BT Cost of Capital

OFCOM’S CONSULTATION DOCUMENTS “PROPOSALS FOR WBA CHARGE CONTROL” & “CHARGE CONTROL REVIEW FOR LLU AND WLR SERVICES”

BT’S COST OF CAPITAL

RESPONSE BY BSKYB (“SKY”)

EXECUTIVE SUMMARY

1. Since Ofcom last estimated BT and Openreach’s cost of capital in 2009, market economies have begun to emerge from the effect of the credit crisis. As a result, certain market metrics that contribute to estimates of BT’s cost of capital have fallen resulting in lower estimates of BT’s cost of capital this time around. Such an outcome is to be expected.

2. One of these metrics, the Risk Free Rate (RFR), is often measured by reference to gilt yields which have shown a sustained decline in recent years. In light of this trend, it would be justifiable to place more weight on 5 year averages for gilt yields as opposed to 10 year averages and, in doing so, a lower RFR (1.4%) than proposed by Ofcom (1.5%) would appear reasonable.

3. Further, there is some inconsistency in Ofcom’s argument that there is a tendency for mean reversion (whereby prices tend towards their historic values) in the RFR while mean reversion does not exist for the Equity Risk Premium (ERP). If Ofcom were minded to accept arguments for mean reversion in prices (and, hence, a higher RFR) this would point to an estimate at the low end of the ERP range as a result while Total Market Return (TMR) would remain steady.

4. It is simply not credible that all of the increase in observed debt premia between 2007 and 2011 (the financial crisis and beyond) is attributable to increases in the risk of default. It is more likely that during this time there was also some increase in the perceived correlation between defaults and recessions i.e. increases in debt beta. In a report1 that was jointly commissioned by Sky and TalkTalk, Europe Economics recommends spreading the changes in debt premia equally between increases in debt beta and increases in the risk of default. One positive consequence of this proposed approach to debt premia is that the BT asset beta is

1 Estimating BT’s Cost of Capital - This response draws heavily upon the Europe Economics report. more stable than under Ofcom’s approach which, in turn, reinforces the suitability of adopting the Capital Asset Pricing Model (CAPM) to estimate BT’s cost of capital.

5. Since 2005, Ofcom has disaggregated its estimates of BT’s cost of capital in order to arrive at a view of the Weighted Average Cost of Capital (WACC) for Openreach and the rest of BT. This is because Openreach’s cost of capital is lower than the rest of BT due to the relatively lower risk of its copper access business. However, Ofcom’s approach to disaggregation is incomplete as it incorrectly applies the same cost of debt for Openreach’s copper access business as it does for BT as a whole.

6. In order to disaggregate Openreach’s WACCs, Ofcom places some weight on the asset beta ranges for comparator network utilities. Openreach’s asset beta is assumed by Ofcom to be at the top of this range or just above it. However, Ofcom erred in setting the comparator network utility asset beta range too high.

7. An Openreach asset beta range of 0.40 – 0.54 is more plausible than the slightly higher range proposed by Ofcom. The combined effect of adopting this lower range as well our higher BT Group asset and equity betas is that there is greater “wedge” between BT Group and Openreach than in 2009 but much the same as it was in 2005. This is a plausible outcome particularly in light of the heightened riskiness of Openreach’s NGA roll out (which should not be considered in the calculation of Openreach’s WACC for LLU and WLR).

8. Sky considers that, not only does the risk associated with BT’s defined benefits pension scheme result in a higher cost of capital, but that this increased cost should be disallowed from regulated charges such as those being proposed for WBA, WLR and LLU. Further, we consider the likely uplift in BT’s cost of capital as a result of pension risk to be highly material given the state and scale of the BT scheme. Ignoring this effect, in part, on the basis that it is too difficult to calculate – as Ofcom has proposed – appears inconsistent with its approach to other aspects of its cost of capital calculation.

9. Sky argues that it is appropriate for Ofcom to make some allowance in its final estimates of BT’s and Openreach’s cost of capital to account for the impact of pension risk and the lower cost of debt for Openreach’s copper access business. Should Ofcom consider that separately estimating these factors could not be done robustly then, as an alternative, it could simply aim lower within the ranges for Openreach’s debt premium and asset beta.

10. In its report, Europe Economics proposes adopting different approaches to debt beta assumptions and the application of comparator data and, as a result, estimates a lower range (7.4% - 8.7%) for Openreach’s WACC than offered by Ofcom (8.0% - 9.2%).

AN APPROPRIATE RETURN ON CAPITAL EMPLOYED FOR LLU / WLR

11. It is often argued that the losses associated with under-estimating the cost of capital (in the form of under-investment in its network by the regulated entity) outweighs the losses associated with setting the cost of capital too high (consumers paying too much and under-investment by the wholesale customers of the regulated firm). While this argument may hold greater credence in retail markets, it holds less weight where there is significant investment in networks and equipment by downstream wholesale operators (such as LLU operators).

12. For charge controlled products like WLR and MPF that are largely made up of capital inputs such as duct and copper, the impact on final prices of the proposed weighted average cost of capital (WACC) is highly material. Ofcom like most other regulatory authorities relies upon the Capital Asset Pricing Model (CAPM) in order to make WACC estimates. Under CAPM, the cost of capital for a firm is calculated by adding together the cost of equity and the cost of debt, weighted by the firm’s gearing levels. CAPM is a tried and tested, robust methodology and, as such, it is entirely appropriate to persist with its use for the purpose of estimating the cost of capital to be included within the charge controls for Wholesale Broadband Access (WBA) in Market 1, LLU and WLR from 2011 – 14.

13. Moreover, since 2005, Ofcom has disaggregated BT’s cost of capital in order to set a separate, lower WACC for Openreach’s copper access business i.e. LLU and WLR. This is an appropriate course to take because the relatively lower risk of this part of BT’s business is more comparable to the risk profiles of other network utilities such as water, gas and electricity than to those of the rest of the BT Group.

14. For the avoidance of doubt, the purpose of this disaggregation is to set the WACC for the LLU and WLR charge controls and, therefore, specifically relates to that aspect of Openreach’s business. Therefore, the Openreach WACC discussed here is the one for copper access and should be completely uncontaminated by the risks associated with the other activities in which Openreach is engaged – such as NGA and wholesale Ethernet services.

15. In order to engage fully in the consultation process, Sky in conjunction with TalkTalk commissioned Europe Economics to advise and report on Ofcom’s proposals for BT’s cost of capital. This Sky response relies upon much of the findings contained within the Europe Economics report.

BT’S COST OF CAPITAL HAS FALLEN SINCE 2009

16. Ofcom last set BT’s cost of capital in 2009 at the height of the credit crisis and as the global economies entered a period of recession. Markets were highly volatile at this time. Lenders were reluctant to lend and a liquidity crisis ensued. There were

observed (temporary) increases in some of the key inputs into cost of capital calculations such as the RFR2 and the Debt Premium (or Debt Margin)3.

17. Since 2009, however, markets have started to normalise as economies have stabilised and started to exit recession. It is hardly surprising, therefore, that this time around Ofcom is estimating lower WACCs for BT. This should not be seen as a cause for concern, only a natural consequence of improvements in macro-economic conditions. The resultant deflationary pressure on the wholesale prices for LLU and WLR are welcome and to be expected.

18. Europe Economics reported on each of the CAPM components and associated valuations conducted by Ofcom (as well as the analysis into the comparator network utility companies conducted by the Brattle Group on behalf of Ofcom). Taking each of these parameters in turn, Europe Economics offered its opinion on Ofcom’s calculations and, where its view differed, offered its own estimates. We discuss the main issues arising in the following sections.

RISK FREE RATE (RFR)

19. The RFR is used within the calculation of both the cost of debt and cost of equity. Estimating the RFR is usually made by reference to the yields on the least risky financial instruments i.e. Government bonds (known as gilts in the UK).

