PERFORMANCE INDICATORS FOR TELECOMMUNICATIONS

AND PRICE-CAP REGULATION

Patrick Xavier*

(Ser ia l No.47)

Faculty of Business Staff Papers

SWINBURNE INSTlTUTE OF TECHNOLOGY A division of Swinburne Ltd

PERFORMANCE INDICATORS FOR TELECOMMUNICATIONS

AND PRICE-CAP REGULATION

Patrick Xavier*

(Serial No.47)

Paper presented to the 1988 Australian Economics Congress 28 August - 2 September 1988

Australian National University, Canberra

ISBN 0 85590 627 8

*Acknowledgements: Much of the work for this paper was done while the author was a visting research fellow at the Public Sector Economics Research Centre, University of Leicester (January-March, 1988) and the Institute of Public Utilities, Graduate School of Business Administration, Michigan State University (April-June, 1988). The author is grateful to Robert Albon, (ANU), and staff of Telecom and OTC for useful comments on the paper.

This paper should not be quoted or reproduced in whole or in part without the consent of the author, to whom all comments and enquiries should be directed.

c Xavier, P, 1988 0 +.

PERFORMANCE INDICATORS FOR TELECOMMUNICATIONS AND PRICE-CAP REGULATION

I INTRODUCTION

In October, 19

Guidelines for

things) requir

87, the Australian Government released its "Pollcy

, Government Business Enterprises" which (amongst other

,es those enterprises to develop, use and publish (in

their Annual Reports) financial and non-financial Performance

Indicators (PIS). However few details were given, particularly about

the nature and coverage of the non-financial PIS. In May 1988, in

announcing its new framework for regulating Australian

telecommunications services, the Government reiterated ~ t s requlrment

that, in their Annual Reports, Telecom and OTC " . . . give an account of performance against previously established goals, xncluding

financial and operational targets and the performance of comparable

telecommunications companies to the extent practicable . . . " (Minister for Transport and Communications, 1988 p.20). Agaln, few detalls as - to the type of PIS required were provided. Accordingly, the prlmary

purpose of this paper is to contribute to the task of identifying the - -

sort of operational PIS that should be required under the categories of financial, economy, efficiency, equity and effectiveness crlterla.

The Government announced that under the new regulatory framework a

new "Price-Cap" system for regulating telecommunicat~ons would be

instituted. Under this system. Telecom and OTC would be regulated by

a CPI-X formula which will act to limlt price increases to a rate

wh~ch is the difference between the movement in the Consumer Price

Index minus a predetermined allowance for expected cost/product~v~tv improvements. Thus, if the CPI is 7% and the "X" factor is set at 3 % . priceincreases for telecommunications services, on average,

wFuld be limited to a maximum of 4%.

Proponents of this system claim that it will protect consumers (from

excessive price increases) while maintaining incentives for increased efficiency. The "X" factor ensures that the telecommunications carriers' expected cost improvement is passed on to consumers by way of real price decreases. Carriers would be encouraged to do better than "X" since they can retain the increased earnings. Less focus on the problematical rate-of-return or financial targgt calculation

would be required and the system itself would simplify regulation azc

reduce the transactions costs involved.

(iii)

LIST OF TABLES

TABLE PAGE

1. Performance I n d i c a t o r s f o r Publ ic E n t e r p r i s e s : Some Major Aspects

2. Aus t ra l i an Telecommunications Commission : Performance I n d i c a t o r s

3. Aus t ra l i an Telecommunications Commission : Corpora te Object ives and Ta rge t s

4 . Aus t ra l i an Telecommunications Commission : Corpora te Object ives and Targe t s

5. P r o f i t b e f o r e I n t e r e s t and Tax a s a Percentage of To ta l Asse t s i n H i s t o r i c a l Cost Terms

6 . Return on T o t a l Asse t s i n Telecommunications, 1982-1983 1 2

7 . Rates- of-Return on Cap i t a l Employed: Aus t ra l i an and Overseas Telecommunications Supp l i e r s 13

8. I n t e r n a t i o n a l t a r i f f Comparison f o r Res iden t i a l Se rv i ce : Average Working Hours r equ i r ed t o ea rn equ iva l en t of Annual Telephone B i l l

9. B r i t i s h Telecom's P r i c e s : I n t e r n a t i o n a l Comparisons

1 0 . O T C i n an I n t e r n a t i o n a l Comparison with Singapore Telecom's I D D Ra tes

11. P r i c e s f o r Dia l Serv ice between t h e US and Selected Count r ies i n 1 9 8 7

12. B r i t i s h Telecom : Opera tor Enqui r ies Performance

13. Value-added Informat ion publ ished by Telecom Singapore

1 4 . Comparative Data on Common C a r r i e r s

15. Opera t iona l Expendi tu re p e r u n i t of T ra f f i c .

1 6 . Investment : Comparative Data on Common C a r r i e r s

1 7 . Investment by Common C a r r i e r s : 3-Year Moving Average

1 8 . Telecommunications Investment a s Share of Gross Fixed C a p i t a l Formation

1 9 . T e l e c ~ m m u n i c a t i o n ~ Equipment Exports by Country

2 0 . Trade Balance : Tota l Telecommunications Equipment

PERFORMANCE INDICATORS FOR TELECOMMUNICATIONS

AND PRICE-CAP REGULATION

Patrick Xavier

Faculty of Business,

Swinburne Institute of Technology, Melbourne

Abstract

The Commonwealth Government's October 1987 Policy Guidelines for

Government Business Enterprises requires these enterprises to

develop, use and publish (in their Annual Reports) financial and

non-financial Performance Indicators (PIS). Few details were given,

paarticularly about the type of non-financial PIS to be used.

Accordingly, this paper sets out to identify appropriate PIS,

classifying them under Financial, Economy, Economic Efficiency,

Equity and Effectiveness criteria. Telecommunications is used as a

case study.

In May, 1988, as part of its Economic Statement, the Government

announced a new price-cap system for regulating telecommunications.

The paper explains that PIS for telecommunications will be of as

much, if not greater interest, under this new system. In addition,

the paper demonstrates that whilst price-cap regulation has merit, it

will also confront several problematical issues. Moreover, the paper

warns that if it results in attention being focussed on price and

productivity changes, price-cap regulatioin will fail to spotlight -

indeed, may distract attention from - crucial aspects of the performance of the telecommunications carriers, in particular dynamic

efficiency and "effectiveness" in terms of achieving policy and

strategic objectives. Drawing attention to these issues now will

help ensure that they are addressed when the detailed plans for

price-cap regulation are being drawn up. <

The paper concludes with a discussion of the preconditions requ~red

for the effective use of a system of PIS.

111.

I V .

(ii)

PERFORMANCE I N D I C A T O R S FOR TELECOMMUNICATIONS AND . ,

P R I C E- C A P REGULATION

CONTENTS

ABSTRACT

INTRODUCTION

PERFORMANCE I N D I C A T O R S FOR TELECOMMUNICATIONS

P R I C E- C A P REGULATION AND.PERFORMANCE INDICATORS

CONCLUSIONS AND RECOMMENDATIONS

A P P E N D I X I : WELFARE C R I T E R I A AND P R I C E REBALANCING 7 5

END NOTES 76

R E F E R E N C E S 7 8

However, while the price-cap system does have merit, it also has its

problems. Moreover, if it results in attention being focussed on

price and productivity changes, price-cap regulation will fail to

spotlight crucial aspects of the performance of the

telecommunications suppliers - in particular dynamic efficiency and "effectivenesst in terms of achieving policy objectives. Thus

another purpose of this paper is to ventilate some of these problems

and deficiencies so that they can be addressed as the detailed plans

for the new system are drawn up.

The paper wlll show that performance indicators will continue to be

required under the new price-cap system. Indeed, slnce the effects

of the new system will be closely watched, there may well be

increased interest ln indicators of performance in a broad sense, le

beyond financial crlteria to include, in particular, dynamic

efficiency and broader aspects of effectiveness. At any rate, the

thrust of the new regulatory scheme is reportedly to move to a system

of results-oriented, post-decision-making evaluation of

telecommunications operations. This, too, will generate greater

interest in the sort of results that the performance indicators

proposed in thls paper wlll monitor. In addition, there are

prospects that under the new system the boards and management of

Telecom and OTC will also be more concerned wrth the sort of

performance indicators proposed in this paper, particularly slnce

several are directly related to aspects of the price-cap formula.

It should be made clear at this point that in advocating a wlder

range of PIS this paper does not In fact seek to increase the - constralnts on Telecom and OTC. On the contrary, in settlng out to

develop an improved system of PIS which facilitates performance

monltorlng, the paper seeks rather to reinforce the Government's

moves towards less interventionist, more results-oriented, regulation

of telecommunications. Clearly an effective resultslperf ormance

monitoring system is crucial if support and confidence in the

regulatory changes are to be sustained. Conversely

an ineffective performance monitoring system will generate pressures

for the regulatory pendulum to swing back towards greater

pre-decision making monitoring by Government. Accordingly it would

seem in the interests of the telecommunications carriers to support

the development of a system of PIS which does effectively monitor and

evaluate the important aspects of their performance. This should

help ensure that their own attention and efforts are appropriately

focussed.

However, the development of PIS should not be left solely to the

telcos. The experience with the development of PIS for the UK

Nationalised Industries suggests that a strong Government lead may be

necessary for satisfactory progress. Moreover, it should not be

surprising if, left to choose its own PIS without the close scrutiny

and involvement of the regulator/government, a public enterprise selects those which represent it most favourably or which are

susceptible to strategic misrepresentation. This paper will provide

examples of where this has occurred in the selection of some of the

PIS currently in use. Unfortunately the short term benefits of such

strategic behaviour might seem more obvious to a public enterprise

than the longer run benefits of an effective performance monitoring

system.

The Government's price-cap regulation announcement made special mention of "international comparisons" in assessing the performance of Australia' s telecommunications suppliers. Although they should be

treated judiciously, and although they frequently need substantial qualification, such international comparisons may be useful, particularly where there are no other producers within a country

which could provide a basis for llyardstick'' assessment of performance. Thus, in seeking performance indicators, this paper will pay special attention to those that may be used in making international comparisons.

The organisation of the paper is as follows. Following this introduction, Section I1 assessses the performance indicators presently published by Telecom and OTC in their Annual Reports, and proposes improvements by way of alternative and/or additional

(complementary) performance indicators categorised under Financial,

Economy, Efficiency, Equity and Effectiveness criteria. Then, Section I11 presents a flpostscriptv discussion (since much of this

paper had already been written when price-cap regulation was announced) of how the PIS proposed in Section 11 will be as, if not

more, relevant under price-cap regulation. Finally, Section IV

presents conclusions and recommendations including an indication of

some of the preconditions or tlenabling" factors for PIS to perform effectively(2).

I1 PERFORMANCE INDICATORS FOR TELECOMMUNICATIONS

Table 1 enables an overview of Section I1 by providing a list of the

major issues which will be discussed in 'the attempt to identify

appropriate performance indicators for telecommunications. We begin

by examining the financial PIS c'omrtionly used in the private sector,

such as the level of profits, rates-of-return on assets and equity

etc. However, as is broadly acknowledged, while comprising one part

of a system of PIS, such commercial/financial criteria alone do not

constitute an adequate set of PIS, particularly for public

enterprises. (See eg Report of the House of Representatives Standing

Committee on Transport, Communications and Infrastructure, 1987, especially Chapter 7.) Thus, performance evaluation needs to extend

beyond financial criteria, to encompass (at least) the following

components of performance: Economy, Economic Efficiency, Equity and Effectiveness. ( )

- 5 -

TABLE I

PERFORMANCE INDICATORS FOR ,PUBLIC ENTERPRISES: SOME PAJOR ASPECTS

1 FINANCIAL CRITERIA: PROFITABILITY/RATES-OF-RETURN

Accounting Issues .-a Creative Accounting

Current Cost Accounting Depreciation Issues Accounting vs Economic Returns

Broader Performance Evaluation Required Including: ECONOMY, EFFICIENCY, EQUITY, EFFECTIVENESS

2 ECONOMY: Are resources being purchased at minimum cost?

Allocative Efficiency: Level of Prices

Structure of Prices Quality of Service

3 ECONOMIC EFFICIENCY

4 EQUITY

Technical Efficiency: Real Unit Cost Reduction

Economies of Scale Productivity Improvements - Labour

- TFP Dynamic Efficiency: Investment

Technological change Innovation

Universal Service Cross Subsidies Price Rebalancing

EFFECTIVENESS: How well are policy objectives being achieved?

Telecom Australia, and OTC, have published PIS in their Annual Report

for several years. We proceed now to assess the adequacy of the PIS

which they publish, in order to identify alternative or additional

PIS which might be useful.

Table 2 presents a copy of pages 6 and 7 of Telecom's 1986/87 Annual

Report which sets out its performance indicators. And Tables 3 and 4

set out Telecom's PIS published in its "Service and Business Outlook"

document. OTC1s PIS are not listed in a similar way but are interspersed through its Annual Report. Thus we discuss them as

appropriate in the various sections of this paper.

1. Financial Performance Indicators and Targets

Telecom uses the ratio of profit to total assets before interest as a measure of its financial performance. ( ) The return for 1986/87 is

given as 10.6% in historical cost accounting terms as Table 5 shows.

OTC does not publish its rate-of-return figure, although figures

provided in its Annual Report allow it to be estimated. For 1986/87

OTC's rate of return figure was 17.9%. Telecom makes no comment

about how satisfactory its rate-of-return is as a measure of

performance. Nor is this achievement compared against a target level -

in Telecom's Annual Report, although its "Service and Business

Outlook" document (September, 1987, p 8) discloses the target level

to be 10.5-11.5% on average. No explanation is given as to why this

target is appropriate. Perhaps there is an implication that the rate

of 10.6% looks "respectablew and/or fair against the returns earned

by other large Australian companies in the private sector (which

averaged about 13% in 1983/84 [Reserve Bank of Australia, 1986, p 61). The point being made here is that, to be understood by external assessors, it should be explained why a particular performance target is appropriate and why achievement against that target is satisfactory or unsatisfacatory.

Although a GBE's financial performance should be assessed against a

pre-established target tailored to its own circumstances and obligations, comparison with overseas suppliers of telecommunications

services do offer some added perspective for assessment of Telecom's

and OTCts financial targets and rate-of-return figures. At any rate

the Government now specifically requires that such international

comparisons be made (see statement by the Minister of Transport and

Communications, 1988, p.185).

Table 6, reproduced from Ergas (19861, indicates the rate-of-return

ranking for telecommunications suppliers overseas for 1982/83. The

Table suggests that Telecom's (and OTC's) rates-of-return did rank

higher than most other telecommunications suppliers. However, since

the rate-of-return of most of these companies is regulated, ( 5 1 it

is arguable that these figures say more about what rate-of-return the

respective regulators have considered acceptable or "fair" than about

performance. Moreover, the ranking information contained in Table 6

provides less infomatiion than actual rate-of-return figures.

Table 7 enables a comparison of more recent rate-of-return data. The

figures suggest that earning8 by Australia's telecommunications

suppliers are roughly equal to or, in OTC's case, exceed the rates

earned by American companies. For Telecom, earnings appear to be

substantially less than British Telecom's rate of 20.0% in 1986/87 (which includes earnings by British Telecom International - OTCfs

British counterpart - since rate-of-return data for this division of British Telecom's operations is not published separately).

