telstra corporation limited · telstra believes the issues involved in local calls are no different...

Telstra Corporation Limited Submission

TELSTRA CORPORATION LIMITED

The Need for an Access Deficit Contribution for PSTN Access Service Pricing

Telstra’s Submission on the ACCC Discussion Paper

Public Version

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Contents

Executive Summary ....................................................................................................................................... 4

Introduction ................................................................................................................................................... 6

(1) Economic profits and the ADC ........................................................................................................... 14

(2) The impacts on investment ................................................................................................................ 24

(3) Whether Telstra charges itself an ADC ............................................................................................... 29

(4) The ADC, “consequential costs” and Telstra’s legitimate interests .................................................... 31

(5) The treatment of local calls ................................................................................................................ 35

(6) The allocation of common costs as between call numbers and call durations .................................... 43

Attachment 1: Cross reference of ACCC questions to Telstra’s response .................................................... 45

Attachment 2: Treatment of Access Deficit in the United States, Canada and the European Union ............... 53

Attachment 3: Economic vs. Accounting Profit [Confidential] ...................................................................... 58

Attachment 4: Incentive Regulation Imposed on Telstra ............................................................................... 59

Attachment 5: The Contribution of Productivity and Price Changes to Telstra’s Profitability [Confidential] .. 63

Attachment 6: Revenue Impact of Removing the ADC [Confidential] ............................................................ 64

Attachment 7: Telstra’s Options for Recovering Access Deficit without an ADC........................................... 65

Attachment 8: Switching Costs and the Incidence of a Profit Tax ................................................................. 66

Attachment 9: Trends in Telstra’s capital expenditure .................................................................................. 68

Attachment 10: Investment indicators for Telstra’s competitors [Confidential] ............................................. 69

Attachment 11: Competitors’ Build vs. Buy Decisions .................................................................................. 70

Attachment 12: ACCC and the Importance of the ADC in Maintaining Competitive Neutrality ....................... 72

Attachment 13: The Access Deficit and the Local Call Deficit ....................................................................... 76

Attachment 14: Modelling the Effect of Telstra Absorbing the Full Access Deficit [Confidential] .................. 83

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Attachment 15: The ACCC views on the AD and Faulhaber cross-subsidies................................................. 84

Attachment 16: Ramsey Efficient Derivation of Optimal Retail Margin Structure........................................... 88

Attachment 17: Competitive neutrality and efficiency ................................................................................... 96

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Executive Summary 1.

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Telstra believes the central issue is whether the costs of the customer access network (‘CAN’) that cannot be recovered through line rentals due to price controls should be recovered equitably from all those who use the CAN for their commercial advantage, including Telstra’s commercial rivals who use it to deliver services to their own customers, or instead whether it should be borne by Telstra and Telstra alone. Telstra submits that requiring it to bear an inequitable portion of those unrecovered costs is contrary to the statutory criteria.

If the ACCC applies the methodology it has used to date for allocating common costs – be they the common costs of the CAN or of the inter-exchange network – then it will be expecting the basic access service to recover more than is possible, given the operation of the Government’s retail price caps. The resulting shortfall is the Access Deficit.

Regulators internationally have consistently adopted this approach to allocating responsibility for recovering efficient costs. Whenever that has resulted in an Access Deficit, they have acted to ensure that that Access Deficit was recovered in an equitable way from all competitors who enjoy the benefits of access to the network, rather than impose it solely on the access provider.

Imposing the burden of recovering the Access Deficit on Telstra and Telstra alone would be inconsistent with competitive neutrality – as the ACCC has clearly recognised until now. It would result in distortions to competition and investment that are contrary to the long-term interests of end users.

Economic modelling attached to Telstra’s submission shows that if the ADC is not included in the price for wholesale services then on even the most conservative assumptions, consumer prices would rise rather than fall in the longer term. Alternatively, Telstra’s ability to continue to serve its many millions of customers, would be improperly impaired.

This outcome is inconsistent with Telstra’s legitimate interests. Also inconsistent with Telstra’s legitimate interests, and with the welfare of Australians, is the transfer that would occur of income from its shareholders – whose existing investments would effectively be expropriated – to the largely foreign owners of Telstra’s competitors.

The ACCC argues that Telstra earns economic profits and that these could be used to cover the access deficit. This “make the rich pay” approach is advanced without any credible empirical evidence or any theoretical backing.

The assumption that Telstra earns high economic profits is dubious. As evidence that Telstra earns economic profits, the ACCC points to estimates it has made based on

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Historical Cost Accounting. Curiously, this ignores the stern criticisms the ACCC has itself made of Historical Cost Accounting, and of its lack of usefulness in addressing precisely the type of issue at hand. This approach is inconsistent at best.

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The reality is that Telstra is subject to wide ranging price caps and faces ever more intense competition in the markets in which it operates. Evidence attached to this Submission shows that far from earning monopoly profits, Telstra has passed back to consumers much of the very substantial productivity gains it has made in recent years.

Additionally, Telstra is surprised that the ACCC has focussed on alleged profits earned by Telstra, without examining the margins that are earned – and even more so, would be earned absent any contribution to CAN costs – by Telstra’s competitors.

Ultimately, taxing profits is the opposite of good regulation. Good regulation should aim at encouraging firms to increase their efficiency and productivity, using the incentive of added profits as the means to this end. The ACCC itself has repeatedly acknowledged this. Now what is being proposed is tax away those profits Telstra has earned in a price-capped context. This is a recipe for poor productivity performance over the longer term.

Rather, in Telstra’s view, consistent with the approach adopted in major jurisdictions overseas, the ACCC must provide for a charge by means of which both Telstra and access seekers would contribute on an equitable basis to the otherwise unrecovered costs of the CAN. Users of the CAN must be asked to pay their way rather than be allowed to enjoy a free ride at the expense of Telstra’s customers and shareholders.

Telstra believes the issues involved in local calls are no different in substance from those that arise in respect of the CAN. Indeed, Telstra rejects the notion of a local call deficit. There is an access deficit that needs to be recovered from retail and wholesale services that use the CAN, including local call services. Because of the operation of the retail price caps, local calls cannot contribute their fair share. Consequently an adjustment to the contributions made by all other wholesale and retail PSTN services is necessitated by social policy.

This is exactly the approach adopted in other jurisdictions where there are binding constraints on cost recovery for the local call service.

Forcing Telstra, and Telstra alone, to bear the burden of recovering the shortfalls associated with local call price constraints would be distorting for precisely the same reasons as apply to the Access Deficit. Rather, the burden should be shared equitably.

Telstra does not believe the ACCC can properly take one approach to the Access Deficit issue and another to the treatment of local calls. The policy and methodological issues involved do not differ, and it is reasonable for Telstra to expect the ACCC to act consistently.

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Introduction 17.

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Telstra has significant concerns about the proposition in the Discussion Paper that an access deficit contribution (“ADC”) should not be included in charges for originating and terminating PSTN access.1

To begin with, the ACCC, despite elsewhere emphasizing the importance it attaches to regulatory certainty and to avoiding unnecessary regulatory risk, now raises the possibility of a drastic change in its overall approach to access pricing. This possible reversal of principles which the ACCC adopted from the outset of its involvement in telecommunications regulation cannot but create significant uncertainty in the way the ACCC exercises its statutory responsibilities. Additionally, it introduces considerable uncertainty into commercial negotiations over access prices, undermining rather than facilitating the commercial, market-oriented, resolution of disputes.

The primary goal of Australia’s telecommunications legislation is to promote the long-term interests of end-users. In Telstra’s view, these interests are best advanced by ensuring that the competitive process, and regulatory intervention in that process, helps secure economically efficient outcomes.

In every major jurisdiction where there is a material access deficit, it has been recognised that securing economically efficient outcomes requires ensuring that competing users of the network contribute on a competitively neutral basis to recovering the costs of that access deficit – see Attachment 2 for a survey of regulatory decisions in the main jurisdictions.

However, the ACCC’s paper appears to suggest that the ADC could be removed, and the full burden of financing the Access Deficit (“AD”) placed on Telstra, without compromising this efficiency goal. The paper’s arguments appear to rest on six key assertions:

1. That Telstra earns substantial economic profits, associated with competition not developing to the extent to which the ACCC had expected, both in respect of PSTN services and in respect of other services. The ACCC asserts that to the extent to which it is the case that Telstra earns economic profits, those profits could be used to finance the AD (or alternatively, imply that there is no AD), either directly or by defining and calculating the AD with respect to the full range of revenues and costs associated with the CAN;

2. That Telstra has invested substantial amounts in its network, and that it would continue to so invest regardless of whether or not it received an ADC.

1 ACCC, 2003, The Need for an ADC for PSTN Access Pricing: Discussion Paper, February.

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The ACCC also claims that removing the ADC would not materially distort the build/buy decisions of Telstra’s competitors. As a result, the ACCC suggests that removing the ADC would not undermine efficiency in investment;

3. That Telstra does not charge itself an ADC, and hence that removing the ADC would go in the direction of competitive neutrality. As a result, it would, in the paper’s logic, contribute to promoting competition;

4. Relatedly, that recovering an ADC amounts to recovery of consequential losses, and hence is inconsistent with the statutory criteria. The ACCC also suggests that removing the ADC would not be inconsistent with Telstra’s legitimate interests;

5. That even if an ADC were allowed, it should be allocated in a manner that does not take any account of regulatory constraints on the retail pricing of particular services, with the result that responsibility for recovery of the ADC may be allocated to calls which could not meet that responsibility without breaching regulatory constraints; and

6. That even if an ADC were allowed, its allocation as between calls and minutes should be set on a basis that is economically arbitrary.

22. It is Telstra’s view that each of these propositions is incorrect. Rather, Telstra submits that:

1. There is no evidence that it earns economic profits, much less monopoly profits, from the services provided by means of the CAN. Additionally, even if there were such evidence, taxation of profits is a very poor way of financing the CAN, all the more so when that taxation is implemented on a discriminatory, rather than a competitively neutral, basis;

2. While Telstra has invested substantial sums in the CAN, and more generally in its networks and services in recent years, it seems positively perverse for those investments to be used as a basis for imposing on Telstra a burden that is discriminatory and not competitively neutral. Moreover, the impact of doing so is likely to be to undermine Telstra’s ability to invest in future, while reducing any incentive Telstra’s competitors may have to undertake the investment required;

3. That even with a properly calculated ADC, Telstra contributes at least as much to financing the CAN as do access seekers, indeed, not only absolutely but also proportionately more. The ACCC’s claims to the contrary are based on faulty reasoning from unsupported premises;

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4. That far from involving a contribution to consequential losses, the ADC merely ensures that access seekers that benefit from the use of the CAN help cover the costs of the CAN;

5. That failure to take account of regulatory constraints on the pricing of local calls in allocating the burden of recovering CAN costs would be no less harmful than failure to recognise the Access Deficit; and

6. That an economically efficient approach to allocating the burden of otherwise unrecovered costs would allocate that burden to the number of calls rather than to call durations.

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This submission falls into two parts. In the first part, Telstra sets out its general view of the issues involved, and contrasts that view with the statements and questions set out in the ACCC’s Discussion Paper. The second part then examines in some detail each of the main contentions put in the Discussion Paper, using as a structure the summary of those contentions set out above.

Telstra’s submission also includes a number of attachments. The first attachment sets out Telstra’s answers to each of the questions put by the ACCC in its Discussion Paper; this relies, where appropriate, to cross-referencing to this document. The other attachments elaborate on or substantiate points raised in the main body of the Submission. A number of the attachments contain confidential financial information (marked confidential), which Telstra expects the ACCC to afford due protection.

A. The core issues

In Telstra’s view, the fundamental issue involved in the ACCC’s Discussion Paper is whether all those who use the CAN should contribute to its costs, and should do so on an equitable basis, or whether those costs should be borne entirely by Telstra.

In taking the view that the costs of the CAN should be recovered on an equitable basis from all of its users, Telstra believes it is adopting an approach that is consistent with ordinary common sense, with the position the ACCC has itself repeatedly adopted in the past, and with the approach that has been repeatedly adopted by regulators overseas.

It is a matter of common sense that, if the CAN is to be viable over the longer term, its costs must be covered. Of course, the CAN is an asset shared by several services, and all of those services bear some responsibility for contributing to its costs. For this reason, Telstra has always modelled the CAN’s costs on a basis that shares responsibility for its costs among the various uses and users that make use of it.

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28. In thus apportioning costs, Telstra has adopted the same approach as that used by the ACCC in its NERA model, as well as that adopted by forward looking cost exercises carried out by telecommunications regulators overseas. In Australia, as in every other jurisdiction which has used forward looking modelling of the CAN for regulatory purposes, this results in an allocation of costs to the PSTN basic access service – that is, the service for which end-users are charged the line rental.

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Because of the price cap regime, in Australia, the costs allocated to the basic access service exceed the maximum revenues Telstra can secure from line rentals. There is consequently a shortfall – generally referred to as “the access deficit” – and if all costs are to be recovered, the amount of that shortfall must be sought from elsewhere. As the deficit arises from constraints on the PSTN line rental – that is, from the provision of a fixed connection which serves to carry PSTN traffic – it is natural to seek its recovery from the traffic which PSTN lines carry.

Similarly, because both Telstra and its competitors use the PSTN lines to supply services, both should contribute to funding the access deficit.

If Telstra’s competitors were not required to contribute, the result would be plainly contrary to the long term interests of end-users:

• The heavier burden that would fall on Telstra would prevent it from competing with access seekers on the merits; as a result, access seekers might expand even though their costs were higher than Telstra’s. Efficient competition, rather than being promoted, would be undermined.

• Additionally, access seekers’ incentives to use Telstra’s infrastructure would be artificially increased, while their incentives to build infrastructure of their own would be reduced, even when doing so would reduce costs overall.

• While the demands on Telstra’s infrastructure would be increased, its long run ability to fund that infrastructure would be undermined, as the prices it could charge for its services would meet the constraint of pricing by ‘free riders.’

In Telstra’s view, all of these outcomes are inconsistent with the statutory criteria. That has been the ACCC’s firmly stated position too, at least until this Discussion Paper. For example, in assessing Telstra’s proposed PSTN Undertaking in 2000, the ACCC stressed the need to include the access deficit contribution to maintain competitive neutrality:

“The Commission notes that if an access deficit contribution were not included in charges for the declared PSTN services, then service providers could supply calls to end-users in competition with Telstra at a price that did not include the access deficit contribution. To compete, Telstra would need to remove the contribution

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from its retail charges to end-users thus reducing the scope for Telstra to recover the deficit from end-users.

In the short term, this could result in Telstra recovering the entire access deficit from monopoly services, or if there were restrictions in it doing so, not recovering the access deficit. This would be likely to harm both Telstra’s legitimate business interests and discourage economically efficient levels of investment. Consequently, to maintain ‘competitive neutrality’, it would seem to be legitimate for Telstra to recover an access deficit contribution through charges for the declared PSTN services.”2 [Emphasis added]

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The ACCC continued this argument in August 2000 when it stated that:

“….if an access deficit contribution were not included in charges for the Telstra declared PSTN services, then service providers, not subject to the same regulatory constraints, could provide services in competition with Telstra at an unfair advantage. To maintain ‘competitive neutrality’, it is legitimate for Telstra to recover an access deficit contribution through charges for the declared PSTN services as this deficit cannot be otherwise recovered on a commercial basis.”3 [Emphasis added]

That the ACCC should have adopted these views (which are documented more fully in Attachment 12) is hardly surprising when account is taken of the manner in which regulators overseas have handled this issue. Three aspects of the decisions taken by regulators overseas are especially worth stressing.4

First, to the best of Telstra’s knowledge, regulators overseas have consistently defined the access deficit in exactly the same way as it has been defined above: that is, as the difference between the costs allocated to the PSTN basic access service and the revenue that can be obtained from that service, given regulatory constraints. Additionally, in determining the efficient costs that are to be allocated to the basic access service, regulators have proceeded in the same way as Telstra (and until now, the ACCC): that is, using volume allocators within a forward looking cost model.

2 ACCC, 2000, A Draft Report on the Assessment of Telstra’s Undertaking for the Domestic PSTN Originating and Terminating Access Services, April, p. 46, and again repeated in ACCC, 2000, A Report on the Assessment of Telstra’s Undertaking for the Domestic PSTN Originating and Terminating Access Services, July, p 42

3 ACCC, 2000, Pricing Guidelines for Access Prices of PSTN Terminating and Originating Access Services Provided by Non-dominant or Smaller Fixed Networks, Position Paper, August, p 22

4 A fuller review can be found in Attachment 2.

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36. Second, having thus defined and measured the access deficit, whenever it was clear that it could not be recouped through raising charges to end-users, regulators have sought its recovery through a supplementary charge on PSTN traffic.

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Third, regulators have consistently stressed that to do otherwise would be inconsistent with the basic principle of competitive neutrality, as it would lead to the access provider being left with the burden of funding the CAN, while access seekers – who also use the CAN – would be freed of contributing to its costs. (The concept of competitive neutrality is reviewed and its implications discussed in Attachment 17).

In the United States, for example, the Federal Communications Commission, in deciding to provide for the recovery of the costs of local service, has – consistent with the requirements of s254 of The Telecommunication Act 1996 – sought to ensure that the ‘federal support mechanisms should be competitively neutral, neither unfairly advantaging nor disadvantaging particular service providers or technologies.’ 5

Equally, the Canadian Radio-television and Telecommunications Commission (CRTC), in determining the means to be used to support local service, has stressed that “the mechanism must be fair to all market participants and should not adversely affect one service provider over another. It should also promote economic efficiency by limiting distortions in the telecommunications market. Further, the mechanism should be competitively equitable by promoting the efficient allocation of resources and avoid unfair advantages to any service or service provider.”6 On this basis, it has consistently emphasized that all suppliers of inter-exchange services must share equitably in the costs supporting basic service entails.

It is at times claimed that OFTEL’s decision not to allow BT to recover an ADC represents an exception to this approach. These claims are inaccurate. The fact of the matter is that OFTEL found that regulatory constraints did not prevent BT from recovering CAN costs, as determined using the same approach that Telstra and the ACCC have adopted in the past. There was, in other words, no AD in the sense in which Telstra has consistently used that term – i.e. the component of properly allocated CAN costs that cannot be recovered through charges for the basic access service as a result of regulatory constraints. It was on this basis – because there was no access deficit – that OFTEL decided not to provide for an ADC, rather than because it felt that BT’s competitors should be excused from bearing the costs of any access deficit.

5 FCC, 2002, ‘Report and Order and Second Further Notice of Proposed Rulemaking’, adopted 12 December 2002, and released 13 December 2002, para 7 and accompanying footnote.

6 CRTC, 2000, para 9.

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41. In short, recognising that an access deficit exists, that it must be funded, and that its funding should fall equitably on all competing users of the PSTN, is fully consistent not only with commercial common sense and with the requirements of the statute but also with the approach adopted by regulators internationally.

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In Telstra’s view, the issues that arise in respect of local calls are no different from those that are posed by the access deficit.

As with the access deficit, so in the case of local calls, generally accepted cost allocation methodologies lead to an allocation of costs, including those of the CAN, that reflect the usage local calls make of the infrastructure those costs provide. These methodologies are exactly the same as the ones the ACCC uses to allocate the costs of the IEN and has consistently used to allocate CAN costs to the basic service. That is, they unitise the pool of costs over the range of uses which those costs support.

This allocation of costs, including the otherwise unrecovered costs of the CAN, results in local calls being asked to provide an overall contribution that exceeds the amount that can be obtained from local calls, given the price cap on those calls. There is consequently a shortfall that is simply no different in kind from that which is described as the access deficit. And in exactly the same way as for the access deficit, if total costs are to be recovered, this shortfall must be met through other revenue sources.

If the burden of recovering this shortfall is placed on Telstra and Telstra alone, that will be inconsistent with competitive neutrality for the same reasons as those set out above. Telstra is required to provide a local call service. If it and it alone must bear the cost recovery burden that involves, then it will have to obtain a greater proportional contribution to the access deficit from other types of calls than will its competitors. This is contrary both to efficiency and to Telstra’s legitimate interests.

Ensuring competitive neutrality requires that the local call service is not allocated a greater share of the responsibility for covering the access deficit than it can fund, given the price cap constraint. As a result, some of the burden of recovering the access deficit must be shifted on to other calls, so as to ensure that all users of the PSTN contribute equitably to the costs of the CAN.

Exactly this issue has, of course, been faced in other jurisdictions where there are overall constraints on local call charges. In particular, many US States and Canadian provinces require the supply as part of the local access service of an unmetered local call, which essentially implies a local call price cap of zero.7

7 The situation in these jurisdictions is different from that in New Zealand, where the controls only apply to residential service. In these jurisdictions, as in Australia, the controls apply to services provided to all end-

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48. Telstra is unaware of any jurisdiction where there are binding constraints of this type on the local call service and they have not been taken into account in determining PSTN access charges. Rather, regulators have recognised that these constraints are simply no different from those that apply to the basic rental, and hence need to be factored into the overall access deficit.

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Telstra consequently believes that if the ACCC is to act consistently, that is, in a manner that meets the legitimate expectations of the parties affected by its decisions, it should:

• Apply the same methodology it uses to allocate other common costs to allocate the costs of the CAN;

• Recognise that this results in an allocation of costs to the PSTN basic access service that exceeds the maximum revenues that service can generate, given the price cap;

• Accept that the resulting shortfall needs to be recovered in a manner that is competitively neutral – that is, that ensures that both Telstra and access seekers contribute on an equitable basis to the costs of the CAN assets which they both use;

• Also recognise that applying the methodology which both it, and all regulators overseas, have used to allocate efficient costs to local calls results in the allocation of an amount of costs, including contributions to otherwise unrecovered CAN costs, that exceeds the maximum revenues that can be secured from local calls;

• Accept that this shortfall too needs to be recovered in a manner consistent with competitive neutrality, all the more so as Telstra and Telstra alone cannot escape the obligation of providing local calls; and

• Set a corresponding access deficit contribution than ensures that all efficiently incurred costs can be recouped.

In Telstra’s view, these issues are uncontroversial and should represent common ground between Telstra and the ACCC. As Telstra has noted, they have been extensively debated overseas, and the position that has emerged from that debate is wholly consistent with the views it has set out.

users, so that shortfalls in respect of one type of user cannot be recouped through higher mark-ups to others.

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51. Telstra has carefully examined the arguments the ACCC has put. In its view, these arguments, taken individually and collectively, lack merit. The next section of this Submission sets out the reasons for this in detail.

B. The ACCC’s arguments

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In this section of its Submission, Telstra examines the following issues:

• Whether economic profits are relevant to the determination and treatment of the access deficit;

• The interpretation of Telstra’s investment to date, and the link between the access deficit and efficient investment;

• Whether Telstra charges itself an access deficit and more generally, whether charging an access deficit involves the recovery of ‘consequential losses’;

• The allocation of costs, including those of the CAN, to local calls, and its implications; and

• If there is an access deficit contribution, how it should be apportioned as between flagfalls and call durations.

(1) Economic profits and the ADC The ACCC asserts that studies it has undertaken have shown that Telstra earns economic profits from the PSTN. Elsewhere in the paper, the ACCC also says that competition has developed more slowly than it expected in non-PSTN services, with the result that prices in those services are likely high relative to costs.

The ACCC appears to draw from these assertions two, somewhat different, inferences. A first inference is that Telstra does not in fact incur an AD, as the overall revenues associated with some complex of services, that includes the CAN, exceed the overall costs those services involve. A second inference is that even if there were an AD, the revenue shortfall could and at least potentially should be covered by the margins the ACCC claims to have identified.

Definitional issues - the need for consistency with costing the Inter-Exchange Network

With respect to the first of these inferences, Telstra agrees that whether it does or does not incur an AD must depend on how the AD is defined. It could well be that some,

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essentially arbitrary, way could be found of defining the AD such that it no longer exists.

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Little purpose is served, however, by engaging in such definitional exercises. The substantive issue is how the costs associated with the CAN should be covered.

That said, it is Telstra’s view that if the ACCC wants to engage in definitional analysis, then the approach adopted to defining the AD must be consistent with the overall methodology used for determining and allocating costs.

It is clear that the ACCC, when it seeks to infer from the claim that Telstra’s revenues cover its overall costs, the claim that there is no AD, is acting in a manner that is inconsistent with its wider approach to defining and allocating costs.

To see this, it is important to start by noting that in line with international practice, both Telstra and the ACCC have adopted the view that to analyse the cost structure of telecommunications networks, it is useful to separately identify the costs of the CAN and of the Inter-Exchange Network (“IEN”) respectively, though the boundaries between these networks are changing and are becoming ever less well defined. It is also common ground that in reality, each of these networks is used by a wide range of services and not merely by those associated with the PSTN. It is equally universally accepted that each of these networks involves some costs that are joint and common to the full set of services, and others that are not. Finally, it is clear that the services of each of these networks are used both by Telstra and by access seekers.

In Telstra’s view, the same approach should be adopted to determining the costs of the CAN as is adopted to determining the costs of the IEN. More specifically, just as the ACCC has accepted that the joint and common costs of the IEN should be determined by allocating costs among uses and users in line with usage, so should the costs of the CAN be allocated among uses and users relying on a usage key. Alternatively, if the ACCC believes that there is some other, preferable, basis for the allocation of those costs, it should articulate that basis and apply it consistently and rigorously across the full complex of assets involved in the provision of the declared service(s).

In taking this view, Telstra notes that adopting an inconsistent approach to determining service costs in the CAN and in the IEN would be economically irrational.

Adopting an inconsistent methodology would be economically inefficient, and hence at odds with the statutory criteria, for at least three inter-related reasons.

First, the nature of common costs or the appropriate manner of their recovery is in no way altered by the mere fact of whether they are incurred in the CAN or in the IEN. To allocate one set of costs on one basis, and another on a completely different basis,

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would distort price signals to final consumers. (The consequences for efficient pricing of alternative approaches to CAN cost recovery are dealt with in more detail below).

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Second, adopting an inconsistent methodology for the CAN and the IEN would distort price signals to suppliers. Access seekers would face a price signal that encouraged them to rely on Telstra’s CAN while by-passing the IEN, regardless of the relative efficiency of these choices. At the same time, Telstra would be incented to avoid costs in the CAN and incur them in the IEN. Over time, network build decisions as to the location of functions and costs in the CAN and in the IEN would inevitably be distorted.

Third, such inconsistent treatment would aggravate regulatory gaming as where costs fell (as between the CAN and the IEN) would be of considerable significance. Accurate regulatory decision-making would be further undermined, with further damage to economic efficiency.

As a result, if the ACCC wants to adopt a new approach to cost allocation, then it should articulate and defend the rules involved in that approach, and apply them consistently to both the CAN and the IEN. To date, the ACCC has not articulated any such consistent approach, despite the extensive opportunities it had to do so in the review of the RAF. Failing that, it should apply to the CAN the methodology it has clearly accepted for determining the allocation of joint and common costs within the IEN. If that is done, then there can be no doubt that the CAN costs determined to be associated with the provision of basic access exceed the revenues that can be obtained for the supply of that service.

Recognising this does not prejudge, or in and of itself determine, the issue of how the resulting shortfall should be recouped.

Economic profits and the recovery of CAN costs

As Telstra has noted above, regulators internationally, whenever they have faced a situation where the costs of the basic access service could not be recovered directly from consumers by reason of regulatory constraints, have sought to ensure that responsibility for recovery of the resulting shortfall was allocated on a usage oriented basis as between the access provider and access seekers. There are, in Telstra’s view, compelling grounds for this approach, both in terms of competitive neutrality and of economic efficiency more generally, so that it is not surprising that it has been so widely adopted.

The ACCC’s paper suggests moving away from this approach on the grounds that Telstra, it claims, earns economic profits, be it on the PSTN or on some wider set of services. In Telstra’s view:

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1. The ACCC has no sound basis for claiming that Telstra earns economic profits, much less monopoly profits, on the PSTN or more widely;

2. Even if it did have such a basis, the ACCC has no sound basis for claiming that Telstra would continue to earn those profits should access prices be set on the basis it advocates;

3. It would in any event be inefficient and contrary to the statutory criteria to use the economic profitability of Telstra’s PSTN services as the basis for determining responsibility for recovery of CAN costs; and

4. Matters are not improved if it is the economic profitability of some wider set of Telstra services, rather than merely the PSTN, that is used as the basis for determining responsibility for recovery of CAN costs.

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Before turning to a detailed consideration of these points, it is worth emphasizing that Telstra does not agree with the ACCC that “the question is whether removal of the ADC would make the PSTN unprofitable.”8 Rather, the key issue that must be addressed is whether removal of the ADC would be consistent with the statutory criteria – which in Telstra’s view it would not. A careful assessment of the arguments the ACCC advances in respect of economic profits shows that those arguments cannot alter that conclusion.

(i) Whether Telstra earns economic or monopoly profits

The ACCC claims that it has carried out analyses that show that Telstra earns economic profits from the supply of PSTN services. It also suggests that Telstra likely earns economic profits from the supply of the wider complex of service that use the CAN.

The ACCC’s analysis relies on the Historical Cost Accounting (“HCA”) information derived from the RAF. However, it is well known that inferences with respect to economic profitability cannot be drawn from HCA data in any simple way (see Attachment 3). Indeed, if the ACCC believed otherwise – that is, if it thought that HCA data accurately reflected economic costs – it could have relied on that data for the setting of access charges, rather than requiring the use of forward looking costing methodologies, with all the difficulties and delays that involves. In using HCA data “as if” they reflected economic costs, the ACCC is being inconsistent with its own,

8 Discussion Paper, at page 13.

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repeated, criticisms of HCA information. The ACCC’s reliance on HCA means that its estimates of profitability have no economic basis.9

73.

74.

75.

76.

77.

It is no less seriously misleading to assume, as the ACCC seems to, that any economic profits Telstra earns are monopoly rents – that is, profits derived from the restriction of output. In particular, to draw any such inference shows a deep misunderstanding of the regulatory context in which Australian telecommunications has operated since the late 1980s.

The essence of that context is that Australia relies on incentive regulation in regulating consumer prices. A path is determined for Telstra’s regulated retail prices, relative to inflation, that requires those prices to fall by at least a pre-established percentage amount each year in real terms (that amount being the “X” factor in the “CPI minus X” formula). As explained in Attachment 4, this X factor has been determined by the Minister inter alia so as to protect consumers from any market power that Telstra may have.

Given this X factor, Telstra, to maintain or increase its rate of return, must increase its Total Factor Productivity (“TFP”) – broadly, the efficiency with which it converts its inputs of capital, labour and materials into outputs – by at least the X factor. If Telstra increases its TFP by more than the X factor, it can retain the profits this entails, at least into the next period when the X factor is reset.

By thus creating a profit incentive for productivity to be increased, the mechanism simulates the outcomes of a workably competitive market. In such a market, firms that do better than the benchmark profit from their efforts; conversely, firms that lag behind suffer losses. In this respect, a workably competitive market differs from one that is perfectly competitive – that is, a market in which market disciplines are such that all firms constantly earn zero economic profits, with the result that there is no incentive to innovate. That perfectly competitive markets are not a useful or appropriate benchmark for economic regulation, while workably competitive markets are, and that incentive regulation offers distinct benefits to consumers and the wider economy, are points that have been widely recognised.10

A key implication is that the economic profits of firms subject to price regulation cannot be assumed to be the result of monopolistic output restriction; rather, they

9 The ACCC also suggests that perhaps the AD should be measured on the basis of historical costs. As the ACCC has repeatedly criticised historical costs, and nothing in the Discussion Paper resiles from those criticisms, Telstra fails to understand this suggestion. It is all the more peculiar as it would involve a single infrastructure being costed using conflicting and inconsistent approaches to asset valuation.

10 See Re Dr Ken Michael AM; ex parte Epic Energy (WA) Nominees Pty Ltd & Anor [2002] WASCA 231 [(“Epic”) decision].

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come from, and are the stimulus to and reward for, outperforming the regulatory benchmark.

78.

79.

80.

This view has been reaffirmed by the Supreme Court of Victoria in its May 2001 decision in TXU Electricity Limited v. Office of the Regulator-General, where it found that firms subjected to incentive regulation should be entitled to the gains in excess of what are stipulated under the price controls:

“Under a price incentive regulation, the regulated firm is rewarded for its efforts in directly improving its profit over a fixed period, usually of some length, and the regulator does not attempt on the review to pass the profits made back to the consumer. In other words, the firm is entitled to reap the benefit of its efficiency in reducing prices and increasing its profits.”11 [Emphasis added]

Again,

“… a CPI--X price capped regulation is an incentive based regulation aimed at ensuring economic efficiency, which is in the interests of both supplier and consumer. The price is fixed on a certain basis, and if the supplier is able to reduce costs and/or increase demand, the supplier is entitled to keep the profits brought about by the efficient conduct of the business.”12 [Emphasis added]

And,

“The essential feature of an incentive regulation is that if costs are reduced and profits increase, the firm is entitled to keep the profits and the original price is fixed on that basis, which is of benefit to both consumer and supplier.”13 [Emphasis added]

The ACCC may, of course, take the view that the Minister has set the benchmark poorly. However, determining that benchmark is not part of the ACCC’s responsibilities. Nor is it properly open to the ACCC to seek to subvert the integrity of the incentive regulation mechanism by substituting its ex post assessment of appropriate profitability for the ex ante performance targets the Minister has established.

Telstra has analysed its TFP performance over the period of price cap regulation and the distribution of the gains from the increases it has achieved in TFP. That analysis,

11 TXU Electricity Limited (formerly known as Eastern Energy Ltd) v Office of the Regulator-General & Ors (2001) VSC 153 at 187, available at http://www.austlii.edu.au/au/cases/vic/VSC/2001/153.html

12 TXU Electricity Limited v Office of the Regulator-General & Ors (2001) at 206


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http://www.austlii.edu.au/au/cases/vic/VSC/2001/153.html


which is more fully set out in Attachment 5 shows that Telstra’s performance in increasing the efficiency with which it uses inputs has been very substantial.

81.

82.

83.

84.

85.

86.

[Confidential Paragraph]

Overall, Telstra believes that the ACCC would err if, despite its repeated criticisms of Historical Cost accounts, it relied on those accounts for the measurement of economic profitability (or for that matter, of the Access Deficit). It would also err if, despite frequent claims that it favours incentive regulation, it regarded economic profits earned under a scheme of incentive regulation as monopoly rents, that is, as arising from an undesirable restriction of output. This is all the more the case as the evidence from Telstra’s TFP performance, and from the distribution of the gains from the substantial and sustained productivity increases Telstra has achieved, are inconsistent with the inferences the ACCC seeks to draw in its Discussion Paper.

(ii) Whether Telstra would continue to earn monopoly profits

The ACCC not only asserts, without any sound empirical basis, that Telstra earns monopoly profits; in suggesting that these profits could be used to cover any otherwise unrecovered CAN costs, it also assumes that eliminating the ADC would not undermine that funding ability.

This assumption is all the more concerning as it is inconsistent with other assertions the ACCC makes in its Paper. In particular, the ACCC claims that should the ADC be removed, it would expect prices to fall by the full amount of the reduction in access charges, forcing down the level of charges for preselected services generally. This would naturally imply that Telstra’s own prices for those services would fall. However, as is shown in Attachment 6, the ACCC’s calculation of the impact on Telstra of removing the ADC does not capture the consequences of this full pass-through assumption and under-estimates the adverse impact on Telstra by over 50 percent. Nor does the ACCC provide any assessment of what would happen to charges once the initial reduction had flowed through – if competitive pressures would durably increase, as it claims, presumably the effects would not be once-and-for-all.

Furthermore, Telstra is most unlikely to be able to recover the ADC from other sources. Attachment 7 shows that Telstra’s options in this respect are very limited, even putting aside the obviously important issue of whether so seeking recovery elsewhere would be efficient.

As a result, the ACCC has no basis in fact or analysis for its assumption that Telstra could continue to finance the costs of the CAN were the ADC removed.

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(iii) Whether Telstra’s economic profitability is relevant to the determination of access charges

87.

88.

89.

90.

91.

Even if the ACCC had established (and it has not) that Telstra earned economic profits from the PSTN, or from the wider set of services that use the CAN, Telstra submits that establishing that fact would not provide a sound basis for imposing on Telstra and it alone the burden of financing the costs of CAN.

To begin with, even if the ACCC believed – and (for reasons set out below) it would err in doing so – that economic profits provided a sound basis for allocating the burden of CAN costs, there can be no reason for analysing Telstra’s current and forecast economic profits and not those of access seekers. To do so would imply differential taxation of Telstra’s profits, in a manner inconsistent with promoting efficient competition and supporting efficient investment. Rather, what the ACCC would need to do is analyse the profitability of each user of the CAN, contingent on the proposed level of access charges, so as to ensure that economic profits were being taxed in a competitively neutral manner.

Even were that done, economic profits would still provide a very poor basis for determining the allocation of CAN cost recovery.

First, economic profits are notoriously difficult to measure and even more so, predict. The difficulties, both practical and conceptual, are even greater when what is attempted is the measurement of the performance of only a segment of the activities of a wider corporate entity. Distributing the burden of CAN recovery on this basis would involve substantial uncertainty. Additionally, it would provide strong incentives for parties to distort these measures, and hence would only add to the error inherent in seeking to assess economic profits. The overall result would be to increase regulatory error and regulatory risk.

Second, taxing economic profits cannot but distort the incentives to be efficient and hence undermine productive and dynamic efficiency. Indeed, the very concept is directly inconsistent with the goal of incentive regulation, which relies on harnessing, rather than punishing, the profit motive. Ex post profit taxation, which is what the ACCC seems inclined to consider, mimics the worst forms of cost-plus regulation14, quite in contrast to the direction Australian telecommunications policy has taken since 1989.

14 The essence of cost-plus regulation is that the firm is prevented from earning profits in excess of its cost of capital, and hence has little incentive to act efficiently. The ACCC’s “profits tax” approach is obviously inferior to even cost-plus regulation in that it curtails the ability of the firm to earn profits without in any way preventing it from incurring losses. As a result, it will have a far more harmful effect on investment than pure cost-plus regulation is generally thought to have.

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92. Third and related, by making the contribution to CAN costs dependent on a firm’s profits, such an approach would allow firms that did relatively poorly to continue to use society’s resources while preventing those that did well from expanding as rapidly as they otherwise would. However attractive so propping up competitors may seem, the High Court’s recent Boral decision confirms that it has nothing to do with the promotion of competition.15

93.

94.

95.

96.

Fourth, the allocative consequences of profits taxation are difficult to predict but are generally likely to be harmful. Given the measurement difficulties involved, taxes that fall only on pure profits, much less on monopoly rents alone, are simply not achievable in the real world. Moreover, actual profits are a narrow and unstable base on which to tax, and measured profits are likely to be even worse in this respect. Actual tax rates may therefore be high but fluctuating, causing substantial price distortions. Additionally, a tax on profits is in practice a tax on a factor of production, and hence will distort input choices, in ways that increase costs and hence prices. Finally, even when firms sell differentiated products, and face customers with different switching costs, there is no a priori reason to believe that the incidence of a profits tax will fall on the least elastic demand – see Attachment 8. For all of these reasons, the ultimate incidence of profits taxes is highly uncertain, but there is no reason to think such taxes will yield improvements in the efficiency with which resources are allocated.

Fifth, all of these inefficiencies will be compounded if the tax falls on one firm and one firm alone. This is because any such discriminatory taxation would prevent that firm from competing on the merits, thus increasing the likelihood of inefficient sources of supply expanding while an efficient source of supply was forced to contract.

Given these deficiencies, it is unsurprising that taxes on profits have little intellectual respectability and have not been seriously considered, much less adopted, by any telecommunications regulator.

(iv) Whether considering a wider set of products than the PSTN would improve outcomes

The ACCC suggests that rather than the focus being solely on the income position of the PSTN, the relevant profits that should be used to finance the CAN could be defined more widely as those earned from the supply by Telstra of the full set of services that use the CAN.

15 Boral Besser Masonry Limited v Australian Competition and Consumer Commission [2003] HCA 5 (7 February 2003).

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97. Elsewhere in its Paper, the ACCC makes essentially the same proposal, though in a different guise, when it suggests that Telstra’s revenues from the PSTN and the ISDN as a whole, and presumably of other CAN-using services as well, should be offset against the costs of the CAN. Obviously, if these revenues merely covered attributable costs and a legitimate share of common costs, offsetting them in this way could not provide a contribution to the otherwise unrecovered costs of the CAN. For this proposal to make any sense, it must be based on the premise that there are economic profits that accrue to this wider set of services and that can and should be taxed to cover the CAN’s otherwise unrecovered costs.