20. Ofcom, in its proposals, cites 5-year averages for both 5-year and 10-year gilts which were at 1.4% and the 10-year averages for 5-year gilts which were at 1.7%. Ofcom also relies upon the Competition Commission’s determination in the Bristol Water case4 which offered a range of 1.0% to 2.0%. Drawing upon these sources, Ofcom has proposed an RFR of 1.5% (compared to 1.8% in 2009).

21. However, we consider that there is a strong case for Ofcom to use a lower RFR of 1.4% for the following reasons;

a) As evidenced by the Europe Economics report, UK gilt yields have shown a marked and sustained decline in recent years5. In light of this trend, it would be justifiable to place more weight on 5 year averages for gilt yields as opposed to 10 year averages (which are likely to over-estimate the RFR) and, in doing so, an RFR of 1.4% would appear more reasonable than Ofcom’s estimate of 1.5%;

b) Proposing an RFR of 1.5% on the basis of the Bristol Water determination, would be an incorrect reading of the Competition Commission’s findings. At no point did the Commission select a point either in the middle or at the top of its proposed 1.0% - 2.0% range as Ofcom implies6; and

2 The rate at which lenders and investors in the least risky assets can be persuaded to forego consumption today for expected returns in the future. 3 The debt premium is the additional rate of return above the RFR that lenders require in order to purchase corporate bonds. 4 Bristol Water plc Price Limits Determination http://www.competition-commission.org.uk/rep_pub/reports/2010/558Bristol.htm 5 Europe Economics, op cit, Figure 2.1 6 Europe Economics, op cit, paragraph 2.7 (a)

c) Ofcom’s claim that there exists some form of mean reversion in prices whereby the RFR would have a tendency to return towards historic values (such as the higher 1.8% of 2009) is inconsistent with the CAPM (and the data in (a) above) which assumes efficiency in pricing where historic values have no bearing. Further, giving weight to mean reversion is at odds with Ofcom’s approach to evaluating the Equity Risk Premium (ERP) which we discuss below.

EQUITY RISK PREMIUM (ERP) & TOTAL MARKET RETURN (TMR)

22. Ofcom has proposed an ERP7 of 5.0% which is unchanged from its conclusions in 2009. This is at the top of the range (4.5% - 5.0%) of arithmetic8 risk premium recommended by Dimson, Marsh and Staunton (DMS) in their “world index”. DMS studies are typically relied upon by Ofcom and other regulatory authorities when estimating the ERP. Ofcom also relies upon its interpretation of the Bristol Water determination in supporting its case for 5.0%.

23. However, as was the case with the RFR, it would be incorrect to conclude, as Ofcom has done, that the Bristol Water determination arrived at a single point estimate for the ERP of 5.0%. In fact, the Commission gave more weight to its overall estimate of Total Market Return (TMR, effectively the sum of the RFR and ERP) of 5.0% to 7.0% than to any implied single point estimate for ERP.

24. Further, there is some inconsistency in Ofcom’s argument that there is a tendency for mean reversion (whereby prices tend towards their historic values) in the RFR (which would make it higher) while mean reversion does not exist for the ERP.

25. Notwithstanding the fact that, strictly speaking, mean reversion is incompatible with the CAPM, if such reversion in prices were to occur it would be more likely to occur in equity markets than in government bond markets. This is because government bond markets are at least as deep, broad and wide as equity markets and have been in existence for considerably longer. Therefore, one would expect that if prices in government bond markets were inefficient transmitters of information to such an extent that historic pricing had some bearing on future prices, then such an effect would be even more pronounced in equity markets.

26. Put simply, it is contradictory for Ofcom to give weight to arguments that the RFR might revert to historic values while arguing than no such reversion would occur in the ERP. If Ofcom were minded to accept arguments for mean reversion in prices, it should give greater weight to the DMS calculations of geometric returns as opposed to arithmetic ones. This would point to an estimate at the low end of the ERP range of 4.5% or even below it.

