Price Cap Formula for Retail Price Regulation Workshop

1. ITU – Oman, Muscat, Wed 6th April 2005Cost and Price Regulation WorkshopRetail price regulation – Price cap formula Dr Chris Pollard Doc Ref: 00712/PN/774.1

2. Agenda • Regulatory requirement for price controls • Price cap formula • Implementing a price cap • Inflation and efficiency factors • Treatment of exogenous factors • The value of “X” • Choosing the basket • Choosing the sub caps • Additional factors • Workshop Price Cap exercise Doc Ref: 00712/PN/774.1

3. Price caps or retail price controls • Price controls also used in markets where competition has yet to develop • The use of price control is a “proxy” for competition • Most effective form of price control is the price cap typically applied using the “RPI – X” formula • Sets a target of price reduction for a group, or “basket”, of services that the operator must meet over a specified period • Sets boundaries on the price changes that the dominant operator may make for those services in the basket • But not an “exact” science! Doc Ref: 00712/PN/774.1

4. Benefits of Price Cap approach Use of price capping for regulation has many advantages • Provides incentives for greater efficiency from the incumbent • Provides greater pricing flexibility for the incumbent • Allows consumers and operators to share in the expected productivity gains • Protects consumers and competitors by limiting price increases • Limits the opportunity for cross subsidization by the incumbent • Streamlines the regulatory process • Reduces the possibility of un-necessary regulatory intervention and micro-management Telecommunications Regulation Handbook; McCarthy Tetrault, World Bank Doc Ref: 00712/PN/774.1

5. = - X TFP TFP Operator Country = D - D Z PInputs PInputs Country Operator The price cap formula Well known as the “RPI – X” formula • Theoretically • where • and • X is a measure of the change in productivity (Total Factor Productivity) in the telecommunications sector relative to the change in productivity for the economy of the country as a whole • Z is a separate variable designed to take account of the exogenous factors that are outside the control of the operator Doc Ref: 00712/PN/774.1

6. Implementing a price cap formula • A significant number of factors and objectives to consider • Rebalancing vs. efficiency • Time period of control and periodicity • Choice of Inflation factor • Treatment of “Z” exogenous factors • Determination of appropriate X • Efficiency factors TFP • Operators costs and information asymmetry • Revenue weights and indices • Price elasticities • Fair return on capital • Services to include/exclude for the basket • The use of subcaps • Treatment of new services, price discounts and carry-over, • Treatment of existing cross-subsidies and access deficits Doc Ref: 00712/PN/774.1

7. Rebalancing versus Efficiency • Different goals for Price Control measures • Trade off may be made between the goals of controlling the speed and levels of rebalancing and the imposition of a efficiency gain factor on the target operator • What are the particular circumstances of the country, the market and the incumbent operator? • How imbalanced are access, local, national and international prices? • Is there an access deficit that might be recognised? • What is the degree of penetration of services in the proposed basket? • What is the overall profitability of the operator? • What is the profitability of each of the key services? • How inefficient is the incumbent operator considered to be? • Socio-political constraints? (Affordability?, IPO?) • What degree of cross subsidization may still be required? Doc Ref: 00712/PN/774.1

8. Price rebalancing • From an economic perspective bringing prices more inline with costs provides a social welfare gain as the correct economic signals about the cost of producing goods and service are sent to the marketplace • Essential part of most early price control measures and the setting of parameters to achieve rebalancing is likely to outweigh any efficiency objectives that are to be incorporated • In setting a price cap to address rebalancing the regulator must decide • Over how long should rebalancing take place, i.e. over how many price control periods? • Is full or partial rebalancing to be achieved? • Should limited cross-subsidisation be permitted? • How to treat any access deficit that is not confused with Universal Service costs? • Access deficit = all customers access cost > access revenue • USO = some customers total cost > total revenue • The price cap applied should not be so tight as to constrain the operators pricing flexibility such that it cannot implement rebalancing Doc Ref: 00712/PN/774.1

