What is the difference between cost-based and retail-price based interconnection charges?

[Response by Eric P. Chiang, May 2009]

One of the main tenets of international directives towards interconnection is the promotion of an environment that best simulates a competitive market. Most agreements state that interconnection (or access) prices should be cost-based.¹However, in the case of access there are also alternative pricing methods that can promote efficiency, such as the retail price-based technique efficient component pricing rule (ECPR) (also known as the retail-minus rule²).

Cost-based interconnection pricing is a goal of many countries as it puts greater burden on the incumbent to stay competitive, as customers lost to entrants represent potential lost profits.

Advantages to cost-based pricing:

promotes the greatest entry, thus competition
most-efficient over the long term
potentially best for customers, who benefit from greater competition
maximizes cost-efficiencies; i.e., avoids duplication of essential facilities

Disadvantages to cost-based pricing:

in the case of access, it allows entrants to focus service in profitable networks, and provides less incentive for entrants to be efficient or build out networks
does not provide incumbents the ability to easily recover all fixed costs except on retail services
gives incumbents an incentive to use tactics to drive out entrants, such as providing poor service to the entrants

The main task when establishing cost-based access prices is the determination of incremental cost, the cost of increasing quantity supplied by a given amount. A concern with cost-based pricing, however, is the ability to recover fixed costs. This is partly resolved by viewing all costs in the long-term, where all costs, including capital, are considered variable. Thus, by pricing interconnection based on long-run costs (e.g., LRIC), most costs are recovered.

Another issue with cost-based pricing is whether incremental costs should be measured using actual past data or estimated using costs of today and the future (forward-looking). Historical costs have the advantage of being transparent and auditable, but the disadvantage of not reflecting new technologies that reduce costs of most elements. Thus, forward-looking costs tend to provide the best estimate for cost-based pricing, and have been widely adopted in practice.

Long-run incremental cost (LRIC): is the additional cost in providing a service compared to the most efficient means of producing the remaining services on their own. Clearly, as long as some costs overlap, the LRIC of a service is less than its stand-alone cost. With interconnection, rather than comparing the additional cost over stand-alone costs, we measure the additional cost of interconnection over the non-interconnection state.

Prices for interconnection are based on the estimated costs of operating the facilities and providing services over the long run. LRIC bases its costs using current technology which better approximates costs in a competitive market. This usually leads to lower interconnection rates. However, it can be a problem if prices are well below the costs of inefficient incumbents. Some form of LRIC prices are now used in many OECD countries as well as in emerging markets. They were first implemented in Australia, Canada, Hong Kong, Chile, and in U.S. local service.

Efficient component pricing rule (ECPR): also known as the retail-minus rule, is an alternative to cost-based pricing, and suggests that access prices should be set such that the effect on incumbent’s profits is unaffected. In other words, the incumbent earns the same profit whether it serves the end customer themselves or whether it is served by the entrant.

For example, if the incumbent’s cost of providing the local portion of a call is $0.01, and the long distance portion (competitive component) is $0.02, and the price it charges its own retail customers is $0.06, then the profit for the incumbent firm is $0.03 if it serves the customer itself.

Using the ECPR rule, the access price would be set as: Incumbent’s retail price – long distance cost of incumbent: $0.06 – $0.02 = $0.04/minute.

This means an entrant will pay the incumbent an access price of $0.04/minute to service the long-distance customer. The incumbent still incurs the $0.01 local cost of completing the call, and thus the incumbent earns $0.03, the same as if it were to serve the customer itself.

The entrant therefore profits from ECPR by reducing the cost of providing the competitive long-distance portion of a call. For example, if an entrant has a long-distance cost of $0.01, matches the incumbent’s price of $0.06, and pays the incumbent an access price of $0.04, its profit would be $0.01. The entrant still earns profits if it undercuts the incumbent’s price, say charging $0.055/minute. If so, consumers are better off while the incumbent’s profit does not change.

In practice, the use of ECPR (or retail-minus) is very limited despite its potential for increasing efficiency. Some form of retail-minus pricing has been used in New Zealand, the U.K., and the U.S., while models for its use in broadband access and other telecommunications services have been devised for potential implementation in other countries, such as in a recent proposal by TATT (telecommunications regulator) in Trinidad and Tobago.

Resources

Cost Concepts for Utility Regulators
University of Florida, Department of Economics, PURC Working Paper, 2006.
Jamison, Mark A.

Methods for Increasing Competition in Telecommunications Markets
University of Florida, Department of Economics, PURC Working Paper, 2008.
Jamison, Mark A.

Footnotes

See also What are common cost models used for determining interconnection tariffs and how do they deal with common costs? on this topic.
Retail-minus rule: another name for the efficient component pricing rule (ECPR)