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Business and Enterprise Select Committee OFCOM WBA Charge Control and Charge Control for LLU/WLR Services Cost of Capital TalkTalk Group response May 2011 A. INTRODUCTION 1. This is TalkTalk Group’s (TTG) response Ofcom’s consultation on the BT Group and Openreach cost of capital / WACC that is part of the consultations for both the WBA Charge Control and Charge Control for LLU/WLR Services. 2. TalkTalk Group provides broadband to over 4 million residential and business customers under the TalkTalk, AOL, TalkTalk Business and Pipex brands. We are the UK’s biggest local loop unbundler, operate the UK’s largest next generation network (NGN) and are BT’s largest wholesale customer. 3. The conclusion that Ofcom reaches on WACC will have a profound effect on UK consumers, on our business and more broadly on the effectiveness of competition and consumer benefits in the UK. For instance, setting the cost of capital too high will result in consumers paying excessive prices, less effective competition, reduced downstream innovation and investment and inefficient upstream investment. A 1% increase in WACC, for example, will result in a £3 per year increase in the MPF and WLR prices and the amount paid by UK consumers by £70 million every year. Setting the appropriate WACC is not a perfect science, nonetheless it is important that the assumptions are sound. 4. Our response draws extensively on the report commissioned by TalkTalk and Sky from Europe Economics (‘EE report’). This response also comments on other aspects of the WACC calculation that are not covered in the Europe Economics report such as how to take into account the impact of the BT pension scheme and the relative riskiness of Openreach versus network utilities. In the event of any inconsistency between this response and the Europe Economics report, this response represents TalkTalk’s view. 5. The key points in our response are as follows: • The so-called ‘Openreach’ WACC must be conceived of, calculated as and applied as the WACC for copper access services activities (i.e. LLU and WLR) and not include the cost of capital of Openreach’s other businesses (such as NGA) • We consider the risk free rate is better set at 1.4% rather than 1.5% given the benchmark data • We consider that Ofcom’s debt premia range for BTG and Openreach of 2.0% to 2.5% is reasonable though there are several strong reasons for selecting a number towards the lower end of the range for Openreach most particularly since the cost of debt is inflated by the pension scheme risk (which should be properly excluded) and also because Openreach should have a lower cost of debt than BTG • We consider that an ERP range of 4.5% to 5.0% is more reasonable than the Ofcom (point) assumption of 5.0% • The assumption of an invariant debt beta that Ofcom used in deriving historical asset betas is, we consider, inappropriate since the variance in debt premia page 2 over the last three years is indicative of variance in debt beta. Assuming a variable debt beta is more realistic and produces a less volatile and narrower asset beta range. Using this method we estimate the BTG asset beta at 0.55 to 0.64 (versus Ofcom’s estimate of 0.45 to 0.60) and the BTG equity beta at 0.90 to 1.03 (Ofcom 0.78 to 1.08) • There appears to be an error in the calculation and presentation of the network utility benchmarks – accordingly the asset beta range of the benchmarks is 0.25 to 0.35 (not 0.30 to 0.40). • On the basis of the corrected network utility benchmarks (0.25 to 0.35) and the risk characteristics of Openreach (which show much more similarity with network utilities than the rest of BT), we consider than the appropriate Openreach asset beta range is 0.40 to 0.50 (Ofcom assumed 0.40 to 0.55). This places the Openreach asset beta (mid-point) a little closer to the network utility asset beta benchmarks than to the RoBT asset beta which is consistent with its relative risk characteristics. Under our assumptions the ‘wedge’ between the asset / equity beta of Openreach and of BTG is higher than under Ofcom’s assumptions. However, this should not be a cause for any alarm since the ‘wedge’ is little more than an imputed output that, as Ofcom notes, has little ‘science’ about it • We remain of the view (and have provided cogent reasoning to support this) that the BT defined benefits pension scheme risk increases the cost of capital and that the additional cost that this causes should be excluded from the cost of wholesale products. Ofcom have provided no cogent reasoning to contradict this position. In