BT Presentation to The Japanese LRIC Working Group 8/12/2000

1. BT PresentationtoThe Japanese LRIC Working Group8/12/2000 Francis Harding Manager, International Regulatory Consulting BT Regulatory Affairs Division

2. Agenda • Introduction • Answering your questions: • Economic Lives and Depreciation methods • Non Traffic Sensitive costs • Maintenance costs: Underground v Overhead • Costing the Universal Service Obligation • Unbundling the local loop • A final observation

3. Top-down model Starting prices Hybrid adjustments made by OFTEL Reconciliation Bottom-up model • Future network demand • Input price and cost reductions • Cost & asset volume elasticities • Improvements in BT’s efficiency RPI-8% Prices at end of price control Setting LRIC in the UK

4. Top Down Model Final Top Down Model Reconciliation exercise Hybrid Adjustments Feedback Improvements Bottom Up Model Final Bottom Up Model Reconciliation Process • Not forgetting efficiency studies

5. Lives and Depreciation Methods

6. Depreciation Methods Notes: L = Asset life, C = Cost of Capital Source: “Study on the preparation of an adaptable bottom-up model, available etc, Europe Economics, April 2000, available from http://europa.eu.int/ISPO/infosoc/telecompolicy/en/Study-en.htm • Most commonly methods used in LRIC studies • Annuities and tilted annuities • … and Economic Depreciation Models

7. Economic Depreciation • The outputs from economic depreciation models are the annualisation profile + the economic life • Economic depreciation is • “the price at which the operator is indifferent between retaining the asset and purchasing a new modern equivalent asset” • “the change in Economic Value in one year” • Economic value = discounted present value of expected revenues less discounted present value of future running costs

8. Calculating economic depreciation • Can be calculated by setting the NPV for the asset over its lifetime to be zero • A process is defined in NERA report for ACCC, “Estimating the LRIC of PSTN access” (1/1999) • For each asset it requires inputs on • Trend in asset prices (of MEAs) • Initial level & future profile of running costs • Forecast profile of output/utilisation • Cost of capital • Iterative calculation involving declining annuity formulae

9. Depreciation methods applied • BT’s statutory and regulatory accounts adopt a policy of straight-line depreciation • CCA accounts reflect price movements through holding losses and gains • Top-down LRIC sues similar methods • UK bottom-up LRIC model applied economic depreciation models • Ireland bottom-up model uses tilted annuity • In Australia • NERA used sum of digits • ACCC used tilted annuity

10. Setting lives in BT • BT reviews asset lives annually • The process considers lives from 4 viewpoints • The physical/technical life • The strategic/planned life • The commercial life • Financial perspectives • There is no “explicit” formula/method • A “soft” approach that mimics economic depreciation? • BT publishes little information about its lives

11. Lives across the world Source: BT response to Telecommunications Council, 30/11/99

12. New data on lives • New sources now available, e.g. • ACCC (7/1999): “A report on the assessment of Telstra's undertaking for the Domestic PSTN originating and terminating Access Services” (http://www.accc.gov.au/telco/fs-telecom.htm) • Europe Economics, April 2000 study for EU • lives and unit costs and other bottom-up model assumptions

13. Some new data on lives

14. Lives of Duct and Cable • The BT life for copper cable is “about 15 years” • The BT life for Duct is 25 years • But this is affected by the large amount of local infrastructure competition in the UK

15. Lives & depreciation: Conclusions • The factors that affect an economic approach to setting lives suggest lives should be fairly consistent across the world • The MPT and study group may wish to consider an economic approach to setting lives for the bottom-up LRIC model • Some of the lives used previously appeared short by international standards • International consensus is that the life for • Optical Fibre is 20-24 years (v 11.2) • Transmission equipment is 10 years (v 6)

16. Overhead v Underground

17. UK Local Loop LRIC models • UK bottom-up model for access networks never populated • BT’s top-down model used as basis for ULL pricing • This model applies cost/volume relationship to current, re-valued asset base • No economic comparison made between overhead and underground • BUT Oftel have undertaken regular studies of BT’s relative efficiency • Latest view is BT 1½-4% off the frontier

