Adoption of a costing model to calculate regulated prices in telecommunications

Chart 1 summarizes various feasible costing alternatives to calculate regulated prices in telecommunications.  This topic is examined in greater detail below.

Historical costs

Historical costing models[1] estimate costs for the network elements of a company’s operation on the basis of the company’s accounting and financial statements.  These costs generally consist of the compilation and review of the operators’ historical accounting data, depending on the rules provided to the industry by the country’s accounting authority.

Chart 1.  Regulated pricing models:  Decisions to be taken

Translation of chart:

What costing standard should be used?
What capital cost rate should be used?
FDC (historical)
Forward-looking costs
Short-term
Long-term
Short-term
Mark-up
Ramsey
ECPR
Simple

 A historical costing model, for the purpose of determining regulated prices, necessarily depends on the quality of financial accounting and costing systems.  In those countries where the regulator acts as the accounting authority, it tends to be easier to adopt a useful accounting system to estimate regulated prices.  The regulator, aware of its tariff needs, simply requires that the accounting subsystems for fixed assets, administrative expenditures, and operating costs, as well as the company’s costing system, be adjusted to reflect the network’s structure in accordance with the requirements of the tariff system.

In those countries where there is a separate accounting authority, one different from the regulatory authority, there must be broad and close coordination so that the accounting system can reflect the information needs and requirements of the regulated tariff and price structure.

As we shall see below, one of the main drawbacks of a historical costing model lies in the regulator’s difficulty in developing a price model that reflects the efficient operation of a telecommunication company.  As a rule, this type of model reflects the historical inefficiencies of a company.  If it is used, ultimately it is the user who ends up by absorbing the company’s past inefficiencies, in the form of higher tariffs.

Nevertheless, historical costing models may ultimately be extremely useful for both operators and regulators.  For the former, a well-developed and efficient historical costing model, when sound management systems are used at the same time, makes it possible to identify inefficiencies in the different services provided by the company and the possibility of adopting compensatory measures.

For the regulator, on the other hand, financial and cost accounting generates key information to compare its models with the reality of companies to derive cost indicators and drivers and to assess the impacts of the regulatory measures that have been adopted on the finance of companies.

Likewise, the information that flows from accounting should be the basis for obtaining long-term incremental prices through top-down models, which we shall be referring to later in the chapter.

Forward-looking costs

The second standard that can be chosen to estimate interconnection prices is the forward-looking costing methodology. Forward-looking costs are those incurred by a company in the future, in contrast to the costs already incurred by a company in the past.  The question that needs to be answered is therefore: What is the value of the network at present and its costs in the future and what are the investments the operator must make toward in the future to keep an efficient business?

As indicated in Chart 1, forward-looking costs can be of two kinds, depending on the term that is being considered:  short-term or long-term.  The analyst must choose which of the two to use in his/her costing methodology.  Let us examine each one of these two categories.

h     Short-term costs: Short-term costs are those that are generated over a forecasting horizon, so that the productive capacity of the enterprise (for example, the number of installed lines) is fixed.  Let us say, for example, that the installed capacity of a given company remains unchanged over the ensuing three years and that it can only expand after the third year, then the short-term is three years.[1]

h     Long-term costs: Long-term costs, however, are those that reflect a productive structure where the company’s installed capacity is variable.  Over the short term, there are no fixed costs; all costs are variable.  In this regard, all costs are avoidable, because the company’s management can, over the long term, choose the size of the company with which it wishes to operate.

Choice of costing standard

Therefore, what is the costing standard that should be used? First, let us say that, for an industry such as telecommunications, characterized by a declining long-run average cost structure (growing economies of scale), the choice of costing is clear: long-term costing must be considered.  For an operator holding SMP[2] that does not work with long-term costing, the regulator has to approve tariffs for the regulated period.[3]  In the near future, however, these tariffs shall be higher than costs, since unit costs shall be reduced as a result of technological breakthroughs taking place in the industry in subsequent periods.[4] Calculating tariffs on the basis of the short-term investment and cost structure therefore implies allowing the dominant operator to obtain monopolistic earnings that are higher than normal profits.[5]

It is therefore concluded that the efficient costing standard must be long-term costs.

Second, the analyst must choose between historical costs and forward-looking costs. In this regard, let us say that the pricing methodology to be chosen, for the reasons set forth in section 2.1, must consider the model that reflects efficient costs and the investor’s opportunity costs.  Since new operators, when taking new investment decisions, bear in mind the costs entailed by these decisions at the time these investments are made, regulated interconnection prices must reflect additional future costs that shall be incurred marginally (or incrementally)[6] as a result of the interconnection process.  Therefore, the standard that must be chosen is that of long-term forward-looking costs.

In this regard, the European Union asserts that

“the implicit correct approach when identifying and measuring ‘real’ economic costs (…) associated with the increase in production is the use of the forward-looking costs concept.  It is only in non-competitive markets that companies can set prices, year after year, according to calculations made on the basis of the original costs of their investment.  In a competitive market, the price paid by the company for an asset or investment is not what determines its profitability.  From the time the investment is made (that is, the time when it is no longer possible to go back on the investment without incurring extraordinary costs of significance), the value of the asset depends on what the company can effectively do with it (…) [regardless of the initial or historical cost of the investment].”[7] (the underlining is ours)

In an industry that has increasing economies of scale and, as a result, declining long-run cost structures, calculation of interconnection costs based on historical costs yields, as a result, charges that are higher than efficient costs, therefore contributing to protecting incumbent operators from the real pressure of the forces of competition.

Setting interconnection prices that do not reflect efficient costs associated with the interconnection service shall lead to the transmittal of mistaken signals to the market, which in turn shall lead to mistaken decisions by the various players on the market with respect to renting or building new facilities.[8]

Therefore, forward-looking costing models are those that best reflect the type of decisions that operators must take, because they pass over the inefficiencies that a company may have had in the past and that are reflected in the methodologies based solely on historical costs.  This means that the recognized operator costs pertain to those associated with an efficient operator, using the best technology that can be installed.  In this regard, ITU[9] recommends the use of long-term forward-looking efficient costs:

“Many countries and multilateral organizations are currently adopting rules and principles that require that interconnection costs be based on [efficient] costs or that they be geared to costs. (…) Without a standard based on costs for the purposes of setting interconnection charges, the dominant operator has the incentive to set prices as high as possible.  This practice limits market entry and leads to costs that are excessively transferred to consumers and can result in the establishment of cross subsidies by the dominant operator.”

The costing model recommended by international regulatory practices is long-term forward-looking costs.  Despite this, the debate at the time of discussing the models to be used is evident.  Operators shall tend to demand that historical costing models be accepted because they reflect the costs that have effectively been incurred in the past.  The use of forward-looking costs surely generates adverse financial impacts, at least over the short term.  This is the kind of discussion that is typical at the bargaining table when interconnection prices are being defined on the basis of regulations.

Victor Mayorga
ACIEM-Colombia