PhD proposal

Ryan Hawthorne

29 January 2014

Contents

1 Introduction 3

2 Research questions 3

3 Motivation 4

4 Literature review 54.1 Review of fixed to mobile substitution in developed countries, including for voice services . . 54.2 Review of fixed to mobile substitution in developed countries for broadband services . . . . . 74.3 Measurement of fixed and mobile substitution in developing countries . . . . . . . . . . . . . 84.4 Review of policy options for broadband, including LLU . . . . . . . . . . . . . . . . . . . . . 84.5 Methodological problems with empirical studies on FMS and LLU policy interventions . . . . 134.6 Gaps in the literature to be addressed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

5 Contribution 1: Construction of quality variable 145.1 Motivation and contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145.2 Research objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155.3 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

5.3.1 NIDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155.3.2 Data on locations of and maximum speeds at local exchanges . . . . . . . . . . . . . . 16

6 Contribution 2: Demand estimation 176.1 Motivation and contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176.2 Research objectives and questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176.3 Research hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176.4 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

6.4.1 Approach I: Multinomial logit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186.4.2 Approach II: Mixed logit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

7 Contribution 3: Implications for telecommunications policy in South Africa 197.1 Motivation and contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197.2 Research objectives and questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207.3 Research hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207.4 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

7.4.1 Open access policies in the EU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207.4.2 Open access policies (predominantly LLU) in developing countries . . . . . . . . . . . 227.4.3 Conclusion on methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

8 Conclusion 22

References 23

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List of Figures

1 Broadband speeds (Kbps) and prices (USD) in South Africa and in Brazil, China,India, Russia and Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 South Africa’s broadband speeds compared to those in Brazil, China, India, Rus-sia and Turkey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Income distribution of fixed and mobile access, (NIDS Wave 1, 2008) . . . . . . . . 154 Income distribution of fixed and mobile access, (NIDS Wave 3, 2012) . . . . . . . . 165 Telkom exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

List of Tables

1 Justifications and testable hypotheses for LLU (Hausman & Sidak, 2005) . . . . . 92 Summary of Hausman & Sidak findings on the impact of LLU (2005) . . . . . . . . 113 Policy lessons from international experience with the development of broadband

(Berkman Centre, 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Households with landlines between NIDS waves 2 and 3 . . . . . . . . . . . . . . . . 16

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1 Introduction

The costs to communicate in South Africa are high, particularly in respect of broadband services (see, forexample, Bonakele et al, 2014) . There is growing pressure to reduce these costs, both from Parliament1

and from the sector regulator, the Independent Communications Authority of South Africa (ICASA)2. Tworecent proposed transactions, the Vodacom/Neotel (ICASA, 2014a) merger and the MTN/Telkom networksharing deal (Lourie, 2014), if approved, will result in significant consolidation of the sector. This mightcause costs to communicate to rise even further. In order to reduce the costs of broadband by addressingTelkom’s market power, ICASA is currently undertaking a Regulatory Impact Assessment for Local LoopUnbundling (LLU) (ICASA, 2014b). A key question in respect of the impact of the Vodacom/Neotel andMTN/Telkom transactions, as well as LLU, is: to what extent are fixed line services a substitute for mobileservices? This will indicate the extent to which Telkom has market power in respect of fixed lines, and willindicate whether the services provided by Neotel and Vodacom, and Telkom and MTN, overlap.

Fixed and mobile substitution has been analysed by a variety of means, including discrete choice modelsof demand. These studies usually evaluate the impact of prices and other variables on the choice of broadbandprovider. This research will extend this literature by measuring the quality of fixed line broadband: whilefixed line broadband prices do not vary significantly over time or between different locations, quality variesconsiderably. Quality varies depending on the distance between a point of aggregation on Telkom’s networkand the customer’s location. The policy implications of the evaluation of fixed to mobile substitution usingthis unique dataset will also be evaluated.

The first contribution of the research will be the development of a unique quality variable, which requireslinking the National Income Dynamics Survey (NIDS) dataset and a dataset on the location and quality ofthe Telkom network provided by broadbandstats.co.za. The second contribution will be the estimation ofdemand and assessment of market power by specifying and evaluating a discrete choice model of demandfor fixed line broadband services. The third and final contribution will be discerning the policy implicationsfrom the results of the demand estimation.

First, the research question is set out. Next, a review of the existing literature is provided. This isfollowed by a description of the motivation and methodology for each of the three main contributions.Conclusions are provided in a final section.

2 Research questions

The focus of the research will be to assess whether Telkom South Africa has market power in respect ofbroadband services, and to review the policy options open to regulators and government flowing from thisanalysis.

To the extent that mobile broadband is a substitute for fixed line broadband, Telkom would not havemarket power. However, since Telkom provides the vast majority of fixed lines in South Africa, if mobilebroadband were not a substitute for fixed broadband, Telkom would indeed have market market power. Theconsequences of the results of this analysis are very different in the two cases: in the event that Telkom hasmarket power, there are a range of potential policy interventions that regulators might consider, includinglocal loop unbundling. If Telkom does not have market power, then other policy options are available toreduce the cost to communicate in South Africa, such as more extensive mobile network sharing. Theextent of fixed to mobile substitution also has policy implications for the assessment of the MTN/Telkomand Vodacom/Neotel transactions, since this will indicate whether the services offered by these companiescompete with one another which in turn will indicate whether the market consolidation will result in alessening of competition.

The first key research question addressed in this paper is therefore: is mobile broadband a substitute forfixed broadband in South Africa? The second research question is: in the context of the nature of fixed tomobile substitution in South Africa, how should policymakers respond?

1See, for one example among many, the Parliamentary Portfolio Committee on Communications’ hearings on the ‘cost tocommunicate’ in South Africa, held in July 2013.

2See, for example, ICASA’s cost to communicate programme (ICASA, 2013).

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Figure 1: Broadband speeds (Kbps) and prices (USD) in South Africa and in Brazil, China,India, Russia and Turkey

Figure 2: South Africa’s broadband speeds compared to those in Brazil, China, India, Russiaand Turkey

3 Motivation

Understanding market power in the telecommunications sector in South Africa is an important precursor toevaluating policy options to address high costs to communicate: if there are firms that have market power,then the sources and effects of that market need to be addressed. Understanding market power in respectof broadband services requires assessing whether fixed line and mobile broadband services are substitutesfor one another.

The costs to communicate, in respect of broadband services, are high in South Africa (see, for example,Bonakele et all, 2014). South Africa has very high broadband prices relative to its developing/middle incomecountry peers, for services that have relatively slow speeds (see Figure 1).

Moreover, South Africa is falling behind its developing and middle income country peers in respect ofbroadband speeds: While India was the slowest of the above group of countries historically, India has nowcaught up to South Africa (see Figure 2). South Africa has significantly slower speeds than the RussianFederation, Brazil, China and Turkey.

There are important policy consequences that flow from the analysis of fixed to mobile substitution. Ifmobile and fixed services do not overlap, the Neotel/Vodacom merger may not give rise to significant concernsin markets for retail voice and data services since Vodacom largely offers mobile services while Neotel largelyoffers fixed line services. Similarly, to the extent that mobile services do not compete with fixed services, theMTN/Telkom transaction raises greater competition concerns since it consolidates spectrum among three

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large mobile players instead of four, and this number reduces to two large mobile players if Cell C is excludedfrom the market due to the skewed spectrum and infrastructure holdings arising from the transactions. Iffixed services (excluded from the MTN/Telkom transactions) were a substitute for mobile services, therewould be greater competition in the market and the MTN/Telkom transaction would be of less concern.

Furthermore, if mobile operator networks constrain fixed line networks sufficiently, local loop unbundlingmay not be necessary. LLU is a remedy imposed on fixed line networks which gives new entrants accessto incumbent fixed lines between customer premises and points of aggregation in the fixed line network(including local exchanges). LLU is imposed on fixed incumbents in the EU and elsewhere to reducebarriers to entry and increase competition for fixed broadband services. To the extent that fixed and mobileservices are substitutes, there may be no need to impose LLU since markets for services provided over thesedifferent network technologies may be sufficiently competitive.

