Hybrid Model Documentation

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DATE

30th_{of November 2006 Dnr 06-13607}

Hybrid Model Documentation

(PTS Hybrid model v 4.1)

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1 Introduction

1.1 Background

The hybrid model is the result of the LRIC process initiated by Post & Telestyrelsen (PTS) in May 2002.

At an early stage of the process, PTS released for discussion a proposed timetable showing how each of the main activities would be conducted. This timetable was discussed and accepted by the parties. The key dates were as follows:

May 2002 – September 2002: Structuring the process

August 2002 – March 2003: BU modelling

August 2002 – June 2003: TD modelling

June 2003 – November 2003: Reconciliation and hybrid modelling

November 2003 – December 2003 October 2004 – December 2004: October 2005 – December 2005 September 2006 – November 2006

Cost results and pricing methodology Updated cost results for 2005

Updated cost results for 2006 Updated cost results for 2007

Consultations with the Swedish telecommunication industry have been conducted at all stages of the process and opportunities have been given to influence the model structure and features.

The current version of this documentation refers to version 4.1 of the hybrid model. This is an updated version of the original version 1.2 published in December 2003 and is part of an ongoing updating process that will take place every year.

1.2 Changes to model documentation

The following sections have been updated or changed. Section 2.4.1.3 Section 2.6.5 Section 2.7.1 Section 4.6 Section 5.7.1 1.3 Summary of results

The results produced by the hybrid model are presented in separate document, Cost results of the LRIC hybrid model version 4.1.

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1.4 Structure of this document

This document describes the structure and principles behind the Hybrid Long Run Incremental Cost (LRIC) model developed by PTS.

The hybrid model consists of several individual models that are inter-related and work

together. Together, they form one model. This document uses the word model to mean

both one of the individual models as well as the overall model that is formed by the combined individual models.

This document does not describe in detail how the models actually work and the nature and role of each of the spreadsheets – this is described in the User Guide. The document describes each of the four main models:

• Consolidation. This combines results from each of the models below and

calculates the resulting service costs.

• Core. This calculates the cost of core network services and systems. It also includes some access costs.

• Access. This calculates the costs of access services such as raw copper.

• Co-location. This calculates the cost of services areas that may be used by other operators to co-locate equipment at TeliaSonera sites.

An overview of each model provided in sub section below. Subsequent main sections describe each model is greater detail.

In practice, the hybrid model is a revised version of the bottom-up model. All the changes (in summary form) made to the bottom-up model following the reconciliation process are documented in the “Changes” sheet in each model. For further,

information on the changes made, consultation of the Hybrid Model Inquiry Log is also recommended.

1.5 Overview of each model

In the following a general guide to each of the main models, that together form the overall hybrid model, is provided.

As mentioned previously the hybrid model consists of four components that are linked together: consolidation; core; access; and co-location models. These are shown in the diagram below.

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Figure 1: Overall structure of the models Co-location model Core model Consolidation model: - transfer of costs - annualisation -- validation -- costing services Input data Input data Input data Access model Input data Access model

The models have some shared data - common data that is used by each model. This shared data is not extensive and so it is entered into more that one model. The consolidation model has a verification function (validation) that enables checks to see that the different models are using the same data. This also allows one model to be adjusted so that cost data for one is different from the other.

Each model is self-contained – it carries out almost all of the calculations associated with its services. This enables each model to be developed independently. The structure shown reduces the number of inter-file links and this simplifies model management.

The final results are calculated in the consolidation model. It is here that data from each model is collected and processed into the final service costs.

As well as the models themselves, some additional analytical work has been required for some areas. These are referred to as “off-line” calculations as they do not form a part of the models. They are, however, no less important to the model since the off-line calculations create input values for the models.

The main off-line analysis concerns road map analysis. This analysis has been made using Graphical Information Systems (MapInfo) and paper maps. This work produced information about the road lengths and hence provides the basis for trench and cabling calculations in the core and access model.

