Proposals on the Development of the LRIC Model for Identification in Japan Presentation to the LRIC Working Group by Cable & Wireless IDC Jonathan Sandbach, Ph.D Director, Economic & Regulatory Analysis Cable & Wireless Global 1

Contents Methodologies for distinction of traffic sensitive vs non-traffic sensitive costs Estimating the cost of Universal Service Asset lives Unbundled copper & fibre Forward looking charges 2

Methodologies for Distinction of Traffic Sensitive vs Non-Traffic Sensitive Costs 3

Hong Kong: “The charge will be based on LRAIC [Long Run Average Incremental Cost], reflecting the use of the traffic dependent portion of the terminating carriers network.” UK: The exchange [local switch] performs a dual function of customer access to the network and the handling of different types of calls. The cost drivers for expenditure are those factors responsible for the levels of provision of specific elements of equipment within the exchange. The main cost drivers are connections [of access lines], traffic and call attempts or a mix of these. The costs of equipment items whose provision levels are dictated by customer connections are clearly those associated with the function of providing access to the network, and are thus driven by exchange lines. This proportion of the “primary plant group” costs are therefore apportioned to Access activities. The costs of equipment provided to satisfy the traffic and call attempts required are clearly driven by the number and duration of those call types contributing to those activities…. Principles used on other countries 4

US: “Element rates shall be structured consistently with the manner in which the costs of providing the elements are incurred.” Australia: Cost classification: For the purposes of calculating costs, Telstra’s PSTN is divided into two components: the customer access network, which is the network connecting each end user to a node (e.g. an IRIM, RSS, RSU). It consists of infrastructure such as network termination points, copper lines, trenches, pillars, and line cards; and the inter-exchange network, which is the network connecting nodes. It consists of infrastructure such as optical fibre, trenches, multiplexers, remote concentrators and switches. Broadly, the costs of the customer access network are regarded as ‘line related costs’, whereas the costs of the inter-exchange network are regarded as ‘conveyance costs’ (i.e. call related costs). Principles used on other countries 5

This alignment of cost causation with revenue recovery is one of the underlying principles of an economically efficient interconnection charge structure. Restricting interconnection charges to traffic related costs is necessary to encourage:  efficient building of alternative access infrastructures. Carriers should only make these investments where it constitutes an efficient use of investment resources. The level of interconnection charges will determine when new carriers decide to invest in new local loop infrastructure, and when to purchase interconnection from the incumbent. If interconnection charges include non-traffic sensitive costs, new carriers will be forced into making sub-optimal decisions, opting to build their own infrastructures when, in fact, it would be more efficient to use the incumbent’s network through interconnection;  efficient use of the long distance and international networks when prices reflect costs. Whenever prices exceed the underlying resource costs, efficient usage of the network by interconnect customers (and ultimately retail customers) is curtailed. If interconnection charges (either those charged by NTT-East or NTT-West to new carriers, or those paid by the NTT group to “itself”) exceed traffic sensitive costs of long distance or international usage, use of these services will be curtailed to the detriment of consumer welfare. Why align the model with cost causation? 6

Analysing network components for traffic sensitive & non-traffic sensitive costs Local Exchange Remote switching / concentrator units (may be collocated with LE) Dimensioned by traffic (traffic sensitive) Dimensioned by access lines (non-traffic sensitive) Subscriber line cards Cable junctions/ distribution points 7

Revenue recovery of traffic sensitive and non- traffic sensitive costs Total Network Cost Incremental to access Common costs Incremental to conveyance Allocated to Allocated to Allocated to Allocated to leased leased lines etc exchange lines Common costs PSTN lines, data, etc. Allocated to Allocated to Al located to Allocated to leased leased lines etc exchange lines PSTN lines, data services, etc Allocated to Allocated to Allocated to Allocated to Allocated to leased leased lines etc exchange lines retail PSTNinterconnect lines, data services, etc Exchange line rental Call Charges Interconnect charges 8

Estimating the cost of Universal Service 9

Cost of Universal Service Cost of universal service = avoidable net cost of unprofitable subscribers + avoidable net cost of unprofitable exchanges - benefits to the universal service provider Note: avoidable costs will exclude: many retail costs (including sales) most overheads all R&D costs 10

