Practical considerations of USO cost modelling David Hughes Doc Ref:

Agenda Two examples of regulator experience in cost modelling Available models Practical issues associated with modelling Doc Ref:

Regulator experience of USO cost modelling Cost modelling is accepted as a method of determining the net cost of a USO The particular cost model used has to be accepted by the stakeholders involved The USP and the contributors to the USO fund Net cost typically calculated yearly in arrears Net cost varies considerably from year to year As tariffs and traffic volumes change Net cost calculation requires a very careful cost analysis, particularly of the access network Almost half the total cost of universal service delivery Doc Ref:

Hong Kong Telecommunications Authority analysis shows impact of tariff rebalancing Tariff rebalancing deferred by incumbent to September 1999 Net cost calculated using regulated rebalanced tariff from 1999 to 2001 Price cap lifted 1st July 1998 HK$M 1998[1] 1999 2000 2001 Total net universal service cost 480 327 170.7 127.9 Uneconomic customers 404 242.6 102.1 74.8 Payphones 76 83.7 67.3 53.2 Miscellaneous and balancing items 0.7 1.3 -0.1 Total customers (m) 2.7 2.6 Uneconomic customers, %age of total customers 46% 23% 9% 7% %age of lines taken by uneconomic customers 47% 24% 8% 6% Deficit per uneconomic customer per month (HK$) 27.1 32.4 34 33 Cost per minute of external traffic (HK cents) 12.8 Reduction in uneconomic lines as tariffs rebalanced Deficit per uneconomic line rises as the number of uneconomic lines goes down Doc Ref:

Key revenue issue Does the universal service tariff used by the USP maximise revenue in the competitive market that it faces? Can the regulator assume that the operator is maximising its profits for the universal service? Is the operator attempting to maximise its minimum revenue per line by minimising any access deficit? Should the regulator define rebalanced tariffs? Rebalanced tariffs increase minimum line charges and therefore increase minimum revenue per line and reduce number of uneconomic lines What about competition from mobile prepaid card services? Doc Ref:

New Zealand Commerce Commission analysis shows the difficulty in coming to an agreement over net cost Actions taken Net cost estimate Sep ‘02 Results of model prepared by PwC (now IBM) for New Zealand Telecom presented to CC $226.5m Nov ‘02 Incorporation of CC’s WACC of 8.2% in model $112m Apr ‘03 Revised model after minor errors identified by Telecom removed $85m Sep ’02 Commerce Commission decided that a bottom up model was required Oct ‘02 Commerce Commission announced decision to use the FCC Hybrid Proxy Cost Model June ‘03 Commerce Commission issued draft determination using the FCC model and a WACC of 6% $38.84m Doc Ref:

New Zealand’s experience points to particular details that need to be considered in modelling USO costs Consistency in treatment of Modern Equivalent Assets (MEA) LRIC model assumes MEA Operating costs should be revised to take account of MEA Network topology should be revised to take account of MEA (CC admits that this may be done only to a limited extent in practice) Use of average call costs rather than incremental call costs The USO business can be considered to be incremental to the main business of the firm Incremental switching costs may be near zero Similar issues may arise for other costs Consistency between efficiency benchmarks and models Definitions of cost elements in efficiency benchmarks need to be consistent with definitions of cost elements in the cost model used Distinguishing between stranded assets and spares Stranded assets are not included in the cost analysis, spares are included A stranded asset is one for which there is (no longer) any use Lines to unoccupied properties may be considered stranded by some regulators Doc Ref:

Available models FCC Hybrid Proxy Cost Model WIK PwC – now IBM Used by Commerce Commission in New Zealand and in Portugal as well as USA Adapted successfully for Jordan Freely available from the FCC Comprehensive cost database Algorithms for scorched earth and scorched node approach for designing a proxy network for costing purposes WIK Used in UK, amongst other countries PwC – now IBM Used by New Zealand Telecom and at least one other operator Revised since it was used in New Zealand Sophisticated model but seems to produce relatively high cost estimates Doc Ref:

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:

Collecting consistent and accurate data is a key issue Need for clear dialogue with USP Clear understanding of the network topology and costs Costing of many components > millions of drops (average drop length may be assumed) Potentially millions of distribution points Potentially 10’s or 100’s of thousands of cabinets Potentially 1000’s of exchanges Definition of incremental switching costs Allocation of common costs Need to know Relationship between cables and ducts Relationship between distribution points and cabinets and cables Doc Ref:

Scorched node approach subscribers DP ‘1’ DP ‘2’ cabinet 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 and revenues 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 Repeat for exchanges 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’ Also the volume of calls is reduced because DP’1’ is eliminated So recalculate the revenue and cost of DP’2’ Calculate the revenues and costs for the cabinet and eliminate if loss making Doc Ref:

Scorched node approach subscribers DP ‘1’ DP ‘2’ cabinet JD500 JD100 Total cable cost from cabinet to DPs = JD600 DP1’s share of cable cost = 0.5 x JD500 = JD250 DP2’s share of cable cost = 0.5 x JD500 + JD100 = JD350 If DP1 is uneconomic, then DP2’s share of cable cost = JD500 + JD100 = JD600 Also traffic is diminished because traffic from DP1’s subscribers is removed Doc Ref:

Costing issue Assumption (1): Assumption (2): ISSUE: In a recent case, we knew how far the distribution point was from a cabinet and we could allocate distribution points to cables, we could not allocate cables to ducts or routes Cable duct Assumption (1): cabinet DP1 DP2 DP3 DP4 DP5 Assumption (2): DP1 DP2 cabinet DP4 DP3 DP5 Costs of DP3, DP4 and DP5 are greater under Assumption (2) than under Assumption (1) because the overall route length is greater Assumption (2) would result in a higher net cost for the USO than Assumption (1) Doc Ref: