Competition and Regulation in the Telecommunications Industry in ...

Competition and Regulation in theTelecommunications Industry inSouth AfricaPrepared for the Competition Commission byJames Hodge & Nicolas TheopoldSchool of Economics, University of Cape TownMarch 2001

Competition and Regulation in Telecommunications4.3.3 Contestability...................................................................................................................................... 434.4 MOBILE....................................................................................................................................................... 454.4.1 Relevant Market.................................................................................................................................. 454.4.2 Market structure ................................................................................................................................. 454.4.3 Contestability...................................................................................................................................... 454.5 VALUE-ADDED NETWORK SERVICES (VANS) ............................................................................................ 474.5.1 Relevant markets ................................................................................................................................ 474.5.2 Market structure ................................................................................................................................. 474.5.3 Contestability...................................................................................................................................... 484.6 OTHER MOBILE SERVICES........................................................................................................................... 484.6.1 Relevant Markets................................................................................................................................ 484.6.2 Market Structure................................................................................................................................. 484.6.3 Contestability...................................................................................................................................... 495. REGULATORY ISSUES FOR THE SA TELECOMMUNICATIONS INDUSTRY AND THEIRPOTENTIAL EFFICIENCY/PUBLIC INTEREST IMPACT....................................................................... 505.1 STRUCTURE................................................................................................................................................. 505.1.1 Vertical separation of networks.......................................................................................................... 515.1.2 Vertical separation of services from networks ................................................................................... 525.1.3 Horizontal separation of mobile services ........................................................................................... 525.2 ENTRY......................................................................................................................................................... 535.2.1 To Restrict Entry or Not ..................................................................................................................... 535.2.2 Dealing with Entry Deterrence........................................................................................................... 555.2.3 To Actively Assist Entry or Not........................................................................................................... 555.2.4 Asymmetric regulation........................................................................................................................ 565.3 PRICING....................................................................................................................................................... 565.3.1 Final consumer prices ........................................................................................................................ 565.3.2 Interconnection (Access) pricing........................................................................................................ 575.4 QUALITY ..................................................................................................................................................... 58CONCLUDING REMARKS.............................................................................................................................. 59BIBLIOGRAPHY ............................................................................................................................................... 60ii

Competition and Regulation in TelecommunicationsList of TablesTable 1.1: A breakdown of the telecommunications market _________________________________________ 2Table 1.2: Cost characteristics of local access technologies for telecommunications _____________________ 6Table 1.3: Direct forward linkages - Telecommnuications share of intermediate input costs for sectors of theeconomy (1997) – percentage of total intermediate input costs _____________________________________ 13Table 1.4: Structure of capital requirements for a fixed line network provider and an Internet service provider(2000) _________________________________________________________________________________ 13Table 1.5: Direct backward linkages – intermediate inputs into the communications industry (1997) –percentage of total intermediate input costs ____________________________________________________ 14Table 2.1: State of European Deregulation (1998)_______________________________________________ 21Table 3.1: Rollout Targets for Telkom in terms of License_________________________________________ 30List of FiguresFigure 1.1: A telecommunications network _____________________________________________________ 4Figure 1.2: Household expenditure patterns (1995)______________________________________________ 15Figure 2.2: Path of Regulatory Intensity ______________________________________________________ 22Figure 3.1: Proposed path of deregulation_____________________________________________________ 31iii

Competition and Regulation in Telecommunications1. The Nature of the telecommunications industryThis first section explores the nature of the telecommunications industry as a startingpoint for competitive analysis. It begins by determining market separation bothvertically (supply chain) and horizontally. This discussion includes a look attechnological convergence and who are the current and future players in the market.It then explores the possible forms of trade in telecommunications and how thatmight impact the geographical scope of the market and contestability. Lastly, itexamines the role that telecommunications plays in the broader economy. This mayinform how to trade off efficiency and public interest considerations.1.1 The telecommunications marketThe telecommunications industry concerns the provision of two-way, one-to-onecommunications of voice, data and video. It is distinct form the broadcasting market,which is typically a one-way, one-to-many communications service. However,convergence means that infrastructures developed for either market can be adaptedto provide the other service. Given these economies of scope, it is often preferable toprovide both services.For regulatory purposes it is important to understand the vertical stages of productionand possible horizontal market divisions in telecommunications. Table 1.1 providesthe commonly used breakdown for telecommunication, noting that the dynamicnature of the industry makes such definitions valid at a point in time only.Table 1.1: A breakdown of the telecommunications marketProduction Stage Description Sub-stages Horizontal divisionsProvision of Network Provision of switching and • customer premises • fixed vs. mobileinfrastructuretransmissionequipment• PABX vs. phoneinfrastructure• Local access • Fixed vs. mobile• Business vs.residential• Voice/data vs.broadband video• National LongDistance• International LongProvision of servicesProvision of additionalinfrastructure andtechnical support tooperate service overinfrastructureDistance• Line lease agreement• Content• value-addedinfrastructure• Technical serviceprovision• Customermanagement (billing& customer support)• basic voice vs. VANSvs. broadcast• Fixed vs. mobile• national long distancevs. international• Business vs.residentialTelecommunications production can roughly be divided into the provision of networkinfrastructure and the provision of services on that infrastructure. Typically a publicmonopoly is vertically integrated and so provides all parts of the production chain andall horizontal markets. However, in the context of deregulation it is important to focuson the various stages of production and not what individual firms do. In this way it is2

Competition and Regulation in Telecommunicationseasier to identify essential facilities and anti-competitive behaviour stemming fromvertical integration. It is also easier to track where competition can feasibly survivewithout regulation.1.1.1 Provision of Network InfrastructureNetwork providers operate the infrastructure on which various telecommunicationservices are run. Networks are made up of switches and transmission. The switchesprovide the routing of voice, data, and video signals through the network. Thetransmission medium can be separated into fixed line (twisted pair of copper wires,fibre optic, coaxial cable) or wireless (satellite, cellular radio, microwave, PCS).The big technological changes in network provision have been (Laffont & Tirole2000):• the rapidly decreasing costs of switches and transmission equipment• the increasing capacity and speed of transmission mediums – both in thetransmission material (e.g. fibre optic) and the improved compression of signals(e.g. ADSL or asymmetric digital subscriber lines which increase speeds oncopper paired wire)• the increasing intelligence of the networks enabling them to improve theirefficiency and begin to offer a wide variety of services beyond mere telephony(discussed below)• the convergence of different industries due to the common use of digital format.The industries relate to the original purpose for which the networks were built –telecommunications (voice), broadcasting (video) and computing (data)There are three different components to the network that can be seen as threedifferent stages of production. These are local access, long-distance andinternational. Figure 1.1 below demonstrates how these three componentsinterconnect to form a complete international telecommunications network. It looks ata mixed fixed line/mobile example. The local access network connects the customerpremises to the local switch through the local loop. From the local switch there is aninteroffice transmission facility to either other local switches or long-distance (nationalor international) points-of-presence. The long-distance networks then transmit thesignal to another long-distance point-of-presence where it is distributed to a localswitch and onto the other customer premises. What follows is a more detaileddiscussion of each component of the supply chain and the various technologicalplatforms used.3

Competition and Regulation in TelecommunicationsFigure 1.1: A telecommunications networkCustomer premisesCustomer premisesFIXED LINELocalLoopLocalSwitchLocalSwitchLongdistancePoPCustomer handsetCustomer handsetBaseStationBaseStationMOBILELocalSwitchLongdistancePoPCustomer premises equipment (CPE)The concern here is the retail supply of customer premises equipment and not themanufacture of the items. CPEs include fixed line telephones, mobile handsets, andPABXs (private exchange equipment for business use). Each of these can beconsidered a separate market. In the heyday of public monopoly, the customerpremises equipment had to be supplied by the incumbent PSTN. This monopolyposition, on what is essentially a service with no natural monopoly features,represented an opportunity for abnormal profits to be made. Almost without fail thefirst step in any deregulation process is to liberalise this part of the supply chain.Local AccessLocal access can now be provided by a number of different technologies, each withdifferent cost structure and therefore different degrees of substitutability with thetraditional public switched telephone network (PSTN). The focus below will be onfixed line (PSTN, data networks, cable TV) vs. wireless (fixed or mobile) options.Although local access is being handled as one stage of production, it should be notedthat this stage can be broken down further. In particular,• connection of premises to local loop• local loop• local exchange (switch)In the search for greater competition at the local access level, it may be desirable tofurther unbundle the production process and find ways to inject competition. Forinstance, the SA White Paper on telecommunications suggests allowing communitygroups and SMMEs putting in local loops that then connect to the Telkom PSTN. Inthe USA, Competitive Access Providers (CAPs) have emerged to connect largecustomers directly to the long distance networks points-of-presence (PoPs),4

Competition and Regulation in Telecommunicationseffectively bypassing the PSTN (these access lines are point-to-point and have noswitching capacity) (Laffont & Tirole 2000).Fixed LineWithin the group of network providers that use fixed line infrastructure, networks werehistorically built to focus on one of three different types of transmission – voice, dataor image. However, increasingly networks are offering all three. This is feasiblebecause almost all networks now use a digital format.In voice, the traditional PSTN consists mainly of copper or coaxial cable transmissionequipment at the local access level and switching equipment that allows two-waytransmission between two individual points on the network by establishing adedicated line between two points for the duration of a call. The transmissionmediums have low capacity or network speed (measured in bits per second) makingthem inadequate for video transmission and a slow but adequate medium for datatransmission. However, recent technological developments in data compression havesubstantially increased the speeds available on these wires (in particular theasymmetrical digital subscriber line systems – ADSL – and other DSL technologies).Upgrading the networks to provide greater speed does require additional investmentsin the local access infrastructure. An alternative is the use of fibre optic, which has afar greater network capacity. Due to the higher cost of fibre optic, it is only costeffective with large businesses and not residential homes in the local accesscomponent of the network. It is used extensively in the long-distance andinternational networks. Either way, it is increasingly possible for PSTN networks to beupgraded to offer video services too. In fact, growing use of capacity for datatransmission (i.e. the Internet and intra-corporate transfers) make the investments infibre optic or ADSL increasingly worthwhile, offering the springboard to broadcasting.Cable TV (CATV) networks (video networks) use a coaxial cable with broadcastquality network speeds as their transmission medium. Initially these networks wereonly focused on broadcast and so were established with one-way, one-to-manytransmission (tree-and-branch structure), disqualifying one-to-one communication.However, where cable operators have entered telephony, they have upgraded theirnetworks to handle two-way transmission. This has enabled the creation of the new‘pay-per-view’ television services, and also allowed them to actively enter the Internetproviders and telephony market.Dedicated data networks may be private or public (Internet). Data can be run overany network and in fact, most local access to dedicated data networks occursthrough either the PSTN, the cable TV network or a mobile service. As such, thediscussion of data networks is largely a long-distance issue. However, largerbusinesses are increasingly being connected directly to these long-distance datanetworks making it worth a mention here. The switching equipment of data networksdoes not establish a dedicated line and instead routes ‘packets’ of data on commonusage lines from one point to another through the path of least resistance. This isefficient for data but as line traffic congestion can delay packets, this has previouslybeen unsuitable for quality voice or image transmission. However, recentInternational Telecommunications Union (ITU) agreements on a common gatewayprotocol for passing multimedia from telephone networks to data networks shouldgreatly improve the quality in the near future (ITU 1999). This will see priority beinggiven to voice and image packets, avoiding the problem of congestion.5

Competition and Regulation in TelecommunicationsTable 1.2 examines the cost structure of different network types. As it reveals, thecost structure in fixed line networks (PSTN or cable) is geared towards sunk andfixed costs making it largely insensitive to traffic volumes. For this reason it is oftennoted that the marginal cost of making a phone call is negligible. In fact, the marginalcost/revenue decision for the PSTN operator is whether to connect a new customeror not (Laffont & Tirole 2000). If the new customer is expected to generate morerevenue than it costs to install the line, then the PSTN will install the line. The resultof this cost structure is that economies of scale and density are reasonably large andthere is a large initial investment required to begin operating local access.The sunk costs are largely the trenches and ducts for wire that can make up to 40%of annualised costs (Caves 1995). Allowing the distribution through poles aboveground does lower costs. These sunk costs are the reason that lower cost entrantsare companies with a local transmission network already in place – e.g. cable TVcompanies or electricity companies. In these cases there are economies of scope asmany of the additional costs of rolling out a network are already incurred. Thedifficulty of course is allocating these costs between the different services. The otherservice that cable can enter once upgraded for telephony is data transmission.Cave (1995) notes that in the comparison of costs between cable and PSTN, thefollowing conclusions may be drawn:• Cost per home passed (the local loop) is higher for a CATV network• The incremental cost of provision of a telecommunications service by a CATVoperator with an established local loop is a small fraction of the total cost faced bya PSTN• For the subscriber already connected to the CATV local loop the cost disparitywith a telecommunications provider is even greater.Table 1.2 assumes that the cable provider already has a local loop in existence andis providing both video and telephony (hence exploiting their economies of scope).The conclusion one can draw is that cable can in all likelihood be considered in thesame market for telecommunications once established.Table 1.2: Cost characteristics of local access technologies for telecommunicationsFixed line CATV network Fixed wireless Mobile wirelessFixed/variable ratio High Medium Low LowSunk/salvageableratioTrafficsensitive/non-trafficsensitiveHigh Medium* Low LowLow Medium* High HighEconomies of scale Medium Medium Small SmallEconomies ofdensityLarge Large Small SmallEconomies of scope Possible Yes No PossibleInitial investmentrequiredRequires specialhandsetLarge Medium Small SmallNo No No Yes*Based on some economies of scope by offering video and telephony services6

Competition and Regulation in TelecommunicationsReproduced from Cave (1995)If the PSTN were to exploit their potential economies of scope into video then part ofthe sunk costs allocated to telephony would be shared with other services. ThePSTN has already lowered some of the costs by exploiting its ability to provideaccess to two-way transmission data networks (i.e. Internet or private data networks).The exponential growth in traffic volume has been associated with data and notvoice. This enables PSTNs to operate at greater levels of capacity utilisation and solower the unit costs. This is a strong reason for the better productivity performance ofUS telephone companies.Wireless NetworksWireless networks differ from fixed line in their use of the radio frequency spectrumfor transmission. The local access process involves a handset for the subscribertransmitting to and from a base station using a specific spectrum that the networkprovider is licensed to use. The base stations are usually connected to each other oranother network through a fixed line infrastructure.In local access there are two types of wireless networks – fixed and mobile. The fixedwireless local loop is a recent addition and is being used to provide a ‘last drop’ to theconsumer for fixed line voice or data networks. It is similar to two-way radio wherethe physical coverage is very limited, and the receiving device (a telephone) is oftenfixed in location. The same receiving device as fixed lines is used. In terms of amarket boundary for competition analysis, it is not designed to compete with thecellular networks but rather to provide a cheap alternative to using fixed wire as thelast drop to the home. Therefore it would usually fall into the fixed telephony market(in fact it is usually rolled out by the PSTN as part of a mixed technology strategy –Telkom is no exception).The cellular networks provide local access but also the added advantage of mobility.The subscriber is required to invest in a handset that cannot be used for fixed line orfixed wireless access (a switching cost). The current mobile networks are constrainedin their network speed to offering voice and data services only. However, the socalled3 rd Generation or Universal Mobile Telecommunications Services (UMTS)hope to achieve networks speeds that would enable the transmission of video too.The first networks of this kind are due to be operational in Japan in 2002.The cost structure of mobile is different to that of fixed lines (see table 1.2). Thespacing of the base stations (and therefore the number required) is dependent on thetraffic volumes. The result is that the initial investment required to establish a localaccess infrastructure is lower than that of fixed lines. It also means that there arelower economies of scale and density, making more network providers viable.A key question is the extent to which mobile competes with fixed line in the localaccess market (i.e. is a close enough substitute to be considered in the samemarket). This is crucial for competition and regulatory analysis. From a use andquality of product perspective, they clearly offer the same potential group of basicand advanced voice products but with mobile having the added feature of mobility.What may therefore determine whether they are in the same product market is thedifference in price between the two or whether other services are bundled in too (inparticular data services). If voice is bundled with data services then fixed linecurrently holds a broader array of products to mobile, where data is available but in afar more limited way due to screen size. The actual cost differential depends on the7

