Application of the Actual Costs Saved and Avoided Costs Saved Standards

Transcription

1 12 April FINAL THE COMMISSION S VIEW ON THE ACTUAL COSTS SAVED AND AVOIDED COSTS SAVED STANDARDS: APPLICATION OF THE FINAL PRICING PRINCIPLE FOR RESALE OF TELECOM RETAIL SERVICES Executive Summary On 30 September 2004, the Commission issued its preliminary views on the application of the statutory cost standards of avoided costs saved and actual costs saved, and requested submissions on those preliminary views. This paper outlines the Commission s revised views on these cost standards, taking into account submissions received from Telecom and TelstraClear ( the Parties ). The paper concludes with discussion of the application of the final pricing principle for bundles of retail services. Application of the Actual Costs Saved and Avoided Costs Saved Standards 1. In Actual Costs Saved the Access Provider notionally continues to participate in the retail market for the service in question. 2. In Avoided Costs Saved the Access Provider notionally withdraws entirely from the retail market for the service in question. 3. The following table summarises the elements of the discounts based on the actual and avoided costs saved standards. Cost Category Actual Cost Saved Discount Avoided Cost Saved Discount Service Specific Variable Costs Included Included Service Specific Fixed Costs Partially Included Included Horizontal Common/Shared Costs Partially Included Included Vertical Common/Shared Costs Partially Included Included Inefficiencies / Excess Profit Included Included 4. Additional costs of wholesaling are not subtracted from the actual costs saved discount or the avoided costs saved discount. Bundles For the purpose of weighting the discounts in a bundle of retail services comprising both price capped and non-price capped services, the weighting method prescribed in the initial pricing principle should be used.

2 2 Definitions For the purposes of this paper, the Commission adopts the following definitions: Service-specific Costs Service-specific costs are costs exclusively incurred in order to provide a particular retail service. Shared and Common Costs Shared and common costs are costs which are not attributable to a specific retail or wholesale service, but are incurred in relation to multiple services or an entire business operation. In turn, shared/common costs can be analysed vertically (in terms of being shared across different functional levels) or horizontally (in terms of being incurred at a specific functional level such as retail but are shared across multiple services). An example of a vertically shared/common cost might be the cost of product billing shared between retail and wholesale operations. An example of a horizontal shared/common cost might be the cost of a retail call centre that handles enquiries relating to multiple retail services. Incremental costs of product The term incremental costs of product X measures the addition to the firm s costs when the output of that product is increased by a given number of units. Incremental costs include both fixed and variable costs.

3 3 Background 1. On 12 May 2003 and 14 June 2004 respectively, the Commission released its determinations on the price and non-price terms and conditions of resale to TelstraClear by Telecom of a number of Telecom s business and residential retail services (Decisions and ). Using a benchmarking approach, the Commission determined that the discount for resale of Telecom s non price-capped services would be set at 16% off standard retail prices. The discount under the initial pricing principle for price-capped services is fixed under the Act at 2%. 2. During May June 2003, both Telecom and TelstraClear applied for a pricing review determination in respect of the discounts set in Decision In July 2004, both parties filed further applications for a pricing review determination in respect of Decision In the pricing reviews, the Commission is required to determine the price payable for the designated access service in accordance with the applicable final pricing principle There are three types of services under review: (1) retail services offered by means of Telecom s fixed telecommunications network; (2) residential local access and calling service offered by means of Telecom s fixed telecommunications network; and (3) bundle of retail services offered by means of Telecom s fixed telecommunications network. 5. The final pricing principles for the three designated access services under review refer to the avoided costs saved and/or actual costs saved standards. These two standards are defined in Schedule 1 of the Act as follows: Actual costs saved means the net costs saved by supplying the service on a wholesale rather than a retail basis to the access seeker. Avoided costs saved means the difference in the access provider s costs between supplying the service on a wholesale basis only and supplying the service on both a wholesale and retail basis, including a share of retail-specific fixed costs. 1 Commerce Commission, Determination on the TelstraClear Application for Determination for Wholesale Designated Access Services (Decision 497), 12 May Commerce Commission, Determination on the TelstraClear Application for Determination for Residential Wholesale Designated Access Services (Decision 525), 14 June Telecom, Application for Pricing Review Determination in respect of Designated Access Services, 3 June 2003; TelstraClear, Application for Pricing Review Determination in respect of Designated Access Services, 30 May Telecom, Application for Pricing Review Determination in respect of Designated Access Services, 5 July 2004; TelstraClear, Application for Pricing Review Determination in respect of Designated Access Services, 2 July Telecommunications Act 2001, Part 2, sections 49 and 52.

