REFORM AND REGULATION OF AUSTRALIAN TELECOMMUNICATIONS

by ALLAN BROWN

Introduction Reform of telecommunications is a central feature of the Australian

government’s programme of microeconomic reform. The guiding principle in telecommunications reform is to open the industry to increased competition. This process is taking place in the context of similar telecommunications reform in most developed and many developing countries, and at a time when the industry itself is expanding rapidly both in terms of size and the range of available products and services.

Traditionally, there have been substantial legal, technical and financial barriers to entry into telecommunications. This paper examines the government’s policy decision in lowering these barrier, and the regulatory framework it has developed to encourage and enhance competition in the industry. The process of telecommunications reform is still underway with additional market entrants and services anticipated, and further changes to the regulation of the industry foreshadowed to come into effect in July 1997.

Breaking Down the Barriers Because of high network sunk costs and low marginal cost of providing

services, telecommunications has traditionally been considered to be a natural monopoly. Until recently telecommunications services in Australia were provided by three carriers, each with statutory monopolies in their respective areas of operation. In 1946 the Overseas Telecommunications Commission (OTC) was established as the monopoly provider of overseas telecommunications services. The Postmaster-General’s Department, established at federation, was broken into separate statutory authorities in 1975, with the Australian Telecommunications Commission (Telecom) taking over the former department’s monopoly provision of tele- communications services within Australia. A third publicly-owned carrier, Aussat, was established in 1981 as the monopoly operator of the domestic satellite system which commenced its commercial activities with the launch of the first satellite in 1985 (Brown, 1991). The three carriers had exclusive access to their respective market segments guaranteed in legislation and were not permitted to compete with each other.

The Davidson Report (Committee of Inquiry into Telecommunication Services in Australia, 1982) advocated increased private sector involvement and competition in telecommunications. In particular, it recommended that private networks be permitted to interconnect with the public network and resell excess capacity, and to provide terminal equipment and certain

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telecommunications services. The Davidson Committee was ahead of its time, however, and the Fraser government did not act upon its recommendations (Barr, 1994). In the mid-1980s limited competition and private involvement in telecommunications was permitted by the Hawke government in the provision of terminal equipment and some non-core services, for example, private switchboards and radio paging services, but competition was inhibited by Telecom’s regulatory role in approving equipment for attachment to the network.

A further tentative step towards competition was taken in May 1988 when the then Minister, Gareth Evans, announced the opening of value- added services to full competition, and the establishment of the Australian Telecommunications Authority (Austel) as a separate, independent regulatory authority for the industry. Austel was given responsibility for protecting the carriers’ monopolies, protecting consumers from unfair carrier practices, technical regulation and promoting industry efficiency.

At about this time various initiatives were also introduced to increase the commercial focus of the government carriers. Importantly, government concern shifted from the day-to-day decisions of Telecom, OTC and Aussat to the monitoring of their performance. The carriers were each required to set financial targets and to provide strategic corporate plans to the Minister. In 1988 OTC was converted from a statutory corporation to an incorporated company. Telecom was brought into line with the other two carriers by being made liable for the payment of customs duties and sales tax from 1987, State payroll taxes from 1988, other State and local taxes and charges from 1989, and Commonwealth income tax from 1991/92 (BTCE, 1995a).

A much more far-reaching package of reforms was announced by the new Minister, Kim Beazley, in November 1990, and incorporated into the Telecommunications Act 1991 (hereafter “the Act”’). The government decided to merge Telecom and OTC into one general carrier, Australian and Overseas Telecommunications Corporation (AOTC), and the merger became effective in February 1992. (The corporate name of the merged entity was changed to Telstra Corporation Limited in April 1993, and in July 1995 its domestic trading name was changed from Telecom Australia to Telstra.) Aussat was sold to a private company, Optus Communications, and the satellite system provided the basis for a second general carrier in competition with Telstra. Mobile licences were granted to each of Telstra and Optus, and a third to another private company, Vodafone. Telecom’s monopoly on the supply, installation and maintenance of the first telephone to a property was removed from July 1991, as were restrictions on the purchase and resale of telecommunications capacity by “service providers” (see below). The 1990 reforms had the effect of shifting the satellite system from the public to the private sector, introducing carrier competition into the telecommunications industry, replacing the monopolies for domestic and international services with a duopoly, and establishing a triopoly for mobile services.

The government assured Optus and Vodafone that the new market

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structure would remain in place until 1997. In particular, it would not issue additional general carrier or mobile licences before July 1997. In return, the general carrier licence granted to Optus imposed requirements upon the company in relation to network construction and the provision of services. Optus is required to be able to supply fixed domestic long-distance (STD) and international long-distance (IDD) services to the entire Australian population by December 1997 (BTCE, 1995a).

The major decisions and events in the government’s telecommunications policy are summarised in Table 1.

