functional separation - arcep · implement accounting separation for its operations. in france,...

In regulated network industries, it issometimes necessary to impose on anintegrated company an obligation ofnon-discrimination in the provision

of access to certain infrastructures in orderto assure effective and sustainable competi-tion on the retail markets which rely onthese infrastructures. For instance, ARCEPmay, in accordance with the body of legis-lative and regulatory texts governing thesector, require an operator found by themarket analysis to have significant marketpower to accede to reasonable requests foraccess to certain parts of its network undernon-discriminatory conditions. The aim isto reduce the risk which exists, at least intheory, that a vertically integrated operatorwith proven power on a wholesale marketlinked to the possession of certain infra-structures will grant its own downstreamretail arm beneficial treatment to the detri-ment of its competitors, which could resultin a distortion of competition on the retailmarkets in question.

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The most obvious formof discriminationand the easiest toimplement is toput compe-ting

companies at a disadvantage by means ofthe pricing of access to infrastructures. Inorder to check whether the obligation ofnon-discrimination is being properlyobserved, the regulator does, however,have an effective tool at its disposal – theability to require the dominant operator toimplement accounting separation for itsoperations. In France, ARCEP requiredFrance Télécom to implement accountingseparation as soon as the sector wasopened up to competition. This require-ment was extended on 7 December2006 (1), following the introduction of thenew regulatory framework. The regulatorrequires France Télécom to provide sepa-rate accounts for its various operations,broken down in accordance with the defi-nition of the relevant markets, and toensure that its retail operations haverecourse to its wholesale services under“equivalent conditions” to those offered toalternative operators entering the retailmarkets. ••• continued on page 2

Accounting separation, functional separation, structural separation,ownership separation – there are a number of regulatory options whichcan be used to impose non-discrimination in the provision of access to

the dominant operator’s network. Separation is not always easy toimplement. An explanation.

REGULATE,SEPARATE, DIVIDE

Functional separation and the digitaldividend – two seemingly unrelatedsubjects. And yet, if one looks at theetymology of the words themselves,there is a similarity: separare, to setapart and dividendus, something whichhas to be divided. The first refers todrawing a dividing line between, onthe one side, an essential facility – theincumbent’s access infrastructure –and, on the other, the various serviceswhich use this infrastructure as acommon input; while the secondrelates to the division betweencompeting uses of a scarce resource –the radio spectrum released by thephasing out of analogue television.Consequently, these two issues –separation and dividend – shave asame economic basis. How toguarantee non-discriminatory access toan essentiel resource is the crux of theseparation issue, and is covered indetail in this Newsletter. How toguarantee the fair division of a finiteresource is that of the digital dividendissue, and this is now concentratingminds both in France and in Europe asa whole.

Aiming

for proportionate separation

In the network industries, non-discriminatory access to the verticallyintegrated incumbent’s essentialinfrastructure is a prerequisite for faircompetition and guarantees thereplicability of the services offered onthe retail markets. Proper accountingseparation, which allows a comparisonto be made between the terms appliedinternally to the downstream arms ofthe integrated organisation and theprevailing prices on the wholesalemarkets, appears to be an effective andappropriate means of controlling thepricing aspect of non-discrimination.

••• Editorial continued on page 2

Nicolas Curien,

Member of ARCEP

I NT H I S

S P E C I A LE D I T I O N

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• How to order the Report ? ppaaggee 1122

FunctionalSeparation:

pros and cons

ppaaggee 88

N° 55 - March / April 2007EEnngglliisshh vveerrssiioonn

OOffccoomm • Ed Richards, CEO, tells us aboutFunctional Separation

Special Edition - Functional Separation

2 LA LETTRE DE L’AUTORITÉ DE RÉGULATION DES COMMUNICATIONS ÉLECTRONIQUES ET DES POSTES ● M A R C H / A P R I L 2 0 0 7

However, ensuring equal treatment ofoperators as far as technical andcommercial issues are concerned requiresthe use of additional regulatory measures,such as powers of investigation, on a caseby case basis.

This makes it tempting to put in place aunified remedy designed to deal with alldiscriminatory practices, i.e. functionalseparation, or even legal (creation ofsubsidiaries) or structural (transfer ofownership) separation of the essentialfacility. In theory, such solutions seemattractive, in that they would reduce, oreven eliminate, any incentive to act in adiscriminatory fashion and would enforcetransparency in the relations between theseparate monopoly entity and the variouscompeting services which are customers ofthat entity. However, from a practical pointof view, a number of problems do arise.First of all, the greater the degree ofseparation, the higher the level oftransaction and reorganisation costsinvolved. Secondly, and to a greater extentthan in the energy sector, deciding where todraw the dividing line is a tricky business inthe electronic communications sector, ashas been demonstrated by the UK’sOpenreach setting, because of the rapiddevelopment of technologies and thegrowth in infrastructure competition.

Finally, separation does not in any wayremove the need to regulate the newbusiness unit which is created by theseparation process, in order to ensure thatit offers a sufficiently wide range ofwholesale services, implements cost-oriented pricing, maintains a satisfactorylevel of quality of service and pursues aneffective investment policy.

This being so, a proportionate regulatorymechanism could consist of trying toreproduce the theoretical benefits offunctional separation while at the sametime avoiding its practical disadvantages,perhaps by means of requiring theseparation of information systems used fornetwork operations and those used forservice operations, and the adoption of agood practice code, similar to the approachadopted by AGCOM in Italy in 2002.

Aiming for a harmonised dividend

The burgeoning development of usesbased on the new wireless electroniccommunications systems, including inparticular third generation mobiletelephony (UMTS), WiMax and personalmobile television (DVBH), requires theavailability of additional radio frequencies.

••• continued on page 3

The provision of such services is based,in particular, on the internal use ofcommercial transfer agreements which canbe controlled by the regulator.