98.

99.

100.

101.

In taking this approach, the ACCC seems not to recognise that in the forward looking costing methodology Telstra has adopted, all services that use the CAN are allocated a share of the CAN’s costs. The CAN’s costs are, in other words, allocated among services in exactly the same way as are the costs of the IEN. There is consequently no sense in which these other services do not contribute to CAN cost coverage.

What the ACCC proposes is therefore that these services should contribute additionally and more than proportionately to the otherwise unrecovered cost of the CAN, with that supplementary contribution reflecting their alleged profitability. In Telstra’s view, such an approach would merely compound the already serious harm inherent in reliance on profits taxation.

To begin with, the difficulties involved in measuring and predicting economic profitability for services such as the ISDN, xDSL or cable modem service are surely even greater than those associated with the measurement and prediction of the economic profitability of a hypothetical PSTN-only CAN.16 For example, to the best of Telstra’s knowledge, there are no TSLRIC models for services such as these, so the calculation of economic costs would be largely if not entirely arbitrary. Regulatory error and regulatory risk would consequently be further increased.

Additionally, taxing the profits from such services, many of which are undergoing rapid technological change, would create formidable distortions to incentives. To begin with, it would discourage the development of services that successfully exploited potential economies of scope, as the profits from these would go into the tax base. In the longer run, economies of scope that could provide real cost savings to the community would be foregone.

16 Of course the CAN modelled in PIE 2 is not PSTN-only. However, if the ACCC wanted to measure economic profits on a TSLRIC basis, it would need to construct such a model not merely for those components the ISDN shares with the PSTN but also for the ISDN specific elements. This would require the ACCC to determine the best way in which a network built today would provide the service potential that corresponds to the ISDN, as well as for each of the other services it needed to cost. Telstra is unaware of any TSLRIC model that does this.

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102. Moreover, the taxed entity would face a situation where new services that failed would have their losses at least partly offset through the lower burden of taxation, while successful projects would be penalised. The result would be to distort the level and structure of risk-taking and more generally to discourage the efficient management of risk.

103.

104.

105.

106.

107.

Finally, the harm would be all the greater if the tax fell on Telstra alone. Again, the result of such an arrangement would be to hinder or prevent Telstra from competing on the merits, as successful services that it developed were taxed while those of its rivals were not.

Economic analysis shows that where services are new and uncertain, and hence where the regulator is poorly placed to determine whether and how they should be provided, the need is even greater than it is in more mature areas for the regulated firm to have strong profit-based incentives for efficient performance. The information asymmetry between the firm and the regulator is greatest in these areas; so too are the inherent uncertainty as to what efficient service provision involves and the potential gains from “getting it right.” In these areas, the benefits of incentive regulation (which relies on the profit motive) are especially great relative to those of the type of cost-plus, zero economic profit, approach the ACCC seems to have in mind. Curtailing, through the kind of profits tax the ACCC proposes, the high power incentives for efficiency and innovative behaviour that profitability would normally provide is therefore all the more costly to consumers.

(2) The impacts on investment The ACCC asserts that Telstra has invested substantial amounts in its network, and that it would continue to so invest regardless of whether or not it received an ADC. The ACCC also claims that removing the ADC would not materially distort the build/buy decisions of Telstra’s competitors. As a result, the ACCC suggests that removing the ADC would not undermine efficiency in investment.

Set out below is first, the proper interpretation of the pattern of investment in recent years, second, a consideration of the impact removing the ADC would have on investment going forward and third, a review of its impacts on the efficiency with which the infrastructure would be used.

(i) The impact of access charges on investment to date

There is no doubt that Telstra has invested substantial amounts in its network in recent years, yielding substantial benefits to consumers. An important driver of this investment has been the strong growth of demand, with the number of access lines provided by Telstra growing, for example, from 9.5 million in 1997/98 to 10 million in

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2001/02. Absent sustained capital investment, it would not have been possible to meet demand growth without seriously compromising quality standards. At the same time, community expectations in terms of service levels have continued to increase and Telstra has faced ever more stringent regulated service level requirements. The upgrading needed to meet these has added to Telstra’s capital program.

108.

109.

110.

111.

That said, Telstra does not believe that a cursory examination of its historical investment levels, such as that seemingly carried out by the ACCC, can be of any relevance to the issue of the allocation of CAN cost recovery. Indeed, the ACCC’s examination suffers from the shortfalls discussed in Attachment 9. Even putting the errors noted in that Attachment aside, the ACCC cannot properly draw from its examination any inferences either as to the investment impacts of access charges to date or about the impact removing the ADC would have on investment going forward.

Starting with the investment impact of access charges to date, the ACCC seems confused as to how these should be examined. When entities are subject to obligations to serve, the investment required to meet those obligations is essentially non-discretionary. As a result, the impact of changes in the profitability of that investment does not take the form of a quantity adjustment (that is, a reduction in investment), as the ACCC seems to believe, but rather of a price change. Specifically, the value of sunk assets is written down,17 through a reduction in shareholder wealth, to the point where the overall anticipated return from existing and required new assets is just sufficient to permit the financing of non-discretionary investment going forward. Although it is obvious that this process of writing down sunk assets cannot continue indefinitely, it clearly can go on for some time in industries where the sunk costs are large relative to cash costs going forward. For so long as it does, the harmful impacts of artificially low access prices on the long-term sustainability of investment will not necessarily be apparent.

As a result, had the ACCC wanted to properly assess the effects access charges have had to date on long-run investment incentives, it should have examined not only the behaviour of Telstra’s investment outlays but also the changes that have occurred in recent years in its shareholders’ wealth. It is Telstra’s view that any such examination would have shown the impacts on Telstra of regulatory decisions to have been substantial and adverse.

Compounding these problems is the fact that the ACCC, though claiming to have examined whether access charges have undermined investment decisions, has not

17 It is obvious that this write down does not and need not involve any accounting change, but rather occurs through the equity market’s changing valuation of the regulated asset base.

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systematically examined the recent investment performance of Telstra’s competitors.18 Yet it is in the decisions of Telstra’s competitors – which unlike Telstra, are not subject to obligations to supply – that distortions in build/buy choices are likely to most rapidly become apparent.

(ii) Investment impacts going forward

112.

113.

114.

115.

116.

Turning now to the impacts that removing the ADC would have on investment going forward, the superficial nature of the ACCC’s assessment – which does not even attempt to identify and model the factors underpinning recorded levels of investment, and hence the impact of altering one or more of its determinants – means that no inferences can credibly be drawn.

For its part, Telstra believes removal of the ADC would seriously distort investment incentives.

As a matter of theory, it is obvious that the only charging arrangement fully consistent with efficient investment decisions by Telstra and competitors is one that replicates the structure and level of the costs of the infrastructure: in other words, that funds the CAN and any common costs of the IEN through a lump sum tax. As a matter of practice, no such lump sum tax exists or is readily conceivable. Compared with that theoretical, but unattainable, ideal, every other taxing arrangement will involve some measure of inefficiency. However, the consequences of not having an ADC would be especially severe because of the highly asymmetric impact on Telstra as compared to its competitors.

To begin with, by placing on Telstra the entire burden of financing the CAN, it would reduce Telstra’s competitiveness relative to access seekers, and hence alter the level of its investment and output as compared to that of its rivals (see the discussion of competitive neutrality at paragraph 127 below and following).

In addition to this direct effect, the signal sent to capital markets by such a decision would be extremely concerning – in essence, the ACCC would announce an intention to use Telstra’s profits, as measured by it, to fund an asset that is obviously used by Telstra’s competitors. While the precise impact this would have on Telstra’s ability to raise capital is difficult to forecast, the likelihood of a material adverse impact is surely apparent. This would compound the cost penalties Telstra would face, further undermining both its competitive position and its ability to invest.

18 Using a variety of investment indicators, Attachment 10 illustrates the CAPEX trends of Telstra’s competitors. Obviously, the ACCC could rely on its powers under the RAF to address this issue far more comprehensively.

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117. At the same time, it seems difficult to believe that removing the ADC would not affect access seekers’ investment decisions in terms of timing, extent and composition – see the discussion in Attachment 11. In essence, an access seeker that was considering replacing the use of Telstra’s CAN by construction of its own network would have to take account of the fact that it could use Telstra’s CAN for free. Although there are circumstances in which competing rollout might still proceed, some otherwise efficient by-pass is highly likely to be deterred.

118.

119.

120.

121.

122.

There are also likely to be differential, potentially distorting, effects among access seekers. The extent to which access seekers have invested in rolling-out access networks varies significantly. Removal of the ADC would benefit those who had made the least such investment, while disadvantaging those whose investments had been greatest. It may well be that all access seekers would see themselves as gaining from such a move, especially given its adverse effects on Telstra; however, any serious assessments of its consequences would need to take account of these differential effects.

The ACCC seems to believe that these distortions may be slight relative to those associated with including an ADC in access charges for the declared service. In particular, the ACCC seems concerned that charging an ADC may induce some inefficient by-pass in areas where duplication of the CAN is least costly.

While the possibility of inefficient by-pass cannot be ruled out a priori, Telstra does not believe it is of any real significance. In practice, commercial rates reflect the threat of by-pass, and access seekers use of Telstra’s infrastructure in CBD areas makes little contribution to the costs of the CAN. Moreover, as a practical matter, it is highly unlikely that by-pass decisions in CBDs are taken on the basis of access deficit considerations; rather they reflect access seekers’ interest in securing a wider range of traffic through fibre-based access networks. Additionally, even if inefficient by-pass in CBDs was a major concern – and in Telstra’s view, it is not – it could be dealt with through differentiating the charging structure, for example, by loading a higher share of the ADC onto terminating than onto originating traffic. Were access seekers likely to so engage in inefficient by-pass, there should be scope for mutually beneficial arrangements to be struck which would avoid it.

This reflects the fact that given the nature of the regulatory regime (in which the charges set by the regulator are far more likely to act as a cap than as a floor on access charges), commercial agreement can provide an effective, albeit obviously not perfect, means of ensuring that inefficient by-pass does not occur. In contrast, in such a regime, commercial agreement simply cannot readily provide the appropriate incentives for efficient by-pass should regulated access charges fail to do so.

As a result, the social costs (in terms of inducing inefficient investment or deterring efficient investment) associated with setting access charges that make too low a

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contribution to CAN costs are likely to be significantly greater than those that would come, in practice, from setting that contribution at levels that were in some sense too high. Again, this is because the charges announced by the ACCC are a ceiling and not a floor.

123.

124.

125.

126.

The fact that there have been few signs, if any, of inefficient by-pass under the current arrangements merely confirms this point. Indeed, the ACCC itself has portrayed the pattern of access seeker investment to date as highlighting the reasonableness of its approach.19

Overall, placing the entire burden of financing the CAN on Telstra, in a situation where access seekers make substantial use of the CAN, would have three effects on investment:

1. It would undermine Telstra’s competitive position, including by harming its ability to raise funds, while artificially advantaging Telstra’s rivals;

2. It would encourage access seekers to continue to rely on Telstra’s facilities, even when it would be more efficient for them not to do so; and

3. It would increase the regulatory risk bearing on overall investment in the telecommunications infrastructure.

Ultimately, these effects must erode Telstra’s ability to maintain and renew its network. At the same time, it is clear that any incentives access seekers have to invest in alternative networks, far from being increased, would be undermined. This is all the more so as were an access seeker to invest in a replacement CAN, it might find its investment treated in the same way as Telstra’s. As a result, the reach and quality of the infrastructure would suffer.

It is no answer to this to say that the ACCC could review its position if there were signs of investment levels being compromised. The ACCC cannot determine what investment levels are appropriate, by who and when. The ACCC plainly lacks the information and capabilities any such decisions require. Moreover, the notion of the ACCC turning the financing tap on and off, in line with its assessment of the adequacy of the industry’s investment levels, merely highlights the regulatory risk any such approach would involve. Rather, it is the ACCC’s responsibility to create a framework within which firms in the industry can take those decisions on a basis that is stable and predictable, competitively neutral and economically efficient.

19 See ACCC, 2001, Response to the Productivity Commission Draft Report : Telecommunications Competition Regulation, pg 28, and also BIS Shrapnel, 2001, Telecommunications Infrastructure in Australia : A Research Report Prepared for ACCC

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(3) Whether Telstra charges itself an ADC 127.

128.

129.

130.

131.

Having dismissed any impacts on investment, the ACCC goes on to claim that the ADC is arguably inconsistent with competitive neutrality. More specifically, the ACCC says that:

“It is questionable that such competitive neutrality arguments for an ADC and related contributions in PSTN OT [origination and termination] have much merit in the current circumstances. There are two main reasons for this. The first concerns whether Telstra in fact charges its downstream operations an ADC. The second point relates to whether Telstra faces an implicit transfer price anyway and what incentives are thereby created where it has downstream market power.”

To the extent to which Telstra understands the points being made, believes each of the ACCC’s claims is incorrect. Quite simply, by definition Telstra makes a contribution to the ADC by incurring the costs.

(i) Whether Telstra charges itself an ADC

The ACCC’s first argument is that Telstra does not charge itself an input price. A range of evidence is cited to the effect that “Telstra does not charge its retail arms an explicit charge for PSTN origination and termination”. The Commission concludes:

“This would mean [that] increasing the access price to its rivals [by including an ADC] would seem only to serve to increase the extent of non-neutrality that is inherent in the existing arrangements.”

This assertion seems plainly inconsistent with the economic notion of opportunity cost. Whether Telstra explicitly charges itself for the ADC or for PSTN origination and termination is completely irrelevant from an economic perspective. Even if Telstra agreed that it made no explicit charge for the ADC or for PSTN origination and termination in its formal price setting process, it would still face such a cost. Whenever an input price is set, whether by Telstra or the regulator, and that input is used by downstream suppliers that compete with Telstra, then ordinary profit-maximisation (that is, behaviour not involving anti-competitive use of market power)20 would drive Telstra to set prices in a competitively neutral manner. This occurs because the input price has an immediate impact on Telstra’s marginal costs, as can be readily shown.

Thus, in producing downstream output, Telstra must produce the upstream input at cost, that cost being an amount say, U. It also incurs a downstream cost, call it, D and if

20 For reasons summarised below, the imputation test can be used to make sure Telstra’s prices are not anti-competitive.

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it retails the product for price, R, its profit is R – D – U. Alternatively, it could sell the input for the access price, A, earning A - U.21 Thus, if Telstra chooses to retail its product, its opportunity cost is A – U. So, in general,22 for its operations to be profit-maximising, R – D – U must equal or exceed the opportunity cost so as to justify downstream supply. This in turn implies R – D must equal or exceed A, which is the essence of the imputation test. For Telstra to do otherwise would be to cut downstream prices to levels where less profit is made through vertically integrated supply than would be made by selling the input to a rival.

132.

133.

134.

135.

136.

In this sense, economic analysis clearly states that under normal conditions (and the ACCC has suggested no reasons why these would not apply), simple profit maximising behaviour will ensure that any ADC is reflected in Telstra’s pricing.

Whether Telstra, as a matter of practice rather than theory, acts as if it faces an internal ADC and PSTN origination and termination charges can be determined by an imputation test. The ACCC itself accepts this point in its recent Information Paper on bundling, where it states that:

"... an imputation test takes account of the wholesale access price an integrated carrier or CSP charges for the essential input that it supplies to its downstream competitors." ACCC (January 2003), Bundling in Telecommunications Markets - A Draft Information Paper, p. 16.

The fact that Telstra’s retail prices are consistent with an imputation test therefore demonstrates that Telstra indeed behaves as if it considers such charges to be opportunity costs. Telstra consequently fails to understand what basis, if any, there is for the ACCC’s assertions to the contrary.

Additionally, the fact that Telstra imputes an ADC to itself means that the charging of an ADC cannot give rise to a margin squeeze on competitors. Here too, Telstra fails to understand what basis, if any, there is for the ACCC’s assertions to the contrary.

(ii) The relevance of Telstra’s current margins

The ACCC’s second argument takes the opportunity cost response to its first argument as its starting point and then proceeds as follows: while “it is sometimes argued that” Telstra implicitly charges itself a transfer price, this ignores “the effects of market power in downstream retail markets [which]... contain a monopoly margin. In this

21 This assumes there are no diseconomies in supplying rivals, the presence of which would not materially change the analysis.

22 Exceptions could include product promotion, most especially when a product was new, and the need to meet competition.

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case, the opportunity cost of selling to an outside access seeker would include a loss of this monopoly margin [and an increase in the access price]... to outside access seekers...[so an ADC would] have the effect of retaining any existing monopoly margins.”

137.

138.

139.

140.

141.

142.

The logic underpinning the ACCC’s statement is by no means apparent. In effect, while the ACCC starts with the (correct) argument that a profit maximising Telstra would act as if it did charge itself an ADC, it then switches from the opportunity cost of a retail sale by Telstra (A – U from above, which is the opportunity cost relevant to the issue of how Telstra’s prices are set) to “the opportunity cost of selling to an outside access seeker” (R – D – U). Of course, the latter is simply not relevant to the argument (since it is not the opportunity cost Telstra faces when it sets its price, but rather is the result of how Telstra sets its price), while the former has nothing to do with monopoly profits, most especially when the access price is set by a regulator.

The ACCC then proceeds as if the ADC was to be set at an amount that reflects the margin Telstra earns on the sale of downstream services – that is, as if the ADC were intended to recover “the opportunity cost of selling to an outside access seeker”.

This, however, is completely inaccurate. Indeed, the fact that Telstra’s retail prices exceed the price floor as determined by an imputation test, both at current and proposed levels of the ADC, plainly implies that the ADC is not determined in this way. In effect, if the ADC were set in such a way that it recouped the margin Telstra earns on downstream sales (that is, the amount the ACCC refers to as “the opportunity cost of selling to an outside access seeker”), then the imputation test would, by necessity, be met exactly.

Rather, as the ACCC well knows, the ADC is merely set to recover that component of CAN costs allocated to the PSTN that because of the price cap cannot be recovered through rentals.

To say that including an ADC would allow Telstra to secure from access seekers the contribution margin it would otherwise have obtained from the sale of downstream services is therefore inconsistent both with the principles underpinning the determination of the ADC and with the empirical evidence generated by the imputation test.

(4) The ADC, “consequential costs” and Telstra’s legitimate interests Building on these errors, the ACCC then asserts that allowing an ADC would permit recovery of “consequential costs” and hence would be inconsistent with the statutory requirements. It implies that recovery of the ADC involves a form of the ECPR. It further suggests that not allowing an ADC to be charged would not undermine or be inconsistent with Telstra’s legitimate interests.

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143. It is difficult to understand the basis for these claims. The ADC does not reflect or recover consequential costs. Consequential losses flow increased competition. The ADC arises solely from the imposition of social policy. Put another way, the ADC forms part of the recovery of the total pool of efficient costs relevant to the service, that pool having been evaluated on a TSLRIC basis. Given that TSLRIC basis, and the fact that the ADC is merely intended to support overall cost recovery, there is no sense in which it can form part of monopoly profits.

144.

145.

146.

147.

148.

149.

To assert otherwise is to claim that the mere recovery of an efficiently incurred cost involves recovery of consequential losses. Since efficient costs are the amount that must be recovered in a competitive market (and hence which cannot be foregone merely as a result of the development of competition), this cannot be the case.

The claim that allowing an ADC would be a form of the ECPR, and hence should be precluded, is extremely difficult to credit. To begin with, the claim is plainly inconsistent with other assertions the ACCC makes. In particular, Telstra does not understand how the ACCC can both assert (1) that recovery of the AD is part of the margin built into Telstra’s current prices and hence that recovery of that amount from competitors is a form of the ECPR; and (2) that Telstra does not currently charge itself an ADC. Even putting that aside, if the mere recovery of efficient costs classifies as a form of the ECPR, and on that grounds should be precluded, then Telstra fails to understand how any common costs could be recovered.

Rather, in Telstra’s view, recovery of these efficient costs is required both for competitive neutrality – which is the basis for the development of efficient competition – and for the respect of Telstra’s legitimate interests.

In taking the view that recovery of efficient costs, and in particular of the access deficit, is required for competitive neutrality, Telstra is being consistent both with the repeated findings of regulators overseas (see Attachment 2), and with the position the ACCC has itself repeatedly put in the past (see Attachment 12).