Competition and Regulation in Telecommunicationsrelative density of subscribers. Wireless is cheaper at lower densities due to the lowfixed costs, while fixed line is cheaper at higher densities. The cross-over point isestimated to be in the range of 200-800 subscribers per km 2 from US and UK studies(Cave 1995). This makes mobile more expensive in urban and metropolitan areaswith high subscriber rates. However, in many developing countries with lowtelephony density of use, cellular is proving to be a good substitute for fixed line(South Africa may well be a case in point). Rapid technological developments inmobile communications could make it even more substitutable.Mobile telecommunications also includes satellite personal communications services.Satellite makes use of more powerful devices to transmit to one of a number of earthstations, which in turn link to each other via one or more satellites. The greaterdistances the receiving equipment must transmit over, means they are larger andmore expensive than cellular. However, the use of satellites enables the network tominimise the number of earth-based transmission stations. This will not be discussedbecause a) the first global start-ups have all failed, and b) the cost is so much higherthan fixed line or mobile that it cannot be considered remotely in the same market.Other wireless communications also include the broadcasting group (radio, free-to-airTV and Pay TV) which are one-to-many operations without two-way capacity and socannot offer telecommunications.Finally, one can include two-way radio and radio trunking. Two-way radio is oftentransmitted over very short distances and includes networks for emergency servicesand communication within a defined corporate space. Often the distances are shortenough that no transmission stations are required, and the hand-held devices aresufficient. The longer distances are covered by radio trunking, which operate in afashion similar to cellular networks. Neither are suitable for public local accesstelecommunications and so will not be discussed further.Long Distance (National and International)Local access networks connect to a long distance network through a point-ofpresence(PoP). The long-distance network is made up of these PoP exchanges anda transmission network. Given that these networks draw on a large pool of localaccess subscribers, they are able to get greater density of use in their transmissionnetworks. As a result, most long distance networks use fibre optic when using a fixedline solution. Alternative transmission mechanisms include satellite and microwave(national only). Despite the choice of technologies available, a single market isdefined as one for national long-distance and for international long distance. Inaddition, as most of these networks have sufficient network speed for broadcastquality, there is no real need to differentiate at the infrastructure stage between voice,data and video.As with local access, there are economies of scope in rolling out fibre optic longdistancenetworks. A substantial proportion of the costs are in paying royalties tolandowners to pass the transmission cable through and putting in place infrastructureto carry the transmission medium (Cave 1995). If a new entrant already has anational infrastructure (e.g. railways, electricity grid), then some of these costs will bespared allowing a faster and cheaper rollout.8

Competition and Regulation in Telecommunications1.1.2 Provision of ServicesThe network infrastructure is the basis on which services are provided. Theincreasing intelligence of telecommunications networks has permitted a proliferationof services that are feasible beyond the basic local, national and internationaltelephony. The new telephony-related services include automatic callback,number/name identification, selective call rejection/acceptance, voice messaging,selective routing of calls, text messaging, fax, calling card, etc. In addition, the rangeof data/video services has proliferated with the most common including a full Internetoffering (email, world-wide-web), EDI (electronic data interchange), paging, manageddata network services, video-conferencing, database access and transactions, videoon-demand.Service provision can be split into two basic components – value-added networkservices (VANS) and basic voice. From this point there can be further separation intowireless vs fixed line, local/long distance/international, and business/residential.VANS are described as including electronic data interchange, electronic mail,protocol conversion, database access, managed data network services, voice mail,store and forward fax, video conferencing, telecommunications related to publishingand advertising services and electronic information services, including Internetservice provision.The provision of services occurs on top of the network infrastructure. Historically thenetwork provider was also the provider of services. However, unbundling the servicefrom the network is feasible and has been the path of most deregulation processes.A service provider who does not own the network offers the service by either leasingpart of the network from the network provider and enhancing this with one or moreservice components, or interconnecting their own network to others in order toprovide the service. The service component is added for essentially two reasons – a)because the network provider does not offer the service (by regulation or choice), orb) the network provider is seen to be inefficient at that service and the serviceprovider is able to offer it at lower cost or better quality.In terms of efficiency arguments, a number of possibilities emerge. It could be that anetwork provider is using dated or inefficient technology at points in the networkwhich a service provider may choose to replicate and then lease or interconnect toother parts of the network to compete. This may be as simple as the credit and billingcomponent, or internet access via the local telephone network but using a nationaldata network. Alternatively, the large network provider may not be able to adequatelyprice discriminate amongst all niches in the market and a service provider may leaseexcess capacity in the network for the purpose of niche resale. This is often the casewith international or national telephony services providers. The internet providesanother example of niche servicing – an important component of what customersseek in service providers is member services such as home page news, links andcommunity information. These can be tailored to niche markets while the cost can bekept the same by leasing lines.The additional components that service providers bring to the network are:• Service-specific infrastructure – this includes additions to the networkinfrastructure required to technically provide a particular advanced service. Forexample, in Internet services these would include a national points of presence(PoPs) network linking to the long-distance data network (Internet backbone),9

Competition and Regulation in Telecommunicationslinking to a server farm that would include a router, authentication server, firewall,mail hosts, proxy servers and local content servers.• Some form of customer management systems – this would include customerinformation, billing and customer support (call centre)• Content – some advanced services may have content that will be received by thecustomer (e.g. Internet, video-on-demand)A local example of separation of network and service provider is the cellular industryin South Africa. The network providers do not retail to the public but insteadwholesale network access to a group of approved service providers. These providersin turn offer retail outlets to access customers, they stock and sell the phones, do thecredit checks, link the customer to the network and perform all billing and debtcollection.Horizontal market divisions in the service component can be taken from the divisionsin the network markets and include:• Local vs long distance vs international – standard voice products• Business vs residential – the business market has greater capacity usage andconcentration changing the cost and product package provided.• Data vs. voice vs. video – separation of voice products from Internet and otherVANS from broadcast type products.• Fixed vs mobile – this would apply across all of the other divisions e.g. mobileInternet may be separated from fixed line by the more limited range ofapplications it supports (for now).A key question when examining the horizontal market divisions is product bundlingand technological change. In terms of product bundling, most voice services offer themore advanced features as part of the service. Are these additional products or arethey part of a basic voice service as most companies provide them? In terms oftechnological change, it needs to be recognised that product boundaries willcontinually change and so need to be reassessed periodically.1.1.3 Features of NetworksThe pricing and competitive behaviour amongst network providers is influenced by anumber of factors peculiar to network industries. First, the value of a network isrelated to the number of customers connected to that network. Therefore, it is in theinterests of all competitors to interconnect with each other to gain access to as broada customer base as possible in order to enhance the value of their respectivenetworks. The ability to interconnect also means that firms can compete with othernetwork providers on one part of their network without having to duplicate the entirenetwork – for instance, firms may compete on long distance telephony by buildingtheir own long distance infrastructure and interconnecting to a local network to reachthe final customers. For service providers interconnection is key. Although theregulation stipulates that interconnection must occur, it is the terms of thisinterconnection that determine the pricing and competitiveness of alternativeinfrastructures.10

Competition and Regulation in Telecommunications1.2 Forms of international tradeAccording to the WTO negotiating rules, trade in telecommunications services canoccur through four possible modes of supply – cross-border supply, consumptionabroad, commercial presence and the presence of natural persons. These will bediscussed in the context of network infrastructure and services.1.2.1 Provision of network infrastructureUntil recently, the most common form of trade between countries has been throughcross-border supply of international network services. Trade occurs through theinterconnection of networks in order to complete or route an international call.Included in this trade is the third-party routing of calls (e.g. Zimbabwe may routeinternational calls via South Africa). Imports are considered to be outgoing calls thatthe network provider in the other country charges to be completed. Incoming calls orones third-party routed by a country’s network are considered exports. Cross-bordersupply is dominated by, but not limited to, interconnection charges for data, voice orvideo. The extent to which trade offers competition depends on whether theinfrastructure of another country is able to service the South African market. This islikely with international services as satellites have broad footprints over wholeregions and fibre optic networks often loop past many countries. It is possible forsatellite communications to bypass all domestic infrastructure by passing signaldistribution through a earth gateway station located in another country.With the growing liberalisation of communications services internationally, anincreasingly important form of trade has become commercial presence. In order toprovide communications services to consumers in a country beyond completing theirinternational calls to another country, network and service providers need to have aphysical presence in that country. All networks, with the exclusion of satellite, requireinvestments in terrestrial transmission equipment and either physical lines or radiofrequency. Even for satellite communication one still requires an earth station to linkto the satellite, and authority for use of radio spectrum.Due to the growing importance of commercial presence as a means of service trade,the presence of natural persons also becomes important on the level of intracorporatetransferees only. The high demands for human capital in production meanthat companies entering a market may require to bring in their own technicalexpertise in order to build and maintain their network or service. However, there areno trade demands beyond inter-corporate transferees.1.2.2 Provision of servicesThe interconnection of networks globally means that many data and video servicescan be provided from another country in a cross-border fashion. It is common to findemail, e-commerce and web-hosting services for South Africans being supplied fromservers in the USA. There is no doubt that domestic e-tailers compete with foreignones.In terms of voice products, there is competition between service providers to routeinternational calls through their networks. In particular, calling cards and call-backservices are a means to capture consumption abroad. When a traveller makes use ofa national calling card when making an international call, the call is routed throughthe network back home and in this way provides revenue and ‘imports’. Many11

Competition and Regulation in Telecommunicationscallback services have sprung up in countries like the USA whereby a customer fromSouth Africa places a call ‘as if’ they were in the USA through the callback operatorcalling them and connecting them to the number they wanted to call. Finally, inmobile telephony one can arrange international roaming agreements for mobilephone users to capture their consumption. Any calls that they make abroad will berouted back through the domestic network, allowing the domestic mobile networkprovider to capture some of the charges on that call.However, for basic voice products in the local access market, the competition mustcome from domestically situated firms. As such, provisions around foreign ownershiplimits will serve to restrict competition.1.3 Role in the economyCommunications services play a key role in any economy – from being an importantintermediate input to business, an enabling medium for a range of content providers,a significant item in household expenditure, and finally a source of demand fornumerous manufacturing and service industries. What follows is a discussion of therole in the broader economy of communications services as a package of bothnetwork and service providers. This component is severely limited by the statisticaldata. This is particularly problematic in a dynamic industry as dated statistics tend tobe widely off the mark. With telecommunications statistics, it is likely that datedstatistics will underestimate the role of the sector in the economy.1.3.1 Role as Intermediate InputThe role of communications as an intermediate to business can be seen to have 2dimensions – a) as a cost item required to operate a business, b) as a strategic andcompetitive tool.As a cost item, communications does not appear that significant for most parts of theSouth African economy judging from the statistics in table 1.3 below. It representsonly 0.1% of total costs in agriculture and mining, 0.4% in manufacturing industriesand 4.4% in service industries. However, these figures definitely underestimate thecost importance of communications for two important reasons. First, the data networkcosts are accounted for under the section titled business services, along with otherbusiness service items. Second, the latest input-output data available for SouthAfrica is 1997, which was based on the 1993 table which was based on the 1988table. In each case, a new input-output table is created by adjusting the old one withnew national accounts data.As a strategic competitive tool, communications are becoming more and more vital tobusinesses globally. Increased globalisation has resulted in the requirement tocommunicate and transmit vast amounts of data to suppliers, industry customers andaffiliates internationally on a timely basis. The rise of electronic commerce, has nowestablished a need in many industries to use communications networks to deal withthe final demand of the household consumer too. In both cases, the need is for highspeed, high quality communications services that are geared to the specific needs ofthe firm and which are available at a cost that does not make it prohibitive tocommunicate or put them at a competitive disadvantage to firms in other countries.What matters most for an economy is the availability of world-class communicationservices at a reasonably competitive price, even if they are not the cheapest.12

Competition and Regulation in TelecommunicationsTable 1.3: Direct forward linkages - Telecommnuications share of intermediate input costs forsectors of the economy (1997) – percentage of total intermediate input costsSector% of intermediatecostsPrimary 0.2Manufacturing 0.4Natural resourceintensive0.3Labour intensive 0.5Scale intensive 0.3Knowledge intensive 0.6Other 0.7Services 4.4Producer services 7.2Consumer services 3.4Infrastructural services 0.7Community/socialservices11.8Source: Wefa SAM (1997)1.3.2 Demand for Intermediate InputsGrowth of the communications industry has some important trickle-down effects forcertain parts of the economy and results in output and employment creation in thesesectors. There are two sources of such demand – investment demand and ongoingoperations demand.Investment demand includes capital goods required by the industry to increase itssize of operations. Table 1.4 shows the capital structure of the fixed line providerTelkom and an Internet service provider M-Web. For the network provider, it is clearthat high tech capital goods (telecoms network equipment and data processingequipment) dominate the inputs (82%) resulting in few trickle-down effects for mostdeveloping countries that don’t have these industries. The service provider has asimilar structure of assets with most in network, computing and software equipment.Table 1.4: Structure of capital requirements for a fixed line network provider and an Internetservice provider (2000)Item Network Provider Internet Provider(M—Web)Telecoms network equipment 72.5 48.2Data processing equipment 9.5 16.4Software and licences - 25.8Other equipment, vehicles, furniture 5.9 9.6Land & buildings 5.5 -Working Capital 6.6 -Total 100.0 100.0Source: Telkom Annual Report 2000, M-Web Annual Report 2000However, there are larger multipliers for ongoing operations. Table 1.5 belowpresents the first-round direct and indirect output multiplier effects of a R1 increase innetwork provision 1 . The multiplier effects are negligible for the primary sectors but1 Data limitations prevent putting together a multiplier analysis for service providers.13