18. Underground v Overhead costs • What data is required? • Cost/kilometre? • Cost/kilometre pair? • How is drop-wire maintenance treated? • Cost differences will arise due to • Differences in Fault rates • Differences in Cost per fault • UK data suggests fixing an underground fault costs 23% > fixing an overhead fault

19. Non-traffic sensitive (NTS) costs

20. OLO Facing ports Processor Tandem facing ports LS facing ports OLO Facing ports Tandem facing ports Processor Access facing ports Processor LS facing ports Common Costs Line Driven Costs Overview of UK Switching costs Tandem Switch OLO network Local Switch CONVEYANCE Concentrator ACCESS Source: Oftel 3/97, “LRIC: the Bottom-up Model”, Fig 2.1    

21. 2 types of concentrators in UK Separate sub-models for processor & concentrator Calls sensitive X Local X Local RCU RCU  Lines sensitive 

22. Inside the concentrator Line Cards Main Distribution Frames Traffic Sensitive Non Traffic Sensitive

23. eg. System X concentrator Model detail - Cost Allocation

24. NTS Costs in Europe • BT’s published accounting documents explain how it splits costs NTS/TS • Line cards are part of NTS business • This follows the principle of cost causality • The same approach has been recommended by the EU in EU published guidelines • The same approach has been adopted in other non-European countries • Hong Kong • Australia • Switzerland, etc etc

25. NTS Costs conclusion • The way the Japanese LRIC model treats local exchange/concentrator costs needs review • The current model seems to treat all local exchange costs as traffic sensitive • This goes against current international costing conventions

26. Universal Service Cost Calculations

27. Universal Service Topics • The scope of universal service and its cost in the UK • Overview of the UK (and European) approach to Universal Service costing • Overview on calculation of benefits from being the USO holder

28. The scope of the USO in the UK • Connection to fixed network for voice, low speed data & fax transmission • Service options must include • A low cost, restricted service package • An outgoing calls barred service & repayment plan instead of disconnection • Ability to receive itemised bills and choose selective call barring • Access to payphones at affordable prices • Access to emergency services, operator assistance & directory information • Geographically averaged prices

29. Observations on scope of UK USO • Reviewed periodically by Oftel • Latest consultation paper in September 2000 • UK obligations are consistent with, but more onerous than those in the EU framework • The need to include higher bandwidth services will be reviewed in future • Not considered the right time to extend to broadband yet

30. UK & European USO cost elements • There are four elements for the net cost calculation: • Uneconomic Areas • Uneconomic Customers • Uneconomic Payphones • Uneconomic Services • But the calculations are difficult ... • Its worse than LRIC! • In Japan the costs of uneconomic customers are likely to be small

31. The Costs of the USO • Current UK USO costs & benefits of USO are • Modelling undertaken by Analysys for Oftel • The only EU country with a USO fund is France • … and that is currently under review by EU

32. The cost of the USO is the difference between the USP’s financial performance with the USO and without the USO Based on the “costs avoided” & the “revenues foregone” Costs Avoided Revenue Foregone Yen Financial Performance without USO USO cost Financial Performance with USO Cost Calculation Principles

33. Services within UK Model • BT PLC currently holds the USO in the UK • The services considered included • Residential and business lines • Connection and rental revenues • Local, long distance & international calls • Calls to mobile operators’ customers • Interconnection revenues • Public payphones (separately) • Revenues and avoidable costs were required for each of these services • by area • by customer (grouping)

34. Total Calls Customer A 100 Customer B 100 Customer A+B 190 45 calls out 45 calls in 45 calls out 45 calls in A B 10 calls Revenues Foregone • Include outgoing and incoming calls • Because the loss of an area/customer  calls lost to (and from) that area/customer • The incoming/outgoing call ratio is a critical assumption for uneconomic customers • Some double-counting issues • It is usual to offset some of the revenue loss by a small amount of substituted traffic

