Conceptual approach of the top-down cost model of Telenor s fixed-line network. Final model specification 11 February 2010

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Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 11 February 2010

Contents 1 Introduction 1 1.1 Introduction to the use of top-down costs 1 1.2 Consultation on draft version of paper 2 1.3 Structure of this paper 4 2 Output of the mapping model 5 3 Inputs to the mapping model 6 3.1 Telenor Fixed product cost accounting model 6 3.2 Financial inputs 7 3.3 Demand inputs 8 3.4 Asset counts 9 4 Overview of the mapping modelling approach 10 5 Network overview 13 6 Main modelling steps 16 6.1 Categorisation 16 6.2 Annualisation 18 7 Summary of principles 22

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 1 1 Introduction Analysys Mason Limited ( Analysys Mason ) has been commissioned by the Norwegian Post and Telecommunications Authority ( NPT ) to develop a LRIC model for interconnection on fixed networks (Markets 2 and 3) and for full and shared access to fixed access networks (Market 4). Analysys Mason and NPT have agreed an approach to deliver these cost models, which will be used by NPT to inform its own pricing decisions in the future. This paper aims to define the concepts and modelling specifications involved in comparing the results of the bottom-up cost model with the (intermediate) top-down cost information, in order to hybridise the bottom-up model. Note that a separate final model specification paper for the bottom-up cost model has been published in conjunction with this paper. 1 In this section we provide: an introduction to the use of top-down costs comments from the consultation on the draft version of this paper the structure of this paper. 1.1 Introduction to the use of top-down costs The process of comparing the top-down cost information to the bottom-up model (to ensure that the bottom-up model is a satisfactory reflection of the actual costs) is called hybridisation. Related terms used for this process are calibration (ensuring that operational and network outputs of the bottom-up model are appropriate) and reconciliation (ensuring that the key financial outputs reflect the costs incurred by a real operator). Hybridisation includes both of these steps. One of the principal challenges of hybridisation is to ensure that the categories and services used in the top-down cost allocation and the bottom-up cost model can be meaningfully compared. This requires a separate, intermediate model (hereafter referred to as the mapping model ) to re-categorise the various cost categories so that comparison is facilitated, as shown in Figure 1.1. Using the (intermediate) results of Telenor s own top-down cost model in conjunction with the bottom-up model results in a hybrid model with more robust outputs. It is necessary to assess how fit-for-purpose the (intermediate) results and outputs of Telenor s cost accounting system are and to what extent re-categorisation is needed. 1 Conceptual approach for the LRIC model for fixed networks Final model specification, 11 February 2010. This finalised paper was released following industry consultation.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 2 Telenor inputs Re-categorised inputs Telenor topdown cost model Telenor intermediate results NPT mapping model Re-categorised intermediate results NPT bottom-up model Telenor outputs Re- categorised outputs hybridisation Figure 1.1: Hybridising the bottom-up model [Source: Analysys Mason] 1.2 Consultation on draft version of paper A draft version of this paper was issued for consultation on 17 September 2009. Comments were received from Telenor, in a letter dated 9 October 2009. 1.2.1 General issues raised As noted in Section 1.1 of Telenor s response, Telenor cannot fully comment on a conceptual design that will be further refined following the consultation on the top-down cost model and subsequent development of the models. A consultation phase on the developed models is planned for early 2010. In Section 1.2 of Telenor s response, Telenor highlights the explicit distinction between model development and the application of model results in pricing decisions. NPT has stated that the development of cost models is a separate process to any pricing decision that may arise in future market analysis work. In Section 1.4 of Telenor s response, Telenor states that the top-down model specification does not address the treatment of fully depreciated assets, and that this means that the starting point is a new network built today. As stated in Section 3.2 of this paper, information about fully depreciated assets that are still in operation will be requested; specifically, the volume of such assets and their gross book value. The likely points of comparison between Telenor s own top-down model and the bottom-up model remain the same as described in the draft top-down model specification. Fully-depreciated assets are necessary to calibrate the total size of the network (number of assets and their capacity) as well as to understand variations between the gross book value and current cost value. Adjustments may be necessary to the bottom-up model so