7 The Equity Risk Premium (ERP) or Equity Market Risk Premium (EMRP) is the rate of return over and above the RFR that investors require in order to put their money into equities of average risk as opposed to the least risky investments i.e. Government bonds. 8 Arithmetic means assume that there is no mean reversion in prices.

27. Further, in taking the view that ERP in 2009 was 5.0%, Ofcom explicitly included a 0.5 percentage point uplift to account for equity market volatility at the time. As this period has now passed and equity markets have become more stable, there is no longer any justification to retain this incremental adjustment and it should be withdrawn. This provides further support for the view that the ERP could be around 4.5% as opposed to 5.0%.

28. Sky notes, however, that many of the arguments for adopting lower estimates for ERP correspond to arguments for raising estimates for RFR (such as those for mean reversion). Therefore, the TMR is likely to be more stable with Europe Economics estimating it to be in the region of 6.0% - 6.5%.

DEBT PREMIUM, DEBT BETA AND RISK OF DEFAULT

29. Ofcom looks at the spread of BT debt over gilt rates since 2008 to arrive at a range for the debt premium of 2.0% - 2.5%. Europe Economics has updated this spread analysis of BT debt and notes that the latest data implies a debt premium at the lower end of this range.9

30. Moreover, this is merely a measure of the BT Group debt premium. Ofcom does not attempt to derive an Openreach cost of debt for the purposes of the cost of capital component of the LLU and WLR charge controls. However, it is apparent (and widely accepted) that Openreach’s copper access business will carry significantly less risk than the rest of BT. As such, it is expected that the element of the debt premium attributable to the risk of default would be lower for Openreach copper access than for BT as a whole. Therefore, the debt premium used by Ofcom and the subsequent cost of debt calculation for the charge control will actually overstate the cost of debt for Openreach’s copper access business.

31. While Sky recognises the difficulties in arriving at a robust estimate of an Openreach-specific cost of debt (there are no Openreach corporate bonds, for example), Ofcom could be minded to choose a point estimate for the debt premium nearer to the bottom of its proposed range in order to account for the tendency of the range estimate to overstate Openreach’s likely cost of debt.

32. While it is common to use corporate bond market spreads as a proxy for debt premia, these spreads will include the cost of insuring against default on the debt irrespective of whether that default arises from market-wide or company specific factors. Not all of the risk of default can be diversified away because the state of the broader economy will influence the likelihood of default on debt. As a result, debt beta will be greater than zero i.e. there will be some correlation between movements in the general market risk premium and the debt premium of a specific firm.

33. Ofcom estimates BT’s debt beta to be 0.1 to 0.15, sometimes relying upon the mid- point estimate of 0.125. However, Ofcom’s modelling assumes that the debt beta is constant. Therefore, under Ofcom’s approach, all the observed increases in debt

9 Europe Economics, op cit, paragraph 5.7.

premia since 2007 are attributed to a perceived increase risk of default and that there has been no increase in the perceived correlation between recessions and defaults. This is implausible and threatens to undermine the integrity of the CAPM for the purpose of estimating BT’s WACCs.

34. As an alternative, Europe Economics proposed a more plausible scenario whereby increases in debt premia are shared equally between increases in the risk of default and increases in debt beta.

ASSET BETAS & EQUITY BETAS

BT Group

35. Ofcom proposes a range of 0.45 – 0.60 for BT Group’s asset beta based upon observed BT equity betas, gearing estimates calculated by reference BT market capitalisation and net debt data and, as previously noted, an assumed invariant debt beta.

36. As a result, Ofcom’s BT Group asset beta demonstrates considerable volatility. CAPM theory anticipates stable asset betas because the level of systematic operational risk to which equity holders are exposed when investing in a firm should be relatively constant.

