Regulation in the UK
It is our policy to be fully compliant with the regulatory framework in which we operate. During the 2004 financial year, we reviewed our compliance activities because we want to ensure that we continue to meet the obligations imposed by the UK’s Communications Act (previously the Telecommunications Act) and the Competition Act while competing fairly and vigorously within the rules. We have published an annual compliance report which can be found in our social and environment report at www.bt.com/betterworld.

Ofcom The UK regulatory environment changed materially in 2003. On 25 July 2003, the Communications Act 2003 (‘‘the Communications Act’’) came into force, bringing in a new regulator, the Office of Communications (Ofcom), and a new regulatory framework for electronic communications networks and services. Ofcom did not, however, assume its regulatory functions until 29 December 2003 and, in the transitional period, the existing regulators continued to carry out Ofcom’s functions relating to networks and services, and spectrum.      Ofcom was set up, as a result of the increasing convergence between telecommunications, broadcasting and radio, to provide a single, seamless approach to regulation across the whole converging marketplace. It amalgamates the roles of five former regulatory agencies: the Director General of Telecommunications (Oftel), the Independent Television Commission, the Broadcasting Standards Commission, the Radio Authority and the Radiocommunications Agency.      Ofcom is headed by a board consisting of a chairman and executive and non-executive members. Currently, the chairman is Lord Currie and the chief executive is Stephen Carter.      The main regulatory changes for providers of electronic communications networks and services are:
	the regulator’s ability to impose conditions without agreement
	the possibility of fines being imposed for breach of regulatory obligations
	the availability of appeals against regulatory decisions, based on their merits
	the creation of a new regulatory regime which, among other things, implements the requirements of the new EU Directives for general authorisations, instead of individual licences, and bases economic regulation on dominance, or ‘‘significant market power’’ (SMP).

Ofcom’s duties and powers
Ofcom has a wide range of general and specific duties laid down in the Communications Act. Below is a summary of those duties and functions of particular relevance to BT’s activities:

	the principal duty to further the interests of citizens in relation to communications matters and, secondly, to further the interests of consumers, where appropriate, by promoting competition. In doing so, Ofcom must secure, among other things, the availability in the UK of a wide range of electronic communications services.
	the duty to have regard to the principles under which its regulatory activities should be transparent, accountable, proportionate, consistent and appropriately targeted.
	the duty to review regulatory burdens on a regular basis and ensure that they do not involve the imposition or maintenance of unnecessary burdens.
	the functions of setting conditions of entitlement (see Regulatory conditions), and enforcing those conditions (see Enforcement). Ofcom’s decisions are subject to appeal on the merits (see Appeals).
In carrying out its duties, Ofcom must consider promoting competition and the use of effective self-regulation; encouraging investment and innovation; and encouraging the availability and use of high-speed data services (including broadband).

Regulatory conditions
Under the new framework, based on 2003 EU Directives, providers are no longer required to obtain licences before offering telecommunications services. Individual licences, such as that granted to BT in 1984, no longer exist. Instead, there is a general authorisation for anybody who wishes to provide electronic communications networks and services.
     Regulation is applied through separate sets of conditions made by Ofcom, of which some apply to all relevant communications providers and others are imposed individually on particular providers which, following a review of the relevant markets, are found to have SMP, or which are designated as ‘‘universal service providers’’. Other general obligations are set out in the Communications Act. The general and specific obligations that form BT’s regulatory environment are described below.

Conditions applying to all providers of electronic communications networks or services
General conditions
The foundation of the new regulatory framework is the set of general obligations referred to in the Communications Act as ‘‘general conditions’’. These apply to all providers of electronic communications networks or services, including ‘‘systemless’’ service providers and internet service providers. These general conditions are mainly concerned with consumer protection, but also address matters such as general access and interconnection obligations, standards, emergency planning and numbering. In addition, a separate condition has been set regulating the provision of premium rate services.

Electronic Communications Code conditions
The Electronic Communications Code deals with powers to carry out streetworks and similar activities for the purposes of providing networks and its application is subject to conditions made by the Secretary of State for Trade and Industry.

