INTERCONNECTION CHARGES

1. Interconnection is crucial for communicating across networks, and makes it possible for the subscribers of two different operators to communicate with each other. It is essential for extending the scope and efficiency of the telecom network, and is especially important for new operators entering the market who normally use the existing facilities of another operator for providing their services. It therefore is fundamental to a competitive market structure.

2. Interconnection involves a linking up of one telecom operator to the infrastructure facilities of another. Interconnections can be considered in terms of network interconnection and access interconnection. The former takes place between operators possessing networks, and the latter between an operator with a network and another without one.

Three broad types of interconnection are considered for policy purposes.

• Connection to the Public Switched Telephone Network (PSTN) of equipment on customer premises, of private telecom networks, or of value-added networks (these types of interconnection do not compete with the basic network).
• Connection of new fixed local networks or long-distance networks to the PSTN.
• Connection of cellular networks or other wireless systems to the PSTN, or of the satellite systems to the PSTN.

4. Interconnection charges include charges for collecting and delivering calls, for installing, maintaining and operating the points of interconnect, payment for supplementary services (such as directory assistance, fault reporting, network maintenance, or inter-carrier billing), and for ancillary and other facilities (such as space in the equipment room). Furthermore, in several cases, there is also a charge to fund the deficit arising due to the provision of universal service. However, if the funding of such a deficit is covered by the telecom tariff, then it should not be a part of interconnection charges, i.e there is a need to avoid double-counting in this context.

5. There are basically two methods for charging for interconnection. One is through sharing of revenues among the interconnected operators of telecom services. The second, which is more commonly used, is to establish interconnection charges on the basis of costs. In a cost-oriented interconnection regime, there is no sharing of revenues between carriers. Instead, the operator from whom interconnection is purchased is paid for providing that interconnection. The principle of cost-orientation in interconnection rates is intended to ensure that the rate charged by the provider of interconnection reflects that operator’s cost of providing the service plus a reasonable profit.

V.1 Procedures Used for Setting Interconnection Charges

6. A number of different procedures have been used to establish interconnection charges. These include,

• the regulator determines the charges, together with other essential elements of interconnection, in advance;
• the regulator sets the standard or guidelines which should be used for establishing the rates through (bilateral or multilateral) negotiations among the operators themselves;
• the operators set the rates through commercial agreement, without the involvement of the regulators;
• In the negotiations between the operators, the regulators stand-by as mediators/arbiters, settling the interconnection charges in case the parties involved fail to agree or if a dispute is brought to the regulator.

In most countries, regulators encourage the operators to settle interconnection rates through negotiations. To assist this process, the regulators normally establish guidelines or a framework which they consider desirable for determining interconnection charges.

V.2 Objectives of Interconnection Charges

7. Essentially, the objectives of interconnection pricing policy are similar to those mentioned in the context of telecom tariffs. This is particularly because of the link between interconnection and the provision of telecom services to end-users. Meeting the objective of efficient provision of services to end-users would necessarily require efficiency of different telecom operators. For reasons similar to those mentioned in the context of telecom tariffs, interconnection charges that are based on costs provide a stimulus for efficient operation.

8. For ensuring efficiency, costs which form the basis of interconnection charges should be the minimum (or efficient) costs incurred in the long run to provide the service. The basic idea is to simulate price pressures similar to those likely to operate in a competitive environment. Such interconnection charges help sustain the long-term viability of a company that produces high quality services at least cost, and allow more efficient sources of supply to displace less efficient sources within the markets. For the interconnecting operator, they promote efficient decisions with respect to whether to build one’s own network facilities or to continue to rely on those of the other operator (i.e. the build-or-buy decisions). Cost-based charges reward good investment decisions, discourage poor investment decisions, and encourage efficient competition even in dependent markets. Moreover, efficiency-oriented interconnection charges will pressurize firms to innovate and to continually improve the range and quality of services.

9. To ensure efficiency of operation, it is necessary to provide flexibility of interconnection. This involves facilitating interconnection among different operators at any specific point (unless technically infeasible), and interconnection being provided to the specific elements of the network for which interconnection is required rather than interconnection being given only for a whole bundle of services. This suggests a need for unbundling of the interconnection services provided.

