Regulation in the UK
The regulatory structure for UK telecommunications is set out principally in the Telecommunications Act 1984, which gives regulatory authority to the Secretary of State for Trade and Industry and the Director General of Telecommunications who heads the Office of Telecommunications (Oftel). The Secretary of State and the Director General are each required to exercise their functions under the Act in the way which they consider is best calculated to ensure, as far as reasonably practical, that all reasonable demand for telecommunication services, including certain community services, is met and to secure the ability of licensed telecommunications operators to finance the provision of the services which they are licensed to provide. In addition, they are required, among other things, to promote the interests of consumers, purchasers and other users in the prices, variety and quality of telecommunication services and equipment, and to promote and maintain efficiency and effective competition among UK telecommunications operators.

With limited exceptions, a licence under the Telecommunications Act is required to run a telecommunication system in the UK. The Secretary of State is responsible for issuing licences after consulting the Director General.

The BT Licence
BT operates in the UK under a number of licences, the most important of which is our licence to operate our fixed-line public telecommunications network (the "Licence"). The Licence remains in force indefinitely, but the Secretary of State may revoke the Licence on 10 years notice. The Licence can also be revoked at any time on various grounds, including non-compliance with an enforcement order from the Director General. In September 1999, the Licence was modified to meet the harmonisation requirements of the European Union Licensing Directive.

The Licence contains terms and conditions designed principally to ensure the widespread provision of telecommunication services in the UK, to protect the interests of consumers and to encourage the development of effective competition in telecommunication services and network provision within the UK.

Under the Licence, we have to fulfil reasonable requests for access to voice telephony, low-speed data and fax transmission services, and reasonable access to public call boxes throughout nearly all the UK, including rural areas (these being the principal elements of the Universal Service Obligation).

Under the Licence, we must allow other licensed operators to interconnect with our telecommunications systems on cost-oriented, transparent and non-discriminatory terms.

We must comply with a variety of fair trading obligations, such as:

• a prohibition on showing undue discrimination between customers or unfairly favouring any part of our own business as against competitors on the basis of price terms or quality of our main services; and
• a prohibition on the unfair cross-subsidy of certain of our activities.

We must publish audited financial statements for the regulated "businesses" and "activities", in order to support the linkage of costs with interconnect prices and with a view to providing demonstrable evidence that we are neither behaving in a discriminatory fashion nor unfairly subsidising our activities. If it appears to the Director General that an unfair cross-subsidy exists between specified parts of our own business, we must take such steps as the Director General may direct to remedy the situation. The regulatory businesses for which separated accounts are currently produced are access, apparatus supply, network, retail systems, mobile, supplemental services and residual services. The Licence also contains provisions enabling the Director General to monitor our activities, including requirements for BT to supply him with information requested.

The Licence contains price control formulae, the overall effect of which requires us to reduce, or restricts the extent to which we can increase, the prices of many of our telephony services to the bulk of the residential market and also the prices for our interconnection services. In addition, the Licence contains certain specific restrictions on the terms on which we can trade. In particular, we are required to publish and adhere to standard prices and other terms for providing certain services and, in general, to apply uniformly a published scale of charges for installing residential exchange lines on premises to be served by a single line.

As a result of our international interests, a Licence condition prohibits us from doing anything, by act or omission, that would detract materially from our ability to meet our Licence obligations to provide UK telecommunication services and to do so to any standards specified by the Director General. BT's directors are required to submit an annual compliance certificate to the Director General.

The Director General may make modifications to a licence if the licensee does not object or the modification is deregulatory. Alternatively, changes to the licence may be referred to the Competition Commission. In either case, the Telecommunications Act requires public consultation before a licence can be modified. Licences may also be modified by legislation, including legislation implementing European Union directives into UK law.

European Union new Directives
In April 2002, the European Union adopted a new package of Directives for the regulation of electronic communications that will be implemented in all member states by July 2003. The new framework aims to be technologically neutral, to allow for reduced regulation as competition develops, to tailor regulatory rules and conditions to the minimum required to deal with identified problems, and to align the "significant market power" trigger for the regulation of specified market sectors more closely with the competition law concept of dominance (including joint dominance and leverage of dominance into related markets). The new framework also allows an enhanced right of appeal against regulatory decisions.

A Commission Recommendation will specify what markets should be analysed for the presence of players with significant market power. National Regulatory Authorities will be obliged to give the utmost regard to this, but will be free to depart from it if necessary. The Commission retains a veto over a limited set of National Regulatory Authorities' decisions in this area if they impact trade between member states.

