interconnection costing model update study · costing methodologies - best practice the adoption a...

Interconnection costingmodel update study

November 2011

www.pwc.co.uk

Contents

Section Page

Interconnection pricing alternatives 6

Costing methodologies – alternatives 8

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Costing methodologies – other issues 15

Costing methodologies – commonpractice

18

Costing methodology 20

Projected timeline 34

Issues raised at initial workshop 36

Introduction

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Purpose of this document

The Uganda Communications Commission (UCC) has commissioned PwC to carry out anupdate/redevelopment of the interconnection costing model that was developed in 2009in order to take into account the changes that have taken place in the Ugandantelecommunications market including changes in technology, services and demandamong others.

As part of the process, the UCC has determined that operators should be allowed tocomment on the methodology to be used.

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comment on the methodology to be used.

This document outlines the methodology that will be used, the proposed structure of themodel and services to be included among others.

Operators are therefore invited to comment on this document and the outlinedmethodology.

Comments on this document can be submitted to the UCC until the 15th ofDecember 2011.

Summary of the proposed approach

The proposed model approach will be:

• Single GSM network modelled

• LRIC

• Forward looking

• Hybrid

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• Hybrid

• EPMU

• Average operator

• Scorched node

The description and discussion of the methodology is presented in the next sections ofthis document.

Interconnectionpricing alternatives

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Interconnection pricing alternatives

Interconnection

Regulated Negotiated

Cost based

FAC

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Price cap

Retail minus

Benchmark

LRIC

Historical/current cost

Mark-up type

Historical/current cost

Top down/bottom up

Costingmethodologies -alternatives

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Costing methodologies - alternatives

Methodology Description Positives Negatives

Fully AllocatedCosts

A system of full cost absorptionwhere all costs are attributed toservices.

Transparent andreconcilable

Captures the real

Embeds economicallyinefficient allocation ofresources

A clear majority of regulators are using an incremental costing model or are progressingtowards it. This is typically lower than average costs in the presence of economies of scaleand scope.

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services.

Takes as a starting point theaccounts of an operator and‘drills down’ into the accounts(FAR, cost centres)

Captures the real(actual) costs of doingbusiness

Allows full recovery ofcosts

resources

Incrementalcost

The additional cost of providingfor an additional increment ofoutput (or cost avoided if theproduct is removed).

CVRs are used to differentiatebetween common and jointcosts.

Efficient resourceallocation

Economic theorysuggest that marginalcost is the basis foroptimal prices

May create costrecovery issues, due tohigh fixed common andjoint cost in telecomindustry


AccountingConvention Description Positives Negatives

Historical Cost recorded at the purchase orconstruction price


Assesses the pastbehaviour, which may

The majority of regulators have forward-looking models, matching the period ofmodelling with the period of regulation, although including some uncertainty regardingfuture demand and new services

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construction price reconcilable behaviour, which maynot relevant for futuredecisions

Forwardlooking(Long run)

Cost based on the current value ofthe assets

A forward looking long runapproach to costs assumes that allinputs are variable in the long run(number of employees, capitalcharges etc.) and thereforeinterconnect charges include areturn on capital.

Supports economicallyefficient decisions

Relevant costs for a newentrant

Establishes target costs

Complex modelling

Incorporatesassumptions

May give volatilemovements in profitover time


Approach Description Positives Negatives

Top down Costs are taken from theaccounting record and areallocated to services based ondemand and allocation rules..


Embeds economicallyinefficient allocation ofresources

A common type of model is a hybrid model, allowing for an efficient network construction andensuring in the same time reconcilability with the actual data. In other words, a bottom-up approach isused and accounting information is then used to cross check.

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demand and allocation rules..

Bottom up Engineering model that estimatesthe cost of a theoretical networkon a green-filed site basis. Themodel will include networkdimensioning rules for differentsizes of demand.