9. Duration and periodicity • Price capping is a form of regulatory contract between regulator and operator • Must be applied over a stable period to allow for realistic investment decisions to be made • Too short a period does not give the operator the time for investment decision to be realised, and this devalues the power of the incentive • Too long a period and there is a risk that sharing of benefits will become biased in the operator’s favour • Typically 3-5 years has been found to be a practical duration before the parameters are fundamentally reviewed • In stable developed environments the permitted change in prices is usually calculated on a yearly basis • A shorter period, for example 6 months, may be worthwhile if market conditions or external factors (such as inflation) are changing rapidly • Or if rebalancing targets need to be closely monitored Doc Ref: 00712/PN/774.1

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11. Choice of Inflation factor • Should reflect changes in operator’s cost • Factor may have to capture, for example, changes in a country’s exchange rate where operators may buy a large proportion or their equipment in a foreign currency • Credible published source • The source, typically a Government agency, must be trusted by all parties • Published on a regular timely basis (at least every 6 months) • Such that the formula may respond quickly to changes in input costs • Understandable • Understood by industry players and public • Stable • Not subject to revision during its currency • Consistent with productivity of the economy • Efficiency gains in rest of economy affect the operator through this factor Telecommunications Regulation Handbook; McCarthy Tetrault, World Bank Doc Ref: 00712/PN/774.1

12. Choice of Inflation factor • Typically a Retail Price Index (RPI) or Consumer Price Index (CPI) is used • Records price changes for retail consumer goods and services • Not necessarily the most accurate reflection of the changes in pricing of goods that a telecommunications operator faces • However, it is the most widely accepted measure of inflation • Alternative factors might be based GDP or GNP price indices that measure the change in prices for goods and services at an economy wide level • Final choice will depend on the availability, reliability and frequency of updating of indices in a particular country Doc Ref: 00712/PN/774.1

13. Source of Inflation figures - Transparency • The Inflation factor – RPI, CPI – is typically determined based on the most recent historical data for practical reasons • Historical data is more readily available from Government sources • In many economies past inflation performance is a relatively good indicator of future inflation • Attempting to forecast inflation would be complex, time consuming and subject to controversy and, potentially, manipulation • A forecasting approach may subsequently require corrections to offset forecasting errors, adding to complexity and regulatory uncertainty • Basing the RPI on historical data does have a disadvantage if, for example, due to external factors inflation varies significantly from past trends. This can be mitigated by increasing the frequency of adjustments to the factor. • Use of publicly available and accepted data increases transparency of the process Doc Ref: 00712/PN/774.1

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15. Exogenous factors - Should a Z factor be included or not? • Exogenous factors affect the rate of return of the telecommunications operator but are outside of the control of the operator. These effects should theoretically be allowed for in setting the price cap. They can be treated through the additional variable “Z” • Relevant exogenous factors include: • Currency fluctuations, • Conflict and especially its affects on commerce (e.g. raising or lowering oil prices), • Natural disasters, • Strikes, and • Unforeseen acts by government that significantly affect the commercial environment. • However, in many cases implemented formulae do not include a “Z” factor because it can dilute the incentive to reduce costs that is a key element of a price cap regulation • in practice it is very difficult to distinguish between effects which result from exogenous factors from those which result from the firm’s own initiatives • “Z” factors make price controls more complex and so less transparent and understandable to customers Doc Ref: 00712/PN/774.1

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17. Choosing a value of “X” • The choice of value for “X” is dependent on the targets set for price cap and may be composed of a number of elements that make up the final percentage required. This may include • A basic factor for efficiency improvement based on TFP • A factor to recognise the improvement in efficiency stimulated by the application of the new capping regime • Research in the US has confirmed the stimulus to efficiency of incentive based price capping regimes • This may be a major component if significant price re-alignment is necessary • A factor to recognise the impact of increased competition in the sector • An optional factor that recognises a potential increase in productivity growth that may result from an impending privatisation • This combination of factors would be expected to produce an “X” value of around 4% in developed countries. • This general conclusion may be less applicable in developing economies Doc Ref: 00712/PN/774.1

