UFB prices: good news and bad news

UFB prices: good news and bad news

Submitted by Vikram on Wed, 20/04/2011 - 6:57pm

20 Apr 2011

There has been one overriding goal of the Government’s Ultra Fast Broadband (UFB) efforts so far- reduce prices to drive up customer uptake. Whether it’s the network architecture or excruciating negotiations, it’s all been about keeping prices down.

That’s a good thing. Even if low prices are only a “necessary but not sufficient” factor to drive customer uptake (there’s other important stuff too like data caps). But let’s focus on the “necessary” bit of UFB prices for the time being.

My view is that initial UFB prices are great. Kudos to the Government. There are however some issues that spoils the picture of a rosy future.

Wholesale Prices

Keep in mind that UFB prices are set as caps on wholesale prices for different products in a contract between the Government and the private partner in the Local Fibre Company (LFC) for a ten year period.

Also keep in mind that “nominal” prices are what we pay, the sticker price. “Real” prices are an economic construct to remove the effect of inflation when analysing price movements over time.

What will wholesale prices look like?

The entry product is 30 Mbps downstream, 10 Mbps upstream, 2.5 Mbps CIR (Committed Information Rate). It is expected to be about $37.50 per month, excluding GST, initially.

The price falls in real terms at 1.2% CAGR (Compound Annual Growth Rate) for a few years before flattening. In 8 years time, 2019, assuming prices haven't flattened the real price will fall 9.2% to $34.05.

Let's assume inflation is at 2.5% per year, which is lower than what it is now but that's what an 8 year average should be. The nominal price will rise by 10.9% to $41.58 per month plus GST.

So it's a decrease in real terms but an increase in nominal terms.

Projected UFB Wholesale Prices

2011 Price

$ Change

% CAGR 2019 Real Price

$ Change

% 2019 Nominal Price

$ Change

%
Entry 37.50 -1.2% 34.05 -9.2% 41.58 10.9%
"Policy" 58.00 -3.6% 43.26 -25.4% 53.09 -8.5%
Business 600.00 -2.5% 490.00 -18.3% 600.00 Nil
Dark Fibre 400.00 -2.5% 327.00 -18.3% 400.00 Nil

The table above shows similarly what will happen to the "Policy" product of 100 Mbps downstream, 50 Mbps upstream, 2.5 Mbps CIR; the business product of 1 Gbps symmetrical; and dark fibre.

Notice how the entry product nominal prices terms rise but those for the higher spec product falls over the 8 years (highlighted yellow in the table)? That’s a deliberate strategy to move people to higher margin products.

Is that a good thing? It’s standard commercial strategy to lower the entry barrier and incentivise people to move to more profitable products. Nothing wrong with that in theory. In terms of economics, price discrimination and using the consumer surplus from those willing to pay more for the higher end product to subsidise the price-sensitive end of the market makes sense. And, it perfectly lines up with the strategy to minimise entry level prices.

This is the reason why the mass market is going to get 30 Mbps download speeds when real-life fibre networks can easily do 10-50 Gbps. It might be a step back from the promise of ultra fast speeds but a “give ‘em more for the same price” tactic is a wise way to kickstart the switchover to fibre.

Can’t afford a Holden Commodore? No problem, how about a Commodore with a Nissan engine at the price of a Nissan? That way you can get the bells and whistles when you want. Buy some more Mbps and CIR. In the meantime, let’s sock it those who want the real deal, the Commodore, now.

The strategy is different in the business market. You get a Commodore with a Toyota engine at Toyota prices.

Retail Prices

Retail prices, i.e. the prices that people and businesses will pay, are more complex to analyse and predict than wholesale prices.

There are cost-based factors like national data, international data and customer service. Then there are more strategic considerations like product differentiation and the impact of competition.

Based on the wholesale prices above, the speculation of retail prices of $60-70 per month plus GST for the entry product and $90-100 per month plus GST for the “Policy” product seems to be in the right range. It’s also been reported that the LFC will pick up the connection costs for the mass market products. Cool.

How will retail prices change over ten years? That’s a hard one. The wholesale prices in nominal terms aren’t going to change a whole lot. So any change in retail prices will be driven by the cost-based factors and the strategic considerations.

Most of the cost-based factors will come down with scale economies and ongoing technological improvements. Competition, as the only remaining strategic variable, is therefore hugely important- it will be the single biggest factor that influences retail prices.

My prediction is that retail prices in nominal terms will remain steady over the first 6 to 7 years. Reduction in input costs will be partially passed on as more data allowances and more bandwidth. The bigger players will have increasing profit margins so there may be some industry consolidation.

After 6 to 7 years, the Layer 2 electronics will have reached the end of their life and will have to be replaced. At that time technology would have advanced to a point where we're likely to get substantially higher speeds for the same price. Also, at that point, the LFCs will have one eye on the regulatory holiday period coming to an end. This will exert downwards pressure on the prices.

Good News

The necessary condition of initial UFB prices and connection costs being a low barrier to jumping onto fibre is going to be met. Even better, no more of Telecom’s unrelenting inflation-linked price rise year after year, sneaked in over Christmas in the vain hope that no one will notice.