Allows for constructionof an efficient network,supportingeconomically efficientdecisions

Economic measure ofdepreciation

Establishes target costs

May understate cost

Less good at modellingopex and indirectinvestments

May not capture ‘realworld’ issues

Complex

Hybrid An extension to the bottom-upmodel, where results arecompared to the actual data of theoperators.

Carries all benefits of abottom-up model, plusensures a coherencewith the actual data

Carries all issues of abottom-up model, butprovides for mitigationactions (adjustments)

Costing methodologies – alternatives

Mark up Description Positives Negatives

Zero mark-up No mark-up applied Stimulates marketentry

Threatens viability ofthe provider

Equi- Mark-up allowing recovery of Balances conflicting Inefficient to some

Regulators have nearly always adopted an EPMU mark-up for the recovery of fixed andcommon costs. Ramsey mark-up would be an appropriate alternative, but difficulties inestimating demand elasticity made implementation difficult.

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Equi-proportionalmark-up(EPMU)

Mark-up allowing recovery offixed costs pro rata to incrementalcosts

Balances conflictingobjectives

Enable common andjoint costs recovery

Inefficient to somedegree, partly offsetsthe benefit derived frommoving away from FAC

Ramseymark-up

Mark-up inversely proportional todemand elasticity

Applied in non-competitivemarkets, with high fixed commoncosts

Promotes efficient finalservice prices

Depends on flexibilityof retail prices

Difficult to quantifyelasticity

Opportunitycost mark-up

Mark-up to incremental costrelated to the lost contribution oftraffic migrated to theinterconnecting operator

Promotes faircompetition

Ensures viability ofincumbent

Provides weakefficiency incentives

Does not addressmonopoly profits


Operator Description Positives Negatives

Actualoperator

The model incorporates real dataabout an operator, such as marketshare, network traffic and

Captures differencesbetween operators

Calculates specific

Needs a separate modelfor each operator

Preserves inefficiencies

When choosing one of these approaches, the Regulator should analyse the costdifferences between operators and whether they can be quantified in a hypothetical model(of an efficient operator).

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coverage.Calculates specifictermination costs

Preserves inefficiencies

Hypotheticaloperator

Parameters are not those of aparticular operator and it hasconsiderable flexibility

No confidentialityissues

One model onlyrequired

Irrelevant where thereare fundamental costdifferences in operators

Averageoperator

This is a mix of the hypotheticaloperator and actual operatormodels.

Enables the calculationof one IC rate

Addresses marketspecific issues

Needs a separate modelfor each operator

New entrant This is a form of hypotheticalmodel, looking at the parametersof a potential new entrant.

Incentivises newentrants

Disregards the specificcosts and limitations inthe market


No of years Description Positives Negatives

Single year Uses a single year as an anchorpoint for multi-year regulatedprices

Simple

Does not requireforward-lookingassumptions

NRA cannot carry outcost modellingexercises each year

It may need a

The majority of the models available on the market are single year models, although it isunlikely a Regulator will carry a costing exercise every year.

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assumptions It may need apercentage assumptionto update the chargeyearly

Multi-year Calculates differenttermination rates for severalyears

Allows multi-yeardepreciationmethodology (economicdepreciation)

Alternative networkdevelopments can bemodelled

More complex

Require forward-looking assumptions

Costingmethodologies –other issues

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Symmetry

Issues with multiple rates:

• Confusing for customers from having different rates for calling subscribers of different operators,even if both were for example, mobile operators;

• Operators would have problems setting prices, billing and running settlement systems betweenthemselves with a multitude of rates;

There are demonstrable differences in cost for delivering traffic on the different types ofnetwork, which are unrelated to inefficiencies

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Volume

• Operators can pass their inefficiencies to customers;

• Limited incentives for cost minimisation;

• New entrants are encouraged to set up cost efficient networks.

Setting single rates – alternatives:

• As the lowest rate of the group of operators;

• As the highest rate of the group of operators;

• As a simple average of the operators;

• As a weighted average of the operators.

