Interconnection Theory & Benchmarking

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Interconnection Theory & Benchmarking

Dr. Christoph Stork


Termination Rates: Monopoly


Termination RateMonopolies require price regulation Termination rates at cost of efficient operator

Incentives to invest in new technologies to reduce costs and expand product offerings Promotes competition Promotes economic efficiency Promote universal service by encouraging rapid uptake through low retail prices

There exists no alternative economic concept to cost base for monopoly price regulation

New Entrant

IncumbentMobile

Operator

Benefit of size: Off-net Price > On-net price = expensive to be called for people of smaller network (Initially, mostly on-net calls, after switching mostly off-net calls)

New entrant needs to compete with its off-net prices with the on-net prices of incumbent to gain market share


Above cost MTR -help dominant to avoid competition pressure

Preventing smaller operators to compete with their off-net prices with own on-net price (Namibia MTR >on-net price) High off-net prices of dominant mobile operator makes it expensive to be called for people changing to new entrant or smaller operators Generating club effects with high on-net / off-net price differentials Possible consequences are: traffic imbalance, net termination payment outflow of new entrants and fixed-line networks


Termination Rate - Too LowBelow cost recovery of terminating network Arbitrage traffic routing may result in undesirable economic outcomes (France: Bill and Keep)


Dominant Operators will argueThey use termination revenue to subsidise access and usage (Two sided market or waterbed effect argument) If MTRs are lowered:

Retail prices will increase There will be less subscribers Operators will invest less

However, the opposite is the case Increased competition leads to lower retail prices and more subscribers Operators have to invest more to stay competitive

Profit from off-net calls increases with lower MTR (MTR = wholesale cost)

Pass on MTR reductions to subscribers = lower off-net prices more traffic Off-net constant = operator makes more money for each outgoing minute, same traffic

Profitoffnet = (Pownoffnet −MTR −Costorigination )*Qoutgoing

Qoutgoing = f (Pownoffnet )


Profit from termination (MTR = wholesale revenue)

Incoming minutes depend on off-net price of other operators MTR limits the off-net price of other operators downwards

Profittermin ation = (MTR − cos ttermin ation ) *Qincomin g

Qincoming = f (Potheroffnet )


Cash Flow Issue Net Termination Payment

Balanced traffic: MTR reduction revenue neutral However traffic often not balanced hence termination net payments

dominant operator can set off-net prices very high eg different user profile use of Please Call MEs

Nettermin ation = MTR * (Qincomin g −Qoutgoing )


Traffic imbalance 2008/09(minutes)


High MTR = subsidisation within the sector

No funds from outside the sector Why should subscribers of one network subsidise subscribers from other networks? Why should one operator be given a subsidy to role out network infrastructure at the expense of another operators?


South AfricaNamibiaSenegal

BotswanaEthiopia

Côte d'IvoireBurkina Faso

BeninGhana

Zambia*Kenya

CameroonMozambique

TanzaniaUgandaRwanda 0.1

0.30.9

1.71.82.32.42.6

4.64.74.8

7.611

11.717.4

18.2

High MTR = active contribution to fixed-mobile substitution

% of households with a working Fixed-line TELEPHONE at home


Two sided market ArgumentInterdependent prices: Price are being determined interdependently, ie changing the price for the one side will change the price of the other side No cost causation: No direct link between incremental cost for a good or service and the price


Readers Newspaper Advertisers

Newspaper - lower price per newspaper = more readers and higher advertising revenue per page

However, few high income subscribers could be better than many low income subscribers for advertising revenue (New Yorker eg) Advertisers have a choice where to place an add (competition), while call termination is a monopoly


Two-sided market would predict

MTR OFF-Net

Fixed

Down

Up

On-net

Up

Up Less Subscribers


Relationship between wholesale price and retail prices to not constitue a two-sided market

Prices are not Interdependent. There exist no unidirectional relationship between termination rates and retail prices Reduction in MTR affects net-payer and net-receivers differently

Cost causation is clear for off-net calling prices


Argument 1 Wholesale Price: contractually fixed Retail Prices: Many prices varying product by product and change frequently

MTROn-Net

Peak

On-Net Off Peak

On-Net Off Off Peak

OFF-Net

Peak

OFF-Net Off Peak

OFF-Net Off Off Peak

Fixed Peak

Fixed Off Peak

Fixed Off Off PeakOn-Net

SMS

OFF-Net SMS

Product 2

Product 1

Product 3....


