Applications of Cost Proxy ModelsUniversal Service

William W. Sharkey*and

D. Mark Kennet**

November 2000

* FCC and The World Bank** George Washington University and The World Bank

November 2000 2

Universal Service Objectives and Funding Mechanisms

Provide “affordable” service to customers in “high cost” areas

Make implicit subsidies explicitBase subsidies on forward looking, not

embedded, costSubsidies should be transferable between

carriers

November 2000 3

Implementation of a Universal Service Program in the U.S.

Some rural carriers question the reliability of proxy models

Some large incumbent carriers question the FCC’s input values and the funding mechanism (based on statewide average costs)

Both federal and state regulators are concerned about the size of the high cost fund

November 2000 4

Results of the FCC Synthesis Model for Universal Service

High cost support is driven primarily by the cost of the local loop

Local Exchange Cost by Network Element*Loop Port EO Usage Signaling Transport

% of Total Monthly Cost83.12% 3.50% 8.16% 0.76% 4.46%* Based on May 27, 1999 outputs of HCPM model for large US companies

November 2000 5

FCC Synthesis Model (cont.)Loop costs are driven by the density of the

subscriber base Loop Cost per Month by Density Zone*

(# per square mile)Monthly Cost % of Total Lines

0-5 $164.24 0.29%5-100 $52.10 7.50%

100-200 $23.30 3.93%200-650 $17.24 13.67%650-850 $15.06 4.79%

850-2550 $13.25 33.46%2550-5000 $11.38 19.17%

5000-10000 $10.35 8.90%10000+ $9.09 8.28%

* Based on outputs of HCPM model for large US companies

using May 27, 1999 Input values

November 2000 6

Conclusions on Use of Proxy Models for Funding USO

Models provide a very reliable method to estimate the relative costs of regions within a country

Whenever a model based approach replaces an earlier approach there will be winners and losers

The open architecture of a model allows all parties to comment on and recommend changes to model structure or input values

November 2000 7

Use of Proxy Models for Pricing of Unbundled Network ElementsTELRIC is designed for this objectiveQuality of service assumed in model

architecture should adequately represent the incumbent carrier’s network

UNE rates must be compensatory Independent calibration of model desirable UNE prices should reflect prices for long term

contracts in order to reduce the incentives for opportunistic behavior by entrants

November 2000 8

Use of Proxy Models for Pricing of Transport and Termination

A proxy model can give guidance for setting both rate structure and rate level

Use of a model forces the regulator to accurately estimate relevant economic inputs (e.g. peak vs. off-peak usage)

November 2000 9

Some Results of FCC Synthesis Model

Current Cost* Current Revenue Model Cost** Model RevenueLoop

NTS $22.96 $10.9 billion $16.64 $8.6 billionTS $0.0041 $1.9 billion

SwitchingPort (NTS) $0.20 $0.41 billion

Local TS $0.0075 $3.5 billion $0.0014 $0.62 billionTandem TS $0.0010 $0.46 billion

TransportDedicated $0.0028 $0.97 billion $0.0005 $0.18 billionCommon $0.0066 $0.82 billion $0.0011 $0.14 billion

Direct $0.0010 $0.13 billionResidual $0.0007 $0.33 billion

Total NTS $10.9 billion $9 billionTotal TS $7.5 billion $1.5 billion

* Current Cost Estimates Derived from Presentation by Richard Clarke, AT&T

** Model Costs are based on May 27, 1999 Model Input Values

November 2000 10

Other Applications of Cost Proxy Models

Targeted universal service support (estimating the incremental cost of high cost customers)

Estimation of productivity factorsCompetition policy (e.g. predicting the viability

of local competition)

Industrial policy (e.g. estimating the cost of broadband infrastructure investment)

November 2000 11

Preliminary Results on Targeted Universal Service in Portugal

We ask the question: In a mixed urban-rural region typical of much of Portugal, what percentage of lines are subsidized by current prices?

The model addresses this by calculating a cost radius about each central office such that lines within the radius cost less than a benchmark

One benchmark is overall average cost for the region – this gives conservative estimate of subsidy

Another benchmark is average revenue

November 2000 12

Conclusions

Proxy models provide a transparent, verifiable and robust tool for estimating a telecommunications cost function

Proxy models can be used for several regulatory purposes, including funding of universal service and interconnection pricing

Input prices should be determined in an open proceeding

Where possible, proxy model outputs should be calibrated using other benchmarks