4 Literature review

4.1 Review of fixed to mobile substitution in developed countries, including for voiceservices

Vogelsang (2010) reviews a range of papers on fixed to mobile substitution (FMS). Many of these werein many cases more than five years old and largely reviewed fixed and mobile voice substitutability. Heevaluates theoretical modelling of FMS and empirical evidence of this in order to draw implications forpolicymakers and identify gaps in the literature. In relation to the literature, Vogelsang (2010) developsfour hypotheses:

• The first is that the decline in the fixed line networks is linked to the rise in mobile networks.

• The second is that mobile and fixed services might be complements or substitutes; in order for fixedto mobile substitution to occur, the two services need to be substitutes.

• Thirdly, assuming that fixed and mobile services are substitutes, the decline in fixed line services isdue to lower relative prices for mobile services.

• Finally, the last hypothesis is that network effects, including through on-net discounting (such asthrough friends and family discounts) generated by the mobile networks are increasing fixed to mobilesubstitution.

Vogelsang (2010) begins by pointing out that there are relatively few models that examine fixed andmobile substitutability from a demand perspective and there are many complexities in modelling the demandand supply characteristics of these markets. The demand characteristics that make fixed and mobile networkscomplex include the fact that the markets are two-sided in nature (there are callers and call receivers), thenetworks have different attributes (mobile networks offer mobility) and there are network externalities.Furthermore, there are complementarities between access and usage and there is non-linear pricing (thereare fixed fees and usage fees).

One of the theoretical models reviewed by Vogelsang (2010) posits two differentiated networks whichdevelop into complements due to network effects (Jeon, 2001). The model suggests that network exter-nalities (and therefore complementarities between the two networks) diminish as substitutability betweentwo differentiated networks increases (Jeon, 2001). Vogelsang (2010) suggests that this might explain whymobile and fixed networks are complements initially when mobile networks are rolled out and then becomesubstitutes when mobile networks are more fully developed. Andersson et al (2009) arrive at the oppositeconclusion, that as mobile networks become more fully developed they help to grow the fixed line network,as calls from mobile to fixed networks generate calls in the other direction.

Supply-side considerations are also important, and Vogelsang (2010) finds that relatively little work inthis area has been undertaken. FMS might be taking place due to falling costs for mobile networks, whichmeans that mobile operators can reduce their prices and cause customers to switch away from fixed linenetworks. Relative price declines for mobile services might arise from cost reductions arising from technicalprogress and/or economies of scale and scope andor greater competition. Mobile networks are significantly

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cheaper to build than the replacement cost of fixed line networks. The fixed costs of fixed line networksin developed countries have largely been recovered already, and they are therefore regulated at incrementalcost, which makes them relatively cheap. Fixed line networks are still being built in developing countries,however, and their costs may be higher. Therefore, while mobile networks might not be significantly cheaperthan fixed networks in developed countries, there may be significant differences in costs between fixed andmobile networks in developing countries.

Vogelsang’s (2010) first hypothesis, that the decline in fixed line penetration is linked to growth in mobilepenetration, is tested using diffusion models. The impact of fixed line penetration on mobile penetration islargely captured in the initial size of fixed line networks. Gruber and Verboven (2001) find that greater fixedline penetration led to lower mobile diffusion in EU countries between 1992 and 1997, which suggests thatthe two services are substitutes to some degree. This result was confirmed by Jang et al (2005) for OECDcountries and Taiwan between 1980 and 2001. In developing and Eastern European countries, there appearsto be greater scope for complementarity between fixed and mobile networks: larger fixed line networksare associated with greater mobile penetration. In Africa, Hamilton (2003) finds that greater fixed linepenetration resulted in higher mobile penetration between 1985 and 1997. Gruber (2001) finds the sameresult in Eastern European countries. Grzybowski and Verboven (2013) arrive at the opposite conclusionfor Central and Eastern European Countries.

The empirical literature on the diffusion of mobile networks is limited in a number of ways (Vogelsang,2010): the first is that time series data over a long period is required in order to be able to develop a diffusionmodel. These models are also not structural in nature and do not assess markets in equilibrium. They alsosay very little about the impact of mobile penetration on fixed line penetration (they focus on the questionthe other way around). Nonetheless, Vogelsang (2010) concludes that the decline of fixed line networks islinked to the rise of mobile networks.

A useful way of assessing whether two products are substitutes is to assess whether the demand for oneproduct is impacted on by the price of another product. Where there are positive cross-price elasticitiesof demand, then the two products in question are substitutes. This has been assessed for fixed line pricesimpacting on demand for mobile services, and the other way around. Some studies find positive cross-priceelasticities of demand in both directions (such as Rodini et al (2003)), while others find that the signs ofthe cross-elasticities differ between directions (see Garbacz and Thompson, 2005 and 2007). The signs maydiffer for each direction partly due to income effects, at least in developing countries (though this may beless of an issue in developed countries) (Vogelsang, 2010). An important feature of these studies is thatthey ought to take into account both access and usage charges (Hausman et al, 1993), which some (butnot all) do, as Vogelsang (2010) points out. Furthermore, considerable lengths are sometimes taken to tryto generate differences in access charges which usually do not vary significantly over time within countries(Ward and Woroch, 2010).

In respect of cross-elasticities of demand for usage of fixed line networks, Vogelsang (2010) finds thatfixed line usage is relatively inelastic to mobile prices, and finds elasticities of between +0.2 and +0.6.Vogelsang (2010) concludes that cross-price elasticities are small and positive and might increase over time,though the evidence for this is limited.

Studies on own price elasticities of demand show relatively inelastic demand for mobile services (elastici-ties of between −0.183 and −0.5) (Vogelsang, 2010), which suggests that there is competition among mobileoperators (since operators are not pricing at monopoly levels). Similarly, fixed line elasticities of demandare low and close to zero for access charges (Vogelsang, 2010). Own price elasticities of demand for fixed lineusage charges are also low and are greater than −1 (Vogelsang, 2010). Overall, Vogelsang (2010) concludesthat fixed and mobile substitutability already exists in developed countries and this effect is growing overtime.

Mobile networks do appear to exhibit economies of scale: thus, as mobile penetration grows, so costs fall.This creates scope for prices to fall (Vogelsang, 2010). It is less clear whether greater competition causesprices to fall: while Crandall & Hausman (2000) find significant price reductions arising from moving from amonopoly to a duopoly, adding further entrants does not result in significantly lower prices. A further costfactor affecting FTM substitution is the call termination rate regime: high mobile call termination rates(relative to fixed line call termination rates) result in many cases in high prices for fixed to mobile callsrelative to mobile to mobile calling rates (due to on-net discounting by the mobile operators) (Vogelsang,

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2010). Furthermore, high mobile call termination rates also result in subsidisation of mobile networks byfixed networks, which might further (artificially) increase fixed to mobile substitution (Vogelsang, 2010).However, call termination rates have declined significantly in recent years but this has not slowed fixed tomobile substitution (Vogelsang, 2010). Finally, it might be the case that fixed-line networks were preventedby regulators from responding to mobile operator tariffs (such as bundled on-net tariffs) and this hasencouraged fixed to mobile substitution (Vagliasindi et al, 2006).

The quality of networks and switching costs may also impact on fixed to mobile substitution. Thequality of fixed-line and mobile networks are very hard to capture in pricing studies. Using prepaid services,it is very easy for consumers to access mobile services, for example (Hodge, 2005). Vogelsang (2010)concludes overall that prices for mobile network services have declined significantly over time while qualityimproved, and this has fostered greater fixed to mobile substitution. While high mobile call terminationrates initially advantaged mobile networks, this effect has declined over time as mobile termination rateshave been regulated.

In summary, Vogelsang (2010) finds some evidence of fixed to mobile substitutability. This evidence islimited by problems with cross-country studies and the paucity of studies on individual countries. The oneexception to this finding is in Austria, where evidence of fixed to mobile substitution is more clear (Briglaueret al, 2011).

4.2 Review of fixed to mobile substitution in developed countries for broadband ser-vices

Nardoto, Valletti and Verboven (2013) analysed broadband penetration and broadband quality across morethan 4,265 UK local exchanges, assessing the effect of where new entrants use LLU lines at those exchangesand where the incumbent, BT, provides services directly to customers or provides services indirectly tocustomers via third parties using a service called Bitstream access. The data was evaluated over 17 periods.The authors further examined the impact of inter-modal competition from cable broadband providers.Their main findings were that LLU does not have an impact on broadband penetration but it does have animpact on broadband quality, as new entrants try to differentiate themselves from their incumbent throughbroadband speed offerings. Inter-modal competition between cable and DSL has a positive impact on bothbroadband penetration and on innovation. While the authors do not assess the extent to which mobilebroadband is a substitute for fixed line broadband, to the extent that LLU has improved quality, thissuggests that competition between fixed line operators plays an important role on quality adjusted pricesin the sector. This indicates that mobile broadband may not sufficiently discipline incumbent fixed linebroadband providers.