That not including an ADC would breach competitive neutrality is readily shown. In effect, if an ADC is not recovered (so the sum of all access charges does not cover the total costs of the access network), then Telstra would incur a loss on every unit of input it sells to a competitor. If it tried to take account of the true opportunity cost of access in its own downstream sales this would put it at a competitive disadvantage to its rivals who do not see the true cost of access in the access charges they face. This is not competitively neutral, and represents the other side of the issue.

Assume, for example, that:

• U is the average direct cost of the access;

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• a contribution to common costs equal to ADC is required to cover total access network costs; and

• rival’s downstream costs are D (the same level as Telstra’s own costs).

150.

151.

Telstra would need to set R = ADC + U + D to ensure cost coverage,23 but its rivals could still be profitable at a price as low as U + D. Indeed, over time, rivals’ retail prices could force Telstra to set a retail price equal to U + D too, implying a shortfall relative to the revenue target required for cost recovery on every unit it supplies itself as well as on every unit it sells.

By violating competitive neutrality, exclusion of an ADC would distort competitive conditions both in the market for the declared service, and in the markets for services dependent on the declared services. The effect, as highlighted by the example set out in Attachment 13, would be to skew outcomes in ways inconsistent with promoting efficient competition and with promoting efficiency in investment in, and the use of, the infrastructure by means of which the declared services are provided. Table 1 below summarises the distortions which would arise.

23 For break-even to be possible, ADC would obviously have to be higher if Telstra only was paying for this, than if all parties were. This of course does not mean to imply that Telstra could secure that higher level of ADC; merely that for costs to be covered, it would have to raise more from itself than from others (which over time would not be feasible).

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Table 1 Efficiency consequences of removing the ADC

Type of loss Further description

Loss of productive efficiency (1)

If PSTN OTA prices are set too low so that they under-recover AD costs, the access provider will have to reduce its scale of operations in the long term. Its scale of operations will therefore be smaller than the efficient size.


If PSTN OTA prices are set too low to fully reflect AD costs, access seekers will be encouraged to use the access provider’s network, even if they could provide the service more efficiently themselves by deploying their own network infrastructure. The resulting lack of network competition also means that in the long run there is less scope for cost and price reductions.


If PSTN OTA prices are set too low for the access provider to recover its costs, then the access provider will in effect face higher network costs than an access or resale based entrant. This may allow firms with higher cost structures than the access provider to enter and compete effectively using access or resale based services.

Loss of dynamic efficiency (1)

If PSTN OTA prices are set too low to fully reflect the AD, then the resulting reduction in returns to investors in the CAN will reduce the incentive to innovate by investing in new network technology. This disincentive affects both the access provider and access seekers (who benefit from cheap infrastructure) and can limit or slow down innovation in the industry.

Loss of allocative efficiency because of advantages conferred on less efficient rivals

If PSTN OTA prices are set too low to fully recover the AD, the access provider may be so handicapped by higher network costs such that some or all of its market share is displaced by higher cost rivals. This means that society’s resources get misallocated to the consumption of services produced by the higher cost rivals.

152.

Quantifying the precise extent of these impacts raises obvious complexities, as it involves modelling a market that would be responding to significantly distorted prices. That said, these impacts would likely be very substantial. Thus, if it is assumed that the markets which Telstra supplies are strongly competitive24, then the result is simply to ensure that Telstra cannot cover its costs, and hence must ultimately be unable to meet its service obligations. Conversely, even if it is assumed that the markets at issue are not strongly competitive, the modelling set out in Attachment 14

24 This is what the ACCC implicitly does when it calculates the benefits it claims consumers would obtain from the option of excluding an ADC on the basis of full pass-through.

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shows, on conservative assumptions, that consumer prices would rise (rather than fall, as the ACCC seems to believe).

153.

154.

155.

156.

Additionally, that modelling shows that there would be a large-scale transfer of income from Telstra and its shareholders to the owners of its major foreign-owned competitors. This represents a direct loss of wealth from Australia and must be taken into account in any reasonable assessment of the consequences of the policy the ACCC is canvassing.

This transfer arises as Telstra fails to recover costs it would otherwise recover. In Telstra’s view, this is directly inconsistent with its legitimate interests, which include, but are not limited to,25 the recovery of costs prudently incurred. Indeed, Telstra believes that any other interpretation of the term ‘legitimate interests’ would be inconsistent with the Epic decision referred to above.26

(5) The treatment of local calls In Telstra’s view, the impact of regulatory constraints on the charging of local calls should be analysed no differently from that of regulatory constraints on access rentals. Indeed, Telstra rejects the notion of a local call deficit. There is an access deficit that needs to be recovered from retail and wholesale services that use the CAN, including local call services. Because of the operation of the retail price caps, local calls cannot contribute their fair share (defined using internationally accepted allocators). Consequently an adjustment to the contributions made by all other wholesale and retail services is necessitated by social policy. Failure to make such an adjustments raises the same problems as the ACCC’s main proposal to exclude wholesale services from contributing their fair share.

Thus, in respect of the CAN:

• Applying to the CAN the same methodology for the allocation of costs among uses and users as the ACCC uses in relation to the IEN results in an allocation of responsibility for cost recovery to the PSTN;

• That allocation involves an amount that, given the regulatory constraint, exceeds the revenues that can be secured from access rentals;

25 For example, Telstra has a legitimate interest in retaining income associated with its capacity to out-preform the price cap, the expectation of that income being both an essential part of the price cap mechanism and the offset for the higher risk to which price cap regulated firms are exposed.

26 See Epic (refer footnote 10 above), at paragraphs 130 – 131.

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• With the result that there is a shortfall to be recovered from other PSTN services, that recovery then being effected by means of the ADC.

157.

158.

159.

160.

161.

Equally, in respect of local calls:

• Applying to the various call types the same methodology for the allocation of costs among uses and users as the ACCC uses in relation to the IEN results in an allocation of responsibility for cost recovery to local calls;

• That allocation involves an amount that, given the regulatory constraint, exceeds the revenues that can be secured from the local call service;

• With the result that there is a shortfall to be recovered from other PSTN services, that recovery then being effected by means no different in principle from the ADC.

The ACCC, in contrast, claims that there is no basis for recovering any such shortfall. To this end, the ACCC argues that first, the view that there is a shortfall is inconsistent with economic definitions of a cross-subsidy; second, that its allocations of costs among calls are purely ‘notional’; and third, that Telstra’s other call services may earn more than their costs, and hence recoupment of any shortfall relative to allocated costs on local calls is unnecessary and potentially improper.

In Telstra’s view, the arguments put by the ACCC lack any merit.

(i) The economic definition of cross subsidy

The ACCC’s views as to the economic meaning of cross-subsidy, and its relevance in this context, are unclear. In particular, the ACCC claims that the economic definition of a cross-subsidy precludes the allocation of indirect or common costs; this is quite incorrect (see Attachment 15for a more detailed discussion); rather, the economic definition of a cross-subsidy simply states that prices are subsidy free if they are set at no less than incremental costs and no more than stand-alone costs. Indeed, quite in contrast to what the ACCC states, it follows from this definition that for any firm that achieves economies of scope, a set of prices, to be subsidy-free, must allocate the common costs associated with supply.27

The Commission also claims:

27 If the prices did not include those common costs, they would be below incremental cost for the combination of products defined by the full set of products. This would not involve a cross-subsidy between services (though the prices at issue might also involve a cross-subsidy) but rather a subsidy from producers to consumers.

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“The means by which Telstra determines there is a local call deficit implies a definition of “deficit” that does not appear to accord with basic economic principles. The identification of a local call deficit by Telstra relies on reallocating part of the AD to local calls and redefining this reallocated amount as a cost. This redefinition of a transfer as a cost is inconsistent with basic economic principles.” [The footnote here reads: “This is the definition of deficit consistent with Faulhaber, op. cit.”]28

162.

163.

164.

165.

166.

This completely misrepresents basic economics. A ‘transfer’ is a movement of income that leaves consumption possibilities unchanged; a ‘cost’ is an expenditure of resources that reduces the resources available for other uses. The resources used to supply the CAN (or for that matter, the IEN) are costs, not transfers, as using them for this purpose precludes their use elsewhere. By definition, recovery of common costs involves their allocation, explicit or implicit, to products that generate revenues through which those costs are covered. That allocation in no way converts the costs into transfers, any more than the allocation by the ACCC of the common costs of the IEN to various uses and users converts those costs into transfers.

The ACCC also misrepresents Telstra’s position. Telstra does not “reallocat(e) part of the AD to local calls (..) redefining this reallocated amount as a cost.” Rather, Telstra notes that because of the local call price cap, there are strict limits on the extent to which responsibility for recovery of the access deficit can be allocated to local calls – in exactly the same way that the price cap on basic rentals limits the extent to which responsibility for recovery of the costs of the CAN can be allocated to the basic access service. As a result, responsibility for recovering those costs, that absent the price cap would have been recovered by local calls, must be allocated elsewhere – again, exactly as responsibility for recovering those costs, that absent the price cap would have been recovered by the basic access service, must be allocated elsewhere.

In short, the only “transferring” Telstra is doing is seeking an allocation of costs consistent with the recovery of costs efficiently incurred.

(ii) The ‘notional’ nature of the ACCC’s cost allocations

Given these views in respect of the underlying definitions, the ACCC then argues that its allocation of responsibility for recovering costs among call types is purely ‘notional.’

The ACCC nowhere defines what it means by ‘notional’ or in what sense the allocation it effects is notional. The view that the allocation of the ADC is ‘notional’ seems

28 Discussion Paper, Section 8.2, at p. 27.

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difficult to reconcile with any of the dictionary definitions of the term.29 The fact of the matter is that the different call types play a central role in the cost allocation methodology adopted by the ACCC – for example, in allocating responsibility for the common costs of the IEN. That this procedure is in no sense ‘notional’ is clear from the fact that changes in the traffic mix affect that allocation directly, both as among uses and as among users, and have direct financial implications for the access provider and for access seekers.

167.

168.

169.

170.

171.

Also plainly inconsistent with the claim that the allocation is purely ‘notional’ is the ACCC’s approach of imputing an ADC to each call in the calculation of the price floor under its proposed imputation test.30 Were the allocation ‘notional’, it would be of no consequence if prices for any individual type of call covered the ADC, so long as it was recovered overall.

Rather, in Telstra’s view, the attribution or allocation of cost responsibility to local calls (as opposed to the other services provided by means of the IEN) is no more ‘notional’ than is the attribution or allocation of cost responsibility in respect of the CAN to basic access (as opposed to the other services provided by means of the CAN).31

(iii) Offsetting revenues from other PSTN traffic

Finally, the ACCC argues that even if local calls did not secure revenues sufficient to cover the costs allocated to them (including in terms of the ADC), the resulting shortfall might be offset by the revenues Telstra obtains from other types of calls.

In Telstra’s view, this claim is no different in its underlying logic from that discussed above as to whether any revenue shortfall on basic access is offset by revenues Telstra obtains from other services. As with that claim, it involves four key errors.

First, the ACCC has no empirical basis on which to assert that any revenue shortfall on local calls, relative to their allocated responsibility for cost recovery, is offset by revenues Telstra obtains from other services. Making out such an assertion would require not merely modelling the current or efficient cost of the end-to-end services

29 The New Shorter Oxford English Dictionary defines ‘notional’ as meaning: “Of or pertaining to an idea; of or pertaining to semantic content..; of knowledge etc.: purely speculative..; existing only in thought, imaginary; hypothetical..”.

30 Because the ACCC relies on a ‘retail minus’ approach for pricing the wholesale local call service, it is this charge that enters into imputation tests that involve local calls. The ‘retail minus’ approach for pricing the wholesale local call service is discussed below at paragraphs 181 and follows.

31 Indeed, calls are no more or no less causally responsible for the common costs of the IEN than they are for the common costs of the CAN. It would make little sense to say that the allocation of the latter to calls was ‘notional’ while that of the former was not.

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provided over the PSTN, but also determining the contributions required from those calls to cover the common costs of the network.32 To the best of Telstra’s knowledge, no such modelling has been carried out.

172.

173.

174.

175.

176.

Second, even if Telstra did secure positive contributions from other call services, that fact would be entirely irrelevant. Rather, the ACCC’s argument would need to rest on the ability to secure those positive contributions in the future. As Telstra faces strong and growing competition in the supply of preselected services, there is no reason to expect those services to generate substantial margins in the years to come. Indeed, the ACCC’s own assumption, in its Discussion Paper, that changes in access prices will be passed on to consumers (and hence will yield what it claims to be benefits), seems largely inconsistent with that proposition.

Third, call charges are subject to a price cap. As the ACCC has itself noted on many occasions, an important goal of the price cap, and more generally of incentive regulation, is to ensure that regulated firms can increase their profits by increasing productivity more rapidly than the “X” factor determined in the cap.

The evidence Telstra has set out clearly shows that its productivity performance has been extremely strong, though growing competition, as well as the cap itself, has resulted in the vast bulk of the productivity dividend being passed on to consumers. Given that the Government, in determining the cap, has ensured that Telstra is not in a position to exploit any market power, the profits earned under that cap are the reward to, and stimulus for, the superior productivity growth Telstra has achieved.

It is not the ACCC’s role to ‘second guess’ the Minister and Parliament in determining the appropriate cap. Nor should the ACCC act to undermine the system of incentive regulation by converting it into a de facto ‘rate of return’ approach in which earnings from price capped services which the ACCC judges to be ‘excess’ can be allocated to purposes the ACCC determines.

Fourth, all of the errors set out above are compounded by the ACCC’s focus on the revenues Telstra and Telstra alone derives from preselected services. Thus, the ACCC nowhere tests the margins derived by other suppliers of preselected services, or considers the ‘ability to pay’ that those margins involve. For the reasons emphasized above, no matter how poor a profit’s tax would be, as a way of funding the costs of regulatory imposts, a discriminatory profit’s tax would be even worse.

32 This is because contribution margins from those calls (i.e. the difference between their revenues and costs) might be required to fund other common costs (such as those the PSTN shares with other services) and hence not in fact be a potential source of coverage of the Access Deficit.

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(iv) The consequences of ignoring the local call price cap

177.

178.

179.

180.

181.

At the end of the day, ignoring the price cap on local calls amounts to requiring Telstra to pay towards the access deficit a higher amount per unit of preselected traffic than is required of Telstra’s competitors.

This is apparent from the ACCC’s own reasoning, which states that any contribution to the access deficit that, because of the local call price cap, Telstra could not secure from local calls, it can and should secure from other call types. Given that Telstra and Telstra alone is required to provide a local call service, and as a matter of commercial reality accounts for the bulk of the supply of local calls, this implies (1) that to the extent the price cap limits, as it does, the recovery of the amount of the access deficit allocated to local calls, Telstra will incur a shortfall; and (2) that shortfall will, in the ACCC’s reasoning, be matched by a higher rate of contribution to the access deficit from other call types.

In Telstra’s view, imposing this burden on Telstra and Telstra alone is plainly inconsistent with competitive neutrality. The result will be to distort incentives in many respects and to generate inefficiencies.

Thus, by the ACCC’s own logic, Telstra, if it is to achieve cost recovery, would have to seek and sustain a higher mark-up on preselected traffic than do its competitors. Even if that were possible in the longer run, and Telstra does not believe it is, the result would be to distort the allocation of output as between Telstra and its competitors, relative to the outcomes of competition on the merits – Telstra’s output of preselected services inefficiently contracting, while its competitors’ output inefficiently expanded.33 Additionally, there would, under any plausible assumptions, be an income transfer from Telstra to its largely foreign-owned competitors, in a manner inconsistent with Telstra’s legitimate interests and with Australia’s economic welfare.

At the same time, the incentives for access seekers to invest in efficient competition with Telstra’s local call service would be eroded. This is all the more the case given the ACCC’s “Retail Minus Avoidable Cost” (“RMAC”) approach to the charging of the Local Call Service (“LCS”), which means that access seekers, when they resupply local calls from Telstra, do not face the same requirement as does Telstra to secure a contribution to the access deficit.

33 The extent of this effect would depend on the long term switching elasticities, but implausible assumptions would need to be made for this effect not to occur. The inefficiency at issue is of course a productive one (rather than necessarily allocative). Since demand elasticities for the preselected services are low, even small productive inefficiencies will swamp any allocative efficiencies from any lowering of prices.

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182. More specifically, under the ACCC’s approach, whenever Telstra sells an additional local call:

1. That additional local call, all other things being held equal, results in an increased amount of the responsibility for recouping the access deficit being allocated to Telstra34;

2. That amount exceeds the amount that can be recouped from the revenue for that local call, given the retail price cap;

3. So that Telstra, if it is to break-even, must seek additional recovery elsewhere.

183.

184.

185.

186.

Access seekers, under the ACCC’s proposed approach, face quite a different choice:

• If an access seeker resupplied a local call under the LCS service, the terms on which it will do so include a contribution to the ADC only up to the amount allowed by the cap – which is less than the full ADC imputed to that call. The access seeker would face no need to recover any additional amount from its retail call charges;

• However, if the access seeker supplied its own local calls, those calls would have to contribute to its own access costs, presumably in much the same manner as Telstra’s.

To that extent, access seekers will have even stronger incentives to rely on the LCS, rather than deploying their own facilities, regardless of whether it would be efficient for them to do so.

There would, however, be an additional distortion, assuming that the ACCC also decided not to impose an ADC. In effect, faced with a fall in the PSTN OTA charge (resulting from removal of the ADC) access seekers could and would substitute use of OTA for use of LCS for local calls to an even greater extent than they now do. This is because the OTA service would provide a lower-charge way of delivering local calls, even though its social costs are likely higher, once account is taken of the additional infrastructure it requires.

As a result, there would be a dual distortion:

• Access seekers would rely on Telstra’s infrastructure rather than their own, even when it was inefficient for them to do so; and

34 This again highlights the fact that the allocation of cost recovery responsibility to local calls is not notional in any meaningful sense.

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• In using Telstra’s infrastructure, they would make skewed choices as between LCS and PSTN OTA.

187.

188.

189.

190.

191.

In Telstra’s view, these effects are not consistent with the statutory goals. Nor does Telstra believe that this assessment should in any way be altered by the ACCC’s claim that taking account of retail price caps on local calls, and hence including a contribution to the resulting shortfall, would cause access prices that were ‘high.’

Access prices based on efficient costs can be neither ‘high’ nor ‘low’ in absolute. Rather, costs are costs, and they are only ‘high’ or ‘low’ relative to the value society derives from the services for which those costs are incurred. If society values the service at more than the costs it must recover then it ought to be provided. Absent public subsidies, this requires making provision for cost coverage, and the ACCC is not in a position to command supply at prices that do not cover costs.

(v) Conclusion on the local call price cap

The ACCC’s arguments in respect of the consequences of the local call price cap are no different in substance from those it advances in respect of the access deficit. In Telstra’s views, they are no more correct in the former context than they are in the latter. Additionally, Telstra does not believe that the ACCC consistently determine these issues differently – that is, take one approach to the Access Deficit and another to the treatment of local calls.

As Telstra has noted, there is no sense in which the allocation of responsibility for recovery of common costs to local calls is ‘nominal’, as the ACCC now claims. When Telstra supplies an additional local call (or equivalently, added duration for a fixed number of local calls), the approach the ACCC has consistently adopted to the allocation of responsibility for recovery of common costs results in its incurring an added liability.35 Conversely, were the number or duration of local calls to fall, responsibility for recovery of common costs would shift, with a greater part likely falling on access seekers. This applies equally to the common costs of the IEN and until now, of unrecovered costs allocated to the CAN.

Whether Telstra earns or does not earn margins on other calls is not relevant to whether there is a shortfall on local calls, relative to the cost recovery responsibility allocated to them, due to the local call price cap. Additionally, even if Telstra did earn such margins, and could continue to do so in the future, taxing those margins to recoup that shortfall would be harmful for essentially the same reasons set out, in respect of the access deficit, at paragraphs 87 and following above.

35 In the form of a greater share of the responsibility for recovery of common costs, including the otherwise unrecovered costs of the CAN.