It should be noted that the figures in Table 7 offer a preliminary comparison only, since in order to improve comparability, adjustments may be necessary. As is well known, comparisons of profitability - particularly internationally - have to be treated warily. As Heald

(1988) warns:

"Comparisons of profitability run into chronic problems because of the scope for manipulation of the figures. write-offs of asset values can be subjected to different accounting treatment, with very thin lines between them. There are both U.K. and international standards on 'unusual' items which either alter or rephase reported profitability. Companies have substantial discretion as to whether items are treated as fexceptionalf (taken before profit is struck) or as 'extraordinary' (taken

after profit is struck). Moreover, the existence of large

reserves, sometimes built up through the application of

comprehensive inflation adjustments or of supplementary depreciation, opens up the possibility for charging write-offs

direct to reserves. Any confidence that auditors will insist

upon consistency would be seriously misplaced." ( p 29)

It should also be noted that, as reiterated by the Byatt Report

(1986), the rate-of-return estimate in historical cost terms does not indicate economic performance. This seems now to be increasingly

recognised. Thus the Victorian Government requires its public

enterprises to aim at achieving a real rate-of-return of 4 per cent,

and the Department of Finance (1987) has suggested that an

appropriate financial target for Commonwealth Government Business

Enterprises be set at 6% in real terms, ie based on current cost

accounting (CCA). Using this approach, the return on total assets

figure published by a GBE will be presented in real terms to allow

comparison against this 6% target. (An extended discussion on

setting financial targets for GBEs and inflation/CCA accounting is

contained in Xavier and Graham, 1987.)

Even if CCA reporting is required, the historical cost accounting

figures should also continue to be published since, despite their deficiencies they do have some usefulness, allowing trends

to be observed, as well as facilitating comparisons with enterprises

nationally and internationally which continue to use historical cost

estimates. The onus could then be placed on an enterprise which

scores poorly in terms of this indicator to explain its poor performance. In this way the performance indicator system would be

playing its proper role of drawing attention to problem areas and

"triggering' investigations and remedial action. Moreover, the

debate about the correct approach to CCA seems yet to be resolve,

and, in such circumstances, as experience in the UK suggests, CCA

might allow even more scope for subjectiveness and creative

accounting than historical cost accounting. Thus as Xavier and

Graham (1987) have shown, significantly varying real rates-of-return,

depending on which approach to CCA is used, are derivable for Telecom and OTC.

- 10 - TABLE 3

CORPORATE OBJECTIVES AND TARGETS

OUR BUSINESS

Maintain viable levels of profitability

Internal funding to reflect viable levels

Maintain ready access to external funds at minimum cost

Contain costs by improved labour productivity

Promote Australian industry

OUR PEOPLE

Encourage our people to actively adopt and promote the business attitude that:

our customers come first success in business builds our future our people make it possible

Provide all employees icith a healthy and safe work environmtnt

ACTUAL TARGET TARGET TO MEASURE 1986/87 1987/88 BE ACHIEVED

BY 1989/90

Profit before interest and 10.6% 10.5-1 1.5% on average abnormal items on total over the period assets Average annual reduction 3% 2-4% on average over in direct operating expenses the period per access line in real terms

Self funding ratio 71% 72-75% on average over the period

Credit rating on domestic AAA AAA AAA capital markets

Average annual increase in 7% 5-7% on average over the number of access lines the period per employee

Purchasing policy aimed at fostering a viable Australian telecommunications industry

Provide funding for Australian-based research and development in telecommunications and related fields

Actively participate in the development of public and private programmes to facilitate a more \. iable internationaily competitive Australian communications industry

Assessment of the views of customers and of staff as surveyed in 1984 compared with a resurvey in 1987/88

Annual reduction in days 10% 5 To 5% lost due to occupational injury and disease occurring during the year in relation to total days worked

TABLE 5

PROFIT BEFORE INTEREST AND TAX AS A PERCENTAGE OF TOTAL ASSETS IN HISTORICAL COST TERMS

Telecom

OTC *

* Unlike most other Commonwealth Government statutory authorities, OTC is required to pay corporate income tax. To facilitate comparability, OTC's income tax payments have been added back into profits in order to compute the rates-of-return before interest and tax shown in Table 5.

[Source: Annual Reports of Telecom, and OTCI

TABLE 6

RETURN ON TOTAL ASSETS IN TEUECOMMUNICATIONS, 1982 - 1983

AUST. UK FRANCE JAPAN US CANADA SWEDEN

NOTE: Return on total assets is net profit plus interest charges divided by fixed assets (htstorlcal cost less depreciation) plus current assets.

SOURCE: Annual reports of the various adrninrstrat~ons. '

- 13 - TABLE 7

RATES-OF-RETURN ON CAPITAL EMPLOYED a: AUSTRALIAN

AND OVERSEAS TELECOMMUNICATI9NS SUPPLIERS

Telecom Australia 10.8 10.6

mc

British Telecom

Cable and Wireless

AT & T

MCI

US Sprint

Bell Canada

Cincinnati Bell.

Michigan Bell

Bell Atlantic

Bell South

Southwestern Bell

20.0

19.5

23.4

0.3 (c)

loss(b)

loss

11.6

11.3

11.9

11.0

11-0

10.6

loss

11.5

a before tax

b loss of about $450 million due to an asset write down of $585 million in 1986.

C due to asset write down

d see end note 5

e rate of return on capital after tax as reported in the Wall Street Journal, 30 June 1988

[Source: Annual Reports]

All this is not meant as argument against the use of CCA but rather

to point out that there is a pressing need for careful consideration

of the accounting principles used by Government Business

Enterprises. Moreover, particularly for telecommunications

suppliers which are experiencing dramatic technological change and

equipment obsolescence (e.g. as fibre-optic rapidly replaces copper

lines) there is a need'to reconsider appropriate depreciation

policies and practices. Without clearly specified, generally

accepted accounting principles, there will probably be more latitude

permitted for the use of different accounting practices than may be

acceptable for regulatory purposes. For such reasons, various

aspects of accounting issues have recently been the focus of much

attention by OFTEL and the FCC.

Since the appropriateness of current cost accounting for Government

Business Enterprises has been receiving considerable attention in

Australia, it is worth pointing out that the issue will not recede

under price-cap regulation. Indeed, OFTEL has on several occasions

called upon British Telecom to resume publishing the current cost

information it did when it was a nationalised industry. British

Telecom, having suspended its publication of current cost information

in its Annual Report, has resisted OFTEL's requests "because of the

uncertainties surrounding the preparation and interpretation of such

statementsw, ( p 13 of the 1987 BT Annual Report's Financial

Supplement). However, OFTEL has disclosed that some CCA information

is being supplied to it by British Telecom (OFTEL, 1988) and reports

(OFTEL, 1988b) that in its 1988 Annual Report, British Telecom has

published some CCA information.

On a broader front, the British Treasury has been endeavouring to

progress (with limited success) the implementation by British

Nationalised Industries of the CCA recommendations of the Byatt Committee report (Byatt, 1986). Edwards, Kay and Mayer (1987)

address Fisher and McGowanls (1983) arguments about the shortcomings

of accounting rates-or-return as a measure of economic performance

and extend the debate about CCA and the economic analysis of accounting profitability into the private sector.

Despite these efforts, some of the problems of measuring financial performance accurately may be difficult to resolve satisfactorily.

And the persistence of such problems will serve to sap confidence in

the usefulness of financial performance indicators. This is another

consideration favouring the move away from rate-of-return regulation

towards "price-cap" regulation, since (in principle) the latter reduces the regulatory focus on the level of profits and, therefore,

the dependence of regulators on the regulated firm's unbiased

assessment in providing correct measures of profit and

rate-of-return.

There is clearly good sense in British Telecom suggestion, (Wheatley,

1987), that to reduce the dependence on the rate-of-return on assets measure, additional, complementary, financial indicators could be

used:

" ~ t is useful, in this connection, to compare earnings indicators with those used in the U,S, in relation to privately owned

telephone companies, Here we find a list very similar to those

used in the U.K. - an inevitable result of the internationalisation of financial markets, In both cases the

interest is highly focused on the stability and quality of the earnings in relation to the shareholdersf investment. Why were none of these measures considered useful or necessary when

British Telecom was a public industry? Obviously some of them

only relate to the existence of share capital, but others could

well have been enquired into in order to discover the return actually being made on the taxpayer's investment in the company.

- - ---- - -

"The Treasury had clear ideas of what it was trying to achieve and expressed this in terms of a real rate of return on new investment. There were, however, long debates about how achievement might be measured and the relationship that existed between internal rates of return and accounting rates of return. capital markets have never tackled the question in this way and have concentrated much more on likely net revenues and cash flows. As an illustration of this, the 5% real rate of return on new investment, which was a Treasury objective, has been difficult to relate to the cost of capital or to the rate of

return obtaining in private industry." (pp 16-17)

Other Financial Criteria

Amongst the supplementary financial criteria worth considering are

the following suggested by British Telecom which are commonly applied

in the private sector, (Wheatley, 1987):

RATIO DERIVATION

Margin

Growth (reduction)

in operating profit

Growth (reduction)

in profit before tax

Turnover per

employee

Profit per employee

Gearing (Net

debt to equity)

Interest cover

Operating Profit

Turnover

Increase (decrease) in operatins profit,

current year

Operating profit, previous year

Increase (decrease) in profit before tax,

current year

Profit before tax, previous year

Turnover

Average number of employees

Operating profit

Average number of employees

Total borrowinqs

Equity

Operating profit

Net interest payable

2. Economy

Telecom and OTC do not publish specific PIS which demonstrate economy

(cost minimisation practices) in the purchase of labour, capital and

other materials. There are many questions which such P I S could

assist in answering. Are wage levels for specific types of labour

higher in Telecom and OTC than in comparable industries? Is capital

borrowed at relatively-competitive rates? As interest rates fall in

Australia, how have costs been affected and with what potential for

prices to be reduced? Are some aspects of wages/costs rising much

faster than others? Are input costs implying that the appropriate . .. - quantities/qualities of inputs are being purchased? Is the input

price index changing as might be expected?

The usual focus on the scale of outputs of telecommunications may

obscure significant developments on the input side. As the telephone

and computer industries have converged from a technological

standpoint, the telephone industry has benefitted from highly

efficient outputs in the computer industry. Will the declining costs

of switching and transport input technologies show up in Telecom's

input cost index? In addition, as frequently observed, under rate-of-return regulation the telephone service business may have

incentives to "cost-pad", "gold plate" or over-invest, for example rn

computer and fibre optic investments (which, in due course, are

capable of producing long-term gains in output at extremely low

marginal costs). Moreover, telephone carriers might have an

additional incentive to engage in such "strategic waste" or

overcapacity in anticipation of future implementation of price-caps

or increased competition (since the existence of significant excess

--A -- capacity could-deb--patentid--competitors [Sappington, 19801). PIS which monitor input costs could help restrain such activities.

Finally a firm itself would no doubt be concerned to keep track of

trends in input costs since this provides essential information for

expense control. Being required to publish such information should

provide further lncentlves for improved performance In lnput cost

control.

Where significant decreases in input costs are enjoyed by tele-

communications suppliers, it is important that consumers benefit as

well. Requiring the telephone carriers to produce input cost PIS

will help ensure that this occurs.

3. Economic Efficiency

The concept of "economic efficiency" may be usefully explained - particularly for operational purposes - by a breakdown into:

(a) Allocative Efficiency

(b) Technical (including "X") Efficiency, and

(c) Dynamic Efficiency

(a) Allocative Efficiency

This is usually discussed in the theoretical literature in terms of

achieving the conditions for "Pareto-optimality". In non-technoical

terms, "allocative efficiency" is concerned with decisions regarding

the production of the "appropriate" quantity/quality of the

"appropriate" goods and services. More specifically, allocative

efficiency embraces "price efficiency" within firms as well as

efficiency in the allocation of factors among firms, of goods among

purchasers and the marginal cost/marginal valuation relationship. In

essence, in regard to telecommunications performance, allocative efficiency prescribes attention to the level of prices, the structure

of prices and the quality of services provided.

Level of Prices -

Telecom's 1986/87 Annual Report contains a graph showlng that the

average prlce level for its basic products has increased by 21.9%

over the flve years slnce 1981/82 (roughly 4.4% per annum),

slgnlficantly less than the 47.2% (about 9.4% per annum) increase I n

the CPI during the same period. (Note that this decllne In real

prrces of 5% per annum is a greater reduction than the 3% sought by

the CPI-3% prlce-cap formula applled to Britlsh Telecom.)

- 19 - -,

This is certainly welcome information, but how good is TeLecomfs performance here? If price increases have been low because Telecom's

rate-of-return is relatively low, or if the producer price index for Telecom's inputs had increased by less than 21.9% during the period, or if productivity improvements coupled with economies of scale and scope reduced real per unit costs by more than 5% per annum, Telecom might not have much to be proud of. Hence, to be more meaningful in regard to performance, discussion of Telecom's price level changes

should refer also to such comparisons rather than only to the CPI

movement.

What about the level of prices for Telecom's services when compared

with levels prevailing overseas? The implication in such a

comparison is that (other things constant) lower prices. reflect lower costs, and so greater efficiency. Table 8 sets out figures which indicate that in regard to the level of telecommunications prices for residential service, Telecom ranks fifth of the eleven countries

listed. Telecomfs approach of using the "number of working hours necessary to pay a telephone billw avoids the problem of exchange rate conversion. But it can-be challenged for other reasons. For example, it is arguable that the comparison should strictly be made on net earnings, not gross, to allow for differences in taxation, etc. The approach also tends to reflect overall differences in productivity rates rather than differences specific to telecommunications.

Consider also Table 9 which undertakes a similar task of ranking telecommunications price levels in different countries and, in addition, provides a useful breakdown between residential and business tariffs. It is presented here to demonstrate a commonly used alternative method of ranking; as a cross check on the ranking provided by Table 8; and to show how a company - in this case British Telecom - can experiment with different methods and "weightsw to find one which presents its performance most favourably. British Telecom, which ranked eighth on Telecom's method, ranked fifth on its own comparison. Australia's position slipped slightly from fifth to sixth place. Canada ranks ahead of Australia in both comparisons, indicating lower telecommunications prices. Of course selectively excluding or including countries to be compared against can also help to change a country's ranking. (McDowall, 1987, and Horton and

Donovan, 1987, provide detailed appraisals of British Telecom's and

other international price comparison approaches. A recent document

produced by Telecom discusses alternative approaches to international

price comparisons for telecomrnunicatiions services, see Telecom

[I9881

TABLE 8

INTERNATIONAL TARIFF COMPARISON FOR RESIDENTIAL SERVICE: AVERAGE WORKING HOURS REQUIRED TO EARN EQUIVALENT

OF ANNUAL TELEPHONE BILL

NOTE: Caiculaied on basts of gross wages per hour tn manufacfuring lnduslry in 1983.

SOURCE. Telecom Australla.