Cost inputs are often confidential. Some versions of the models will have disguised values. The source data is identified by comments fields. The source name is identified by a code. The code can be traced back to the name of a source using a code sheet (this is confidential). Due to camouflaging of some input parameters, the final result presented in the public version of model will differ slightly from the result obtained when running the model with confidential inputs.1

1.5.1 Consolidation model

The consolidation model brings together the outputs of each of the main models.

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The consolidation model collects the cost data from each model. Additional numerical data about the number of services, and other technical values are also collected. The data is linked into the consolidation model.

The cost data is annualised using annuities. This annualisation converts the capital costs of equipment into average annual costs, based on the equipment lifetimes, price trends and scrap values. In addition, a capital charge is added using the cost of capital. Each cost item is given an allocation – this defines what network element or service the cost relates to. The cost is then allocated and network elements are transformed into service costs using a routing / allocation table technique.

The allocation allows cost items that were calculated in one model to be transferred to other services (thus access line cards or main distribution frame costs are calculated in core model but are used as part of access service calculations in the consolidation model).

The routing tables are constructed using data supplied from the main models. The routing tables define how each product uses the network elements, and along with products volume data, it enables the services to be costed from the network element cost information.

Additional inputs and calculations in the consolidation model allow an initial allocation of operating costs (in the core and access model) using mark-ups to be transformed to operating costs using a functional area approach. Furthermore, indirect and common costs that do not constitute part of the other models are input and allocated to the final service costs.

1.5.2 Core model

The core model calculates the network systems and associated costs that are needed for a network operation of the scale of TeliaSonera. It calculates the cost of switching and transmission systems. The core model therefore deals with the element costs that are driven by traffic (call volumes and numbers of calls) in contrast to the access model, where costs are driven by number of customers.

The core model should be understood to have a different boundary to the core

network. The core model also calculates costs of line card and the main distribution frame (MDF). These costs are part of the access network, but are included within the core model calculations. These access-related costs are allocated to access service costs in the consolidation model. Furthermore, since the allocation of costs between access and core relies on the boundary between access and core as stipulated by TeliaSonera’s network some core model costs related to transmission are allocated to access in the consolidation model.

The starting point for the core model is the volume data for each service. The PSTN call services and non-PSTN services define the overall network size. The dimensioning of the network for PSTN is done through a routing table that defines how each service uses the network. Taking account of how non-PTSN services such as leased lines use the network, gives an overall dimension for the network. The equipment needed to create the overall network is calculated next – technical design rules are used to calculate the numbers and sizes of each element.

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Network costs that relate to other services (not PSTN services) are then excluded. The final costs of the many network elements needed for the PSTN services are finally exported to the consolidation model along with routing table data and volumes data. Off-line calculations are used to estimate inter-site distances and building costs per square metre.

Key features of the core model are:

• three layer switch network assumed with telephony servers providing some of

the functionality currently provided within local exchanges and tandem switches;

• additional international gateway and IN platforms as required;

• circuit-switched voice technology is assumed, based on the Ericsson ENGINE

solution;

• transmission is based on SDH (Synchronous Digital hierarchy);

• rings are used to provide resilience. Optical systems are usually used, but microwave is also used; and

• some sites are connected via spurs, due to local geographical features such as

e.g. valleys.

1.5.3 Access model

The access model calculates the equipment and costs needed to create an access network for Sweden with the scope of services and demand as faced by an operator with SMP such as TeliaSonera.

The access model calculates the amount of cables and equipment needed to connect from the Main Distribution Frame (MDF) to the customer premises. The main items in the access network are copper cables, ducts and trenching. Distribution points and splitting points are also required.

Fibre is also used in the loop and hence fibre distribution links are also included. The access services are calculated in the consolidation model. This stage allows for additional costs that are calculated in the core model to be added to the cost calculated in the access model.