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192. Rather, it remains Telstra’s view that responsibility for cost recovery must be allocated in a manner that takes account of regulatory constraints on the costs individual services can recover. The failure to do so will breach competitive neutrality (as Telstra and Telstra alone is under an obligation to provide the price constrained services), prevent the development of efficient competition and raise prices to consumers. As the modelling Telstra has carried out shows, this will be the case even if one assumes, as the ACCC does at some points in its Discussion Paper but not others, that the relevant markets are not currently effectively competitive and are not likely to be so in the near future – a view Telstra strongly disputes.

193.

194.

195.

196.

197.

Finally, Telstra notes that in the United States and Canada, where regulatory constraints prevent full cost recovery from the local call service, regulators have taken this into account in determining access charges. This is, Telstra submits, precisely because the failure to do so could not be consistent with either the legitimate interests of the service provider, or with the long term interests of consumers.

(6) The allocation of common costs as between call numbers and call durations

The ACCC has maintained that the ADC should be allocated equally as between call numbers and call durations. In its view, such a 50/50 split is reasonable in the absence of any compelling logic for an alternative allocation.

In its recently lodged Undertaking, Telstra has proposed prices based on this allocation. However, this should not be seen as an agreement on the underlying principle. Rather, Telstra remains of the view that the ADC ought to be allocated to call flagfalls.

The ACCC disputes Telstra’s arguments on several grounds. A number of these are, in Telstra’s view, wrong as a matter of principle.

The ACCC claims that an allocation to flagfalls would not match the current pattern of retail prices. That the ACCC should use retail prices as the relevant comparator is surprising, given that it subsequently criticises Telstra’s estimates of the flagfall and duration elasticities as being derived from retail prices, rather than being elasticities for the declared service. That said, the ACCC’s comment is, in Telstra’s view, irrelevant, as it is obviously the case that the current structure of retail prices for PSTN services is influenced by the current structure of access charges. The issue is not the current structure of retail prices but rather that of developing charging arrangements for the declared service that best advance the goals of access pricing.

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198. The ACCC then turns to the issues involved in applying a Ramsey pricing approach to the allocation of the ADC as between flagfalls and call durations. The ACCC advances three basic criticisms of Telstra’s approach.

199.

200.

201.

202.

The first is that Telstra uses elasticities for final demand, while the service at issue is an input into the production of the final service. This criticism is incorrect. The input service is used in fixed proportions to produce the final service. As a result, the relevant elasticities fall out of those for final demand.

The ACCC’s second criticism is that even with a Ramsey approach, some share of costs should be allocated to each service. While this is correct in principle, the ACCC’s error is in not recognising that, when demands are interdependent, the share of costs allocated to a service need not be positive.

Finally, the ACCC criticises the specific estimates Telstra has used as being out of date.

Telstra attaches to this Submission a comprehensive model that examines the efficient allocation of the ADC as between flagfalls and call durations (see Attachment 16). As part of that work, the relevant elasticities are estimated using up-to-date data. The results confirm that the efficient allocation involves imposing the entire charge on flagfall. Telstra consequently believes the ACCC should amend its views in this respect.

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Attachment 1: Cross reference of ACCC questions to Telstra’s response

Question raised in the ACCC discussion paper

Reference to Telstra’s response Paragraph Numbers

1 Should access seekers still be required to make a contribution to the AD?

For reasons set out in its main Submission, Telstra believes securing efficient outcomes requires that all competing users of the PSTN contribute on a competitively neutral basis to recovering the costs of the access deficit.

87-95

2 If there is to continue to be an AD, how should it be defined and measured?

Telstra believes that the approach adopted in defining AD must be consistent with the overall methodology used for determining and allocating common costs. Therefore, Telstra submits that the same approach should be adopted to determine the costs of the CAN as is adopted in determining the costs of the IEN. This will result in the allocation of CAN costs to the basic access service in excess of the amount that can be recovered in line rentals. The difference between these amounts constitutes the AD.

55-67

3 If an ADC were to be retained, how should it be spread over calls and minutes?

Telstra attaches to this Submission a comprehensive model that examines the efficient allocation of the ADC as between flagfalls and call durations (see Attachment 16) using up-to-date data. The results confirm that the efficient allocation involves imposing the entire charge on flagfalls.

194-202

4 Is, it reasonable to incorporate a “local call deficit surcharge” to the charge for PSTN OT?

See answers to questions 16 and 17 below. 155-193

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5 The Commission seeks comments from interested parties on the real nature of the ADC; in particular whether it is notional or whether it should be viewed in the service specific way favoured by Telstra?

The ACCC has not defined what it means by ‘notional.’ In Telstra’s view there is nothing in the ADC to suggest that it is any sense hypothetical or only referring to a concept (which is the essence of the dictionary definition of notional). For reasons set out in its main Submission, Telstra believes that the ACCC’s allocations of common costs, including the otherwise unrecovered costs of the CAN are service specific and not in any meaningful sense notional. One obvious indicator of this is the fact that these cost allocations vary in line with the relative volumes of the different services.

96-104

6 Interested parties are invited to comment on Telstra’s profitability and incentives to invest efficiently in the PSTN, both in retrospect and in prospect.

For reasons set out in its main Submission, Telstra believes that the ACCC has seriously misunderstood (1) the nature of profitability in a regime of incentive regulation and the importance of protecting the incentives such a regime provides for efficiency and (2) the impact that removing the ADC would have on investment incentives.

Specifically on investment incentives, Telstra believes that the removal of ADC would seriously distort investment incentives. Placing the entire burden of financing the CAN on Telstra would have the following effects on investment:

• It would undermine Telstra’s competitive position, including by harming its ability to raise funds, while artificially advantaging Telstra’s rivals;

• It would encourage access seekers to continue to rely on Telstra’s facilities, even when it would be more efficient for them not to do so; and

Profitability: 71-82

Incentives to invest: 105-126

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• It would increase the regulatory risk bearing on overall investment in the telecommunications infrastructure.

7 Is it necessary to have an ADC — perhaps at a lower or a higher level than currently — in order to ensure the long-term viability of the PSTN?

It is likely that the removal of the ADC would erode Telstra’s ability to maintain and renew the PSTN. Furthermore, access seekers would be able to use the CAN for free, hence facing little incentive to build their own networks. Even if an access seeker did contemplate investing in a replacement CAN, it would run the obvious risk that its investment might be treated in much the same way as Telstra’s. As a result, if the ADC were removed, the reach and quality of CAN infrastructure is likely to suffer.

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8 Would the lack of an ADC put Telstra at a disadvantage in being able to efficiently recover its legitimate costs in the face of greater competition for its retail PSTN-based services?

The ACCC has asserted that retail prices would fall to reflect the reduction in access charges as a result of the removal of the ADC. Telstra faces very limited options to recover the ADC from other sources such as non-PSTN services because whereas Telstra is a price taker in markets with strong competition, in others, it is already likely to be profit maximizing. There is also little scope for OPEX reduction after the reductions in recent years while CAPEX reduction may affect service quality and/or network integrity. In short, absent the ADC, Telstra would not have viable, much less efficient, options for recovering its legitimate costs.

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9 Are there alternative ways of defining the AD? Should, for example, the Faulhaber definition of deficit be used for the AD?

The Commission’s comparison of Faulhaber’s definition of cross subsidy and the ADC makes little sense. The AD is concerned with whether Telstra is allowed full cost recovery. It measures the extent to which certain costs are not recovered by certain revenues. In contrast, the formal economic (Faulhaber) definition of cross-subsidy provides the circumstances under which one can meaningfully claim that a product or a group of products “cross-subsidise(s)” other products and is not at all well related to cost

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recovery. For example:

• Prices that do not involve cross-subsidies need not guarantee cost recovery: Wherever there are costs shared by all products, prices exist that involve no cross-subsidies, but which do not cover the costs of total production. These are any prices that cover the incremental costs of all combinations of products, but not the incremental cost of the whole.

• Subsidy-free cost recovery can be impossible: One of the singular results of the cross-subsidy literature was that subsidy-free prices might not exist at all. In such peculiar cases, cost-recovery with subsidy-free prices is impossible.

• Cost-recovery, in limited circumstances, is possible in the presence of cross-subsidy: A minimal requirement for this result is that competition is limited (since a cross-subsidy signals that stand-alone supply of the subsidised products is potentially profitable). Enabling such cross-subsidies was the reason commonly given to justify statutory protection of telecommunications monopolists.

10 Would the Faulhaber approach be consistent with Telstra legitimate commercial interests?

There is no inconsistency between using the Faulhaber approach to defining subsidy free prices and setting prices that recover all common costs, including those of the CAN. What Telstra seeks, and believes it has a legitimate commercial interest in securing, is full recovery of efficient

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36 Ibid, at p. 19. Two typographical errors were corrected in this quote. The actual quote reads, “the inclusion of these indirect costs may be able to be justified by having regard Telstra legitimate commercial interests in recovering all its reasonable costs.”

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costs. Thus, Telstra agrees with the Commission’s intuition when it says,

“The inclusion of indirect costs may be able to be justified by having regard to Telstra’s legitimate commercial interests in recovering all its reasonable costs”.36

In addition, dynamic efficiency demands that Telstra be allowed to recover the unrecovered AD costs elsewhere. Absence of such cost recovery would send a very poor signal to regulated firms, Telstra included, curtailing what would otherwise have been efficient future investments. Ultimately this would result in significant harm to the long-term interests of end-users.

11 Should the net revenues from services sharing common costs with the PSTN (especially the ISDN) be brought into the calculation of the AD? Should this also depend on the extent to which other service margins have faced increased competitive pressure in practice as compared to earlier expectations and what of their future performance?

In Telstra’s view, the same approach should be adopted to determine the costs of the CAN as is adopted to determine the costs of the IEN. More specifically, just as the ACCC has accepted that the joint and common costs of the IEN should be determined by allocating costs among uses and users in line with usage, so should the costs of the CAN be allocated among uses and users relying on a usage key.

In taking this view, Telstra notes that adopting an inconsistent approach to determining service costs in the CAN and in the IEN would be both procedurally unacceptable and economically irrational.

With respect to margins, see the discussion of profitability in Telstra’s main Submission.

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160-168

12 Should the AD be based on historic costs or continue to be based on

The Commission has consistently condemned HCA in the past and advance no arguments now that would change the substance of their

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forward-looking costs as measured in the n/e/r/a and PIE2 models?

criticisms. Again, adopting an inconsistent approach to determining service costs in the CAN and in the IEN would be both procedurally unacceptable and economically irrational. It would lead to distortions as the boundaries between the CAN and IEN shift.

13 Is basing the AD on a historical cost consistent with the LTIE criteria which is concerned with encouraging efficient investment?

See answer to question 12 above.

14 Are there any other issues interested parties consider are relevant to the definition and/or calculation of the AD?

There are a number of issues that are addressed in the body of the submission and the attachments.

15 The Commission invites interested parties to comment on the relative merits of allocating the AD to minutes as against calls, with particular reference to the efficiency criteria in LTIE.

Telstra attaches to this Submission a comprehensive model that examines the efficient allocation of the ADC as between flagfalls and call durations (see Attachment 16) using up-to-date data. The results confirm that the efficient allocation involves imposing the entire charge on flagfall.

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16 The Commission invites comments on whether it is possible to identify a “local call deficit”.

In Telstra’s view, the impact of regulatory constraints on the charging of local calls should be analysed no differently from that of regulatory constraints on access rentals. Thus:

(a) Applying to the various call types the same methodology for the allocation of costs among uses and users as the ACCC uses in relation to the IEN results in an allocation of responsibility for cost recovery to local

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calls.

(b) That allocation involves an amount that, given the regulatory constraint, exceeds the revenues that can be secured from the local call service.

(c) With the result that there is a shortfall to be recovered from other PSTN services, that recovery then being effected by means of a surcharge that is no different in principle from the ADC.

17 Parties are asked to comment on the impact on LTIE of increasing the ADC to reflect the possibility that the ADC cannot be fully recovered from local calls.

Ignoring the price cap on local calls amounts to requiring Telstra to pay towards the access deficit a higher amount per unit of preselected traffic than is required of Telstra’s competitors. Even if that were possible in the longer run, and Telstra has no reason to believe it is, the result would be to:

(a) distort the allocation of output as between Telstra and its competitors, relative to the outcomes of competition on the merits – Telstra’s output of preselected services inefficiently contracting, while its competitors’ output inefficiently expanded, and

(b) there would be an income transfer from Telstra to its largely foreign-owned competitors, in a manner inconsistent with Telstra’s legitimate interests and with Australia’s economic welfare.

Imposing this burden on Telstra and Telstra alone is plainly inconsistent with competitive neutrality. The result will be to distort incentives in many respects and to generate inefficiencies.

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At the same time, the incentives for access seekers to invest in efficient competition with Telstra’s local call service would be eroded. This is all the more the case given the ACCC’s “Retail Minus Avoidable Cost” approach to the charging of the Local Call Service, which means that access seekers, when they resupply local calls from Telstra, do not face the same requirement as does Telstra to secure a contribution to the access deficit.

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Attachment 2: Treatment of Access Deficit in the United States, Canada and the European Union This attachment details the treatment of access deficits by regulators in the United States, Canada and the European Union. It shows that regulators in all three jurisdictions have sought to implement greater, if not total, rebalancing of tariffs to eliminate any access deficit, and that where any deficit remains due to policy constraints on rebalancing, it is recovered via various mechanisms that seek to spread the costs in a competitively neutral manner across incumbents and all competitors.

United States

In the United States The Telecommunications Act 1996 opened the telecommunications market to competition and commenced the move towards the elimination of any access deficit. This move gathered momentum in May 2000 when the Federal Communications Commission (FCC)’s released its ‘Report and Order on Interstate Access Support’.37 This sets out transitional arrangements over a five-year period for the total elimination of the access deficit that is recouped from the federal (interstate) jurisdiction, that is, the cost of the local loop that is attributable and recovered from long distance services.38

While there is formally no ‘access deficit contribution’ in the United States, the Carrier Common Line Charge (CCLC), and the Pre-subscribed Interexchange Carrier Charge (PICC), introduced in 1997 to replace the CCLC, plays a very similar role to an access deficit contribution.39

• The CCLC is a per minute charge on interstate calls levied on interstate long-distance providers to recover the cost of the local loop. This charge is subsequently passed on to the end user via higher long distance call rates.

• The PICC, a flat monthly charge levied by the local exchange carriers (LECs) facing price cap regulation on the long distance provider, was to replace the

37 FCC, 2000, ‘’Sixth Report And Order In CC Docket Nos. 96–262 and 94–1 Report and Order in CC Docket Nos. 99–249 Eleventh Report and Order in CC Docket Nos. 96–45’, Released and adopted on 31 May 2000, (‘Interstate Access Support Order’).

38 Traditionally, 25% of the cost of the local loop of the incumbent local exchange carriers (ILECs) has been attributed to the long distance services via the cost separation rules.

39 These charges were introduced to allow the recoupment of the local loop cost due to the capping of the Subscriber Line Charge (SLC), which is a flat rate per line charge levied directly on the subscriber.

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CCLC as a transitionary measure towards further rebalancing.40 Since 2000 the FCC has adopted a plan that would increase the subscriber line charge (SLC) through time in order to phase out the PICC.41

For Local Exchange Carriers (‘LECs’) subjected to rate of return regulation, similar reform to eliminate the access deficit has also been implemented. As per the reforms for the LECs facing price cap regulation, the FCC has mandated that the CCLC for the rate of return LECs be completely phased out by July 1, 2003 in line with rising SLCs.42

The SLC increases are insufficient for full tariff rebalancing, so to ensure that LECs do not bear the full burden of the access deficit, and to minimise cross-subsidisation, the FCC converted any remaining implicit support to explicit support.43 Implicit support is cross-subsidisation allowed by the regulator where some services are charged at higher than cost to allow other services to be provided at below-cost rates44, while explicit support refers to direct monetary payments to carriers. The FCC established new explicit interstate access support mechanisms that would ensure LECs would be compensated for the access deficit incurred. The fund for price cap LECs would be capped at $650 million annually to ‘cover the “gap” between capped end user charges and LEC permitted revenues under price caps based on embedded costs45. Similarly the fund for the rate of return LECs allowed the recovery of the access deficit incurred based on embedded cost, and this is not capped.46

The important thing to note is that the current contribution system to the universal service fund is governed by s254 of The Telecommunication Act 1996 that requires that:

40 FCC, 2000, para 19.

41 FCC, 2000, paras 29–30.

42 Refer to FCC, 2001, ‘Second Report and Order and Further Notice of Proposed Rulemaking in CC Docket Nos. 00–256, Fifteenth Report and Order in CC Docket No. 96–45, and Report and Order in CC Docket Nos. 98–77 and 98-166’, Released on 8 November 2001 and adopted on 11 October 2001 (‘Further Interstate Access Support Order’).

43 FCC, 2000, paras 30–31.

44 Some examples of cross-subsidisation are cross-subsidisation between products, such as when caller identification or call waiting services are charged above costs to subsidise basic access, and between customer types, as when LECs charge business customers more for interstate access than residential customers.

45 Embedded cost is the historical cost as recorded in the carrier’s accounts. FCC, 2000, para 205.

46 This treatment is different from that imposed on price cap carriers where the support was capped. The Commission felt that the price cap carriers are less dependent on the interstate access charges and universal support scheme, and are also better able to exploit economies of scale to generate cost savings. FCC, 2001, para 133

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‘[e]very telecommunications carrier that provides interstate telecommunications services shall contribute, on an equitable and nondiscriminatory basis, to the specific, predictable, and sufficient mechanisms established by the Commission [FCC] to preserve and advance universal service’47 The FCC further ensured that the ‘federal support mechanisms should be competitively neutral, neither unfairly advantaging nor disadvantaging particular service providers or technologies.’ 48

Canada

In Canada, an access deficit is not separately identified from the general universal service obligation fund, thus the regime seeks to ensure that LECs are compensated for the total revenue shortfall.

Faced with the problem of being unable to fully rebalance even when establishing a framework for local exchange competition in 1997, the regulator, the Canadian Radio-television and Telecommunications Commission (CRTC) clearly identified the importance of implementing a contribution scheme that was competitively neutral:

In the Commission's view, whichever contribution scheme is selected, support for universal access at affordable rates and, to the extent possible, competitive equity must be maintained. All local basic exchange customers, including residential and those in high cost/low revenue areas, must also, to the greatest extent possible, have the opportunity to realize the benefits of competition in terms of price, innovation, and services offered. At the same time, no undue barrier to competitive entry in any local exchange market sector and no unfair disadvantage to incumbents relative to competitors should result from the contribution scheme established. Finally, IX [interexchange] service providers must not be forced to fund local exchange competition to an unfair extent in order to facilitate competition.49 [Emphasis added]

The CRTC continued the practice where the shortfall in revenue from the provision of the local loop was funded entirely by interexchange carriers providing long distance services50, because

47 s254(d) Telecommunications Act 1996.

48 FCC, 2002, ‘Report and Order and Second Further Notice of Proposed Rulemaking’, adopted 12 December 2002, and released 13 December 2002, para 7 and accompanying footnote.

49 CRTC, 1997, ‘Local Competition’, Decision CRTC 97–8, 1 May, paras 152, 155.

50 CRTC, 2000, ‘Changes to the Contribution Regime’, Decision CRTC 2000–745, 30 November, para 11.

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[r]etaining IX [interexchange] contribution as the only explicit contribution source, in a competitive context, will maintain the comparative clarity and simplicity of the current regime.51

Reforms in 2001 saw the implementation of a new scheme allowing access rates to be increased52 while requiring all telecommunications providers (fixed and mobile) to contribute to the shortfall based on a percentage of their gross telecommunications revenues53. A national fund was established to subsidise residential telephone services. The advantage of the new regime over the previous would be fairness of treatment over all service providers.

The mechanism must be fair to all market participants and should not adversely affect one service provider over another. It should also promote economic efficiency by limiting distortions in the telecommunications market. Further, the mechanism should be competitively equitable by promoting the efficient allocation of resources and avoid unfair advantages to any service or service provider.54 [Emphasis added]

European Union

Following public consultation in 1992, the European Commission (EC) called for the liberalisation of all public voice telephony services by 1 January 1998, subject to additional transitional periods of up to five years for Member States with less developed networks, (Spain, Ireland, Greece and Portugal).55 This move towards open competition increased the pressure for implementation of a cost-oriented tariff. Major tariff reforms were then pursued by Member States to correct historical tariff imbalances.56

In 1996, the EC imposed a 1 January 1998 deadline for Member States to fully rebalance thus eliminating the need for access deficit schemes henceforth.57 Nevertheless, for operators

51 CRTC, 1997, para 182.

52 CRTC, 2000, para 138.

53 The contribution for 2001 was set at 4.5% of eligible revenues and would be adjusted annually.

54 CRTC, 2000, para 9.

55 EC, 1996, ‘Directive 96/19/EC of 13 March 1996 amending Directive 90/388/EEC with regard to the Implementation of Full Competition in Telecommunications Markets’ (Directive 96/19/EC), para 2.