- 21 - TABLE 9

BRITISH TELECOM'S PRICES: INTERNATIONAL COMPARISONS

micat British Telecom Sill priced in ovenrSxi tariffs expressed as an index (Apnl 1987,

Business Residential ............................................................................................. !taly ................. : 171 1 33

France.. .......................................................................................................... 133 118 West G e m l y ............................................................................................... 129 133 Japan ............................................ : ................................................................ 109 110 Spain ............................................................................................................. 1 05 87 AushIia ........................................................................................................ 101 1 0.1 Brit lnP Telccoin ............................................................................................ 100 I00 USA (New h r k City and .4TGT) ................................................................... 99 99 Cmacia ........................................................................................................... 87 74 Netherlands ................................................................................................... 66 92 Sweden .......................................................................................................... 56 ti3

lltr data 111 ttrr llbovc table miak Lo bills rvflt~ting British Mecorn businiw and resideritid custon~ers' d l usage patterns. Time bill elements have btwt priced at the latest charges available in each of the countries concenled, Wig account of their different genera! price levels and conwrted to the s t e w eguivaletlt uskig international purchasing power indices.

[Source: B r i t i s h Telecom, Annual Report,

But just how good is Telecom's performance here? Albon (1987 a)

reminds us that the lThours of work to purchase a standard package of

telecommunications services" measure is "tricky" and has to be used

with caution. For instance, it involves costing a given basket of

services in different countries, and the resulting rankings are

sensitive to the composition of the basket. Factors which might

complicate international comparisons are differences in

telecommunications products, service level and quality, marketing,

geography, topography, cross-subsidisation, rate structure, the call

pattern, etc. Nonetheless, on the basis of the figures in Table 8,

Albon points out that Canada ranks ahead of Australia, and suggests

that this is a noteworthy comparison in view of the significant

similarities in standard of living, population, density and

dispersion which exist between Canada and Australia. While Canada's

overall population, at about 25 million, is larger than Australia's

(approximately 16 million), that larger population is spread over an

area nearly a quarter larger again, so its density is almost the

same, The dispersion of population, with a major concentration in

the south-eastern corner and a smaller concentration in the

south-west, is also remarkably similar. Albon concludes by pointing

out that:

"Telecom has never answered the charge that it is

cost-inefficient relative to Canada, on its own measure, and has

not shown why Canada is different." (p 28)

Certainly, it would be instructive, and potentially constructive, for

Telecom to consider why Australian telecommunications seems to

perform less favourably than its Canadian counterpart on this

measure, Indeed, this presents an example of the way in which PIS

can act constructively to trigger investigations which could yield

information germane to effecting remedial improvements.

Looking only at the level of prices is, of course, being myopic. In Telecomts case, it should be pointed out that although its prices

were higher than its Canadian counterpart, so was its rate-of-return

on assets (see Table 6). More generally, while Telecom's prices were

in the middle range for the advanced economies, its profitability was

amongst the highest. Ergas (1986) has concluded from his study,

which includes such comparisons, that,

"Together, these criteria imply that the Australian

[telecommunicationsl network is at least not technically

inefficient (since it is achieving an above average return on

investment without having above average prices) and may in fact

be operating at levels of technical efficiency above the OECD

average, particularly when geographical constraints are taken . -

into account." ( p 2 5 )

Ergas' conclusion has been challenged by Albon (19871, but his

approach, which considers levels of prices jointly with rates of

return earned, is undoubtedly more appropriate than a consideration

of level of prices alone.

OTC's Price Level

OTC published its performance indicators in its Annual Report for

1986/87 in a way different to that of Telecom. The reduction in the

real level of prices is shown in a graph depicting a fall in the

average number of hours worked to pay for a 7 minute IDD call to the U.K. or U.S.A. The cost is shown as having declined from 1.4 hours of work in 1983, to less than 1 hour in 1987. Comparison with

telecommunications charges for other countries based on the same

approach would have also been useful but were not provided.

An example of such an international comparison is pnovided in The

1987 Annual Report of Singapore's telecommunications authority. The comparison which includes OTC, is reproduced as Table TO. Of course,

such a comparrson wrll change as exchange rates alter but is of lnterest nevertheless, particularly when a country's exchange rate 1 s

relatively stable, or when rates averaged over, say, one year, are

used.

According to Table 10, at the end of 1986, OTCfs charge per minute

for calls to Singapore was 2.33 Singapore dollars, fractionally

higher than Telecom Singapore's charge of 2.30 Singapore dollars for

calls to Australia. It should be noted, however, that this

comparison was made in 1986, after there had been a significant fall

in the value of the Australian dollar against the Singapore dollar

(which would have significantly reduced the cost of a call from

Australia in the comparison). If reliable, such comparisons might be seen to have important implications, not only for business

telecommunications expenses, but, for example, as a factor in a

country's ability to compete in attracting the regional headquarters

of multi-national companies to its shores. But, of course, as

mentioned earlier, doubts can quickly be raised about the reliability

of such comparisons. Nevertheless, they can be useful by placing the

onus on those who measure poorly, to explore and explain their

position. The information provided by such explanations could also

be useful to outside assessors of a company's performance.

Perhaps this 1s one reason why the Federal Communications Commlsslon

in the USA prepares and publishes International telephone prlce

comparlsons between the Unlted States and nlne other countrles - not at the moment lncludlng Australla. The prlces are glven for dlal

calls that orlglnate in the U.S.A. and termlnate rn the other nlne

countries, and the prxces for dlal calls that orlglnate rn the other

countrles and termlnate In the U.S.A. The prlces are stated I n

U.S. dollars per mlnute of use, beglnnlng with a one mlnute call and

endlng wlth a twelve mlnute call. The prlce comparlsons for 1987

reproduced In Table 11 Illustrate the method used and show that

prlces for dlal calls from the U.S.A. usually tend to be much lower

than the prlces for dlal calls from the other countrles to the Unlted

States. Moreover, the prxce differences tend to lncrease as the

length of the call Increases.

OTC should be required to undertake and publlsh a similar set of comparisons.

(ii) Structure of Prices

The structure of telecommunications prices is another important aspect influencing performance in regard to allocative efficiency.

Accordingly, the conclusion of one commentator's analysis (Albon,

1987) of Telecom's pricing structure, is pertinent to this study:

"One thing is certain. The present pricing structure is highly inefficient and cannot be justified on the basis of either major

approach (access charging or Ramsey) to optimal

telecommunications pricing." ( p 22)

TABLE 10

OTC IN AN IN!FER@ATIONAL COMPARISON WITH TELECOM SINGAPORE'S IDD RATES

Minus slgn ~ndlcatesslngapore rate IS lower.

"Basedonexchange rateinks raterevlew- end 1986

[Source: Telecom Singapore, Annual Report for 1986-871.

Country of Destination

USA Canada Italy Switzerland Sweden W. Germany UK Austral~a South Korea Tarwan Japan Hong Kong W Malaysia Thailand

Singapore Outgoing Rate Ymin.

3.40 3 40 450 450 450 3 50 260 230 300 300 3.00 2.20

80 2 40

Cmesponding lncoming Rate Slmin.

404 4 67 8 37 896 6.08 380 3.25 2 33 5 66 4 51 690 2 20 1 62 2.50

% D i i ~ n c e

- 16 - 27 - 46 - 50 - 26 - 8 - 20 -- 1

47 33

- 57 0

- 51 - 4

- N N U Y . . . . 8%;;

-VI "PP'PP x - m o

m-m --- """" 'PPP PY?? 8 E8Z3 fZ$2%8

VIV)V) VIM--.

"PPP * r m N OPCO* ,

W C N N LPCnrV)

VI C3C3Cn ZAW-vMn CIWW)- V)---

PPPP ?PFP Y??? W-0- P W N - 0-0- Q m P N W-Wg

cnuw, ",w zzzz! PPP JPPP "?'P *PO mm4m N O m 9490 8SZZ

= - - 8 or- +-* Z S 8 Z 388%

--a - . . . N N N YNYW .2Z% EZSS 2%Z3

- PPP PPPf "?-p '-.;;+x m*+-

O J W * 3sze VW 2z!

PPP? N"?' PIP .j* SSw% 3 Y 3 3 2% 2s

P UNC ?' . . . . $j

V) C

C w

V) C

0 m

V)

N s

VI

i VI U

(I) 4

M

; V)

?' N,

0%

Y m 0

V)

S Ul

v,

?' N N

- 4 0 w

V)

7 ul JI

VYI)

N N 8P

9 F;8

F? NC ah)

vm Y?' UC 4 m

V, V ) r

PP 58

V) (nr

.-1N OIN ca

V) V)L

aJP 4N Urn

Albon estimated that this form of pricing inefficiency results in a

welfare loss to the Australian community of about $250 million per

annum, based on 1985-86 figures (Albon, 1987 b, p 21). Yet neither

Telecom's Annual Report nor its Service and Business Outlook

publication, refer to performance indicators and targets in regard to

the structure of prices.

The broad problem is that access charges are far too low and usage

charges (for the most important services) are far too high. As Albon

concluded from his study:

"The fundamental imperative is to reduce charges on long-distance

calls and to retrieve the lost revenue through higher access

charges and the introduction of charges on unpriced services.

The reductions in deadweight losses. from lower STD charges could

be attained without any offsetting increase if access charges

were raised in a manner consistent with taxing surplus. Given -

the very low elasticities of demand for business and most

residential demand, the task should not be too difficult.

Lowering STD by raising tariffs on underpriced services reduces

deadweight losses at both ends." (p 21)

Evidently, Telecom is well aware of the importance of aligning prices

more closely with costs, as evidenced by Cutler's (1987)

acknowledgement that:

"Major realignments are also needed on the price side. Since

1981 Telecorn has actively sought to bring the balance between

local and STD charges more closely inta line with economic

rationality. Considerable progress has been achieved; but the outcome has been compromised by politically-imposed changes in

the size of local calling zones and by real or presumed

resistance to the timing of local calls.

"Looking to the future, I believe that three elements will be

vital if more rational price structures are to be put in place.

Firstly, to align charges more closely to costs, we need to

re-think the actual components and structure of charges. Second,

charges for different services (eg data and voice) should be

harmonised insofar as they involve substitutable facilities.

And, third, prices for dedicated services and interconnection

should reflect the full cost these impose on the network,

incluing in these costs the provision of redundancy and of

back-up capacity." (p 6 4 )

OTC, too, is well aware of the need for prices to reflect costs,

"OTC1s pricing policy is to alter prices to reflect cost

movements. This can result in price reductions for large scale

and automated services, such as IDD telephone, and increases for labour-intensive and smaller-volume services, such as telegram."

(1986/87 Annual Report, p 3 3 )

What performance indicators could be used in regard to monitoring

progress in relation to adjustments to the structure of prices?

Albon (1986) suggests an approach which would provide a means of

ascertaining progress and facilitating such monitoring:

"The appropriate way to.proceed would be to set a target date for

the completion of a rebalancing program that is based on the

desire to achieve allocative efficiency while retaining

justifiable and defined subsidies. All changes in tariffs would

then be steps towards this goal. Achievement of the goal would

also require some equipment changes (eg in regard to metering) so

that some co-ordination between those making pricing and

investment decisions would be necessary. Community obligations

would have to be clarified. This is a responsibility for the

Government." (p 22) , ,

If a programme of gradual rebalancing, with target dates specified,

existed, it would allow Telecom and OTC to report on, and for

external assessors to evaluate, progress made. Being required to

It is not yet possible to identify just how technically efficient

Telecom is. An approach which is commonly used is to define the

production frontier according to the practices of the most productive

firms in an industry and to measure the technical inefficiency of the

firm being studied in relation to this frontier. However the

requisite rigorous econometric and other research has just not been

done. Thus, for the present, we must base assessment of technical

efficiency on whatever available evidence can be assembled, such as

real unit cost reductions and productivity improvements.

Value-Added. This is sometimes used as an indicator of technical

efficiency. Both Telecom and OTC display their value-added estimates

proudly. As Table 2 shows, Telecom declares that its value-added was

55.2 billion, or 2.2% of GDP, and then proceeds to describe the

distribution of value-added to employees ( 5 4 . 2 % ) , to providers of

capital (22.1%), and for re-investment (23.7%).

OTC reports that its value-added increased from $213.9 million in

1985-86 to $262.7 million in 1986-7. The latter figure was divided

among employees (35.8%), payments to the Commonwealth Government

(32.2% comprising 15.2% for dividends and 17.1 for income tax), and

redeployed in the business (31.9%).

However, this presentation of value-added data provides far less

information about performance than, for example, the presentation in

Table 13 reproduced from Telecom Singapore's Annual Report for

1986/87. Trends in value-added per employee, per 5 employment costs,

and per $ of investment in fixed assets, etc., would be useful

performance indicators.

- . . - - . . -

Labour Productivity

his is another commonly used indicator of technical efficiency. In

Table 3, Telecom refers to "an improvement in labour productivity (number of access lines per employee) of about 7%, consistent with

our longer term average target of 5-7%." In addition, Telecom refers

to " . . . A reduction in direct operating expenses per access line in real terms of about 4%. This is consistent with our longer term average target of 2-4% reflecting significant improvements in

efficiency." -

report on progress in its Annual Report would ensure continuing

attention to improving the structure of prices. But there will

clearly be difficulties even in implementing the changes gradually.

For instance, as discussed more fully later, equity considerations

could be a constraint. And there is likely to be opposition from

some quarters. However, there would probably also be many

supporters, for example, metropolitan users who frequently use STD.

And with the prospect 'of increased competition, and/or as technology

makes bypass by major users more and more feasible (as it has in the

USA), the incentives for Telecom and OTC to persevere in effecting

changes are significant. This is because the changes advocated are

likely to be forced upon Telecom and OTC by competition which would,

in particular, affect the long-distance market. The changes that

Telecom and OTC make would reduce the attractiveness of presently

overpriced routes to potential competitors and, in any case, would

help render them more able to withstand competition that does emerge.

Moreover, it would reduce the incentives for bypass by major users.

(iii Quality of Service -

The quality of telecommunications services supplied by a carrier is

an important aspect of its performance. Where competition does

exist, attention to the quality of service will probably constitute a

major element of competition (as evidenced in the USA), since

consumers will make their decisions based on price-quality

characteristics. Eowever, where competition does not exist, there is

no such comparable pressure for suppliers to be as concerned over

quality. Indeed, there is concern in some quarters that quality

deterioration may even be seen to be a way of lowering costs so as to

improve "productivity* indicators or profits. (7)' Thus, in the Australian situation, quality of service indicators which facilitate

monitoring are required to simulate the pressures of competition on

quality of servlce improvements.

What are the aspects of telecommunications quality of service for

which performance indicators are required? Th.ese depend, of course,

on the service characteristics which both residential and business

customers consider important. And thus every effort should be made

to establish what these are, including questionnaire surveys and

personal interviews with large users.

While OTC does not, Telecom lists a range of quality of service

achievements and targets as shown in Table 4. However, some of these

targets could - and should - be expressed in more quantitative terms, as the examples provided by British Telecom demonstrate. Such a

quantitative expression of targets will facilitate measurement of

achievements against targets, allowing performance to be more

precisely assessed.

Repair Service

As an example, in regard to the task of fixing service faults,

Telecom expresses its measure of performance to be "customers

satisfied with fault repair response", with achievement in 1986/87

reported to be 75%, the target for 1987/88 being 75%, and the target

to be achieved by 1989/90 being 90%. By contrast, British Telecom's

repair service targets are more specific and verifiable:

"The standard we are working to in 1987/88 is that all faults

which interrupt service should be cleared within two working

days. During 1988/89 we shall be improving our performance so

that by March 1989, under the standard Repair Service covered by

our line rental charges, we shall be aiming to restore service to

business customers within half a day (5 working hours). For

residential customers, who pay a lower rental. for their lines and

are generally more dispersed, we shall aim to restore service

within one working day (9 working hours) or by later appointment

if the customer so desires.

