Expert Report of Janusz A. Ordover and Allan L. Shampine September 24, 2012 I. QUALIFICATIONS AND QUESTIONS TO BE ADDRESSED ................................................................... 1 A. JANUSZ A. ORDOVER ....................................................................................................................................... 1 B. ALLAN L. SHAMPINE ........................................................................................................................................ 1 C. QUESTIONS TO BE ADDRESSED......................................................................................................................... 2 D. ACKNOWLEDGEMENT ...................................................................................................................................... 4 II. BACKGROUND ................................................................................................................................................ 4 III. ECONOMIC ISSUES OF CONCERN .......................................................................................................... 12 A. INCENTIVES FOR INVESTMENT ....................................................................................................................... 13 B. IMPACT ON EFFICIENCY AND QUALITY .......................................................................................................... 16 C. PRICING.......................................................................................................................................................... 21 D. INTRODUCTION AND REMOVAL OF PRODUCTS ............................................................................................... 25 E. NON-PRICE TERMS ......................................................................................................................................... 26 F. TIMING AND STRUCTURE OF THE SAU ........................................................................................................... 28 G. OTHER ISSUES ................................................................................................................................................ 30 IV. CONCLUSION................................................................................................................................................. 31 V. DECLARATION .............................................................................................................................................. 31 I. Qualifications and Questions to be Addressed A. Janusz A. Ordover 1. My name is Janusz A. Ordover. I am Professor of Economics and former Director of the Masters in Economics Program at New York University, where I have taught since 1973. During 1991-1992, I served as Deputy Assistant Attorney General for Economics at the Antitrust Division of the United States Department of Justice. As the chief economist for the Antitrust Division, I was responsible for formulating and implementing the economic aspects of antitrust policy and enforcement of the United States, including co-drafting the 1992 U.S. Department of Justice and Federal Trade Commission Horizontal Merger Guidelines. I also had ultimate responsibility for all of the economic analyses conducted by the Department of Justice in connection with its antitrust investigations and litigation, including economic analyses of collusion and other anticompetitive industry practices. I have written and consulted in the telecommunications sector and other network industries in the US, Australia, New Zealand, and in the EU on behalf of private parties as well as regulators. A copy of my curriculum vitae is attached as Exhibit 1. B. Allan L. Shampine 2. My name is Allan L. Shampine. I am a Senior Vice-President of Compass Lexecon, an economic consulting firm. I received a B.S. in Economics and Systems Analysis summa cum laude from Southern Methodist University in 1991, an M.A. in Economics from the University of Chicago in 1993, and a Ph.D. in Economics from the University of Chicago in 1996. I have been with Compass Lexecon (previously Lexecon) since 1996. I specialize in applied microeconomic analysis and have done extensive analysis of network industries, including telecommunications and payment systems. I am the editor of the book Down to the Wire: Studies in the Diffusion and Regulation of Telecommunications Technologies, and I have 1 published a variety of articles on the economics of telecommunications and network industries and on antitrust issues. I am an editor of the American Bar Association journal Antitrust Source. In addition, I have previously provided economic testimony on telecommunications issues on a variety of matters before the United States Federal Communications Commission and state public utility commissions. A copy of my curriculum vitae is provided as Exhibit 2. C. Questions to be Addressed 3. We have been asked by counsel for NBN Co Limited (“NBN Co”) to provide our advice on whether certain aspects of NBN Co’s proposed Special Access Undertaking (“SAU”) will provide appropriate incentives for, and constraints on, NBN Co over the term of the SAU. In particular, we have been asked to provide our expert opinion on whether, in the context of a vertically separated, wholesale-only network provider such as NBN Co, the proposed SAU is likely to lead to: Efficient investment in and use of the National Broadband Network (“NBN”), having regard to issues of network scope as determined by the Australian Government (e.g., fiber to 93 percent of Australian premises); An efficient level of costs associated with the construction and operation of the network; The maintenance of (or increase in) an appropriate level of quality in the supply of wholesale service to access seekers over the NBN; Pricing over the entire period of the SAU that is efficient and not anti-competitive with respect to its effect on downstream markets, subject to the requirements of the pricing of Reference Offers and uniform national wholesale pricing; Incentives for effective engagement between NBN Co and its customers in relation to the non-price terms of supply of its services; and 2 Incentives for efficient product development and withdrawal. 