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

Price Cap Regulation Annual Pricing Formula Annual Productivity Improvement Hurdle Service Basket Structure (service groups) Rate Change Flexibility (rebalancing subsidies) Adaptability to competition (e.g new services)

Price Cap Regulation Administrative Streamlining Recovery of Exogenous (extraordinary) Cost Universal Services and Service Quality safeguards New Investment Incentives

Price Cap Regulation –Plan formula; PI (t) = CPI (t-1) – X + exogenous adj PI (t) = max price increase in the current year CPI (t-1) = Inflation measure X = expected productivity

Price Cap Regulation Incentive opportunity for improved earning. Controls prices directly. Stimulates efficiency & promoted transition to competition. Consumer benefits from efficiency. Increased flexibility, streamlining.

Price Cap Regulation Incentive (Price) Reg. –Market-based prices, rate restructuring, equalize subsidy burdens –Efficiency increases drive increased earnings –Increased flexibility, streamlined processes Rate of Return Reg. –Cross-subsidies, exposure to cream-skimming –Goldplating, low incentives for efficiency –Inflexible, Administratively burdensome

Price Cap Regulation investment has risen and service quality remains high The PR annual pricing rules set the Price Cap limits for overall rates. This rule preserves the first share of telco productivity benefit to ratepayers. Telco can improve earnings if it can be more efficient than previously under cost plus regulation.

Price Cap Regulation POTENTIAL EFFECT ON THE VALUE OF THE TELCO –Incentive regulation increases efficiency which increases future cash flow growth –Although risk is higher than under ROR, new growth opportunities and increased telco competitiveness enables realization of greater potential value –Fair incentive regulation plan leads to higher telco valuation

Price Cap Regulation Telco value effect from higher FCF, growth rate –Firm value is SUM of present value of its future free cash flow to equity (FCF) discounted at investors required return

Price Cap Regulation Telco value effect from higher FCF, growth rate (contd) –IF FCF = $TT50m this year, with 6% growth, 20% discount rate: Telco value = FCF / ( DR - %g ) = $TT357 million If Telco FCF = $TT55m, growth at 6%, value = $TT393 m If Telco FCF = $TT50m, growth at 7.0%, value = $TT385 m If FCF = $TT55m AND growth at 7%, value = $TT423 m

Price Cap Regulation Earnings Experience in other Price Reg. Cases –Earnings have improved in the majority of cases. Higher earnings raises risk of RECONTRACTING Regulators often view higher earnings to indicate the past rules have been too easy. Resetting the rules to tighter limits means telco efficiency gains come back to haunt them

Price Cap Regulation Earnings Experience in other Price Reg. Cases (contd) BT: X was 3%, 4.5%, 6.5%, 7.5%, now 4.5% with sunset US FCC: 3.3%, 4.0%, with 50/50 earnings gain sharing, later 5.3% without sharing. Court struck down 1997 reset to 6.5%

Price Cap Regulation TELCO ANNUAL EFFICIENCY TARGET ( % X ) Based on telco monopoly status and advantages of economies of scale Rate regulation seen to prevent pricing abuse. Telcos are capital intensive, i.e. have high fixed costs. Gained label as declining cost industry. % X is an annual price reduction commitment from telco to benefit consumers based on reasonable rate of efficiency gains

Price Cap Regulation TELCO ANNUAL EFFICIENCY TARGET ( % X ) –X can be based on complicated, contentious econometric studies –X can be based on regulated financial performance but often can battle over normalizing adjustments. Setting different X%s by basket introduces risk of political subjectivity.

Price Cap Regulation TELCO ANNUAL EFFICIENCY TARGET ( % X ) Simple X can be based on past average annual rate of price increases. E.g. if average tariff rates have risen 2% over last several years while average RPI was 8%, then X = 6% –If new RPI is 10%, then new price cap limit is up 4% = (10% - 6%)

Price Cap Regulation X from Historical Price method (past rate trends) –Need to overlay forward-looking rate impacts –Need to adjust for extraordinary one-time charges Example: Look at actual returns over last 5 years and compare to revenue requirements for each year to meet market-based return Assume overall rate increases needed to meet market return were 1% 0% 2% 0% -1% over past 5 years, which is 0.4% annual rate If RPI annual rate in those years was 7%, the business as usual X in plan would be 6.6% ( = 7% RPI - 0.4% )

Price Cap Regulation X from Historical Price method - DIFFICULTIES Argue over the number and amount of adjustments for past extraordinary charges Maintains a ROR approach going forward and makes it easy to calculate a higher X in future if earnings improve –This limits incentives, because higher earnings raise the X later. Can negotiate X on other basis but use this method to understand what the range of risk is

Price Cap Regulation EARNINGS SHARING RULES –Can get lower efficiency improvement target ( X ) because consumers will share 50% (?) of higher earnings –Best feature is tradeoff for lower X, justifies a symmetric low-end earnings safety net as telco protection –BAD FEATURES Reduces incentive payoffs to telco from efficiency gains Hard to eliminate later in plan ( later rate shock issue) Continues a ROR feature within incentive regulation

Price Cap Regulation Exogenous price cap adjustments –Temporary rates to recover costs that are unique to telco –Telco must file and demonstrate cost is mandatory, unavoidable, beyond its control, unique to telco –Bad Features Regulators can push downward adjustments, fight against upward recovery permission Continues a ROR feature within incentive regulation

Price Cap Regulation GENERAL SERVICE BASKET FORMAT Structure service baskets to facilitate flexibility for impending competition. –POTS ( socially protected ) services often set rate freeze or other limits for a few years. Extent of this concession can be traded-off for more flexibility elsewhere. –Non-competitive (Non-POTS) services - X hurdle applies. –Competitive services - NO X, competition limits prices.