18. Efficiency targets • The “X” factor should represent the extent that the operator can increase its productivity over that gain in the rest of the economy • Telecommunications companies can expect greater productivity growth than other companies due to the higher contribution of technological advances and reducing unit costs to their inputs • This efficiency gain can be determined either by • Measuring the historical productivity gains (Total Factor Productivity) made by the operator over an appropriate period • Research in the US indicates that the long run TFP differential for US companies was in the range of 2% to 3% (Taylor 1997) • Studies of BT’s Real Unit Operating Expenditure in the 1990s indicate that it achieved a 4.8% per annum improvement (Frontier Economics) • Using international experience to provide a benchmark, and the regulator's judgement, where historical data is less reliable • In markets undergoing significant regulatory change past productivity will not be a reliable indicator for performance in the future • Technological catch up in developing countries means that higher gains in productivity may be possible than in developed countries Doc Ref: 00712/PN/774.1

19. Example of TFP on OECD countries • Productivity growth rates were roughly similar in developed countries • Potential for greater divergence from these values in developing countries Source: Telecommunications industry and productivity convergence in OECD countries Doc Ref: 00712/PN/774.1

20. Typical range of “X” factors calculated • In the UK the value of the “X” factor for retail services was increased over time • 1984 – 3.0% • 1989 – 4.5% • 1991 – 6.25% • 1993 – 7.5% • 1998 – 4.5% retail, 8.0% network • Increase reflects two factors • initial regulatory caution to ensure revenue requirements are met • better than expected performance from the regulated company • ICASA in South Africa has just proposed an “X” factor of 4.0% (Nov 2004) Source:Telecommunications Regulation Handbook; McCarthy Tetrault, World Bank Doc Ref: 00712/PN/774.1

21. Modelling the impact - knowledge of the target’s costs • An essential part of designing a retail price cap for a regulator is being able to predict accurately the impact it will have on the operator • This requires the construction of a detailed market and cost model in order to • to forecast the changes in prices, demand, revenues, costs and profits for the operator • check that particular proposed values of “X” are appropriate • Prices and revenues can usually be readily sourced from the operator • Operator should be under a duty to disclose all prices • Potential changes in demand can be obtained from research agencies and other third party resources • The model also requires knowledge of the operators cost base in a considerable detail • The most problematic part of the task! Doc Ref: 00712/PN/774.1

22. Information Asymmetry • The incumbent operator has much better information about its true costs than the regulator and may use this to its advantage How to counter this asymmetry? • Reporting requirements on the operator • Build full disclosure requirements into the Law or secondary regulations such that the regulator may obtain fullest supporting evidence of underlying costs • This requirement is relevant both to the Price regulation discussed here and to Interconnection regulation discussed earlier in the workshop • Place weight of responsibility on the incumbent to justify costing and pricing positions that it adopts Doc Ref: 00712/PN/774.1

23. Acceptable costing methods • Typically historic costing accounting and fully allocated models are acceptable • This is the basis on which the operator is almost certain to have developed its pricing rationale • The development of incremental costing methods to cover the entire business of an operator in addition to its normal accounting is beyond normal regulatory requirements • Permits correlation with revenue reporting and statutory published accounts Doc Ref: 00712/PN/774.1

24. Revenue weights vs Indices • “X” is applied to a weighted basket of prices that are to be controlled • The weights given to each service price may be determined typically either by indices or actual revenues. • Indices are in fact calculated from revenue weights • The advantage of indices is their simplicity and transparency of operation, their weakness is that in practice they can result in a higher price level for price controlled services than intended • For example, if the operator can increase the price of a service that has rapid sales growth, and has to reduce the price of a service that has little or no sales growth, using percentages of prices can provide the regulated operator with unintended leniency in the price cap. • For this reason it may be advisable to focus on the real value of revenue that the operator is being required to give away, rather than look at indices • Working directly with revenues at all stages of the price control mechanism, makes calculations more complicated, but this approach has the advantage of maintaining a closer relationship between the original modelling work that underpins the calculation of ‘X’, and the changes in prices and revenues resulting from the application of the price controls • Most cap mechanisms adopt prior years revenue weights as the most practical means of weighting the impact of the price changes within the basket Doc Ref: 00712/PN/774.1

25. Calculation of compliance - an example Doc Ref: 00712/PN/774.1

26. Elasticities of demand • Elasticities need to be considered in understanding the change in volume with price changes and the effect on total and proportional revenues of the operator • Empirical elasticities rarely exist for the region or developing countries • Accepted international values may be used, but some account must be taken of local conditions • Is there any primaryresearch to provide anindication of elasticities? • Lower levels of developmentand affordability issues willtend to render servicesmore price elastic Doc Ref: 00712/PN/774.1

27. Cost of capital impact on calculations • Although price capping has replaced rate of return regulation, the operator’s return on capital employed (ROCE) is a key input in to the modelling used to set a value for “X” • As has been discussed earlier a “fair” return is usually based on the regulated operator’s Costs of Capital • The operator’s cost of capital is just as relevant to the setting of fair and reasonable retail charges as it is in setting incremental cost based interconnection charges • In order to define a fair return that is based on economic profitability it is often necessary to make adjustments to the capital base including: • Revaluing assets from historic to current cost • Adjusting the rate-base to accurately reflect the capital necessary for an efficient business • Adding intangible assets to the base (e.g. R&D, IPR) • Removing “imprudent” purchases such as gross over-capacity or lavish offices for executives! Doc Ref: 00712/PN/774.1

28. Choosing a basket • Typically a retail price cap is applied to those services where competition is yet to be effective • In many cases it is also applicable services where pricing is out of line with costs since, were competition effective, it would tend to push prices closer to their cost base Included: Excluded: Non-competitive services Local access – exchange lines Local calls National calls Competitive services e.g. Internet services Cross-subsidising services International calls Leased Lines Interconnection services? Mobile services? Doc Ref: 00712/PN/774.1

29. Additional services in the basket • Services such as Interconnection charges or Access charges may also be included in the Price Cap to promote competition. • This enables productivity gains in the provision of wholesale services to be passed on to competitors • Wholesale or access services would be placed in a separate basket from retail services to avoid a dominant operator being able to exert a price squeeze • The inclusion of mobile services in a retail price basket or not would need to be carefully evaluated • Mobile services are usually not included as they are one of the first services to be provided competitively • provides sufficient pressure on prices • However, a vertically integrated incumbent may have opportunities to manipulate both fixed and mobile pricing to its advantage if mobile services are not included Doc Ref: 00712/PN/774.1

30. Sub-caps • The use of sub-caps within the main basket cap have two objectives • Controlling the rate of rises in access charges – social implications • Ensuring decreases occur, particularly in markedly over priced services • However, sub-caps should be used prudently as excessive use becomes effectively price control on a service by service basis • Allows the incumbent no flexibility in pricing • Closely resembles rate of return regulation which is known to be less effective at achieving the desired economic result • Typically a positive sub-cap is applied to access charges (exchange line installation and rental) to control the rate at which these permitted to increase • Access sub-caps have been in the order of +2% to +10% • A sub-cap may be applied to a specific service that is • known to be particularly overpriced, for example retail leased lines, to ensure that the prices are reduced at a rate the regulator intends, or • an important input used by competitors Doc Ref: 00712/PN/774.1

31. Controlling the increase in access charges • Rebalancing of exchange line rental charges is one of the most difficult and contentious parts of designing the overall price cap and any sub-cap on access charges • Due to the legacy of socio-political price setting, in many countries the access price is significantly below cost • Permitting rates to be raised as quickly as many operators might like creates a significant risk of “rate shock” amongst residential customers • Constraining the rate of rebalancing too much will add weight to incumbent's arguments for any access deficit to be recognised and recompensed • adds additional regulatory and financial burden to both new entrant operators and the regulator through requirement to consider, (and possibly implement and manage) ADC schemes or funds • Similarly, the method and rate at which competitive entry is permitted in the lucrative international sector has a fundamental impact on the rate of removal of cross subsidisation and the incumbent’s ability to cover its access deficit Doc Ref: 00712/PN/774.1