4 4 Application of the Actual Costs Saved Standard Overview 6. The actual costs saved standard is applied when calculating the discount for retail services offered by means of Telecom s fixed telecommunications network in a market in which Telecom does not face limited competition for that service, and the Commission has decided to require that particular service to be wholesaled in that market. This standard is also to be applied when calculating the discount for the price-capped residential local access and calling service. Service-Specific Variable Costs 7. The Commission considers that actual costs saved must include the variable costs specific to the particular regulated service that is subject to resale. Service-Specific Fixed Costs 8. Telecom submits that actual costs saved means the costs that would be saved by the incumbent by supplying at wholesale to a reseller some of the service that it would otherwise retail itself. Implicit in Telecom s view is that there is no hypothetical exit by the access provider under the actual costs saved standard. In the report attached to Telecom s submission, NERA refer to [t]he net costs saved as a result of supplying the relevant quantum purchased by the reseller as distinct from savings as a result of supplying the entirety of the service on a wholesale rather than a retail basis. 6 In Telecom s view, the actual costs saved equate to the variable costs of providing that particular service (i.e. a proportion of the total of the service-specific unit retailing cost multiplied by the units of the service). Telecom argues that fixed retail costs would continue to be incurred, as the access provider continues supplying a quantity of the same service to other parties at the retail level and, hence, no fixed costs should be included in the actual costs saved discount In contrast, TelstraClear assumes a long-run view and hypothetical exit by the access provider. TelstraClear would include as actual costs saved the variable and fixed costs associated with the service. That is, actual costs saved would include the service-specific fixed retailing costs of the resold retail service, as well as the service-specific unit variable cost of retailing the service multiplied by the quantity of those services that are provided by way of wholesale The Commission considers that the extent to which retail service-specific fixed costs should be included in the actual costs saved discount depends on the assumptions made in respect of the increment of service withdrawn from retail, the lumpiness of the fixed costs, and the timeframe allowed for the incumbent to adjust its costs. For example, if it 6 Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004: Annex A: NERA, Interpretation of Avoided and Actual Costs Saved, page Ibid. 8 TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph 20.

5 5 were assumed that only one unit of the service is withdrawn from the retail level (and instead supplied to the access seeker on a wholesale basis), the only costs saved might be marginal retailing costs. However, if it were assumed that the entire service were withdrawn from retail, then all service-specific fixed and variable costs would be saved. 11. The Commission considers that the Act does not require the assumption of hypothetical exit by the access provider from the retail market for the service. The definition of actual costs saved is not explicit as to cessation or continuance of retail supply. By contrast, the definition of avoided costs saved does not assume continued retail supply, since it refers to supplying the service on a wholesale basis only. 12. As the actual costs saved definition refers to supply on a wholesale rather than a retail basis to the access seeker instead of a wholesale basis only, continuation of retail supply to persons other than the access seeker is contemplated. Accordingly, the Commission considers that Telecom is to be regarded as continuing to participate in the retail market. 13. The relevant increment over which Telecom s actual costs saved should be assessed is the likely volume of service supplied in aggregate to access seekers. This will require a view to be taken as to the likely volume supplied to access seekers, for example based on forecasts from the relevant parties. This volume increment would then influence the quantum of costs that would be saved, and hence the size of the discount. 14. In practice, it is likely that over time, at least some of the retail service-specific fixed costs would be scaleable and hence any partial withdrawal from retail would lead to a scaling back of the fixed costs. Therefore, in respect of the volume of the service supplied to access seekers, there might be some saving of service-specific fixed costs, as a result of the access provider reducing its volume of retail sales of the service in question. The Commission considers that such savings in service-specific fixed costs are to be included in actual costs saved. 15. However, this does raise the question of what timeframe is appropriate when assessing retail service-specific fixed costs. One option may be to fix the timeframe according to the term of any wholesale determination, and to consider the extent to which any retail service-specific fixed costs are capable of being scaled back within that period. Alternatively, it may be appropriate to adopt a longer run perspective, such as the (fiveyear) sunset provisions of the Act. Horizontal Shared and Common Costs 16. As noted, Telecom would not include any fixed costs in the actual costs saved discount Unlike avoided costs saved, the actual costs saved does not include any reference to a share of retail-specific fixed costs. Actual costs saved refers to a particular service, and Telecom will continue to supply both the specific service as well as other services at the retail level. Most horizontal shared/common costs (i.e. retail costs incurred across multiple 9 Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004: Annex A: NERA, Interpretation of Avoided and Actual Costs Saved, page 24.

