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1. Introduction In the European Commission s efforts to liberalise telecommunications markets across Europe and to enable effective competition by tearing down incumbent operators monopolies, interconnection pricing is seen as a matter of prime importance. Indeed, new market entrants should be able to offer services to end-users, thereby using the incumbent s network to gain access to the desired customer group. As a consequence, the European Commission issued a Recommendation on Interconnection Pricing 1, stating that interconnection tariffs should be cost-oriented and preferably be determined implementing the concept of long run average incremental costs (LRAIC). In this paper, it is our aim to concisely discuss the different approaches that can be taken in order to model costs. Firstly, we will elaborate on the LRAIC-concept, defining and illustrating its various constituents. Subsequently, an overview of different approaches on how to implement LRAIC will be presented. Whilst illustrating the methodological evolution of these approaches, it will become clear why LRAIC is the preferred method to apply. 2. The LRAIC-concept Definition LRAIC is an acronym that stands for Long Run Average Incremental Cost and refers to a cost modelling approach. Given certain initial conditions, LRAIC calculates the cost of providing a predefined increment. Stated otherwise, when determining LRAICs, one asks himself what the cost would be, seen from a long-term perspective, of adding a service or product to an existing portfolio of services and/or products. In general, the increment can be broadly defined as the provision of any additional quantity of economical output, be it a single new service or product, a whole set of new services/products or just a capacity increase. Initial Conditions A clear definition of the initial conditions is of utmost importance as the cost of the increment depends on the products/services that are comprised within the initial situation. The initial products/services determine whether shared costs 2 are or are not to be taken into account when calculating the cost of the increment. Consider the example shown in figure 1: in situation I, both products A and B are produced at the initial situation, hence the increment is defined as the production of product C. As shared costs 1 and 2 are already required at the initial situation, the cost of producing C only comprises its direct variable and fixed costs (blue shaded area). In situation II on the contrary, solely product A is produced at the initial situation; the increment is defined as the production of both products B and C. The cost of producing C now also includes an appropriate part of shared costs 1 (orange shaded area). 1 Commission Recommendation 98/195/EC of 8 January 1998 on Interconnection in a liberalised telecommunications market. Part 1 Interconnection Pricing 2 Shared costs are costs that are associated with a group of products and cannot be directly attributed to a single product. Often, shared costs do not vary proportionally with product quantities. As an example, one can consider duct and trench costs. They relate to a group of telecommunications services (PSTN/ISDN-traffic, ADSL etc.) but costs do not vary significantly with the actual number of cables. 2
Direct variable costs Products A B C Sit. I: Cost of product C (solely C as increment) Direct fixed costs Shared costs 1 Sit. II: Cost of product C (both B & C as increment) Shared costs 2 - Figure 1: The importance of the initial conditions - Increment Moreover, also the definition of the increment is crucial. Once again, the cost of the increment depends on its definition since a distinction is being made between LRIC (Long Run Incremental Costs) and LRAIC (Long Run Average Incremental Costs). When imagining a situation where additional shared costs are required for realising the increment (e.g. the set-up of a new server for network management purposes), an allocation method has to be defined in order to attribute these costs to the constituent products of the group. Whereas the LRAIC-approach will identify allocation keys that allocate a part of the shared costs to all products of the increment and thereby calculates an average price for the various products, strictly spoken the LRIC-method will allocate these shared costs to the product that is firstly added to the increment. The difference is illustrated in figure 2: whilst the product portfolio A, B and C constitutes the increment and one considers product A to be firstly added, shared costs for the 3 products will be completely attributed to product A when applying the LRIC-method. Adversely, when LRAIC is being implemented, shared costs will be divided over all three products. Whereas it is common in telecommunications literature to refer to LRIC, in reality often LRAIC is intended since for a group of products, it is more logical to distribute shared costs amongst all of them than to allocate costs to one single product. Costs When deriving costs from the general ledger, one inevitably takes into account merely historical costs. Cost accounting methods based on these figures sadly fail to furnish us with an accurate view on the current cost of providing a given product/service. Indeed, costs of obsolete investments, sunk costs and historical inefficiencies of telecommunications operators shall be undesirably included, thereby distorting the calculation of actual costs. As opposed to historical costs, forward-looking costs tend to look ahead and consider the costs that would be applicable when building a network, featuring the same functionality as the existing one, at present. As a consequence, when taking investment decisions, one should consider all costs to be variable ( on the long run ) and decisions should be oriented towards efficient operation. When doing so, only costs incurred by an efficient operator are taken into account. Please note however that the network of an incumbent, even when adapted for efficient operation, might still differ significantly from the theoretically optimal one. Therefore, great 3
