John Prince Issue: Latin America I 1998
Article no.: 7
Topic: Termination Fee:The Way Forward For Accounting Rates Reform
Author: John Prince
Title: Permanent Secretary
Organisation: Office of the Prime Minister, Trinidad and Tobago
PDF size: 40KB

About author

Not available

 

Article abstract

The issue of reforming accounting rates arrangements has been brought to the fore in light of the US FCC’s approach to unilaterally impose new benchmarks on the rest of the world. This approach is raising serious concerns particularly for developing countries. Not only there is the fundamental encroachment of sovereignty and absence of legal authority for unilateral reform, questions abound concerning the reliability and applicability of the methodology in prescribing the proposed rates. This article recommends a way forward.

 

Full Article

Reform of accounting rates arrangements is by no means a new subject. In fact, the Organisation for Economic Co-operation and Development (OECD) for a number of years has been seeking to replace traditional settlement mechanisms with a cost-oriented system. In 1992, the International Telecommunication Union (ITU) Standardisation Sector developed recommendation D140 which stipulates, among other things, that international telephone accounting rates should be more reflective of the actual cost of dispensing the service. This issue has been resurrected due to the effort of the US Federal Communications Commission (FCC) in attempting to unilaterally impose new benchmarks on the rest of the world. Methodology of Rate Determination The FCC believes that accounting rates should be reduced to reflect cost. Toward this end, the ideal method of pricing IMTS is a competitive or non-discriminatory interconnection rate. A proxy of this rate is the Total Long Run Incremental Cost (TLRIC) for terminating international services plus a reasonable addition for common cost. The TLRIC comprises all costs a carrier incurs to provide the service, including risk-adjusted returns on capital. Given that the adjustment period is in the long-term, no fixed cost is assumed. Therefore, the FCC benchmark equation may be represented as: where P is the settlement rate, C1 is the actual variable cost of providing a unit of the service and D is the mark up or common cost. It should be noted that C1 constitutes the following three components: · the cost of transmission (international facility component); · switching cost (international gateway component), and · local transmission cost (national extension component). Based on estimates for US carriers, the tariff component was estimated at 6-9 US cents/min for all foreign carriers. This variable was then combined with three subsets of development indices resulting in aggregate benchmark settlement rates of: 15 US cents for high income countries, 19 US cents for middle income countries and 23 US cents for low income countries. Review of the Model This formula, even from a cursory glance, portends serious consequences for telecommunications infrastructural development, particularly in developing countries. Beyond the fundamental encroachment of sovereignty and absence of legal authority for unilateral reform, questions abound concerning the reliability/applicability of the methodology used by the FCC in prescribing the proposed rates. The bases for costing used in the model are far removed from what is obtained when basing the calculations on developing countries. Advantageous procurement arrangements and the attendant lower per unit cost of capital goods, compounded by relatively high volume of traffic, permit US carriers to operate at economies of scale that are unattainable for most carriers in developing countries. In the circumstances, any cost-based or cost-oriented approach to determine accounting rates ought to be based on actual cost rather than what prevails in the economy with probably the strongest telecommunications sector. It is even more surprising to note the conclusion that price elasticity of demand for IMTS in all developing countries is greater than one without engaging in any form of measurement. Notwithstanding the well-known difficulties in calculating elasticities, even in small economies, such values must not be assumed as haphazardly as the FCC did. Per capita income is, at best, a crude estimate of economic welfare. Per capita income does not inform on income distribution. There are developing countries with relatively high per capita income where as few as 10% of the earners account for over 40% of total income. Thus, the bulk of the population accesses a small portion of the income pie. Any international profile of per capita income will therefore overstate the economic welfare of the majority of the population in those countries. This situation is more real than apparent in developing countries. There is also a misleading tendency to assume that, in general, there is a positive relationship between per capita income and teledensity. For example, per capita income in Trinidad and Tobago is among the highest in the Americas, yet the country has one of the lowest teledensities in the region. Accounting Rates and International Trade It is interesting to note that while accounting rates are being discussed in terms of monopoly vs competition in structuring prices, the fundamental concepts of international trade are seldom regarded. Revenue from trade in goods and services is invariably determined in terms of trade between countries. More precisely, by the double factorial terms of trade. Underpinning the theory of terms of trade are factors such as, international