Ad hoc correction of non-price discrimination

However, discrimination can also benon pricing-related. It may, for instance,take the form of employing delayingtactics in the processing of orders, or elsenot providing sufficient relevantinformation necessary for introducing aservice on the retail market. It may alsotake the form of giving preference to therequirements of internal operationscompared with those of competingoperators, when planning thedevelopment of the network orestablishing the conditions of access toinfrastructure. This bending of the non-discrimination rules can prevent acompeting operator from establishing aviable service offering from the pricing,commercial or technical points of view. Itmay also adversely affect its quality ofservice or its plans for developing its own

infrastructures, which in the end will havea detrimental effect on the level ofconfidence placed in it by its existing orpotential customers.

It is therefore of great importance that,in order to ensure the development of fairand sustainable competition, the regulatorshould check that the non-discriminationobligation is being properly applied fromthe non-price point of view. In theabsence of an automatic detectionmechanism, the regulator must beconstantly vigilant in order to be able toidentify suspect practices and, if necessary,to impose corrective measures. It mustcarry out audits on a case-by-case basisand set often long and complexprocedures in motion. This situation aroserecently in France, with the opening of aninquiry into the non-discriminatoryprovision by France Télécom of the

optical fibre links necessary to allowalternative operators to connect remoteMDFs (2).

However, the effectiveness of regulationto correct problems identified on an adhoc basis is sometimes questionable.Therefore, in addition to ensuring thatactual equivalence of inputs exists, makingsure that interested parties haveconfidence in this equivalence of inputs isalso important in order to preventalternative operators from overestimatingthe risk. This was one of the argumentsput forward in the United Kingdom forthe functional separation of BT, which ledin January 2006 to the creation ofOpenreach, a separate division responsiblefor marketing the incumbent’s networkaccess infrastructures.

Chinese wall mechanisms and dealing with the problem

of asymmetric information flowsFunctional separation involves making a

separate business of the incumbent’s divi-sion responsible for the sale of access to theinfrastructures to which the non-discrimi-

nation obligation relates, andapplying to this new businessunit a certain number of

operational rulesto create a Chinesewall between itand the other

services offered by theincumbent operator. Thefunctionally separate businessis obliged to maintain strict

equivalence of inputs between all itsvarious carrier customers and also, there-fore, between the company of which it ispart and competing companies. The opera-tional rules established aim in particular atcontrolling the flow of informationbetween the newly created business unitand the other arms of the incumbentoperator, as well as the order managementprocesses within this new business unit,the behaviour of its employees and itsmode of corporate governance.

Functional separation appears to be apotentially effective way of dealing withthe problem of asymmetric informationflows between the incumbent operatorand the regulator and, in more generalterms, with the issue of guaranteeing non-discrimination. Indeed, it has severaladvantages. Functional separation increasesthe transparency of the relationship

« Functional separation devolvesresponsibility for non-discrimination from theregulator to themanagement of the newlycreated business. »


Furthermore, in orderto minimise the cost of rolling out thesevarious networks and to guarantee thewidest possible geographical coverage,as well as indoor penetration in denseareas, it will be necessary for thesesystems to be able to benefit fromlower frequencies, i.e. below 1 GHz,which have better propagationproperties, in addition to thefrequencies already allocated to them atpresent. In fact, it just so happens thatthis would now be possible, becausethese highly sought-after frequencies inthe VHF and UHF bands, which up tonow have been allocated exclusively toaudiovisual services, are due to bereallocated between now and 2011, dueto the switch-over from analogue todigital television, and as the latter is sixtimes less spectrum hungry thananalogue, this will automatically resultin a release of frequencies – the so-called digital dividend.

Although the dividend will not actuallybe available until the end of 2011, it isimportant that we begin now, in 2007, toreassess the situation and to establishthe terms for dividing up the spectrum.Two important milestones have alreadybeen reached, the first last February, atCommunity level, with the definition bythe RSPG (Radio Spectrum PolicyGroup) of the digital dividend, and thesecond, in March, with the French lawon the modernisation of audiovisualbroadcasting and the television of thefuture, which specifically mentions thedigital dividend, states that electroniccommunications services are an eligibleuse for this dividend (even though it islikely to remain mainly in the hands ofthe audiovisual sector) and establishes aparliamentary digital dividendcommission, which is to rule on ascheme for the reuse of frequenciesproposed by the Prime Minister. It isvery important, while all this is goingon, for France to take action to establishthe precise extent of the digitaldividend, taking into account the impactof the development of signalcompression techniques (the MPEG-4standard) and network planning (SFNarchitecture). It will then be in a goodposition to work, within the Europeanframework, towards the identificationand, if possible, the harmonisationwithin the dividend of a band ofcontiguous frequencies reserved forwireless broadband systems.

Nicolas Curien

M A R C H / A P R I L 2 0 0 7 ● LA LETTRE DE L’AUTORITÉ DE RÉGULATION DES COMMUNICATIONS ÉLECTRONIQUES ET DES POSTES 3

between the divisions managing the partsof the network subject to the non-discrimination obligation and the otherservices offered by the incumbent, makingdiscriminatory behaviour easier to detectand, where appropriate, to sanction it.

The nub of the matter is that byreducing the incentive for and/or theability of the employees managing theseparts of the network to grant preferentialtreatment to the incumbent’s own retaildivisions to the detriment of alternativeoperators, functional separation makessuch behaviour far less likely. It also allowsresponsibility for non-discrimination to bedevolved from the regulator to themanagement of the newly createdbusiness. This means that, whereas in theabsence of functional separation theregulator has to take steps on a case-by-case basis to re-establish equivalence ofinputs, with functional separationequivalence of inputs is the rule, and it isup to the separated business unit to justifyany departure from this rule which mightbe necessary for the efficient operation ofthe integrated company and to obtain theregulator’s approval for any such change.

Functional separation, followed bylegal separation – the experience of

the energy industryWhere functional separation is consi-

dered insufficient to guarantee total non-discrimination, legal (or structural)separation of the operator may be recom-mended. This consists of converting thenewly created business unit into a subsi-diary, in order to make the relationshipbetween this business unit and the incum-bent’s other divisions even more transpa-rent. The final stage is complete separationof ownership, i.e. the sale of the news u b s i -d i a r yto differentshareholders.Total separation ofthe retail arms of theincumbent from thedivisions controlling access to the relevantparts of the network is, in theory, the onlyway of completely eliminating any incen-tive to discriminatory behaviour on thepart of the incumbent operator.

The regulation of the energy industryoffers an interesting example of how this

concept has been put into practice. In theelectricity and gas sectors, Europeanregulation has imposed first the functionalseparation and then the legal separation ofthe transport and distribution operations.In France, an electricity transmissionsystem operator, operationally indepen-dent from EDF, was established in 2000,pursuant to the law of 10 February 2000on the modernisation of the publicelectricity supply service, transposing theCouncil’s Directive 96/92/EC whichopened up the electricity industry tocompetition. The functional separation ofEDF’s distribution business was imposedby the law of 9 August 2004, in pursuanceof Directive 2003/54/EC. Theunbundling of network operations in theinternal market was accelerated by therequirement to implement legal separationimposed by this second Directive,functional separation alone of thedistribution business being permitted onlyon a temporary basis. The question ofseparation of ownership of the electricitytransport companies is currently thesubject of debate in Europe.

Separation is a tricky issue in

the telecommunications sector Although the functional separation of

the network divisions of the incumbentoperators has been imposed in the energysector on the basis of EuropeanDirectives, this solution has not yetbecome part of the European regulatoryframework governing the electroniccommunications sector. Functionalseparation is currently under review inseveral countries, but so far has only beenimplemented in the United Kingdom,

and is being approached with caution bymost regulators. The apparent appeal ofsuch a solution must not be allowed tomask the difficulties involved inimplementing it, particularly whenconsidering the distinctive features of theelectronic communications sector.

« It is possible that functionalseparation will result inincreased network accesscosts for all operators across the board. »



Generally speaking, the implemen-tation of functional separation entailscosts which are well in excess of thoseinvolved, for instance, in theimplementation of accounting separation.These costs relate to the reorganisation ofthe company, the duplication of technicalstaff and engineers and, in general, thesplitting up of various activities whichhad presented a certain degree of synergy.In the case of telecommunications, it istherefore possible that functionalseparation will therefore result inincreased network access costs for alloperators across the board.

Greater regulatory control aimed atpreventing discrimination on the part ofthe incumbentalso runs the riskthat the incum-bent will thenmake less effortwith respect tothe overall qua-lity of the servicesprovided. Although thisproblem is notsolely restrictedto the telecom-m u n i c a t i o n ssector, it shouldbe noted thatwhen evaluatingthe first resultsof the Open-reach undertaking, Ofcom identified areduction in quality of certain productswhich could be interpreted as achievingequivalence of inputs by means of ageneral levelling down (3). However, thiscould also be simply a temporary effect, asquality seems to have improved in certainrespects, according to Ofcom’s latestreport (4).

The British experience shows thatfunctional separation is a not a substitutefor other regulatory mechanisms butshould be regarded as a supplementarydevice. In other words, it does not doaway with the need to regulate otheraspects of the newly created business unitsuch as its tariffs, quality of service,investment management or even therange of services it markets. Even if it is afunctionally separate business unit, thenetwork access division of a particularoperator will not always, as a matter ofcourse, offer the range of services

this sector mean that regularmodifications to the regulatory structurein place will be necessary as the markets inquestion develop. This is the very basis forthe European regulatory framework,which provides for periodic reviews – atleast once every three years – of eachmarket analysis and therefore of theobligations imposed in this respect by theregulators. This requirement can seem outof step with a long-term remedy likefunctional separation.

Several of the measures mentioned here are mandatory (accounting separation,creation of a business unit, etc.), while others are optional and can sometimes beapplied to differing degrees. And, finally, some components can only be imposed inconjunction with others.• Separation of functions

- Creation of a separate business unit “A”, responsible for the production and supplyof the products in question.- Obligation to supply all operators under non-discriminatory conditions(equivalence/equality)- Separation of operational support systems- Separation of the brand (total = different name/partial = “A, a division of B”)

• Separation of employees

- Employees are not permitted to work some of the time for A and some of the timefor another department of the incumbent- Restrictions on the movement of A’s managers to the rest of the group- Physically separate offices and places of work

- Pay incentives- Code of conduct, notice boards, training

• Separation of information

- Limits on the flow of information between A and the other divisions(firewalls, Chinese walls)- Implementation of separate access systems (information specific tothe needs of the employee)- Separation of information management systems

• Financial separation

- Accounting separation- Separate budgets- Financial autonomy

• Separation of strategies

- Separate management- Separate management board, independent of the group- Strategic investment decisions taken independently by A

• Monitoring of compliance with obligations/performance

- System for reporting breaches (integrated/independent)- Independent complaint handling committee- Sanctions applied in the case of default- Publication of performance indicators (by an independent body/third partycertification)- Submission to the regulator of contracts signed between A and the incumbent(and/or alternative operators)- Publication of compliance reports (by the regulator/by a third party)

The main “components” of functional separation

Accounting separation: separatefinancial reporting for each of theoperator’s lines of business in itsregulatory accounts.

Functional separation: creation of aseparate business unit along withoperational rules to establish Chinesewalls between this new business unitand the incumbent operator’s otheroperations.

Legal (or structural) separation: makingthe new business unit into a separatesubsidiary.

Ownership separation: divestment bythe operator of its newly createdsubsidiary (resale to differentshareholders).

Glossary

necessary for the growth of the retailmarket.

Other problems relate more specificallyto the particular nature of the electroniccommunications sector and make it moredifficult to impose an obligation toimplement the functional separation ofcertain infrastructures belonging to avertically integrated operator with SMP.Three partly related examples are givenbelow.