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Figure 2: Overall scope of the access model Access Network Model Access Network Model RSS PDP PDP SDP SDP SDP Customer Site NTP Line cards PDP Demux RSM Line cards SDP SDP LE RSM Fibre Copper Fibre Copper FAM FAM PDP SDP LE MDF site

The diagram shows that access model calculated costs from the MDF via a tree- and branch style network to customer premises. Primary distribution points (PDP) may be used to split the cables. Secondary distribution points (SDP) can also be used to split the cables to the final drop-off points. These final drop points or final splits (not shown) link the customer site to the cables in the street – over the final drop. Not all links will have the need for primary and secondary splits as well as the final split – the majority need only one distribution point.

Fibre access Multiplexers (FAMs) are used in the street (where needed) to provide optical systems links to copper final delivery to customers.

The costs of the cables and equipment are calculated using data about the populations and node sizes. Much of this analysis is carried by geotype and is done as an off-line analysis.

1.5.4 Co-location model

This model calculates the systems and costs required to equip space in TeliaSonera buildings that is suitable for co-location space services. The main components of the co-location services modelled at different sites in the SMP operators network are:

• Location of equipment;

• Installation and mounting of equipment;

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• Placing; and

• Power, cooling and ventilation.

Co-location is relevant in relation to switched interconnection, access to unbundled local loop, and other potential purposes. However, the model only explicitly considers the co-location costs of the unbundled loop. However, the model takes account of sharing of costs between other co-location services and other increments.

Unlike services in the core and access network, co-location services consist of

relatively few cost categories. They are mostly standalone “sub-products” that may be combined by the operator who demands location. Therefore, although the co-location model is simpler in structure compared to both the core and access models, cost inputs are more detailed in order to capture costs at a sufficiently granular level. The main co-location cost is the cost of space. It is assumed that space in buildings is, in the long run, an incremental cost – hence the building size is variable in the long run. Without this assumption the building costs would be fixed.

For practical modelling purposes the co-location model also calculates the costs of other services, including interconnection capacity, regional and local POI and installation of raw copper and shared raw copper (the latter two services are termed “change” costs).

1.6 Definitions and principles common to all models

Some concepts and definition are used throughout this document and it is useful to understand the main ones.

Scorched Node. This is a TeliaSonera site that has a voice switch or concentrating equipment (Remote Subscriber Stage - RSS) that has been used to replace a voice switch. The location and number of these nodes cannot be altered. The equipment within each may be altered (or “scorched out”). A scorched node may contain several different types of equipment and it is typically a building varying from small hut to large exchange site in a city.

MDF-site: Is the location where the Main Distribution Frame (MDF) is located. The MDF is located together with a switch, concentrator or Remote Subscriber Multiplexer (RSM). In principle, an MDF-site with only an RSM (no switching or concentrating functionality) is not ‘scorched’ under the scorched node definition, as defined by the MRP. As one of the main purposes of the access model is to calculate the cost of copper access, however, and copper access is defined from the MDF to the customer premises, PTS has decided to take the existing MDF locations in TeliaSonera’s network for given as well.

Geotype. Each site can be classified to be in one of several geotypes. A geotype depends on the density of subscribers per km2_{. Costs of services may therefore vary by geotype.} Geotypes enable the model to represent the diversity of areas in Sweden, whilst

avoiding the need for detailed analysis and estimation for every one of the 10,000 or so switch zones. The geotypes used in the model are:

• City: over 1,000 lines per km2

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• Rural A: 10 to 100 lines per km2

• Rural B: 1 to 10 lines per km2

• Sparse: up to 1 lines per km2_{; at least one access network subscriber line.}

• Empty: no access subscriber lines.

Access Zone. Each MDF is assumed to have an access zone around it. The subscribers in the zone connect to the node via the local access network for the zone. Subscribers are generally connected to the scorched node that they are closest to (with a few exceptions where local geography makes it more cost effective to connect subscribers to another nearby zone due to an obstacle such as a lake or due to local clustering of households).