Over the next 12 months, European National Regulatory Authorities will define markets and examine them for the presence of players with significant market power. Licences and licensing conditions will also need to be adjusted to comply with the Authorisations Directive, which calls for simpler and more streamlined general authorisation processes.

The Communications Data Protection Directive - originally part of the new framework, but now progressing separately - has not yet been finalised and may have cost implications for industry, particularly in the area of data retention.

Competition
Competition Act
In addition to telecommunications industry regulation, BT is subject to general competition law.

The Competition Act 1998, which came into effect in March 2000, brings the UK in line with European Community law by prohibiting anti-competitive agreements and concerted practices and the abuse of a dominant market position. In the case of telecommunications, the Director General of Telecommunications has concurrent investigatory and enforcement powers with the Director General of Fair Trading. They also have significant new investigative powers. Breach of the relevant prohibitions could lead to fines of up to 10% of turnover in the UK for each year of infringement (up to a maximum of three years) and/or result in claims for damages in the civil courts. There are also powers to order a company to cease an infringing activity.

There is a new statutory independent appeals mechanism for decisions under the Competition Act.

The competitive environment
The UK telecommunications market is fully open to entry and highly competitive. As a result, the UK Government and Oftel have indicated their expectation that it will be appropriate to move away from sector-specific (including licence-based) regulation to greater reliance on the Competition Act as individual markets become competitive.

In January 2000, Oftel published a strategy statement based on the principle that regulation should go no further than the minimum necessary to protect consumers. The strategy is underpinned by a programme of effective competition reviews, which are intended to ensure that the regulatory framework responds to changed competitive conditions: where it is found that competition is delivering benefits to consumers in the sectors reviewed, regulation will be reduced or withdrawn as appropriate. These reviews will need to be incorporated into the market reviews mandated by the new EU Directives, which will come into force in 2003. See "European Union new Directives".

Although it is some years since the Telecommunications Act abolished our monopoly in telecommunications, obligations placed on BT, including pricing regulation and the requirement to provide universal service, discussed below, are generally more onerous than for other licensees.

Pricing regulation
Fixed network
We are subject to price controls on our fixed network services in the UK at two levels: retail and network. Fixed network competitors are generally not subject to direct price controls, although there are some controls on mobile network operators.

Retail price controls
We are subject to two sets of UK retail price controls, one on certain public-switched telephony call charges and exchange line rentals, and one on certain private circuits. Each price control is based on a formula calculated by reference to the UK Retail Prices Index (RPI) and a factor, X.

For services covered by the controls, the weighted average of base prices cannot increase in each year beginning 1 August by more than the annual change in RPI minus X. In times of low inflation, the overall effect of this control requires us to reduce our base prices.

The retail price control for public-switched telephony, applying from August 1997 to July 2001 and extended to July 2002, is RPI minus 4.5. Although it is measured on services used by the lowest 80% of our residential customers classified by bill size, controlled base prices must be available to all residential customers. The price control formula and our performance against the formula are set out in the table below.

Price control formula (RPI-X)

		Years commencing 1 August
		1996		1997		1998		1999		2000		2001
% RPI movement for the relevant perioda		2.14		2.94		3.75		1.35		3.32		1.93
X in price control formulab		7.50		4.50		4.50		4.50		4.50		4.50
% required reduction in pricesc		(4.92	)	(1.56	)	(0.73	)	(3.15	)	(1.09	)	(2.44	)
% reduction in prices overall		(4.92	)	(1.56	)	(0.73	)	(3.24	)	(1.20	)	(2.73	)d
a Annual increase in RPI to previous June
b From 1 August 1997, the RPI formula covers the main switched telephone services provided to the lowest 80% of BT's residential customers by bill size
c After permitted carry forward of any unused allowance or shortfall from previous years
d Base price changes implemented up to 21 May 2002

Under the current controls, we have also given an assurance that a "control" price package will be made available to business customers. This package must have call charges no higher than the prices used for calculating adherence to the residential price control, and line rental increases no more than the change in RPI.

Under the price controls for private circuits that applied from August 1997 to July 2001, prices for domestic analogue and low-speed digital private circuits could not increase by more than the change in the RPI in any year. The application of the analogue price cap has been extended until July 2005 and the low-speed digital private circuits cap was removed in July 2001.