Competition and Regulation in Telecommunicationssignificant for the manufacturing sectors - metal products and equipment(transmission and receiving devices); chemicals, rubber and plastic products (plasticcasings for equipment); paper and printing (marketing and office materials). Thelargest gains are in other service industries, in particular, other communication orbusiness service providers, distribution, transport and utilities. A second round ofoutput and employment creation can be expected stemming from additions to wageand capital income created by the first-round effects.These figures are not high compared to agriculture or manufacturing. Part of thereason for this is a low participation of SA industry in communications equipment,with much derived demand going to imports from other countries. This may changewith time and raise the average multiplier effect.Table 1.5: Direct backward linkages – intermediate inputs into the communications industry(1997) – percentage of total intermediate input costsSector% of intermediateinput costsPrimary products 0.0Manufacturing 20.0Natural resource intensive 0.6Labour intensive 2.6Scale intensive 4.5Knowledge intensive 12.1Other 0.2Services 80.0Producer services 44.3Consumer services 20.2Infrastructural services 13.9Community/socialservicesTotal intermediates/Totalinput costs1.622.9Source: Wefa SAM (1997)1.3.3 Medium for Content ProvidersWhat the analysis of communication services as an intermediate input or as a sourceof derived demand fails to convey, is that entire industries are based around theexistence of communications services and would not exist otherwise - these are thecontent providers. Too often we view the communication services as a demandderived from growth in other industries or in household income. What we fail toappreciate is that innovation, cost reduction, quality improvement and independentexpansion of communication services enable the growth and expansion of a largecontent industry that is transmitted over the communications infrastructure. Thisprocess is one where the communications industry itself creates demand throughinnovation and investment. The links to these content industries cannot be portrayedusefully by an input-output table.The content providers could most easily be classified according to voice, data andimage/video content. Voice would include those companies producing content forradio broadcast - from music to programming. Video/image would be those producing14

Competition and Regulation in Telecommunicationsfor television or education broadcast - from advertising to dramas. Finally, datacontent would be associated with those firms providing content for the Internet orprivate data networks - from online news corporations to electronic commerce. In allthese industries, expansion of the network and lowering the costs of transmissionexpand the number of people connected to the network and therefore expand themarket for content. Enhancing the speed and quality of the networks open up theopportunities for new content products to be introduced which also expands themarket for content. An important question remains - how big are the multiplier effectson content providers stemming from improvements to the network and its expansion.1.3.4 Household Expenditure ItemFinally, communications enter the household consumption function. Communicationsdoes not represent one of the main items that households spend their income on, butat 2.4% of household income, it is still a significant item. In fact, as figure 1.2 shows,households on average spend more on communications than on investments/savings, education, house operations, pensions and fuel/power. The size ofexpenditure is also sufficiently large that price movements in the sector will influenceboth the welfare of consumers and the price level – the consumer price index. In fact,the 1995 survey probably underestimates the expenditure item as it would excludethe rise in cellular telephony and the Internet (both significant expenditure items).Figure 1.2: Household expenditure patterns (1995)15

Competition and Regulation in Telecommunicationsfoodhousingincome taxtransportcloth/footfurniture/equiphealthinsuranceread/recr/holsdrink/cigspersonal carecommunicationsinvest/savingseducationhouse operationpensionsdomestic workersfuel/powerother0.64.143.33.32.72.52.42.121.81.61.63.8510.214.716.118.20 2 4 6 8 10 12 14 16 18 20Percentage of ExpenditureSource: Statistics South Africa, Income and Expenditure Survey, 199516

Competition and Regulation in Telecommunications2. International Reform of Telecommunications Regulation2.1 The Rationale for RegulationRegulation is the intervention of a government body in a market, through the use ofprice, access or product controls. Price controls occur in telecommunications, whereTelkom has to get its tariffs approved by the South African regulator, ICASA. Thesame goes for access controls, as ICASA has the right to issue licenses for thedifferent types of telecomm markets, as it has in Telkom for the fixed line market andMTN and Vodacom for the mobile phone market.There are two basic types of theories about regulation we can differentiate: normativetheories outlining the response to market failures and positive theories describing thedynamics between policy makers and recipients of regulation.2.1.1 Normative Theory of RegulationThe normative theory postulates that regulation ought to be introduced when there ismarket failure. How market failure is identified and how it arises are the questionsthat remain to be answered.As to the identification of market failure, we identify four types of efficiency that haveto be fulfilled to guarantee an efficient outcome:• Allocative efficiency: occurs when goods are priced at marginal cost, hencesold at the true economic cost to the producer, without any rents that mayhave been derived from the market structure.• Cost efficiency: when a firm or industry produces at the lowest possible costlevel. In some industries, it may be possible that many competitors lead toallocative efficiency, but that the lack of scale effects means production is notcost efficient.• Dynamic efficiency: when cost savings are implemented efficiently and thereis no delay in the development and introduction of new products.• Distributional efficiency: finding the socially desired trade-off between themaximisation of surplus and the distribution thereof.Having identified the different types of efficiency, the ways in which market failurearises have to be identified. Here, we identify three basic types:• Externalities: any transaction has a cost and a benefit to it. These costs andbenefits may well differ for the individual and the society. A car driver, forexample, will not take into account her effects on pollution when planning atrip. When the social costs exceed the private costs, or the private benefitsexceed the social benefits, the level of activity is too high. When socialbenefits exceed private benefits, allocation will be lower than desired. Anexample for the first would be car usage, an example for the secondinvestment by firms who do not take into account the beneficial spill-overs forother companies. Taxes, in the case of over allocation, and subsidies in thecase of under allocation may be used to rectify the situation.17

Competition and Regulation in Telecommunications• Natural Monopoly: occurs when it is more expensive to have severalcompanies providing the same product than it is to only have one. Publicutilities, such as water and electricity and most other network industries areclassic examples of natural monopoly. Single product monopolists will derivetheir advantage from economies of scale, whereas multi-product naturalmonopolies may also derive their advantages from economies of scope 2 .• Large specific investments and hold-up problems: when private activity investslarge amounts in assets that may only be used for one purpose, there is apotential for the extraction of rents from a contract partner. If a pipelinecompany invests in a pipeline from an oil field to a refinery, this asset is onlygood for transportation between these two points. Once it is built, theinvestment is sunk. The oil field operators might be able to extract the sunkcost from the pipeline builders should they have other possibilities for thetransportation of their oil. Private contracting may be costly in this case andregulation the preferred tool.Regulation must hence be used in sectors where competition is not sustainable dueto one of the three reasons mentioned above. The success of regulation is to bemeasured by the efficiency criteria outlined.2.1.2 Positive Theories for RegulationRegulation does not only exist to correct market failures. This is apparent from thefact that regulation continues to exist in sectors with no natural monopoly features.Regulation also exists because it is a powerful means to redistribute wealth insociety. Regulation can be used to tax one group of consumers and redistribute toanother without imposing a more transparent tax-subsidy approach (Posner 1971).Classic examples in telecommunications are cross subsidisation from long distanceto local calls, from urban areas to rural areas and from business users to domesticusers.An alternative to government using regulation for social welfare-improvingredistribution, is for specific interest groups to capture the regulatory process throughlobbying government. Stigler (1971) observed that companies demand regulation inan attempt to earn abnormal profits at the expense of consumers. Politicians areprone to interest group pressure since single voters are unable to monitor and coercethe policy maker. The successful pressure group in the regulatory game need not becompanies only, but whoever it is they should have low costs of organisation andhigh potential payoffs relative to the competing interest groups. A good example forthis is the success of EU farmers in extracting rents from the rest of the population,whereas consumers with a lower per-head payoff and a much larger membershipfind it difficult to extract benefits from policy makers.The same forces that drive politicians to regulate sectors, may also drive them toderegulate. If interest groups that are being adversely affected by regulation organisemore effectively (or if the cost of the regulation to them increases enough to makethem organise) then they may be able to reduce the level of regulation. Intelecommunications, the advent of the Internet has meant that an inefficient2 When the cost of producing two products together is less than producing them separately18

Competition and Regulation in Telecommunicationsmonopoly has had greater costs to a group of industry users who have becomeharsh critics of the continued monopoly.2.2 Different Types of RegulationHaving identified the different types of factors that create the need for regulation, andthe criteria to judge the success of regulation, the question arises about the ways inwhich regulation is administered. Here we differentiate between theories forsituations when the regulator has perfect information and theories when the firm hasmore information than the regulator.2.2.1 Regulation under Perfect Information• Marginal Cost (MC) pricing: is possible under the case of a weak naturalmonopoly, i.e. one where the average cost is upward sloping over some of thedomain. In this case, MC pricing is possibly efficient• Ramsey Pricing: under strong natural monopoly (i.e. the average cost curve isdownward sloping over the whole domain reflecting high fixed costs and lowmarginal costs), MC pricing will lead to a loss and be unsustainable. Amechanism has to be found by which the distortion is minimised, given cost isbeing covered.o Single Product Ramsey Pricing: set price equal to average cost, hencecovering cost at the minimum possible distortiono Multi-Product Ramsey Pricing: when elasticities of demand differ indifferent markets, setting the same price-cost markup for both marketsis not optimal, since the dead weight loss (DWL) is proportionate to theelasticity of demand. Hence the price-cost mark-up ought to beinversely proportionate to the price elasticity of demand – i.e. theproduct which whose demand is more sensitive to price changes willhave a lower price-cost markup. In telecommunications, it is oftenassumed that access is inelastic and usage is elastic. If this is the case,then access charges should be high enough to cover most of the fixedcosts and usage charges extremely low.Clearly, the implementation problems associated with MC and Ramsey pricing arethose of asymmetric information. The regulator will have less than completeinformation about the cost structure of the regulated firm, making the implementationdifficult. Lastly there may be distributional concerns, as those goods that are inelasticwill have the highest mark-up, but these also tend to be necessities (like basicaccess to a telephone).2.2.2 Regulation under Asymmetric InformationIn reality, MC and Ramsey pricing will suffer from information asymmetries betweenregulators and the firms. Under these circumstances the regulator needs to designregulation that overcomes the information asymmetries to provide effectiveregulation. Two types of regulation have been implemented in practice. These are:• Rate of Return regulation: this is based on the Ramsey idea of having pricesset so that the firm covers its cost and achieves a “fair” return on capital.Hearings are used to determine prices after a test year. The problem with this19

Competition and Regulation in Telecommunicationssystem is that the firm has no incentive to continually reduce cost. Inflated costis created through the attraction of capital rather than efficiency, an incentiveto inflate costs before a rate hearing and the need for very detailed regulation.• Incentive regulation: has been created to deal with the inefficiencies inherentin rate of return regulation. There are two basic types of incentive regulation:o Price-cap regulation: imposition of a price ceiling on a basket of goods,adjustment of the ceiling with the formula CPI-X, where CPI is theconsumer price index and X is the average increase in efficiencyexpected. The potential problem with this mechanism is the uncertaintyabout the true level of cost and hence the crudeness of the mechanism.Errors in the index may lead to windfall gains for the firms or heavylosses. Furthermore the incentive to minimise cost can lead todecreased product quality and to the elimination of goods which do notshow potential for efficiency increases.o Earnings Sharing: whilst price cap regulation achieves cost efficiency,earnings sharing attempts to strike a balance between cost andallocative efficiency. There is a sharing in the risk and rewards from anydeviation in the rate of return between consumers and producers. Theadjusted rate of return is determined by a sharing of the deviation fromthe target rate of return ( ra = rt + h( r* − rt), where 0

Competition and Regulation in TelecommunicationsThe results are robust in the way that different model specifications regarding inputand output prices, as well as using slightly different data sets do not change the basicresults that incentive regulation does have beneficial effects on efficiency.A further result from the modelling is that those regulated companies with the highestexpenditures on research and development benefited most from the change to IR, aresult that is consistent with intuition.Bergman et al (1998) note that more and more European countries have started touse price cap regulation, initiated by the United Kingdom, which introduced themeasure in 1988 due to a report by Stephen Littlechild, pointing out the productiveand dynamic inefficiencies inherent in ROR. Among other states, France, Germanyand Sweden also introduced PCR in the early 1990s.Despite the positive effects on productive efficiency of PCR, there has been criticismof the system relating to strategic behaviour and allocative efficiency. The strategicbehaviour component relates to the timing of rate reviews. To maximise the costreduction incentives for the firms, the regulator has to increase the time betweenhearings, such as to allow some appropriation of the gains made by savings. This,however, increases the scope for the firm to act strategically: before adjustments,cost savings are not fully exploited, so as to signal a lower savings potential to theregulator. Once the new rates have been installed, maximum savings are beingexploited as they can be benefited from for the maximum possible time.As to allocative effects, the problem is that the X-factor is backward looking ratherthan future oriented. The nature of negotiations between the regulator and the firmsdictates that X-factors are based on historical experience rather than future potential.It is the superior knowledge managers have in comparison to regulators that makes itpossible for companies to exploit extra profits.Large segments of the telecomm industry are potentially competitive, though, and itis thus the aim of European policy to liberalise these markets, as effectivecompetition can replace regulation and ensure better market outcomes.2.3.2 Liberalising Network Industries: a Three Stage ProcessThe table below illustrates the state of liberalisation of different public services inEurope as of spring 1998 3 :Table 2.1: State of European Deregulation (1998)Germany France Italy Spain Sweden UKAir transport High Medium High Medium↑ High HighElectricity Medium↑ Low↑ Low↑ Medium↑↑ High↑ Very HighPostalservicesMedium↑↑ Low↑ Very Low↑ High↑ Very High Medium↑Rail Low↑ Low↑ Very Low↑ Very Low↑ High Very HighTelecoms Very High High↑ Medium↑↑ High↑ High↑ Very High3 Ibid. p.8021

Competition and Regulation in TelecommunicationsThis describes the different states that network industries were in at that moment intime. As the system evolves towards a more liberalised system, there are differentdemands on regulation in the different phases. The book differentiates between threephases:1. Monopoly2. Monopoly and Competition in some Markets3. CompetitionFigure 2.2: Path of Regulatory IntensityPhase 1 Phase 2 Phase 3RegulatoryIntensityPhase 1The problems associated with an industry in phase 1 of liberalisation are best dealtwith through the measures outlined in the previous sections: close regulation of themonopolist to ensure productive and allocative efficiency. Ramsey pricing would bethe preferred measure under perfect information, but is not possible due to theimpossibility to access accurate data for effective regulation. ROR has the problemsassociated with over investment in capital expenditure to increase the absolute levelof profits allowed and the lack of incentives for cost reduction. Regulatory lag could,however, provide limited incentives for cost reduction, as the rate of return would behigher for the period between rate reviews. PCR, on the other hand leads to efficientproduction, but lacks on the allocative side due to information asymmetries about thetrue efficiency potential of the firm.Phase 2TimeHere, there is introduction of competition in some parts of the operations. It ispossible that effective competition will never be possible in all parts of the operations,as duplication of some network components may not be viable in all fields. Intelecommunications, for example, fibre-optic backbones are existent on differentnetworks in some countries, but there hardly ever is any duplication of “the last mile”,i.e. the connection from the user’s premises to the local exchange. The viability forduplication of these parts is not given.In the second phase of liberalisation, there are three strands of activities that have tobe pursued: firstly the separation of the regulator from the monopolist, secondly theregulation of incumbent pricing and thirdly the regulation of interconnection.As to the independence of the regulator, it has to be ensured that there is no captureof the regulator for any of the parties involved in the market. This is important to instil22