A zone is typically a few km2_{(city) up to about 100 km}2_{in area (rural). The overall area} covered by a node depends on the access technology used – the limits of copper cables sets restrictions on the distance customers can be located away from the node. The scorched node assumption means that the zones are effectively fixed.

Note that there are many parts of Sweden that require no access zone at all, as there are no customers in the “zone” – the zone has only lakes, forests and mountains with no population to service. These are allocated to the last of the geotypes listed above, and play no further part in the analysis of costs in the access network.

Fibre access multiplexer (FAM). This is an item of electronics that multiplexes copper subscribers with fibre-accessed customers. The combined data is linked back to a scorched node via fibre optic link where the data is de-multiplexed. A FAM is typically in a street cabinet or larger customer-building basement.

Remote subscriber multiplexer (RSM). This is a scorched node site that has multiplexing equipment. The RSM combines data and voice service from customers and transmits them over a fibre link to another scorched node site where they are de-multiplexed and linked to other systems such as voice switched and data systems. Any voice-switch site may be converted to an RSM and vice versa under the Scorched node rules. The RSM will have copper line termination cards.

Core-access demarcation. For ease of modelling the demarcation of the models and the services are different. The access service includes all equipment from the customer premises up the scorched node, including the line cards in the scorched node. Thus, access includes copper terminating line cards in the RSS and in a voice switch. The MDF is also included in the access network costs. The model demarcation, however, is at the MDF site where the access model includes all the costs from the Network Termination Point (NTP) up to (and excluding) the MDF. The differences of core and access models and networks are illustrated in the diagram below. Please note that the core-access demarcation is defined in relation to TeliaSonera’s actual network. The access network is defined up to (and including) the line card located in the RSS or LE (existing RSM’s will be located in the access network). In the hybrid model, a large number of RSSs are replaced by RSMs. The access-core demarcation remains at this

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site, even though the node in principle has no switching or concentrating functionality. This is to ensure that the costs modelled correspond to actual services provided2.

Figure 3: core and access network versus model demarcation

Core Network Access Network Access Network Model Core Network Model RSS RSS Transit Switch (TS) Local Exchange (LE) LE PDP PDP SDP SDP SDP Customer Site NTP Line cards TS PDP Demux Demux RSM Line cards SDP SDP LE RSM RSM Fibre Copper Fibre Copper FAM FAM PDP SDP

The core model includes the line card and MDF calculations, even though these are access network cost items.

Main distribution frame (MDF). The main termination point for copper access cables in a scorched node site. The copper pairs from the customer are linked from the MDF to the equipment in the scorched node.

Spur. A path to one or more sites that has only one physical route.

Ring. A logical or physical connection that has two paths that therefore can (optionally) provide alternative routes should one path round the ring fail.

Logical versus physical link. The logical link (or links) is the path between two items of equipment. The physical path is the actual route taken by the data between the equipment. There may be two logical paths, but it is possible for these to be on the same physical path or on diverse paths.

Capital versus operational costs. A fundamental feature of the BU model is the different determination of capital related costs and operational costs. Capital costs (or capex) are a result of the purchase and installation costs of the equipment. The total capital cost of a particular type of item is the cost of one item multiplied by the number of items required. The lifetime of the equipment, price trends and scrap values are also capital related data. They are used, along with the purchase costs to determine the average cost per annum – the annualisation calculation is carried out in consolidation. The depreciation is calculated in the consolidation model (and is only related to the capital cost). Operational costs are a result of maintaining, operating and repairing the equipment once bought. This is an on going or annual cost. Operational costs are

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derived through the functional are approach (see below), hence the capital cost and operational costs are not directly related.

