May 24, 2016

By Malcolm Webb

Where to now for mobile mergers?

The EC recently declined the proposed UK merger of mobile operators Three and O2.  We look at the learnings for markets outside of the EU.

“Now let me make one thing clear: the combination of Three (the smallest operator in the market) with O2 makes us able to stand up to the new Leviathan BT (in the blunt words of Dido Harding, chief executive of TalkTalk, earlier this week), not to mention to the old top-of-the-heap predator Vodafone, and is the only way we can guarantee that five years from now customers will still be getting more and paying less for mobile services.”

Canning Fok, Chairman of Three UK, in his letter to the Financial Times on 4 February 2016[1].

On 11 May 2016, the European Commission (EC) declined to approve the proposed merger[2].

As colourfully described by Mr Fok, the merger would have brought together the fourth operator (Three) with the second operator (O2) to produce the largest MNO in the market, with a revenue and subscriber market share exceeding 40%.  Vodafone and EE would be the remaining MNOs. As well as wholesale capacity commitments (which we discuss later), Hutchison had offered not to raise the price for consumers for voice, text or data in the five years following the merger and to invest £5bn in the combined UK businesses over that period.

There are several relevant characteristics of the UK mobile market.  According to the EC, the UK mobile market is currently competitive, with retail mobile prices among the lowest in the EU.  Three and O2 were strong players: Three was regarded as an important challenger, consistently introducing the cheapest retail offers; O2 has a strong position with high brand value and reputation.  Despite a competitive retail and wholesale market, MNOs were continuing to invest, including investing billions of pounds to deploy 4G.  Ofcom claimed that cashflow margins for the industry have exceeded 12%.

This article considers some of the main features of the EC’s decision.  There had been much debate over whether the EC would approve four-to-three mergers in the telecoms sector leading up to the decision.  The EC was clear on the effect of the proposed merger on the retail market: “The significantly reduced competition in the market would likely have resulted in higher prices for mobile services in the UK and less choice for consumers than without the deal.”  But this was not the only reason for its decision.

In this article, we focus on the two other key features of the decision – the complications that arose from the existing network sharing agreements and the adequacy of wholesale capacity deals as a remedy in this merger.  We also try and extract some learnings that may be applicable to markets outside the EU where potential market consolidation is being considered.

The network sharing agreements

There are two pairs of network sharing agreements in the UK, MBNL (Three and EE) and Beacon (O2 and Vodafone).  The merged entity would have been a party to both agreements.  This proved to be a major stumbling block for the EC and the UK regulators. 

The EC was concerned that the merged entity would have a full overview of the network plans of Vodafone and EE.  There were also broader concerns about the involvement of the merged entity in both sharing agreements, noting that it would have “weakened EE and Vodafone and hampered the future development of mobile infrastructure in the UK, for example with respect to the roll-out of next generation technology (5G)”. 

The merged entity remaining a party to both network sharing agreements would have resulted in asymmetric consequences – the merged entity would have knowledge of plans of each of their other competitors, but the competitors would not have the same advantage as they would only be party to one of the two agreements.  We can also appreciate that there may have been strategic opportunities for the merged entity to frustrate the pace and scale of development of one or the other shared network.

The Irish merger involving Three Ireland and O2 Ireland also featured a network sharing arrangement (between O2 and Eircom, which was the third and smallest player in the market).  The concessions by Hutchison included a commitment to offer Eircom to continue the network sharing agreement on improved terms.

We don’t have details of the concessions made by Hutchison in relation to the sharing arrangements.  Hutchison had offered up behavioural remedies, however the EC considered them inadequate - they would have been difficult to implement and monitor effectively according to the EC and “did not resolve the structural problems created by the disruption to the current network sharing agreements in the UK”.

There may have been structural options, but they would each have presented complications.

The merged party and the other two operators could have formed a single sharing agreement, maybe limited to passive assets.  This would be a complex arrangement to put in place and did not appear to be on the table.  If confined to passive, it would have involved the parties forgoing benefits of active sharing, which may have been unpalatable for the other two operators.  From a regulatory perspective, it would have created a whole new set of issues, with the removal of any effective mobile infrastructure competition and co-ordination risks substantially increasing. 

Another alternative may have been for the merged entity to exit both agreements (the merger would already have provided many of the benefits of sharing) and the two competitors to strike their own sharing arrangement. But that relied on the two competitors reaching agreement, which was outside the control of the merging parties.

Wholesale capacity deals

Hutchison had proposed measures aimed at strengthening the development of existing MVNOs and supporting the market entry of new MVNOs. 

According to Mr Fok in his letter to the Financial Times:

“Three+O2 will enable other meaningful competitors in the UK market to offer services on a completely level playing field by offering for sale fractional shared ownership interests in our network capacity — in effect selling slices of the same network capacity and quality we use to serve our own customers.”

Hutchison’s offer appears to be something similar to the MVNO conditions that applied to the recent Austrian, German and Irish mobile mergers – that is that a proportion of the merged entity’s capacity would be made available to one or more MVNOs.  It had been reported that Three had entered into agreements with Sky and Virgin Media for approximately 20% and 10% respectively of the merged entity’s capacity.

The EC commented that “Even if those offers were taken up, the mobile virtual operators would have been commercially and technically dependent on the merged entity, with limited ability or incentive to differentiate their offerings, including in terms of network quality”.

This is a more pessimistic outlook on capacity deals than we would have expected.  A clean capacity deal is likely to have allowed for the emergence of a “full” or “thick” MVNO – where the MVNO maintains their own core infrastructure, but relies on the host MNO only for access to its RAN. This gives the MVNO reasonably significant control over service development and routing and is typically easier to switch customers to an alternative host MNO (e.g., without the need to replace the customer’s SIM card).

If the commercial model proposed by Hutchison was the same as the German and Irish concessions, it would have involved access to dedicated capacity for a fixed price to be paid upfront, rather than pay-as-you-go, which would have allowed greater freedom for the MVNO to develop differentiated pricing.  It is notable also that the German and Irish concessions included divestment of blocks of spectrum, which would have allowed for the possibility of the MVNO to step up in time to become an MNO by acquiring spectrum.  It doesn’t appear that Hutchison offered to divest spectrum in the proposed UK merger.

There is some dependency in these MVNO arrangements, but there will be a contractual framework that can provide for quality of service obligations by the host MNO and appropriate remedies in case of failure to meet those obligations.  And, of course, there is also some dependency in RAN sharing arrangements, which are already a feature of the UK market. 

The Competition and Markets Authority (CMA) saw the only effective remedy as “divestment – to an appropriate buyer approved by the Commission – of either the Three or O2 mobile network businesses, in entirety, or possibly allowing for limited ‘carve-outs’ from the divested business. The divestment would need to include the mobile network infrastructure and sufficient spectrum to ensure a commercially viable fourth MNO in the UK”[3].

It appears Ofcom saw it in similar terms.  It commented “Many of our concerns relate to competition between operators who own the networks on which mobile phones rely. Only these four companies can make your mobile signal faster, more reliable and widely available.”[4]

Other issues

A four-to-three merger would have impacted the wholesale market as well as the retail market.  The merger would have left MVNOs with one less option and, as stated by the EC, “would have left prospective and existing mobile virtual operators in a weaker negotiating position to obtain favourable wholesale access terms”.  This would be a concern even for a thick MVNO when it comes time to renegotiate terms to avoid lock-in. This was also an issue for the CMA, who were concerned that MVNOs may obtain poorer commercial terms as a result of the reduced competition at MNO level. 

A related concern expressed by the CMA was that, if fixed-mobile convergence increases in future, BT/EE (and, potentially, to a lesser extent Vodafone) may have limited incentives to provide mobile service to fixed operators (such as Sky or TalkTalk). That would have left two potential suppliers of MVNO services to fixed operators, if BT/EE is excluded.

The other issue arose from the unusual feature of the UK market, at least as compared to other European markets, that most phone contracts are still sold in shops, with independent retailers taking a big share.  According to Ofcom, the merger would shift the balance of power between mobile networks and the independent retailers that help constrain the price of mobile handsets and bills.

Learnings for other markets

The EC’s decision obviously will have a significant impact on future mobile mergers in the EU (including the proposed merger in Italy, again involving Hutchison and rival Wind).

For markets outside the EU, there are some learnings from the EC’s decision:

• Existing or proposed network sharing arrangements need to be carefully analysed when considering future market consolidation as they can seriously complicate things.  When negotiating new sharing agreements, attention should be given to future consolidation possibilities and provide terms that enable change under certain conditions.
   
• For four-to-three mergers, MVNO remedies should be considered if they can be accommodated in the clearance process.  MVNO remedies will need to be designed to enable MVNO flexibility, access to future technologies and sufficiently generous commercial terms to enable viable retail competitors in a consolidating market.  The German and Irish capacity models may still be attractive to regulators and competition authorities outside of the EU. 
   
• Consideration should be given to whether spectrum divestments should be offered, as well as MVNO remedies.  Both the German and Irish models involved some spectrum divestment commitments as well as capacity commitments, which was viewed positively by the regulators, particularly as it potentially allowed MVNOs to climb the ladder of investment and become MNOs.
   
• To overcome concerns about incentives to invest and potentially higher retail prices following the merger, Hutchison had made investment and retail pricing commitments.  The EC did not appear to have given these much weight (which may have been down to the nature of the commitments), but in principle we can see these sorts of commitments being an important component of a remedies package, if behavioural commitments are allowed.
   
• Where they are allowed, behavioural commitments should be as robust as possible in order for them to be given weight. Transparency will be important, so measures should be included to allow for independent oversight of behavioural commitments, reporting, audit rights, etc.  The commitments should be measurable and there should be significant consequences for failure to meet them.  
   

Disclaimer

This article is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this article.