Competition and Regulation in Telecommunicationsconfidence in any companies wishing to enter the market, providing them with thecertainty that they will have a level playing field.On the front of price regulation, the monopolist has the possibility to use rents frommonopoly markets to subsidise activities in the competitive markets and thus gain anunfair advantage. The importance therefore lies in analysing the level and structureof prices set by the monopolist.Network industries have a large part of their cost in fixed components, making theallocation of costs to services very difficult and arbitrary. Considerable effort thus hasto be expended towards the analysis of the cost structure and to the development ofa “fair” level of prices to be set by the incumbent in the competitive market.Deviations in both directions are potentially damaging: setting prices too low willdiscourage entry by firms even it they were more efficient than the incumbent. Shouldprices be set too high, then entrants will be able to enter even if they are less efficientthan the incumbent. Furthermore, it will jeopardise the profitability of the companyand thus the cross subsidies to unprofitable market segments necessary for universalservice obligations.Even in the most competitive telecomm markets, such as Germany 4 , not all aspectsof the network have been subjected to competition, such as the last mile. There isstrong controversy about the correct level of interconnection pricing between thenetwork components of Deutsche Telekom and its competitors. Once again, theincentives of the incumbent and competitors are opposed. If interconnection pricesare set too high, the monopolist will receive an overly high amount for theinterconnection services and thus deter entry by efficient companies. Should theprices be set too low, however, this will also attract inefficient entry. Furthermore, itwill discourage investment by the incumbent into new technologies, as entrantsconsequently do not carry a “fair” share of costs and risks of the investments andbenefit disproportionately from the incumbent’s investments.When interconnecting networks, there are different possibilities to design accessprices:• Efficient Component Pricing Rule (ECPR): this mechanism warrants entry aslong as the entrant is at least as efficient as the incumbent. It is assumed thatretail prices are fixed, i.e. that allowing the entrant access does not have aneffect on the incumbent’s price. The cost structure is defined by the averageincremental cost of access, b, the average incremental cost of providing thecompetitive part of the service, c, and the retail price of the service, p. Theoptimal access price is thus defined as: a = b + [ p - (b + c)]. In the context of along-distance telephone context, b would be the cost of connecting thecustomer from her home to the local exchange and c the cost of routing thecall on backbone infrastructure. The problem associated with the ECPR is thefact that allocative effects are being ignored, due to the assumptions of ahomogenous fixed product, a fixed coefficient of technology and the inability ofcompetitors to bypass the incumbent.• Ramsey access pricing: in the spirit of optimal pricing for society, Ramseyaccess pricing also takes some allocative effects into account. The formula forthe calculation of the access price changes to: a = b + σ(p – (b + c)). σ is what4 Purton (2000), SURVEY - FT TELECOMMS: Former monopoly loses significant market share23

Competition and Regulation in Telecommunicationsis called the displacement ratio, namely “the change in incumbent’s retailprices as access prices vary” divided by “the change in the incumbent’s salesof access services to its rival as the access charge varies”. When the threeassumptions quoted above hold, then σ=1, otherwise σ

Competition and Regulation in TelecommunicationsIn the three phases of liberalisation, there are different challenges for the regulator. Inphase 1, classical regulation challenges are to be dealt with, i.e. achievingproductive, allocative and dynamic efficiency. Once competition is introduced inphase 2, the regulator has to deal more with the behaviour of incumbents andentrants toward each other and the abuse of market power by incumbents, and theprovision of “fair” access prices for entrants to non-competitive parts of the network.In phase 3, regulation becomes more light-handed and revolves around the fairdistribution of universal access obligations and the adherence to fair tradingpractises, since competition takes care of the other aspects of regulating price andentry.2.4 Convergence in TelecommunicationsOver the past decade, telecommunication has been subjected to a technologicalrevolution, decreasing natural monopoly characteristics of the industry and creatingnew markets in mobile telephony, the use of the Internet and wireless local looptechnologies.Whereas in the past, the market to be regulated was clearly defined and regulation ofplayers revolved more around technical regulation, today the market boundarieshave become blurred. Competition has the potential to decrease the need forregulation in some of the more competitive markets, but has increased the potentialfor asymmetric regulation. Whereas in the past the emphasis was laid on efficiencyand principal-agent problems of inducing the correct behaviour in regulated utilities,nowadays the problems lie more in the area of dominance of incumbents, a lack ofmarket boundaries, the pace of technological change influencing cost and uncertaintyabout future technologies.In the past, the more concentrated regulation of single sectors was by nature definingthe rules of play and creating competitive environments. In the present context,however, competition agencies have gained greater importance, observing themarkets and acting ex-post only if there is evidence of anti-competitive behaviour.An example of classic sectoral regulation is that of OFTEL, the UK office fortelecommunications regulation. In Malaysia, on the other hand, regulation of theentire broadcasting industry has been attributed a single agency, dealing with alltelecommunications and broadcast issues.25

Competition and Regulation in Telecommunications3. Current Regulatory FrameworkThe most crucial factor influencing the structure and performance of themarket is the regulatory regime. This section examines the regulation of thetelecommunications market in South Africa as a basis for the discussion ofstructure and conduct in the next section.3.1 Background and Objectives of Current RegulationThe momentum towards restructuring the telecommunications market inSouth Africa came in the late 1980s when the previous governmentinvestigated the option of having the public telecommunications managed asa commercial enterprise. The momentum came from both observation ofchanges internationally and the fact that inefficiencies in the delivery ofcommunications services locally resulted in poor returns to capital and risingdebt – hindering its ability to serve the needs of a growing modern economy.After Telkom was incorporated in 1990, a study by Coopers & Lybrand wasinitiated to examine the policy options for restructuring the industry tomaximise the economic and social benefit, including improving telephonepenetration, affordability and service levels. The recommendations of thereport, released in 1992, included most of the elements of the eventualregulatory regime enacted in the Telecommunications Act of 1996. Theseincluded an exclusivity period for Telkom, resale of capacity for voice trafficprevented for 3-5 years, stringent licence conditions for Telkom during thisperiod of exclusivity, and the establishment of an independent regulator. Italso included a call for some immediate steps to be taken – including theissuing of two mobile communications licences and the opening up of theVANS and customer equipment markets.The government acted on the mobile licences (issued June 1994) and theopening of the VANS and customer equipment markets (1993). However, themajor revamp of the regulatory regime would have to wait for a change ingovernment and a process of broad consultation through a Green/WhitePaper process. The White Paper was only released in March 1996 and theensuing legislation enacted in November 1996. This meant that although afive-year monopoly period was recommended for Telkom back in 1992, thatmonopoly period only began to take effect in 1997.The Green/White Paper process did, however, contribute to the finalregulatory outcome because it included a number of objectives other thanincreasing competition, efficiency, innovation and profitability in the industry.In particular it called for the following social goals to be part of the objectivesof a telecommunications policy:• promote the universal and affordable provision of telecommunicationservices;• ensure that, in relation to the provision of telecommunication services, theneeds of the local communities and areas are duly taken into account;• encourage ownership and control of telecommunication services bypersons from historically disadvantaged groups;26

Competition and Regulation in Telecommunications• encourage the development of human resources in thetelecommunications industry;• promote small, medium and micro-enterprises within thetelecommunications industry;These are the public interest considerations that permit the deviation ofregulation from full promotion of competition. The most important economicgoals expressed in the objectives were:• promote the provision of a wide range of telecommunication services inthe interest of the economic growth and development of the Republic;• encourage investment and innovation in the telecommunications industry;• encourage the development of a competitive and effectivetelecommunications manufacturing and supply sector;• ensure fair competition within the telecommunications industry;• ensure efficient use of the radio frequency spectrum;3.2 Independent Regulatory Body – SATRA to ICASAAn important component of the new telecommunications regulation was theestablishment of an independent regulatory body, a function that used toreside with the Department of Communications and Telkom. The new body,the South African Telecommunications Regulatory Authority (SATRA),consisted of 3 to 5 councillors and one chairperson, all Presidentialappointments based on the recommendations from a parliamentarycommittee. The act specifically excludes people who may have conflictinginterests such as a financial interest in the industry itself, and demands thatthe committee be representative of the population and with sufficient expertiseamongst them. The councillors are appointed for 4 years and the chairperson5 years. The council can appoint a sizeable staff and occasional consultantsto assist it in performing its function. In 2000 SATRA was merged with the IBA(Independent Broadcasting Authority) to form ICASA (IndependentCommunications Authority of South Africa). The rationale behind the movewas the increasing convergence of broadcasting, telecommunications andcomputing.The source of funding is an important determinant of the independence of theregulator. The intent of the regulation was that in the long run SATRA/ICASAwould be wholly financed through various licence and tender fees from theindustry itself. This would give the Authority an important financialindependence from the Department of Communications (DoC). However,currently the Authority requires supplementary financing through the budget ofDoC subject to the usual approval of parliament. The telecommunicationsindustry has perceived the tying of SATRA/ICASA funding to DoC as animportant loss of independence as its actions may be subject to politicalinterference. ICASA acknowledges that it is under-resourced and so unable toregulate the sector properly (Business Report January 2001). This isproblematic enough while they are managing the Telkom monopoly position,but is very worrying for the future when regulation becomes more complex(phasing in competition and regulating access and retail prices more closely).27

Competition and Regulation in TelecommunicationsThe purpose of SATRA/ICASA is to regulate the industry in terms of theTelecommunications Act (1996) and pursue any new policy directions that areissued by the Minister of Communications as long as they are consistent withthe broad objectives expressed above and if prior consultation has takenplace. Many aspects of the Telecommunications Act provided only limitedguidance and regulatory principles and so much of the initial work ofSATRA/ICASA was to put some concrete guidelines together for the purposeof regulation. The regulatory aspects left to the discretion of the regulatorincluded interconnection, facilities leasing, GPMCS (global personal mobilecommunications services) and licence conditions.Despite this show of independence, the Act permits the Minister ofCommunications to amend, withdraw or substitute any decision by theregulator. This provision has already been used by DoC to withdraw SATRA’sguidelines on interconnection and facilities leasing. Further, the implication ofthe Minister setting policy means that the shape of deregulation is left to theMinister. Although the White Paper provides guidelines for deregulation, it issubject to review by the Minister who also is entrusted with setting the datesfor which segments of the market are opened for competition, and the numberof new entrants. The regulator role is merely to call for tenders for licencesand issue licences according to fair and transparent criteria.SATRA/ICASA has lost credibility in the industry as both independent andeffective through failure in a number of crucial regulatory episodes. The firstincident occurred shortly after the passage of the Act, when Telkom claimedthat the Internet was a basic service and therefore fell under its exclusivityagreement. Although SATRA eventually ruled that this was not the case,Telkom took the challenge to the courts ensuring that the matter dragged onanother 6 months.The second major incident was the as yet unsuccessful issuing of a thirdcellular licence through a ‘beauty contest’ process. SATRA made arecommendation for Cell C to be awarded the licence, going against theexternal consultant’s recommendations. One of the losing bidders, Nextcom,challenged the outcome and has succeeded in delaying the process in thecourts for over a year. In the process, it has been alleged that there waspolitical interference in the licensing process, eroding the credibility of SATRAas an independent body.Finally, Telkom accused VANS operators of illegally providing telephony totheir clients in contravention of the Act. The action it took was to deny furthercapacity to them and in some cases withhold services. SATRA ruled againstthe unilateral action by Telkom but was duly ignored by the operator. Theissue has been partly resolved after AT&T threatened to take the issue to theWTO where South Africa has committed to an opening of the VANS sectorand to a telecommunications reference paper that upholds action against anticompetitivepractice by industry players.28

Competition and Regulation in Telecommunications3.3 Fixed line Networks3.3.1 Local AccessThe attainment of social objectives played an important role in deciding howto regulate the fixed line market. It was felt that rapid infrastructure rollout topreviously under-serviced areas was critical to the promotion of universalservice and economic empowerment. As these areas are generally either lowincomeor rural, the feeling was that immediate competition in fixed lineservices would not serve the objectives best. The reasoning was:• new entrants would target the more lucrative and easily establishedbusiness and long-distance markets first and not seek to rollout in theseunder-serviced areas,• competition in these markets would squeeze the profitability of Telkom andso limit its own ability to rollout in these unprofitable areas, and• the option of contributions to a universal service fund was not desirableuntil basic exchange infrastructure was in place in some areas to whichlow income households could be more cheaply connected.This coincided with the need to restructure Telkom itself to face competition –such as improving efficiency and rebalancing its tariffs to remove crosssubsidisation.It is also felt that the granting of an exclusivity period helped toraise the market value of Telkom allowing for a better price on the equity sale.For these reasons, the Telecommunications Act gave Telkom a regulatedmonopoly for five years, extendable to six, in the local access market. Toensure that the exclusivity period fulfilled the goals of infrastructure rollout andpreparing Telkom for competition, strict licence conditions were placed on thenetwork provider. The licence conditions included rolling out 2.81 million newlines over the exclusivity period, of which 2/3rds will be in under-servicedareas and for priority customers. It is estimated that this will require capitalinvestment in the region of R53 billion. The specific rollout targets arepresented in table 3.1 below. The only part of local access network that is notcovered by the exclusivity agreement is customer premises equipment (CPE),which was opened to full competition immediately on passing the Act.Telkom wins an extra year of exclusivity if by the end of the fourth year it hasachieved a roll-out of 90% of its cumulative five-year total line target and 80%of its five-year under-serviced line target. This will be granted if Telkomaccepts a new five-year total of three million new lines and a proportionateincrease in its under-serviced line target. There are financial penalties forfailing to reach these targets. Telkom pays penalties of R450 per line for thefirst 100,000 and R900 per line for each extra line missed. If it misses PriorityCustomer targets the penalty per unit is R4,500, schools R900, publicpayphones R2,250 and villages R1,125.29

Competition and Regulation in TelecommunicationsTable 3.1: Rollout Targets for Telkom in terms of License1997/8 1998/92001 2002 Total1999/2000Total new access lines 340000 435000 575000 675000 665000 2690000bought into serviceNo. in under-serviced 265000 318000 359000 357000 378000 1677000areasNo. for priority 3240 3845 4055 5060 4046 20246customersNo. of villages served 510 610 610 800 644 3174No. of payphones 20000 25000 25000 25000 25000 120000No. of replacement lines 20000 13000 65000 551000 603000 1252000Source: JEDPIn addition to these rollout targets, Telkom is committed to upgrading thenetwork and its service record. This involves upgrading the entire network todigital by 2000, lowering the waiting period for installation, lowering thenumber of faults per 100 lines and reducing the time to fix faults. The licencealso allows for restrictions on price increases introduced by Telkom to ensurethat its monopoly position is not abused during the exclusivity period. Theseare set for a bundle of services (including local, long-distance andinternational) and are restricted to the CPI -1.5% for the first three years, afterwhich SATRA will set price caps.The White Paper on telecommunications suggested that once exclusivity hasended, then initially the local loop should be open to entry with operatorsconnecting to the PSTN of Telkom (see figure 3.1). The thinking was thatentry was unlikely anyway but co-operative organisations or SMMEs might bewilling to connect specific communities and so be encouraged. After a furtheryear, it was envisaged that a full switching network could be licenced incompetition to Telkom, providing the local exchanges too. The exact shape ofderegulation is currently under review. However, the timing of issuing asecond PSTN licence is bound in the WTO and must be complete before theend of 2003.30

Competition and Regulation in TelecommunicationsFigure 3.1: Proposed path of deregulationEnd ofTelkom’sexclusivity1 2 3 4 5 6Radio (paging, trunking, etcCellular NetworksCPEVANSFullCompetitionNational long distance servicesResaleLicenced carriersLocal LoopBusiness LLTelephony LLInternational servicesSwtiching NetworksRepresents Telkom exclusivitySource: White Paper on Telecommunications3.3.2 Long-distanceLong distance was bundled together with local access in the granting ofexclusivity to Telkom until a review of policy and a subsequent call from theMinister to proceed with licensing. The initial thinking in the White Paper wasto introduce the licenced resale of long distance facilities operated by Telkomby 2000. Two years later it was envisaged that the regulator could licencelong-distance carriers with their own facilities but who connected to theTelkom PSTN. Finally, a full service PSTN would be licenced by 2003.Currently the resale has not materialised and we await the decision on otherlicencing. Any licence holder would be eligible for universal service fundcontributions, human resource contributions and a licence fee of 1% ofturnover. There may be additional conditions attached but these are unlikelyto exceed any that Telkom would have to bear.3.3.3 Value-added Network Services (VANS)Value added network services by definition do not have facilities of their ownbut lease from network providers. The sector has been open since 1993 withlicence holders required to lease Telkom capacity and are prevented from theresale of capacity and of carrying voice traffic, until a date set by the Minister.The White Paper envisaged resale to commence in year 4 of exclusivity(2000) but it has not materialised. The licence conditions also include noundertaking of anti-competitive practices and adhering to practices thatprotect the customer. They are also eligible for a universal service and humanresource fund contributions.31

