|Issue:||Asia-Pacific I 2002|
|Topic:||The Bandwidth Tsunami, Network Innovation and the Evolution of Bandwidth Markets|
In the past, international capacity was allocated by carriers and consumers paid the price. Recently, competing cable operators have increased capacity dramatically and driven down prices – especially in the Asia-Pacific region where capacity is growing faster than anywhere else. With today’s technology, just one new cable can significantly impact competition in the region. Currently, customers lease bandwidth and obtain control similar to on self-built networks. Present-day ease of upgrading capacity has profound commercial and regulatory consequences that have yet to be resolved.
It does not seem so long ago that international capacity markets were well ordered, predictable and stable places. Carrier personnel met every six months around the pool in Hawaii and in bars in Washington DC to jointly plan cable systems, allocate capacity and strike prices for capacity and minutes exchanged. Consumers, of course, paid the price for this stability through high international collection and capacity charges. The changes in the last three or four years have been dramatic. Competing private cable operators have entered the market and capacity has increased 10, 20 or more times. Most operators, new and old alike, are struggling. Global Crossing and FLAG are in Chapter 11. Level 3 has abandoned Asia by selling its network to Reach. Tyco has been caught up in the Enron backwash. Even the venerable Teleglobe seems headed for Chapter 11. But consumers are enjoying price reductions of 40-60 per cent year on year. So, has the market failed? Should we go back to the old days, as was suggested earlier this year by a number of desperate executives at the Pacific Telecommunications Conference in Hawaii? What are the implications for regulation? Is the picture bleaker because of Enron? Should consumers care if carriers and their bankers have burnt billions of dollars? Trends in International Cable Capacity International bandwidth capacity in the Asia-Pacific region is growing faster than anywhere else. The capacity available on newly deployed infrastructure, in contrast to the capacity of older cable systems, is such that the installation of just a single new cable network might itself have a significant impact on competition in the Asia Pacific region. Technological innovation will sustain further growth in the bandwidth available on existing and new networks. New multiplexing technology (e.g. dense wave division multiplexing or DWDM ) will enable networks to increase significantly the capacity of each fibre. The deployment of DWDM technology on existing networks can be achieved at lower cost than installing new cables. The pattern of cable ownership is changing also. In the recent past, capacity was built by large consortia of 40-100 members each who intended to use it to provide their own services. The new breed of specialist bandwidth vendors abstains from retail activities but invests in global network infrastructure specifically for the purpose of selling capacity at the wholesale level. This new breed of bandwidth vendors participate in private cable consortia in order to obtain international capacity on terms which provide it with exclusive rights of access and control over its share of the cable for the life of the cable (including the right to implement upgrades to the cable). This enables the vendor to make autonomous decisions to upgrade the amount of capacity available on its share of the fibre without consultation or participation from the original participants or the entity holding the ownership rights. Given that a large proportion of new cable is unlit, and given the continuing emergence of new technologies for upgrading cable to ever higher capacities, gross bandwidth seems likely to continue to grow at a high rate and may well exceed demand in the medium term. Transformation of the demand side The supply-side changes discussed above are matched by developments on the demand-side. In the past, the bandwidth capacity on offer from network owners to other carriers and service providers has been limited to comparatively small volumes (E1 links, with multiples of 64 E1s being supplied in the form of a single STM-1 link) and on 3-5 year leases with commercial terms which were little better than the retail terms offered to large corporate customers. However, a key characteristic of contemporary capacity markets is the trend for wholesale customers to seek to acquire bandwidth on terms that place them in substantially the same position as if they had constructed their own network. Specifically, bandwidth buyers are now concerned not solely with price but also with: · Obtaining access to large volumes of capacity (STM-4, STM-16, STM-64 and rights of access to entire wavelengths); · Securing long-term supply arrangements; · Capping the costs associated with long-term supply; · maximizing the flexibility with which they can utilise the capacity (for example by a right to request capacity upgrades on minimum notice periods pursuant to an agreed pricing regime or a right to request equipment upgrades for the support of new and innovative services); · Ability to drop the fibre to a range of locations and increase the number of drop points as demand grows in new locations; · Ability to route their own traffic; · Diversity of routing and network redundancy considerations; and · Ability to manage financial reporting and taxation implications. Buyers can achieve these objectives through long term large capacity deals (STM-4s or above over a 10-15 year period). At the same time, the high level of price instability has encouraged the emergence of very short term capacity deals – at the E1 or below level – ranging from three to six months. Customers are resisting the early termination and penalty clauses which used to characterise international capacity deals. Some bandwidth wholesalers are actually paying out a customer’s contracts with competitors to attract the customer to their networks, even for relatively short term deals. So, the day of the 3-5 year IPLC lease for an EI are dead. Deals are either very short term or very long term. However, as will now be discussed, the long term deals are looking wobbly because of an over-reaction to Enron. Casting out the Enron Demons Treatment of a long term capacity deal as a finance lease can be very advantageous for buyer and seller and can