TABLE 1 MAlOH DEVELOPMENTS IN AUSTRALlAN TELECOMMUNICATIONS POLICY 1946- 1997

1946 1975

1981 1982 1988 1989

1991

1992

1993

1994 1995 1997

~~~~

OTC established as publicly owned operator of overseas services. Postmaster-General’s Department broken up. Telecom established as publicly owned operator of domestic services. Aussat established as publicly-owned operator of domestic satellite system. Davidson Report released. OTC converted from statutory corporation to incorporated company. Austel established as industry regulator. Value-added services opened to full cornpeti tion. Telecom and OTC subject to price cap regulation. Opt us selected as second general carrier. Removal of Telecom’s monopoly on supply, installation and maintenance of first telephone. Removal of restrictions on purchase and resale of telecommunications capacity by service providers. Telecom and OTC merged to form AOTC. AOTC. Optus and Vodafone general mobile licences. Optus commenced operations. Vodafone commenced operations AOTC renamed Telstra. Commencement of review of post-1997 arrangements. Post- 1997 arrangements announced. Legislated carrier duopoly scheduled to end 30 lune. Carriers required to interconnect service providers and other carriers. Responsibility for telecommunications to pass from Austel to ACCC. . ~~~ ~ ~ ~ . . . ... ~~ ~~~ _____

Regulating for Competition Until 1997 Austel has the major responsibility for the regulation of

telecommunications. Nevertheless, the Act enables Austel to refer certain matters involving anti-competitive behaviour, misuse of market power, exclusive dealing arrangements and misleading or deceptive conduct, to the Australian Competition and Consumer Commission (ACCC, formerly Trade Practices Commission [TPC]). The TPC investigated various activities of the carriers, most notably during 1992/93, concerning complaints of misleading advertising by Telstra and Optus in relation to comparison of carriers’ prices.

Although Telstra faces rivals in the provision of telecommunications services, competition in the industry is far from even. Telstra enjoys considerable market power by virtue of its ownership and control of the

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local customer access network (CAN). This structural imbalance was a deliberate decision of the government when it opened the industry to competition in the early 1990s. It had a range of options available to it other than merging Telecom and OTC which would have resulted in more even competition (Ergas et al., 1990). It decided, however, upon what has been described as “a necessary political compromise” which preserved the predominant position of the publicly owned carrier, while at the same time introducing a degree of competition to the industry (Maddock, 1992, p. 256).

The government’s reform decisions recognise the incumbent advantages enjoyed by Telstra, and the primary objective of the government’s telecommunications policy since 1990 has been to encourage and enhance competition in the industry. In introducing the Telecommunications Bill I992 to the House of Representatives in May 1991 the then Minister advised that the government’s aim was “to ensure that by 1997 there is a significant, recognised network competitor to Telecom-OTC”, and that “the creation of one strong competitor is the best way of achieving genuine and sustainable competition quickly”. To achieve this goal it was necessary “to assist the second carrier [Optus] in overcoming the formidable advantages associated with Telecom-OTC’s control over the customer base, infra- structure and access to information so that the second carrier will be able to compete from as level a playing field as possible” (Beazley, 1991, pp. 3096-97). The government intends Optus to establish its market base, develop expertise and build infrastructure prior to the introduction of open competition in 1997. It considers that if unrestricted competition were introduced before 1997 both Optus and Vodafone would take longer to gain the “critical mass” necessary to provide effective competition to Telstra (BTCE, 1995a).

The Act thus essentially presumes that structural market conditions in telecommunications will, at some unspecified future time, be capable of supporting “sustainable Competition”. As a major means to that end, Austel has been given the responsibility of facilitating and fostering the development of competition in the industry. The Act also imposes on Telstra a number of “competitive safeguards” of a behavioural nature, which are designed to ensure that the corporation does not stifle competition by creating barriers to entry or by misusing its market power. The most significant competitive safeguards relate to interconnection, accounting separation, customer access and non-discrimination. These are now considered in turn.

I . Interconnection A prerequisite to the introduction of competition in telecommunications

is to provide the means for new entrants to interconnect with the incumbent carrier’s CAN. The technical and financial barriers facing a new entrant are much greater in relation to the provision of the local segment of calls than for long distance segments. Interconnection avoids the need for a new entrant to bear the high cost of duplicating the incumbent’s local

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distribution network. A major difficulty with this form of competition, however, is that there is a direct conflict of interest between the incumbent and the new entrant over the price of interconnection. This conflict requires the regulator either to determine the price of interconnection directly, or to establish the pricing principles to be applied by the network owner for arriving at interconnection charges (Cave, 1991).

The exercise of establishing pricing principles for interconnection is itself inherently complex and controversial. It has been observed that “the price of interconnection. , . is an interesting intellectual question, and a bit of a test for micro-economics, since it involves not only a ‘bottleneck’ issue but also consideration of common costs, externalities, declining costs, market power, supplying inputs to competitors, price discrimination and equity” (Cronin, 1995, p. 27). A major difficulty is that pricing rules which meet theoretical requirements tend to have information problems which make them unworkable in practice (BTCE, 1995~) . The Act provides for Telstra and Optus to negotiate the charges for interconnection, and for Austel to intervene if the carriers are unable to agree. In 1990 the government decided that the charge for interconnection was to be on a “directly attributable incremental cost” (DAIC) basis. This principle was designed to assist Optus become established by allowing Telstra to cover its cost of providing interconnection, but to make no economic rent from interconnecting other carriers. In June 1991 Austel was required to determine the initial interconnection charges. It decided that DAIC was to be based on long-run incremental cost, to comprise separate contributions to Telstra’s capital and variable costs, and to be applied to both the existing network and any new capacity provided for the purpose of intercoonnection (Davey, 1993).

