Regulators are often tempted by interventions that look good in theory, but fail in reality. A prime example of this is trust in "accounting" or "operational" separation to resolve a concern that one part of a business might confer an unfair advantage on another. Ofcom was too timid when it allowed BT and Openreach to remain in the same company under functional separation.
This post examines the reasons why the Payment Systems Regulator (PSR) should be bolder from the outset with respect to the regulation of the infrastructure provider for the New Payments Architecture (NPA). Getting the regulatory approach right will create a clearer, simpler and cheaper regulatory environment that better supports competition amongst payment providers and protects consumers.
Risk mitigation key to the success of the NPA
The PSR has recently consulted on possible competition issues in the NPA arising from Pay.UK’s procurement process to select the monopoly provider of Core Infrastructure Services (CIS).1 This is the essential layer that almost every bank or payment service provider will have to interact with to process interbank payments and to offer overlay services. It is hence critical to fulfilling the ambition underpinning the NPA.
And there are very real competitive risks, as the PSR notes:
- Vertical issues, where the CIS provider could favour its own overlay services over those provided by independent competitors
- Horizontal issues, where the CIS provider could favour a payment system it has an economic interest in, which competes or has the potential to compete with the NPA interbank system
- Monopoly issues, such as lax control of costs or restrictive price / non-price conditions
It is encouraging that vertical competition issues and mitigation options feature prominently in the PSR consultation, given the importance of data and innovation for services provided over the CIS. Appropriate mitigation of these risks will be key to the success of the NPA.
The false allure of softer mitigation options
When looking at the regulation of infrastructure companies, regulators often face a lobbying barrage of warnings that greater integration is necessary to coordinate network investment and promote innovation. It might be tempting for regulators to start with a softer mitigation approach (such as accounting or operational separation), consider if it works, and review the need for stronger options a few years down the line (such as structural separation, or at least legal separation).
But the reality is that - sadly - softer mitigation options often fail to deliver, for example because these ignore or underestimate the porous nature of Chinese walls between business units, the incentives for career progression within a vertically integrated company or the powerful biases that corporate culture and human relationships can generate. Furthermore, it is often difficult for the Board and Executive team of a vertically integrated business to devise a coherent strategy that reconciles the preference of some shareholders for the stable long term returns of an infrastructure business with the preference of others for the more volatile returns of the services market.
Some industries, such as energy and railways, have long had structural separation of network monopolists, while others have resisted it. One clear example of the damaging effect of vertical integration comes from fixed telecommunications in the UK.2 The infrastructure provider Openreach has until recently remained part of BT, which also provides retail services in competition with other Communications Providers (CPs). Despite increasingly intrusive regulation, this limited separation (in accounting and operation terms) has failed to deliver:
- A fully competitive retail market: as pricing and quality of access to Openreach infrastructure frustrated the emergence of a level playing field, BT Retail continued to retain a high - and rising - share of residential and small business broadband connections (from 27.7% in 2009Q4 to 35.9% in 2017Q4).3 It is doubtful this growth came by way of fierce competition on the merits: by Ofcom’s own estimates, there was a gap of £4bn between BT’s returns and the benchmark cost of capital in the nine years to March 2014 4
- Investment and innovation, as the UK is playing catch-up to European and OECD peers in terms of full-fibre broadband connections 5
Ofcom itself recognised the failure of that soft separation arrangement, and its 2015/16 Strategic Communications Review concluded that legal separation was required.6 While this represented a step forward, recent experience shows it still did not go far enough: The annual report of the Openreach Monitoring Unit (July 2019 7 acknowledged material progress whilst highlighting ongoing concerns. These included a lack of transparency of BT oversight on Openreach’s board and persisting complaints voiced by the industry about Openreach’s conduct (e.g. confidential information being shared with the rest of BT, insufficient engagement on passive remedies to open up the network, fair and equal treatment of all competitors).
Getting the right regulatory approach for payments
The payment infrastructure appears to be even less suited than fixed telecoms to a soft mitigation approach.
1/ Competition risks are likely to be higher:
- The CIS is a more obscure access market for the general public compared to now essential broadband networks, and less public scrutiny means reduced reputational risk for the monopoly provider
- The payment infrastructure space is likely to be even more technically complex and dynamic than fixed telecoms. The regulator would find it more difficult to enforce the additional regulation required to support softer mitigation (e.g. equivalence of input, wholesale pricing and quality of service standards). Separation would reduce the dependence on detailed conduct regulation and would create a simpler regulatory environment for the PSR, Pay.uk and all other stakeholders involved
2/ The alleged benefits of a soft mitigation approach are less obvious:
- The capital employed for the CIS will be lower than for a national fixed telecoms network, this will reduce the scope of benefits arising from accounting separation in avoiding cross-subsidies or other price-related concerns
- It is likely possible to replicate knowledge and understanding that would arise from integrated service provision, e.g. via industry fora, governance rules and open API. Pay.uk has an important role to play in this respect
Stronger intervention might be clearer, simpler and cheaper
We would encourage the PSR to consider these factors in the round. It should seek to learn from the experience of stakeholders in other sectors. The PSR has shown themselves to be bold in the past, they may need to be so again. Being more decisive now could well reduce cost and improve outcomes for competitors and consumers more in the long run.
- Excluding the Hull area, where for legacy reasons the integrated provider is KCOM
- Paragraph 4.55, https://www.ofcom.org.uk/__data/assets/pdf_file/0021/63444/digital-comms-review.pdf