Figure D1: The
relationship between the concepts of incremental, common and standalone costs,
and the proposed floors and ceilings
D.1 At present, the main basis of costs used to regulate BT is fully allocated costs using the historic cost accounting convention. For example, interconnection charges for use of BT's network are currently set on the basis of fully allocated costs. In future, Oftel proposes to use the appropriate costing methodology for its regulatory decisions, which would usually be forward looking long run incremental costs. For the next control period Oftel proposes that interconnection charges will be based upon long run incremental costs, provided that a robust methodology can be established. The methodology to calculate long run incremental costs is discussed in greater detail in the next section of this Annex.
D.2 Long run incremental cost is a forward looking concept and so would be reflected more accurately by the use of current cost accounting (CCA) rather than historic cost accounting (HCA). In the HCA approach the basis for the valuation of an asset is its historic cost, its cost at the time that it was purchased. In the CCA approach the basis for valuation is the replacement cost of an asset, how much it would cost today if it were to be replaced.
D.3 Forward looking costs are the appropriate basis for interconnection charges because they reflect resource costs. Ideally for economic efficiency, the prices of retail services should be set in a way which encourages consumers to take account of the resource costs of their purchasing decisions. Operators would be encouraged to set efficient retail prices if they could purchase a major input (interconnection) at a charge that was set by reference to the cost of the resources consumed by its provision. Since replacement costs would be the costs faced by a new entrant, signals would be given to encourage efficient entry into and exit from interconnection services, if the incumbent's interconnection charges were set on the basis of forward looking costs. An entrant into provision of interconnection services that was more efficient than the incumbent could make a profit by setting a charge below the incumbent's charge, whereas an inefficient firm would be unprofitable if it were to match the incumbent's charge. In addition, efficient entry into retail services would be encouraged, although this would depend also upon the nature of retail prices.
D.4 In its purest form, the concept of forward looking costs requires that assets are valued using the cost of replacement with the modern equivalent asset (MEA). The MEA is the lowest cost asset which serves the same function as the asset being valued. It may incorporate the latest available and proven technology and is the asset which a new entrant might be expected to employ. In a world in which technology is changing rapidly, it is quite likely that, for some assets, the MEA will differ from the asset that an incumbent currently has in place. For example, BT continues to use analogue local switches to serve a proportion of customers, but the MEA for a local exchange would always be a digital switch.
D.5 In the preparation of its CCA accounts, BT uses an MEA approach for some asset groups, but adjusted for the technology mix in three years' time (the 'three year look'). The valuation method used by BT is based on the lower of its net replacement cost and its recoverable amount. Only where an asset is not expected to be replaced in its existing form because of technological advances might the 'three year look' approach be adopted. Since BT plans to replace all of its remaining analogue switches within three years, its CCA valuation of local exchanges is on the basis that all switches are digital. But the approach may not always lead to the use of the MEA as the basis for asset valuation. For example, in the next three years BT expects to retain transverse screen cable in some transmission circuits, rather than replacement with optical fibre circuits. To that extent, the 'three year look' approach differs from pure MEA. BT argues that its approach is justified because it reflects the practical difficulties and time lags involved in updating a nationwide network to the latest available technology.
D.6 For the calculation of long run incremental cost (LRIC), the network has been defined as a stand-alone network of inland Public Switched Telephone Network (PSTN) services and private circuits. The network assumed in the incremental cost methodology therefore excludes advanced services such as Integrated Services Digital Network (ISDN) and Virtual Private Networks.
D.7 Incremental costs include only the costs that are caused by the provision of a defined increment of output. In the methodology to calculate incremental costs, the increment in question is the whole of the output of a service - two services are considered: conveyance and access. The long run incremental cost of conveyance is the cost that would be saved in the long run if no traffic were provided over the network, but access were to continue to be provided. It is assumed that all assets are replaced in the long run and so it is assumed that there are no sunk costs in the long run. The incremental cost of access is the cost that would be saved in the long run if no final links to customers were provided (but, hypothetically, conveyance continued to be provided). If there are economies of scope between conveyance and access, it will follow that there are common costs of the network, ie costs of the stand-alone network that are incurred when conveyance and access are provided simultaneously, but are incremental to neither of conveyance nor access on its own.
