSTN Originating and Terminating Access services) to cover call costs and the accessdeficit contribution. That is, as line rental charges increase, there is scope for callcharges (including local call charges) to fall.

The “disincentive” problem which can arise, however, under the current retail pricecontrol arrangements is that the reduction in access deficit contribution (per call) is lessthan the price reduction necessary to “fund” the increase in line rental charges. As aresult, where Telstra is making a loss on local calls, the margin between the local callprice and the sum of local call costs and the access deficit contribution increases. IfTelstra was earning excess profits on local calls, the margin between costs and revenuewould decrease. Either way, this mode of rebalancing creates incentives against raising

104 The Commission understands that Telstra defines the local call deficit as being the differencebetween the price of a local call revenue, and per call costs and per call access deficit contribution –see section 7.4.1.

105 Telstra submission on the Discussion Paper, p. 16.

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line rental charges.106 This is because the “benefit” of reduced local call prices andincreased line rental charges is spread across all PSTN call prices.107 This problemcould be alleviated if a wider selection of services were included in the basket, therebyallowing price reductions in those services to be taken into account as part of therebalancing process.

106 This effect is moderated or reduced to the extent that lower local call prices lead to an increase indemand for local calls, which will make a contribution to the access deficit.

107 This is not to suggest that, if Telstra were to fully rebalance, it would make a loss.

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Box 7.1 Incentives for rebalancing with current line rental/local call sub-cap

To examine the incentives for rebalancing created by the line rental/ local call sub-cap,this box presents a hypothetical example. The figures used have been taken fromTelstra’s 1999-2000 Annual Report :

Local calls: Revenue $2 650 mCalls 11 346 mAverage per call charge 23.4 cents

Line rental: Revenue $2 020 mLines 10.4 mAverage per line charge $201.20

Under the sub-cap, the sum of price movements (weighted by revenue derived fromeach product) must be equal to CPI – 0 per cent. Suppose that local call prices arereduced by 10 per cent. If this is the only charge that occurs, the possible increase inline rental is 13.1 per cent.108

A 13.1 per cent increase in line rental results in an additional $265 million in linerevenue; i.e. the access deficit is reduced by $265 million. Telstra allocates 70 per centof this reduction to local calls109 – $185.5 million or 1.6 cents per call.

Thus while the local call price drops by approximately 2.3 cents, the access deficitcontribution for local calls falls by only 1.6 cents (i.e. by less than the fall in local callprice). Thus if Telstra is making a “loss” per call, then the quantum of that lossincreases. Even if there is no loss, but in fact Telstra is earning excess profits on eachlocal call, the per-call profit margin is reduced. The increased loss, or reduced profitmargin, is equal to $79.5 million (i.e. 0.7 cents per call multiplied by 11 346 calls),which is the quantum of the access deficit allocated to non-local calls.

7.4. Local call price parity

The local call parity arrangements require that the average price charged by Telstra toresidential, charity and business customers in non-metropolitan areas for untimed localcalls in 1999-00 must not exceed the average price charged by Telstra to residential,charity and business customers in metropolitan areas for untimed local calls in 1998-99by more than 0.4 per cent. A similar price control exists for 2000-01. The intention ofthe arrangements is to ensure that customers in non-metropolitan areas have access tountimed local calls at prices which are linked to those charged in metropolitan areas,and that the benefits of any price reductions are passed on to all consumers within areasonable period of time.

108 i.e. (0.1)*(2650)/(2650 + 2020) + (0.131)*(2020)/(2650 + 2020) = 0. This scenario, for simplicity,assumes no demand response (i.e. a reduction in demand for lines or increase in demand for localcalls) as a result of these price changes.

109 Telstra submission on the Discussion Paper, p. 10.

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That said, these controls do not recognise cost differentials which may exist betweenmetropolitan and non-metropolitan areas. Where differentials exist in the cost ofproviding untimed local calls to such groups between metropolitan andnon-metropolitan areas, this requirement is likely to give rise to price-cost disparities.

Telstra has provided the Commission with estimates which indicate that the sum of thewholesale costs (i.e. conveyance and indirect costs) and the access deficit contributionfor local calls differs by a factor of up to c-i-c across CBD, metropolitan, 110 provincialand rural geographic zones. (More disaggregated estimates are likely to show evengreater differentials.) According to Telstra, the estimates suggest that the wholesalecosts of local calls may exceed the price-capped revenue of 20 cents per call111 in somezones.

*** COMMERCIAL-IN-CONFIDENCE ***Year CBD Metropolita

nProvincial Rural Average

1999-00 c-i-c cents c-i-c cents c-i-c cents c-i-c cents c-i-c cents

2000-01 c-i-c cents c-i-c cents c-i-c cents c-i-c cents c-i-c cents

Table 7.3 Telstra estimates of efficient conveyance costs, indirect costs and the accessdeficit contribution for local calls [c-i-c]

The Commission is not able to express a view on the absolute quantum of these costs(because it has not undertaken a study of local call costs). However, its work inassessing Telstra’s proposed wholesale charge for Domestic PSTN Originating andTerminating Access services indicates that the relativities between the sum of costs andthe access deficit contribution for these geographic areas are about right.112

This means that, if Telstra was to reduce its call charges in CBD and metropolitan areasto levels where the price was just sufficient to recover costs, the access deficitcontribution and GST, then it would make a loss (or, a greater loss, according to Telstraestimates) on local calls supplied in rural and provincial areas. To prevent this fromoccurring in CBD and metropolitan areas, Telstra would need to charge pricessignificantly in excess of those necessary to recover costs, the access deficitcontribution and GST. Hence, there is likely to be over-charging for some consumers(e.g. those in CBD locations) and under-charging for others (e.g. those in rural areas).

This is likely to affect competition, investment and consumers in a number of ways.

110 These categories have been used for the purposes of estimating costs . The definition of“metropolitan” for this purpose differs from the definition in the price control arrangements where itincludes CBD locations.

111 That is, the price cap of 22 cents per call minus 2 cents GST.

112 Undertaking Report, pp. 26-27.

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The development of competition in the market for local calls is likely to be influencedby the pattern of the price-cost differentials. Other things equal, new entrants will havean incentive to enter the market for local telephony services in regions where the costof providing such services is less than the price charged by Telstra. On the basis ofTelstra’s cost estimates for 1999-00 and 2000-01, this is likely to be CBD and somemetropolitan areas. There will be less incentive for new entrants to seek to offer localcall services in regions where cost recovery appears unlikely.

Also, investment can be similarly affected. Where there is a significant differentialbetween price and underlying costs (as in the case of CBD areas) facilities-based entryis more likely to occur, rather than entry based on the use of Telstra infrastructure(i.e. access-based entry). This is because, as explained above, wholesale prices for useof Telstra’s infrastructure are likely to be influenced by the retail price controlarrangements and therefore involve prices that are above-cost. As a result, investmentin excess of economically efficient levels may occur.

Moreover, the Commission notes that there are equity considerations which mayoutweigh these impacts, and in particular the desirability of providing a degree ofequality in prices paid by metropolitan and non-metropolitan consumers. These issuesare considered further in Chapter 9.

In its submission, Telstra suggested that, if it were to be retained, the price parity ruleshould apply to all carriers:

The implications of removing the local call parity conditions could result in reasonably largegains for consumers in CBD and metropolitan areas and would have no impact on consumers inprovincial and rural areas.

There are, however, significant horizontal equity issues that the Commission may considerrequire retention of the metro/non metro parity arrangements. If this is the case, theCommission should extend this requirement to all service providers. This would maximise anybenefits the Commission might find in retaining the parity arrangements.113

In the Commission’s view, applying the price parity rule (if it were to be retained) toother carriers is of questionable merit. To the extent that the price parity rule applyingto Telstra results in charges that are below the level necessary to recoup costs and theaccess deficit contribution, this is likely to constrain the charges that Telstra’scompetitors can levy for local calls in those areas. Also, applying the price parity ruleto other carriers could discourage them from entering areas where costs of supply arehigher than in the areas which they currently serve.

113 Telstra submission, p. 15.

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7.5 Conclusions

This chapter has focused on the current price control arrangements and examinedparticular ways in which they appear to affect competition, investment and consumersin telecommunications markets. It concluded that:

§ the price control arrangements result in line rentals being priced below thelevel needed fully to recover the access deficit contribution, forcing otherservices to be priced above cost in consequence;

§ the access deficit flowing from the pricing of line rentals below cost affects thedetermination of access charges under the telecommunications access regime,raising those charges above the estimated efficient cost of their provision;

§ these effects result in prices which do not accurately reflect the efficient costsof providing the services, and so tend to:

§ discourage competition in the markets for services which are pricedbelow cost and in regions where the price control arrangements inhibitcost recovery;

§ distort investment patterns and hence the type of competition whichdevelops, by altering “build-buy” incentives and discouraging facilities-based competition for services which are priced below cost and inregions where the price control arrangements inhibit cost recovery;

§ force effective cross-subsidy of consumers of some services byconsumers of other services, and of consumers in some regions byconsumers in other regions;

§ reduce the range of choices available to consumers by limiting the extentto which Telstra can bundle its service offerings and/or offer price-quality trade-offs to its customers.

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Chapter 8 Distributional Impacts of AlternativePrice Control Arrangements

8.1 Introduction

As outlined in Appendix A, the terms of reference direct the Commission to considerthe distribution of the short-term and long-term community and economic benefits andcosts from any substantial changes proposed to the current price control arrangements.

In particular, the terms of reference direct the Commission to have regard to thedistributional impacts of changes to the price control arrangements on the following:

§ different types of household and business consumers;

§ consumers from different geographic areas; and

§ consumers with different income levels.

Accordingly, this chapter will analyse the impacts of specified changes to the pricecontrol arrangements on these groups of consumers. In order to do this, this chapterwill:

§ outline two broad types of alternative price control arrangements that will beconsidered;

§ describe a methodology for analysing the impacts of these alternativearrangements on the different groups of consumers specified above;

§ outline the difficulties the Commission has experienced in applying thismethodology; and

§ provide some analysis of the distributional impacts of the two broad types ofprice control alternatives on different groups of consumers.

8.2 Alternative price control arrangements

Based on the analysis of the previous four chapters, price control arrangements willprovide the greatest benefit to the community as a whole when the Government:

§ applies a broad CPI – X per cent price cap to a range of services, the marketsfor which are not yet fully competitive;

§ removes all other existing sub-caps on the price of services included in thebroad price cap; and

§ removes the local call parity requirement.

As indicated in Chapter 2, however, efficiency is not the only objective of the pricecontrol arrangements. This is because whilst a certain set of price control arrangements

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may make the community as a whole better off due to a fall in average prices over timeand because of an improved environment for increased competition, investment andconsumer choice, not all consumers will benefit to the same extent. That is, while a setof price controls may be to the benefit of the community as a whole, certain groups ofindividuals within that community may be made worse off. In turn, this may be ofsome concern to the Government.

Accordingly, just as it is important that a change to the price control arrangements willmake the community as a whole better off, it is also important that measures are takento ameliorate the potential adverse impacts on particular groups of consumers. Beforedeciding how to design policies to provide assistance to those who may bedisadvantaged by changes to the price control arrangements, however, it is important togain an understanding of who these potentially disadvantaged groups might be. Thecentral aim of this chapter, therefore, is to determine the distributional impact ofchanges to the price controls in order to provide the basis for recommending polices toprotect the welfare of potentially needy groups in Chapter 9.

It follows, therefore, that this chapter will consider the impact on particular groups ofconsumers of those services that the Commission recommends should be retained infuture price control arrangements. Hence, in section 8.4 and 8.5, the Commission willanalyse the distributional impact of the following two alternative sets of price controlarrangements:

§ the removal of a number of sub-caps from the current price controlarrangements; and

§ the removal of the local call parity requirement.

Before analysing these impacts, section 8.3 below will outline the methodology theCommission has applied to determining these impacts.

8.3 Methodology for determining distributional impacts of changesto the price control arrangements

In order to estimate the distributional impacts of changes to the price controlarrangements, the Commission engaged the National Centre for Social and EconomicModelling (NATSEM) to undertake an analysis of current expenditure by householdson basic Telstra services.

In consultation with the Commission, NATSEM developed a two-stage proposal forestimating the distributional impact of changes to the price control arrangements. Thefirst stage, undertaken by NATSEM, involved estimating expenditure profiles fordifferent groups of consumers of telecommunications services. The second stage of thedistributional impact analysis, undertaken by the Commission, involves applyingexpected price changes under alternative price control arrangements to current levels ofexpenditure. Based on this, it is then possible to estimate how the expenditure patternsof different groups of consumers might change as a result of changes to the pricecontrol arrangements, and how this may effect their welfare.

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8.3.1 Modelling expenditure levels for different groups of consumers

Ideally, estimates of current expenditure levels would involve determining averageexpenditure levels for different groups of consumers on each of the services that theCommission recommends should continue to be subject to price control arrangements.The different groups would be based on those identified in the terms of reference forthis review – ie. different types of business and household consumers; consumers fromdifferent geographic areas and consumers with different income levels.

Due to limitations in available data, however, NATSEM were only able to estimateexpenditure patterns according to:

§ residential consumers’ total level of telecommunications expenditure byservice; and

§ residential consumers’ geographic region of residence.

Further, the data provided to NATSEM only allowed it to determine expenditure levelsacross five of the six services that the Commission believes should continue to besubject to retail price controls. These services were line rentals, local calls, nationallong distance (STD), international long distance (IDD) and fixed-to-mobile services.Accordingly, data on expenditure levels on connection services was not available forthis study.

Hence, whilst NATSEM was able to estimate expenditure patterns for residentialconsumers across different geographic regions, and estimate expenditure patterns byservice for low and high-expenditure consumers, it was not able to estimate thedistributional impacts of price control changes on the following groups of consumers:

§ different types of household and business consumers; and

§ consumers with different income levels.

Hence, the Commission’s analysis of the distributional impacts of price control changeson these groups of consumers is, by necessity, qualitative in nature.

That said, it is possible that expenditure level could be an indicator of income level fordifferent consumers. Price control arrangements applying to consumers with thebottom 10 and 50 per cent of bill sizes are intended to protect those on low-incomelevels. Hence, one could assume that consumers’ expenditure levels are an indicator oftheir income levels. As NATSEM points out, this assumption is afforded some supportby the ABS Household Expenditure Survey, which reveals a broad positive relationshipbetween household income and telecommunications expenditure.114 Accordingly, onecould attempt to estimate the distributional impact of changes to the price controlarrangements on consumers with different income levels by observing the impact thesechanges would have on both high and low-spend consumers.

114 NATSEM Consultancy Report for the Australian Competition and Consumer Commission (2000),Analysis of Current Expenditure on Telstra Services, December, p.5

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The Commission is wary of placing too much reliance on this approach, however, asthere are many reasons to suspect that some wealthy consumers may have low levels oftelecommunications expenditure. Similarly, some low-income consumers may havehigh levels of telecommunications expenditure. Hence, any conclusions regardingconsumers with different income levels which are based on observations oftelecommunications expenditure levels must be treated with caution.

