Costing and funding a USO 7 th February 2005

1. Costing and funding a USO7th February 2005 Doc Ref:

2. Background • The universal service provider is obliged to provide services to customers that it would not serve as a rational profit making operator • Typically these customers are “unprofitable” • They are: • High cost customers • Provide low revenue • A regulator may need to determine whether the USP is disadvantaged by the cost of its obligation in order to ensure fair competition • If disadvantaged, the USP is typically compensated • In doing so, it needs to take account of its other objectives • Establishing efficient allocation of resources through • Efficient markets • Efficient operation by the USP • And any net benefits the USP receives Doc Ref:

3. A USO gives rise to benefits and costs. A USP is not necessarily burdened by a USO. USO established Is the USP disadvantaged? What are the criteria for deciding when the USP is disadvantaged? What compensation is needed to overcome disadvantage? How should the net cost of the USO be calculated? Which licensed operators benefit from the USO? How should the their contribution be calculated? Who should contribute and in what amount? Doc Ref:

4. When is the USP disadvantaged? Not disadvantaged Disadvantaged • Cross subsidies from other services • Suppresses demand for calls • Could reduce profitability • USO costs & benefits taken into account in IPO share price • Shareholders are not disadvantaged at this stage • Reduction in call charges for highly profitable services • Reduces possible cross subsidy • Reduction / elimination of super normal profit • USO cost reduces ROCE below WACC Reduction in market power in relevant markets USO established Privatisation & retail price controls Competition introduced Retail price controls phased out liberalisation Doc Ref:

5. USO benefits may help the USP to maintain super normal profitability in other services • Through ability to sustain higher tariffs than competitors, or exploit additional revenue streams and lower costs • Ubiquity of infrastructure • Opportunity for leased lines, broadband, etc • Larger scale • Lower procurement costs • Lower maintenance costs • Market reach • Wider geographic coverage • Wider coverage of the income levels • Brand • The USP becomes the default service provider • Network effects • Traffic is proportional to the size of the network • Advertising revenue • In USO areas Doc Ref:

6. Intangible benefits • Recognised by the EU • UK £61m (against a USO cost of £53 - £73m) • Australia: A$80 - 136m (but ACA disagreed with the estimates prepared) • Italy and Switzerland also recognise intangible benefits • Rejected by New Zealand as not significant • Intangible benefits are difficult to calculate • Cost of the USO after intangible benefits can be determined through auction or tender for role of USP Doc Ref:

7. Possible hurdles for determining disadvantage • Market power test • Relevant markets? • What level of market power should be taken as being the level when the USP becomes disadvantaged? • Relatively soft measure – no absolute value • Consistent with other regulatory tests • Is the USP subject to price controls? • If the purpose of these is to regulate profit and improve efficiency • Any compensation would increase profitability or reduce efficiency by allowing additional cost and therefore work against price control • Therefore compensation is not consistent with price controls • Profitability test • Is ROCE greater than or less than average for the industry? • Is ROCE greater than or less than WACC? • Must take account of efficiency of operation of the USP • Do costs outweigh benefits of being a USP? • What is the cost to the USP? • What are the benefits derived? • Costs may outweigh benefits but market power may maintain high profitability Doc Ref:

8. How can compensation needed to overcome disadvantage be estimated? • Competition for the role of USP • Market view of required compensation • Takes account of benefits as well as net cost • Difficult to undertake in a mature market • Process is beyond the scope of this presentation • Calculating the net cost of the USO • Applicable if USP profitability is close to normal profit levels • Inapplicable if USP profitability is a lot higher than normal profit • Benefits estimation is likely to be inaccurate, therefore it is difficult to determine level of disadvantage Doc Ref:

9. USO net cost calculation Universal service cost = avoidable costs – revenue foregone - intangible benefits Costs and revenues are determined line by line or area by area Revenue per line = Access revenue per line + revenue from USO services + net revenue from other services provided* Cost per line = Access costs per line + costs from USO services * because that line is in use The loss on any loss making line or area is added to the USO net cost Doc Ref:

10. Base assumptions • USO net cost calculation estimates the difference between the operator’s business performance with and without the USO • By identifying parts of the business that a rational operator would not have undertaken without the USO • And estimating the net cost of those parts of the business • The biggest of these is coverage of uneconomic areas or customers • The regulator needs to assume: • Efficiency of operation of the business • An efficient market • Therefore the net cost calculation assumes that the USP is • A rational and efficient operator • In an efficient market Doc Ref:

11. Efficiency assumptions • Long Run Forward Looking Incremental Costs • Prices in an efficient market will tend to such an estimate of costs • Issues about measurement, how long is the long run, and allocation of common costs • Modern equivalent assets • These are the costs that a competitor to the USP would face • Can work to the advantage of the incumbent in building access networks, where costs of civil works are large since these would be inflated • Efficient operator • Avoid subsidising inefficiency and poor technology choice • Network topology – scorched node, not scorched earth • Operating costs to take account of MEA • Efficient market • Rebalanced tariffs v actual tariffs • Issues about controlled tariffs Doc Ref:

12. Modelling the USO costs simulates the investment decision of a rational operator in an efficient market • Smallest area for which a separate investment decision is made • JT told us that this was a distribution point serving up to a few tens of lines • Revenue assumption for that area • We used historical revenue per line for a region – distinguishing between urban and rural • A better assumption would have been to correct this historical revenue by assuming rebalanced tariffs • Tariffs are rebalanced in an efficient market • Calculated cost of access and other services • The cost of reaching that distribution point • The cost of the distribution point • An assumed tail cost from the distribution point to the premises • Cost of cabinet and reaching the cabinet • Switching costs, etc • Uses Long Run Forward Looking Incremental Costs Doc Ref:

13. USO net cost:Universal service cost = avoidable costs – revenue foregone - intangible benefits Distribution of revenue per line Surplus revenue Cost covered by revenue Revenue foregone Line costs Avoidable cost JD Low cost lines High cost lines Lines, distributed by cost Doc Ref:

14. USO net cost:Universal service cost = avoidable costs – revenue foregone - intangible benefits Distribution of revenue per line Surplus revenue Avoidable cost Cost covered by revenue Revenue foregone Line costs JD JD Low cost lines High cost lines Lines, distributed by cost Doc Ref:

15. Simulation of the investment decision of a rational operator in an efficient market subscribers distribution points • At what level does a rational and efficient operator make the investment decision to provide a telephony service for a particular geography? • Subscriber? • Cabinet or other distribution point? • Local exchange? • An incumbent indicated that its investment decision is made for a distribution point • All typical customers beyond that will be served once the distribution point is provided LE cabinet Doc Ref:

16. Scorched node approach, the basis of the calculation DP‘2’ DP‘1’ subscribers • Calculate the revenues and costs for each DP and identify loss making DPs • Sum the losses of loss making DPs • Eliminate loss making DPs • Recalculate the costs of remaining DPs • Repeat (1) to (4) for the remaining DPs and repeat until no more loss making DPs • Calculate the revenues and costs for each cabinet • Repeat (1) to (5), substituting cabinets for DPs • E.g. If DP’1’ is loss making it is removed. • The cost of DP’2’ increases because it is no longer sharing a cable route with DP’1’ • So recalculate the cost of DP’2’ and re-evaluate its revenues and costs • Calculate the revenues and costs for the cabinet and eliminate if loss making cabinet Doc Ref:

17. Costs included (in principle) The incremental capital and operating costs associated with the provision of the USO within the following • Customer premises • Local access cabling • Switching and transmission • Engineering and maintenance • Marketing and product development and management • Sales and customer support • Value added or supplementary services • Telephone directory • Planning • Preparation of cost and revenue estimates • Cost of provision of emergency services Doc Ref:

18. Efficiency issues • Local loop network • Scorched node v scorched earth design of the network excluding uneconomic areas or customers • Scorched earth design is an ideal network for an operator excluding all uneconomic customers and areas • This represents the network that a rational and efficient operator would build without the USO • Scorched node design assumes historical view of network • This is a compromise that removes uneconomic branches of the historical network • It may have some inefficiencies • Modern equivalent assets • Forward looking view of the network • Need to take account of changes in operational costs • Spare capacity – judgement required • Levels should be those of an efficient operator • Impaired assets • Eg redundant capacity • Costs should not be included • Rebalanced tariffs • Difficult to estimate the impact • Change in tariff leads to change in demand • Therefore revenue profile changes Doc Ref:

19. Revenue included (in principle) • Services contracted by the customer • Services included in the definition of the USO • Line connection and disconnection • Line rental • Outbound calls • Charges for operator services. • Charges for provision of emergency services – not applicable in Jordan • Value added and supplementary service revenues • Inbound calls • transit, switching and termination charges from mobile and international calls and calls from other operators • Interest Doc Ref:

20. The USO is often funded by contributions from other operators • Those that benefit because of the USP’s cost disadvantage – ie competitors to the USP • Those that do not themselves provide access in uneconomic areas • Therefore: • International carriers – bypass, preselect carriers, VoIP • Access providers with no or minimal provision in uneconomic areas • Contributions should be made in proportion to net revenue • Net revenue is gross revenue minus charges paid to other contributors • Small operators should be excluded • Cost of collection higher than revenue collected • Do not significantly affect the USP Doc Ref:

21. Should mobile operators pay a contribution? Pro contribution • They are competitors to USP • Revenues derived from international calls and other services are used by USP to subsidise USO Anti contribution • Mobile coverage obligation may be similar or better than universal service obligation • Already provide service in high cost areas • Therefore subsidy may be considered to subsidise technology choice of incumbent Doc Ref:

22. Most countries fund the USO cost using an industry fund • EU – state funding allowed • Contributors – long distance and international operators, alternative access providers, mobile operators, sometimes satellite operators • Only major industry players – eg Italy: > 1% of revenue, Canada: companies with less than $C10m • Contributions in proportion to net revenues • Gross revenues – payments to other operators • Eligible traffic of each operator – Canada • Fund distributed by the regulator • Australia, Canada, Hong Kong Doc Ref:

23. Technology to be used should be sufficient for the Basic Telephony Service and the payphones • The existing PSTN or extensions using the same technology base • The existing mobile infrastructures, or extensions to them, with some restrictions on the speed of data transmission available • Fixed wireless access networks with appropriate coverage • Next generation networks including fibre to the premises, voice over broadband or IP • Care will be needed to ensure continued provision of broadband Doc Ref: