Criteria for choosing an investment cost annualization methodology and the transition from copper to fibre

Transcription

1 March 20 Criteria for choosing an investment cost annualization methodology and the transition from copper to fibre Public consultation Autorité de régulation des communications électroniques et des postes

2 Contents. Analyses and practices applied up until now he principle of annualizing investment costs History of the practices employed by ARCEP Defining a simple model: historical costs Stimulating infrastructure-based competition: asset replacement paths Guaranteeing strict cost recovery: economic current costs Need to refer to an investment record Results of the current methodology for the copper local loop Comparison of ARCEP practices and those employed by other NRAs around Europe 3.4. Lessons to draw Specific questions concerning copper cables, in view of their gradual replacement by optical fibre How to recover the investment costs of copper cables at the end of their lifecycle? Which reference costs to use in future for copper cables? Geographical and temporal considerations... 7 Appendix - Definitions and properties... 9 Autorité de régulation des communications électroniques et des postes 2

3 Introduction he rise in internet traffic, the development of media content and the emergence of new personal and collective services will result in growing demand from consumers for ultra-fast broadband access over optical fibre networs in the coming years. he deployment of new generation ultra-fast broadband networs across the country therefore represents a major development issue at once social and economic in France. Carriers have been involved in large-scale fibre-to-the home (FH) networ rollouts along the main thoroughfares in the country s biggest cities for many months now, which should soon result in a growing rate of adoption for the new technology. In June 200, the French government unveiled the national ultra-fast broadband programme, which was allocated a budget of 2 billion. he implementation of this programme over the coming months should also help accelerate the spread of ultra-fast broadband across the country, and especially of optical fibre, and mae it accessible to all households and businesses. ARCEP helped bring about the first solution for accessing France elecom civil engineering bac in his solution was perpetuated by the adoption of ARCEP s analysis of the maret for accessing the passive infrastructure that constitutes the wireline local loop. his included access to the copper pair and access to underground civil engineering infrastructure. Under the provisions of the French Postal and electronic communications code, CPCE (Code des postes et des communications électroniques) resulting in particular from the Law on modernising the economy of 4 August 2008, and the Law on bridging the digital divide of 7 December 2009 ARCEP defined the regulation governing ultra-fast broadband networ rollouts through two decisions: the first, dated 22 December 2009, specifies the terms of infrastructure sharing in very high-density areas and the second, dated 4 December 200, lays out the terms that apply in more sparsely populated parts of the country. he economic terms and conditions governing access to France elecom local loop civil engineering ducts were stipulated in Decision No of 9 November 200. his decision, which concerns the tariffs charged for accessing the ducts, deals primarily with cost allocation between fibre and copper and restates the principle of using a single method for calculating annualized investment costs for the same asset, in accordance with the European recommendation. When used to deploy an optical fibre networ, civil engineering ducts will be treated the same way as when they are used for the copper local loop networ, and the economic current costs method defined by Decision No of 5 December 2005 will therefore be employed. his consultation is an extension of the wor performed in 200, its purpose being to determine whether the copper networ s eventual replacement by optical fibre networs will require adjustments to be made to the annualization methodologies that are currently in effect. After having provided some bacground here on its previous choices concerning investment cost annualization, ARCEP will lay out the issues that are specific to fibre deployments. Autorité de régulation des communications électroniques et des postes 3

4 Staeholders are requested to comment first on the properties of the different methods that have been employed by ARCEP up until now. hey are then invited, as a lead-up to largescale optical fibre rollouts, to propose possible amendments to the methods employed to ensure that this technological transition taes place smoothly. his consultation will run until 2 May 20. Responses must be sent via to: annualisation@arcep.fr. ARCEP is also engaged in parallel efforts on this topic with European regulators and the European Commission. Autorité de régulation des communications électroniques et des postes 4

5 . Analyses and practices applied up until now.. he principle of annualizing investment costs For certain wholesale tariffs, ARCEP may decide to impose an obligation of cost-oriented pricing as a result of its maret analyses. here are several possible approaches to costoriented pricing: notwithstanding price comparisons provided for by the regulatory framewor, a tariff can be based on costs that correspond to the regulated carrier s actual costs, or on the costs of a generic efficient operator. Moreover, because tariffs generally remain the same throughout the year, it is advisable to assess costs on an annual basis. Investment costs are recorded for a given year whereas assets are employed over time, which results in charges being set for the asset s entire period of use. o ensure that operators are treated fairly and equally over time, it is necessary to maintain a stable charge. his is illustrated in the following graph established for an asset with an initial value of 00, with a lifespan of 30 years and replaced twice. he vertical bars represent investment expenditures, with a 2.0% rate of inflation and a.0% rate of technical progress. he curve here represents the annualized investment costs based on the constant amortization formula (see above), with rate of return of 7% in real terms and thus a rate of return of 9.% in nominal terms. Euros Year he different methods employed for annualizing investment costs spread these costs out over time and result in a series of annuities, each of which corresponds to the portion of the investment costs allocated to the year in question. Each annuity is calculated based on the economic record for the year in question: - at the start of year, the carrier maes an investment I, - at the end of the year, this investment has a value of I + and has produced an annuity of A. According to Article D3 of the regulatory portion of the CPCE, ARCEP may consider prices being charged in comparable marets in France and abroad. Autorité de régulation des communications électroniques et des postes 5

6 Achieving economic equilibrium implies that, for a discount factor of a: or: I + + A = (+a)i A = (I I + ) + ai In all of the methods, annuities therefore include two components: - the first (amortization) corresponds to the depreciation of the value of the asset in question; - the second (return on capital employed) corresponds to the cost of holding the capital or the opportunity cost of the sum invested. Ultimately, once the source of the investment costs to be taen into account is determined, the fact of annualizing investment costs supposes the choice of a cost amortization method. heoretically, if investments are regularly spread out over the years during which the infrastructure is used, any annualization methodology will mae it possible to obtain stable annuities over the period of use of these assets, thereby ensuring the fair and equal treatment of operators over time..2. History of the practices employed by ARCEP.2.. Defining a simple model: historical costs In the past, ARCEP has employed historical costs for the cost accounting of interconnection products subject to price control obligations, obtained directly from the regulated operator s accounts. hese costs have the advantage of simple implementation: neither the amortization periods nor the amortization methods are altered with respect to accounting entries. ARCEP did, however, allow itself to restrict the scope of the considered costs to only those it deemed relevant. he amortization method most commonly used in accounting is constant amortization. For an investment I with an economic lifespan of made in year 0, amortization for year is therefore calculated as: I Amo =, he annuity obtained with a nominal rate of return of a n which is constant throughout the period is therefore: I I A = + an( ( )) In practice, a tariff based on thus-calculated annual investment costs could translate into operators being treated unfairly over time. Indeed, for a given investment, the application of linear amortization results in annuities that decrease over time. his is what is depicted in the graph below for an asset with an initial value of 00, with a lifespan of 0 years, under a Autorité de régulation des communications électroniques et des postes 6

7 scenario of a.0% rate of technical progress and a 2.0% rate of inflation, with a real rate of return of 7.0% (9.% nominal rate of return). Annuities resulting from constant amortization Euros Year Amortization Return on capital employed Furthermore, in instances where several assets are replaced simultaneously, the series of total annuities will include sudden fluctuations, which leads to a lac of predictability on the tariffs for operators Stimulating infrastructure-based competition: asset replacement paths In accordance with the objectives laid out in the French Postal and electronic communications code 2, ARCEP considered it necessary to adopt a more economical approach to the annualization of investment costs for certain assets, taing account of the economic signal sent by the tariff to the different players. When woring on setting unbundling tariffs following the adoption of the European regulation of 2000, and at a time when certain technologies such as the wireless local loop (WLL) and cable appeared to constitute truly competitive alternatives to the copper local loop for serving subscribers, it was deemed necessary to introduce a long-term economic signal aimed at alternative operators for access products. It was within this context that the asset replacement path method was implemented for the first time. It was then extended to the assessment of interconnection costs on fixed networs in his method consists in establishing annual infrastructure costs: - taing account of the latest available technologies (which France elecom would use if it were to rebuild its networ); 2 In the current wording of the CPCE (Article D3 of the regulatory portion), the Postal and electronic communications regulatory authority will ensure that the chosen methods promote economic efficiency, stimulate lasting competition and optimise benefits to the consumer. he code therefore explicitly stipulates that a distinction exist between the accounting costs considered for regulatory purposes and the costs recorded for the purposes of social accounting: the cost accounting methods [ ] can be distinct from those applied by the operator. Autorité de régulation des communications électroniques et des postes 7

8 - considering the restrictions to which France elecom is subject in terms of the location of subscriber connection points and interconnection points (so that the scope of the services assessed corresponds to the scope of the services actually sold); - while maintaining the capacity of the France elecom networ (optimal provisioning with corresponding economies of scale). While factoring in the economies of scale achieved by the incumbent carrier, this method is designed to allow an alternative operator to mae an informed choice between building its own networ and renting existing infrastructure from the incumbent (i.e. mae or buy ), in instances where it is at least as efficient as the benchmar (efficient) operator. his method therefore enables the development of infrastructure-based competition. In practice, as it has been implemented in eeping with ARCEP decisions, the asset replacement path method is based on economic annuities (constant annuities adjusted to tae account of price changes). For an investment I with an economic lifespan of made in year 0, with a constant rate of technical progress g (expressed in real terms), a constant real rate of return a r, and noting h=(+g)(+a r ), the economic annuity at the start of year is calculated in constant euros as: * I A h = ( + a r ) +, ( + g) ( + h) Inflation needs to be taen into account to obtain an annuity in current euros: * A A = j= 0 ( + inflation By definition, economic annuities will change apace with the price of the assets: j ) A ( + inflation ( + g) = A ), It has by now been clearly established that economic annuities is the amortization method most capable of producing a stable cost signal, not only over the life of a given asset but also in cases where assets are replaced. he stability of economic annuities for a given investment is illustrated in the graph below, depicting an asset with an initial value of 00, with a lifespan of 0 years, under a scenario of a.0% rate of technical progress and a 2.0% rate of inflation, with a real rate of return of 7.0% (9.% nominal RoR). Autorité de régulation des communications électroniques et des postes 8

9 Euros Economic annuities Year Amortization Return on capital employed he stability of economic annuities in the case of replaced assets is illustrated in the following graph, established for an asset with an initial value of 00, with a lifespan of 30 years and replaced twice. he annuities correspond, on the one hand, to constant amortizations and, on the other, to economic amortizations under a scenario of a.0% rate of technical progress and a 2.0% rate of inflation, with a real rate of return of 7.0% (9.% nominal rate of return). Euros Year Annuities resulting from constant amortization Economic annuities.2.3. Guaranteeing strict cost recovery: economic current costs Contrary to what had been anticipated, neither the existence of cable networs in certain metropolitan areas nor the expected emergence of new forms of access (WLL, PLC) robbed the France elecom copper local loop of its status of essential infrastructure. his means that, for copper local loop assets, the choice between building a new networ ( mae ) or renting the existing one ( buy ) is meaningless and the long-term economic signal constituted by replacement costs has no reason to exist. On the contrary, the reuse of these assets that are not bound to be replicated should be encouraged. Using an approach based on the operator s real investments in these assets is therefore more suitable than modelling that results in a mae or buy type signal. he economic current costs method, in which the lin between the tariff and actual investments is clearly established, is thus more appropriate than the asset replacement path method. Autorité de régulation des communications électroniques et des postes 9

10 In instances where certain parameters have been assessed incorrectly, applying the asset replacement path method can indeed result in the setting of tariffs that could lead the regulated operator to perceive fees that do not correspond to the sum invested. Assessing parameters is a particularly delicate matter when it comes to the copper local loop: - as an essential infrastructure, the copper local loop is managed by a single carrier, which means a maximum degree of asymmetry in the information; - assessing the parameter of asset life is especially complicated since the assets that mae up the local loop have never yet been replaced. In the case of the local loop, then, applying the asset replacement path method was based on the hypothesis that investments would be automatically renewed at the end of their amortization period but observation of the France elecom networ revealed that the actual lifespan of the assets in question was longer than predicted. he economic current costs method has the advantage of guaranteeing that a fully amortized asset no longer produces annuities. he sum of the discounted annuities rendered by the economic current costs method do not change when a parameter assessment error occurs. his means that, while the asset replacement path method produces annuities for as long as the assets are in service, the economic current costs method produces annuities only for as long as the assets have not been fully amortized. In instances where an asset that is still in service after it has been fully amortized is not replaced, the economic current costs method produces an annuity of zero for this asset, whereas the asset replacement path method continues to attach a value to the use of this asset. It was notably because of this property that the economic current costs method was chosen in 2005 to assess copper local loop costs 3. he economic current costs method therefore satisfies the demand that quality of service be maintained (the operator continues to have an incentive to invest efficiently), but guarantees the strict recovery of investment costs and ensures that the incumbent carrier does not enjoy an undue financial advantage. As with the historical costs method, the economic current costs method is based on the actual investments made by the regulated operator, but instead of the constant amortizations that are generally applied in accounting, it employs economic annuities (annuities that eep pace with changes in price, in other words which neutralise the effect of inflation and technical progress proper to the assets in question). he record of investments in copper local loop assets is in fact characterized by a great deal of irregularity, and so requires the use of a method that maes it possible to obtain a stable cost signal. 3 It should be mentioned that when ARCEP adopted the economic current costs method to annualize the investment costs on copper local loop, it was employed in a consistent manner for setting all of the tariffs for access products using the corresponding assets. Autorité de régulation des communications électroniques et des postes 0