4. We have also been asked to consider the merits of the following elements of the SAU: The overall structure of the SAU, i.e., splitting out an initial regulatory period of ten years (the “Initial Regulatory Period”) from the subsequent regulatory period of twenty years (the “Subsequent Regulatory Period”) where substantial detail is provided for the Initial Regulatory Period and, for the Subsequent Regulatory Period, which is broken up in a series of three to five year SAU variations (the “regulatory cycles”), only the key principles are provided to be implemented; The SAU’s thirty year time frame; The adoption of later period regulatory cycles which are to be between three and five years; The switch to a “building block” period when initial costs have been recovered (i.e., when the Initial Cost Recovery Account is extinguished); The incorporation of an expectation that the net cash flows and beginning and ending values of relevant inputs such as the Initial Cost Recovery Account and Regulatory Asset Base for a particular Annual Building Block Revenue Requirement structure specified in later regulatory cycles will have a net present value of zero; and Implementing contract changes resulting from regulatory recourse by an access seeker only at the end of an existing executed Standard Form of Access Agreement, which are limited to two year terms. 3 D. Acknowledgement 5. With respect to this report, we have read, understood and complied with the “Practice Note CM 7: Expert Witnesses in Proceedings in the Federal Court of Australia” supplied to us by counsel for NBN Co – Webb Henderson. We agree to comply with the terms of the Practice Note. II. Background 6. Our opinions are based upon our specialized knowledge as economists, the economics literature as cited in the body of the report, and certain materials provided to us to consider by Webb Henderson. A complete list of the materials is attached as Exhibit 3. The materials provided by Webb Henderson are: NBN Co’s finalized SAU; The NBN Co Corporate Plan 2012 – 2015, dated August 6, 2012 (“NBN Co Corporate Plan 2012-2015”); ACCC Determination – Applications for authorisation lodged by NBN Co Limited in respect of provisions of the HFC Subscriber Agreement entered into with SingTel Optus Pty Ltd and other Optus Entities, dated July 19, 2012 (“ACCC Determination”); A Statement of Expectations from shareholder Ministers in the Australian Government to NBN Co, dated December 17, 2010 (“Statement of Expectations”); and 4 Background facts provided by counsel as set forth in the remainder of this section.1 7. NBN Co is a wholly-owned Government Business Enterprise (“GBE”) which will operate as a commercial entity and provide wholesale access to a layer 2 bitstream service on an open and equivalent access basis. NBN Co has been directed by the Australian Government to connect between 90 and 93 percent of Australian premises using fiber to the premises (“FTTP”) technology, initially supporting downlink speeds of up to 100 Mbps. The remaining 7 to 10 percent of Australian premises are to be connected through a combination of wireless and satellite technology with downlink speeds of at least 12 Mbps. 8. The Australian Government has also directed NBN Co to apply uniform national wholesale access pricing to its products. Uniform national wholesale pricing (“UNWP”) across all geographic areas is supported by an entry-level product tier with pricing and specifications independent of the technology platform over which it is delivered. NBN Co is also subject to stringent non-discrimination obligations. 9. NBN Co is a wholesale-only broadband service provider, prohibited by legislation from supplying services over the NBN to persons other than a carrier or service provider,and from owning or controlling a retail carriage service provider.2 10. NBN Co is not a legislated monopoly. However, there are the following legislative and structural conditions on other network carriers who currently own or will build 1. We have not been asked to opine on the specifics of the methodologies, such as the precise calculation of the Regulatory Asset Base or the price levels of the Offers, but rather on the economics of the overall approach. 2. NBN Co is, in limited circumstances, permitted to also supply directly to utilities. 5 fixed-line superfast access networks in Australia.3 First, NBN Co has entered into commercial arrangements with two of Australia’s largest telecommunications companies (Telstra and Optus) to retire their legacy networks (i.e., copper and hybrid fiber networks) which will facilitate migration of retail and wholesale customers for voice and broadband services to the NBN4; and while a new entrant could establish and operate a network to compete with the NBN, there is a statutory obligation which requires any new FTTP infrastructure to meet the technical specifications for the NBN and for all superfast broadband networks to provide access seekers with open and equivalent access to that network on a wholesale-only basis.5 11. Under the Competition and Consumer Act 2010 (“CCA”), NBN Co may provide the ACCC with a written undertaking in connection with the provision of access to a listed carriage service. On December 5, 2011, NBN Co submitted an SAU with the ACCC which contained detailed commitments to apply for a period of 30 years in relation to the service description, return on revenue, and price and non-price terms of access to the NBN (the “Original SAU”). 