"Minor faults which do not interrupt service, and initial

temporary repairs, should be rectified within 3 working days.

"By the end of this year we shall have in place arrangements

which will enable customers to report faults at any time - 24 hours a day, 7 days a week." (British Telecom, Quality of Service Report, October, 1987, p 1 )

Telecom's service targets for business customers are more

specifically stated. For example, Telecom offers "a premium service

based on negotiated contracts or fee for service for guaranteed

response within 2 hours or as required by the customer."

While such premium services to business customers are welcome, lt is

important to ensure that service to residential customers does not

deteriorate as a consequence. This reinforces the case for

publication of performance indicators which facilitate quality of

service monitoring for both residential and business customers.

Installation of Service

From Table 4, it may be seen that Telecom measures this aspect of

service quality in two ways:

. customers satisfied with telephone service installation commitment (with a target of 90% by 1989/90);

. new telephone services connected within 13 working days of application (with a target of 90% by 1989/90).

The first point worth making is that British Telecom's targets for

installation are to have orders completed in 6 days for business and

8 days for residential, although it notes that customers often glve

longer periods of notice so that the performance indicator based on

how quickly installation is completed could be misleading.

Recognising this, British Telecom now prefers to use an indicator

based on "appointments made, and appointments kept". It should be

noted that in the Performance Report contained in its 1985/86 Annual

Report, Telecom Australla also foreshadowed the use of such a - measure:

"Telecom is developing a new approach to customer service-based

on the concept of making commitments to customers at the time of

application for service and then measuring performance in terms

of success in meeting these commitments. The new commitment

working concept recognises the fundamental need to provide

service when the customer wants it and will lead to a substantial

improvement in the quality of service provided." (p 6)

However, this approach is not referred to again in Telecom's 1986/87

Annual Report. And it is not clear why not.

Operator Services

As Table 4 indicates, Telecom also has performance measures and

targets relating to the proportion of customers "satisfied" with

customer assistance services. This criterion seems rather vague with

performance difficult to verify. By contrast, British Telecom uses

more specific criteria upon which performance is more easily verified

and assessed:

"From April 1988, Directory Enquiry customers should increasingly

get through first time, and our aim is that operator calls for

whatever purpose should normally be answered within 15 seconds.

We shall be carrying out periodic checks, jointly with OFTEL, on

congestion in the Directory Enquiry service so that we can report

on this aspect of the service as well as on the time taken to

answer." (British Telecom, Quality of Service Report, October

1987, p 2)

Since it may assist in identifying performance targets for Telecom,

Table 12 reproduces British Telecom's recent Operator Enquiries

performance figures.

TABLE 12

BRITISH TELECOM : OPERATOR ENQUIRIES PERFORMANCE

Full Year , Month of Month of 1985186 - March '87 Sept '87

Operator calls answered in 15 seconds

Directory Enquiry calls answered in 15 seconds

[Source: British Telecom. Quality of Service Report, Oct, 1987, p 21

Public Payphones

A notable omission from the range of Telecomrs quality of service indicators is one relating to public payphone serviceability. For

those in transit or those without a telephone at home, for example,

the proportion of payphones which are not "out of order" is an

important part of quality of service. To provide an example of the use of a performance indicator in this regard, British Telecom

reached an average public payphone serviceability across the U.K. of - 85% in September 1987, and announced a target of 90% serviceability

by March 1988. It has also stated that joint monthly studies with OFTEL would be carried out to ascertain success in achieving this

target. (British Telecom. 1987. p 2). Telecom should be required to publish performance achievements and targets for this aspect of its

service as well. to ensure that the quality of this important part of

the range of services it provides is not neglected. (8)

In concluding this section on quality of service, it is reiterated

that the discussion here has focussed on just a few examples of the

use of PIS in this regard. Since demand is sensitive not just to

price but to quality, it is in the interests of telecommunications

suppliers as well as their customers to ensure that strenuous efforts

to improve the quality of service in aspects valued by customers are

sustained. And the publication of appropriate PIS will help ensure

that this occurs. On competitive routes in the USA, competition is

being waged in terms of quality of service (particularly as an

oligopolistic price leadership structure emerges with MCI and US

Sprint maintaining their prices slightly below AT & T each time the

latter varies its prices). On currently non-competitive routes, the

Bell Operating Companies (BOCs) are concentrating significant

attention on quality of service perhaps at least partly in

preparation for when they are permitted to compete in other

telecommunications routes and services. In Canada, although there is

no competition on the basic telephone network, Bell Canada has made

customer service the major thrust of its corporate strategy. That

such efforts are not misplaced was made clear recently in the'^^ when large business users were strident in their complaints about the

quality of services provided them by British Telecom.

(b) Technical (including "X") Efficiency

Technical inefficiency occurs where a firm's output is less than its

maximum achievable output (on its production frontier) because factor

inputs are idle or combined in inappropriate proportions. This

aspect of economic efficiency is concerned with whether Telecom is

using the optimal mix of input, given factor prices, and is operating

on its production frontier or, at any rate, progressing towards least

cost production (taking into account the effort of its management and

other employees).

It is not yet possible to identify just how technically efficient

Telecom is. An approach which is commonly used is to define the

production frontier according to the practices of the most productive

firms in an industry and to measure the technical inefficiency of the

firm being studied in relation to this frontier. However the

requisite rigorous econometric and other research has just not been

done. Thus, for the present, we must base assessment of technical

efficiency on whatever available evidence can be assembled, such as

real unit cost reductions and productivity Improvements.

Value-Added. This is sometimes used as an indicator of technical

efficiency. Both Telecom and OTC display their value-added estimates

proudly. As Table 2 shows, Telecom declares that its value-added was

$5.2 billion, or 2.2% of GDP, and then proceeds to describe the distribution of value-added to employees (54.2%), to providers of

capital (22.1%), and for re-investment (23.7%).

OTC reports that its value-added increased from $213.9 million in

1985-86 to $262.7 million in 1986-7. The latter figure was divided

among employees (35.8%), payments to the Commonwealth Government

(32.2% comprising 15.2% for dividends and 17.1 for income tax), and

redeployed in the business (31.9%).

However, this presentation of value-added data provides far less

information about performance than, for example, the presentation in

Table 13 reproduced from Telecom Singapore's Annual Report for

1986/87. Trends in value-added per employee, per 5 employment costs,

and per $ of investment in fixed assets, etc., would be useful

performance indicators.

Labour Productivity

This is another commonly used indicator of technical efficiency. In Table 3, Telecom refers to "an improvement in labour productivity

(number of access lines per employee) of about 7%, consistent with

our longer term average target of 5-7%." In addition, Telecom refers to " . . . A reduction in direct operating expenses per access line in real terms of about 4%. This is consistent with our longer term

average target of 2-4% reflecting significant improvements in

efficiency." -

TABLE 13

VALUE-ADDED INFORMATION PUBLISHED BY TELECOM SINGAPORE

PRODUCTIVITY DATA

alue added per % employment cost

110 3.0

70 Value added per employee

50 0.9

38.1 Value added per S

investrnentinf~xedassets - - - I. - -, , , , - - - - I, I., , -, , , -- 30 1 I , 0.2

I I 82/83 83/84 84/85 85186 86/87

Year I Value added per employee

65.030 60.130 68.600 67.740 72.680

[Source: Tetecom Singapore. Annual Report, 1986-871

Value added per S employment costs

Value added per S Investment In flxed assets

(beforedep~clatlon)

3.48 0.39 2.94 0.34 2.95 0.34 3.03 0.28 3.48 0.28

I

The sixth column of Table 14 allows the labour productivity statement

to be put into perspective. As the table shows, Telecom ranks the

lowest of all the countries shown in terms of lines per employee, both in 1974 and in 1985. Again, a noteworthy comparison.with

Australia's 69 lines per employee is Canada's 125. From Australia's

low level, appreciable improvements on this measure may not be

surprising. As Tomlinson (1986) points out, there is a well known

correlation between lines per employee and connections per 100 dwellings, with countries tending to move up a common track. Whilst

the improving trend in lines per employee is welcome, it will not

reveal much about whether or not Telecom's relative productivity performance has changed.

- 40 - TABLE 14

COMPARATIVE DATA ON COMMON CARRIERS in constant U . S . $ at 1980 prices and exchange rates

Revenue per Main Line

Operational Expenditure per Main Line

Main Lines per employee

Australia

Belgium

Canada

France

Germany

Italy

Japan

Netherlands

Spain

Sweden

Switzerland

United Kingdom

United States

* 1975 data used for 1974

[Source: ITU/OECD]

One can of course provide several reasons for Australia's low ranking

in terms of lines per employee, including geography and density.

Moreover, it is true that in any event, the figures are not strictly

comparable because of different sub-contracting practices (with some

countries subcontracting a greater number of workers, thus showing a

higher lines per (permanent) employee figure, different hours worked

per employee, different range of services provided, varying degree of

plant modernisation etc. Nevertheless, international comparisons

might be useful in indicating broad differences in performance and

relative shifts in such performance over time. Another reason for drawing attention to these figures is to indicate how figures can be used selectively and in best light as a performance indicator. Despite Telecomls low ranking here, it has, in fact, managed to use

the lines per employee situation to suggest strong productivity

performance. Of course, because of the considerable potential for

improvement, Telecom can confidently expect aspreciable improvements,

and has chosen to focus on the increase in lines per employee as a

performance indicator of productivity improvement.

Table 14 also indicates that despite a sharply growing number of main lines, Telecom was able to increase slightly--its-average revenue per main line. However, whilst for many countries operational

expenditure per main line fell, for Australia this increased from U.S.$ 236 to U.S.$ 264.

Another indication of operational perfmance is provided by Table 15

which indicates that operational expenditure per unit of traffic rose

in Australia, from U.S.$0.22 in 1974 to U.S.$0.28 in 1985, by contrast with falls for all other countries in the table (for which

the comparable data is available).

In concluding this section it is worth repeating that although broad relationships and trends in the figures can be revealing and useful if they trigger investigations by 'poor performers1, too much should not be made of the comparisons in themselves. As the OECD (1988) emphasises:

I1International comparisons need to be undertaken with caution in that differences in market structures, pricing and accounting procedures, employment policies, as well as relative degrees of

use of new switching and transmission technologies, can bias corn par is on^.^^ ( p 22)

TABLE 15

OPERATIONAL EXPENDITURE PER UNIT OF TRAFFIC* (Expressed in Constant U.S.$ at 1980 prices and exchange rates)

Australia

Belgium

Canada

France

Germany

Italy

Japan

Netherlands

Spain

Sweden

Switzerland

United Kingdon

United States 0.10 - * Traffic measured in charged calls except France and Sweden, measured in pulses and United Kingdom, measured in number of calls.

[Source: ITU/OECD]

Total Factor Productivity

Even an accurate labour productivity measure would, however, be only

a partial measure of productivity. Such a measure which focuses on a

single factor, labour, takes no account of factors such as:

. increased capital intensity;

. investment in Research and Development, which yields better technical processes

or better products;

. greater capacity utilisation; . -

. improvements in organisation; and - . use of a more skilled workforce;

all of which contribute to productivity growth.

Total factor productivity (TFP) measures which recognise the

contribution of these factors are no doubt preferable, but their

calculation is fraught with difficulties, eg. the presence.of scale

effects, the difficulties of measuring capital, the problems of

defining the (changing) product set, the problems of properly

segregating and measuring inputs, etc.

There have, nevertheless, been considerable overseas efforts to

estimate TFP for telecommunications. OFTEL (1988 refers to one estimate, by Foreman-Peck (19881, which suggests that Brltish

Telecom's trend rate of increase in total factor productivity lay between 1.6% and 2% during the period 1964/65 to 1980/81. But an

alternative set of figures, using different data derived by Pryke for

the period 1968-1978, and by Molyneux and Thompson (1987) for the

perlod -1-478-1985; gtves---a hrgheravq-e'Tigurebf 3% over the period

1968-1985 - though over the period 1978-1985, an increase of only one half per cent a year was found. Studies for both the U.S.A. and

~anada" ) suggest a rate of increase in productivity of over 3% a

year. Bell Canada claims to have achieved a TFP increase of over 6%

in 19886/87 (Annual Report, 1987). An estimate for West Germany

produced a figure of about 2 1/2 (two and one half) % . OFTEL

estimates that " . . . if past U.K. experience is the basis, the likely level of productivity increase seems to lie within the range of 2-3%

a year." (OFTEL, 1988, p 9) *

In the light of such estimates, de Ridder's (1986) disclosure that

" . . . preliminary estimates find Telecom's TFP growth in the nine

years to 1984/85 was nearly 7%'' (p8) is striking, particularly when

compared with the trend TFP growth for the Australian economy, of

1.4%. However, almost two years after this disclosure, Telecom could

not advise whether further work confirmed its 7% preliminary

estimate. As stated earlier, estimating Telecom's TFP is difficult

but important. Perhaps Telecom could follow the lead of its overseas

counterparts and enlist (more) outside help for its TFP estimates.

Alternatively, if it is confident of its own resources, it should

publish its methodology and data to allow outside commentators to

evaluate and contribute to an important task.

Reducing Real Unit Costs Due to Increasing Sales

In a network-based industry with substantial fixed costs, a major

determinant of reducing unit cost is an increasing level of output.

One estimate for telecommunications in the U.K. suggests that each 1

per cent increase in demand for calls reduces unit costs by 0.3 - 0.5 per cent (OFTEL, 1988, p 9). Hence, apart from the commonly

published growth of sales figures demonstrating business strength,

they also suggest prospects for real unit cost decreases. No doubt

the strong rate of growth in demand for domestic (4% for telephone

and 13% for data services in 1986-87) and international (20% in

1986-87) telecommunications means that this factor has been an

important reason for Telecom's and OTC's declining real unit costs.

But no estimates of its significance is available. Telecom and OTC

should be required to publish estimates of decreasing unit costs due

to this factor (e.g. so that its contribution to the "Xu factor in

the price-cap formula can be monitored).

(c) Dynamic efficiency

For the technologically dynamic telecommunications industry, probably

of greater importance than allocative and technical efficiency, is

"dynamic1' efficiency.

Dynamic efficiency refers to the nature and level of innovation and

entrepreneurship including a company's responsiveness-and adaptation

to changes in technology and consumer tastes and preferences.

The concern here is whether Telecom and OTC are at least keeping

abreast with worldwide innovation in the range and quality of

telecornmunications services offered. As communications becomes

increasingly perceived to be a competitive edge in business, this has

become an increasingly important issue for Australia. Telecom and

OTC list a range of new service improvements and products which they

now offer or which are in the pipeline, but it is difficult to gauge

Telecom's and OTC's dynamic efficiency in this regard without

comparison with the service offerings available in other comparable

countries. Thus, to facilitate such assessment, Telecom and OTC

should be required to compare progress in their service offerings

(including their quality, geographical coverage and ability to meet

demands) against those available in other countries in comparable

periods. One must guard against the possibility though of technology

rather than market-driven service developments.

