Pricing Strategies in the Context of Price Regulation

1. Pricing Strategies in the Context of Price RegulationbyPatrick XavierSchool of BusinessSwinburne UniversityMelbourne Australia ITUWorkshop(2)

2. Pricing strategies under price regulation The objective of this presentation is: • to explain the characteristics of price cap regulation since this is a scheme in increasingly use and may be used in Thailand to regulate TOT (indeed that TOT might argue should be used rather than direct government approvals or profit regulation)

3. Pricing strategies under price regulation • to indicate strategies for use under price regulation.

4. 1. Direct price control • Approval of price changes (increases & decreases) by government or by the regulator. • Since price increases are usually politically unpopular, approval tends to be usually given with reluctance and delays. • This is increasingly seen to be inappropriate in competitive circumstances.

5. 2. Rate of Return Regulation (RRR) • Essentially the limitation of profits to a “reasonable” level • Experience (eg. in the US) indicate that the use of RRR can involve long arguments about what a “reasonable” rate of return is. • Can also involve detailed and long argument over what costs were necessarily (and efficiently) incurred.

6. Rate of return regulation (con’t) • This could lead to detailed involvement of the regulator in the investment and commercial decisions of the service provider • The recognition of such disadvantages of RRR (and many others) has led to an increasing use of an alternative price control approach, so-called “Price-cap regulation”.

7. 3. Price-cap regulation • Under the price-cap scheme, a service provider’s price increases would be limited to the rate of inflation less an agreed “X” factor (based in principle on expected productivity improvement). • In principle, there would be no restriction on the level of profits.

8. Price-cap regulation (con’t) • Regulators favoured the price-cap scheme because it focused directly on price increases -- a variable that is more transparent -- than “necessary” cost expenditure. • Operators have favoured the scheme because it should allow less intrusive price regulation than RRR.

9. Price-cap regulation (con’t) • Also, it promises to permit unrestricted profits. • In fact, in many cases, operator profits have shown increases under price-cap regulation.

10. Price-cap regulation (con’t) • It is not unlikely that the price-cap scheme will be considered for use in Thailand to regulate TOT’s prices. • The focus of this presentation is to indicate strategies for TOT to consider if it is required to operate under the scheme.

11. Price-cap regulation (con’t) • Essentially the price cap scheme restricts price increases to “CPI - X” where: • CPI (Consumer Price Index) is the inflation rate • the “X” factor is (in principle at any rate) based mainly on the productivity improvement potential of the regulated company.

12. Price-cap regulation (con’t) Thus if inflation is 8% and the “X” factor is set at 3% making the formula “8% - 3%”. This means price increases will be restricted to no more than 5% per year for the duration of the formula.

13. Price-cap regulation (con’t) In principle, there would be no restrictions on the level of profits that accrue (thus sustaining incentives for the company to ‘beat’ the expected productivity improvement reflected in the ‘X’ factor). The formula is usually set for between 3 to 5 years and reviewed at the end of this period.

14. Price-cap regulation (con’t) Probably the most effective way to further explain the operation of the price cap scheme is to examine its characteristics when applied in various countries.

15. Price-cap regulation in the UK • 1984: CPI-3%. Line rentals, local & long distance calls; individual cap of CPI + 2% on line rentals until 1997. • 1989: CPI - 4.5%. Line rentals, local & long-distance. • 1991: CPI - 6.25%. Basket extended to include international calls.

16. Price-cap regulation in the UK • 1992: CPI - 7.5%. Line rentals, local, long distance, international. Some individual price caps placed on certain services. • 1997-2001: CPI - 4.5%. Single basket of line rental, connection, and call (local, long distance, and international) charges for small to medium usage households (light user scheme).

17. Price-cap regulation in the UK • 1997-2001: CPI - 0%. Line rentals for small business. Low usage small business service packages must be as good as for residential segment.

18. Price-cap regulation in Canada • 1994: Direct price control. Three regulated increases for 1996, 1997 and 1998 to bring residential service rates into line with costs. • 1995: Rate of return. Utility segment (the non-competitive part of the industry). • 1998-2002: CPI - 4.5%. Utility segment.

19. Price-cap regulation in France • 1995: CPI - 4.5%. Basic voice telephony services without discount schemes, comprising access, line rentals, calls (local, national, international and payphones). • 1996: CPI - 5.5%. Basic voice telephony services, as defined above. • 1997: CPI - 9%. Basic voice telephony services, as defined above.

20. Price-cap regulation in France • 1999: CPI - 4.5%. Basic voice telephony services, as defined above.

21. Price-cap regulation in Sweden • 1993: CPI - 1%. Basket of telephony services supplied to households and smaller companies; Light user schemes providing users with low consumption reduced subscription fees. • 1997: CPI - 0%. Customer access charges-customer line connection and rental.

22. Price-cap regulation in Australia • 1989 CPI - 4% Line rentals, local, long distance & international. Sub-caps. CPI - 0%. local calls and residential rentals. Notifiable and disallowable: Connection fees, payphone calls, calls to directory assistance.