12. On December 20, 2011, the ACCC commenced formal consultation on the Original SAU as part of its assessment process but in June 2012 suspended further consultation in preparation for NBN Co’s submission of a revised SAU. In response to feedback from the industry and the ACCC, NBN Co has developed a revised SAU. References to the SAU are, unless otherwise noted, to the revised SAU. 3. A “superfast” network is a fixed-line network providing a download speed of greater than 25 Mbps. 4. We understand that Telstra’s hybrid fiber network will still be used to provide Pay TV services. 5. We understand that these obligations are set forth in sections 141-143 of the Telecommunications Act 1997 (Cth). 6 13. The SAU maintains a term of 30 years but utilizes an incentive-based modular approach which proposes different terms and conditions to apply for different periods, with varied levels of detail provided in each module. NBN Co’s proposed SAU is separated into a “Main Body” – which includes a number of general terms and conditions in relation to NBN Co’s SAU and which will apply for the roughly 30 years of the SAU6; “Module 1” – which specifies the detailed terms and conditions in relation to supply of services on the NBN for the initial roughly 10 years of the SAU (the “Initial Regulatory Period”)7; “Module 2” – which sets out both the high-level terms and conditions in relation to supply of the NBN (which provide continuity from Module 1) for the period which commences at the end of the Initial Regulatory Period and ends at the end of the SAU term (the “Subsequent Regulatory Period”) and certain detailed commitments in relation to the content of the variations to the SAU which NBN Co will submit as consecutive 3-5 year replacement modules throughout the Subsequent Regulatory Period. “Replacement Modules” are not included in the initial submission of the SAU but will be submitted as consecutive variations to the SAU immediately prior to commencement and throughout the Subsequent Regulatory Period to complement the principles contained in Module 2. These modules will contain a detailed set of terms and conditions in relation to supply of services on the NBN that will be assessed by the ACCC as part of the statutory review and acceptance process for SAU variations, and will apply for periods of between 3 and 5 years. 14. In addition to the modular approach described above, NBN Co’s proposed SAU comprises the following key features. First, a commitment by NBN Co to supply certain offers over the entire period of the SAU which would allow access seekers to supply end-to-end 6. The SAU is set to expire June 30, 2040. 7. The Initial Regulatory Period is set to run through June 30, 2013 but may be extended for one year under some circumstances. 7 services to their customers (i.e., “Reference Offers”, which are subject to periodic updating to maintain relevance), and a commitment by NBN Co to supply certain other offers at the commencement of the SAU, the withdrawal of which may only be undertaken in accordance with the withdrawal process set out in the SAU (i.e., “Non-Reference Offers”, which will be added to over time). Second, the specification of maximum prices in the SAU, which are to apply as initial prices to products that comprise the Reference Offers, until June 30, 2017; and the Non-Reference Offers, as at the commencement date of the SAU. Third, a price increase limit of CPI-1.5% per annum to apply to prices of all individual products throughout the roughly 30 year term of the SAU on a use-it-or-lose-it basis (except the prices of Reference Offers which are set in nominal terms until June 30, 2017).8 And finally, a principled approach to pricing of new products over the entire duration of the SAU whereby NBN Co is to have regard to a variety of factors, including the Government’s Statement of Expectations, uniform national wholesale pricing, market factors, existing prices and the importance of maintaining affordability to drive product take-up rates. 15. The SAU includes the adoption of a long term revenue constraint methodology (“LTRCM”) which is consistent with the “Building Block” revenue methodologies used by the ACCC and other regulators, as well as the establishment of an Initial Cost Recovery Account (“ICRA”) as part of NBN Co’s LTRCM that is a separate regulatory account which will 8. The individual price increase limit is specified as (1 + CPI) x (1 – 1.5%) – 1, but is referred to for simplicity in the remainder of the report as CPI – 1.5%. The two are roughly equal, but CPI-1.5% results in a slightly higher individual price increase limit (assuming positive CPI). As specified in the SAU, the effect of the individual price increase limit is that real prices (with some limited exceptions concerning time or time and materials based charges) must decline by 1.5% or more per year, subject to NBN Co not having to decrease its nominal prices. That is, if CPI is below 1.5%, NBN Co is not required to decrease its nominal prices. 8