The Hybrid Cost Proxy Model: Portugal Edition D. Mark Kennet William W. Sharkey Instituto das Comunicações de Portugal November, 2000

2 Forward-looking economic cost Represents the cost of a competitive new entrant with newly constructed facilities if it: Operates efficiently using modern technology employed in efficient network configurations Serves the total demand for costed item Serves customers located in their current positions connected by efficient network routing to efficient switching machines Earns a “normal” return appropriately adjusted for risk

3 Definition of efficient network model Most economically efficient technology capable of providing stated level of service Model should reflect substitution between technologies as relative prices change

4 Implications of FLEC assumption Embedded network is irrelevant Except for scorched node wire center assumption Assists consistency with record-keeping and geographical constraints Assumes use of only current best, least-cost technologies Costs must be those of a network that is efficient for the desired purpose (e.g. voice grade network for universal service; higher quality network design may be appropriate for interconnection and unbundled element pricing)

5 Advantages of Proxy Model Approach Proxy modeling: Minimizes data collection requirements and administrative burdens on companies Is the only methodology reasonably capable of needed levels of disaggregation Addresses consistently the costs of families of interrelated network elements Provides transparency and rigor to the costing process

6 HCPM Overview Open data structure Input files can be easily verified and modified by the user Alternative inputs can easily be accommodated (both publicly available Census data and geocoded customer location information can be used) All source code is freely available

7 HCPM Overview (cont.) Loop design module deploys plant to the specific locations determined by customer location module Explicit optimization routines are used minimum cost spanning tree algorithms for the design of feeder and distribution routes optimization over technology type: fiber, HDSL, or analog

8 A Typical Wire Center

9 Steps in Network Design Use a clustering methodology to determine serving areas (SA) Overlay a grid structure on each cluster and assign customer locations to micro-grid cells Design distribution plant for each SA Design feeder plant to connect all serving areas to the central office switch

10 The Clustering Algorithm Divisive method Maximal size serving areas are created subject to maximum copper distance constraint maximum line count constraint

11 Geocode and Surrogate Locations, Évora service territory Évora

12 Closer view of Évora locations

13 Clusters Created for Évora

14 Grid Overlay for Every Serving Area (Cluster) Microgrid

15 Distribution Plant in a Microgrid Vertical Branching Cable Cable Junction Points Drop Wire

16 Cable Junction Point Microgrid Boundary SAI Populated Cell Unpopulated Cell Connecting Microgrids to a Remote Terminal

17 Distribution Network for Évora

18 Pinetree feeder Feeder backbone Serving Area Interfaces Central office Feeder branches

19 “Optimized” feeder routing Central office Serving area interfaces

20 The Feeder Algorithm Minimum structure distance network

21 The Feeder Algorithm (cont.) Minimum cable distance network

22 The Feeder Algorithm (cont.) Balanced network

23 The Feeder Algorithm (cont.) Balanced network with rectilinear distance

24 The Feeder Algorithm (cont.) Balanced network with junction nodes

25 Feeder Network for Évora

26 The Switching and Interoffice Network Tandem Switch Interoffice Trunks IXC or CLEC Wire Center Wire Center End office Switch End office Switch Dedicated Common Direct Point of Presence

27 Switching Costs Line ports Trunk ports Common control call processing Signaling network costs

28 Interoffice Networks (a) Mesh-like Interoffice Network A B b C (b) Interoffice Ring Network C B A

29 Expenses Cost of capital Depreciation Operating Expenses Overhead Costs

30 Cost of capital Very contentious issue – essentially two broad choices Base on historical rate of return; or Assume that competition changes capital market structure for firms Should real option value be included?

31 Economic depreciation Difficult to estimate “economic depreciation since depreciation allowances in telecommunications were determined under “cost plus” regulation International benchmarks may prove useful