Argument 2 Termination rates are mostly symmetrical ... contradicts the two-sided market argument

If Asymmetry then smaller has higher MTR MTR cannot be increased because of higher market share (newspaper

Operator 1

Operator 2


Argument 3 MTRs are wholesale costs and wholesale revenue at the same time

Reductions in termination revenues at same time as reductions in termination expenditure Who benefits from termination rate reductions depends on many factors

Generally net-payer pay less and net-receiver receive less However, net-receivers may also receive more as shown for Vodacom South Africa


Argument 4 Operators have a choice to pass on MTR reductions - no automatism

MTR reductions can be passed on to subscribers = lower off-net prices Should it not be passed on, then the operator makes more money for each outgoing minute Concrete choices an operator to maximise profits No automatic response in retail prices to changes in termination rate Retail prices are complex and diverse and pricing strategies are driven by user profiles and market niches, not by revenue replacement

p=x+a Off-Net

Price

Operator 1

q=f(x+a) subject to price elasticity of

subscribers of operator 2Quantity of calls

terminated

Operator 2

Argument 5 Operators can only set their own retail prices but not those of other operators... Cannot control q and p

The consequences of own choices depend on the decision of others.


Argument 6 Price interdependence has to work both ways

If termination rates and retail rates were interdependent, then one would also be able to observe increases in termination rates while retail prices decrease Interdependence of prices has to work in both directions If lower termination rates lead to higher reatil prices, why has no one suggest to increase the arbitrarily set terminations rates MTRs of US 5$ leading to free calling and data?


Argument 7 Termination rate payments are payments between operators

The industry consists of net-payers and net-receivers of termination rate payments Termination could not be a two-sided market for net-receivers and an ordinary market for net-payers Net payers will benefit directly from lower termination rates and may set their prices in response differently to net-receivers The link between MTR and retail prices could not possible be two sided for some and one-sided for other operators


Waterbed Effect ArgumentPredicted outcome of a Two sided market The waterbed effect describes a situation where if mobile termination rates go down, some other prices need to go up, usually usage and access prices Speculation about the pricing behaviour of mobile operator Assumes that all operators react the same way (even net interconnection payers) Assumes operators base their decisions on revenue replacement rather than profit maximisation


Cost

of O

ECD

bas

ket i

n U

S ce

nts

0

1000

2000

3000

4000

Mobile Termination Rates 2009 in US cents

0 5 10 15 20 25

OECD countries: Mobile termination rates versus cost of usage (source TMG2010)


OECD countries: Mobile termination rates versus minutes of use (source TMG2010)

Min

utes

of u

se

0

125

250

375

500

Mobile Termination Rates 2009 in US cents

0 5 10 15 20 25


Interconnection Benchmarking

Namibia


Interconnection DisputeConsultative workshop on interconnection models ... agreement that benchmarking Policies, act (not in place till today) and licence required cost based termination rates The final study benchmarked international best practice, termination rate trends and termination cost to derive at an interconnection model Various interconnection models were discussed with in an iterative process The final consensus solution was only reached after the completion of the study


BenchmarkingProcess of establishing interconnection rates based on cost of termination in other jurisdictions Undertaking full forward-looking cost modelling is challenging, expensive, time-consuming, and often required information is not available Cost benchmarks may need to be adjusted for population density, local area size, extent of urbanisation, traffic patterns and call durations, input prices, scale economies, exchange rates, taxes etc Whatever country or operator seems similar enough, there are always enough factors which are different to expose the selection to criticism


Conditions for the selection of countries

The billing system needed to be based on Calling Party’s Network Pays (CPNP) Countries had already or were in the process of implementing cost based termination rates A pragmatic criteria was the availability of data EU and selected African Countries


Reducing MTR to cost of efficient operator (1-2 Euro cents), EU Recommendation from 7 May 2009

Symmetric termination rates Glide path to allow operators to adjust their business models

Step 1: Benchmarking Regulatory best practice


Termination Rate Trends in Euro cents

2.2

7.8 7.9

11.2

9.8

8.7

2.1

6

7.1 7.6 7.8

8.4

2

4.6

5.3 5.72

6.9

7.7

0.5

2.75

4.9 4.5

6.5 6.3

0.3

4.4

3

4.5 5

2

3

Cyprus Sweden Finland Austria France UK India

2006 2007 2008 2009 2010 2011


Ofcom’s Proposed MTRs (April 2010 UK pence)