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 3 that assets in use beyond their accounting lifetime are not unrealistically replaced. This would allow the bottom-up model to reflect the actual cases where fully depreciated assets remain in use. 1.2.2 Changes to the conceptual approach This paper is an update to the draft version previously issued. Several aspects of the paper have been clarified, based on Telenor s comments and development of our own understanding of the approach. Between the draft paper and this final paper, we have modified the following two principles. Principle 2 Principle 2 originally stated: Telenor will not be required to submit full documentation for or detailed outputs from its regulatory cost model. Further detail on Telenor s cost allocations may be requested as our understanding of the bottom-up model (and its divergence from actual costs incurred by Telenor) improves. The optional statement suggesting that we may (or may not) request additional data is not relevant for a principle, and has therefore been removed. Instead, in Section 4 of this paper, we state that where significant variations are identified, we will work with Telenor in an iterative manner to understand these variations. This principle has therefore been modified as follows: Telenor will provide an explanation of their top-down cost model so that NPT will be able to apply outputs of the model in an educated and reasonable manner. It will not be required to submit full documentation for, or detailed outputs from, its regulatory cost model. Principle 3 Telenor raised an issue on the use of the term inefficiencies. We now define inefficiencies as follows: Efficient production is defined as production at the lowest costs possible given the operating conditions, reasonable demand forecasts and technologies prevailing at the time the expenditure was committed. Inefficiency is therefore any deviation from this. In case of perceived inefficiencies, argumentation that underpins this finding will be provided, and Telenor will be invited to comment on this.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 4 This clarification of the term inefficiencies has been added to section 4. The principle will be maintained. Principle 7 Principle 7 originally stated: Although the bottom-up model will have the ability to vary the approach to depreciation, only the results based on straight-line depreciation will be compared with top-down data for the purposes of hybridisation. This principle has been modified to make clear that straight-line depreciation calculations will be made in the mapping model. The fact that the comparison of depreciation will use the straight-line method remains the same. This principle has therefore been modified as follows: The mapping model will determine straight-line depreciation for both the top-down expenditures and the expenditures from the bottom-up model, to allow comparison for the purposes of hybridisation. 1.3 Structure of this paper The remainder of this document is structured as follows: Section 2 describes the outputs of the mapping model (including possible hybridisation outputs) Section 3 describes the inputs to the mapping model Section 4 provides an overview of the approach to the mapping model Section 5 provides an overview of the network to be modelled Section 6 outlines the steps in the modelling process Section 7 summarises the modelling principles described in this document. This paper will guide further modelling efforts and also form the basis of the final model documentation.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 5 2 Output of the mapping model The principal outputs that will be provided by the mapping model to be used for hybridisation of the bottom-up model are: total cost and unit costs to provide each service asset counts: total installed equipment in 2008 (and other years, if appropriate) annualised capex costs (depreciation and cost of capital) per asset group in 2008, by cost component 2 operating cost components in 2008. Certain costs or certain assets may need to be excluded from the calibration. For example, next-generation network equipment will need to be excluded prior to comparison with the outputs of the bottom-up model, which does not include these features. This will only be done on a like-for-like basis: we will compare bottom-up model outputs only against top-down data that represents the same parts of the network. It should be noted that the outputs are likely to be at a more aggregated level than the inputs to the mapping model that are provided by Telenor. Detailed inputs are required to understand the structure of costs, but simultaneously reconciling numerous cost categories can present a challenge. Principle 1. The mapping model outputs which will be used to reconcile the bottomup model will be at a high level of aggregation, possibly involving only 3-4 opex groupings and 3-4 capex groupings. Financial calculations will be expressed in nominal Norwegian krone (NOK), although for many outputs we will also consider the effect of inflation on costs. 2 Asset groups are discussed later in this document, but are simply an interim stage of cost allocation. Asset groups are a higher level concept than assets in a network and are based on our understanding of how different assets and accounts are related.