PUBLIC. Information for TelstraClear, 17 October Network Strategies Report Number 25031

Transcription

1 TSO issues from the Commerce Commission Information for TelstraClear, 17 October 2005 Network Strategies Report Number Contents 1 Implications of adopting NGN 1 2 Tilt 2 3 Treatment of new lines 6 4 Proposed numbers for line rental 6

2 TSO issues from the Commerce Commission 1 1 Implications of adopting NGN In the NGN proposed by Telecom, all current switched/tdm (time division multiplex) circuit and transport equipment will be replaced with IP equipment. In the TDM network the line card is in the switch; in the NGN it will be much closer to the customer it may be where the existing cabinet is (through a media gateway, or MGW) or in the customer s premises (through an integrated access device (IAD), or similar). The TDM equipment of tandem switches, local switches, RLUs and street cabinets will be replaced with routers (backbone, edge, etc), soft switches and gateways. The capital cost of these is not expected to be hugely different from the TDM equivalent. However, the operating costs should be less, an important driver for implementing a NGN. The part of the access network between the line card and the location of the TDM switch, currently non-concentrated (independent of traffic), will become concentrated and will probably be considered part of the core network. Since it will be concentrated fewer fibres may be needed. This will slightly reduce the cost of the network. If this part of the access network is considered core, it will probably by modelled by CostPro. Specifically, the CostPro model could include each edge router. This would provide a more accurate assessment of costs. Alternatively it may average the edge routers within each current ESA, which would probably reduce the accuracy of the result. However the complexity of the HCPM model will be reduced because it may not need to perform the iterations currently used to detect hanging costs. The effect of removing hanging costs with both methods is likely to be comparable. If the network is in HCPM, the link is removed if the associated clusters are non-viable (HCPM deletes those customers and then calculates the new network, the difference being the TSO). If the network is in CostPro, an equivalent cost per customer is calculated; that cost is added to the TSO for every non-viable customer. The NGN will be tightly integrated with non-pstn networks. The concentration of voice and data services occurs in the customers premises through the IAD. The routers

3 TSO issues from the Commerce Commission 2 that replace the TDM switches will therefore also route data traffic, so instead of network sharing being limited to transport structure and perhaps cable sheaths, the NGN will share all transport and routers, including the concentrated part of the access network between the IAD and the TDM switch. Hence, the TSO cost will reduce. This is another important driver for an operator implementing NGN. 2 Tilt The Commerce Commission states in its letter of 19 September The TSO model has treated real tilts as if they were nominal which is inconsistent with the approach used in the TSLRIC pricing review proceeding. The TSO model s treatment of tilts will be aligned with that used in the TSLRIC i.e. all tilts are to be nominal and will be applied to all future TSO determinations. The existing approach to the tilt in the TSO model is correct and does not require amendment. In other words, no adjustment for inflation is required. If the Commission has decided to apply a different approach in the TSLRIC proceeding then it has made a serious error. For both the TSO and TSLRIC proceedings Telecom provided nominal costs of relevant capital assets. From these costs the modeller must calculate an annualised cost by depreciating the asset over its lifetime using a suitable method of depreciation. Clearly it is important to factor in expected price changes of the asset over its lifetime. There are a number of different possible approaches for example, the use of straight line depreciation or an annuity function. Typically in this type of cost modelling we apply a price trend (or tilt) in the depreciation formula to ensure that we capture the relevant price changes over time. If the price of the asset is declining over time (which is the norm for equipment of this type) then the price trend will capture this effect. The addition of a tilt changes an accounting method of depreciation to one approximating economic depreciation. The Commission has chosen to apply a tilted annuity function as opposed to a tilted straight line function or other proxies for economic depreciation.

4 TSO issues from the Commerce Commission 3 Clearly the values assumed for the price change or tilt are very important. The Commission originally sourced information for tilt values from Telecom in the first TSO Determination on the basis of recent observed price changes and industry expectations regarding likely changes in prices. 1 This is very clear price changes (inflation) have been taken into account: However, while there may be a netting out of factors that need to be taken into account, Telecom has provided the Commission with supporting evidence in the form of (real) price changes taken from their negotiated contract prices list, the percentage labour attributable to each asset, and the (real) labour price shift. This implies that the Commission originally based its selection of tilt values on very specific information on observed (actual) price changes. In other words the tilt is based not on hypothetical estimates of price change but on evidence of actual price changes. This means that nominal or actual equipment prices do not need to be adjusted for inflation. The tilt and the manner in which it has been estimated has already achieved this. Thus to include CPI on top of the tilt is to double count. Further evidence that the application of an inflation factor is incorrect lies in the annualisation formula itself. The formula calculates the annualised capital charge by applying the tilt to the cost of the asset over time. Let us consider the formula used to calculate the annualised capital charge from capital investment using a tilted annuity 2 : t 1 [ 1+ α ] [ r α ] V 1+ α 1 1+ r N where: V is the cost of the asset, 1 2 Commerce Commission, TSO Final Determination , 17 December 2003, paragraph 126 Source: Commerce Commission, TSO Discussion Paper and Practice Note Implementation Issues Paper, 19 April 2002, paragraph 203

