L IBERALISATION & R EGULATION IN THE E LECTRONIC C OMMUNICATIONS S ECTOR

1. LIBERALISATION& REGULATIONIN THE ELECTRONIC COMMUNICATIONS SECTOR The Economics of Competition in the Telecommunication Sector http://www.netmode.ntua.gr/ Courses/Graduate/Liberalization & Regulation in the Telecommunication Sector Vasilis Maglaris <maglaris@mail.ntua.gr> Vassilis Merekoulias <merek@netmode.ntua.gr>

2. Presentation Overview • Basic Economic Concepts • Regulation and Market Economy • Key factors for industry restructuring • Key characteristics of telecommunications networks and their evolution • Costing and pricing principles for regulated services • Presentation of the basic steps in costing methodology • Asset valuation alternatives (HC- CC) • Cost standard alternatives (FDC- LRAIC) • Cost accounting systems used by the incumbents in member states • Common deviations from cost orientation

3. Basic Economic Concepts • Economics is concerned with determining: • the most efficient way of allocating society’s limited economic resources among different possible uses • the conditions under which the market economy can lead to the optimum allocation of resources • the overall structure of market prices of goods and services that lead to the maximum satisfaction of consumers given limited and scarce resources

4. Basic Economic Concepts • Perfect competition is defined as the market where we have: • A lot of firms, where no firm is able to affect the terms of the market by itself. (price taking behavior) • Economically and physically homogeneous product • There is perfect knowledge and perfect foresight of consumers and producers. • There are no barriers to entry and exit for capital and labor • There is no-discrimination between buyers and sellers

5. Basic Economic Concepts • In the short run, the typical firm takes the price (P) from the market and produces an output (Q*) that maximizes its profits (MR=MC). At Q* if P>AC the firm makes economic profits (extra profits). In the long run, those extra profits are eliminated by the entry of new firms in the market, that increase supply (S) and drive down the price until P=AC. • At equilibrium the product is produced a the minimum possible cost (technical efficiency, MC=AC), and social welfare is maximized since resources are allocated in precise accordance with consumer preferences (MC=P)

6. Competitive Market Competitive Firm s0 S1 MR=MC MC AC P0 0 P1 1 D Q0 Q1 Q Q* Q Theoretical perfectly competitive markets D=P=AR=MR

7. Theoretical Monopoly Market • There may be only one firm in the market if there are barriers to entry due to: • Size of investment (fixed capital) • Mobility of investment (sunk costs) • Institutional (public goods) • Market power

8. Theoretical Monopoly Market • Equilibrium (profit maximization) is where MR=MC, but at that output MC not equal AC (technical inefficiency) and MC < P (economic inefficiency, under-allocation of resources). Thus there are two other possible pricing schemes • P = MC, and because there are practical difficulties to define this output, • P = AC, where normal profits are made (full cost price) • NATURAL MONOPOLY: In some industries, the downward sloping section of the AC curve extends over a very large output range (relative to total market demand). In this case it is more efficient to have one firm producing the whole output, instead of several.

9. P P* (MR=MC) P* MC AC P=MC P=AC D Q Q* MR Theoretical Monopoly Market

10. P MC P2 AC P* Q Q* Q/2 Theoretical Natural Monopoly Firm

11. Theoretical Natural Monopoly Firm • A single firm would be able to provide services at lower rates and with a wider coverage • A single firm would be better in achieving technical efficiency and to avoid duplication of investments and excess capacity • Economics of scale can be fully utilized to the benefit of all consumers

12. Monopoly & Regulation • Role of Regulation: to ensure that monopolies behave in accordance with the public interests and do not misuse their monopoly power • Economic Objective of Regulation: to help achieve the optimum level of production from a societal point of view, i.e. to ensure production in the desired quantities and at appropriate prices (efficient) for all consumers.

13. Telecom. Industry Restructuring • Industry was deemed to be ‘natural monopoly’ for decades • Existence of large fixed costs • Duplication of networks was neither privately profitable nor socially desirable • Deregulation and competition were introduced as a result • Growing awareness of the inefficiency of incumbent monopolists (rate of return regulation, distorted price levels and structure) • Technological change

14. Telecom. Industry Restructuring • Incumbent operators are being privatized • Markets have been largely regulated • Proliferation of services & multiplication of networks • Large number of actual or potential players • Shift of regulatory focus from incentive regulation to economic efficiency

15. Cost Characteristics • Very large fixed investment costs, part of which is sunk costs • Economies of scale: reduced unit costs with increased output • Economies of scope: cost savings related to supplying a number of services by the same firm • Economies of density:reduced network costs per connection with increased density of connections • Structural elements of a network • Access Network • Switching • Transmission