Avoidable net cost of unprofitable subscribers Distribution for each Message Area of: Subscriber Bills + Incoming Call Revenue At “Iteration 0”, this will be based on actual subscriber data (or samples thereof) supplied by NTT/E & NTT/W Subscriber “pure” Incremental costs (excluding common costs) for Message Area Source:LRIC Model Note: calculation of this distribution requires the LRIC model to analyse traffic sensitive & non-traffic sensitive costs Yen Iterations Adjustment for loss of calls to/from unprofitable subscribers R i = R i-1 * l i / l i-1 where R i is subscriber revenue (from distribution) at iteration i l i is number of lines of lines not defined as USO at iteration i Iterations stop when l i = l i-1 Analysis for each Message Area illustrative 11 USO Iteration 1 Iteration 2 Iteration 3

illustrative 12

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Asset Lives 15

International benchmarks PwC has conducted an analysis of asset lives for over 30 telecommunication operators globally, 20 of which are in the top 50 (based on company revenues) The following table summarises asset lives used for different types of equipment 16

International benchmarks 1 17

International benchmarks: switching 18

International benchmarks: transmission equipment Years 19

International benchmarks: cable The life attributed to cabling will mainly depend on the type of technology and cable used (copper v. fibre optic). The life of aerial cable is shorter due to likely damage and technical obsolescence. The following chart shows the number of companies using various asset lives for underground copper and fibre cables. 20

International benchmarks: duct 21 Low asset lives for duct is sometimes a result of extensive competition in local infrastructure provision. Therefore, we would expect appropriate asset lives for NTT to be at top end of this range.

Benchmark survey performed in June 1996 on plant asset lives AssetAverageMinimumMaximumStandard Deviation Conduit/duct Source: INDETEC The results compare to an estimate of 56 years used in the HAI model (another of the major US cost models). International benchmarks 22

International benchmarks: power equipment Research indicates that 10 years appears to be a reasonable figure for the average in the industry with regards to DC power equipment. In Europe and the US Telcos have adopted service lives for DC power in the range of 10 to 12 years, and in Asia 9 to 15 years. 23

Main drivers of economic depreciation Electronics (e.g. switching & transmission) …technical obsolescence Duct & cable...physical life 24

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Long asset life Shorter asset life 26

Possible Model (1) LetP be price of asset at year 0 pbe annual % price increase of asset M be annual operational cost of asset in 1st year, as % of asset price m be annual % increase in operational cost in subsequent years of asset’s life r be discount rate d be asset life N be net present cost of infinite renewal of asset after d years N = P Provided p r 27 … … … …

Possible Model (2) Maximise N with respect to d: First order condition is: Provided p r Can be solved for d 28

Example (1): low maintenance equipment Assume: 8% discount rate Assume: 0.5% operational cost as % of asset price in year 1 of asset life rising to % after r years Annual % price increase of asset -5%-2%0%1% Annual % increase 15% in opex in each year of asset life25% Annual % price increase of asset -5%-2%0%1% Annual % increase 15% in opex in each year of asset life25% optical fibre cable duct Assume: 1% operational cost as % of asset price in year 1 of asset life rising to 2-3% after 5 years 29

Example (2): high maintenance cost Assume: 8% discount rate Assume: 2% operational cost as % of asset price in year 1 of asset life rising to 4-6% after 5 years Annual % price increase of asset -5%-2%0%1% Annual % increase 15% in opex in each year of asset life25% Annual % price increase of asset -5%-2%0%1% Annual % increase 15% in opex in each year of asset life25% Assume: 5% operational cost as % of asset price in year 1 of asset life rising to 10-15% after 5 years Electronic equipment 30

Asset life data: way forward LRIC Working Group should formerly survey overseas regulatory authorities to collect up-to- date estimates of asset lives. C&W IDC would be glad to do this on behalf of the WG. 31

Unbundled Copper & Fibre 32

LRIC for unbundled copper & fibre Important points: duct sharing optimal cable sizes sharing of common costs with other services (e.g.PSTN) cable asset life exclude subscriber line card (not required for unbundled loops) Example of unbundled copper model: see 33

Forward looking charges Total conveyance costs Volumes Unit costs now Volume sensitive costs Fixed costs Internet access PSTN 34 If the model is to be used to set charges going forward in time it is essential that it reflect projections of: - equipment costs; - network usage volumes This last element (usage volumes) is important to capture the correct economies of scale. In other countries, one of the most important drivers of local network usage growth is Internet access traffic. An example is given on the next slide.

Internet access volume data Internet access (0845) traffic growth on PSTN “This annex provides an illustration of the growth experienced in 0845 traffic. Since the introduction of the NTS formula and the wholesale adoption of the Virtual Point of Presence (VPOP) model by the industry for Internet access this may be used a a quantification of Internet access traffic since it will be predominantly such. Figure C1 is a direct plot of the traffic, measured in minutes for each quarter over the period Q1 1994/1995 to Q3 to 1999/2000. This gives a graphic indication of the explosive nature of the rate of growth.” Source: OFTEL 35