11 Need to refer to an investment record As with any method based on the actual infrastructure of the regulated operator, the economic current costs method supposes access to a reliable and detailed investment record. However, no accounting record was ept of investments that France elecom made in access-related assets prior to 993. Only a fictional record was available and it was not used as it was unrealistic (according to this account, all France elecom investments were made in three stages: 979, 984 and 990 for copper cables, 974, 984 and 99 for civil engineering). he use of this record would have also translated into very brutal fluctuations in annualized capital costs. A detailed investment record was therefore reconstructed based on non-accounting data. his reconstruction wor was carried out in 2005 in tandem with all of the staeholders. he results of this exercise were made public in Decision No of 5 December For investments made after 993, ARCEP was able to use accounting records directly Results of the current methodology for the copper local loop Once the entire record had been reconstructed, it was possible to calculate annualized investment costs using the economic current costs method. So, for a series of investments I i made during years i prior to, the total annuity in economic current costs for year is obtained with the following formula: I i ( i) A ( ) = h + ar + ( inflation j ) i i ( g) + < + j= i ( + h) with g, a r and h corresponding to the parameters introduced earlier. he economic current costs method maes possible both: - the strict recovery of France elecom investment costs since, for each investment, the sum of the discounted annuities is equal to the expenditures. In concrete terms, for an investment I with an economic lifespan made in year 0, noting A annuity (nominal) in year and a n with a supposed constant rate of return, the following equality is verified: A ( ii) I = ; ( + an ) - and the equal treatment of operators over time. Autorité de régulation des communications électroniques et des postes

12 he economic current costs method is not based on investment forecasts since its aim is only to annualize actual past expenditures. It can therefore not result in creating a provision for replaced or renewed assets 4. Every year, the amount remaining to be amortized is altered by taing account of logged amortizations and newly made investments 5. his operation falls within the scope of regulatory accounts audit. he method adopted in 2005 resulted in unbundling tariffs that were compatible with real infrastructure-based competition: there are now around 9 million unbundled lines in France, most of which (close to 8 million) are fully unbundled. At the end of 200, alternative carriers had installed their equipment in 5,42 exchanges which account for roughly 83% of all lines. In addition, this method for annualizing investment costs was used in a consistent manner to set all tariffs, both retail (telephone subscription) and wholesale (unbundling, wholesale line rental). It made it possible to reconcile the maret price and underlying costs for all services that employ the copper local loop. ARCEP therefore considers that, in the absence of any contextual change, this method could remain relevant for determining the cost of services that are based on the copper local loop (bitstream, unbundling, wholesale line rental, telephone subscription). Respondents are invited to comment on the use of the economic current costs method for determining annualized investment costs for the copper pair, drawing a distinction between the properties of the economic annuities and those tied to the source of the chosen relevant expenditures. Respondents are ased to express themselves in particular on how equitable the different forms of annualization are over time, depending on the type of investment record used (theoretical regularly staggered or actual fluctuating). Respondents are invited to comment on the verification of equation (ii) by the annuities calculated using the different annualization methodologies. On the matter of equation (i), respondents are invited to specify the extent to which discounting the annuities calculated using the economic current costs method could result in the recovery of an amount that differs from the actual expenditure. In particular, respondents are ased to cite any instances in which a form of provision for a replacement of 4 On the other hand, based on economic annuities, this method facilitates reinvestment to the extent that it produces annuities that evolve apace with the price of the assets: as is the case with constant amortizations, reinvestment does not incur dramatic fluctuations in the annuities used to calculate the tariffs. 5 Should a change in method be considered, it should be implemented based on the last remaining amount to be amortized. For instance, if constant amortization is deemed more relevant today, it is based on this amount that the annuities must be calculated. Assessing tariffs cannot be based on historical costs as supplied by France elecom accounting since it does not tae account of the amortizations actually realized using the regulatory annualization method in effect between 2005 and 200. Autorité de régulation des communications électroniques et des postes 2