Grzybowski and Verboven (2013) assess fixed and mobile substitutability among 133,825 households in 27EU countries between 2005 and 2011 using a discrete choice model of demand. They use maximum likelihoodestimation for the analysis. The authors find that the services are perceived as substitutes over time onaverage but that there is significant heterogeneity between countries, and the extent of substitutability is arelatively recent phenomenon. For example, they find that while fixed and mobile services may be substitutesin Central and Eastern European countries including Romania, Lithuania and the Czech Republic, theseservices are weak complements in Sweden, the Netherlands and Malta. At the same time, the demand foreach type of service is independent in the UK, Luxembourg and Slovenia. Including fixed line broadbandin their analysis introduces greater complementarity between fixed and mobile services. The authors findthat the introduction of fixed line broadband has slowed FMS. The authors used household survey data(the Eurobarometer) and price data from Teligen. Prices used were composite price bundles for services,including usage and access charges. Instead of assessing whether mobile voice and fixed voice services aresubstitutes by themselves, their model allows households to choose bundles of fixed voice and mobile voiceservices, as well as choose different providers including incumbent and competitor fixed or mobile providers.The model is further extended for households to choose between different types of internet, including DSL,dial-up, mobile broadband, cable, other (including satellite, wifi, etc.) and no internet. The authors findthat having a mobile broadband connection makes fixed and mobile services greater substitutes while havinga fixed line broadband connection makes fixed lines and mobiles strong complements. They further findthat fixed and mobile services offered by the incumbent are viewed as complements rather than substitutes.This is because consumers generally see fixed and mobile voice services as substitutes but once fixed line

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broadband is taken into account, fixed and mobile services become complements.

4.3 Measurement of fixed and mobile substitution in developing countries

Hamilton (2003) evaluates fixed and mobile substitution across 23 African countries between 1985 and 1997.The study measured the impact of mobile penetration (subscriptions / population * 1000), GDP per capita,institutional factors (using the International Country Risk Guide), economic freedom, democracy, extentof urbanisation and trade on fixed line penetration (measure in two ways: fixed telephone lines supplied/ population, and demand for fixed telephone lines / population). She finds that mobile penetration ispositively associated with fixed line penetration for most specifications of her model, which supports thehypothesis that mobile networks and fixed line networks are complements. This might be because greatercompetition from mobile operators induces fixed operators to invest in their networks and improve thequality of their services, which in turn causes fixed line networks to expand. She finds however considerablevariability in her results over time (she finds much stronger complementarity in 1987 than she does in 1997)and between countries. She also finds some evidence of substitutability between fixed lines and mobilephones as penetration of mobile phones grows.

Narayana (2008) estimates fixed and mobile substitutability in India using a logit model of demand,and estimates the impact of relative prices for mobile services on the demand for fixed lines in addition toestimating the impact of relative prices for fixed line services on the demand for mobile services. In additionto access and usage prices, Narayana (2008) used income, family size, age, education, caste and occupationas explanatory variables. For usage charges, Narayana finds very high and positive levels of cross-priceelasticities between mobile and fixed line services in both directions, which suggests that the two servicesare substitutes. However, access charges for each type of service do not appear to explain demand for theother service.

Ward & Zheng (2012) evaluate own-price and cross-price elasticities of demand for fixed and mobiletelephony in 31 provinces in China between 1998 and 2007. They find that the two services are substitutes.For access charges, the authors use Average Revenue Per User (ARPU) while for usage they use AverageRevenue Per Minute (ARPM). The authors use changes in state ownership and concentration in neighbouringprovinces as instrumental variables for prices to deal with the endogeneity problem between quantity andprices and estimate own price and cross-price elasticities using Generalised Method of Moments (GMM).

4.4 Review of policy options for broadband, including LLU

One of the key potential interventions to achieve competitive outcomes in markets for broadband servicesis local loop unbundling (LLU) and open access network policies more generally. Unbundling of the localloop is a regulatory process which allows several internet service providers to use the copper lines betweenthe fixed line operator’s nearest point of network aggregation (usually a local exchange) and the end-customer’s premises. This notion is applied to mobile networks in the form of facilities leasing rules (such asmast sharing and radio access network sharing), roaming regulations and mobile virtual network operator(MVNO) regulations. Unbundling of the local loop is intended to facilitate services-based competition,innovation, lower prices and offer consumers and businesses a variety of access options for ICT services.

The impact of LLU interventions has been assessed by a range of academics and institutions, includingHausman & Sidak (2005) , the Berkman Centre (2010) and Nardoto, Valletti, Verboven (2013) . Hausman& Sidak (2005) considered both the impact of LLU on voice services and broadband in the US. The FederalCommunications Commission (FCC) implemented mandatory unbundling using the Total Element LongRun Incremental Cost (TELRIC) methodology. LLU was partly rolled back after a US court decision in2002 removed line sharing as a means of unbundling (which was offered at very low rates), citing a failureby the FCC to consider competing alternatives, including cable (Hausman & Sidak, 2005). The FCCsubsequently considerably reduced the scope of open access policies in the US (Berkman Centre, 2010).

Hausman & Sidak (2005) considered both the impact of LLU on voice services and broadband in theUS. The Federal Communications Commission (FCC) implemented mandatory unbundling using the TotalElement Long Run Incremental Cost (TELRIC) methodology. LLU was partly rolled back after a US courtdecision in 2002 removed line sharing as a means of unbundling (which was offered at very low rates), citing

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Retail competition in the form of innovation andlower prices is desirable

Lower retail margins, greater investment by in-cumbent

Unbundling is necessary to generate facilitiesbased competition

Entry by co-axial cable providers and mobile op-erators

Unbundling results in future facilities based en-try

Conversion from LLU based entry to facilitiesbased entry

Competition in wholesale markets is desirable Competing last mile networks, lower prices forlast mile facilities

Table 1: Justifications and testable hypotheses for LLU (Hausman & Sidak, 2005)

a failure by the FCC to consider competing alternatives, including cable (Hausman & Sidak, 2005). TheFCC subsequently considerably reduced the scope of open access policies in the US (Berkman Centre, 2010).

During the course of the period in which open access policies were in place, Hausman & Sidak (2005)found that prices for telephony services in the US increased more rapidly. They reviewed several articlesand reports which found that lower unbundled facility pricing caused the incumbents to invest more (suchas Willig et al, 2002), while others found that investment by incumbents declined (such as Hazlett et al,2003). The entry of the cable networks into voice telephony and broadband services in the US also meantthat unbundling was not necessary to generate facilities based competition in the US. The authors alsofound that the ‘stepping stone hypothesis’, or ladder of investment theory, was not applicable in the US.Hausman & Sidak (2005) found that, in fact, new entrants used unbundled network elements as a greaterproportion of their networks over time. Some studies showed that US states that had lower prices resultedin a greater proportion of unbundled lines used by new entrants in their networks (such as Crandall etal, 2004). Hausman & Sidak (2005) also found that only limited wholesale competition had developed inthe US, largely for high capacity dedicated links offered to enterprise customers and other new entrants(Competitive Local Exchange Carriers).

Similar to the US, Hausman & Sidak (2005) found that prices for retail telephony services in the UKincreased after the introduction of unbundling. While prices for broadband services fell significantly, thiswas attributed by the OECD (2001) to competition from cable providers. Furthermore, investment intotelecommunications services in the UK fell after 2001, although this could be attributable to the burstingof the telecommunications bubble. Hausman & Sidak (2005) comment that facilities based entrants, suchas COLT, entered the market in 1993, long before unbundling was put in place, and have expanded theirmarket considerably, particularly for business customers. There has been very little conversion of unbundlingbased entry to facilities based entry, largely because of the already successful facilities based entrants. Theauthors further conclude that there is significant wholesale competition in the UK market, largely due tothe presence of facilities based entrants, including electricity utilities. Finally, Hausman & Sidak (2005)conclude that the reason that there has been limited further expansion of cable networks in the UK hasbeen the regulated supply of copper local loops below cost, which has had the perverse effect of entrenchingBT’s dominance there.

