Draft Determination: Proposed Fixed Portability Costs and Charges

October 2001

Contents

Draft Determination under Condition 28.2(a) of BT’s Licence

Explanatory Memorandum

Determination Schedule 1

Determination Schedule 2

Consultation

Draft Determination

TELECOMMUNICATIONS ACT 1984

PORTABILITY COSTS AND CHARGES

DETERMINATION UNDER CONDITION 28.2(a) OF BT’s LICENCE

WHEREAS:

NOW, THEREFORE, THE DIRECTOR, PURSUANT TO CONDITION 28.2(a) OF THE LICENCE HEREBY DETERMINES THAT:

DAVID ALBERT EDMONDS

DIRECTOR GENERAL OF TELECOMMUNICATIONS

XX XXXX 2001

Explanatory Memorandum

1. Number Portability is a facility that enables customers to retain their telephone number when switching operator. The easier it is to switch the greater the pressure on operators to make their services competitive, as failure to do so could lose them customers. For Portability to be effective, it is important that the inter-operator charges (for processing the port) reflect the cost of providing the service. Higher charges might discourage operators from attracting customers on other networks, which would be of detriment to the competitive process. For this reason, on 18 July 2001, Oftel published Draft Determination: Proposed Fixed Portability Costs and Charges in which it proposed charges for BT’s Portability inter-operator charges on the basis of BT’s long-run incremental costs (LRIC) in processing Portability orders. Oftel believes that LRIC most closely represents the costs on which businesses in competitive markets make investment decisions.

2. Respondents agreed that inter-operator charges based on LRIC were appropriate for the provision of Portability, although BT had concerns with the methodology and calculations used to derive the charges. Oftel therefore intends to set charges for the provision of Portability by BT on the basis of its LRIC. However, first, it needs to consult on draft charges for processing block Non-Geographic Portability as draft charges for processing these orders were not set out in the July 2001 draft Determination. In addition, Oftel is taking this opportunity to re-set costs and charges for the Portability services referred to in the July 2001 draft Determination, as it has received later wage rate data from BT.

Setting the charges for fixed Portability services

3. In the July 2001 draft Determination, Oftel proposed to set charges for BT’s fixed Portability services based on estimates of the direct labour input required for each service and these were derived for each service on the basis of a BT time and motion study (although full explanations of the calculation of this and of the other data underlying the charges have not been received by Oftel). The proposed charges also included standard estimates of hourly labour costs for the appropriate grades of staff. In addition, Oftel allowed for indirect labour costs, other operating costs, depreciation and the cost of capital. BT proposed that these should be based on weighted average rates of mark-up over the direct labour cost derived from BT’s accounting data for five "similar product groups". The Director General accepted this general approach, although he made a number of adjustments to the mark-up rates proposed by BT.

4. In its response to the July 2001 draft Determination, BT argued that Oftel had not taken into account all the costs that it incurred in the provision of Portability and that the charges as proposed by Oftel would result in BT making a gradually increasing loss. Oftel has considered BT’s arguments but maintains that the methodology it has used to calculate the charges is robust. It therefore proposes to set charges for block Non-Geographic Portability orders on the same basis as it set charges for other Portability services. However, the charges for the services set out in the July 2001 draft Determination that have been re-set here are higher than those set out then. This is because Oftel has taken account of the latest wage rate estimates supplied by BT.

5. BT argued that the charges should contain a mark-up for common costs. Oftel’s view is that this would be contrary to the long run incremental cost (LRIC) methodology underlying the Network Charge Control. In short, this is because any common costs between services such as Portability and the inland network have already been taken into account in setting the Network Charge Control and in the charges for services such as local loop unbundling (LLU). It is not appropriate to allow a mark-up for common costs in the charges for Portability. This could be justified only if BT could show that not all Access/Network common costs had been included in calculating the mark-ups for the new Network Charge Controls and local loop unbundling.

6. BT stated that current fully allocated cost (CCA FAC) data should be used in setting the charges, because this is a good approximation to LRIC plus equal proportionate mark-ups (LRIC + EPMU). However, even if this approximation were accepted as valid, it would not justify the use of CCA FAC data in this context, because Oftel does not believe that LRIC + EPMU is the appropriate cost basis in this case. It seems unlikely that FAC could approximate to variable costs, since by definition FAC includes an apportionment of fixed overheads.

7. BT incorrectly believed that Oftel applied a cost-volume elasticity (CVE) of 0.45 to direct labour. It is possible that some confusion might have arisen because the CVE enters into the model in two ways. First, it is used to project movements in costs as volumes of "ports" change and is thus a key determinant of the value of ‘X’. As described in the July draft Determination, a CVE of 1 was applied to direct labour in making the cost projections. A CVE of 0.45 was however applied to indirect costs. Oftel initially calculated the weighted average of the CVEs for direct labour and indirect costs as 0.75, a figure that BT accepted as reasonable. However, the implicit weighted average CVE (i.e. the average of the direct CVE of 1 and the indirect CVE of 0.45) is likely to be higher than 0.75 as this figure was calculated before the final reductions in indirect costs were made, which has the effect of reducing the proportion of costs subject to the CVE of 0.45.

8. Secondly, as described in the July 2001 draft Determination, the CVE of 0.45 was used to scale down the average mark-ups over direct labour used to allow for indirect costs in order to arrive at an estimate of the incremental indirect costs incurred. For example, if on average, indirect costs were 50% of the direct labour costs of existing comparable products, Oftel would allow 45% of this, equivalent to a mark-up of 22.5% over direct labour, as its estimate of the additional indirect costs incurred as a result of the provision of Portability. This has the effect of reducing Oftel’s estimate relative to BT’s of the amount of indirect costs that need to be recovered from Portability charges.

