Commission Communication on interconnection pricing in a liberalised telecommunications market (98/C 84/03)

(Text with EEA relevance)

1. BACKGROUND

The Community has developed a regulatory framework for telecommunications that provides for open and competitive markets from 1st January 1998, with transition periods for certain Member States. The Community market of 190 million fixed telephone lines presents opportunities for market entry into one of the fastest growing sectors of the economy. The market for telecommunications services in Europe has been growing at a rate of about 8 % per annum (in nominal terms) since 1990, and OECD comparisons of competitive and non-competitive markets indicate that growth rates can be expected to increase significantly following liberalisation. Current telecommunications investment in the Community is running at about ECU 40 billion per year.

The subject of interconnection is of particular importance to the development of a competitive market in telecommunications. Interconnection to the incumbent's network is essential for most new entrants in order to access the existing base of telecommunications users in a national market. The EU regulatory framework for telecommunications sets out principles for interconnection to be implemented at national level under the supervision of the national regulatory authorities for telecommunications (NRAs).

Publication by the Commission of Recommendations on Interconnection is foreseen in the European Parliament and Council Directive 97/33/EC on Interconnection in Telecommunications (1). The aim of such Recommendations is to assist the national regulatory authorities in carrying out their obligations under the Directive and thereby 'facilitate the development of a genuine European home market` (2).

2. THE REGULATORY FRAMEWORK FOR INTERCONNECTION

The EU Regulatory Framework for interconnection is set out in Commission Directive 96/19/EC (3) (the 'Full Competition` Directive) and the EP and Council Directive 97/33/EC on Interconnection in Telecommunications (the Interconnection Directive). In addition to the ex ante rules contained in these two Directives, the competition rules of the Treaty apply.

Under the 'Full Competition` Directive, Member States have to ensure that telecommunications organisations publish, by 1 July 1997, the terms and conditions for interconnection to the basic functional components of their voice telephone service and their public switched telecommunications networks, including the interconnection points and the interfaces offered according to market needs. Terms and conditions for interconnection, which include interconnect price lists, must be non-discriminatory, proportional and transparent, and based on objective criteria.

Furthermore, by 1st January 1998, Member States must ensure that telecommunications organisations provide interconnection on these terms and conditions to undertakings authorised to provide such services or networks. The deadline for implementation of this Directive into national law was January 1997.

The 'Full Competition` Directive provides minimum requirements concerning interconnection. The Interconnection Directive, which came into force in August 1997 and is to be implemented into Member States' national laws by 31 December 1997, goes further than the full competition Directive by laying down a harmonised set of principles for interconnection. In addition to the obligation for fixed network operators with significant market power to provide interconnection to their networks at cost oriented prices, it sets out the supervisory role of the national regulatory authorities who must, among other things, ensure publication of a 'reference interconnection offer` describing the terms and conditions for interconnection.

The Interconnection Directive also requires that agreements involving interconnection to fixed network operators with significant market power are made publicly available.

Certain Member States have been granted transition periods for liberalisation of voice telephone services and public telecommunications networks, with corresponding deferments for the publication deadlines referred to above (4). However, the Interconnection Directive requires all Member States to ensure publication of a 'reference interconnection offer` by 1 January 1998. In the case of transition countries, the scope of this reference interconnection offer is limited to the terms and conditions for interconnection of already liberalised services, i.e. mobile networks and cross-border interconnection of fixed and mobile (5) networks.

The application of the principles set out in Commission recommendations is without prejudice to the duty of the Member States and of undertakings to comply fully with the EU competition rules, taking account of the specific positions set out in the Communication from the Commission on the application of the competition rules to access agreements in the telecommunications sector (6).

3. COMMISSION RECOMMENDATION ON INTERCONNECTION PRICING (7)

3.1. Scope of the recommendation

When two networks interconnect, each operator seeks to charge the other for resources provided. In the telecommunications sector, interconnection charges paid to the incumbent operator represent one of the largest costs incurred by new market entrants - often amounting to about 40 % of expenditure. The most basic interconnection service provided is that of call termination (i.e. delivering a call which originates on one network to its destination on another network), and the recommendation concentrates on pricing principles for call termination.