23. Price-cap regulation in Australia • 1991: Notifiable and disallowable 008 services, leased line charges, mobile services. • 1992. CPI - 5.5%. Connections, line rentals, local calls, long distance, international, domestic leased lines, international leased lines, mobile services

24. Price-cap regulation in Australia Sub-cap: CPI - 2% connections, rentals and local calls. Sub-caps: CPI - 5% Long distance; international calls. Capped at CPI -0%. Increases in prices for connections, rentals, local calls and long distance calls.

25. Price cap regulation in Australia Notifiable and disallowable. Payphone calls, calls to directory assistance, connections for resellers. • 1996 to 1998: CPI - 7.5%. Connections, line rentals, local, long-distance and international calls, leased lines, mobile telephone services.

26. Price cap regulation in Australia Sub caps. CPI - 1%. Residential connections, line rentals, long distance calls and international calls. Before increasing any charge subject to these price control arrangements by more than the CPI increase during a calendar year, Telstra is required to obtain the prior consent of the regulator.

27. Price cap regulation in Australia There is a direct price control of 25 cents on local calls from fixed phones and 40 cents on local calls from payphones. Notifiable and disallowable: Directory assistance.

28. Price cap regulation in Australia • 1999 to 2001: CPI - 5.5%. Connections, line rentals, local, long distance, international calls, domestic and international leased lines and digital cellular mobile telephone services. CPI -0%. Line rentals and local call services (sub-basket). CPI - 0%. Connection services (sub-basket)

29. Price cap regulation in Australia CPI - 1%. Connections, line rentals, local, trunk and international call services consumed by the average of the bottom 50% of Telstra’s pre-selected residential customers by bill size.

30. Price cap regulation in Australia The regulator’s consent is required for an increase in line rentals applicable to the bottom 10% of Telstra’s pre-selected residential customers by bill size, such consent to be based on ensuring that such bills will not increase in real terms.

31. Price cap regulation in Australia Revenue-weighted untimed local calls for non-metropolitan Australia for 1999/2000 and 2000/2001, not t exceed that in metropolitan Australia for the previous year, in each case. Cap of 25 cents: Untimed local calls Cap of 40 cents: Directory assistance.

32. Strategy for a regulated service provider • As overseas experience indicates, price regulation is almost certain to be applied to an incumbent former monopoly with “market dominance”. • If so, it is TOT’s interests to consider what sort of price regulation system would be in its best interests and begin trying to influence decisions in this direction.

33. Strategy for a regulated service provider • Price-cap regulation is more “arm’s length” than other forms of price regulation likely to be applied to TOT and likely to provide more price re-structuring flexibility (TOT will want) but armed with appropriate information, TOT can also influence the setting of a price-cap formula that is to its advantage.

34. Strategy for a regulated service provider Seek: • the lowest level of “X”. • none or as few restrictions on price re-structuring as possible (in other words no sub-caps on individual services). • inclusion of services whose prices are likely to be significantly reduced, such as long distance and international.

35. Strategy for a regulated service provider • At least in the first formula -- when the price cap formula is likely to be relatively generous to the company -- seek a longer term (5 years rather than three) so that any higher than expected profit achieved can be enjoyed for a longer period.

36. Strategy (i): seek lowest level of “X” • It is the level of “X” in the CPI - X formula that determines the size of the fall in real prices. A lower “X” would require a lower real price fall (and allow higher revenue/profits).

37. Strategy (i): seek lowest level of “X” • Since the size of “X” set will be influenced by the size of productivity improvement attainable, TOT should arm itself with information concerning its past and potential labour and total factor productivity. • TOT should also benchmark productivity performance for telecommunications operators in other countries.

38. Strategy (iii): seek minimum sub-caps • Sub-caps on individual services restrict price re-structuring (which TOT will find necessary to undertake for commercial reasons) • Thus TOT should seek minimum sub-caps arguing that a promised benefit of price-cap regulation is that it would permit greater price flexibility, including restructuring.

39. Strategy (ii): seek inclusion of services with significantly falling prices • Where the price of a service falls sharply, it will decrease the average price of the basket of services in a price-cap basket. This means that the price of other services in the basket do not need to decrease as much, or indeed, may increase, with the basket still satisfying price-cap requirements.

40. Strategy (ii):seek inclusion of services with significantly falling prices • TOT could point to the fact that in the UK, France & Australia, the price of international calls was included in the price-cap basket in 1991. [Some countries do not include international calls in the price cap “basket” so that the formula is more demanding.]

41. Strategy (ii):seek inclusion of services with significantly falling prices • TOT should also seek to have discounts and one-off special prices included in the price-cap basket. • [It may also be possible to re-construct pricing to be part of the price-cap regime.] • Then of course there is “creative accounting”….

42. Conclusion • This presentation has indicated that if price regulation is to be applied to TOT (which is almost certain), price cap regulation may be preferable to other alternative approaches such as direct approval or rate-of -return regulation.

43. Conclusion TOT should be prepared -- not least through the collection of benchmarking information: • on the characteristics of price-cap schemes applied in other countries and the effects of such schemes • productivity trends and levels achieved • services with rapidly falling prices, etc.

44. Conclusion Armed with such information, TOT will: • not only better understand the potential impacts of price regulation but • can significantly improve the outcome of negotiations with the government/regulator and, indeed, its ability to compete successfully in the new competitive environment.