Comparison of Price Control Regimes

42. This section discusses both the similarities and contrasts evident among the price control regimes used in the UK, Australia and the US which have been examined in the previous sections of this report. From this earlier discussion, it is evident that the price control regimes of each jurisdiction are evolving and that they exist in static forms for limited periods of time. Accordingly, the discussion in this section examines the evolution of the price controls in each jurisdiction.

43. Six key aspects of the various price control regimes are examined in this section. These are summarised in Table 3 and are discussed below.

    Table 3
    Comparison of Price Control Regimes

    Characteristic	United Kingdom	Australia	United States
    Underlying objectives of price control regime	Objectives remained stable encompassing price reductions for consumers and tariff rebalancing.	Initial focus on price reductions for consumers and limited tariff rebalancing in the pre-competition environment which later expanded to protection of competition.	Objectives remained stable encompassing price reductions for consumers.
    Carrier flexibility to price basic connection services	Real price increases allowed.Initial limitation set by agreement, then by formal sub-cap. New proposal removes limitation.	Initial regime limited price increases to CPI, later limited to 2% then 1% below CPI under a separate sub-cap.	No specific constraints exist.
    Complexity of price control structure	First and second regimes were relatively simple, third became more complex, fourth and fifth regimes have removed some of the complexity.	Initial regime was relatively simple, second regime became more complex with a series of sub-caps, new regime returns to a simpler model.	Initial regime is inherently complex being combined with ROR regulation attributes.Second "interim" price-cap is more complex with three instead of two price-cap options.
    Changes in productivity factor	Steady increase - initially set at 3%, then 4.5% and is currently 7.5%	Steady increase - initially set at 4%, then 5.5% and will move to 7.5%	Minimum productivity factor has increased from 3.3% to 4%. (Partly explained by error in original productivity study)
    Scope of services under the price-cap	Services where BT maintains a degree of monopoly power.Scope expanded to include outgoing international services under third regime.	Comprehensive coverage of carrier services under each regime.	Comprehensive coverage of all carrier services under each regime.
    Term of price control	Initial regime was set for 5 years, subsequent regimes were 4 years. However, mid-term changes to the price-cap have occurred twice.	First regime lasted 4 years. Second regime set for 4 years but extended by six months. New regime will have 4 year term.	Initial regime had 4 year term.Term of second regime unclear.

    Objectives

44. The adoption of price-cap regulation carries inherent "core" objectives that are evident in any period of price-cap regulation in any jurisdiction. That is, the improvement of carrier efficiency and the distribution of resulting benefits to consumers in the form of lower real prices. Each of the jurisdictions examined embrace these objectives. In addition to these core objectives, the pursuit of other policy objectives is also evident -

    The UK has specifically sought to encourage tariff rebalancing to move prices more in line with costs - particularly with basic connection services

    In Australia, the price-cap has also embraced the objectives of protecting competition and encouraging tariff rebalancing.

    Constraint on Connection Charges

45. Each of the three jurisdictions has demonstrated a different approach to the flexibility of carriers to adjust connection charges. This in turn reflects the pursuit of specific policy objectives. A key element of the UK approach is to allow real price increases in connection services. This started out as a limitation on price increases of RPI plus 2% under the initial price-cap and under the recent proposal connection charges will not be subject to any limitation. The ability of BT to seek real increases in connection charges is matched by other measures that provide access to low volume users at subsidised prices. The Australian approach has always limited connection charges to CPI or below. Under the initial regime increases were limited to CPI. The second regime tightened this to CPI minus 2% while this will be relaxed to CPI minus 1% under the recently announced regime. The US regime has no specific pricing rules relating to connection charges.

    Complexity of Price Controls

46. The UK and Australia have similar experience in the change in the overall complexity of their price control regimes. Both started with relatively simple models that became more sophisticated with the introduction of measures such as sub-caps applying to certain services. Subsequently, both reverted to simpler structures. The FCC, while only just into its second LEC price-cap regime, shows a consistent pattern with its second model being more complex than the first.

47. Evidently regulators have tended to tinker with their respective price-cap structures following their initial introduction before reverting to their simpler forms. This suggests that the more complex approaches are not significantly more effective than the simpler forms that they have replaced.

    Productivity Factors

48. An evident trend among the three jurisdictions is the steady increase in the value of the productivity factor adopted in the price-cap formula. Each now has a higher "X" factor in its current regime compared with its initial model. When the price control regimes have been reviewed, regulators have sought greater productivity gains in the face of technological developments which have fueled rapid growth in network efficiency. The growth in the "X" factor reflects conservative estimates of the potential for productivity improvements and the exercise of caution by regulators to avoid setting targets which may harm carrier profitability by forcing deep price reductions.

    Coverage of Services

49. The Australian and US approaches take a broad view of the scope of services that are subject to price control. This contrasts with the situation in the UK where services included in the price-cap must effectively pass an "insufficient competition" test. That is, only those services that are in markets where BT maintains monopoly power are included within the scope of the price-cap.

    Price-Control Term

50. It is evident among the jurisdictions examined that the normal duration of a price control regime is four years. Four years tends to balance the carriers' need to have some degree of certainty concerning future regulatory practice with the regulators' flexibility to intervene in the market to pursue policy objectives and to make corrections where considered necessary.

51. The UK's initial price-cap had a five year term. Subsequent price-cap regimes have adopted four year terms. However, these have been subject to mid-term changes. In Australia, all regimes have a four year term. However, the second regime was extended by six months pending the finalisation of the government's announcement on the future industry structure. In the US, the initial LEC price-cap had a four year term. It is, however, unclear how long the recently announced "interim" plan will last.

    Implications for Hong Kong

52. The review of price controls in the three jurisdictions that were examined above has a number of implications for Hong Kong in setting new price control arrangements to follow the expiry of the current regime in mid-1996. Some key implications from the overseas experience may be drawn. These concern the following -

    Continuation of price controls

    Setting clear policy objectives

    Setting the productivity factor

    Term of the price controls

    Complexity of the price-cap structure

    Continuation of Price Controls

53. A fundamental issue that Hong Kong must face is whether there is a need for the continuation of price controls to apply to HKTC in the emerging competitive environment. That is, the impact of price-cap regulation or other forms of price controls on the process of competition must be carefully examined. The experience of the UK is particularly relevant in this context where it is acknowledged by the regulator that the regulation of BT's prices under the price-cap constrains the competitive process.

54. It may be argued that the introduction of competition per se in Hong Kong precludes the need for the application of price controls to HKTC. Natural market forces would impose discipline upon all market participants to strive for improved efficiency and would not enable any single participant to set prices in excess of industry cost. However, this argument fails to recognise the imbalance of market power and scope of operations evident among carriers in Hong Kong's FTNS sector and the likelihood of this continuing for many years.

55. The overseas experience indicates that price control regulation of dominant market participants is considered appropriate in an otherwise competitive market. While the effects of price controls are not all positive, the benefits are evidently considered to outweigh the costs. The UK has persisted with price-cap regulation of BT following the introduction of open competition from 1991. The Australian approach will also persist with regulation of Telstra's prices following the introduction of open competition from mid-1997. In the US, the LEC price-cap regime will continue to apply in increasingly competitive local exchange environments.

56. The implication for Hong Kong is that the introduction of competition should not be considered as a sufficient reason per se to dismantle price control regulation of HKTC. HKTC will be expected to maintain a dominant position across the market segments where it operates. However, there may be alternatives to the existing price-cap arrangements in view of the negative effects of price-cap regulation which include a hindrance to the establishment of effective competition.

    Setting Clear Policy Objectives

57. The Phase one report of the overall price control review discussed the objectives underlying Hong Kong's price-cap structure. The report stated that while the HKG's telecommunications policy did not specify objectives concerning the price-cap, general underlying objectives could be implied.

58. From the experience of overseas jurisdictions, it is evident that the pursuit of specific policy objectives has a direct bearing on the form of the price controls. For example, the policy of tariff rebalancing in the UK has lead to an initial RPI + 2% price-cap on connection charges which is currently proposed to be scrapped.

59. The pursuit of particular policy objectives would help shape Hong Kong's future price control arrangements. If, for example, price-cap regulation of HKTC was to continue and this was to adopt the objectives to encourage tariff rebalancing and to close HKTC's access deficit, connection and line rental services could be excluded from price-cap regulation. If the objective was the general reduction of tariffs, a widely defined single service basket would be appropriate. The implication for Hong Kong is that specific policy objectives must be identified so that future price control arrangements may be structured accordingly.

    Setting the Productivity Factor

60. The determination of the productivity or "X" factor used to define the price-cap is crucial to the success of price-cap regulation. Set too high carriers are forced to make deep tariff reductions which will negatively impact profits. Set too low consumers are forced to pay higher prices than they otherwise would need to have and as a result, the profits of carriers are higher. The reality of setting the "X" factor is that it is necessarily speculative and based on a number of subjective factors.

61. The overseas experience shows that the productivity factors have steadily increased indicating that they were initially set too conservatively. This tends to reflect a cautious approach taken by regulators. The implication for Hong Kong is that if it decided to continue with the price-cap regulation of HKTC, it need not be overly cautious by setting an "X" factor that is at the low end of an acceptable range of values. In any event, the setting of an "X" factor should follow a detailed study of the potential for achieving future productivity growth and the productivity gains achieved in past periods.

    Term of the Price Controls

62. The three year term of Hong Kong's current price-cap regime may be criticised on the basis that it is too short a period to objectively evaluate its effectiveness. The need to complete the review prior to the end of its term effectively means that the price-cap is largely judged on its first two years only. The overseas experience indicates that the four year term is considered appropriate. However, mid-term reviews have become an established practice in the UK. The implication for Hong Kong is that should it persevere with the price-cap approach, the adoption of a four year term with a regular (if not on-going) review would seem most appropriate.

    Complexity of the Price-Cap Structure

63. In comparison to the price controls in the overseas jurisdictions that have been studied, Hong Kong's price-cap is administratively simple. The other jurisdictions have tended to advance to more complex structures before reverting back to the simple approach. The implication for Hong Kong is clear - keep to the simple structure as far as possible given the constraint of specific policy objectives.

    Conclusion

64. This Phase two report has reviewed the basic features of the price control regimes in the UK, Australia and the US. This has tracked the changes in successive versions of the price controls which have evolved over time. The review sought to identify the implications of the collective overseas experience with price control regulation for Hong Kong as it approaches the task of setting future price control arrangements in line with HKG policy.

65. Hong Kong must carefully consider whether the application of price controls including price-cap regulation to HKTC is appropriate. While regulators have embraced this form of regulation it is not without its drawbacks. Should price-cap regulation be considered appropriate for Hong Kong, the overseas experience suggests the following points -

    that clear policy objectives be identified

    the productivity factor be set after careful review and that it need not be overly conservative

    the term of price-cap be four years and be kept under close review

    simple approaches are preferred to complex approaches

September 1995
Office of the Telecommunications Authority