Value of Flexibility

A key debate in the literature questions the versatility of FL-LRIC from the standpoint of option-theoretic considerations. Hausman (1999) is one of the pioneers of the debate. The subsequent papers by Economides (1999), Hausman and Myers (2002), Alleman (2002), Alleman and Rappoport (2002, 2005 and 2006), Vogelsang (2003), Pindyck (2005a, 2005b and 2007) and Cave (2006) add to the debate. An issue at the centre of the debate is the versatility of FL- LRIC in responding to the stochastic processes that de…ne downstream value.

Of particular importance is the question about the value of the ‡exibility to respond to downstream stochastic processes.

The arguments in the literature see a transition in the characterization of the anomaly attributed to cost-based prices from the standpoint of option pricing theory. This transition has three strands of arguments. First, that sunk costs truncate cash ‡ows and result in an asymmetrical distribution of risk. Second, regulatory prescriptions give rise to investment in‡exibility and therefore have an opportunity cost from a real options perspective. Third, the asymmetri- cal ‡exibility to adapt to downstream stochastic processes at the level of an exchange line has value. These three strands of arguments are however not concisely compartmentalized and in fact at times overlap in the literature.

In the …rst strand of arguments, Hausman (1999) frames the issue as one where the fundamental premise of TSLRIC (US equivalent term for FL-LRIC) is fundamentally ‡awed because it assumes a perfect contestability standard under which costless entry and exit exist. Hausman argues that costless entry and exit presume no sunk costs and this presumption deviates from the reality in the access market where the bulk of the investments are sunk. Therefore, going by this argument, TSLRIC does not permit a mark-up over cost to allow for the risk associated with sunk investments. Hausman observes that while TSLRIC makes an allowance for the cost of investment and variable costs, it makes no allowance for sunk costs. Hausman concludes that because TSLRIC ignores the sunk nature of investment, it confers free options to third parties. Hausman and Myers (2002) take a similar strait and argue that the non-existence of barriers to entry truncates the upside because of either entry or the threat of entry. At the same time there is no downside protection because of the existence of sunk costs. This gives rise to an asymmetrical distribution of cash ‡ows and hence lower than expected returns. Therefore, according to this argument, an upward adjustment of the regulated rates is required to correct this anomaly and ensure competitive returns.

(2002) are however vulnerable. Now cost, in the context of TSLRIC/FL-LRIC, includes a mark-up for a competitive return – in addition to being forward- looking, equivalent to the costs of a least cost provider, being incremental, having a long-run orientation, and being exclusive of monopoly pro…ts and cross-subsidies (see Economides, 1999). The relevant instructive provision, com- petitive returns, implies a return on capital that is equivalent to what assets with a similar risk exposure would earn. Such risk must however necessarily include the risk attributable to sunk investments.

Alleman (2002), Alleman and Rappoport (2002, 2005 and 2006) and Pindyck (2005), adapt the second strand of arguments. These authors take the premise that regulatory prescriptions give rise to investment in‡exibility and therefore have an opportunity cost from a real options perspective. As real options theory suggests, the ‡exibility, for example, to delay, abandon or start/stop a project has value.6 _{The delay option is considered particularly relevant in telecommu-}

nications because once a service provider sinks capital, they in e¤ect exercise their options. The opportunity cost associated with such exercise is however not incorporated in cost-based prices. The primary context of these studies is that the traditional approach to pricing access is static and assumes that management has no ‡exibility to change direction as the states of nature are revealed through the passage of time. For example, Pindyck (2005) observes that in the presence of uncertainty, there is an opportunity cost of investing rather than waiting for the arrival of new information about the prospects of an investment. Pindyck adds that when the investment option is exercised there is an associated loss of value which should be included as part of the invest- ment cost. Accordingly the traditional approach to pricing does not capture the value of managerial ‡exibility. Pindyck suggests that a real options ap- proach to pricing would capture the asymmetrical distribution of risk in the access infrastructure. The core of the second strand of arguments are perhaps best encapsulated in Alleman and Rappoport (2002) and run as follows:

If the company faces a common carrier obligation to provide broad- band services and to maintain payphones, the requirement to provide broadband services eliminates the company’s option to delay. Simi- larly, the inability to exit the payphone business eliminates the …rm’s ability to exercise its abandonment option. . . .regulation can restrict the ‡exibility of the …rm through the imposition of price constraints and by imposing costs associated with either delay, abandonment, or shutdown/restart options. . . the real options analysis provides a means of capturing the ‡exibility of management to address uncertain- ties as they are resolved. . . the ‡exibility that management has includes options to defer, abandon, shutdown/restart, expand, contract, and switch use.. . . ..the deferral option is the one that is generally illustrated and is treated as analogous to a call option. . . the question is: what is the investment worth with and without management ‡exibility. . . ...in these situations (broadband and payphones), the in- cumbent carriers are precluded from exercising the option to delay in the …rst case, and the option to abandon in the second case. A related option is the ability to shutdown and restart operations. . . ... the lack of op- tions has not been considered in the various cost models that have been utilized by the regulatory community for a variety of policy purposes.