Competition and Regulation in Telecommunications3.3.4 Private Networks (voice)Eskom and Transnet both have large private networks that could potentiallybe used in competition to Telkom. In fact, it is widely believed that one ofthese two would likely get the second public switched licence in partnershipwith an empowerment group and an international operator. There are evenmoves at this point to combine the two into a single corporate entity. Theyhave the advantage of not only having a large existing network, but alsoextensive transmission networks over which to layout a new communicationsnetwork. There are also numerous other private networks that operate withina corporation on their land and lease capacity from the PSTN. The WhitePaper envisaged that resale of leased capacity could occur in year 4. This hasnot happened.In terms of the Act, a licence is required to operate a private network thatextends beyond the boundaries of land owned by the corporation, except forTransnet or Eskom. No such licences are available until notice from theMinister. In addition, in order to limit the potential competition from Transnetand Eskom at the end of the exclusivity period, or at the point where resale ofcapacity is allowed, the Act states that neither of these two may “install orextend their telecommunication facilities so as to cause unnecessaryduplication of such facilities with the telecommunication facilities of Telkom, orembark on any major installation or extension of their telecommunicationfacilities, without the proposed installation or extension in question havingbeen referred to a liaison committee”. The liaison committee includes Telkomand so they must authorise network expansion. If agreement is not met,SATRA may intervene and make a decision on network expansion.3.4 Mobile communications3.4.1 CellularThe Telecommunications Act recognises the licences of Vodacom and MTNto operate a cellular network. It also requires that within two years SATRAinvestigate the feasibility of issuing more licences. This has occurred and onemore licence was due to be awarded in early 2000 (currently pending).SATRA is required to conduct a further feasibility study for a fourth cellularlicence by July 2001. The Act allows SATRA to establish licence conditionsfor any licence that may help achieve the objectives laid out above. Thusfarthey have included limitations on foreign ownership, requirement to have aBlack empowerment partner, economic development through local purchasingand exports, universal service obligations (beyond USF contributions) andhuman resource development. The scheme developed for the cellularlicences was to attach values to certain development actions for which thenetwork operators were credited. The requirement was for a credit amountand the licence holder could choose the mix of activities that fulfilled thisobligation.In addition, there were some specific service conditions:32

Competition and Regulation in Telecommunications• MTN and Vodacom were required to install 7,500 and 22,000 communityservice telephones respectively to under-serviced areas over a period offive years• Achieve a population coverage of 60% within 2 years and 70% within 4years.• Price increases limited to the CPI or below in any one yearThe conditions for a new licence have similar requirements but have beenrelaxed to attract international investors. In particular, the new entrant will beallowed domestic roaming on the MTN and Vodacom networks to providethem with extensive coverage while their network is being rolled out and theywill be protected from further new entrants for 5 years. There is also nospecified shareholding size for the required empowerment partner.The Act also recognises that in order to provide a cellular service, the licenceholders will need to provide long-distance and international services, oftenthrough alternative technologies (satellite or fixed line). To protect the Telkommonopoly, the cellular providers are not allowed to make use of any fixedlines other than those from Telkom, and all international services must berouted through the Telkom network. They are of course free to negotiateinternational roaming services for when the consumer is out of the country.The key structural issue for the cellular industry is the separation of networkfrom service provider. The network providers provide wholesale airtime toretailers who then retail this airtime to customers on a per minute basis. Thisseparation has been the regulatory path in the UK and makes regulationeasier as the focus becomes regulation of the network provision and not anypotential abuse of dominance in the service supply component stemming fromvertical integration.3.4.2 SatelliteSatellite networks can be used for transmission of national long-distance andinternational traffic, as well as Global Mobile Personal Communications. AsTelkom does not have any satellite network itself, the network provision isopen to competition. However, in order to protect the Telkom monopoly oninternational traffic, all signal distribution for incoming and outgoing calls to SAthrough earth stations must take place through the Telkom service provider. Inthe event that the Satellite network is able to bypass the Telkom facilitiesthrough satellite-to-satellite links or earth stations positioned outside theborders, a bypass fee must be paid. This fee has yet to be negotiated. Thisarrangement will end when Telkom exclusivity ends.3.5 Interconnection, Facilities Leasing and NumberingInterconnection is crucial to a competitive environment as the value of anetwork depends on the number of subscribers. It is also necessary for aseparation of service providers from network providers. Under the Act andsubsequent guidelines issued by SATRA, interconnection with a majorprovider is ensured• At any technically feasible point in the network,33

Competition and Regulation in Telecommunications• Under non-discriminatory terms,• In a timely fashion under conditions that are transparent and fair, and• At rates determined by ICASA. These will be set at the long runincremental cost (LRIC) of building and maintaining a network by anefficient telecommunications provider, including an average return oncapital. The information required for setting such rates, will be determinedby the Chart of Accounts and Cost Allocation Manual (COA/CAM) that isobligatory for all network providers to submit.ICASA reserves the right to settle disputes over interconnection and enforcethe minimum requirements established above for interconnection agreements.Similar guidelines have been established for facilities leasing, anotherimportant practice for furthering competition in the telecommunicationsindustry.The numbering plan has yet to be finalised by ICASA though a proposedpolicy document has been released which provides us with an insight into theprinciples that ICASA is working with.For local access, the competition concerns revolve around number portability.Consumers face a cost of switching local access providers if they have tochange their telephone number. This represents a barrier to entry and limitseffective competition from any new entrant. The switching costs includeinforming all associates of the change and, for businesses, adjusting anyletterheads, business cards and informational material that has the number onit. These costs are significant enough to prevent numerous changes occurringand so initially provide the incumbent with some market power. ICASA hasnot made a decision on this or provided any direction. The key problem is thatit does come with costs to the network provider because their networks needto be upgraded to operate number portability. ICASA is putting aside a blockof numbers in case number portability does not materialise and the newentrant requires its own numbers.For long-distance network providers the preferred outcome is that a customercan pre-select a long-distance network provider and so there is no need todial additional digits first. Again, ICASA has not made policy on this butsuggests that pre-selection “may be a requirement under the new regulatorystructure” (SATRA 1999). An interim measure is to use as short as possible‘carrier access code’ until pre-selection is available. The recognition is that theshorter the access code, the less inconvenience to customers and so the lessdiscrimination against the entrant. In order to allow consumers the flexibility toselect an alternative provider for individual calls, it is preferable to have preselectionoverride codes too. The issue of offering pre-selection concerns theupgrading of Telkom’s networks.For long-distance service providers who resale leased capacity, the accesscodes will be necessary. Maintaining these as short as possible is a means tomake them more convenient to customers. If regulation allows serviceproviders to be pre-selected too, then these would not be necessary.34

Competition and Regulation in Telecommunications3.6 Public Interest ConsiderationsTwo important social objectives of telecommunications policy are universalservice and human resource development. These are given concrete supportin the Act through the formation of two funds and a supervising agency foruniversal service.3.6.1 Universal ServiceThe Universal Service Agency (USA) has been established with the goal ofinvestigating and recommending ways to achieve universal service. Thisincludes defining what the universal access or service targets are. TheAgency has two tools with which to influence universal service. First, they mayrecommend licence conditions that help bring about universal service/access.Currently, both the cellular network providers and Telkom have significantobligations to provide services to under-serviced areas, as discussed above.While these conditions remain, new entrants will be given similar conditions toensure no competitive advantage is given to them.Second, the Universal Service Fund (USF) was established to subsidise"needy persons towards the cost of the provision to or the use by them oftelecommunications services", and to repay Telkom and other licence holderswith universal service obligations for extending their services to poorly orunserviced areas and communities. For now, Telkom will receive most of themoney as it rolls out to these areas. The fees are non-discriminatory and havebeen set by SATRA at 0.16% of turnover per annum for network providers,R1500 per annum for VANS and R1000 per annum for private networks.3.6.2 Human Resource DevelopmentThe Department of Communications will manage the Human Resources Fundwhose goal is to "promote the provision of adequately skilled humanresources at all levels of the telecommunications sector in sufficient numbers... in such a manner as to redress past unfair discrimination in education,training and employment". The annual contributions to this fund are half thoseto the universal service fund and are similarly non-discriminatory.The Act makes provision for a wide range of applications for which this Fundcan be used, from training in schools through to postgraduates, from unskilledto artisans. The funds may be used for applications from bursaries toupgrading teaching staff and facilities in selected institutions.35

Competition and Regulation in Telecommunications4. Market Structure and Contestability AnalysisRegulation has clearly shaped the domestic telecommunications market byrestricting competition in most services. The analysis of market structures istherefore relatively uninteresting. What is more interesting in most cases isthe level of potential entry if the markets were opened to competition. Thisprovides some indication of what might happen if free entry was allowed andso what regulatory safeguard measures might be required. This section looksat the different stages of production in telecommunications and provides initialanalysis of relevant markets, market structure, and contestability. Thepurpose is to provide some guidance for strategic interventions by theCompetition Commission and not to provide exact data on the state of themarket and its performance. This is best done at the point of the competitioncomplaint as the industry is continually changing. ICASA (Gazette Number:21925 General Notice Number: 4715) has a recent review of the PSTN pricesand performance in recent years.4.1 Provision of Customer Premises Equipment (CPE)4.1.1 Relevant MarketsThe relevant market is the supply and not manufacture of CPE. Within thiscategory, the most obvious horizontal division of the market would be:• Fixed line telephones (including fixed wireless which uses the samephone)• Mobile handsets• PABXsIn terms of competition analysis, there may be scope for more narrowdefinitions depending on the features of each piece of equipment. This wouldneed to come out in a specific enquiry.4.1.2 Market StructureThe market for supplying (CPE) is fully liberalised with free entry.Fixed line telephonesThe main market players are retailers and Telkom. Telkom is likely to remaina highly dominant supplier because the incumbent PSTN always retains anadvantage by being vertically integrated with local access provision. Theadvantages may stem from:• customer convenience• a default situation whereby a phone is provided unless otherwiserequested• ability to have the phone paid off over a longer period through integrationwith the customer billing system• customer database for promotional material36

Competition and Regulation in TelecommunicationsIn the UK, the incumbent BT still had over 50% of the market after 10 years ofliberalisation.Mobile handsetsThere are likely to be no dominant players in the provision of mobile handsets.The crucial difference to fixed line is that the market for CPE supply wasliberal from the start and that the network providers were not involved inretailing them. The service providers who did provide them and who wouldhave some vertical integration advantage are sufficiently numerous not tohave market power.PABXsThis is likely to be a more competitive market than fixed line phones asbusinesses are likely to source directly from manufacturers.4.1.3 ContestabilityThe market for supply of CPE is an open one with no real barriers to entry.There are also a large number of firms in the market. However, there areadvantages for vertically integrated service providers (fixed or mobile) thatneed to be monitored. This problem may be particularly acute with fixed linewhere there is only one service provider (Telkom) and a history of monopolysupply (so starting at 100% coverage).4.2 Fixed Local Access4.2.1 Relevant MarketLocal access can be defined as a distinct market from long-distance. The keyquestion here is whether access through other technologies – specificallycable, fixed wireless and mobile – are suitable substitutes for fixed line PSTNto fall in the same relevant market. This is important as it will influence thelevel of competition in the market and therefore some of the regulatorychoices made. All offer telephony and so it is tempting to define them all as inthe same market.In search of a more narrow definition, the most natural division of the marketwould be to separate fixed from mobile. In the fixed category would lie cable,fixed wireless and the PSTN. On the surface there appears to be a stronglevel of substitutability between the mobile and fixed in South Africa as manycustomers who do not have access to a fixed line have purchased cellular.However, it is important to recognise that there are some crucial differencestoo.• cellular offers mobility for which fixed line is a poor substitute• fixed line has greater bandwidth (if purchased), permitting it to transfervideo and data faster than cellular• there are differences in customer equipment presenting switching costs(though not significant)37

Competition and Regulation in Telecommunications• on a common national pricing system, cellular is more expensive thanfixed line access.• Many customers make use of both suggesting they are not substitutes butcomplements• The two are regulated separately in most countries which suggests thatthey are considered separate marketsAlso, the current level of substitutability may have been enhanced by twotemporary factors:• Excess demand for telephony that existed when cellular operators werelicenced - excess demand raises the effective price of fixed line for thosewithout access (because they incorporate the cost of waiting) making ahigher priced cellular a closer substitute.• Public monopoly – Telkom is less efficient than many international playersin liberalised markets and may also be pursuing monopoly pricing. Thecombination of possible inefficiency and monopoly pricing means thatprices may be inflated making them more substitutable with the moreexpensive mobile technology.It is difficult to determine whether the level of substitutability in South Africa issufficient to have mobile and fixed categorised in the same market. It is alsounclear whether the level of substitutability may actually decrease as soon asmore competition is introduced into fixed line market and saturation of localaccess demand is reached. What is clear is that they are usually regulatedseparately and so considered separate markets. It may therefore be wise toadopt a more cautious narrow market definition for now, separating fixed linelocal access from mobile.However, it is going to be important to review this periodically. In particular,given the more rapid rate of technological change in mobile, specificallyimpacting on costs and bandwidth (UMTS), the market boundaries may wellchange and the two considered sufficiently substitutable.The second case is to see if fixed access should be split further. The divisioninto cable, fixed wireless and PSTN does not seem a suitable division as allare merely alternative means of delivery of what is essentially a fixed localaccess product. Regulatory practice also usually places them in the samemarket, suggesting that this is the case. The one dimension on which todifferentiate may be bandwidth. However, for telephony this is not an issue, itis only an issue for VANS. Further, the PSTN can provide broadband accessat a higher monthly rental fee. The conclusion would therefore suggest thatcable and fixed wireless should be included in the same market and merelyconsidered different technological options but still offering the same service.The provision of local access can be split horizontally into business andresidential customers. The reason for this is the very different usage patternsand the density of demand. These serve to make business customers muchmore profitable, as there are lower installation costs and higher usage ofcapacity.38

Competition and Regulation in Telecommunications4.2.2 Market structureFixed local access is provided exclusively by Telkom. This exclusivity periodis due to end in May 2002, but with the option to extend for an additional yearif Telkom meets a certain proportion of its proposed rollout to under-servicedareas and network performance targets by the end of 2001.4.2.3 ContestabilityThe primary barrier to entry is of course the regulated monopoly. A keyquestion for competition analysis is whether the deregulation of the sectorwould result in entry in South Africa. Entry can be defined as both complete(offering services to the entire market) or partial (servicing only a componentof the market). This requires a focus on the other barriers to entry that exist inthe fixed local access market. The discussion of entry barriers also examineshow specific regulatory decisions may impact on the size of the barrier facedby potential entrants.Entry Barriers• High sunk infrastructure costs – the high level of sunk costs (as discussedin section 1) are why local access is considered to be the only naturalmonopoly component in the telecommunications production chain. Theexcess capacity at the local access level also implies that it is sociallywasteful to duplicate resources, adding to the natural monopoly concerns.The high sunk costs imply low marginal costs, allowing the incumbentspace to pursue a credible predatory pricing strategy to deter entry.These costs can be reduced if the entrant has an existing localtransmission infrastructure that they can ‘piggyback’ on. It is for this reasonthat the majority of entrants at the local level in other countries are cableoperators who have incurred much of the fixed costs of putting in a localloop already. However, there are currently no cable operators in SouthAfrica. Another possibility is the fixed wireless approach where costs aremore closely related to traffic volumes and so less investment is requiredinitially. Finally, the regulator could grant an entrant permission to‘piggyback’ on the incumbent’s infrastructure (poles and ducts).An alternative strategy, and one being mooted by ICASA, is to grant asingle entrant protection from further competition in all sections of themarket (incl. long-distance) – i.e. licence a second national operator (SNO)only. The rationale is to provide the entrant with higher profits toincentivise them to make the sunk investments. The problem with thisstrategy is that it usually favours the incumbent more than the entrant, asthey are the ones with a greater market share over which to makeabnormal profits. Other problems include the lack of incentives for theentrant to serve low-usage customers (resulting in a cherry-pickingstrategy), and a questionable impact on long-term structural change andcompetition. This was the UK experience, with Mercury (the entrant)concentrating on business customers and selected households. In fact,Armstrong et al (1995:241) note of the British duopoly policy, “(t)hedeliberate restrictions on competition contained in the duopoly policy,together with insufficient attention paid to overcoming BTs incumbency39

Competition and Regulation in Telecommunicationsadvantages, acted to preserve the essentially monopolistic character ofthe old system in the core area of network operation”.• Customer switching costs – customer switching costs include the cost ofchanging numbers only, as equipment will have a common standard.Costs are usually considered higher for business than residential. Thesecosts are seen to be significant enough for customers not to switch often.Given the history of monopoly, switching costs are likely to provide theincumbent with a significant advantage. Further, full number portability isunlikely to be granted by an incumbent interested in maintaining marketpower and would need to be regulated. Armstrong et al (1995) note thatthis has proved important in inducing cable providers to enter the localtelecommunications market in the UK.• Interconnection pricing – the reality of competition at the local access levelis that calls may originate or terminate at the competitor’s network. When acall is made from a subscriber of one network to a subscriber of anothernetwork, then an interconnection charge is imposed to route and terminatethe call. The implication is that interconnection costs will have a significantinfluence on the price of calls for both networks. This applies equally tointerconnection charges with foreign networks and with domestic mobilenetworks. The key issue is whether the pricing of interconnection canaffect the ability of a competitor to compete in the market. Clearly, ifinterconnection affects the price of their product, then it must be able toaffect their competitiveness. There are two possible scenarios that allfavour the incumbent.First, a common interconnection price is agreed. In this case it wouldfavour the incumbent to overprice interconnection. The reason is simple.The primary problem faced by an entrant is that on balance there will bemore traffic terminating at the incumbent’s network than on their own, dueto the fact that the incumbent has more subscribers. High interconnectioncharges will therefore affect a far greater amount of calls made bysubscribers of the entrant, than those subscribers of the incumbent. Theresult is a higher average price for local calls for the entrant relative to theincumbent.Second, an interconnection price for each network is negotiated. Theincumbent again has far greater market power and so will be able to usethis to get better terms out of the entrant than they are willing to offerthemselves. Again the result is higher average call costs for the entrant’ssubscribers.Another strategy for the incumbent would be to delay the reaching of anagreement, which would prevent the entrant from launching their service.Although the ICASA rules would then call on the regulator to break thedeadlock, the decision on what the interconnection level would be couldensure further delays. These time delays would impose heavy costs on theentrant.Regulation can overcome these problems to an extent by stipulating alevel of interconnection charges that come into effect if better terms cannotbe negotiated. This lowers the incentive for the incumbent to delay40

Competition and Regulation in Telecommunicationsproceedings and ensures that further regulatory delays do not occur if nonegotiated terms are agreed. The problem is estimating theinterconnection rate. The nature of network industries is that many costsare common costs and so there is discretion in how they are allocated. It isin the interests of the incumbent to allocate as much of its costs to theservice where they expect the least competition, and where they are ableto negatively influence the price of their competitors the most. This is ofcourse local access. The incumbent is therefore likely to try pass off asmuch of the costs into local access to justify high interconnection pricesthat penalise both other local access providers and all other services thatinterconnect (long-distance, VANS, mobile).Interconnection pricing can also be used to compensate for otherincumbency advantages to facilitate entry. The usual strategy is to forcethe incumbent to offer interconnection rates that are below cost to providethe entrant with some advantage of their own. Either way, failure to resolvethe interconnection issue satisfatorily will result in greater uncertainty forpotential entrants in all other services as local access is the essentialfacility in telecommunications. Uncertainty can only lead to lowerinvestment incentives, especially when there are high sunk costs.• Current network coverage and universal service subsidies – given highsunk costs and customer switching costs, there are low incentives to enterdirectly into competition with the incumbent where the incumbent has alocal loop in place. The exception to this is high usage customers(especially long distance usage) that have high density – i.e. businesscustomers. However, for lower usage customers, the entrant may havemore incentive to enter areas that are not currently served by theincumbent. The exception would be areas that are not serviced becausetheir usage is very low (usually poor households) and/or where installationcosts are very high per subscriber (i.e. rural areas). This can be overcomeif the entrant has access to the universal service subsidy to part fund theinstallation of local loops in these areas.If the unserviced areas are a large part of the market, then access touniversal service subsidies and rapid entry into the market are important inestablishing a viable local access base for the entrant. Regulation can helpby favouring the entrant in the provision of universal service subsidies andservicing new property developments.Likelihood of EntryThe high barriers to entry at the local access level have made this the last‘natural monopoly’ component of the telecommunications system. Entry thathas occurred in other countries has tended to be in the business componentof the market as high usage and density serve to lower installation costs, andallow investments to be written off quickly. Their high use of long-distanceservices provides the capacity to make investments in the more lucrative longdistancemarket. Entry takes the form of establishing long-distance networksand local bypass of the PSTN to these networks.Competition that has emerged in the residential component of the market hasgenerally been from cable companies using their economies of scope. As41

Competition and Regulation in TelecommunicationsSouth Africa does not have a cable TV operator, this is not a source of entrynow. It is also unlikely to be the case in the future, as a cable TV companywould only be interested in a small group of high income earners, plus thechoice of technology for pay TV in South Africa is satellite (Multichoice andSentech). The low teledensity in South Africa suggests that the entrant maybe tempted by the number of unserviced areas. However, the reality is thatthey are unserviced because they are the least viable group of potentialsubscribers. Therefore, unless the universal service funding was sufficient tomake these customers profitable, they are unlikely to be served by theentrant. Clearly entry at the residential level is unlikely to be significant unlessthere is significant incentives from the regulator for entry, including puttingrollout conditions in the licence, providing access to universal servicesubsidies, having favourable interconnection agreements and possiblylowering competition in long-distance through a duopoly policy to allow themto cross-subsidise services. Either way, the entrant is unlikely to get asignificant share of the local access market to act as a disciplining effect onthe incumbent. Rate regulation of the incumbent will be the primary tool forensuring the protection of consumers against abuse of dominance.4.3 Long Distance4.3.1 Relevant MarketThe long distance market can be separated into national and internationalnetworks. It is also possible to talk of network providers and service providersin the long-distance market (unlike the local access market). There is littlereason for separating the market in any other way, as most long-distancenetworks are now fibre-optic and so can carry voice, data and broadcastquality. Choice of technology also matters less.4.3.2 Market structureThe network infrastructure for long distance is predominately owned byTelkom, but other network providers exist. In the national long distancemarket, Transtel and Esitel (the telecommunications arms of Transnet andEskom), have considerable long-distance infrastructure that is used for privatepurposes and which Telkom can lease capacity for public purposes. Thisprivate network exists for historical reasons. In the international long-distancemarket, there are a large number of international players that operate fibreoptic and satellite facilities that cover South Africa. They exist because theirinfrastructure is not located on South African soil and so cannot be regulated.Sentech holds capacity in satellite broadcasting services.Despite other infrastructure providers existing, Telkom has exclusive rights tooperate a long-distance network in South Africa. Therefore these companiesare forced to lease to Telkom who then provides the public service. TheTelkom monopoly means that the prices of all other services that use longdistancenetworks (mobile, Internet, VANS) are determined by Telkom. If thismarket structure leads to cost inefficiencies, underinvestment or monopolypricing, then the impact affects the full range of telecommunications products.42

Competition and Regulation in Telecommunications4.3.3 ContestabilityThe primary barrier to entry for network and service provision is of course theregulated monopoly. Again the key question is how will the market change ifentry was liberalised. In answering this question for long-distance, it isimportant to separate the network provision from the service provision, as thebarriers to entry are considerably different. Entry can also be partial orcomplete. Partial may include business or metropolitan areas only, whilecomplete would include a national service.Barriers to entryThe barriers to entry for network providers include:• Sunk costs – the long distance network has fewer sunk costs to a full localaccess network. In addition, long distance is not considered a naturalmonopoly because excess capacity is not a problem. The collecting oflocal traffic and funnelling it down a single long distance network ensureshigher capacity utilisation and scope for more than one network toprofitably exist.The level of sunk costs for long-distance networks can be more easilylowered than in local access. First, there are more established networksdelivering other services making economies of scope possible (includerailway, electricity). Also, satellite is a viable alternative to fixed line givenhigh capacity utilisation rates. Finally, in South Africa there exist privatenetworks with a national long-distance network already installed that hasspare capacity. The incremental cost of providing the service to localaccess subscribers involves providing a point-of-presence (PoP) switchand extending the network to areas that are not covered yet.The sunk costs can be lowered for initial entry if the entrant is able to leasecapacity from the incumbent on entry while they roll out a more completenetwork (those that intend getting a full network). This is the equivalentissue to allow a new mobile network operator to roam on existing networksduring the rollout period.• Customer switching costs – customer switching costs between longdistance networks are focused on the dialling process. If there are morethan one long-distance providers, then it is necessary for the subscriber tomake the choice. Given that the incumbent is going to be the naturaldefault if no specific choice is made (because they own the local accessnetwork), this offers the incumbent a distinct advantage over competingnetworks. The worst possible scenario is if the customer has an incumbentdefault and needs to tap in an access code to use a competing longdistance provider. The longer this code is, the higher are the switchingcosts.The least distortionary means is to have the customer pre-select the longdistanceprovider of choice and then any long-distance call without anaccess code will be routed through their network of choice. If thesubscriber wishes to override their selection, then the access code can beused. However, it is preferable that as short as possible access code isused to limit switching costs.43

Competition and Regulation in Telecommunications• Interconnection pricing – a long distance call must originate and terminatein a local access network. As such, the cost of interconnection will impacton the overall cost of the long-distance call. Unless the incumbent isvertically separated (as with AT&T), there is a danger that the incumbentcan set interconnection rates at higher levels for competing long-distancenetworks and so raise the costs of their rivals. As discussed in the localaccess section, there are also dangers of delaying interconnectionagreements to raise rivals costs. The other danger with interconnection isthat the incumbent offers a lower quality of connection to competing longdistanceproviders, making their service less attractive to subscribers.• Facilities leasing – as with interconnection pricing, the price at whichfacilities are leased will influence the price of rival’s costs. If the entrantneeds to lease facilities as a short-term measure, then the price of leasingwill be an important influence on average costs. It is clearly in the interestof the incumbent to overprice these services. The preferable arrangementis for the leasing price to at least reflect long run costs of providing thefacilities. However, it is also feasible that the incumbent price below cost inoff-peak periods to get rid of excess capacity.For long-distance service providers the barriers to entry are substantially less.Service providers lease network capacity from network providers and thenresell it to subscribers on a per minute basis. The infrastructure they require isa billing system and a switch connection to the long distance provider’s pointof-presence(they are routed through the local access network like all others).However, service provider’s face the same customer switching costs ascompeting network providers. In liberated markets the pre-select option israrely made available to service providers because of the highly contestablenature and proliferation of suppliers. Service providers also face the problemof interconnection pricing and facilities leasing. The facilities leasing is more ofa problem for service providers than network providers because they lease allfacilities and not just where they have not rolled out.Likelihood of entryEntry into long distance network and service provision is highly likely in SouthAfrica if the market were liberalised. On the network side, Transtel and Esitelalready have networks in place, and international network providers alreadyexist but cannot sell directly to the subscriber. Given the growth in data traffic,there is considerable scope for other entrants into the market. Opening resaleand network competition at the same time makes it highly likely that initialcompetitors will lease facilities while they establish their own networks. Thiswill accelerate the process of competition. Competition in service provision iseven more likely given the low costs of entry. However, the regulatorydecisions around facilities leasing, customer switching and interconnectioncosts will have a considerable impact on the entry of firms and the coverageof their networks.44

Competition and Regulation in Telecommunications4.4 Mobile4.4.1 Relevant MarketThe discussion of the relevant market in fixed local access determined thatmobile access was not a substitute for fixed local access, though it may beconsidered as such in the near future. Also on the horizon are the so-called3 rd generation cellular services (UMTS). These can be separated from thecurrent 2 nd generation GSM networks in that they have broadband capacityand so are able to provide a range of product options that the GSM networkscannot. Although these can be seen as two distinct markets, there areeconomies of scope in their production. Finally, network provision can beseparated from service provision.4.4.2 Market structureThere are currently two network providers, MTN and Vodacom, with a thirdnetwork licence currently being issued to Cell C (pending litigation). Themajority shareholder in MTN is M-Cell and in Vodacom is Vodafone andTelkom (50%). The large shareholding of Telkom is potentially a cause forconcern, especially as mobile is increasingly becoming a substitute for fixedlocal access. This shareholding gives Telkom the chance to act strategicallyto influence the degree of substitutability and transfer price betweencompetitive and uncompetitive markets. The market shares have stabilised ataround 61% for Vodacom and 39% for MTN (Telkom 2001). Given that themarket has grown at almost 50% per annum, the primary concern of bothnetwork providers is signing up subscribers, and not competing on price towin subscribers away from the other network. Recent estimates are that if CellC entered the industry at this point, they would only secure a 10% share ofthe market by 2003 (Business Report 19 February 2001). TheTelecommunications Act requires the regulator to examine whether a fourthlicence is desirable or not.The network operators do not deal directly with the public but wholesaleairtime to appointed service providers who in turn retail network access to thepublic or corporations using their own tariff structures. The service providerscurrently appointed to each network are:• MTN network – Autopage Cellular, M-Tel, Nashua, Nedtel, PlesseyCellular, Radiospoor Cellular, Sebcom, Supercall, Transtel and TTC.• Vodacom network – Afritel, Autopage Cellular, Cellphones Direct, GSMCellular, Nashua, Nedtel, Plessey Cellular, Radiospoor Cellular, Supercall,Teljoy and Vodac4.4.3 ContestabilityThe primary barrier to entry for network provision is regulation – the need for alicence (currently restricted to three). In service provision there is lessregulatory intervention but service providers need to be approved by thenetwork providers for reasons of protecting their reputation and customerservice levels.45

