WorldCom Presentation to the LRIC Working Group

1
WorldCom Presentation to the LRIC Working Group

• Michael D. Pelcovits, Ph.D.
• Vice President and Chief Economist
• Tokyo, Japan
• December 13, 2000

2
Overview

• Universal Service - The US Experience
• Setting Depreciation Rates
• Traffic-sensitive and non-traffic sensitive costs
• Outside Plant Types

3
Universal Service - The U.S. Experience
4
Overview

• US Regulatory Background
• Defining Universal Service
• Calculating Universal Service Costs
• Determining Subsidy Amount
• Funding and Distributing Universal Service Support

5
US Regulatory Background

• Historically, low prices for local exchange
  services were subsidized by above-cost pricing of
  long-distance and other services
• Upon ATT divestiture, access charges imposed on
  long-distance companies replaced much of this
  subsidy

6
US Regulatory Background

• Dual responsibility for universal service
• Federal government has jurisdiction over
  interstate services, mainly long distance and
  access (interconnection) to long distance
  carriers
• State governments have jurisdiction over local
  services, short-haul toll and access for
  short-haul toll
• Joint Board of state and federal regulators is
  convened to address issues of joint responsibility

7
US Regulatory Background

• Telecommunications Act of 1996 required
• Implicit subsidies to be replaced by explicit
  subsidies
• Competitively neutral assessment of support
• Competitively neutral availability of funds
• Cost of subsidy determined without reference to
  rate base or rate of return

8
Defining Universal Service
Federal-State Joint Board defined supported
services as

• Voice-grade access to network
• Touch-Tone dialing
• Single-party service

• Access to emergency services
• Access to operator services
• Access to long-distance carriers
• Access to directory assistance

9
Defining Universal Service

• In subsequent proceedings, the definition of
  universal service was expanded to include the
  ability to access data services at 56kbps or
  higher

10
Defining Universal Service

• U.S. also provides targeted programs to
  low-income subscribers
• LifeLine - reduced rate, limited usage service
• LinkUp - reduction or waiver of initial
  installation costs
• Schools and libraries
• Universal service fund provides support for
  Internet connectivity

11
Universal Service Costs

• Prior to Telecomm Act of 1996, subsidies were
  based on embedded (accounting) cost
• Federal subsidies based on allocation of loop
  cost to federal jurisdiction
• State subsidies determined through residual
  ratemaking

12
Universal Service Cost

• Joint Board was concerned that basing universal
  service support on embedded cost would fund
  inefficient operations
• Use of forward-looking economic cost encourages
  efficient operation by all carriers
• Provide incentives to incumbents to improve
  efficiency
• Discourage inefficient entry decisions by
  competitors

13
Universal Service Cost

• Joint Board found that a cost model should be
  used to estimate universal service cost
• Provides greater geographic disaggregation than
  accounting data
• Competitively neutral, because not based on any
  one carriers network

14
Universal Service Cost

• FCC adopted 10 criteria for assessing cost models
• Technology - least-cost, most efficient
  technology for providing supported services, with
  scorched node topology
• All network functions must have an associated
  cost
• Cost estimated is long-run, forward looking
  economic cost

15
Universal Service Cost

• 10 criteria (continued)
• Rate of return set at FCCs approved level of
  11.25
• Depreciation lives and net salvage rates should
  be in FCC-prescribed range
• Model should include all services provided by the
  network, to reflect economies of scale

16
Universal Service Cost

• 10 Criteria (continued)
• Reasonable allocation of joint and common costs
  to supported services
• Model should be open -- all calculations and
  software open to inspection and review, all input
  data verifiable
• Critical assumptions and input variables must be
  changeable
• Disaggregation of results at least to the level
  of the wire center

17
Determining Subsidy Amount

• Much of FCCs system for determining subsidy
  amount is specific to peculiar nature of US dual
  jurisdictional system
• In general
• Each state computes average forward-looking cost
• National benchmark is set at 135 of national
  average forward-looking cost
• Federal support is available for 76 of per-line
  forward-looking cost gt 135 of national average

18
Determining Subsidy Amount

• After total amount of state subsidy is
  determined, support is targeted to high cost wire
  centers
• Ensures that support goes only to lines that
  require support
• Wire centers with cost lt national benchmark
  receive no support
• Wire centers with cost gt national benchmark
  receive support proportional to the degree to
  which costs exceed the national benchmark

19
Funding Distribution of Support

• Total nationwide support requirements are funded
  by an assessment on each carriers interstate and
  international revenues derived from end users
• Access charges reduced to account for replacement
  of implicit subsidies with explicit subsidies

