Dr Chris Pollard

1. ITU – Oman, Muscat, Tue 5th April 2005Interconnection and Price Regulation WorkshopAccess and Wholesale Costing and Pricing Dr Chris Pollard Doc Ref: 00712/PN/774.1

2. Agenda • Distinguishing “Interconnection”, “Access” & “Wholesale” pricing • Access – regulated • Wholesale – unregulated • Retail minus pricing • Avoidable cost definitions • Wholesale price levels • Competitive dynamics • Margin squeeze • Inappropriate wholesale policy? • Summary Doc Ref: 00712/PN/774.1

3. Regulatory approaches to pricing • Interconnection pricing • Designed to ensure the most economically efficient use of essential facilities or “bottleneck” services • Where no “alternative choice” exists • Based on long run incremental costs plus a mark up for joint and common costs • Access pricing • Facilities or services of dominant operator (access provider) are used, BUT • Access seekers do have an alternative choice of building their own facilities • Hence, less powerful requirement for incremental or cost based pricing • Wholesale pricing • Services are “freely” offered by dominant operator to other operators • No regulatory intervention required ex ante • However, expectation that services would not be priced at retail price • Dominant operator saves on marketing and billing costs Doc Ref: 00712/PN/774.1

4. Access Services • As competition has evolved so it has become desirable to broaden the scope of interaction between dominant and other operators and the concept of ‘Access’ has arisen • “access” means the making available of facilities and/or services, to another undertaking, under defined conditions, on either an exclusive or non-exclusive basis, for the purpose of providing electronic communications services. • It covers inter alia: • access to network elements and associated facilities, which may involve the connection of equipment, by fixed or non-fixed means (in particular this includes access to the local loop and to facilities and services necessary to provide services over the local loop), • access to physical infrastructure including buildings, ducts and masts; • access to relevant software systems including operational support systems, • access to number translation or systems offering equivalent functionality, • access to fixed and mobile networks, in particular for roaming, • access to virtual network services; EU Directive 2002/19/EC What is the legal position in your country? Doc Ref: 00712/PN/774.1

5. Access service pricing • While competing operators could create their own infrastructure, there are sometimes sound economic reasons why access to an dominant incumbents facilities are beneficial to competition • Sharing of facilities that are expensive to reproduce or may have an environmental impact (radio towers & masts) • Choice of pricing, and underlying cost base, may therefore be based on a number of different rationales • Although all are essentially “cost oriented” to avoid competitors “subsidising” the operation of the dominant operator • From full retail through “retail minus” and “fully allocated cost based” to incremental cost based are all possible rationales depending on the competitive dynamic of the services in question • “cost-oriented" means based on cost, and may include a reasonable profit and may involve different cost methodologies for different facilities or services Doc Ref: 00712/PN/774.1

6. Wholesale services • Another specific form of access now frequently included under the umbrella of ‘Interconnect’ is access to standard, retail services at a ’wholesale’ price. • Customisation of these services may sometimes be offered – eg multiple leased line services could be offered in an aggregate format • The offering of ‘wholesale’ prices to operators is often viewed as a purely commercial transaction, in principle no different to that between an operator and any other non-operator major user of his services. • In principle, therefore, should not attract ex-ante regulatory intervention • However, in certain areas the regulator may deem such services to be necessary to support the development of competition, and may therefore influence or determine the terms on which they are offered. • Boundary between “access” and “wholesale” service is not always clear Doc Ref: 00712/PN/774.1

7. Retail Minus Pricing Doc Ref: 00712/PN/774.1

8. “Retail Minus” I • Wholesale services (and many Access services) are most likely to be offered at retail or retail minus levels • Wholesale is distinct from interconnect in as much as the services may be resold by service providers or resellers without extensive infrastructure of their own • Resellers are potentially replacing only the incumbent’s sales and marketing process with their own, which may be either • more efficient, or • represent innovative bundling of service components, or • represent the addition of further functionality to the basic service or product. • For this reason regulatory regimes where wholesaling is encouraged typically allow the wholesale price to be set in relation to the retail prices rather than against the disaggregated incremental costs of the service components as is typically used in interconnect determinations Doc Ref: 00712/PN/774.1

9. Retail minus II • The economic argument underlying the retail minus approach is • if wholesale prices were based on the incremental costs of the original operator this would not incentivise any entrant to invest in infrastructure. • The costs to the entrant would only be the marginal costs without any fixed costs incurred in investing in infrastructure. • This would potentially result in minimal new infrastructure investment and an unbalanced development of competition to the incumbent. • It is argued that a dynamically efficient wholesale discount is that which encourages efficient entry by service providers and is just sufficient to induce new investments in the networks by both the incumbent and the service providers. • Entry by service providers will be efficient if they either reduce the costs of providing the existing service or add value through service not provided by the incumbent. • The resolution of these issues and balance of approaches is dependent on the type of competitive environment that the Regulator wants to foster within that particular market. Doc Ref: 00712/PN/774.1

10. “Retail minus” III • For a standard retail service “retail minus” is typically expressed as: • Wholesale charge = Retail charge minus “avoidable” costs saved • Avoidable (or avoided) costs saved • Marketing, selling, billing, accounting and customer support costs directly associated with serving a retail customer • Set against this are the costs associated with setting up the interfaces and relationships with the reseller • Two approaches to assessing these retailing costs • Based on the treatment of common costs of retailing across the whole organisation • “Avoidable costs are the costs that an access provider could avoid if it ceased retail operations completely, whereas avoided costs are those costs that the access seeker actually avoids when it ceases retailing to the end-users who are now supplied by its competitor.” (ACCC, 2002) • Some inconsistency on definitions used between, Australia, New Zealand and the US Doc Ref: 00712/PN/774.1

