Review of ITV Networking Arrangements Cost Sharing Between Licensees

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Review of ITV Networking Arrangements Cost sharing between licensees

This version is non-confidential. Confidential redactions are indicated by [].

Statement Publication date: 16 December 2010

Review of ITV Networking Arrangements

Contents

Section Page 1 Summary 1 2 Context of the current review 5 3 Consultation responses 9

Annex Page 1 Development of the Channel 3 network 23

Review of ITV Networking Arrangements

Section 1 1 Summary

1.1 We have decided, following consultation with stakeholders, that the system of cost sharing between Channel 3 licensees specified in the existing Networking Arrangements should be retained for the moment.

The requirements upon Ofcom

1.2 The ITV Networking Arrangements (the ‘NWA’) are a set of arrangements between the holders of the 15 regional Channel 3 licences (the ‘Channel 3 licensees’).1 The statutory purpose of the NWA is to enable the Channel 3 licensees, when taken as a whole, to be a nationwide system of services which is capable of competing effectively with other television broadcast services in the UK.2

1.3 Ofcom has a statutory duty to carry out a general review of the NWA from time to time under section 293 of the Communications Act 2003 (the ‘Act’).3 Essentially such a review is intended to assess whether the arrangements enable the licensees to meet the statutory objective to provide a competitive, regionalised Channel 3 service. If, following a review, we conclude that modifications to the NWA are necessary, we can require the Channel 3 licensees to give effect to any modifications that we propose.

1.4 In considering whether to propose modifications to the NWA, we are required under Schedule 11 of the Act to consider whether the agreements would, as modified, represent a satisfactory means of achieving their statutory purpose. We must also take account of the likely effect of modified NWA on the ability of the Channel 3 licensees to maintain the quality and range of regional programming and other programming which contributes to the regional character of the services. We may not propose modifications if we consider they are likely to prove prejudicial to the ability of the licensees to comply with their public service or regional programming obligations or if they fail to satisfy certain specified competition tests.4

The current review

1.5 During our second review of public service broadcasting (‘PSB’), both ITV plc and the non-consolidated licensees (‘NCLs’)5 submitted evidence suggesting that the

1 The 11 regional English and Welsh licences are currently held by ITV Broadcasting Limited (a wholly owned subsidiary of ITV plc). The two Scottish licences are held by STV Central Ltd and STV North Ltd, both subsidiaries of STV Group plc (‘STV’). The licences in Northern Ireland and the Channel Islands are held by UTV Ltd (‘UTV’) and Channel Television Ltd (‘Channel’) respectively. 2 Where the term ‘ITV1’ is used in this document, it refers collectively to all of the regional Channel 3 services, including those broadcast in Scotland and Northern Ireland. 3 In October the Government announced its intention to introduce changes to legislation which would require Ofcom to review the NWA when it considers it necessary or when requested to do so by the Secretary of State, in place of the current duty to conduct a review not more than one year after the previous review. At the time of writing further details are not available. 4 We are required to consult the Office of Fair Trading (‘OFT’) on whether proposed arrangements meet the relevant competition tests. Further information about the respective roles of Ofcom and the OFT can be found in ‘A letter from the Office of Fair Trading setting out OFT/Ofcom Concurrency Arrangements’ at http://stakeholders.ofcom.org.uk/consultations/ofcomresponses/concurrency_oft/. 5 Throughout this document, STV, UTV and Channel are collectively referred to as the ‘non- consolidated licensees’ (‘NCLs’).

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approach used to allocate network costs between the regional licensees was inequitable. Both sides argued that the existing structures provided a significant net benefit to the other group of licensees.

1.6 In the PSB review statement, we noted that the NWA had since their inception in the early 1990s provided different degrees of benefit to the different licensees.6 We also recognised that the value of the regional licences was in decline and acknowledged that unless all of the regional licensees were willing participants in the network, the existing arrangements would become unsustainable. We said that we would consider the issues identified by the licensees as part of our next review of the NWA.

1.7 We issued a consultation document on the NWA in July 2010.7 In the consultation, we examined the reports submitted to us separately by ITV plc and NCLs during the PSB review. Using the information contained in these reports, we set out to build up a picture of the cost sharing arrangements between the licensees and evaluate the impact of those arrangements on each party.

1.8 In light of the many complex financial arrangements between the licensees and the licensees’ differing views about the status of those arrangements, we first sought to make clear which costs we believed were directly related to the provision of the networked Channel 3 service. In doing so, we differentiated between those costs which we considered to be intrinsic to the provision of a national, networked broadcast service of the kind required by the Act and those which we believed were not sufficiently connected to the network service; in a number of cases costs in this latter category were subject to a separate commercial agreement between licensees.

1.9 We then sought to evaluate those cost sharing arrangements which we considered to be relevant against an appropriate alternative benchmark. The preliminary conclusion that we derived from this analysis suggested that ITV plc’s contribution to relevant common costs in 2009 could have been up to £[] more than would be the case under an appropriate alternative cost sharing mechanism. Of this, £[] would have been incurred under the approved NWA.

1.10 Although this analysis had been relatively straightforward, it was unclear to us whether changes to the cost sharing arrangements within the NWA were warranted. For instance, the consolidated Channel 3 ownership structure which existed in 2009, and therefore the relative burden of costs between ITV plc and the other licensees, was not the result of regulatory intervention but of commercial decisions taken by ITV plc’s predecessors in full knowledge of the system of cost allocation in place. Beyond this, we were also mindful that the commercial viability of certain licences could be threatened if costs were shared on the basis of the alternative mechanisms identified. This was a particularly important issue in light of the provisions prohibiting us from proposing modifications which are likely to prejudice the ability of licensees to meet their public service obligations.

1.11 Taking these factors into account, we set out three options for sharing costs within the NWA; maintaining the status quo position; full implementation of an appropriate alternative cost sharing mechanism; or the development of an alternative mechanism designed to identify the level at which it would be ‘efficient’ for the smaller licensees

6 See our Second Public Service Broadcasting Review: Putting Viewers First – Annex 3: the networking arrangements and their impact on the Channel 3 licences at http://www.ofcom.org.uk/consult/condocs/psb2_phase2/statement/annex3.pdf. 7 A copy of the consultation document can be found at: http://stakeholders.ofcom.org.uk/binaries/consultations/itv-networking/summary/itv-networking.pdf

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to contribute to network costs based on what a theoretical new entrant might be prepared to pay. It was not clear to us, however, that the latter two options could in practice be implemented in such a way as to satisfy the requirements of Schedule 11 of the Act. In particular we were concerned that these options, which were likely to require larger contributions to the Network Programme Budget (‘NPB’) from the smaller licensees, could adversely affect the ability of those licensees to fund regional programming. Consequently, it was our preliminary view that only the status quo was likely to be compliant with the current statutory framework for NWA.

Consultation responses

1.12 We received two responses to our consultation document – one from ITV plc and one collectively submitted on behalf of the NCLs. Although both sets of licensees have expressed reservations about our analysis and proposals, in their responses they have each confirmed that they broadly preferred the status quo position outlined in option 1.

