on 27 February 1998
ITEM FOR FINANCE COMMITTEE
HEAD 106 - MISCELLANEOUS SERVICES
New Capital Account Subhead "Cash compensation for early termination of exclusive telecommunications licence"
Members are invited to approve a new commitment of $6.7 billion million for payment of cash compensation to Hong Kong Telecom International Limited for the early surrender of the exclusive telecommunications licence.
We need to make cash compensation to Hong Kong Telecommunications International Limited (HKTI) as part of the agreement with its parent company Hong Kong Telecommunications Limited (HKT) for surrender of the exclusive telecommunications licence granted to HKTI Telecom International Limited (HKTI), ahead of the expiry of the licence in 2006.
2. The Secretary for Economic Services proposes to create a new commitment of $6.7 billion for cash compensation to HKTI for early surrender of the exclusive telecommunications licence granted to it under the Telecommunication Ordinance.
3. Government granted HKTI a licence under the Telecommunication Ordinance (Cap. 106) in 1981, which provides it with exclusive rights for certain external circuits and telephone services. The licence is not due to expire until 30 September 2006. These exclusivities are out of line with the best current international practices and have adverse implications on our regional competitiveness both in telecommunications and services generally. With these considerations in mind, Government has negotiated and signed with HKT, the parent company of HKTI, an Agreement a which will, subject to Members' approval of certain aspects of it, result in the early surrender of the HKTI licence. For the Agreement to become operative, a condition precedent is that the appropriation procedures for compensation, with an after tax value to HKTI of $6.7 billion, are completed. After satisfaction of all the conditions precedent set out in the Agreement, HKTI will surrender its licence on 31 March 1998 in return for two equal payments of $3.35 billion, the first on 31 March 1998 and the second on 1 July 1998.
4. The HKTI licence contains exclusive rights valuable to the company. We have liberalised international telecommunications services as much as we can within the constraints posed by the licence. We have permitted call-back services, virtual private networks and International Simple Resale (ISR) of facsimile and data. But the exclusivities over the core IDD services and public circuits remain. For routes over which call-back is not permitted (including those to the Mainland, which comprise 49.8% of all external traffic) competition is very limited and consumer prices have not reduced significantly. On call-back routes HKTI has benefited, despite the additional competition, from the carriage of the additional traffic which call-back has generated. The HKTI licence is a distortion in the Hong Kong telecommunications market, and deprives consumers (residential and business alike) of choice and price reductions. It reduces the opportunities of telecommunications providers to offer alternative products and full service, and harms Hong Kong's overall competitiveness through higher prices and lack of choice.
Agreement with HKT
5. In the conditions which apply in the Asia-Pacific region today, the HKTI licence is an unnecessary barrier to Hong Kong's competitiveness. As a matter of policy the Government does not renege on licences which it has granted as to do so would create an unacceptable precedent and undesirable uncertainties for holders of any Government licence issued. To resolve the HKTI licence satisfactorily, we negotiated with HKT the early surrender of the HKTI licence on a "willing buyer, willing seller" basis. These negotiations have resulted in the Agreement which was executed by both parties on 20 January 1998. The essential components of the Agreement are as follows -
The Financial Model
- HKT will surrender the HKTI licence on 31 March 1998 with external services-based competition beginning on 1 January 1999 and external facilities-based competition beginning on 1 January 2000 (at which date the last remaining exclusivities in telecommunications will expire);
- the Telecommunications Authority will amend the Fixed Telecommunication Networks Services (FTNS) licence given to the Hong Kong Telephone Company (HKTC), also a subsidiary of HKT, to encompass external telecommunications services and circuits, and lift the structural separation hitherto enforced on HKTC and HKTI;
- subject to approval of the Provisional Legislative Council (PLC), the statutory price control arrangements for HKTC through the Telephone Regulation will be lifted, and in its place HKTC will be permitted a phased increase in the ceiling on residential exchange line tariffs (subject to improved market contestibility and market discipline in prices), increases in business exchange line tariffs (subject to market pressure) and to maintain (subject to a review in early 2000) the CPI(A) - 4% cap on the other services currently so restricted b; and
- subject to Finance Committee's approval, Government will pay HKTI cash compensation of $6.7 billion (net of tax) in two equal tranches on 31 March and 1 July 1998.