For instance, in the USA, and probably other parts of the world,

there is a growing suspicion that technology developments, e.g. ISDN,

may be running well ahead of cost-effective industry needs. Moreover

there is concern that if demand falls.short of expectations, the

burden of recovering the high costs of such developments may be

spread over users of basic telephone services - especially those with inelastic demand schedules - as well. Notwithstanding such sensible

concerns about the need to ensure that technology developments are

market oriented and serve'useful business or domestic purposes, the

benefits derivable from new technology are broadly recognised.

OTC stresses repeatedly in its 1986/87 Annual Report that keeping up

with innovations in service offerings is crucial for Australia. And

as Cutler (1987) emph.asises, Telecom is well aware of the importance

of dynamic efficiency but - as with OTC - is hampered by financial constraints:

"Better management of costs and prices will serve little purpose

if Telecom is not offering the range of technologies and services

its users require. This is partly a question of managing

technological change - and notably, in the area of network capabilities, Telecom has generally been more innovative than its

relatively small size in world terms might lead one to expect.

But maintaining an adequate rate of technological advance also

critically depends on investment levels - and it is here the sensitive questions need to be faced. Is it rational to

persistently maintain Telecom's investment levels well below

those warranted by its capital costs and prospective rate of

return - as successive governments, acting in the name of budgetary austerity, have done? Is it truly impossible to place

the relations between Telecom and its owner on a sounder basis,

closer to that found in the private sector, rather than retaining

Telecom's vulnerability to the government's short-term financial

needs?

"These issues are not new - they were raised by the McKinsey

report on Telecom commissioned by the Coalition Government in

1980 and by the Ergas Report in 1986. Yet appropriate action has

not been forthcoming; and without progress in this respect it is

difficult to see how Telecom's long-term efficiency can be

assured." (p 64)

How valid is Telecom's complaint about investment constraints?

According to the figures in Table 16, on the basis of per capita

investment (on a three-year average) during 1979-1983, Telecom's

investment levels compared favourably with most other countries.

Indeed, during the 1981-83 period, Telecom's per capita investment of

U.S.S 311 was almost four times that of Canada's. However, during

1983-85 there was apparently a dramatic decline to U.S.S 75 per

capita, still slightly higher than Canada's rate of U.S.S 73. But as

Table 17 shows, in aggregate terms Australia's investment of

S 1169 million during 1983-85 was considerably less than Canada's

level of S 1839 million.

Table 18 provides figures which indicate the share of investment in

tele.c~mmunication~ as a percentage of Gross Fixed Capital Formation.

Australian investment in telecommunications has evidently declined

since the 3.4% achieved in 1974. In 1985, investment in

telecommunications comprised 2.7% of Gross Fixed Capital Formation

which was slightly less than most other countries in the table,

including Canada (2.8%). Of course, these figures do not take into

account differences in the countries' investment requirements due to

cllmate, topography, demography and economy. And in any case, they

relate to the past. The current and future investment requirements

to enable this country to keep abreast with accelerated developments

in telecommunications equipment and services, raises the issue of

constraints on Telecom's and OTC's freedom to borrow to a new level

of importancelo. This is especially true in the new system of

monitoring and accountability which emphasizes post-decision

monitoring through performance indicators. If a Government Business

Enterprise is to be held responsible for its performance, it seems

only reasonable that as far as practicable, it should not 'be unduly

frustrated in its investment decisions, including their financing.

Amongst the various alternative ways of providing Telecom and OTC

with more investment funds is for the Government to reduce or forego

its dividend requirements from them, thereby serving to build up its equity holding in these vital high-growth, capital-intensive

businesses. Another alternative - if the view persists that borrowings by Telecom and OTC should be tightly restricted - is to allow a portion of Telecom and OTC to be privatised and receipts returned for investment purposes. An added advantage of this measure

would occur if the new part-owners could inject new (complementary)

skills into the telco s'operations. At any rate, the measure will

have the advantage of generating from amongst the new owners,

including the professional analysts who advise them, a new set of

self-interested, motivated, monitors. This advantage was evidently a major consideration in the New Zealand decision to sell a portion of

its telecommunications corporation and several Government-owned

enterprises to private interests

TABLE 16

INVESTMENT : COMPARATIVE DATA ON COMMON CARRIERS (In constant U.S.S at 1980 prices and exchange rates)

Per Capita Investment Index*of Network 3-Year Average Sizes for 1985

(U.S. = 100)

Australia

Belgium

Canada

France

Germany

Italy

Japan.

Netherlands

Spain

Sweden

Switzerland

United Kingdom

United States

OECD

* Based on Main Lines

[Source: ITU/OECDI

TABLE 17

Australia ~ustrfa 8elgi um Canada oenmark finland France Ge many Greece Ice1 and Ire1 and Italy Japan Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden S w i tzerl and Turkey United Ki n g d ~ m United States

INVESTMENT BY COMMON CARRIERS: 3-YEAR MOVING AVERAGE (Millions of US$ in 1980 prices and exchange rates)

OECD : 45592.66 50120.91 52824.24 52544.34 43866.16

EEC (10) 16218.77 17155.32 17778.17 18093.50 18948.15 EEC (12) 18324.38 1 9093.74 19534.17 19800.97 20630.14

[Source: OECD (1988) p 1151

TABLE 18

Austral la Austria Be1 gi urn Canada Denmark Finland France .Germany Greece Iceland Ireland Italy Japan Luxembourg Nethcrl ands New Zealand Norway Portugal Spain Sweden S w i tzerl and Turkey Uni ted Ki ngdom United States

TELECOMMUNICATIONS INVESTMENT AS SHARE OF GROSS FIXED CAPITAL FORMATION

(Based on national currency and current prices)

GROHTH IN RATIO

Source: ITU -- telecommunications investment OECD -- Gross Fixed Capital Formation

( 1 ) Excludes investment in land and buildings 1980/83

+ 1975 ( 2 ) 1983/84

3. Equity Considerations

No doubt, equity (or "fairnessw) considerations are as, if not more,

important to policy makers (and the electorate) than seemingly

esoteric efficiency concerns, (see eg. Williamson, 1984). The

primary issue concerning equity in regard to telecommunications is

probably contained in the question: what social objectives should be

sought from the telecommunications network and how can they best be

attained? But equity considerations can complicate

telecommunications policy reforms guided by economic rationality.

Indeed, at times, perceptions of equity may conflict with efficiency

considerations,

Universal Service

In common with many overseas telecommunications suppliers, Telecom is

charged with providing universal service, ie "... to provide every household with the opportunity to obtain a telephone at an affordable price ,." (Telecom, Annual Report, 1986/87, p 5). In this task,

Telecom has been demonstrably successful, with a telephone in over

nine out of ten homes and telephone penetration expected to reach 96%

by 1990. As telephone saturation sets in, the focus will be on how to facilitate access to the network for those Australians who would

otherwise be unable to afford one.

These issues of universal service are the subject of concern in many

countries. Writing with a focus on the Canadian situation, Waverman (1988) concludes:

I t . . . the distribution of income can not be altered much by subsidising access .to telephone services. Stated differently, the poor are not poor because of the price of access nor will the aggregate level of access demanded increase much becacse of a general subsidy to access - people at the threshold will take service but the demand of all other residential consumers will be unchanged. If one wanted to subsidise access or price below the - - Ramsey price level in order to produce universal service, it is

more efficient and equitable to subsidise those households at and

below the threshold level than to subsidise all access." (p 14)

(emphasis in original)

I agree with Waverman's conclusion that rather than blanket subsidies

through, for example, holding down telephone fixed charges, subsidies

could and should be more directly targeted to those who need it (in terms of criteria specified by the government). Indeed many

economists have long argued that equity concerns are more

cost-effectively addressed through direct subsidies rather than by

interfering with efficiency-based pricing. Emerging policy decisions

overseas seem consistent with this advocacy. Thus, in the U.S.A.,

there is now an increasingly widespread use of "lifelinev* services,

and direct subsidies paid to those who qualify for assistance on the

basis of federal or state government criteria. In Australia,

however, the Government has decided to continue with the blunt

targetting of cross-subsidy practices, (Minister for Transport and

Communications, 1988).

And as the new telecommunications services become commonplace,

attention will shift onto the meaning and coverage of the aim of

universal service. Should government be concerned to monitor

penetration of new services? Are there implications for public

policy if only business users or the rich are benefitting? Should

the prospect of a society of information "haves*' and vvhave-notsv*

concern policy makers? If so, performance indicators will be

required to facilitate monitoring and policy deliberations.

Cross-subsidies

An issue related to universal service is that of cross-subsidies.

Indeed, in Australia the discussion of universal service has often centred on the provision of telephone facilities to people in rural and remote areas at prices which do not fully cover costs. Attempts to reduce cross-subsidies between metro and non-metro customers

(which according to the Minister of Communications is now worth over $450 mi1lion.a year) and between long distance and local calls, by

rebalancing telecommunications prices to more closely reflect costs *

may well result in currently subsidised customers incurring

significantly higher telecommunications bills.

Moreover, rebalancing based on the principle of Ramsey pricing could

dramatically alter prices. As an example, Bell Canada estimates the

own price elasticity of demand for local service to be -0.04 and the

toll own price elasticity of demand to be -0.8. Therefore, Ramsey or

efficiency criteria would suggest that the percentage mark-ups over

marginal cost on local versus toll, be in the order of 20 to 1, with

local service being taxed much more heavily than toll. (Waverman,

1988). In such circumstances, can it be stated unambiguously that

such moves will lead to welfare improvement?

Unfortunately, economic theory does not provide unambiguous guidance

about whether rebalancing telecommunications prices to more closely

reflect costs (and demand) would necessarily result in welfare

improvement. Since there is likely to be increasing debate over

price rebalancing, this point warrants further discussion and this

occurs in Appendix 1.

The point being made here is that because of the potentially

significant redistributive effects of price rebalancing, equity

impacts should be monitored and considered alongside efficiency

considerations. Thus, Telecom should be required to monitor, and

publish indicators of, the impact of price rebalanclng on various

groups of customers, particularly the poor. This will help ensure

that those considered to be deserving by government will be

assisted. If Telecom is to be the vehicle of such assistance, it

should publish indicators through which its performance in this

regard, too, may be monitored.

Effectiveness

For an increasing number of companies, telecommunications is now

regarded as a strategic resource rather than a business overhead.

The increasingly important role that telecommunications plays in

modern business is the result of technological advances and

socio-economic trends. The convergence of computing and

communications technologies has dramatically increased the potential

of information transmission and processing services available to

business. At the same time, the long-term structural shift into the

service economy is increasingly dominated by the information sector.

These major trends put Telecom and OTC at the leading edge of

Australia's competitiveness and economic development.

Such developments also make it very important that Australia's

telecommunications operations are not only efficient but effective in

the sense of achieving telecommunications policy objectives. And

evidence of this effectiveness should be open to review by outside

assessors. Thus, Telecom and OTC should be required to publish

indicators of how effective their operations have been in terms of

achieving objectives (set in consultation with the Government) .

Certainly, in broad descriptive terms this would not be difficult, as

much of OTC's and Telecom's Annual Reports and the latter's "Service

and Business Outlook" document are already dominated by the aim of

demonstrating their effectiveness. But there is a need to do so in a

way which facilitates assessment. Better, not necessarily more,

information is needed.

One way of providing better information is by publishing, where

possible, quantitative targets and achievements. But quantifying

effectiveness to the required extent will not be easy. Indeed there

are at least five major difficulties with assessing effectiveness

which would be only partially overcome by further continued effort.

These are:

(i) the problem of reducing a dimension of achievement to a quantitative scale;

(ii) the fact that the benefits and costs of many policies accrue over a significant period of time;

(iii 1 the problem of separating out the impact of environmental

factors (as opposed to that of programme inputs and outputs), on the

final outcomes and the cost of their attainment;

(iv) the difficulty of capturing all of the quality information

relevant to assessing outcomes; and

(v) the problem of selecting a small number of summary

statistics to characterise a whole distribution of performance variables, particularly in the absence of an explicit evaluation

function for outcomes.

But some increase in quantitative information will be possible.

For instance, if a reducing international trade deficit (let alone

surplus) in telecommunications equipment is a policy objective,

quantitative information would establish that Australia has certainly

not been very effective. As Table 19 shows, Australia's exports of

telecommunications equipment in 1984 was about $9 million, about the

lowest of comparable countries. By contrast, in 1984 Canada exported telecommunications equipment worth $651 million. As Table 20

indicates, Australia's imports of telecommunications equipment have

been growing strongly, so that in 1984 the trade deficit on this item

stood at $249 million. And expected further developments in

telecommunications are likely to increase this deficit further cnless

measures are put in place to reverse or at least slow down the trend

of increasingly larger deficits.

By contrast, Canada, which had a trade deficit on this item of

$16 million in 1979, five years later, in 1984, had managed to

convert this to a trade surplus of $206 million. So network size is

not necessarily an obstruction. And it is increasingly becoming

imperative that we address those factors that are.

What is required to begin with is for Telecom and OTC and the

Government to agree on a strategy for the development of Australian telecommunications. In doing so care should be taken to avold an

unnecessary imposition of constraints. For instance, a government

-owned telecommunications corporation is not necessarily less

innovative than a privately-owned one as Telecom France has been

demonstrating with its Minitel programme which has involved giving

away terminals to all telephone subscribers (with fees charged for

access to the various services). Nor is a monopoly supplier

necessarily less successful in developing and marketing new products

and services as Bell Canada has demonstrated. Much of the turnaround

in Canada's trade balance in telecommunications equipment, discussed

earlier, has been due to the activities of Bell Canada (and its more

than 80 subsidiaries).

It is true that Bell Canada has a successful manufacturing arm in

Northern Telecom. But if this is what is required, why shouldn't

Telecom develop a similar relationship? One view worth considering

is that part of Telecom be sold to a telecommunications equipment

manufacturing company. Not only would such a sale inlect welcome

capital for Telecom's investment programme, the liaison could have

other mutual benefits as Northern Telecom and Bell Canada have

demonstrated (see Telephony, 1987).

Whilst in the longer term effective competition will be required to

provide substained incentives and/or penalties in favour of market

oriented enterprise, there is much which can be done which need not

await the development of such competitive forces. Moreover as

experience in the USA and UK are indicating, even where permitted,

effective competition could be slow in developing. As the European

Economic Community Green Paper (1987) and various OECD reports (e.g.

OECD, 1988) have shown, many developed countries are recognising the

urgency of reconsidering telecommunications policy. It is

increasingly imperative that Australia adopts the same sense of

urgency in deciding its telecommunications strategy and the roles

that Telecom and OTC should play. And once decided they should be

supported in the pursuits of their tasks and judged by their

performance. As effective competition develops, the market will

provide its acid test of this performance. Until then there must be

more dependence on the sort of PIS which have been the subject of this paper.

- 57 - TABLE 19

TELECOMMUNICATIONS EQUIPMENT EXPORTS BY COUNTRY

$ THOUSAND

________---------------------------------------------------------------------------------------------- ! ! ! ! ! ! !

1 ! t

I ! 1 9 7 8 ! 1 9 7 9 ! l 9 d C ! 1 9 8 1 ! l o 8 2 ! 1 ! 1 9 8 4 ! CACR !