1.13 In their response, the NCLs maintained that the focus of our review had been too narrow. They considered that we ought to have taken account of the broad range of financial relationships between the licensees, particularly those enabling network content to be shown on ITV plc’s digital channels. They did not believe that there were any “workable or desirable” alternatives to the status quo.

1.14 ITV plc, in contrast, considered there were good reasons to support option 3. Nevertheless, given our view that a profit based analysis would not provide a sufficiently robust basis for cost sharing arrangements, ITV plc was concerned that the work required to determine efficient contribution levels could be significant if Ofcom believed that modelling based on a theoretical new entrant was necessary. In light of this and “in the interests of looking forward to try to establish the basis for a new and more sustainable arrangement for Channel 3,” ITV plc confirmed that it did not intend “to press actively” for a change to the existing cost sharing arrangements at present.

Our conclusions and next steps

1.15 In light of the responses we have received from the licensees and our own analysis, we consider that it is appropriate to retain the existing system of cost allocation in the NWA for the time being.

1.16 It is clear, however, that the NWA were devised in and for the broadcasting landscape of the early 1990s, when it was possible to sustain a networked national Channel 3 service based on a federation of regional services under different ownership. However, over time, erosion in the value of PSB status and changes in the ownership structure, combined with the inability of licensees to achieve a consensus on change has, as we noted in the consultation document, placed considerable tensions on the existing system.

1.17 In our last PSB review we noted that,

“the new licensing period from 2014 onwards allows a review of the regulatory assets allocated to the Channel 3 licence and the

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potentially attractive opportunity of a reassignment of regulatory assets to ensure that their value is maximised.”8

1.18 As part of this process, we have a duty under section 229 of the Act to submit a report to the Secretary of State by June 2012 giving our opinion on whether the licensees will be able to contribute to the fulfilment of the purposes of public service television broadcasting at a commercially sustainable cost in the next licensing period. In giving our opinion, we must consider the effects of arrangements that would allow for a renewal of the relevant licences and of the conditions included in the relevant regulatory regimes. We must also include in that report any recommendations that we consider should be made to the Secretary of State for the exercise of his powers under the Act, including his power under section 230 of the Act to suspend the right to renew the existing regional Channel 3 licences.9

1.19 Any order under section 230 suspending the right of renewal must apply to all the regional Channel 3 licensees, or none of them – it cannot differentiate between the licensees. Hence, in determining whether or not to recommend the exercise of the Secretary of State’s power under section 230, we will have to consider whether the licensees as a group are able to sustain cost-sharing arrangements under the NWA which will enable them to contribute to the public service broadcasting remit of a competitive Channel 3 service in the future.

1.20 Although in this review we have concluded that it would not be appropriate to change the existing cost sharing arrangements in the NWA at this time, we are unclear that the Channel 3 service as currently configured will be sustainable in the next licence period, i.e. enable the licensees (taken as a whole) to be a nationwide system of services which is able to compete efficiently with other television programme services provided in the UK. In particular, we think the licensees need to consider whether the networking arrangements should be extended beyond the current linear standard definition version of ITV1. It may, for example, be appropriate that future arrangements should look to include other closely related services such as ITV1 HD and/or ITV1+1 and to reassess the cost sharing arrangements needed to support the Channel 3 service (or set of services). We would strongly encourage licensees to begin a dialogue now to consider how they would develop robust arrangements which will be sufficient to underpin a competitive set of PSB services at a commercially sustainable cost in the next licensing period.

8 See Putting Viewers First, paragraph 8.40. 9 See section 229 of the Act.

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Section 2 2 Context of the current review Statutory framework for review of the Networking Arrangements

2.1 Channel 3 is a free-to-air, commercially funded national television broadcast channel made up of 15 regional licensed areas. The 11 regional English and Welsh licences are currently held by ITV Broadcasting Limited, a wholly owned subsidiary of ITV plc. The two Scottish licences are held by STV Central Ltd and STV North Ltd, two subsidiaries of STV Group plc (‘STV’). The licences in Northern Ireland and the Channel Islands are held by UTV Ltd (‘UTV’) and Channel Television Ltd (‘Channel’) respectively. Throughout this document STV, UTV and Channel are referred to collectively as the ‘non-consolidated licensees’ or ‘NCLs’.

2.2 It is a requirement of the Communications Act 2003 (the ‘Act’) that each of the regional licences contains licence conditions to ensure certain specified outcomes. These outcomes include:

2.2.1 fulfilment of the public service remit, namely the provision of high quality and diverse programming;

2.2.2 securing that a certain proportion of programming is made outside of the M25 area (the ‘out of London quotas’);

2.2.3 securing that the service includes a sufficient amount of high quality, regional programming;

2.2.4 securing that regional news is broadcast at regular intervals; and

2.2.5 securing that approved Networking Arrangements (‘NWA’) are in force.

2.3 The origins of the NWA date back to the Broadcasting Act 1990 (‘the 1990 Act’), which required the Channel 3 licensees to conclude a set of arrangements, approved by the Independent Television Commission (the ‘ITC’), that would enable them to work together to produce a national television service. The relevant provisions in the Act were largely drawn from the provisions of the 1990 Act which they superseded.10

2.4 Section 290(4) of the Act defines networking arrangements as arrangements that:

2.4.1 apply to all the holders of regional Channel 3 licensees;

2.4.2 provide for programmes made, commissioned or acquired by or on behalf of one or more of the Channel 3 licensees to be available for broadcasting in all the regional Channel 3 services; and

2.4.3 are made for the purpose of enabling regional Channel 3 services (taken as a whole) to be a nationwide system of services which is able to compete effectively with other television programme services provided in the UK.

2.5 As part of our responsibilities under the Act, we have a statutory duty to carry out a general review of the approved NWA from time to time under section 293, and we

10 Further information about the development of the Channel 3 network can be found in Annex 1.

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may require the channel 3 licensees to modify the NWA as a result. Currently, each such review must be carried out no more than one year after the previous one.11 In carrying out such a review, we must consider a number of specific issues alongside our principal duty to further the interests of citizens and consumers. These duties include:

2.5.1 whether the NWA are a satisfactory means of achieving the purpose set out in paragraph 2.4.3 above;

2.5.2 the likely effect of the NWA on the ability of the licensees to maintain the quality and range of regional programming or programming which contributes to the regional character of the services;

2.5.3 whether the NWA would be likely to prejudice the ability of any of the Channel 3 licensees to comply with their public service remits; and

2.5.4 whether the NWA satisfy the competition tests set out in Schedule 11 of the Act.12

2.6 Under the transitional arrangements in Schedule 18 of the Act, the approved NWA are those arrangements approved by the ITC under the 1990 Act and in effect immediately before the commencement of section 291 of the Act, as modified following reviews by Ofcom under section 293 of the Act.