Functional areas and operational cost calculations. Operational costs are based on a definition of functional areas. These are areas of the business that are needed to carry out a set of related functions such as operational work on (say) switches. Functional areas are defined to have a set number of staff. The costs of this functional area are therefore independent of the capital cost. The models allocate the cost of the functional area to the capital items in proportion to a cost factor. The cost factor is defined as a

percentage of the capital cost – the percentage is an initial estimate of the operating cost as a fraction of the purchase cost. Costs are allocated pro-rata. Therefore if the capital cost of equipment varies, then the total operational cost is still fixed (it is defined by the functional area size). The allocation of the total operational cost will vary slightly. However, if every item’s capital cost increases similarly, the allocation will remain the same.

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2 Consolidation

model

2.1 Definitions and assumptions

The consolidation model uses the costs relating to core, access and co-location that are produced by each of the separate models. The costs are brought together in the

consolidation model.

The consolidation model produces the final cost of each service. It also undertakes some checks for consistency between the other three models.

As well as annualised costs, any cost may be expensed, hence the cost is recovered as a one-off payment. Some cost items that are relevant to access or co-location services are typically treated in this way. Core PSTN costs would not normally be expensed. The model therefore calculates service costs as a mixture of one-off and annualised costs. The choice of annualisation or expensing is essentially a pricing decision.

2.2 Structure of consolidation model

The consolidation model structure is captured in the navigation map. This is reproduced in the diagram below.

Figure 4: consolidation model - navigation map

The consolidation model has three main stages – input, calculations and output. The main functions of the consolidation model is the calculation of service costs from the cost category inputs of the core, access and co-location models, and the integration of functional area costs, including common business costs.

2.3 The main functions of the consolidation model

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• annualisation of capital costs to give an annual cost. Optionally the cost item may instead be expensed (treated as a one-off cost);

• allocation of operational costs from the functional area approach to network

elements; and

• calculation of service costs.

These functions are discussed in more detail in the sections that follow.

The consolidation model contains come central data values and calculations, but its prime purpose is to consolidate all of the calculated costs from each model and calculate the service costs from these cost inputs.

The design is based on disaggregated cost data. This approach based on a collation of cost data enables all costs that contribute to each service to be identified individually. The collated input costs from each model are annualised (or expensed as appropriate). This involves adding together different cost types such as equipment costs, installation costs, operating costs, indirect costs and common costs to derive a single cost (annual or one-off) that represents the long-run cost that must be recovered. The assumed cost of capital, price trends, lifetimes and scrap values are combined in this calculation. The disaggregated approach also allows the user to use alternative annualisation

formulae for any cost category. A number of different annualisation options have been provided. These are discussed in more detail in the next section. However, the default method used by PTS is tilted annuities.

The annual cost of each cost category is allocated to network elements or services. The user is allowed the flexibility to define the allocation to use.

The resulting element costs are then processed into service costs. Routing tables and other allocation/combinatorial techniques are used as required.

The final cost of services is then subject to an “uplift” for common business costs. A feature of the approach taken is that the costs, when input to the consolidation model, can be altered (or overwritten) to give another value and the results directly evaluated. This approach to sensitivity analysis is not a normal action (it invalidates the true results), but it is easy to carry out.

Another approach for sensitivity analysis is to alter the allocation of the cost category. If a cost category is not given an allocation (by removing or deleting the network element allocated to the particular cost category) then the cost is taken out of the service cost. It is easy to compare the new value with the normal value and hence see the sensitivity of any service to a particular cost category. This type of analysis is also referred to as the “delta” method – the user can quickly see the difference or delta caused by any one cost. This means that the contribution of any one cost to a service can be easily be evaluated.

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2.4 Annualisation assumptions

2.4.1 Cost of Capital

The cost of capital measures the opportunity costs of the sources of capital (debt and equity) invested in the company.

PTS has estimated the cost of capital for a fixed SMP operator in Sweden in

accordance with the guidelines determined by PTS on 15 October 20033.

2.4.1.1 Overall approach

In line with the adopted guidelines, PTS has applied the same cost of capital for core, access and co-location services and estimated the cost of capital on a nominal and pre-tax basis.

