INTRODUCTION
Of all aspects of interconnection, charging is perhaps the most complicated. It is the area that causes most disputes among carriers and most disagreement among economists. For regulators and policy makers setting the financial terms of interconnection can be a very difficult exercise. Interconnection charges are never the result of straightforward mathematical calculations. They involve choices between standards, processes and methods. The choice is not neutral; it depends on the objectives that regulators wish to achieve and is in most cases conditional upon availability of specific data and varies according to the specific service provided. The object of this module is to provide an overview of the many intricate questions involved in interconnection charges.
Learning outcomes:
The participants are expected to:
- Become familiar with the different approaches of interconnection charging.
- Appreciate the importance of the cost-based methodology.
- Recognize the complex costing and charging methodologies without entering into detailed economic analysis.
- Be able to understand the difference between fully allocated and forward looking incremental methods.
- Appreciate how the structure of interconnection charges can impact the terms of competition.
Reading assignments:
The general materials outlined in the introduction to these course materials, and especially Chapter 4 of Trends in Telecommunication Reform 2000/2001 which has been reproduced in Study Group 1 Question 6-1/1 Report on Interconnection, ITU-D Document 1/057/REV1, dated 20/10/2003.
In addition, participants are encouraged to refer to:
Module outline:
The module will focus on three items:
- Different charging options
- Variations in cost-based approaches
- The structure of interconnection charges.
Note: Commercial and financial terms of interconnecting with mobile networks, the Internet and with converged services are treated in Modules 6, 7 and 8, respectively.
I. DIFFERENT CHARGING OPTIONS
There are at least four different approaches of charging for interconnection services.
Bill and Keep
Under this approach, operators terminate each other's traffic without charging for interconnection services. The carrier that bills the customer keeps the full retail amount collected.
This method has been used in many countries for
- Interconnection of fixed network local calls.
- Interconnection between fixed and mobile operators where mobile calls are billed on the receiving party pays basis.
- Internet interconnection.
Bill and keep, also known as sender keeps all, is an easy to implement mechanism and spares operators the need for complex cost studies and ongoing transfer of settlement accounts. However, the system can only be sustained if several conditions are met:
- There is a balance in traffic flows between interconnecting carriers.
- The network costs are similar.
- Carriers agree to a mechanism to compensate for any imbalance of traffic.
Without such conditions, the bill and keep approach can result in slowing the development of the network of new entrants whose traffic volume is in most cases lower than the incumbent (see reference 50).
Price sharing
Under this mechanism, the charge for interconnection is based on the retail price charged to the end users, subject to discounts agreed between carriers. The retail price of each interconnected call is shared among carriers according to a pre-determined percentage. Although easy to implement this approach works only in cases where prices are capped and not related to cost. The main drawback of this approach is that it hinders the reduction of retail prices towards cost.
Revenue sharing
In this case the operators pay a percentage of the revenues derived from interconnected services based on an agreed percentage. Additional charges may also be added. In many cases, regulators prescribe revenue sharing until competition is fully established.
In Korea, interconnection between fixed and mobile networks started on a revenue sharing basis. The regulatory regime stipulated that cellular suppliers would take 70% of the revenue from the calls terminated in their networks while the fixed carriers would retain only 30%. This arrangement was used on a transitional basis until the build out phase of the mobile network was completed. Starting in 2000, the revenue sharing mechanism was replaced by cost based arrangements.
Cost based Approaches:
Of all charging approaches, cost based interconnection charges have been singled out as the best method for promoting a competitive environment. The World Trade Organization (WTO) Reference Paper on Regulatory Principles (see Module 1) enshrines the principle of cost based interconnection. Likewise, the principle of cost based interconnection constitutes an important cornerstone of the interconnection framework within the Asia Pacific Economic Cooperation (APEC) and within the European Union. It has been incorporated into the regulatory regimes of a growing number of developing countries including Botswana, Jordan and Malaysia. The importance and benefits of cost-based interconnection has been highlighted earlier in the module related to the principles of interconnection. Cost-based interconnection tends to reflect the economic costs of interconnection and is the method most compatible with competitive markets. Cost based interconnection prices allow economically efficient pricing, which can be fair to both incumbents and new market entrants, and encourage competitive entry.
II. VARIATIONS IN COST-BASED APPROACHES
There are many variations of the standards used to calculate costs. Each method focuses on the specific kinds of costs that regulators and policy-makers agree should be recouped through interconnection charges.
While it is not possible to study each possible variation, it is generally agreed that most methods for calculating cost falls under two main cost standards: Fully allocated costs and long run incremental costs.
Fully Allocated Cost
The allocated cost approach is a rule that allocates and distributes total network costs to network services. Under this approach, the total cost for providing service, including historical and depreciated investment costs, is divided by the volume of service provided.