Common practice:

• The use of a weighted average, with the weights based on traffic volumes, on the basis that thisshould result in the overall profitability of the industry being close to the reasonable rate of return.

Symmetry

Benchmark – ERG study

• An ERG study on asymmetry (European Regulators Group) concluded that termination rates shouldnormally be symmetric and asymmetry, acceptable in some cases, requires an adequate justification.

• Potential reasons for asymmetry include exogenous factors, e.g. 900Mhz has lower cost than1800Mh and less are needed for the same coverage.

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Volume

• However this should be mitigated by Regulators, by eliminating cost differences due to frequenciesallocation, either by aligning spectrum endowment of operators or by ensuring that licenses areacquired at market price, so that the asymmetry can be removed.

– 8 operators chose the cost reference of an efficient operator

– 1 uses the lowest cost of all the MNOs

– 3 use an average or a weighted average of costs of all the MNOs

– 2 use the highest costs of operators

– 2 use the actual costs of each operator

– 4 use a benchmark

– 5 did not decide yet

Costingmethodologies –common practice

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Costing methodologies - best practice

The adoption a forward looking, hybrid, symmetrical, long run incremental cost approachrepresents best practice among a variety of competing methods

• In order to achieve efficient resourceallocations, interconnection chargesshould be cost based

• FAC is sometimes used in the interim

With LRIC based prices, competitors areable to decide whether to use anincumbent network or build their own

LRIC calculates the costs at which areasonably efficient operator wouldproduce a required service

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Cost

Incremental cost of A

Standalonecost of B

Volume

mc1 unit

Long-run Incremental CostFully Allocated Costsproduce a required service

Cost

Volume

Averagecost of B

AB

Averagecost of A

AB

Costingmethodology

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Bottom-up LRIC Model

Key characteristics

• Builds a hypothetical network

• Engineering model designed to meet a given level of demand at a prescribed grade ofservice

• Allows for construction of an efficient network

• All inputs are variable in the long run (number of employees, capital charges etc.)

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• All inputs are variable in the long run (number of employees, capital charges etc.)

• CVRs are typically specified through network engineering rules, rather than explicitlycaptured as percentage relationships between costs and volumes.

• Includes a mark-up to cover fixed common and joint costs

• Retail costs are not to be recovered through interconnect rates since interconnectservices are wholesale services which do not require retail activities

Key modelling concepts

• Basis for valuing asset prices is the replacement cost of an asset as derived from theapplication of current cost accounting (CCA)

• Apply the Financial Capital Maintenance concept

• An annuity approach is used in the model to estimate the annualised capital costs,including the cost of capital


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including the cost of capital

• Use Efficient component Pricing Mark-Up (EPMU) approach

• Scorched node – current location and number of network nodes are the basis for themodelled network topology

Example: Mobile Operator: Main network elements modelled

• Switching and Access

- Base Transceiver Stations

- Base Station Controller

- Mobile Switching Centre

- Home Location Register

• Platforms

INHLR PSTN

MSC MSC

INSMSC ININ


HLR INSMSC

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- Intelligent Network

- SMS Platform

- Voicemail Platform

• Transmission

- Microwave

- Cable (copper/fibre)

- Satellite

• Technologies modelled:

- Options: 2G only / 3G only / 2G-3G;

- NRAs many times chose to ignore 3G on thebasis that operators would invest in 3G if it isa cheaper technology, therefore there no risk of under-recovered cost by including 2G only;

- 3G modelling ultimately depends on the extent and type of services delivered

B ayN etwo rks

BSC

BTSBTS

MSMSMSMS

Bay N etwor ks

BSC

BTSBTS

MSMSMSMS

The following table lists the proposed services to be modelled. The final list will depend on theinformation that is actually provided during the data request and the consultation regarding theservices that are actually provided.

