TA 96 on pricing

• Prices for interconnection and for UNEs to be based on cost, to be nondiscriminatory, and may include a reasonable profit– Cost to be determined without reference to

rate-of-return or rate-based proceeding• Resale prices: on the basis of retail sales

less marketing, billing, collection and other avoidable costs

So what is cost?

• Accounting cost or economic cost?• Fully allocated cost or incremental cost?

Fully allocated historical cost

• Start with the $$$ in the company books• Allocate all $$$ to the various services

provided by the company

Fully allocated historical cost

Total Investment and Expenses

Local service State toll

State access

Interstate access

Direct costsIndirect costs

Overhead

Economic costs

• Forward looking (not historical)• Incremental (additional costs)

Total Service Long Run Incremental Cost Study (TSLRIC)

• TSLRIC is equal to the firm’s total cost of producing all of its services assuming the service (or group of services) in question is offered minus the firm’s total cost of producing all of its services excluding the service (or group of services) in question.

TSLRIC

• Important points– Costs are looked at in the long run, so all

relevant costs are variable– Only direct and shared costs are included

• Some allocation is necessary for shared costs• Overhead costs are not considered

– TSLRIC is used as a floor for pricing services• Why?

Total Element Long Run Incremental Cost (TELRIC)

• Applies TSLRIC methodology to UNEs to set a basis for UNE prices

• TELRIC basically asks, “What is the forward looking cost of providing a UNE, assuming that all other network elements are produced at current levels?”

TELRIC

• Based on an efficient network model– Not based on actual ILEC costs– Efficient network model is based on the

network that would be built today, using most efficient technology and most efficient engineering methods

Steps in a TELRIC study

• Identify forward looking investment• Determine the utilization factor• Divide by demand to get unit investment• Multiply by the Annual Charge Factor

Points of Contention

• Study area selected—affects the level of averaging in the study– For example, for local loops,

• Wire center, census block, city block

• Network optimization– Do you use the current locations of wire

centers or the optimum locations? • Will increase costs if use current locations

Issues in arriving at an investment

• What should the utilization factor be?• If you assume that you can only use an asset at

85% capacity, then you will increase the unit investment cost.

• What should demand be?• The higher the demand, the lower the unit

investment cost

Investment calculation

• Assume $100,000 piece of equipment• Assume a 90% utilization factor• Assume demand is 2,000 units

($100,000/90%) / 2,000 = $111,111 / 2,000 = $55.55

Annual Charge Factor (ACF)

• Translates investment into recurring costs• ACF = Plant Specific Factor + Capital

Carrying Charge– Plant Specific Factor and Capital Carrying

Charge are also forward looking

ACF

• Plant specific factor– Support staff– Maintenance– Insurance– Floor space, plus other costs

• Capital Carrying Charge– Depreciation– Cost of capital (debt and equity)– Income taxes

Issues in arriving at the ACF

• What should depreciation be?– The shorter the depreciable life, the higher the

percentage• Ten year life = 10%; 20 year life = 5%

• What should the cost of capital be?– Covers both debt and equity capital

• Impact of risk is important

ACF example

• Plant Specific Factor = 10%• Capital carrying charge = 30%• Unit Investment = $55.55

($55.55)*(10% + 30%) = ($55.55) * (40%)= $ 22.22 recurring costs

Supreme Court upheldTELRIC

ILEC argument Court findingTELRIC formula should consider historical cost associated with providing a specific network element

ILECs failed to demonstrate the unreasonableness of setting rates on a forward-looking basis

TELRIC is needlessly complicated and impractical

TELRIC rate proceedings are surprisingly smooth running

TELRIC simulates but does not produce facilities-based competition

$55 billion in competitive capital spending 1996-2000 says otherwise

FCC’s NPRM

• Notice of Proposed Rulemaking, – WC Docket No. 03-173; FCC 03-224– Adopted September 10, 2003– First comprehensive review of TELRIC pricing

in the seven years since it was adopted• “To the extent that the application of our TELRIC

pricing rules distorts our intended pricing signals by understating forward-looking costs, it can thwart one of the central purposes of the Act: the promotion of facilities-based competition.”

In the NPRM, the FCC

• Notes that UNE prices – 1) should be set in a manner that sends

efficient entry and investment signals to all competitions;

– 2) should provide ILECs an opportunity to recover the forward-looking costs of providing UNEs

• Affirms the use of forward-looking costs

In the NPRM, the FCC asks . . • What should the impact of the Triennial Review Order be

on UNE pricing rules– For example, if copper loop replaced by fiber, what should the

UNE price be?• Questions about TELRIC theory:

– “in the real world, however, even in extremely competitive markets, firms do not instantaneously replace all of their facilities with every improvement in technology. Thus, even the most efficient carrier’s network will reflect a mix of new and older technology at any given time.”

– “simultaneously assuming a market inhabited by multiple competitors and one with a ubiquitous carrier with a very large market share may work to reduce estimates of forward-looking costs below the costs that would actually be found even in an extremely competitive market.”

In the NPRM, the FCC asks . . .• Should the TELRIC rules more closely account

for the real-world attributes of the routing and topography of the ILECs network in the development of forward-looking costs?– Should it be existing network? Or a network that

reflects ILEC plans over an objective time horizon?– After years of price caps, should we assume ILECs

are now productive, so we don’t have to worry about CLECs paying for ILEC past inefficiencies?

– What network configuration should be used? Current routes used by ILECs? Existing rights-of-way?

More questions asked by the FCC

• What fill factors should be used?• What switch discounts should be used?• What cost of capital? Should it differ by UNE?• How should depreciation be calculated?• How should expense be calculated?

– Based on current ratio of expense to investment? Based on current expenses adjusted for productivity and inflation?

• Should UNEs be de-averaged by geography and by class of service of CLEC customer?– especially if retail rates are not averaged (example, business

and residential rates are not averaged, but the UNEs are)

Further questions • Resale pricing

– FCC originally adopted a “reasonably avoidable” standard – any costs that “reasonably can be avoided” by the ILEC when it provides a service at resale must be considered avoided in determining the wholesale discount

– Eighth Circuit found the rules to be inconsistent with the plain meaning of the statute—appropriate standard should be “those costs that the ILEC will actually avoid”—also should remember that ILEC is both a wholesaler and a retailer

– Now asks, if FCC should identify categories of costs that could be considered presumptively avoided; also how to treat common costs since ILEC is both wholesaler and retailer