On a national average basis, the initial interconnection charge was approximately 3.14 cents per minute, with the charge incurred at both ends of a call. This meant, for example, in the case of an Optus customer making a call to another Optus customer, Optus would be charged by Telstra around 6.28 cents per minute of conversation time. The interconnection charge was renegotiated in July 1994, this time with Austel acting as mediator between Telstra and Optus rather than setting the charge directly. The outcome was an increase of around 11 per cent, to an average of approximately 3.5 cents per minute (BTCE, 1995~). Although the pricing principle for the determination of the interconnection charge is favourable to Optus, Telstra’s long-distance (STD and IDD) interconnection charges comprise around 40% of Optus’s revenues for these services. Vodafone is similarly liable for payment of charges for its mobile customers interconnecting with Telstra’s CAN.

Because the government requires local calls to be charged on an untimed basis, the interconnection charge is still too high to allow Optus to compete in the local call market. (A local call between Optus customers of, say, four minutes’ duration would incur an interconnection charge of around 28 cents - 3.5 cents x 2 x 4 - in excess of Telstra’s current standard local call rate of 25 cents.) Without its own local distribution network, and given the

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pricing principles applied to the determination of interconnection charges, Optus is currently confined to the STD, IDD and mobile call markets (but see below].

2. Accounting Separation Telecommunications companies have a high proportion of fixed to

variable costs, and of joint costs. Also, as capital and additional capacity are usually acquired in large and indivisible lumps, incremental costs can be difficult to separate. The conceptual and practical difficulties in multi-product firms of allocating costs are thus accentuated in telecommunications. The problem this provides to regulation is to prevent cross-subsidisation, by the network owner, of services facing competition by proceeds from those areas relatively sheltered from competition. Information asymmetry between the established carrier and the regulatory authority, in relation to capital and operating costs, can exacerbate this problem.

The Act addresses this issue by requiring “accounting separation” by all carriers. To this end Austel has developed a chart of accounts and cost allocation manual (COA-CAM) which specifies the principles to be followed by the carriers in allocating costs to various areas of their activities and in reporting financial data to Austel. The primary intention of accounting separation is to require Telstra to engage in arm’s length transactions between different parts of its operations, and in particular for its internal transfer prices to be based on cost. The COA-CAM provides that any transfer price used by Telstra should be the price that it charges to its customers and, where the service does not have a market, to be based on long-run incremental cost (Davey, 1993). Accounting separation also provides Austel with information for use in other regulatory functions, especially the determination of interconnection charges and price regulation (see below).

3. Customer Access Competition in telecommunications is inhibited to the extent that

subscribers are discouraged from or inconvenienced in switching between carriers. To foster the attainment of sustainable competition, therefore, the government has adopted a policy of “equal access” to enable telephone subscribers to be able to use Optus long distance services in the same way and as easily as those provided by Telstra.

When Optus commenced operations in 1992 subscribers needed to dial “1” before their required number in order to have their call carried by Optus. This was an interim arrangement until Telstra’s network was upgraded to facilitate “preselection”. In early 1993 Austel commenced the conduct of a series of ballots, on an area basis and starting with the major capital cities, whereby all telephone subscribers were issued with ballot papers and invited to specify their choice between Telstra and Optus as their preferred long distance carrier. Those who chose Optus were

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transferred to the private carrier for all STD and IDD calls, while those specifying Telstra or not participating in the ballot remained with the public carrier.

Austel’s schedule for balloting provides that all subscribers will be offered preselection by June 1997. Callers are still able to override their preselected carrier (without charge) and have their call carried by the alternative carrier by dialling a four-digit code before the relevant long- distant number. To February 1995, Optus had obtained around 14% of that portion of the market which had been contested under the preselection ballot (BTCE, 1995a).

4 . Non -discrimin ation There exists the potential for Telstra to retard the development of

sustainable competition in the industry by misusing its market power in the form of price discrimination. In particular, it could offer low non- cost-justified tariffs to customers it selectively targets as most likely to switch to Optus, while charging higher prices to subscribers it considers less likely to change. There are, therefore, regulatory arrangements in place which are intended to prevent Telstra from discriminating between customers unless such discrimination can be reasonably cost justified.

Austel has disallowed a number of tariffs proposed by Telstra involving the bundling of local and long distance calls and considered to have a net anti-competitive effect (Davey, 1993). Following liberalisation of the anti- discrimination provisions of the Act in May 1994, however, Telstra has developed a range of discount tariffs which can be considered to involve price discrimination but are in compliance with the amended legislation (see below).

Universal Service Obligation Historically, one of the obstacles to private involvement and competition