32. An un-financed access deficit creates a risk of ‘stranded assets’ • Where there exists a significant AD and liberalisation occurs, cream-skimming will occur. • This is because new entrants will easily be able to enter into those markets (international) where the incumbent must continue to earn especially high profits in order to provide cross-subsidy revenues for access. • ADs that are not fully financed work to transfer wealth from shareholders to subscribers - and to a degree also new entrants. • This transfer of wealth occurs over the life of the access assets that have been sunk by the operator. • Investors will not then reinvest in access as they cannot earn a fair return. • More generally, this can also raise the risk of investing in a country, i.e. the risk premium rises (lack of respect for investor’s assets). • In effect the regulatory risk has increased for investors Doc Ref: 00712/PN/774.1

33. International experience of rebalancing Doc Ref: 00712/PN/774.1

34. International comparisons • The slides that follow show some examples of international experience of rates of rebalancing under price caps. • Access rental increases • UK 2% pa • EU - ~4.3% pa on average • OECD ~3.2% pa on average • South Africa 5 – 9% pa (real) • Peru 30% pa • Evidence suggests that the loss of market share for international services tends to migrate towards a common figure irrespective of the particular rebalancing profile applied. Doc Ref: 00712/PN/774.1

35. Tariff rebalancing trends, in US$ - Average of 39 major economies 12 10 8 6 4 2 0 1993 1990 1991 1992 1994 1996 1995 1997 300 minutes, local calls 3 mins Int'l call to US Monthly line rental ITU and OECD • ITU data indicates an average increase of approx. 3% per year for access and local calls • For OECD countries, residential increases were on average 3.2% per year Source: ITU Source: OECD Doc Ref: 00712/PN/774.1

36. EU • Following the full liberalisation in Jan 1998 residential access charges rose on average at 4.3% per annum • Several countries were already well down the path of rebalancing so the immediate impact may have been less marked Source: EU Doc Ref: 00712/PN/774.1

37. Source: analysis of BT data UK rebalancing occurred over many years • UK rental charges were not as significantly out of alignment as many less developed countries • Competition was introduced relatively slowly • 90% increase has been gradually achieved over 15 years • Rentals remained in a sub-cap of RPI+2% from1984 to 1997 Doc Ref: 00712/PN/774.1

38. Peru • Rebalancing programme incorporated in privatisation plan prior to liberalisation in 1998 • Figures represent real changes Doc Ref: 00712/PN/774.1

39. New entrants' international market share Doc Ref: 00712/PN/774.1

40. Additional factors Doc Ref: 00712/PN/774.1

41. “New” services • Part of the objective of incentive based regulation is to encourage the incumbent (as well as new operators) to innovate and provide a wider choice of services • “New services” that the operator may introduce are therefore not included within the price cap basket • This allows it full flexibility to price a new service as the market requires • Typically any new service not offered at the time of the implementation of a price cap regulation is deemed to be an unregulated service unless it includes existing products or services that are price capped • However, without adequate safeguards, there is scope for services to be removed from regulation through “modification” or “enhancement” to existing price capped services • Regulators need to be aware of the potential for such manipulations that could make the price cap “leak” • Regulator may publish a “definition” of a new service to remove confusion Doc Ref: 00712/PN/774.1

42. Treatment of discounts in the price cap • Many operators have a policy of discounting published list prices, either to strategic customers or in recognition of volume • Should discounts contribute to price “reductions” and the calculation of compliance with the value of “X”? • An operator would argue that by including discounts, it is given the incentive to offer deals that offer savings to the customer. • The regulatory risk in including discounts is that they may be tactically targeted at key customers and high value services, • E.g. targeted at high spending business customers, that would be most susceptible to the offerings of new competitors once they arise, in order to secure long term business and, potentially, frustrate market entry • Including discounts may also enable a particular “X” factor to be more easily met with discounts that do not represent real price cuts • In general, the responsibility should be placed on the operator to demonstrate to the regulator that a discount approach is broadly applicable, and not strategically targeted, before it is allowed in the assessment of compliance with the cap Doc Ref: 00712/PN/774.1