13 the regulated operator s assets appears, and to specify in what way the formulas need to be amended to ensure the strict recovery of investment expenditures..3. Comparison of ARCEP practices and those employed by other NRAs around Europe he approach taen by ARCEP has led staeholders in France to question the consistency of the practices employed across Europe for annualizing investment costs. At first glance, the economic current costs and the asset replacement path methods may appear to be exceptions when compared to the practices of other European NRAs, all of whom have adopted methods called HCA 6 or CCA 7. he European Commission accepted the use of historical costs in its recommendations for some time, but it is now woring to enact a shift to accounting methods in current cost. he Commission also recommends adopting a forward-looing approach and factoring in technical progress by referring to modern equivalent assets. It requires national regulatory authorities to compare top-down 8 and bottom-up 9 approaches, but leaves it up to NRAs to choose their implementation modalities. he disparities in the terms employed by the different regulators suggests, sometimes mistaenly, considerable disparities in the actual practices. his is why ARCEP formed a woring group with its European counterparts to examine the reality of the investment cost annualization methodologies that were actually being used. he following findings emerged from this group:. On the matter of the amortization formulas employed, regulators occasionally use different terminology but all in fact refer to five main modalities: - constant amortization (seven instances, including the one used in the past by ARCEP for investments related to mobile call termination), in most cases referred to as historical cost accounting 0 ; - constant amortization, taing account of price changes (two instances employing the version with operating capital maintenance, or OCM, two instances employing the version with financial capital maintenance, or FCM) generally referred to as current cost accounting ; - constant annuities (five instances); - constant annuities adjusted to tae account of changes in price or economic annuities (four instances, including one which does not tae technical progress into account a modality that corresponds to ARCEP s approach to investments tied to France elecom wireline services, referred to as economic current costs 6 HCA: Historical Cost Accounting 7 CCA: Current Cost Accounting 8 A top-down approach consists of assessing costs based on those incurred by the regulated operator. 9 In a bottom-up approach, costs are established based on a technical-economic modelling of one or several carriers businesses. 0 Fourteen NRAs supplied detailed responses to the questionnaire that ARCEP sent out prior to the first woring meeting. Lie ARCEP, some regulators use different approaches in different situations. Autorité de régulation des communications électroniques et des postes 3

14 (coûts courants économiques) and asset replacement path (coûts de remplacement en filière)) generally referred to as current cost accounting ; - constant annuities adjusted to the scale of demand and changes in price (two occurrences), referred to as economic depreciation. ARCEP does therefore not stand out from its European counterparts for employing heterodox amortization modalities. 2. Discussions with the other regulators also helped to reveal the degree to which the choice of a top-down, bottom-up or hybrid approach was central. In many cases, this choice is in fact more influential than the choice of amortization formula. Using investment cost sources which differ depending on the economic context, lie its European peers, ARCEP leaves open the possibility of departing from accounting records to adopt a more economical approach to tariff regulation. Respondents are invited to comment on the methods used by the other European regulators and the European Commission recommendations on annualized investment cost methodologies..4. Lessons to draw ARCEP has had occasion to issue decisions concerning the two aspects of annualized investment cost determination: - the cost amortization modality on the one hand, - and the source of investment costs to be taen into account, on the other. It does appear today that economic annuities (employed by the asset replacement path and economic current costs methods) is the amortization modality that is the most apt to produce a stable cost signal that would ensure that players are treated fairly and equally over time, regardless of the type of investment cost considered. Constant amortization, on the other hand, could induce jagged signals that disrupt the players long-term strategies or encourage opportunistic behaviour. Various responses may be brought to the question of the source of investment costs, however, depending on the regulatory situation and how much information ARCEP has at its disposal: - a record of actual investments appears to be the most appropriate when regulating an essential infrastructure since it provides a guarantee of reliability within a situation of very imperfect information on assets whose lifespan is hard to estimate: combined with economic annuities, it is the current economic cost method that ARCEP uses for the copper pair cost; - a modelled investment record that corresponds to an efficient operator but which Economic depreciation consists of spreading out annual costs in such a way as to obtain stable unit costs. It is therefore based on establishing a growth hypothesis for demand. Autorité de régulation des communications électroniques et des postes 4