8.3.2 Expenditure data provided by Telstra

Telstra was able to provide the Commission with a random sample of around 250,000customer bills for the month of October 2000. This sample contained data onexpenditure levels for each of these customers on line rental, local calls, STD, IDD andfixed-to-mobile services. Further, the data indicated the postcode of each consumer inthe sample. These data were provided on a commercial-in-confidence basis.

For the purposes of this analysis, the data was “cleaned” to ensure that the sample ofbills captured the normal expenditure patterns of residential consumers. That is, theCommission sought to remove bills that appeared to be abnormally high or low for thatparticular month. In this regard, the following measures were taken:

§ removal of business customers’ bills (about 50,000);115

§ removal of extraordinarily large expenditure values (about 1,000);

§ removal of bills which had no positive balances on line rental or other services(about 25,000); and

§ removal of bills which had no expenditure for any service except for linerental (about 29,500).

This reduced the sample to about 140,000 bills.

8.3.3 Incorporating price changes under alternative price control arrangements

Due to limitations in the data provided to NATSEM, the second stage of the analysiswas not possible in time for the release of the Draft Report. As discussed in Chapter 5,the Commission now has estimates of how the prices of those services it recommendsshould continue to be subject to price control arrangements might change as a result ofdifferent price control arrangements. Given the estimates of how demand for theseservices will respond to changes in prices for these services (as outlined and used inChapter 5), the Commission was able to estimate how it thought expenditure levelsmight change for each of these services.

More importantly, however, the Commission was able to estimate how it thoughtconsumer welfare might change as a result of these changes in expenditure patterns.That is, as discussed further below, just because a consumer increases their expenditure

115 This was done by excluding all samples with expenditure on line rental not equal to $13.85 permonth, $16 per month, or multiples thereof. It is assumed this will exclude most business customersas these represented standard line rental offerings for residential customers in October 2000.

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on a particular service doesn’t necessarily mean they are worse off. This is becauseincreased expenditure on a service also leads to greater consumption of this service. Solong as the consumer values additional consumption of this service more than the pricethey pay for it, they will be better off. Hence, a better measure of the impact onindividual consumers is how their welfare changes in response to a change in pricesrather than their level of expenditure per se. As indicated in Chapter 5, this can bemeasured using standard measures of consumer surplus.116

In order to calculate this, the Commission developed a simple model for estimating theimpact of changes to the price control arrangements for the average consumer in eachof the five expenditure quintiles and each of the three geographic areas. Givenestimates of average expenditure on each service from the NATSEM analysis, and theestimates of demand elasticity outlined in Chapter 5, the Commission is able to applyestimated price changes under alternative price control arrangements to estimate howexpenditure levels might change for average consumers in particular groups. In turn,this can be used to estimate changes in consumer surplus for these consumers.

It is now possible to look at how expenditure patterns of consumers might change as aresult of alternative arrangements. This is further picked up in section 8.4 below.

8.3.4 Summary

In summary, analysis in the following two sections covers the estimation of expenditurepatterns for certain groups of consumers, and analysis of the impact of different sets ofprice control arrangements on different groups of consumers. Where expenditurepatterns for certain groups are not available, analysis of distributional impacts will bepurely qualitative in nature.

8.4 Distributional impact of the removal of sub-cap arrangements

The removal of the sub-caps from the price control arrangements will almost certainlyhave some distributional consequences.

As indicated in Chapter 5, removal of the sub-caps should give Telstra the freedom torebalance prices for those services included in the broad CPI – X per cent price capsuch that the welfare of the community as a whole is improved.

As noted in the draft report, rebalancing studies conducted in Australia over the pastdecade suggest a common trend in the way prices of price-controlled services willadjust if Telstra is given the freedom to rebalance its prices. In particular, mostrebalancing exercises suggest the price of line rentals will rise and the per call price ofother services in the broad CPI – X per cent price cap will fall if Telstra has thefreedom to fully rebalance its prices.117

116 For a definition of consumer surplus, refer to section 5.4 of tis report.

117 See for example, Productivity Commission, Telecommunications Economics and Policy Issues, StaffInformation Paper, Canberra March 1997 and Access Economics, Review of Price controlArrangements on Telstra , August 1998.

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The Commission’s analysis in Chapter 5 is consistent with these previous studies.

8.4.1 Price changes under alternative price control scenarios

Table 8.1 shows estimated price changes for price controlled services in the first year ofnew price control arrangements for three alternative scenarios. These scenarios arebased on modified 1999-00 price and cost data, as data from 2000-01 is not available.118

These scenarios are:

(a) a “broad cap only” case with no sub-caps. Such a scenario would leave Telstra freeto rebalance prices within the bounds of a CPI – 5 per cent reduction in prices;

(b) the “ACCC-preferred” model, incorporating sub-caps on the price of line rental toprevent excessively fast rebalancing and a 22 cent (GST inclusive) sub-cap on localcalls; and

(c) a “CPI – 0 per cent broad cap” case where Telstra would be subject to all the pricecaps outlined in the ACCC preferred model, except that X in the broad CPI – X percent price cap would be set at zero. This case is considered in response tosubmissions to the Draft Report by Telstra and CWO advocating that X be set atzero in the broad CPI – X per cent price cap.

Broad cap only CPI – 0 percent broad cap

ACCC-preferred

% change % change % change

STD -29.8% -11.2% -20.1%

IDD -21.2% -9.8% -15.3%

Fixed-to-Mobile -23.9% +0.2% -16.2%

Line rental – business 27.4% 10.0% 10.0%

Line rental – residential 25.2% 10.0% 10.0%

Local calls -3.8% 0.0% 0.0%

Table 8.1 Expected price changes, first year of new price control arrangements

Some patterns of price change are evident across all of these scenarios. Firstly, there isa tendency for the price of line rental to increase towards costs (in the broad-cap-onlycase, this occurs quite rapidly). Secondly, there is a tendency for per call prices to fall.Like the increases in the price of line rentals, these per call price falls are greatest in thebroad cap only model.

It is noteworthy, however, that this second effect is somewhat muted in the CPI – 0 percent broad cap case. That is, without a positive X value, there is no pressure on STD,IDD and F2M services to fall in order to ensure the average price of the basket falls.With X equal to zero, the average price of the basket needn’t fall at all.

118 For a detailed description of how the Commission estimated these price changes, refer to section 5.5of this report.

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The implication of this is that high-use consumers of call services are likely to derivemore benefit from removal of the sub-caps than low-use consumers will. This isparticularly the case for those consumers that use STD, IDD and F2M servicesextensively.

Only the first year of the new price control arrangements is estimated here. This isbecause accurate estimates would require long-range forecasting of changes in demandpatterns. The Commission does not have access to this type of forecasting information.

The remainder of this section looks at the Commission’s estimates of the impact ofthese types of price changes on:

§ consumers with different income levels;

§ consumers in metropolitan and non-metropolitan areas; and

§ different types of household and business consumers.

8.4.2 Consumers with different income levels

Data provided by Telstra to the Commission and NATSEM, as indicated in section 8.3,allow for the analysis of consumer expenditures, but not across different income levels.Based on these data, NATSEM was able to rank consumers from lowest to highestexpenditure, and thereby determine average expenditure patterns for the lowestexpenditure quintile through to the highest expenditure quintile of residentialconsumers. Table 8.2 shows these expenditure profiles. These data are commercial-in-confidence.

Line rental Local calls STD IDD Fixed-to-mobile

Total

Lowest quintile $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

Quintile 2 $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

Quintile 3 $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

Quintile 4 $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

Highest quintile $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

All $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c $ c-i-c

Table 8.2 – Average monthly expenditure profiles by quintile [c-i-c]

The average expenditure across all of the bills was $ c-i-c per month, of which linerental makes up approximately c-i-c per cent.

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This table illustrates the following points:

§ the lowest 20 per cent of consumers by expenditure size spend a largeproportion of their bill on line-rental (approximately c-i-c per cent) and verylittle on other services; and

§ the highest 20 per cent of consumers by expenditure level make extensive useof most services, with STD and local calls the most significant expenses forthese consumers. Line rental represents a relatively small proportion of theiroverall telecommunications expenditure (approximately c-i-c per cent).

The next step was to examine how the price changes estimated in Chapter 5 underalternative price control arrangements might affect consumers with differentexpenditure profiles.

For the purposes of exposition, the expected price changes in table 8.1 above have beenapplied to the following cases:

§ the lowest expenditure quintile;

§ the middle expenditure quintile; and

§ the highest expenditure quintile

The following tables 8.3, 8.4 and 8.5 show the average monthly expenditure of each forconsumers in each of these quintiles and how this might be expected to change underalternative price control arrangements. Note that these tables only examine the effectof the changes in the first year of their operation. All figures, with the exception of theoverall per cent change in expenditure are commercial-in-confidence.

Quintile 1 Currentexpenditure

Broad cap only CPI – 0 per centbroad cap

ACCC-preferred

$ %change

$ %change

$ %change

$

STD $ c-i-c -29.8% $ c-i-c -11.2% $ c-i-c -20.1% $ c-i-cIDD $ c-i-c -21.2% $ c-i-c -9.8% $ c-i-c -15.3% $ c-i-cF2M $ c-i-c -23.9% $ c-i-c 0.2% $ c-i-c -16.2% $ c-i-c

L/Rental $ c-i-c 27.4% $ c-i-c 10.0% $ c-i-c 10.0% $ c-i-cLocal $ c-i-c -3.8% $ c-i-c 0.0% $ c-i-c 0.0% $ c-i-cSum $ c-i-c $20.97 $19.18 $ c-i-c

% change 15.6% 6.4% 5.8%Table 8.3 Impact of changes to the price control arrangements, lowest expenditure

quintile

The predicted price changes, when applied to the lowest expenditure quintile data,suggests that the total level of expenditure on telecommunications services for low-usage consumers is likely to rise under all sets of arrangements. Primarily, this is dueto line rental being a large proportion of telecommunications expenditure for theseconsumers.

While low-usage consumers may spend slightly more as a result of these changes to theprice control arrangements, it is noteworthy that of all three options considered, low-

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usage consumers would be expected to experience the smallest rise in overallexpenditure in the ACCC preferred case.

In contrast, the application of a broad price cap shows the largest rise in price, ataround 15.6 per cent in the first year of the price control arrangements. This is themajor rationale for the “ACCC-preferred” option including a limit on the speed atwhich Telstra can increase the price of line rental.

It should be noted that there are various means to compensate consumers who may bepotentially disadvantaged by changes to the price control arrangements. This isdiscussed further in Chapter 9. All figures, with the exception of the overall per centchange in expenditure are commercial-in-confidence.

Quintile 3 Currentexpenditure

Broad cap only CPI – 0 per centbroad cap

ACCC-preferred

$ %change

$ %change

$ % change $

STD $c-i-c -29.8% $ c-i-c -11.2% $ c-i-c -20.1% $ c-i-cIDD $ c-i-c -21.2% $ c-i-c -9.8% $ c-i-c -15.3% $ c-i-cF2M $ c-i-c -23.9% $ c-i-c 0.2% $ c-i-c -16.2% $ c-i-cL/Rental $ c-i-c 27.4% $ c-i-c 10.0% $ c-i-c 10.0% $ c-i-cLocal $ c-i-c -3.8% $ c-i-c 0.0% $ c-i-c 0.0% $ c-i-cSum $ c-i-c $41.31 $40.84 $40.15% change 4.2% 2.5% 0.7%Table 8.4 Impact of changes to the price control arrangements, middle expenditure

quintile

Analysis of the middle quintile shows that the average consumer in this group will berelatively better off as compared to those in quintile 1 under all three sets ofarrangements in the first year. However, there may still be a small increase inexpenditure for this group of consumers in all cases. In particular, overall expenditurewill still rise under the broad cap only case, but by less than for quintile 1; will increasemarginally under the CPI – 0 per cent broad cap case and will remain virtuallyunchanged in the ACCC preferred case.

This again reflects the varying speed with which Telstra is allowed to increase the priceof line rental to cost under the three alternative scenarios. In the broad cap, Telstra isonly constrained to meet the overall CPI – 5 per cent broad price cap, while in theACCC-preferred case it is constrained by both the CPI – 5 per cent broad price cap andthe CPI + 10 per cent sub-cap on line rental prices. In the CPI – 0 per cent broad pricecap case, consumers would experience the same increase in line rental charges, butreceive much smaller decreases in the per call price of services. All figures, with theexception of the overall per cent change in expenditure are commercial-in-confidence.

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Quintile 5 Currentaverage

expenditure

Broad cap CPI – 0 per centbroad cap

ACCC preferred

$ %change

$ %change

$ %change

$

STD $ c-i-c -29.8% $ c-i-c -11.2% $ c-i-c -20.1% $ c-i-cIDD $ c-i-c -21.2% $ c-i-c -9.8% $ c-i-c -15.3% $ c-i-cF2M $ c-i-c -23.9% $ c-i-c 0.2% $ c-i-c -16.2% $ c-i-cL/Rental $ c-i-c 27.4% $ c-i-c 10.0% $ c-i-c 10.0% $ c-i-cLocal $ c-i-c -3.8% $ c-i-c 0.0% $ c-i-c 0.0% $ c-i-cSum $ c-i-c $94.27 $98.37 $94.93% change -4.1% 0.0% -3.5%Table 8.5 Impact of changes to the price control arrangements, highest expenditure

quintile

For consumers in the top expenditure quintile, changes to the price controlarrangements that give Telstra more freedom to rebalance are likely to lead to lowerlevels of expenditure on average. This is because cost savings that result from falls inthe price of STD, IDD and fixed-to-mobile services are likely to outweigh any increasein expenditure on line rentals.

In summary, the data indicate that high-use consumers of telecommunications will berelatively better off if the Government were to choose to remove the sub-caps from thecurrent price control arrangements.

It should also be noted that while expenditure levels for some groups of consumers mayrise, it does not necessarily follow that these people will be made worse off as a resultof changes to the price control arrangements. That is, just because a consumerincreases their expenditure on goods and services does not necessarily mean they areworse off. To illustrate, when somebody first purchases his/her first car, s/he will beincreasing his/her expenditure on cars. Presumably, however, that person will be betteroff, because s/he derives benefits from their increased expenditure on this service. Ifincreasing expenditure made the individual worse-off, s/he wouldn’t have made thepurchase in the first place.

Similarly, with telecommunications services, increased expenditure may be consistentwith increased welfare. That is, whilst a consumer may be paying more for their basketof telecommunications services, this may be, in part, because they are consuming morecalls in response to the lower price of calls.

Accordingly, a better indication of the impact on different groups of consumers is toconsider the impact on different groups of consumers’ welfare. In this regard, theCommission has estimated likely changes in consumer surplus under the Commission’spreferred set of price control arrangements for each of the expenditure quintiles. Theseare outlined in Table 8.6 below.

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Quintile Consumer Surpluschange

1 (bottom 20%) -$0.90 per month

2 -$0.25 per month

3 +$0.93 per month

4 +$3.03 per month

5 +$9.41 per month

Table 8.6 Welfare change per expenditure quintile

Close inspection of Table 8.6 indicates that while high expenditure consumers willexperience large increases in welfare as a result of the Commission’s preferred set ofprice control arrangements, low-expenditure consumers may be slightly worse off. Inthis regard, the Commission notes that it would expect the lowest 35.5 per cent ofresidential consumers, by expenditure level, could potentially be worse off as a result ofchanges to the price control arrangements. However, less than 20 per cent ofresidential consumers would be worse-off by more than $10 per annum (or 83 cents permonth) under these changes. Compared with the gains to the community as a whole,the Commission believes that the extent to which low-expenditure consumers may beworse-off could be quite low.