in telecommunications has been the government’s policy of requiring Telstra to undertake certain community service obligations (CSOs). In particular, the provision of telephone services to the remote areas of Australia on a non-discriminatory and uniform basis has long been a policy objective. Other telecommunication CSOs have included access by telephone subscribers to directory assistance and emergency numbers. The losses incurred in providing such unprofitable services were traditionally cross-subsidised from Telstra’s profitable areas of operation. This became no longer appropriate with the introduction of competition, as it would have placed Telstra at an unreasonable competitive disadvantage in relation to the other carriers.

The regulatory response to this issue has been the implementation of new arrangements, administered by Austel, based on the Universal Service Obligation (USO). Telstra is nominated by the Act as the universal service carrier, and the cost to it of providing the US0 is required to be shared

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amongst Telstra, Optus and Vodafone according to each carrier’s proportion of total network connection time (in minutes). Because the US0 cost computation necessitates the use of confidential Telstra data, Telstra itself has been given the task of calculation, but by using a methodology agreed to by Austel and the other carriers and auditable by an external party (Austel, 1994b). The current methodology uses the “avoidable cost” approach which estimates the value of costs which would be avoided - including operating costs, depreciation and opportunity cost of capital - and revenues lost, if the USOs were not provided. Revenues which would otherwise be foregone are deducted from avoidable costs to arrive at an estimate of net cost which is designated the Net Universal Service Cost (NUSC). Table 2 sets out the NUSC and the levies payable by Optus and Vodafone, assessed by Austel, for the three years up to and including 1994195.

TABLE 2 NET UNIVERSAL SERWCE COST ($ MILLION): 1992193 TO 1994195

LEVY

Year ended 30 June NUSC Total Optus Vodafone

1993 1994 1995

~~

149.17 1.46 1.46 230.00 8.31 8.28 0.03 235.81 13.73 13.29 0.44

Source: Austel.

5. Price regulation The prices of telecommunications services in Australia have always

been subject to some form of regulation. Price regulation was exercised directly by the government, through the Minister, until 1984 when it came under the purview of the Prices Surveillance Authority. The regulation of telecommunications prices passed to Austel when it was established in June 1989. The regulation of prices in telecommunications was necessary when Telecom, OTC and Aussat were monopolies, and is still required to prevent Telstra exercising its market power to the detriment of the development of sustainable competition.

Competition in telecommunications has necessitated a move towards “rebalancing” Telstra’s tariffs to bring prices more closely into line with costs. For some services this process has also required “de-averaging”, which is a more specific form of rebalancing. This refers to charging prices related to the cost of providing individual services as distinct from the average cost of a similar cluster of services. Notably, the price of Telstra’s STD calls has historically been based on distance rather than the intensity of traffic, even though economies of scale and lower unit costs were achieved on busier (thicker) routes (Austel, 1994a).

The Act gives Austel greater control over a carrier’s prices in those segments of the telecommunications market where the carrier is deemed to be “dominant”. In particular, a dominant carrier is constrained in its ability to exercise price discrimination. Subject to oertain conditions, Austel can

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direct a carrier to supply specified basic carriage services (BCS). All carriers are required to file tariffs with Austel for all BCSs they provide, and Austel can disallow any tariff it considers to breach its price regulation principles. While a dominant carrier must charge in accordance with its filed BCS tariff, a non-dominant carrier is required only not to exceed the charges in its tariff.

At the commencement of competition in 1992 Austel declared Telstra to be dominant in the four call segments of the market, namely, local, STD, mobile and IDD. In April 1994, following the attainment by both Optus and Vodafone of significant shares of the mobile market, Austel determined Telstra to be no longer dominant in that market. In September 1994 Telstra advised Austel that it had formed the view it was no longer dominant in the market for international services and, accordingly, intended to charge prices below its tariffed rates for some IDD calls. Austel conducted a detailed inquiry into the matter and in August 1995 released a report concluding that Telstra was in fact dominant in the international call market and that its IDD prices were to remain subject to regulation (Austel, 1995b). Telstra subsequently announced that it would challenge this finding in the courts.

Telstra’s prices - but not those of Optus or Vodafone - are also subject to price cap regulation by Austel. Price caps were first applied in the United Kingdom in 1984 in relation to British Telecom, and have also been adopted for telecommunications regulation in the United States, the Netherlands, Germany, Sweden and Denmark, and in the UK and Australia for other utility services such as water, gas and electricity.

A price cap involves two main variables, an inflation index - in Australia the Consumer Price Index (CPI) - and an “X-factor”. Under the price cap, the average of a basket of prices is prohibited from increasing in any period by a percentage in excess of CPI-X. The price cap therefore ensures that the average price of regulated services falls in real terms by at least the amount of the X-factor. To maintain profit margins firms subject to price cap regulation must improve their overall productivity by at least the value of X, and any improvement in excess of X will, ceteris paribus, increase their profitability. Regulated firms thus face positive and negative incentives to improve productivity, and the resulting gains are shared with consumers by way of lower real prices. Price caps have been designed to apply to monopolies and other firms with substantial market power, and are intended to produce results - improved productive and allocative efficiency - normally associated with increased competition. An overall price cap allows a multi-product firm to move towards rebalancing its prices by increasing its prices for various products by differing proportions within the overall average limit. Price cap regulation also allows the government to determine the crucial X-factor, but to remain at arm’s length from day-to-day involvement in price setting (Xavier, 1995).