! ! ! ! ! ! ! ! . t ! ._________-------------------------------------------------------------------------------------------- ! A U S T l A L I A ! 2 0 6 5 83PZ ! 2 ! 1 1 5 8 s ! 1 0 2 5 2 ! 2 I 4 b 4 ! 8 9 7 q ! 2 0 . 1 ! !AUSTWI A ! 1 4 5 0 2 ! 1 7 9 6 4 ! Z l b l ] ! 1 9 0 0 6 ! 2 1 1 0 3 ! Z L f S f ! Z b q 4 4 ! 9 .5 ! ! ~ E L C I U * I L U X ! 2 7 4 4 5 0 ! 2 6 6 8 7 b ! k l b f A L ! 2 9 6 1 7 7 ! 2 3 1 6 1 5 ! 2 4 1 1 R S ! 1 9 6 5 3 1 ! - 5 . 6 ! ! C A N A D A ! l r c 3 7 0 ! l v o 4 c a ! 2 ~ 7 2 9 ~ ! s o 0 8 8 7 ! 1 a q s 8 6 t i t l o s ~ ! 6 5 0 5 9 2 ! 3 4 . 2 r !DEMWA.C ! 7 3 4 1 0 ! 4 6 4 0 1 ! V q Q 7 7 ! 9 b 3 1 2 I 9 3 0 1 1 ! 9 ? 2 5 2 ! V Z 5 0 2 ! 3.9 ! ! ~ I U L A ~ D ! 1 6 1 2 7 ! 2 8 2 2 9 ! 6 2 1 1 9 ! 8 C 2 2 6 ! 87QQ7 t tO4OQQ ! 9 7 0 3 1 t 1 4 . 9 I ! i r r m c c ! c i v v 6 a ! ~ 7 1 8 5 ~ ! 35432: ! 4 7 7 2 0 6 ! s v ~ s . 7 ! 7 0 3 8 ~ 1 ! 5 7 9 8 8 7 ! 5.5 I

!GE*nAMT ! 8 7 L 1 5 0 ! 9 6 1 9 2 9 ! 1 1 0 4 C 1 6 ! 1 0 1 0 6 5 5 ? 1 3 0 5 6 k 8 ! VO5L25 ! 6 9 5 6 5 2 ! 0.b ! !GREECE ! 8 9 5 2 ! 1 9 0 7 5 ! 1 7 1 l S ! 1 1 6 8 5 ! 1 2 6 2 0 ! 1 0 7 4 7 ! 9 9 2 2 1 1 .8 ! ! ICE LA NO^ ! o 1 o ! o ! o ! O ! o ! o ! o e I . ! IRELAUD ! 2 0 4 Q 2 ! 2 9 3 0 8 ! 6 ! 7 3 0 3 s ! 9 5 4 5 6 ! 8 0 1 2 5 ! l O O 9 l L ! 3 0 . 6 1 !:TALT ! 1?12SS ! 16Qv:R ! 1 9 0 6 1 8 ! 1 4 7 1 5 8 ! 2 1 7 1 6 7 ! 2 2 3 6 4 8 ! 2 3 2 0 8 6 1 5 .2 ! !JAPAN ! QOZ755 ! R I q 1 7 7 ! - 9 7 6 0 1 6 ! 1 3 3 2 L f l ! 1 5 0 Z Q 6 0 ! I 8 8 7 ? 5 2 ! 24450SO ! 1 8 . 1 ! ! IETMtPLAMDS ! 3 5 0 2 7 3 ! 4 6 9 6 2 1 ! S b 3 9 Q 9 ! 4 4 0 1 1 7 ! 2 6 6 2 4 7 ! 2 2 5 5 2 0 ! 2 6 7 7 1 8 ! -4 .3 ! INCV Z E A L A W Q ! 2 6 1 ! 2 5 9 3 ! S 8 & 3 I 5bSL ! 6 5 5 9 ! 6 0 6 8 ! 7 5 2 5 1 75.1 ! ! BOmUAT ! 4 2 7 2 7 ! 5 2 7 1 6 ! 7 2 8 2 0 ! 7 1 6 0 6 ! 6 5 7 9 7 ! 6 4 6 3 7 ! 6 4 1 1 3 . 1 7 . 1 1 ! r o w t u t r ~ ! 8 1 1 0 3 - b ! 1015s ! 1 3 2 7 8 ! 1 1 3 1 6 ! 6 3 4 6 ! 5 2 1 9 I - 4 . 3 I l s r ~ 1 h ! . ~ 0 9 7 1 ! 6 4 9 0 9 ! 90199 ! 6 7 9 2 9 ! 5 7 6 2 7 ! 5 9 8 4 1 ! 3 ~ 0 8 9 ! - 3 . 5 ' !SUZD€M ! 6 7 3 0 1 1 ! OOOQZI ! 8 b b 2 0 1 ! 8 0 1 6 7 0 ! 8 2 6 7 6 5 ! 8 0 6 1 5 8 1 8 8 2 1 5 1 ! 4.6 ' ! S Y X T Z E R L A * O ! 5 4 0 1 3 ! 8 9 9 7 6 ! 7 s l 4 8 ! 8 3 4 7 5 ! 7QO4O ! 1 0 0 6 2 2 ! 7 6 1 6 0 t 5.9 ! ! T u P t t Y ! 9 7 ! V ! l ! 1 5 3 ! f ! 1 2 4 I 1 3 2 5 ! 5 6 . 6 ' !UNITED KIWGDOn ! 4 0 4 0 9 2 ! L a 5 2 2 6 I 5 1 8 4 7 5 ! 6 0 5 3 0 5 ! 5 5 4 3 0 3 ! 5 7 4 7 2 2 1 5 8 3 6 5 L ! 6.9 ! !UWITCD STATES ! 6 7 4 3 5 4 ! f q S 1 2 6 ! 8 8 8 4 7 6 ! 10Se4.25 ! 1 2 3 5 5 5 8 ! 1 1 5 4 1 1 4 ! 1 1 0 9 7 6 0 i 8.6 ! ! € E L- 1 0 ! 2 S Q 7 4 1 1 ! 2 Q 8 S 2 f 0 ! 3 5 0 7 1 7 2 ! 3 2 0 7 7 1 6 ! 3 0 6 2 L 8 4 ! 5 0 S 7 6 7 5 ! 2 9 5 8 8 6 8 I 2.2 I

IOCCD TOTAL ! 5 1 3 7 3 9 1 ! 5 8 9 4 q 6 0 ! 6 8 2 5 1 2 2 ! 7 0 3 1 6 6 6 ! 7 3 8 5 5 4 9 ! 7 7 6 7 7 5 4 ! 1 5 6 6 7 7 0 ! t ----------------------------------------------------------------------------------------------------- SOURCC: OtCb

COR*OU*O AV€R&Ci! CROVTM #ATE

TABLE 20

TRADE BALANCE : TOTAL TELECOMMUNICATIONS EQUIPMENT

$ Thousands IA 1 -- .- .- .- .- ., .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- .- I .- .- .- I

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I11 PRICE-CAP REGULATION AND PERFORMANCE INDICATORS

The price-cap formula has been used for several years in the U.K. to

regulate British Telecom. And in May 1988, the U.S. Federal

Communications Commission decided to advocate its use, beginning with

AT & T. However, while the price-cap system of regulation does have

merit in the sense that its underlying rationale seems to be to

provide more incentives for economic efficiency, it has its . .

limitations and problems, and these should be recognised if we are to

design an effective monitoring and regulatory system for Australia's

telecommunications industry. The second primary task of this section

is to demonstrate that the sort of PIS suggested in Section I1 will

continue to be required under price-cap regulation.

To begin with, price-cap regulation is hardly new or revolutionary.

There has for long been in practice in Australia a sort of informal

price-cap monitoring for telecommunications and other public

enterprises. As discussed earlier in Section 11, Telecom and OTC

have regularly shown in their Annual Reports how their price

increases have been lower than CPI increases. And other public

enterprises have usually provided similar information in their Annual

Reports. Indeed, in the State of Victoria, this price-cap monitoring

was formalised in 1983 by the Labor State Government through an

explicit requirement that the state's public enterprises (which

include electricity, gas, water supply etc.) do not increase their

prices on average by more than the CPI increase.

What is somewhat new in the telecommunications price-cap system is

the explicit and formal incorporation of a specified 'X' or unit cost reduction factor. This feature has merit and will ensure that

consumers receive some of the benefit of productivity and cost improvements. However, in spotlighting attention on

telecommunications average price changes and on expected productivity

requirements, price-cap regulation does not - indeed, nay reduce - focus on the dynamic efficiency and effectiveness aspects of

telecommunications performance which are at least as important.

This is a potential imbalance in regulatory attention which this

paper warns of and tries to redress. Regulation should be concerned

with improving performance and, as this paper emphasizes, the

indicators of perfomance go well beyond price level and productivity

changes - particularly for telecommunications.

As foreshadowed earlier, we turn now to examine why the PIS discussed

earlier in Section I1 will continue to be required under price-cap

regulation.

1. FinancialIRate-of-Return Indicators Will Still Be Required - -

When a "price cap" is set, regulators must inevitably have to

consider an intended or appropriate rate-of-return, since "too high"

a rate would not be politically acceptable and "too low" a rate would

not be "fair" to the telecommunications operator. And once a

price-cap has been set, regulators will want to continue monitoring

the rate-of-return, since this would be pertinent to revisions in the

formula. As Helm (19871, observing the UK situation, points out:

"X can in fact be chosen on the basis of a whole range of

criteria. Though nominally a price rule, it is these criteria

which determine the sort of animal RPI-X actually is. If rate of

return is the residual criterion (to maximise share proceeds for

example), then RPI-X is not a price formula at all, but rather a

rate of return. It will then suffer from the objections of

cost-inflation incentives outlined above. Though it is difficult

to ascertain precisely what considerations were taken into

account, there can be little doubt that rate of return

considerations have been- used in both gas and telecoms, and it is

therefore not surprising that OFTEL has subsequently investigated

BT's relatively high rate of return (OFTEL, 1986). On a purely

price-based rule, such a study would be irrelevant." ( p 16)

It is important to recognise that since the level of profits attained

is likely to be restricted, incentives to efficiency are also likely

to be restricted. It is true that before the firm has begun to earn

its'acceptable level of profits, there will be incentives for

increased efficiency provided by the prospect of earning increased

profits. However, once, the firm achieves this acceptable level, the

incentives dissipate and the familiar disincentives to efficiency and

cost-padding problems of rate-of-return regulation might be expected

to recur.

Thus, the problems of how the rate-of-return level is to be measured

and how the appropriate target level is to be determined, remain.

Accordingly., asset revaluation, depreciation practices and other

current cost accounting issues will still have to be resolved and

many of the problems which have been discussed in relation to

rate-of-return regulation could remain with a "price capw.

It should be noted, too, that the shorter the period for which a

"price capw is set, the more it resembles rate-of-return regulation

and the less are the incentives to improved efficiency. If the firm

fears that when its "price cap" is reviewed, profits will be driven

down to a minimum acceptable level, it may have a reduced incentive

to seek maximum efficiency in the period immediately before the

review. To sustain incentives for efficiency, it may be preferable

to use a formula whereby exceptionally high profits are shared --.. --between the company and consumers, and where the formula is rolled

forward from one year to the next, so that "clawback" is partial and

operates over an extended period. OFTEL (1988, p 8) considered that

for British Telecom, a "price cap" formula fixed for a time period of

between three and five years is appropriate. The FCC and the

Australian Government have nominated a period of three years.

2. An Input Price Index for the Regulated Firm - ---- - OFTEL has been using, and the FCC and Australian Government are

proposing to use, a Retail Price Index in the "price cap" formula.

However, there may be objections to the use of a CPI since it

represents a basket of retail prices to the consumer, that includes

items which are not part of the input costs of the regulated firm.

Therefore,. it does not reflect the changes in the firm's costs which

would justify increases in the prices of its products. Indeed it is

possible that for telecommunications, the firm's input prices in fact

fall.

The alternatives to the CPI are an industry-based index (if it is to

capture relevant costs) or a cost-of-inputs index.

OFTEL (1988) acknowledged this problem:

"However, there is no readily available index of BT's input

prices (though OFTEL has been examining ways in which an

aggregate index could be put together based upon components

derived from a number of existing sources). Furthermore, the

index should not reflect all BT's actual costs because BT can

influence prices for some of its inputs, and care must be taken

not to remove the incentive to exert downward pressure on these

prices as would happen if they could be passed on to BT's

customers. It may, therefore, be preferable to obtain an

understanding of the general relationship between changes in BT's

(acceptable) input costs and the RPI, and to use this as a basis

for a broad adjustment to the X factor. In the case of the price

control formula applied to British Gas, a particular element in

the formula is the price of gas itself. There does not appear to

be any one input to BT's production process whose price is

outside BT's control and which is so dominant as to require

special treatment. Nevertheless, if it could be demonstrated

that in future years the aggregate index of BT's input prices

would show a movement which was sharply at variance from the expectation for prices as a whole, then this should probably be

taken into account in setting the formula." (p 10)

But the complexity of the problem is illustrated by the FCC's (1988)

conclusion after considering discordant submissions on the issue:

"The CPI, PPI, some subset of either the CPI or PPI, or the

'implicit' GNP deflator, each fails in some way to capture the

costs faced by carriers in the provision of service. We are

therefore proposing the use of an index not named by the

commenters, but which we believe will provide the best available

measure of inflationary changes faced by dominant carriers - the GNP price index (GNP-PI), also known as the 'fixed-weight GNP deflator'. *' (p 196)

An input price index will continue to be of interest. However, as

discussed earlier in Section 11, input prices for telecommunications

could well decrease sharply, eg because of technological change and

economies of scale in the computer industry. Thus, attention to

developing and publishing an input price index continues to be

warranted under price-cap regulation.

Economic Efficiency Performance Indicators

(a) Performance Indicators of Allocative Efficiency

(i 1 The Level of Telecommunications Price Increases

Before setting the price-cap, and before each modification to it, there will be interest in whether the level of prlces at the

commencement of the price-cap period is appropriate. Thus indicators of performance in regard to the level of prices, including

international comparisons, will still be of interest. In addition,

during the period of the formula there wlll be interest in just how

much of the permitted prlce increase is actually used. Moreover, -- tliere ~ I l l also be interest in whether telecommunications prices rlse

faster than in periods before the price-cap system was implemented. (As mentioned in Section 11, Telecom's price increases over the last nine years rose, on average, 5 % per annum less than the CPI.)

(ii) The Structure of Prices

The price-cap formula is concerned with the average level of prices

(of a basket of telecommunications services) and therefore permits

price rebalancing within this average. While this allows more price

flexibility that prices may be adjusted to more closely reflect

costs, there may be concerns that this cost-alignment would not

occur, particularly where competitive pressures are inadequate (see

e.g. Trebing, 1988). Thus there will still be a concern to monitor

whether individual price movements are in line with cost structures.

Moreover, if Ramsey pricing is used to recover the substantial joint

costs of telecommunications supply, this could transgress perceptions

of equity. As we saw earlier, in principle, Ramsey pricing can

result in unacceptably high individual price increases. Indeed, this

concern may precipitate proposals for individual rather than average

price-caps. Such concerns led to an agreement between British

Telecom and OFTEL which constrained individual price increases to no

more than 2% greater than the CPI movement. The FCC proposal limits

changes in individual prices in each year to no more than 5% up or

down (since in the U.S.A. predatory pricing is a concern) unless the

FCC can be persuaded that a larger change is justified at a formal

hearing. In Australia, the Government will "establish separate CPI-X

price-cap arrangements for business and residential subscribers to

ensure that the benefits of efficiency changes are equitably shared

among customer groups" (p 1471, and ". . . The residential formula will limit both the increase in the average price of all standard services

and the change in price of standard access charges" (p 148).