Other general obligations Other obligations corresponding to licence conditions under the old framework now apply directly through provisions of the Communications Act. These are:
	payment of administrative charges (broadly the equivalent of licence fees under the old framework)
	provision of information to Ofcom when required to do so.

Conditions applying to BT only
USO (universal service obligation) conditions
BT has been designated as the supplier of universal service for the UK excluding the Hull area, where Kingston Communications is the designated provider. The services covered by the USO are defined in an Order issued by the Secretary of State for Trade and Industry. Our basic obligation is to provide a single narrowband connection to the fixed telephone network, but additional USO conditions relate to issues such as schemes for consumers with special social needs and the provision of call box services.
     Ofcom is to carry out a fundamental review of the USO with a consultation expected in summer 2004 and a statement towards the end of the year. All aspects of the USO will be reviewed, including schemes for consumers with special social needs, disconnections, payphone provision, minimum data speeds, scope of USO and funding.

Significant market power (SMP) conditions and market reviews
The EU Directives on which the regulatory framework is based require member state national regulatory authorities (in the case of the UK, Ofcom) to define and analyse markets (‘‘market review’’) and to determine whether any communications provider has SMP, which is aligned with the competition law concept of dominance. Economic regulation can only be imposed following a market review and finding of SMP.
     In markets where Ofcom finds that a provider has SMP, it must impose appropriate additional obligations in the form of SMP conditions as specified in the Communications Act. These may include obligations to meet reasonable requests to supply certain services to other communications providers, not to unduly discriminate, and to notify price changes. In some cases, additional obligations relating to, for example, price control and regulatory accounting have also been, or will be, imposed.
     Under provisions in the Communications Act, conditions of BT’s former licence are kept in force as necessary pending the making of new significant market power conditions following reviews of the relevant markets. Where market reviews have not yet been completed in relation to services for which BT was formerly regulated, BT is accordingly still regulated under conditions of the former licence.
     In the UK, the majority of market reviews have been completed, although some are still in hand, and the local loop unbundling review has only recently commenced (see Other market reviews). The current status of the UK market review programme and its implications for and effects on BT are summarised below.

Narrowband market reviews
Five reviews of narrowband markets were concluded in November 2003. In four of these reviews, BT was found to have SMP in some or all of the markets concerned, and conditions were imposed accordingly, including price controls (see Pricing regulation), non-discrimination, publication of charges, terms and conditions, and the publication of a ‘‘Reference Offer’’ in relation to access services. While many of these obligations are similar in scope of application and severity to those which applied under the old regulatory regime, a number of changes have been introduced. Some of these are favourable to BT. For example, BT is no longer subject to SMP conditions in retail international calls made by business customers or in wholesale international services on country routes accounting for 95% of call volumes. In addition, BT was found not to have SMP in markets for wholesale unmetered narrowband internet termination. However, these reviews also produced some outcomes less favourable to BT: for example, Oftel’s proposal to require us to provide digital wholesale line rental products was confirmed.

Wholesale broadband access market review
The consultation period on this market review closed on 6 February 2004, and the publication of Ofcom’s final decisions is awaited. In the consultation document, Ofcom proposed that BT has SMP in markets for wholesale broadband origination and conveyance, and set out plans to impose a full range of SMP obligations.
     BT is required to pass margin squeeze tests in advance of any price change on some of the wholesale products in our broadband portfolio. Margin squeeze tests are designed to address a particular risk where a company with market power upstream is vertically integrated and sells an upstream input both to its own downstream operation and also to its downstream competitors. The test is to determine whether the company would be profitable in the downstream market if it had to pay the same price for the upstream input as its downstream competitors. This Direction has been continued pending completion of the market review, and margin squeeze tests are likely to appear as regulatory remedies in the event that BT is found to have SMP in broadband access.
     On 3 April 2003, Oftel began an investigation into BT’s proposed price change of the IPStream products, on the grounds that there might be a margin squeeze on the Datastream products (regarded by Ofcom as the upstream product). We agreed voluntarily to reduce the corresponding Datastream prices and, in May 2004, announced our intention to further adjust the prices to ensure there are adequate margins between Datastream and IPStream Home 500 (see Traditional services for wholesale customers).