First of all, the competitive dynamics of



Next, as certain parts of the networksare replicated or will be replicated in themedium term, it is difficult to find anappropriate point at which to set the boun-daries of the business unit to be separated.This difficulty does not arise in the electri-city industry, as the transport and distribu-tion networks are natural monopolieswhich do not call for any duplication. Inthis case, unlike the electronic communi-cations sector, functional separation doesnot raise any question of the possibledisadvantage to the operator on which it isimposed, compared with alternative opera-tors which can continue to benefit fromtheir vertical inte-g r a t i o n .Should thec r i t e r i o nused toe s t a -blish thed e m a r -c a t i o npoint of the separatebusiness unit be the total lack of replica-tion of the infrastructures required bycompetitors, or simply the dominant posi-tion of the operator on the wholesalemarkets linked to these infrastructures?

Finally, segmentation can be difficult todefine in practice and on a stable basisover time, since it is not limited to passiveinfrastructures (civil engineering, highstructures, radio masts, etc.), andparticularly because telecommunicationsnetworks are constantly undergoing rapidtechnological change, unlike other sectors.In particular, the characterisation ofcertain parts of the network as a naturalmonopoly can change over time in linewith the development of the technologiesand investment strategies of the variousoperators.

Ultimately, ending up, as a result offunctional separation, with another“monopoly” which will need to beregulated on an ongoing basis would seemto be contradictory when compared withthe principles of the regulation introducedin France and elsewhere in Europe overthe last ten years, which aims to developsustainable competition by means ofinvestment in infrastructures and thereduction, or eventual elimination even, ofregulation in the industry.

A final general argument, but onewhich is particularly relevant in a sectormarked by profound technological

change, raises the issue of adequateincentives for investment in thefunctionally separate networks, sincesuch decisions are not made in isolationfrom the strategies of the players on theretail markets or, naturally, from thechoices made by the operator on theparts of the network which have not beenseparated. A mechanism for coordinatingthe various players would probably beessential, but would be particularlycomplicated to organise, withoutnecessarily being able to achieve asatisfactory balance between non-discrimination and efficiency.

Finding an effective and proportionate remedy

is a major concern Another approach, which currently

seems to be under consideration by theItalian regulator AGCOM, is to separatethe entire network from the retailservices (5). While this solution simplifiesthe question of deciding on thedemarcation point of the division to beseparated, it does not clearly separate theparts of the network which have beenreplicated from those where theincumbent is required to provide access toits competitors under non-discriminatoryconditions. Therefore, although it doesprovide transparency in the relationsbetween the business units selling access tothe network and those offering retailservices, it can be particularly difficult todefine and control the rules required togovern the operation of the separatedbusiness unit. With this configuration,independence from downstream activitiesshould only be required for certaininfrastructures.

In theory, the implementation of func-tional separation within the incumbent,achieving greater transparency, as well asadequate incentives to provide equivalenceof inputs, leads to simplified and moreeffective regulation, as far as non-discrimi-nation is concerned. In practice, however,defining the demarcation line of such a

business unit raises anumber of issues.Furthermore, functionalseparation gives rise to a whole range ofcosts and does not remove the need forregulation of prices, quality of service,investments or the services offered in theaccess network.

Ultimately, it is only by carefullyassessing the benefits of such a measure asfar as its anticipated effects are concerned,taking into account conditions through-out the industry in the country in whichthis measure is to be implemented, andtherefore of the gains to be achieved fromgreater competition, that it can beestablished whether it will prove to be aneffective and proportionate measure.

On a smaller and more pragmatic scale,without directly imposing the creation of aseparate business unit, it is also possible toimpose operational rules on the incumbentdrawn from various “components” of func-tional separation and which have the sameobjective of achieving non-discrimination.This was the course chosen by AGCOM in2002, when it imposed on Telecom Italia(TI) rules requiring the separation of theinformation systems of the divisionsresponsible for network management andthose selling retail services, together with acode of conduct for its employees.Similarly, current regulation in France isbased on a combination of various non-discriminatory mechanisms. For instance,with regard to access to France Télécom’slocal loop, accounting separation has beenimposed, along with regular monitoring ofFrance Télécom’s operational processes andof various quality of service indicators forits LLU services.

(1) ARCEP Decision No. 06-1007(2) Optical fibre links which France Télécom is obliged,subject to availability, to offer to alternative operators, aspart of its LLU service offering (ARCEP Decision No. 05-0277)(3) Cf. Ofcom’s “Report on the Implementation of BT’sUndertakings”, Fourth Quarterly Report, 5 September2006.(4) Cf. Ofcom’s “Report on the Implementation of BT’sUndertakings”, Fifth Quarterly Report, 12 February2007.(5) In 2002, AGCOM imposed on Telecom Italia (TI)rules requiring the separation of the information systemsof the divisions responsible for network management andthose selling retail services, together with a code ofconduct for its employees. It now seems that the Italianregulator is considering going still further by imposingoperational separation within TI, still using the samemodel of separation between the network infrastructuresand the retail services.

« Functional separation does notremove the need for regulation ofprices, quality of service,investments or the services offeredin the access network. »

Jacques Champeaux, Executive Director, Regulatory Affairs, France Télécom

The latest news on the subject ofseparation stems from the declara-tions made by the EuropeanCommissioner in charge of the

Information Society, which recommend allo-wing national regulators to oblige operatorshaving significant market power to separatenetwork and services. As an example of this,Viviane Reding mentions the “break up” ofATT in 1984, as well as the creation ofOpenreach in the UK, a division of BT with aremit to commercialise certain access productsreputed to be monopolies.

Openreach is the remedy that BT nego-tiated with the British regulator, Ofcom, follo-wing the failure to develop unbundling in theUnited Kingdom, in the place of solutions thathave functioned in other countries, particu-larly in France. While, for some people, func-tional separation seems to be a guarantee of

non-discrimination, it also has major draw-backs.

Degradation of service quality Firstly, it removes any incentive to ensure

the operational quality and economic perfor-mance of access activities, which are subject tothe separation obligation : the entity in chargeof these, by its very nature and governance, hasno direct interest in the smooth operation ofretail services. Yet, the quality of access servicescalls for the deep and permanent involvementof the network owner, to ensure good inter-meshing between the customer process and thenetwork process. So, while such a separationmay, on paper, lead to greater equality of treat-ment between retail operators in the perimeterdefined by the separation process, it also meansa general degradation of service quality. Thishas been observed with Openreach, as it haswith the electricity and rail sectors andrecently, unfortunately, in the British railnetwork. In addition, equality remains theore-tical, as long as the historic operator isn’t reallysupplied by the separate entity in charge of theaccess network, which, according to Ofcom, isstill mainly the case of BT and Openreach.