6 6 services) will continue to be incurred by Telecom in both scenarios and therefore would not be saved. However, there may be some instances where horizontal shared/common costs could be scaled back to reflect the partial withdrawal from supply of a service at the retail level. 18. Accordingly, horizontal shared/common costs are to be excluded from the actual costs saved, unless it can be demonstrated that they are affected by the partial withdrawal of the service from retail level supply. Vertical Shared and Common Costs 19. TelstraClear would include as actual costs saved an allocation of vertical joint and common costs 10 that are shared between retailing and wholesaling and attributable (by an avoidability test) to retailing. TelstraClear reasons that [a]s the counterfactuals involve Telecom exiting retail supply, it will be able to avoid some of these vertical joint and common costs Telecom considers the defining characteristics of actual costs saved include that the service continues to be sold by the access provider at the retail level to retail customers 12, implying that vertical common costs are not avoided. 21. In shifting from retail supply to wholesale supply, it may be that only a portion of the vertically shared/common costs can be saved. For example, some of the billing functions costs would still occur, as the access provider would still need to bill wholesale customers. 22. The Commission considers that vertical shared and common costs are not excluded by the definition of actual costs saved. Although Telecom continues to participate in the retail market, it will partially withdraw from that market. It seems reasonable to anticipate that it would save at least some of the vertical shared and common costs associated with the service in question. On this basis, vertically shared costs should be included in the calculation of the relevant discount to the extent that they are attributable to the volume of the service that is withdrawn from retail level supply. Inefficiencies and Excess Profits 23. Clause 3(1) of Schedule 1 to the Act provides that: In relation to a telecommunications service, in applying an applicable initial pricing principle or an applicable final pricing principle that takes a retail price for the service and subtracts any avoided costs saved by the applicable access provider of the service, the applicable access provider is not entitled to recover any of the following things in respect of those costs that form a part of the avoided costs saved associated with its retail operations: (a) inefficiencies in the provision of the service giving rise to higher costs: 10 TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph Ibid, paragraph Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph 44.

7 7 (b) profits in excess of what would represent a reasonable return (including reasonable profit) on capital invested. 24. In its Preliminary Views Paper 13, the Commission stated that presumably the reference is restricted to avoided costs saved on the grounds that in the context where competition is not limited or lessened, and actual costs are to be applied, the presence of effective competition will ensure that there will be no significant inefficiencies. 25. TelstraClear considers that the clarifying language in clause 3(1) of Schedule 1 (which expressly excludes the access provider from recovering inefficiencies or excess profits through the avoided costs saved discount) does not preclude counting inefficiencies and excess profits as actually saved. TelstraClear argues that elimination under both costs standards is consistent with the purpose in section 18 of the Act. Merely because clause 3(1) states for the avoidance of doubt, TelstraClear says it does not logically follow that the factors in clause 3(1) are irrelevant to other definitions Ordover and Klick (for TelstraClear) state that [a]lthough clause 3 of Schedule 1 of the Telecommunications Act only refers to inefficiencies and excess profits being eliminated under the avoided costs saved standard, we believe that their elimination under both standards is consistent with the statute s overall goal The wording in clause 3 unambiguously prevents the access provider from recovering inefficiencies and excess profits when the applicable pricing principle takes a retail price for the service and subtracts any avoided costs saved by the access provider. Clause 3 does not mention the actual costs saved standard. Subclause 3(2) provides that subclause 3(1) is for the avoidance of doubt. The Commission considers that a clarification in respect of one standard does not necessarily affect the interpretation of a different standard. 28. The absence of any clear direction in the Act on this point may be due to the circumstances in which the actual costs saved discount applies, namely for services supplied in markets that are found to be effectively competitive (in the wording of the Act, not subject to limited competition ), and for price-capped services. The implication is that competitive pressures and the price-caps imposed on Telecom may have been considered sufficient to mitigate concerns over inefficiencies and excess profits. 29. However, the Commission considers that competitive forces and the price cap might not be sufficient to remove all such elements from Telecom s prices. 30. Given the section 18 purpose statement, the Commission considers that it is reasonable to take into account any inefficiencies and excess profits in respect of the actual costs saved. To the extent that these factors exist, the actual costs saved discount would be greater. This would allow a more efficient access seeker to enter the retail market and place competitive pressure on Telecom. 13 Commerce Commission, Avoided and Actual Costs Saved: Application of the Final Pricing Principle (Preliminary Views Paper), 30 September 2004, paragraph TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, page TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, Annex 1: Ordover and Klick Paper, page 16.