elasticities of demand and supply, exchange rates, technology gap and level of development of the domestic economies. In developing countries, especially those with low teledensities, revenue from international telephony usually constitutes a significant proportion of total revenue. Therefore, their capacity to finance network development is circumscribed by earnings of hard currency from international telephone calls. The quantity of such earnings is determined by the product of the settlement rate (per unit) and the number of calls. It must be stated categorically, the cost of production of one firm may not be representative of that of another, even in the same industry in the same country. The variance of cost of production widens between international firms in the same industry based on interplays among size, technology, human resource quality and cost, levels of socio-economic development, geographic location, diversity, etc. As with other items of cross-border trade, the cost of production of each telephone service provider could vary from country to country. It follows, therefore, that accounting rates models for a specific country should be based on the actual cost of the service in that country. Economic Welfare vs Efficiency The quest for liberalised/competitive markets has been encouraged under the pretext of economic efficiency. Economic efficiency, in a nutshell, refers to the combination of factors that realise least-cost production. This level of production is invariably predicated on economies of scale and usually invokes a price structure that is dictated by cost of production. The more competitive the market, the closer is the price-cost relationship or rather, the greater the impact of economies of scale on the price level. Economic efficiency often runs against the principles of welfare economics, which make special provisions for the collective well being of a population, in particular the less fortunate. Subsidised as well as cross-subsidised pricing to make basic commodities affordable to a broad section of civil societies are enduring fundamentals of welfare economics. The development of the telephony industry worldwide is heavily indebted to the theory of welfare economics, in particular the concept of universal service. The concept was enshrined in the Universal Telephone Preservation Act of 1984 which preserved a range of subsidies to encourage the expansion of universal service. Prior to 1984, the Ozark Plan of 1970 institutionalised subsidies for the development of universal service notwithstanding the fact that the level of telephone penetration in the US was already above 50%. Nevertheless, the clamour for higher levels of telephone penetration in the US continued. The future expansion of universal service in the US has been ordained, or rather secured, by the Telecommunications Act of 1996. In essence, section 254 of this Act is devoted entirely to universal service. More importantly, the report that accompanied the draft bill stated: “The goal of the new universal service section is to clearly articulate the policy of congress that universal service is the cornerstone of the nation’s communications system. This new section is intended to make explicit the current implicit authority of the FCC and the States to require common carriers to provide universal service”. A landmark declaration in the law is that once a service or capability has been declared part of the remit of universal service, it becomes eligible for subsidy support. The law further states that financial contribution to the preservation and advancement of universal service will be provided by all telecommunications carriers offering interstate telecommunications services. The indications clearly show that the US has used, and continues to use, subsidies as one of the principal strategies for the pursuit of universal service purposive to developing its telecommunications sector. In the circumstances, the US should not be averse to subsidies being used as an instrument for telecommunications infrastructural development in any country, in particular a developing country. This situation is of great importance against the background of a global environment where more than half of the world’s population does not have ready access to telephone service. It is reasonable to expect that developing countries would seek to employ modalities to achieve a viable, if not optimum, level of universal service within the parameter of their national development policies. Unfortunately, these countries are not in positions to replicate the methods of the US and other developed countries to attain their respective levels of telephone penetration. Universal service must therefore be factored into the pricing of international telephony services in developing countries. This means that any price formula for international telephony should not be prescribed simply on the basis of cost. The rate should of necessity include, inter alia, provisions for network expansion. This is one of the imperatives to protect human welfare in respect of a service which has been universally designated a basic necessity. The Price Function It has been postulated in certain accounting rate models, that in markets where competition is pervasive, accounting rates would finally settle at base level. However, in markets where competition is inadequate, firms should be required, in the interest of consumers, to operate under a system of reference/proxy pricing which simulates the existence of competition. The fundamental price/cost relationship proposed is that the firm is expected