2010/11 2011/12 2012/13 2013/14 2014/15

0.50.9

1.5

2.5

4.6

0.50.9

1.5

2.5

4.3

Vodafone/ O2/ Orange/ T-Mobile, H3G H3G


CPNP Countries that had cost data available Adjusting cost benchmarks to Namibia was not possible, incumbent prefered not to provide cost data Common sense check based on annual reports and traffic volume

Step 2: Benchmarking Cost of Termination


Mobile termination costs Namibia (N$/ZAR): MTC being the most efficient operator

Current MTR

MTC total expenditure per minute

MTC opex per minute

MTC direct cost and depreciation per minute

MTC direct cost per minute

MTC 50% of dircet cost and depriciation per minute 0.24

0.34

0.48

0.97

1.02

1.06


Mobile termination cost per minute in N$/ZAR 2009: target rate 0.30 (including 25% mark-up)

Tanzania LRIC + mark up

Australian Efficient Operator (44% market share)

Swedish Efficient Operator

French Efficient Operator (upper level)

MTC’s estimated cost of termination

Austrian Efficient Operator

Telecom Namibia’s estimated cost of termination

French Efficient Operator (lower level) 0.12

0.14

0.23

0.24

0.24

0.26

0.35

0.59


Step 3: Namibian Benchmark Model

Termination rates = cost of an efficient operator Technologically and service neutral (in line with Namibia’s ICT policies and the Act) Facilitate emergence of IP-based NGNs Recommendation should be implemented in terms of the current licence conditions and act


Leo Telecom Namibia MTC

Model 1: Immediate N$0.30

2nd choice: if accompanied by other

regulatory interventions

2nd choice: Removing distortionary factors immediatelybut request higher transit charge

for outgoing international calls

No comment

Model 2: Symmetric glide path to N$0.30 that started 1 July 2006

2nd choice: if accompanied by other

regulatory interventions

1st choice: Compensates for market distortions of past

years

No comment

Model 3: Symmetric glide path to N$0.30 starting 1 July 2009

Rejected: sees no reason to wait to remove market

distorting factors

Rejected: only gradually removes market distortions and

disadvantage TN and consumers unjustifiably for two years longer

No comment

Model 4: Asymmetric glide path to N$0.30 starting 1 July 2009

1st choice: because of current traffic

imbalance

Rejected: only gradually removes market distortions and

disadvantage TN and consumers unjustifiably for two years longer

No comment

MTC model: reduction to N$0.60 until 2011

Rejected: same as for Model 3

Rejected: same as for Model 3 Otherwise: Drop in EBITDA margin to 37% because

of having to compete on a

level playing field


After several consultations with all operators: Industry consensus

Immediate drop of termination rates to N$0.60 to catch up with the region and international developments Glide path to the estimated cost of an efficient operator + 25% mark-up, ie NS0.30 Immediate fixed-mobile convergence of termination rates It gives time to MTC and Leo to conduct LRIC studies and contest the results


Mobile and Fixed Termination rates in Namibia

Jan 2009 July 2009 Jan 2010 July 2010 Jan 2011

4.165.54

6.938.319.14

4.165.54

6.938.31

14.68

MTR FTR


Prices for off-net calls general price development Profitability of incumbent operator (predicted EBITDA margin 36%....)

Step 4: Evaluating Impact


Cheapest product available for Low user OECD basket of incumbent (MTC) in Namibia

