With the roll-out of Next Generation Networks in the fixed telecoms world and increased network sharing in LTE mobile networks, margin squeeze is attracting increased attention. What’s at stake is to maintain competitive retail markets in a situation where multiple service providers use the network of a network operator which also competes in the retail market.
A margin squeeze may occur where a vertically integrated operator sells both the retail service and an essential wholesale input to that service. Specifically, a squeeze arises when the difference between the operator’s retail price and its wholesale price is too small for an efficient competitor to: i) purchase the wholesale input; ii) provide the remaining inputs needed to create the retail services and iii) sell the retail service on a profitable basis. In practice, there are two main scenarios in which margin squeezes may occur.
Firstly, where the price of a wholesale service is regulated on a retail-minus basis the difference between the retail and wholesale price may be too small for an efficient competitor to compete and make a profit. Secondly, where the wholesale price of the vertically integrated operator is regulated but its retail service is not, retail prices could be set at a level which does not allow competitive operators to be profitable. The intention in such a case could be for the incumbent to drive competitors out of the market so that it can put up its retail price – short term pain for possible long term gain. Looking in more detail at the two cases, retail-minus regulation is used by certain regulators for some fixed network services.
For example, the UK regulator Ofcom has argued that retail minus may be appropriate for certain innovatory services where there is considerable uncertainty about service performance and it is important to encourage new investment. For this reason Ofcom has not imposed price regulation on BT’s VULA service (next generation bitstream) although the service is subject to a number of conditions.
However, it does require that VULA prices are set at a level which ensures there is no margin squeeze. In its draft recommendation on non-discrimination obligations of 7 December the European Commission outlines an approach for NGA (but not legacy access networks) which has something in common with Ofcom’s. The recommendation proposes that NRAs should not maintain or impose cost-orientation on NGA wholesale inputs providing certain conditions are met such as equivalence of input and the satisfactory outcome of an economic replicability (margin squeeze) test. In mobile networks, national roaming charges and prices paid by MVNOs are often set on the basis of commercial negotiations although this may accompanied with the potential threat of retail minus if that does not work.
In practice, commercial negotiation often does the trick, particularly when there are a number of operators in the market, but there is always the possibility of retail minus in the background and hence, the possible need to identify what the margin actually is. As mobile telecoms moves from a voice orientated business to LTE, it becomes increasingly difficult to determine what margins are because there is no clear relationship between data volumes and revenue.
Margin squeeze tests can also be applied in situations where wholesale prices are required to be cost orientated. A potential problem arises in situations where the margin squeeze test is failed since this could result in wholesale prices being set below costs – indeed, this has happened in Austria.
Setting wholesale prices below cost is warranted in situations where the incumbent is trying to squeeze competitors out of the market but seems inappropriate where prices have been reduced to remain competitive in the market. For this reason regulators and competition authorities need to take account of the prevailing circumstances when acting on margin squeeze tests where wholesale input prices are subject to cost orientation.
In this context it is interesting to note that the European Commission Draft Recommendation on non-discrimination obligations does not propose the use of margin squeeze testing for legacy access networks, where cost orientation is required. According to a 2009 ERG survey, 12 NRAs have a procedure to carry out margin squeeze tests and, indeed, a large number of tests have been conducted.
The importance of testing is likely to increase in the future, for example in the context of NGA network rollout. Given the increasing recognition that setting wholesale inputs in NGA networks on a cost orientated basis may have a negative impact on roll-out, margin squeeze testing will inevitably become an essential part of an NRA’s regulatory toolkit. Finally it’s worth saying something about margin squeeze tests themselves. Put simply there are many types of test and the appropriate way to conduct a test will depend on the circumstances under consideration.
In many cases regulators and competition authorities may do well to test for margin squeeze using two or more different methodologies. To give some idea of the approaches/issues involved: tests can be conducted on an ex ante basis or an ex post basis; tests can be conducted either on an Equally Efficient Operator basis (essentially the incumbent’s costs) or a Reasonably Efficient Operator basis (the costs of a potential competitor). The Commission’s recommendation has, probably sensibly, come out in favour of the former; tests can examine either projected or realised cash flows and/or look at year by year results.
There are arguments in favour of both approaches;for bundled products tests can be carried out either on a product by product basis or at the level of the aggregate bundle; A further and crucial factor to consider is the period over which the test is to be conducted. This is particularly important for new innovative products such as Next Generation Access where it may take a number of years to achieve a positive rate of return.
Written by Jonathan Wilby, Senior Consultant, Coleago Consulting