New Zealand presented an example of a country that did not mandate local loop unbundling (otherthan one, light form of LLU, Bitstream access) before 2005 (when the Hausman & Sidak, 2005 paper waspublished). Since then, New Zealand has implemented LLU (see, for example, Comcom (2013)). In 2003,however, the Commerce Commission decided not to implement LLU, for four reasons (Hausman & Sidak,2005):

• Fixed-wireless networks would provide an alternative to copper over time;

• The gains from LLU in other countries have been limited;

• There is limited demand for LLU as a competitive means of entry; and

• LLU is a resource intensive activity, particularly in determining the terms of access.

Despite the lack of LLU (in the period leading up to 2005), prices for telephony services in New Zealanddid not increase significantly. Investment into telecommunications nonetheless declined in New Zealand,

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partly due to global declines in investment in telecommunications and partly due to significant investmentsby Telecom in the 1990s (Hausman & Sidak, 2005). Facilities-based entry developed despite the lack ofLLU: TelstraClear invested in a significant network in competition to Telecom, although it decided to scaleback investment in this network in 2003. A number of other facilities based entrants, including fixed-wirelessproviders, entered the market. At the time of the Hausman & Sidak (2005) article, there was no mandatoryunbundling and so the ‘ladder of investment’ or ‘stepping stone’ hypothesis could not be tested. A wholesalemarket for access services had not developed at the time either.

In Canada, the Canadian Radio-Television and Telecommunications Commission (CRTC) mandatedunbundling but instead of using Total Element Long Run Incremental Cost (TELRIC) used in the US orTotal Service Long Run Incremental Cost (TSLRIC) used a measure of forward looking cost (excludingjoint and common costs) plus a 25% mark-up. The CRTC initially limited LLU to a period of 5 years butsubsequently extended this indefinitely. Hausman & Sidak (2005) found that prices for retail telephonyservices increased by more than the rate of inflation and conclude that unbundling has not resulted in lowerprices. While investment in Canadian telecommunications increased by new entrants (often incumbents inother parts of Canada) and incumbents following the introduction of LLU, Hausman & Sidak (2005) foundthat a more sophisticated econometric analysis is required to understand whether this was caused by otherfactors, such as an increase in overall demand or the effects of the entry of facilities based competitors thatwas independent of the LLU decision. The authors also found that facilities based competition from cableproviders and even satellite was significant enough to eliminate the need for greater competition among DSLproviders using LLU. The stepping stone hypothesis was partly confirmed in Canada, in that investment inwholly owned access lines by new entrants increased significantly after LLU. Nonetheless, because the shareof LLU lines increased as a percentage of total lines in new entrant networks, the authors found that thestepping stone hypothesis was not confirmed, in that the proportion of wholly owned lines should increaseover time according to the stepping stone hypothesis. Hausman & Sidak (2005) found that Canada hadonly a small wholesale market, and so LLU did not achieve its desired impact in this regard.

Germany’s Regulator of Telecommunications and Post (RegTP) did not use marginal cost pricing whenintroducing LLU (Hausman & Sidak, 2005). Nonetheless, prices for telephony services declined significantlyafter 1999 after the introduction of LLU, although Hausman & Sidak (2005) explain that this may havebeen due to other factors, such as competition from mobile telephony. Investment by the incumbent inGermany, Deutsche Telekom, declined after the introduction of LLU. Hausman & Sidak (2005) explain that,while inter-modal competition between copper and cable operators is less extensive in Germany, this is dueto the fact that Deutsche Telekom (the copper-based fixed line incumbent) owned the cable networks until2000, and competition from cable operators was developing at the time of writing their report in 2004. Theauthors found that there is also little evidence in support of the stepping-stone hypothesis, even though newentrants invested heavily in their own facilities after LLU was introduced. Wholesale competition had notdeveloped by the time that Hausman & Sidak wrote their report in 2005.

In summary, Hausman & Sidak (2005) found that, as at the time of their publication, LLU did not resultin lower retail prices but did result in lower investment in the sector in many cases (see Table 2). They foundthat facilities based entry in the form of cable providers took place regardless of LLU and that thereforeLLU was not necessary to stimulate facilities based investment. They found no evidence in support of theladder of investment (stepping stone) theory, and they concluded that wholesale competition did not ariseas a result of LLU. LLU therefore did not achieve its objectives, according to the authors.

The authors’ research also suggests, however, that LLU implemented using incremental costs (such asTELRIC or TSLRIC) was less successful than where joint and common costs were taken into account. Forexample in Canada and Germany, where joint and common costs were taken into account when setting pricesfor unbundled network elements, there was greater investment by new entrants into their own networks (seealso Cave, 2006) .

The Berkman Centre (2010) report, published 5 years after the Hausman & Sidak (2005) report, cameto different conclusions regarding open access policies in analysing outcomes in the US against outcomes inother countries. The Berkman Centre report found that the US had fallen behind many other developedcountries in respect of broadband penetration and speeds. Furthermore, the report concluded that (BerkmanCentre, 2010): ‘Our most surprising and significant finding is that “open access” policies - unbundling,bitstream access, collocation requirements, wholesaling and/or functional separation - are almost universally

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Lower prices andmore innovation

No facilitiesbased compe-tition withoutLLU

Ladder of in-vestment

Wholesale com-petition

US ILEC capex decreased;Prices increased

Cable share ofbroadband: 66%

No evidence insupport

Competition forenterprise cust.

UK Telecoms prices flat,broadband prices fall;CLEC reach 50% share;ILEC capex decreased

Cable share ofbroadband: 41%

No evidence insupport

51% of whole-sale revenuescontrolled byentrants

NewZealand

Call prices flat; rentalprices increased; ILECcapex decreased

Facilities basedBB: 28%

No evidence insupport

No evidence

Canada Prices increased, CLECcapex decreased, ILECcapex increased thendecreased

Cable share ofBB: 64%

No evidence insupport

CLEC 20% ofwholesale lines

Germany Prices decreased, Capexdecreased

Very low cableshare

No evidence insupport

No wholesalemarket

Table 2: Summary of Hausman & Sidak findings on the impact of LLU (2005)

understood as having played a core role in the first generation transition to broadband in most of the highperforming countries; that they now play a core role in planning for the next generation transition; and thatthe positive impact of such policies is strongly supported by the evidence of the first generation broadbandtransition.’

The Berkman Centre (2010) report further found that countries with the slowest broadband speeds andhighest prices, such as the US and Canada, relied on inter-modal competition between cable and DSL todeliver broadband. Countries that had the fastest speeds and lowest prices had DSL and cable broadbandproviders and additionally had new entrants that relied on the use of facilities owned by incumbents throughopen access policies. Countries between these positions usually had ineffectively enforced open access regimesor had only recently implemented open access policies.

The key lessons learned in respect of open access policies assessed in the Berkman Centre (2010) reportare reproduced on Table 3.

The Berkman Centre report (2010) found, in general, that open access policies, particularly LLU, ledto more competition, lower prices, higher broadband speeds and more innovation in a number of countries.Open access policies are being extended to next generation optical fibre networks.

As discussed above, Nardoto, Valletti & Verboven (2013) analysed broadband penetration and broad-band quality across more than 4, 265 UK local exchanges, assessing the effect of where new entrants use LLUlines at those exchanges and where the incumbent, BT, provides services directly to customers or providesservices indirectly to customers via third parties using a service called Bitstream access. The data wasevaluated over 17 periods. The authors further examined the impact of inter-modal competition from cablebroadband providers. Their main findings were that LLU does not have an impact on broadband penetra-tion but it does have an impact on broadband quality, as new entrants try to differentiate themselves fromtheir incumbent through broadband speed offerings. Inter-modal competition has a positive impact on bothbroadband penetration and on innovation.