SMP apparatus conditions
The Government has made provision in the Communications Act for Ofcom to review markets for terminal apparatus (eg telephones) and impose conditions on accounting methods, systems and separation, and to impose price controls in relation to hard-wired phones on any provider designated with SMP. Ofcom is considering whether to conduct a review of hard-wired telephones.

Enforcement
The Communications Act sets out the enforcement process to be followed in relation to breaches of conditions. Where a breach is not remedied following notification by Ofcom, Ofcom may take legally enforceable enforcement action and/or impose a penalty of up to 10% of relevant turnover. In addition, a person who suffers loss or damage as a result of the breach may, with Ofcom’s consent, sue for damages, and, in the case of serious and repeated contraventions, Ofcom may restrict or suspend the provider’s entitlement to provide electronic communications networks or services.
     The Communications Act contains similar enforcement procedures (though with much smaller penalties) for matters such as non-compliance with a request for information or non-payment of an administrative charge.

Appeals One of the main features of the new regulatory framework is that full appeals on the merits are now available against regulatory decisions. Consequently, appeals can be made against matters such as:
	SMP, SMP apparatus (see above) and USO designations
	the setting, modification and revocation of conditions
	enforcement actions, including the imposition of a penalty.
Any person affected by a decision may appeal to the Competition Appeal Tribunal. However, the Tribunal must refer on to the Competition Commission for determination any matters in any appeal which relates to price controls.       In an appeal by BT, the Competition Appeal Tribunal has ruled that it was wrong for Oftel to force us to supply mobile companies with the private circuits that connect their cell sites to their main networks more cheaply, on the basis that such circuits were interconnection, than we had done historically.

Competition
The competitive environment
The UK telecommunications market is fully open and highly competitive.
     Although it is some years since the Telecommunications Act abolished the monopoly of the former statutory corporation, British Telecommunications, obligations placed on BT, including pricing regulation, network access, non-discrimination obligations and the requirement to provide universal service, are generally more onerous than for other providers of electronic communications networks and services.

Competition and the UK economy
The growth of mobile over the last decade has been a major factor in shaping the UK’s telecommunications landscape. Mobile now accounts for approximately 30% of the total UK voice minutes. BT’s market share of the total UK voice market including mobile is estimated to be approximately 40%.
     BT’s share of the residential fixed-voice market, as measured by the volume of fixed-to-fixed voice minutes, declined to an estimated 70% in the 2004 financial year, compared with an estimated 73% in the 2003 and 2002 financial years. CPS has been one of the contributors to the loss of share in the fixed-voice market. We estimate that BT had 42% of the market for business fixed-voice calls in the 2004 financial year, compared with an estimated 45% and 49% in the 2003 and 2002 financial years, respectively.
     The estimated market shares are based on our actual minutes, market data provided by Ofcom and an extrapolation of the historical market trends.
     We also estimate that BT has supplied approximately 80% of exchange lines in the UK during the three years under review.
     The growth in cable operators’ networks in the UK has historically had an adverse effect on BT’s share of the residential market as a result of increasing competition from these cable operators. However, in the 2004 financial year, BT grew its residential customer base by 190,000. Current and future wholesale line rental arrangements will allow BT’s fixed-line customers to move PSTN lines to other operators which are expected to be the source of more competition in future.
     Since 2000, we have been required to provide other operators with the use of the lines connecting BT’s local exchanges to our customers and to other operators to install equipment in our exchanges (local loop unbundling) (see Other market reviews).

Competition Act
In addition to telecommunications industry regulation, BT is subject to general competition law.
     By virtue of provisions in the Competition Act 1998, UK competition law is in line with European Community law in prohibiting anti-competitive agreements, concerted practices and the abuse of a dominant market position. In the case of electronic communications, Ofcom has concurrent investigatory and enforcement powers with the Office of Fair Trading. Breach of the relevant prohibitions could lead to fines of up to 10% of relevant 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. A company may also be ordered to cease an infringing activity. There is an independent mechanism for appeals to the Competition Appeal Tribunal against decisions under the Competition Act.
     The Competition Appeal Tribunal is hearing Freeserve’s appeal against Ofcom’s decision in which BT was found not to have infringed the prohibition on abuse of a dominant position in relation to BT Openworld’s consumer broadband products.