Products A B C Direct variable costs Direct fixed costs Shared costs LRAIC product A A B C Direct variable costs Direct fixed costs LRIC product A Shared costs - Figure 2: Defining the increment: LRIC vs. LRAIC - care should be addressed when deciding upon the efficient network topology; prices being set too low might discourage both the incumbent s as competing operators investments in additional capacity or qualitative customer service. 3. Implementing the LRAIC-concept: translating theory into reality First and foremost, it is essential to state that hitherto, no single cost modelling approach can claim to be the sole, ultimate implementation of the LRAIC-concept. In recent years, different approaches have been developed and a distinct evolution can be perceived in consecutive models. However, most models can be classified into one of two generic categories, i.e. bottom-up or top-down models. In this last section, we will present these methods and discuss pros and cons. 3.1 Top-down approach Top-down models take the current financial situation of an operator as input. The required information can be retrieved from financial accounts (balance sheet, income statement etc.) or from budgetted accounts. FDC-HCA As a first, simple attempt, the Fully Distributed Cost 3 Historical Cost Accounting method is a classic cost accounting system, allocating all historical costs to the various products and services. Obviously, no correction is being made for inefficient operation or obsolete technologies. 3 The Fully Distributed Cost (FDC) method is also known as the Fully Allocated Cost (FAC) method. 4
FDC-CCA The Fully Distributed Cost Current Cost Accounting method also distributes all costs, but aims to adapt them to today s technological situation. This is being realised through a revaluation of the operator s assets at current prices. Indeed, adaptations are made in order to eventuate in an accurate view on what costs would be if historical investments were carried out at present. As for some assets market prices no longer exist (due to e.g. technological obsolescence), one tries to identify the price of a modern equivalent asset (MEA), i.e. an asset featuring the same functionality as the old one. Whereas FDC-CCA clearly is superior when compared to FDC-HCA, still no correction is made for inefficient operation. LRAIC Implementation of the LRAIC-concept requires not only adaptation for today s prices, but also for inefficient operation. Top-down models typically use efficiency ratios to accomplish full efficiency. As can be expected, these ratios often cannot be defined unequivocally and therefore tend to be arbitrarily. 3.2 Bottom-up approach As opposed to a top-down model, a bottom-up model does not rely on historical financial data. Several approaches can be taken, mainly differing in their initial conditions. The most commonly used approaches are described below. Scorched earth Sensu stricto, it considers the theoretical situation of setting up a complete new network today, featuring the same functionality as the existing one but designed for 100% efficient operation. Consequently, the structure of this network is used as a basis for calculating costs of providing incremental services. This approach is called the scorched earth approach or the greenfield scenario. (Modified) scorched node It is apparent that in reality however, the topology and nodes of an incumbent s network cannot be altered readily. Accordingly, the scorched node approach, which assumes all parameters to be variable (including the network topology), is often considered as being too radical. Therefore, in practice other approaches can be preferred. In the scorched node approach, the existing network nodes are said to be fixed, though all other network elements can be optimised. In the modified scorched node approach, topology is variable indeed, but the actual network is opted for as the optimising process starting situation. In both models, optimisation algorithms will iterate the network structure until an efficient solution is obtained. Please note that, since they incorporate the physical structure of the network, bottom-up models usually are very well suited to model capital expenditure (CAPEX) costs. However, such models are in general far less suited for determination of operational expenditure (OPEX) costs. 3.3 Comparison of the different approaches In figure 3, a comparison of the different approaches is presented. Operators/regulators usually start the modelling process with a top-down FDC model, then gradually migrate to a LRIC top-down model and eventually develop a LRIC bottom-up model. The shift from a classical FDC model towards a more sophisticated LRIC bottom-up model causes an increase of the number of assumptions (as allocation keys, efficiency factors, etc. become necessary inputs) and hence the complexity of the model rises accordingly. Thereby, it is crucial to pay attention to the possible evolution of costs. 5
Number of assumptions FDC Possible cost evolution CCA LRIC (top down) LRIC (bottom-up) Complexity - Figure 3: Comparison of different approaches - When applying a CCA revaluation, costs might actually rise 4, but generally one expects costs to decrease when shifting to a LRIC model. Lowest costs normally are achieved using a LRIC bottom-up model. 3.4 Conclusion From our discussion above, we can conclude that there is no single best approach. Whereas bottom-up models typically are very performant in calculating CAPEX costs, OPEX costs often can be identified more accurately by top-down models. Accordingly, a hybrid approach, combining the relative strengths of both approaches, is the most favorable in many cases. Moreover, one should realise that, when applying a bottom-up and top-down model to a given operator, results of both models will undoubtedly differ. In that regard, reconciliation, i.e. scrutinising the factors that provoke the differences, usually proves to be a necessary process, allowing to attain a profound insight in the elements affecting the cost calculations. Finally, one should always bear in mind that cost models are merely means of support in the operators and regulators decision-making process. Incautious adoption of the cost models output can eventuate in tariffs that might disturb telecommunications markets and have a destructive impact on the liberalisation process. Obviously, this is to be avoided at all cost. 4 This is certainly applicable to labour-intensive costs as current labour costs are higher than historical ones (due to a.o. inflation and salary increases) 6