Pro-competitive Regulation of Local Loop Unbundling

Claudio Leporelli, Pierfrancesco Reverberi

Dipartimento di Informatica e SistemisticaUniversità degli Studi di Roma “La Sapienza”

Local loop unbundling

• new entrants rent from the incumbent the copper wires to customers’ premises and connect them to their own networks at the incumbent’s local exchanges

• the control of an access line:

- eliminates origination costs

- produces termination revenues

- overcomes cost disadvantages for diverting and then returning traffic to the incumbent’s network

• LLU is suitable to obtain the advantages of infrastructure competition and overcome the limits of pure resale

• LLU provides entrants with technical and economic flexibility in arranging new advanced services

Empirical evidence

• local exchange competition based on LLU is facing overwhelming difficulties

• in the USA, seven years following the Telecom Act, only 2.3% of the lines were unbundled without switching (FCC, 2003)

• in the EU, up to December 2003, 1.2% of the lines were unbundled, with the highest penetration rates in Germany (3.6%) and Finland (2.9%)

• in Italy, there are about 538,000 unbundled lines, that is 2% of the total amount

Motivations and aims

• we analyse the motives for which LLU may fall short

• we emphasise incumbents’ incentives to leverage on structural barriers so that OLOs’ LLU plans fail

• we define price squeeze tests based on an analysis of the operational implications of LLU

• we propose measures to reduce anti-competitive effects due to incumbents’ strategies or regulatory inconsistencies

• we point out some fundamental issues that regulation should tackle to support the development of competition in relevant markets

Operational implications and implementation costs (1/2)

• LLU implementation requires making significant irreversible investments in indivisible infrastructures

• in each site, an OLO has to set up (or rent from the incumbent) transport lines to its own switch, modular co-location facilities and network equipment

• LLU is not without social costs, since it produces certain unavoidable “competition costs”

• If pro-competitive regulation pursues dynamic efficiency, then it must suitably deal with increased costs and their distribution among all users benefiting from competition (ERG, 2004)

Operational implications and implementation costs (2/2)

• upstream costs derive from:

- services used consistently by incumbents and OLOs (loop rental);

- services used differently (co-location services);

- services used exclusively by OLOs (on-site assistance)• downstream costs derive from services used on their own

by incumbents and OLOs to provide their final services (e.g. commercial activities)

• backhaul facilities necessary to link the co-location site to an OLO’s network constitute a bottleneck

• there are remarkable differences in incumbents’ and OLOs’ unit costs of final services

(Dis)-incentives to anti-competitive strategies

a) Co-location services (1/2)

• co-location charges should reflect the cost of using the space and services supplied in each site

• incumbents should not be allowed to impose costs on OLOs that are not self-imputed or not related to using incremental resources

• incumbents should be prevented from bundling the wholesale product with other components unnecessary for the retail product

• co-location charges cannot be easily controlled since they are computed independently for each site

(Dis)-incentives to anti-competitive strategies

a) Co-location services (2/2) • there are not sufficient incentives for incumbents

to reduce the costs of co-location services by innovative solutions (such as co-mingling)

• some co-location services, which incumbents simply resell, can be over-lucrative

• in Italy, co-location services supplied at market prices, associated with the geographic averaging of loop rental, made LLU more expensive in urban areas

(Dis)-incentives to anti-competitive strategies

b) Loop rental (1/2) • key principles:

1. incremental costs of actually available and efficiently provided resources:

- an excess of spare capacity is inefficient- difficulties in obtaining spare loops for new

subscribers 2. asset depreciation and return on investments:

- low-usage lines (e.g. in holiday homes) could be efficiently replaced by mobile services

(Dis)-incentives to anti-competitive strategies

b) Loop rental (2/2) • key principles:

3. geographic market segmentation:

- an averaged loop rental should be calculated excluding a priori areas where USO are operational

- different competitive conditions distinguish areas where DSL services can be supplied from others

- OLOs in ULL, contrary to indirect access or bypass operators, are sharing the burden of USO (Armstrong,2001)

- this undermines the regulatory principle of competitive neutrality

(Dis)-incentives to anti-competitive strategies

c) One-off charges

• a technologically neutral regulation should extend to LLU the regime of temporary exemption typical of the wholesale and retail DSL markets

• an OLO should not bear duplicated switching costs when it gains a new subscriber in resale and when it subsequently supplies the same subscriber by LLU

• simplified procedures should be introduced to supply LLU services to subscribers in carrier pre-selection

• when giving up a line, an OLO should be rewarded for activities having permanent and transferable effects (such as line quality certification or improvement)

(Dis)-incentives to anti-competitive strategies

d) LLU process steps • incumbents may artificially impose a plethora of

procedures (from pre-ordering to ordering, provisioning and fault reporting)

• incumbents may impose restraints on the selection of agents responsible for the whole process implementation

• incumbents should be prevented from non-price discrimination (e.g. delaying supply to OLOs) by appropriate financial penalties

• an LLU contract should have economic and contractual effects even before the service become operational (win- back activities, origination and termination costs, etc.)