5 TSO issues from the Commerce Commission 4 α is the tilt, t is the year in the economic life of the asset, r is the rate of return (WACC), and N is the economic life of the asset. To take time-to-build into account, the formula is multiplied by the following factor: 1+ r 1+ α u where u is the time to build. This formula is used to calculate the annualised capital charges for subsequent periods by applying tilt through incrementing the parameter t. No further adjustment is required for inflation as inflation is already taken into account in the tilt factor. Exhibit 1 below illustrates the effect of double counting the CPI by way of an example. The first column assumes the t parameter is incremented each year, while the second column explicitly adjusts the capital expenditure by the tilt and by the CPI each year. Annualised charge 1 Year No CPI doublecounting Double-counting the CPI Exhibit 1: Example illustrating the double counting of the CPI [Source: Network Strategies] 1 Assumes a capital expenditure of $100, cost of capital of 7.1%, a life of 10 years, a tilt of -5% and inflation of 2.5%.

6 TSO issues from the Commerce Commission 5 The formula was used in the appropriate way to calculate the annualised cost of assets for TSO from prices determined for TSO (that is, t was incremented from period 1 to 2). However it was not used in this way for the interconnect draft determination because the Commission, following Telecom s lead, has taken the unprecedented approach of factoring CPI in separately: in this instance the investment costs were updated using the tilt and CPI factors separately 4, and t was kept at 1. The corollary of this is: The price changes have not been applied consistently between TSO and interconnection: the TSO correctly advances the asset charge by applying the tilt in the annuity formula; the interconnect model incorrectly advances the asset costs by applying tilt and inflation prior to the annualisation calculation. If the t parameter in the tilted annuity formula cannot be used to update the charge over time then the formula does not have any use. In conclusion, no change is required to the approach in the TSO for applying the tilt as it is applied to nominal data and the tilt itself captures the relevant price changes. This also affects the Commission s proposal to update the unit costs for the and determinations: For the modelling for both and , the tilted unit costs will be adjusted by a tilt mechanism and will be used in the model. The Commission is intending to use the tilt unit costs and they will be adjusted by the tilt mechanism. This is not required if the treatment of tilts is not changed, as recommended, because the annualisation formulas correctly apply the tilt through the increment of the t parameter. 3 4 Source: Commerce Commission, TSO Final Determination , paragraphs 316 and 380 Source: Draft determination, paragraph 153, and clarified by Jan de Bruin, of 5 May 2005.

7 TSO issues from the Commerce Commission 6 3 Treatment of new lines TSO appears to use the same number of lines as TSO : paragraph 380 of the determination lists the key updates to that year s model, and does not mention the number of lines. Therefore new lines are not considered in the calculation. This implies that the Commission has not made any assessment relating to the decrease in active TSO lines over time that we would expect as existing customers covered by the TSO disconnect and new customers not covered by the TSO are connected. 4 Proposed numbers for line rental The Commission states 5 that: Telecom has not taken increased line rentals by CPI. The Commission proposes that the standard line rental used in the provision of TSO 04/05 revenue is deemed to have increased to $36.31 ($40.85 including GST) as at 1 January 2005, in line with a 2.5 percent increase in the CPI in the year since the last price increase was calculated. Network Strategies has CPI values 6 of 1111 and 1141 for Q and Q respectively, resulting in a CPI increase of 2.7% during this period. A base CPI of has been used. This corresponds to Q4 1989, the period during which the CPI + 0% control on line rental was imposed. The quarterly CPI value is the value which is applicable to the midpoint of the quarter. Following advice from Statistics New Zealand, the quarterly value was not adjusted to determine monthly values, and the quarterly value was applied to each month in the quarter to obtain a CPI-adjusted line rental. 5 6 Commerce Commission. Industry progress report TSO Determinations for 2003/04, 2004/05 & 2005/06. Letter from Bruce Officer to Grant Forsyth. 19 September Source: Statistics New Zealand.

8 TSO issues from the Commerce Commission 7 We calculated maximum allowable monthly year-end 2004 line rentals (Exhibit 2) based on lag periods 7 of between two and three calendar months. However CPIs are released on the eleventh working day after the end of the quarter to which they relate, so the actual lag period is n months minus eleven working days. Our results show that the Commission s allowable monthly rental of $36.31 (ex. GST) is similar to the line rental we calculated based on a lag of three months (minus eleven working days). We have presented results for 2003 and believe that the line rental adjustment should also be applied to this TSO period. Line rental (NZD) for Q4: 2003 (ex. GST) 2004 (ex.. GST) 2003 (inc. GST) 2004 (inc. GST) Allowable line rental 2 month lag (minus 11 working days) month lag (minus 11 working days) Actual Telecom line rental Exhibit 2: TCNZ allowable line rental [Source: Network Strategies] The allowable line rental would be higher without the lag. The Commission has not said what period it is using for lag, if any. Network Strategies view is that a lag of almost three months is too conservative. Network Strategies would therefore recommend a lag of two months. 7 Note that the lag takes account of the time required to implement the price change.