On the other hand, the success of unbund-ling in France shows that vertical integrationspurs the historic operator to perform well andthat this benefits the market as a whole,through the real application of the principle of

non-discrimination, which is permanentlycontrolled by multi-lateral working groups andthe monitoring of operational indicators.

Risk of under-investment Secondly, separation presents a major risk

of under-investment in the new access infra-structures, because of the lack of incentives forthe access network operator, which, as a virtualmonopoly removed from competitive pressure,has no interest in the development of offers inthe retail market. Moreover, chronic under-investment is a constant characteristic of casesof separation observed in network industries inthe past.

Finally, unlike the electricity and railsectors, the technologies of telecommunica-tions access networks develop rapidly. So,wanting to fix an effective and durable frontieris a vain hope. The risk of errors, costs anddelays in implementation are disproportionateagainst any eventual gains.

All of this shows that separation is not sucha good idea after all. We can hope that, in thisfield, the players in the French market will gobeyond the traditional roles they generallyplay: what France Telecom would lose in termsof efficiency, in both the operational andeconomic fields, following a functional separa-tion, would not be gained by its competitors,who would suffer just as much, and wouldcertainly not benefit consumers. ■

In September 2005, BT took the deci-sion to offer Ofcom a series of volun-tary Undertakings (1) – in lieu of areference to the Competition

Commission and potential full structuralseparation – that included the formation of a

separate new business division to be calledOpenreach. The implementation of thisfunctional separation solution came withOfcom’s commitment to review the removalof retail regulation.

BT’s Undertakings are a set of legally

binding agreementsThe key elements of the operator’s under-

takings are as follows:1. Equivalence of Inputs for BT’s downstream

activities and for BT’s wholesale customersfor Access and Backhaul services:

• same products• same supply timescales, terms and condi-

tions, including price and service levels • use of the same systems and processes

• same service, system and process reliabilityand performance

• same controlled access to and sharing ofcommercial information relating toproducts, services, systems, processes,network coverage and capabilities.

2. ‘Chinese wall’ separation between up anddownstream product divisions within BT.

3. Effective, transparent and public accoun-ting separation obligations.

4. A clearly separate (from the incumbent’sother business units) upstream businessunit with:

• transparent, forceful obligations – public,published, monitored and reported targets

• separate staff, management, and remunera-tion incentives

• specific obligations with respect to

Is it really a good idea?

Grant Forsyth, Head of Global Interconnection - Commercial,


Without this

assurance, BT

would

undoubtedly have

been more

reluctant to invest

in its 21C next

generation

network

Openreach : BT’s vie


Separationpresents a majorrisk of under-investment in thenew accessinfrastructures

Special Edition- Functional Separation


commercial and customer informationconfidentiality

• monitoring and oversight by an indepen-dent Equality of Access Board

• governed by a independent managementBoard

5. Effective regulation to ensure enforcementincluding:

• open to directions from Ofcom and/or courtenforcement

• reference to the Competition Commission• third party actions for damages.

The benefits of functional separation

BT, Ofcom, competitors and consumersall benefit from the undertakings.

First of all, BT benefits from retaining the

efficiencies of a vertically-integrated operatorand removing the uncertainty of future harshregulatory remedial actions, thereby allowingit the ability to invest and innovate withgreater freedom. Without this assurance, BTwould undoubtedly have been more reluctantto invest in its 21C next generation network.

Ofcom benefits through having a clearerregulatory focus on the incumbent telecom-munications operator, which is now subject tostrict oversight of its compliance with non-discrimination principles.

Furthermore, competitors can have greaterconfidence in the industry through a levelplaying field which will result in increasedinvestment and innovation leading to greaterchoice and lower prices to the benefit of allconsumers.

And last but not least, investor confi-dence has not been dampened. The creationof Openreach and its own separate reportsprovides a clearer picture of the financialperformance of different parts of the busi-ness. The increased transparency is likely tolead to BT having greater analyst coverageand greater access to capital funding in thefinancial markets.

Helping to create a climate of confidencefor sustainable infrastructure competition,investment and innovation, BT has shown arelatively strong share performancecompared with many of its European peerssince it announced its undertaking to func-tionally separate. ■

1http://www.btplc.com/Thegroup/Theboard/Boardcommittees/EqualityofAccessBoard/EqualityofAccessBoard.htm

Accounting separation, which isalready being implemented, is notsufficient to guarantee the opera-tional and financial equality of access

which would enable alternative operators tocompete with the incumbent on a level playingfield, i.e. allow them to replicate its retailservices developed on the basis of non repli-cable infrastructures, at least under reasonablefinancial terms.

The first problem is that accounting separa-tion does not reduce the asymmetry of infor-mation hampering the regulators. Because ofthe time-consuming processing involved,instead of being an ex ante tool designed toprevent discriminatory behaviour, it is in factonly of any use in the context of any ex postproceedings, and therefore incompatible withthe fast-moving development of the market.

Furthermore, it fails in particular to resolvethe issue of operational discrimination. Wehave had to wait three years to see the LLU andbitstream quality of service indicators start toconverge with those of France Télécom’s retailservices. Now that a new cycle of investment isbeginning with NGN and NGA networks, theindustry cannot afford such delays.

The solution we really need is functionalseparation, on the lines of the Openreachmodel implemented by BT and which, as faras we know, has been a success both for thatoperator and for the British market, to the

extent that its implementation is beingseriously discussed in a growing number ofcountries and in the European Community.