20
Funding Distribution of Support

• All universal service support is portable among
  carriers
• If a competitive carrier takes a customer in a
  high-cost area from the incumbent.
• Or if a competitive carrier sells new services in
  a high-cost area
• That carrier is eligible for the same high-cost
  support that would be available to the incumbent

21
Size of Universal Service Funds

• High-cost support 1.9 billion
• Non-rural carriers 399 million
• Rural carriers 1.5 billion
• Schools Libraries 2.25 billion
• Low-income support 672 million
• LifeLine 632 million
• LinkUp 40 million

22
Conclusions

• US Universal Service support is competitively
  neutral
• Costs determined using forward-looking
  methodology, not specific to any carrier
• Subsidy Amount is equitable among states and
  among carriers
• Funding of support is through assessment on all
  carriers
• Distribution of support is portable and equitable
  among carriers

23
Setting Depreciation Rates
24
Depreciation in the U.S.

• FCC Depreciation Policies and Practices
• Results for Regulated Local Exchange Carriers
  (LECs)
• Comparison to WorldCom Depreciation Practices

25
FCC Depreciation Policies Practices

• Concepts
• Whole Life
• The useful life of plant at the time the plant is
  purchased
• Depreciation expense computed under this method
  equals (Original Investment - Net Salvage) /
  Useful Life of the Plant

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FCC Depreciation Policies Practices

• Concepts
• Remaining Life
• The useful life of plant remaining as of the time
  of a depreciation study
• Depreciation expense using this method equals
  (Original Investment - Accumulated Depreciation -
  Net Salvage) / Average Remaining Life of the Plant

27
FCC Depreciation Policies Practices

• Concepts
• Net Salvage
• The amount for which plant can be sold at the end
  of its useful life minus the cost of removal
• Can be positive (switches can be sold and used by
  other phone companies) or negative (poles must be
  removed and disposed of)

28
FCC Depreciation Policies Practices

• Concepts
• Survivor Curves
• Mathematical formula that predicts what
  percentage of a given vintage of plant will be
  removed from service in a given year
• In the United States, typically an S-shaped curve

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FCC Depreciation Policies Practices

• Before 1981
• Rates based on whole life
• Resulted in insufficient depreciation as
  equipment lives shortened

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FCC Depreciation Policies Practices

• After 1981
• Changed to remaining life
• Prevented insufficient depreciation
• Amortizations used to make up previous shortfall

31
FCC Depreciation Policies Practices

• After 1981 (contd)
• Lives, salvage values, and survivor curves
  decided in triennial meetings
• FCC, State regulators, Company
• opportunity for comment by public
• determined by plant account

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FCC Depreciation Policies Practices

• After 1981 (contd)
• LEC provided information on historical and
  projected retirements
• Adopted lives strongly influenced by projected
  retirements
• prescribed lives match historical retirements
  only 30 percent of the time

33
FCC Depreciation Policies and Practices

• To support their proposed depreciation lives,
  companies provide, by plant account
• Five most recent years of actual data on plant
  and reserves
• Three year forecast of additions, retirements,
  and plant
• Actual and projected data on salvage and cost of
  removal

34
FCC Depreciation Policies and Practices

• Companies also provide a description of any
  market or technological changes that will affect
  future retirements

35
FCC Depreciation Policies and Practices
36
FCC Depreciation Policies and Practices
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FCC Depreciation Policies and Practices
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FCC Depreciation Policies and Practices
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FCC Depreciation Policies Practices

• Depreciation Simplification - 1993
• To reduce reporting burden, FCC simplified
  depreciation process
• Set ranges for depreciation lives and net salvage
  values based on already approved values
• average values by plant account, plus or minus
  one standard deviation

40
Adopted Ranges
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FCC Depreciation Policies Practices

• Depreciation Simplification - 1993 (contd)
• Less support required if claimed lives and net
  salvage are within the ranges
• For claimed values outside the range, the
  previous level of support is required
• Bell companies have claimed lives at the low end
  of these ranges, with few changes in the last
  four years

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Results for Regulated LECs

• ILEC reserves have grown faster than investment
  in plant..

