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.DDirector, Economic & Regulatory

AnalysisCable & Wireless Global

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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

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Methodologies for Distinction ofTraffic Sensitive vs

Non-Traffic Sensitive Costs

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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

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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

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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?

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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

Cablejunction

s/distribut

ionpoints

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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 PSTN interconnect lines, data services, etc

Exchange linerental

CallCharges

Interconnectcharges

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Estimating the cost of

Universal Service

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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

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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 AreaSource:LRIC ModelNote: calculation of this distribution requires the LRIC model to analyse traffic sensitive & non-traffic sensitive costs

Yen

IterationsAdjustment for loss of calls to/from unprofitable subscribersRi = R i-1 * l i / l i-1

whereRi is subscriber revenue (from distribution) at iteration il i is number of lines of lines not defined as USO at iteration iIterations stop when l i = l i-1

Analysis for each Message Area

illust

rativ

e

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USO

Iteration 1Iteration 2Iteration 3

Avoidable net cost of unprofitable exchanges

Local exchange Incremental Cost* Incremental Revenue* Net Avoidable CostA) (B) (A) – (B)

Exchange L Yen 501 Yen 200 Yen 301

Exchange M Yen 595 Yen 300 Yen 295 USO

Exchange N Yen 500 Yen 350 Yen 15

Exchange O Yen 385 Yen 500 - Yen 115

Exchange P Yen 505 Yen 700 - Yen 195

Exchange Q Yen 400 Yen 600 - Yen 200

* Adjusted for loss of unprofitable customers

illust

rativ

e

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Other US cost issues (1)

Public Payphone ServiceIt is generally accepted that it is important for advertising revenues from public payphone boxes to benetted off from public payphone costs. Thus:

Net cost of payphone line = incremental cost of payphone line – average advertising revenue per payphone

NTT/ E and NTT/ W should be required to provide the relevant data average advertising revenue perpayphone for each Message Area from an analysis of the income ledgers. If NTT/ E and NTT/W areunable to produce actual figures, other members of the WG should be requested to provide estimates.

Emergency Call ServiceEmergency service access is usually provided free of charge, but the costs of that to network operators isnot something which is included in universal service calculations and, in the UK, are recovered throughsurcharges on retail and wholesale charges for other services.

IslandsThe standard methodologies requires transmission links crossing water to the assumed to use the mostcost efficient technology. In many cases this is likely to be micro-wave for shorter distance (say up toabout 40km.), and satellite or submarine cable for long distances.

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Other US cost issues (2) Outlying Islands

This problem is more important for Japan than for Europe and the US (or eventhe UK). It is necessary for the model to include the appropriate transmissiontechnology for transmission links to outlying islands where NTT/E andNTT/W are required to provide service as part of their USO. It will benecessary to select the lowest cost for each island from the following alternatives:

Microwave Microwave Cost = [ roundup ( route length / maximum hop length ) + 1 ] * ( fixed cost ofinfrastructure towers + equipment cost per T1 channel * number of T1 circuits )

Submarine cable Submarine cable cost = [ rounddown ( cable length / maximum length without repeater) – 1 ] * cost perrepeater + length of cable sheath * ( cost per km + number of fibres * cost per fibre)

Satellite Satellite cost = fixed cost of aerial + cost per T1 circuit * number of T1 circuits

actual cost = minimum (microwave cost, submarine cable, satellite cost)

Asset Lives

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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

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International benchmarksAsset Category Europe

(Years)

USA

(Years)

Asia

(Years)

Average

Service Life

(Years)

Transmission Equipment

PDH Transmission 4 - 12 7 - 10 6 - 12 10

SDH Transmission 10 - 14 7 – 10 6 – 15 10

Switching Equipment

Digital Switching Equipment 10 - 12 7 – 12 6 – 10 10

Power Equipment

DC Power equipment 10 - 12 10 – 12 9 - 15 10

Cables and duct

Copper cable 14 - 20 14 – 20 10 – 15 15

Optical Fibre cable 10 - 30 15 – 25 10 – 20 20

Duct and boxes 10 – 40 40 – 50 15 – 35 35

1

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International benchmarks: switching

Digital Exchange Switching

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Years

No.

of

Com

pani

es

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SDH equipment only

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

International benchmarks: transmission equipment

Years

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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.