8 8 31. In practice, given that the wholesale access prices are determined on a retail-minus basis, any retail inefficiencies should be captured by focussing on Telecom s retail costs, rather than those of some hypothetically efficient benchmark. Any inefficiencies embedded within those costs would automatically lead to a higher discount, and hence to a lower wholesale price. 32. In summary, the Commission considers that inefficiencies and excess profits should not be disregarded under the actual costs saved standard. Accordingly, the Commission will apply the actual costs saved discount consistently with the principle set out in clause 3(1) regarding the avoided costs saved discount. Costs of Wholesale 33. The wholesale provisions of the Act require Telecom to provide access seekers with wholesale access to its retail services (supplied by means of its fixed telecommunications network). This raises the issue of whether, in providing such wholesale access, Telecom incurs any additional costs in wholesaling designated services, and if so, how those costs should be accounted for. 34. Telecom argues that the actual costs saved discount should be reduced by the amount of any additional onset and ongoing costs of wholesale that the incumbent would incur by a partial shift to wholesale supply. 16 Telecom states that [i]n relation to the actual costs saved pricing principle, the use of the term net costs saved must also refer to any increase in costs incurred by the access provider in offering wholesale externally 17, i.e. the discount is net of additional wholesaling costs. NERA contends that [i]n order for the word net to have meaning, it must refer to the costs of wholesaling, since net conventionally indicates that something has been subtracted. 18 NERA argues that Telecom ought to be allowed a credit (i.e. a reduced discount) for the extra costs it would incur in providing resale access. 35. TelstraClear does not consider that the costs of wholesale supply are relevant to the calculation of the wholesale discount. 19 It argues that the costs of the system and processes required for a wholesale business will be incurred under both factual and counter factual scenarios and logically therefore be part of the cost difference between the two. 36. There appears to be two broad types of wholesale costs that Telecom may incur: the first consists of onset costs (such as fixed set-up costs relating to OSS), and the second consists of administrative costs of customer transfer. 37. It may also be the case that access seekers also incur costs of a similar nature in order that they can access the Telecom systems. 16 Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, page Ibid, paragraph Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004: Annex A: NERA, Interpretation of Avoided and Actual Costs Saved, page TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, page 10.

9 9 38. The word net in the definition of actual costs saved could be taken to refer to onset costs of wholesaling, on the basis that the expression net costs saved suggests that something is netted off from costs saved. The definition is silent as to what might be netted off. If the word net is taken to refer to additional costs associated with wholesaling, there is no guidance as to the extent to which such costs are to be netted off. Equally, the expression net costs saved might be intended to refer to a difference between levels of other costs. The expression plausibly refers to the costs saved as a result of supplying a volume of the service at wholesale relative to the costs of supplying entirely at the retail level. 39. An across-the-board reduction of the discount (ie an increase in wholesale charges) based on the level of wholesaling onset costs (as suggested by Telecom) might not create the necessary incentives for investment in systems that support resellers. If the discount were to be reduced without such investments being in place, it is unclear what incentives Telecom would face. 40. The Commission believes that it is most appropriate to apply the following principles for the allocation of these costs: Cost minimisation: the cost allocation mechanism should provide an incentive to operators to minimise the cost of providing wholesale access. Cost causation: cost causation implies that those customers who cause costs should pay those costs. Alignment of costs with benefits: the cost allocation mechanism should provide for the recovery of costs from both retail customers who churn away from Telecom to a resale competitor and those who decide to remain with Telecom, as resale generates industry-wide benefits as well as benefits that accrue only to churning customers. Practicality: the cost allocation mechanism should be both easy to implement and to enforce. 41. In addition, the Commission should consider the impact of cost allocation on the incentives of the Parties to compete with each other for customers; and the implications of the switching costs faced by customers. 42. Having considered the application of the cost-allocation principles to the issue of additional wholesale costs, the Commission s view is that each operator should bear its own onset costs of wholesaling. This position is consistent with the above principles: the principle of cost minimisation suggests that Telecom as the access provider should be required to bear at least some of its system set-up costs, as otherwise it would have little incentive to minimise these costs, particularly as they would be borne by its retail competitors; the principle of aligning costs with benefits clearly points towards recovering costs not only from those who directly utilise the resale service (in particular, those retail customers who switch away from Telecom to a resale competitor), but also from those who decide to remain with Telecom. This is because the resale regime promotes retail competition, with benefits likely to accrue to a wider set of retail