16. Structural Elements of a network • Access Network: Connects the user’s terminal to a local switch (twisted pair of cooper wire, coaxial cables, optical fibres). By far the most expensive part of the network • Switching: The switching function is performed at the exchanges (local, transit) by automatic, computer controlled equipment. The next costly function after access network. The vast majority of switching costs are in local exchanges. • Transmission: cables, radio-links and satellites connecting transit exchanges, as well as electronic equipment (transmitters, repeaters, etc). Not as significant in the total cost picture as access and switching costs

17. Trends in investment costs • Transmission • Optical fibre cables have reduced the cost of cables substantially • Prices for copper wires are relatively stable, but new compressing techniques are increasing its capacity • At present it is not economical to replace installed copper cable in the access network • Switching • Prices for electronic equipment have decreased rapidly and are expected to continue declining in the future • Value added services and intelligent services introduce new types of costs to network operators and leads to an increased share of costs for processing and value added components • Development costs are usage independent fixed costs, but they are not regular sunk costs

18. Trends in investment costs • Although investment costs are becoming cheaper, the level of investments in telecom services is growing rapidly and capital costs still constitute a substantial share of total costs of production • Decreasing cost trends reduce the economic lifetime of installed capacity. Investment must be depreciated at a faster rate and profitability requirements must be raised • Development of broadband services is closely related to reductions in costs of transmission. However, substantial demand will increase the demand for transmission capacity, and will bring up the costs for access and switching as a result of major network upgrades • Digitalization increases economies of scope for provision of facilities, but reduces economies of scope for service provision

19. Demand Characteristics • Saturation levels for basic telephony • Fast growing diversified demand for an increasing range of services • New services need to establish a critical mass of network subscribers • After a period of growing segmentation between user groups in terms of markets, services and interests bundles of services and interest groups. • Changing demand conditions result in different cost and market structures for the different customer groups

20. Competitive Evolution • Entry into Local/LD/Intl Markets • Facilities based • Resale • Unbundling • Alternative Reform Paths • US, UK, NZ, Europe

21. Issues for competitive era • Provision and scope of USO • Interconnection is crucial for the development of effective competition and to provide access to bottlenecks • Residential access network still presents significant barriers to entry, LLU • Entry of efficient competitors • Coordination of investments in facilities and new technologies • Duplication of networks • Preservation of competition on some segments when another segment is monopolized • Competition in telecommunications does no come about as easily as in other sectors

22. Technological Attributes • the routing of service • the location of bottleneck • the storability of output • the speed of technological change • the proliferation of networks • PSTNs, Cable companies, Competitive access provider, Mobile operators, LAN linking computers, ISP

23. Key Characteristics of Telecom Networks Telecom Networks differ from other network industries: • in their technological attributes • in their cost & demand characteristics • in the pace of regulatory reform and industrial restructuring

24. Role of Technical Change • Changing structures of network costs • Development of broadband services • Lifetime of equipment is reduced • Digitalization • Satellite and cellural

25. Basic pricing goals (non competitive services) • Encouragement of the effective competition • Avoidance of: • price squeeze, • predatory pricing and • excessive pricing practices • Transmission of the «correct» economic signals • Coverage of the incumbent's accounting cost and allowance for a reasonable rate of return

26. Basic pricing principles • The prices have to be: • Adequately unbundled • Publiced • Competition oriented • Non descriminatory • Cost orientated

27. Why cost orientated ? • Cost is an adequate benchmark when competition doesn’t exist • As soon as three factors are taken into consideration • Incumbent’s efficiency • Network technology • Cost of capital (“Reasonable profit margin”) • In case cost orientation cannot be obtained: Bottom -up models as benchmarks Then use best practice

28. Network Access Retail Other services Basic costing principles (for regulatory purposes) • Cost causation principle • Activity based costing • Network costing • Objectivity principle • Transparancy principle • Auditability • Accounting Separation • Consistency principle

29. Basic cost elements • Salaries of personnel • Depreciation of network elements • Depreciation of buildings and vehicles • Transport costs • Marketing cost • Overhead • etc.

30. Depreciation • Depreciation is the yearly recognition of the cost of assets usage and corresponds to the decrease of asset value • Historical cost - cumulative depreciation = Net book value

31. Depreciation - ExampleLinear method • Historical cost = € 1.000.000 • Depreciation rate = 20% • useful life = 5 years • Depreciation year 1 = € 200.000 (1.000.000 x 20%) • Depreciation year 2 = € 200.000 (1.000.000 x 20%) • Net book value year 2 = € 600.000 • (1.000.000 - 200.000 - 200.000)

32. The regulator does not care about them Cost objects • Commercial services • Local calls • long distance calls • International calls • Leased lines • Monthly rentals • Wholesale products • Interconnection services • Local Loop unbundling • Competitive products

33. Cost of services Cost elements • Cause causality • principle • application • Asset valuation • method • Cost standard • selection From cost elements to cost of services

