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Our Ref: D412033/26758 Mr Sean Riordan Acting Director Telecommunications Regulatory Australian Competition and Consumer Commission GPO Box 520J Melbourne VIC 3001 [email protected] RESPONSE TO REVIEW OF PRICE CONTROL ARRANGEMENTS The Western Australian Government welcomes the opportunity to provide comment on the discussion paper, Review of Price Control Arrangements, issued by the Australian Competition and Consumer Commission. In short, the WA Government strongly believes that the current arrangements governing the prices of prescribed telecommunications services should be maintained and enhanced. The attached submission makes the following points: 1. Price increases for basic telecommunications services are likely to adversely impact on consumer welfare as well as contributing to a reduction in economic growth. 2. The impact of price increases is likely to be particularly severe in the fledgling broadband service market. 3. The cost of relaxing price controls significantly outweighs the cost of retaining current controls. 4. Facilities-based competition is unlikely to occur in many regional parts of Australia. 5. Changes to the price control arrangements will increase incentives for service providers to offer value added services. 6. Tightening the definition of the services subject to price control can enhance the effectiveness of the current price control arrangements. 7. A specific price cap should apply to fixed-to-mobile calls and the price cap on local calls via public payphones should be maintained. Should you need clarification on any of the points made, please contact the Department of Industry and Resources: Sheryl Siekierka (phone: (08) 9222 5677, email to: [email protected]) or Grant Coble-Neal (phone: (08) 9222 5321, email to: [email protected]). Yours sincerely, CLIVE BROWN MLA MINISTER FOR STATE DEVELOPMENT Friday 24 September 2004 Submission to the ACCC REVIEW OF PRICE CONTROL ARRANGEMENTS September 2004 Introduction The Western Australian (WA) Government welcomes the opportunity to provide comment on the discussion paper, Review of Price Control Arrangements, (the Review) issued by the Australian Competition and Consumer Commission (ACCC). In short, the WA Government strongly believes that the current arrangements governing the prices of prescribed telecommunications services should be maintained and enhanced. This position is based on the need to ensure that the future needs of businesses and consumers are adequately met. Telecommunications prices are rising According to the ACCC Telecommunications Report 2002-03, Report 2, (the Report) PSTN1 prices increased for residential (household) and small business consumers in 2002-03.2 The Report states on page 67 that the cause of the price increase is in part due to “…the relaxation of the price controls applying to Telstra. This has particularly affected basic access prices…” The Report goes on to state that “…facilities-based competition for fixed line customers is struggling to emerge outside the CBD regions of capital cities, which provide the customer densities necessary to support cable rollout by smaller carriers…” Rationale for price control in telecommunications In considering arguments based on efficiency, the ACCC should carefully weigh the impact that telecommunications price changes have on the efficiency of the entire economy against the efficiency outcomes realised within the telecommunications industry. The WA Government holds the view that telecommunications services are essential for the efficient functioning of WA’s economy. This belief is underscored by the ubiquity of telecommunications, which permeates virtually every aspect of Australian economic and social life. Indeed, close analysis of household and industry expenditure patterns reveals that the economic need for telecommunications is as fundamental as the economic need for energy. However, while the economic impacts of energy price increases are readily appreciated, there is generally little understanding of what economic impact telecommunications price increases would have on economic activity in WA. Examining household and industry expenditure patterns, it is possible to glean an indication of the potential economic impact. Table 1 presents average household budget allocation shares for energy, health and telecommunications. Comparing telecommunications expenditure to other politically sensitive budget items suggests the order of significance within the total budget is similar to that of domestic energy fuel-power and petrol. 1 2 PSTN is an acronym for Public Switched Telephone Network. See page 63. 2 Inspecting budget shares across Gross Income Quintiles, it is clear that telecommunications, like energy consumption, accounts for a relatively larger share for households with lower income. Table 1. Australian household expenditure: energy, health and telecommunications Gross Income Quintiles Lowest 2 3 4 Average Budget Share (%) Domestic fuel and power 8.05 3.83 2.49 1.78 Transport 30.17 17.46 14.78 13.87 Petrol 6.48 4.22 3.35 2.67 Household service and operation 16.90 7.75 5.41 4.31 Telephone and facsimile charges 7.95 3.73 2.67 1.91 Medical care and health expenses 10.78 5.76 4.04 3.56 Source. Household Expenditure Survey 1998-99, ABS catalogue 6535.0. All Highest households 1.16 10.46 1.84 3.04 1.29 2.65 2.03 13.40 2.68 4.69 2.14 3.69 Table 2 provides the industry overview of Western Australia’s dependency on telecommunications. It is clear from the table