10 10 customers than those who actually switch. For example, as a result of enhanced competition at the retail level, Telecom may have to reduce prices and/or improve service quality in order to retain retail customers. This will benefit those customers who decide to stay with Telecom. the principle of practicality would also be met. Each operator bearing their own set-up costs would avoid the need to determine and allocate these costs. As Telecom s relevant onset costs are one-off, difficulties could also arise as to how the costs should be shared amongst entrants, and whether a portion of these allocated costs should be reallocated to subsequent entrants. the principle relating to competition is likely to be met by a cost-recovery mechanism that supports effective competition, and in the present case, this is likely to be achieved by maintaining a level playing field in retail markets. Set-up costs are incurred by access seekers as well as access providers and those costs appear to be broadly related to the size of the operator. Requiring each operator to bear their own set-up costs will be consistent with the principle of maintaining effective competition. 43. The effect of applying the principle of cost causation is ambiguous in this case. It could be argued that the parties seeking wholesale access to Telecom s retail services cause these costs to be incurred by Telecom, which suggests that these costs should be recovered from access seekers. However, it could also be argued that the costs are a result of a policy decision to introduce a regulated wholesale regime in order to address a competition issue arising from Telecom s position in retail telecommunications markets in New Zealand. This would suggest that Telecom should also contribute to these costs. 44. The Commission considers that the purpose expressed in section 18 of the Act would therefore be best served if both parties were each to bear their own onset costs of wholesaling. This approach is consistent with the principles of cost minimisation, aligning costs with benefits, practicality, and effective competition. 45. The Commission considers that, in principle, the recovery of customer transfer costs should be by a way that is separate from the wholesale discount. Recovering these costs on a per-transfer basis is likely to be consistent with a number of the cost recovery principles referred to earlier. However, in this case the parties have reached a commercial agreement in relation to the transfer cost, and the Commission is not required to form a view about this cost. 46. The Commission considers that it is appropriate to adopt the same approach to wholesaling costs under both cost standards.

11 11 Application of the Avoided Costs Saved standard Overview 47. The avoided costs saved standard is defined in Schedule 1 of the Act as: Avoided costs saved means the difference in the access provider s costs between supplying the service on a wholesale basis only and supplying the service on both a wholesale and retail basis, including a share of retail-specific fixed costs. 48. This standard is to be applied by the Commission when calculating the discount for the designated access service: retail services offered by means of Telecom s fixed telecommunications network (among others), where that service is offered in markets in which Telecom faces limited, or is likely to face lessened, competition for that service. 49. In the Preliminary Views Paper the Commission proposed that common costs should be included in the discount for avoided costs saved, since the definition of avoided costs saved refers to the access provider s costs 20 which the Commission took to mean the costs of the entire company, including common costs. That is, avoided costs saved comprised fixed and variable retail-specific costs together with average common costs. Avoided costs saved was equivalent to the incremental cost of all regulated retail services, and so included the service-specific fixed retailing costs of the resold services, the service-specific variable retailing costs of the resold services, and the average common costs. 50. Telecom submits that avoided costs saved means the costs saved when the incumbent ceases producing only the single service in question, in the long-run. Specifically, for a single service, Telecom would include in the discount the service-specific fixed retailing costs together with the service-specific variable retailing costs. Telecom would not include common costs in the discount, except fixed costs such as corporate overhead, that are saved in the counterfactual. 21 Telecom stresses that a large wholesale discount would encourage resale entrants to depend on reselling services, rather than developing their own facilities. 51. TelstraClear argues that the access provider should be regarded as hypothetically exiting retailing altogether, so that the full incremental cost of all regulated retail services should be treated as avoided. That is, avoided costs saved should include the service-specific fixed retailing costs of resold retail services, plus the service-specific variable cost of retailing the wholesale service(s), plus the proportion of vertical shared/common costs that are shared between retailing and wholesaling and attributable (by an avoidability test) to retailing, plus the horizontal shared/common fixed cost for resold services. 20 Commerce Commission, Avoided and Actual Costs Saved: Application of the Final Pricing Principle (Preliminary View), 30 September 2004, paragraph Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, Annex A: NERA, Interpretation of Avoided and Actual Costs Saved, page 11.