6. In order to assess fairly the financial impact on HKT of the early surrender of the HKTI licence and to estimate the corresponding tangible benefits, the Government constructed, with the assistance of a consulting firm, a financial model of the fixed external and internal telecommunications market in Hong Kong. The model c establishes a "base case" which assumes the development of the telecommunications markets without the surrender of the HKTI licence until 2006. It takes into account the continuing impacts of the liberalisation which do not break HKTI's exclusivities (call-back, ISR of facsimile and data, etc.) and considers international developments in accounting rates and natural market expansion. The cumulative Net Present Value (NPV) of the net cash flow of HKTI and HKTC is then calculated until 2006.
7. The financial model constructs, in parallel, a "liberalisation case" which does the same for the liberalised market. It adjusts for price changes in the market and stimulation in the market as lower prices increase demand. It also considers redistribution of traffic among the competitive operators and the different forms of services. For instance, from costing data it is clear that ISR of voice will be cheaper, and of better quality, than call-back services. The price of call-back services will rise as the current below-cost contracts between Hong Kong and overseas operators fall to be renegotiated. The model, therefore, migrates call-back customers to ISR on the routes where this is allowed.
8. The model also takes account of market share loss by HKTC as more customers switch to other FTNS operators which would also provide full external service products, and as the accelerated opening up of HKTC's existing local access network to its competitors under the Agreement starts to take effect. From the model we estimate the net reduction in HKT's cashflow of the "liberalisation case" over the "base case". Similarly from the model we obtain the net savings in consumer payments. Sensitivity tests have been conducted on the model and the results show the financial impact on HKT will be in the range $12 billion to $20 billion (NPV). The most probable level of the impact on HKT is towards the middle of the range.
9. The tangible economic benefits which we estimate will result from this Agreement amount to $17.1 billion (NPV) comprising $14.8 billion (NPV) in IDD reductions and $2.3 billion (NPV) in leased circuit reductions. Given our estimate of the size of the external services market in the base case to 2006 of $106 billion (NPV), the reductions posited are of the order of 16%. These are conservative figures and, given the actual costs involved (e.g. ISR based services would give comparable profit margins to call-back services even at a lower price to the consumer) we may well see greater tangible benefits than we are estimating.
10. We estimate there will be considerable intangible economic benefits arising from the Agreement, and that these are likely to exceed the tangible benefits in their value for Hong Kong's future prosperity. Key intangible benefits include -
- Greater consumer benefits
Flowing from competition in terms of increased choice, new services, innovation, etc.
- Increased competitiveness for the Hong Kong economy
A wider variety of more efficient telecommunications services will benefit Hong Kong's entire services sector as this is underpinned by telecommunications.
- Increased attraction for Hong Kong as a telecommunications hub and regional business location
Telecommunications figures highly in business decisions about the location of regional headquarters. Improving telecommunications will favour Hong Kong in taking such decisions.
- New investment and new employment
The Agreement will give rise to considerable further investment in telecommunications. Already we are seeing announcements of such investments (see paragraph 11 below). The additional regional headquarters will also generate investments and jobs outside the telecommunications sector.
- Positioning Hong Kong as an Information Society
Government's vision is to make Hong Kong a leader not a follower in the Information Age. To meet this objective, we need to maximise our Information Infrastructure to ensure it is economically efficient. The Agreement provides the right environment for this. It is this intangible benefit which could prove to be the greatest single bonus to Hong Kong of the Agreement.
11. It is our view that the Agreement is a good deal for Hong Kong and is a major step forward in transforming and stimulating our economy as it moves to meet the challenges of the Information Age. For this we need diversity of telecommunication suppliers, products and routes. Already we are seeing, in anticipation of the approvals necessary for the Agreement to go forward, movements to make the necessary large-scale investments. One FTNS operator has recently announced its forecast investments of $8 billion and the creation of 1 000 jobs directly (and at least that number indirectly) as a result of the Agreement to surrender the HKTI licence early.
12. There are three elements to the compensation package within the Agreement. These are -
- Cash compensation
$6.7 billion net of tax to HKTI
- Waiving of royalty from 20 January 1998
The waiving of royalty will mean revenue forgone of around $3.1 billion (NPV) on the part of Government. This is the amount HKTI would have paid had it retained its exclusivities until 2006. In a liberalised environment, this revenue forgone is partitioned between the competitive external telecommunication providers in proportion to their share of external revenue. As we are forecasting that HKT's market share in a competitive market would fall well below 50%, HKT's share of the revenue forgone and hence the compensatory amount will be far less than $3.1 billion (NPV).