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 6 3 Inputs to the mapping model The following sections describe the parameters that we expect to be included in the model and the type of financial, demand and technical inputs that the hybridisation process requires from Telenor. A more detailed specification of the required data inputs, suitable for guiding the data collection efforts, was developed separately. 3 Some of the data required will be collected as part of the bottom-up data collection process, and as a result may not be included explicitly in the top-down data collection request. Ideally, the data collected will provide information for a number of years between 2004 and 2008, which can be used to allow hybridisation (i.e. calibration) of the bottom-up model over a series of years. Where data is not available over multiple years, an assessment will be made as to whether there are concerns over aspects of the hybridisation process. 3.1 Telenor Fixed product cost accounting model Telenor Fixed uses a product cost accounting model to prepare regulatory reports as requested by NPT. This top-down model takes information from Telenor s fixed asset register, its accounts, engineering insight and various other sources, to progressively allocate opex and depreciation costs to services (or products in Telenor s terminology). From NPT s meeting of 18 June 2009 and conference call of 6 August 2009 with Telenor, it is understood that the two main allocation steps are as follows (see Figure 3.1): R to A1: The allocation of resources (R), consisting of opex and depreciation cost items, to activities (A1). The allocation step is followed by the secondary allocation from A1 to A2 to aggregate cost information A2 to C1: The allocation of activities to products (C1). This allocation is followed by secondary allocation steps to C2 and C3, to arrive at the costs of externally sold wholesale and retail products. 3 Top-down verification of LRIC model for fixed networks Data request for Telenor, 17 September 2009.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 7 Resources Activities Products R A1 C1 358 wholesale and retail products Cost and 430 activities, of as produced revenues which 100 corresponding with 72 cost centers network elements C2 Direct cost of 222 bundled goods allocated to wholesale and GL-products in A1 retail products A2 Depreciation by investment Activity cost and category network elements C3 222 externally are allocated to sold wholesale products and retail products Figure 3.1: Telenor cost model structure [Source: Telenor] Allocation on basis of: - FTE - interviews - evenly split - other Allocation on basis of: - Income - traffic - subscribers/customers orders - core network drivers - access cable length - revenues, cost of goods sold - FTE - other Given the number of resources, activities and products, and the variety of allocation keys being used, full insight into the allocation steps can only be obtained by reviewing the full model implementation. This level of detail is not required to achieve the objective of the hybridisation process, i.e. to increase the robustness of the costing results of NPT s bottom-up model. As a result, Telenor is not required to supply full documentation (which in any case is unlikely to be available in a suitable format) or other highly detailed information from its cost model. Principle 2. Telenor will provide an explanation of their top-down cost model so that NPT will be able to apply outputs of the model in an educated and reasonable manner. It will not be required to submit full documentation for, or detailed outputs from, its regulatory cost model. 3.2 Financial inputs The assets in operation, their capital cost, the operational costs to operate those assets and the services they provide will be the main inputs to the mapping model, as they constitute the full costs to be allocated to the individual services. The model will therefore use the following financial inputs (note that this list is non-exhaustive):

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 8 capex data for a number of years between 2004 and 2008 indicating, among others, gross book value (GBV), net book value (NBV) and, where available, gross replacement cost (GRC), in-year depreciation, capitalisation date and asset lifetimes details of assets under construction, any fully depreciated assets that are still in operation in the network, and information on capitalised opex will also be required as input detailed opex accounts for a number of years between 2004 and 2008. The model will also take as input the breakdown matrix that maps opex cost components and capex activities to services according to the categorisation described in Section 6.1. Additionally, the following information will be used to inform our understanding of allocation keys: information to determine the price trends of network, IT equipment and opex categories (this may be informed by capex data outlined above) fixed network staff numbers by department working capital requirements the weighted average cost of capital (WACC). Should Telenor have any current cost accounting (CCA) values for its assets, this can also be used to reconcile cost inputs for the bottom-up model (e.g. the construction cost per kilometre of copper). 