Nevertheless, the Government will be interested in monitoring what

sort of rebalancing is occurring within these broad categories and

whether they are justified by cost structure movements. This means

that PIS concerning changes in the structure of prices will continue

to be required.

(iii 1 Quality of Service

A major concern of price-cap regulation is its potential impact on

quality of service. The worry is that a firm will now be able to

increase its profits not only by increasing revenue, but by reducing

costs by reductions in the quality of service, particularly where

competition is absent or inadequate. Hence, quality of service

performance indicators will continue to be required under the new

price-cap system.

In the U.K., concern has focused on the need to ensure that British Telecom improves the performance of its fault repair service and the

provision of new service. In OFTELfs view:

"This particular aspect of performance is of such importance that

a case could be made for incorporating some kind of financial

penalty in the price control formula were BT to fail to deliver a given quality of service. For example, it would be possible to

reduce permitted price increases by some amount for each failure

to meet a performance target. It would be important in setting

up a foxmula of this kind both to ensure that the particular

measure of quality was of central importance to consumers

(otherwise there would be the danger of diverting BTts resources

wastefully), and that the penalty was set at such a level .that it

affected performance while not penalising the company to an

unreasonable extent. LOF.TEL, 1988, p -11

Some time after privatisation, British Telecom decided to cease its

publication of quality of service reports. Under pressure from

OFTEL, BT recommenced publication of six-monthly quality of service

statistics in October 1987. During the period when BT was not

publishing these statistics, OFTELts chairman considered this

information important enough to conduct and publish quality of

service information generated from customer surveys and this practice

evidently would continue:

"Now that BT has started to publish its own figures it is less

imperative that OFTEL continues a full programme of research into

quality of service. It would not be sensible for OFTEL to

attempt to replicate every year, measures which can easily be

obtained within the BT network. However, I believe that OFTEL has much to gain from conducting independent investigations,

partly because of the important links which such investigations

can forge with consumer and other interests and partly because

investigations of this kind can often identify problems which

need fuller study. My objectives in continuing OFTEL1s work on

quality of service will be to improve my understanding of

consumers1 attitudes to BT1s performance, to obtain evidence

about the reliability of BT's performance, to obtain evidence

about the reliability of BT1s statistics - as necessary, and to cover topics that are not dealt with in BT1s statistics." (OFTEL,

1987, pp 1-21

(b) Performance Indicators of Technical Efficiency

The "X" in the CPI-X formula, is in effect, an attempt to specify a

reasonable expectation about the average reductions in real costs per

unit of output to be achieved by a regulated firm. In other words,

when "X" is 3 the implication is that it is reasonable'to expect a 3

per cent reduction per annum in real unit costs. But determining a

generally acceptable level of "X" will not be simple. For instance,

in the U.S.A., the U.S. Telephone Association proposed a 2%

productivity factor, while the FCC decided on 3%. Individual

carriers are complaining that 3% will require them to double recent

productivity levels.

Although "X" is often referred to as a productivity improvement

factor, as was noted earlier, the unit cost reductions can result

from an increase in the volume of sales, as well as from productivity

improvements. Thus estimates for both will be required.

Volume of Sales. In a network-based industry with substantial

fixed costs - ie in a situation in which total costs do not change in proportion to volume - a major determinant of unit costs is the level of output. As volume rises, unit costs tend to fall. Thus where the

demand for services ii rising rapidly, it makes it easier to achieve

the CPI-X target while making substantial profits. Accordingly, In considering the specific figure for "X" there are two options:

either an assumption can be made about expected increases in volume

over the next three years, and about the effect this would make on

unit costs, or a change could be made to the formula which would mean

that it altered year by year as the volume of demand changed.

An argument against including a separate adjustment for changes in

volume is that increases in volume may be the result not of increases

In demand outside a firm's control, but of the firm's own efforts by

way of advertising or innovation. In such cases it would clearly be

undesirable to establish a formula which discouraged such efforts

they result in a tightening of the formula. OFTEL considers that one

way around this problem would be to avoid adjustments related

directly to volume, but to include an element related to the major

reason for externally stimulated changes in demand - the growth of GDP (OFTEL, 1988, p 10).

Productivity. The major consideration for determining the size of

of "X" is the deduction that should be made for expected productivity

improvements. The simplest measure to derive is that of labour

productivity. But labour productivity is a very partial measure.

Thus, although more difficult to derive, total factor productivity

measures would continue to be of much interest.

(c) Dynamic Efficiency: The Rate of Investment and Innovation

Would a price-cap encourage -dynamic efficiency? Schwartz (1988)

considers this issue in the context of. regulation in the USA and

includes:

"One might also hope for the more rapid introduction of new services and advanced technology than would'3e tle case under

conventional regulation . . . It is true that, in theory, the cap-index approach would discourage uneconomic investment; that

is, investment whose cost cannot be reasonably expected to be

recovered in a relatively short time with prices capped. This is not the same thing as saying that the approach would also be

..-

superior to conventional regulation in encouraging technological

investment that will ultimately reduce costs. On the contrary, one of the consequences of cost-plus regulation is that under certain circumstances, investment may be made even in the absence

of an assured market for the services to be supported by the

investment. The key variable is time. Under conventional

regulation, investment is recovered over a longer period than is

usual under competitive conditions. A cap still might be

superior to conventional regulation in that it encourages

efficiency, but it would be a mistake to conclude that it will be

as effective as vigorous competition." (p 3 4 )

In the USA, the FCC has foreshadowed that it would keenly observe

what in fact does occur in regard to investment and innovation under

price-cap regulation. In the Australian context, too, where less

competition exists, there seems little reason to be confident that

price-cap regulation in itself will necessarily lead to improvements

in dynamic efficiency. As emphasised earlier, deliberate policies

and efforts should address this task and performance indicators will

be required to monitor progress.

4. Equity

We have already touched on equity concerns when discussing price

rebalancing. It was, of course, equity concerns which led to the

formation of rate-of-return regulation,-and equity concerns which

explain why, despite its problems, it survived for so long. And now

it is equity concerns which raise some of the main doubts over

price-cap regulation. Who benefits and who bears the costs? Is this

redistribution fair?

In the U.S.A. Representative Edward Markey, Chairman of the

Telecommunications Subcommittee, called the FCC's price-cap proposal

"the FCC's social welfare plan to redistribute the wealth from

telephone consumers to telephone company shareholders", (Telephony, August 10, 1987, p 10). Certainly Wall Street approved of the

proposal with a rise in the price of AT & T shares.

Where competitive pressures are absent or inadequate, as in Australia, the doubts might be even greater. To what extent will

less cost-padding and/or greater than expected efficiency

improvements be passed on to consumers or simply appropriated by the

firm as higher profits (or government through higher dividends)?

Will strategic behaviour by the regulated firm allow such profits to

continue? (To guard against excessive profits, the New York Public

Service Commission's regulation of the New York Telephone Coinpany

includes a "sharing mechanism" whereby 50 per cent of any return on

equity above 14 per cent is passed back to customers by way of price

reductions.) The efficiencies sought by the firm, eg., through price

rebalancing, could hurt some, whilst benefitting others. Is this a

welfare improvement? What if those adversely affected are the poor?

Will innovations in service offerings be affordable only to business

and the well-to-do? Which groups will need assistance and in what . - - . . -

way(~)? In order to at least partly allay such concerns, the impacts

on various sbcio-economic-geographic groups could be reported on by

Telecom. And if Telecom is required by the Government to deliver

assistance to those deemed to be deserving, then indicators which

facilitate assessment of Telecomls performance in this regard will

also be required.

5 . Performance Indicators of Effectiveness

Finally, and most importantly, performance indicators of

effectiveness - the extent to which longer-term strategy and pollcy objectives are being achieved - will still be required under price-cap regulation. As discussed earlier, it will probably not be

easy to identify and apply such performance indicators for

effectiveness, but it will be necessary to do so. Sustained effort

should lead to improved PIS and, in the process, also result In a

clearer understanding of strategic and performance objectives for

telecommunications in Australia. - - - -- - -- - - - --

CONCLUSIONS AND RECOMMENDATIONS

The conclusion of this paper need only be very brief. This will

allow space in an already long paper to be devoted to making

concluding recommendations regarding the conditions required for

effective use of a system of PIS.

The primary conclusion regarding PIS is that, used judiciously, they

can be useful in monitoring aspects of performance and in identifying

areas of poor performance requiring investigation and remedial

attention. This paper has advocated that the rage of PIS used for

telecommunications include indicators of financial, economy,

efficiency, equity and effectiveness performance. However, merely by

the Government issuing a guideline that the telecommunications

suppliers and other Government Business Enterprises (GBEs) develop,

use, and publish PIS, will not ensure their effective use in ways

which do, indeed, allow improved results-oriented assessment, and

serve to encourage and facilitate improvements in performance. Such

effective use depends on the existence of several enabling factors

pertaining to the use of PIS. In other words, how well PIS perform

will depend on the extent to which these factors exist and prevail.

Some of these factors are discussed below.

1. There must be clearly specified objectives for GBEs and firm

government commitment to a system of post-decision appraisal. This

includes an acknowledgement that such a system minimises the

requirement for =-decision approvals. To require that GBEs be

judged by results, particularly those suggested by the published PIS

which are agreed upon, and yet continue to require the performance-

inhibiting approvals of the past, will soon lead to GBE frustration

and probably dysfunctional behaviour.

- 71 - . .

2. GBEs will also need to be firmly committed-to the system of

post-decision appraisal through the use of PIS. And they wlll need

to be committed to the aspects of performance that the PIS are to

measure. To engender such commitment, it is important that the

aspects of performance which the PIS are designed to measure, are

considered to be key aspects. Otherwise, not only will the nominated

PIS attract management attention and resources from other more worthy

areas, but the PIS will fail to sustain the support of management and

this will soon impact on the success of the new results-oriented

regulatory system;

3. The aspects of performance suggested in this paper should at

least provide a basis for discussion about the crucial aspects of

performance. Most GBEs would probably agree that economy,

efficiency, equity and effectiveness are amongst the broad components

of performance that should be pursued. But it is, of course,

essential that the Boards and management of GBEs be closely consulted

about the development of PIS. And, after some experience with PIS,

they should be consulted.again regarding ways of improving the system

of PIS. This co-operative development mlght (hopefully) reduce the

potentially adverserial nature of a PI system. But the development

of a system of PIS should not be left entlrely to a GBE since there

is the possibility that the short term benefits of "strategic"

selection of PIS might seem more obvious than the longer term

benefits of an effective system.

4. Once the specific indicators are decided upon, their development

and effective use will depend upon the availability of adequate and

reliable data. And there must also be confidence that the PIS are

indeed measuring performance. This is because there is widespread recognition of the potential for strategic misrepresentation that

information asymmetry offers many GBEs. To foster trust in their commitment to the system and an appreciation of data sources and

difficulties, GBEs should allow external assessors to inspect, "on

siten, the way that their data is compiled from scratch.

5. External assessors, including Parliament, consumer groups and

academic commentators, should find the PIS understandable and useful

to the task of performance monitoring and assessment. Otherwise,

interest in PIS will wane and, subsequently, so too will the pressure

for further development and improvements to the PI system. If this

occurs, the pressure could well build up to swing the "control

pendulum" back the other way, i.e. towards increased controls.

6. The internal users of PI information - GBE management - must find the PIS relevant to their task of assessing performance for the

purpose of facilitating management decisions and performance

improvement. After all, the ultimate objective of the system of PIS

should be not just to monitor but to encourage and assist an

improvement in performance. If the PIS required to be published are

not relevant and useful to a GBEs board or management, there is the

possibility that two sets of PIS will develop. One set for external

display and another unpublished set used internally by management

(which is in fact more relevant to decision making and performance

improvement). More research is required into GBE management views of

performance indicators. One notable problem in designing management

- relevant PIS, which is sometimes raised, is that the level of aggregation required for external and internal use of PIS may

conflict. Whereas many external assessors - and probably top management of the GBEs - will focus on aggregate indicators of price increases, revenue, costs, TFP etc, such a level of aggregation might

be of little use to down-the-line managers of smaller units within

the GBE. What is required is management indicators which are

sufficiently disaggregated so as to be useful to middle management

but which can be reliably aggregated to the level of the PIS which

are published in Annual Reports. Perhaps such a system could be

devised where the GBE is firmly committed to the PI system being

used, since this would align individual managers to be, in turn,

similarly committed. Moreover, such an alignment of management

effort would be crucial in nurturing the development of the change in

"corporate culture" required for sustained performance-oriented

behaviour.

7. This alignment of management values is more likely where a GBE's

own performance evaluation of its managers and the rewards and/or

penalties it accords them, is based, at least in important part, on

achievements as demonstrated by the published PIS. However, rewards

and penalties should be tied closely to outcomes that are in fact

within managerial control. It makes little sense to reward or

penalise management for outcomes due to environmental factors which

they cannot affect. But it might be very difficult to avoid doing - - . .. ---

this in practice because of the problem of sorting out the impact of

effort from those of environmental factors.

8 . The implementation of price-cap regulation will not reduce the

need for PIS, indeed it seems likely to encourage the use of PIS by

GBEs. According to Wheatley (1987):

"Since privatisation, British Telecom has invested heavily in new

accounting systems aimed at providing much more information about

product costs. It now has specific obligations to avoid certain

cross-subsidies, e.g. between the network and the apparatus

business, which it did not have as a nationalised industry and

the pressure of competition has also revealed many inadequacies

in the costing system that is present. A valid question here

would seem to be why its old owners, the government, did not

insist on these reforms being made before.

"It is true that the real unit cost indicator was tried, but it

proved difficult to use for internal control purposes and lacked

apparent relevance to managers. The trigger to a much greater

interest in costs was provided by the changed regulatory

mechanism whereby cost savings could be retained within the

company. RPI-X is a much greater incentive than rate-of-return.

This change could have been made at any time in the past 25 years

and it is again interesting to wonder why it was not done when

the industry was publicly owned." ( p 18)

Well, in Australia it will be, at least in regard to

telecommunications.

9. The reforms in regulation should not be seen as a substitute for

increasing the use.of various cost-reducing approaches. Most

importantly they should not substitute for enabling and encouraging

an increase in the level of effective competition faced by the

telecommunications and other GBEs. After all, an underlying guiding

principle of price-cap regulation is to simulate the incentives of

competitive behaviour. Where effective competition can exist, it

should not be restricted.

But neither is the absence of effective competition a convincing

reason to restrict the telecommunications and other GBEs from

engaging in activities which are performance-improving and which are

consistent with the results of competitive or contestable markets.

This paper has referred in particular to two areas of pressing

concern in telecommunications - improving dynamic efficiency and effectiveness performance. These concerns are unlikely to be

adequately addressed by price-cap regulation whose focus will be more

directly on price and productivity changes. It is increasingly

imperative that the role to be played by Telecom and OTC in a

strategic pursuit of dynamic efficiency and effectiveness not be

restricted.

10. As evidenced by statements made by Telecom, at least some GBEs

now accept that competition can bring about pressures for beneficial

change. Indeed, for Telecom the very prospect of increasing

competition is already having a significant influence, including

being more "customer driven". This is an encouraging sign that a

gradual, judicious increase in competition will sustain similar

incentives for continued adjustment and improvement in performance.