That said, for some consumers – and in particular low-income consumers – a loss inwelfare of greater than $10 per annum could be significant. Accordingly, theCommission discusses a range of compensation packages that could be established toprovide benefits to potentially disadvantaged consumers is discussed in detail inChapter 9 of this report.

Although no formal attempt was made to model the expected price changes in years 2and 3 of the new price control arrangements, the patterns exhibited in tables 8.3, 8.4and 8.5 would be expected to continue in these years. That is, the expenditure ontelecommunications services for consumers in the lowest expenditure quintile wouldlikely continue to rise, would stay about the same for the middle quintile and would fallfor consumers in the highest quintile. The exception is the CPI - 0 per cent case whereit is unlikely that expenditure levels will decrease for even high expenditure consumers.

Is expenditure level a good indicator of income level?

In order to determine whether this has any implications for consumers on differentincome levels, however, it is necessary to establish a nexus betweentelecommunications usage and income levels. In this regard, the Commission notesthat the ABS’s Household Expenditure Survey 1998-99 has data on consumption of

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telecommunications services by income quintile. This is illustrated in table 8.7 andindicates that there is a relationship between low-use and low-income.119

Lowest20%

Secondquintile

ThirdQuintile

FourthQuintile

Highest20%

Allhouseholds

Telephone and facsimilecharges (account)

12.41 15.35 18.66 21.17 25.49 18.61

Table 8.7 Results of Household Expenditure Survey, 1998-99, $ per week averageSource: ABS, Household Expenditure Survey 1998-99

As stated in section 8.3, however, the Commission has some reservations about usingusage levels as a proxy for income levels. This is because there are many examples ofhigh-income consumers who may have low levels of telecommunications expenditureand low-income households that have high levels of spending. For instance, manyhigher income users of telecommunications services may have access to companyfacilities, such as a mobile phone, which reduces their level of expenditure on theirhome telephone. Similarly, high-income consumers with second houses, such asholiday homes, are likely to have a low-use account attached to the second house.

On this point, it is notable that the data provided by Telstra in fact included a largenumber of bills which contain expenditure on line rental (i.e. $13.85, before GST), butno expenditure on other services. It is the Commission’s understanding that theseconsumers are included in the calculation of the “low spend” bottom 10 per cent pricecap. While it is uncertain why these consumers would only purchase line rentals, it isquite possible that these samples will represent consumers with a second house wherethe phone wasn’t used during the month in question. This might suggest that a largenumber of consumers are receiving assistance based on low spending that would bebetter targeted at low-income consumers. This point is discussed further in Chapter 9.

In summary, therefore, if usage levels are used as a proxy for income levels, it may beconcluded that higher-income consumers will gain relatively more from the removal ofsub-caps than lower-income consumers. This may imply that if sub-caps are removedfrom the price control arrangements, some measures may be needed to ensure low-income consumers are not significantly disadvantaged by these changes. Measures toensure this are also discussed in Chapter 9.

If, however, it is thought usage levels are not a good proxy for income levels, thestrength of this conclusion is weakened.

8.4.3 Different types of household and business consumers

Just as it is difficult to estimate expenditure patterns for consumers with differentincome levels, it is also difficult to estimate expenditure patterns for different types ofbusiness and household consumers. However, it is to be expected that high-usage

119 The Commission is unable to use the ABS’s Household Expenditure Survey as a basis forexpenditure on individual telecommunications services as the Survey only collects data on overalltelecommunications expenditure, rather than on a service-by-service basis.

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household and business consumers will benefit more from the removal of sub-capsunder price control arrangements that give Telstra more freedom to rebalance its prices.

The Commission is, however, able to draw some broad conclusions on the likely effectof price changes on households as opposed to businesses.

In this regard, there are two factors that suggest business consumers are likely tobenefit more from the removal of the sub-caps than household consumers:

§ firstly, the price of business line rental – at $300 (before GST) per year – issignificantly closer to cost (estimated at $346 (before GST) per year) than isthe price of line rental for household consumers – at $190.90 (GST exclusive)per year;120 and

§ secondly, business lines tend to be used more intensively (more calls are madeper line) than household lines.121

This suggests that an increase in line rental that is offset by falls in the price of calls islikely to benefit business consumers more than residential consumers.

8.4.4 Consumers in different geographic areas

The price changes that would result from the removal of certain sub-caps suggest thathigh-users of per call services will benefit more than low-users of per call services ifTelstra is given the freedom to rebalance its price-controlled services.

In this regard, the Commission notes that NATSEM’s analysis of expenditure patternsacross different geographic regions indicates that rural consumers, on average, devote afar greater proportion of their total expenditure to STD calls than do urban consumers.This is illustrated in Table 8.8 below, which indicates that rural consumers devoteapproximately c-i-c per cent of total expenditure on STD calls, whilst major urbanconsumers only devote approximately c-i-c per cent of their overall expenditure to STDcalls. All data in this table are commercial-in-confidence.

120 This estimate of TSLRIC is higher than that used in Chapter 5, as the $346 TSLRIC cost estimateincludes an indirect cost contribution. This contribution is removed from the TSLRIC estimate usedin Chapter 5.

121 Estimates and assumptions used for an international benchmarking study suggest that a smallbusiness line generates about two and a half times more local calls than does a residential line. SeeProductivity Commission, International Benchmarking of Australian Telecommunications Services,Research Report, AusInfo, Melbourne, March 1999, particularly Appendix F.

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Total STD IDD F2M L/Rental Local

Major urban c-i-c c-i-c c-i-c c-i-c c-i-c c-i-cc-i-c %

Other urban c-i-c c-i-c c-i-c c-i-c c-i-c c-i-cc-i-c %

Rural c-i-c c-i-c c-i-c c-i-c c-i-c c-i-cc-i-c %

All c-i-c c-i-c c-i-c c-i-c c-i-c c-i-cc-i-c %

Table 8.8 Expenditure of consumers by location, by service type ($)[c-i-c]

Accordingly, the Commission has reason to believe that rural consumers couldpotentially be relatively better off as compared to urban consumers as a result of theremoval of sub-caps from the price control arrangements.

This is reflected in Tables 8.9 that outline how expenditure patterns would be expectedto change for the average consumer in each of the three geographic areas.

Broad cap only CPI – 0 per cent broadcap

ACCC-preferred

Expend.Change

% change Expend.Change

% change Expend.Change

% change

Major Urban $0.93 pm 1.9% $0.96 pm 2.0% -$0.14 pm -0.3%

Other Urban $0.30 pm 0.6% $0.57 pm 1.2% -$0.69 pm -1.4%

Rural -$0.44 -0.8% $0.45 pm 0.8% -$1.15 pm -2.1%

Table 8.9 Change in total average expenditure by geographic region

Further, a comparison of the three scenarios in Table 8.9 indicates that the averageconsumer in all three geographic areas would spend less under the Commission’spreferred set of price control arrangements. This compares with that the CPI – 0 percent case, where the average consumer would spend more in all three geographic areas,and the “Broad Cap Only” case where only the average rural consumer would havelower levels of expenditure. Further, the extent to which the average consumer is betteroff is greatest in the Commission’s preferred case.

It is important to note, however, that the size of the change in expenditure for averageconsumers is likely to be fairly small.

As indicated in section 8.4.2, however, the distributional impact of changes to the pricecontrol arrangements on different groups of consumers is better assessed with referenceto their change in welfare rather than simply the change in the size of their expenditure.Accordingly, Table 8.10 outlines changes in consumer surplus for the averageconsumer in each of the three geographic areas outlined above.

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Broad Cap only CPI – 0 broad cap ACCC preferred

Major Urban $1.81 pm -$0.19 pm $1.94 pm

Other urban $3.48 pm $0.54 pm $3.11 pm

Rural $5.00 pm $0.87 pm $4.07pm

Table 8.10 Average change in consumer welfare ($) per month

Table 8.10 indicates that major urban consumers will be better off under theCommission’s preferred set of price control arrangements. However, other urban andrural consumers will be best off under the Broad Cap only case. The average consumerin all three areas will be worst-off under the CPI – 0 per cent broad cap arrangement.

However, whilst this might indicate a preference for adopting a broad CPI – 5 per centcap only, the Commission believes this outcome must be balanced against thepotentially adverse distributional impact on low-spend – and more particularly low-income – consumers. In order to ameliorate the potentially adverse impacts on thesegroups of consumers, the Commission still has a preference for the set ofrecommendations it makes in this report.

It is also noteworthy that the average rural consumer will benefit most under all threerebalancing scenarios.

8.5 Distributional impact of the removal of the local call parityrequirement

The distributional impact of the removal of the local call parity requirement isconsidered under two different scenarios:

§ the absence of other price control arrangements on local calls; and

§ the retention of a 22 cent cap on untimed local calls.

Using the Commission’s TSLRIC estimates from its PSTN undertaking assessment,Telstra has provided, in a commercial-in-confidence submission on the DiscussionPaper, estimates of the wholesale costs of local calls (including an access deficitcontribution) by area in 2000-01. These are shown in Table 8.11 below. All data in thistable are commercial-in-confidence.

CBD Metropolitan Provincial Rural Average

c-i-c cents c-i-c cents c-i-c cents c-i-c cents c-i-c cents

Table 8.11 Wholesale local call TSLRIC cost estimates by area, 2000-01 [c-i-c]

Source: Telstra commercial-in confidence submission, p. 19.

These estimates indicate that the wholesale cost of local calls differs substantially bygeographic area.

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In the context of these cost differences, the impact of the two scenarios identified aboveare discussed in turn below.

8.5.1 Absence of other price control arrangements on local calls

The removal of the local call parity requirement in the absence of other price controlarrangements on local calls would allow Telstra, if it desired, to increase local callprices in non-metropolitan areas where local calls are currently provided below costsand lower them in metropolitan areas where they are currently provided above costs.

Whether particular customers will win or lose, and to what extent they will win or lose,will depend on:

§ geographic location; and

§ level of usage of local calls.

Bearing these in mind, the effects on particular customers are discussed below.

Different types of households

Households that, for one reason or another, make many local calls will be affected themost. These could include households with more members and those that do not haveaccess to other call services (such as mobile services or calls from work) or othermeans of communication (e.g. as the result of disabilities). The Commission does not,however, have data to quantify the impact across different types of households.

Different type of businesses

Similarly, businesses that make many local calls will be affected most by the removalof the price control arrangements. These include businesses with more employees andwhich are more dependent on outgoing and incoming local calls services for doing theirbusiness. Businesses that rely heavily on mobile services, such as tradespeople, would,by contrast, be expected to be among those least affected. This is because they wouldbe expected to devote a smaller proportion of their overall expenditure to local calls.

Different geographic areas

In the short-term it would be expected that customers in rural areas, where local callsare currently provided significantly below costs, would be those that would be mostadversely affected by the removal of the local call parity requirement. Customers inmetropolitan areas where local calls may currently be priced above costs would beexpected to be the major beneficiaries. Further, the lower use of mobile phones in non-metropolitan areas122 would tend to exacerbate the adverse effects on rural consumers.

In the longer term, consumers in rural areas could be expected to benefit from greateraccess and facilities-based competition that is more likely to arise with call servicesbeing offered by Telstra being closer to costs. That is, given the price of local calls islikely to be below cost in rural areas, there is likely to be a disincentive for competitive

122 NATSEM, 2000, Barriers to Telecommunications Use in Australia, NATSEM, Canberra, p. 7.

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facilities based entry into the local call market. To the extent that the removal of thelocal call parity requirement may lead to the price of local calls being more reflective ofcosts, there is a greater potential for facilities based entry in the local call market inrural areas. In the long-term, therefore, removal of the local call parity requirementcould lead to greater competition, lower prices and a greater choice of services forconsumers in rural areas.

Similarly, metropolitan consumers may be made better off from a reduction ininefficient entry in the local call market. This issue was discussed in more detail inChapter 7 of this report.

Notwithstanding this, the alignment of prices to costs should make the community as awhole better-off. This was discussed in Chapter 5 of this report. The Commissionnotes, however, that there may be equity considerations that suggest the retention of thelocal call parity requirement in spite of these efficiency implications.

Different income levels

The impact on customers with different income levels depends on the extent to whichexpenditure on local calls is related to consumers’ income levels. That is, if people onhigher incomes make more local calls, they would be expected to be the main onesaffected by these changes. If, however, it is people on low incomes that tend to makemore local calls they will be the main consumers affected.

The Commission does not, however, have specific data that can indicate thedistributional impact of the changes in the local call parity requirement on people withdifferent income levels.

8.5.2 Retention of a 22 cent cap on untimed local calls.

The retention of the 22 cent cap on untimed local calls would act as a constraint onTelstra’s pricing of local calls in non-metropolitan areas where price is currently belowcost. On the other hand, in metropolitan areas, call prices would still have the potentialto fall.

Telstra estimates that the gain to CBD and Metropolitan consumers of an alignment oflocal call prices to costs in these areas would be $ c-i-c million annually.123

Hence, while much of the analysis above regarding the impacts on different types ofconsumers will hold again in this case, these results will be limited to the impact onconsumers in metropolitan areas.

8.6 Conclusions

The removal of certain sub-caps, as recommended in this report, will allow Telstra toincrease the price of line rental. However, any increase in the price of line rental willbe more than offset by falls in the prices of other telecommunications services.

123 Telstra commercial-in confidence submission, p. 22.

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It follows that changes to the relative price of telecommunications services are likely toaffect different groups of consumers in different ways.

Based on analysis of current expenditure patterns estimated by NATSEM, theCommission believes that:

§ consumers in all regions would on average be potentially better off if therecommendations in this report are implemented. However, given non-metropolitan consumers tend to have higher levels of expenditure on telephonecalls (especially STD), they are likely to benefit more than urban consumers asa result of the decrease in per call charges that could occur if the changesrecommended in this report are adopted;

§ in the longer-term, the changes to the price control arrangements shouldgenerate even greater benefits to consumers. That is, by giving Telstra morefreedom in the way it structures its prices, and by allowing final prices to betterreflect underlying costs, competition, efficient investment and greater consumerchoice can flourish in telecommunications markets;

§ businesses would be expected to benefit relatively more than residentialconsumers as a result of the introduction of the recommendations in this report.This is because business consumers tend to be more intensive users oftelecommunications services per line (ie. they make more calls per line) thanresidential consumers, and because the price of line rental for businessconsumers already covers the costs of line rental for these consumers; and

§ the impact on low-income consumers is uncertain. However, to the extent thatlow usage is an indication of low income, then high-income consumers willbenefit more from the price changes allowed under the recommendations in thisreport than low-income consumers. In particular, the results of the analysisconducted by the Commission indicate that low-spend residential consumerscould, potentially, be marginally worse-off as a result of the removal of the sub-cap arrangements. Consequently, this indicates there is likely to be a call forpolicy measures to protect low-income consumers from changes to the pricecontrol arrangements.