By using this method, the new entrant is supposed to contribute to the cost of capital assets determined according to their original cost, taking into account depreciation rules in addition to an allowed rate of return. Historical cost amounts for the purchase and installation of facilities and equipment as well as personnel costs are usually determined from accounting records.
This method has been mainly criticized on the grounds that it does not provide a reliable method to measure costs because it is based on historical accounting of costs. Historical accounting does not reflect changes in current and future costs and may reflect operational or technological inefficiencies of the incumbent. These inefficiencies are passed on to the interconnecting operator.
Long Run Forward Looking Incremental Costs
Long run incremental pricing models are based on the calculation of the costs of providing an additional unit of service over the long run. Forward-looking cost analyses attempts to identify costs that will be incurred during some real or theoretical future period. This avoids the pitfall of including excessive embedded costs in rates imposed on end users of competitors. An incremental cost is the extra cost added to an existing base of costs required to provide a defined additional increment of a given service. Focusing on the incremental cost of establishing interconnection is often seen as the most economically efficient means of determining the impact of a competitor's interconnection on the incumbent operator's cost s of service.
Incremental costs are based on forward-looking approaches rather than on historic approaches. In other words they anticipate actual and future costs using current technology and best performance standards and do not rely on costs incurred in the past. In economic terms, the short run incremental cost of telephone service usage-the extra cost imposed on a carrier by a single additional telephone call or minute of use-is virtually zero. In the long run, however, the presumption is that all network facilities and operations are optimally configured to account for the precise volume of anticipated traffic. Viewed over the long term, then, an incremental telephone call yields an incremental extra investment and extra operating cost.
Incremental costs do not include costs that are unchanged by the new increment like shared costs. Consequently incremental costs do not allow operators offering interconnection to recoup all of the costs incurred in providing interconnection. However, regulators generally allow a mark-up to the final cost estimate to allow for the recovery of common costs.
There are different approaches for costing mark ups including:
- Constant mark up: In the first case, the same percentage mark-up is applied to all services regardless of the difference between services using the same common facilities.
- The Baumol-Willig rule, also known as the efficient component pricing rule: This rule assigns mark up on the basis of opportunity costs that would have returned to the supplier should no business have been diverted to new entrants (see reference 51).
- The Ramsey pricing rule: Mark ups are set inversely proportional to the price elasticity of demand. The Ramsey rule can be difficult to implement because it requires overcoming uncertainties around elasticity estimates (see reference 52).
Today, most regulators and policy-makers argue that the ideal method for calculating the level of interconnection charges would be based on long run forward looking incremental cost or one of its variants. The forward-looking approaches better reflect the working of competitive markets. The approach also has the advantage of determining rates that facilitate competition because it provides analytical tools that help determine the cost that would be found in competitive markets based on the current costs of an efficient operator employing modern technology. Simply put, LRIC charging requires the incumbent to charge for access to its network at prices based on the assumption of what the network would look like if it were built today in the most efficient manner.
This approach has been implemented in many countries with different variations:
Long Run Average Incremental Cost (LRAIC) - under this approach, the increment is defined as the total service. The approach includes allowance for fixed costs specific to the service concerned. In other words, the LRAIC approach differs from LRIC in that it includes all types of costs related to a certain increment including the cost of capital equipment and not only the costs for adding one additional increment. LRAIC does not include costs shared by several increments. The European Commission recommended that interconnection charges in European Union Member States be calculated using LRAIC. It is also used in Hong Kong, India and Singapore.
Total Element Long Run Incremental cost (TELRIC) - The FCC developed the TELRIC charging approach to implement the interconnection provisions of the 1996 Telecommunications Act. This approach includes the incremental cost resulting from adding a specific network element in the long run. The price of a network element includes the forward looking costs attributed directly to the provision of services using that element, which include a reasonable return on investment plus a reasonable share of the forward looking joint and common costs (see reference 53). For a comparison between TELRIC and LRAIC see Morten Falch, "TELRIC- The way towards competition? A European point of view" Review of Network Economics Vol. 1, Issue 2- September 2002 .
Total Service Long Run Incremental Cost (TSLRIC) - This approach measures the difference in cost between producing and not producing a service. The main characteristic of TSLRIC is that the increment is the total service. In other words, it is the total service that provides the floor for the calculation of the interconnect charge (see reference 55).
III. STRUCTURE OF INTERCONNECTION CHARGES
After the cost of interconnection has been determined, the next issue for regulators is to determine how the interconnection seeker will be charged. This is an area where disputes between interconnecting carriers have been prevalent. There is no single or best approach, and the international and regional frameworks for interconnection principles (the WTO Reference Paper, the European Union Interconnection Directive and the APEC Interconnection Framework) are silent on the issue.
