NEWS ANALYSIS : Direct line to confusion

Last week British Telecommunications put its prices up and down on the same day. Transatlantic charges were cut by 20 per cent, while domestic rentals were raised by twice the inflation rate. Confusing it may have been - but in the increasingly ba fflingworld of the telephone call, it was par for the course.

To see how complex the world of the telephone is becoming, watch the advertisements. On television, a company called Energis has just finished a seven- week run of commercials telling us how it has strung phone lines between electricity pylons.

In the papers, an even less well-known company has been placing advertisements by the dozen. "Calls to the USA for only 20p a minute," says Swiftcall, trumpeting its ability to undercut international Mercury calls by up to 60 per cent.

And in all the media, spot the advertising campaign that is not running any more. Mr Grayson, Harry Enfield's creation for Mercury, has Brylcreemed his hair for the last time.

The telephone industry is going through an unparalleled upheaval, with new players arriving, existing ones making "strategic withdrawals", and price wars breaking out all over the place. For the consumer there is unmatched choice, but also unmatched potential for bafflement.

But as the battle reaches its height, it is possible to explain such apparent contradictions as BT's up-down move. The key is to see it not as one battle, but three. The local, long-distance and international markets are quite distinct: they have their own characteristics and their own winners and losers.

A dozen years ago, the market could hardly have been simpler. Wherever you called in the UK, you used BT. Abroad you would use it to link up with another monopoly provider, probably also state-owned. It was simple, but you also paid what BT wanted and accepted the service as it was.

In 1984 that started to change. BT was privatised and Mercury, owned by Cable and Wireless but encouraged by the government, started nibbling away at the giant's monopoly. In 1991 the competitive floodgates were thrown fully open. Cable television operators were allowed to provide telephone services (the UK is the only country where they can) and a variety of other companies decided that they, too, wanted to nibble at BT's famously adipose profits.

For the telephone user, all this competition seems like good news. According to BT, the average residential bill has fallen by 29 per cent since 1984, while business bills have tumbled by 51 per cent. But competition is only one driver; technological changes have played at least as large a part - without them it would have been almost impossible to introduce any real rivalry.

In the old days, the telephone network relied on vast numbers of electro-mechanical switches. Not only did they need many engineers to maintain them, they could not easily be connected to any other network. BT's monopoly was technical as well as regulatory.

Privatisation and deregulation coincided with a great shift to digital exchanges, which needed less maintenance and could also talk to other systems. That meant Mercury could offer a full residential network without having to put lines physically into houses. Instead, domestic customers pressed a button on their phone that told the local BT exchange to push the call on to the Mercury network.

Despite this, and Mr Grayson's advertising, Mercury was never very interested in residential customers. It concentrated on big customers, particularly in the City, and put fibreoptic cable - vastly more capacious than traditional copper - directly into their offices. This business was much more profitable, not least because Mercury did not have to pay BT local connection charges.

This cosily profitable arrangement continued until the 1991 Duopoly Review. Mercury skimmed some of the cream, but developing technology, combined with steady staff reductions, kept BT's profits in the stratosphere.

The review upset the apple cart by saying that anyone could apply for an operator's licence. National Grid, which runs the electricity distribution system, announced it would establish a long-distance national network, stringing optical fibre along its earth wires. Ionica, a Cambridge-based company with heavyweight industrial and financial backing, said it wanted to tackle the domestic market by beaming phone calls into homes by radio.

And Mercury found its two most lucrative markets under siege. In the City, MFS and Colt - both US-backed - moved in to skim as much cream as they could by offering sophisticated systems to dealing rooms, while a number of companies launched an assault onthe transatlantic market.

Transatlantic business had always been extraordinarily profitable. When BT was state-owned, the government told it to keep local call costs low, for social reasons, and to make up its losses on long-distance and, especially, international routes. That meant Mercury could undercut BT on these and still make generous profits.

It also meant there were opportunities for light-footed operators to scoop business away from both of them. Companies called "international simple resellers" leased capacity on transatlantic routes and sold it at a price well below Mercury's.