Price Cap Regulation SERVICE BASKET GROUPINGS –Multiple service baskets allow different degrees of flexibility, from low (POTS) to high (competitive). –Need rules for services previously in non- competitive basket to transfer to competitive basket. –Competitors will be hostile to telco pricing flexibility, charging unfair competition (predatory pricing).

Price Cap Regulation Oftel - BT Price Regulation –RPI - X% now covers only 25% of BT retail revenues –Incl. connection, line rental, local, national, international calls –Current 4.5% retail X expired July 31, 2001 Max. rise of %RPI for residence line rental charge Per Call charges must be lowered to offset line rental change Compliance based on price change for lower 80% of res.

Price Cap Regulation Oftel - BT Price Regulation (contd) –Small business safeguard cap requires calling package be available at same level as residence reference tariff.

Price Cap Regulation –Safeguard cap on retail price of analogue private circuits at 65kbit and lower capacity. NO limit on higher cap circuits. –Three Overall Baskets #1COMPETITIVEOperator Assistance, new services #2PROSPECTIVELY COMPETITIVE during plans period –IDD and inter-tandem conveyance –Inter-tandem transit –Access to DQ services, Op. Services Info System, Directory Assistance System and phonebooks.

Price Cap Regulation #3NON-COMPETITIVE BASKET during plan period RPI - 8% cap to each sub-basket below Safeguard cap of RPI+0% on each service and on each time-of-day band – General Network: Call origination, local-tandem conveyance, single transit –Call termination –Interconnection specific

Price Cap Regulation NUMBER PORTABILITY –View that switching to potential competitor will be reduced if customer must lose their familiar number –Since 1996 in UK. –Initiated in 1999 in US. Central office software conversions to enable are being implemented –US: Number portability fee added to portable lines, based on incremental cost studies for central office upgrades

Price Cap Regulation TERM OF INITIAL PLAN & PERFORMANCE REVIEW –Often an initial 4 year period before comprehensive review –Review runs risk of tighter rules if earnings are up but offers opportunity to re-negotiate other changes –Rule to allow for an early plan review or temporary waivers for extraordinary circumstances may be desirable –Desirable to minimize other reporting/monitoring oversight requirements

Price Cap Regulation INITIATION OF PRICE REGULATION PLAN –Often a ROR earnings reset to start rates at right level –Other buy-ins, sweeteners, conditions are negotiated –If there is initial ROR reset, new price rules ( % RPI - % X ) first applied in one year Need ( days?) lead time for advance filing of proposed tariff for compliance review Rates may be changed within price caps ___ times annually with ___ days public notice

Price Cap Regulation UNIVERSAL SERVICE SUPPORT - USA –US Law requires implicit subsidy embedded in rates be made explicit and recovered on a competitively neutral basis. –Rural less dense service areas have higher costs to serve than dense metropolitan areas –Existing subsidy structure drives competitors to cream-skim, i.e. price below tariff in low cost metro, avoid high cost rural area –Subsidy costs are identified and recovered pro rata on all tele-communications providers based on gross retail revenue share

Price Cap Regulation UNIVERSAL SERVICE SUPPORT - UK –Goal is to ensure a basic level of telecoms service is available. –Basic service: network connection, free emergency calls, voice calls, access to directory information, itemised billing and call barring services, reasonable availability of public call boxes Special packages for low income or disabled consumers Basic prices are geographically averaged across UK so remote areas get same charge, benefit from competition –FUTURE: cross-industry fund that is proportionate, non-discriminatory & transparent

Price Cap Regulation QUALITY OF SERVICE STANDARDS –Concern that profit motive may reduce service standards BT call failure rates have fallen from 4% to 0.5% Pay phone serviceability has risen from 80% to 95% BT offers voluntary compensation for service quality failures –pays customer about TT60 per day after two days lost service

Price Cap Regulation QUALITY OF SERVICE STANDARDS Oftel uses (contd) –consumer, business advisory panels, holds public forums, seminars and workshops Conducted international survey to compare the competitiveness of BT-UK charges –US: some cable companies offer $25 if they miss appointment –US: pro-rata bill adjustment if dial tone out over 24 hrs.

Price Cap Regulation COMMON EFFICIENCY IMPROVEMENTS –US: Annual 5% employment reductions for several years via: attrition, early retirement incentives, job restructuring, department consolidations work outsourcing, e.g. cable installation automation, e.g. billing systems, self-service T-tone menus from 45 employees per 10K access lines in 1990 to 26 now –UK: Employee levels declined steadily from 230K in 1984, only rising again to be at 217K recently

Price Cap Regulation OTHER EFFICIENCY INITIATIVES –Performance bonuses, sales commissions, variable salary component based on achieving telco performance goals –broader merit-based salary bands –budget targets and reviews –assessment, training, retraining programs –amnesty/recapture for prior disconnects but with restrictions –spread out payments for initial non-recurring charges –Complete Choice grouping of vertical services –external performance benchmarking

Price Cap Regulation A A bad Price cap plan 1.An unreasonable % X 2.Unreasonable constraints on rate flexibility..baskets, sub-caps, sub baskets 3.Ignoring costs and an appropriate ROR..USO, rate rebalancing etc. 4.Not recognizing pricing and bundling plans or carry over treatment…naming a few 5.Unclear determination of X and other variables

Price Cap Regulation Questions ?