In addition, we are subject to a control on our retention for calls to O2 UK and Vodafone mobile phones. Our retention is defined by our retail price net of termination payments to the mobile operator. Under this control, applying from 1 April 1999 to 31 March 2002, our retention for calls to O2 UK and Vodafone cannot increase by more than RPI minus 7 each year. In February 2001, Oftel extended this control by four months until 31 July 2002, to be reviewed as part of the broader review of retail price controls.

Review of retail price controls
In March 2001, we accepted Oftel's proposal for a one-year extension of the current retail price controls of RPI minus 4.5 until 31 July 2002. Oftel said that it would consult again to determine whether there is sufficient competition to remove retail price controls from 1 August 2002. This further round of consultation began on 31 July 2001 with the publication of a consultative document by Oftel, Competition in the Provision of Fixed Telephony Services and continued with the publication on 31 January 2002 of Oftel's proposals in its consultative document Protecting Consumers by Promoting Competition. Under Oftel's major proposals in this latest consultative document:

• we would be required to provide a cost-based wholesale line rental product to competitors and new entrants at a regulated price and in a way that does not discriminate between our retail business and third party suppliers;
• for those services covered by the existing control, our prices to the lowest spending 80% of our customers would be pegged at their current level and not allowed to rise with inflation, using an RPI minus RPI price control. The services covered by the control would be extended to include our retention for calls to all four mobile networks, replacing the current separate control on BT for calls to Vodafone and O2 UK; and
• there would be a form of control at RPI plus 0 for some or all customers in expenditure deciles 3, 4 and 5, possibly achieved by an extension to the current Light User Scheme, which already has an RPI plus 0 protection within it.

In our response to Oftel submitted at the end of April 2002, we argued that considerably more retail de-regulation is possible going forward. Oftel's final proposals for retail price controls will be published in June, and we need to decide whether to object to these prior to the expiry of the current controls on 31 July 2002. If we object, the issues could be referred by Oftel to the Competition Commission, in which case the current retail price controls of RPI minus 4.5 would be rolled over for a further year from 1 August 2002 to 31 July 2003.

Network charge control
We operate under interconnection agreements with most other licensed operators.

A new network charge control period began on 1 October 2001 and will last for another four years. It requires us to set reasonable charges based on long-run incremental costs for our standard interconnection services. Depending on the degree of competition for these services, charges are cap controlled each year by RPI minus X (where X ranges from 7.5% to 13%) for services Oftel considers unlikely to become competitive in the near future; safeguard cap controlled (i.e. no increases above RPI during any relevant year of the overall control period) for services likely to become competitive; and those services considered fully competitive are not subject to direct charge controls. The network charge controls that ended on 30 September 2001 capped charges for services unlikely to become competitive in the near future at RPI minus 8.

We must publish a notification to the Director General and other licensed operators if we intend to amend existing charges or to offer new services.

Non-UK regulation
We must take account of the regulatory regimes in the countries in which we operate or wish to operate.

European Union
The European Union is pursuing a policy of progressive liberalisation and harmonisation in telecommunications. Since January 1998, the provision of infrastructure and all telecommunication services has been liberalised in the European Union. Specific directives imposed rules for, among other things, voice telephony, leased lines and interconnection, with particular emphasis on organisations with significant market power and with a common set of principles for licensing and enforcement. These have largely been implemented in national legislation. The European Commission reviewed progress during 1999 and 2000 and a new regulatory framework has been agreed. See "European Union new Directives".

Rest of the world
All of the markets in which we operate around the world are regulated, and in each we have to obtain licences or other authorisations and comply with the conditions of these. The degree to which these markets are liberalised varies widely: while many are fully open to competition, others place restrictions on market entrants, such as the extent to which foreign ownership is permitted, or on the services which may be provided. The extent to which the national incumbent operator is effectively regulated also varies considerably. Our ability to compete fully in some countries is therefore constrained.

Other significant changes and issues
Local loop unbundling
In April 2000, following consultation, we accepted an amendment to our Operating Licence which required us to provide unbundled local loops to other operators to enable them to provide telecommunications services, including broadband DSL-type services, to end customers. The amendment came into force in August 2000 with local loop unbundling to be available from July 2001.

The EU thereafter passed a Regulation requiring local loop unbundling, line sharing and sub loop unbundling to be offered from 30 December 2000, thereby bringing forward the implementation date. We published a revised standard reference offer on 29 December 2000.