be an important factor in the buy/build decision faced by many carriers discussed above: · as an operating lease, the buyer must recognise the annual charges as a cost in its all important ebita calculation (ie as an operating expense) and the seller can only bring to account the annual payments received from the buyer over the life of the contract; · as a finance lease, the buyer gets to treat the lease as an asset acquisition, which is excluded from ebitda (which looks healthier) and as a sale of trade stock, the seller can bring to account most or all of the contract value in the current year (which means its sales revenue goes up). There has long been consensus that leasing standards around the world are inadequate to deal with the complexities of leasing arrangements. The issues associated with bandwidth leases are made even more confusing as a result of the physical peculiarities. While it is possible to identify the specific fibre core or wavelength that is the subject of a leasing arrangement, the asset is packaged inside a cable sheath with numerous other fibre cores (each carrying multiple wavelengths), with the cable being located under land or sea. Access to, and control over, the leased asset can only be obtained via the multiplexer equipment connected to that cable. There will undoubtedly be examples of aggressive accounting practices – designed to exploit the arbitrary distinctions between different types of leases to the detriment of shareholders, as seems to have occurred with Enron and capacity deals. However, this does not mean that we should “throw out the baby with the bathwater”. There are forms of long-term transactions for the supply of bandwidth capacity which have been justifiably accounted for as if they were a transfer of beneficial ownership – when the risks associated with the network infrastructure such as damage and obsolescence did not actually pass to the lessee. RegulatoryIimplications A number of regulatory regimes around the Asia Pacific region continue to regulate the incumbent carrier as a “dominant operator”. The substantial amount of excess international capacity in the market raises questions about whether any operator could possibly be regarded as dominant. In Hong Kong, OFTA recently considered this issue in relation to Reach, a joint venture which combines the international assets of the Australian incumbent, Telstra, and the Hong Kong incumbent, PCCW/HKT. OFTA’s Competition Guidelines provide that: · an operator with 75% or more market share is presumed dominant; · an operator with less than 25% market share is presumed non-dominant; and · there are no presumptions for operators with market shares between 25%-75%. However, working out market share in relation to international capacity is a slippery exercise because of the difficulties in defining and selecting the right measures. There are at least 4 ways of measuring capacity: · activated capacity – the amount of capacity being used by customers; · equipped capacity – the amount of capacity which is already equipped with terminal equipment and which is therefore readily available for use; · total available capacity – activated and equipment capacity plus remaining capacity ie. unlit fibre activated using existing technology; and · upgradeable capacity – capacity which can be obtained by installing new technology, such as DWDM, which is potentially almost limitless. Reach argued to use available capacity since the ‘overhang’ of capacity which could be readily activated by lighting fibre with existing technology disciplined pricing in the market. Opponents argued that as available capacity required significant capital expenditure to buy and install equipment, only equipped capacity could be safely used. OFTA noted that even using the narrower equipped capacity definition, Reach’s market share had fallen below 50 percent by the end of 2001, and therefore, applying the Competition Guidelines, Reach could no longer be presumed dominant. However, in the end, OFTA decided it was too unsafe to use market share figures because capacity was a very volatile measure – Reach’s share had dropped from above to below 50 percent as the result of a single competing cable being activated. OFTA instead preferred to focus on other factors to measure dominance, particularly barriers to entry. OFTA concluded that the rapid change in the international capacity market demonstrated that the barriers to entry had substantially decreased. New specialist cable operators had entered the market, capacity had increased many times over and prices had fallen dramatically. As OFTA noted “entry has occurred to such an extent that there is now considered to be a significant amount of over capacity”. OFTA concluded that: “spare capacity on sink infrastructure is a form of imminent market entry in response to any pricing behaviour above competitive levels. And the threat of entry is viewed as the ultimate regulator of competitive conduct”. OFTA was also strongly influenced by the structural separation between Reach’s international network and the PCCW/HKT local loop and the difference in ownership between Reach and PCCW because of Telstra’s half share of Reach which dilute the economic incentives for PCCW to leverage its power in the local loop to assist Reach. Should Consumers Care? So should end users be concerned about the business failure of an army of large and small international carriers, including “trusted” names like KPNQwest or Teleglobe? Unless they are shareholders, probably not. The investment is sunk and irreversible – the cable is on the ocean floor and is not going to be pulled up even if the owner goes bust. A new owner is like to come along and buy the assets at a distressed value, giving it a very low cost base and therefore even more scope to drive consumer prices lower and lower. This is exactly what happened with the new Iridium: the lower call charges which flow from the low purchase price for the satellite system might now mean it is economically viable. But there must come a point where the carnage amongst the telecommunications carriers does impact consumers. Telecommunications clearly is a high risk, capital intensive business, and capital markets at the moment are refusing to put any money into new investment. It would be a brave soul who says that this does not matter because we already have enough cable capacity on the ocean floors thanks to the overly ambitious plans of the failed operators.