that more than half of WA’s economy is explained by the Services, Mining and Retail/wholesale trade sectors. Table 2 also shows the total requirements coefficient, which quantifies the need for communication services in terms of its share of industrial output for each of these sectors. Within the Services sector (finance and insurance, property and business services, education, cultural and recreational services, and personal and other services) the share of communications services in final output is six times larger than petrol and 1.7 times that of electricity, gas and water3. For the Retail/wholesale trade sector, the share of communications services is nearly double that of the Services sector. Given these magnitudes and the size of the Services, Mining and Retail/wholesale sectors it is apparent that telecommunications price increases would have a substantial impact on economic activity. Table 2. Communications requirements by selected sector (WA) Total requirements Industry Share of GSP4 (%) coefficient (%) Services 22.4 3.4 Mining 20.2 2.1 Retail/wholesale trade 9.8 6.5 Manufacturing 9.0 2.4 Construction 8.1 1.9 Health and community services 5.8 2.5 Transport and storage 4.7 3.8 Government 4.1 5.0 Agriculture, forestry and fishing 2.9 2.2 Electricity, gas and water supply 2.7 2.1 Accommodation, cafes and restaurants 1.6 3.9 Source. ABS Australian National Accounts, State Accounts Table 28, cat. 5220.0 2002-03 and Australian National Accounts, Input-Output Tables 1996-97, Table 6 cat. 5209.0. 3 The petroleum and coal products total requirements coefficient for the services sector is 0.6 while the electricity, gas and water total requirements coefficient is 2.0. 4 GSP is an acronym for Gross State Product. 3 Establishing an explicit link between economic activity and telecommunications service price changes requires a sustained research effort. An indication, however, would be available from the volume (quantity) prices implied by the ACCC’s method of calculating the various telecommunications price indexes. Analysis of changes in volume measures in conjunction with changes in industry revenue would provide a means of establishing to what extent individual telecommunications carriers are able to exercise market power at the expense of the national and State economies. Consumers (both household and small business) have a limited range of responses to price increases: • • If substitution is not feasible, consumers either reduce call volumes to stay within a prescribed budget or increase telecommunications expenditure by reducing expenditure on other unrelated goods and services. If substitution is feasible: o In response to a uniform price increase across the range of telecommunications services, consumers may be able to reduce telecommunications use in favour of increased transport. In most cases, transportation and telecommunications are poor substitutes. o In response to a relative increase in fixed line prices, consumers may be able to reduce fixed line use in favour of mobile telephony. However, the increased fixed line price is likely to adversely impact on Internet access via dial-up and broadband (ADSL) 5 access. The fledgling retail broadband market is likely to be particularly price sensitive because most consumers have budget allocations that are defined by fixed income. For example, a fixed line is required to support broadband access via ADSL. For ADSL subscribers, an increase in fixed line rental will force a reduction in broadband expenditure. The incumbent, who has a virtual monopoly on fixed line access, could drop the price of retail ADSL to offset the impact of the fixed line price increase on consumers. The consequence is likely to have a substantial impact on competition, as was evidenced earlier this year. In short, fixed line access is an essential facility element6. The obvious counter-argument is that increases in fixed line rental will encourage an alternative carrier to build a duplicate network. There are, however, several market failures that have not yet been fully explored by Australian policy makers: • Facilities-based competition is not the most efficient outcome in areas where the customer base is unable to support more than one 5 ADSL is an acronym for Asymmetric Digital Subscriber Line. An essential facility element is a service that does not have a close (viable) substitute and is part of a bundle of facility elements that make up a service bundle. Essential facility elements are sometimes referred to as monopoly building blocks. See Hausman, J. (1999) ‘Regulation by TSLRIC: economic effects on investment and innovation’, Multimedia und Recht. 6 4 facilities provider. There are likely to be many areas of Australia, such as regional WA, where this is the case. • Investment uncertainty, which is largely caused by the reality that telecommunications infrastructure is sunk and irreversible. The main implication here is that investing in telecommunications is highly risky because the infrastructure cannot be easily reused or resold if the firm making the investment exits the industry. In practice, service providers impose a high hurdle rate of return on investment proposals, resulting in less investment in infrastructure. • Non-price competitive forces in the presence of asymmetric information with respect to the flow of relevant market information between parties7. There are many examples of ‘signalling’ and ‘credible threat’ tactics being employed by the principal facility providers8. Both the mobile telephone and