The In-House Lawyer

On 2 November 2010, Ofcom issued a decision concluding that the pricing policies of BT Group plc (BT) in relation to its offering of residential broadband services did not amount to a margin squeeze prohibited by s18 of the Competition Act 1998 (Chapter II) and/or Article 102 of the Treaty on the Functioning of the EU.

Ofcom examined the pricing policies employed by BT in relation to those of its wholesale products that were then used as inputs to retail broadband products (such retail broadband products being the ones used by customers to access the internet). Its outcome was based on an in-depth analysis of BT’s financial performance between 1 June 2002 and 31 December 2004 (the period of investigation). BT was found to enjoy a position of dominance in an upstream market for ‘residential wholesale intermediate broadband services’ and thus owed a responsibility not to let this position distort competition. Ofcom looked at whether BT abused its position of dominance by denying its downstream operators sufficient margins to function profitably. Despite Ofcom’s provisional finding being one of infringement of Chapter II and Article 102, BT was able to furnish new evidence in the form of financial data and arguments that led Ofcom to subsequently change its mind.

Background

The investigation first commenced in 2002 based on a complaint from Freeserve.com plc (Freeserve), but was thought to have been quickly resolved when Ofcom decided there was no evidence of anti-competitive behaviour by BT in the period up to June 2002. An appeal filed by Freeserve with the Competition Appeal Tribunal (CAT) resulted in parts of the Ofcom’s decision on predatory pricing being set aside for lack of reasoning. These were reconsidered by Ofcom with a similar outcome, ie BT had not operated a margin squeeze in the period up to June 2002. While doing so, Ofcom decided to extend the scope of its investigation to BT’s residential broadband pricing policies in the period between 1 June 2002 and 31 December 2004.

Statements of objection were issued to BT on the basis of provisional findings that indicated BT had infringed both Article 102 and the Chapter II prohibition. However, BT was able to produce detailed submissions using new arguments, as well as financial information that had not previously been provided to Ofcom that countered the provisional findings and led to a non-infringement decision.

Ofcom acknowledged that it was dealing with a significantly different marketplace to the one that existed during the period of investigation at ‘technological, regulatory and competitive’ levels. Moreover, even the products that were the focus of the investigation had since been superseded by other wholesale products developed to better suit the emerging competitive landscape.

Two relevant markets were chalked out for the purposes of the investigation:

1. the upstream market in which BT could possibly hold a dominant position; and
2. a downstream one that would be affected by BT’s conduct.

The downstream market was identified as one for residential asymmetric broadband internet access services. This market was thought to be subject to a ‘national common pricing constraint’, leading to the conclusion that the downstream market was national in nature.

The assessment of the upstream market noted the existence of activities at ‘distinct functional levels’, leading up to the provision of retail broadband services. On this basis, the upstream market was found to be one for residential wholesale intermediate broadband services, and again, the market was considered national in nature.

Whether BT held a dominant position in the upstream market

During the investigation, the upstream market, or at least part of it, displayed signs of ‘an immature market and a fast rate of growth’. This meant Ofcom could not conclusively apply the traditional measure of market shares, which, in an immature market, might rely on an unstable market size and other transitory factors, leading to a possibly inaccurate estimation of market power.

Instead, Ofcom considered a host of market share measures in its efforts to understand market power in the upstream market. These included, among others:

1. the wholesale intermediate services market (taking into account only those operators providing direct constraints at a wholesale level) – this resulted in a very high market share for BT of effectively 100%;
2. imputing wholesale intermediate shares from the retail market – BT’s share was over 40% post-December 2002 and over 50% post-October 2003; and
3. broadband coverage in absolute terms, as well as relative to cable operators (this was an example of taking into account indirect constraints due to the distinct lack of direct constraints on BT during the investigation) – BT achieved a high level of coverage during the investigation, with an absolute share that rose to 96% by December 2004.

BT displayed high market shares despite the varied measures for calculation used by Ofcom. These, when viewed in conjunction with significant barriers to entry to the upstream market (high level of sunk costs, administrative burdens and uncertainty over the viability of business models), lack of evidence of switching, and economies of scale and scope, all supported the view that BT enjoyed a position of dominance in the market for residential wholesale intermediate broadband services.

Whether BT engaged in margin squeeze in the downstream market

The next question was whether BT had then abused this position of dominance during the investigation. Ofcom identified certain criteria that would have to be fulfilled to conclude there had been a margin squeeze:

1. BT would have to be vertically integrated, ie operating in related upstream and downstream markets;
2. in the upstream market, BT would have to enjoy a position of dominance;
3. BT’s pricing decisions in the downstream market ought to be capable of influencing competitive conditions in that market;
4. the difference in the margin between the price charged by BT for the upstream input and the downstream product, respectively, would be insufficient to cover the costs of BT’s downstream operations; and
5. there ought to be no valid objective justification for BT’s conduct.

Ofcom began by looking at BT’s historic accounting data, which showed losses incurred by the undertaking during the investigation. This being insufficient to warrant a finding of abuse, Ofcom then examined BT’s financial performance using net present value (NPV) calculations (a method that assesses the overall profitability of the business or project over its life). The NPV analysis produced negative results, indicating BT’s downstream operations would be loss making for the period considered. The analysis suggested that ‘losses could not reasonably be expected to be recovered from future profits under competitive conditions’ and supported a provisional finding of infringement.

However, the provisional finding prompted BT to adduce additional evidence in the form of updated financial information and new arguments. BT identified certain adjustments and approaches used by Ofcom when conducting its analyses that seemed inappropriate. Ofcom’s approach noted assumptions within BT’s business plans that were overly optimistic and adjusted these downwards. That being said, this approach made no room for those assumptions that were overly conservative that could then be adjusted upwards. BT’s objection was recognised as partly valid, and in light of the new information that had been furnished, Ofcom’s provisional finding of infringement was reversed.

Conclusion

The evidence to support an argument that BT had abused its dominant position was insufficient, particularly considering:

1. the investigation related to an immature market that was experiencing a rapid rate of development;
2. the analysis was based on uncertain financial forecasts in BT’s business plans that were used when making management decisions; and
3. the aforementioned business plans were used as a starting point for Ofcom’s analysis, and necessitated the making of several assumptions and adjustments, resulting in an NPV analysis that was extremely sensitive to the slightest change.

When faced with an NPV analysis that was less than robust, coupled with a nascent yet dynamic market, Ofcom could not justify a finding that held BT had abused its dominant position when offering residential broadband services. Ofcom’s decision has finally brought to a close one of its longest running regulatory cases. Having done so, however, it has now revived an appeal originally filed by Freeserve before the CAT (relating to BT’s conduct up to June 2002) that had been stayed pending the outcome of this investigation.

By Niamh Grogan, partner, and Kamya Rajagopal, associate, SJ Berwin LLP.

E-mail: niamh.grogan@sjberwin.com;kamya.rajagopal@sjberwin.com.