The arguments by Alleman (2002), Alleman and Rappoport (2002, 2005, 2006) and Pindyck (2005), have their basis in the implications of the oblig- ation to serve. The thrust of these arguments is that if a service provider is constrained by regulation and if as a consequence there result limitations on, for example, when and where to enter a market or when and where to exit, then there are opportunity costs from a real options perspective, which should be added to the cost of investment and be borne by the users of the access in- frastructure. The fundamental question must therefore be whether regulation imposes such constraints. The case in telecommunications suggests that the implications of regulation on investment timing, which we refer to here as Tier

I ‡exibility, may not be as severe as suggested in the literature. If one consid- ers the case of, for example, broadband roll-out, the facts are that a capacity access provider has the leverage to determine the technology and the pace of roll-out. Regulatory encumbrances on the timing of investments are in the main non-existent. In fact Alleman and Rappoport (2002) observe that at the time of their study there was no legislation in the US restricting the ‡exibility of service providers with respect to network roll-out. In the UK, the timing and location of broadband roll-out has proceeded in accordance with the discretion of the access providers. Now if the exercise of an investment option by a service provider is sub-optimal for reasons other than restrictions imposed by regula- tion, then it is inappropriate that the cost of this should be borne by either competing access seekers or retail subscribers. Absent regulatory constraints, a service provider has an obligation to ensure that the timing of their investments is optimal.7

Turning to the analogue access market, the e¤ect of regulatory intervention by way of universal service obligations –the one area where regulation impacts investment timing ‡exibility – are unlikely to be consequential because these obligations a¤ect peripheral catchment areas. One would therefore expect that network roll-out, in the main, proceeds in a manner consistent with the dis- cretion of an incumbent. In conclusion, while acknowledging the merits of the second strand of arguments, it is nevertheless noted that the implications of these may not be as severe as suggested in the literature because of the said mitigating factors. More generally some researchers, for example, Economides (1999) suggest that in oligopolistic interactions, …rst mover advantages can be crucial and therefore the value of waiting may be negative.

The third strand of arguments suggest that cost-based access prices, inde- pendent of investment timing ‡exibility, are distortionary because they do not respond to the value of the ‡exibility to adapt to the stochastic processes that

7_{It is instructive to note that Tier I ‡exibility and the value of this is independent of the}

obligation to provide mandatory access. The opportunity cost related to Tier I is necessarily added to the direct costs to establish the aggregate cost of investment.

de…ne downstream value at the operational level.8 _{This cluster of arguments}

alludes to asymmetrical operational ‡exibility that arises as a consequence of the obligation to provide capacity access to third parties who have the ‡exibil- ity to align entry and exit decisions to the stochastic dynamics at the level of an exchange line. To give an example of arguments that subscribe to this clus- ter, Pindyck (2007) observes that local loop unbundling is ‡exible, allowing an entrant to rent facilities in small increments for short durations with no long- term commitments. Pindyck argues that the operational ‡exibility conferred to entrants is of great value and is costly for incumbents to supply. Pindyck concludes that the traditional approach to pricing access is not e¢ cient and discourages incumbents, and in the long run undermines the objective of pro- moting facilities-based competition. Vogelsang (2003) notes that access seekers do not have a long term commitment to the access infrastructure and are thus able to protect themselves from downside risks, leaving an incumbent exposed to the risk of stranded assets if demand vanishes. Cave (2006) suggests that FL-LRIC is not adequately responsive to the distribution of risk between an incumbent and an access seeker. He notes that FL-LRIC ignores the fact that access seekers have the option of continuing to buy access products unlike in- cumbents - therefore the appropriate access price should include the access price and the value of the option to buy. Cave concludes that regulatory strategy should be designed to generate sustainable infrastructure-based competition where feasible.

The common thread in the third strand of arguments is that access seekers are not bound by long-term commitments and can walk in and out at the level of exchange lines. In essence, an incumbent provides access at the option of its rivals who utilize the infrastructure at their discretion. This gives the access seeker the advantage of exercising the option when, for example, it can attract business at the level of an exchange line. Equally the access seeker has the leverage not to exercise the option when, for example, an exchange line is de-

activated. This protects an access seeker from the downside of operational risk but confers to it the upside potential. On the other hand an incumbent, having sunk capital, is exposed to the full spectrum of risk. All this gives a signi…cant competitive advantage to an access seeker. The asymmetrical distribution of risk e¤ectively confers an advantage to the access seeker analogous to a free …nancial option at the level of delivery points. Such asymmetrical distribution of risk has value and therefore a price.9