Enterprise Act
The Enterprise Act 2002 aims to give more independence to the competition authorities, to reform insolvency and bankruptcy laws and to tackle trading practices that harm consumers.
     The key provisions of the Enterprise Act, including the new cartel offence and the section on director disqualification, entered into force on 20 June 2003. It is now a criminal offence, punishable by imprisonment or a fine, or both, to engage in cartel activity. In addition, where companies infringe UK or EC competition law, company directors can be disqualified from acting as such for a maximum period of 15 years.

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.

Price control formula (RPI-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. The current retail price control for public-switched telephony, applying from August 2002 to July 2006, is RPI minus RPI (ie the value of X is RPI and prices cannot increase). It is measured on services used by the lowest 80% of our residential customers classified by bill size. From August 2002, the services covered by the control were extended to include BT’s share of the revenue for calls to all four mobile networks, replacing the previous separate control on BT for calls to Vodafone and O₂. The price control formula and our performance against the formula are set out in the table above.
     Under the new controls, we have also given an assurance that increases in line rental for business customers will be no more than the annual 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. For all retail analogue private circuits and 8 Mbit/s digital private circuits, we have voluntarily given an assurance to adhere to a RPI+0% price cap from 30 June 2003 (ie applied retrospectively) until 30 June 2006.
     As part of the review of price controls in 2002, BT was required to provide a cost-based wholesale line rental product to other service providers at a regulated price and in a way that does not discriminate between BT’s retail business and service providers. This product (Wholesale Access) has been available from BT since 1 September 2002. Further consultation by Ofcom has resulted in an enhanced wholesale access product being available from 29 March 2004.

Network charge control
We operate under interconnection agreements with most other operators. The current network charge control period began on 1 October 2001 and will last for four years from that date. 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 Ofcom considers unlikely to become competitive in the near future; and safeguard cap controlled (ie no increases above RPI during any relevant year of the overall control period) for services likely to become competitive. Those services considered fully competitive are not subject to direct charge controls. Later in 2004, Ofcom will begin a review of the network charge control to determine what control should apply from 1 October 2005.
The main network price caps are listed below:      

Basket	X Factor in RPI – X formula		Duration
Call termination	10		30 Sept 2005
Call origination	10		30 Sept 2005
Tandem layer	13		30 Sept 2005
Safeguard cap	0		30 Sept 2005
Interconnect specific	8.25		30 Sept 2005
Local exchange FRIACO	7.5		30 Sept 2005
Number portability	5		31 July 2006

The number portability charge control runs from 1 August 2002 until 31 July 2006. The charges are controlled by a RPI minus X formula, with X set at 5%. Under the new regime, General Condition 18 requires all providers to offer number portability, among other things, on reasonable terms and for charges to be cost-orientated. Ofcom is currently consulting on proposals for Condition 69A, presently maintaining the number portability charge control, to be replaced by a non-binding undertaking from BT that we will continue to comply with its terms, including the RPI-5 charge control as though the provision was still operative until 31 August 2006.
     BT must publish a notification to Ofcom and other operators if we intend to amend existing charges or to offer new services. Notice periods range from 28 to 90 days for regulated services, depending on the degree to which they are judged to be competitive.

FRIACO
FRIACO (flat-rate internet access call origination) is a service that provides flat-rate charges for internet dialled access. On 21 July 2003, Oftel issued a Direction on the intelligent network component of the FRIACO price that required BT to delete this component from the charge retrospectively to 1 June 2002. BT incurred rebate payments in the 2004 financial year of around £16 million.

Wholesale access charge control
The charges for wholesale access services are also subject to price control. The charges for the line rental (residential and business products), line transfer and new line installations have been set by Ofcom and are subject to a price control of RPI minus 2%, effective from 1 September 2002 for four years. The control applies to the aggregate of all charges (rental, transfer and installation) as well as to line transfers separately. We are also under an obligation to notify Ofcom and service providers if we intend to amend existing charges. Notice periods range from 28 to 90 days, depending on the specific service.
     On 28 November 2003 Oftel published its statement on the fixed narrowband wholesale exchange line market. This statement contained new obligations on BT to provide business ISDN2 wholesale line rentals with cost-oriented prices. We must also provide residential ISDN2 and ISDN30 wholesale line rentals at retail minus prices. Furthermore, the wholesale ISDN2 business and ISDN30 products have to be provided in accordance with a functional specification defined by Ofcom. Ofcom is conducting an investigation into the prices of business ISDN2 wholesale line rental.