Arrangements included in the NWA

2.7 The approved NWA currently comprise:

2.7.1 Network Supply Contract (‘NSC’) – an agreement between ITV Network and each of the regional Channel 3 licensees in relation to the acquisition, commissioning and scheduling of network programmes. The NSC includes arrangements relating to the NPB, the fund used to pay for programmes in the network schedule;

2.7.2 Statement of Principles – the principles by which ITV Network carries out its functions on behalf of the regional Channel 3 licensees, including the principle that ITV Network acts in the interests of all the licensees and independently of any production interests of any of them;

2.7.3 Code of Practice – which provides guidance to programme producers on how ITV Network selects and commissions programmes for broadcast on the Channel 3 network and the terms on which such programmes are licensed for broadcast;

2.7.4 Network Programme Licence (‘NPL’) – a standard form contract for programme commissions from a regional Channel 3 licensee made between ITV Network and the relevant licensee; and

2.7.5 Tripartite Commissioning, Production and Compliance Agreement (‘TA’) – a standard form contract for programme commissions from independent

11 In October the Government announced its intention to introduce changes to legislation which would require Ofcom to review the NWA only when it considers necessary or when requested to do so by the Secretary of State. At the time of writing further details are not available. 12 Full details of the competition tests can be found in Annex 5 to the consultation document.

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producers made between ITV Network, the independent producer and the regional Channel 3 licensee carrying out compliance work.

2.8 There are a number of other contractual arrangements between the Channel 3 licensees. These range from matters closely related to the provision of a national networked service, such as transmission, to those not directly connected to it, such as use by ITV plc of the ITV brand.13

The current review

2.9 During our second review of public service broadcasting (‘PSB’), both ITV plc and the NCLs submitted reports suggesting that the approach used to allocate network costs between the regional licensees was inequitable.14 Both sides argued that the existing structures provided a significant net benefit to the other group of licensees.

2.10 We noted at the time our intention to analyse the licensees’ reports as part of our next review of the NWA. In the autumn of 2009 we invited extra comments from the parties and by March 2010 had received a series of additional submissions from each of the licensees.15 Following a full assessment of that material, we set out our proposals in a consultation document, published in July 2010.16

2.11 In the consultation document, we sought to isolate those costs we believed were directly related to the provision of the Channel 3 network service. In doing so, we differentiated between costs which we considered to be intrinsic to the provision of a national, networked broadcast service of the kind required in the Act (and which needed to be shared between licensees) and those which we believed were unconnected to that service. In a number of cases, the latter were already subject to separate commercial agreements between licensees.

2.12 We then sought to evaluate the cost sharing arrangements against an appropriate alternative benchmark which we decided in most, but not all cases, should be each licensee’s share of qualifying revenue (‘QR’). Our preliminary conclusion from this analysis was that ITV plc’s contribution to relevant common costs in 2009 could have been up to £[] more than would have been the case under the alternative benchmarks. Of this, £[] would have been incurred under the approved NWA.

2.13 In the final part of our consultation document, we assessed whether it was appropriate to propose amendments to the cost sharing arrangements within the NWA to reflect this analysis. We considered there were three possible options:

2.13.1 Option 1: under this option we would retain the existing system of cost allocation in the NWA;

2.13.2 Option 2: under this option we would require amendments to the NWA to ensure that costs were allocated between licensees on the basis of QR; or

13 A number of these agreements are described in detail in section 4 of the consultation document. 14 The reports by Spectrum Value Partners for ITV plc (the ‘Spectrum report’) and Ingenious Consulting for STV and UTV (the ‘Ingenious report’) are described in Section 3 of the consultation document. 15 The main submissions made by the parties are outlined in section 3 of the consultation document. 16 A copy of the consultation document can be found at: http://stakeholders.ofcom.org.uk/binaries/consultations/itv-networking/summary/itv-networking.pdf

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2.13.3 Option 3: under this option we would carry out further work to determine whether the smaller licensees could pay more towards network costs, by comparing the current level of payment with the maximum amount which a theoretical new entrant would be prepared to pay.

2.14 Our preliminary assessment of the three possible options suggested that only Option 1 was likely to be compliant with both the statutory purpose of NWA to enable Channel 3 to compete effectively with other services, and our duty not to propose modifications which could prejudice the ability of licensees to meet their public service obligations, including regional programming.

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Section 3 3 Consultation responses Introduction

3.1 In our consultation document, we examined a range of issues including the relevance of individual financial arrangements to the NWA, the merits of alternative cost sharing methodologies and the viability of amendments to the NWA to reflect our findings. We invited the views of respondents on each of these areas through a series of specific questions.

3.2 We received two responses to our consultation – one from ITV plc and one collectively submitted by STV, UTV and Channel. In this section, we set out the responses we received from the licensees to the consultation questions. We address each of the question topics in the order in which they appeared in the consultation and offer our view on the arguments presented before outlining our conclusions.

Criteria employed by Ofcom

3.3 In the consultation document, we noted that criteria set out in the Act define which arrangements are capable of being approved by us as networking arrangements.17 The Act states that such arrangements must apply to all regional licensees, provide for programmes to be commissioned or acquired for transmission across the network and exist for the purpose of enabling the licensees “to be a nationwide system of services… able to compete effectively with other television programme services provided in the UK.” As a starting point, therefore, it was our view that only arrangements which satisfy those criteria have a sufficiently close nexus to the approved NWA to be relevant to an assessment of any burden which the cost sharing arrangements within the NWA place on the licensees.

3.4 We asked respondents whether they agreed with our decision to use the criteria set out in the Act as a basis for determining which costs were relevant to cost sharing arrangements within the NWA.

Licensee comments

3.5 ITV plc said that it broadly agreed with the basis on which we had determined the relevance of specific costs to the cost sharing arrangements within the NWA.

3.6 In contrast, the NCLs disagreed with our approach. They said that we had sought to determine whether any ‘subsidy’ was paid by one set of licensees to another rather than, as they had suggested, taking account of the broader range of financial relationships between licence holders. The NCLs considered that our assessment gave a misleading impression of the licensees’ financial arrangements because it was limited to a specific set of cost sharing relationships whilst ignoring other financial arrangements which shifted the economic benefits in favour of ITV plc. Our conclusions were, in the view of the NCLs, therefore based on selective and incomplete analysis of the situation.

17 See section 290(4) of the Act.

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3.7 The NCLs also drew our attention to the requirement in Schedule 11 of the Act that, in assessing the suitability of NWA, we must consider the ability of licensees “to maintain the quality and range of the other programmes… which contribute to the regional character of the services.”18

Our response

3.8 Although the NCLs have suggested the approach we have taken in the review has been unduly narrow, the consultation document makes clear that the NWA, and therefore our powers of review, are limited to arrangements made for the purposes specified in section 290(4) of the Act. We consider any decision by us to include within the scope of our review financial agreements which do not meet the criteria for NWA specified in statute, however significant those arrangements may be to the parties concerned, would have been outside our statutory powers. Consequently, we have focused this review on the cost sharing arrangements that are relevant to the operation of the NWA.

3.9 There is no uniquely correct way to share common costs. Therefore, the purpose of the analytical work within the consultation was not to determine whether or not any particular licensee was being ‘subsidised’ by any other but instead to compare the impact of the existing cost-sharing arrangements against appropriate alternative benchmarks. It is for this reason that we laid out a range of options for cost sharing between the licensees within a consultation document.

3.10 We have taken account of the statutory obligation highlighted by the NCLs to consider the ability of licensees to produce high quality regional programming in assessing the options we outlined in the consultation document.

