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Economic study on IP interworking:

Summary of findings

Paul Reynolds

3GSM World Congress15 February 2007


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2 Economic study on the IP interworking: Summary of findings

Overview

The imminent migration to all-IP networks has raised a regulatorydebate about appropriate IP interconnection charging models

Key areas discussed:

NGN all-IP networks create the potential for large efficiency and

welfare gains

IP interconnection arrangements are critical to realise these gains

A number of policy implications flow from the analysis of IPinterconnection


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Future NGN interconnect enables economic efficiencyimprovements over current arrangements

Todays IP interconnect Future NGN IP interconnect

Best efforts quality

Packets transported along multipleblind routes without regard forcontents

Packets can only be counted at

network handoff points Interconnect pricing negotiated

bilaterally at handoff, in isolation ofretail pricing

Unlike circuit switched services, nonecessary link between retailcharging model andinterconnection model

Priority assigned by packet

Quality of service (QoS) can beguaranteed, with different quality fordifferent services

Differential charging by priority

Single party could provide virtualtunnel QoS path (e.g. IPX) forquality-critical services

VERDICT: INEFFICIENT

LARGE ECONOMIC EFFICIENCY GAINS POSSIBLE BUT HOW CAN THEY BE CAPTURED?


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IP interconnection is a critical lever for efficiency

Interconnect fees have important market effects

They impact cost recovery, and hence investment & innovation incentives

They impact retail prices, and hence consumer demand

IP interconnect therefore represents a critically important leverage point in

improving efficiency, especially in capturing the potential gains enabled byNGNs

Simply transposing a partial version of the current (inefficient) IP interconnect

arrangements into the NGN environment would be a massive lost opportunity, and wouldprobably undermine the rationale for upgrading to NGN



What is the efficient direction of interconnect payments?

The efficient direction of interconnect payments can be derived from twofactors

The efficient retail pricing model

Network costsRETAIL PRICING MODEL

NETWORK COSTS

Efficient messageexchange

Efficient messageexchange

Efficient direction ofinterconnect fee

Efficient direction ofinterconnect fee

Efficient allocation ofcharges among

customers

Efficient allocation ofcharges among

customers

Cost distributionamong networksCost distributionamong networks



The efficient interconnect model can be deduced if thedistribution of retail benefits and network costs are known

100%initiatingparty

100%receiving

party

100%

originating

network

100%

terminating

network

Distribution of benefits

Distr

ibution

ofcosts

BAK

i.e.Inter

conn

ectfee

=0

RPNP

IPNP Deriving the efficientwholesale model from theretail model and network costs

(assuming total cost of amessage = total benefit)



What happens if the wrong interconnection model isimposed?

If an inefficient model is imposed, services will not be provided to an efficientextent and costs may not be covered

Networks will seek to recover their costs by distorting their behaviour e.g. by targeting onlylow cost customers, changing network design decisions or by raising other prices

These changes can lead to market outcomes that are far from efficient, includingsuboptimal network coverage and underinvestment in quality

Ultimately service offerings may be limited (e.g. retail usage caps) and overall consumerbenefits lower


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BAK is efficient in special circumstances only

BAK is only efficient under special conditions:

Where traffic is stable and balanced between peers (networks of similar size and cost)

Where the distribution of costs among networks happens to align exactly with the

distribution of benefits among retail customers

In most cases, BAK leads to market distortions and damages efficiency

By setting the interconnect price to zero, BAK requires a network to gain all of its revenuesfrom its own retail customers, which usually leads to inefficiencies in retail pricing

Because BAK is inflexible, it gives rise to network structure bias (the hot potato problem)and may lead to under-investment in quality and coverage of networks

A rational firm will not provide transit services under a BAK pricing model

These inefficiencies are likely to be amplified in an all IP-world

QoS increases the costs that need to be covered by wholesale and retail revenues, leadingto a larger cost gap if costs cannot be recovered

This might prevent the introduction of QoS in any form


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IPNP can outperform BAK

IPNP will outperform BAK in most situations

The fee should not be locked in but should instead respond to market developments

It is the model most commonly applied in telephony (already has wide consumer

acceptance)

For transit interconnection, it provides a means to cover transit costs that would otherwisebe stranded by BAK

For the most part it encourages beneficial messages and discourages spam

Works well where the sender gains the most benefit

Where the recipient gains the most benefit, repeated or returned calling patterns, or offlinerelationships, can sufficiently compensate so that beneficial messages are still sent


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RPNP can also outperform BAK

RPNP has the potential to outperform BAK on efficiency

Provided that the level of the fee responds to market developments

For transit, RPNP provides a means to cover costs that would otherwise be stranded by

BAK

However, if applied generally it would risk a massive growth in spam

The sending network and/or the sender would face zero costs, and the recipient may notbe able to prevent the messages


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There is no single best IP interconnect model;variety is necessary to optimise efficiency

Model Advantages Disadvantages Implications

BAK

Apparently simple and low costalthough requires monitoring ofretail market conditions, operator

costs and/or traffic balance

Leads to market distortions inmost cases

These are amplified in a QoS

environment and when BAK isapplied to transit

Suitable only in limitedsituations (e.g. sustainedtraffic balance between

peers) and is not flexiblewhen circumstances change

IPNP

Likely to perform well in manysituations because itdiscourages spam but it doesnot significantly impedemessages which benefit mostlythe receiving party

IPNP can provide efficient

signals to operators

Regulators have beenconcerned in some cases thatthe level of termination chargesmay not be effectivelyconstrained. Such concerns arelikely to be less relevant in anall-IP world.

Likely to be the bestperforming model in mostcommon situations

RPNP

RPNP can be efficient inparticular circumstances andcan adjust dynamically asconditions change

Encourages spam

May be suitable in somesituations, althoughdominated by IPNP in mostcases


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Policy conclusions

Proceed cautiously

Regulators should be very cautious in mandating IP interconnection charging models forthe unfolding NGN IP environment

This analysis shows that there is no justification for regulatory intervention to mandate asingle IP interconnection model at this stage. It is too early to tell what model or modelswill prevail commercially

Regulatory intervention to prescribe a particular model, such as BAK, is likely to be pre-emptive and risky

Dont mandate a single charging model

Even if a particular charging model develops commercial currency, it does not follow thatthis would be appropriate to mandate as it may inhibit the development of better models

Evidence from the IP environment to date is that the industry can work out appropriate IPinterconnection models without the need for ex ante regulatory intervention


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Policy conclusions(continued)

Dont assume bottlenecks will be replicated

The deployment of NGNs has the potential to change the way many services are delivered.A regulator should not assume that existing bottlenecks will be replicated

Use existing regulatory frameworks

Existing regulatory frameworks are generally sufficient to resolve problems should theyarise (where they are telecom sector-specific and based on an objective assessment ofmarket power and general competition powers)

Employ consumer welfare analysis Should regulators feel a need to act, they should address the particular circumstances only

When considering IP interconnection charging models that might be applied in anyintervention, a clearly defined assessment framework that reflects the drivers of consumer

welfare and broader economic efficiency should be employed


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Economic Study on IP interworking:Summary of findings

Paul ReynoldsCRA International

1 UndershaftLondon EC3A 8EE+44 (0)20 7664 3701 (ph)

+44 (0)20 7664 3998 (fax)[email protected]

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