Initially in 2005, LEs that were served by an LLU new entrant had higher broadband penetration.However, LLU new entrants were likely to target high income consumers and businesses that were morelikely to take up broadband in the first place, which reflects an endogeneity problem (i.e. rather than LLUresulting in higher broadband uptake, greater broadband uptake was encouraging the growth of LLU). Theauthors solve this by assessing dynamic panel data over time. They conclude that LLU has either no ora very small positive impact on broadband penetration, while inter-modal competition (between cable andDSL) has a significant impact on penetration. Nardoto et al (2013) do not compare LLU with no open access

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Core lesson Case study or sec-tion

Open access policies, unbundling in particular, played an important rolein facilitating competitive entry; where facilities based entrants werepresent, access based entrants played an important role in catalysingcompetition; In some cases, access based competition resulted in in-creased competition, technological progress, lower prices and service in-novation

Japan, Denmark, theNetherlands, Norway,Sweden, France, UK,New Zealand

Having an actively engaged regulator enforcing open access policies ismore important than formally adopting open access policies; incumbentsresist open access policies whether they are formerly government ownedor not.

Japan, South Korea,France, UK, Canada

Broadband providers are regulated as carriers, and their carrier functionis regulated separately to their services function

All surveyed countries

Open access rules are being applied to next generation access networks,particularly to fibre based broadband networks.

Japan, South Korea,Sweden, Netherlands,France, UK, EuropeanRegulators GroupEU,New Zealand

Vertical integration between fixed and mobile is increasingly allowed,with open access principles being applied to mobile networks

Japan, South Korea ap-ply access; France andGermany experience in-tegration but do not ap-ply access

In the two earliest instances in which functional separation was imple-mented, it had rapid effects on competitive entry, penetration, pricesand or speeds

UK, New Zealand

Where functional separation was introduced, it had a significant impacton competitive entry, prices and / or speeds

UK, New Zealand, Swe-den, Netherlands, Italy,Australia

Functional separation is increasingly being adopted to support open ac-cess, particularly for next generation access networks

Japan, South Korea,Denmark, Norway, Swe-den, the Netherlands,UK, France, Germany,Italy, New Zealand

Entrepreneurial competitors have tended to enter through bitstream orunbundled access

Japan, South Korea,Denmark, Norway, Swe-den, the Netherlands,France, UK

Unbundled access is often used by incumbents from neighbouring regionsor countries; entry often takes place by acquiring entrepreneurial newentrants

Denmark, Norway, Swe-den, Finland, Germany

Where open access policies are weakly implemented countries rely onfacilities based competition with weaker results

Germany, Canada

The high costs of next generation access are causing countries to workout ways to share costs, risks and facilities rather than the duplication offacilities for facilities based competition; they aim to mitigate the loss offacilities based competition with new models of open access and sharedfacilities, tailored to fibre

European RegulatorsGroup, the Nether-lands, France, Ger-many, Switzerland,UK

Table 3: Policy lessons from international experience with the development of broadband(Berkman Centre, 2010)

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policy at all in their dataset, however: rather, they compare LLU with bitstream access, a service basedform of open access policy. Bitstream access does not require that new entrants invest in network buildto exchanges and equipment installation and monitoring. It might be the case, therefore, that Bitstreamaccess allows for sufficient competition to develop in order for broadband penetration to be maximised.

The authors then go on to assess whether LLU has had an impact on broadband quality. It turns outthat consumers that use a new entrant that uses LLU experience broadband speeds that are 20.1% higherthan users that use BT. This is because LLU operators are able to control the customer experience whileoperators using Bitstream cannot: LLU operators offered speeds that were on average 47.3% greater thanoperators that used Bitstream.

4.5 Methodological problems with empirical studies on FMS and LLU policy interven-tions

The first methodological problem encountered with fixed and mobile substitution models is that, as with alldemand estimations, price and quantity are determined simultaneously (see, for example, Ward and Zheng,2012). Furthermore, a significant amount of data is required to estimate diffusion models over time (Vogel-sang, 2010). In addition to this, pricing data for network services are complex, with connection (installationcharges), access charges and usage charges all playing an important role. Technological improvements alsoimpact on prices over time. For example cameras, navigation and music all improve the experience of owninga mobile phone (see, for example, Ward & Zheng, 2012). Furthermore, the call termination rate regime mat-ters: different call termination rates mean different usage prices, subsidies for handsets, and access chargesand therefore failure to capture all of the relevant prices may result in seriously biased results (Vogelsang,2010).

Some of these methodological issues have been solved using fixed-effects. For example, within-countryidiosyncrasies can be controlled for to some extent by using country dummy variables (such as in Hamilton,2003) and technological progress can be captured through the use of a dummy variable for each year (suchas in Ward & Zheng, 2012).

While price data for individual countries may work better than for cross-country studies, there may notbe sufficient variability in the data to make sensible inferences from it (Vogelsang, 2010). For example, accesscharges within country do not vary significantly over time and therefore the impact of access charges onfixed and mobile substitutability are difficult to assess. The number of subscribers on broadband networksalso appear to be inflated in many countries (and therefore studies) due to the inclusion of inactive prepaidsubscribers (Vogelsang, 2010). The inflated subscription numbers might also be due to the advent of machineto machine communications that use mobile SIM cards.

A further problem that arises in cross-country studies in developing countries is endogeneity between theuptake of fixed lines and mobile broadband where the government owns the incumbent fixed line operatorand also makes policy for the mobile sector (Hamilton, 2003). In many developing countries in Africafor example, the fixed line operators tend to be state owned and report to the Minister responsible fortelecommunications. The fixed line operator might therefore be in a position to influence the number ofmobile subscriptions. This means that the number of mobile subscriptions and the number of fixed linesmight be jointly determined. Ordinary least squares would attribute changes in fixed line subscriptions tomobile subscriptions when in fact the two are jointly set by a third party, the government. Accordingly,mobile penetration would be correlated with the error terms in the regression model. An instrumentalvariable approach presents one possible solution to this problem, and involves finding an alternative variablethat is correlated with the mobile phone penetration variable but is not correlated with the error terms in theregression model. The author used this approach, using the percentage share of private participation in theeconomy (private credit extension as a percentage of GDP) as a proxy for the extent of mobile penetration.

A further drawback of the Hamilton (2003) study is that it pools a large group of heterogenous coun-tries, from Arabic speaking North African countries to French speaking West African and English speakingSouthern African countries. There are significant differences between these countries. For example, Frenchspeaking West Africa has a very different administrative law system to the common law system employedin English-speaking Southern African countries. While Hamilton (2003) controls for these problems usingfixed effects for each country, and then separately using fixed effects for different regions, it is not clear thatpooling very different countries in the first place makes any more sense than, for example, pooling a group

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of sub-Saharan African countries with Western European countries does.In addition to this, it is difficult to control for the regulatory and policy specificities applicable in different

countries which might lead to different outcomes for fixed and mobile substitutability. For example, the UKhas seen tremendous uptake in LLU lines at least in part due the functional separation imposed on BT, thefixed line incumbent there (see Cave, 2006). This has led to highly competitive outcomes resulting in highquality for fixed line broadband in the UK (see, for example, Nardotto et al, 2013) which may have the effectof limiting fixed to mobile substitution. This is in contrast to countries that are in transition in EasternEurope that are more likely to have weaker institutions and therefore less competitive fixed line sectors.

A problem that arose in the assessment of the impact of LLU in terms of broadband penetration andquality was that there was endogeneity between explanatory variables. Nardoto, Valletti & Verboven (2013)used average income levels and new entrants using LLU at Local Exchanges (LEs) as explanatory variables toassess the impact of LLU on broadband penetration and broadband quality. However in 2005, for example,LEs that were served by an LLU new entrant had higher broadband penetration. LLU new entrants werelikely to target high income consumers and businesses that were more likely to take up broadband in the firstplace. The authors solved this endogeneity problem by using a system GMM approach, and using laggeddifferences of the explanatory variables as instruments for the endogenous variables, following Blundell andBond (1998) and Blundell et al (2000).

Finally, there is likely to be considerable heterogeneity among different categories of customers using fixedand mobile services. There are groups of customers that use fixed and mobile services as complements (suchas business customers and perhaps high usage residential customers) and groups that substitute betweenfixed and mobile services (see, for example, Hamilton, 2003 and Grzybowski and Verboven, 2013). Thismeans that differing levels of substitutability need to be considered for different groups of customers.