10. Flexibility of interconnection is important also for dealing with unfair competition. Charges for interconnection with a dominant operator’s network are a substantial portion of a new entrant’s expenditure, often amounting to 40 per cent of gross revenues. It follows that these charges should not be predatory for competitors to flourish and thereby increase the efficiencies of the market. To address the issue of unfair competition, it is necessary to identify those elements of the network which are crucial for facilitating competition through interconnection, or are required for essential services. It would be necessary to closely monitor the interconnection charges for these elements, and might even be necessary to specify the level (or floors and ceilings) for these charges, if the situation so requires.

11. For other interconnection services, the regulator could address the issue of charges in the case of a dispute or a lack of agreement among the operators.

12. Combining the principle of cost-orientation with flexibility of interconnection implies that interconnection charges should not discriminate between different operators, including the operator which belongs to the same business group as the interconnection provider. Alternatively, there should not be any discrimination between the implicit interconnection charge for the interconnection provider’s vertically integrated facility, and the charges for interconnection paid by other operators.

13. Since the interconnection provider enters into a commercial relationship with the interconnection seeker, it would be legitimate for the interconnection charge to include a normal commercial return on the investment.

14. An important feature of the regime for interconnection charges in certain countries (e.g., Australia and the United Kingdom) is that the system provides a preference in favour of the newcomer operator. Thus, for example, an incremental cost concept chosen as a basis for interconnection charge could be less than the most comprehensive one, but with a provision that a more comprehensive cost basis would be used after a threshold level of market share is achieved by the newcomer. One reason for this favourable treatment is the view that the newcomer starts with a competitive disadvantage, in particular due to the various types of interconnection problems that can arise, and the difficulty of initially generating an adequate market to cover the relatively high start-up costs.

Objectives of Interconnection Charges: A Summing Up

15. Interconnection is a key to a competitive market. Emphasizing efficiency in the end-user market implies that it should also be an important concern for interconnection. Otherwise, the operators requiring interconnection would not be able to operate efficiently. A need to encourage efficiency in interconnection implies that interconnection charges should be based on costs. Cost based interconnection charges should incorporate a normal commercial return, and there should not be any discrimination among different operators, unless a cost-difference justifies dis-similar treatment. However, a favourable treatment could be provided to newcomers till they achieve stability (defined in terms of criteria such as market share).

16. Interconnection should be provided in a flexible manner, including provision of unbundled interconnection services. Special focus should be given to formulating interconnection charges for those services which are crucial for competition or are required for essential services. For other services, the regulators might need to intervene in terms of specifying floors and ceilings, or leave the negotiation of the charges to the operators themselves. Nonetheless, the regulators would need to step in if there is a dispute regarding interconnection charges.

V.3 Different methodologies for fixing interconnection charges

17. It is relatively easier to determine the cost of physically linking-up an operator with another operator’s network than to determine the cost of providing other interconnection services. Therefore, most of the focus regarding interconnection charges has been on the determination of these charges for the latter aspect.

18. In several instances, the set-up costs associated with establishing and maintaining interconnection facilities are shared between the interconnecting operators. Interconnection charges have generally been based on the time period (duration as well as peak- or off-peak period) and the distance covered by the call. Different countries have used different methodologies for fixing interconnection charges. Nonetheless, the local interconnection rates between fixed to fixed operators in these countries have been within a narrow range.

19. Revenue sharing formulae for interconnection could reflect one or the other of the various methodologies used, including an assessment of the costs of providing the interconnection services or using some benchmarks based on the prevailing international charging structure. The various methodologies for fixing charges for provision of interconnection services include:

(a) Charges based on the structure or the level of actual tariffs in place for telecom

services. This is a simple method, but the charges are not necessarily linked to costs. This might contribute to inefficient operation and to inefficient pattern of investment.

(b) Charges imposed on a per-minute basis for the calls made. This is a variant of the tariff-based methodology.

(c) Charging for interconnection on the basis of the capacity to which access is provided. The operator receiving the interconnect service pays a flat charge linked to its anticipated peak period traffic. This method has been found difficult to implement fully, mainly because interconnecting carriers have underestimated their peak demand. Thus, this system of pricing has made entry of competitors difficult, and reduced the competitive pressure in the market.

(d) Linking charges to the actual elements of the network used by a call. This unbundles the components of the network and matches the price more closely to cost. However, it is complex to administer.

(e) A methodology which has been the subject of considerable discussion is the "efficient component pricing rule" (ECPR). This rule is based on three principles.