The government faces a dilemma, however, in setting the X-factor for Telstra. The higher the value of X the greater the short term productivity improvement forced upon Telstra and the greater the benefits passed on to consumers in the form of lower prices. On the other hand, the major source

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of improved medium to long term productivity in telecommunications is the replacement of obsolete plant with modern, more efficient technology. The government, therefore, needs to allow Telstra to generate sufficient surplus funds to be able to maximise its productive and dynamic efficiency (Nightingale, 1995; Whiteman, 1990). As sole shareholder, the government will also be mindful of the effect of the level of X upon the amount of dividend it receives from Telstra.

The price regulation provision applying to Telecom and OTC from 1989 to 1992, and to Telstra from 1992 to 1997, are summarised in Table 3. The initial price cap period ran from July 1989 to June 1992, immediately before the introduction of carrier competition and a revenue weighting method was adopted to calculate an average allowable price movement for the basket of services. A similar price cap applied to OTC’s international calls. The government decided to supplement its price cap arrangements with Notification and Disallowance (N&D) provisions by which the Minister had direct control over the prices of certain services considered too sensitive to be regulated by Austel. The N&D provisions were first applied to connections, public payphones and operator assisted calls, and later extended to leased line and mobile services.

TABLE 3 PRICE REGULATION OF TELSTRA SERVICES: 1989/1988

Notification & Period and price cap Basket of services Other constraints Disallowance

PRE-COMPETITION 1989/1992: CPI-4 Rentals

Local calls STD calls IDD calls

POST-COMPETITION 1992/1995: CPI-5.5 Rentals

Local calls STD calls IDD calls Connections Mobile services Leased lines

1996/1998: CPI-7.5 Rentals Local calls STD calls IDD calls Connections Mobile services Leased lines

Connections Public payphones Directory assistance Mobile services Leased lines

-Basket of 3 services (connections, rentals, Directory assistance local calls) CPI-2.0% Interconnection for

-Basket of all STD calls: CPI-5.5%

-Basket of all IDD calls: CPI-5.5% -Connections, rentals, local calls, individual STD calls: CPI

-Connections, rentals, Directory assistance individual STD and Interconnection for IDD calls: CPI-l% service providers

-Local calls, public payphone charges: no nominal increase 1.1.96 to 31.12.98

Public payphones

service providers

Source: Austel

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Telecom’s strategy during this initial period was to raise its overall prices by the maximum allowed by the price cap and, concurrently, to move towards rebalancing its prices nearer to costs. The overall prices for domestic services fell by 13% in real terms (about 4% per year on average) as required by the price cap. Within the basket, however, the nominal price increases for STD calls were proportionately less than that for local calls. OTC, on the other hand reduced the prices for IDD calls by an average of 25% in real terms, more than twice the reduction required under the price control arrangements (Austel, 1994a). This appears to have been an adjustment of IDD prices to align more closely with costs in preparation for competition with Optus.

The second period of price cap regulation applied from July 1992 to December 1995. Two studies of the 1989/92 price cap arrangements suggested that efficiency gains in telecommunications were sufficient to support an X-factor in excess of 4% (Xavier, 1993; Abraham, 1994). The government seems to have shared this view. For the second price cap period it increased X to 5.5%. The overall price cap continued to cover rentals and local, STD and IDD calls, and was extended to include standard telephone connections, leased lines and mobile services previously covered under the N&D provisions. For 1992/95 around 75% of Telstra’s revenue was covered by the price cap controls (BTCE, 1995a).

The second price cap regime also included three sub-caps: the price for a revenue weighted basket comprising connections, rentals and local calls was to increase by no more than CPI-2; for a basket of all STD calls, no more than CPI-5.5; and for a third basket of all IDD calls, no more than CPI- 5.5. Further, Telstra could not increase its prices for connections, rentals, local calls or individual STD calls by more than CPI in any one year. The purpose of these additional provisions was to constrain Telstra’s ability to offset price reductions on more competitive services with increases in less competitive areas, especially connections, rentals and local calls. However, by limiting particular price increases, especially for connections, rentals and local calls, the sub-caps severely retarded the pace at which Telstra was able to rebalance its prices (see below). For 1992/95 the N&D provisions continued to apply for public payphones and directory assistance, and were extended to include interconnection charges payable by telecommunications “service providers”.

Telstra reduced its charges for its price capped services by 3.6% in nominal terms in 1992/93, and by 3.7% in 1993/94. This resulted in real price reductions of 5.5 and 5.4%, respectively. However, it lowered its overall price caps by only the bare minimum required by the regulation. In fact, in order to comply with the price caps for both 1992/93 and 1993/94, Telstra relied on the provisions of the regulations which allowed it to carry forward up to 1% of the required price reductions into the following year. For 1994/95 Telstra reduced its revenue weighted price cap charges by around 5.6% - 10.1% in real terms -which was actually 1.1% more than required by the price constraint (and which it carried forward into the subsequent price cap period) (Austel, 1995~) .

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In recent years, the larger part of Telstra’s price reductions have been concentrated in areas subject to greatest competition with Optus, namely, mobile, STD and, especially, IDD calls. Moreover, most reductions resulted from special discount arrangements, rather than across-the-board reductions to standard charges. The nature of the discounting was such that it tended disproportionately to benefit Telstra’s large volume, high expenditure customers. For 1994/95,95% of overall price reductions under the price cap was accounted for by “specials” and other discounts (Austel, 1995~) . The attraction to Telstra of discounts targeted to specific customer groups is that they have less an adverse impact on revenues than across- the-board rate cuts, and thus assist Telstra to retain its more profitable customers and minimise its loss of market share from competition (Austel, 1994a).