Low User Medium User High User

8.74.51.8

13.46.9

2.8

13.46.96.9

20.2

6.96.9

24.8

16.511.0

41.1

24.1

11.5

Sep-05 Dec-08 May-10 Mar-11 Sep-12 Sep-12 in 2005 prices

MTC 2005 2006 2007 2008 2009 2010 2011

Revenue N$ million 769 937 1,113 1,232 1,390 1,407 1,453

Shareholders’ Equity N$ million 646 903 999 1,136 1,153 1,166 1,121

Taxation N$ million 146.5 171.3 177.0 180.7 198.8 187 160

Net profit after tax N$ million 293 337 340 358 388 397 319

Capital Expenditure in million N$ 160 188 340 286 260 410 237

Total assets N$ million 915 1,169 1,329 1,608 1,632 1,791 1,696

Dividend N$ million 110.0 80.0 245.0 220.8 369.5 383.6 364

Dividend as % of after tax profit 37.5% 23.7% 72.1% 61.7% 95.4% 96.7% 114.2%

Return on equity 45.4% 37.3% 34.0% 31.5% 33.6% 34.0% 28.4%

Profit Margin 38.1% 36.0% 30.5% 29.0% 27.9% 28.2% 21.9%

EBITDA margin 61% 60.2% 52.2% 50.9% 53.8% 55.8% 53.2%

Active SIM cards in 1000 403.7 555.5 743.5 1,008.7 1,283.5 1,535 1854.7

Full-time Staff 276 272 296 397 416 395 407

Monthly ARPU in N$ 159 141 125 102 90 54

Source: MTC Annual Reports


Impact of Termination rate reduction in Namibia

No waterbed effect Dominant mobile operator

More subscribers EBITDA margin 50+% 3rd cheapest dominant operator in Africa


Case Study Kenya


MTR US cents

Mar 2007 Mar 2008 Mar 2009 July 2010 July 2011 July 2012 July 2013 July 2014

1.131.321.642.542.54

5.056.01

7.14


Monthly cost of OECD Low User basket in US cents, based average exchange rate for 2011 based on OECD 2006 Definition

Jan-10 Sep-10 Jan-11 Sep-11 Oct-11 Sep-12

2.12.12.12.12.1 1.81.81.81.81.8

3.9

2.02.02.02.02.0

5.8

2.52.72.32.3

6.3

7.3

Safari Airtel Orange Yu

Safaricom increased prices and then dropped them again


Safaricom’s voice traffic in billion minutes

Jul-Sep 2010 Oct-Dec 2010 Jan-Mar 2011 Apr-June 2011 Jul-Sep 2011 Oct-Dec 2011 Jan-Mar 2012

5.265.22

6.27

5.415.254.92

6.01


Safaricom’s traffic and subscriber market shares

Jul-Sep 2010 Oct-Dec 2010 Jan-Mar 2011 Apr-June 2011 Jul-Sep 2011 Oct-Dec 2011 Jan-Mar 2012

65%67%68%69%68%70%76% 77%78%

88%86%86%86%94%

Safaricom share of traffic Safaricom share of subscribers

Safaricom’s key performance indicators for financial years ending in March 2007 2008 2009 2010 2011 2012

RevenueKsh billion 47 61 70 84 95 107USD million 542 701 805 959 1,083 1,222

After-tax profitKsh billion 12 14 11 15 13 13USD million 137 158 120 173 150 144

Dividend paidKsh billion 3 2 4 8 8 8.8USD million 34 23 46 91 91 101

Subscribers in million 6.10 10.23 13.36 15.79 17.18 19.1EBITDA Margin 51.7% 45.9% 39.6% 43.6% 37.7% 35%Base stations 1558 1899 2162 2501 2690

Voice Average Revenue per User (ARPU)

Ksh 356 294 303

USD 4.07 3.36 3.46Average minutes of use (MoU) 60.6 96 116Average implied price per minute (ARPU /Average MoU)

Ksh 5.87 3.06 2.61

US cents 6.71 3.50 2.98

Source: Safaricom annual reports Average exchange rate for 2011 used for conversion


Impact of Termination rate reduction in Kenya

The reaction to the termination rate reduction was immediate, leaving no doubt about the causal relationship Retail prices dropped by 60%, immediately the day after reduction was announced - Opposite effect to the waterbed effect! 9.5% more subscribers in last quarter or 2010 quarter Safaricom is a good example for what happens if a dominant operator does not respond to competitive pressure or tries to increase price after cutting them In both instance Safaricom lost market share and traffic to other operators


Case Study South Africa


Mobile Termination glide Path in South African cents

Peak Off Peak CommentSince 2001 125c 89c

March 2010 89c 77c political intervention

March 2011 73c 65c Gazette No. 33698, 29 October 2010

March 2012 56c 52c

March 2013 40c 40c

15 April 2010

Loosing Billions

10% loss or 10% less revenue? There is a big difference

17 May 2010

400 million

less revenue in one

quarter

22 July 2010

17 November 2010

Staff retrenchment to offset impact Vodacom: R800 million loss in revenue

1 March 2011

17 May 2011

Vodacom: R1.5 billion loss in revenue

R500 million net interconnect loss

17 May 2011

MTN: ZAR 2.5 billion lost in revenues Telkom interconnect revenue dropped 37.4%

28 March 2012

“I know that it is counter intuitive, but it is what happens,” said

Knott-Craig.