And, used effectively, PIS can assist in guiding the nature, extent

and speed of the adjustment.

APPENDIX 1 : WELFARE CRITERIA AND PRICE REBALANCING

Consider briefly five criteria of welfare improvement:

1. The "Pareto" criterion whereby a policy improves welfare if there is some gain and no-one is made worse off.

2. The Kaldor-Hicks "potential Pareto improvement" criterion whereby a measure is considered to improve welfare if the gainers could compensate the losers and still feel better off.

3. A change can be regarded as a "Pareto improvement" if it can be shown that the "losers" from rate rebalancing would be even worse off without these rate changes.

4. A change is a llRawlsian'' improvement if it can be shown that the "most disadvantaged group is made no worse off1*.

5. A change is an "incrementally superfair" improvement if "any individual prefers the changes in the prices he faces to the changes in the prices (consumption bundle) of any other individual". (Baumol, 1987).

Applying these criteria to rebalancing telecommunications prices in Australia, eg. higher access and lower toll prices, leads to the following results:

1. The measure is not (necessarily) "Pareto optimal" since there are losers.

2. The measure could be "Pareto optimal", since the substantial net gains that have been estimated from such price rebalancing. (~lbon; 1987 b) show that.after rate rebalancing, winners could compensate losers and still be better off. Of course, no such compensation may be forthcoming.

3. An improvement under thewPareto improvement" criterion does not seem demonstrable (at least in current circumstances).

4. Price rebalancing is clearly not a "Rawlsian" improvement (unless - government policy undertakes to insulate the most disadvantaged group from being made worse off).

5 . Price rebalancing is unlikely to be "incrementally superfair".

There has also been a number of papers - notably by Feldstein - which have addressed specifically the use of distributional criteria to be used in public enterprise pricing. However, Waverman (1988) concludes that the practical guidance they provide is disappointing.

ENDNOTES

1 Thus the range of PIS in this paper are proposed within the rationale of a 'performance contracting systemf whereby the Government 'contracts' to require consultation in the development of long range strategic plans but only minimum pre-decision making approvals, so long as its enterprises perform satisfactorily in terms of agreed criteria and PIS. This sort of performance contract has been formally used in France and Korea and has been advocated by several commentators as being suitable for broader use. Of course, the rationale of performance contracts could be less formally applied (as is advocated here).

2 The brief discussion on the preconditions for effective use of performance indicators, in Section IV, draws on a longer analysis which, although important for the effective use of PIS, had to be deferred to a subsequent paper in order to keep this one within reasonable length.

see Patrick Xavier MINDING EVERYBODY'S BUSINESS - Performance Indicators for Public ~ n t e r p r i s e p a n c e Indicators for Australia's Postal Services: How Well Will They Perform? (forthcoming)

3 These are frequently referred to as the '4Es' . The coverage of these concepts will satisfy those who would prefer to use a '3Cs" categorization, viz., customers, cost and competition (see Heald, 1987).

The return on equity figure - now evidently widely used in the private sector as a summary measure of financial performance - is not published probably because of unresolved arguments about whether, and, if so, how much of Government loans to Telecom should be treated as equity.

The allowed rate of return on AT&Tts regulated services is 12.2% (reduced from 12.75% in 19871, AT&T earned a 14.4% return on average equity (including regulated and non-regulated business). The Local Exchange Carriers also had their allowed rate-of-return reduced from 12.75% to 12.2% in 1987 due to a fall in the cost of capital. Bell Canada's permitted return on equity was 12.25% to 13.25% in 1987.

6 More specifically, Albon observed that Telecom ' s major departures from efficiency principles of pricing include the following:

. access charges cover far too little of the total cost relative to usage charges given the size of "overheadw costs relative to variable ones;

. long distance charges are far above marginal costs both at peak and off-peak periods;

. while varying according to distance, duration and time of day, STD charges do not vary with density (eg Sydney-Melbourne charge is same as Young-Broken Hill charge);

. local charges, especially metro ones, are far above peak and off-peak marginal costs and do not vary with time of day or duration; and

. particular services (eg directory assistance, public telephones, telegrams and data services) are run at large losses and must be made up from profits from other services, creating deadweight losses at both ends.

This is a major concern relating to the introduction of price-cap regulation in the USA.

It is true, however, that as portable cellular telephones become widely used, there will be less need for payphones to service transit users, although-the need for payphones will persist, e.g. to service areas of relatively low telephone penetration.

9 Bell Canada disclosed that ". . . , we have increased our productivity, the efficiency of our people, by 4.5% to 7% a year for the past three or four years. This is tremendous when you consider that as a whole the industry at large has increased by less than 1% (Telephony, 1987), It was not clear from the article whether Bell Canada was referring to labour productivity or TFP.

lo~his issue receives more attention in the Report of the House of Representatives Standing Committee on Transport and Communications (1987).

REFERENCES

Albon, (1987) The Welfare Costs of the Australian Telecommunications Pricing Structure, Australian University (November)

National

Australian Treasury (1987) Rate of Return Reporting for Government Business Enterprises - Implementation Issues (October)

British Telecom (1987) Quality of Service Report (October)

Byatt, Report (1986) Accountinq for Economic Costs and Changinq Prices - A Report to H. M. Treasury by an Advisory Group, H.M.S.O.: London (two volumes)

Cutler, T. (1987) Telecommunications in a New Aqe - What are the Policy Issues? Paper presented to a symposium on Telecommunications Deregulation organised by the Centre of Policy Studies, Monash University. Published in the proceedings of that conference

De Ridder, J. (1986) How Efficient is Telecom?, paper presented to the 15th Conference of Economists, Monash University .

Department of Finance (1986) Statutory Authorities and Government Business Enterprises - Proposed Policy -Guidelines, Australian Government Publishing Office, Canberra, (June)

Department of Finance (1987) Policy Guidelines for Commonwealth Statutory Authorities and Government Business Enterprises, a policy information paper issued by the Minister for Finance, Senator Peter Walsh, Australian Government Publishing Service, Canberra, (October)

Edwards, J., Kay, J. and Mayer, C. (1987) The Economic Analysis of Accountinq Profitability, Clarendon Press: Oxford

Evatt Research Centre (1988) The Capital Fundinq of Publish Enterprise in Australia.

Ergas, H. (1986) Telecommunications and the Australian Economy, report to the Department of Communications, A.G.P.S., Canberra

Federal Communications Commission (1988), Further Notice of Proposed Rulemaking (in respect of Price-Caps), cc Docket, No 87-313, (May 12)

Foreman-Peck, J. and Manning, D. (1988) How Well is BT Performinq? An International Comparison of Telecommunications Total Factor Productivity, Department of Economics, University of Newcastle upon Tyne, (unpublished)

Fisher, F. M. and McGowan, J. J. (1983) "On the Misuse of Accounting Rates of Return to Infer Monopoly Profits", American Economic Review 73, 82-97

Graham, B. and Xavier, P. (1987) Inflation Accountinq for Australian Public Enterprises - Economic Rationale and Financial Implications, Swinburne Institute of Technology, Faculty of Business Staff Papers, No 37, (July)

House of Representatives Standing Committee on Transport, ~ommunications and 1nf rastructure ( 1987 ) , Constructing and Restructuring Australia's Public Infrastructure, AGPS, Canberra

Heald, D. (1988) Rates of Return in European Public Utilities: Unlocking the Puzzle, paper presented at the Royal Economic Society/Association of University Teachers of Economics Conference, New College, Oxford, 23-25 March

H. M. Treasury (1978) U.K. White Paper, Nationalized Industries, (Cmnd 7131, H.M.S.O.)

H. M. Treasury (1988) Accounting for Economic Costs and Chansinq Prices, a situation report by the Treasury (January)

Helm, D. (1987) Requlatinq the Newly Privatized Utilities: The RPI - X Formula, Centre for Business Strategy, London Business School, Working Paper Series, No 37

Horton, R. and Donovan J. (1987) "International Comparisons of Telecommunications Chargesn, Telecommunications Policy, Vol 11, No 3, (Sept)

Minister for Transport and Communications (1988), Australian Telecommunications Services: A New Framework, AGPS, Canberra

Molyneux R. and Thompson, D. (1987) "Nationalised Industry Performance: Still Third-Rate?", Fiscal Studies

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OFTEL, (Office of Telecomrnnications, U.K.) (1987) British Telecom's 9uality of Service 1987

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OFTEL (1988b) The Control of British Telecom's Prices (July)

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Telecom Australia (1986) Managing Government Business Enterprises: Control and Accountability (August) <

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Telephony (1987) "Trail-Blazing Northern Neighbour", December 18, p26-36

Tomlinson, W. (1986) "Productive Labourl1, IEE Proceedings, Vol. 130

Trebing, H.M. (1988) llTelecommunications Regulation : The Continuing Dilemma1', Institute of Public Utilities, Michigan State University

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Waverman, L. (1988) Rate Rebalancinq, The Demand for Access and Distributional Equity, (University of Toronto)

Wheatley, J. J. (1987a) Performance Measures in Telecommunications: Changing Needs, paper presented to the E.I.A.S.M. Conference in Brussels, 27-28 April, 1982- - -

Wheatley, J. J. (198713) British Telecomls Experience with Price Requlation, paper presented to the 1987 U.S. West Academic Seminar, Keystone, Colorado, 4-7 August, 1987

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Xavier, P. and Graham, B. (1987) Financial Tarqets and Dividend Requirements for Commonwealth Government Business Enterprises - Are They Appropriate and How Should They Be Determined and Measured?, paper contributed to the Sixteenth Conference of Economists, Surfers Paradise, Queensland, (August), and subsequently circulated as Swinburne Institute of Technology, Faculty of Business Staff Paper no 39, (August)

Zajac, E. E. (1982) "Towards a Theory of Perceived Economic Justice in Reg~lation~~, Bell Laboratories Economic Discussion Paper No 235, (January)

Swinburne Institute of Technolo=

Faculty of Business

LIST OF STAFF PAPERS PUBLISHED TO DATE

No. 7 1981 'A Note on Customs Unions Theory: The Viner Controversy R.I.P.' by D.J. Thomas.

No. 8 1981 'Disequilibrium and the Expectations-Augmented Phillips Curve' by Max Grant.

No. 9 1981 'A View of Ideological Pressures in the Context of Managerial Power' by Max Brown.

No. 10 1981 'Short Term Prediction of Student Numbers in the Victorian Secondary Education System' by Miles G. Nicholls.

No. 11 1982 'The Legal Protection of Geographical Trade Names: Prognosis for a Case of Champagne' by Bruce Clarke.

No. 12 1984 'Corporate ~ianning Practice in Major American and Australian Manufacturing Companies' by Noel Capon, Chris Christodoulou, John U. Farley and James Hulbert.

No. 13 1984 'A Modified Markovian Direct Control Model in Fixed Time Incorporating a New Objective Function Specification' by Miles G. Nicholls.

No. 14 1984 'Government Intervention in the Labour Market - A Case Study of the Referral and Placement Activity of the Commonwealth Employment Service in a Major Metropolitan Area' by John B. Wielgosz .

No. 15 1984 'Big Business in the U.S. and Australia: A Comparative Study' by Noel Capon, Chris. Christodoulou, John U. Farley and James M. Hulbert .

No. 16 1984 'Modelling the Demand for Tertiary Education - A n Exploratory Analysis Based on a Modified Human-Capital Approach' by Miles G. Nicholls .

No. 17 1984 'Formal Corporate Planning Practices of Major Australian Manufacturing Companies' by Chris Christodoulou.

No. 18 1984 'The Australian Short Run Demand for Money Function. Further Theoretical Considerations and Empirical Evidence Using Bayesian Techniques' by Edgar J. Wilson.

No. 19 1984

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No. 36 1987

'Alternative Job Search and Job Finding Methods: Their Influence on Duration of Job Search and Job Sa t i s fac t ion ' by John B. Wielgosz and Susan Carpenter.

' A Comprehensive Study of Strategic Planning i n Australian Subsidiary and Non-Subsidiary Companies' by Chris Christodoulou and Peter T. Fitzroy.

'Towards an Optimal Taxation Structure i n Australia ' by David 3 . Thomas.

' A Suggested Theoretical Basis fo r the Interpreta t ion of the Effects of Income on the Demand fo r Tertiary Education' by Miles G. Nicholls.

'Austrian Economics and Australian Patents' by Bruce Oakman.

'Ensuring a Future fo r your Organisation' by Chris Christodoulou.

'The Long Search: A Pursuit of Organizational Understanding from the Perspective of "System" Thinkers' by Max Brown.

'Managing the Introduction of New Technology' by John Newton.

'Positive Economic Analysis and the Task of S t a t e Enterprise Efficiency and Control' by Patrick Xavier.

'P rof i tab i l i ty of Horizontal Takeovers i n the Australian Industr ia l Equity Market: 1978 to 1982' by M.A. Johns and N.A. Sinclair .

' A Comparative Examination of Subsidiary and Non-Subsidiary Stra tegies ' by Chris Christodoulou.

'Solving Linearly Constrained Nonlinear Programming Problems by Newton's Method' by Fatemeh Ghotb.

'An Economic Appraisal of Recent Reforms i n Public Enterprise Pricing Policy i n Victoria' by Patr ick Xavier.

'Australian Manufacturing Companies and Academic Inst i tu t ions: A Comparative Analysis of S t ra teg ic Planning' by Noel H. Kelly and Robin N. Shaw.

'Centralisation of Information and Exchange with Special Reference t o The South Australian Winegrape Industry' by C. Hunt, P. Tiernan, E. Wilson.

'The Impact of Home Office Culture on Subsidiary S t ra teg ic Planning' by Chris Christodoulou.

' A Comparison Between Guarantees Standby Credits and Performance Bonds' by Ann Johns.

'The Effects of Uncertainty and Incomplete Informastion .in a Foreign Exchange Market subject t o Noisy Rational Expectations' by Edgar J. Wilson

No. 37 1987 ' In f la t ion Accounting f o r Australian Public Enterprises - Economic Rationale and Financial Implications' by Barry Graham and Patrick Xavier.

No. 38 1987

No. 39 1988

No. 41 1988

No. 42 1988

NO. 43 1988

No. 45 1988

No. 47 1988

'Financial Targets and Dividend Requirements fo r Commonwealth Government Business Enterprises - Are They Appropriate and How Should They be Determined and Measured?' by Patrick Xavier and Barry Graham.

'Whither Co-Operative Federalism?: - A n Analysis of the Commonwealth Government's Plan f o r Reform of Companies, Secur i t ies and Futures Legislation' by Peter Pascoe.

'An Analysis of the Pricing of Section 23 Expert Reports' by Ann Johns.

'Food Laws: Reviewing the Regulatory Framework' by Sandra Edmonds . 'Share Prices and Divestiture' by J Barker.

'Marketing Education i n Malaysia: Implications f o r Australian Tertiary Inst i tu t ions ' by Christopher Selvarajah

'Forecasting the Demand f o r Tertiary Education using Econometric and Markovian Models' by Miles G. Nicholls.

'Power Pays-An Analysis of the Relationship Between Managerial Power and Interdepartmental Relations' by Max Brown.

'Workers Part icipation - Concepts, Issues and Prospects. An Australian Perspective' by Christopher Selvarajah and Stanley Petzal l . 'Performance Indicators f o r Telecommunications and Price-Cap Regulation' by Patrick Xavier.