Assessment of individual agreements

3.11 In addition to the approved NWA, the regional licensees are also parties to a number of other arrangements that potentially have a bearing on the provision of the Channel 3 network service.19

3.12 However, the licensees disagreed as to which of these arrangements were pertinent to our assessment of the specific cost-sharing provisions in the NWA. Reports commissioned by three of the companies holding regional Channel 3 licences – STV and UTV on the one hand and ITV plc on the other – also offered markedly different approaches to and analyses of those arrangements.

3.13 In the consultation document, we sought to assess each of the categories of arrangements described in the Spectrum report – such as transmission costs and Network Centre costs – against the criteria set out in section 290 of the Act to determine which arrangements were relevant to the cost sharing provisions in the NWA.20 We asked respondents whether they agreed with the assessments of relevance which we made in relation to those individual agreements.

18 See Schedule 11, section 7(4) of the Act. 19 For instance, in some cases, there is the need to attribute costs between ITV1 and the ITV plc owned channels in order to then determine how the costs of the ITV1 networked service are shared between the licensees. 20 In the case of the ITV1/Digital Channels Programme Pricing Agreement (the ‘Programme Pricing Agreement’ or ‘PPA’), which sets out a framework for the allocation of costs between the Channel 3 licensees and ITV plc in relation to the acquisition of broadcast rights for, respectively, ITV1 and digital channels owned by ITV plc, we considered there were compelling reasons to disregard the

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Licensee comments

3.14 In relation to specific assessments made by us in the consultation document:

3.14.1 ITV plc was concerned by references to the Services Agreement (‘SA’)21 in sections on Network Centre and transmission costs. ITV plc considered that only a few elements of the SA could plausibly fit the criteria we had selected. ITV plc was concerned that regulation should not be inadvertently over extended as a result of the review.

3.14.2 ITV plc disagreed with our view that the Programme Pricing Agreement (‘PPA’)22 met the criteria for NWA. ITV plc argued that primary purpose of the agreement was to enable ITV plc to access network rights for use on its digital channels, not on the Channel 3 service. It considered that a useful by-product of the agreement, enabling the joint acquisition of sports rights by ITV Network and ITV plc, should not by itself result in the arrangements as a whole being classed as regulated NWA. Nevertheless, ITV plc supported our decision to disregard the PPA from consideration.

3.14.3 ITV plc also argued that it would be hard to deny that the Carlton Granada merger undertakings cap23 has a very significant impact on the intra- Channel 3 economics and therefore on our core responsibilities in relation to the NWA. ITV plc considered that our approach to the NWA suggested that we believed the cap substantially fettered our statutory authority to make changes to the NWA.

3.14.4 The NCLs considered that Ofcom’s argument for setting aside the effect of the cap on the network budget was artificial and ignored the reality of the situation. They said that the undertakings resulted from the Competition Commission’s finding that the Carlton/Granada merger would be likely to have an adverse effect on the NCLs and that clearance for the merger had required “a further set of protections which included the cap, and those protections were to be transposed into the NWA (that was itself an undertaking).” The NCLs considered that any assessment of Channel 3 cost sharing arrangements without a parallel review of the merger undertakings served no practical purpose. Nevertheless, they argued that no changes in circumstance since 2003 had lessened the continuing need for the “protections” which the undertakings afforded them.

3.14.5 The NCLs also reiterated their concern that Ofcom’s approach excluded bilateral commercial arrangements which, in conjunction with the NWA, governed the financial relationships between the Channel 3 licensees. The agreement from consideration even though it satisfied the section 290 criteria. These are discussed in paragraphs 4.61 to 4.66 of the consultation document. 21 The Services Agreement (‘SA’) is an agreement between ITV Network and each of the licensees which sets out the basis on which ITV plc provides (and is paid to provide) certain ‘non-core network functions’ and ‘relevant activities’ to the network. The services included within these categories include the collection of BARB data, provision of network programme listings and IT, financial and engineering services. 22 See footnote 20 above. 23 Among the undertakings given by Carlton Communications plc and Granada plc (ITV plc’s predecessor companies) to the Secretary of State for Trade and Industry in 2003 was an agreement to ‘cap’ the contributions made by the NCLs to the Network Programme Budget at their 2003 levels, increasingly annually by RPI. Further information about the undertakings can be found in our consultation document at paragraphs 4.75ff and in our 2005 review consultation at paragraph 3.20.

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NCLs argued that it was important Ofcom took account of these arrangements even though the NCLs accepted that “strictly [such arrangements] do not form part of the NWA.” In response to our comment that the NCLs had not produced objective evidence to support their assertion that the PPA’s terms were inequitable, the NCLs stated that it was difficult to get information from ITV plc and ITV Network, which were the only bodies able to supply evidence on these points.

Our response

3.15 We believe the scope of our review is clearly defined and our grounds for applying statutory criteria to assess the relevance of intra-licensee cost sharing arrangements – including those within the SA – are appropriate given the purpose of the review to evaluate the specific burden which the NWA impose on the different licensees.

3.16 As acknowledged in the consultation,24 we appreciate that the PPA is concerned with the allocation of costs between ITV Network and ITV plc in relation to the latter’s digital channels, rather than the allocation of costs between the Channel 3 licensees. However, it remains the case that the agreement does include terms relating to the joint acquisition of rights which are not separated from the “primary purpose” of rights acquisition for the digital channels which ITV plc identifies in its response. On this basis we remain satisfied that the PPA meets the statutory criteria. Nonetheless, we remain of the view that the cost-sharing arrangements in the PPA should be disregarded for the reasons we stated in the consultation document.25

3.17 It remains our view that it would not be appropriate for us to take account of ancillary bilateral commercial agreements between ITV plc and each of the NCLs within our assessment of cost sharing arrangements which are relevant to the NWA. As the NCLs themselves recognise, these agreements do not form part of the NWA. Consequently, while we note the agreements were signed a number of years ago when ITV plc’s digital channels were less established and had a lower share of viewing than at present, we have not sought to assess the NCLs’ position that these ancillary commercial arrangements now provide a benefit to ITV plc which would offset any burden imposed by the cost-sharing arrangements that sit within the NWA.

3.18 In relation to complaints by the NCLs as to the transparency of cost allocation information, we can only repeat that ITV Network has contractual reporting obligations regarding the allocation of such costs.26

3.19 Finally, as regards the merger undertakings cap, the costs of the cap are, as we noted in the consultation document, specific to ITV plc and do not result from the operation of the network service. In our view, they are burdens which derive from the merger between Carlton and Granada which made ITV plc the largest single business among the Channel 3 licensees rather than from ITV plc’s status as a regional broadcaster licensed by Ofcom. To suggest, as the NCLs do, that this distinction is artificial is to confuse the regulatory framework which exists to ensure ITV plc’s continuing compliance with its merger undertakings with distinct statutory provisions designed to enable the licensees collectively to provide a competitive network service. It remains the case that any review of the merger undertakings is properly a matter in the first instance for the parties to take up with the OFT.

24 See paragraph 4.63 of the consultation document. 25 See paragraphs 4.61 – 4.66 of the consultation document. 26 See paragraph 4.66 of the consultation document.