Swiftcall, founded in 1993 by the Irishman Tom McCabe, is typical. From its office by the Tower of London it runs an international exchange that routes calls round the world. Residential customers pay Swiftcall £20 plus VAT in advance, and are then givena pin number. Calls to the US cost 24p a minute (plus the domestic call rate, to get through to Swiftcall) compared with Mercury's 38p. The cost of the calls is deducted from the £20 pot, topped up as necessary.

Graham Milne, Swiftcall's marketing manager, says it now has 20,000 accounts and that its turnover quintupled during 1994. Before Christmas, Mercury responded to the threat by cutting the cost of daytime transatlantic calls for its largest customers from44p to 20p a minute. Last week BT cut its rate for all customers from 44p to 34p (all excluding VAT). But Mr Milne says they will have to do much more before Swiftcall is squeezed out of the market. "At 20p a minute we make a healthy profit and we have room to cut rates further."

Meanwhile, Mercury has been taking drastic action to defend itself against attacks that can only become fiercer. In early December it announced 2,500 job cuts, said it was pulling down its payphones and gave Mr Grayson the chop. In future, it said, it would sell its residential services through the cable television companies.

Cable companies were the biggest immediate beneficiaries of the 1991 review. US groups had moved into the UK cable market in the late 1980s, but had failed to convince the public that their offerings were better than satellite or the established channels. Some had offered telephony - but only as a connection to Mercury, which charged heavily for the privilege. BT would have nothing to do with these newcomers.

The review transformed the cable companies' prospects by allowing them to set up their own exchanges and provide a full residential phone service. They offered to put in lines for £30 or less (compared with BT's £90), and undercut it on both rentals and call costs. The only disadvantage was that subscribers had to change phone numbers.

The results were spectacular. There are now 750,000 cable telephone lines installed, against 312,000 a year ago; and 50,000 new lines are being installed every month. Seventy per cent of cable customers are now taking both television and telephone. Laterthis year the business will get a further boost when the requirement to change numbers disappears.

Cable companies are still little more than a minor irritant to BT, with its 26 million residential lines. But while competitive pressures are building in other sectors, BT is easing them in the home market. As part of its policy to "rebalance", or increase domestic rates as long-distance ones come down, it has for the last few years been putting domestic rental charges up by 2 per cent above the inflation rate - the most allowed by Oftel. This, it says, is because its domestic business is unprofitable:it is prepared to risk the greater competition higher prices will surely attract.

Ionica is more than content with this trend. It will be launching itself to the public later this year, and is aiming directly at the residential and small-business market. Rather than digging up roads and burying wires, however, it will beam calls directly to roof-top dishes by radio. Like the mobile networks, Ionica will build transmitting aerials across the country, which should mean it will be able to offer near-national coverage in a few years.

Nigel Playford, its managing director, believes there is plenty of room for Ionica and the cable operators. "Even if the cable companies win 15 per cent of the lines, that still leaves 85 per cent in the hands of BT," he says. His company will, he adds, always be able to undercut BT on new lines because its technology is cheaper, and will also aim to woo customers away with a range of new services. It will, for example, be able to put two lines into a home as easily as one.

Energis, the other newcomer, is launching itself into the long- distance market, where there is already fierce competition between BT and Mercury. It has strung more than 2,000 miles of fibreoptic cable between its pylons, and has been advertising simplyto tell the world it exists.

It is now focusing on business customers, charging similar prices to Mercury but, it hopes, distinguishing itself with its service. Businesses are, for instance, told how many calls they have "lost", or failed to answer.

Energis says it is on course to launch a residential service next year. It will give householders an "Energis box" that will automatically route long-distance calls on to its network. But, like Mercury, it will have to pay BT a connection fee. A spokeswoman denied industry rumours that it had decided not to go ahead with these plans because it thought BT's fee too high.

At the moment there is one clear loser in the telephone battle - Mercury - but it will be a while before we can say whether it has also lost the war. New fronts will be opened: for example, there will probably be a fight to win business from Internet users by offering greater "bandwidth" or line capacity. And new contestants will enter the fray. Consumers should benefit from the chaos: whether they think it is worth the confusion is another matter.