TNAG-2247-FCO40-3230-Business-interests-in-Hong-Kong-Cable-&-Wireless-1991 — Page 143

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Given this situation, Hong Kong's policymakers face a number of fundamental issues. In particular:

1. Does the Government want to favour large users, who already enjoy good service and options, over residential and small business users? As discussed above, a second network would most likely lead to higher local tariffs, with a disproportionately large impact on less-well-off consumers. In other words, does the Government intend to abandon its long-standing social policy of ensuring universal telephone service at low rates? If so, why at this time? What would be the social

consequences?

2. Are subsidies to a second network justified when few improvements to service choice and quality will be achieved? We have pointed out that higher tariffs or some other forms of subsidy will be needed to make a new network viable, yet the scope for service improvement is limited because Hong Kong already offers broad product choice and very high quality service. We have also pointed

out earlier that significant economies of scale exist in local telephony, and that a second

network would be unlikely to match Telco's superior scale economies. Whether or not

large customers shift from Telco to a second network, Telco will have to invest essentially the same amount to maintain and upgrade its network and provide the backup service that users of the unproven second network will seek.

3. Would Telco's substantial commitment to invest in Hong Kong's telecommunications infrastructure be put at risk if a second network were to severely erode its profitability? If the Government were to allow a second

network yet insist on keeping Telco's local tariffs low, Telco's profitability would suffer and its shareholders might seek to reconsider the company's aggressive investment program - with potentially dire consequences for Hong Kong's telecommunications infrastructure. Similarly, shareholders will want to ensure that Telco is compensated adequately for continuing to invest in universal service at a time when it is losing revenue on overseas calls handled by a second network.

Also, Telco shareholders will want to ensure adequate compensation for allowing a second provider to have access to Telco's local network and customer base. As a second network will cover only a small portion of Hong Kong's 2.5 million customers, it will need to rely on Telco to deliver the bulk of its local calls. Thus, Telco will be providing

McKinsey&Company, Inc.

CONFIDENTIAL