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The Relationship Between Access Pricing Regulation and Infrastructure Competition

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The Relationship Between Access Pricing Regulation and Infrastructure Competition The Relationship between Access Pricing Regulation and Infrastructure Competition Report to OPTA and DG Telecommunications and Post by Brunel University March 2001 Professor Martin Cave* Dept of Economics & Finance Brunel University Professor Sumit Majumdar Imperial College Management School ir. Hendrik Rood Technical University of Delft & Stratix Consulting Group BV Dr Tommaso Valletti Imperial College Management School Professor Ingo Vogelsang Department of Economics Boston University *Author for correspondence: [email protected] TABLE OF CONTENTS* Executive Summary Page 3 0. Introduction Page 16 1. The Theory of Access Pricing and its Linkage with Page 18 Investment Incentives. 2. Country Experiences Page 33 3. The Relationship between Access Pricing, Page 44 Regulation and Investment In the US and European Telecommunications Sectors 4. Investment Strategies in the Netherlands Page 52 5. Conclusions Page 72 Glossary Page 83 *This report sets out our analysis and our conclusions. More detailed information, including references to the literature, further information on our econometric work and a review of investment by major firms in the Netherlands market, can be found in our Working Papers, referred to in the text. EXECUTIVE SUMMARY 2 Introduction 1. We were commissioned by the DGTP and OPTA to analyse the relationship between the regulation of access pricing and investment behaviour in the fixed telecommunications industry, in the context of the Netherlands. The key question investigated how regulatory decisions relating to the access by operators to one another’s network (especially to the network of the dominant incumbent) influence the extent of competition in the market and the form which it takes. The most prominent decisions of this type relate to the price at which access is granted, but other dimensions, such as the quality of interconnection and the eligibility of different classes of operators to buy interconnection at wholesale prices, are also important. The two key forms which competition takes are infrastructure (or facilities based) competition and service competition. In practice, however, most operators, apart from pure resellers, find themselves in a situation involving the use of a mixture of their own and other operators’ facilities. 2. In order to investigate the issue, we deployed a number of separate types of analysis: § first, we investigated the impact of access pricing on investment decisions from a theoretical point of view, using the existing literature relating to the impact of access pricing on industry structure in a world which has settled down to an equilibrium, but extending that analysis to the more difficult but realistic context in which competition is developing and entrants are making decisions on where and how to invest; § second, we used available quantitative data to analyse the relationship between investment behaviour by some or all of the firms in the industry and the access pricing régime; we were limited by the availability of data, and tested a number of different hypotheses, some of them using US state-level data and others data from EU member states or OECD countries; § third, we undertook three country case studies, analysing in greater depth the development of access policy, its linkages to policy objectives relating to the form of competition and its apparent effect on the development of competition; § fourth, we carried out a detailed analysis of the recent investment behaviour and strategies of a number of major firms in the telecommunications sector in the Netherlands. As well as KPN, these included firms pursuing a variety of entry strategies, including Versatel, Tele2, Worldcom and Cable TV companies. 3. Then, on the basis of these four discrete modes of analyses, we drew some tentative general conclusions, focusing particularly upon the question of whether infrastructure competition was helped or hindered by a policy of price access at or below a parsimonious estimate of its costs. To anticipate, we concluded that low access prices were fully consistent with the development of infrastructure competition, but that the development of such competition might be promoted even more strongly by a policy which involved a rising profile of access prices. 3 4. We now set out the individual components of our analysis (paras 5 - 44) and our conclusions (paras 45-53). How access regulation is likely to influence investments. 5. Economic theory, as well as regulatory policy, has recognised the key importance of access regulation for the development of competition. Most of the analysis has been developed within a static context, ignoring ‘real time’ interactions among the investment decisions of firms in the period of transition towards competition. 6. The static theory of access pricing can be briefly summarised. Absent complexities of the kind considered below, access prices should be set equal to marginal cost. Because of economies of scale, this may impose losses upon the access provider which cannot be subsidised from elsewhere – in which case mark-ups over marginal cost would ideally be imposed to ensure that those losses were recovered in the most efficient manner (Ramsey prices). However, telecommunications operators are often subject to regulatory restraints upon their retail tariffs, which have the effect of making some services artificially profitable and some loss making. If the sole aim were to ensure that entrants only come into the market if they are more efficient than the original supplier, they should be charged access prices which are equal to the incremental cost of the service plus the profit which the incumbent was making from the service and which it needs to cross-subsidise other services at the retail prices enforced by the regulator. In practice, regulators have generally declined to adopt the above principle, known as the efficient component pricing rule, favouring instead access pricing based upon forward looking long-run incremental costs. Forward looking costs are preferred to historic costs because technical progress lowers costs over time, and entrants in making decisions over whether to build their own infrastructures should be comparing their own forward looking costs with access charges reflecting the same calculation in relation to the incumbent. 7. Turning to a more dynamic analysis, a range of further considerations relating to the timing and sequence of investments by incumbent and entrants must be taken into account. A firm’s decision to invest in infrastructure will be influenced by its expectation of the access pricing régime. If it is narrowly cost-based, then investment incentives will be muted. At the very least, the access pricing régime must take account of the distribution of risks between access providers and access purchasers. This allocation is changed for example, by the adoption of capacity pricing – whereby an access seeker commits to lease a given amount of capacity supplied by an access provider, rather than buy services on a per-minute basis. The purchase of capacity shifts risks from access provider to access seeker, and hence should be associated with a lower price for access. 8. An analogy to the issue of risk and rewards available to the builder of infrastructure is provided by an analysis of firms’ investment decisions in R&D. The operation of a patent system secures rewards to investors in intellectual 4 property, just as high access prices secure returns to builders of infrastructure. In both cases, the rewards to the first mover are significant. In the case of infrastructure construction, there may be advantages in being the “first entrant” relative to a subsequent entrant. This difference alerts us to a significant distinction in interactions in firm behaviour dependent upon whether the market being served is a new market, or one in which the historic operator enjoys the benefits of incumbency. In the former case, all firms are on an equal footing in terms of their history. In the latter case, there is a clear difference between the incentives faced by the incumbent, which has lower costs and enjoys considerable advantages, and those faced by entrants as a group. In our analysis below, we find examples of both cases. 9. Focussing more narrowly upon the relationship between access regulation and the form of competition, we have utilised and developed some recent work on three different forms of competition by entrants, facility based competition, local loop unbundling and carrier selection. These involve levels of infrastructure investment by entrants in descending order. If facility based competition is pursued, the analysis suggests that, even if reciprocal and cost- based termination charges are ideal in the long run, the regulator may choose to allow a higher termination charge for the entrant in order to increase the rewards for aggressive competition for market shares. It should be recognised, however, that these results hinge upon a special model. Our own attempts to extend the model have yielded similar results, also based on special assumptions. In terms of consumer welfare, in the short term increased competition should counteract the effect on costs of higher access charges. The policy will also speed up the arrival of effective competition. 10. Reviewing the theoretical literature as a whole, we identify a number of cases in which, in a dynamic context, the optimal access pricing régime appears to depart from the simple rule of forward looking cost-based pricing. In particular, examples can be found where departures from level pricing over time appear to be desirable, because they provide necessary extra incentives to engage in facility based competition. The desirable trend in access pricing appears to be upwards over time (relative to cost). In other words, when an incumbent is established in a market, offering the entrant (or entrants) a schedule of access prices which rises over time may be desirable. 11. The form of ex post regulation of access charges has an impact on the ex ante incentives to invest in infrastructure. In the long run, cost-based access charges should be promoted.
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