Katia Rocha PUCRio

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Katia Rocha (PUC-Rio Ipea)katia.rocha_at_ipea.gov.
brGabriel Bragança (Ipea)Rafael Moreira
(Anatel)

• Access Regulation of Brazilian Fixed-Line
  Telephone Operators and the Mark-up on the Cost
  of Capital

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Regulatory Framework

• 1998
• Privatization of the telecommunication sector
• Creation of Anatel
• Brazilian Telecommunications Regulatory Agency
• 2005
• Numerous directives were created with the
  objective of increasing competition

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Regulatory Framework

• Objective
• increase competition, especially in the
  traditionally concentrated local fixed telephone
  market
• ensure results in regulated sectors as near as
  possible to those that would prevail in a
  competitive market
• seek moderate tariffs and efficient results from
  the technical, allocative and dynamic standpoint

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Regulatory Framework

• Questions
• more attention in keeping tariffs low than to the
  question of dynamic efficiency the pattern of
  investments in infrastructure and innovation.
• in a sector like telecommunications, which is
  subject to such dynamic technological
  transformations, this imbalance is a serious
  error

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Local Competition
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Long Distance Competition
Market Share International ( Ebit)
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Regulatory Framework

• 2005
• Anatel Resolution 396
• new cost-oriented regulatory framework for
  interconnection of telecommunication networks
• tariff policy based on long-run incremental costs
  (LRIC).
• LRIC consist mainly (particularly in the local
  fixed segment) of the sunk costs and the
  corresponding return on capital invested.
• LRICi opexi ki X WACCi
• k (Invested Capital)

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LRIC - Motivation

• Teory of Economic Regulation tells
• The opening of access to the incumbents network
  and a correct access pricing play a fundamental
  role in the efficiency of the regulation and the
  maximization of social welfare

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LRIC - Motivation

• Teory of Economic Regulation also tells
• Sidak and Spulber (1997), Valletti and Estache
  (1998), Gans and Williams (1999), Jorde, Sidak
  and Teece (2000), Gans (2001), Mandy and Sharkey
  (2003), Kotakorpi (2004) and Hori and Mizuno
  (2006)
• Argue the need of establishing a markup on the
  costs based approach to stimulate investment

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Internation Experience

• European Commission Regulations
• the use of LRIC for the assessment of cost
  oriented interconnection tariffs for terminating
  access - Recommendation 98/195/EC 8 January 1998
• Europe
• Interconnection rates in the majority of
  developed countries use a version of LRIC
  methodologies in order to determine interconnect
  rates for the fixed networks of dominant
  operators
• Outside Europe
• Australia Canada Japan US

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Real Option

• Question
• "are regulators, based on a cost-based approach,
  providing the correct incentives for investment
  and dynamic efficiency???"
• Salinger (1998), Alleman e Noam (1999), Hausman
  (1999), Hausman e Myers (2002), Pindyck (2004 e
  2005)
• investments will be discouraged when failing to
  consider the value of the options in determining
  tariffs or prices based on costs

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Real Option Reasoning

• Regarding the Brazilian fixed telephone system
• incumbent must provide access to its
  infrastructure to new entrants
• investment in infrastructure has several features
  
• uncertainty of demand
• unpredictable technological shocks
• flexibility of delay investment
• competitive erosion.
• by incurred in the investment in infrastructure,
  the landline operator is actually providing an
  option to access its network.
• Regulator should consider this option as an
  effective cost incurred by the operators when
  establishing the proper tariffs, i.e., the access
  price.

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Objective of the Study

• An effort to estimate the access option
• Pragmatic approach
• Since Anatel is currently estimating the WACC for
  for BR telecom sector
• We propose a markup on the cost of capital WACC
  as Pindyck (2004 2005).

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Model

• P cost based LRIC corrected by the access
  option f

• LRIC investment cost k reimbursed for its
  capital cost through a WACC (?) based annuity
  payment, over lifetime T of the facility

• Option premium f is included as an effective
  cost
• ? mark-up on WACC

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Model

• V PV of cash flows
• Merton (76) compensated geometric brownian
  motion with jumps (technological shocks are
  common stylized factors of the sector)
• When a jump occurs, the project decreases (? lt 0)
  its value by ? percent
• Assuming non-arbitrage arguments CCA

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Model

• Option dynamics (perpetual call option) follows
  the PDE
• Subject to standard boundary conditions

• Usual zero barrier
• Value-matching condition
• Smooth-pasting condition

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Model

• Solution
• ? is positive root of the following
• Optimal exercise timing V
• Constant A

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Pulses per Average Line in Service

• demand for local fixed telephone service
• pulses billed per ALS (Local F-F)
• subscrition fee per ALS (recorded billed)
  (cte)

Estimation volatility F-F 2.87 per month, or
10 p.a. considering that the variance grows with
time. conservative hypothesis for VC-1 traffic
due to the lack of data volatility of
fixed-mobile (VC-1) traffic volatility
fixed-fixed traffic.
due to the lack of data for VC-1 traffic, we
adopted the conservative hypothesis volatility of
fixed-mobile (VC-1) traffic volatility
fixed-fixed traffic.
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Estimates of an ALS (average line in
service)(stochastic in red)
Brandão and Dyer (2005) approach
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Jumps

• Anatel analysis (2007) estimate a technological
  shock (?) of 20 on PV of project.
• Also jumps occur once every five years, meaning a
  jump-frequency (?) of 20 p.a.

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Mark-up on WACC 0.4 (14)
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Mark-up on WACC 0.4 (14)
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Mark-up on WACC 0.4 (14)
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Conclusion

• Mark-up on cost of capital helps to incorporate
  the real option reasoning in cost-based
  regulatory framework of Brazilian interconnection
  Fixed-Line Rates
• The result points to a markup of roughly 0.4,
  recalling that this will be applied on a
  remuneration base greater than BRL 25 billion
  (roughly US 14 billion in October 2007).