C.1 In August 1995 the economic consultants, NERA, were appointed to evaluate the top-down model developed by BT and the bottom-up model developed by the Incremental Cost Working Group. NERA's report contains a description and assessment of both models and sets out the strengths and weaknesses of each. NERA also made a number of recommendations for each model to improve the quality and reliability of their results. The further work currently being undertaken by BT on the top-down model and the developments by the Working Group of the bottom-up model largely follow the NERA recommendations. Copies of NERA's report are available from Oftel's library.
C.2 Since the first consultative document the Working Group has been further developing the bottom-up network model, which estimates the incremental cost of conveyance. This work, much of which is now completed, has included the following:-
C.3 Members of the Working Group have contributed data for the network model. Based on this information Oftel has produced a set of generic figures for the '90% network', ie a network serving 90% of UK customers (assuming the average customer mix). Some parts of the model and of the generic figures are the subject of ongoing discussion and dispute amongst members of the Working Group. It is expected that the remaining work on the network model for a 90% operator will be completed by the middle of April at the latest.
C.4 The network components identified in the bottom-up model are different from the current classification of components used by BT. In Oftel's view, the classification of components in the bottom-up model is more transparent and logical than the current set of components. Oftel proposes therefore that the network controls should adopt the new set of network components, ie that the component charges set by BT under the network caps will be on the basis of the new set of components. Oftel will expect BT to produce its Financial Statements on this basis for 1997/98 and subsequent years. Table C.1 sets out a comparison between the current and new sets of network components:-
Table C.1: The current set of components and the components proposed for the network caps
Current set of components New set of components for
the network baskets
local exchange local switch
concentrator
main and digital junction tandem switch
switching
junction transmission RCU-local transmission
trunk transmission local-tandem transmission
(including local-local transmission)
inter-tandem transmission
Note: The transmission components may be further sub-divided into link and length related costs.
C.5 In the new set of components the costs of the concentrator (or, under the network caps, the charge for the concentrator) would be separately identified from the local switch. Transmission would be classified according to the type of switches between which conveyance occurs, ie between the remote concentrator and the local switch, between the local switch and the tandem switch and between two tandem switches. In the current classification, trunk transmission relates to inter-tandem links but also includes long local-tandem links, whilst junction transmission bundles together RCU-local links and the remaining local-tandem (and local-local) links. As the bottom-up model shows, each of the three types of transmission has quite different cost characteristics.
C.6 Using the generic figures currently produced by Oftel for the network model (90% network), floors and ceilings can be estimated for network components:-
Table C.2: Component floors and ceilings in the bottom-up model (using data for 1993/94) Figures shown in pence per minute
Floor Ceiling
Switching:
Local switch 0.19-0.23 0.19-0.23
Concentrator 0.16-0.20 0.48-0.60
Tandem switch 0.05-0.07 0.05-0.07
Transmission:
RCU-local 0.29-0.35 0.39-0.46
Local-tandem 0.04-0.06 0.05-0.07
Inter-tandem 0.30-0.56 0.32-0.58
Notes: The figures for RCU-local transmission reflect the proportion of calls expected to be conveyed through remote rather than host concentrators.
The cost of capital used in the calculations is a real pre-tax rate of 8%, which is broadly consistent with the figures for the cost of capital suggested in Chapter 7.
C.7 As described in the first consultative document, the floors are given by the incremental cost of conveyance, broken down into the costs of network components. The ceilings are given by the stand-alone cost of conveyance, broken down into the costs of components (in pence per minute). These are the proposed floors and ceilings because, in the incremental cost methodology, the increments are taken to be the whole of conveyance and the whole of access. In Annex D of the first consultative document the proposed floors and ceilings were contrasted with the average incremental and stand-alone costs that would be derived if each network component were taken as an increment. It was suggested that the definition of the increments in the methodology meant that the proposed floor would be related to, but normally larger than the average incremental cost of the network component (ie if the component were defined as the increment) and that the proposed ceiling would be related to, but normally smaller than, the average stand-alone cost of the component.
C.8 The definition of the increment in the methodology as the whole of conveyance leads to the result that for local and tandem switches the floor is equal to the ceiling. The ceiling for a network component is found by adding to the floor (on a pence per minute basis) the common costs between conveyance and access that are relevant to that component. In the bottom-up model there are two sources of such common costs. Concentrators serve both access lines and traffic - part of the capital cost of concentrators and associated operating costs are incremental to neither conveyance nor access, but constitute common costs. Common costs also arise from the sharing of duct between transmission and access. The common costs that arise from concentrators are included in the ceiling for concentrators; the common costs that arise from duct sharing are included in the ceilings for the transmission routes. None of the common costs identified in the bottom-up model is associated with local or tandem switches. In consequence, the ceilings for these components are equal to the floors.