The cost of call termination is only one part - albeit a very important part - of the total interconnection charges faced by a new entrant. It is important to stress that the comparative data in this document should not be taken as a comparison of the full interconnection charges facing a new entrant in each Member State.

3.2. Cost orientation

The Interconnection Directive imposes cost-oriented interconnection charges on certain network operators with significant market power. The principle of cost orientation implies that the price charged for provision of a service should reflect the underlying costs incurred in providing that service. Thus in arriving at principles for interconnection pricing, it is necessary to analyse the way in which the act of interconnection imposes costs on a network.

Most of the costs involved in a telecommunication network are one-off costs, which are incurred, for example, when trenches are dug, ducts and cable installed, and when switches are purchased and programmed. Other on-going costs also occur, such as for maintenance, switch reprogramming, and administration costs.

A fixed network has to be dimensioned according to the quality of service required during the period of peak traffic load which it will be required to handle. If a network has to handle peak hour traffic from other interconnected networks, additional capacity will be necessary to maintain the desired quality of service (8). An analysis of the capacity costs required to provide that service quality (given demand, or subsequently, actual interconnect traffic figures) will enable costs to be apportioned among interconnecting parties.

In an ideal situation, where an industry comprised established market players with relatively stable market shares, capacity based charging would be the most efficient interconnect pricing rule. However these conditions do not apply in newly liberalised telecommunications markets, and the usual basis for interconnect pricing is traffic based pricing - with adjustments as appropriate for time of day, day of week variations - such that the total traffic-related forward looking interconnection costs of an efficient operator are recovered.

3.3. Costing methodologies

The issue of setting fair and efficient cost-oriented interconnection prices is being faced in liberalised markets all around the world. There is a clear trend towards the use of a forward-looking long run average incremental cost (FL-LRAIC) approach for interconnection pricing, as shown in the table below. Indeed, the Interconnection Directive recognises that 'charges for interconnection based on a price level closely linked to the long run incremental cost for providing access to interconnection are appropriate for encouraging the rapid development of an open and competitive market` (Recital 10).

The forward looking long run incremental cost provides an analytical framework which can be used to obtain an estimate of the cost that would be found in a fully competitive market.

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In a competitive market, the price a firm pays for an asset or investment is not what governs its return. From the moment the investment is made (i.e. the time when the investment cannot be reversed without significant cost), the asset's value to the firm depends on what the firm can do with that asset. It can either sell the asset to the highest bidder or it can use the asset to produce a good or service which the firm sells to generate an income.

The goods or services produced with the help of that asset usually face competition from close substitutes produced by competitors. If any of those competitors has superior efficiency - such that it is able to supply a superior quality/price package to consumers - other less efficient market players will need to respond accordingly, rather than continue pricing on the basis of their embedded or historic costs. In other words, firms are compelled to look forward to survive, rather than backward to their original investments (9).

The forward-looking approach is implicit when identifying and measuring the economic or 'real` costs (i.e. LRIC) associated with the increment in output. In the particular case where the increment is a single unit, incremental costs will be the same as marginal costs. In the short run, the size of any increment is limited by the capacity of the firm's existing productive assets. The long run however, is the time horizon in which the firm can undertake capital investment to increase this capacity. In this regard, the long run is the time horizon in which the firm could adjust (downwards or upwards) all of its inputs, including the size of each and any of its production plants, to meet a decrement or increment in the volume of production. Thus, the entire investment cost entailed in any point of interconnection, and any investment in network and switching capacity required to handle interconnected traffic, would be avoidable, and thus captured by a long run incremental cost measure (10). The total of all such measures, including the incumbent operator's own increment in traffic, would then form the total of all incremental interconnection costs. This figure would then be divided up in a fair and transparent manner between the notified operator and those interconnecting, with the result that the cost of interconnection to any party is the long run average incremental cost (LRAIC).

Costs calculated in this way do not include an operator's joint and common costs. In order to allow an operator to recover all its legitimate costs, the interconnection charge also needs to take account of the forward looking joint and common costs of an efficient operator, for example by means of 'mark-ups` applied to the LRAIC of each service (11).