D.8 In order to establish a robust methodology to calculate long run incremental costs, the Interconnection and Accounting Separation Task 19 Steering and Working Groups have been overseeing the development of two modelling exercises. BT has developed a top-down model, which starts from its management accounts and removes costs that are not incremental. The Incremental Cost Working Group has constructed, and populated with data, a bottom-up model of the network using economic-engineering models that attempt to identify, for a fully efficient operator, the engineering elements required to build a network and to estimate their generic costs.
D.9 BT's top-down model contains a large number of categories of cost (583). Some categories relate to direct costs, others to indirect costs (eg personnel). For each category BT has identified one or more cost drivers and a cost-volume relationship, describing the rate at which cost would fall in the long run with a decline in the volume of the cost driver(s).
D.10 Starting from the level of cost in each category derived from BT's HCA accounts, the volume of the cost driver associated with retail and non-PSTN activities is applied to the cost-volume relationship to give the costs relevant to the stand-alone network. The volumes of the cost driver associated with each of conveyance and access are identified. Each is applied to the cost-volume relationship starting from the point relevant to the stand-alone network, to yield the incremental cost. The total incremental costs of conveyance and access are found by summing over all 583 categories. The incremental cost of conveyance is split into the costs of network components by applying the proportions that are used in BT's management cost accounts by service. Finally, an attempt is made to convert the costs of network components from HCA to CCA by an adjustment factor given by the ratio of CCA costs to HCA costs for that network component in BT's management accounts.
D.11 BT regards the top-down model as a demonstration of a methodology and recognises that it may require some restructuring and development. Oftel is aware that there are a number of areas where the model requires improvement before it will produce robust results. Problems with the top-down model in its current form include the level of aggregation at which the conversion from HCA to CCA costs is carried out, the fact that some of the cost-volume relationships appear to be out of date, and the complexity of the model which, combined with a lack of adequate documentation, makes it difficult to audit. Strengths of the top-down model are that it examines costs in a highly disaggregated way and that it is fully articulated, ie it reflects the complex inter-linkages which often occur in relating a cost to a network component.
D.12 The bottom-up model consists of three constituent economic-engineering models. The incremental cost of conveyance is derived from the Network model, which models the cost of a typical tandem and local switch and typical transmission links, each dimensioned at the capacity needed to serve a specified percentage of UK traffic. Thus far the Working Group has focused upon the costs of an operator with 90% of UK traffic, but future work will lead to sets of generic figures for an operator with 60%, 30% and 10% of UK traffic (assuming the UK average customer mix). For modelling purposes it has been assumed that the number and location of BT's switches are given (the 'scorched node' assumption). The alternative would be to assume a pure greenfield approach and allow the number and location of switches to be fully optimised, but the Incremental Cost Working Group considered that this would lead to excessive complexity in the modelling.
D.13 The replacement cost of switches and transmission links is converted into a cost per annum by using an annuity formula. Operating costs are allowed for in the model through ratios of operating costs to capital costs for switching, transmission and access. The operating cost factors are derived by Oftel from information submitted by a number of operators on the relationship between operating costs and gross replacement costs on their existing networks.
D.14 The incremental cost of access is derived from the other two constituent models: the costs of the provision and maintenance of lines from the exchange to the cross-connect point are modelled in the Feeder model, and from cross-connect point to households in the Distribution and Drop model.
D.15 Further work remains to be done by the Working Group to refine the bottom-up model and the generic data with which it is populated. First, the algorithms in the model tend to abstract from logical inter-relationships between parameters, leaving them to be taken into account outside of the model by each operator when deriving its model inputs. Therefore, care will need to be exercised to ensure that the generic figures, derived by Oftel from the data submitted by a range of operators, are based on a set of consistent assumptions. Second, the modelling of operating costs is not fully articulated and the derivation of the operating cost factors inevitably involves an element of judgement. Third, the modelling of transmission will require further work, to develop the costs for point-to-point transmission in a network of PSTN and private circuits and to compare these costs with a transmission network of intermediate multiplexing (the approach that characterises BT's transmission network). The strengths of the bottom-up model are its transparency and relatively simple structure. It allows operators to understand the derivation of network costs, because it explicitly focuses on the parameters which drive network dimensioning.