4.6 Gaps in the literature to be addressed

Many of the studies cited above attempt to assess fixed and mobile substitution across a number of differentcountries (including Hamilton (2003) and Grzybowski & Verboven (2014)).These studies inevitably runthe risk of pooling observations from countries with widely divergent regulatory systems and consumertastes. Furthermore, many of the studies discussed above tend to focus on voice services rather thanbroadband services. The assessment of fixed to mobile substitution in respect of broadband services islimited to Grzybowski & Verboven (2014), which suffers the limitation that it pools data from a numberof diverse countries. Assessing fixed to mobile substitution for broadband services in one country thereforewill contribute to this gap in the literature.

Furthermore, the quality of broadband service is not taken into account in any of the papers cited, otherthan Nardoto, Valetti & Verboven (2014). The latter does not address fixed to mobile substitution however:it addresses the effectiveness of LLU using data on fixed lines (cable and copper). Furthermore, it usesbroadband speeds as a measure of quality. The quality variable to be developed will take advantage of thephysical properties of copper based broadband: the broadband speed achievable over copper is inverselyproportional to the distance between the local exchange and the customer’s premises.

Finally, the local loop unbundling policy reviews have not taken into account the nature of developingcountries which tend to have limited coverage fixed line networks, and near universal mobile network cov-erage. The policy options to be researched in the context of the nature and extent of FMS in South Africawill therefore make a contribution to this area of the literature.

5 Contribution 1: Construction of quality variable

5.1 Motivation and contribution

Fixed to mobile substitution (FMS) has not been measured formally in South Africa. This analysis requiresdetailed data on consumer choices. To this end, a dataset on consumer choices on fixed and mobile servicesusing the National Income Dynamics Study (NIDS) and broadbandstats.co.za will be developed. Thisinvolves developing a variable for the quality of fixed line broadband in South Africa by calculating thedistance from Telkom exchanges to customer premises in order to assess whether consumers that havereplaced fixed with mobile tend to be further away from local exchanges (which gives rise to poorer quality

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Figure 3: Income distribution of fixed and mobile access, (NIDS Wave 1, 2008)

broadband). The locations of TelkomâĂŹs exchanges have been collated from Broadbandstats.co.za. Thelatter dataset also contains the maximum speeds available at each of Telkom’s exchanges, an additionalmeasure of quality. This dataset will then be used to develop descriptive statistics on consumers thatsubstitute between fixed and mobile networks as a first contribution towards answering whether mobilenetworks are substitutes for fixed line networks.

5.2 Research objectives

The objective of this contribution is to build a measure of quality of fixed lines from NIDS and Broad-bandstats.co.za data and to provide descriptive statistics as to whether quality impacts on customer choicesabout broadband.

5.3 Methodology

5.3.1 NIDS

NIDS is a national panel data study on households that has collated more than 20, 000 individual observationsin each of four waves (the fourth wave is forthcoming this year, 2015). The broadbandstats.co.za datasetcovers the period 2011-2013, corresponding to NIDS waves 2,3 and 4.

The NIDS dataset reveals that approximately 12.3% of the households sampled (15%, using the weightedsample) had a working landline, while 74% of households sampled (79%, using the weighted sample) owneda cell-phone, in 2008 (wave 1). While cellphone ownership was reasonably balanced across income quintiles,having a working landline was strongly influenced by income (see figure 3). While more than half of thehouseholds in the top income quintile had a working landline, only a small fraction of poorer householdsowned one.

The panel dimension of the NIDS and Broadbandstats.co.za data will be exploited since the Broad-bandstats.co.za data captures upgrades to local exchanges between 2011 and 2013. While there are only 3usable waves of NIDS, these upgrades will allow us to explore substitution between fixed and mobile, holdinghousehold idiosyncracies fixed.

NIDS reveals that, for wave 2 (2010/2011), fixed line penetration among households sampled decreasedfrom 12.3% (15%, using weighted results) of households in 2008 to 10.8% (17%, using weighted results) in2010/2011 and cellphone ownership had increased from 74% (79%, using the weighted sample) to 77% (82%using the weighted sample) over the same period. Wave 3 (2012) results showed that fixed line penetrationamong households sampled decreased from 12.3% of households sampled (15% of the weighted sample) to7.5% (12% using the weighted sample) between 2008 and 2012. At the same time, cellphone ownership hadincreased to 90% (88.7% using the weighted sample). Access to fixed lines had become even more skewedrelative to access to cellphones by 2012 (see Figure 4). This suggests considerable substitution from fixedlines to mobile services among South Africans, particularly by lower income South Africans.

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Figure 4: Income distribution of fixed and mobile access, (NIDS Wave 3, 2012)

Wave 3Wave 2 Yes-W Yes-NW No TotalYes-W 388.0 29.0 402.0 819.0Yes-NW 28.0 19.0 165.0 212.0No 191.0 94.0 8,106.0 8,391.0Total 607.0 142.0 8,673.0 9,422.0

Table 4: Households with landlines between NIDS waves 2 and 3

To be more precise, of the approximately 819 households sampled in Wave 2 (2010/2011) of the NIDSsurvey that had a fixed line telephone, only 388 (47% of the sample) had a fixed line telephone in Wave 3(2012) (see Table 4). A further 219 households that did not have a landline in working order in Wave 2 hada working landline in Wave 3.

This suggests that a considerable proportion of households are switching away from fixed lines. In orderto determine the causes of this, it is important to understand whether those households disconnected theirlandlines for reasons unrelated to changes in consumer preferences, including income, geographic location(moving to a location where landlines are not available) and changes in household size (larger householdsmay have a preference for landlines). The NIDS dataset allows for the control of all of these variables.

A further variable that should be controlled for is variability in broadband quality. In order to use fixedline broadband in South Africa, a landline in working order is required. While consumers may cease to usetheir landline to make voice calls due to ownership of a mobile phone, broadband may be slowing fixed tomobile substitution.

NIDS does not directly ask whether the household’s fixed line is being used for broadband services.Nonetheless, there are a number of proxies for this including household expenditure on landlines (spend overa certain voice usage average might indicate broadband use) and NIDS contains questions about internetexpenditure separately to expenditure on ‘mobile experiences’ and separately to expenditure on telephoneexpenses. While the questionnaire allows for internet to be included in telephone expenses, the questionnaireimplies that internet expenditure on mobile phones would be captured separately.

5.3.2 Data on locations of and maximum speeds at local exchanges

Broadband quality depends on distance between local exchanges and households: the greater the distance,the lower quality. Households are also only able to achieve the maximum speed available at their localexchange. The locations and maximum speeds of local exchanges are available for 2011 and 2012 fromthe broadbandstats.co.za dataset, which is a website that collates maximum speeds and the locations ofTelkom exchanges throughout South Africa (see Figure 5). There are 8 available broadband speeds in thedataset: 384kbps, 512kbps, 1Mbps, 2Mbps, 4Mbps, 8Mbps, 10Mbps, 20Mbps. There are approximately2,000 exchanges located throughout South Africa. The location data will be used to determine distances

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Figure 5: Telkom exchanges

between each household where a landline is available, and the local exchange (mapped on Figure 5).

6 Contribution 2: Demand estimation

6.1 Motivation and contribution

This component of the research will provide a contribution towards understanding the elasticity of demandfor fixed and mobile services in South Africa, which has not been undertaken previously. As discussedabove, demand estimation for these services will assist policymakers in selecting policy choices for thetelecommunications sector in South Africa.

As discussed above, the literature suggests that households largely view fixed and mobile voice servicesas substitutes, though the literature is not conclusive (Vogelsang, 2010). The inconclusive nature of theliterature is partly due to the fact that finding high quality price data for different countries is difficult giventhe complexities of telecommunications prices (installation, access and usage prices) and service qualities(such as high speed broadband vs. low speed and the variety of mobile services that are bundled withtradition mobile voice services). Furthermore, significantly different results for fixed to mobile substitution(FMS) arise depending on the basket of fixed and mobile services included in the analysis. While fixed andmobile voice services may be substitutes for some households, once fixed line broadband is included in thecustomer choice set fixed and mobile services become complements rather than substitutes (Grzybowski &Verboven, 2014). There is also considerable heterogeneity between countries and between households inresults for fixed and mobile substitutability.

6.2 Research objectives and questions

The objective of the research is to estimate a model of demand for telecommunications services in SouthAfrica. This will allow for the calculation of own-price and cross-price elasticities of demand for telecommu-nications services. This in turn will establish whether fixed and mobile broadband services are substitutes inSouth Africa, and will enable the identification of market power in markets for telecommunications services.