Since the introduction of the price caps Telstra’s profits have progressively increased to reach a record level of $1.76 billion (after tax) for the 1994/95 financial year (Telstra, 1995). In response to these results the government has decided to raise the X-factor further, to 7.5%, for the third period of price cap regulation from January 1996 to December 1998. Table 3 shows that the basket of services subject to the overall price cap covers the same seven major services as for 1992/95.

Although the basic CPI-X formula might suggest an administratively simple form of regulation, in practice the regulator requires a substantial amount of information to assess the historic and prospective productivity of the regulated firm (Nightingale, 1990). This problem is exacerbated by the use of sub-caps in an attempt to constrain the regulated firm in rebalancing. According to Xavier (1993, p. 42), the attempt to fine tune the Australian telecommunications price cap scheme “has resulted in a complicated, more intrusive, less transparent system than was originally intended”. It is notable, therefore, that for the third period of price caps the system has been somewhat simplified. In particular, the three sub-caps on separate baskets of services have been eliminated. Nevertheless, connections, rentals and individual STD and IDD calls are each subject to a cap of CPI-1, and a new provision has been introduced freezing the price of local and public payphone calls until December 1998.

Service Providers In addition to competition among the carriers,. there is a second level of

competition in the industry among “service providers” which are firms which use services and/or facilities provided by the carriers to supply certain telecommunications services. Telstra and Optus supply some, but not all, of the services offered by the service providers. The service providers therefore both compete with, and complement, the operations of the carriers. consistent with its overall approach to telecommunications, the government’s policy is to encourage competition in the service provider industry. In speaking to the Telecommunications Bill 1991 the then Minister announced that one of the intentions of the legislation was

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to provide “a framework for fostering competition among all service providers . . . consistent with fostering sustainable network competition” (Beazley, 1991, p. 3096).

The service provider industry comprises four types of firms: suppliers of value-added services, for example, recorded information services and voice mail; suppliers of private network services within large firms, government departments, etc.; facilities managers, which organise and supervise telecommunications services and equipment for large private and public organisations; and “resellers”, which acquire telecommuni- cations services and capacity from one or more carriers for “repackage” and resale to third parties. “Switchless” resellers do not own or operate telecommunications networks, but use the switches and networks of the carriers to engage in the arbitrage of telecommunications services. They typically purchase bulk network services from the carriers at a discount for resale at a price less than that which their customers can negotiate individually with the carriers. “Switched” resellers have their own switches and equipment attached to the carriers” networks. They lease line capacity from the carriers and supply additional services, such as specialised billing and usage reports, which enhance the basic service acquired from the carriers (BTCE, 1995a).

In 1995 Austel undertook an examination of the resale segment of the service provider industry to assess the extent to which it was evolving in accordance with the government’s policy objectives. Austel found that the resale segment of the industry was dominated by only a few firms, there was little genuine price or non-price competition, and that resellers experienced generally low profitability. There was limited competition among switched resellers and only marginally more competition among the switchless firms. According to Austel (1995a), the major problem was that the legislation did not guarantee resellers the right to interconnect with the carrier’s networks, and effectively gave the carriers the ability to determine which products to supply to them and the basis of such provision: “[tlhe ability of the carriers to dictate prices and terms and conditions for network products and end-to-end services allow the carriers to exercise a high degree of market power over both switched and switchless service providers” (p. 36). Austel concluded that “the pre- conditions for the Government’s objective in relation to the tele- communications industry - that of fostering competition through service providers - are not yet in place” (p. 9), and that “the service provider industry is currently not performing in a way which would be expected from a commercially sustainable industry” (p. 13). Equipment Industry

Over 200 companies manufacture telecommunications equipment in Australia, and in 1994/95 they had sales totalling $4 billion and employed an estimated 11,000 people (Lee, 1995). Telecom’s purchasing policy was traditionally the most important influence on telecommunications equipment manufacturing in Australia. By the early 1980s around 90% of Telecom’s equipment were produced in Australia. General industry

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assistance programs such as high tariffs, preference and offset policies, research and development (R&D) grants and export development incentives also affected the size and structure of the domestic equipment industry.

As a result of government decisions in 1985 and 1991, the level of tariff protection for telecommunications equipment was scheduled to fall progressively to 5% by 1996. Concurrent with the announcement of the reduction in tariffs the government introduced several programs to provide support and incentives for the further development of the equipment industry, the most important of which are the carriers’ industry plans and the Information Industries Strategy.

In 1992, Telstra (then AOTC) released its industry plan which comprised a number of undertakings in relation to its future purchase of telecommunications equipment. The plan anticipated purchases by the company totalling approximately $10 billion between 1992 and 1995, the greater portion to be sourced from domestic suppliers. One of the criteria used by the government in evaluating the bids for the second carrier licence and the third mobile licence was the bidders’ proposals in relation to the local manufacturing industry. As conditions of the licences issued, Optus is required to spend $2 billion on telecommunications equipment and to achieve 70% Australian content, and Vodafone $400 million with 60% local content.