37. As stated above, Europe Economics considers that one cause of this asset beta volatility could be Ofcom’s implausible assumption of invariant debt betas. In its report, Europe Economics demonstrates that by apportioning increases in debt premia equally between debt beta and the risk of default, derived asset betas become far more stable. This is a more credible outcome.

38. The resultant asset beta range for BT Group that is proposed by Europe Economics is narrower but slightly higher than Ofcom’s range i.e. 0.55 – 0.64.

39. The asset beta is derived from de-levering observed equity betas based on historic gearing levels. However, in order to estimate BT’s cost of capital for the charge control, a forward looking view of optimal gearing is required. BT’s historic gearing levels are not viewed as a robust proxy for optimal gearing and, instead, Ofcom applies its preferred gearing assumption of 50% and then re-levers the asset beta to conclude on an implied re-levered equity beta range of 0.78 – 1.08.

40. Under Europe Economics’ alternative approach, the BT Group equity beta range is narrower at 0.9 – 1.03.

Openreach

41. At this stage, in order to estimate a copper access business cost of capital for Openreach that reflects the lower level of systematic risk, Ofcom (via Brattle) benchmarks the asset betas of comparator network utilities. Brattle suggests an asset beta range of 0.3 – 0.4 for these comparator companies based upon a debt

beta of 0.15. From this, Ofcom proposes a value for Openreach’s asset beta of 0.40 – 0.55 which translates – based on the 50% gearing assumption – to an equity beta range of 0.68 – 0.98.

42. Under Ofcom’s approach, the Openreach asset beta is 0.05 below the BT Group asset beta. While there is no doubt that the asset beta, implied equity beta and ultimate cost of capital for Openreach’s copper access business will be lower than for the rest of Openreach and BT as a whole, the “wedge” between the copper access data and the rest of BT could be larger than Ofcom proposes. For example, the increased risk associated with NGA may heighten the BT Group cost of capital but not that of the copper access business. It is more important that the Openreach copper access business asset beta is anchored to the top of the comparator range and, as such, little weight should be given to maintaining the 0.05 differential when Ofcom determines its final asset beta in the coming months.

43. Sky notes that Ofcom has rounded up Brattle’s proposed range for comparators from 0.29 – 0.36 to 0.3 – 0.4. Further, the 0.29 – 0.36 range is based on a debt beta of 0.15, not the 0.125 that Ofcom sometimes assumes for BT in its analysis. Using this lower debt beta, the asset beta range would be 0.27 – 0.35. Under the higher debt beta assumptions that underpin the alternative approach proposed by Europe Economics, the upper bound of this range would move to 0.40 which, in turn, implies an Openreach asset beta range of 0.40 – 0.54.

44. This is broadly the same as the range proposed by Ofcom but, by re-levering using Europe Economics higher debt beta range (2.0 – 2.5), the Openreach equity beta becomes 0.60 – 0.83 compared to Ofcom’s 0.68 - 0.98 range.

TREATMENT OF BT’S PENSION SCHEME

45. In the final statement of its Pensions Review, Ofcom determined that:

“we proposed to make no adjustment [to BT’s cost of capital] at this stage, although we proposed to retain the option to assess this further as and when we considered the cost of capital in the future.”10

46. Ofcom goes on to note that:

“although these Guidelines set out the approach Ofcom would normally expect to take, they will not be binding upon us in the future and each case will be considered on its own merits”11 (emphasis added).

47. This current consultation provides the first estimation of the cost of capital for regulated services since the determination of the Guidelines on pension costs. Disappointingly, Ofcom has given cursory consideration to an adjustment to account for BT’s defined benefit pension scheme with a one sentence reference:

10 Ofcom Pensions Review Statement; 15 December 2010 paragraph 2.12 http://stakeholders.ofcom.org.uk/binaries/consultations/btpensions/statement/statement.pdf 11 ibid, paragraph A1.6

“The pension guidelines developed as part of the Pensions Review state that cost of capital of BT Group (or Openreach and the Rest of BT) should not be adjusted to reflect the existence of a DB scheme.”12

48. In support of its conclusions to its Pensions Review consultation and resultant Guidelines, Ofcom cites:

a) the need for consistency between the way it deals with all aspects of BT’s defined benefit pension scheme and its regulatory approach across time;

b) the lack of a robust methodology for calculating any adjustment; and

c) a lack of materiality of any adjustment.