- Rebalancing of local residential exchange line tariffs (in return for accelerating the opening up of the HKTC network to greater competition)
HKT will be subject to price caps on the pace of rebalancing as set out in the Agreement. The Agreement requires the HKTC network to be opened up to its competitors such that at least 50% of residential exchange lines are available to them by 1 January 1999. With greater competition as its competitors gain access to more exchange lines HKT will face substantial competitive disciplines in trying to increase prices up to the price caps. Even if HKT could price up to the price caps the maximum impact on consumers of rebalancing is estimated at $3.4 billion (NPV). Not all of this impact would accrue to HKT as its competitors would gain a significant amount in proportion to their market share and tariffs. The Agreement, taken together with the regulatory obligations, provides considerable consumer protection in the event of increases in local exchange line tariffs. For example, the existing flat rate local charging system is locked in place and HKTI will not be able to discriminate in its charges between those consumers with a choice of residential line supplier and those without choice.
13. The total cost to the community of the Agreement is a maximum of $13.2 billion, well below the tangible consumer benefits of $17.1 billion (NPV). HKT will not be able to realise all of this as some will accrue to its competitors. We estimate the amount HKT will realise in compensation will not exceed the lower bound of our valuation range for the licence of $12 billion to $20 billion (NPV).
14. The foregoing has demonstrated that the Agreement reached with HKT is a reasonable one and a good deal for Hong Kong. The sum of $6.7 billion to compensate HKTI is an essential component as it will enable us to obtain an early surrender of the HKTI licence and allow us to license competitors in sufficient time to have effective competition starting from 1 January 1999. The total compensation package for HKT is only about 6% of HKT's market capitalisation despite the fact that HKTI accounts for more than 30% of HKT's annual profit after tax ($3.7 billion out of $11.2 billion in 1996-97). The amount of cash compensation was arrived at after consideration of the financial models and through negotiations. As such it is part of an overall package for the resolution of the HKTI licence. If any one part of the package fails then the whole Agreement fails. If the whole Agreement fails, the HKTI licence with its exclusivities will remain in place until 30 September 2006. Consumers will be paying an additional $17.1 billion (NPV) for the external services, with no choice on a number of routes, less choice on the other routes and a reduced choice of technology. Non-surrender of the HKTI licence would bring reduction in Hong Kong's competitiveness, less investment and fewer quality job opportunities as Hong Kong falls to the back of the pack in the race to become the premier telecommunications hub and leader of the Information Age in the Asia Pacific region. Benefits of such failure will be small to consumers - royalty payments will resume and there may be some delay in increasing local exchange line rentals towards cost, but the latter is inevitable as it is not realistic to expect the below-cost environment to be sustainable. There will be no benefits to telecommunications companies except possibly the HKT group.
15. All in all, we now have a unique opportunity to liberalise the last monopoly in Hong Kong's telecommunications. Significant benefits will flow from the Agreement.
16. We propose the creation of a non-recurrent commitment of $6.7 billion to meet the cash compensation payment. The Commissioner for Inland Revenue has advised that the exclusive telecommunications licence to HKTI is regarded as a capital asset of the company, and compensation to be payable to it by Government for the early surrender of the licence is of a capital nature which is not chargeable to profits tax under the Inland Revenue Ordinance. The question of grossing up the commitment to ensure receipt of $6.7 billion net of tax by the HKTI therefore does not arise.
17. Subject to Members' approval of this proposal, we will pay the compensation to HKTI in two equal instalments of $3.35 billion on 31 March 1998 and 1 July 1998 through supplementary provision under delegated authority.
18. The background to the Agreement is given in Enclosures 1 to 3.. We briefed the PLC Economic Services and Information Policy Panels at a joint meeting on 9 February 1998.
Economic Services Bureau
(a) Full text of the Agreement is at Annex A to the Provisional Legislative Council Brief "Resolution of the Licence of Hong Kong Telecom International Limited" issued on 20 January 1998, now reproduced at Enclosure 1.
(b) Details are set out in PLC Brief, "Telephone Ordinance (Chapter 269) Telephone (Repeal) Regulation 1998" issued on 6 February 1998, now reproduced at Enclosure 2.
(c) Details are set out in the PLC Supplementary Brief "Surrender of the HKTI Licence, Financial Modelling and Fair Competition" issued on 27 on January 1998 , now reproduced at Enclosure 3.