the case of BT, which has a relatively large and risky defined benefits scheme the impact will be large. We accept that it is not simple to calculate the precise impact but we consider that making no adjustment and/or ignoring the impact would be wrong. Accordingly we consider that a possible way to take account of this is to select assumptions near the bottom of the range for debt premia and asset beta • We consider that there are very strong reasons for not ‘aiming up’ or selecting assumptions at the top end of the ranges. First, the asymmetry of consumer benefit argument that is often used to justify aiming up is not present in this case – in fact in this case it is more economically efficient to ‘aim down’. Second, the ranges are already skewed or biased in the sense that the most likely value lies towards the bottom end of the range particularly since the ranges do not account for Openreach having a lower debt premia than BTG or for removing the impact of the BT pension scheme risk • Ofcom will need to update its analysis prior to the final decision. In doing this Ofcom needs to be careful in the way different assumptions move. For instance, if a higher risk-free rate is assumed this would imply (under most assumptions) a fall in the ERP 6. This response laid out as follows: • Role / scope of Openreach WACC page 3 • Risk free rate • Debt premia, debt beta • Gearing • Equity risk premia (ERP) • BT Group equity / asset beta • Openreach equity / asset beta • Impact of BT pension scheme • Overall results and conclusion 7. If there are any questions regarding this submission please contact Andrew Heaney ([email protected] or 07979 657965). ROLE / SCOPE OF ‘OPENREACH’ WACC 8. The WLA consultation addresses the question of what is the appropriate WACC to use in the calculation of LLU and WLR costs (referred to as ‘copper access services’) As a short hand Ofcom refer to the WACC for the copper access services as the ‘Openreach’ WACC – for instance at footnote 113 Ofcom state that “Note that the cost of capital for Openreach is more specifically a rate for BT’s copper access services business.” This is also consistent with the approach that Ofcom used in the 2009 LLU Charge Control1. 9. We fully agree that the Openreach WACC should be the WACC for only the copper access services and not for other businesses that form part of Openreach (such as the NGA investment). Consequently the ‘Rest of BT’ WACC will represent the WACC for the other BT divisions (e.g. BT Global Services, BT Wholesale, BT Retail) as well as the non-copper access services parts of Openreach (such as NGA). The RoBT WACC should apply for IPStream (which is part of BT Wholesale). 10. As Ofcom has, in this response we use the terminology of ‘Openreach’ WACC to mean WACC for copper access services. To avoid any misunderstanding, it may be better in its Statement for Ofcom to describe this WACC as the ‘copper access services WACC’ (or ‘LLU/WLR WACC’). RISK FREE RATE 11. Ofcom assumes a risk free rate (RFR) of 1.5%. This is based on the 5 and 10 year averages for 5 year gilts (which are 1.4% and 1.7% respectively, see §6.68). Ofcom says that “… we continue to favour the use of 5 year gilt yields when estimating the 1 See LLU Appeal Determination §2.253 page 4 risk-free rate …” (Consultation2 §6.58) though it ‘considers 10 year gilts’ (which are coincidently 1.4% and 1.7% as well). 12. Ofcom rejects giving too much weight to more recent figures for the RFR (which are much lower and even negative for some periods) since they ‘based on a period of unusual market activity’ such as the financial crisis and quantitative easing (Consultation §6.60). We agree that recent rates alone are not a robust indicator of the future RFR. 13. However, even ignoring the most recent market data there appears to be a downward trend in RFRs over the last 10 years. Using a 10 year average would give no weight to this downward trend in RFR. For this reason we consider that the 5 year average (of 1.4%) is a more relevant and robust assumption to use than the 10 year average (which is 1.7%). Thus 1.4% should be preferred over 1.5% as the point assumption for RFR. 14. This (point) assumption for RFR is also consistent (or not inconsistent) with the Bristol Water case where the CC used a range of 1% to 2%. As pointed out in the EE Report (§2.7(b)§§), the CC did not recommend 2% as the correct risk-free rate – rather for various reasons (that do not read across to this situation) they selected a WACC at the top of the range which was consistent with a RFR of 2%.
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