Cabling

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37

Years

No

. o

f C

om

pa

nie

s

Copper Cable

Optical Fibre Cable

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International benchmarks: duct

Duct

10 15 20 25 30 35 40 45 50 55

Years

No.

of

Com

pani

es

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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

Asset Average Minimum MaximumStandard Deviation

Conduit/duct 51.56 45.00 60.00 4.81

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

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International benchmarks: power equipment

DC Power

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Years

No. of

Co

mp

anie

s

• 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.

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Main drivers of economic depreciation

Electronics (e.g. switching & transmission)… technical obsolescence

Duct & cable ... physical life

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Estimating asset lives (1)

Economic asset lives depend on:

Comment

Maximum physical life of asset upper bound

Trend in asset cost positively related to asset life

Operational (e.g. maintenance cost) negatively related to asset life

Trend in operational cost as asset negatively related to asset life gets older

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Estimating asset lives (2)Example: duct & fibre

Long physical life

Increasing labour cost for installation

Low maintenance cost & trends

Example: transmission electronics

Medium physical life

Falling cost of equipment

Medium maintenance cost & trends

Long asset life

Shorter asset life

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Possible Model (1)

LetP be price of asset at year 0

p be 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

d

d

dd

dd

d

r

r

m

mr

rMP

Mr

mM

r

mM

r

mM

rP

Mr

mM

r

mM

r

mM

rP

Mr

mM

r

mM

r

mM

1

11

1

11

1.1

1

1

1

1

1

11

1

1

1

1

1

1

1

11

1

1

1

1

1

1

1

122

12

12

N = P

Provided p < m & m <> r

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…

…

…

…

Possible Model (2)

Maximise N with respect to d:

First order condition is:

r

p

r

m

rM

mr

p

m

p

m

r

ddd

1

1log

1

11

)1(1

1log

1

1

1

11

Provided p < r & m <> r

Can be solved for d

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Example (1): low maintenance equipmentAssume: 8% discount rate

Assume: 0.5% operational cost as % of asset price in year 1 of asset life

rising to 1.0-1.5% after r yearsAnnual % price increase of asset -5% -2% 0% 1%

18.6 20.9 22.9 24.0

13.6 14.7 15.5 15.9

Annual % increase 15%in opex in eachyear of asset life25%

Annual % price increase of asset -5% -2% 0% 1%

15.5 17.4 19.0 19.9

11.5 12.4 13.1 13.4

Annual % increase 15%in opex in eachyear of asset life25%

optical fibre cableduct

Assume: 1% operational cost as % of asset price in year 1 of asset liferising to 2-3% after 5 years

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Example (2): high maintenance costAssume: 8% discount rate

Assume: 2% operational cost as % of asset price in year 1 of asset life

rising to 4-6% after 5 yearsAnnual % price increase of asset -5% -2% 0% 1%

12.8 14.3 15.5 16.2

9.6 10.3 10.8 11.1

Annual % increase 15%in opex in eachyear of asset life25%

Annual % price increase of asset -5% -2% 0% 1%

9.5 10.6 11.4 12.0

7.3 7.8 8.2 8.4

Annual % increase 15%in opex in eachyear of asset life25%

Assume: 5% operational cost as % of asset price in year 1 of asset liferising to 10-15% after 5 years

Electronicequipment

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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.

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Unbundled Copper & Fibre

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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 www.analysys.com

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Forward looking charges

Totalconveyance

costs

Volumes

Unit costs

now

now

now

Volume sensitive costs

Fixed costs

Internet access

PSTN

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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 toQ3 to 1999/2000. This gives a graphic indication of the explosive nature of the rate of growth.”

Source: OFTEL

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