6.3 Research hypotheses

The main research hypothesis is that the demand for fixed line telecommunications is quality elastic: poorquality results in less uptake of fixed line telecommunications products.

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The alternative hypothesis is that quality of fixed line services does not have a significant impact ondemand for fixed lines once demand for mobiles is taken into account.

The main relationship between the variables to be assessed is whether the choice of fixed and / or mobilebroadband is linked to the available quality of fixed line connections.

6.4 Methodology

The quality variables (distance to exchange, and maximum speed of exchange) developed in the first con-tribution (discussed above) will be used to estimate demand using the NIDS dataset.

The discrete choice model can be applied to aggregate, market-level data as well as to individual customerdata.

There are several behavioural modelling approaches to estimating discrete choice models of demand forconsumer level data (Davis & Garces, 2010). These include multinomial logit, generalised extreme values(including nested logit), mixed logit and probit.

Some of these models have closed form solutions, including multinomial logit and nested logit, whileother models, including mixed logit and probit, require simulation (Train, 2009).

An important part of this contribution will be to evaluate these alternative methods and select the bestoption for the questions being asked and the data available. Two possible approaches are presented here:the multinomial logit and mixed logit models of demand.

6.4.1 Approach I: Multinomial logit

The most widely used model for estimating discrete choice models of demand is the conditional logit model,an extension of the multinomial logit (MNL) model (Mcfadden, 1973). A MNL model will be estimated asfollows:

Consumer i’s utility derived from product j is given by:

Uij(pj , rj , zi; θ) = Vij(pj , rj , zi; θ) + εij (1)

where pj and rj are the price and intrinsic value, respectively, of product j and zik is a vector ofcharacteristics of consumer i and zij is a generic element. There is a vector of parameters to be estimated,θ, and a stochastic error term εij .

All estimates are relative to the outside option, which is choosing no service at all.We further assume that:

Vij(pj , rj , zi; θ) = rj − αpj + Σγjnzin (2)

where α is the price co-efficient and γ is the vector of co-efficients for consumer characteristics.Consumer i will choose product j if Uij ≥ maxj 6=k,k∈Ci

Uik where Ci is the choice set. This occurs withthe following probability:

Pij = Pr[Vij + εij ≥ maxj 6=k,k∈CiVik + εik] (3)

We assume that εij are independently and identically distributed (IID) across individuals and alternativesand follow a type I extreme value distribution and have a scale parameter σε. This means that the choiceprobability can be solved using the logit formula, given by:

Pijt = Pr[j|pit] = exp(Vijt)∑k∈Ci

exp(Vikt)(4)

where pj is the vector of prices for each product j that consumer i may choose from.In order to estimate Equation 4, log-likelihood will be used. The probability that consumer selected the

choice observed is: ΠjPyij , where yij = 1 if consumer i chose product j and ij = 0 otherwise.

The log likelihood function can be written as :

L(α, r, γ) = yij

N∑i

∑j

log(Pij) (5)

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where the values α, r and γ maximise the estimator L.The main problem with the multinomial logit (MNL) model is the unreasonable Independence of Irrel-

evant Alternatives (IIA) assumption. This assumption means that a product’s market share is determinedby its characteristics. An implication of this is that the introduction of a new product that is a directsubstitute for one of the existing products in the product set will reduce the market shares of all otherproducts in proportion to their market shares, including any product that is a direct substitute. This seemsunreasonable since we would expect the new product to take significantly more market share from its directsubstitute than from distant alternatives.

A mixed logit model, which does not rely on the IIA assumption, is a possible alternative approach andis discussed next.

6.4.2 Approach II: Mixed logit

The utility function for consumer i and product j in the mixed logit function is given by (see, for example,Davis& Garces, 2010):

Uij(pj , rj , zi; θ) = Vij(pj , rj , zi; θ) + εij (6)

where the key difference between this and Equation 1 above is that consumers are allowed to havedifferent co-efficients on prices, αi. The latter are assumed to have a normal distribution and a densityfunction given by αif̃(α|µ, σ2), where αi has mean µ and variance σ2.

The αi are assumed to be uncorrelated with the error term εijt and the explanatory variables pj , rj , zi.The probability of consumer i choosing product j is given by:

Pij(α) = Pr[j|pi, ., α] = exp(Vij(αi))∑k∈Ci

exp(Vik(αi))(7)

where pj is the vector of prices available to consumer i. The unconditional choice probability is, in themixed logit model:

P̄ij =∫αPijf(α|µ, σ2)dα (8)

The probabilities in Equation 8 are estimated by simulation. We first draw a vector of values αr fromthe normal distribution N(µ, σ) and label it r = 1. We then calculate the probabilities in Equation 8. Weiterate this approach R times and then calculate the choice probability:

P̄ij = 1R

R∑r=1

[ exp(Vij(αr))∑k∈J exp(Vik(αr))

] (9)

L(α, r, γ, µ, σ) = yij

N∑i

∑j

log(P̂ij) (10)

where the values α, r and γ and the distribution parameters N(µ, σ) maximise the estimator L.

7 Contribution 3: Implications for telecommunications policy in SouthAfrica

7.1 Motivation and contribution

The purpose of this contribution is to evaluate the policy options available to policymakers in South Africain the context of the results of the first two contributions, particularly in relation to how and where openaccess policies ought to be implemented. As discussed above, there is a gap in the literature as to how andwhether to implement open access policies in countries with limited coverage fixed line networks and almostfull coverage mobile networks.

As discussed above, there is a debate on the impact of open access fixed line policies on a range of policyoutcomes, including competition, broadband penetration, pricing and speeds. While some research, such as

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that developed by Hausman & Sidak (2005), suggests that LLU has not had the desired impact on developingfacilities based entry upstream and has not resulted in lower prices to consumers, other research, such asthat developed by the Berkman Centre (2010) find that open access policies, implemented by a engagedregulator, have had a significant impact on expanding broadband penetration and resulting in lower pricesand faster speeds. More recent research on the impact of LLU in the UK shows that while LLU did nothave a significant impact on broadband penetration, it had a significant impact on the quality provided bynew entrants, who offer speeds that are on average 20% faster than those provided by the incumbent, BT(Nardoto et al, 2013).

There is therefore considerable debate as to how the telecommunications sector ought to be regulated infuture, including whether open access policies should be followed at all, and if they should be implementedwhether they should be implemented for fixed or mobile services or both, or whether indeed the regulatorshould employ a ‘light touch’ approach. This is an important on-going debate in South Africa, which willbe informed by the quality variable to be developed in the first contribution and the demand estimationproposed in the second contribution, discussed above.

7.2 Research objectives and questions

The research objective is to evaluate how and why open access policies have been implemented in othercountries and assess whether and how they should be implemented in South Africa, in the context of qualityand price factors, and customer demand characteristics evaluated in contributions 1 and 2.

7.3 Research hypotheses

There are two competing hypotheses internationally for the regulation of telecommunications services:

• There is very little that telecommunications regulators ought to do, given the significant levels of‘inter-modal’ competition between different technologies (such as fixed and mobile) (see discussion inHausman & Sidak (2005) for example, set out above);

• There is significant scope for intervention in telecommunications markets in bringing about greatercompetition through open access policies (see discussion in the Berkman Centre (2010) report forexample, explained above).

These two hypotheses will be evaluated in the context of the results of the analysis to be developed incontributions 1 and 2, taking into account the limited coverage of fixed line networks and almost universalcoverage mobile networks in South Africa.

7.4 Methodology

The methodology to be employed will include a review of existing literature on open access policies andregulator decisions on market definition and effects of firm conduct in the telecommunications sector inSouth Africa and in other countries. These policy choices will be evaluated in the context of the price andquality datasets from the first contribution and demand estimation from the second contribution. Policyimplications for policymakers and regulators will be drawn from this component of the research.

7.4.1 Open access policies in the EU

There are several possible policy options open to policymakers and regulators. For example, Nationalregulatory authorities in the EU may impose obligations, including LLU, on operators that have SignificantMarket Power (SMP) (see, for example, ECP, 2000). The European Commission publishes recommendationson relevant markets. In 2003, in relation to wholesale fixed line services, the EC defined the following markets(EC, 2003):

• Wholesale unbundled access to metallic loops and sub-loops for the purpose of providing broadbandvoice services (Market 11);

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• Wholesale broadband access, including Bitstream access, which allows for the transmission of data inboth directions and other wholesale access provided over other infrastructures, if and when the offerfacilities equivalent to Bitstream access (Market 12);

• Wholesale terminating segments of leased lines (Market 13); and

• Wholesale trunk segments of leased lines (Market 14).

In 2007, the EC revised the total number of markets susceptible to ex-ante regulation down to 7 from 18(EC, 2007). The markets described above in the 2003 recommendation were also found to be susceptibleto ex ante regulation in the 2007 recommendation, except for the market for wholesale trunk segments ofleased lines, which was eliminated. The wholesale fixed line markets were renumbered 4,5 and 6 in the 2007recommendation. The markets relating to LLU have therefore remained reasonably consistent over time.

Local loop unbundling was mandated in the EU in December 2000, for operators found to have significantmarket power in the fixed public telephone network supply market (ECP, 2000; see Box 11). LLU as it wasinitially conceived in 2000 in the EU was aimed largely at the metallic path facilities owned by fixed lineincumbents (ECP, 2000). The 2000 LLU regulation required that incumbents were able to recover their“costs plus a reasonable return, in order to ensure the long term development and upgrade of local loopinfrastructure.” The regulation further imposed a non-discrimination obligation, which required that theincumbent provide local loops to third party operators in the same manner in which it provides local loopsfor its own downstream services. Incumbents were required to provide access to the following facilities (EPC,2000) :

• A loop or local sub-loop, authorising use of the full frequency spectrum of the twisted metallic pair(‘full unbundled access’) or the use of the non-voice band frequencies of the loop or sub-loop (‘sharedaccess’);

• Collocation, including the physical space and technical facilities needed to accommodate a third partyoperator; and

• Related facilities, including cable connections and relevant information technology systems.

These requirements were consolidated and re-iterated in the 2002 interconnection and access directive(EPC, 2002b) .

A key problem in the implementation of LLU is that upstream fixed line incumbents are able to use anumber of price and non-price means of excluding their downstream rivals (as discussed above in section7.2.1). In order to resolve this, the EU undertook further reforms in 2009 to allow for functional separationafter its successful implementation in the UK (EPC, 2009). In terms of the new regulation, a nationalregulatory authority imposing functional separation must set out what legal status the separated entity willhave and what assets and staff are to be separated. The regulator may also set rules for the incentivisationof staff and for the governance of the separated wholesale entity. Regulated entities are also able to effectvoluntary separation, similar to that undertaken by BT (as discussed above). These reforms extended theEU’s open access framework to include duct access, and information on space availability within ducts.

The European Commission’s current plans are to maintain and extend LLU to facilitate the introductionof a European virtual broadband access product (EC, 2013). This will enable the fixed line incumbent’sdownstream rivals to use next generation access (largely optical fibre based) networks owned by incumbents(EC, 2013). The EC proposes not only to allow for passive access to loops and sub-loops but virtual accessthat provides equivalent functionalities to passive access. The EC proposes three offers for the EuropeanVirtual unbundled access product:

• Offer 1: Access to layer 2 (the data layer) of the network (in terms of the International StandardsOrganisation (ISO) seven layer model for communications protocols), which allows for equivalentfunctionalities to physical access and where the network is handed over closer to the customer thanthe national or regional level;

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• Offer 2: Access to layer 3 (the network layer of the ISO seven layer model for communications protocols)of the network, the Internet Protocol (IP) layer, such as Bitstream access, at either regional or nationallevel.

• Offer 3: Access to wholesale terminating segments of leased lines for exclusive use of the access seeker,offering permanent symmetric capacity, unlimited usage, and with service grade agreements, by meansof a point to point connection and with layer 2 (the data layer of the ISO model for communicationsprotocols) network interfaces. (EC, 2013)

The EU’s maintenance and extension of LLU is in line with recent research funded by the EC which foundthat markets 4 and 5 relating to wholesale fixed line access (discussed above, emanating from EC(2007)) willcontinue be susceptible to ex-ante regulation (Ecorys, 2013). Specifically, the research found that (Ecorys,2013):

‘High and non-transitory barriers to entry exist and are expected to remain for the relevant timeframe;the relevant market structure is not expected to tend to effective competition within the relevant timeframeand application of competition law alone is not expected to be able to sufficiently resolve the market failuresconcerned.’

This suggests that LLU will be in place in the EU in the short to medium term.

7.4.2 Open access policies (predominantly LLU) in developing countries

Open access policies, including LLU, have largely been implemented in developed countries due to theirlarge, well developed fixedline networks. While there is less experience with open access policies in devel-oping countries, LLU has been implemented in countries such as Brazil (Scaramuzzi, 2012), Jordan (ITU,2011), Turkey (OECD, 2013), Nigeria (discussed below) and Tanzania (Robinson, 2014), for example. Somedeveloping countries, like South Africa (discussed below), and Mexico (Schiavoni, 2013a), are in the processof implementing LLU.

In practice, the implementation of LLU has not been effective in some instances. For example, while LLUhas been implemented in Nigeria by the Nigerian Communications Commission, the fixed line incumbentthere, Nitel, is effectively not operational which makes LLU ineffective (Southwood, 2012 and Koboldt,2013).

Many developing countries have not implemented LLU. For example, the Telecommunications RegulatoryAuthority of India’s (“TRAI”) view is that “the sharing of copper loop through unbundling or bit streamsharing which was at one time considered important for increasing broadband penetration has lost relevanceespecially for rural area” (TRAI, 2011). More recently, it appears as though TRAI has adopted measuresfor the “sharing of active and passive infrastructure” (Kaur, 2013). In Chile, the regulator appears to havefound, in line with court rulings in the US, that sufficient inter-modal competition exists between cableand copper fixed line networks such that regulation of fixed line networks is not justified there (Schiavoni,2013b).

7.4.3 Conclusion on methodology

There is very little existing research on the implementation of open access policies, including local loopunbundling, in developing countries. While LLU may not be suited to all developing countries, such asChile where inter-modal competition with cable networks exists, or Nigeria where the fixed line incumbentessentially isn’t operating, many developing countries have already implemented it or are considering doingso. The methodology to be employed for this contribution will therefore be to evaluate available policyoptions proposed in other countries and in South Africa, in the context of the nature of fixed to mobilesubstitution in South Africa.

8 Conclusion

The proposed Vodacom/Neotel and MTN/Telkom transactions raise considerable competition concerns,exacerbated by high costs to communicate in South Africa, particularly as regards broadband services.

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ICASA is reviewing these transactions, as well as considering implementing local loop unbundling. Theeffects of the transactions and local loop unbundling depend on whether fixed and mobile networks aresubstitutes: to the extent that they are, the MTN/Telkom transaction is of less concern (since Telkom fixedis excluded from it), while the Vodacom/Neotel transaction raises more concerns since Neotel’s fixed andVodacom’s mobile services would be substitutes for one another.

Fixed and mobile substitution (FMS) has not been formally measured in South Africa. In order toevaluate FMS a unique dataset will be developed, combining the National Income Dynamics Survey (NIDS)dataset with that of Broadbandstats.co.za, in order to develop a quality variable for fixed lines. Usingthe NIDS dataset will also enable controlling for other variables such as household size and income. Inthe first contribution, this dataset will be developed and analysed at a reasonably high level including bydeveloping a set of descriptive statistics on the variable to be generated. In the second contribution, theNIDS and broadbandstats.co.za data will be used to estimate demand, and therefore market power, in thetelecommunications sector in South Africa. This includes assessing the extent and nature of fixed to mobilesubstitution in South Africa. A third and final contribution will be the evaluation of policy options in thecontext of the analysis produced from the second contribution.

This research addresses an important gap in the literature on fixed to mobile substitution and policyoptions for developing countries where the extent of mobile coverage far exceeds fixed line coverage. WhileFMS has been researched for voice services extensively, research on broadband services is more limited.Where it does exist, it does not take into account the varying levels of quality available for broadbandservices. The policy options available to policymakers and regulators will also be evaluated in the context ofFMS in South Africa. There is a considerable gap in the research on telecommunications policies in respectof the implementation of open access policies, including LLU, in developing countries with limited coveragefixed line networks and near ubiquitous mobile coverage. These gaps will be addressed through the researchproposed here.

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