Contrary to this, however, AFORST is notin favour of structural separation which means,in other words, the dismantling of the incum-bent operator, even to the extent of splitting upits ownership of its network managementoperations and its retail services. Apart fromthe high cost of implementation involved, thissolution, by setting a fixed boundary aroundthe transferred assets, would not be able to takeinto account technological progress and woulddiscourage the owner of the network frommaking the necessary investments.

A flexible incentive toolFunctional separation, on the other hand,

offers the necessary flexibility to adapt to tech-nological and competitive changes in themarketplace. It avoids the need for complex,costly and, to a certain extent, ineffective regu-lations. It stimulates innovation and efficiencyin the competing services, and, particularly asfar as NGA networks are concerned, it wouldmake it possible to include ducts and fibres inthe access services offered to third party opera-tors as a matter of course. It is an effectivemeans of encouraging the incumbent operatorto behave honourably. And above all, contraryto the incumbents’ constant refrain, functionalseparation does not mean “over” regulation.

On the contrary, it is a straightforward meansof implementing the non-discrimination prin-ciple and is an effective way of introducingprogressive deregulation, while targeting onlyrelevant bottlenecks at any given time.

And finally, what about the other risksalleged by the incumbents? Financial risk? Infact, financial analysts seem to agree on thebenefits of functional separation in terms ofreturn on investment and increased marketvalue through a better distribution of riskbetween the network and retail operations.Risk of curbing the rollout of FTTH? Just theopposite, in fact. Such a solution allows theincumbent operator to enhance the value of itsinfrastructures by making them available to allunder non-discriminatory conditions. Thiswill act as an incentive to invest both in basicinfrastructure and in services for all operators.So, why are they so against it? ■

So why are they so against it?

Legal and Regulatory, BT Global Services

wpoint

Richard Lalande, Chairman of AFORST

Functionalseparation is aneffective means ofencouraging theincumbent tobehave honourably

We do believe thatall regulatorsshould have thepowers to imposefunctionalseparation underthe EUFramework even ifonly as a power oflast resort.

Ed Richards, CEO, OFCOM

In September 2005, Ofcom’s strategicreview of regulation of the UK telecomssector was completed by BT offering aseries of legal undertakings under national

competition law. The undertakings gave acommitment to create a new business unit of30,000 people, to be called Openreach, whichwould have its own senior staff, capital expen-diture budget, offices, employee incentiveschemes and brand identity. Openreach wouldcontain the ‘natural monopoly’ parts of the BTbusiness, in particular access and backhaulinfrastructure. This is increasingly beingdescribed in Europe as ‘the UK model of func-tional separation’.

When we started our review in 2004, theUK market had been open to competition for20 years. But competition remained weak and

fragmented, with BT still in a very strong mar-ket position in all market segments. As a conse-quence, consumers were losing out, particularlywhen it came to the deployment of new servi-ces such as broadband. We looked at a range ofoptions for change but it was clear that the BTaccess network was a natural monopoly andwould remain so for the foreseeable future. Thecore challenge was therefore to get the regula-tion of that natural monopoly right.

Partly this would be achieved by full andeffective implementation of the EU regulatoryframework. We looked for best practice fromother regulators, and to take one example, drewheavily on the successful policies of ARCEP inlocal loop unbundling. But designing remediesmore effectively would not address the problemof the lack of incentive on BT to comply withregulation. As a vertically integrated companyin which managers of wholesale and retail pro-ducts often worked physically alongside eachother, BT had both the motive and the meansto discriminate against competitors.

A full ownership separation of BT wouldhave addressed such problems, but would taketime as it would require an investigation of upto two years by the Competition Commission.And it was not necessarily the only way toremove incentives to discriminate. Putting themonopoly parts of BT with a separate manage-

ment and incentive structures would also havethe same effect. From this was born the idea of‘Functional Separation’.

How is the policy working in practice? Sofar, very well. Openreach went from a theoryto a practical reality in six months. It’s creationhas prompted a new wave of investment in theUK telecoms market which in turn has trigge-red a major price war in the broadband market.Importantly, there have been big benefits forBT itself – we have been able to deregulateretail markets and BT’s share price has risenpartly because of confidence that there is a newstability in the relationship with the regulator.Ironically, some European incumbents whowere initially very hostile to functional separa-tion are now seriously examining it for this rea-son.

How relevant is this UK experiment toother regulators? We certainly don’t believe thatall regulators would need to follow the UKapproach to achieve effective competition – thisdepends on national market circumstances.The degree of ‘Functional Separation requiredin different national markets would also differ.But we do believe that all regulators shouldhave the powers to impose functional separa-tion under the EU Framework even if only as apower of last resort. ■

www.ofcom.org.uk

The objective of functional separationis to create a virtual company withinan integrated operator, with respon-sibility for managing access to

certain resources. In the United Kingdom, BThas set up an entity of this type, known asOpenreach, to control the British incumbent’saccess and backhaul networks. These arenetwork elements over which BT is likely toretain its dominant position for some time tocome. New investment in fibre access networks(FTTx) will be made through Openreach. Thisbusiness unit treats other divisions of BT ascustomers and applies the same conditions tothese internal customers as it applies to thirdparty operators. All procedures, including theinformation systems, production systems and

the employee pay structure, are designed toensure non discriminatory treatment of thegroup’s external and internal customers.Compliance with the non discrimination obli-gation is monitored by the Equality of AccessBoard, which reports to the BT Board ofDirectors. Openreach will also present separatefinancial statements.

Separation with a viewto reducing the need for regulationThe Openreach system was not imposed by

the British regulator Ofcom as part of the reme-dies established following the market analyses,but rather as a result of bilateral negotiationsleading to a series of Undertakings by theincumbent operator. This was in BT’s interests,

Functional separation in the UK

Winston Maxwell, Partner, Hogan & Hartson


Compliance with

the non

discrimination

obligation is

monitored by

the Equality of

Access Board,

which reports to

the BT Board of

Directors

Functional separation: what we can learn from the British experience


because functional separation will, in theory,lead to speedier deregulation of its other opera-tions, allowing it more room for manoeuvre onits retail markets. The British incumbent consi-ders that if the conditions of access to the “buil-



ding blocks” of the network are the same foreveryone, and this equivalence is both verifiableand verified, then the regulator will be able toconcentrate on that part of BT and relax itscontrol over the group’s other operations. Bycreating a situation where the group’s behaviourin the upstream market is deemed to be irre-proachable, BT hopes to be able to gain greaterfreedom of action in the downstream markets.