broadband markets have many examples, e.g. investment intentions surrounding the deployment of fibre to the home. Such tactics increase uncertainty, which by definition reduces the efficient operation of service markets. Investment in new infrastructure generally occurs once service providers, chiefly resellers, have established a sufficiently large and stable customer base to ensure return on investment. The investment occurs as part of a cost reduction strategy where service providers transfer customers off infrastructure rented from wholesale service providers. With respect to the previously noted investment in the CBD, new telecommunications infrastructure is driven by competition in the data market. While competitors may provide voice services via the new infrastructure, it is data revenue, not voice revenue that is driving facilities-based competition. In the absence of comprehensive policy reform to adequately address the above three market failures, price controls on essential facility elements should be retained as an explicit second-best option. In particular, the objective should be to maintain an upper limit on prices, thereby acting as a proxy for competition. The risk of the proposed strategy is minimal because effective competition combined with technological change are likely to drive service prices set by the market below the regulated price. Regulatory responses in the presence of asymmetric information To date, the discussion of telecommunications services subject to price control implicitly assumes that the reason for price control and the precise nature of the service are widely known and understood. The economic analysis contained in the Review discussion paper explicitly justifies the price control regime in the context of containing market power. Another argument for regulation is to address inefficiencies created by the 7 Information asymmetry occurs when one party involved in a two-party transaction has more or better information than the other party. For example, Telstra has better information about its operational costs than the ACCC. 8 ‘Signalling’ refers to tactics designed to convey information to competitors with the implicit aim of limiting effective competition. ‘Credible threat’ refers to information conveyed that supports the signal. An example of a credible threat is a capacity to engage in a substantial capital program in specific geographic areas in a bid to destroy small competitors. 5 existence of market failure. A principal source of market failure within the telecommunications market is asymmetric information. An effective way of dealing with the problems caused by asymmetric information is to place the burden of proof on the market participants with the informational advantage. The rationale for a regulatory approach with incomplete information is based on the following principles: • A profit-seeking firm will always extract the maximum revenue it can from the market. In the telecommunications industry, where carriers sell services in multiple markets simultaneously, prices will rise the most in markets where the price elasticity of demand is least elastic. This means the price of telephone line rentals, local calls, and trunk (STD) calls. Since market pricing depends on demand conditions as well as supply characteristics, without effective competition or regulation, there is no guarantee that telecommunications carriers will price services according to marginal cost. Therefore, there is no guarantee that the telecommunications market will price services efficiently. • The ultimate regulatory objective is to ensure that economic efficiency, which is the sum of consumer and producer surplus, is maximised. Given asymmetric information, the ACCC should place emphasis on enhancing consumer welfare (by increasing consumer surplus). • For a service provided universally, a price reduction is always welfare enhancing for the consumer. • A new service innovation may, or may not, be welfare enhancing. The total welfare gain is dependent on consumer preferences, which are not known to the regulator. • Any implied trade-off between a price reduction and a service innovation only occurs at the margin within an optimisation framework. The ACCC cannot observe this point other than by monitoring market outcomes in areas where competition is fully effective. • On the balance of probabilities, it is safer for the ACCC to rely on price reductions as a means of enhancing consumer welfare. • Productive, allocative and dynamic efficiency are optimised when competition is working effectively. Given these principles, this submission argues for a two-tiered approach to price control. In the first tier, universal maximum prices for essential facility elements are retained absolutely at their current level (in real terms) as a guarantee that prices cannot rise above a prescribed maximum. In effect, the Tier 1 rule imposes a static price ceiling. The second tier applies a simple dynamic pricing rule as a proxy for effective competition. Given that effective competition is most likely to occur in metropolitan markets, the pricing rule could be as simple as setting the maximum price equal to the average price set by competitive forces in metropolitan areas. 