43. Carry over • The term “carry over” refers to the use of unused price changes arising in one period in the next capping period • For example, the operator could exceed the price reductions required in the first period and subsequently offer a far lower reduction in the next period • The Regulator may treat carry over in three ways • Permit automatic carry over • Permit carry over on a discretionary case by case basis • Disallow carry-over • The risk with automatic carry over is that it gives the operator scope to target the majority or all of its price reductions at services where competition becomes effective earliest, making competitive entry more difficult. In contrast, an operator might argue that it gives the operator the opportunity to bring forward price reductions and delay price increases, all to the customer’s benefit • Disallowing carry-over is not considered productive as it represents a further limitation on the pricing flexibility of the operator • On balance, and certainly in the early years of new price cap regulations, it appears most effective to treat carry over on a discretionary case by case basis, provided the case is made clearly by the operator concerned Doc Ref: 00712/PN/774.1

44. Other factors that may need to be considered • Implementation of Elapsed Time Charging (ETC) • Legacy telephone networks may still rely on pulse metering and charging for local or national calls on relatively long increments (e.g. 3 minutes) • Average durations for fixed PSTN calls are often only 1 – 1.5 minutes • Charging in this manner can result in over recovery of costs for the actual duration of a call • Conversely, retail call prices may be unbalanced and too low, and the full costs of call delivery still not recovered • Within a price cap regime operators should be encouraged to migrate to per second billing, (supported by all modern switches) or at least shorten the charging increment considerably • The impact of the change on billing must be factored into the revenue forecasts made in planning the value of “X” to impose • Peak/Off peak charging • Similarly, recognition of the difference in delivery cost for a peak and off-peak call should be brought in to any pricing plan • If this is yet to be implemented, this must be recognised in revenue projections to support the determination of “X” Doc Ref: 00712/PN/774.1

45. Quality of service • Should Quality of service factors be included in a Price Cap formula? • Quality of service is an important element in the “utility” of any service delivered to a customer • If placed under pricing constraints, a monopoly or dominant operator could reduce its QoS as a means of reducing costs and thus increasing its profitability • Normally QOS is addressed through monitoring adherence to set targets • An alternative approach is to create QoS factor within the Price Cap formula such that if specific quality parameters fall below certain threshold levels, then additional percentage reductions are required in the relevant prices • Any reduction in quality should then result in a reduction in prices for customers • Conversely, increases in quality may permit increases in prices • A QoS factor in a price cap is an attractive option as it may reflect the real price/quality trade-off that is present in competitive markets • But it can be complex to administer for developing regulatory authorities Doc Ref: 00712/PN/774.1

46. Managing and adjusting the basket • At each, typically annual, review point, compliance with the value of “X” must be evaluated and assessments made of carry over or inclusion of specific discounts • Where the operator is non-compliant alternative more stringent regulatory measures may be needed, such as direct regulatory setting of key prices • Over the longer term, a price cap is a dynamic measure and services may be removed from, or brought under the cap, depending on the particular market developments • While the cap may run for 3-5 years, regulators should avoid the temptation to adjust the primary values of the cap (clawback) within the set duration as this can be seen as breaking the regulatory contract with the operator Doc Ref: 00712/PN/774.1

47. In summary • Retail price capping using an RPI – X formula is an efficient and powerful regulatory tool • However, the price cap may have to serve multiple objectives that place conflicting demands upon it • Hence, determining a reasonable and fair value of “X” is not necessarily a simple task. It must be • Supported by detailed modelling of the impact • Based on reasonable and transparent assumptions • Understandable to the regulated operator, competing operators and customers • It has been found to be the most effective form of price regulation devised so far Doc Ref: 00712/PN/774.1

48. Thank You Doc Ref: 00712/PN/774.1

49. Workshop Price Cap Exercise Doc Ref: 00712/PN/774.1