• There should be a price ceiling to protect the users from excessive charges.
• There should be a price floor to prevent large companies from destroying smaller entrants through low prices that do not cover costs.
• A competitive market standard should be used for pricing of the interconnection services offered by one company to another. The competitive market standard of ECPR provides that the interconnection charges should take into account both the costs of giving interconnection as well as the earnings lost by the incumbent operator (i.e. the interconnect provider) because of the telecom traffic that is diverted from that operator to the new entrant.

20. Using the ECPR would imply that in order to be financially successful, a new entrant has to be much more efficient than the incumbent operator. Moreover, since the profit situation of the incumbent will not be adversely affected by the entry of a competitor to whom interconnection is provided, this method is considered less politically disruptive. It is also suggested that the previously planned expenditure for social objectives is more likely to continue under ECPR, and that this methodology reduces the incumbent operator’s incentives to destroy the level playing field by skimping on the quality of access.

21. The ECPR, however, has been criticized on a number of grounds, including that,

• It reduces competition and thus the efficiency of operation.
• The incumbent operator does not have much incentive to improve the services for users of its telecom services because it makes a return whether or not the whole call is made only on its network.
• The loss in diverted traffic is not easy to determine.
• This approach would sanctify the market revenue that the incumbent operator acquires in a situation of monopoly or near-monopoly.
• Further, ECPR could result in a delay in the introduction of new products which might compete only in part with an existing product (e.g., e-mail telephony).

It is also worth noting that with excess demand for certain telecom services (such as in India), diversion of the market away from the incumbent is unlikely, or is likely to be small, until the excess demand has been catered to. Without market diversion, the ECPR is like a cost- based rule with floor and ceiling prices.

22. Due to the various problems with the ECPR methodology, this approach has not been used in general; it is being considered for use only in New Zealand. Some countries, such as Australia and the United States, have explicitly ruled out the use of this methodology because of the view that it does not contribute to an efficient functioning of the telecom sector.

23. In contrast, most countries either use cost-based interconnection charges or have decided to adopt the methodology of cost-based interconnection charges, in particular some form of long-run incremental costs.

(f) Similar to the case of telecom tariffs, marginal costs, incremental costs and fully allocated costs have been considered for pricing interconnection. The issues mentioned earlier in Section III remain relevant in this context also.

24. In general, there is agreement that the access price should cover at least the directly attributable incremental costs incurred in providing access, i.e. those costs which are necessarily incurred (or caused by) the provision of access. It is further suggested that if the interconnection provider must enhance the facility to provide the service, it is legitimate for that operator to incorporate some proportion of the cost of doing so in the interconnection price.

25. Parallel to the concept of total service long run incremental costs (TSLRIC) , which focus on end-user service, cost concept under interconnection is that of the total element long-run incremental costs (TELRIC). Under TELRIC, interconnection charges are paid for the elements of the network that are used. Taking the example of call termination, the cost of interconnection would vary with the path taken by the call. Depending on the location of the port of interconnection and the called user, there may be a different number of switching stages and network elements involved in delivering the call. TELRIC would consider these aspects in determining the interconnection charge. The costs covered under TELRIC include the incremental direct costs of providing the network elements, plus a reasonable share of forward looking joint and common costs. They incorporate the appropriate risk-adjusted cost of capital and depreciation rates.

(vi) Similar to the discussion on telecom tariffs, interconnection charges could also involve two-part pricing. One suggestion in this regard is that fixed costs should be recovered through fixed charges while variable costs should be recovered through a per unit charge related to the underlying activity (including time of day variation for peak and off-peak periods.

(vii) Price caps, used in conjunction with long-run incremental costs, are another mechanism considered for setting interconnection charges. The issues relevant here are the same as those mentioned earlier in the context of telecom tariffs.

(viii) Certain other aspects considered in the context of interconnection charges include floor and ceiling prices, that the incumbent operator should provide non-discriminatory treatment for access, and preferential treatment being given to the new entrant.

V.4 Mark-up

26. For the reasons mentioned in the section on telecom tariffs, the issue of mark-up arises for interconnection charges also. For example, with TELRIC, the FCC’s advice on allocation of the forward looking common costs is to use percentage mark-ups over directly attributable costs, and relatively low mark-ups on certain critical network elements, such as the local loop and co-location, that are most difficult for entrants to replicate quickly.