3.3 Demand inputs In order to allocate the network costs according to service usage, traffic volumes are an essential input to the model. The following traffic volumes will therefore required (note that this list is non-exhaustive): number of access lines (copper/fibre/other), distinguishing active from inactive voice minutes per service per year (where service distinguishes between destinations, between originating, terminating and transit, and, possibly, between PSTN/ ISDN and VoIP) number of calls per service per year call attempts per service per year total network traffic in peak hours versus off-peak hours, per year demand volumes for other services (DSL, leased lines). Ideally, this information will be gathered for a number of years between 2004 and 2008. Note that demand for services not included in Markets 2, 3 or 4 (such as DSL and leased lines) is required to ensure that the costs of shared network elements is correctly divided between these services and the ones of interest.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 9 3.4 Asset counts The following information will also be required to calibrate the bottom-up model: number of kilometres of copper and fibre (cable sheath length) and trench/duct at various levels of Telenor s network floor space in exchanges number of switching nodes (exchanges, data centres) number of various different types of switches. Ideally, this information will be gathered for a number of years between 2004 and 2008.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 10 4 Overview of the mapping modelling approach An overview of the mapping model that will be used to validate the results of the bottom-up model by using inputs, intermediate results and outputs from Telenor s cost accounting system is shown below in Figure 4.1. Asset counts Asset counts, grouped into BU categories 1 Asset counts (BU) Annualised investment costs GBV, NBV, in-year depreciation, grouped into BU categories 2 Annualised capex costs per category (BU) Operational costs Operational costs, grouped into BU categories 3 Opex costs per category (BU) Service costs Matrix describing capex/opex cost breakdown per service Demand per service Manual analysis of breakdown and allocations 6 Total cost per service (TD) Total demand per service (TD) / Unit cost per service (TD) 4 5 Total cost per service (BU) Unit cost per service (BU) Key Telenor input Process step (intermediate) output Figure 4.1: Overview of mapping model structure, showing the six verification steps [Source: Analysys Mason] The model will verify key intermediate results and outputs of the bottom-up (BU) model at six different levels, and will operate as follows: asset counts taken from Telenor s management system are mapped onto the categories used in the bottom-up model, and then compared to the asset counts derived in the bottom-up model (verification 1 in Figure 4.1) capex charges (in-year depreciation, plus the cost of capital determined from the NBV) from Telenor s cost accounting system are mapped onto the asset groupings as defined in the bottom-up model, and their values compared (verification 2)

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 11 opex charges from Telenor s cost accounting system are mapped onto the opex activities as defined in the bottom-up model, and their values compared (verification 3) total service costs are also verified by deriving the total costs of services (according to the service categories as defined in the bottom-up model). Total service costs are then compared to those in the bottom-up model (verification 4) unit service costs are verified by taking into account the demand per C3 category, mapping this demand onto the services as defined in the bottom-up model, and finally using the demand to unitise service costs. These unit costs are then compared with the unit costs as determined in the bottom-up model (verification 5) where verification shows significant differences in costs between Telenor s cost accounting model and NPTs bottom-up model, the calculation in the bottom-up model that resulted in that particular cost level will be reviewed. Based on additional discussion with Telenor, the breakdown of the cost item will be compared manually and in more detail with the cost breakdown that is used by Telenor in its cost accounting system. If, based on this discussion, it is concluded that the allocation in the bottom-up model can be refined to better reflect actual costs, then corresponding changes will be made in the bottom-up model. Inefficiencies will however not be considered as a valid reason for changing allocations or cost levels (verification 6). Verifications 2 and 3 will rely directly on cost data supplied by Telenor, using categories specified in a data request. This approach will benefit from understanding the costs underlying Telenor s cost model. Efficient production is defined as production at the lowest costs possible given the operating conditions, reasonable demand forecasts and technologies prevailing at the time the expenditure was committed. Inefficiency is therefore any deviation from this. In case of perceived inefficiencies, argumentation that underpins this finding will be provided, and Telenor will be invited to comment on this. Principle 3. The financial outputs of the bottom-up model will be reconciled against cost data supplied by Telenor (and derived from its accounting systems) that have been allocated by Telenor into categories specified in a separately issued data request document. The comparisons indicated above will be made on the basis of a broad comparison of GBV, NBV, in-year depreciation and operating costs. Agreement between top-down and bottom-up outputs will not be enforced.