The economic cost of interconnection is generally the starting point in establishing economically efficient interconnection prices.
In many jurisdictions, regulators set interconnection prices based on long run incremental costs (LRIC). (For example New Zealand, Australia, the United Kingdom, the European Community, and the United States.) The most common form of LRIC is Total Service Long Run Incremental Cost (TSLRIC), known as Total Element Long Run Incremental Cost (TELRIC) in the United States.
There are numerous methods of estimating LRIC. Approaches to modeling LRIC can be broadly categorized as bottom-up and top-down modeling approaches. Bottom-up models include scorched earth or scorched node methods. Click here for a comparison of bottom-up and top-down modeling approaches.
“Bottom-Up” Modeling
Bottom-up modeling uses detailed data to build a hypothetical network that can supply telecommunications services, including interconnection services. The costs of this network, including capital costs and operations and maintenance costs, are then allocated to all the services provided. Bottom-up modeling has the following steps:
Step 1: Define the services to be modeled (for example local access services). This step includes gathering data on the number and location of customers in the geographic area under consideration
Step 2: Determine the design of the network — what facilities are required to provide the service, and where should they be located? Figure 1 illustrates a typical design of such a local service network and the facilities that are needed to provide telecommunications services. As the figure shows, a PSTN generally includes: wires and support structures that connect customers to telephone switches (loop facilities); end-office and high-level switches; and facilities that connect the switches (transport)
Figure 1: Generic PSTN Network Structure
Source: Macv Sullivan, Presentation on “The Basics of Interconnection”, ITU Workshop on Telecommunication Reform, 3-5 May 1999.
Step 3: Determine the amount of each type of equipment needed to construct the network
Step 4: Estimate the costs of each element. For each type of equipment multiply the amount required by its unit prices to arrive at the total investment cost. (TSLRIC models usually use current “best-in-market” costs)
Step 5: Convert the total investment cost, for each network element, into an annual (or monthly) amount. This amount equals depreciation costs and cost of capital for the firm in question
Step 6: Estimate annual (or monthly) operations and maintenance costs and non-network costs. This includes direct out-of-pocket operating expenses associated with the investment and indirect expenses, such as corporate overheads
Step 7: Estimate total costs for each network element by adding the annual (monthly) amounts calculated in Steps 5 and 6
Step 8: Divide the total costs of each network element by the relevant cost-driver, to arrive at unit costs. For example, use the number of lines to derive the unit costs for subscriber loops, or the number of minutes to derive unit switching costs.
“Scorched Earth” and “Scorched Node” Models
Step 2 — designing the network to be modeled — requires the regulator to make choices about how much optimization to include in the modeled network. These choices can be represented on a spectrum, as shown in Figure 2. (The distance between the points on the spectrum is illustrative only.)
Figure 2: Approaches to Network Design in TSLRIC Models
The scorched earth approach represents one extreme. It assumes that nothing is fixed, not even the location of the nodes. The scorched earth network is what an entrant would build if no network existed, based on the location of customers and forecasts of demand for services. This approach would give the lowest estimate of LRIC, because it removes all inefficiencies due to the historical development of the network.
At the other extreme, LRIC can be estimated from the current costs of the existing firm, using a top-down modeling approach. This will give the highest estimate of cost because it does not allow for optimization.
The “scorched node” approach to LRIC estimations represents a compromise between the two extremes. It assumes that the location of network nodes is fixed, and the operator can choose the best technology to configure the network around these nodes. Scorched node models are common internationally. Regulators in Australia, New Zealand, the United States, the United Kingdom, Austria, Switzerland, Denmark, the Netherlands, and Ireland have adopted the scorched node approach.
Regulators must make trade-offs between different objectives. Basing the estimate of LRIC on current costs would mean that entrants would pay more than the efficient costs, potentially reducing entry. Basing the estimate on a scorched earth approach is also problematic. It could deter the network operator from making investments that are efficient given the actual configuration of the network, since the scorched earth approach ignores the existing network configuration.
“Top-Down” Modeling
“Top-down” modeling attempts to measure LRIC starting from the firm’s actual costs, as set out in its accounts. This method does not involve detailed network modeling. Instead, a top-down model separates the firm’s assets and costs into service groups, and then adds the costs associated with interconnection to arrive at an estimate of LRIC. This usually involves the following five steps:
Step 1: Identify the firm’s services and separate out interconnection services
Step 2: In the firm’s accounts, identify and separate all costs and assets
Step 3: If a cost item or asset is attributable to only one service, allocate it to that service
Step 4: Use allocation rules to allocate shared and common costs between services
Step 5: Calculate LRIC for each service by adding up the costs allocated to that services, including an appropriate return on those assets allocated to the service.
“Top-down” modeling uses the firm’s current operating costs and historic capital costs. These are not forward-looking costs. It is more difficult to take account of future changes in costs in a top-down approach than in a bottom-up approach that can incorporate explicit assumptions about technological change and its impact on the firm’s choice of inputs.
It is possible to make adjustments to top-down approaches to remove inefficiencies in the firm’s current network configuration and costs, but it is difficult to do so transparently. The incumbent firm will have more information about its historic performance and its accounts than the regulator or new entrants.
Comparison of “Bottom-Up” and “Top-Down” Modeling
| |
Bottom-up models |
Top-down models |
| Advantages |
Can model costs that an efficient entrant would face
Flexible — can change assumptions readily
Transparent — much of the information used is publicly available |
Incorporate actual costs
Useful for testing results from bottom-up model
May be faster and less costly to implement, but this depends on how well categories in the financial accounts match the data required |
| Disadvantages |
May optimize “too much” or omit costs. If this happens, the operator will be under-compensated and will reduce investment in the network
Modeling of operating expenditure is usually based on simple margins instead of real-world costs
Data needed for the model may not exist
The modeling process can be time-consuming and expensive |
Include the firm’s actual costs, and so are likely to incorporate inefficiencies
Less transparent — confidentiality issues mean other stakeholders may not have access to the information used
The parties may dispute the cost allocation rules used (the rules used to allocate shared and common costs among specific services)
Data may not exist in the required form |
RELATED INFORMATION
Economic and Accounting Measures of Cost
Useful Economic Concepts
Commonly Used Cost Models
Benchmarking Interconnection Rates