The government’s Information Industries Strategy was introduced in 1987 and expanded in the Working Nation White Paper (Keating, 1994). The Strategy is administered by the Department of Industry, Science and Technology and aims to foster growth and development of the domestic telecommunications and computer industries. In return for the achievement of specific levels of performance in relation to investment, R&D expenditure and exports, participating firms are eligible for tax concessions as well as benefits under the government’s procurement policies (BTCE, 1995a).

8. Post-1997 Arrangements In mid-1994 an industry-based advisory committee, the Tele-

communications Advisory Panel (TAP), chaired by the Minister for Communications and the Arts, was established to examine further legislative and regulatory changes to the industry. One of its terms of reference explicitly stated that the review’s findings should be consistent with the recommendations of the 1993 “Hilmer Report” (Independent Committee of Inquiry into Competition Policy in Australia, 1993) which were adopted by the Council of Australian Governments (representing the Federal government and all State and Territory governments) in April 1995. The Hilmer Report had recommended, among other things, that general economy-wide regulations be favoured over industry-specific regulation, that the Trades Practices Commission be expanded with the addition of wider responsibilities and renamed the Australian Competition and Consumer Commission (ACCC), and that the ACCC regulate an access

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regime assuring competitors access to certain “essential facilities” which cannot be economically duplicated but which it considered were necessary for competition.

Following publication of a paper outlining the issues to be considered by the TAP (DOCA, 1994) and a twelve month consultation period, the Minister, Michael Lee, announced a package of further policy reforms for the industry to become effective from July 1997. From that date there will be no regulatory restriction imposed upon the number of carrier licences issued, and no specific infrastructure rollout requirements imposed on new carriers. Carrier licences will be issued for a fee based merely on the recovery of the administrative cost involved in processing applications and allocating new licences. The Minister claimed that “[tlhe new arrange- ments will give Australia one of the most competitive telecommunications industries in the world” (Lee, 1995).

From July 1997 there will no longer be any distinction between general and mobile carriers. For the purposes of regulation the industry will be divided simply into carriers and service providers. Post-1997 there will also be no restriction on the number of service providers. In response to Austel’s report on the service provider industry (Austel, 1995a), which was presented by Austel as an input to the TAP review, the Minister advised that from July 1997 there will be mandatory access in telecommunications based on the access regime in the 7kade Practices Act 2974 which will provide “much greater scope for service providers to deliver an increasing range of services”. Carriers will be required to interconnect all requesting carriers and service providers as long as sufficient capacity is available and the specified interconnection is technically feasible. Terms and conditions of interconnection will be determined by commercial negotiation, with unresolved disputes subject to the arbitration mechanism under the trade practices legislation.

From July 1997 the administration of telecommunications competition policy is to be transferred from Austel to a new division within the ACCC, and the residual Austel functions (principally licensing and technical regulation) will be taken over by the Spectrum Management Agency. The remaining regulatory arrangements for the industry will remain in place, including the competitive safeguards, US0 arrangements and the requirement for carriers to make local equipment purchasing commitments as a condition of their licences.

9. Sustainable Competition or Perpetual Telstra Dominance? With only a few years’ experience of competition and with further

market liberalisation to take effect from 1997, there is, as yet, no clear indication of the eventual extent and character of competition in Australian telecommunications. Moreover, the BTCE has noted that “[tlhe publicly available data do not permit detailed conclusions about the extent to which genuine and sustainable competition has developed” (BTCE, 1995a, p. 127). A number of points can be made, however, on the results to date and prospects for the future.

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Benefits arising since the introduction of competition to tele- communications have included an expansion in the range of products available and an improvement in the quality of service provided by the carriers. So far, however, the quantifiable gains flowing directly from the introduction of competition have been limited. It has been estimated that Telstra’s price reductions for services covered by the price caps represented a benefit to its customers of approximately $300 million in 1992/93, $315 million in 1993194 and $500 million in 1994/95 (BTCE, 1995a, Austel, 1995~). Additional benefits have been received by the customers of Optus, Vodafone and the service providers. Reductions in the real prices of telecommunications services, however, are affected by regulation, technology and economies of scale as well as by competition, and it seems that not all or even the major part of the price reductions can be attributed to competition alone.

It was pointed out in Section 5 that Telstra reduced its prices by no more than required by the price caps in both 1992/93 and 1993/94, and by barely more than the price cap in 1994/95. This suggests that it has been regulation and not competition that has been mainly responsible for Telstra’s price reductions. The BTCE has noted that “falls in price achieved since the introduction of competition in 1992, have been similar to the declines experienced prior to the introduction of competition” (BTCE, 1995b, p. 10). The effect of competition has been to influence the extent to which the regulated overall price reductions have been distributed across the range of Telstra’s products. They have tended to concentrate on mobile, STD and IDD calls, and to benefit primarily large volume, high expenditure customers. While regulation has been largely responsible for the extent of the price reductions, competition has caused the reductions to be distributed unevenly across subscriber groups.

