Structural separation explained and applied

There has been a trend towards structural separation of operators in countries with ongoing difficulty in attaining a competitive downstream retail market, or those who wish to prevent common competition problems in future markets.

In some instances, the government or national regulatory authority may force the legal and operational separation of a vertically integrated telecommunications company (usually the fixed-line incumbent). There are also examples, such as Ireland and New Zealand, where the company itself is exploring a voluntary separation of its wholesale network functions from its retail service operations.

Chronic competition problems are commonly traced to a dominant operator with a disincentive to allow free competition against its most profitable retail products. Either through active discriminatory practices or through less obvious means, a dominant network infrastructure operator has the ability to significantly hinder competition. There are many examples around the globe where this has been proven to the case.

There are three levels of separation under consideration by regulators and policymakers. These are:

  1. full structural separation involving separate ownership of previously commonly owned divisions;
  2. functional separation of infrastructure and retail business lines involving staff divisions; and
  3. accounting separation between the infrastructure and the retail business.

Structural separation
The fundamental aim of structural separation (and also of functional separation) in network industries is to give the access provider with Significant Market Power (SMP) an incentive to grant all access seekers (service providers) non-discriminatory terms and conditions.

Structural separation requires an operator to separate its network infrastructure from those units offering services using this infrastructure. Also known as 'ownership unbundling' or 'divestiture', structural separation means that all of the network elements are placed in a separate legal entity and are under a different ownership. Determining what constitute network elements is a difficult process, and there may be new challenges with upcoming NGN infrastructure.

Structural separation is regarded as a blunt instrument that may help to ensure fair competition where it affords greater freedom of choice for consumers in a market otherwise dominated by one operator. However, simply because a possible remedy is available does not mean it should always be applied. Regulators will always have to take into account the competitiveness of those markets under their responsibility. This can vary dramatically from country to country and even within a country.

Structural separation should only be used when other regulatory options have first proved inadequate, and after a comprehensive cost/benefit analysis has been conducted. Structural separation may have profound effects on investment, valuation, and systemic operations (among other areas), and would be an extremely difficult policy to reverse.

Accounting separation
Other methods of promoting competition, such as accounting separation, do not address non-price discrimination – such as delays in switching customers to competitors, placing limits on wholesale product offers, or providing different service quality. In addition, policing obligations for non-discrimination in vertically integrated operators are notoriously difficult. However, these problems would be resolved by an act of separation.

Examples of structural separation
A well known example of separation in telecommunications – and one generally considered a success - is that of AT&T from the Regional Bell Operating Companies (RBOCs) in the United States in 1984. With this action, not only were the local operations of AT&T structurally separated from its long distance and international operations, but ownership of the two groups of companies was separated by means of a share swap. With their ownership separate from AT&T, the RBOCs (or Baby Bells) no longer had an incentive to favour AT&T over its long distance competitors. Therefore, all long distance competitors obtained access to local telecommunications services from RBOCs on similar, non-discriminatory terms. The divestiture also eliminated concerns about anti-competitive cross-subsidies between AT&T's local and long distance operations.

The government of Singapore, often a leader in government initiated ICT schemes, announced a competitive tender in 2006 offering up to USD 500 million funding for a national broadband network infrastructure to carry next generation services. The network of optical fibre cables will be operated in a structurally separate manner from the operating service companies’ switches and routers.

Another example of a forced separation is found with the incumbent Mongolian Telecommunications Company (MTC) which was separated by the Mongolian government in 2004 into two entities. As a result, Telecom Mongolia (a partly-privatized operator) now operates a retail service business, while an entirely new and separate government-owned company, Information and Communication Networking Company (ICNC), operates a wholesale network business.

The separation in Mongolia has highlighted the difficulty in allocating assets and liabilities so as to ensure the ongoing sustainability of both entities.  As of June 2008, ICNC was being heavily subsidized by the government as the mandated tariff structure did not allow for it to meet its costs, and the division of MTC assets was biased in favour of the services company.

Voluntary separation
There may be advantages for operators in undergoing a form of ownership separation. The Irish incumbent, eircom (which has been purchased by a private equity fund) is considering a voluntary structural separation between its network infrastructure (which would be placed in the equity fund), and its retail division (which would be taken over by eircom's employee share ownership trust). It is anticipated that such a separation may increase the value of the overall entity by better matching assets with investors, as the more stable and cash-generating wholesale division would be separated from the potentially high-growth retail division.

In August 2006, Telecom Corp. of New Zealand announced plans to separate its wholesale and retail businesses. However, the suggestion was not wholly accepted by the New Zealand government and so in September 2007 it ordered Telecom Corp. of New Zealand to split into three operating divisions (wholesale, retail and network).  As of 2008, the outcome of these plans remains unclear.

The implementation costs of structural separation include several components, such as: branding, buildings, communications, advertising, financial and management reporting systems, hardware and software, information systems, legal, office equipment, recruitment and transition planning.

In 2003, Telstra (Australian incumbent operator) estimated that its full structural separation would cost AUD 2 billion in 2003 (around USD 1.9 billion), and would require an annual incremental operating cost of AUD 80 million (around USD 76 million) per year.

In 2001, it was estimated that total economic costs of the proposed structural separation of BellSouth in the US state of Florida would be USD 1.2 billion, including an estimate for additional costs of structural separation. This would have been higher than the supposed benefit of local competition in Florida, which was estimated to be as high as USD 248 million per year.

Structural separation causes a number of significant regulatory challenges.

First, it is difficult to coordinate infrastructure investment with service development, particularly where technological change is rapid. As fibre is extended out from the central office to the street cabinet or to the home to enable fast broadband access, investment coordination is likely to become more important due in part to the uncertainty of demand for new services and higher bandwidths.

Second, it is difficult to define the best way to separate the operation into its component parts. NGN may create more logical separation points between the infrastructure that carries electronic communications and the services that they comprise, as it is possible for a NGN to be oblivious to the types of services and content that it carries. However, the task is by no means straightforward nor is there likely to be a generic solution.

What is more likely to happen is that networks will continue to be hybrids of different legacy systems which makes it difficult to identify an appropriate boundary at which to apply structural separation. There is therefore a risk of imposing and entrenching an inappropriate structure on the market.

Third, there are substantial costs associated with the break-up of the integrated firm. Structural separation of ownership may have a considerable impact on the share value of the regulated company.

However, there is evidence that a voluntary separation may actually create rather than destroy shareholder value, as is seen in the interest of the Irish incumbent to voluntarily separate its network from its service operations.

Sources: EU Commission Impact Assessment 2007; European Union MEMO/07/458 Nov. 2007

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