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 12 Principle 4. Financial reconciliation will be done on the basis of GBV, NBV, in-year depreciation and operating costs, to achieve broad (rather than exact) agreement between top-down data and bottom-up calculations. Verifications 4 and 5 will be based on information supplied by Telenor indicating how much of the cost in each category is allocated to various services. This will be compared with the total cost to provide services as calculated in the bottom-up model. Principle 5. Telenor will supply a matrix displaying the amount of cost (NBV, GBV, in-year depreciation and operating cost) in each category that is allocated to each product/service, to be used for reconciliation with the service costs calculated in the bottom-up model. Verification 6 will be conducted on an iterative basis, as divergences between costs calculated in the bottom-up model and those supplied as top-down input are discovered. The outputs of the mapping model will clearly not be available for industry parties, since they will use confidential Telenor data. However, the calculation shell of the mapping model (with all confidential data removed) will be made available as part of the consultation process.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 13 5 Network overview This section provides an overview of the model reference design for the current Telenor network. The conceptual design paper for the bottom-up model explains the reference design in more detail. It is understood that Telenor s PSTN network consists of 2 international gateways (IGW) that switch between Norway and other countries, 4 call servers (CS), 28 media gateways (MGW) to switch traffic at transit level, 4 and about 200 local switches (LS). The access network consists of approximately 5400 remote switching units (RSU) and remote switching stage (RSS) concentrators, and approximately 6 million kilometres of twistedpair copper wire. A schematic overview of the PSTN core network is provided in Figure 5.1. Access node buildings Distribution node (Local switch) Core node (Main exchange) RSS/ RSU CS PoI RSS/ RSU RSS/ RSU LS MGW IGW Local switching Transit switching Interconnect switching Figure 5.1: Overview of the PSTN network topology of Telenor [Source: Analysys Mason] It is understood that the IP network contains about 5 core routers (used for routeing between distribution and core nodes, and between core nodes), approximately 60 4 There are also two legacy transit switches (EOT) still present in the network. These are however being re-classed as local switches.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 14 distribution routers (used for routeing between the edge and the core routers) and approximately 2500 access nodes (DSLAM/Ethernet switches). A schematic overview of the IP network is provided in Figure 5.2. Access nodes Distribution nodes Core nodes DSLAM BRAS RADIUS DSLAM Layer 2 aggregation switches Layer 3 edge routers Layer 3 distribution routers Layer 3 core routers Layer 2 aggregation switches DNS Access routing Distribution routing Core routing Service and control platforms Figure 5.2: Overview of the IP network topology of Telenor [Source: Analysys Mason] An illustration of Telenor s copper access network topology is provided below in Figure 5.3. Access lines terminate in the main distribution frame (MDF), typically located at the network nodes called the remote switching stage (RSS) or the remote switching unit (RSU). 5 These nodes can either be deployed in accommodation (i.e. a building) or as a field deployment. These nodes are routed back to an exchange: this cable is not included in the access network. The last distribution point in the network, where the so-called drop cable arrives from the network termination point (NTP) of the end-user, is called the end distribution point or endefordeler (EF). This can be deployed either in a manhole, on a pole, or in a cabinet. Between the MDF and the EF, there may be: no other distribution points a distribution box (DB), also called a hovedfordeler (HF) a DB and one or more additional distribution points, or mellomfordeler (MF). The primary network is the part of the access network from the MDF to the first distribution point. The secondary network is the access network from the first distribution point to the last distribution point. All segments between HF and EF are included in the 5 These are vendor-specific terminologies: RSS are provided by Ericsson and RSU by Alcatel-Lucent.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 15 secondary network. Hence, customers connected directly to the MDF (via an EF) have no primary segment. It is understood that the cable links between EF can be branched. This topology can vary depending on the geography. Fibre connections can be deployed to buildings with high demand, while in remote areas of Norway, a mix of copper, radio and satellite links can be employed. Access network NTP RSS/RSU drop cable EF Also known as hovedfordeler, (HF) or main distribution point NTP Distribution box (DB) RSS/RSU Exchange drop cable EF NTP Distribution boxes (DBs) RSS/RSU EF drop cable Endefordeler, (EF) or end distribution point Secondary network Also known as mellomfordeler, (MF) Primary network (from MDF) Figure 5.3: Overview of the copper access network topology [Source: Analysys Mason]