27. The points mentioned in section III about mark-up methodologies are relevant here also, including the difficulty of getting appropriate data for estimating Ramsey mark-ups. Thus, some type of uniform mark-up or a mark-up based on the "cost-axiomatic approach" mentioned earlier, would be an easier option to consider for interconnection. An important consideration in this regard is that the definition of costs calculated using the concept of TSLRIC or TELRIC may include a normal commercial return on investment. A normal rate of return is included in these costs because the concept of costs considered are the "economic costs" of providing access to the network facilities. These costs include the normal profits earned through economic interaction.

V.5 Conclusions

28. The discussion above suggests a number of principles to be borne in mind with regard to interconnection charges. This section summarizes those principles, and suggests some options for interconnection charges in certain specific situations.

29. Normally regulators encourage the operators to settle interconnection rates through negotiations. In this process, intervention by the regulators is sought in the event of a difficulty or a dispute.

30. Interconnection charges for establishing a connection with another operator’s infrastructure facilities should be separated from charges for using the network facilities. The set-up costs associated with establishing and maintaining interconnection facilities should be shared between the interconnecting operators.

31. It would not be possible (nor desirable) to specify interconnection prices for each one of the interconnection services. The interconnection services should be divided into essential services (essential for competition or for consumption), and others. While the regulator would address the issue of interconnection charges for both these services when there is a dispute or lack of agreement among operators, greater control and scrutiny has to be exercised for interconnection charges for essential services. This includes changes in these charges for essential services being subject to specific approval.

32. Further, in order to increase the predictability of the process and to assist negotiations among the operators, cost-concepts should be identified on the basis of which a range (floor and ceiling) normally expected for these charges could be specified.

33. Even for interconnection, efficiency would require cost-based interconnection prices. The relevant concept of cost is incremental (i.e. forward-looking) costs, for example TSLRIC or TELRIC, calculated for an efficient (i.e. the most productive) operator. The costs should be those which reflect cause and effect relationship to the maximum extent possible, i.e. should incorporate all directly attributable costs. Further, the interconnection charge should include a normal commercial return.

34. Being based on costs, a change in the interconnection charge should itself be linked to a change in costs (or in efficiency). The relevant components for such a consideration will depend on the specific prevailing situation.

35. A price cap mechanism could be combined with prices for essential services and for the prices given in terms of floor and ceiling. Such a pricing mechanism will address the issues of efficiency and unfair competition, provide flexibility of operation, and exert pressure to improve efficiency over time.

36. To promote competition and to guard against unfair competition, interconnection charges should be non-discriminatory. If a relatively higher charge has to be imposed on any operator, it should be based on a demonstrated difference in the cost of providing the particular interconnection service to that operator. Similarly, the interconnection price charged to competitors must not be greater than the interconnection provider’s best price to its own vertically integrated operations (unless there is a cost justification). To limit the possibility of unfair competition, interconnection charges for any service providing the same functionality should not have a different price, whether to competitors or to own vertically operated facility.

37. As much as possible, the charging structure should be unbundled so that a telecom operator pays for what it uses and is not forced to pay for what it does not use. In view of the principle of non-discrimination mentioned above, the interconnection charges for unbundled elements of a service must be priced the same across all bundled services. Furthermore, for consistency of pricing of unbundled services, any part of a service should be priced at less than the price of the whole service (unless cost justification is provided). Similarly, an interconnection charge various parts of this service (unless cost-justification is provided).

38. Since the operator seeking interconnection has to operate with a reasonable profit in the market, the interconnection charge should be below the end-user price of the service. In fact, there might be a need to provide a preferential treatment to a new entrant. For that purpose, the interconnection charge could be based on a cost-concept which provides an interconnection charge lower than a concept which has a wide coverage of costs. This preference could be granted for a transition period, based on certain criteria such as market share. The preference could be removed once the entrant’s market position is stabilized.

39. Full implementation of the above-mentioned principles would require developing appropriate cost-accounting methodology, and collection of detailed data. This would require time, and the question is whether the decisions on methodology and determination of interconnection charges should be suspended while detailed data is being collected. The answer to this question has to be in the negative. There is a need to determine both the methodology and to take other decisions soon, and this will be done on the basis of the available information, albeit imperfect. Thus, while detailed cost information is being collected, a decision on methodologies for interconnection charges would be taken, and these charges could be based on a quick (but rough) estimate of the relevant costs, or on revenue sharing arrangement, or on international benchmarks.

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