D.16 The top-down and bottom-up models have different treatments of depreciation. The top-down model assumes straight line depreciation; the annuity approach in the bottom-up model implies a depreciation profile with relatively little depreciation in the early years of the asset life and relatively more in later years. Neither approach, however, captures the profile of economic depreciation. This is an issue that will need to be explored further in both models.
D.17 Since the top-down and bottom-up models have different strengths and weaknesses, both will have a role to play in deriving the robust methodology to calculate incremental costs. Improvements to both models will continue to be made under the guidance of the Incremental Cost Steering and Working Groups. One way in which the models will be developed is to ensure that key issues (eg economic depreciation) are treated in a consistent fashion and that parameter assumptions (eg asset lives and cost of capital) are the same in both models, except where differences reflect differing levels of efficiency. This should bring the results of the two models closer together and allow each model to provide a useful cross-check on the other. It will then be possible to derive robust results for incremental costs by identifying the source of any remaining differences and making judgements about the appropriate parameter values or methodological approach. A report by consultants giving details of the two models and the further work planned will be available shortly from Oftel's library.
D.18 The proposed system of ceilings and (guideline) floors on the charges set by BT for network components was outlined in Chapter 5, Interconnection and Network Charge Cap. The level at which the ceilings and floors would be set is discussed in greater detail in this section.
D.19 A simplified representation of the relationship betweenvarious concepts of cost (incremental, common and stand-alone cost) and the proposed floors and ceilings is shown in Figure D.1. The current methodology to calculate incremental costs breaks down the cost of the stand-alone network into the incremental cost of access, the incremental cost of conveyance and the common costs between access and conveyance.
Figure D1: The
relationship between the concepts of incremental, common and standalone costs,
and the proposed floors and ceilings
D.20 In principle, by defining each network component as an increment, the incremental cost of conveyance could itself be broken down into the incremental costs of the network components and the common costs between those components. Common costs between components would exist if there were economies of scope between components, which might arise, for example, from the co-location of switches or the sharing of duct between different transmission links. For simplicity, in Figure D.1 it is assumed that there are just two network components: switching and transmission. (In the current interconnection regime the network components are local switch, main switch, junction transmission link, junction transmission length, trunk transmission link and trunk transmission length.)
D.21 The current methodology to calculate incremental costs does not, however, define each component as an increment, but takes the increment to be the whole of conveyance and derives the costs of components accordingly. This definition of the increment abstracts from any common costs between network components, ie the incremental cost of conveyance is necessarily equal to the sum of the costs of the components.
D.22 Using the current methodology, the proposed floor to the charge for (say) transmission would be given by the incremental cost of transmission plus a proportion of the common costs between switching and transmission, expressed as an average per unit of output (eg pence per minute). The remaining common costs between switching and transmission would be included in the proposed floor for switching. Therefore, floors given by the current incremental cost methodology would normally be higher than the average incremental costs of components, because they would include a proportion of the common costs between network components.
D.23 The stand-alone cost of a component is the cost that would be incurred if (hypothetically) that component, but no other components, were provided. It is therefore given by the incremental cost of that component plus all of the common costs that are relevant to that component.
D.24 The common costs between access and conveyance can be broken down into the costs that are common between access and transmission (arising, for example, from duct sharing) and the costs that are common between access and switching (arising, for example, from concentrators). The stand-alone cost of transmission would be given by the sum of the incremental cost of transmission, the common costs between switching and transmission and the common costs between access and transmission. Similarly, the stand-alone cost of switching would be given by the sum of the incremental costs of switching, the common costs between switching and transmission and the common costs between access and switching.
D.25 Using the current methodology, it is proposed that the ceiling to the charge for (say) transmission would be calculated as the proposed floor for transmission (ie the incremental cost of transmission plus a proportion of the common costs between switching and transmission) and the common costs between access and transmission. The proposed ceiling would therefore normally be lower than the stand-alone cost, because it would include only a proportion of the common costs between network components rather than all of such costs.
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