International Benchmark

Vertical integration: equivalence of treatment and models of separation

Vertically integrated operators with significant market power (SMP) may have incentives to discriminate in favour of their own retail services. For example, by applying better wholesale prices internally or by giving their retail services access to more or better information or systems.

National regulatory authorities (NRAs) may impose a non-discrimination obligation to prevent such behaviour. This obligation can be based on equivalence of inputs (EoI) or equivalence of outputs (EoO). EoI implies that exactly the same products, prices and processes are offered to competitors as to the SMP operator’s own retail arm. EoO means that the products offered by the SMP operator to alternative operators and to its own retail business are comparable in terms of functionality and price, although different systems and processes may be used.

To ensure compliance with non-discrimination, NRAs may also consider imposing some form of separation on the vertically integrated incumbent. When NRAs do so, they must ensure that the separation obligation remains proportionate to the identified competition problem.

In simple terms, the equivalence model adopted (EoI or EoO) sets out the level and form of non-discrimination protection available to competitors, whereas the model of separation should help to ensure the compliance and enforcement of the chosen equivalence model.

In the academic literature, Martin Cave defined in 2006 different models of separation, ranging from simple accounting separation to more complex ownership separation.

Martin Cave’s separation options (Cullen International)

Model of separation

Description

Accounting separation

Costs and revenues of upstream and downstream products are allocated in different baskets. Preserves efficiency of vertical integration but does not provide equivalence of access.

Creation of a wholesale division

The incumbent has a separate wholesale division which supplies upstream inputs to competitors. The retail arm still has a preferential way to access products. No equivalence of access.

Virtual separation

First form of equivalence of access, as internal and external customers are treated equally. No physical separation of the businesses.

Business separation (BS)

Physical separation of businesses and new business practices, e.g. new office location, new brand, separate OSS, separate management information systems.

Business separation with localised incentives

As BS but it also involves incentives for senior managers in the separated entity

Business separation with separate governance arrangements

As BS with localised incentives but it requires also the creation of a divisional board with non-executive directors independent of the group

Legal separation

Separate legal entities under the same ownership

Ownership separation

Separate legal entity with different ownership


In 2016, the UK national regulatory authority (Ofcom) published Strengthening Openreach’s strategic and operational independence. In that document, Ofcom identified eight possible models of separation to apply to the vertically integrated incumbent BT.

Ofcom’s models of separation (Cullen International)

Model of separation

Description

Accounting separation

Separate financial reporting, with costs and revenues of the upstream and downstream products allocated into different baskets

Creation of a wholesale division

A separate wholesale division established to supply inputs to competitors but without equivalence of access

Virtual separation

Services offered to internal and external customers on equal terms, without any physical separation of the businesses

Functional separation

Physical separation of the business and its processes, e.g. location, staff, branding, management information systems

Functional separation with local incentives

Functional separation with separate governance and different management incentives to those of the wider firm

Functional separation with independent governance

Creation of a divisional Board with non-executive members who act independently from the group Board

Legal separation

Upstream business is established as a separate legal entity within the wider group but remains under the same overall ownership

Structural separation

Split of the vertically integrated operations into separate legal entities, with no significant common ownership and ‘line-of-business’ restrictions to prevent them re- entering each other’s markets

 

Under European law, the EU 2009 regulatory framework introduced separation as an "exceptional" regulatory remedy that might be imposed by NRAs, differentiating it from the standard remedy of accounting separation set out in the Framework Directive. The EU 2009 regulatory framework also provides for the possibility of voluntary separation by an SMP operator. The two procedures are set out in articles 13a and 13b of the Access Directive.

Article 13a of the Access Directive gives to the NRAs the power to impose functional separation when they have demonstrated that it is the only way to achieve competition in the market after all other remedies from the regulatory framework have failed.

 

However, the term functional separation as used under European law is quite flexible and this flexibility can cause some confusion when seeking to clarify the different models of separation used. In particular, article 13a seems to incorporate different models of separation that can be imposed by an NRA, including both the creation of an independent operating business entity and legal separation. However, article 13a of the Access Directive, as further clarified by the BEREC Guidance on functional separation of 2011, does not refer either to accounting separation (a standard remedy under article 13 of the Framework Directive) or to structural separation, which could be in principle be imposed under competition law (by the national competition authority).

Even if structural separation cannot be mandated by NRAs as an “exceptional” remedy under article 13a, vertically integrated operators can propose it voluntarily under the procedure set out in article 13b of the Access Directive.

The terms of articles 13a and 13b are carried over to the new EU regulatory framework in articles 77 and 78 of the European Electronic Communications Code of 17 December 2018. These articles contain the provisions on functional and voluntary separation in very similar terms to those set out in the Access Directive.