to match expenses, (marginal costs) with marginal revenue at the lowest point. This approach promises fairness by restricting profits that may be deemed excessive, and is perfectly acceptable where the circumstances permit financial viability. However, economic theory has established that in a significant number of markets, whenever the price of a good is commandeered to the level of marginal cost, bankruptcy is inevitable. This led to the development of the theory of second best pricing that allows for the coverage of the total cost of the firm. It is now standard in price theory for diseconomies of scale to be taken into account in price fixing. The FCC should be aware of the fact that the TLRIC is indeed marginal cost at its lowest level, a pricing situation that is unrealistic even in most developed economies. It is only where constant returns to scale prevail at the level of optimal combination of factor output in a perfectly competitive market that TLRIC is the sole determinant of price. And wherever such markets exist, it is extremely difficulty to source, store and constantly update reliable estimates of matrices of factor/output combinations and costs. Cost data are not only difficult to source, collate and update, but accurate disaggregation also presents substantial problems. The difficulties posed by disaggregation are, in general, much more acute than other cost-related problems. Consequently, where cost is used as a calculus of price, total average cost of the firm is its best yardstick. Accounting rate reform models are by and large restricted to cost. They are either classified as ‘cost-based’ or ‘cost-oriented’. From whichever approach, the hypothesis remains the same: accounting rates should be denominated (purely or largely) on the basis of cost. Interestingly enough, the same models define and treat accounting rates as prices. More precisely, accounting rates are wholesale prices for international telephone service. But is cost the only determinant of price? Indeed, it is not. Except where the market for a product/service is perfectly competitive, demand will affect the price of the product/service. Indications are that the international market for voice telephony is not perfectly competitive. In the circumstances, the demand curves faced by carriers in different countries are more likely to differ than be identical. This begs the question: is the deficit experienced by the US in terms of international voice telephony simply reflective of price distortion by foreign carriers, or, is it indicative of a strong demand from US consumers for the service, or a combination of both factors? This question remains unanswered in the FCC model. The debate on reform of the current settlement regime has been narrowly focused on cost. The text of the debate would change drastically if accounting rates models are balanced by the inclusion of elements from the demand side, e.g. a factor to estimate marginal utility. To so do, a fee for service seems to be the way to go. As a subtext, it must be explained that, where marginal utility of demand varies among consumers in different geographical locations, demand elasticities follow suit. This could easily result in cross-border voice telephony. It follows that the assumption that the elasticity of demand for international voice telephony is greater than one for developing countries per se is highly questionable. Given that elasticities are very difficult to estimate with comfortable degrees of accuracy, revenue forecasting from cost-inclined models can be very misleading. In the circumstances, to predict increased revenue due to lower accounting rates seems to be a highly ambitious expectation. This contention supports the call for case studies to uncover quantitative evidence of the actual cost of providing the service in developing countries as well as to ascertain the impact of the proposed FCC benchmark rates on revenue in those countries. A Distributed Charge Model Based on the foregoing arguments, it is proposed that the current settlement regime be reformed on the basis of a Fee For Service (Termination Fee) Model determined by the following model: Where: · T is the termination fee; · Cw is the weighted average of the distributed cost to terminate a call in a country; and · @Ut is a factor (coefficient) for universal service, measured in terms of teledensity, over a transition period. The cost should be distributed over items such as: international transmission facilities, (where applicable) international switching facilities and national extension. Included also should be costs associated with investment (depreciation, interest payments and return on equity), developmental costs such as R&D, and the operational cost of the firm. The universal service coefficient should be informed by factors including: existing level of teledensity, the capability of the country to expand its telephone network, and an average required level of telephone penetration for developing countries, as prescribed by the ITU. Conclusio Transition periods for the attainment of the benchmark for penetration should be dependent on each country’s optimum capacity for network expansion and the correlation between revenue from international telephone transactions and total revenue of the firm. It is recommended that assistance from multilateral institutions such as the World Bank and the ITU should be diligently pursued to realise a representative sample of case studies, to ascertain, inter alia, the average cost of terminating cross-border calls by region and the impact of the FCC benchmarks on revenue.