3.4. Cost accounting systems

The Interconnection Directive requires that organisations with obligations for cost-oriented interconnection charges must implement cost accounting systems which are capable of demonstrating that interconnection charges do indeed follow the principles of cost orientation and transparency. The Directive does not specify a particular cost accounting system, but does require transparency of the system used.

Currently most incumbent operators have accounting systems based on fully distributed historic costs which were developed in monopoly environments. However, it is clear from the above discussion that the use of historic costs for calculating interconnection charges is not consistent with a competitive market, and will tend to lead to an over-statement of the interconnection costs.

In response to the new competitive environment, operators need to develop new accounting systems to provide the information which is needed both for internal management purposes and for external regulatory purposes. The Commission is therefore recommending that NRAs should set deadlines for implementation by incumbent operators of new cost accounting systems based on current costs and activity-based accounts. National regulatory authorities will want to be assured that costs which appear to be common are distributed to the fullest extent possible, taking into account the relevant direct and indirect cost drivers. Activity based accounts which use current costs provide a 'top-down` check through reconciliation with interconnection costs calculated according to 'bottom-up` forward looking long run average incremental costs.

Experience suggests that it can take about 2 years for an incumbent operator to implement a new accounting system, although this period could decrease as cumulative experience is gained in the sector.

3.5. The use of 'best current practice` prices during the transition to LRAIC based systems

Recent years have seen considerable research carried out by regulatory institutions, consultancies, and academics into identifying the long run average incremental cost (LRAIC) of telephone networks, or parts of telephone networks. This involves building 'bottom-up` models whereby an economic/engineering model of an efficient network is developed, from which interconnection costs can be calculated by aggregating the costs of individual network elements. Reconciliation of the results of these models with the results obtained from 'top-down` models (which take as their starting point the current cost accounts of an operator, and seeks to arrive at an interconnection cost by a process of allocation and elimination of cost elements) serve to demonstrate that the calculated interconnection costs are broadly accurate. These models have been subject to intense debate and analysis by regulators, market players, and academics alike.

However, in most cases the results of this work have not yet been incorporated into regulated interconnection prices. At the present time, very few countries appear to be in a position to calculate per minute interconnection charges based on actual estimates of long-run average incremental costs.

Therefore, as an interim measure, to be used until the information required to complete the calculation of 'bottom-up` LRAIC-based costs is available, (cross-checked where appropriate by top-down models based on current cost accounts), and national regulatory authorities have the experience, regulatory and economic resources to complete such a costing exercise, interconnection charges obtained by employing a 'best current practice` approach provide a check that interconnection charges proposed by an incumbent are consistent with an efficient competitive market.

If the operators' proposed interconnection charges lie outside the range of 'best current practice` charges given here, national regulatory authorities may use their rights under the Interconnection Directive to request justification of the proposed charges. Where appropriate, NRAs can require retrospective changes to interconnection charges.

4. DERIVATION OF 'CURRENT BEST PRACTICE` PRICES

4.1. Comparison of interconnection charges for call termination in Member States

The interconnection charge per call minute (for call termination) varies with the path taken by the call. Depending on the locations of the point of interconnection and the called user, there may be a different number of switching stages and inter-exchange links involved in delivering a call, and this can give rise to a complex tariff structure for interconnection.

In order to simplify comparisons, the approach taken in the recommendation is to examine the interconnection charges to the incumbent's fixed public network under three different scenarios:

(i) 'Local` level interconnection

A call handed over for termination at the local level represents interconnection at (or nearest to) the local exchange to which the destination user is connected, and represent the lowest level of interconnection charge which is available in a given country.

(ii) 'Single transit` interconnection (metropolitan level)

Single transit interconnection allows access to all customers in a metropolitan region, such as a large city. This is likely to be the level of interconnection most often demanded by new entrants in a national market.

(iii) 'Double transit` interconnection ('national` level)

Double transit interconnection allows access to all customers on the incumbent's network ('national` level' interconnection). A call handed over at this level normally incurs the highest level of interconnection charge.