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 16 6 Main modelling steps 6.1 Categorisation Cost components The bottom-up model will define a list of cost components that are designed to represent each of the separate network and business opex components required to provide voice and access services over the fixed network. In defining these cost components, it is important to group costs that have similar characteristics, in terms of cost drivers and changes over time, to balance modelling complexity. In general, the structure of a company s accounting system is determined by operational demands and service evolution, rather than regulatory cost allocation requirements. As such, Telenor s cost centre allocation will likely be used as a high-level guide when defining the cost components, but for ease and consistency of modelling, it is likely that the definition will need to differ from the current definitions used for resources and activities in the Telenor cost accounting model (Figure 3.1). Mapping of resources and activities onto cost components as defined in the bottom-up model will therefore be required. Principle 6. Telenor will be requested to map its own costs onto categories suggested for compatibility with the bottom-up model. Figure 6.1 below provides a provisional list of the opex cost components that the bottom-up model is likely to use. This list may be changed, amended or simplified based on further analysis of the information available.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 17 Opex cost components Personnel-related cost components: Provision and installation of equipment Maintenance and repairs Network planning and development Wholesale billing Directory services Emergency services Other G&A and overheads Other cost components: Non-personnel costs related to provision and installation of equipment Materials and other equipment maintenance Non-personnel costs related to wholesale billing Switching software IN and service platforms Other network O&M Office IT (licences, etc.) Licence and numbering fees Switch building rentals Office building rentals Energy Other operating costs Bad debt on wholesale services Cost of sales: Mobile interconnection Fixed interconnection International interconnection Out-payments for international outgoing calls Other network cost of sales Figure 6.1: Provisional list of opex cost components [Source: Analysys Mason] Asset groups The bottom-up model will similarly list a set of capex asset groups, which again are likely to differ from the list of resources and activities defined in Telenor s cost accounting model, and the capex elements in Telenor s fixed asset register (FAR). Figure 6.2 below gives a generic list, which can be used to aggregate all capex items. Capex asset groups Voice platform Internet platform Data network ATM platform Transmission trenching and ducting National transmission Other core platforms Access trenching and ducting Access network cabling Other access Other Overheads International transmission Figure 6.2: Generic list of capex activities [Source: Analysys Mason]

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 18 A total capex charge for each of these capex asset groups is calculated as depreciation plus cost of capital by means of straight-line depreciation. Services A potential list of services whose costs will be calculated in the bottom-up model is shown in Figure 6.3. The mapping model will seek to map the product costs as determined by Telenor s accounting system onto the services. Services On-net voice call Off-net (Telenor to OAO) voice origination Off-net (OAO to Telenor) voice termination Off-net (Telenor to international) voice origination Off-net (international to Telenor) voice termination Transit call minutes Internet dial-up Call to non-geographic services (e.g. 08xx, directory, emergency services) Voicemail service (VMS) retrieval OAO to international voice call PSTN/ISDN access lines Wholesale line rental (WLR) lines Copper access lines (LLU) Shared access lines (SLU) Fibre access lines Other access lines DSL access (retail) DSL bitstream access Transmission services (leased lines) Co-location International to OAO voice call Fixed SMS Figure 6.3: Provisional list of services [Source: Analysys Mason] 6.2 Annualisation The investment incurred by a business over time can be expressed in various ways: cumulative capex: the total of all investments made in the business GBV: the total of all investments made in the business, less the investments made in assets that have been replaced or retired GRC: the total investment required to replace the entire network asset base today NBV: the GBV less accumulated depreciation on assets. The efficiently-incurred expenditures in a fixed business must be recovered over the lifetime of the business. Any tied-up capital (i.e. investments that are not recovered in the year they are incurred) must earn a normal return on investment. The method by which these expenditures are recovered is, in general terms, the depreciation method.