Services modelled - Voice

Voice services

Voice services Outgoing On-net

Voice services Outgoing Off-net to mobile

Voice services Outgoing Off-net to fixed

Voice services Outgoing Off-net to international

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Voice services Outgoing Inbound roaming

Voice services Outgoing Calls to Voicemail

Voice services Outgoing Outgoing on-net IP voice traffic

Voice services Outgoing Outgoing off-net IP voice traffic

Voice services Outgoing Outgoing other calls not included above

Voice services Incoming Calls from other Mobile operators

Voice services Incoming Calls from Fixed operators

Voice services Incoming Calls from international

Voice services Incoming Inbound roaming

Voice services Incoming Incoming off-net IP voice traffic

Voice services Incoming Incoming calls not included above

Services modelled – Other services

SMS messages

SMS Messages Outgoing On-net

SMS Messages Outgoing Off-net to mobile

SMS Messages Outgoing Off-net to international

SMS Messages Incoming From other mobile

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SMS Messages Incoming From international

MMS messages

MMS Messages Incoming On-net

MMS Messages Incoming Off-net

MMS Messages Outgoing On-net

MMS Messages Outgoing Off-net

Data traffic

Data traffic - Traffic in Mb

Model structure

Key8. Core

2. Demand

7a. Radio

4. Networkdesignparameters

5. UnitInvestment &opex

6. NE Demand

3. Routeingfactors

1. Masterfiles

7b. Radio

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Key

Input sheet

Calculationsheet

Control

8. CoreEquipmentdimensioning

11. ServiceCosting

7a. RadioNetworkDimensioning(2G)

A. Results10. AnnualizedNetwork cost

6. NE Demand

9. Transmissiondimensioning

NetworkDimensioning(3G)

Estimation of network elementdemand

Usage(calls, SMS

etc)

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Unsuccessful%, Holding

times

RouteFactors

Busy Hour &SMS Factors

NetworkElementDemand

Radio dimensioning

Average cellradius

Area of eachregion

No of requiredcells forcoverage

GSM 900Spectrum

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Additionalcapacityrequired

CapacityPlanningFactor

Grade ofService

ErlangTable

coverage

Capacityprovided bycoverage cells

Traffic No of TRX for900 and 1800

TrafficDistribution(by area)

Trafficdemand byarea type

Trafficdemand(radio BHE)

TRX/Sector/Cabinetcapacity

GSM 1.800Spectrum

Additionalcapacity tobuild

Total number ofsites (900 onlyand shared)

Number ofcabinets

Number ofBSC

TRX per BSCcapacity

Core equipment dimensioning

Capacityplanningfactor

Traffic percore platform

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No. of MGW,MSS, HLR,SMSC, etc.

No ofsubscribers

Minimumnumber ofcore platforms

Capacity percore platform

Transmission dimensioning

Trafficbetweenelements

Number ofsites/nodes

# of radio andfibre links

Distribution oflinks by type

Av no ofmicrowavehops

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elements

Regionaltrafficdistribution

Number oflinks by typeand capacity

Standard linkcapacity

No of Radioequipmentelements

Averagedistancebetween links

Km of fibreand # ADMsneeded

Number ofcore nodes

Traffic mappingbetween corenodes

Routercapacity

Number ofrouters

Estimation of total cost by NE and unit cost

• Having dimensioned the equipment, total investment costs are calculated based oncurrent equipment prices and related costs.

• Total investment costs are then annualized based on asset lives and price trends.

• The mark-ups and license costs are computed into the NE annualized cost.

• Finally, unit cost of service are calculated based on demand by each service, therouting factors and annual NE costs.