With regard to the possible distributional impact of removing the local call parityrequirement, the Commission believes metropolitan consumers of local calls will berelatively better-off in the short-term than rural consumers of local calls.

However, rural consumers may not be disadvantaged if the 22 cent price cap on localcalls is retained (i.e. if the 22 cent price cap is retained, the price of local calls will notrise in rural areas, and will fall in real terms). In the long-term, moreover, ruralconsumers could be expected to gain as a result of increased competition, investmentand greater consumer choice that could follow if prices are given more freedom toreflect underlying costs. Other Government initiatives such as the Universal ServiceObligation (USO) tendering process and the provision of untimed local calls inextended zones should improve the quality, range and affordability of services in ruralareas.

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Chapter 9 Options for CompensatingDisadvantaged Consumers

9.1 Introduction

The terms of reference instruct the Commission to have regard to the most appropriatemeans of promoting economically efficient and equitable pricing outcomes, particularlyin relation to potentially disadvantaged residential and business customers in bothmetropolitan and rural areas. The Commission interprets this in terms of assessing thecurrent arrangements and considering options with respect to ensuring fairness andappropriate compensation for the proposed price control arrangements.

In order to provide recommendations on the most appropriate means of promotingfairness and adequate compensation with least overall cost, this chapter:

§ establishes what the Commission understands to be the equity objectives of theprice control arrangements and assesses these against standard criteria;

§ analyses the effectiveness of the current price control arrangements in meetingfairness and compensatory objectives;

§ provides justification for a gradual adjustment path for residential line rentals;

§ assesses the compensatory requirements and options appropriate for theCommission’s recommendations;

§ assesses various funding options; subsidies inherent in pricing, generaltaxation and industry levy; and

§ considers the transparency and administrative ease of different approaches.

Conclusions are presented at the end of the chapter.

9.2 Social objectives of the price control arrangements

As discussed in Chapter 2, the Commission believes that whilst the efficiencyobjectives of the price control arrangements are clear, interpretation of the equityobjectives is not as straightforward. In considering the distributional impact of theprice control arrangements, the terms of reference instruct the Commission to haveregard to consumers:

§ in different types of households and businesses;

§ from different geographic areas; and

§ with different income levels.

On this basis the Commission identifies the following groups as being the focus ofconcern:

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§ low income earners;

§ rural households and businesses; and

§ people suffering other disadvantages, e.g. disabilities.

In this report, the Commission uses the following criteria for assessing the success ofpolicies pursuing fairness and appropriate compensation: 124

§ Effective targeting – the provision of assistance to people who are in need andthe avoidance of provision for those who are not.

§ Achievement of horizontal equity; which means that people who have similarincome or ability to pay contribute a similar tax or subsidy amount.125

§ Achievement of vertical equity, reflected in the criterion that tax or subsidycontributions differ according to differences in income or ability to pay (ie,those better-off pay more and those worse-off pay less).

§ Maintenance of appropriate incentives for consumption and investment.

§ Minimisation of administrative costs, including the costs of raising anddistributing funds to achieve social outcomes.

§ Transparency – the awareness by those who fund the assistance of the purposeand cost of the assistance.

9.3 Existing policies aimed at disadvantaged users oftelecommunications services

The Commission categorises the following features of the current price controlarrangements as being directed towards the achievement of equity outcomes:

§ the low-spending residential price cap of CPI − 1 per cent on a basket ofservices comprising connections, line rentals, local calls, trunk calls andinternational calls of the bottom (low-spend) 50 per cent of Telstra’s pre-selected customers (the “bottom 50 per cent sub-cap”);

§ the requirement that Telstra’s average price charged to residential, charity andbusiness customers in non-metropolitan areas for untimed local calls 1999-00and 2000-01 must not exceed the average price charged by Telstra toresidential, charity and business customers in metropolitan areas for untimed

124 These criteria are based on: Bohm, P., Social Efficiency – A Concise Introduction to WelfareEconomics, second edition, MacMillan, London, 1987; and Institute for Fiscal Studies (UK), TheStructure and Reform of Direct Taxation, George Allen & Unwin, London, 1978.

125 “Lifecycle” considerations can be relevant for determining the degree of horizontal equity. That is,people with similar incomes but different circumstances might warrant suitable differences in theirfinancial contributions.

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local calls in the preceding financial year by more than 0.4 per cent (the “localcall parity requirement”);

§ the provision, that should Telstra propose to increase its line rental charge forresidential customers by more than the CPI, it must obtain prior consent fromthe Commission if that line rental is to be used by anyone falling within thebottom (low-spend) 10 per cent of Telstra’s pre-selected customers for thepurposes of ensuring that such customers on average, experience no realincrease in their average telephone bill (the “bottom 10 per cent sub-cap”).

These features of the price control arrangements appear to be designed to achieve twotypes of equity outcomes:

§ to maintain ongoing affordability of telephony services for low-spendingcustomers; and;

§ provide for a degree of equality in the prices paid by non-metropolitan andmetropolitan customers.

The Commission believes that it is of relevance to note that there are other assistancemeasures relating specifically to telecommunications services that are also aimed atachieving fairness and distributional objectives. In particular:

§ The Universal Service Obligation (USO) entitles all people in Australia,wherever they reside or carry on a business, to have reasonable access on aequitable basis to standard telephone services, payphones and prescribedcarriage services.

§ A government-funded telephone allowance (currently $17.20 per quarter) isadded to the pension payments of pensioner concession cardholders that aretelephone subscribers.126

§ Telstra provides concessional rates for telephone connection and a local callallowance to Department of Family and Community Services (FaCS) andDepartment of Veterans Affairs (DVA) pensioners.127

126 This rate is periodically updated. In September 2000, it was paid to almost c-i-c million PensionerConcession Card holders, implying an annual cost of over $ c-i-c million. The following groups areeligible:§ All Department of Family and Community Services and Department of Veterans Affairs

pensioners including Age, Care and Parenting Payment (single), Mature Age, Mature AgePartner and Bereavement allowees,

§ New Start Allowance, Widow Allowance, Partner Allowance, Sickness Allowance, SpecialBenefit and some Parenting Payment recipients aged 60 or older and in receipt of incomesupport for nine months or more,

§ Disability Support Pension recipients.People in the latter two groups are able to retain the card for a period of 6-12 months after loss ofentitlement due to earnings from employment.

127 Eligible pensioners for the purposes of these discounts are listed in Telstra’s Standard Form ofAgreement (Public Switched telephone Service, Section 16.1) as “any person who has a PensionerHealth Benefits Card, a war widow or war widower, a special rate disability pensioner, an extreme

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§ Telstra provides an access service, InContact, which can be used to receivecalls, but not to make them (with the exception of emergency and some othernumbers). This service requires telephone connection (at discounted rates forpensioners) but thereafter incurs no continuing (rental) charges.

9.3.1 Submissions

In its submission on the Discussion Paper, Telstra states it is cognisant that the sub-capsthat apply to basic access and the local call parity requirement have been imposed onTelstra to meet the social objectives of increasing telephone penetration among lowincome groups and to ensure that consumers in rural areas face prices for basictelephony that are similar to those faced by consumers in metropolitan areas.

It suggests that a new price control framework should be introduced with the followingfeatures:

§ Retention of the full consumer basket with an overall cap of CPI − 0 per centas a broad safety net to ensure that consumers as a whole are no worse offfrom future prices changes;

§ Provision of a gradual and certain time path for line rental increases, therebyavoiding “rate shock”;

§ Given that Telstra is no longer the sole provider of local call services, theextension to other service providers of the local call parity requirement cap;

§ The retention of the current cap on the bottom 10 per cent of customers byspending, to insulate very low income groups from line rental chargeincreases; and

§ Removal of the cap on the bottom 50 per cent of customers by spending, as itinhibits innovative pricing and product bundles.

CWO claims in its submission on the Discussion Paper that the present funding basefor the cross-subsidies provided for by the price caps is too narrow and produces largeefficiency losses as a consequence. It also claims that the residential access subsidylacks transparency and constitutes poorly targeted social assistance. This seesresidential access subsidies being received by people who are not in need of them. Dueto peculiar market characteristics combined with automatic pre-qualification for thesubsidies, CWO cites availability of basic access subsidies for holiday homes, secondlines and high users of mobile services to the benefit of wealthy people.

AAPT in its submission on the Discussion Paper argues that price control arrangementsshould only be applied where competition has not developed or is unlikely to deliver

rate disability pensioner, an extreme disablement adjustment disability pensioner or an increased ratedisability pensioner.” The concessions entitle eligible pensioners to discounts of $27.50 (50 percent) on in place connections and $54.80 (29 per cent) on new connections. In addition, eligiblepensioners are not charged for the first $1.10 of local calls (standard or neighbourhood) per month.(Charges quoted are GST-inclusive.)

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the desired social outcomes. For this reason it advocates the removal of a number ofservices it regards as subject to sufficient competition from the price controlarrangements – notably mobile services, leased lines, national long distance andinternational calls. It also suggests that price control arrangements be applied to theservices that fall under the auspices of the USO and only with respect to geographicalareas where competition is muted. In AAPT’s view these changes would mean theabolition of both the broad and the low-spending price caps and ameliorate the need forthe local call parity requirement. It claims no particular view on the requirement orotherwise for the continuation of the 10 per cent low-spend price cap, but suggests thatit could be accommodated within the framework specified. These issues are notcovered in AAPT’s submission on the Draft Report.

MCT in its submission on the Discussion Paper suggests that price controlarrangements should be more transparent and applied to services disaggregated on ageographic, product and end-user basis. To help facilitate disaggregation it submitsthat the local call parity requirement be removed. Over time it suggests that risingcompetition will alleviate the need for price caps and cross-subsidisation with respectto certain markets.

RSL COM in its submission on the Discussion Paper supports the continuation of pricecontrol on basic access on the basis that it does not believe that the elimination of theaccess deficit would necessarily translate into lower prices for PSTN originating andterminating access while Telstra is the dominant supplier in both markets.

Vodafone suggests “equity goals can be better achieved through a “more targetedapproach (such as the USO contestable fund)”.

ATUG’s submission on the Draft Report favours “income related assistance for lowincome earners using existing and proven social welfare processes for distribution”.

CTN advocates the continued use of price caps to pursue equity objectives as “the mostefficient way to share the benefits of cost savings across the full spectrum of Telstracustomers.

9.3.2 Commission’s analysis

In terms of the criteria specified above, the Commission has some substantialreservations about the effectiveness of the existing price cap arrangements in achievingequity objectives.

As indicated in Chapters 5 and 7, one of the impacts of the current price controlarrangements is that the price for line rental is below costs for the majority ofcustomers giving rise to what is referred to as an “access deficit”. As a result of this,call prices for many services are charged above costs to help recover the access deficit.There has also historically been a high degree of geographical averaging in Telstra’sretail prices which means that non-metropolitan customers generally pay the same pricefor telecommunications services as metropolitan customers despite costs being higher

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in non-metropolitan areas.128 In combination, these pricing arrangements lead to lowusers of telecommunications services cross-subsidising high users oftelecommunications services, and metropolitan users cross-subsiding non-metropolitanusers of telecommunications services.129

In relation to the targeting criterion, it is therefore apparent that the current pricecontrol arrangements constitute a blunt instrument for delivering assistance to peoplewho are in need and avoiding provision for those people who are not. This is becausethe sub-cap provisions in essence operate under the implicit assumptions that:

§ people who spend the least on telephony services are in need of assistanceregardless of income; and

§ high users of telephony services with low incomes are undeserving ofassistance.

The former means that high-income earners who happen to have low use of fixed linetelephony services are made eligible for assistance. Examples of this includehigh-income earners who are able to make calls from work; are high users of mobileservices; have a second home with a low use telephone; or have a second line used forinternet services.

Similarly, the local call parity requirement also has major shortcomings in terms oftargeting. It is implicit that all rural business and residents are deserving of assistanceregardless of income.

Approximately c-i-c telephone subscribers were estimated to fall within the scope ofthe “lowest 10 per cent” sub-cap in July 2000.130 This represented around c-i-c per centof total residential fixed-line subscribers. However, only a very small fraction of thesesubscribers appear to have taken up the safeguard package available to them. Incomeand other socio-demographic attributes of these customers are not available, as Telstradoes not collect them. Telstra-specific requirements and arrangements do not coverlow-spend customers of service providers other than Telstra.

The current low-bill arrangements do not restrict the possibility of a creeping increasein the real value of low bills. This is because the Determination:

§ Requires Telstra to have available products, or other arrangements, which,if taken up by affected customers, would ensure that the average telephone billof the lowest-bill residential customers does not increase in real terms. The

128 The local call parity requirement of the price control arrangements explicitly requires Telstra’saverage price on untimed local calls to be similar in non-metropolitan and metropolitan areas.

129 Faulhaber, G. R., “Cross-Subsidisation: Pricing in Public Enterprises”, American Economic Review,65, 1975, pp. 966-77, defines a cross-subsidy in terms of the requirement that some customers payless than the avoidable costs of providing a service to them. As the transfers considered here do notnecessarily imply this, the term is used here in a more general sense.

130 Calculated as 10 per cent of the number of Telstra pre-selected customers at that date.

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Commission understands that there has been an extremely low take-up of theoptions provided by Telstra for low-bill customers (in the order of 0.5 to 1percent of eligible customers). Therefore, low-bill customers haveexperienced an average increase in the real value of low-bills.

§ Requires that the average bills of low-bill residential customers, at the time ofthe increase in line rental, do not increase in real terms. Therefore, anyprevious increases in line rental, which have led to an increase in the real valueof low-bills (for reasons outlined above) become built into the comparisonwhich is made.

The low take-up of the low-bill provisions highlight a further problem in that Telstrahas the flexibility to develop products and arrangements that can comply with thecurrent price cap provisions, but may be unattractive to low-bill customers (e.g due tofees charged). The Commission has also been concerned that the low-bill productsTelstra have introduced since mid-1999 have effectively required customers correctlyto forecast their future telephone bill spend, lest they be worse-off by opting-in.

Pensioner concession cardholders include most people over 60 years of age that receiveincome support. They do not include the full range of income support customers orlow-income earners. For example, New Start and Sickness Allowance recipients under60 years of age, certain recipients of Parenting benefits, Family Tax Benefit recipientsand some full time students are excluded. Employed persons on low incomes are alsoexcluded. The Health Care Card program picks up such categories.

Pensioner concession cardholders are eligible to receive the Telephone Allowance ifthey are telephone subscribers at the time the allowance is paid. Health Care Cardholders are not eligible for the Telephone Allowance.

Million

Pensioner Concession Card (PCC) holders c-i-c

PCC holders receiving Telephone Allowance c-i-c

Health Care Card holders c-i-c

Table 9.1 Holders of pensioner concession and health care cards, December 2000Source: Department of Family and Community Services/Centrelink.

9.4 The adjustment period allowed for increases in residential linerentals

As indicated by the analysis in both Chapters 5 and 7, there are likely to be strongbroad community benefits from allowing the price of services in the price controlbasket to rebalance in a way that removes the divergence between prices and costs. Atpresent neither business nor residential line rentals recover full costs (inclusive of anindirect cost contribution) on average, but the difference between price and cost ismuch greater for residential line rentals than for business. However, the Commission

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believes that for social reasons, Telstra should be restrained from adjusting its linerental prices too rapidly, and that it is therefore appropriate for provision to be made fora phased introduction of line rental increases.

9.4.1 Submissions

All of the submissions that address this issue (with the exception of CTN) support atleast some level of rebalancing to remove the divergence between prices and costs.

CWO in its submission on the Discussion Paper argues controls on line rentals should“either be discontinued or adjusted to allow Telstra the opportunity to raise line rentalsto cost.”

Vodafone recommends removal of controls on line rentals “as quickly as practical” inits initial submission, but accepts the Commission’s “staged approach” in itssubmission on the Draft Report.

AAPT in its submission on the Discussion Paper recommends confining controls tonon-metropolitan areas other than “selected regional centres.” In its submission on theDraft Report it “sees little merit in the Commission’s rate shock proposal”. AAPTprefers the existing sub-cap including line rentals and local calls.

RSL COM is slightly equivocal on the issue, but appears to support line rentals risingto cost. ATUG in its submission on the Discussion Paper favours elimination of theaccess deficit but questions its size. This appears also to be its position in itssubmission on the Draft Report.

Telstra’s submission on the Discussion Paper argues that substantial productive anddynamic efficiency gains could be achieved by price rebalancing (notably line rentalrebalancing) providing a framework can be developed to minimise social adjustmentcosts and to protect potentially disadvantaged consumers. It considers that customersshould be insulated from the large price shocks that would flow from “immediate andfull rebalancing” and suggests what it calls a “glide path” with a CPI + X cap on basicaccess and local calls where X was between [c-i-c] per cent and [c-i-c] per cent.

9.4.2 Commission’s analysis

The Commission believes it would be desirable to avoid the rate shock of an immediateincrease in the residential line rental, but is also aware that delaying the increase woulddelay the achievement of the substantial benefits to the community in general,particularly from the improved investment incentives that would flow from removingthe customer access deficit. The maximum adjustment period it considers appropriateis five years.

A gradual increase in the residential line rental would serve mainly to ease the rateshock for those people who would not qualify for a subsidy. This would help to makethe shift to a more efficient and equitable means of providing assistance more palatableto those people who will miss out or be required to fund the alterative arrangements.

There is a range of ways in which the price of line rental could be rebalanced. Thiscould include a “CPI + X” per cent price cap on line rentals or by limiting the increasein monthly line rental charge to a specified amount each year. The Commissionbelieves the period over which Telstra should be allowed to rebalance should notexceed 5 years. Giving Telstra the freedom to achieve full cost recovery of costs

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(including an indirect cost recovery element) would require “X” to be set at 10 per cent,given the Commission’s expectation that line costs will fall at around two per cent realper annum.

9.5 Options for new compensation arrangements

If the price controls are amended to permit gradual rebalancing of telephone chargesover a period of several years, some consumers are likely to incur a loss as a result.Rebalancing will result in decreases in call charges, accompanied by an increase in linerental charges. Consumers who make relatively few calls are unlikely to be able torecoup the increased cost of line rental from reductions in call charges. Compensationwould reduce or eliminate the resulting losses for eligible consumers.

Any new arrangement must consider:

§ Who to compensate;

§ What amount to compensate; and

§ How the compensation should be paid?

Funding arrangements are considered in later sections.

Who to compensate?

In order to achieve the desired targeting, any compensation scheme would need tofocus on low-income consumers rather than those with low telecommunications spend.However, not all low-income consumers will lose as a result of rebalancing. Typically,only consumers with low telecommunications spend will lose. It follows that thecompensation scheme should focus on low-income consumers with lowtelecommunications spend. This is shown in the diagram below as the shaded areawhere the populations of the two groups overlap.

Figure 9.1 The intersection low-income and low-spending consumers

Low-income status may be inferred from a consumer’s eligibility for certain welfarepayments. Eligibility to hold a Pensioner Concession Card is one such indicator which,as mentioned above, is already used to establish eligibility for the Telephone

Low-spending

consumers

Low-incomeconsumers

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Allowance. Extending the definition to include Health Care Cardholders would includeunemployed persons, other income support clients and employed persons on lowincomes. However, as eligibility for a Health Care Card reflects reversiblecircumstances relating to employment status and income (inter alia), Health Care Cardholders are generally a more mobile group than Pensioner Concession Card holders.

As shown above, approximately c-i-c telephone subscribers held Pensioner ConcessionCards in September 2000. A further c-i-c million people held Health Care Cards (notall of whom are necessarily telephone subscribers).

The Commission has estimated that consumers with telephone bills of less than $32.27per month are likely to lose off as a result of rebalancing. Such consumers can beidentified from their telephone bills. Consumers pre-selected to Telstra are likely to bereadily identifiable by Telstra from Telstra’s billing database. The Commissionestimates that around c-i-c fall into this category. Of these, almost half will incur a lossof less than $10 in the first year. The remainder (just under c-i-c) will lose by between$10 and a maximum of $19.10 in the first year, and slightly more in the succeedingfour years. Customers in this latter category form the lowest 19 per cent of Telstra’scustomer base by bill size, with monthly bills for basic (fixed) telecommunicationsservices of less than $23.

Consumers pre-selected to carriers other than Telstra for all their basic telephoneservices may be identifiable from the billing databases of those carriers. However,consumers who receive bills from a number of carriers cannot be identified withoutaccess to, and aggregation of, all the relevant bills.

Defined on this basis, the groups can be shown diagrammatically as below. Low-income consumers are represented on the left-hand side of the diagram and includetelephone subscribers who hold Pensioner Concession Cards and so receive theTelephone Allowance (PCC/TA). Adding Health Care CardHolders (HCC) to thegroup enlarges it (although not all HCC holders will be telephone subscribers). Low-spending consumers are shown on the right-hand side of the diagram. Because of theidentification difficulties associated with customers not pre-selected to Telstra, they aredefined for practical purposes to include only Telstra pre-selected customers.

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Figure 9.2 Intersection of low-spending consumers, low-incomeconsumers and social security target groups

The overlap between the groups is also shown in the diagram. Area A represents thenumber of Pensioner Concession Card holders who are low-spendingtelecommunications consumers. Area B represents the number of Health CareCardholders who are also low spending telecommunications consumers. Theremaining areas represent consumers who have either low incomes or lowtelecommunications spend, but not both.

Because telephone companies do not generally collect income data from theircustomers, the number of subscribers likely to fall within Areas A and B is difficult toestimate. However, as shown in Chapter 8, low-income consumers typically havemuch lower average levels of telecommunications spend than consumers in the upper-income quintiles. Consequently, the proportion of low-spending consumers in the low-income group almost certainly exceeds the proportion of low-spending consumers inthe population of (Telstra pre-selected) telephone subscribers as a whole (35.5 percent). If, for example, two-thirds of all the low-spending consumers were also eligiblelow-income consumers, then the size of Areas A and B would be 1.0 million (1.5m x0.67). The exact number will be dependent on how low-spend and low-income aredefined, and on the relationship between the two in the population of telephonesubscribers. That number must be less than the number of consumers likely to bedisadvantaged as a result of rebalancing, that is, less than 1.5 million.

The number would be reduced if compensation were to exclude those low-spendingconsumers who face very small losses from rebalancing. Compensating very smalllosses may be expensive relative to the benefits to the consumers involved. Asmentioned earlier, fewer than 20 per cent of Telstra pre-selected customers areestimated to lose more than $10 in the first year from rebalancing. These are typicallyconsumers with monthly bills for fixed-line services of less than $23.

Commission estimates suggest that most rural consumers will be better off as a result ofrebalancing. This is because rural consumers generally have relatively high callvolumes, particularly for the more highly-priced long-distance calls. Such calls mustfall in price under the proposed price control arrangements. Consequently, specialcompensation arrangements for rural consumers are unlikely to be required. Low-

Low-incomeconsumers

PCC/TA

HCC

A B

Low-spendingconsumers

(Telstrapre-selectedcustomersonly)

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income rural consumers whose bills do increase as a result of rebalancing will beeligible for compensation under the general arrangements.

What amount to compensate?

Consumers who lose as a result of rebalancing will lose by an amount determinedprimarily by the size of the line rental increase and the number and type of phone callsthey make. This is likely to differ for each consumer.

The maximum loss any consumer could face is equal to the increase in line rental. IfTelstra were to increase line rentals by the maximum amount possible under therecommendations, the maximum increase has been estimated by the Commission ataround $19.10 in the first year, and a little higher in each of the following two years.This amount will be offset for consumers who make phone calls by an amount equal tothe reduction in call charges on those calls. For some consumers, the losses could bevery small. The Commission estimates that fewer than c-i-c consumers are likely tolose more than $10 in the first year.

Compensating actual losses

In order to ensure that consumers in the targeted income groups do not lose as a resultof rebalancing, the amount of compensation paid must be sufficient to compensate forthe loss they incur. An approximation of this amount can be calculated as the increasein the bill size for a given level of telephone use.131 However, calculating such anamount is likely to be difficult. It requires identification of an appropriate“benchmark” level of telephone use for each customer. It also requires access to eachcustomer’s billing details, and so implies the necessary involvement of Telstra in thecalculation and administration of the compensation payment. The losses would rangefrom a few cents per consumer to the maximum amount of $19.10 per consumer in thefirst year. Losses of less than a certain amount (e.g. $10 in the first year) could beexcluded if required.

Compensating average losses

A much less administratively complex, but somewhat less well targeted, variant onsuch an arrangement might see all eligible consumers, or groups of consumers,compensated by a fixed amount equal to the average loss sustained as a result ofrebalancing. The average amount has been estimated by the Commission to be $9.66 inthe first year. Among consumers who lose more than $10 in the first year, the averageloss is higher, at $14.88. Such an arrangement would tend to over-compensate thoseconsumers who experience small losses, while under-compensating others.

Compensating the maximum loss

A scheme that compensated all eligible consumers by the maximum amount that couldbe lost due to rebalancing ($19.10 in the first year, slightly more in the succeeding twoyears) would avoid under-compensation and its attendant problems. Instead, however,it would result in inevitable, and possibly substantial, over-compensation.

131 A phone bill may increase for reasons unrelated to rebalancing if, for example, a consumer makesmore calls, or more expensive calls.

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How to compensate?

Compensation payments could be made either directly to eligible consumers, or as adeduction from their telephone bills.

Direct payments

Direct payments of a relatively simple nature (e.g., a fixed amount payable to eacheligible customer) could be administered by a central agency, such as Centrelink, ifappropriate arrangements were made. Centrelink already administers the TelephoneAllowance, and is able to identify categories of income support and other clientsagainst which eligibility for the payment could be assessed. However, without accessto the billing information of individuals, payments linked to the losses incurred byindividual consumers could not be calculated. Direct payments (including theTelephone Allowance) are, in addition, issued separately from telephone bills and somay not be obvious to the recipients as compensation for increases in those bills.

Deductions from telephone bills

A more transparent means of compensation would involve deducting an amount fromthe bills of eligible consumers equal to the desired compensation payment. Access tothe bills of individual consumers, together with evidence of their eligibility for thepayment, would be required if this were to be achieved. Such a scheme wouldnecessarily require the involvement of Telstra in its administration. The amountsdeducted could be either fixed on a per-consumer basis, or calculated in accordancewith the losses incurred by individual customers.

Indicative costs for schemes with different consumer targets and compensationamounts are shown in the following table. It is assumed that only low-incomeconsumers who lose from rebalancing will be compensated. The range shows themaximum and minimum costs expected to be incurred, and reflects differingassumptions concerning the number of consumers likely to satisfy the eligibilitycriteria.

The costs relate to the first year of operation of the scheme only. In the remaining twoyears of rebalancing in the proposed three-year price control period, the costs could beexpected to be higher, as the amount compensated is likely to rise on a per-consumerbasis, especially if cumulative losses are taken into account, and the number ofindividuals in the target group is likely to change. These costs exclude administrationcosts.

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Amount compensated $ million

Maximum loss due to rebalancing($19.10 per consumer in first year)

• All consumers who lose• Excluding consumers with losses < $10

in first year

c-i-c - c-i-c

c-i-c - c-i-c

Average loss due to rebalancing• All consumers who lose ($9.66 per

consumer in first year)• Excluding consumers with losses < $10

in first year ($14.88 per consumer infirst year)

c-i-c - c-i-c

c-i-c - c-i-c

Table 9.2 Indicative costs of compensation scheme, first year of operation

Assessment of the Options

The compensation arrangements considered above target low-income consumers whoare worse off as a result of rebalancing. Consumers who do not fall into in-needcategories, and consumers who do not lose from rebalancing, are excluded from thearrangements.

Ideally, consumers should be compensated for losses experienced as a result ofrebalancing. As this is likely to differ for each consumer, and can only be calculatedwith reference to the billing information of individual customers, such a compensationarrangement is likely to be complex to establish and administer. Compensationpayments based on the maximum loss sustained by consumers would beadministratively less complex but would over-compensate almost all consumers. TheCommission’s preference is to base compensation on the average loss per consumer,and to limit it to low-income consumers facing losses of more than $10 per year.

The compensatory nature of any payments is more likely to be obvious to consumers ifthe payments are linked to the billing process itself than if they are deliveredindependently of telephone bills. Should Telstra be required to administer such apayment, consumers would need to be able to satisfy Telstra of their eligibility.(Telstra presently offers pensioner discounts to subscribers who quote their PCCnumber.)

9.6 Funding inherent in pricing structures

Under the current price control arrangements financing of equity objectives effectivelyoccurs though “cross-subsidisation”. This form of funding is questionable on bothfairness and cost to the community bases.

Under the existing arrangements, regardless of the incomes of the payers and payees,high users of telecommunications services that more than fully recover costs maketransfers to low users of telecommunications services that do not fully recover costs.This means that:

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§ high users of telephony services with low incomes can subsidise low users oftelephony service with high incomes; and

§ metropolitan users with low incomes can subsidise non-metropolitan userswith high incomes.

This would appear to fail both the horizontal equity and vertical equity tests. Further,the current price control arrangements would appear to generate outcomes where thesocial objectives are in conflict with each other.

The “taxation” of high users of call services and of metropolitan customers can alsoresult in high costs to the community. Optimal tax principles would tend to suggestthat an industry-specific cross-subsidy is not an efficient form of taxation as it will benarrow and lead to a higher rate than a tax levied more broadly.

To provide an indication of the losses resulting from financing the cross-subsidy via theprice control arrangements, the Commission has derived estimates of the marginalexcess burden (marginal deadweight loss) of raising the last dollar of taxation revenue.All else being equal, a tax on a particular good, service or activity will have a greaternegative effect on efficiency (ie, produce a greater “substitution effect” or a moredistortionary effect on economic activity) the greater:132

§ the elasticity of demand or supply of the taxed good, service or activity; and

§ the tax rate applied.

The following formula133 expresses the marginal deadweight loss for the last $1 of taxrevenue raised by a “tax”:

dDWL/dT = −tε p−1 / (1 + tε p−1)

where DWL is the deadweight loss, T is taxation revenue, t is the tax rate, ε is the own-price elasticity of demand and p is the average call price including tax (normalised sothat the tax exclusive price is equal to 1).