15 satisfies the incumbent carrier s interconnection constraints appears the most apt to produce a mae or buy signal that enables the development of infrastructure-based competition over the long term, while maintaining the conditions of service-based competition (by allowing each to benefit from economies of scale): combined with economic annuities, it is the asset replacement path method. he investment costs for all regulated services should now be processed using this approach. Call termination provides a good example here 2. It now appears that optical fibre will eventually replace the copper networ and could therefore rid that component of the copper local loop (cables, cabinets) of its property of non replicable infrastructure. In high-density areas 3, several competing local loops will be deployed alongside the copper local loop. Carriers, both France elecom and alternative telcos, have already performed substantial networ rollouts in 48 high-density municipalities. For more sparsely populated areas, however, ARCEP Decision No of 4 December 200 lays out an infrastructure-sharing scheme for a sizeable portion of this new networ at concentration points composed of at least,000 lines. In any event, the copper networ s replacement by fibre could also accelerate the obsolescence of corresponding assets, which creates uncertainty over the recovery of investment costs. he non-replicable nature of the civil engineering infrastructure is not, however, liely to be called into question: able to be used by both copper and optical fibre technology, this civil engineering, which represents 60% of the local loop s replacement value, remains an essential infrastructure, and the advent of fibre does not bring with it any new information on the lifespan of the civil engineering. In addition, ARCEP Decision No of 9 November 200 guarantees that the recovery of corresponding costs will not result in a 2 o assess the costs of a reciprocal service such as call termination (fixed or mobile), where each operator enjoys significant maret power on its own networ, an efficient common generic cost benchmar is needed. his is why, in this instance, ARCEP refers to hybrid investment records, resulting from a modelling whose hypotheses draw on existing carriers references. Because of the fact that, in their construction, these modelled records are comprised of stable recurring investments, as networ deployment is supposed to occur in an ongoing fashion and the assets being employed have a relatively short average life, the choice of the amortization method in this case has a limited effect on the cost of call termination (see models that ARCEP has submitted for public consultation). In this specific instance, applying one type of amortization rather than another will have little effect. Historically, the mobile call termination model was based on constant amortization whereas the fixed call termination model, in which France elecom plays a central role, was based on economic annuities. oday, in a bid to achieve consistency between the methods and in light of the guarantee of stability they provide, constant annuities constitute a natural benchmar for all call termination services, both fixed and mobile. 3 As defined in ARCEP Decision No of 22 December 2009 which stipulates, in accordance with Articles L and L of the French Postal and electronic communications code, the terms governing access to ultra-fast broadband optical fibre electronic communication lines, and the instances in which the concentration point can be located on private property. Autorité de régulation des communications électroniques et des postes 5

16 change in the unit cost paid by copper local loop networ customers, other than changes resulting from the marginal increase in the total number of connections (copper and fibre) that use the civil engineering (and which contribute to covering its costs). Fibre rollouts therefore give rise to questions over the status of the copper pair cables and the possible acceleration of their obsolescence. Because the annualized investment cost methodology currently being employed is tied to the non-replicable nature of the copper local loop, the following section raises several points to consider when examining the annualization methodologies that need to accompany this technological transition. Respondents are invited to remar on the preliminary analysis which tends to confirm that local loop civil engineering ducts constitute an essential infrastructure. At what point in time, or under what circumstances, would this qualification cease to be relevant for the local loop networ s copper cables? 2. Specific questions concerning copper cables, in view of their gradual replacement by optical fibre 2.. How to recover the investment costs of copper cables at the end of their lifecycle? oday, all of the investments that France elecom maes in copper cables for the local loop are covered by the entirety of the copper local loop s users, according to a single annualized investment cost formula. With the deployment of fibre come questions of the relevant scope of investment costs that will be shouldered by the last remaining users of the copper local loop, and how these costs should be annualized. On the one hand, as operators roll out their optical fibre networs, customers will switch over to these new access networs and France elecom s copper loop will find itself with spare capacity. his means that, using a consistent method and without any additional considerations regarding efficiency, the number of customers using the copper networ is expected to decrease more quicly than the cost of the cables in the base of relevant costs. Efficiency considerations could therefore result in a decreased scope of the relevant costs according to the number of connections to the copper local loop. On the other hand, the smooth transition from copper to fibre during this period requires France elecom to maintain its copper networ and to continue to mae the necessary investments to guarantee a sufficient quality of service, at least in those areas where fibre is not available. It is entirely possible to imagine an accelerated obsolescence for all investments made in the copper networ, which results in a forecast lifespan for copper assets that is shorter than what is currently being applied, i.e. 25 years. Autorité de régulation des communications électroniques et des postes 6

17 In any event, the annualization methods employed for the retained costs will need to be used in a consistent manner for setting all of the tariffs for the access products that use these assets. Respondents are invited to comment on efficiency considerations and on the impact of the reduced life of assets which could alter the copper networ s annualized investment costs Which reference costs to use in future for copper cables? If copper were to be considered as replicable (at least in certain areas: see above), ARCEP could be induced to retain reference costs other than those that are being used today, and which would be justified by the goal of preventing France elecom from benefitting from undue supplementary income due to its status of incumbent carrier who owns the copper local loop. his change could result in a gap between the costs incurred by France elecom and the amounts spent on copper local loop access services. his cost benchmar would: - on the one hand, incorporate a notion of efficiency which, all things being equal, would result in a reduction in the scope of costs considered compared to the costs actually incurred; - and, on the other hand, enable efficient operators to mae an informed choice between renting the copper pair and building an optical local loop, which would liely lead to an increase in the considered costs. Respondents are invited to comment on the objectives that ARCEP will need to consider to assess copper local loop costs, and on the means to be implemented to this end Geographical and time considerations Fibre rollouts are expected to result in the definition of two geographical areas: - in the first, operators would engage in infrastructure-based competition; - in the second, operators would share a single infrastructure, either copper or fibre. he divisions between these two areas may not correspond to divisions between highdensity and more sparsely populated areas given the existence of residential neighbourhoods in high-density areas. he absence of optical fibre rollouts in certain areas could both consolidate the copper local loop s status of essential infrastructure and enable the perfect recovery of investments in copper, at least those incurred in these parts of the country not covered by fibre. Given the different economic signals that could prove relevant in each of these two areas, creating a distinction in the way copper costs are evaluated may be considered. Respondents are invited to comment on the interest and feasibility of introducing a geographical distinction for investment costs. Autorité de régulation des communications électroniques et des postes 7