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Additional arrangements between the licensees

3.20 In their rebuttal to the Spectrum report, the NCLs argued that any consultation which failed to take account of all intra-licensee arrangements “whether they are strictly part of the NWAs or not” would be flawed. Along with some issues which we had considered alongside other arrangements, the NCLs also raised the sharing of revenue derived from premium rate services27 and the allocation of back-end revenue shares from programmes commissioned by ITV Network. 28

3.21 On the basis of the information that we had when drafting the consultation document, it was not clear to us whether either of those arrangements could be considered germane to the financial arrangements within the NWA. We asked respondents to provide an account of the relevant processes and revenue sharing principles and to explain whether they considered these arrangements had sufficient nexus with the NWA to be relevant to our assessment of the cost burden which the NWA placed upon the licensees.

Licensee comments

3.22 The NCLs argued that the consultation document disregarded material issues which they had raised in their previous submission. They referred us back to the points they had made in their rebuttal to the Spectrum report.

3.23 Nevertheless, the NCLs did take the opportunity to reiterate their view that it was inappropriate to allocate revenue from premium rate services on the same basis as contributions to the Network Programme Budget. They suggested that QR share represented a more appropriate allocation method than the existing method of revenue allocation and would be more consistent with red button revenues which were already allocated on a QR basis and which the NCLs considered to be very similar. The NCLs also believed that the costs deducted by ITV Network from the revenue which they were entitled to were considerable and reiterated their concern that they did not receive the accounting information that they were entitled to.

3.24 The NCLs additionally expressed dissatisfaction at having received no revenue from overseas sales of commissioned programmes, known as ‘back-end revenue’, despite the fact that an agreement with PACT had been in place for some years.

3.25 In contrast to the NCLs’ position, ITV plc argued that revenues from premium rate services were allocated on the current NPB-related basis because the relevant vote or competition was embedded within the editorial of the show which gave rise to it. ITV plc believed that there was no rationale to a position of QR-based revenue allocation over and above financial self-interest given that the smaller licensees contributed towards production costs on the basis specified in the C1/C2 mechanism.29 ITV plc also stated that, to the best of its knowledge, revenue was allocated by ITV Network after the exclusion of direct costs including production costs.

27 See paragraph 4.81f of the consultation document. 28 See paragraph 4.83f of the consultation document. 29 The C1/C2 mechanism determines the contribution that each regional licensee makes to the Network Programme Budget. It was explicitly designed so that the larger licensees bore a greater share of the costs of the provision of the network service in order to ease the perceived burden on the smaller licensees of regional programming obligations. For further information about the C1/C2 mechanism, see paragraphs 4.8 – 4.15 of the consultation document.

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3.26 In relation to back-end revenue shares, ITV plc said its understanding was that ITV Network’s business affairs and finance units were responsible for collecting revenue from producers. ITV plc noted that the revenue collected thus far seemed to be lower than had been anticipated. As a consequence, it said that ITV Network had begun a series of audits of the revenue generated from secondary sources and reported by independent producers. As with revenue from premium rate services, ITV plc understood that ITV Network intended to allocate this revenue on a C1/C2 basis between the licensees.

3.27 In addition, ITV plc made clear its view that agreements relating to these issues did not fulfil the statutory criteria and were therefore irrelevant to the current review.

Our response

3.28 In the absence of further information from the licensees, we have no grounds for including the revenue-sharing arrangements in relation to premium rate services and back-end revenue within the scope of this review.

3.29 We note the concerns expressed by the NCLs on the allocation of this revenue. However, we can see arguments in favour of either an approach based on QR share or one based on C1/C2 shares. Since this remains a matter outside the scope of this review, we consider that it is for the licensees to develop a set of principles that should apply to the sharing of revenue.

Evaluation of alternative cost allocation methodologies

3.30 In order to evaluate the impact of the cost sharing arrangements identified by us as relevant to the NWA, we examined a range of alternative allocation methods – namely share of viewing, willingness to pay and share of network qualifying revenue (‘QR’) – to determine whether any provided a suitable benchmark against which to compare the existing arrangements. Our analysis suggested that licensees’ QR represented the most appropriate benchmark, except in relation to some aspects of transmission costs where it was possible to apply the cost causation principle directly.30

3.31 We asked respondents whether they agreed with our evaluation of alternative cost allocation methods. We also asked whether respondents considered it would be appropriate to apply different benchmarks to different categories of costs.

Licensee comments

3.32 ITV plc stated that it broadly agreed with our analysis, arguing that cost causation and distribution of benefits represented the most appropriate approach, with QR used as a test for benefit distribution. ITV plc also noted that if the NCLs considered, as quoted in the consultation document,31 that a ‘federal system of regional broadcasters... must have a system of cost sharing which matches revenue entitlement’ it was not clear why the NCLs would continue to support the existence of the C1/C2 mechanism.

3.33 The NCLs did not consider that any of the alternatives put forward as possible benchmarks in the consultation document were workable or desirable. Although as a

30 The cost causation principle states that an economically efficient outcome will result if costs are recovered from those parties whose activities cause the costs to be incurred in the first place. 31 See paragraph 5.30 in the consultation document.

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general principle they accepted the allocation of costs on a QR basis, they argued that contributions to the Network Programme Budget represented an exception to this. They believed that without the C1/C2 mechanism the Channel 3 service would have been economically unviable in parts of the UK with the result that no applicants would have sought to supply such a service. They favoured QR as a benchmark except in relation to content, because it was both simple and well understood by all licensees.

3.34 The NCLs stated that an approach based on cost causation would ignore financial reality, giving rise to unaffordable costs – they cited the distribution costs connected to the ITV1 HD service as a case in point. They also contended that cost causation was impractical in a number of cases where it was difficult to determine precisely where and in what proportion costs were caused.

3.35 The NCLs considered that an approach based on share of viewing would be difficult to measure and verify.

3.36 The NCLs also viewed willingness to pay as an extremely impractical basis for the sharing of costs. They did not accept that any new entrant operating under standard commercial principles would be prepared to sacrifice the entirety of its potential profit in return for a licence. The NCLs considered our view that there would be close correlation between these different approaches to be “over simplistic” because it took no account of the high level of fixed costs faced by the licensees. They argued that the C1/C2 mechanism had been put in place because the costs of regional broadcasting would be similar in each region notwithstanding QR share and sought to emphasise that profitability depended not only on each licensee’s QR share but also the level of QR for Channel 3 as a whole.

Our response

3.37 Our objective in this section of the consultation document was to consider whether it was possible to develop appropriate alternative benchmarks against which to evaluate the impact of the current cost-sharing arrangement on the licensees. While we note that none of the licensees consider that there any additional alternative methodologies to those outlined in the consultation, we also acknowledge the strong view expressed by the smaller licensees that no alternatives to the current cost sharing arrangements are realistic because they fail to take account of fixed regional broadcasting costs.

