1
Introduction

• The pressure on all types of operators to
  implement cost-based pricing, especially for
  interconnect services, is growing
• I will deal with issues around the
  determination of tariff levels, and how to
  determine tariff structures.
• I will also touch upon how tariffs for commercial
  services will typically be determined in a
  negotiation process

2
Price Determination
SEMINAR ON ITU PRICING MODELSTBILISI, GEORGIA,
NOVEMBER 14-15, 2002

• By
• Cleveland Thomas

3
Why are interconnection rates so important?

• Sellers of Services
• Protect retail
• market positions
• - discourage
• cherry-picking
• - protect retail
• tariffs
• Increase revenues

• Regulators
• Protect retail
• customers
• Promote competition
• Give efficiency
• incentives
• Deter uneconomic entry etc.

• Buyers of services
• Minimize overall
• costs
• Enable competitive
• tariffs
• Simplify roll-out of own retail services

4
Key issues for pricing wholesale /interconnect
services

• The growing importance of jointly-provided
  services
• The importance of taking both long and
  short-term considerations
• The importance of recognizing that the
  interests of the regulator are, in the longer
  term, fundamentally opposed to the interests of
  the telecoms industry
• The need to understand the implications of
  pricing decisions across retail and wholesale
  services
• The need to understand that wholesale relations
  between operators are bilateral (both sides are
  buyers and sellers)

5
Key differences between a Regulatory
Commercial Approach

• Commercial Approach
• Driven by demands
• rather than costs
• Long-term profit maximizing
• Must fit with overall strategy and retail tariff
  structures
• Art based on science

• Regulatory Approach
• Cost-based
• FAC vs.. LRIC
• historic vs.forward-
• looking
• Mark-up
• zero
• uniform
• Ramsey
• ECP

6
Tariffing must be approached in an integrated
manner.
7
Value-Based Price of a Wholesale Service
8
Different cost-bases can provide the starting
point for (cost-based) tariffs

• Short Run Marginal Cost (SRMC)
• Cost of one additional unit of output, given
  existing capacity
• Long Run Incremental Cost (LRIC)
• Cost of adding a service or increment, including
  capacity costs
• Stand Alone Cost (SAC)
• Cost of providing one service by itself
• Fully Allocated Cost (FAC)
• Directly attributable cost plus a pro rata share
  of overheads
• These cost types will be addressed in more detail
  later

9
Tariffs must also include a mark-up

• Type of mark-up
• Zero mark-up
• Uniform mark-up
• Ramsey Pricing

• Pros
• stimulates entry
• strong efficiency incentives
• prevents excess profits
• easy to calculate
• balances conflicting objectives
• promotes efficient final svc. Prices
• prevents excessive profits

• Cons
• threatens viability of seller
• promotes uneconomic entry
• distorts competition
• arbitrary
• inefficient
• impact depends on flexibility of final service
  prices
• inelasticity may be due to lack of competition

10
Tariffs must also include a mark-up

• Type of mark-up
• Efficient Component Pricing

Pros - promotes fair competition - deters
uneconomic entry - ensures viability of seller
Cons - provides weak efficiency
incentives - does not address monopoly profits
11
The Choice of mark-up can have a dramatic effect
on tariff levels
Illustrative Interconnect Charges (pence/call
minute)
Note Price for the use of a local Tandem
12
Tariff structure is an important as tariff level
A generic tariff is a combination of one or
more of the following elements initial
charge (one-off charge - only one time) fixed
charge (time-based) call set-up (unsuccessful
vs. only successful calls) charge per unit
Other dimensions also need to be considered
geographical structure (distance) time-of-day
structure charging unit (per minute, per
second) The link to the retail tariff
structures must also be considered same
structure ? closer links to cost-drivers ?
higher complexity ?
13
Examples of importance of tariff structures
An infinite of solutions give the same result (3
minute call)

• True results depend on expected calling patterns
• expectations will differ among operators
  depending on
• retail customers served
• retail services offered
• each wholesale customer will have individual
  wishes for the optimal tariff structure

14
Arriving at tariffs in this market segment will
involve a set of negotiations
Regulator
Operator 1
Operator 2
15
Overview of typical positions
Target
Walk-away
Start
- Tariffs based on LRIC equal
mark-up - WACC equal 15
Position- Tariffs based on historic
FAC- Tariffs based on WACC of 18
Reasoning- Tariffs should cover all
historic costs - Risk of business is high
- Tariffs based on LRIC equal mark-
up - WACC equal 12.5- Cost of capital at
minimum level to ensure viable
business
- Tariffs should cover incremental costs
- Level of cost of capital is more
important than cost
16
Impact of different views on revenues
17
Key Conclusions

• Pricing is an integral part of your overall
  commercial strategy for dealing with wholesale
  and interconnect
• All parties negotiation interconnect and
  wholesale tariffs should address the issues with
  a broad, long-term view to ensure that value
  stays in the industry
• Regulatory-lead, cost-based pricing of these
  services should only be a last resort when
  negotiations fail
• Developing optimal tariff structures is as
  important as determining the tariff level
• Determining tariff levels and structures is not a
  one-off exercise, but rather part of an ongoing
  negotiation process