18 he transition from copper to fibre will in all lielihood be only gradual. he implementation of adjustments that may result from the considerations listed above must therefore occur apace with the deployment of fibre and its adoption in retail marets, while guaranteeing operators sufficient visibility into the future to mae the investments needed to build a fibre networ that covers the majority of France. It is necessary to ensure that: - France elecom is encouraged to maintain its copper networ in those areas where it cannot be replicated, but without benefiting from a competitive advantage; - alternative operators are supplied with the relevant cost references on which to base their decision of whether to invest in replicating the copper networ. Respondents are invited to comment on the roadmap for implementing a possible change in methods. Autorité de régulation des communications électroniques et des postes 8

19 Appendix - Definitions and properties Autorité de régulation des communications électroniques et des postes 9

20 . Definition of the investment cost annualization methods Preliminary definitions he different notions of value Modern equivalent asset and rate of technical progress Amortization of an asset in the context of sectoral regulation he different methods he historical cost accounting method Current cost accounting methods OCM version of the cost accounting method FCM version current cost accounting Constant annuity methods (eeping pace with variations in price) he economic current costs method he asset replacement path method he methods sensitivity to investment date and price variations Hypothesis of no variation in price Hypothesis of inflation with no technical progress Hypothesis of technical progress without inflation Autorité de régulation des communications électroniques et des postes 20

21 . Definition of the investment cost annualization methods What we propose here is a standardized presentation of investment cost annualization methods, in order to obtain a single conceptual framewor. here could be formal differences between this presentation and the method generally employed by carriers, but no fundamental changes have been made to the methods compared to the practices employed by carriers and the Authority to date... Preliminary definitions... he different notions of value he asset purchase price is the price paid to acquire it. his corresponds to the gross boo value logged in the company s balance sheet and to the actual investment made. he asset s net boo value is the price attached to it in the company s balance sheet after deducting any possible amortization and past provisions. his value corresponds to the investment that would need to be made to ensure the same service. he current replacement cost of the asset is the price that would be paid on a given date for an asset with the same productive output. his may be referred to as the gross replacement cost (GRC). he replacement cost is assessed using the concept of modern equivalent asset (MEA) or the rate of technical progress...2. Modern equivalent asset and rate of technical progress In a document published on 24 November 2000 called Principles of implementation and best practice regarding Forward-looing Long Run Incremental Cost modelling, the IRG (Independent Regulators Group, since replaced by BEREC) points out that a forward-looing approach requires assets to be valued using the cost (maret price) of replacing them with their modern equivalent (i.e. Modern Equivalent Assets or MEA), in other words, the lowest cost asset, providing at least equivalent functionality and output as the asset being valued. he notion of MEA therefore maes it possible to trac price variations in a set of assets over time, with a productive output that remains unchanged. Alternatively, the MEA cost reference can be translated through the rate of technical progress. A positive rate of technical progress corresponds to decreasing asset prices. Variations in price resulting from technical progress can be evaluated: - either within the national economy (technical progress measured based on national price indexes); - or within the company that uses the factor of production to produce its goods and services (technical progress calculated based on the actual asset purchase price, possibly adjusted according to their productive output) Autorité de régulation des communications électroniques et des postes 2

