Backward-Looking Cost-Based Pricing of Access

The traditional approach to computing interconnection charges consists in applying the methodology of cost-of-service regulation to the operator's wholesale offerings. There are a variety of possible cost allocations.

A popular cost-of-service methodology is that of additive or usage-proportional markups. Suppose that several services utilize a common element. After the allocation of costs that are attributable to a particular service to the corresponding services, there remains a residual corresponding to the "fixed cost" or "common cost." This unallocated residual is then spread across services, and the additive markup on each price is the same for each service. In other words, a usage-proportional markup is tantamount to a fixed (price-independent) excise tax, whose magnitude is computed so as to cover the unallocated cost.

It is interesting to note that usage-proportional markups satisfy the ECPR. ECPR requires the access price to be equal to the operator's opportunity cost on the competitive segment. The operator's price on the competitive segment is equal to total marginal cost, that is, the marginal cost of access plus the marginal cost of the segment itself, plus the markup. The access charge, which is equal to the marginal cost of access plus the markup, is thus equal to the difference between the price and the marginal cost on the competitive segment, that is, the opportunity cost.

Another popular approach to allocating the fixed cost is that of uniform or price-proportional markups. The markup over the marginal cost of a service is proportional to this marginal cost. The uniform markup is thus akin to a proportional (VAT type) tax. Unlike additive markups, uniform markups do not satisfy ECPR. Because the total marginal cost of the competitive segment exceeds the marginal cost of the access facilities used by this segment, the price of the competitive segment is inflated more than that of the access segment, and so the access charge is set below the operator's opportunity cost. The burden of cost recovery then falls disproportionately on the competitive segments.

The benefit of fully distributed cost pricing is that it commits the regulator to allow the operator to recoup its investments and to break even. Thus, to a large extent, it solves the problem of regulatory takings. In particular, an operator who incurs a large fixed cost to install fiber optics in the local loop or to endow switches with new functions need not be concerned that this investment will later be expropriated by the regulator's setting low access charges, for example.

Despite this advantage, in the context of retail pricing, fully distributed cost pricing has been as frequently decried by economists as it has been used in practice. It has well-known flaws. First, it is determined through a cumbersome process. For example, a rebalancing of access charges must be cost justified, a requirement which is likely to imply a delay of several months in the rebalancing. Second, fully distributed cost pricing is cost based and therefore does not encourage cost minimization. Third, it yields an improper price structure and is a vastly suboptimal way of financing the access deficit. Because it is cost-based, it "subsidizes" inelastic-demand segments to the detriment of elastic-demand ones. In the presence of competition, fully distributed cost pricing tends to create an inefficient amount of entry. For example, under uniform markups, an inefficient entrant producing the same service as the operator in the competitive segment finds it profitable to enter as long as its cost handicap relative to the operator is smaller than the markup on the operator's marginal cost on the competitive segment. Furthermore, under all fully distributed cost methods, the markup on access invites inefficient bypass.

To alleviate the cost of the first and third drawbacks (delays in price revisions, inefficient entry in the competitive and bottleneck segments), the prices set by fully distributed cost methods have sometimes been interpreted as ceilings or caps, providing, in particular, flexibility to respond to competitive threats such as those by competitive access providers. By letting operators respond to competition, this downward flexibility has perhaps brought actual prices closer to Ramsey levels, but fully distributed cost methods still have only limited appeal.

From Rate-of-Return Regulation to Price-Cap Regulation

1 Rate-of-Return Regulation and the Review Process

For many years, the dominant method of regulation for private monopolies was so-called rate-of-return regulation. The regulated firm was allowed to charge prices that would cover its operating costs and give it a fair rate of return on the full value of its capital. If costs moved out of line with those prices, the firm would ask for a new set of prices. The main virtue of this "regulatory contract or compact" was to guarantee that the company would recover its costs. This absence of risk could attract capital at a low price. However, this method did not give incentives to the firm to keep its costs down.

To improve efficiency, "prudency reviews" were introduced to assess whether a new investment was necessary. If an investment was not judged "used and useful," then the regulator might not allow it to enter the rate base. Prudency reviews raise the concern of excessive micromanagement by regulators. Furthermore, by allowing regulators to substitute their own business judgement for that of the utilities' managers and boards, they potentially jeopardize the guarantee against expropriation afforded by rate of return regulation. Prudency reviews have therefore remained relatively limited.

The bureaucratic delays of the lengthy process leading to price revisions generated so-called regulatory lags, which had the beneficial side effect of creating some incentives for cost minimization. Indeed, during such lags, the firm was residual claimant of any cost decrease. To mitigate the effects of these delays on profits regulators introduced indexation clauses, for some items outside the control of firm, or pass-through clauses. For example, an electric company might be entitled to a complete pass-through to the consumer of its energy purchase expenditures in the wholesale market. A danger, then, is that the firm has little incentive to bargain for low prices of the corresponding inputs.

Another important feature of rate-of-return regulation is that individual retail prices are determined through accounting procedures and therefore do not obey commercial principles. In particular, they poorly reflect demand considerations. As discussed earlier, the review process determines a revenue requirement meant to cover operating costs plus a fair rate of return on undepreciated capital. Loosely speaking, this revenue requirement sets an average price or price level. It does not yield the price structure. The latter is the outcome of a cost allocation process. Costs that can unambiguously be allocated to a service are included in the price of this service; costs that are common to several services (which is the case for most equipment, be it wires or switches) are allocated according to some accounting rule to the different services. 

2.3.1.2 Price-Cap Regulation

Price-cap regulation was introduced in the United Kingdom under the name of "RPI - X". The firm is required to keep the weighted increase in a basket of its prices to less than the increase in a specified price index (for example, the retail price index, RPI), less x percent. The x percent factor induces a decline in real terms to account for anticipated technological progress. The price control remains in place for a fixed period of four to five years during which the firm fully bears its cost.

In practice, price-cap regulation resembles rate-of-return regulation in some respects. On the one hand, the revision of price cap every four or five years uses all the information available about the firm including its present and projected operating costs, its assets, its investment plans, and its demand forecasts. This information enables the regulator to constrain the rate of return of the firm on the upside. (Sometimes rent extraction is performed more explicitly when earning-sharing schemes are appended to the price cap to redistribute excessive profits to consumers. A consequence of such profit sharing, of course, is a weakening of the incentives for cost minimization) On the other hand, the profit downside is also partly insured through a common understanding that the regulator should allow a reasonable rate of return; indeed, regulatory statutes include an appeal mechanism to protect the company against excessively zealous regulators.

Price-cap regulation differs from rate-of-return regulation in other respects. First, the revision of the regulatory constraint is in principle less frequent, thus providing stronger incentives for cost reduction. Second, and conceptually a more drastic departure, the firm has flexibility as to the choice of its price structure. As we have seen, the firm is then able to price-discriminate in a way that minimizes the social distortion associated with cost recovery. In contrast with the regulator, the regulated firm has strong incentives to acquire the information about demand elasticities and to make use of this information; if it misjudges demand elasticities or does not act on knowledge of them, its profit will be substantially smaller.