The Weighted Average Cost of Capital (WACC) is calculated as the weighted cost of debt and equity:

d e ( T) C D E D C D E E WACC × − × + + × + = 1 ,

where E is the market value of equity, D the market value of debt, E+D is the market value of the company, C_e the cost of equity, T the effective tax rate, and C_d the cost of debt.

The cost of debt, Cd, reflects the interest rate that lenders would require for lending

their money, i.e. the risk free-rate adjusted to reward lenders for the risk that the borrower will default.

The cost of equity has been estimated according to the Capital Asset Pricing Model (CAPM) according to which, the cost of equity is calculated as

Ce = E(Rj) = Rf + βj [ E(Rm) – Rf ],

where E(Rj) is the expected return on asset j; Rf is the risk-free rate; βj measures how

sensitive asset j is to movements in the market portfolio; and E(Rm) is the expected

return on the market portfolio.[ E(Rm) – Rf ] is the market risk premium, in practice

often referred to as the Equity Risk Premium (ERP).

The calculations of the individual parameters are discussed below.

2.4.1.2 Cost of debt

The cost of debt has been estimated as the sum of the risk free rate and a debt premium.

The risk free rate has been estimated at 3.66% using a 12-month average of a 10-year

Swedish government bond4.

3_{Konsultationsrapport – kommentarer rörande AMI:s rapport om kapitalkostnad för svenska}

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PTS has estimated the optimal gearing for a fixed operator to lie between 20-40%. The debt premium has been estimated at 1.00% and 1.40% for a gearing of 20 and 40% respectively.

Finally, PTS has used the corporate tax rate of 28% as proxy for the effective tax rate.

2.4.1.3 Cost of equity

The cost of equity has been estimated using the perspective of a marginal international investor.

The international market risk premium has been estimated to 4.5% using the highest estimates of Dimson/Marsh/Staunton and Damodaran.

Beta has been estimated for TeliaSonera using daily observations for a three-year period (plus one month) using the MSCI world index as proxy for the portfolio of the marginal internal investor.

Table 1 Estimate of beta for TeliaSonera using MCSI World and daily observations for 3 years Period Obs. Beta Std.error Low 95% High 95% R2 18.08.00-16.09.03 770 1.199 0.0949 1.013 1.386 0.17 The estimated beta of 1.199 corresponds to an unlevered beta of 1.042 using an average debt/equity ratio of 0.21 and corporate tax rate of 28%. However, the relevant beta is that of a fixed SMP operator in Sweden, not an integrated operator like

TeliaSonera. The estimated company beta of TeliaSonera corresponds to a weighting of the asset betas of the fixed and mobile division (and other divisions). PTS has estimated the beta of a mobile SMP operator at 1.10, suggesting that the beta of a fixed SMP operator should lie in the range between 0.95 and 1.0 (with an average beta of 1.04 for the integrated operator). Due to the difficulties and uncertainties involved in adjusting the estimated company beta of TeliaSonera, PTS has decided to simply round down the estimated beta of 1.04 to 1.00.

2.4.1.4 Summary of calculations

The calculations of the WACC using the above parameters are summarised in the table below:

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Table 2 Estimating the cost of capital for fixed SMP operator Low gearing High gearing

Risk-free rate 3.66 3.66

Equity risk premium 4.50 4.50

Unlevered Beta 1.00 1.00 Levered Beta 1.18 1.48 Cost of equity 8.97 10.32 Debt premium 1.00 1.40 Cost of debt 4.66 5.06 Gearing 20 40 Tax-rate 28 28 Post-tax WACC 7.85 7.65 Pre-tax WACC 10.90 10.62 Range 10.62 – 10.90 Mid-point 10.8

On this basis, PTS has applied a cost of capital of 10.8 % in the hybrid model. 2.4.2 Annualisation options

The consolidation model offers a number of annualisation options. These are:

• Straight-line depreciation

• Tilted Straight-line depreciation

• Sum of digits depreciation (front loaded)

• Standard annuity function

• Tilted annuity function

Straight-line depreciation divides the asset’s price by the asset’s life to produce an annual depreciation charge. To calculate the annualisation charge, a capital charge is added. The straight-line annualisation factor used in the model is:

⎟ ⎠ ⎞ ⎜ ⎝ ⎛ ₊ × ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + − CoC AL ) CoC ( SV CV AL 1 1 ,

where CV is the capital value of asset, SV the scrap value of the asset, AL the asset life and CoC the cost of capital.

Tilted straight-line depreciation takes account of expected price changes for assets. It will result in a steeper depreciation profile when prices are falling than unadjusted straight-line depreciation. The tilted straight-straight-line annualisation factor used in the model is:

⎟ ⎠ ⎞ ⎜ ⎝ ⎛ ₊ ₋ × ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + − CoC PT AL ) CoC ( SV CV AL 1 1 ,

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where PT is the price trend.

The sum of year digits (SOYD) is a simple method for generating a front-loaded depreciation schedule. It may be a useful approximation if the asset’s operating costs are expected to rise or its price or the revenue it generates is expected to fall. The sum of years digits annualisation factor used in the model is5,6:

⎟ ⎠ ⎞ ⎜ ⎝ ⎛ ₊ + × ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + − CoC AL ) CoC ( SV CV AL ₁ 2 1

The annuity approach calculates both the depreciation charge and the capital charge. A standard annuity calculates the charge that, after discounting, recovers the asset’s purchase price and financing costs in equal annual sums. In the beginning of an assets lifetime the annualisation payment will consist more of capital charges and less of depreciation charges; this reverses over time resulting in an upward sloping depreciation schedule. The increase in the depreciation charge over time exactly counterbalances the decrease in the capital charge with the result that the annualisation charge is constant over time. The standard annuity function used in the model is:

AL AL CoC CoC ) CoC ( SV CV ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ + − × ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + − 1 1 1 1

A tilted annuity calculates an annuity charge that changes between years at the same rate as the price of the asset is expected to change. This results in declining annualisation charges if prices are expected to fall over time; for a large enough tilt the slope of the depreciation profile will also be negative. As with a standard annuity, the tilted annuity should still result in charges that, after discounting, recover the assets purchase price and financing costs. The tilted annuity function used in the model is:

AL AL CoC PT PT CoC ) CoC ( SV CV ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ + + − − × ⎟ ⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + − 1 1 1 1

The choice of the depreciation methodology should ideally be the one which best reflects economic depreciation, this implies that holdings gains and holdings losses, which follow from changes in asset prices, should be taken into account. Compared to the tilted straight line depreciation formula the tilted annuity approach as the

advantage that the annualisation charge is independent of the age of the asset. The fact that the hybrid model is (artificially) modelling new assets therefore becomes less of an issue7.

5_{Note the formula used is a simplified version of the sum of digits (front loaded) annualisation formula.}

This simplification is possible since the costs we are modelling are those for the first year in an asset’s life.

6_{Note that sum of years digits depreciation may also be back-loaded. This is the reverse of the}

depreciation under sum of years digits front-loaded.

7_{Otherwise, it could be argued that the bottom-up model should not model the costs in year 1 but}

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PTS has therefore decided to annualise costs on the basis of tilted annuities8. This approach was also used in the bottom-up model and is supported by TeliaSonera. Note that the majority of equipment costs and installation costs are passed on to the consolidation model where they are annualised. However, there are a few exceptions. These are building costs and common site costs that are annualised in the core model. 2.4.3 Annualisation parameters

Price trends, residual (scrap) values and equipment lifetimes are specified for all cost categories and are used in the calculations. These inputs are made in the separate core, access and co-location models. The consolidation model merely imports these values and then uses them in the annualisation process.

