Introduction The pressure on all types of operators to implement cost- based pricing, especially for interconnect services, is growing I will deal with issues around the determination of tariff levels, and how to determine tariff structures. I will also touch upon how tariffs for commercial services will typically be determined in a negotiation process

Price Determination By Cleveland Thomas SEMINAR ON ITU PRICING MODELS TBILISI, GEORGIA, NOVEMBER 14-15, 2002

Why are interconnection rates so important? Sellers of Services Protect retail market positions - discourage cherry-picking - protect retail tariffs Increase revenues Regulators Protect retail customers Promote competition Give efficiency incentives Deter uneconomic entry etc. Buyers of services Minimize overall costs Enable competitive tariffs Simplify roll-out of own retail services

Key issues for pricing wholesale / interconnect services The growing importance of jointly-provided services The importance of taking both long and short-term considerations The importance of recognizing that the interests of the regulator are, in the longer term, fundamentally opposed to the interests of the telecoms industry The need to understand the implications of pricing decisions across retail and wholesale services The need to understand that wholesale relations between operators are bilateral (both sides are buyers and sellers)

Key differences between a Regulatory & Commercial Approach Commercial Approach Driven by demands rather than costs Long-term profit maximizing Must fit with overall strategy and retail tariff structures Art based on science Regulatory Approach Cost-based – FAC vs.. LRIC – historic vs.forward- looking Mark-up – zero – uniform – Ramsey – ECP

Tariffing must be approached in an integrated manner. Retail Wholesale Service N Service 2 Service 1 Value to Customer Expected competitive action Own costs to produce Price Cross elasticitys Service N Service 2 Service 1 Value to Customer Expected competitive action Own costs to produce Price Cross elasticitys Optimization Regulatory interests

Value-Based Price of a Wholesale Service

Different cost-bases can provide the starting point for (cost-based) tariffs Short Run Marginal Cost (SRMC) –Cost of one additional unit of output, given existing capacity Long Run Incremental Cost (LRIC) –Cost of adding a service or increment, including capacity costs Stand Alone Cost (SAC) –Cost of providing one service by itself Fully Allocated Cost (FAC) –Directly attributable cost plus a pro rata share of overheads These cost types will be addressed in more detail later

Tariffs must also include a mark-up Type of mark-up Zero mark-up Uniform mark-up Ramsey Pricing Pros stimulates entry strong efficiency incentives prevents excess profits easy to calculate balances conflicting objectives promotes efficient final svc. Prices prevents excessive profits Cons threatens viability of seller promotes uneconomic entry distorts competition arbitrary inefficient impact depends on flexibility of final service prices inelasticity may be due to lack of competition

Tariffs must also include a mark-up Type of mark-up Efficient Component Pricing Pros -promotes fair competition -deters uneconomic entry -ensures viability of seller Cons -provides weak efficiency incentives -does not address monopoly profits

The Choice of mark-up can have a dramatic effect on tariff levels Illustrative Interconnect Charges (pence/call minute) Note:Price for the use of a local Tandem

Tariff structure is an important as tariff level A generic tariff is a combination of one or more of the following elements : – initial charge (one-off charge - only one time) – fixed charge (time-based) – call set-up (unsuccessful vs. only successful calls) – charge per unit Other dimensions also need to be considered – geographical structure (distance) – time-of-day structure – charging unit (per minute, per second) The link to the retail tariff structures must also be considered – same structure ? – closer links to cost-drivers ? – higher complexity ?

Examples of importance of tariff structures True results depend on expected calling patterns expectations will differ among operators depending on –retail customers served –retail services offered each wholesale customer will have individual wishes for the optimal tariff structure An infinite of solutions give the same result (3 minute call) Charge per minute Call set-up

Arriving at tariffs in this market segment will involve a set of negotiations Regulator Operator 1Operator 2

Overview of typical positions Start Position - Tariffs based on historic FAC - Tariffs based on WACC of 18% TargetWalk-away Reasoning - Tariffs should cover all historic costs - Risk of business is high - Tariffs based on LRIC + equal mark-up - WACC equal 15% - Tariffs should cover incremental costs - Level of cost of capital is more important than cost - Tariffs based on LRIC + equal mark- up - WACC equal 12.5% - Cost of capital at minimum level to ensure viable business

Impact of different views on revenues

Key Conclusions Pricing is an integral part of your overall commercial strategy for dealing with wholesale and interconnect All parties negotiation interconnect and wholesale tariffs should address the issues with a broad, long-term view to ensure that value stays in the industry Regulatory-lead, cost-based pricing of these services should only be a last resort when negotiations fail Developing optimal tariff structures is as important as determining the tariff level Determining tariff levels and structures is not a one-off exercise, but rather part of an ongoing negotiation process