(Dis)-incentives to anti-competitive strategies

e) Duplication of network segments

• while interconnection rates are generally cost-oriented, backhaul transport services are supplied at a higher charge than the incumbent’s implicit price for self-supply

• OLOs are thus prevented from accessing the incumbent’s scale economies

• backhaul transport charges should be consistent with charges for other indirect access forms

• the emphasis on infrastructure competition should not conceal the need for sharing non-duplicable resources

Price squeeze tests (1/2)

a) Cost recovery (EC, 1998)

• a price squeeze occurs when the incumbent’s

downstream subsidiary is not profitable based on the

upstream price charged to its rivals by the incumbent

b) Sustainability (EC, 1998)

• the margin between the price charged to downstream

competitors for access and the incumbent’s retail price is

insufficient for a reasonably efficient provider to operate

Price squeeze tests (2/2)

• a margin squeeze can be triggered due to predatory retail prices, or (unlikely with cost-oriented intermediate service prices) to excessive wholesale charges

• the results of the alternative test formulations depend on the differences in costs between incumbents and OLOs

• the wholesale access charge for an OLO exceeds the incumbent’s imputed price for self-supply, due to vertical integration economies and raising rivals’ cost strategies

• downstream cost differences derive from economies of scale and scope in firms’ own network segments and sales activities, technological or operational efficiency

Sustainability testthe retail price passes the cost recovery test, but the efficient OLO cannot compete downstream

Ma

Cue

Cde

Ca

Cdi

retail price

wholesale price

Ca incumbent’s cost of providing access

Ma margin on accessCdi (Cde) incumbent’s (entrant’s)

downstream costsCue entrant’s upstream extra

costs

Implementation issues (1/4)

• it is not clear what downstream costs of a reasonably efficient entrant are

• the proper retail price floor should exceed the one related to the cost recovery test, due to the specific wholesale costs exclusively imputed to the entrant

• it is doubtful that an incumbent’s pricing scheme that passes the cost recovery test, but not the sustainability one, can be censored ex-post, but…

• …the sustainability test is essential as ex-ante prescription to the incumbent of a retail price floor or as retail minus rule for setting intermediate prices

Implementation issues (2/4)

• In the ERG Common Position on pro-competitive remedies (ERG, 2004), it is stated that: i) regulators may trade static inefficiency for dynamic efficiencies resulting from intensified competition

- the access price should allow for disadvantages of the entrant in scale and scope economies and due to consumers’ switching costsii) appropriate wholesale charges should allow entrants to share the benefits from the incumbent’s scale economies upstreamiii) if the downstream market has to be competitive, then the margin squeeze test should be conducted on that assumption, not drawing on current market shares

Implementation issues (3/4)• because of input indivisibilities and lumpy

investments, wrong assumptions concerning the scale of entry (e.g. unbundled lines on each site) could alter the results

• the incumbent’s intermediate services can be used for providing differentiated retail services related to different relevant markets

• since unit costs of upstream services are similar, while retail prices are different, price squeeze tests may obtain opposite results when applied to different markets

• aggregating markets considered different by the Commission (EC, 2003) does not make sense,but…

Implementation issues (4/4)

• …prices of intermediate services might vary according to their downstream use, while imposing that price squeeze tests be satisfied for each market

• particular concern should be posed on bundles of retail services, such as access (a not replicable product) and traffic (a competitive product)

• most OLOs cannot replicate the bundle, while only subscribers in carrier selection/pre-selection (but not those in LLU) can enjoy the bundle

• it follows that price squeeze tests should be applied at a sufficiently detailed level so as to identify anti-competitive effects in single relevant markets

Residential access Costs and revenues(per month in €)

Cost recovery test Sustainability test Numerical estimate(supplied by Wind)

Loop rental (wholesale) 10.79 10.79 10.79

(Imputed) cost of co-location services C C + D 2.80

(Imputed) cost of site equipment k k + d 1.20

Connection costs 1.18 2.26 2.25

TI’s or OLO’s cost for supplying free traffic

0.63 0.81 0.81

Total costs of the access network 12.60 + C + k 13.86 + C + D + k + d

17.85

Downstream costs (estimated as 23% of the access network costs for the incumbent, and as 35% of the access network costs for the OLO)

2.90 + 0.23*(C + k)

4.85 + 0,35*(C + D + k + d)

6.25

Total costs of the retail service 15.49 + 1.23*(C + k)

18.72 + 1.35*(C + D + k + d)

24.10

Cost of of the OLO’s backhaul transport services(including downstream costs)

1.35*P 2.03

Total OLO’s retail costs(including backhaul transport)

18.72 + 1.35*(C + D + k + d + P)

26.13

Loop rental (retail) 12.14 12.14

Retail revenues from one-off charges 0.5 0.0

Total retail revenues 12.64 12.14

Deficit (total retail costs minus revenues)

2.85 + 1.23*(C + k)

6.58 + 1.35*(C + D + k + d + P)

13.99

Conclusions (1/2)

• a primary policy goal of the European NRF is preserving the technical and economic feasibility of LLU

• in the short run, users cannot benefit from OLOs’ higher technological efficiency, due to structural entry barriers

• due to private opportunity costs related to entry, incumbents have no interest in reducing these barriers

• those OLOs pursuing a ladder of investment strategy should be properly assisted

• this requires setting up sufficient incentives to remove the incumbent’s gains from sabotaging practices, including the threat of structural separation

Conclusions (2/2)

• a pro-competitive application of the regulatory principle of cost-oriented prices should:

- provide incumbents with incentives to behave consistent with dynamic efficiency

- allow OLOs to benefit from sharing scale economies and “competition costs”

- ensure neutrality of the effects of intermediate prices on competition among technologies and agents

- identify geographic cost differentials, to orientate public intervention, focusing support where really necessary

• the objectives of ensuring universal service and promoting competition should be made compatible