Introduction

• The pressure on all types of operators to implement cost-based pricing, especially for interconnect services, is growing

• I will deal with issues around the determination of tariff levels, and how to determine tariff structures.

• I will also touch upon how tariffs for commercial services will typically be determined in a negotiation process

Price Determination

By

Cleveland Thomas

SEMINAR ON ITU PRICING SEMINAR ON ITU PRICING MODELSMODELS

TBILISI, GEORGIA, NOVEMBER 14-15, 2002TBILISI, GEORGIA, NOVEMBER 14-15, 2002

Why are interconnection rates so important?

Sellers of Services

• Protect retail

market positions

- discourage

cherry-picking

- protect retail

tariffs• Increase revenues

Regulators

• “Protect” retail

customers• Promote competition• Give efficiency

incentives• Deter uneconomic

entry etc.

Buyers of services

• Minimize overall

costs

• Enable competitive

tariffs

• Simplify roll-out of own retail services

Key issues for pricing wholesale /interconnect services

• The growing importance of jointly-provided services

• The importance of taking both long and short-term considerations

• The importance of recognizing that the interests of the regulator are, in the longer term, fundamentally opposed to the interests of the telecoms industry

• The need to understand the implications of pricing decisions across retail and wholesale services

• The need to understand that wholesale relations between operators are bilateral (both sides are buyers and sellers)

Key differences between a Regulatory & Commercial Approach

Commercial Approach

• Driven by demands

rather than costs

• Long-term profit maximizing

• Must fit with overall strategy and retail tariff structures

• Art based on science

Regulatory Approach

• Cost-based

– FAC vs.. LRIC

– historic vs.forward-

looking

• Mark-up

– zero

– uniform

– Ramsey

– ECP

Tariffing must be approached in an integrated manner.

Retail Wholesale

Service NService 2

Service 1

Value toCustomer

Expectedcompetitive action

Own costs to produce

Price

Cross elasticity’s

Service NService 2

Service 1

Value toCustomer

Expectedcompetitive action

Own costs to produce

Price

Cross elasticity’s

OptimizationRegulatory interests

Value-Based Price of a Wholesale Service

0102030405060708090

100

Ret

ail

Tar

iffs

FA

C

Cho

sen

Pri

ce

Mic

row

ave

alt.

Incr

. Cos

t

Different cost-bases can provide the starting point for (cost-based) tariffs

• Short Run Marginal Cost (SRMC) – Cost of one additional unit of output, given existing capacity

• Long Run Incremental Cost (LRIC) – Cost of adding a service or increment, including capacity costs

• Stand Alone Cost (SAC) – Cost of providing one service by itself

• Fully Allocated Cost (FAC) – Directly attributable cost plus a pro rata share of overheads

These cost types will be addressed in more detail later

Tariffs must also include a mark-up

Type of mark-up• Zero mark-up

• Uniform mark-up

• Ramsey Pricing

Pro’s stimulates entry strong efficiency

incentives prevents excess profits

easy to calculate balances conflicting

objectives

promotes efficient final svc. Prices

prevents excessive profits

Cons threatens viability of seller promotes uneconomic entry distorts competition

arbitrary inefficient

impact depends on flexibility of final service prices

inelasticity may be due to lack of competition

Tariffs must also include a mark-up

Type of mark-up

• Efficient Component Pricing

Pro’s

- promotes fair competition

- deters uneconomic entry

- ensures viability of seller

Cons

- provides weak efficiency incentives

- does not address monopoly profits

The Choice of mark-up can have a dramatic effect on tariff levels

Illustrative Interconnect Charges (pence/call minute)

Note: Price for the use of a local Tandem

CallType

LRICwith noMark-

Up

Ramsey AC/Uniform

mark-up

ECPR

Local 1.1 2.8 2.3 2.1

National 1.1 1.6 2.3 4.3

Int’l 1.1 1.4 2.3 8.0

Tariff structure is an important as tariff level• A generic tariff is a combination of one or more of the following elements :

– initial charge (one-off charge - only one time)

– fixed charge (time-based)

– call set-up (unsuccessful vs. only successful calls)

– charge per unit

• Other dimensions also need to be considered

– geographical structure (distance)

– time-of-day structure

– charging unit (per minute, per second)

• The link to the retail tariff structures must also be considered

– same structure ?

– closer links to cost-drivers ?

– higher complexity ?

Examples of importance of tariff structures

• True results depend on expected calling patterns

• expectations will differ among operators depending on – retail customers served

– retail services offered

• each wholesale customer will have individual wishes for the optimal tariff structure

An infinite of solutions give the same result (3 minute call)

16

14

12

10

8

6

4

2

00 1 2 3 4 5 6

Charge per minute

Call set-up

Arriving at tariffs in this market segment will involve a set of negotiations

Regulator

Operator 1Operator 2

Overview of typical positions

StartPosition

- Tariffs based on historic FAC- Tariffs based on WACC of 18%

Target Walk-away

Reasoning

- Tariffs should cover all historic costs - Risk of business is high

- Tariffs based on LRIC + equal mark-up - WACC equal 15%

- Tariffs should cover incremental costs - Level of cost of capital is more important than cost

- Tariffs based on LRIC + equal mark-

up - WACC equal 12.5%- Cost of capital at minimum level to ensure viable business

Impact of different views on revenues

02468

101214161820

Call Set-up Minute Rate Net Impact

Scenario A - Expectedshort calls duration

Scenario B - Expectedlonger calls

Key Conclusions• Pricing is an integral part of your overall commercial strategy for dealing with

wholesale and interconnect

• All parties negotiation interconnect and wholesale tariffs should address the issues with a broad, long-term view to ensure that value stays in the industry

• Regulatory-lead, cost-based pricing of these services should only be a last resort when negotiations fail

• Developing optimal tariff structures is as important as determining the tariff level

• Determining tariff levels and structures is not a one-off exercise, but rather part of an ongoing negotiation process