Telstra’s broad pricing pattern indicates substantial surpluses of revenue overattributable costs for STD, IDD and fixed-to-mobile calls. It is reasonable to regardthem as the source of funding for any subsidies inherent in the pricing structure andcompensation arrangements.

The analysis is conducted for STD and fixed-to-mobile calls. The revenue contributionof national long distance and fixed-to-mobile calls to the cross-subsidy is assumed to bethe difference between the efficient weighted average cost per call and the weighted

132 Gabbitas, O. and Eldridge, D., Directions for State Tax Reform, Productivity Commission StaffResearch Paper, AusInfo, Canberra, 1998, p.20.

133 The formula is sourced from Albon, R., “The Efficiency of State Taxes”, The Australian EconomicReview, 30, 1997, pp. 273-87.

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average price charged by Telstra per call. 134 This difference is treated as the “tax rate”in the Commission’s calculations.

The estimates of effective tax rates, the elasticity assumptions 135 and the resultingmarginal DWL estimates are shown in Table 9.2.

National long distancecalls

Fixed-to-mobile calls

Tax rate (t) c-i-c c-i-c

Elasticity (ε) c-i-c c-i-c

Marginal DWL for last $1 of taxrevenue raised

50 cents 27 cents

Table 9.2: Estimated marginal deadweight losses from funding the cross-subsidy

In comparison with the marginal deadweight loss figures in Table 9.2, Campbell andBond have estimated the marginal excess burden of income tax in Australia, based on1988-89 tax rates, to be in the vicinity of 24c for the last dollar of tax revenue raised.136

Given that marginal tax rates have since been reduced, most recently with the changesto the tax system with the introduction of the GST, this figure could be expected to bean overestimate with respect to current income tax rates. On the other hand, Campbelland Bond’s figure may have been an underestimate for several reasons. First, itexcludes the effect of the part of the wedge between the value of labour and the rewardaccounted for by payroll tax. Second, it only takes account of explicit income tax rates,thereby ignoring the implicit taxation effect from the withdrawal of welfare paymentsas income increases. Third, it only includes the addition to deadweight loss from thedistortion in the work-leisure choice despite other margins also being affected.

This analysis indicates that the marginal excess burden of the cross-subsidy is quitehigh relative to general taxation with respect to national long distance calls, but less sowith respect to fixed-to-mobile calls. As the effective tax rates are similar, this seemsto be driven by the lower own-price elasticity for the latter types of calls. This suggeststhat to the extent that the cross-subsidy can be shifted to more inelastic telephonyservices, the marginal excess burden could be reduced and potentially be brought morein line with that that for income tax revenue. However it also suggests that from anefficiency perspective, it may be desirable to shift the funding of the cross-subsidyaway from telephony services and into the general taxation system.

134 Telstra’s weighted average prices for the two call types are sourced from Australian Competitionand Consumer Commission, Telecommunications Charges in Australia 1995-99 , Canberra 2000.Weighted average cost estimates comprise retail, transmission and origination and termination costs.These were calculated by the Commission using a mixture of public and commercial-in-confidencedata.

135 The elasticity estimates are based on Telstra commercial-in-confidence data.

136 Campbell, H. F. and Bond K. A., “The Cost of Public Funds in Australia”, The Economic Record,73, 1997, pp. 22-34.

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9.7 Funding by general taxation

In moving to funding from general taxation there is a range of possibilities, including:

§ an increase in existing taxes on goods and services;

§ an increase in existing income taxes; or

§ the introduction of a new explicitly designated tax, say in a similar fashion tothe Medicare levy.

The Commission considers only the first two of these in this Report.

9.7.1 Submissions

CWO in its submission in response to the Discussion Paper alludes to the followingadvantages of a direct subsidy to consumers funded out of general taxation revenue:

§ The use of the broadest possible funding base means that the excess burden ofraising funds is minimised because the tax wedge between end-user prices andcosts, and the resulting loss in allocative efficiency is minimised;

§ It would enable improved targeting of assistance to people genuinely in need;

§ It is a more transparent means of assistance; and

§ It would open up the possibility that other carriers could offer fixed lineservices to recipients of the subsidy, therefore ensuring productive efficiencyand competitive neutrality.

In its submission on the Draft Report, one party expanded on these points and criticisedthe Commission’s marginal deadweight loss estimates. In doing so, it claims thatgeneral taxes are 40 times more efficient than either a telecommunications industryfund or current telecommunications service mark-ups.

The Services Providers Industry Association (SPAN) in its submission in response tothe Discussion Paper states that a more focused targeting of assistance for communitygroups in the low-volume/low-income category should be considered as an alternativeto price control arrangements. This is echoed by the Australian TelecommunicationsUsers Group (ATUG) which argues that current product or service pricingarrangements that are structured to achieve public policy or social policy objectivesshould be administered and funded by government programs.

9.7.2 Commission’s analysis

Equity and broad community welfare considerations are important in assessing theappropriateness of moving to a taxation basis of funding of subsidies and othercompensation to disadvantaged telecommunications users.

To the extent that the taxation system treats people earning equivalent incomes on asimilar basis and has a progressive structure, it enables funds to be raised in a more

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equitable manner than detailed with respect to the cross-subsidy arrangements underthe price control arrangements. However, the extent of this advantage depends on thefairness of the taxation structure.

Consideration of the broad community benefits of a tax and transfer approach requiresassessment of whether the marginal excess burden of taxation is less than the broadwelfare losses imposed by the cross-subsidy implicit in the price control arrangements.To the extent that the tax can be levied more broadly than the case of implicit taxesconfined to telecommunications services, this would lower the requisite tax rate to funda given subsidy amount, and all else being equal, should produce a smaller efficiencyloss.

A “first-best” approach to taxation would be to apply a tax of an equal rate on allgoods, services and activities, but this is only appropriate where all markets are“perfectly competitive” and where other conditions apply. In practice, the presence ofnon-competitive markets, externalities and the difficulties associated with taxingcertain activities such as leisure, mean that “second-best” taxation is inevitable. Thismay make explicit taxation a less attractive option. The following considerations areimportant:

§ In the situation where a range of taxes already exist in the economy, theseexisting taxes need to be taken into account in measuring the broad welfarelosses that would arise from altering the tax structure to realise a given amountof revenue. In this “general-equilibrium” context, cross-price effects thatresult from changing a tax on a given good, service or activity may also have abearing on the quantities supplied or demanded of other goods, services oractivities and thereby affect both broad community welfare and the amount oftaxation revenue raised.

§ The broad community welfare effects of adding an extra tax on incomes orother goods and services will also depend on existing taxation levels, and themarginal deadweight loss from taxation tends to increase as the tax rateapplied increases.

§ Efficiency losses will also vary depending on the supply elasticities for labourand capital and the demand elasticities for goods and services, respectively.

In the case of taxes through the prices of Telstra’s services compared with increasingexisting taxes, it was noted in the previous section that it appears that the marginalexcess burden from income tax in Australia is below that for a cross-subsidy funded outof certain call services, but not by much. This is at odds with the conclusion of oneparty that general taxation is forty times more efficient than industry based taxation.There are several reasons for the discrepancy of conclusions:

§ Most importantly, this party’s conclusions are based on an analysis of themarginal deadweight loss that, inter alia, fails to identify fully the increase inthe deadweight loss from increasing the income tax rate and fails to identifycorrectly the change in taxation revenue from each tax.

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§ Telecommunications “taxes” are quite wide given that nearly all householdsand business in Australia use telephony services, and compare well in thisregard with many existing taxes.

§ The demand for telephony services is fairly price-inelastic (and clearly in theinelastic region) in most cases.

In drawing an appropriate comparison, the introduction of the GST in 2000 has servedto increase the preference for general taxation over industry taxation. TheGovernment’s new taxation system has broadened the indirect tax base by, forexample, bringing services into the tax ambit and has been accompanied by thelowering of income tax rates. The new tax system is likely to have substantiallylowered the marginal excess burden of raising revenues through general taxes.

9.8 Funding by industry levy

The introduction of an industry levy to fund subsidies is a second possible alternativeapproach to the current implicit tax arrangements.

9.8.1 Submissions

For reasons previously discussed, CWO strongly rejects funding through an industrylevy.

AAPT claims in its submission on the Discussion Paper that the industry in effect fundsthe consequences of price control arrangements. In support of its proposed changes tothe price control arrangements it claims that the new arrangements could largely beaccommodated by the industry-based funding mechanism used for the USO.

Vodafone also supports the USO approach.

ATUG supports assistance funded from taxation, not from industry.

9.8.2 Commission’s analysis

As discussed in relation to subsidies funded out of general taxation, to the extent thatthe raising of a given level of tax revenue from a broader base leads to a reduction inthe marginal excess burden of taxation, there will be an improvement in broadcommunity welfare. In this sense, any extension of the tax base to other carriers(beyond that which might apply implicitly already) to fund a given level of subsidy islikely to increase broad community benefits.

Before considering further options for industry funding it is necessary to consider twoways in which carriers other than Telstra already contribute to the cost of subsidies:

§ First, other carriers bear some of the costs of Telstra’s cross-subsidy under theoperation of the existing price control arrangements, explicitly whereinterconnection charges include a contribution to Telstra's access deficit, andimplicitly where competing carriers price their services to match Telstra’sofferings.

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§ Second, all carriers contribute to the net cost of services provided by Telstra inUSO areas according to their shares of eligible telecommunications revenue.To the extent that the price control arrangements serve to keep line rental andlocal call prices below costs in USO areas, this adds to the net cost of the USOand all carriers’ funding contributions.

One means of improving industry funding is through targeting the source of the implicitlevies. To the extent that particular services or service offerings within them areconsumed by people in different income groups, it may be possible for carriers to fundthe cross-subsidy from particular services or service offerings as a proxy for income.The Government could cap the cross-subsidy amount based on the number of eligiblelow income earners, and leave it up to the carriers how to fund this across retail serviceofferings as deemed appropriate. Another possibility would be for the Government tospecify the services that carriers should be permitted to fund the subsidy from, takingthe equity criteria outlined by the Commission more explicitly into account.

Enabling carriers to have discretion on the revenue contributions from various retailservices to fund the subsidy would be expected to lead to a lower marginal excessburden of taxation than the existing cross-subsidy. This could arise if it is possible forcarriers to finance more of the subsidy from more inelastic services and across abroader range of services than is possible under the present arrangements. Onepossibility might be increasing the subsidy amount contributed by business line rentals.

The removal of the price control arrangements might mean that profit maximisationand network externality effects encourage price discrimination by carriers that wouldalso increase economic efficiency. This would be on the basis that greater flexibility tooffer a raft of pricing arrangements and methods of financing the subsidy, would notonly benefit carriers and many consumers as well, but also be of net economic benefit.Notwithstanding differences in the amount of competition, the range of pricingarrangements that can be observed in the mobiles market137 may provide an indicationof what could be expected in the fixed market.

This policy option would make all carriers’ contributions to equity objectives moreexplicit and provide them with greater flexibility to fund subsidies from variousservices and service offerings. It is likely however, that funding would need to belimited to retail services. Otherwise a carrier could transfer the costs of the subsidy onto another carrier through interconnection charges and then effectively undercut it inthe retail market.

In conclusion, the Commission’s analysis suggests that payment of direct subsidiesfunded from within the telecommunications industry to achieve equity objectives is animprovement upon the cross subsidies implicit in the price cap arrangements.However, while the position is not totally clear, this broad approach has someshortcomings compared with the use of the general tax system to fund subsidies,particularly in regard to the equity in financing and incentives criteria framed by theCommission.

137 Mobile companies tend to offer different pricing plans to suit different types of users. These tend totrade-off high handset and/or subscription prices with lower call prices and vice versa.

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9.9 Administrative and transparency issues

Current arrangements

Under the present price control arrangements, the main administrative costs are thoseborne by Telstra in conforming with them, and the costs to the Government ofmonitoring Telstra’s conformity. These costs are believed to be relatively small,although Telstra claims that the bottom 50 per cent sub-cap is particularly difficult toadminister and leads to additional billing costs that it would not otherwise incur.138 AsTelstra incurs the majority of its billing costs regardless of the operation of the pricecontrol arrangements, these arrangements would appear to impose low additionaladministrative costs.

The fact that the price control arrangements do not require an explicit tax and transferpayment system means that they are not a transparent means of achieving socialobjectives. This probably also contributes to some of their unfair features, both inrelation to those people who bear the costs and those who receive assistance.

Nonetheless, the fact that the price control arrangements are not themselves transparentdoes not rule out the use of a complementary measure to make them more so if this wasregarded as sufficiently important. One example might be quantification and reportingof where and by whom the funds for the subsidy are borne and where and to whom it ispaid.

Funding from taxation

Given there is an existing general taxation system, the additional administrative costs ofraising revenue to fund the subsidy would be negligible. The level of transparency of atax would vary depending on the circumstances – an increase in general income tax tofund the subsidy is not particularly transparent, but some kind of specific tax such asthe Medicare levy is very transparent.

Industry funding

To the extent that the scheme could be incorporated into existing eligibility and billingarrangements the administrative costs could be negligible. Should however extensiveinformation gathering and processing be required to administer targeting and financing,the administrative costs could be quite high. As discussed above, the Commissionbelieves that there are existing means of determining eligibility, which may be easilyand cheaply employed under this option. These are also supported by Telstra on thegrounds of administrative ease in determining eligibility compared with the price caparrangements.139

In practice it would be possible to design a subsidy and tax system that was quitetransparent in this instance. For example explicit payment and debit amounts could beshown on customer bills.

138 Telstra, Administrative Problems with the Bottom 50% sub-cap, supplementary submission on theCommission’s Discussion Paper, December 2000.

139 Ibid.

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9.10 Conclusions

The existing price control arrangements appear to serve distributional andcompensatory objectives poorly both in terms of the eligibility for, and who bears thecosts of, the cross-subsidies implicit in them. This should provide sufficient reason tosearch for alternative methods of promoting these outcomes.

In considering alternative approaches for achieving distributional and compensatoryobjectives the Commission has applied a number of criteria:

§ Effective targeting;

§ Equity in financing;

§ Maintenance of appropriate incentives;

§ Minimisation of administrative costs; and

§ Transparency.

Overall, these tend to favour a move away from the current delivery and fundingmethod for achieving social policy objectives.

The Commission proposes that the Government remove the price cap constraints onTelstra applied for equity reasons that prevent it from being able to rebalance its pricesto costs, but that the constraint be lifted gradually.

The compensation arrangements considered above target low-income consumers whoactually lose as a result of rebalancing. Consumers who do not fall into in-needcategories, and consumers who do not lose from rebalancing, are excluded fromcompensation. The Commission’s preference is to base compensation on the averageloss per consumer, and to limit it to low-income consumers facing losses of more than$10 per year.

The compensatory nature of any payments is more likely to be obvious to consumers ifthe payments are linked to the billing process itself than if they are deliveredindependently of telephone bills. Should Telstra be required to administer such apayment, consumers would need to be able to satisfy Telstra of their eligibility.(Telstra presently offers pensioner discounts to subscribers who quote their PensionerConcession Card number.)

