Cost systems and models

1. Cost systems and models 27 january 2003

2. Cost systems and models I. General principles II. Regulation and models: some examples III. Fixed Interconnection example

3. I. General principles • ART’s experience in cost systems: • Fixed networks (i.e. France Telecom) • Cost of universal service • Interconnection tariffs (leased lines, traffic conveyance services) • Control of retail tariff (predation tests) • Unbundling of the local loop: the cost of a copper pair • Mobile networks • Interconnection tariffs (termination charge)

4. I. General principles Set up a general framework. Main choices: 1. Accounting separation. • Purpose of the system: • non discrimination (internal cession price equal to external cession price. For example to verify that the cost of a minute of transit in a switch is the same for FT as for competitors. • Identify the profitability of the activities and the existence of cross subsidies (for example between communications and the rental fee) • To calibrate the system: • Identify the main activities • In France, the system which was set up for FT identified 6 “boxes”: Access network, Conveyance network, Telephony communications, Interconnection, Leased lines, Others. • The system must be flexible enough to allow evolutions with new activities (Internet, …)

5. I. General principles 2. Audit: • France Telecom is audited every year. • The mobile operators are not audited. 3. Transparency: • As far as France Telecom is concerned, the opinion of the auditors is published; • In the UK the accounts of BT are published

6. I. General principles 4. Cost structure : • It is important to define precisely the different types of costs (direct/indirect/common, network/commercial); • It is needed to better understand the system of the operator; • It is needed to adopt pertinence decision to define the cost allocation (interconnection tariffs, universal service,…)

7. I. General principles 5. Choice of reference costs: • Historical costs based on the accounting of the operator: • Necessity for the regulated operator to have a complex accounting system and for the regulator to understand and trust the system (role of the audits) • Advantage: robustness • Inconvenient: not a good signal ART used historical costs for interconnection from 1998 to 2002 with international benchmark and efficiency studies. It still uses historical costs for mobile operators.

8. General principles 5. Choice of reference costs: • LRIC (long run incremental costs) • Incremental cost: you must define services, identify one as the increment and to affect to the services the cost of production, once all other services are produced; • Long term costs: all the costs are variable (no fixed costs). And we take actual costs based on the best industrially available technologies • Tariffs are based on LRIC+ contribution to common costs to avoid deficits for the regulated operator.

9. I. General principles 5. Choice of reference costs: • Issues with LRIC (long run incremental costs) • The regulator must be able to implement a system that is not directly based on the accounting system of the regulated operator. • It needs to understand the top down model of the regulated operator (FT uses the same accounting system but with actual costs and efficiency consideration) and to build with the sector a bottom-up model to be able to analyse the results of the top down model. At the end of the process, it must conciliate the two models. • It is a long and complex process to be implemented only if the regulator is sure to have enough expertise. • Used in France for fixed interconnection and unbundling of the local loop.

10. I. General principlesConclusion • The regulator needs time to develop an expertise. It needs different tools: • Audits; • Models; • Discussions with all the operators. • It must be careful to have at the end a coherent global model you adapt for the different uses.

11. II. Regulation and models: exampleuniversal service Universal service costs • The cost of public payphones • The cost of directories • The cost of social tariffs • The cost of the obligation, to connect at a reasonable price, all the people who ask for a fixed connection. It is the more complex cost to be measured and a model was developped in France to measure the deficits of the unprofitable zones

12. II. Regulation and models: exampleuniversal service The costs of unprofitable zones is determined by: • Dividing France in 12 000 zones; • Determine the deficit of unprofitable zones using “avoidable costs” that means the costs that could be avoided if the zone was not connected. A very complex and fine model is needed to measure the differences of costs depending on the density and the geography. ART used audited accounts to feed the model.

13. II. Regulation and models: exampleunbundling of the local loop ART uses LRIC costs and measures the cost of a pair of copper (the use of LRIC was required by a decree) It developped a bottom-up model but used the top-down model.

14. II. Regulation and models: examplemobile interconnection ART uses historical costs with a model that was developped with the operators. 1. Describe the network 2. Describe the traffics and the way they use the network in order to dimension the network and to allocate the costs 3. Value the costs

15. III. Fixed interconnection example:the LRIC implementation • From 1998-2002, ART used historical costs

16. III. Fixed interconnection example:the LRIC implementation • In 2001, ART launched studies to implement LRIC. There were two main subjects to be done: • Define the principles • Understand and audit the top down model of FT • Develop with the sector a bottom-up model • The entire process required one year.

17. III. Fixed interconnection example: the LRIC implementation • Principles: • LRIC are used as an efficiency signals that means the costs that an efficient operator would incur if it used the most efficiency technology; • The efficiency signal must be realistic and take into account a industrial technology; • Besides it was decided in France to maintain the number of the nodes of the network (scorched node assumptions).

18. III. Fixed interconnection example: the LRIC implementation • Top down model: • FT takes the systems it used in historical costs as the basis for LRIC calculations; • It takes the same operational costs as FT estimates it was efficient; • As far as equipments are concerned, it used actual costs that means the market price to value the equipments and not the historical prices; • This approach had the advantage of the robustness and could be audited.

19. III. Fixed interconnection example: the LRIC implementation • Bottom-up model: • A mission was assigned to a consulting firm which: • Do an enquiry in the sector (operators, equipment manufacturers) to identify the best available technologies and the prices of the equipement; • Develop an Excel model which respect the following objective: • To modelize the cost of a conveyance network that could make transit the same trafic as the one of FT ,that covers the whole territory and that uses efficient technologies with the same number of equipments (scorched nodes).

20. III. Fixed interconnection example: the LRIC implementation • Bottom-up model: steps to dimension the network • Choose the technology and describe the equipments and the rules to dimension the network; • Modelize the traffic and the routes in the network; • For example, for the switches, you must modelize all the traffic transiting through the switches to determine the size of the switch you need.

21. III. Fixed interconnection example: the LRIC implementation • Bottom-up model: steps to determine the cost • Determine a WACC; • Determine a depreciation formula; • Determine the cost inducers;

22. III. Fixed interconnection example: transmission: general architecture (1/3)

23. III. Fixed interconnection example: the measure of the transmission lengths (2/3)

24. III. Fixed interconnection example: The cost assumption (3/3)