56 EC, ‘Directive 96/19/EC’, para 5.

57 EC, 1996, Communication on Assessment Criteria for National Schemes for the Costing and Financing of Universal Service in Telecommunications and Guidelines for the Member States on Operation of Such Schemes, (Communication on Assessment Criteria), COM (96) 608, Annex B.

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who ‘are subject to regulatory constraints which have prevented them from completing the process of tariff rebalancing and this has resulted in tariff structures which are substantially out of line with the capital invested in providing local access’58 the EC extended the deadline for another 2 years.

While the EC pushed for full rebalancing of tariffs, it recognised that in the interim it was necessary to allow other means of recouping the deficit in a non-discriminatory manner.

Member States should phase out as rapidly as possible all unjustified restrictions on tariff rebalancing by the telecommunications organizations and in particular those preventing the adaptation of rates which are not in line with costs and increase the burden of universal service provision. Where this is justified, the proportion of net costs insufficiently covered by the tariff structure may be reapportioned among all parties concerned in a non-discriminatory and transparent manner.59 [Emphasis added]

The important point to note is that while the EC does not currently permit any access deficit schemes, it only abolished such schemes after full rebalancing had, or was supposed to have, taken place.

For example, British Telecom (BT) was permitted to charge Access Deficit Contributions by the UK regulator, Oftel, until 1996 when the regulator removed the RPI+2% constraint on the incumbent’s line rental charges.60 Further, in December 2002, the EC noted that BT’s charges covered the incremental cost of providing the line and that there are no regulatory constraints that prevent BT from further rebalancing.61

58 EC, 1996, ‘Communication on Assessment Criteria’, Annex B.

59 EC, 1996, ‘Directive 96/19/EC’, para 20.

60 Valletti, Tomasso, M., 1999, ‘The Practice of Access Pricing: Telecommunications in the United Kingdom’, London School of Economics, Politecnico de Torino and CEPR paper prepared for the Economic Development Institute, The World Bank, p. 9.

61 View expressed by Oftel and reported in EC, 2002, ‘Eighth Report on the Implementation of the Telecommunications Regulatory Package’. COM2002 (695), December, p. 43.

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Attachment 3: Economic vs. Accounting Profit [Confidential]

[Confidential submission]

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Attachment 4: Incentive Regulation Imposed on Telstra This attachment discusses the objectives of the incentive regulation regime currently imposed on Telstra. Specifically, it provides evidence that the price cap regulation has been introduced to protect customers from any market power that Telstra may have, while at the same time encouraging it to seek efficiency gains. It also shows that the price cap regulation ensures that these gains are passed on to consumers in the form of lower prices.

The Australian Competition and Consumer Commission (ACCC)’s views on the role of incentive regulation, especially in the utilities sector, are discussed first. The objectives of the regulation on Telstra are then reviewed.

The Role of Incentive Regulation

The ACCC has continually supported the use of incentive regulation. For example, Professor Fels, the Chairman of ACCC, has said that:

"Incentive regulation brings in a regulatory scheme of incentives which maximise public benefit efficiencies, particularly in natural monopoly network industries such as some parts of telecommunications, gas and electricity.

The public benefit efficiencies can include greater productivity, lower prices and better quality of service for consumers".62 [Emphasis added]

When applied to utilities, because of their inherent natural monopoly characteristics, the ACCC saw the benefits of the incentive regulation via CPI minus X as:

”Achieving greater productivity: the utility has a strong incentive to pursue productivity improvements. Where it fails to achieve cost reductions consistent with X, its profits will fall. Further, as it can keep any cost savings above those reflected in X, at least in the regulatory period, it has an incentive to aim for greater cost reductions than are provided by productivity growth of X per cent.

Passing on productivity growth to customers: CPI−X forces the utility to pass on the cost reductions (reflected in the set value of X) in lower prices to customers rather than let them through to higher profits.

Whittling away monopoly profit or existing cost-inefficiency: where the utility commences regulation with above normal profits and/or existing cost inefficiency, X can be set above TFP growth in order to whittle these away. Indeed, the gradual

62 As cited in ACCC, 1999, International Regulation Under the Spotlight, Media Release October 12 available at http://www.accc.gov.au/media/mr%2D193%2D99.htm. (accessed 24 February 2003).

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http://www.accc.gov.au/media/mr%2D193%2D99.htm


elimination of above normal profits was the emphasis of Vogelsang and Finsinger in establishing the theoretical basis for this form of regulation.

Restructuring prices: CPI−X allows the utility to restructure its pricing towards greater efficiency. As the cap applies to the weighted average of the utility’s prices and not to specific prices, the utility is able to raise (at least relative to the CPI change) one or more of its prices if other prices are reduced sufficiently to satisfy the cap. When freed in this way, the pursuit of profitability will lead the utility to change its pricing structure towards a Ramsey–Boiteux configuration to exploit the more inelastic demands in keeping with the ‘inverse elasticity rule’. The pursuit of profits means that the utility will have an incentive to move prices towards a more efficient configuration.” 63

Incentive Regulation of Telstra

The CPI minus X price control has been the chosen regime for regulating the telecommunications incumbent’s prices since 1989. In selecting the regime to regulate Telstra’s predecessors’64 prices when competition was introduced, the Government stated that the goals of the price control were:

“(a) to create pressures for efficiency in monopoly areas of Telecom and OTC’s business;

(b) to provide incentives for Telecom and OTC to efficiently restructure their prices in order to recover common costs of production in the most efficient fashion;

(c) to induce Telecom and OTC to strive for and pass on cost reductions from greater productive efficiency; and

(d) to ensure that the benefits of efficiency changes are equitably shared among consumer groups.”65

These goals form the basis of the ACCC’s CPI minus X price cap regime and they are reflected in the objectives of the price cap mechanism implemented. For example, in the

63 ACCC, 2000, Incentive Regulation, Benchmarking and Utility Performance, November, pp. 13-14

64 They were Telecom and Overseas Telecommunications Corporation (OTC).

65 Refer to Australian Telecommunications Services: A New Framework, Statement by the Minister for Transport and Communications, Canberra, 25 May 1988. p 147, as cited in ACCC, 2001, Review of Price Control Arrangements, February , p 3.

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latest review conducted over 2000 and 2001, the ACCC has stated that the price control is to constrain Telstra’s monopoly power by limiting:

“... the ability of Telecom and OTC to set prices above costs, provide an incentive to seek efficiencies in order to meet their price control obligations, and allow the carriers to restructure (or “rebalance”) their prices for greater efficiency.”66

The fact that Telstra would be constrained in exercising any market power that it may have was again reinforced by the ACCC in its final review report. When recommending the current regime be continued, it commented that:

“A broad CPI – X per cent price cap is desirable because it should make the community as a whole better-off and has the potential to encourage Telstra to improve the efficiency with which it produces telecommunications services. The community as a whole can be made better off by limiting the exercise of monopoly power and by giving Telstra the freedom to restructure prices in a way that allows it to efficiently recover common costs. In turn, this can benefit consumers by leading to lower prices for national long-distance, international long-distance and fixed-to-mobile services. Further, there is an incentive for Telstra to become more efficient in the production of telecommunications services as a CPI – X per cent price cap gives Telstra an incentive to reduce costs”.67 [Emphasis added]

Finally, as the CPI minus X cap provides an incentive for Telstra to continually seek efficiency gains and to grow the market, any profits that are obtained by Telstra while it faces such regulation could not be monopoly rents.

This is best summarised by Professor Fels. In a paper delivered to the Directorate-General for Competition of European Commission, he stated that:

“Incentive regulation, as applied by the Commission [in Australia], works on two levels. First, it encourages operators to reduce their costs in any given regulatory period. If the provider realises cost savings in that period, it retains those savings. Second, where revenue caps operate to restrict revenue per unit of output, an operator who is able to increase volume above the forecast level is able to retain the benefit of that market growth. The overall effect is to encourage operators to maximise profits by making efficiency gains and growing the market. These gains can then be shared with consumers in the longer term.”68[Emphasis added]

66 ACCC, 2000, Review of Price Control Arrangements, Discussion Paper, September, p. 11

67 ACCC, 2001, p xiv

68 Fels, A, 2001, Regulating Access to Essential Facilities, paper presented to the Directorate-General for Competition, European Commission, February available

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This view was reaffirmed by the Supreme Court of Victoria. In its May 2001 decision in TXU Electricity Limited v. Office of the Regulator-General, it stated that firms subjected to incentive regulation should be entitled to the gains in excess of what are stipulated under the price controls.

“Under a price incentive regulation, the regulated firm is rewarded for its efforts in directly improving its profit over a fixed period, usually of some length, and the regulator does not attempt on the review to pass the profits made back to the consumer. In other words, the firm is entitled to reap the benefit of its efficiency in reducing prices and increasing its profits.”69 [Emphasis added]

Again,

“… a CPI--X price capped regulation is an incentive based regulation aimed at ensuring economic efficiency, which is in the interests of both supplier and consumer. The price is fixed on a certain basis, and if the supplier is able to reduce costs and/or increase demand, the supplier is entitled to keep the profits brought about by the efficient conduct of the business.”70 [Emphasis added]

And,

“The essential feature of an incentive regulation is that if costs are reduced and profits increase, the firm is entitled to keep the profits and the original price is fixed on that basis, which is of benefit to both consumer and supplier.”71

Conclusion

Incentive regulation was imposed on Telstra and its predecessors to ensure that, in the event that Telstra has market power, it would be restricted in its ability to exercise it. Additionally and importantly, CPI minus X price controls encourage Telstra to seek efficiency gains and to grow the market as it would be able to retain gains in excess of the allowed X factor during the price cap period, while in the longer term, as the X factor is further adjusted, consumers will benefit from lower prices.

http://www.google.com.au/search?q=cache:_4Cu9-4-9WIC:agenda.anu.edu.au/ejournal/pdf/8-3-a-1.pdf+%22Allan+Fels%22+and+%22incentive+regulation%22&hl=en&ie=UTF-8 (accessed 24 February 2003)

69 TXU Electricity Limited (formerly known as Eastern Energy Ltd) v Office of the Regulator-General & Ors (2001) VSC 153 at 187, available at http://www.austlii.edu.au/au/cases/vic/VSC/2001/153.html



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http://www.google.com.au/search?q=cache:_4Cu9-4-9WIC:agenda.anu.edu.au/ejournal/pdf/8-3-a-1.pdf+%22Allan+Fels%22+and+%22incentive+regulation%22&hl=en&ie=UTF-8

http://www.google.com.au/search?q=cache:_4Cu9-4-9WIC:agenda.anu.edu.au/ejournal/pdf/8-3-a-1.pdf+%22Allan+Fels%22+and+%22incentive+regulation%22&hl=en&ie=UTF-8

http://www.austlii.edu.au/au/cases/vic/VSC/2001/153.html


Attachment 5: The Contribution of Productivity and Price Changes to Telstra’s Profitability [Confidential]


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Attachment 6: Revenue Impact of Removing the ADC [Confidential]


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Attachment 7: Telstra’s Options for Recovering Access Deficit without an ADC

Option Constraint Feasibility

Basic Access/Local calls

• Price caps limit price flexibility

• Wholesale regulation results in strong price competition in retail markets

No

Other PSTN services

• Lower interconnect prices (from elimination of ADC) will result in lower market prices for these services

No

Recover the cost of the CAN by increasing the price of the following services

Non-PSTN services

• In markets with strong competition Telstra is a price taker

• In other markets Telstra is already likely to be profit maximising

Very limited

Compensate by reducing OPEX/CAPEX

• Large operating cost reductions in recent years – little room for further cuts without affecting service quality

• Limited scope for reducing CAPEX without affecting service quality and network integrity, given regulatory obligations on service standards

Very limited

Recover the cost of the CAN through returns from international investment activity

• Reduced competitive advantage in foreign markets

• Some international investments have relatively high risk profiles as evidenced by Telstra’s recent write-down of its investment in Reach

Very limited

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Attachment 8: Switching Costs and the Incidence of a Profit Tax This attachment shows that even when firms sell differentiated products and face customers with different switching costs, there is no a priori reason to believe that the incidence of a profits tax will fall on customers with the least elastic market demand.

A firm will recover a fixed profit tax in the same way as it will recover fixed costs - according to Ramsey principles. Ramsey principles dictate that the firm will recover the tax from those customers with the least elastic demand. When products are differentiated, Ramsey principles dictate that the firm recovers the tax from customers with the least elastic firm-specific demand.

The intuition behind this result is that, when deciding from which customers to recover a profit tax from, Telstra will consider those customers’ Telstra-specific elasticities of demand (or switching elasticities). A switching elasticity measures the change in the firm’s (as opposed to the market’s) demand given a change in the firm’s price. Specifically, if one customer has a relatively high switching elasticity then the firm will prefer not to mark up this customer’s price otherwise she may switch to a competitor. Conversely, if another customer has a low switching elasticity then the firm may mark up this customer’s price without the same risk that the customer will switch.

Some simple algebra can be used to illustrate this point. Assume that two firms (A and B) supply a service. If customers decide to switch from one firm to another they incur a switching cost c. Thus, customers who have previously purchased from firm A will face future prices of:

P = Minimum[PA, Pb + c]

Thus, firm A will only retain a customer if:

PA + t < Pb + c

where t is the price increase imposed on the customer to recover the profit tax. Clearly, firm A can impose a larger price increase on customers with greater switching costs.

However, the socially efficient outcome would be for the firm to recover the profit tax from the customer or group of customers with the lowest market demand elasticity. The market demand elasticity measures the change in market (as opposed to firm) demand given a change in price. The market demand elasticity does not necessarily coincide with the firm specific demand elasticity or, in the example above, customers with the greatest switching cost (c) do not necessarily have the lowest elasticity. When this is the case, the customers who the firm prefers to recover a profit tax from are not the customers from which it would be socially efficient to recover the tax from.

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The reasons why the Telstra’s customers’ switching elasticities may be low relative to the market demand elasticity are listed below:

• Telstra is the incumbent and the only firm with an obligation to serve. Thus, customers who have low switching elasticities would have been less likely to switch to competitors in the past and thus are more likely to have remained with Telstra.

• Customers with relatively low expenditure are less likely to incur the fixed costs of searching and monitoring competitor’s offers. These customers are less likely to be attracted to competing offers and are less likely to have switched from Telstra to its competitors. Thus, Telstra may have a greater proportion of customers with low switching elasticities than its competitors.

• Customers with low expenditures are also likely to have low margins for competitors. Therefore, competitors are unlikely to spend much effort in attracting them.

Although these customers may have low switching elasticities, there is no a priori reason to believe that they have low market demand elasticities. Thus, when firms face customers with different switching costs, there is no a priori reason to believe that the incidence of a profits tax will fall on the least elastic market demand.

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Attachment 9: Trends in Telstra’s capital expenditure This attachment clarifies an apparent factual error in the discussion paper relating to Telstra’s capital expenditure. Table 1 in the Commission’s discussion paper appears to misrepresent the trend in Telstra’s capital expenditure - it appears not to take into consideration the effects of inflation. If this is the case, then the quoted investment levels are nominal and, therefore, incomparable with each other. Additionally, the ACCC’s conclusion that CAPEX has grown would be incorrect.

Figure 1: Telstra’s Real Capital Expenditure ($m) from 1994-95 to 2001-02, June 2002 dollars

$0

$200$400

$600$800

$1,000$1,200

$1,400$1,600

$1,800

1995 1996 1997 1998 1999 2000 2001 2002

SwitchingTransmissionCustomer AccessMobile NetworksBroadband NetworkInternational InfrastructureOther

Source: Table 1 of the ACCC discussion paper

Figure 8 charts Telstra’s real CAPEX. It illustrates that since 1996, annual real investment has increased for only ‘International Infrastructure’ asset category. Total annual real investment has fallen by $878 million since 1996 despite strong economic growth.

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Attachment 10: Investment indicators for Telstra’s competitors [Confidential]


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Attachment 11: Competitors’ Build vs. Buy Decisions Figure 2

Figure 2: Competitors’ Build vs. Buy Decisions

illustrates that competitors’ decisions of whether to build infrastructure to customers’ premises or to buy wholesale services from an Access Provider depend on the relative costs of these two options. It can be assumed that over recent years the build cost is higher than the buy cost for Regional, Provincial and some Metropolitan areas, given the absence of competitive infrastructure. Conversely, the build cost can be assumed to be lower than the buy cost for other Metropolitan customers and the majority of CBD customers given the existence of competitive infrastructure.

SIOs in each geographic area

Cents/min

Call conveyance

Indicative build cost

ADC

Regional Provincial Metropolitan CBD

5.51 c/min

1.60 c/min 1.33

c/min 1.22 c/min

Buy Build

SIOs in each geographic area

Cents/min

Call conveyance

Indicative build cost

ADC

Regional Provincial Metropolitan CBD

5.51 c/min

1.60 c/min 1.33

c/min 1.22 c/min

Buy Build

Source: Rates extracted from Telstra 2003 PSTN Undertaking

However, should the ADC be removed from Telstra’s rates for OTA services, the build vs. buy decision would be distorted. For a large proportion of customers, it will become less expensive for competitors to buy wholesale services from Telstra rather than build their own infrastructure. This will be true even for a number of customers whom, if the ADC were in place, it would be cost-effective for competitors to serve using the build option. In other words, removal of the ADC could substantially reduce the incentive for competitors to invest in their own local network infrastructure, and may lessen the ability for competitors to recover the costs associated with existing investment.

Competitors’ tendencies to prefer to buy than build their own infrastructure is further illustrated in Figure 3. This Figure reveals that Optus already has a preference to provide services to customers using Telstra’s local call resale product (a decision to buy) rather than by directly connecting them to their own network (a decision to build). The removal of the ADC will serve to strengthen this preference.

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Figure 3: Optus’ local call resale services and direct customer connections

0

50

100

150

200

250

300

350

Jun 98 Sep 98 Dec 98 Mar 99 (estimate)

Customers000's

LAT (Direct Connect) Local Call Resale

0

50

100

150

200

250

300

350

Jun 98 Sep 98 Dec 98 Mar 99 (estimate)

Customers000's

LAT (Direct Connect) Local Call Resale

Source: Gale, Andrew (1999), “Local and Long Distance - Investor Presentation,” Optus, March 1999.

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Attachment 12: ACCC and the Importance of the ADC in Maintaining Competitive Neutrality The principle of competitive neutrality ensures that any regulatory arrangements should not confer an unfair advantage or disadvantage towards any of the firms competing in a market. With regards to the access deficit arising from the price control imposed on Telstra, competitive neutrality requires that Telstra should not be made to bear the full burden of the access deficit. The Australian Competition and Consumer Commission (ACCC) has, in the past, advocated the view that access seekers should share the burden of the access deficit and therefore sustain Telstra’s ability to compete on its merits in the telecommunications market. This attachment seeks to document the ACCC’s views on the matter.

As recently as 1999, in determining the principles for the calculation and recovery of the access deficit, the ACCC noted a number of reasons for requiring access seekers make an access deficit contribution. These reason include:

• Provide incentives for future investment in the CAN;

• Fund the maintenance of the CAN;

• Protect Telstra’s legitimate business interests by avoiding under recovery of costs; and

• Avoid inefficient build/buy decisions – if there is no or limited scope for Telstra, operating efficiently, to recover the costs of the CAN, there will similarly be limited scope for an efficient competing carrier to recover the costs of investing in an alternative CAN – this in turn will increase the incentive for other carriers to use Telstra’s CAN rather than to build alternative infrastructure, even if it is more efficient to do so.72 [Emphasis added]

The incorporation of the access deficit contribution into interconnection charges was also deemed essential by the ACCC because failure to do would have detrimental effects, both on Telstra and on society as whole.