12 12 Service-Specific Variable Costs 52. The Parties disagree on whether the access provider exits from the retail of one service only (Telecom s view) or withdraws from all the retail services and stops functioning as a retail entity (TelstraClear s view). 53. The Commission considers that the avoided costs saved standard assumes hypothetical exit by the access provider from the retail market for the relevant service. The definition of avoided costs saved does not assume continued supply of the service by Telecom on a retail basis, since it refers to supplying the service on a wholesale basis only, and does not link the relevant supply to the access seeker (as does the actual costs saved definition). 54. It follows that avoided costs saved includes all of the service-specific variable costs. Service-Specific Fixed Costs 55. The Commission considers that where the access provider notionally withdraws altogether from retail supply of the service, service-specific fixed costs are avoided costs saved and therefore are included in the discount. Horizontal Shared and Common Costs 56. Telecom considers that the words including a share of retail-specific fixed costs in the definition of avoided costs saved refer to a share of the retail-specific fixed costs that relate to a number of services. Telecom considers that there are fixed costs that are specific to retail but that might relate to multiple services, and regards the expression as referring to the share of such costs that is attributable to the particular retail service in question. 22 Fixed costs that relate to both retail and wholesale functions are not retailspecific, and must be excluded from the wholesale only cost profile. Since retailspecific fixed costs might relate to multiple retail services, a share of these costs must be included in the avoided costs saved on the basis that they would be scaled-back by the access provider when configuring the business that sold the particular service on a wholesale-only basis. 23 Telecom accepts, therefore, that the avoided costs saved discount may include some horizontal shared costs: To the extent that implementing the subtraction of one cost profile from another, as required by the avoided costs saved definition, picks up changes in shared costs then this will of course be appropriate. For instance if, over the long run, retail-specific fixed costs that are shared between services are reduced by the change to providing the service in question on a wholesale only basis then this reduction will be part of the avoided costs saved Telecom disagrees with the Commission s preliminary view that the words the access provider's costs in the definition of avoided costs saved refer to the costs of the entire company, including common costs. Telecom says this construction...simply overlooks 22 Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph Ibid. 24 Ibid paragraph 39.

13 13 the fact that the avoided costs saved definition refers to the difference in the access provider s costs between the two cost profiles TelstraClear argues that there are certain retail costs that, not being specific to individual retail services, would not be avoided if Telecom ceased retailing that service alone, but would be avoided if Telecom ceased retailing multiple services. If the wholesale discount does not take those retail costs into account, TelstraClear says, the reseller would effectively be subsidising Telecom s retail business and Telecom could exit its retail business altogether but still receive a contribution to horizontal joint and common costs In TelstraClear s view, the words including a share of retail-specific fixed costs in the definition of avoided costs saved means that horizontal joint and common costs are relevant. Since retail-specific costs attributable to the service are excluded to the extent it is necessary to consider supplying the service on a wholesale basis only, TelstraClear argues that the reference in the definition to a share of retail-specific fixed costs must mean horizontal joint and common costs. The expression would otherwise be redundant. TelstraClear consider the expression refers to aggregated horizontal joint and common costs, hypothesising Telecom's exit from the retail market for all regulated services (not only the particular service in question) in order that these retail-specific costs can be identified. 60. The approach proposed by TelstraClear, whereby the incumbent is assumed hypothetically to exit from the production of all retail designated services, implies that the resulting costs saved would include a substantial amount of shared/common costs. This being the case, some method of allocating them between services would be required. 61. TelstraClear observes that if horizontal joint and common costs are relevant to the avoided costs saved discount, then it becomes necessary to decide how to calculate the share of those costs to be included in the avoided costs for the resale service. 27 Similarly, NERA note that if this approach were adopted it requires an allocation of retail costs common to resale regulated services. 28 Telecom states: an allocation of common costs (whether total, or retail specific) cannot be simply read into the avoided costs saved calculation for efficiency/section 18 reasons. 29 Telecom notes that where specific treatment of common costs was intended, as in the case of forward-looking common costs in relation to calculating TSLRIC, it was specifically provided for in the legislation. 62. Having included service-specific variable and fixed costs, the avoided costs saved standard also refers to a share of retail-specific fixed costs. Given that retail servicespecific fixed costs have already been included, the Commission considers that this latter term must refer to retail-specific fixed costs which are shared across multiple retail services. 25 Ibid paragraph TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph Ibid paragraph Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, Annex A: NERA, Interpretation of Avoided and Actual Costs Saved, page Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph 37.

14 A further issue that has arisen is whether Telecom is assumed to exit from the retail market for the particular single service, or from retailing all of the regulated resale services. The Commission notes that this assumption will have implications for the magnitude of the discount, given the level of cost sharing across multiple services. 64. The Commission considers that the expression access provider s costs is sufficiently wide to encompass horizontal shared/common fixed costs. This, however, does not resolve the question as to whether the relevant increment is determined by the hypothetical exit from the retail market for the particular service, or from retailing all regulated services. 65. The definition of avoided costs saved does not expressly deal with the allocation of common costs. Accordingly, the Commission would need to develop an allocation methodology. The Commission does not consider that it is significant that the Act deals specifically with how common costs should be treated in the different context of the TSLRIC calculation. The threshold question is whether the Act requires allocation of common costs; if it does, then a methodology for allocation must of necessity be developed and applied. In deciding on an appropriate allocation methodology the Commission is required to consider the legislative purpose stated in s 18, and to make the decision it considers best gives, or is likely to best give, effect to that purpose. 66. If it is assumed that Telecom is to exit the retail market on a service-by-service basis, then for each service under consideration, an allocation of horizontal shared/common costs would have to be made. If all regulated services are considered together, then the shared/common costs across the individual services would become directly attributable to the overall increment, and hence no specific allocation to individual services would be required. 67. The Commission notes that the allocation of these horizontal shared/common costs depends on whether a single discount is set for all regulated services, or different discounts are used for different services (or customer types etc). If a single discount were used (which is typically the case in the US, and also Australia for the local carriage service), then the increment would include all retail services subject to regulated resale. All the retail costs associated with those services (including costs shared or common to them) would go into the discount. The same percentage discount on price could be used for all relevant services. As noted above, there would not be a need to allocate costs to one service However, if multiple discounts were used, the significance of allocation of shared/common costs between the services increases. Economic efficiency reasons would favour the use of multiple discounts, so that, for example, different percentage discounts would be applied for residential services and for business services where, as seems likely, their demand price elasticities vary significantly. In this case, an allocation of shared/common costs between services that reflected this would ideally be required. The practicality of implementing this approach may be constrained, for example, by the availability of sufficiently detailed data. 30 Although it is likely that any retail costs that are shared between the increment of regulated resale services and non-regulated retail services (such as mobile) would still have to be allocated in some manner.

15 This practicality issue will only become apparent at the data gathering/analysis stage of a determination. For example, the feasibility of multiple customer-type discounts will depend on whether there is anything in Telecom s costs/accounts that can be attributed to those different customer segments (or different services etc). 70. As previously noted, most US state regulators have set a single discount. However, in principle there may be reasons to have multiple discounts. 71. TelstraClear s submission indicates that the Commission should set out its view on the mechanism by which any shared/common costs should be allocated. 31 At a high level, it is likely that either a sophisticated allocation based on relative demand elasticities, or a simpler rule of thumb, might be used. The use of a rule of thumb to allocate shared/common costs is a second-best approach, although the specific nature of the rule is likely to depend on the nature of the costs being considered. For example, it is likely that the rule should reflect the drivers of the shared/common cost, to the extent that these can be identified. The Commission expects that these drivers will only become apparent during detailed examination of the access provider s costs and, hence, the appropriate allocation must be determined in the particular case. Vertical Shared and Common Costs 72. TelstraClear contends that the same logic regarding vertical shared/common costs applies in relation to avoided costs saved as applies to actual costs saved : The factual/counterfactual which applies under each of the definitions of avoided costs saved and actual costs saved necessarily require an allocation of vertical joint and common costs. As the counterfactuals involve Telecom exiting retail supply, it will be able to avoid some of these vertical joint and common costs Telecom considers that it must be assumed that Parliament has deliberately not referred to common costs in the definition of avoided costs saved, but allows that there may be shared costs which can change with the increments of activity or output of a single service under consideration. 33 Telecom acknowledges that a reduction in horizontal shared costs in moving to wholesale only supply should be included in avoided costs saved. 74. In the case of avoided costs saved, where the entire volume of the service is being withdrawn from retail, the Commission considers that vertical common costs are necessarily included in the comparison of the wholesale only and wholesale plus retail costs profiles. It follows that vertical shared/common costs should be included in avoided costs saved. 31 For example, see Ordover/Klick, pages TelstraClear, Submission to the Commerce Commission on Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph Telecom, Submission on the Commerce Commission s Issues Paper: Avoided and Actual Costs Saved: Application of the Final Pricing Principle, 22 October 2004, paragraph 39.