During 2001, we offered line sharing as required by the EU Regulation. Oftel will determine the prices for the broadband frequency band of a shared loop after consultation and input by BT of relevant cost calculations.

On 20 March 2002, the European Commission announced infringement proceedings against five member states with regard to the Regulation on Local Loop Unbundling. This does not include the UK.

Carrier pre-selection
From 1 January 2000, the European Commission required the provision of carrier pre-selection (CPS) by Member State operators with significant market power. CPS allows customers to opt for certain classes of call to be carried by an alternative operator, selected in advance, without having to dial additional access codes.

Software changes to our local exchanges could not be introduced before January 2001 (for national and international calls) and January 2002 (for all other calls) and the UK Government applied to the European Commission for a deferment of our obligation. The European Commission granted a limited deferment until 1 April 2000, but decided that CPS should be provided in the interim by means of auto-diallers on customers' premises.

We introduced permanent CPS service in two phases, national and international calls on 12 December 2000, and all calls on 8 December 2001. Both phases were launched ahead of schedule, with interim CPS being withdrawn on the launch of phase 2.

Leased lines
Oftel published a Direction in respect of Partial Private Circuits (PPCs) in March 2001. This resulted from a review of the competitiveness of the national leased lines market in the UK and the need for regulation in this sector. Oftel concluded that more competition was needed in the provision of wholesale 'terminating segments' and required that we offer PPCs to other operators at cost-based prices. Following a period of industry negotiation on detailed terms and conditions for the new products, the PPC portfolio was successfully launched on 1 August 2001 encompassing 'local tails' leased lines at a range of bandwidths from 64kbit/s to 622Mbit/s. Take up of the new products by other licensed operators has been extremely rapid. Following subsequent requests from other licensed operators, Oftel has carried out investigations on a range of technical and commercial PPC-related issues, and is expected to announce the results of these investigations during Spring/Summer 2002. We are continuing to develop further enhancements to the initial product range.

Universal service
In August 2001, Oftel published the conclusions of its review of universal service (USO). We endorse Oftel's view that the time is not yet right to extend the USO to include broadband services. However, we are disappointed by Oftel's failure to acknowledge the strong case for industry funding of the significant net costs that fall on us in providing universal service. We remain committed to universal service.

Flat rate internet interconnection
On 26 May 2000, Oftel issued a Direction stating that we should provide an interconnection product under our licence for flat rate internet access call origination (FRIACO). The Direction requires us to provide call origination for internet access, not on the standard pence per minute basis but with charging based upon network capacity purchased. The Direction required us to offer FRIACO at the local exchange level from 1 June 2000. We complied with this Direction. In November 2000, Oftel began consulting on proposals to make FRIACO available at the next level up from the local exchange (at the digital main switching unit). A Final Direction on single tandem FRIACO was issued on 15 February 2001 requiring us to offer such a product, but with safeguards to prevent network congestion.

The charges for both FRIACO services are subject to RPI-X controls under the Network Charge Control regime.

UK Government's review of telecommunications and broadcasting regulation
The UK Government has completed a review of telecommunications and broadcasting regulation. A new regulatory body is being established, called the Office of Communications (Ofcom) to amalgamate the roles of the five existing regulatory agencies: the Director General of Telecommunications; the Independent Television Commission; the Broadcasting Standards Commission; the Radio Authority and the Radiocommunications Agency. Ofcom will be headed by a chairman and chief executive supported by executive and non-executive board members.

The legislation is being dealt with in two parts. The first stage is the Office of Communications Act passed in March 2002, which enables the board, office and budgets of Ofcom to be established, but does not enable Ofcom to exercise any regulatory functions. The second stage is a Communications Bill. The draft Bill was published in May 2002 and the final Bill is expected to be passed by Parliament by the Summer of 2003. It will confer regulatory functions on Ofcom, which will be able to take up those functions when the Bill is brought into force, possibly later in 2003. The main changes for telecoms will be the introduction of fines for breach of regulatory obligations and, in combination with statutory instruments to be issued by the Summer of 2003, the creation of a new regulatory regime to implement the requirements of the new EU directives for general authorisations, instead of individual licences. We support the Government's vision for the converging sector and welcome the intention not to apply broadcasting rules to internet content. We also welcome the provisions in the draft Bill for full rights of appeal against regulatory decisions, and the incorporation within Ofcom of incentives to reduce the level of regulation when appropriate.