6 Net economic costs of price control arrangements Section 5.3 of the Review discussion paper (Distributional Impacts) refers to the need to consider the “…economic benefits and costs from the current or any future price control arrangements...” In effect, the reference to distributional impacts hints at the economic cost of imposing price controls against the social benefit of equitable pricing for non-metropolitan consumers. An explicit examination of the issue raises two fundamental issues: • Consumers in regional areas could be forced to pay more for telecommunications services than their metropolitan counterparts as a result of any ‘tariff rebalancing’. • There is a risk that the current price control regime is imposing an economic cost that substantially outweighs the social benefit. With regard to the first issue, regional and some metropolitan consumers are already facing substantial disadvantage with respect to the availability and cost of telecommunications services. Removing or relaxing price controls are likely to exacerbate the disadvantages. In relation to the second issue, the economic cost is likely to be small. On one hand, there is a risk that the price levels set by the CPI-x formula could be set higher than the monopoly price. However, the upper limit for a profit maximising monopolist (the worst possible case) is the point where the price elasticity of demand is unit elastic. If the imposed price ceiling is higher than the price implied by unit price elasticity, then the price control is not effective at enhancing market efficiency by reducing economic rents. On the other hand, a price set too low will give service providers every incentive to provide convincing evidence that the price ceiling should be increased. Given that the service providers have detailed information about their own operational costs, service providers should bear the burden of proof in arguing for an increase in the price ceiling. Removing or relaxing a price ceiling that is lower than the monopolist’s profit maximising price will impose a substantial cost in terms of reduced economic activity. There are no circumstances in which it is reasonable for the ACCC to remove price controls. The price control can simply be maintained, in real terms, at its current level as a guarantee that prices cannot escalate above the specified price if there is a sudden and unexpected reduction in competition. In time, where competition is fully effective it is likely that the market price will drop below the current level of prices set by the ACCC. This expectation is based on a long history of well-documented efficiency gains derived from cost reducing advances in telecommunications technology. Indeed, the ACCC can build this expectation into its price control regime by adopting the two-tiered pricing rule. That is, apply the market price established in areas where competition is an effective disciplining mechanism (e.g. metropolitan areas) to areas where competition is not effective (e.g. nonmetropolitan areas). The maximum price charged anywhere should be the competitive metropolitan market price, which in turn will be equal to, or less than the Tier 1 price ceiling. In evaluating this strategy, the following issues are relevant: 7 • Profit seeking firms will always choose the strategy that minimises cost. • The Universal Service Provider (currently Telstra) has a limited range of responses to this regime, namely: o Abandon unprofitable areas. Abandonment is effectively ruled out under the universal service regime; o Erode the quality of the service subject to price control. This occurs by reducing maintenance expenditure, reducing staffing levels etc; or o Ruling out the first two options, choose the technology that minimises cost. With limited ability to abandon customers or erode the quality of service, Telstra as the Universal Service Provider, would have to consider upgrading its equipment since new equipment is inherently more efficient than aging equipment. This response will occur even if the service area is unprofitable since the Universal Service Provider will seek the strategy that minimises losses9. The ACCC’s regulation rule is simple: it should impose the competitive market price, observed in metropolitan areas, on non-metropolitan regional areas for services that are supplied universally. At the same time, the ACCC should continue its price controls in metropolitan areas, either at the current price level (in real terms) or continuing the CPI-x formula. Continuing advances in technology are cost reducing, thus ensuring a sustainable telecommunications industry. Definition of Service Subject to Price Control To date, discussion of services subject to price control implicitly assumes that the services are well defined. Unfortunately, definitions appear to be implied and imprecise. The recognition that declining quality of service undermines the price control regime means that the service must be precisely and explicitly defined. This is reinforced by the discussion concerning voice over internet protocol (VOIP) contained in section 5.4 New and emerging technologies of the Review discussion paper. A new service platform, such as VOIP could provide the platform for providing a PSTN equivalent service. However, recent history shows that VOIP quality is substantially less than carrier grade voice services. This kind of fundamental change therefore requires a precise definition of the service in the interests of consumers and to provide greater certainty for service providers. Impact of price control arrangements on new and emerging technologies The discussion on page 31 refers to allowing “…Telstra to price above-cost in certain markets [which] may actually encourage it to invest in new and innovative technologies…” In the context of the Australian telecommunications regulatory framework, this argument is tenuous. Past economic studies in the US have analysed the effect of rate-of-return 9 It should be noted that the Universal Service Provider is paid a subsidy as compensation for incurring a loss in unprofitable areas. 