Competition and Regulation in TelecommunicationsAgain the key question is how will the market change if entry was liberalised.In answering this question for mobile, it is important to separate the networkprovision from the service provision, as the barriers to entry are considerablydifferent.Barriers to entryIn the network component the barriers to entry include:• Sunk costs – if the network provider is required to roll out a completenationwide network (as is the case in South Africa), then the sunk costswill clearly be high. However, with mobile, as opposed to fixed line, thelevel of infrastructure required depends on the level of traffic (see section1). The result is that there is a lower investment required to launch aservice, but which can rise in proportion to the growth in subscribers. Thismakes entry easier and more likely that the industry can support morethan one or two network providers. A further means of easing the entry ofa new network is to allow the use of infrastructure from competing networkproviders until a full network is up and running. The reduction in time toenlist subscribers means that the entrant can start generating a return ontheir investment sooner, thereby lowering costs of establishment.• Interconnection pricing – as with any network, a mobile network needs toconnect to all other networks in order to provide their subscribers with thechance to call anyone else. The key interconnection prices are fixed localaccess, other mobile networks and long-distance. There are similarconcerns about overpricing of interconnection, especially when there is adominant player in the mobile networks or a player that isvertically/horizontally integrated into other markets (long-distance or localaccess). The dominant player concerns were discussed in detail underlocal access. Problems are non-standard pricing, delaying interconnection,or overpricing interconnection. For the vertically integrated/horizontallyintegrated firm there are opportunities to engage in transfer pricing fromthe competitive segment to the uncompetitive segment. If there is a localaccess monopoly with a mobile network, it may be in their interests toraise local access interconnection prices for all mobile networks (includingtheir own). There is no fear of retaliation in the local access market wherethere is no competition, and overpricing enables them to extract rents fromother mobile providers and also affect the overall substitutability of mobilewith fixed line.• Facilities leasing – similar concerns to interconnection arise on facilitiesleasing. The difference is merely the nature of the contract, but theproblems of strategic pricing of facilities remains the same.• Customer switching – customer switching costs include the usual numberswitching issues, but also would include the use of long-term contracts bythe current service providers (linked to specific network providers). Longtermcontracts are part of the product range offered by service providers(including pay-as-you-go) and serve the customer by providing a chanceto ‘hire’ a phone as part of the contract – thereby saving them from thepurchase price. However, the length of contracts would need to be46

Competition and Regulation in Telecommunicationsexamined more closely to see whether they constitute significant barriersor not.The entry of service providers is far easier. The sunk costs include a retailnetwork and customer billing system. However, they also need to beapproved by the network providers so some quality assurance is required.This is justifiable on business grounds. Only if the network provider hasvested interests in another service provider, is there a potential cause forconcern around discriminatory behaviour to favour their service provider.Likelihood of entryThe lower initial sunk costs involved in mobile network establishment meansthat the market is able to sustain far more network operators. The existence ofscale economies does mean that a limited number of competitors will exist,especially if they are limited to provide a national service. The level ofcompetition is likely to be fiercer in mobile networks because there was noinitial monopoly.4.5 Value-added Network Services (VANS)4.5.1 Relevant marketsThe VANS sector can be separated from basic voice. The sector comprises ofa number of potential horizontal markets that will receive greater clarity inspecific complaints and investigation. The market can be split roughly intopublic data services (Internet provision) and private data services. Each ofthese may be further sub-divided. For instance, it may be possible to subdivideInternet based on access mode. Currently, Internet content andservices delivered to mobile phones differ from that delivered to PCs on fixedlines. The key difference is the smaller screen and no broadband, and so theservices are more limited. Although 3G cellular will bring broadband, it will stillretain the small screen and so this market division may persist. It may also bepossible to separate fixed line access into dial-up and leased line access.Vertical divisions could include the separation of customer management fromnetwork management (core backbone). However, in relation to generaltelecommunications regulation, the markets can be considered as one.4.5.2 Market structurePublic data networks (Internet)Internet access includes both leased line and dial-up access. South Africaranks 25th in the world in terms of number of Internet sites. There are anestimated 2.5 million Internet users in South Africa (media africa.com 2000).Telkom provides the physical infrastructure backbone for Internet as theyhave a monopoly over this component. The leased networks are thenmanaged by various companies including The Internet solution, Pipex InternetAfrica, Sprint SA, SAIX, OpenNet, and UUNet. Of these, SAIX (Telkomowned)offers a full infrastructure for Internet service providers (ISPs),allowing even small niche players to establish and run an ISP withoutinvesting in actual points-of-presence (PoPs) to connect to the local switch.47

Competition and Regulation in TelecommunicationsThere are also a large number of service providers who lease capacity fromthe networks and retail to the public at their own tariffs. There are currentlyover 100 Internet Service Providers (ISPs) in South Africa, of varying size. Atthe end of 2000 there were a few large ISPs - M-web, Worldonline and Xsinetin dialup access, and Internet Solution in leased line access. The difficulty indetermining market structure in this sector is that the market changesdramatically each year. The most recent development has been theintroduction of Absa freemail that is apparently signing users at a rate of 8000per week (Business Report March 2001).Private data servicesThe industry was launched when VANS service provider licences were issuedin 1991. There are currently about 60 license holders with approximately 12000 customers and a total annual revenue of around R180-200 million. Thetop three service providers have a market share of 75% and are Trafix,EDS/Vanco and FirstNet. Other significant networks include GOVNET, InfoVan, and Denel Informatics.4.5.3 ContestabilityThe VANS market has scale economies and sunk costs but not on a scalenear that of a PSTN or mobile network. This makes it a relatively contestablemarket, reflected in the greater number of market players. The key positionthat Telkom holds as the only provider of lines to all these operations, raisesconcerns over whether it is favouring its own companies in these markets.There is also scope for strategic behaviour from other players in the market asthey exploit customer switching costs or market power.4.6 Other Mobile Services4.6.1 Relevant MarketsBefore the arrival of mobile telephony, a range of other mobile servicesexisted. Most important are paging, radio trunking and wireless data services.Unfortunately for the operators of these services, the launch of mobiletelephony has cut deeply into their market. The reason is that mobiletelephony has an expanding range of service products beyond basic voice arevery close substitutes to these other mobile service products. Cellular phonesoffer paging style services (SMS, informational services), radio trunking (longdistance radio communications) and wireless data (email and increasinglyInternet). The result is that these sectors have stagnated.4.6.2 Market StructureThe discussion focuses on the companies specialised in these products.However, competition can be seen to include the mobile networks.Paging SectorThe paging industry was the first to have private operators issued licencesand is well established in South Africa. In 1999 there were 21 pagingcompanies with an estimated market of 110 000 pagers and revenue of R12148

Competition and Regulation in Telecommunicationsmillion. The dominant operators are Radiospoor (40%), Autopage (25%),Paging Plus (10%). A handful of these operators do not provide services tothe public but operate their private corporate paging services only.Radio TrunkingThe first radio trunking licences in South Africa were only issued in 1993, ayear before the introduction of cellular networks. The expansion of the cellularnetworks has stunted the growth of radio trunking as they are directcompetitors in mobile communications services. There are currently 11licensed operators sharing a market of between 5000 and 7000 radios. Thesector is relatively small with revenues of R9 – R12.5 million per annum. Thesector is dominated by 3 operators – Fleetcall, Q-Trunk and One-to-One.Wireless Data ServicesThere are currently only 2 wireless data network providers, Swiftnet and WBS.4.6.3 ContestabilityAs with VANS, entry barriers are low to these mobile offerings. The fact thatthe same services are feasible over the cellular networks make this a highlycontested market.49

Competition and Regulation in Telecommunications5. Regulatory issues for the SA telecommunicationsindustry and their potential efficiency/public interestimpactThe current regulatory regime in telecommunications has to change by theend of 2003 in compliance with South Africa’s commitment to the WTO. Indeciding how the regulatory regime will change, one needs to take account ofthe range of objectives laid out for telecommunications policy and not justfocus on regulating for efficiency only. The full list of objectives werediscussed in section 3, but are repeated here. They include• promote the universal and affordable provision of telecommunicationservices;• ensure that, in relation to the provision of telecommunication services, theneeds of the local communities and areas are duly taken into account;• encourage ownership and control of telecommunication services bypersons from historically disadvantaged groups;• encourage the development of human resources in thetelecommunications industry;• promote small, medium and micro-enterprises within thetelecommunications industry;• promote the provision of a wide range of telecommunication services inthe interest of the economic growth and development of the Republic;• encourage investment and innovation in the telecommunications industry;• encourage the development of a competitive and effectivetelecommunications manufacturing and supply sector;• ensure fair competition within the telecommunications industry;• ensure efficient use of the radio frequency spectrum;There is no specific priority ordering of objectives and different interest groupswill rank them differently. The regulatory outcome will depend on thebargaining process amongst the different interest groups.This section examines the various regulatory options on the table. Rather thanput down various possible models, the discussion is structured around fourcritical components of the regulatory regime – namely structure, entry, pricingand quality. The interconnection between policies on each component will bemade clear.5.1 StructureThe key structural questions in telecommunications deregulation are:• Whether to separate the natural monopoly component (or essentialfacilities) – fixed local access – from the parts of the networks that offerpotential for competition – CPE supply, long distance (vertical separation)• Whether network provision as a whole should be separated from serviceprovision - VANS or even basic voice (vertical separation)50

Competition and Regulation in Telecommunications• Whether mobile networks should be separated from fixed networks(horizontal separation)5.1.1 Vertical separation of networksThe issues around vertical separation of local access to other parts of thenetwork are relatively straightforward. The case for vertical separationessentially rests on reducing the opportunities for anti-competitive behaviourand so reducing the complexity of regulation. If a firm with essential facilities isvertically integrated (like Telkom), then they have tremendous scope forbehaving anti-competitively. This could occur by either granting lessfavourable access to competitors than to their own downstream service(different price, quality or customer access dialing 5 ) or overpricing themonopoly component (local access) and cross-subsidising the long-distancenetwork to the detriment of competitors. If there is vertical separation, thenthere is little incentive for discriminatory access provision or crosssubsidisation,which leaves the regulator to concentrate on ensuring that thereis no monopoly pricing of access only. The cost saving in this case is aregulatory one.The economic argument against vertical separation is that it will destroy anyeconomies of scope that may exist between the two networks. If these aresignificant, then the potential efficiency cost may well outweigh the regulatorycost of closer supervision of the incumbent. An equally powerful argumentagainst vertical separation is the cost of undertaking the exercise when theincumbent is already integrated. The cost is not only the internal restructuringcost but also the time delays in the deregulation process.There is no clear side on which the decision of vertical separation should fall.In the case of the UK, the desire to have a rapid privatisation intelecommunications led them to reject the vertical separation model 6(Armstrong et al 1995:215). In contrast, the USA adopted the verticalseparation model when they brought an antitrust case against AT&T in1974alleging anti-competitive behaviour against other long distance networks. Thecase was finally settled 8 years later and resulted in the separation of localaccess in 1984. More recently there have been attempts by some of theRBOCs (Regional Bell Operating Companies) to get permission to move intolong distance, which have been resisted by the regulator with the conditionthat greater local access competition must proceed it.Considering that South Africa has already gone some way down thederegulation path without breaking up Telkom, suggests that it would bedifficult to do it at this point. It would also be difficult to get equity partnerconsent for the process, with the likely result that they will pursue the matter incourt causing further delays to the deregulation process. This reasoning islikely to rule the day, making it largely unnecessary to really evaluate thecosts and benefits of each policy in South Africa. The fact that this is not on5 Forcing customers to dial an access code to use the competing long distance networks, therebyraising switching costs.6 Armstrong et al (1995) note that another reason for avoiding the breakup was that BT managementwas opposed to the idea and the regulator needed their support for a rapid privatisation.51

Competition and Regulation in Telecommunicationsthe table for discussion at the moment and that the models considered arejust the number of full facilities based competitors, supports this reasoning.If there is to be vertical integration, then naturally there needs to be at leastseparate accounting to facilitate regulation of local access and competitionanalysis. However, given Telkom’s history of conduct since the partialprivatisation 7 , there may be good reason to ensure that there is closecompetitive oversight of the interconnection process and agreements.5.1.2 Vertical separation of services from networksEven if there is no separation of networks, there is the possibility of separatingthe service component from the network component. The reasoning for thisroute is the same as for separating networks – to remove the possibility ofanti-competitive practice by the owner of the essential facility. The argumentsagainst are also the same – economies of scope and the cost of industryrestructuring. The range of services that could be separated include localbasic voice, long distance basic voice, VANS and broadcasting.In the case of basic voice, local or long distance, there appears to be a strongeconomies of scope case against vertical separation. In the USA, where thepath to deregulation was vertical separation of markets, the RBOCs andAT&T were still permitted to offer basic voice. There are equally compellingreasons for not separating VANS and broadcasting from network provision.However, there is precedent for doing so from the UK where the incumbentwas prevented from entering broadcasting services on the basis of assistingentry of cable television companies into local access telephony. The USApursued the same route and also prevented the RBOCs from entering theVANS sector initially.In the South Africa case, momentum may again decide the direction of policy.The existing regulatory regime does not restrict Telkom from enteringdownstream markets. However, it has not been that successful in doing so todate, suggesting that vertical separation may not be that necessary. However,Telkom has had little incentive to make a success of downstream services, asall service providers must lease their lines from it anyway. However, oncethere is facilities competition, there may be greater incentive for Telkom to notonly enter these markets but also behave anti-competitively.Despite the momentum in regulation, it may be feasible to separateVANS/broadcasting services at this point precisely because Telkom has notmade large inroads into the market.5.1.3 Horizontal separation of mobile servicesHorizontal separation of mobile services would require that no firm hasoperates or has holdings in both fixed local access and mobile. The case forseparation is twofold: a) as fixed local access is an essential facility, theprovider can discriminate against its mobile rivals, and b) that mobile is one ofthe few close competitors to fixed local access and so it may be desirable to7 In particular their dealings with VANS operators, denying them additional capacity after alleging theywere providing clients with telephony and not just data services.52

Competition and Regulation in Telecommunicationsseparate the markets to ensure maximum competition. The case against isthe economies of scope argument.The second argument for horizontal separation is a potentially very powerfulargument in the South African scenario. As discussed in section 4, there isunlikely to be a cable competitor on a broad scale in South Africa due to lowaverage incomes and the current technology choice of satellite for Pay TV. Itis also unlikely that a significant residential local access competitor willemerge unless there is some form of exclusivity granted (and even then thereis doubt). The most likely disciplining force from industry players will comefrom mobile and so it would be advisable to avoid corrupting this competitionby allowing cross-ownership. It is also relatively easy to implement as thecurrent cross-holding is exactly that – a share holding and not an integratedorganisation. Restructuring would come at little cost.5.2 EntryThe key entry issues in telecommunications deregulation are:• Whether or not to restrict entry into any parts of the market• How to deal with possible entry deterrence if entry is permitted• Whether or not to actively assist the entrant(s) in competing with theincumbent• How to deal with asymmetric regulation of the incumbent and entrant(s)5.2.1 To Restrict Entry or NotA primary question in the South African regulatory debate at present iswhether to open up the telecommunications sector completely or merelyintroduce one or two new entrants.The Duopoly AppraochThe option favoured by Telkom and the primary contender – a Transtel/Esitelledconsortium – is for a duopoly with exclusivity for another 3-5 years.Telkom also would want a so-called ‘level playing field’ where the entrantwould have all the same universal service obligations as Telkom. There isalso considerable government support for this approach. It appears as if muchof the government support comes from the fact that a further exclusivity periodwith a duopoly will maximise the revenue objective of government. The IPO ofTelkom and the sale of Transtel/Esitel will both realise higher prices if anexclusive duopoly is in place – a premium to reflect the abnormal profits theyare likely to get in future.The public rationale for supporting such a policy is a line of reasoning thatgoes like this - no firm is going to enter local access in residential andunderserviced areas unless they are forced to do so in their licenceagreements. If this is the case, no firm will bid for the licence unless itreceived some protection from other entrants in the more lucrative parts of themarket – namely long distance and business local access (in essencemaintaining the cross-subsidy).53