We address each of these issues below.

49. Whilst Sky recognises that it is important for Ofcom to adopt a consistent regulatory approach, there are circumstances when a departure from previous practice may be justified. Indeed, Ofcom must not fetter its discretion. In assessing a particular policy or regulatory matter it is incumbent on Ofcom to assess the merits of the case afresh taking into consideration all relevant factors including relevant regulatory precedent. However, importantly, Ofcom can adopt a different approach should circumstances dictate. In the current consultation, Ofcom has provided no explanation as to how it assesses the merits of taking a fresh approach in its consideration of the effects of BT’s defined benefits pension on the cost of capital.

50. Sky disagrees with Ofcom’s view that there is not a robust methodology to calculate the necessary adjustment. Sky, together with, Cable & Wireless Worldwide and TalkTalk Group, engaged Price Waterhouse Coopers (PwC) to develop a possible approach for estimating an adjustment. PwC noted that such an estimate was likely to be no more uncertain then many other input variables used to calculate the regulatory cost of capital.

51. Lastly, using PwC’s conservatively estimated adjustment, Sky showed a (significantly material) £45m annual reduction in regulated wholesale input costs to providers.

52. It remains Sky’s strong view that to make no, or zero, adjustment to the cost of capital to account for BT’s defined benefit pension is wrong. While Sky does not underestimate the difficulty of calculating an adjustment, a robust and defensible approach has been presented by PwC, as noted above. As an alternative, Ofcom could simply aim lower within the ranges for asset beta and debt premia.

12 Ofcom, op cit, paragraph 6.159

CONCLUSION

53. In the table below, we show below how Europe Economics’ estimates of the cost of capital components compare to Ofcom’s proposals.

Comparison of Ofcom January 2011 and this report Cost of Capital Components13

Openreach BT Group Ofcom This report Ofcom This report Equity Risk Premium 5% 4.5-5.0% 5% 4.5-5.0% Asset beta 0.4-0.55 0.4-0.54 0.45-0.60 0.55-0.64 Debt Beta 0.125 0.2-0.25 0.125 0.2-0.25 Equity Beta 0.68-0.98 0.6-0.83 (50% 0.78 - 1.08 0.9-1.03 (50% (50% gearing) gearing) (50% gearing) gearing) Real risk-free rate 1.5% 1.4-1.5% 1.5% 1.4-1.5% Inflation 2.5% 2.5% 2.5% 2.5% Debt premium 2-2.5% 2-2.5% 2%-2.5% 2-2.5% Tax rate 25% 25% 25% 25% Post-tax real WACC 3.9% (mid- 3.0-3.9% 4.2% (mid- 3.6-4.4% (4.0% point) (3.5% mid- point) mid-point) point) Pre-tax nominal WACC 8.0-9.2% 7.4-8.7% 8.3%-9.5% 8.3-9.4%

54. The key differences in approach relate to debt beta assumptions and the application of comparator data. The result is a lower estimate for Openreach’s WACC.

55. When it comes to selecting a point estimate, it should be noted that for some of the ranges the appropriate value will be at the lower end of the range (such as for the debt premium). Moreover, continuing developments in debt and equity markets are likely to have some bearing on where in the range to aim when final point estimates are being made. For example, continuing low gilt yields would point towards an RFR of 1.4% - 1.5%. But if gilt yields rise and equity markets normalise then the case for selecting an ERP below 5.0% becomes stronger.

56. Sky notes that, in its report, Europe Economics proposes a likely BT Group equity beta of around 0.95 – 1.0 and copper access beta of 0.70 – 0.75.

Sky June 2011

13 Europe Economics, op cit, Table 8.1