This view is not shared by all incumbentoperators. France Télécom considers that theOpenreach system creates inefficiencies, leadingto a general reduction in quality of service forall operators. The French incumbent operatoralso rejects the idea that it is possible to draw aclear boundary around the infrastructure andservices to be managed by the Openreach busi-ness unit. Its view is that any demarcation willquickly become outdated because of the rapiddevelopment in networks and services. Many ofthese objections come down to the conclusionthat functional separation would not be aproportionate remedy, that the costs of theremedy would exceed the expected benefits.

Even if functional separation were explicitlymentioned in the European Access Directiveand the French Post and ElectronicCommunications Code, the regulator couldnot impose this solution unless the remedypassed the proportionality test.

In France, the proportionality of a remedysuch as this would depend on the market towhich it applies. In the residential broadbandmarket, it is possible that the operational proce-dures already implemented by France Télécomare sufficient to achieve a satisfactory level ofnon discrimination, whereas in other markets,such as the wholesale bitstream market forinstance, the level of non discrimination is stillunacceptable. Consequently, functional separa-tion would be appropriate for the bitstreammarket, but not necessarily for the residentialbroadband market.

Encouraging a culture of non-discrimination

One of the lessons from the Openreachexperience is that non discrimination is notsimply a matter of compliance with a series ofdetailed non discrimination rules, but involvesthe creation of a true culture of non discrimina-tion among all the personnel responsible formanaging access to shared resources. Withoutsuch a culture, any detailed non discriminationrules imposed by the regulator will remain adead letter and some form of functional sepa-ration will become necessary.

In France, a culture of non discrimination iscreeping into France Télécom. Alternativeoperators sometimes say that France Télécom“has understood” non discrimination for

certain services, and that for those servicesFrance Télécom is implementing truly nondiscriminatory procedures with respect to thirdparty operators. In the case of other services ormarkets, however, alternative operatorscomplain of systematic discrimination, despitethe existence of detailed non discriminationrules. In these markets, the non discriminationrules are inadequate because they are notbacked by a culture of non discrimination. Insuch circumstances, functional separationwould be a proportionate remedy.

Preserving investment incentivesIn addition to proportionality, the func-

tional separation remedy would also need tosatisfy the criterion of encouraging efficientinvestment in networks and innovative services.Some people say that functional separationremoves incentive for investment, citing theexample of French “cable plan” in the 1980’s,generally considered a failed experiment inseparating network ownership from operation.This same line of argument has been advancedwith respect to all the remedies imposed onFrance Télécom with regard to its optical fibresor new services. Some feel that any access reme-dies on new infrastructure will kill investment.

ARCEP’s approach across markets has beento impose remedies which preserve investmentincentives. The regulator has, in certain cases,abandoned the concept of cost-oriented pricingin favour of a concept of “non-excessive”pricing, which allows a greater return on invest-ment in order to compensate for the riskincurred. This same pro-investment approachcan be transposed to the remedy of functionalseparation. Some investment banks even go asfar as to say that functional separation wouldencourage investment in new optical fibrenetworks. The incumbent’s separate businessunit is regarded by the financial market ashaving the characteristics of a utility, allowing ahigher gearing ratio and more attractive finan-cing opportunities.

The investment bank J.P. Morgan goes evenfurther. In its view, an incumbent operatorwhich rolls out a major programme of invest-ment in optical fibre within the framework of afunctional separation scheme such asOpenreach has every chance of receiving theblessing of the authorities, allowing it tobecome the only FTTx operator on the market

and discouraging anyparallel investment byother public or privateshare-holders. By adopting a functional separationsolution for new investment in fibre networks,the incumbent can gain credibility as a“neutral” operator and thus pre-empt this newmarket. The bank adds that this stratagemwould have little chance of succeeding inFrance, given the active efforts of the regulatorand the government to establish shared opticalfibre networks outside the ambit of France

Télécom. In other coun-tries, however, the banksees functional separationas a tool which couldfacilitate the creation of anew fibre monopoly.This is the “dark side” ofstructural separation.

Finding a legal basisIs it necessary for EC directives to be

amended before ARCEP can impose functionalseparation? The regulator has already imposedseveral measures that resemble functional sepa-ration in the context of non discriminationremedies. Its decision on accounting separationrequires France Télécom to establish internalprotocols to ensure that the operator uses thesame inputs as its competitors when developingits retail services. Unfortunately, the internalprotocols that France Télécom is required toput into place are not published, which makesthis measure less effective in terms of creating aculture of non discrimination recognised by themarket. One of the benefits of functional sepa-ration is to create a verifiable culture of nondiscrimination which can be recognised as suchby other players on the market, and will in turncreate a certain degree of confidence in, andderegulation of, the incumbent.

Imposing functional separation of theOpenreach type in France would probablyrequire a more specific legal basis than thatprovided by the current provisions of the AccessDirective and the French Post and ElectronicCommunications Code. It was probably inorder to remove any ambiguity on this pointthat the Chair of the European RegulatorsGroup (ERG) called, on 12 October 2006, fora revised Access Directive to specificallymention this remedy. If functional separationwere explicitly provided for in the ECDirectives and national law, it could beexamined in the ERG’s Remedies Paper andthus gain in legitimacy. The regulator wouldthen find it easier to bring this subject up withthe incumbent operator, perhaps within thescope of wider dialogue about the deregulationof the operator’s other operations. ■

« In the residential broadband market, it is possible that theoperational procedures already implemented by FranceTélécom are sufficient to achieve a satisfactory level of nondiscrimination, whereas in other markets, such as thewholesale bitstream market for instance, the level of nondiscrimination is still unacceptable. »

ARCEP’s 2006 Annual Report


1997-2007: although it cannot be saidthat the regulatory process over the pastten years has been all smooth sailing –having been marked by a series of

conflicts and disputes with stakeholders – it hasnevertheless been carried out with a certainserenity thanks to a solid foundation of highquality texts at both the European and nationallevel, and to a reasoned and professionalapproach. Of course it would be presumptuousfor ARCEP to take sole credit for the very posi-tive strides made during the past decade, but itscontribution remains undeniable.