11. What are avoided and actual costs? • As defined the New Zealand Telecommunications Law (2001): • “Actual costs saved means the net costs saved by supplying the service on a wholesale rather than a retail basis to the access seeker” = avoided (Aus) • “Avoided costs saved means the difference in the access provider’s costs between supplying the service on a wholesale basis only and supplying the service on both a wholesale and retail basis, including a share of retail-specific fixed costs” = avoidable (Aus) Source:NZCC 2004 Doc Ref: 00712/PN/774.1

12. Retail Minus IV • The “avoided” cost standard is a more stringent rule than the “actual” cost standard • “the discount for the avoided cost saved standard incorporates both the average incremental cost of retailing (AICR) and unit common costs (ACC), whereas that for the actual costs saved standard includes only the AICR.” • The cost standards are applied depending on the level of competition in the relevant market: • “average or best retail price minus a discount comprising avoided costs saved pricing, in the case of a service offered by Telecom in markets in which Telecom faces limited, or is likely to face lessened, competition for that service; or” • “average or best retail price minus a discount comprising actual cost saved, in the case of a service offered by Telecom in markets in which Telecom does not face limited, or lessened, competition for that service”. (NZCC, 2004) • The lesser the competition, the greater the discount required Doc Ref: 00712/PN/774.1

13. Regulated discount rates in Australia and US • Regulated discount rates vary between 14% and 25% in US • Australian regulator found a smaller applicable discount • In New Zealand the applicable discount for fixed services is 16% Doc Ref: 00712/PN/774.1

14. In contrast, Oftel proposed significant discounts for leased lines • Oftel believed that there was significant excess profitability, and inefficiency, built into BT’s retail leased line charges prior to considering avoidable costs that should be discounted to create a wholesale price • Oftel proposed significant discounts to retail charges for wholesale leased lines or Partial Private Circuits of up to 55% Doc Ref: 00712/PN/774.1

15. Wholesale DSL discount margins • Regulated discounts in the UK are much more significant, of the order of 50% • However retail prices are now falling significantly Residential end-user prices and ISP margin; Oftel June 2003 Business end-user prices and ISP margin; Oftel June 2003 Doc Ref: 00712/PN/774.1

16. Unbundling and Co-location • Unbundling of local loop facilities (or unbundled network elements UNE) and co-location are examples of access services that are now considered by regulators to be vital to the development of competition • Because of the view that competing local infrastructure is unlikely to be built, the local loop has become bottleneck or essential facility, such that its wholesale pricing is based on incremental costing • Significant regulatory effort in many countries has been expended developing cost models and wholesale charges based on incremental costing approaches to ensure that charges for UNE are fair and will stimulate the market • However, to date, unbundling has not been the success the regulators have hoped for • As previously shown In the leading countries on average less than 2% lines unbundled • Unattractive, or inappropriate, wholesale pricing as much as technical difficulty (and operator intransigence) are the main causes of its failure Doc Ref: 00712/PN/774.1

17. Competitive dynamics Doc Ref: 00712/PN/774.1

18. Competitive dynamics - “Margin squeeze” • Risk of margin squeeze is significant where a dominant operator is providing wholesale inputs to competitor's service while providing the same retail services itself • Margin squeeze - setting wholesale charges at such a high level compared to retail charges that competitors cannot make a successful business thus limiting the development of competition • Regulatory measures such as accounting separation and, in the extreme, structural separation limit scope for margin squeeze • However, in addition, regulators and competition authorities need to be vigilant in services were the risks of margin squeeze are perceived • This can lead to scrutiny a of access and wholesale charges in significant detail • The risk of squeeze puts pressure on regulators to set aggressive wholesale rates Doc Ref: 00712/PN/774.1

19. Competitive dynamics - What is the correct discount? • Wholesale discounts can be very significant compared to retail prices • especially where regulators have determined levels of pricing based on incremental costs and used bottom up costing models based on the concept of “efficient” network design • A recent publication in the US suggests that inappropriate regulatory wholesale pricing policy for UNE (setting prices too close to marginal cost) has seriously damaged the fixed telecommunications sector leading to collapses in investment and employment • “…misguided regulatory policies may have also played a major role in the collapse of the industry….” “….public policies that discourage investment can have negative effects on economic growth and consumer benefits.” (Pociask, 2005 Economic Policy Institute) • In seeking to encourage competition by setting aggressive wholesale rates, regulatory authorities run a risk of placing the rates too low for costs to be fully recovered and discouraging further investment by both existing and new entrants Doc Ref: 00712/PN/774.1

20. In summary • Provision of access and wholesale services between operators has become a vital part of a competitive telecommunication market • Wholesale costing approaches based on incremental costs or retail minus methods are reasonably well understood • However, the determination of wholesale prices by regulators has not always had the intended economic results • How much should regulators intervene in the setting of wholesale price levels? • Can negotiations between an access provider and an access seeker ever represent a negotiation between equals? Doc Ref: 00712/PN/774.1

21. Thank You Any Questions? Doc Ref: 00712/PN/774.1