Non-UK regulation
BT must comply with the regulatory regimes in the countries in which we operate or wish to operate. The obligations placed on BT and our suppliers continue to be relevant to our business models and have cost implications for our end-user services. These rules are generally applied by national regulatory authorities operating under a government mandate. The impact of the decisions of these bodies can have a material impact on our business models from time to time.

European Union
The degree to which the European directives have been implemented varies by country. While 2004 should see a general move towards the new regime, in some countries the directives may not be fully implemented until 2005. In most, but not all, member states the primary legislation that will enable the introduction of the new regulatory regime is going through, or has been through, the legislative process. The processes of identification of operators with SMP and the subsequent setting of regulatory obligations on those operators are mostly in progress. The implementation process in Germany is notably behind that in other major member states.
     BT will not have universal service obligations outside the UK, although in certain member states we may be required to contribute towards an industry fund to pay for the cost of meeting universal service obligations in those countries. Any findings that BT has SMP in any non-UK market are not expected to have a material impact. We are lobbying the European Commission and other EU bodies with responsibility for electronic communications for consistent and timely implementation of the new directives and associated regulation.
The availability of cost-oriented access products from regulated incumbents remains an important element of our strategy around the world and we continue to press these incumbents, their national regulatory authorities and at EU level for such access. Their availability varies by country.

Rest of the world
The vast majority of the markets in which we operate around the world are regulated, and in the majority of these we have to obtain licences or other authorisations and to 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 restrictions on the services which may be provided. The extent to which the national incumbent operator is effectively regulated also varies considerably. BT’s ability to compete fully in some countries is therefore constrained.

Other significant changes and issues
Mobile call termination
In early 2003, the Competition Commission ruled that mobile termination rates were against the public interest and recommended one-off cuts of 15% in real terms before 25 July 2003 and RPI minus X cuts for the following two years (X = 15% for Vodafone and O2 and X = 14% for T-Mobile and Orange). (There are two types of mobile termination charge.)
	When a BT fixed-line customer makes a call to a mobile phone, we incur a termination charge payable to the mobile operator. This charge is incorporated in the cost of the call.
	When a customer of any mobile operator makes a call to another mobile network, this can pass through BT’s fixed network. In this case, BT passes the termination charge on behalf of the calling mobile network to the receiving mobile network.)
Oftel introduced changes to the mobile operators’ licences to implement the one-off 15% cut by 25 July 2003 and Ofcom is currently undertaking a market review of mobile termination rates to evaluate what, if any, controls should exist going forward. Ofcom’s latest proposals seek to implement the Competition Commission’s original findings.      The financial effect has been to reduce group revenues by over £200 million during the 2004 financial year. However, payments to mobile operators have reduced by exactly the same amount, leaving a neutral effect on profits.

Strategic Review of Telecommunications
During 2004, Ofcom will be carrying out a strategic review of the UK telecommunications sector and published its first consultation in April 2004. The review will be comprehensive, wide ranging and will assess the options for enhancing value and choice in the UK telecommunications sector while having regard to investment and innovation. Ofcom’s proposals will be set out in a report to be published before the end of 2004.
     The review focuses on five fundamental issues, relating respectively to: the key attributes of a well-functioning telecoms market for citizen-consumers; the achievement of sustainable competition; the possibility of a significant reduction in regulation; incentivising efficient and timely investment in next-generation networks; and the relevance of the issue of structural or operational separation of BT.

Funds for liabilities
Under conditions relating to the Electronic Communications Code, an electronic communications provider which has apparatus on or in the public highway is required to make financial provision to cover damage suffered by highway or other relevant authorities, resulting from works carried out by the communications provider, for the removal of its network, if necessary, in the event of the liquidation or bankruptcy of the company.
     The conditions require the company to provide Ofcom annually with a certificate that, in the company board’s opinion, the company has fulfilled its obligations to ensure the availability of the required funds.