The fundamental question regarding the government’s tele- communications policy is the extent to which post-1997, competition will continue to depend upon regulatory arrangements which favour new entrants and constrain Telstra’s pricing behaviour. In particular, the competitive safeguards examined in Section 3 are intended by the government to be progressively removed as competition develops. Austel’s study of the market for international services, which found Telstra to be dominant in that market, also revealed the nature of competition that had developed between Telstra and Optus. Austel concluded that Telstra’s ownership of the CAN afforded it substantial advantages including its unique ability to jointly market local calls and related products, and increased opportunities for customer contact. Accordingly, Optus’s marketing strategy is based almost entirely on price, and it owes its market share in the long distance markets mainly to undercutting Telstra’s prices - on average, by around 9% (Austel, 1995b).

Austel revealed further that Optus was largely confined to the residential sector of the international market with only limited presence in the business sector. However, it achieved its market share entirely in its first year of operations, and its growth of market share “stopped dead” (p. 63)

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in late 1993 following completion of the preselection ballots for the major capital cities. Austel also founded evidence of “market signalling” (p. 51) from Telstra to Optus about the limits of acceptable competition and market share loss, and considered there to be few commercial incentives for Optus to compete more strongly with Telstra as it could lose substantially more revenue from further price cuts than it would gain from increased market share. Telstra therefore faced a “relatively tame competitor” (p. 52) in Optus. Austel concluded that “the structural and strategic conditions underpinning Telstra’s price leadership role are very strong” (p. 68), and that “Telstra controls to a very substantial degree the level and nature of the competition it faces” (p. 55). These conclusion are generally consistent with Ergas’s analysis.

To what extent then is this situation likely to change post-1997? Although there will be no regulatory barriers to the licensing of new carriers from July 1997, it is not clear that greater liberalisation will attract any further large scale entry into the STD or IDD markets. As the BYCE (1995b, p. 31) points out, “by the end of the duopoly in 1997, Optus and Telstra would have acquired substantial first mover advantages”. The same applies for the mobile telephone market where the current established tripoly seems likely to deter further entry after 1997. The planned phasing out of analog mobile telephony from 1996 and its replacement by fully digital technology will, however, relieve Optus and Vodafone of the payment of interconnection charges to Telstra’s analog network for mobile calls and may allow each of them to obtain a larger share of the mobile market.

It was seen in Section 6 that the market power exercised by Telstra in relation to non-carrier interconnection substantially inhibits competition from the resale segment of the service provider industry. The proposed new arrangements granting service providers guaranteed access to Telstra’s network, together with the probability of lower service provider inter- connection charges, should ensure that resellers provide stronger competition to the general carriers from July 1997 and have a further downward effect on prices (Ergas, 1995). Nevertheless, their operations are likely to remain confined to specialised niches of the telecommunications market.

There is one major development which has the potential to upset Telstra’s current commanding position in Australian telecommunications, namely, the construction by Optus of its broadband cable network. Optus plans for its network to be accessible to 50% of the Australian population by 1998, and to offer a complete range of telecommunications services, including local and long distance calls, pay TV and interactive services.

It is unlikely that the duplication of Telstra’s CAN for the carriage of telephony services only would be economically feasible. However, Optus apparently considers local network duplication to be viable if it can defray the cost by revenues from pay TV and interactive services. In other words, it intends its pay TV and interactive services to cross-subsidise its telecommunications operations. Optus hopes to achieve a significant share

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of the emerging pay TV market (via its pay TV subsidiary, Optus Vision), and to win a share of the local call market (estimated to be around $3 billion annually) by undercutting Telstra. It also expects that once it has its ”foot in the door”, a significant proportion of its new local call and pay TV customers will switch to the company for their long distance calls (a major attraction being that they would then receive one regular telephone bill, rather than two). By increasing its shares of the STD and IDD markets Optus plans to play a more substantial role in a continuing duopoly fixed- line telecommunications market.

This strategy by Optus is not assured of success, however. Telstra is responding to Optus’s cable rollout by building its own broadband network for the carriage of pay TV and interactive services. Whereas a broadband network is the means for Optus to enter the market for local calls, for Telstra it provides the basis for it to defend its local call market (or at least to minimise its loss of local call market share). The construction of two, overlapping broadband networks may well be highly economic inefficient. Nevertheless, with “deeper pockets” than Optus, Telstra is in a much stronger position to finance the high costs involved - estimated at $3 to $4 billion for each company.

Telstra is also matching Optus in pay TV. With one nationwide market rather than multiple localised markets, and with the population only 18 million, pay TV could well prove to be a natural monopoly in Australia. If so, Foxtel, the joint venture between Telstra and Rupert Murdoch’s News Corporation, may eventually emerge as a the dominant pay TV operation. The failure of Optus Vision in pay TV would be likely to confine Optus to a marginal role in the telecommunications market and ensure dominance by Telstra for the foreseeable future.

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