Competition and Regulation in TelecommunicationsClearly this approach has a stifling effect on competition – that is why theincumbent, main contender and revenue-maximising government support theapproach, and the rest of the industry does not. The approach has some meritif it is able to permanently alter the market structure of local access in theshort exclusivity period allowing the regulator to ‘exit’ control of incumbentpricing in the medium term. Evidence from other countries suggests that thisis unlikely to be the case. The UK pursued this model and after a seven yearduopoly period the incumbent still had 97% of the residential local accessmarket, 87% of the business local access market and 76% of the Internetmarket. Clearly this policy had no significant long-run impact on the marketstructure and no reduction in regulatory activity and hence regulatory cost.The approach may also has merit if it is able to significantly raise access totelephony by residents of underserviced areas (social goal). This is also aquestionable assumption. The primary tool for universal service will be thenon-distortionary USF, which raises money from a tax on alltelecommunications operators. The duopoly approach is an attempt tosupplement this with internal cross-subsidy – an inefficient alternative that willhave business local access and long-distance supporting residential access.Raising the penetration of telephony is probably better served through raisingthe USF tax rather than distorting competition, especially if the adjustment hasto come eventually.Open Competition ApproachEvidence from most countries suggests that in the residential local accessmarket there is a considerable natural monopoly element resulting in theincumbent remaining highly dominant even with completely open entry. Ifduopoly is not going to succeed in changing this either, then tight regulation oflocal access will remain a part of regulatory life for the foreseeable futureregardless of entry strategy. If this is the case, it seems that one should reapthe gains from competition in other parts of the telecommunications marketnow rather than later, while supporting some long-term market structurechange in local access.This approach would open up the market for long-distance network and resaleto make this a competitive component. This is a potentially competitive marketand so is likely to see entry. It also offers significant gains for business andthe Internet, both of which make considerable use of the long-distancenetwork. In this way the policy supports the intermediate role of the sector ingrowing business in South Africa.In the local access market there are two possible approaches. One approachwould be to open entry completely. In this scenario, entry is likely to occur inthe business component, linking businesses to the long-distance networks (asin the USA). If the incumbent is cross-subsidising residential then the amountof bypass will be greater. To ensure that the incumbent is not overly exposedto bypass, the universal service approach should be entirely through the USFand not built into contracts. Entry could also be encouraged into residentiallocal access through bidding for USF funds to install local loops inunderserviced areas (a successful USA approach).54

Competition and Regulation in TelecommunicationsThe alternative is to maintain a cross-subsidy approach and allow entry intothe business local access on condition of certain residential obligations. Thisappears less attractive as it requires considerable regulatory oversight and isdistortionary and so less preferable to a raising of the USF contribution.Under the more open competition approach, the likely main competitor forlocal access will be mobile. This being the case, the regulator would need toensure that no cross-holdings exist to limit scope for strategic behaviour bythe incumbent.With both the duopoly and open competition model, the incumbent will haveconsiderable market power and scope to limit entry. The regulator will need tohave tight control of prices by the incumbent (but not the entrant), and adoptmeasures to limit entry deterrance and promote entry. These are discussedbelow.5.2.2 Dealing with Entry DeterrenceAs noted in section 4, the primary means for entry deterrence is throughunfavourable interconnection pricing with the PSTN and customer switchingcosts. The regulator has a difficult task in ensuring fair interconnection qualityand access pricing. Interconnection pricing is dealt with in detail in 5.3.The switching cost issue is more clear. For long-distance network competition,pre-selection of default provider should be available and short access codesfor long-distance service providers. Number portability for local access is afurther support policy. If competition in local access is not expected to besignificant anyway, it may be prudent to delay the implementation of fullnumber portability in local access as it has cost implications for the incumbentand any entrant.5.2.3 To Actively Assist Entry or NotEven a so-called level playing field will not always result in significant entryand competition because the incumbent is starting from a position of 100%market share and they still own a strategic resource – information. Informationabout who the customers are and their behaviour. They also have a largeamount of technological learning behind them. As a result, the entrants willremain at a disadvantage. If the regulator is interested in changing the marketstructure of the industry to lower regulatory costs in the long-run, then theycan try favour entrants to ensure more rapid entry. There are a number ofways of doing this:• Reducing sunk costs – allow entrants in local access or long-distance tomake use of poles and ducts of the incumbent to roll out infrastructure• Reducing interconnection prices – allowing below-cost interconnection toallow entrants to overcome initial learning costs• Favourable access to USF subsidies – the auctioning of subsidies toprovide local access would favour new entrant bidders• Reduce universal service obligations – allow entrants to make a lowerpayment to the USF or in the duopoly model, to have lower contractualdemands.55

Competition and Regulation in TelecommunicationsAll these policies may be desirable in South Africa. The last option may bepolitically sensitive to implement if an open competition model is taken,because the rationale is to rather raise the contribution to the USF to supportuniversal service rather than use distortionary cross-subsidisation.5.2.4 Asymmetric regulationIn a more liberal telecommunications environment, the incumbent will remainregulated in all markets where it is dominant, but entrants will not. Thisasymmetric regulation may distort entry conditions.If the incumbent has a price cap basket that includes both local access andother prices, then it would be possible to reduce prices on long-distancedramatically to fight off competition and raise residential local access chargeswhile still remaining in the price cap bounds. This will be detrimental touniversal service and limit entry to the more competitive components of themarket. To eliminate this possibility, it would be preferable to have a separateprice cap for local access.Forcing the incumbent to drive down the price of a particular service through aprice cap, may also reduce prices below those that would attract entrants intothe market. This may arise because the incumbent can price at marginal costas its fixed costs are already sunk, but entrants need to price at long-runmarginal cost which includes the installation of capacity.Finally, there is a danger to forcing cross-subsidisation of services by theincumbent. In the face of cream-skimming, this regulation could make theincumbent unprofitable. The implication is that in the open competition model,the incumbent must be allowed to price local access according to costs. TheUSF would then play a more important role in reducing access charges forpoor households instead of the internal cross-subsidy of Telkom.5.3 PricingLong after the market is opened to competition, the incumbent will havesufficient market power to warrant strict price regulation. The entrants willusually not warrant such regulation as they lack the market power. Thissection looks at how final consumer prices and interconnection prices shouldbe regulated.5.3.1 Final consumer pricesThe policy of choice by ICASA for final consumer price regulation is the pricecap. The price cap has the potentially desirable feature of incentivising theincumbent to reduce costs. However, it also has its problems. Primaryamongst them is that because costs are uncertain it can lead to politicallyembarrassing windfall gains for the incumbent or severe losses. The fear ofimposing losses on the incumbent and the subsequent review process,means that regulators tend to err on the side of caution and offer generousprice cap targets. South Africa is a case in point with a mere 1.5% belowinflation target for the first years of the exclusivity period in the face ofdeclining costs from technological change.56

Competition and Regulation in TelecommunicationsOne of the price cap issues is what to include in the bundle. As alreadymentioned, it is advisable to remove monopoly components into a separateprice cap to avoid transfer pricing by an integrated incumbent. This wouldleave one price cap for local access and one for all other prices. Somecountries have then left certain prices outside of the cap under the reasoningthat those markets were competitive. However, the trend now is to include allother prices as the scope for strategic anti-competitive behaviour by thedominant incumbent is enormous (the USA is a case in point withprogressively greater price control of AT&T).There may also be consideration of an earnings sharing approach (discussedin section 2). Under this scheme, any under or overshooting of the target isshared between incumbent and consumer. The incentives are less highpowered but they are politically more manageable.Another pricing issue is the structure of prices. Local prices are ordinarilymade up of a monthly access charge in order to cover the fixed costs ofestablishing the network and a usage charge to cover marginal costs (whichare very low in the case of telecommunications). Optimal pricing suggestsraising the access charge well above marginal cost as demand is inelasticand lowering the usage charge closer to marginal cost as demand is elastic(Ramsey pricing). Universal service suggests the opposite, with low accesscharges to allow low-income households to get access. As each user needsto cover the costs of linking them to the network, an alternative is to have amenu of tariffs to suit the preferences of each consumer (this is not unfairprice discrimination as the consumers have a choice from a bundle ofoptions). The high-usage customer (business or heavy Internet user) wouldopt for a high access charge, low usage charge option while the poorerhousehold would opt for a low access charge, high usage charge option.An optimal range of pricing options is unlikely to emerge in a monopolyscenario, but will emerge under competition (note that in cellular in SA thereare many such pricing options from pay-as-you-go – with high usage rates –to subscription options, while in fixed line there are less options). Thissuggests that while the incumbent remains dominant, the regulator may wishto impose pricing structures as well as price caps to get optimal pricing in themarket. The precendent for such action is the UK where early into theprivatised model options for low-usage customers was enforced 8 (resulting in1.5million users taking this option) and more recently a high usage optionenforced (for heavy Internet users).5.3.2 Interconnection (Access) pricingThe approach chosen in South Africa for interconnection pricing is one ofpricing at LRIC (long-run incremental cost). However, because so many costsare common, it is very difficult to come to any firm decision on what can beincluded or not – providing scope for abuse. Further, these agreements mustbe negotiated and if unresolved the regulator will intervene. Considering thatthere will remain a monopoly on part of the network, strategic behaviour willresult in the following outcomes:8 Armstrong et al (1995)57

Competition and Regulation in Telecommunicationsa) if two networks do not compete in any markets (as is the case of twonational providers from different countries) then the outcome mayresemble costs more closely,b) If there is uneven traffic flow, one provider will deliberately overprice inorder to gain an effective subsidy from users of the other network (acommon practice amongst African national providers and one whichTelkom could employ in a duopoly scenario)c) If the two networks do compete in other segments of the market (such asprovision of long distance communications) then there is incentive todeliberately overprice in order to ruin the competitiveness of the othernetwork in the other market.As Telkom will have a dominant position in the local access market regardlessof model chosen, it is likely that they will have the incentive to overpriceaccess.An alternative is to bundle interconnection pricing with the price cap bundle –a global price cap as suggested by Laffont & Tirole (2000). This has theadvantage of the incumbent viewing access as just another product. If itoverprices local access then it needs to lower other prices to compensate.This may mean that long distance prices are not overly high in the end.The level of price for interconnection needs to recover a portion of the ‘accessdeficit’ from other firms if there is no scope for cross-subsidy (i.e. the openmarket option). In this case, the regulator needs to ensure that there is nocost transfer from the long-distance operations of the incumbent.5.4 QualityThe existence of price controls often necessitates the use of quality controlstoo. The reason is that a price-regulated firm has incentives to lower thequality of service to meet price controls instead of lowering costs. The currentcontract with Telkom for the exclusivity period has such measures. As Telkomis likely to still have some price controls in the post-exclusivity period due totheir dominance, quality measures would be appropriate too. There are arange of quality measures that can be used, including:• call completion rate• faults per 100 lines• speed for repairing faults• speed of installing a line• public phone box maintenance and repairQuality can be incorporated through financial penalties (current method),incorporating a quality index in the price cap, or an informal warning anddiscipline through more stringent price caps in the next round.58

Competition and Regulation in TelecommunicationsConcluding RemarksThere are many industry analysts who view the past 5 year exclusivity periodof Telkom to be a mistake by continuing to hamper downstream businesses.These analysts will argue for complete liberalisation. Other groups of societywill view the universal service rollout and low loss of jobs as success pointsfor the policy, and will look to continue this in the form of an exclusiveduopoly. The WTO commitment ensures that we need to at least move to alimited entry policy. However, in the end, the policy framework forderegulation of the telecommunications industry is going to be a politicalprocess.Ayogu and Hodge (2000) note that the distribution of gains and losses in thefull competition model favour the wealthy in society – the businesses and theheavy users of telecommunications. The low-income groups are likely to bearall the short-term adjustment costs (job losses) for some uncertain futurereward (jobs from downstream users of telecommunications and lower priceson future telephone use). Given the constituency of the government, thissuggests a gradual liberalisation approach may be preferred, where revenuemaximisation occurs and the gains can be transferred to the losers throughfiscal policy.If the full competition model is to be adopted, it needs to be structured toprovide stronger universal service support and deliver downstream benefits tolow-income groups rapidly. This suggests maybe raising the USF levy andpursuing strict competition and regulatory enforcement in the sector to lowerprices and benefit downstream job creators.59

Competition and Regulation in TelecommunicationsBibliographyArmstrong M, Cowan S. Vickers J. 1995. Regulatory Reform: EconomicAnalysis and British Experience. MIT Press, LondonAyogu M, Hodge J. 2000. ‘The socio-economic context and institutionalfoundations of privatisation and regulatory reform in South Africa’, GDNConference, December 10-13, Tokyo, 2000Bergman L, Doyle C, Gual J, Hultkrantz L, Neven D, Roller L, Waverman L.1998. Europe’s Network Industries: Conflicting Priorities. CEPR, UK.Cave, M “Alternative Telecommunications Infrastructures: Their CompetitionPolicy and Market Structure Implications”, 1995Hodge J. 2000. ‘Liberalising Communications Services in South Africa’,Development Southern Africa, vol. 17 (3), Sept.ICASA. 2000. “Notice in respect of a review of fees and charges in the publicswitched telecommunications sector” Government Gazette Number:21925 General Notice Number: 4715ITU, “Trends in Telecommunication Reform 1999: Convergence andRegulation”, 1999Kridel D, Sappington D, Weisman D. 1996. ‘The Effects of IncentiveRegulation in the Telecommunications Industry: A Survey’. Journal ofregulatory Economics, vol 9, pp. 269-306Laffont J, Tirole J. 2000. Competition in Telecommunications. MIT Press,Cambridge, MA.MediaAfrica.com. 2000. South African Internet Market 2000.M-Web. 2000. Annual ReportPosner R. 1971. “Taxation by Regulation”, Bell Journal of Economics andManagement Science. Vol. 2(1). Pp. 22-50Purton, P. 2000. “Former Monopoly loses significant market share”, FinancialTimes SurveyResende M. 2000. “Regulatory Regimes and Efficiency in US LocalTelephony”. Oxford Economic Papers. Vol 52 pp. 447-470RSA. 1995. White Paper on Telecommunications Policy.RSA. 1996. Telecommunications Act 103SATRA. 1999. Interconnection Guidelines.SATRA. 1999. Telecommunications Numbering into the Twenty-first Century.Consultative Document July.Statistics South Africa. 1995. Income and Expenditure SurveyStigler, G. 1971. “The Theory of economic Regulation”. Bell Journal ofEconomics and Management Science. Vol. 2(1). pp. 3-21Telkom Annual Reports 1995-200060

Competition and Regulation in TelecommunicationsTelkom. 2001. “Accomplishments in the Telecommunications Sector duringSouth Africa’s Democratisation Process”, http:www.telkom.co.za/government_ regulatory/index.shtmlWEFA. 1997. Social Accounting Matrix61