9. In BT’s response to the July draft Determination it stated that LRIC: FAC ratios are in general a good approximation to CVEs. Oftel does not accept this. For example, the LRIC: FAC ratios of some network components are in excess of 0.75, when the average cost-volume elasticity used in setting the Network Charge Control, which BT accepted, was 0.25. Oftel also does not agree with BT that it necessarily follows that a CVE of 1 for direct labour is likely to imply a similar CVE for other cost categories. It is clear in general that different categories of cost can vary with output in different ways. For example, if output of one service doubles it may be necessary to double the number of employees directly engaged in providing it, but it is unlikely to be necessary to double the number of managers or support staff.

10. BT also sought clarification of the main assumptions underlying the proposed value of ‘X’ of 5. As noted in the July 2001 draft Determination, assumptions about underlying rates of real unit cost reduction (i.e. before volume effects), input price changes and the cost of capital are consistent with those set out in Proposals for Network Charge and Retail Price Controls from 2001, February 2001. The projection of Portability costs is based on a forecast of volumes of ports, which then generates projections of unit porting costs via explicit assumptions about CVEs and asset-volume elasticities (AVEs) for porting activity. The forecasts of port volumes are derived from the projections for access line numbers from the charge control review model. Further details are given below:

11. Oftel has revised the starting charges for the Portability services set out in the July 2001 Determination and proposes to set charges for block Non-Geographic Portability services on the same basis. The revised proposed costs for the services that were originally set out in the draft Determination of July 2001, and the proposed costs for block Non-Geographic Portability services, are set in Schedule 1. The revised proposed charges for the services set out in the draft Determination of July 2001, and the proposed charges for block Non-Geographic Portability services, are set out in Schedule 2.

12. The only difference in the methodology used to set the draft starting charges within this draft Determination and those set out in the July 2001 draft Determination is that in July Oftel assumed that wage rates were to increase by 3% per annum (nominal). However, this estimate has now been increased to 4% per annum in 2000/1 in line with BT’s estimates.

13. Oftel proposes that these costs and charges should apply from 1 January 2002.

Portability services and charge controls

14. In the July 2001 draft Determination, Oftel explained that it was proposing to set charge controls for Portability services because they are non-competitive (the Donor Operator has no reason to keep its charges for processing Portability orders low as its competitors and not it pay for these services). Oftel proposed that the value of ‘X’ to apply to the non-conveyance elements of Portability should be 5.

15. Oftel sets the value of ‘X’ so that the value of BT’s rate of return projected by the financial model for the last year of the charge control is equal to the cost of capital. This approximates to the workings of a competitive market in which excess profits are gradually eroded by competition. In general, the value of ‘X’ will reflect the expected rate of reduction in real unit costs over the period as well as the erosion of any excess profits existing at the start of the charge control period. The proposed value of ‘X’ reflects the expected rate of cost reduction, as the charges for number portability services to apply from 1 January 2002 do not contain any excess profits. The Director General proposed to place the Non-conveyance Standard Service elements of both Geographic and Non-Geographic Portability services into a new charge control basket (‘Fixed Portability Non-Conveyance Basket’).

16. The Director General maintains that it is appropriate to include both Geographic and Non-Geographic Portability in a charge control and that the value of ‘X’ for this basket should be 5. Oftel does not propose to change the value of ‘X’ for this basket despite the fact that Oftel now proposes that the basket should be expanded to include the four block Non-Geographic Portability services. The value of ‘X’ does not change because only very small volumes of the additional services are sold and therefore they have a negligible weight in the charge control constraint.

17. The proposed charge controls are to apply for four years from 1 January 2002. Within this control, BT would have flexibility to increase or decrease charges in each charge control year as long as the overall control was met. However, the weight of each service within the basket is set according to the revenues received from each service in the prior year. Therefore, frequently purchased services will have higher weightings within the basket. Oftel expects that the conveyance elements of the charges for Portability services should be consistent with the charges for equivalent conveyance services i.e. single transit.

Next Steps

18. Subsequent to consultation on the proposed charges included within this draft Determination, Oftel intends to issue a final charge Determination and consult on proposed modifications to BT’s licence to give effect to charge controls for the non-conveyance elements of Portability services. Oftel proposes that the new charges and controls should be effective from 1 January 2002.

Determination Schedule 1

Part A – Proposed costs incurred in providing Non-Geographic Portability

1. Per line set-up costs for single line Portability orders

2. Per line set-up costs for block Portability orders

3. Average porting conveyance costs

(i) Freephone

(ii) Local rate

(iii) National rate

(iv) Premium rate

(v) 0844 Calls

(vi) 0871 Calls

Part B – Proposed costs incurred in providing Geographic Portability

1. Per-line set-up costs

2. Average porting conveyance costs

Determination Schedule 2

Part A – Proposed charges in respect of Non-Geographic Portability

1. Charges with respect to per-line set-up costs

2. Charges with respect to per line set-up costs for block Portability orders

3. Charges with respect to the average porting conveyance

Part B – Proposed charges in respect of Geographic Portability

1. Charges with respect to per-line set-up costs

2. Charges with respect to the average porting conveyance

Consultation

Oftel seeks the views of consumers and industry on the proposed costs and charges for fixed Portability services set out in Schedule 1 and Schedule 2 of this determination by Thursday, 22 November 2001. Oftel is not inviting comments on other respondents’ comments. Comments should be made in writing and sent to:

Mike Galvin
Oftel
50 Ludgate Hill
London
EC4M 7JJ
Tel: 020 7634 8869
Fax: 020 7634 8847
e-mail: mike.galvin@oftel.gov.uk

Written comments will be made publicly available in Oftel’s Research and Intelligence Unit except where respondents indicate that the response, or parts of it, is confidential.