C.9 BT Network will not be selling network components to interconnecting operators, it will be selling interconnection services. Interconnection services are combinations of network components and their charges are derived by applying routing factors to the component charges. In this context, the distinction between interconnection services and network components is important. Since there is no interconnection service that comprises just a local switch or a tandem switch (with the exception of single tandem transit segments), BT Network will always sell a local or tandem switch in combination with other components. As a consequence, at the level of interconnection services, BT Network will always have a degree of freedom in setting charges within floors and ceilings. Floors and ceilings for some interconnection services, implied by the floors and ceilings for network components in table C.2 above, are reported in table 5.3 of Chapter 5.
C.10 A number of issues that could significantly affect the results of the bottom-up model are currently under discussion or in dispute in the Working Group. The appropriate economic depreciation profiles constitutes one area that the Working Group will continue to explore. Other issues where there is a divergence of opinion in the Working Group include the level of operating costs for switching and the appropriate cost of capital.
C.11 Some figures received very recently from BT suggest that the figures above may substantially understate the duct investment required for the transmission network. Oftel will look with great care at the corroborating evidence that BT can bring forward to support its view and how it can be reconciled with the information relating to duct costs supplied to Oftel over many years. The recent figures for transmission duct investment provided by BT, if accepted, could lead to a substantial increase in the floor for the transmission components and, in particular, the cost of transmission between the remote concentrator and the local switch. There might also be important implications for the figures supplied by BT in the context of the price control financial modelling exercise. In the calculations above, Oftel has chosen to use information based on more established methodologies to estimate the gross replacement cost of duct and its allocation on a causal basis between conveyance and access. Such numbers are broadly consistent with the figures supplied by BT for the price control financial modelling exercise.
C.12 Both the top-down and bottom-up models will estimate the costs of a stand-alone network providing both PSTN services and private circuits. In terms of the costs of conveyance, the inclusion of private circuits (compared to a stand-alone PSTN) would tend to reduce the average incremental costs of transmission, by allowing larger and more cost effective transmission equipment to be used. The inclusion of private circuits can also be expected to reduce the average incremental cost of access (by allowing the cost of duct to be spread over a larger number of lines).
C.13 The inclusion of private circuits may reduce the average incremental costs, but it would raise the total incremental costs of conveyance and access. Compared to a stand-alone PSTN, the size of the common costs would be unaffected but the apportionment of those common costs under an equal mark-up regime would be different. Diagram C.1 illustrates the implications for the apportionment of common costs of including private circuits in the network.
Diagram C.1: Representation of PSTN and private circuit costs
C.14 In diagram C.1 the costs of a stand-alone PSTN (ie with no private circuits) would be given by:-
Cost of stand-alone PSTN = A + B + C + D + E + F
This cost could be broken down into:-
Incremental cost of conveyance (PSTN) = A + D
Incremental cost of access (PSTN) = C + F
Common costs between
conveyance and access (PSTN) = B + E
C.15 Under equal mark-ups the common costs apportioned to conveyance and access would be given by:-
Common costs apportioned to conveyance = (B+E) x A+D
A+C+D+F
Common costs apportioned to access = (B+E) x C+F
A+C+D+F
C.16 With the inclusion of private circuits (PCs) in the network the total costs of the stand-alone network would increase. In the diagram above the incremental cost of private circuits has been split into three different types: costs that relate to conveyance (denoted 'G'), costs that arise from access (denoted 'H'), and costs that are specific to private circuits (denoted 'I'). The costs of the stand-alone network of PSTN and private circuits would be given by:-
Cost of stand-alone PSTN+PCs= A + B + C + D + E + F + G + H + I
C.17 The costs of this larger network could be broken down as follows:-
Incremental cost of
conveyance (PSTN+PCs) = A + D + G
Incremental cost of
access (PSTN+PCs) = C + F + H
Common costs between conveyance
and access (PSTN+PCs) = B + E
PC specific costs = I
C.18 The inclusion of private circuits would create no common costs - any costs that are common between the PSTN and PCs would already be included in the costs of the stand-alone PSTN. Under equal mark-ups the common cost would, however, be apportioned differently. Some of the common cost would be apportioned to the private circuit specific costs as well as to the incremental costs of conveyance and access, which would be likely to leave a smaller amount apportioned to conveyance:-
Common cost apportioned to conveyance = (B+E) x A+D+G
A+C+D+F+G+H+I
Common cost apportioned to access = (B+E) x C+F+H
A+C+D+F+G+H+I
Common cost apportioned to PC specific costs = (B+E) x I
A+C+D+F+G+H+I