43
Results for Regulated LECs

• ...Leading to an increase in ILEC Reserve Ratios
  (Reserves/TPIS)

44
Overall cost of capital

• Cost of capital in US cost models includes
• Economic depreciation expense
• Levelized equity return and interest on invested
  capital
• Converted to level annual cost using an annuity
  calculation
• Income taxes on equity return

45
Comparison to WorldCom Depreciation Practices

• ILEC Depreciation Lives for Circuit Equipment,
  Cable, and Poles - 65 of ILEC plant - are
  shorter than those used by WorldCom
• Depreciation lives used in the NTT Cost Model are
  shorter than ILEC lives

46
Comparison to WorldCom Depreciation Practices
47
Traffic-sensitive and Non-Traffic sensitive Costs
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Overview

• Importance of proper classification
• Classification of Outside Plant equipment
• Classification of Central Office equipment
• Implications for pricing structure

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Importance of Proper Classification

• Fundamental element of any cost study is to
  identify cost drivers
• What kind of demand causes costs to vary?
• Are multiple demand factors implicated in cost
  changes?
• Whats the functional relationship between
  changes in demand and changes in cost?

50
Importance of Proper Classification

• As a general principle - cost recovery should
  match cost causation
• Encourages efficient consumption behavior
• Prevents under- or over-recovery of costs
• Sends correct pricing signals to new competitive
  entrants

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Overview of Network
Exchange
Trunks to
Area
Other Wirecenters
Boundary
Wire
Center
Serving Area
Serving Area
SAI
Feeder Cable (Copper or Fiber)
Distribution Cable (Copper)
Serving Area
Terminal/Splice
SAI RT
Drop or
Service Wire
NID
LEGEND
Serving Area
NID Network Interface Device
RT Remote Terminal
SAI Serving Area Interface
Adapted from Engineering and Operations in the
Bell System, 2nd Edition, 1983
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Loop Plant
Fiber
Wire Center
Distribution Cable
SAI
Remote Terminal
Drop Wire
Feeder Cable
Copper
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Loop Plant - Drop Distribution

• Drop
• Connection from subscriber premises to
  distribution cable
• NTS in nature
• Distribution
• Connection from drop wire to SAI (serving area
  interface)
• NTS in nature

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Loop Plant - Serving Area Interface

• SAI
• Cross-connect between distribution cable and
  feeder cable or RT
• NTS - size is driven by number of lines in
  serving area

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Loop Plant - Remote Terminal

• Remote Terminal is present only if pair gain or
  digital loop carrier systems are used
• Consists of line cards, digital multiplexer, and
  fiber optic terminal
• Loop carrier systems may be run in either
  concentrated or unconcentrated mode

56
Loop Plant - Remote Terminal

• TS/NTS nature depends
• Line cards are always NTS, they vary with the
  number of lines served
• Multiplexer and fiber optic terminal may be NTS
  or TS, depending on whether carrier system is run
  in concentrated mode

57
Loop Plant - Feeder

• Feeder is the connection from SAI or RT to the
  wire center
• Feeder is either copper or fiber optic cable
• Copper Feeder is always NTS
• Fiber Feeder can be TS or NTS, depending on
  whether carrier system is run in concentrated mode

58
Wire Center Equipment
COT
Processor
Matrix
MDF
Line Unit
Trunk Unit
Interoffice Terminations
59
Wire Center Equipment

• COT/MDF
• If feeder is fiber, it terminates at a Central
  Office Terminal
• TS or NTS, depending on whether carrier system is
  run in concentrated mode
• If copper, it terminates on the Main Distribution
  Frame
• MDF is always NTS

60
Wire Center Equipment

• Line Unit - terminates lines in the switch and
  provides functions such as dial tone, digit
  reception
• NTS in nature
• Processor - Used in call set-up, determining how
  call should be routed
• TS (call attempts) in nature

61
Wire Center Equipment

• Matrix - Forms connections from lines to lines or
  from lines to trunks
• TS (holding time) in nature
• Trunk Unit - Interface between switch and
  interoffice transmission equipment
• TS (attempts holding time) in nature

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Conclusions

• Most loop plant is NTS in nature
• Limited exception where loop carrier systems are
  used, and where they are run in concentrated mode
• Exception affects only feeder transmission
  equipment and fiber optic cable, other DLC
  equipment is NTS in nature
• Line-related switching equipment is NTS in nature
• Similar exception for loop carrier systems

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Outside Plant Structure
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Outside Plant Structure

• US Models consider three categories of plant
• Aerial - mounted on poles
• Buried - cable placed in trenches or plowed
• Underground - cable in conduit

65
Outside Plant Structure
66
Outside Plant Structure

• US Models optimize placement of plant by
  considering
• Life cycle maintenance cost
• Life cycle capital cost, including initial
  installation costs and relative depreciation rates