Track record thus farThe first point to be made is how well the

legal framework has worked and howsuccessful the process of opening the marketsup to competition – on the impetus of theEuropean Commission – has proven, particu-larly in France where broadband offers are nowamong the highest quality and least expensivein Europe.

Naturally, this is due first and foremost tothe dynamism of the players – whether FranceTelecom or its competitors – to their innova-tion and their investment. What betterexample to illustrate this than the introductionof the service boxes which have helped spurFrance to the top of the ranking in Europe,with the lowest prices (and among the lowest inthe world) and the highest bitrates (nowreaching 20 Mbps), not to mention the highestlevels of IPTV and VoIP usage of anywhere inthe globe.

But this success is also the fruit of pragmaticand efficient regulation based on a solid regula-tory and institutional framework. Thanks towell-defined European directives, which weretransposed faithfully by the Parliament intonational law, and to successive governmentswhich provided the regulator with the neces-sary means to carry out its tasks, the Authorityhas managed to create a healthy competitiveenvironment which has encouraged invest-ment, innovation and regional development,all of which have served the public interest.

Of particular importance is the fact that thissuccess story has proven beneficial to consu-mers: between 1998 and 2005, retail pricesdecreased by just over 30%, on average, whileconsumption increased by close to two and ahalf times, which translated into a consumersurplus of more than 10 billion euros over thatseven-year period.

The next stepsEasing retail market regulation

If the Law of 1996 created a framework thatwas geared essentially to opening the classic tele-phone network up to competition, the currentframework, which was put into place in 2004, hasintroduced a great deal more flexibility and reacti-vity. This flexibility has allowed the regulator toadapt its actions to the true state of competition ina given market, particularly thanks to the marketanalysis process.

The prospect of the gradual eradication ofsector-specific regulation and its replacement bycompetition law is no longer a utopian view. Itdoes, however, require close collaboration betweenARCEP and the competition authority, somethingwhich has been well underway for several yearsnow.

Achieving progressively lighter regulationbegan in summer 2006: regulation has alreadybeen lifted for several France Telecom retail fixedtelephony offers, as the focus has shifted to regula-ting wholesale markets, in other words the rela-tionships between operators.

But easing regulation does not mean no regu-lation at all! In addition to postal sector regulation– a task that the Parliament assigned to ARCEP inMay 2005 – the Authority has a number of otherresponsibilities: managing frequency and numbe-ring resources, overseeing universal service,regional development and consumer protection.

Generally speaking, ARCEP actions will bedevoted more and more to achieving symmetricalregulation, in other words a situation where thesame rules are applied in the same fashion to allmarket players, and no longer to only the incum-bent carrier or the dominant players in a givensegment. Once healthy competition has takenhold, the task for ARCEP is to focus on thoseelements that will allow consumers to exercisetheir freedom of choice, regardless of the type ofoperator, in a lasting and efficient way – elementswhich include consumer information, terms ofcontract cancellation, number portability, termsfor accessing value-added services, quality ofservice guarantees, etc.

FibreThe tremendous success of broadband in this

country needs to be consolidated and furtheramplified by the next stage of market develop-ment, namely ultra-broadband and the deploy-ment of fibre optic networks to the premises.Several players have already announced forthco-ming investments in this area. Fibre is a new tech-

nological disruption, andone that will requiremassive investments. As aresult, the sharing ofpassive infrastructure willplay a critical role in theshape of things to come.

Public authorities – andlocal authorities in parti-cular – as well as ARCEPhave a central part to playin creating a frameworkthat is propitious to thedeployment of this new local loop, while remai-ning mindful of fostering competition betweennational players. In particular, Authorities willneed to prevent the creation a new monopoly overthe fibre loop and, ultimately, enable the develop-ment of an alternative local loop.

The digital dividend The digital dividend is the third major issue

facing not only France but also Europe as a whole.The emergence of new mobile technologiesengenders a growing need for frequencies, toenable the development of wireless broadband andmobile TV. The phasing out of analogue televisionand its replacement by digital broadcasting, whichconsumes fewer radio resources, will free upmuch-coveted low frequency bands that boastparticularly good propagation and indoor penetra-tion capabilities, and which are therefore essentialto achieving broad coverage across the nation.

As a result, there is now a pressing need toidentify the quantity of frequencies liberated bythe end of analogue broadcasting – as has alreadybeen done in several countries around the globe(the United States, Japan, South Korea) – and toexamine the options for reassigning these frequen-cies and prepare the technical roadmap for imple-menting the digital dividend. It goes withoutsaying that the reuse of these frequencies willrequire that particular attention be given toharmonisation at the European level.

Cleary, a number of challenges lie ahead forARCEP in this rapidly evolving regulatory envi-ronment. Having blown out its tenth-birthdaycandles, the Authority is now looking to thefuture. Armed with experience and recognised byits peers inside the European Union and beyond,it is ready to forge ahead – continuing to upholdits responsibilities and to work for the commongood. ■

Paul Champsaurchairman of ARCEP

Ten years on : positive results for thenational economy and for consumers



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• ARCEP published its 2006 AnnualReport on July 2nd 2007. As this isARCEP’s 10th birthday, the Report alsocovers the French regulator’s actionssince the opening oftelecommunications market tocompetition.

• The French version of the Report canbe downloaded directly from ARCEP’sWebsite (www.arcep.fr/publications)or can be ordered from ARCEP (seethe form below).

• An electronic edition of ARCEP’sAnnual Report will be published inEnglish in the course of July onARCEP’s Website and a CD-Romversion will also be available.

2006 ARCEP’s Annual Report is out!

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