After two years in the making, including extensive public consultation, the European Commission has finally published its long-awaited Recommendation on the regulation of Next Generation Access Networks (NGAs). Issues of natural monopoly remain relevant in many geographic areas. The need to regulate wholesale broadband access is not expected to diminish as operators start to roll out fibre access networks. However, the desire of many policy makers to see fast roll-out of NGAs means that the long-standing problem of deciding appropriate terms for wholesale access to the incumbent’s network has become acute, as these terms are crucial for the incumbent’s investment incentives.
High speed broadband now!
The objective is to provide incentives for investment in NGAs now – i.e. to provide incentives to operators to make investments whose costs will largely be sunk, at a point in time where uncertainties about demand and customer willingness to pay for high speed broadband access remain high. So that regulators can provide such incentives, the NGA recommendation allows for the inclusion of a ‘risk premium’ in the regulated wholesale access price. This is a ‘de facto’ acknowledgment that the current regulatory system with its focus on the principle of cost-based pricing of third party access does not provide adequate investment incentives for incumbent network operators – or at least not as quickly as policy makers would like. Whilst such pricing may provide an opportunity for competitors to rely on third party access to existing network infrastructure while they climb the ‘ladder of investment’ and gradually build out their own infrastructure, it leaves regulated incumbents with the full investment risk: if regulated access charges effectively allow third parties to enjoy wholesale ‘pay-as-you-go’ access at prices that do not compensate the network operator sufficiently for the risk incurred, they provide little incentive for incumbents to upgrade their networks but rather to wait and see what demand and willingness to pay turn out to be.
How to compensate the network operator for the investment risk?
Whilst recognising that incumbent network operators need to be given a strong incentive to take us out of this stalemate in the form of an uplift to the regulated wholesale access prices for NGA, the Recommendation does not help the national regulatory authorities (NRAs) any further in solving the difficult problem of how an appropriate “risk premium” for wholesale access prices should be determined. And for the same reason, it does not provide operators with much certainty in terms of understanding what cap regulation will impose on the return they might expect from their NGA investments.
A simple example of real options
Assume a simple two-period model where there is uncertainty about the willingness to pay of consumers for super-fast broadband, and thus the amount of money that an operator can make from providing both retail services to its own customers and access services to competitors at regulated terms. More specifically, assume that the operator needs to invest in a network upgrade in order to support super-fast broadband services, which costs 100. Assume that under a cost-based regulatory regime for setting access charges, making this investment enables the operator to earn revenues of 20 in period one, based on demand from early adopters of super-fast broadband services. In the second period, revenues may continue to be 20 if such services do not develop mass-market appeal. Alternatively, super-fast broadband may turn into a mass market proposition, generating revenues of 150. Assume that there is a 50% chance of either outcome.
For the sake of simplicity, we ignore the effect of discounting future revenue streams and look at the simple sum of revenues and cost, averaged over both the high and the low demand scenario. This gives us an expected profit of:
50% x (20 + 20) + 50% x (20 + 150) – 100 = 5.
From this, one might conclude that the regulatory regime determining the prices at which the operator has to provide access gives sufficient incentives for making the investment. Even though the investment would be loss-making in the low-demand scenario, the expected profit if demand is high provides sufficient compensation.
However, this ignores that the operator has another option – namely to wait and see how demand develops, and invest only in the high demand scenario. Obviously, this means giving up revenues in the first period, but at the same time the network upgrade can be avoided if demand does not justify the investment. Using the same calculation, the value of delaying investment until uncertainty has resolved is 50% x 0 + 50% x (150 – 100) = 25.
This means that the operator is better off delaying the investment until it is clear whether upgrading the network is profitable. In order to provide an incentive for the operator to invest now, it would be necessary to provide some compensation for giving up the real option to wait and see, e.g. through permitting higher access charges in the case where the operator invests now and demand turns out to be high.
The theory of real options helps us understand the underlying problem and to examine what adjustment to regulated access prices might be needed in order to provide appropriate incentives to invest now rather than to wait and see. The example in the box on the right provides a simple illustration.
Pindyck1 has estimated the impact on taking into account the value of the real option to ‘wait and see’ on the return that fixed, local voice telephony operators in the US should be allowed to enjoy, finding that this could reasonably be 1-5% higher than the cost of capital normally allowed for in regulated prices. However, estimating the appropriate mark-up is by no means straightforward and the result depends on the specific details of the investment risk. The UK regulator, Ofcom, has accepted in principle that the theory of real options is relevant to NGA, but has not yet made any actual determinations where this is reflected in the wholesale access price. NRAs will, however, need to get their hands dirty at some point and establish an appropriate risk premium (or at least set out the methodology they would apply in order to provide some guidance to network operators and access seekers whose negotiations take place on the basis that either side could fall back on the outside option of asking the regulator for a determination).
Letting access seekers share the investment risk
Another interesting aspect of the Commission’s Recommendation is the direction to NRAs to accept alternative wholesale price structures rather than a simple ‘one size fits all’ solution. Different prices would reflect the extent to which the access seeker retains its options. This would allow network operators and access seekers to share the risk of network roll-out: an access seeker who was willing to make a long-term commitment to a certain capacity could be rewarded with a lower access price, with the difference to the ‘pay-as-you-go’ price made up for by the corresponding amount of risk transferred to the access seeker. This kind of flexibility in the structure of regulated wholesale access prices would seem a good principle to support – not least because one would expect to observe similar agreements in a competitive market.2
It is good to see that the Commission has moved away from the focus on co-investment in the earlier drafts of the Recommendation to a more general notion of allowing for risk sharing by whatever means. However, the NRAs will again need to provide some details on how they would go about assessing whether different wholesale access prices are in fact non-discriminatory, without much guidance from the Commission. This means that considerable scope remains for NRAs to regulate NGA rather differently across the EU.
In practice, the question of what forms of price differentiation would be acceptable as an expression of risk sharing is closely related to the question of how one would calculate an appropriate risk premium. What is the monetary value of the risk transferred to the access seeker, depending on the timing of the investment and the geographical area covered? What sort of long-term commitment should give what kind of discount on the wholesale access price?
Even though there are no clear-cut guidelines on how one should calculate the appropriate risk premium in a world of real options, or how an NRA should decide whether a particular wholesale tariff structure is appropriate, we believe these guiding principles might provide some help:
First, any discount on the generally available ‘pay-as-you-go’ access price (which would have to include an appropriate risk premium) should be linked to an investment pledge on behalf of the network operator and a commitment to buy a certain volume over a certain period of time on behalf of the access seeker.
Second, such agreements should not be exclusive and there should be no prohibition for the access seeker to resell capacity bought under a long-term contract.
Third, it is reasonable to expect that the demand uncertainty diminishes over time. Hence, a long-term access agreement concluded sooner than another agreement for the same volume should in all likelihood have a lower (or at least not a higher) higher access price.
Fourth, the greater the number of wholesale lines per node that an access seeker commits to buy, the greater is the risk transferred from the network operator to the access seeker and hence the lower is the justifiable, non-discriminatory access price.
Fifth, the longer the duration of the agreement, the more risk is transferred to the access seeker and hence the lower monetary access price.
Sixth, a network operator with SMP in the relevant market should not be allowed to award its own retail arm lower access prices on the basis of an alleged volume commitment or risk transfer. A vertically integrated operator cannot easily share risk with itself by transferring risk from the network business to the retail arm – the overall level of risk that rests on the entity is the same. Any transfer of risk from the network business to the retail arm should make little difference for the price offered to retail customers, as the higher risk taken by the retail arm would be accompanied with higher required margins for the retail arm.
It will certainly be interesting to see how the NRAs implement the new NGA Recommendation and whether anybody takes the opportunity to move away from access prices based on long run incremental costs. In any case, despite the European Commission’s renewed focus on an Internal Market for communications services, the NGA recommendation leaves ample scope for an increasing divergence in regulatory approaches across the EU.
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- Pindyck, Robert S., “Pricing capital under mandatory unbundling and facilities sharing”, NBER Working paper no. 11225, March 2005. [↩]
- See for example, the Irish Competition Authority, determination no. M/09/015, 21 Aug ‘09, ref: the acquisition of BT Communications Ireland’s SME customers by Vodafone Ireland. As part of the merger agreement, BT commits to investing in the unbundling of a number of local exchanges in return for Vodafone committing to buy a certain volume of wholesale access lines in those exchange areas. [↩]