Implicit taxes to fund cross-subsidies inherent in the price control arrangementsproduce higher distortions at the margin than do the general income and indirect taxbase. Further, this method of finance does not meet fairness, transparency and othercriteria well either. This indicates that broad community benefits would flow frominstituting an alternative means of funding the cross-subsidy. The Commission is ofthe view that this subsidy would be better financed out of general taxation or anindustry fund contributed to by all carriers according to their shares of eligibletelecommunications revenue.

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Chapter 10 Conclusions

The Commission now draws on the analysis of the previous chapters to provide asummary of the Commission’s conclusions from this review. Based on theseconclusions, the Commission makes a number of recommendations for the future of theprice control arrangements.

Objectives

An important consideration when determining whether price control arrangementsshould continue and, if so, in what form, is the objectives underlying price controlarrangements. That is, without an understanding of what the price controlarrangements are intended to achieve, it is impossible to know whether they shouldcontinue and what form they should take.

The Commission has reviewed various sources on the objectives of the price controlarrangements and has concluded that the two major objectives of the price controlarrangements are to:

§ make the community as a whole better off; while

§ ameliorating any adverse impacts on particular groups of consumers.

The approach of this report, therefore, has been to consider how well the current pricecontrol arrangements meet these objectives, and whether or not they could be bettermet by an alternative set of price control arrangements in the future.

In addressing these questions, the Commission’s analysis has reached a number ofconclusions on how the price control arrangements could be improved for the nextperiod of price control arrangements. Based on these conclusions, the Commission hasdeveloped a set of recommendations that it believes would make the community as awhole better off without significant adverse impacts on particular groups of consumers.

In this chapter, these conclusions are divided into those that would make thecommunity as a whole better off and those that would help to ameliorate adverseimpacts on particular groups of consumers. The recommendations that result fromthese conclusions are also outlined.

Increasing efficiency – making the community as a whole better off

Competition

The Commission has analysed the state of competition in each of the price-controlledmarkets in order to determine the effectiveness of current levels of competition forproducing competitive market outcomes. Measures of competition have included bothmarket structure and market performance indicators, including concentration ratios,firm dominance and consideration of natural monopoly features.

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The analysis finds that although competition has developed over the past few years, themajority of the price-controlled markets are still not effectively competitive. Theanalysis finds that Telstra still faces little competition in the market in which line rentalservices are sold and only limited competition in respect of the local call market.Competition in both national long-distance and international call markets remains lesseffective than a cursory inspection might indicate, with Telstra retaining a high marketshare in each and price still seemingly well above efficient cost. While market sharesare more dispersed in mobile services markets, there is still a concern about marketpower and high prices in fixed-to-mobile services. The Commission considers that themarkets for leased lines have become more competitive in recent times due to rapidtechnological progress in the transmission of large amounts of voice and data.

Further, any case for the removal of price control arrangements in the national long-distance and international call markets, as supported by some carriers, rests on thestrength of the access regime in Part XIC of the Trade Practices Act as Telstra still hascontrol over essential inputs to these services. Without a well-developed accessregime, Telstra’s control of the customer access network could weaken competition inthese markets considerably.

Replicating competitive market outcomes

A broad CPI – X per cent price cap is desirable because it should help create outcomesthat closer reflect those one would expect in competitive markets and provide Telstrawith the incentive to adopt more efficient production processes. Outcomes that betterreflect those in competitive markets are promoted by limiting the exercise of monopolypower and by giving Telstra the freedom to restructure prices in a way that allows it torecover common costs in a more efficient way. A broad CPI – X per cent price cap canalso provide Telstra with the incentive to seek more efficient production processes as itallows it to keep any profits it makes from cost savings in excess of those needed toreduce the price of services by X per cent per annum.

The composition of the price cap should include those services for which theCommission believes competition has not fully developed. The Commission believescompetition has not yet developed fully in the market for local calls, line rentals andconnections. Further, the Commission is not convinced that competitive forces aresufficiently strong to achieve effectively competitive outcomes in the markets in whichSTD, IDD and fixed-to-mobile services are supplied.

While the Commission recognises that most of these services are subject to some levelof wholesale price regulation under the access regime that it administers under PartXIC of the Trade Practices Act, the Commission does not believe that the accessregime is sufficiently mature with regard to these services such that they should beremoved from future price control arrangements yet. Whilst it would appear thatcompetition is developing in the markets for most of these services – especially withregard to STD and IDD services – the Commission is still concerned by the apparentdifference between the retail price and efficient cost of providing these services. TheOffice of Telecommunications (Oftel) in the United Kingdom has recently made asimilar conclusion when deciding these services should continue to be the subject ofretail price controls. Hence, until competition has developed further in these markets,

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the Commission believes these services should remain under some level of retail priceregulation.

The Commission considers that the markets for other mobile services and leased lineshave become sufficiently competitive such that they should both be removed from theexisting broad price cap.

In order to assess the extent to which the community as a whole would be made betteroff under alternative price control arrangements, the Commission engaged AccessEconomics to help develop a model for assessing gains under a number of differentprice control arrangements.

Based on an application of this model, the Commission concludes that the communityas a whole would be made better off by the removal of certain price controlarrangements, such as: the CPI – 0 per cent sub-cap on line rentals and local calls; theCPI – 0 per cent sub-cap on connection services; and the CPI – 1 per cent sub-cap on abasket of services for the lowest 50 per cent spend consumers. This is because thesesub-caps limit the extent to which Telstra can efficiently rebalance its prices towardscost.

Hence, the analysis shows that the community as a whole would be made better off byretaining a single broad price cap on all price-controlled services, while removing anyother sub-caps on individual services or groups of services. The Commission notes,however, that there are also equity objectives that need to be taken into account indeciding whether some of these sub-cap should be retained.

Recommendation:

§ A broad CPI – X per cent price cap should be retained for the next pricecontrol period

On a related matter, estimates provided to the Commission by Telstra suggest the costof providing local calls varies substantially according to the geographic area in whichthese calls are made. Whilst the Commission has conducted a study into the cost ofproviding local calls in different geographic areas, the relative cost disparitiessuggested in Telstra’s analysis are not inconsistent with market inquiries made by theCommission in this regard.

Given the disparity between costs in rural and metropolitan areas, removal of the localcall parity requirement, which requires the price of local calls in rural areas to bebroadly the same as those in metropolitan areas, would be expected to generate benefitsfor the community as a whole. Whilst the size of these gains is hard to specify,tentative analysis by the Commission suggests these could be between $9 and $19million per annum. Accordingly, these gains are likely to be considerably less than thegains that would accrue from the removal of the sub-caps outlined above.

Competition, efficient investment and consumer choice

The Government has implemented a range of pro-competitive structural and regulatoryreforms in recent years aimed at increasing competition in telecommunications marketsand providing an increase in the choice of services available to consumers.

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While price control arrangements can help protect consumers during the transition frommonopoly to competition, there is also a danger they can inhibit the development ofcompetition, efficient investment and the long-term benefits of consumers – especiallyif they are not implemented consistently with pro-competitive reforms.

In this regard, analysis suggests that the sub-caps, which restrict the ability of Telstra toraise the price of line rental towards cost, have had significant impacts on thedevelopment of competition and the efficient operation of the access regime as a resultof the consequent access deficit. For instance, where this forces the price of wholesalecharges above efficient levels, there is a potential that this may deter investment thatwould otherwise be economic.

Accordingly, the analysis finds that there is considerable scope for the price controlarrangements to hamper the competitive developments expected to unfold over the nextfew years. Changes to the price control arrangements that will allow the price ofservices to begin moving closer towards costs are considered to be an extremelyimportant objective for the next period of price control arrangements. This conclusionfurther supports the view that sub-caps should be removed in order to give Telstra theincentive to efficiency restructure its prices for price-controlled services. This wouldinclude the removal of the CPI – 0 per cent sub-cap on a basket of line rentals and localcalls, the CPI – 0 per cent sub-cap on connections, and both price control arrangementsthat target the bottom 10 per cent and 50 per cent of Telstra customers by bill size.

Further, the removal of the local call parity requirement also has the potential to unlockmuch larger longer-term dynamic efficiency gains for consumers in all regions ofAustralia. In this regard, the Commission’s analysis finds that the removal of the localcall parity requirement has the potential to enhance the development of desirablecompetition and efficient investment in the local call market in both rural andmetropolitan parts of the country. That is, removal of the local call parity requirement,which forces Telstra to price below cost in rural areas, has the potential to increaseinvestment and the development of competition in rural markets. In turn, this has thepotential to improve the range of services and therefore consumer choice available torural consumers.

Combined with the potential for the community as a whole (as outlined above), theCommission believes there are strong reasons to question whether the local call parityrequirement should be retained.

That said, the Commission recognises there are equity objectives which aim to ensurethe benefits of competition are shared more evenly between consumers in allgeographical areas. This would imply, therefore, that there is an argument for theretention of the local call parity requirement.

The Commission believes, however, that other Government initiatives such as the USOtendering and the provision of untimed local calls in extended zones may be sufficientto ensure that the quality, range and affordability of services in rural areas is protectedin an environment of increasing competition in telecommunications markets. In thiscontext, it may be questionable whether the local call parity requirement should beretained.

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However, the Commission considers that, even in the absence of a local call parityrequirement, rural users will benefit more from the recommendations in this report thanmetropolitan users. This will be the result of their greater use of long-distance calls,which would be expected to fall in price.

The Commission also believes there may be arguments for retaining the 22 cent localcall price cap in order to protect rural consumers from increases in price that mightotherwise result from the possible removal of the local call parity requirement.

Further, the hearings indicated that the main concern for rural consumers regarding anypotential removal of the local call parity requirement is the likelihood of a sharpincrease in the price of local calls. The Commission considers this concern could bemet by the retention of a 22 cent cap on local calls. To the extent that this may lead toTelstra incurring losses on the provision of local calls in rural areas, such concernswould be addressed through the USO scheme.

Recommendation:

§ All existing sub-caps in the price control arrangements (with the exception ofthe 22 cent sub-cap on local calls) and the local call parity requirement shouldbe removed

Potential for further productivity gains

Telstra is expected to achieve considerable gains in productivity over the next fewyears, and the Commission considers these should form the basis of the X factor in thebroad price cap. It is also considered that some account should be taken of yardsticksfor benchmarking cost reduction targets, including productivity levels achieved bycarriers in other countries, and the productivity growth achieved in the economy as awhole.

The Commission also considers that the choice of duration of the price controlarrangements is an important consideration when determining the form a CPI – X percent price cap should take. In particular, the longer the period over which a CPI – Xper cent price cap will apply, the greater the incentive to reduce costs in excess of thoseneeded to meet the CPI – X requirement. That said, a shorter duration for the pricecontrol arrangements may be needed in light of the speed of technological change andadvance of competitive forces in telecommunications markets.

Recommendation:

The Commission believes that X in the broad price cap should be set in the orderof 5 per cent, and should apply for a period three years.

Revenue weights should be based on past year revenue levels

The Commission believes that the current practice of measuring revenue weightsaccording to revenue earned in the current year to which the broad CPI – X per centprice cap applies has the potential to limit the incentives Telstra has to rebalance pricestowards costs.

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Further, there is a practical advantage for Telstra in using past year revenue weights, asTelstra will be better able to plan its pricing packages in order to meet its price controlobligations, as it knows how it will have to set prices in the year to come in order tosatisfy the CPI – X per cent price cap constraint.

Recommendation:

The revenue weights used to determine whether Telstra has complied with itsprice control arrangements should be based on past year revenue levels.

Ameliorating the potential adverse impacts of changes to the pricecontrol arrangements

Just as it is important that a change to the price control arrangements will make thecommunity as a whole better off, it is also important that measures are taken toameliorate the potential adverse impacts on particular groups of consumers. Beforedeciding how to design policies to provide assistance to those who may bedisadvantaged by changes to the price control arrangements, however, it is important togain an understanding of who these potentially disadvantaged groups might be. In thisregard, the terms of reference ask the Commission to have regard to the impacts ofprice control changes on low-income consumers, different types of household andbusiness consumers, and those from different geographic areas.

For the purposes of simplicity, therefore, the Commission has identified low-incomeand rural consumers as the two main groups to be the focus of equity considerations.Accordingly, the Commission analysed the impact of changes to the price controlarrangements on these different groups of consumers, and then considered how tocompensate potentially disadvantaged consumers who fell within these groups. Theconclusions and resultant recommendations are outlined below.

The distributional impact of changes to the price control arrangements

The removal of the sub-caps, as recommended in this report, will allow Telstra toincrease the price of line rental. However, any increase in the price of line rental willbe more than offset by falls in the prices of other telecommunications services.

It follows that changes to the relative price of telecommunications services are likely toaffect different groups of consumers in different ways.

Based on analysis of current expenditure patterns, the Commission believes that:

§ Consumers in all regions would on average be potentially better-off if therecommendations in this report are implemented. However, given non-metropolitan consumers tend to have higher levels of expenditure in telephonecalls (especially STD calls), they are likely to benefit more than urbanconsumers as a result of the decrease in per call charges that could occur if thechanges recommended in this report are adopted;

§ In the longer-term, the changes to the price control arrangements shouldgenerate even greater benefits to consumers. That is, by giving Telstra more

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freedom in the way it structures its prices, and by allowing final prices tobetter reflect underlying costs, competition, efficient investment and greaterconsumer choice can flourish in telecommunications markets;

§ businesses will be expected to benefit relatively more than residentialconsumers as a result of the introduction of the recommendations in thisreport. This is because business consumers tend to be more intensive users oftelecommunications services per line (ie, they make more calls per line) thanresidential consumers, and because the price of line rental for businessconsumers already covers the costs of line rental for these consumers; and

§ the impact on low-income consumers is uncertain. However, to the extent thatlow usage is an indication of low income, then high-income consumers willbenefit more from the price changes allowed under the recommendations inthis report low-income consumers. In particular, the results of the analysisconducted by the Commission indicate that low-spend residential consumerscould, potentially, be marginally worse-off as a result of the removal of thesub-cap arrangements. Consequently, this indicates there is likely to be a callfor policy measures to protect low-income consumers from changes to theprice control arrangements.

With regard to the possible distributional impact of removing the local call parityrequirement, the Commission believes metropolitan consumers of local calls will berelatively better-off than rural consumers of local calls.

However, rural consumers may not be disadvantaged depending on:

§ whether or not the 22 cent price cap on local calls is retained (i.e. if the 22 centprice cap is retained, the price of local calls will not rise in rural areas, and willfall in real terms); and

§ the extent to which other Government initiatives such as the Universal ServiceObligation (USO) tendering process and the provision of untimed local calls inextended zones improve the quality, range and affordability of services in ruralareas.

Conclusions regarding means to ameliorate the potential adverse impacts ofchanges to the price control arrangements

The Commission has analysed the current price control arrangements and alternativesin achieving equity objectives in terms of five criteria, which are specified in Chapter 9,relating to targeting, financing, incentive effects, administrative simplicity andtransparency. The Commission’s analysis makes the following seven conclusions:

1. The current price control arrangements appear to be not well targetedtowards protecting low-income consumers

An important conclusion from the Commission’s analysis is that the targeting ofassistance usually involves the provision of assistance to people who are in needand the avoidance of provision to those who are not. Analysis by the Commissionfinds that the current price control arrangements do not appear to be well targeted –

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especially with regard to low-income consumers. This is because low-incomeconsumers appear to be targeted by price control arrangements that protect low-usage consumers. Although low usage does have some correlation with lowerlevels of income, there are many reasons to believe that some wealthier consumersmay also have low usage of those services included in the price control baskets.For instance, a wealthy person owning a holiday home is likely to receiveprotection under the current price control arrangements from increases in telephonyprices if s/he spends little time at the holiday home throughout the year.

