Introduction

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. SEMINAR ON ITU PRICING MODELSTBILISI, GEORGIA, NOVEMBER 14-15, 2002 Price Determination By Cleveland Thomas

3. Why are interconnection rates so important? 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 Sellers of Services • Protect retail market positions - discourage cherry-picking - protect retail tariffs • Increase revenues

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

6. Tariffing must be approached in an integrated manner. Wholesale Retail Cross elasticity’s Cross elasticity’s Service N Service N Service 2 Service 2 Service 1 Service 1 Value to Customer Value to Customer Expected competitive action Expected competitive action Price Price Own costs to produce Own costs to produce Optimization Regulatory interests

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 Pro’s • 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 Pro’s - 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 Call set-up 16 14 12 10 8 6 4 2 0 0 1 2 3 4 5 6 Charge per minute 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 2 Operator 1

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