Like retail tariffs, interconnection tariffs may also include time-of-day variations for peak, off-peak and intermediate periods, reflecting the network operator's need to manage demand and network capacity jointly. To simplify comparison, the approach in the recommendation is to examine only the highest peak rate interconnection charges (12). Only call-related costs are included in the comparison; non traffic related costs, for example costs related to the provision of interconnection links or the number of interconnection ports utilised, are not included.

Current charges for international call termination are not taken into account in the 'best practice` comparisons, because at present these charges are based on the accounting rate system and are not cost-oriented. (There is increasing pressure to bring down the prices currently charged under the international accounting rate system, and this will be reinforced when the WTO agreement on basic telecommunications services becomes effective in 1998. From 1 January 1998, within the EU, the implications of Community law are that charges for cross-border interconnection between Member States should be based on the cost of call termination at the national level.)

Comparison of interconnection charges around the world reveals very significant differences, not only in the actual charges but also in the relative charges for interconnection at these three different levels. This is not unexpected given that many of these charges are a result of negotiation and do not necessarily reflect an obligation for cost-orientation. Comparisons based on non-EU countries are thus often of limited value at present.

Since July 1997, most fixed network operators in EU Member States have published their interconnection charges in line with Directive 96/19/EC. Current interconnection charges for call termination in EU Member States are shown in Annex II of the recommendation (as of 1 September 1997). In some cases these are the charges proposed by incumbent operators and as such are still subject to approval and possible adjustment by national regulatory authorities.

4.2. Calculation of 'best current practice` prices

The 'best current practice` prices given in the recommendation are based on the interconnection charges in the three lowest priced Member States. The precise calculations are explained in Annex II of the recommendation. The 'best current practice prices` so derived are expressed as a range which is considered to be wide enough to take account of recognised cost differences between Member States.

Cost differences between EU Member States may occur as a result of factors such as average density of connections, labour costs, or permitted rate of return on capital employed. Insufficient empirical evidence is currently available to make a full evaluation of the effect of each of these factors, but the evidence that does exist indicates that such differences are unlikely to be large enough to invalidate the 'best current practice` charges recommended here. The difference between the top and bottom bands of the recommended 'best current practice` charges varies from 60 % (local level interconnection) to 100 % (metropolitan level interconnection).

5. OTHER ISSUES RELATED TO INTERCONNECTION PRICING

5.1. Categories of interconnecting organisation

The Interconnection Directive grants certain categories of organisation the right and obligation to negotiate interconnection with each other. The organisations concerned may be in the same Member State or in different Member States. There are four such categories of organisation, identified in Annex II of the Directive.

The Directive allows different tariffs, terms and conditions for interconnection to be set for different categories of organisations which are authorised to provide networks and services, where such differences can be objectively justified on the basis of the type of interconnection provided and/or the relevant national licensing conditions.

Different charges based on the relevant national licensing conditions must be objectively justified. Some Member States have indicated that in order to achieve strong competition in both infrastructure and services, their licensing/authorisation framework may link interconnection conditions for an organisation to its level of investment in infrastructure. Such a policy has to be applied in a way that is consistent with other provisions, inter alia in the Directive, concerning non-discrimination, and should not lead to any restriction or distortion of competition. In particular, fixed and mobile operators with significant market power must apply similar conditions in similar circumstances to interconnected organisations providing similar services, and must provide interconnectlion facilities and information to others under the same conditions and of the same quality as they provide for their own services, or those of their subsidiaries or partners.

5.1.1. Interconnection with Mobile operators

Interconnection charges between fixed and mobile networks have tended to be considerably higher than interconnection charges between fixed networks. Differences between Member States in the interconnection charges for mobile operators have in turn been a contributing factor to the differing rates of growth in mobile telephony between Member States.

However, the cost of conveying a particular call from a point of interconnection to its destination on the terminating fixed network is basically the same whether the call originates on a mobile network or another fixed network, and therefore there is no justification for the large differences in interconnection charges imposed by fixed network operators depending on the type of network on which the call originated. The 'best practice` interconnection charges set out in the recommendation are applicable for interconnection by mobile networks operators as well as by other fixed network operators on a non-discriminatory basis. The fact that a mobile operator may have a different licence or authorisation does not justify differentiation in interconnection tariffs for the same call termination services provided by a fixed network operator with significant market power.