“… in the long-term, not allowing Telstra to recover a part of any residential access deficit from originating and terminating access charges may:

72 ACCC, 1999a, Principles for Determining Telstra’s Access Deficit and Contributions by Interconnecting Carriers and Carriage Service Providers, as quoted in Telstra Corporation’s Further Submission to the Productivity Commission Inquiry into Telecommunications Competition Regulation, August 2001, p. 9

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• encourage inefficient entry, by constraining Telstra from competing on its relative merits in the long-distance and mobile markets;

• discourage efficient investment by entrants (by making using Telstra’s CAN more commercially attractive than building alternative facilities);

• prevent Telstra from recovering legitimate costs;

• result in Telstra under-investing in upgrading the CAN; and

• create inefficient arbitrage opportunities (as different calls using the CAN will incur different charges).”73

Furthermore, on numerous occasions, the ACCC has emphasised the importance of Telstra being able to recover its costs from all PSTN services, including interconnection charges. As noted by the ACCC, competition would ensure that without an access deficit contribution, Telstra would never be able to recover the CAN cost fully.

“Not allowing Telstra to recover a part of the access deficit from interconnection charges would create the potential for inefficient entry (as Telstra would incur a cost not borne by other carriers) and the prospect that Telstra would not be able to recover its legitimate costs.”74 [Emphasis added]

And in the assessment of Telstra’s undertaking in 1999, the ACCC commented that:

“[i]f there is no contribution to any residential access deficit in the charges for originating and terminating access, competition in the provision of these services will restrict the scope for Telstra to recover any part of any residential access deficit from the revenue (retail or wholesale) from these services. In the short-term this will either require any residential access deficit to be recovered through charges for other call services (e.g. local call services) or be borne by Telstra. In the longer-term, as competition expands into these other call services, the scope for recovery will be further reduced.”75 [Emphasis added]

In the assessing the subsequent undertaking in 2000, the ACCC stressed the need to include the access deficit contribution to maintain competitive neutrality.

73 ACCC, 1999b, Assessment of Telstra’s Undertaking for Domestic PSTN Originating and Terminating Access, Final Decision, June, p. 47

74 ACCC, 1999c, Interconnection Charges and Telstra’s Access Deficit, Discussion Paper, September, p 2.

75 ACCC, 1999b, p 47

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“The Commission notes that if an access deficit contribution were not included in charges for the declared PSTN services, then service providers could supply calls to end-users in competition with Telstra at a price that did not include the access deficit contribution. To compete, Telstra would need to remove the contribution from its retail charges to end-users thus reducing the scope for Telstra to recover the deficit from end-users.

In the short term, this could result in Telstra recovering the entire access deficit from monopoly services, or if there were restrictions in it doing so, not recovering the access deficit. This would be likely to harm both Telstra’s legitimate business interests and discourage economically efficient levels of investment. Consequently, to maintain ‘competitive neutrality’, it would seem to be legitimate for Telstra to recover an access deficit contribution through charges for the declared PSTN services.”76 [Emphasis added]

The ACCC continued this line of argument in August 2000 when it stated that:

“….if an access deficit contribution were not included in charges for the Telstra declared PSTN services, then service providers, not subject to the same regulatory constraints, could provide services in competition with Telstra at an unfair advantage. To maintain ‘competitive neutrality’, it is legitimate for Telstra to recover an access deficit contribution through charges for the declared PSTN services as this deficit cannot be otherwise recovered on a commercial basis.”77 [Emphasis added]

The above has been reiterated by the ACCC in its pricing principles papers for non dominant PSTN providers78.

76 ACCC, 2000, A Draft Report on the Assessment of Telstra’s Undertaking for the Domestic PSTN Originating and Terminating Access Services, April, p. 46, and again repeated in ACCC, 2000, A Report on the Assessment of Telstra’s Undertaking for the Domestic PSTN Originating and Terminating Access Services, July, p 42

77 ACCC, 2000, Pricing Guidelines for Access Prices of PSTN Terminating and Originating Access Services Provided by Non-dominant or Smaller Fixed Networks, Position Paper, August, p 22

78 ACCC, 2001, Pricing Guidelines for Access Prices of PSTN Terminating and Originating Access Services Provided by Non-dominant or Smaller Fixed Networks, Pricing Principles Paper, March, p 22, and ACCC, 2002, Revised Pricing Guidelines for Access Prices of PSTN Terminating and Originating Access Services Provided by Non-dominant or Smaller Fixed Networks, Pricing Principles Paper, January, pp 23-24

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In summary, it is clear from statements made by the ACCC that it has traditionally considered the access deficit contribution important in ensuring competitive neutrality amongst the players in the telecommunications market. In the past, the ACCC has clearly deemed that the non-inclusion of an access deficit contribution would restrict Telstra from recovering ‘legitimate costs’ and it would not be able to compete on an equal footing with its competitors.

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Attachment 13: The Access Deficit and the Local Call Deficit This attachment uses a simple hypothetical example to illustrate the effect on competitive neutrality of removing the ADC component from PSTN O&T access charges that Access Seekers pay Telstra. The example shows that removing the ADC so that Telstra no longer recovers the fixed costs of providing a service or services to Access Seekers, breaches the principles of competitive neutrality.

An extension to the first example is used to illustrate that if Telstra is unable to recover its own contribution to the Access Deficit from local calls, due to regulations affecting the retail prices Telstra is able to charge, then the principles of competitive neutrality will be further breached. This is the local call deficit issue.

Competitive Neutrality

Before the examples are discussed it will be useful to define the concepts of competitive neutrality that are used in this attachment. Competitive neutrality can be divided into two forms:

• weak competitive neutrality, and

• strong competitive neutrality.

Weak competitive neutrality dictates that, whatever the arrangements, the most efficient carrier should be able to compete successfully. In other words, access prices should be set such that the carrier with the lowest marginal cost in the production of the good that uses the regulated facility as an input into production is able to compete in the market or markets successfully so as to capture market share commensurate with its cost advantage.

Strong competitive neutrality dictates that in addition to the above condition being met, the access price does not perpetuate monopoly rents, that incumbents be compensated for legacies of regulation and that equally efficient competitors be able to recover their cost of capital.

Example 1: Energy bars and the Access Deficit Contribution

For the first example, one firm, TS, builds a tennis court at a fixed cost of $50. TS successfully convinces each of the 50 residents of its town to pay $1 to join the tennis club and thus TS breaks even.

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After several rounds of tennis are played, it turns out that everyone wants to consume one energy bar while playing tennis, which is produced at a unit cost of $1. TS provides bars to the townspeople at cost.

Therefore, over the two services, TS is just breaking even. Membership revenues exactly cover the fixed costs of the tennis court and club and energy bar revenues exactly cover marginal cost.

The scenario so far is summarised under Scenario 1 in Table 3.

After an initial period of commercial stability, the Local Council decides that it is in the long-term interest of end-users (LTIE) to limit the price of membership to no more than $0.60. In response, TS’ only option to remain a viable entity is to increase the price at which it sells energy bars at the club. TS marks-up the price of bars by $0.40 per unit, to $1.40, and prohibits customers from bringing energy bars to the tennis court. The tennis club remains open since TS again just breaks even:

Membership revenues of $30 [50 members x $0.60]

+ energy bar profits of $20 [50 units x $0.40 mark up]

= Fixed costs of $50

This scenario is summarised under Scenario 2 in Table 3.

Observing the profits TS earns on energy bars, the Competition Commission decides to introduce competition into the market in which bars are supplied, by declaring that TS must permit anyone to sell energy bars at the club. The Competition Commission determines the lowest access charge that allows TS to remain viable.

One method to calculate the appropriate access rate is to begin with the access deficit that results from the Council’s price controls.

The access deficit is equal to the amount by which club membership revenues fall short of overhead costs, in this example, $20 [$50 fixed cost overhead – $30 membership revenues]. Dividing the access deficit by 50 units, the total amount of energy bars sold to club members, gives $0.40. This is the access deficit charge (ADC) that all units of energy bar sales must bear so that TS remains viable. The appropriate access price is then given by the ADC plus the unit cost of granting access. Since the latter is zero in this example, the appropriate access price is $0.40.


To see that the recovery of the access deficit allows TS to just breakeven, assume that competitive energy bar suppliers capture a 50% share (25 units) of bar sales and that under

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competition, the market price of energy bars will be equal to $1 plus the access fee of $0.40. Thus, TS’ bottom line is equal to:

Membership revenues of $30 [(50 members x $0.60 membership fee]


+ access revenues of $10 [25 units x $0.40 access fee]

- Fixed costs of $50

= Profit of $0.

The lowest access rate (to the tennis court) that TS can afford is $0.40 per energy bar sold. If TS were not allowed to recover the $0.40 from competitive energy bar suppliers then competition in the energy bar market would drive the price of bars down to $1 (the marginal cost of supply). Thus, TS’ would make be unviable, incurring overall losses equal to:


+ energy bar profits of $0 [25 units x $0 mark up]


= Profit of -$20

TS’ $0.40 access charge satisfies the principle of weak competitive neutrality defined above. Suppose the cost of energy bars to competitive energy bar suppliers is only $0.90. With an access rate of $0.40, competition would set the price of bars at $1.30. While TS, whose cost of producing bars remains at $1, could profitably undercut this price, competitors would end up capturing the market. This is the case because TS makes more money by selling a unit of access to competitors than it would by selling an energy bar to consumers. TS’ profit becomes:


+ energy bar profits of $0 [0 units]



= Profit of $0


Thus, the most efficient competitors are able to compete successfully and therefore the principle of weak competitive neutrality is still satisfied. There is a price available to the

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competitive energy bar suppliers with the lowest marginal cost that allows them to compete in the market successfully in a winner takes all competition.

Furthermore, it can easily be shown that the principle of strong competitive neutrality is also satisfied. The access price does not perpetuate monopoly rents, incumbents are compensated for legacies of regulation and equally efficient competitors are able to recover their cost of capital.

If the access price was instead set at $0, then the condition of weak competitive neutrality would again be satisfied. Competition would drive the market price of energy bars down to the unit cost of the most efficient competitors. If this is less than TS’ cost of $1, TS will withdraw from the energy bar market. If the competitive price is greater than $1, TS will find it profitable to continue to serve the energy bar market. Either way, the most efficient provider ends up profitably serving the market.

Strong competitive neutrality, on the other hand, is not satisfied with an access price of $0. An access rate equal to $0 breaches this principle because it would not allow TS to recover its costs. If TS were equally as efficient at selling energy bars as its competitors, total revenues from membership and energy bars would not be sufficient to cover its $50 fixed costs.

summarises these results Table

2

Table 2: Summary of competitive neutrality results

Access Charge Weak competitive neutrality satisfied

Strong competitive neutrality satisfied

$0.40 YES YES $0 YES NO

Table 3: Summary of tennis court and energy bar example

1) Before price controls and

access regulation

2) After price controls and before access

regulation

3) After price controls and

access regulation - Case 1


access regulation – Case 2

(a) Fixed costs $50 $50 $50 $50 (b) Membership rate per consumer

$1 $0.60 $0.60 $0.60

(c) Number of consumers

50 50 50 50

(d) Membership charges collected

$50 $30 $30 $30

(e) Shortfall in recovery of fixed costs79

$0 $20 $20 $20

(f) Marginal cost of energy bars80

$1 $1 $1 $0.90

79 (a) minus (d)

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1) Before price controls and

access regulation

2) After price controls and before access

regulation


access regulation - Case 1


access regulation – Case 2

(g) Access charge per energy bar sold

n.a. n.a. $0.40 $0.40

(h) Price of energy bars81

$1 $1.40 $1.40 $1.30

(i) Total surcharge recovered from energy bar consumers82

$0 $20 $20 $20

Example 2: Mineral water and the Local Call Deficit

A small extension to this example can be used to illustrate the local call surcharge issue. Assume that, to wash down the energy bars, each tennis club member purchases a bottle of mineral water. Consumers therefore purchase 100 units of products complimentary to the tennis club service provided by TS: 50 energy bars and 50 bottles of mineral water. TS has no competitors in the mineral water market and each bottle of mineral water also costs TS $1 to produce.

Suppose that the Local Council continues to limit membership rates to $0.60. Thus, to allow TS to just breakeven the Commerce Commission now allocates the access deficit ($20) over sales of both energy bars and mineral water. The consequent access deficit charged to competitive energy bar suppliers is $0.20 [$20 deficit/100 units].

To recover its costs TS must sell mineral water at no less than $1.20 [$1 unit cost + $0.20 ADC]. The 50 units sold in the mineral water market would therefore produce a contribution to TS’ fixed costs of $10. Since, under competition, the price of energy bars drops to $1.20 [$1 unit cost plus $0.20 ADC], TS’ profits remain at zero:



+ mineral water profits of $10 [50 units x $0.20 mark up]


80 Reflects marginal cost of lowest cost producer – this is the only marginal cost that is relevant given competition.

81 (f) + (g) where (g) is applicable.

82 [(h) – (f)] times (c)

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= Profit of $0

Not only does this access pricing policy satisfy conditions of (weak and strong) competitive neutrality relative to the energy bar market, it also has the property of being neutral across products. That is, each unit of consumables sold at the tennis club, whether by TS or its competitors, ends up bearing the same access deficit contribution.

However, again the Local Council intervenes, after observing profits in the supply of just mineral water, by limiting the price of mineral water to its marginal cost of $1. Clearly, the mineral water market provides no source of contribution toward recovery of the access deficit and, thus, TS would make a loss of -$10. The local call deficit of -$10 arises since the Competition Commission allocates some of the access deficit to mineral water sales yet, due to Local Council policy, the Tennis club is unable to recover that part of the access deficit.



+ mineral water profits of $0 [50 units x $0 mark up]



= Profit of -$10

Similar to the above example, allowing TS to charge $1.20 for mineral water and $0.20 for access to its tennis court satisfies the principle of weak and strong competitive neutrality - the most efficient competitors are able to compete successfully, the access price does not perpetuate monopoly rents, incumbents are compensated for legacies of regulation and equally efficient competitors are able to recover their cost of capital.

However, allowing TS to only recover $1 from mineral water violates the requirements of strong competitive neutrality, since TS is not able to cover its costs “including the legacies of regulation”. Here, the legacy of regulation includes not only limits on membership revenues, but also limits on the price of mineral water. Table 4 summarises these results.

Table 4: Summary of competitive neutrality results

Price of Mineral

water

Access Charge Weak competitive neutrality satisfied

Strong competitive neutrality satisfied

$1.20 $0.20 YES YES $1.20 $0 YES NO

$1 $0.20 YES NO

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$1 $0 YES NO

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Attachment 14: Modelling the Effect of Telstra Absorbing the Full Access Deficit [Confidential]


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Attachment 15: The ACCC views on the AD and Faulhaber cross-subsidies The Commission, in the context of measuring the AD, refers to Faulhaber and cross-subsidies twice.83 In the first instance it notes its own definition of the AD is not the same as the Faulhaber definition of a cross-subsidy.84 This is not surprising as the Commission’s definition is concerned with cost recovery, which the presence or absence of cross-subsidy says little about. The Commission also mistakenly argues that the Faulhaber definition does not allow cost allocations. In the second case, the Commission considers Telstra’s position as redefining a “transfer” (the reallocation of “the AD to local calls”) as a cost and that this “does not appear to accord with basic economic principles.”85 This, however, both mischaracterizes Telstra’s position and basic economics.

The economic basics are straightforward:

• Regulation that does not allow cost recovery is economically inefficient and does not have legitimate regard for Telstra’s commercial interests;

• Faulhaber subsidy-free prices allow any cost allocation that lies between incremental and stand-alone costs; and

• In general, some but not all subsidy-free prices also allow full cost-recovery.

Telstra’s position is also straightforward. Given the Commission’s cost allocation rules, current prices do not allow cost recovery on those costs allocated to the basic access service. This creates an AD which are in effect unrecovered allocated costs (not transfers) and must be recovered somewhere. Put another way, the cost allocation to lines implies prices that are not feasible and an alternative allocation is necessary. Reallocation of the access deficit is the means by which this is achieved.

Local calls can potentially make a contribution to shared costs. To the extent that the contribution of local calls exceeds the costs allocated to them, an additional contribution is made toward the unrecovered AD (and if the contribution of local calls does not exceed the costs allocated to them the pool of unrecovered costs is enlarged). However, regulatory constraints on the local call price means that the amount of the AD allocated to them under the ACCC’s own allocation procedures cannot be recovered from local calls. Consequently,

83 ACCC, 2003, “The need for an ADC for PSTN access service pricing: Discussion paper”, February, Section 5.2, at pp. 18-19 and Section 8.2, at p. 27.

84 Ibid, Section 5.2, at pp. 18-19.

85 Ibid, Section 8.2, at p. 27.

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Telstra must be allowed to recover the remaining AD (including any unrecovered local costs) elsewhere.

These points are now explained in detail.

In the past the Commission has defined the AD, in essence, as the difference between revenues earned on standing charges less certain costs, being the attributable long run line costs plus contributions towards organisational level, retailing and other costs shared by fixed line services.86 Oddly, the Commission, in the section immediately following, titled, “Definition of Cross-subsidy”, contrasts its approach with the Faulhaber definition of a cross-subsidy:

“the definition used by the Commission differs from that suggested by regulatory economists, in particular by Faulhaber. Under this definition a deficit or surplus would be defined according to the difference between attributable costs and attributable revenues.” An omitted footnote cites Faulhaber’s 1975 paper on cross subsidy.87

This comparison makes no sense. The AD is concerned with whether Telstra is allowed full cost recovery. It measures the extent to which certain costs are not recovered by certain revenues. In contrast, the formal economic (Faulhaber) definition of cross-subsidy provides the circumstances under which one can meaningfully claim that a product or a group of products “cross-subsidise(s)” other products and is not at all well-related to cost recovery. For example:

• Prices that do not involve cross-subsidies need not guarantee cost recovery: Wherever there are costs shared by all products, prices exist that involve no cross-subsidies, but which do not cover the costs of total production. These are any prices that cover the incremental costs of all combinations of products, but not the incremental cost of the whole.

• Subsidy-free cost recovery can be impossible: One of the singular results of the cross-subsidy literature was that subsidy-free prices might not exist at all. In such peculiar cases, cost-recovery with subsidy-free prices is impossible.

• Cost-recovery, in limited circumstances, is possible in the presence of cross-subsidy: A minimal requirement for this result is that competition is limited (since a cross-subsidy signals that stand-alone supply of the subsidised products is potentially profitable). Enabling such cross-subsidies was the


87 Ibid, at p. 18.

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reason commonly given to justify statutory protection of telecommunications monopolists.

The Commission goes on to say,

“The inclusion of a share of organization-level costs or indirect costs in the Commission’s current practice would not be in accord with [the Faulhaber] definition and adds an arbitrary element in that these could be “allocated” across the services that share than in an infinite variety of ways.”88

This is incorrect. Faulhaber subsidy-free prices can and typically do include contributions toward shared costs. Only allocations that create cross-subsidies are ruled out. It is true that in the usual case, where subsidy-free prices exist, many, typically infinitely many, allocations of shared costs are subsidy-free. Not surprisingly, without further criteria, choice among these is arbitrary. However, as far as subsidy-free prices go, there is nothing pejorative in that.

The choice range is narrowed further if cost recovery is also required, since this rules out a range of subsidy-free prices that cover incremental, but not total, costs. Again, without further criteria, a choice will typically remain.

Telstra’s own recommendations are consistent with the subsidy-free and cost-recovery requirements, and it would be inconsistent with cost-recovery not to allow full recovery of the AD (as the Commission appears to be contemplating).

Dynamic efficiency demands that Telstra be allowed to recover the unrecovered AD costs elsewhere. Absence of such cost recovery would send a very poor signal to regulated firms, Telstra included, curtailing what would otherwise have been efficient future investments. Ultimately this would result in significant harm to the long-term interests of end-users. In addition, the Commission’s intuition is correct when it says,

“the inclusion of indirect costs may be able to be justified by having regard to Telstra’s legitimate commercial interests in recovering all its reasonable costs”.89

The Commission also claims,

“The means by which Telstra determines there is a local call deficit implies a definition of “deficit” that does not appear to accord with basic economic principles. The identification of a local call deficit by Telstra relies on reallocating

88 Ibid, at pp. 18-19.

89 Ibid, at p. 19. Two typographical errors were corrected in this quote. The actual quote reads, “the inclusion of these indirect costs may be able to be justified by having regard Telstra legitimate commercial interests in recovering all its reasonable costs.”