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 19 Depreciation method A number of approaches to depreciation can be used for the purpose of hybridising a bottom-up model using a top-down validation. The most common approaches are: straight-line depreciation tilted annuities adjusted tilted annuities. A standard and transparent methodology used in historical cost accounting (HCA) is straight-line depreciation. Straight-line depreciation simply divides the price of an asset by its lifetime to produce an annual depreciation charge, as shown in Figure 6.4 below. Additionally, a cost of capital charge has to be applied. Investment Figure 6.4: Example of straight-line depreciation [Source: Analysys Mason] Cost of capital recovered Depreciation charge 1 2 3 4 5 Year Tilted annuities based on GBV or GRC is a slightly more advanced method. A tilted annuity calculates an annuity charge that changes between years at the same rate as that at which the price of the asset is expected to change. In a tilted annuity approach, the tilt takes into account future input asset price declines (increasing unit costs in early years), as shown in Figure 6.5 below. Note that setting the tilt to zero results in a conventional annuity.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 20 Change in asset price over lifetime of asset Figure 6.5: Example of tilted annuity depreciation [Source: Analysys Mason] 1 2 3 4 5 Year Additionally, in an environment in which demand levels on the fixed network are in decline, the historical cost accounting fully accounted costs (HCA-FAC) of traffic, while low, can be expected to rise. One option is to apply an additional tilt to the tilted annuity used, as shown in Figure 6.6 below, to set a price with a specified trend that can take into account the utilisation of assets over time, as well as equipment price trends, in order to calculate the economic cost of the services over the economic lifetime of assets. Change in asset price over lifetime of asset Plus change in utilisation over lifetime of asset Figure 6.6: Example of tilted annuity depreciation with additional tilt [Source: Analysys Mason] 1 2 3 4 5 Year The mapping model will use straight-line depreciation, based on values recorded in Telenor s accounting system, given the following: for the purpose of ensuring the validity of the bottom-up model, only one type of check is required and straight-line depreciation is the most straightforward tilted annuity depreciation requires knowledge of the gross replacement cost (GRC) or current cost accounting (CCA) value of all assets (which is not commonly available), or access to the full details available in the FAR (which is disproportionate to the purpose of the mapping model).

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 21 Principle 7. The mapping model will determine straight-line depreciation for both the top-down expenditures and the expenditures from the bottom-up model, to allow comparison for the purposes of hybridisation. WACC and currency The mapping model will allow the user to set the WACC at the appropriate level, allowing for a return to be calculated on the regulated services. WACC values will be determined by the advisor appointed by the NPT as part of a separate project. The calculations will be expressed in Norwegian krone (NOK) and will display data, including output, in nominal terms since the data available from Telenor s accounting systems and annual reports is presented this way.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 22 7 Summary of principles This section summarises the principles of the top-down modelling and hybridisation for fixed networks identified in this paper. Operators are asked to reference their responses against these principles. Principle 1. The mapping model outputs which will be used to reconcile the bottomup model will be at a high level of aggregation, possibly involving only 3-4 opex groupings and 3-4 capex groupings. Principle 2. Telenor will provide an explanation of their top-down cost model so that NPT will be able to apply outputs of the model in an educated and reasonable manner. It will not be required to submit full documentation for, or detailed outputs from, its regulatory cost model. Principle 3. The financial outputs of the bottom-up model will be reconciled against cost data supplied by Telenor (and derived from its accounting systems) that have been allocated by Telenor into categories specified in a separately issued data request document. Principle 4. Financial reconciliation will be done on the basis of GBV, NBV, in-year depreciation and operating costs, to achieve broad (rather than exact) agreement between top-down data and bottom-up calculations. Principle 5. Telenor will supply a matrix displaying the amount of cost (NBV, GBV, in-year depreciation and operating cost) in each category that is allocated to each product/service, to be used for reconciliation with the service costs calculated in the bottom-up model. Principle 6. Telenor will be requested to map its own costs onto categories suggested for compatibility with the bottom-up model.

Conceptual approach of the top-down cost model of Telenor s fixed-line network Final model specification 23 Principle 7. The mapping model will determine straight-line depreciation for both the top-down expenditures and the expenditures from the bottom-up model, to allow comparison for the purposes of hybridisation.