3.38 We do not accept the assertion that, in relation to the Network Programme Budget, there are no suitable alternatives even to consider as a benchmark. The C1/C2 funding arrangement was essentially a mechanism proposed by the ITC as a way of providing indicative costs to bidders in the 1992 licence auction. It was accepted (and amended subsequently) by the licensees themselves prior to the consolidation that took place from 2000 onwards. It is not based on any particular economic principles; for instance, there is no economic reason why contributions to the NWA should be modified depending on whether the relevant licensee is above or below four per cent of total qualifying revenue. Further, although the original approach to cost sharing proposed by Ofcom’s predecessor, the ITC, recognised that “licensees will necessarily incur some fixed unavoidable costs which for smaller regional licensees will account for a larger proportion of revenue”,32 it did so on the basis that the proposed cost sharing structure would reflect licensees’ ability to pay given the

32 See Independent Television Commission, Invitation to Apply for Regional Channel 3 Licences, paragraph 128.

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specific regional obligations then in place. In light of the reductions in regional obligations placed on licensees since that time, as noted in the consultation document,33 we might have already expected further adjustments in the C1/C2 arrangements towards QR.

3.39 In order to evaluate the impact of the C1/C2 funding arrangements we need to have a benchmark against which to make comparisons. As set out in the consultation document we consider that QR share remains an appropriate benchmark.

3.40 We note the comments by the NCLs that contributions to the costs of an HD service may be unaffordable if determined on a cost causation basis, while at the same time stressing the increasing importance of such services. We note that the current definition of a Channel 3 service dates from 1990 and recognise that it may not be appropriate for the next licence period from 2014. Instead, it may be more appropriate to consider a set of Channel 3 services e.g. encompassing the main service (whether in SD or HD) together with “+1” services, on demand services etc, if licensees are to provide a robust Channel 3 offering in the next licence period.

Options for cost allocation within the NWA

3.41 In the final part of our consultation document, we noted that ITV plc’s contribution to relevant common costs was £[] greater than would have been the case if costs had been shared according to an appropriate alternative benchmark measure. In light of this we considered whether it would be appropriate to propose amendments to the cost sharing arrangements within the NWA.34

3.42 We considered there were three possible options:

3.42.1 Option 1: under this option we would retain the existing system of cost allocation in the NWA;

3.42.2 Option 2: under this option we would require amendments to the NWA to ensure that costs were allocated between licensees on the basis of QR; or

3.42.3 Option 3: under this option we would carry out further work to determine whether the smaller licensees could pay more towards network costs, by comparing the current level of payment with the maximum amount which a theoretical new entrant would be prepared to pay.

3.43 Our preliminary assessment of the three possible options suggested that only Option 1 was likely to be compliant with the statutory purpose of NWA stated in the Act and with our duty not to propose modifications which could prejudice the ability of licensees to meet their public service obligations, including regional programming.

3.44 We asked respondents to explain which of the three options they preferred or whether they considered that an alternative approach would provide a fairer distribution of costs. We asked them to take account of the fact that any decision we took to propose modifications to the NWA had to be informed both by our general duties and the specific obligations contained in Schedule 11 of the Act. We also

33 See paragraph 7.16f in the consultation document. 34 As noted in paragraph 7.5 of the consultation document, although we sought to build up a comprehensive picture of the financial arrangements between the licensees in order to evaluate the burden which the cost sharing arrangements specified in the NWA impose on the different parties, the focus of our review is on the costs incurred by the licensees within the existing approved NWA.

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asked licensees to set out the likely impact which they believed each of the options would have on their business.

Licensee comments

3.45 The NCLs questioned whether the concept of ‘fairness’ could be applied in relation to the financial arrangements between the Channel 3 licensees unless all relevant financial arrangements were taken into account, including those which enabled network funded programmes to be shown on ITV plc’s wholly owned channels. They also argued that it was unrealistic to conclude that a new entrant would be prepared to take into account flows of value from the regulated arrangements while ignoring flows of value from other financial relationships between the licensees.

3.46 The NCLs considered that Ofcom’s questions were academic in the absence of a formal review of the Merger Undertakings. Nevertheless, given a frame of reference they considered to be highly subjective, the NCLs maintained that only Option 1 could ensure the requirements of Schedule 11 of the Act were met. They argued that only this option would ensure that regional licensees were able to provide a service in all parts of the country, allowing them to continue to fulfil their public service obligations even within a challenging commercial environment.

3.47 The NCLs rejected the other options. They said that the move to QR-based cost contributions envisaged under Option 2 would undermine their financial viability and consequently contravene Schedule 11 of the Act. The NCLs argued that any suggestion that a move towards a QR based approach might have been anticipated given reductions in regional programming since the arrangements came into force ignored the broader commercial issues which they now faced, including a ‘collapse’ in network advertising revenue.

3.48 The NCLs also considered that Option 3 was incompatible with Schedule 11 of the Act, because they believed it would undermine their ability to deliver regional programming. They argued our proposed approach of assessing willingness to pay was flawed because it implied a new entrant would be prepared to pay ‘its last pound of profit’ to obtain a licence. They also argued it would be difficult to calculate the efficient contribution level outlined by us in the consultation document because any determination of EBITDA was liable both to be subjective and to prove costly.

3.49 ITV plc argued that historically cost sharing arrangements in the NWA had rested on two premises:

3.49.1 that there was enough money in the system to provide for arrangements “which mandated cross subsidy within the network to smaller licensees”; and

3.49.2 that the network architecture assumed licences would be in separate ownership.

In light of what it considered had been a dramatic change of circumstances even since the Carlton/Granada merger, ITV plc argued that the current position was unsustainable. Specifically, ITV plc believed that the current arrangements provided for an unjustifiable distribution of profit between the licensees, contrasting losses in its own broadcasting businesses in 2009 with profits made by UTV and STV in the same year.

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3.50 ITV plc also maintained that our approach towards our duties under Schedule 11 of the Act in effect amounted to an acceptance that spending on network programming should be sacrificed in favour of less popular regional programming. Over time it considered that “de-investment” on this basis would adversely affect the continued provision of a competitive Channel 3 service.

3.51 Taking all these points into account, ITV plc did not accept that Option 2 would be inconsistent with Ofcom’s statutory duties. Nevertheless, and despite the fact that it considered there were good arguments in favour of Option 3, it was prepared to accept Option 1 “in the interests of focussing on trying to fashion a new and more sustainable set of arrangements between the licensees.”

Our response

3.52 We note the position of both the NCLs and ITV plc in support of Option 1, which we stated in the consultation document represented our preferred approach. However, we consider it appropriate to respond to some of the concerns raised by the licensees about our analysis of the options.

3.53 First, we would dispute the characterisation of our review by the NCLs as highly subjective. As we explained in the consultation document, the criteria we have used to determine the relevance of specific arrangements to our review are clearly grounded in the statutory framework. We accept that – in determining the value of a licence – a new entrant could include in its calculations an assessment of other commercial agreements it might be able to make with ITV plc. However, it is important to note that the new entrant would not be constrained by an existing bilateral agreement – it would be free to negotiate a new (potentially more valuable) financial arrangement. In any case, this does not alter the fact that such deals would be commercial agreements beyond the scope of regulation.

3.54 We do not consider that it would be appropriate for us to comment on agreements that were entered into by the licensees without any form of regulatory involvement and which relate to the exploitation of network assets on other channels. Although we recognise that the NCLs believe these agreements transfer value to ITV plc, compensating for any ‘cost’ imposed on the larger licensees by the C1/C2 mechanism, that, if correct, is the outcome of commercial negotiations between the parties and therefore outside the scope of this review of the NWA.