16 16 Inefficiencies and Excess Profits 75. In relation to the avoided costs saved standard, it is not in dispute that the access provider is not entitled to recover inefficiencies nor excess profits. As indicated earlier, clause 3(1) of Schedule 1 to the Act specifically provides that the access provider cannot recover for these factors. Application of the Final Pricing Principle for Bundles of Retail Services 76. The final pricing principle for a bundle of retail services offered by means of Telecom s fixed telecommunications network, requires a calculation in accordance with the following formula: a - b = c where a is the retail price of the bundle b is a discount off the retail price. This discount must be determined by using, (a) in the case of a non price-capped service offered by Telecom in markets in which Telecom faces limited, or is likely to face lessened, competition for that service, avoided costs saved pricing; or (b) (c) in the case of a non price-capped service offered by Telecom in markets in which Telecom does not face limited, or is not likely to face lessened, competition for that service, actual costs saved pricing; or in the case of Telecom's price-capped residential access and calling service, actual costs saved pricing c is the wholesale price 77. The question arises as to how this pricing principle is to be applied to determine the discount when bundling of vertical services (e.g. voic , call waiting, etc.) with the basic local service is ubiquitous and the different services have different discounts. The actual costs saved discount applies to the basic local price-capped service component, while the avoided costs saved discount applies to all the other, non-price-capped services. 78. The initial pricing principle for bundles of retail services in Schedule 1 of the Act was amended by the Telecommunications (Initial Pricing Principle) Order 2003, which came into effect in January The final pricing principle for the same designated access service was not amended by that Order. As amended, the applicable initial pricing principle provides that for a bundle comprising both non-price-capped and price-capped retail services, the overall discount must be determined by weighting the discounts for each of the various services in proportion to the standard retail price for those services when they are offered outside the bundle. Further, non-designated services included in the bundle must be weighted in proportion to the standard price as just described, but must not be discounted. 79. In the event that the Commission were required to apply the final pricing principle to a bundle comprising both price capped and non-price capped services, it would be necessary

17 17 for the Commission to determine some means of weighting the different discounts applicable to the different components of the bundle. The final pricing principle for bundles does not prescribe any method by which such weighting should be made. Although the initial and final pricing principles are distinct provisions and the wording of one has no necessary effect on the application of the other, there is nothing in the circumstances in which these principles respectively apply that suggests different approaches should be adopted to the weighting of the discounts. Accordingly, the Commission considers that the weighting method prescribed in the initial pricing principle could be used in applying the final pricing principle, in the absence of any reason to consider that this would not best give effect to the legislative purpose stated in s 18.

18 18 Appendix: Provisions of the Telecommunications Act 2001 referred to in the Statement Section 18 describes the purpose of Part 2 and Schedule 1 to 3 as follows: Section 19 states: Section 52(a) states: (1) The purpose of this Part and Schedules 1 to 3 is to promote competition in telecommunications markets for the long-term benefit of end-users of telecommunications services within New Zealand by regulating, and providing for the regulation of, the supply of certain telecommunications services between service providers. (2) In determining whether or not, or the extent to which, any act or omission will result, or will be likely to result, in competition in telecommunications markets for the long-term benefit of endusers of telecommunications services within New Zealand, the efficiencies that will result, or will be likely to result, from that act or omission must be considered. (3) Except as otherwise expressly provided, nothing in this Act limits the application of this section. (4) Subsection (3) is for the avoidance of doubt. If the Commission or the Minister (as the case may be) is required under this Part or any of Schedules 1 to 3 to make a recommendation, determination, or a decision, the Commission or the Minister must (a) consider the purpose set out in section 18; and (b) if applicable, consider the additional matters set out in Schedule 1 regarding the application of section 18; and (c) make the recommendation, determination, or decision that the Commissioner or Minister considers best gives, or is likely to best give, effect to the purpose set out in section 18. A pricing review determination must include (a) the price payable for the designated access service, which, in the opinion of the Commission, is determined in accordance with (i) the applicable final pricing principle (as affected, if at all, by clause 2 or clause 3 of Schedule 1); and (ii) any regulations that relate to the applicable final pricing principle; Clause 1, Part 1, of Schedule 1 of the Act: Actual costs saved means the net costs saved by supplying the service on a wholesale rather than a retail basis to the access seeker. Avoided costs saved means the difference in the access provider s costs between supplying the service on a wholesale basis only and supplying the service on both a wholesale and retail basis, including a share of retail-specific fixed costs. Clause 3(1), Part 1 of Schedule 1 of the Act: (1) In relation to a telecommunications service, in applying an applicable initial pricing principle or an applicable final pricing principle that takes a retail price for the service and subtracts any avoided costs saved by the applicable access provider of the service, the applicable access provider is not entitled to recover any of the following things in respect of those costs that form part of the avoided costs saved associated with its retail operations: (a) inefficiencies in the provision of the service giving rise to higher costs: (b) profits in excess of what would represent a reasonable return (including reasonable profit) on capital invested.