34. Methods of cost causation principle application • Linking cost elements with cost objects • Activity based costing • Network costing

35. S E R V I C E C O S T Activity based costing General Ledger and Salary database Personnel cost Business processes - departments Questionnaires- Time spend to activities Activities Cost drivers What is the reason for the activity to be performed Allocation to services Allocation to services Overheads

36. A C C E S S S E R V I C E C O S T Activity based costing General Ledger and Salary database Personnel cost Customer service Activities related to customer service- access Number of lines Allocation to services Already allocated cost Overheads

37. A C C E S S S E R V I C E C O S T Activity based costing Personnel cost €10.000.000 General Ledger and Salary database Customer service 30%, € 3.000.000 Activities related to customer service- access 50%, € 1.500.000 Number of lines - 2.000.000 € 0,75 /line Overheads 20.000.000 Assume 5%, € 100.000 or € 0,05/line Allocation to services Already allocated cost

38. S E R V I C E C O S T Network costing General Ledger and Fixed Assets Register Cost of assets Physical network elements What is consuming the capacity of the element: Minutes, calls, subscribers? Cost drivers Grouping of elements based on cost driver analysis Network entities Routing factors Service recipes, volume per service and total volume

39. Tandem Local Link 1 Tandem Switch 1 1 RSU - Local Link Local Switch Local Switch 1 1 RSU- Local Link- 2 min. Tandem - local link - 2min Local switch - 2min Tandem switch - 1min Telephone Sub. Telephone Sub. Routing Factors - 1 min of local call

40. L O C A L C A L L S E R V I C E Network costing- example switches Depreciation, Air condition Buildings, power, network management, etc. Cost of local switches Local switch components access and local switch components traffic Cost driver = minutes local switch traffic (actual min. x routing factors per service) RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link Local -Tandem transmission link Tandem - Tandem transmission link local switch traffic minutes used for local calls

41. L O C A L C A L L S E R V I C E Network costing- example switches Depreciation, Air condition Buildings, power, network management, etc. Cost of local switches € 10.000 Local switch components access and local switch components traffic - 70% € 7.000 Cost driver = minutes local switch traffic = 20.000 x 1,8 = 36.000 cost per minute = € 0,195/min. RSU - traffic cost Tandem switch cost RSU-local transmission link Local - Local transmission link Local -Tandem transmission link Tandem - Tandem transmission link local switch traffic minutes used for local calls assume 16.000 x 0,195 = € 3.120 Assume 0,195 + 0,10 +…+ 0,05 =

42. Cost of capital • The total cost of a service also includes a rational rate of return (profit margin) • This rate of return is based on the cost of capital of the incumbent (WACC) • The cost of capital that corresponds to each service equals the capital employed for this service multiplied by the rate of return (WACC)

43. = Accounting Equation Capital employed Balance Sheet Total Assets Total liabilities EQUITY FIXED ASSETS LONG TERM LIABILITIES CURRENT ASSETS SHORT TERM LIABILITIES TOTAL ASSETS TOTAL LIABILITIES

44. Cost of debt after tax debt Cost of equtiy equity + Χ Χ WACC = Debt +Equity 34.200 300.000 [(7% Χ (1-40%)]Χ 100.000 + 15% Χ 200.000 11,4% = = 100.000 + 200.000 WACC (Weighted Average Cost of Capital) Example: Cost of debt =7%, debt € 100.000, cost of equity 15%, tax rate 40%, and Equity € 200.000

45. Capital employed Service B Capital employed Service Α x WACC x WACC Service Α Service Β Network element 1 Network element n Activity 1 Activity 2 Activity n Cost element 1 Cost element 2 Cost element n Cost Model Structure

46. Asset valuation • Asset valuation influences cost in two ways: • Depreciation cost (directly influences the cost of service) • Net book value (indirectly influences the cost of service via working capital) • Two alternatives: • Historical cost • Current cost

47. Historical prices • The cost of asset acquisition when the asset was bought or constructed • The cost of the asset corresponds to a past decision that may be obsolete due to technology changes or other reasons

48. Current prices • There are a lot of alternative ways in order to calculate current cost • Modern equivalent asset: An asset that has the same functionality as the existing one and uses the most efficient and economic technology established in the market place (forward looking) • Replacement cost • Secondary market • Cost adjusted to inflation • The usage of current prices sends the correct signals to the market

49. Cost calculation • There are two main approaches in service costing (cost standards) • Fully distributed cost (FDC) • Long Run Average Incremental cost (LRAIC) • EU is in favour of LRAIC because it is theoretically suitable for efficient pricing • Both cost standards permit incumbent’s cost coverage

50. Fully distributed cost • According to the FDC standard the cost of a service derives from the usage of a set of algorithms that allocate both direct and indirect costs to it • Some of the indirect allocations are arbitrary and may cause cost distortion