3.55 In response to ITV plc’s suggestion that our approach to the duties specified in Schedule 11 of the Act will result in de-investment and threaten the overall competitiveness of the Channel 3 network, the current legislative provisions clearly and explicitly require us to ensure that the quality and range of the regional programming are maintained.

3.56 Finally, although ITV plc points to losses made by its broadcasting business in 2009 to demonstrate that the current model of cost allocation is flawed, we note ITV plc’s recent interim statement reported a significant increase in its Broadcasting and Online segment’s EBITA (before exceptional items) during the first half of 2010.35 It is our view that ITV plc’s experience demonstrates the practical difficulties of using profit measures to test the suitability of the network’s cost sharing arrangements where licensees are highly operationally geared (or indeed where the operational

35 See ITV plc’s 2010 interim statement at http://www.itvplc.com/files/financialreport/35843/2010_Full_Interim_Statement_FINAL_pdf_with_Sky. pdf.

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gearing of licensees may be different). Where a high proportion of a business’ cost base is fixed and revenues can be volatile (as witnessed by the significant fall in advertising revenues in 2009), then operating profits will also be volatile. Therefore, we do not believe that the volatility inherent in a measure such as EBITA, which is closely aligned to the cyclical nature of broadcast advertising revenue, could provide the budgetary certainty required to enable network commissioning staff, for example, to make decisions about programming investment levels over a reasonable time period.

Determining efficient contributions to NWA from smaller licensees

3.57 In the consultation document, we noted that the maximum amount the smaller licensees could contribute to the NWA while maintaining a viable business was unclear. Nevertheless, we considered it was potentially possible to determine this ‘efficient’ contribution level and implement option 3 while recognising there were difficulties in doing so. We asked respondents to set out how they would attempt to determine ‘efficient’ contributions.

Licensee comments

3.58 The NCLs questioned whether work on this issue could have any value, given their view that the merger undertakings would prevent this option from being implemented.

3.59 The NCLs also believed that Option 3 assumed a new entrant would be prepared “to simply break-even” in order to obtain a licence when any rational new entrant would in fact be looking for a return on its investment. They also maintained that any new entrant operating on commercial principles would “take into account all flows of economic benefit” (emphasis in the original) before making an investment decision, including those outside the approved NWA such as the principles to be applied to the sharing of ITV1 HD transmission costs.

3.60 ITV plc considered that the “easiest and most effective approach” would be to use the licensees’ most recent stated profits to establish the amount which they could afford to pay towards the NPB. ITV plc questioned whether an approach that required an assessment of what a theoretically efficient licensee would be prepared to pay would be consistent either with the approach taken by us in the past (notably in the 2008 review where ITV believed our conclusions had been predicated on an analysis of Channel TV’s “particular circumstances”) or with our statutory duties. In ITV plc’s view, such an approach would favour certain licensees by placing their ability to make profits ahead of the ability of other licensees to provide regional programming. ITV plc also questioned whether such an approach would be a productive use of time and resources. It believed that effort should instead be channelled into forging a new set of arrangements.

Our response

3.61 Although we note the NCLs’ views, we would draw their attention to the fact the consultation document stated explicitly that the ‘efficient’ contribution level for the smaller licensees could be “represented by the maximum amount a new entrant would be prepared to contribute while still being able to earn a reasonable return on its investment in the licence…”.36 In response to their concern that our consultation option did not take account of other relevant financial arrangements, we can only

36 See paragraph 7.25 of the consultation document.

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reiterate the point made above that we consider such deals to be commercial arrangements beyond the scope of the regulated arrangements.

3.62 In light of the fact that both ITV plc and the NCLs have agreed with our proposal to leave the cost sharing arrangements in the NWA as they are, we do not propose to consider the practical implementation of option 3 in detail at this time. Nevertheless, we note ITV plc’s view that it may be appropriate to develop new arrangements. We have already noted the considerable tensions that exist in the current system, as well as the fact that sustainable networking arrangements require all of the licensees to be willing participants. We would, therefore, welcome proposals from the licensees on updated arrangements. In the first instance, however, we consider it is up to the licensees to develop – and achieve consensus on – new proposals.

Other issues

3.63 Both the NCLs and ITV plc took the opportunity to supplement their specific responses with additional comments on related issues.

Licensee comments

3.64 The NCLs argued that no good purpose has been served by recent NWA reviews. They said that they

“…would like to see Ofcom reviewing whether the requirements of the current NWAs are actually met rather than continually postulating how they can be changed, when in reality changes to the NWAs are difficult if not impossible for reasons which Ofcom has itself explained.”

As a result, they considered that, rather than discontinuing regular reviews, we should instead use them to ensure that a new complete set of documents were put in place and enforced by the licensees.

3.65 ITV plc challenged comments made by us in the consultation document which it believed implied that programming opt outs by STV had been “legitimately claimed”.37 ITV plc made clear its view that “opt outs which are legitimate pursuant to the terms of the Network Supply Contract still involve subsidies given the increased burden which falls on ITV plc to pay for programming for the rest of the Network.”

3.66 Finally, ITV plc questioned whether we were correct in the consultation document to suggest either that the regional channel 3 services had an obligation to achieve 98.5% coverage for analogue and digital transmission or that those obligations made transmission a shared cost rather than one to be born by individually licensees.38 ITV plc argued that regional licences place obligations on licence holders at an individual level and that consequently it was clear “that the ultimate responsibility for transmission falls individually on each regional Channel 3 licensee…” (emphasis in the original).

Our comments

3.67 In response to the points raised by the NCLs, we have, since at least the 2006 review, made repeated requests to the licensees to agree and submit a formal set of

37 Specifically, ITV plc referred to paragraphs 6.14 and 6.19 of the consultation document. 38 See paragraph 6.6 of the consultation document.

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documents to us for our approval. In our most recent correspondence on the issue, during October 2010, ITV Network argued that it would not be appropriate to do so while some aspects of the NWA are subject to legal process.39 Although it is the case that the NWA are subject to regulation, they are first and foremost contractual agreements between the licensees and their agent, ITV Network. It is, in our view, for the licensees rather than Ofcom to ensure that contracts are kept in good order.

3.68 We recognise the NCLs’ strongly held view that the full range of financial arrangements between the parties are relevant to any assessment of the burden the NWA place on the licensees. As the NCLs have acknowledged, however, such documents are not part of the approved NWA and do not, in our opinion, meet the statutory criteria for the arrangements as laid out in the Act.

3.69 In relation to ITV’s reference to the devolution agreement, we would point out that the source of the data referred to in our consultation document was the Spectrum report submitted by ITV plc.

3.70 Finally, in relation to transmission, ITV plc has seemingly not taken account of the fact that the multiplex capacity on DTT Mux 2 which it procures for its Channel 3 services is reserved for public service broadcasters by order. Coverage levels are not therefore the by-product of the obligations placed on licensees individually – the coverage obligation attaches to the Channel 3 service as a whole. In the case of DTT capacity, it is also a trade-off for the granting of the use of a regulatory asset. Licence terms are set specifically in order to secure the widest possible level of coverage for the UK’s main public service channels40 and enable them to compete effectively with one other.

