Interconnection pricing

APT Policy and Regulation Forum for the Pacific Honiara, Solomon Islands – 27th April 2010 – 29th April 2010

Ivan Fong – Telecom Fiji Limited

Introduction

• The provision of widely-available, affordable, reliable and secure ICT services will require substantial private sector investment

• Many countries in the Pacific are relying on competition to stimulate investment

• Markets are being liberalized to allow entry of new fixed, mobile and broadband service providers

Interconnection

• The physical linking of telecommunications systems in order to allow the users of one system to communicate with users of the same or another system

• An incumbent monopolist has little incentive to allow direct competitors to call or be called by its customers

• Commercial agreement may be difficult• Small changes in pricing have large $impact• Usually there is a mandatory requirement that competing

networks be interconnected• Regulatory framework may be an incentive to dispute

Each Carrier Must Interconnect

TFL

Carrier 2

Carrier 1

Carrier 4Carrier 3

Rationale for regulation

• Where there is market failure, • i.e. market is not effectively competitive, and the condition is

likely to remain intervention may be used to:– level the playing field– ensure appropriate investment signals and – protect consumers

• Regulators undertake tests to determine if there is Significant Market Power in the “market”

• If there are findings of SMP, then regulator has to decide whether to regulate or not

Terminating Access Monopoly

• Once a consumer has chosen a telecom provider, calls from the customers of all other networks must be delivered to that network

• The network operator effectively has a monopoly over the business of terminating calls to that consumer.

• The network provider can safely raise the price of terminating access above cost without risking losing significant market share

• Each network provider’s terminating service represents an effectively monopolized economic market

Customer

Network of Customer’s Provider

Network X

Network Y

Network Z

X

Setting Interconnection Rates

• How should regulators set rates?• The standard answer is through requiring that interconnection rates be cost-

based • Why?

– Efficient cost based pricing attempts to mimic competition;

– Pricing below costs is not sustainable;

– Pricing above costs not sustainable;

• Regulators sometimes consider other factors:– Benchmarking – what type of benchmarking?

– Impact on Competition

– Impact on Demand

– Social factors

Cost Modeling

• The preferred cost standard must be selected (historical v. forward-looking)• Data must be gathered and analyzed, and assumptions tested• The process can be expensive and is usually contentious and time

consuming• Nevertheless, forward-looking cost models designed to estimate “total

service long run incremental costs” (TSLRIC) are considered world best practice for estimating regulated firm costs

Model Method 1:Historical Accounting Costs

• Costs based on accounting records• Assignment of direct costs and allocation of common costs• Fully Allocated Costs (FAC) when all direct and common costs

are assigned and allocated• Uses existing network capacity and configuration• Replacement cost alternative

FAC Model Flow Chart

Costof

ServiceX

Cost of plant and equipment

dedicatedto Service X

Salaries and wagesof employeesdedicated to

Service X

Allocation of non-attributable firm-wide Costs

across all services

+ + +

+ =

Advertising andmarketing

dedicated toService X

Allocation of costs common

To ServicesX, Y and Z

Direct Costs

Indirect Costs

Historical Accounting CostsPros and Cons

• Allows company to recover past investments– essential in a developing economy– cost of Capital key

• May also be used to compute the access deficit charge (ADC)• Accounting records may misstate asset values • Poor record keeping – makes work difficult• Assignment decisions and allocation methods can have a dramatic effect on

costs• Can include operator’s inefficiencies• No credit for fully depreciated assets

Method 2: LRIC Cost Models

• Design a new, efficient network to provide the current array of services– adopt best in use technology– optimize switching and transmission network

• Cost out the hypothetical network• Identify interconnection and service costs• Regulators in many jurisdictions use LRIC models

LRIC Cost Definitions

• Long Run Incremental Cost– From a given level of output, the additional cost of providing an increment

of service– Typically does not include any overhead– Effect of spare capacity is to reduce LRIC

• Total Service Long Run Incremental Cost– The increment is the entire amount of a service from zero to current level– Will include “efficient” overhead– Ignores current network and focuses on network a start-up firm would build

(green field)

Interconnection Costing Example:Access and Local Calling Networks

Efficient firm common costs

Access Calling

IncrementalCost ofAccess

Switching and TransmissionCommon Cost

IncrementalCost of

TransmissionIC IC

Transmission

RSS Local

Switching

Direct

Indirect

TSLRIC Model Pros and Cons

• Considered best international practice • Provides economically efficient price signals• Competitive Market Standard• May be quite different than book costs• Usually lowers interconnection rates (not always)• Requires detailed studies of carrier costs – can be costly

Benchmarking

• Benchmarks look to rates that have been determined or set in other jurisdictions as a rough guide to the costs a full-blown economic model would generate

• Every country is different and finding a set of relevant benchmark countries can be difficult

• In general, the benchmark countries should not include those where rates may contain a monopoly element

• In so far as possible, the benchmark countries should be similar in terms of basic factors such as population, geography, market structure, market penetration, benchmarks based on regulated or unregulated prices, cost based benchmarks, non-cost based benchmarks etc.

• Benchmark analysis may be just as contentious as cost modeling – what is the right benchmark point to use?

Other Interconnection Pricing Alternatives Are Used

• Sender Keep All (Bill and Keep) – where traffic is relatively balanced

• Retail Minus • Revenue Sharing

Access Deficit and Universal Service Issues

• Requiring interconnection at cost-based rates will affect the incumbent’s retail price structure – in general this is a good thing

– one purpose of competition is to rationalize pricing structures to encourage economic efficiency

• Where the rate structure has been used to subsidize certain services to promote social goals such as universal service or low cost residential access, adjustments can be made but these arrangement should not persist

Access Deficit and Universal Service Issues

• Standard approach– separate subsidy mechanisms from interconnection pricing– require support for social programs from the widest possible

base• In low income countries it may not be possible to arrive at a rate structure

that both allows affordable access and cost recovery– these are difficult problems for regulators

• The use of cross-subsidy should be avoided to the greatest extent possible when designing mechanisms to encourage the proliferation of ICT services

Conclusion

• There is a significant role for regulators in promoting competition, ensuring efficient provision of services and maximum investment opportunities

• Regulation always has unintended side-effects• Excessive regulation will reduce investment• Excessive deregulation will cause uncertainty and reduce investment

Thank you