January 2012 OECD Low User Basket costs in USD (FX= average 2010)

Country Name Cheapest product from Dominant Operator Cheapest product in country % cheaper than dominantRank US$ Rank US$Mauritius 1 2.39 5 2.39 Dominant is cheapestEthiopia 2 2.61 7 2.61 naNamibia 3 2.74 8 2.74 Dominant is cheapestKenya 4 2.85 1 1.90 33.4%Egypt 5 2.91 9 2.91 Dominant is cheapestSudan 6 3.53 6 2.46 30.5%Ghana 7 3.87 11 3.28 15.1%Libya 8 3.90 14 3.90 Dominant is cheapestRwanda 9 4.28 3 2.16 49.4%Guinea 10 4.62 2 1.93 58.1%Sierra Leone 11 5.04 13 3.88 23.1%Uganda 12 5.51 10 2.94 46.6%Congo Brazaville 13 5.63 17 5.63 Dominant is cheapestTanzania 14 5.82 12 3.75 35.7%Algeria 15 6.21 4 2.28 63.3%Tunisia 16 7.24 18 6.46 10.9%Senegal 17 8.11 24 8.11 Dominant is cheapestBotswana 18 8.16 20 7.66 6.0%Sao Tome &Principe 19 8.21 25 8.21 Dominant is cheapestNigeria 20 8.40 16 5.22 37.8%Madagascar 21 8.45 27 8.45 Dominant is cheapestMali 22 8.78 29 8.78 Dominant is cheapestBurkina Faso 23 8.88 28 8.53 4.0%Benin 24 9.10 22 7.92 13.0%Mozambique 25 10.00 33 10.00 Dominant is cheapestChad 26 10.14 34 10.14 Dominant is cheapestD.R. Congo 27 10.37 19 7.62 26.5%Côte d’Ivoire 28 10.41 36 10.41 Dominant is cheapestCameroon 29 10.44 35 10.28 1.5%South Africa 30 11.07 32 9.83 11.2%Togo 31 11.18 38 11.18 Dominant is cheapest


40

55

70

85

100

Jan 11 Mar 11 May 11 Jul 11 Sept 11 Nov 11 Jan 12 Mar 12 May 12

8ta Cell CMTN South Africa Vodacom South AfricaVirgin Mobile


January 2012 May 2012

2732

2430

Cheapest prepaid product from Dominant OperatorCheapest prepaid product in country

Ranking of South Africa among 46 African countries - prepaid mobile for OECD low user basket


Prices did not go up

neither after 1st nor 2nd MTR cut

Telkom Fixed-line operating revenues and expenses in ZAR million (Telkom 2011, Telkom 2012, FY ending March)

2011 2012 Change

Interconnection Revenues

Total Revenues 1,679 1,757 78Mobile Domestic 498 375 -123Mobile International 186 630 444Fixed 328 262 -66International 667 490 -177

Interconnection Expenses

Total Expenditure 5,193 4,839 -354Mobile network operators 3,704 3,218 -486

Fixed 404 306 -98International network operators 792 1,029 237

Interconnection Loss Total -3,514 -3,082 432Interconnection Loss Mobile only -3,206 -2,843 363

Interconnect revenue up, expenses down, net improved by ZAR432 million

Telkom past on MTR cuts 100% to customers

Revenue up 7.8%, profits up 27.9%

Interconnect revenue down 10.3%, expenses down 13.4%, net interconnect profit up 6.2% in South

Africa, additional ZAR 66 million

10.2% increase in traffic from Telkom due to

pass through of MTR cuts

MTN South Africa

Revenue up 7.7%

EBITDA

margin up by 1.2%

CAPEX up 5%


MTN South Africa: ZAR million Financial year ending December

2010 2011 changeRevenue 6,568 5,924 -644

Expense: interconnection and roaming 5,483 5,183 -300

Net Interconnect 1,085 741 -344

Still a net receiver of ZAR 741 million net Overall higher profits in 2011 compared to 2010


MTN and Vodacom: profits up Vodacom: R66 million more after cuts

Vodacom: net profit from termination R1.14 billion MTN: net profit from termination: R741 million

Increase prices? Invest less?

Retrench staff?


ConclusionTraffic flows are complex and who benefits from termination rate cuts depends on business strategies and the competitive interactions of all operators Cost based termination rates lead to more and fairer competition an thus more subscriber, traffic, investment and a bigger pie of revenues to be shared among operators

Quick and steep glide path to lower MTRs to cost of an efficient operator


Exercise: Should Pure LRIC be used as a

base for the NBC to charge broadcasters that would like to be

on digital national backbone?

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Interconnection Theory & Benchmarking