The average interconnection charges paid by a mobile operator may of course differ from those paid by another fixed network operator as a result of variations in the distribution of point of interconnection, call destinations, call durations, and differences in the 'time of day` calling pattern.

The cost of call termination on a mobile network is in most cases not subject to price regulation under the Interconnection Directive. The one exception occurs if the mobile operator is designated by its NRA as having significant market power on the national market for interconnection (i.e. the fixed market for interconnection and the mobile market for interconnection combined). In this connection, the Commission has made the following statement to the European Parliament (13):

'The Commission confirms that Article 7(1) of the Interconnection Directive is to be applied to all organisations operating the public telecommunications networks and/or publicly available telecommunications services as set out in Parts 1 and 2 of Annex I [i.e. fixed network operators], which have been notified by national regulatory authorities as having significant market power, and only to those organisations.`

The implications of this statement are that the Commission does not support on the basis of the Interconnection Directive a general obligation for cost oriented interconnection tariffs on mobile operators that do not have significant market power on the national market for interconnection. This is without prejudice to the duty of Member States and of undertakings to fully comply with the EU competition rules, taking account of the specific positions set out in the Communication from the Commission on the application of the competition rules to access agreements in the telecommunications sector.

5.1.2. Interconnection with organisations in other Member States

A characteristic of today's (pre-1998) telecommunications market is that an operator in one Member State that originates traffic and bills customers can interconnect with the national operator in a second Member State in order to deliver traffic, without needing to be authorised in the second Member State (14). The Interconnecting operator neither owns nor operates infrastructure in the destination Member State, and in the case of transit via third countries or use of satellite links or submarine cables, may lease rather than own some parts of the infrastructure used for delivery of traffic to the destination Member State.

This practice of 'cross-border interconnection` will remain a feature of the post-1998 liberalised EU market, and the principle of non-discrimination requires that all operators authorised in one Member State (ie incumbents and new entrants) receive equivalent treatment when delivering traffic to another Member State. This has implications for both the authorisation procedures in the Member States and the reference interconnection offer.

Firstly, it means that all points of interconnection open to national operators should also be open to authorised operators in other Member States who wish to deliver cross-border traffic. Secondly it means that an operator that merely interconnects to deliver traffic, and that is not offering services or providing infrastructure in the destination Member State, should not have to be authorised or established in the destination Member State.

Thirdly it is proposed that the reference interconnection offer should include - as a discrete unbundled element of the interconnection offer - terms and conditions and tariffs for the transmission link between the actual point of interconnection and the border (15). This will alleviate the administrative problems which could otherwise hamper the development of competition for telecommunications services between Member States, and will avoid discrimination between new entrants and incumbent operators providing cross-border services.

For competitive equality, it should also be possible for an operator from another Member State who merely terminates traffic to rent such a transmission link (i.e. the link between the point of interconnection and the border) from an alternative infrastructure provider where available, without needing to be authorised or established in the destination Member State, and without affecting the status of the operator with regard to the terms and conditions for interconnection (16).

5.2. Universal service and other supplementary charges

The Interconnection Directive allows Member States to set up universal service schemes, whereby the net cost of universal service obligations can be shared among organisations providing public telecommunications networks and/or voice telephony services. The Directive requires charges for interconnection to be separated from charges related to universal service contribution; this includes any supplementary charges resulting from temporary tariff imbalances ('access deficit` type charges).

The ONP Voice Telephony Directive 95/62/EC requires telephone tariffs to be cost oriented. Thus compensation for tariff imbalances ('access deficit` type charges) are only permissible where a national regulatory authority imposes tariff constraints on an operator relating to the speed of tariff re-balancing, in accordance with Article 12(2) of Directive 95/62/EC. An operator that does not have regulatory constraints on its retail tariffs cannot claim access deficit type contributions.