But wait, there’s more. The second bit of good news is the change in market structure will provide people and businesses with a growing diversity of options. There’s going to be some really exciting innovation and new business opportunities. The monopoly elements of the network- the copper and fibre loops- are going to be separated out. This will leave a layer of retail providers competing with each other on a sort of level playing field.

The real kick will come from those higher up in the value chain then using widespread fast broadband for their ventures. A simple example is someone coming along and providing people free Internet access on an advertising model. Or perhaps someone with valuable content bundling in Internet access on a subscription model- think Netflix or online gaming.

(If you want to know more about these possibilities, come along to UPLoad 2011: New Ventures With Fast Fibre and NetHui.)

Bad News

Now for the bad news. It isn’t going to be a fibre utopia.

1. Everybody knows and expects network costs will keep going down. Nobody knows just how much. Think about your Internet access in 2001. What kind of contract would you have locked yourself into back then that you’d be happy with today? Think about Moore’s Law and how exponential increases in performance are the norm. Locking in prices over ten years in the face of such unknowns is dicey.

It’s clear that CHF has been (or has been forced to be in the name of “price certainty” and “building the business case”) conservative. A real reduction of 1.2% to 3.6% every year is exactly that, exceedingly conservative. Worse, the LFC has no incentive to innovate and push prices down.

What this means is that while the rest of the world, including Australia, will have reducing broadband prices, we’re going to be paying relatively more and more.

This might not be evident for a while as the nominal price, what hits our bank account every month, is going to be steady. However, at some point world prices will be so below what we’re paying that we’re going to feel ripped off. Again. Just like today.

Ask yourself, if you knew for sure interest rates are going to go down, would you lock yourself into a ten year fixed rate mortgage that gives you only a tiny fraction of the possible decline?

2. The safety net of the Commerce Commission oversight is being legislated out. If prices get out of whack before 2020, there isn’t any independent body that can right the balance. Prices are fixed in the contract and only the parties to the contract, the Government and the private partner, can change them with mutual agreement. No need for consulting the people or the businesses impacted.

That’s a real problem that exposes the conflict of interest the Government faces in having dual roles- an investor and a regulator. All over the world, and in New Zealand up to now, this conflict was resolved by different arms of Government providing different perspectives.

Checks and balances are central to our democracy. Removing the Commerce Commission from being able to regulate if necessary removes the customer’s perspective; the Commerce Commission’s expertise; and the ability for people to have a say.

A quick look at the last few years in comparison to the situation before that shows just how effective the Commerce Commission has been in reducing price gouging and giving us more choice. The result? Government is booting it out of the picture till 2020.

3. What happens if things don’t go to plan? What if there is insufficient customer uptake? Or the returns from low priority areas don’t justify continued roll out of the network on a framework based purely on economic returns? Or a future Government wants focus on social equity outcomes rather than economic returns? Or, despite the Government’s best efforts, copper-based services refuse to die? Or, technology changes more rapidly than expected and prices for new products can’t be mutually agreed?

So many unknowns. The best way is to build in flexibility and adaptability. Allow for changes with widespread consultation. Instead, what we see is rigid price contracts for such a long period of time that you can almost guarantee that things will not go according to today’s plan. Rigid contracts provide for investor certainty and lower upfront prices but have the potential for things to go massively wrong. Of white elephant proportions.

4. Hidden amongst the details is a “legislative subsidy”, i.e. changes to the law that provide greater profit to the Government’s partner, particularly if it is Telecom for most or all of the UFB areas. To get Telecom to put in the $4 or $5 billion more needed, the money we (the public) are putting in via the Government isn’t sufficiently attractive. Telecom wants more. Or, perhaps, they sense an opportunity to get more.

So the deal includes a number of sweeteners. The result is that we will pay more for our current copper-based broadband and have less choice, less innovation in the next few years while we wait for fibre.

It gets worse. Telecom’s separated company, the new Chorus, will have a monopoly on both copper and fibre local loops in most parts of New Zealand. That kills infrastructure-based competition and technical advances on the copper loop- exactly the things that Government is touting as the competitive check to fibre-based prices.

What all of this means

The Government’s view is that the price of the good news is the bad news. That’s what it’s going to take to give us our fibre future and deliver on their election promise with the money they have to spend on this.

Then there’s the “Gang of 11”- consumer groups including InternetNZ and major industry players (other than those who want a slice of the UFB money). They say bring on this wonderful fibre future and the good news. But the bad news so outweighs the good news that it can’t be ignored.

There are ways to reduce the impact of the bad news, making it more balanced with the good news. That however needs everyone to work together rather than brushing off or talking past one another.

In my opinion, treating the UFB as a regular procurement exercise and making deals behind closed doors has been a mistake. Buy-in comes from including people, not excluding them.

What were the alternatives? One that particularly appeals to me is the NZCID report (pdf) based on lessons from comparative nations. It looks like a good way to bridge the gap between the imperatives of a 3 year election cycle and the reality of 30-100 year infrastructure lifecycles.

It’s not too late yet to fix things. For example, replace the regulatory holiday with a special access undertaking.

You Decide

Ultimately, it’s up to you to decide which view you want to back. Because, one way or the other, you’re going to be paying for it.

Workstream:

Unconstrained broadband

ends

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