22 .2. Amortization of an asset in the context of sectoral regulation aing variations in the value of the assets into account, the annuity paid at year-end for the use of an asset in year corresponds to the difference between the net price of the asset at the start of the year 4 (initial expenditure), capitalized at the relevant rate of return (regulatory rate of return 5 in each individual case) and its net value which is re-evaluated according to the technical progress at year-end 6. he annuity 7 is therefore written as follows, depending on whether it is expressed at current prices or in constant prices: ~~ ~~ A = ( + a, n ) VN VN or A * = ( + a, r ) VN * VN * It can also be expressed thus: ~~ ~~ A = ( VN VN ) + a, nvn or A * = ( VN * VN * ) + a, rvn * When annualized, investment costs therefore comprise two components: - the first component corresponds to the asset s loss of value over the period being considered, which translates into a regulatory amortization 8 ; - the second component corresponds to the carrying cost of capital or the opportunity cost of the amounts invested, which results in the return on fixed capital employed 9. he annuity can therefore be expressed as follows, depending on whether it is expressed at current prices or in constant prices: * * * A = Amo + Cap or A = Amo + Cap All of the annualized cost methodologies can be reported based either on net values (and reevaluated net values) or directly on amortizations. here is a strict equivalence between the two types of reporting, with the net value of the asset being calculated by recursion based on the investment and past amortizations, expressed in constant or current prices depending on the method being used: * VN = I Amo i or VN = I Amo i i= = he presentation in what follows is based on amortizations. i * 4 Notation: VN in current prices, VN* in constant prices. 5 Notation: a in a generic fashion, a,n if the rate is nominal and applied to the net value in current prices, a,r if the rate is real and applies to the net value in constant prices (indice disappears if the parameter is supposed constant during the period being considered). 6 Notation: V ~ N ~ in current prices, ~ ~ V N * in constant prices. 7 Notation: A in current prices, A* in constant prices. 8 ~~ * * ~ ~ * Notation: Amo = VN VN in current prices, Amo = VN VN in constant prices. 9 Notation :: Cap = a,n VN in current prices, Cap* = a,r VN* in constant prices. Autorité de régulation des communications électroniques et des postes 22

23 he way in which the annual amortization is calculated differs from one annualized investment cost methodology to the next. Five main amortization methods are employed for the purposes of sectoral regulation: historical cost accounting (HCA), current cost accounting with financial capital maintenance (CCA FCM) or operational capital maintenance (CCA OCM), economic current costs (ECC) and asset replacement path (ARP)..3. he different methods.3.. he historical cost accounting method his method relies entirely on the accounts of the regulated enterprise for the amortization schedule: - the regulatory amortization chosen corresponds to the amount logged as an amortization in the accounts; - the cost of capital is obtained by applying the nominal rate of return to the net boo value of the asset (resulting from accounting amortization). he annuities produced by this method therefore depend on the enterprise s choice of amortization method. In practice, however, these choices are governed strictly by accounting rules so the ris of having to depend entirely on the company s accounts is only relative. As a result, this method cannot be strictly applied in situations where the regulated activity is modelled. It is nevertheless possible to approach the annuities calculated by the historical costs method by considering, to put it very simply, that the method is characterized by a constant amortization over the economic life of the asset: the value of the asset s amortization in current euros is constant for each period. For an investment I with an economic life of made in year 0, the amortization for year is therefore calculated: I Amo =, he annuity in historical costs obtained with a nominal rate of return a n which is consistent over the period is therefore: I I A = + an( ( )) It should nevertheless be mentioned that: - although constant amortization is the most common, other amortization methods also exist in accounting; - the length of the amortization period can differ from the length of the economic life; - exceptional amortizations exist in accounting, for instance in the case of the definitive non-use of an asset before it has reached the end of its accounting life, Autorité de régulation des communications électroniques et des postes 23

24 which alters the net boo value (but which are not taen into account in cost accounting since they are exceptional items) Current cost accounting methods Current cost annualization methods adjust the amortization according to variations in the price of the assets being considered, due to technical progress 20 and general variations in price. As with the historical costs method, cost accounting methods rely on constant amortizations OCM version of the cost accounting method Under CCA OCM systems, it is the gross replacement value, in other words the current price of an asset with the same productive output, expressed in constant euros, which is amortized. his maes it possible to neutralize any possible inflation along with the technical progress. he gross replacement cost of an asset with a value of I and an economic life invested in year 0 is expressed for year, when the actual rate of technical progress g is constant: I Grossreplacement cost = ( + g), it is expressed in constant euros. Amortization in CCA is then given by: * GRC Amo = his corresponds to the constant amortization of an asset purchased in year with no inflation. Because it is in constant prices, the annuity in constant euros, with a real rate of return a r is written as: * GRC GRC A = + ar ( ( )) Inflation needs to factored in to obtain an annuity in current euros. If the investment is made in year 0, the annuity in current euros is: * A A = ( + inflation j ) j = FCM version current cost accounting he second approach to CCA is a more financial one in that it aims to maintain the enterprise s financial capital: whatever transpires, the sum of the discounted annuities must be equal to the initial investment. 20 Variations in price tied to technical progress are addressed either directly through the rate of technical progress, or indirectly through application of the notion of modern equivalent asset. See the appendix for more detailed explanations of these concepts. Autorité de régulation des communications électroniques et des postes 24