The structure of interconnection charges differs from country to country depending on various policy choices. The variations depend on the degree of alignment of interconnection charges with both the cost of interconnection and the structure of the retail prices charged by the interconnection providers to end users.
Examples of variations include:
- Whether the interconnection charge reflects the existence of fixed and variable costs of interconnection (Explained in the next section. Fixed costs remain constant over time, regardless of how much the network is used. There are two main types of fixed costs: one time investment costs, also known as capital expenditures, and recurring operating expenses. Variable costs are directly related to the level of network usage. Variable and fixed costs are often dubbed "traffic-sensitive" and "non traffic sensitive" costs, respectively).
- Whether interconnection charges reflect any peak and off-peak retail prices.
- Whether the charge contains a universal service obligation.
- Whether the charge is unbundled.
Fixed and variable charges:
The terms fixed and variable charges refer to whether costs vary with the network usage. Fixed costs refer to costs that do not change regardless of network usage. These costs are generally known as non-traffic sensitive costs.
Examples of fixed costs include capital investment in major facilities and equipment of the interconnection suppliers as well as labor. Variable costs vary according to the level of usage of the network. Measuring usage can be performed in terms of volume of traffic or circuits or capacity. An example of a variable cost includes costs related to switching.
This difference in cost can be reflected in an interconnection charge, which may include both fixed and variable costs. In other words, an interconnection charge can contain a fixed portion for fixed costs and a variable portion in the form of a usage charge such as a per-minute charge for interconnect traffic carried.
Peak and off peak charges:
The interconnection charge paid by the interconnection seeker can be averaged (uniform) or may vary depending on traffic volume. Averaging and de-averaging are often implemented in retail prices, e.g., when retail prices reflect a different rate for peak hours that is higher than the rate for off-peak hours. De-averaged prices are mainly designed to increase network use in off peak hours and decrease congestion in peak hours, improving network efficiency and saving carriers the expense of upgrading their network to meet the demands of peak loads.
It is important that the peak/off peak differentials in retail prices be reflected in interconnection charges. Failure to do so could result in unfair competition for both parties. If the interconnection charge is averaged it becomes easier for new entrants to compete for peak load customers because they can offer services at prices lower than the peak prices of the incumbent. On the other hand, new entrants would be unable to compete for off peak customers. In both cases competition is curtailed.
Bundled vs. Unbundled charges
The term bundled interconnection charges means that the interconnection seeker pays a single price for a standard set of interconnection functions whether used or not. Unbundled charges means that the new entrant only pays for the component(s) of the interconnection package it needs for interconnection services. The interconnecting carrier is not required to pay for components and functions that it will not use to provide services to its customers.
Unbundling is increasingly recognized as an important regulatory requirement. With the adoption of the WTO Reference Paper on Regulatory Principles, unbundling requirements have become an internationally agreed interconnection principle.
Charging for unbundled access can have far reaching implications for the success of fair competition. Unbundled access frees new entrants from additional charges, it facilitates new entry and helps promote the benefits of competition.
Recovery of costs related to Universal Service Obligations and other social obligations
In many cases the regulatory framework mandates that interconnection charges contain, either explicitly or implicitly, an element intended to contribute to the universal service obligation of the incumbent carrier. Universal service obligations are obligations that are imposed upon carriers to provide service to customers and to regions that are deemed commercially unattractive. Universal service and universal access is a public policy goal in almost every country. It aims to ensure availability, affordability and accessibility of telecommunications services.
A variety of instruments have been used in different countries to support different aspects of universal access/service policy. Under a monopolist regime, universal service has been pursued through the use of cross-subsidization techniques. Profits from long distance and international services were used to subsidize the provision of local and rural lines. With the introduction of competition and the entry of multiple operators, the financing of universal service obligations has evolved.
Many countries have implemented an access deficit charge (ADC) regime in which incumbents raise interconnection charges to defray their universal service obligation costs. The technique has been used in the United States since 1984, requiring long distance carriers to pay local carriers per minute access charges. ADCs have also been used in Australia, the United Kingdom and Canada.
This technique has come under mounting criticism as a technique that is inefficient and non-transparent. Regulators are revising this approach to universal service funding.
- One approach is to finance universal service obligations through a transparent funding mechanism (see reference 56). In addition, the WTO Reference Paper on Regulatory Principles stresses that universal service obligations should be transparent, non discriminatory, competitively neutral and no more burdensome than necessary.
- In order to ensure transparency, many regulators require that any contribution to universal service obligations be separate from interconnection charges. When universal service obligation contributions are included in standard interconnection prices, it is not easy to evaluate the extent of universal service contributions.
- Including universal service obligation contributions with interconnection charges may also result in excessive charges to competitors.
- Interconnection costing and universal service costing often use different cost standards and different methodologies (see reference 57).
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