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WACC

Dimensionedswitchingequipment

License cost

AnnualisedEqpt costs

Transmissioncosts

Network costsby NE

Total costsby NE

Opex andCapexmark-ups

Dimensionedaccessequipment

Dimensionedtransmissionequipment

Demand byservice

Routingfactors

Unit cost byservice

Equipmentcost

Annualization procedure – tilted annuity

The value of an asset may be influenced bya number of factors including:

• Its running costs and changes in runningcosts over its lifetime;

• The value of its outputs and changes invalue of outputs over its lifetime;

ntt

r

i

irIC

1

11

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• Its productivity (in terms of the volumeof outputs it can generate) and changesin productivity over its lifetime; and

• The existence or expectation of achallenger asset (i.e. an alternativetechnology), which threatens to redefinethe modern equivalent asset.

The best approach for annualization istherefore using a tilted annuity approach.

Where:

C is the constant annual capital changein period t

It=0 is the replacement value of the assetat the start of the period

r is the cost of capital

n is the useful life of the asset

i is the annual change in the price of theasset.

32

WACC methodology

• The cost of capital is calculated using relevant benchmarks and publically availabledata.

• The result is the pre-tax WACC which will be used for the annualization

Post -Tax WACC =

Ke(E/V) + Kd(1-Tx)(D/V)

Target Gearing

Pre - Tax WACC =

After-Tax WACC/(1 -Tx)

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Cost of Equity

Ke = Rf + ße(Rm-Rf)

Cost of Debt

Kd = Rf + Pd

Equity Beta

ßeRisk Free Rate

Rf

Debt Premium, PdMarket Risk Premium

Rm-Rf

Corporate Tax Rate Tx

Target Gearing

D/V

E/V

Country risk

CR

Projected timeline

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Key activities and deliverables

Below is the proposed timeline of this project.

Please note that in order to achieve this timeline it will be crucial that operators submitthe complete data request on time.

• 12th December 2011: PwC to receive complete data request by all operators.

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• 12th December 2011: PwC to receive complete data request by all operators.

• 12th – 16th December 2011: PwC to have meetings with operators in Kampala todiscuss received data.

• December 15 2011: UCC to receive responses on proposed model methodology

• Week of 30th January: Presentation of final results to operators

Issues raised atinitial workshop

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Key activities and deliverables

Some of the issues that were raised during the workshop carried out on November 1st.2011 include:

• Enforcement of compliance with Regulations

• Timeline for implementation after issuance of final report by PwC

• Possibility of leaving interconnection rates to bilateral negotiations

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• Possibility of leaving interconnection rates to bilateral negotiations

• Possibility of incorporating network externality

• Effects of current economic turmoil and high inflation on the model / sources are to beused for inflation projections

• Effect of operators having and operating old assets

• Possibility of using international benchmarks, including benchmarks of neighbouringand other Sub-Saharan countries

• Operator to be modelled (e.g. Average, existing, most efficient, etc.)

• Cost of SMS messages

Key activities and deliverables (cont)

• Scope of interconnection study (does not include the financial regulation aspects ofMobile Money)

• Possibility of using asymmetric tariffs (pros and cons)

• Desirability of national roaming

• How to take into account infrastructure sharing

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• How to take into account infrastructure sharing

• Effect of transit traffic

• Benefits of a decentralised point of interconnection

Contact us

This publication has been prepared for generalguidance on matters of interest only, and does notconstitute professional advice. You should not actupon the information contained in this publicationwithout obtaining specific professional advice. Norepresentation or warranty (express or implied) isgiven as to the accuracy or completeness of theinformation contained in this publication, and, to theextent permitted by law, PricewaterhouseCoopersLLP, its members, employees and agents do notaccept or assume any liability, responsibility or dutyof care for any consequences of you or anyone elseacting, or refraining to act, in reliance on the

Telecoms and Technology, UK

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[email protected]

Michael Hardt

acting, or refraining to act, in reliance on theinformation contained in this publication or for anydecision based on it.

© 2011 PricewaterhouseCoopers LLP. All rightsreserved. In this document, “PwC” refers toPricewaterhouseCoopers LLP (a limited liabilitypartnership in the United Kingdom) which is amember firm of PricewaterhouseCoopersInternational Limited, each member firm of which is aseparate legal entity.


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