8 regulation and other types of ‘incentive regulation’ on capital investment. The fundamental issue is that rate-of-return and incentive regulation is aimed at ensuring an adequate return on invested capital10. According to his paper Incentive regulation in the US telecommunications industry, Professor John Panzar observes that the literature is inconclusive on the impact of such regulation. Further, on page 14 Professor Panzar observes that: “…a price cap regime operates by giving the firm the incentive to reduce costs…’’ He then states that: “…a price cap regime may be effective in allowing the firm to reduce costs…” In our view there are two principles involved: • The need to ensure a flexible regime that facilitates the timely adoption of appropriate technology for the benefit of consumers; and • The need to ensure essential services that offer real value to consumers are set at prices that encourage adoption. Precise service definition within the two-tiered price control system will allow the first principle to be satisfied. Under this regulatory regime, the possibility of national revenue loss caused by aggressive price cutting in metropolitan areas will provide a strong incentive for service providers to avoid a price war. Instead, competition is likely to occur on the basis of offering value-added services. With respect to the second principle, it is necessary to establish a test other than simply arguing historical precedent. Namely, regulation should seek to address specific market failures. Although the current price control regime is justified on social grounds, it may also be appropriate as part of the solution to address market failure induced by natural monopoly. On this: • Natural monopoly is an empirical issue. While competition is clearly sustainable in the CBD, other areas such as in parts of regional Australia appear to have insufficient customers to support effective facilities-based competition. • If natural monopoly exists as a result of insufficient scale, then Australian telecommunications policy should be flexible enough to reflect differences in competitive outcomes across geographic areas. Price control arrangements could be justified as a means of imposing a discipline on the incumbent in the absence of effective competition. In our view, there is insufficient evidence to justify relaxing or removing the current price controls. Other Matters Two other matters canvassed by the discussion paper are the impact of fixed to mobile prices, and price caps on public payphones. In practice, increasing numbers of consumers making fixed to mobile calls do so after being redirected from the intended fixed line number to a mobile telephone without 10 See Panzar, J. (1999), ‘Incentive regulation in the US telecommunications industry’, in 1999 Industry Economics Conference, 3-16, http://www.pc.gov.au/research/confproc/iec1999/iec1999.pdf. 9 their prior knowledge or consent. Consequently, they are not in a position to manage their call costs. This clearly impacts the most on consumers in the lowest income group. A price cap specifically targeting fixed to mobile calls would be an effective way of providing practical assistance to these consumers. With respect to payphones, the ACA’s report Payphone Policy Review (page 34) makes the qualified recommendation that the ACCC consider an increase in the price cap on local calls from Telstra payphones. This recommendation follows a discussion of falling payphone revenues and the impact that this has on competition in the payphone market. The implied argument is that relaxing the price cap will remove an inadvertent margin squeeze on non-Telstra payphone providers. This argument appears to suggest that the price caps would lead to a reduction in payphone availability. There are a number of issues at play here: • Non-Telstra payphone providers are not compelled to supply payphone services in unprofitable areas. • Telstra receives a universal service subsidy as compensation for providing payphones in unprofitable areas. As the ACA’s report makes clear, the key users of payphones are indigenous communities, younger people, those living in rented accommodation, unemployed people, those receiving government payments and those on lower incomes. This leads to the conclusion (page 24 of the ACA’s report) that: “…This higher share of use is because the characteristics of these people mean that they have poor access to other telephone services. This suggests that payphones are important for social equity and the government should use tools such as the [universal service obligation] to ensure that payphones are provided in socially disadvantaged areas…” Increasing the cost of local calls reinforces the disadvantage of those who rely on payphones for their electronic communications, and so highlights the need to think very carefully about rises in charges. CONTACT OFFICERS: Grant Coble-Neal State Development Strategies Department of Industry and Resources 2 Havelock Street WEST PERTH WA 6005 Sheryl Siekierka State Development Strategies Department of Industry and Resources 2 Havelock Street WEST PERTH WA 6005 Phone: (08) 9222 5321 Fax: (08) 9222 5612 Email: [email protected] Phone: (08) 9222 5677 Fax: (08) 9222 5612 Email: [email protected] 10