The purpose of a universal service charge is to ensure that the social cost of universal service in a Member State is shared by the players on that market. It is not appropriate for the social costs in one Member State to be subsidised by telephone users in all other Member States. Thus, contributions to universal service should not be imposed either directly or indirectly on organisations which merely interconnect to deliver traffic to a Member State and do not actually offer telecommunications services in that Member State.

In the same way, an 'access deficit` implies that profits from national and international services provide a cross-subsidy to the 'local access` business. Presently, under the international accounting rate system, incumbent operators are earning significant revenues when terminating calls from other countries. The 'excess profits` earned from terminating incoming calls from other Member States represent a cross-subsidy to consumers in one Member State from callers in all the other Member States. Thus when operators in other Member States interconnect to deliver traffic to a Member State, it is inappropriate that they should contribute either directly or indirectly to any access deficit type scheme in that Member State.

In accordance with the principle of non-discrimination, it follows that when calculating the contributions to be made by operators in a Member State to universal service costs or access deficits, the traffic of these operators which is incoming from other Member States should not be taken into account when assessing the level of contributions.

6. CONSULTATION

The key points covered by the recommendation were set out in a working document prepared by the Commission Services (DGXIII). Following an initial presentation to the ONP Committee (17) at its meeting on 10 July 1997, the working document was discussed in detail at a second meeting of the ONP Committee on 10 September 1997. In accordance with the inter-institutional modus vivendi on advisory committee procedures, the agenda for the ONP Committee meeting of 10 September 1997 and a copy of the working document were sent to the European Parliament.

Further consultation on the basis of the working document was held with market players at a public workshop held in Brussels on 9 September and attended by approximately 200 people.

Comments received as a result of this consultation have been taken into account. There is general support for the Commission to provide guidance in the areas covered by the recommendation, but incumbent operators and new entrants hold different views concerning the recommended 'best current practice` prices.

(1) OJ L 199, 26.7.1997, p. 32.

(2) Directive 97/33/EC, recital 12.

(3) OJ L 74, 22.3.1996, p. 13.

(4) Later dates agreed for certain Member States:

Discarding a TABLE

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(5) Under the Interconnection Directive, some Member States may be granted a transition period for cross-border interconnection of fixed and mobile networks.

(6) OJ C 76, 11.3.1997, p. 9.

(7) OJ L . . ., . . . 1998.

(8) At times of the day when few calls are being made, little or no reconfiguration or investment in capacity will be required to handle additional traffic from interconnected networks, and so the costs incurred by the terminating network will be relatively small. At the peak period, however, an additional increment of traffic will require a corresponding addition in network capacity if the terminating network is to maintain the same service quality. Capacity investment represents the bulk of the additional costs incurred in a network when terminating interconnected traffic.

(9) This is a major source of risk in market economies, and is one of the reasons that a firm's value, as measured by the value of its shares, can change significantly in a short period. Only when a firm has substantial market power is it possible for it to demand from customers (or competitors in the case of interconnection) a price calculated to provide it with a required rate return on its past investments. Interconnection charges that are based on historic costs serve to protect an incumbent from the real pressure of a competitive market.

(10) While the cost characteristics of telecommunications networks are rather different than is found in unregulated competitive markets, the corollary of LRAIC in a competitive market is known as the competitive price.

(11) Mark-ups may be uniformly applied to the LRAIC of each service. Alternatively, NRAs could require that common costs be recovered on call origination, but not call termination. The underlying aim should be to ensure that common costs are not allocated in a disproportionate way to less competitive services.

(12) The duration of peak and off tariff periods, and their comparative price levels, varies considerably between Member States and this makes it difficult to compare 'average` prices.

(13) EP Procès verbal, para. 2-122, 10.6.1997, p. 48.

(14) Under the international accounting rate system, this usually happens at a virtual point of interconnection approximately in the middle of the international half circuit.

(15) The 'border` needs to be interpreted in an appropriate manner taking into account the type of infrastructure used eg satellite, submarine cable or terrestrial circuit.

(16) Some Member States may have different terms and conditions for interconnection depending on whether or not the interconnecting party owns and operates telecommunications infrastructure.

(17) An advisory committee comprising representatives of Member States, set up under Article 9(1) of Directive 90/387/ECC.