35. Costs covered in the UK USO model • All EFFICIENT long run avoidable costs were considered • Network component costs • Operating costs, including depreciation • Costs for retail activities • E.g. Marketing and sales, billing • Cost of capital employed • But different cost estimates were required • Incremental service unit costs more appropriate for costs of uneconomic areas • Marginal service unit costs more appropriate for costs of uneconomic customers

36. The basic UK USO costing formula • Incremental costs of serving uneconomic customers and uneconomic areas • The revenues foregone if these uneconomic customers and areas were no longer served • Plus the substitution revenues from calls made by these customers using other means • The costs of these substitution revenues • The benefits of being the USO provider

37. The UK USO calculation structure Determine unprofitable areas Calculate loss due to unprofitable areas Iterate to remove double counting Volume, revenue & cost data Determine unprofitable customers Calculate loss due to unprofitable customers in profitable areas Iterate to remove double counting Calculate costs of unprofitable payphones Sum of total loss Calculate Benefits Total net cost of USO

38. Revenues Costs Customers Customers Uneconomic Customers Profits The costs of uneconomic customers • Distributions required • not averages • The distribution tails determine the net costs • Calculations are sensitive to small changes in assumptions

39. Revenue per Payphone Low High Low Cost per payphone Unprofitable payphones High The cost of public payphones • Costs & revenue distributions may vary by geographic area

40. USO benefits

41. Features Lifecycle Ubiquity Brand Payphones Customer Loyalty Benefits Advertising USO Benefit Categories

42. Lifecycle Benefits • Serving a customer when uneconomic increases loyalty when economic • When non-economic areas become economic, they display higher loyalty • Provision of advanced services to schools will reinforce this benefit • Can be estimated through modelling and surveys

43. Ubiquity Benefits • Customers choose USP because of USO • Strengthens marketing message as available everywhere • Assumes loyalty of customers moving to economic areas affected by USO • All customers - not just previously uneconomic • Can be estimated through modelling and survey

44. Brand/Reputation Benefits • USO will give USP a community service image • Brand strengthened and linked to national identity • If USO requirements for schools and hospitals will reinforce this benefit • Benefits realised in improved customer loyalty through more effective marketing campaigns • Benefits can be estimated • In absence of USO, what spend is necessary to create same brand image ?

45. Payphone benefits • Payphones provide advertising and profile for USP • Displays company logo enhancing corporate reputation • Space in payphones available for advertising • Possible value for selling to 3rd parties • Can be measured with reference to marketing opportunities and payphone locations

46. Other Potential Benefits • Buyer power/bulk discounts • USO customers buying non-USO services • Network effects • Advertising from Directories • Marketing benefit from access to full range of telephone data

47. Benefits Summary • Benefits do exist • But are not easy to define and quantify from accounting records • Four features of USO deliver loyalty and marketing benefits • Lifecycle, Ubiquity, Brand and Payphones • All can be estimated through modelling and surveys

48. Unbundling issues in Europe

49. Background to EU LLU Legislation • The focus is on “metallic pairs”, i.e. Copper • Does not apply to Fibre or Coaxial cable • Fibre to big businesses may be competitive • Key target markets are small/medium enterprises and consumers • LLU Directive is a short-term measure, to ensure “implementation” by 1/1/2001 • LLU will eventually be included in the expected “Access and Interconnect” directive (due 2002) • The scope of LLU may change in the final A&I • It could be broadened to include Fibre

50. Requirements of EU Directive • Three types of LLU mandated : • Full LLU (at MDF site) • Shared LLU (at MDF site) • Sub-loop unbundling (between MDF & customer) • Clear indications on • Cost-orientation obligation • Non-discriminatory service • The scope & contents of the LLU Offer • Existing directives also oblige SMP operators to offer equivalent wholesale services to others • “Bitstream” access will also be required