2. There is potential for measures aimed at compensating disadvantagedconsumers to conflict under the current price control arrangements

Under the current price control arrangements, there is scope for conflict betweenmeasures geared towards assisting low-income and rural consumers. For instance,the local call parity requirement means that low-income metropolitan consumers oflocal calls will cross-subsidise wealthy rural local-call consumers.

3. The current price control arrangements can create inefficient incentives

As indicated above, sub-caps and the local call parity requirement compromise theability of prices of telecommunications services to make the community as a wholebetter off. In particular, some price control arrangements have the potential tocreate a divergence between the price of a service and its costs. In turn, this canlead to outcomes that are not in the interests of those people whom the price controlarrangements seek to protect, such as the local call parity requirement which maylimit investment in local call services in rural areas. This is because the local callparity requirement would appear to force the price of local calls below their cost ofprovision in rural areas. This is likely to act as a disincentive for any potentialinvestors who might otherwise invest in rural areas.

4. The price control arrangements are administratively simple, although they arenot transparent to consumers

The price control arrangements, by directly restricting the prices that Telstra cancharge, minimise administrative costs compared with a system where shortfallswere funded through industry or government-funded subsidies.

However, the fact that the price control arrangements do not require an explicit “taxand transfer” system means that they are not a very transparent way of achievingequity objectives.

5. Equity objectives would be better served by more targeted assistance packages

The current price control arrangements do not appear to take a direct approach intargeting assistance to those in need. Targeting lower income-consumers, forexample, might be more effectively achieved by using a means-tested subsidy, orby extending existing Commonwealth programs for pensioners, the unemployed orthose with health care cards.

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Recommendation:

§ Targeting of low-income groups should be based on measures of income ratherthan usage levels for telecommunications services

6. Equity objectives are better funded through broad-based measures, and fromservices with low responses to changes in price.

Where taxes or cross-subsidies are levied for funding of redistribution programs,they should be levied on as many services as possible. Under this approach, theimpact in any one market is likely to be kept to a minimum. To illustrate, raising aset amount of revenue to fund a given Government program by levying a small taxon all goods and services will have a smaller adverse impact on consumerbehaviour in any given market than levying a large tax on telecommunicationsservices alone.

In a similar way, measures to ameliorate the adverse impact on particular groups ofconsumers as a result of changes to the price control arrangements are best achievedby taxing, or cross-subsidising from, those services that have a low level ofresponsiveness to changes in their own price. This is because any increases inprices needed to fund a package will have a smaller impact on the final quantities ofthese services consumed. Hence, the impact on consumer behaviour from raisingthe prices of these services will be minimised.

In this regard, it is found that the losses from funding the equity measures throughthe current price control arrangements are substantial in comparison to agovernment scheme funded from taxation revenue or an industry-funded scheme.

Recommendation:

§ Targeted assistance or other equity measures recommended in this reportshould be funded through government or industry-based funding.

7. Adjustment period for line rental

The removal of the sub-caps, as recommended in this report, will allow Telstra toincrease the price of line rental. However, there may be an argument on equity groundsfor phasing in this increase. That is, given the price of line rentals lies at a little overhalf their cost of provision, such a control would have the advantage of minimising“rate shock” in the event that Telstra chose to rebalance too quickly.

There is a range of ways in which the price of line rental could be raised to cost. Thiscould include a “CPI+X” per cent price cap on line rentals or by limiting the increase inmonthly charges for line rental to a specified amount each year.

The Commission believes the period over which Telstra should be allowed to rebalanceshould not exceed 5 years.

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Recommendation:

§ There should be an adjustment period over which rebalancing of the price ofline rental is allowed to occur

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Appendix A: Summary of Terms of Reference

The Minister for Communications, Technology and the Arts, under subsection 496(1)of the Telecommunications Act 1997, directed the ACCC to hold a public inquiry underDivision 3 of Part 25 of that Act about:

(a) the need for price control arrangements under Part 9 of the Telecommunications(Consumer Protection and Service Standards) Act 1999 for carriage services,content services and facilities supplied by Telstra Corporation Limited (ABN 33051 775 556) (“Telstra”) to continue after the expiry of the Telstra Carrier Charges-Price Control Arrangements, Notification and Disallowance Determination No. 1 of2000 at the end of 30 June 2001; and

(b) if there is a continuing need for price control arrangements, the nature of suchfuture arrangements, including their duration, means of implementation andmechanisms for their review.

The ACCC were directed to consult with relevant stakeholders in connection with theconduct of the inquiry including, but not limited to, the public generally, thetelecommunications industry, business, small business and residential consumerorganisations and rural and regional organisations.

In the direction to the Commission, the Minister required that the Commission haveregard to the following matters when conducting this review:

(a) the current state of competition in each of the price controlled markets;

(b) the extent to which further efficiency gains could be achieved with and withoutprice control arrangements;

(c) the impact of the current, and any alternative future price control arrangements, on:

(i) competition and the future development of competition, having regard inparticular to the telecommunications access regime under Part XIC of theTrade Practices Act 1974;

(ii) the availability, choice and prices of services to consumers and any otherimpacts on consumers; and

(iii) the telecommunications industry, including on economically efficientinvestment decisions;

(d) the distribution of the short-term and long-term community and economic benefitsand costs, including the impacts on different types of household and businessconsumers and geographic areas, from any substantial changes proposed to thecurrent price control arrangements having regard, in particular, to the incomeprofiles of consumers who might be significantly affected by such changes; and

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(e) the most appropriate means of promoting economically efficient and equitablepricing outcomes, particularly in relation to potentially disadvantaged residentialand business customers in both metropolitan and rural areas.

The ACCC is directed to provide the report to the Minister setting out its findings as aresult of the inquiry by 31 January 2000.

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Appendix B: Summary of Relevant Price ControlArrangements

At present, Telstra is subject to a number of price control arrangements under variouspieces of legislation. The terms of review for this inquiry ask the Commission to hold apublic inquiry into whether there is a need for price control arrangements to continueafter the expiry of the Determination at the end of 30 June 2001.

Accordingly, the Commission interprets this as a direction to assess the current pricecontrol arrangements under the Determination, with a view to determining whetherthese, or alternative arrangements, should continue after 30 June 2001. Hence, pricecontrol arrangements that arise under other pieces of legislation will not be the focus ofthis review.

The Commission considers the following price control arrangements from theDetermination are of most relevance to this inquiry:

§ a broad price cap of CPI – 5.5 per cent on a basket of digital cellular mobiletelephone services, fixed-line connections, domestic leased lines,international leased lines, line rentals, local calls, trunk calls andinternational calls;

§ a cap of CPI − 0 per cent on a basket of local calls and line rental services;

§ a cap of CPI − 0 per cent applies to a basket of connection services;

§ a cap of 22 cents per call (GST inclusive) on the provision of basic untimedlocal calls, with a similar cap of 40 cents per call applicable to calls madefrom Telstra public payphones; and

§ a low-spending residential price cap of CPI − 1 per cent on a basket ofservices comprising connections, line rentals, local calls, trunk calls andinternational calls. The revenue weights are based on the average bill sizeof the bottom (low-spend) 50 per cent of Telstra’s pre-selected customers.

Further, Telstra’s average price charged to residential, charity and business customersin non-metropolitan areas for untimed local calls in 1999-00 must not exceed theaverage price charged by Telstra to residential, charity and business customers inmetropolitan areas for untimed local calls in 1998-99 by more than 0.4 per cent. Asimilar price control exists for 2000-01.

Finally, should Telstra propose to increase its line rental charge for residentialcustomers by more than the CPI, it must obtain prior consent from the Commission ifthat line rental is to be used by anyone falling within the bottom (low-spend) 10 percent of Telstra’s pre-selected customers. The Commission cannot consent unlessTelstra has made other products available, or made alternative arrangements, such thatcustomers in the bottom (low-spend) 10 per cent would, on average, experience no realincrease in their average telephone bill if they took up these offers.

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Appendix C: List of Submissions

Submissions on the Discussion paper

Name of organisation Industry role

1. AAPT Service provider2. Australian Consumers’ Association Consumer organisation3. Australian Telecommunications Users

Group (ATUG)Consumer organisation

4. Cable and Wireless Optus Service provider5. Dilip Jadeja Consumer6. Indigo Shire Council Local government7. Macquarie Corporate Telecommunications Service provider8. Paul Matthews Consumer9. Powertel Service provider10. RSL COM Service provider11. Service Providers’ Industry Association

(SPAN)Industry Association

12. Tamworth City Council Local government13. Telstra Service provider14. The Country Women’s Association of

Western AustraliaConsumer organisation

15. Vodafone Australia Service provider

Submissions on the Draft Report

Name of organisation Industry role

16. AAPT Service provider17. ATUG Consumer organisation18. Cable and Wireless Optus (c-i-c) Service provider19. Consumers Telecommunications Network Consumer organisation20. Small Enterprise Telecommunications

Centre (SETEL)Consumer organisation

21. Telstra (c-i-c) Service provider22. Vodafone Australia Service provider

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Appendix D Public Hearings

Over the period 6 November to the 20 November 2000, the Commission held 12 publichearings in a number of locations around Australia. Commissioner John Martin chairedthe public hearings. A full list of venues for the hearings and a list of attendees isprovided below

The hearings provided an opportunity for community groups and individuals, who maynot have otherwise have had the opportunity, to participate in open discussion of theissues. Further, by travelling to a number of different locations, the Commission gavepeople from different geographic areas an opportunity to participate in theCommission’s review of the price control arrangements.

The Commission would like to thank all parties that contributed to the public hearings.The Commission also wishes to recognise that many people who attended hearings inregional areas had travelled significant distances to contribute the hearings.

Hearing Locations

TownsvilleBrisbaneSydneyTamworthAlbury WodongaCanberraAdelaideMelbournePerthAlbanyAlice SpringsHobart

Hearing Attendees

AAPT LimitedAlbury Wodonga Shire CouncilAustralian Telecommunications Users Group (ATUG)Aurora EnergyAusboneAustralian Pensioners League (WA)Business South AustraliaCable and Wireless Optus (CWO)Canberra Consumer RepresentativesConsumers Association of South AustraliaConsumer Affairs Advocate (Tasmania)COSBOA

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Department of Communications, Information Technology and the ArtsGlen Innes Business Enterprise CentreGreen Phone IncMacquarie Corporate TelecommunicationsMarconiNorth Queensland Consumer AssociationNTCOSPastoralists and Graziers AssociationPowertelPrice Waterhouse CoopersSETEL – Small Enterprise Telecommunications Centre LimitedSPANSouthern Cross TelcoTamworth and District Business Enterprise CentreTamworth Shire CouncilTamworth Senior CitizensTEDICORE – Telecommunications and Disability Consumer ProtectionTelstra Corporation LtdTOPSVodafone Pacific LimitedWestern Australian Farmers Federation

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Appendix E: History of the Price ControlArrangements

The following summary provides some broad details on the structure of the pricecontrol arrangements, and how they have changed over the four control periods. It isnot an exhaustive list of provisions or changes.

Price control arrangements from 1989 to 2001

The following price control arrangements were applied to Telstra (previously alsoTelecom/OTC and AOTC) from 1989 and continue to 30 June 2001, when the currentprice control arrangements cease.

§ July 1989 toJune 1992

§ Arose from 1988 Ministerial Review that rejectedrate-of-return regulation in favour of price-cappingregulation of “CPI minus X per cent” kind.

§ Revenue weighted basket of line rentals, local calls,STD and IDD calls capped at CPI – 4 per cent.

§ Sub-caps of CPI on local calls and residential rentals.

§ Notifiable and disallowable: connection fees,payphone calls, calls to directory assistance, 008services*, leased line charges*, mobile services*.

§ AUSTEL regulated for compliance.

§ (* notifiable and disallowable only from January1991)

§ July 1992 toJune 1995(December1995 onextension)

§ Basket now combined domestic and international andextended to include service connection charges,mobile services and domestic and international leasedlines.

§ Revenue weighted basket of connections, line rentals,local calls, STD calls, IDD calls, domestic leasedlines, international leased lines, mobile services, wascapped at CPI – 5.5 per cent.

§ Sub-cap of CPI – 2 per cent on connections, rentalsand local calls.

§ Sub-cap of CPI – 5.5 per cent on STD calls.

§ Sub-cap of CPI – 5.5 per cent on IDD calls.

§ In addition, prices for connections, rentals, local callsand STD calls could not increase by more than CPI

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each year.

§ Notifiable and disallowable: payphone calls, calls todirectory assistance, connections for resellers.

§ AUSTEL remained as regulator.

§ January 1996to December1998 (June1999 onextension)

§ Revenue weighted basket of its main services(connections, line rentals, local, trunk andinternational calls, leased lines and mobile services)by 7.5 per cent in real terms for each calendar yearbetween January 1996 and December 1998.

§ Sub-cap on untimed local calls, which could not riseabove 25 cents per call for calls made from residentialor business phones, and 40 cents per call for callsmade from a public payphone.**

§ Sub-cap on standard prices for connections, linerentals, trunk calls and international calls by CPI – 1per cent.

§ Notifiable and disallowable: payphone calls, calls todirectory assistance, increase in any charge subject tothe price control arrangements by more than the CPI.

§ ACCC became the regulatory body in mid-1997.

§ ** Local call parity introduced December 1997 –untimed local calls in non-metropolitan areas not toexceed untimed local calls in metropolitan areas inprevious period. Applies to both business andresidential (separately).

§ June 1999 toJun 2001

§ Revenue weighted basket of its main services(connections, line rentals, local, trunk andinternational calls, leased lines and mobile services)by 5.5 per cent in real terms for each year betweenJuly 1999 and June 2001.

§ Sub-cap of CPI – 0 per cent on a basket of local callsand line rental services.

§ Sub-cap of CPI – 0 per cent on a basket of connectionservices.

§ Prior to June 2000, cap of 25 cents per call on theprovision of basic untimed local calls, with a similarcap of 45 cents per call applicable to calls made fromTelstra public payphones. Post July 2000, cap of 22cents per call for local calls (GST inclusive) and 40

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cents for payphone calls (GST inclusive).

§ Low-spending residential sub-cap of CPI – 1 per centon a basket of services comprising connections, linerentals, local calls, trunk calls and international calls.The revenue weights are based on the average billsize of the bottom (low-spend) 50 per cent ofTelstra’s pre-selected customers.

§ Local call parity conditions – residential, business andcharity customers in non-metropolitan areas must notpay higher average prices (by more than 0.4 per cent)than residential, business and charity customers inmetropolitan areas in the previous period.

§ Telstra must obtain prior consent from theCommission if it proposes to increase its line rentalcharge by more than CPI and that line rental is to beused by anyone falling within the bottom (low-spend)10 per cent of Telstra’s pre-selected customers. TheCommission cannot consent unless Telstra canprovide that these customers (low-spend) would, onaverage, experience no real increase in their averagetelephone bill.