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part of the AD to local calls and redefining this reallocated amount as a cost. This redefinition of a transfer as a cost is inconsistent with basic economic principles.” [The footnote here reads: “This is the definition of deficit consistent with Faulhaber, op. cit.”]90

This completely misrepresents Telstra’s position and basic economics. The AD is defined as unrecovered costs. These costs must be recovered somewhere for both dynamic efficiency, which is in the long-term interests of end-users, and if legitimate regard is to be had for Telstra’s commercial interests. Reallocating these costs is the only means by which they can be recovered. Moreover, under any allocation, these unrecovered costs remain costs. It certainly is not true that by renaming the unrecovered costs the “AD” they are no longer costs. Yet this is what the Commission appears to suggest. Indeed, the Commission argues that Telstra is redefining a transfer as a cost, which they note, would be inconsistent with economic principles. This is an abuse of terms. The AD represents unrecovered costs, and the only “transferring” Telstra is doing is seeking a reallocation of costs consistent with cost recovery. The only redefinition that is occurring here is that of the ACCC in attempting to redefine the Access Deficit to not be a cost.

Finally, if the Commission’s views here were not confused enough, it is not at all clear what the quoted footnote means or is relevant to. Without trying to figure this out, it is worth reiterating that (1) Telstra’s position is consistent with Faulhaber’s in that Telstra wishes for a subsidy-free cost allocation, that is, one that is not open to competitive arbitrage, and (2) Telstra also wishes to be allowed full cost recovery. Both of these desires are consistent with basic economic principles.


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Attachment 16: Ramsey Efficient Derivation of Optimal Retail Margin Structure

Introduction

This attachment:

• explains how the access pricing margins relate to or help to explain the structure of retail margins; and

• numerically determines the Ramsey-efficient way to set the retail flagfall margin relative to the retail duration margin using the most available time series data obtained from Telstra over the period July 1998 to September 2002.

A standard Ramsey-pricing approach is used in order to construct a model that is able to describe the relationship between retail and access margins. This model, in combination with the estimated elasticities obtained from Attachment 13, will then be used to estimate optimal retail margin structures.

Theory

The Programming Problem91

In order to see how a Central Planner (CP) would set retail margins it is necessary to set-up a programming problem in which retail prices are chosen in order to maximise total welfare, including consumer plus producer surplus, subject to the constraint that the owner of the PSTN, Telstra, earns only normal profits.92 A CP or regulator is assumed to solve this

91 This analysis assumes that the Central Planner has access to an error-free information set. This is unlikely to be the case in reality. In fact, the efficiency losses that result from a Central Planner setting prices incorrectly based on a less than perfect information set are likely to dominate any potential allocative efficiency losses in an unregulated market.

92 The CP is assumed not to explicitly restrict the rivals to earning only normal profits because it is believed that entry or exit will dissipate any above or below normal profits that materialise in the downstream market.

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programming problem by choosing the appropriate (two dimensional) vector of per call and per minute margins (or price less long run marginal cost).93

The CP’s programming problem can be written in the following way:

Max S(P) + πT(P) + π R(P) (1)

subject to

πT(P) = 0 (2)

where the hat ‘^’ in π R indicates that this is the rival’s maximum value profit function. The lagrangean function that is maximised in order to arrive at the solution to this programming problem is:

= S(P) + πℑ T(P) + π R(P) + λ[πT(P) – 0] (3)

where λ is the lagrange multiplier that determines the benefit to society the CP believes is achievable by a relaxation in Telstra’s normal profit constraint. The maximisation of (3) implies the following first order conditions:

CP∂

∂ℑ = CPS

∂∂ +

C

T

P∂∂π +

C

R

Pˆ∂π∂ + λ

C

T

P∂∂π = 0 (4)

MP∂∂ℑ =

MPS

∂∂ +

M

R

Pˆ

∂π∂ + λ

M

T

P∂∂π = 0 (5)

λ∂∂ℑ = πT(P) = 0 (6)

The conditions (4) and (5) can be simplified in two ways. Using the envelope theorem (and assuming classical income effects are zero):

CPS

∂∂ = -CT(P) – CR(P) (7)

MPS

∂∂ = -MT(P) – MR(P) (8)

93 The notation to be used throughout this attachment is the same as that defined in Attachment 14

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Conditions (7) and (8) imply that the derivative of consumer welfare with respect to prices is equal to the negative of the demand functions. These are well known conditions in economics. It is also known from the rival’s profit function at (1) in Attachment 14 and Telstra’s profit function at (1) in Attachment 14 that the derivatives of profits with respect to prices are:94

C

R

Pˆ∂π∂ = CR (9)

M

R

Pˆ

∂π∂ = MR (10)

C

T

P∂∂π = CT + ( )M

TMM ccP −−

C

T

PM∂∂ + ( )CT

CC ccP −−C

T

PC∂∂ + (aM – cM)

C

R

PM∂∂

+ (aC – cC)C

R

PC∂∂ (11)

M

T

P∂∂π = MT + ( )M

TMM ccP −−

M

T

PM∂∂ + ( )CT

CC ccP −−M

T

PC∂∂ + (aM – cM)

M

R

PM∂∂

+ (aC – cC)M

R

PC∂∂ (12)

It is possible to use this information in order to say something about the relationship between the margin in calls relative to the margin in minutes that maximises welfare subject to Telstra earning only normal profits. Substituting (7) to (12) into (4) and (5) and rearranging yields:

Tmm

C

T

PM∂∂ + T

cmC

T

PC∂∂ + maM

C

R

PM∂∂ + maC

C

R

PC∂∂ = -ΦCT (13)

94 In the case of the rivals the result to follow comes from applying the envelope theorem.

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Tmm

M

T

PM∂∂ + T

cmM

T

PC∂∂ + maM

M

R

PM∂∂ + maC

M

R

PC∂∂ = -ΦMT (14)

where ≡Tmm ( )MTMM ccP −− and ≡Tcm ( )C

TCC ccP −− are the minutes and calls margins, maM ≡

(aM – cM) and maC ≡ (aC – cC) are the interconnection margins, and Φ ≡ λλ+−

1. Equations (13)

and (14) determine the structure of margins in the industry that maximise welfare. What is meant by the structure of margins? This is the retail margin obtained from minutes relative to the retail margin made from calls.

Optimal Margins

It is possible to solve (13) and (14) for the optimal margin structure. First define the following terms:

ΩC ≡ maMC

R

PM∂∂ + maC

C

R

PC∂∂ (15)

ΩM ≡ maMM

R

PM∂∂ + maC

M

R

PC∂∂ (16)

Substituting (15) and (16) into (13) and (14) respectively yields the matrix system:

∂∂

∂∂

∂∂

∂∂

M

T

M

TC

T

C

T

PC

PM

PC

PM

Tc

Tm

mm = - (17)

Ω+ΦΩ+Φ

MT

CT

MC

Equation (17) can be solved for the retail margins using Cramer’s Rule as follows:

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= Tmm

( ) ( )

M

T

C

T

C

T

M

TM

T

CT

C

T

MT

PM

PC

PM

PC

PCC

PCM

∂∂

∂∂

−∂∂

∂∂

∂∂

Ω+Φ−∂∂

Ω+Φ (18)

Tcm =

( ) ( )

M

T

C

T

C

T

M

TC

T

MT

M

T

CT

PM

PC

PM

PC

PMM

PMC

∂∂

∂∂

−∂∂

∂∂

∂∂

Ω+Φ−∂∂

Ω+Φ (19)

The ratio of the duration margin to the call margin, (18) divided by (19), is:

Tc

Tm

mm =

( ) ( )

( ) ( )M

T

CT

C

T

MT

C

T

MT

M

T

CT

PMC

PMM

PCM

PCC

∂∂

Ω+Φ−∂∂

Ω+Φ

∂∂

Ω+Φ−∂∂

Ω+Φ (20)

Re-writing the right hand side of (20) in terms of elasticities and the left hand side in term of the ratio of margins to prices yields:

Tc

Tm

rr = ( ) ( )[ ]

( ) ([ ) ]TMC

TC

TMCM

TM

TM

TCM

TM

TCMC

TC

TC

CPMPRMPCPR

εΩ+Φ−ηΩ+Φ

εΩ+Φ−ηΩ+Φ (21)

where ≡ TCε T

C

C

T

CP

PC∂∂ is the own price elasticity of call demand, ≡ T

Mε TM

M

T

MP

PM∂∂ is the own

price elasticity of duration demand, ≡ TMCη T

C

C

T

MP

PM∂∂ is the cross-price elasticity of duration

demand in response to a change in the per call price, ≡ TCMη T

M

CP

M

T

PC∂∂ is the cross-price

elasticity of call demand in response to a change in the per minute price, ≡ PTCR CCT is

Telstra revenue from calls, and R ≡ PTM MMT is Telstra revenue from minutes.

The existence of cross-price effects across firms and interconnection margins complicates the Ramsey-pricing condition. These two complications are now explained.

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In general terms the Ramsey pricing condition says that a price should be set relatively high if demand is relatively unresponsive to it. In the case in which there is more than one firm this statement can be generalised – a price should be set relatively high if the demands of all firms, including Telstra and its rivals in this case, are relatively unresponsive to it. This means that, for example, if Telstra calls and minutes demand and rival supply are relatively unresponsive to flagfall then the flagfall retail margin should be set relatively high.

How does this tie-in with the interconnection margin? The interconnection margins should be set so as to complement the optimal retail margins. An interconnection margin should be set relatively high if there is a high pass-through of this interconnection margin into the retail margin that should be set relatively high. For example, suppose that the Ramsey-efficient margin structure is that the flagfall margin should be set high relative to the duration margin. If there is a high pass-through of an increase in the flagfall interconnection margin into the retail flagfall margin, and a low pass-through of an increase in the duration interconnection margin into the flagfall retail margin, then the flagfall interconnection margin should be set relatively high.

It is easy to show that when the complication associated with non-zero interconnection margins is removed the super-elasticity Ramsey-Pricing rule is obtained in the context of calls and minutes. If the interconnection margins in (21) are set equal to zero, so that ΩM = ΩC = 0, the following is obtained:

Tc

Tm

rr =

ε−η

ε−η

TM

TMCT

C

TM

TC

TCMT

M

TC

RR

RR

(22)

In this case the duration margin should be set low relative to the flagfall margin when duration and calls are relatively unresponsive to flagfall and relatively sensitive to the per minute price.

Taking this further, if the cross price elasticities are zero then (22) simplifies again to:

Tc

Tm

rr = T

M

TC

εε (23)

In this case the relative margins depends only on the relative own price elasticities. The duration margin should be set low and the flagfall margin high when call demand is insensitive to price and duration demand is relatively sensitive to price.

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Another interesting case comes about when demand is responsive to either flagfall or per minute prices but not both. If the demand for calls and minutes respond only to per minute prices, for instance, then (22) becomes:

Tc

Tm

rr = T

MTM

TC

TCM

RR

εη− (24)

In this case, the ratio of the duration margin to the flagfall margin is negative, meaning that the duration margin should be negative, if calls fall in response to an increase in the price per minute, η < 0. This in turn means that the price per minute should be set below cost. If a higher per minute price causes an increase in calls, so that the cross-price effect is positive, then the duration margin should be positive. The positive duration margin should be relatively small if the cross-price effect is small relative to the own price effect.

TCM

Calibration Exercise

The task of this section is to numerically determine the Ramsey-efficient margin structure. The econometric results of Attachment 14 indicate that the elasticities and are zero. Substituting these zero restrictions into (21) yields the expression for the Ramsey-efficient margin structure at (24). This implies that the Ramsey-efficient margin structure depends on the elasticities of calls and minutes with respect to the price per minute. The estimated elasticities of Telstra duration and call demand with respect to a change in the per minute price, presented in Attachment 14 are = -0.66, and = -0.92, while the average Telstra duration and call revenue per month, estimated over the period of econometric investigation, are = $17,634,899 and = $41,902,754. Substituting these numerical estimates into (24) yields the optimal margin structure:

TCε

TCMη

TMε

TCMη

TMR T

CR

Tc

Tm

rr =

)17634899(66.0)41902754(92.0

− = -0.388 (25)

This suggests that the retail duration margin should be negative and the call duration margin should be positive. In fact, the retail duration margin should be subsidised so that it is 38% below LRMC.95 At the very least, this result suggests that 100% of the access deficit

95 Note that if Telstra were the only firm operating in the retail market then (25) increases to –0.146. The fact that this is higher is intuitive - the existence of rivals makes Telstra demand more elastic with respect to the per minute price, which places more of the burden of financing the access deficit onto flagfall.

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should be financed by the retail flagfall margin and none of the access deficit should be financed by the retail duration margin. And since the retail final product and wholesale inputs are used in fixed proportions then this retail finding translates one-for-one into a wholesale finding. In other words, since retail flagfall ought to wholly finance the access deficit then this should be supported by a high wholesale flagfall interconnection margin and low duration interconnection margin.

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Attachment 17: Competitive neutrality and efficiency There is no well-established definition of competitive neutrality in economics or public policy. Competitive neutrality is taken to mean different things in different contexts, though the overall intent of the concept is clear enough.

The Australian government uses the term to refer to the principle that government enterprises should not enjoy a competitive advantage over private enterprises simply because they are owned by the government. It is a condition underlying Section 13.3 (1) of Part 13 of the 1974 Trade Practices Act in Australia. The Act says “The objective of competitive neutrality policy is the elimination of resource allocation distortions arising out of the public ownership of entities engaged in significant business activities: Government businesses should not enjoy any net competitive advantage simply as a result of their public sector ownership.”

In telecommunications, where an incumbent telephone company provides entrant carriers access to its facilities, the term is used to capture the notion that the regulated access price should not be set to provide a particular advantage to the access provider or to the access seeker. Instead, it should be set to maintain a level playing field between the two types of firms. For instance, William Tye suggests competitive neutrality is achieved when a more efficient competitor will be successful in a “winner-takes-all” competition.96

With respect to government regulation, competitive neutrality is also sometimes referred to as regulatory neutrality. The idea of competitive neutrality in this context is that government regulation should not provide a competitive advantage for one organization over another. For example, if the government imposes regulations to stop retail outlets owned by the Coles Myer group opening on Sundays while leaving other retailers free to open on Sundays, this would provide a competitive advantage to other retailers, and would constitute a failure of regulatory neutrality.

In the economics literature a more commonly used terminology than regulatory neutrality is symmetric regulation. Symmetric regulation is regulation that does not provide a competitive advantage for one firm over another. Asymmetric regulation involves regulations that tilt competition in favour of one firm over another, typically to temporarily favour a new entrant over an established monopolist. Asymmetric regulation thus involves regulation that causes a failure of competitive neutrality.

Regulations that tie the hands of one form of competitor while leaving the other unrestricted, allow the unrestricted competitors to take away business from the restricted firms, and gain market share.

96 See William Tye. Competitive Neutrality: Regulating Interconnection Disputes in the Transition to Competition, ACCC Regulation and Competition Conference, Manly Beach, Australia, July 25-26 2002.

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In general, such asymmetric regulation leads to several types of inefficiencies. To discuss these inefficiencies it is useful to define three types of efficiency commonly distinguished by economists:

Productive inefficiencies – these arise when firms do not minimise the cost of producing a given level of output. For instance, due to the cost of the infrastructure involved, it could be productively inefficient to run two access networks rather than just one;

Allocative inefficiencies – these arise when resources are not allocated (at a point in time) to those who value them the most. Examples include the setting of prices above cost (for a regular good), or the setting of prices at cost (when the consumption of the good produces a positive or negative benefit to other consumers); and

Dynamic inefficiencies – these arise when resources are not efficiently allocated over time (in an inter-temporal sense). Examples include the delay of investment even though the investment is valued by society, or where innovation is thwarted by an inability of the firms to capture the benefits of the innovation.

Regulations that lead to a failure of competitive neutrality result in all three types of inefficiencies.

Such regulation distorts competition. In the context of telecommunications regulation, this has been emphasized by numerous academics.97 By providing an artificial advantage for one set of firms, it allows these firms to survive (and indeed gain market share) even when they offer products that are less desired by consumers (resulting in allocative inefficiencies), have higher costs (resulting in productive inefficiencies), and are less innovative (resulting in dynamic inefficiencies). These inefficiencies are ongoing.

In addition, there are one-off (productive) inefficiencies associated with users being induced to switch from the regulated firms to the unregulated firms because of the asymmetric nature of the regulation. This switching involves real resource costs.

Regulatory gaming is also likely to arise since the firms that benefit from the asymmetric regulation will be willing to spend resources to maintain the regulations, and the schemes that are hurt by the asymmetric regulation will be willing to spend resources in an attempt

97 See for instance John Haring “Implications of Asymmetric Regulation for Competition Policy Analysis” Office of Plans and Policy, Working Paper Series No. 14, Federal Communications Commission, Washington, DC. December 1984; Alfred Kahn “The Uneasy Marriage of Regulation and Competition” Telematics, 1984, Vol 1, No. 5, pp. 1-17; Dennis Weisman “Asymmetrical Regulation: Principles for Emerging Competition in Local Service Markets” Telecommunications Policy, 1994, Vol 18, No. 7, pp. 499-505; Mark Schankerman “Symmetric Regulation for Competitive Telecommunications” Information Economics and Policy, 1993, Vol 8, pp. 3-23; Chapter 8 of David Sappington and Dennis Weisman “Competition, Regulation, and Deregulation” in Designing Incentive Regulation for the Telecommunications Industry (Cambridge, MA: The MIT Press, 1996); and William Tye supra note 96, at 37-40.

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to get it removed. This extra spending results in an unnecessary waste in resources (a further productive inefficiency).98

Despite the inefficiencies caused by asymmetric regulation, regulators have occasionally resorted to using it in the telecommunications industry, in the early stages of the transition from monopoly to competition (for instance, in the United States, AT&T used to be subjected to more stringent regulation than other long-distance carriers).

The usual justification given by proponents of asymmetric regulation for this approach is that it is needed to give a temporary boost to new entrants so they can compete on an equal footing with a dominant incumbent. As William Tye puts it, “In other words, asymmetric regulation has been justified as a means of protecting fledgling firms and new entrants from the full rigors of the market place and, potentially, from unfair attempts by the incumbent to exploit the advantages of incumbency.”99 Similarly, David Sappington and Dennis Weisman state “Asymmetric regulation is generally justified with a variant of the infant-industry argument; if fledgling firms are protected from the rigors of the marketplace in the early stages of their development, they will eventually become viable competitors.”100

Most economists reject this approach. Dennis Weisman states “Economists (this one included) have been seemingly universal in their condemnation of asymmetric regulation”101, while William Tye notes “Deliberate attempts to tilt the marketplace, even temporarily, in favor of entrants have been controversial, to say the least.”102

For one thing, to the extent asymmetric regulation is imposed on the incumbent firm due to its large market share, the result will be a weakened incentive for both the incumbent and the entrants to compete (David Sappington and Dennis Weisman).103 Competitors will refrain from competing too aggressively since if they are successful the regulatory bias they enjoy may be removed. Similarly, if the incumbent competes too aggressively it faces the prospect of continued handicapping due to its market dominance. Both effects dull the natural forces of competition, and mean what is intended as a temporary lift-up to new entrants to encourage eventual competition may end up causing a permanent reduction in actual competition.

98 This point has been made by Dennis Weisman “Transition to Telecommunications Competition Amid Residual Regulatory Obligations” Public Utilities Fortnightly, 1987, Vol 120, No. 3, pp. 14-18.

99 See supra note 96, at 37.



102 See supra note 96, at 37-38.


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This is especially so when other policies aimed at promoting competition are in any event in place. In these cases, the consensus view in the economic literature is that the main effect of asymmetric regulation will be to distort market outcomes.

Additionally, these justifications of asymmetric regulation are plainly irrelevant to a regime, such as Australia’s, where the transition to competition has occurred long previously. Indeed, one of the key features of the move from the pre-1997 regime to the current legislation was to go beyond the asymmetric approach that had characterised the earlier regime (and under which Optus enjoyed a lengthy period as a protected entrant).

In short, economists who have considered regulatory issues have emphasised the importance of competitive neutrality – which in this context requires symmetric regulation. Moves away from competitive neutrality almost invariably reduce efficiency and are inconsistent with the long term interest of end users.

telstra corporation limited · telstra believes the issues involved in local calls are no different...

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