Concluding comments

3.71 In light of the responses we have received from the licensees and our own analysis, we consider that it is appropriate to retain the existing system of cost allocation in the NWA for the time being.

3.72 It is clear, however, that the NWA were devised in and for the broadcasting landscape of the early 1990s, when it was possible to sustain a networked national Channel 3 service based on a federation of regional services under different ownership. However, over time, erosion in the value of PSB status and changes in the ownership structure, combined with the inability of licensees to achieve a consensus on change has, as we noted in the consultation document, placed considerable tensions on the existing system.

3.73 In our last PSB review we noted that,

“the new licensing period from 2014 onwards allows a review of the regulatory assets allocated to the Channel 3 licence and the potentially attractive opportunity of a reassignment of regulatory assets to ensure that their value is maximised.”41

3.74 As part of this process, we have a duty under section 229 of the Act to submit a report to the Secretary of State by June 2012 giving our opinion on whether the

39 Letter from Jonathan Rogers (ITV Network) to Kate Stross (Ofcom), 22 October 2010. 40 See, for example, our statement on the planning options for digital switchover at http://stakeholders.ofcom.org.uk/binaries/consultations/752493/statement/statement.pdf. 41 See Putting Viewers First, paragraph 8.40.

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licensees will be able to contribute to the fulfilment of the purposes of public service television broadcasting at a commercially sustainable cost in the next licensing period. In giving our opinion, we must consider the effects of arrangements that would allow for a renewal of the relevant licences and of the conditions included in the relevant regulatory regimes. We must also include in that report any recommendations that we consider should be made to the Secretary of State for the exercise of his powers under the Act, including his power under section 230 of the Act to suspend the right to renew the existing regional Channel 3 licences.42

3.75 Any order under section 230 suspending the right of renewal must apply to all the regional Channel 3 licensees, or none of them – it cannot differentiate between the licensees. Hence, in determining whether or not to recommend the exercise of the Secretary of State’s power under section 230, we will have to consider whether the licensees as a group are able to sustain cost-sharing arrangements under the NWA which will enable them to contribute to the public service broadcasting remit of a competitive Channel 3 service in the future.

3.76 Although in this review we have concluded that it would not be appropriate to change the existing cost sharing arrangements in the NWA at this time, we are unclear that the Channel 3 service as currently configured will be sustainable in the next licence period, i.e. enable the licensees (taken as a whole) to be a nationwide system of services which is able to compete efficiently with other television programme services provided in the UK. In particular, we think the licensees need to consider whether the networking arrangements should be extended beyond the current linear standard definition version of ITV1. It may, for example, be appropriate that future arrangements should look to include other closely related services such as ITV1 HD and/or ITV1+1 and to reassess the cost sharing arrangements needed to support the Channel 3 service (or set of services). We would strongly encourage licensees to begin a dialogue now to consider how they would develop robust arrangements which will be sufficient to underpin a competitive set of PSB services at a commercially sustainable cost in the next licensing period.

42 See section 229 of the Act.

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Annex 1 1 Development of the Channel 3 network

A1.1 The regions comprising the Channel 3 licence areas are of very different population sizes and hence advertising revenue earning potential. The individual licence areas were subject to auction as a result of the 1990 Act. The bidders for each licence were required to meet a quality threshold and business plan test with licences awarded (in the absence of exceptional circumstances) to the highest qualified bidder in each region.

A1.2 The 1990 Act included restrictions which prevented companies from holding regional licences in more than two areas. This restriction was supplemented in 1991 with a further proscription on any company holding two ‘large’ licences (i.e. licences for regions whose share of the network’s total revenue exceeded four per cent).43 Few companies chose to bid for multiple licences during the auction process and ultimately the licences were won by 15 separate bidders.

A1.3 Subject to the statutory requirements in the 1990 Act, the form which the NWA were to take was initially a matter for negotiation between the successful bidders. However, in its guidance to applicants for those licences the ITC raised a series of issues which it expected the NWA to address. Among other things, the ITC proposed that contributions to the Network Programme Budget (‘NPB’) should be shared between licensees according to a formula which took account of the different earning potential of each licence area. Under the ITC’s formula the holders of ‘small’ licensees (i.e. licences for regions whose share of the network’s total revenue did not exceed four per cent)44 would make lower contributions to the NPB than their relative size would otherwise warrant, with the large licensees making proportionately higher contributions. The ITC’s proposal was, with minor adjustments, accepted by the new Channel 3 licensees and included within the first NWA.

A1.4 The cost sharing arrangements in the NWA were therefore originally devised in the context of fragmented network ownership, to ensure that each licensee could meet its regional programme obligations while also making a contribution to the costs of the network schedule.

A1.5 Over the course of the 1990s the ownership restrictions on the regional Channel 3 licences were progressively relaxed in response to increasing competition and pressure from the licensees to allow consolidation. Secondary legislation in 199345 allowed a company to own any two licences with the exception of the London weekday and weekend licences. The Broadcasting Act 1996 allowed further consolidation within the network, subject to a restriction preventing any company holding a combination of licences that would give it more than a 15% share of overall UK television audience viewing time. All restrictions on consolidation between regional licensees were repealed in the Communications Act, although

43 See the Broadcasting (Restrictions on the Holding of Licences) Order, 1991. The large licences specified in the order are those now known as STV Central, Central, Anglia, London (weekday), London (weekend), Granada, Meridian, Wales & West of England and Yorkshire. 44 The small licences are those now known as Border, Channel, STV North, Tyne Tees, Ulster and Westcountry. 45 See the Broadcasting (Restrictions on the Holding of Licences) (Amendment) Order, 1993.

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separate rules were introduced under Schedule 14 preventing companies with other specific media interests from holding Channel 3 licences.

A1.6 In response to this gradual relaxation of the ownership rules there was a consolidation of regional licence ownership by a series of mergers culminating in the 2003 merger of Carlton Communications plc and Granada plc to form ITV plc, holding 11 of the 15 licences. Separate consolidation means that the two Scottish licences are now owned by STV Group, while UTV and Channel are now the only holders of a single licence.

A1.7 As a result of the consolidation process, ITV plc now owns all but one of the ‘large’ licences as well the Tyne Tees, Westcountry and Border ‘small’ licences. The NCLs between them own a single ‘large’ licence, STV Central, as well as the remaining ‘small’ licences (STV North, Ulster and Channel Islands).

A1.8 The licensees agreed small increases to the level of contribution to the NPB by the small licensees and a consequential reduction in the contributions needed from the large licensees in 1995 and 1998. However, other than this, although the ownership of the Channel 3 licences has been consolidated from the original 15 companies, the cost sharing arrangements in the NWA have remained unchanged since 1991.

A1.9 The lack of change in the past ten years is primarily due to the merger undertakings to which ITV plc is subject. In 2003, in order to secure regulatory approval for the merger of Granada plc and Carlton Communications plc, the merged group gave undertakings to the Secretary of State concerning the cost sharing arrangements for the NPB. The undertakings capped the individual contributions made by the NCLs to the NPB at their 2003 level increased in line with RPI, thereby limiting the possibility of further changes to the cost sharing arrangements in the NWA.