The hybrid model uses the economic life of equipment to measure asset lives. An overview of the asset lives and (forward-looking) price trends used are provided in the table below:

Table 3 Asset lives (years) and price trends in the hybrid model

Cost category Asset lives Price trends

Access Trench (incl. mini-duct trench) 40 +2% Access Duct (including mini-duct) 40 +2%

Core trench 40 +2% Core duct 40 +2% Poles 20 +2% Copper cable 25 +6% Line cards 10 -3% Fibre cable 20 -5% Cabinets/distribution points 15 +1% Manholes 40 +1% MDF 15 0% NTPs (copper) 20 0% NTPs (fibre) 20 -5% Frame unit 10 -2% Switchblock unit 10 -4% Processor unit 10 -5% Software 10 -4% Port unit 10 -3% ODF 10 -5% ADM 10 -5% STM Multiplexers 10 -5% STM Cards 10 -3% Synchronization 10 0%

8_{Note that tilted annuities do not work well when asset prices are declining rapidly (understating costs}

compared to economic depreciation) or where asset prices are rising over time (overstating costs compared to economic depreciation) but less than a lot of the other methodologies). Hence, using tilted

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Cost category Asset lives Price trends

Cross-connects 10 -4%

Signalling points 10 -4%

Submarine cable links 20 -4%

Microwave 15 -8%

IN 10 -5%

Power supply unit 10 -2%

Back-up power 10 -2%

Air conditioning unit 10 1%

Security system 10 1%

Site preparation 15 0%

Buildings 30 +2%

Although the model has the functionality to use scrap values, these are assumed to be zero for almost all cost categories. The only cost category using a scrap value as an input is building costs. Here the scrap value is set at 30% of today’s building value.

2.5 Working capital

Working capital costs are the costs of maintaining balances of physical or financial stocks (assets and liabilities). The cost of working capital is calculated by multiplying the cost of capital with the calculated working capital.

Based on empirical evidence from the top-down model the cost of working capital has been set to zero.

2.6 Functional area costs

The approach to modelling operating costs and indirect costs relies on a functional area approach. The approach uses information on allocations performed by mark-ups in the separate models to allocate costs of each operational (or functional area) that is needed.

Each of these areas is dimensioned in order to define the total operational costs expected for an efficient operator (using average cost per staff member). These results define the expected total operating and indirect costs required to run the domestic PSTN network of an operator with SMP in Sweden.

This approach consists of several stages:

• Define the operational areas;

• Define the size of each area;

• Calculate the cost of each area; and

• Allocate the cost of each area to network elements, such that the total is equal

to the sum of the functional areas.

The latter allocation of costs to network elements is performed by means of an

allocation table and weights provided by an initial allocation of costs using mark-ups in core and access models.

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2.6.1 Functional areas

The FA costs in the I_FA_Costs sheet have been grouped into three different major cost categories:

• Network costs;

• Non-network costs;

• The IC and Access specific costs and

• Overhead costs.

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Figure 5: Detailed depiction of the FA cost categories

Costs

Network costs relating to ongoing

costs* Network costs relating to one-off works Non-network costs IC and access specific costs

Ar

ea

s

Switched network management Switched network maintenance Network management system Switched network planning Core transmission management Core transmission maintenance Core transmission planning Access transmission management Access transmission maintenance Access transmission planning

Switch implementation division (installs equipment) Transmission implementation (installs equipment) Access Implementation Corporate Overheads Human resources Finance Support systems Admin

Customer oriented costs Billing

Debtor handling Other IC specific

* the hybrid model caters for additional categories of network costs related to ongoing costs that are not used. These include: ‘Site

management (excl. HQ)’, ‘Field Engineering – core’, ‘Field Engineering – access’ and ‘others - to be added if needed’. Furthermore, the total cost of power and air condition are shown to enhance transparency. Note that some of the cost categories stated above may have no staff costs, only non-pay costs. While it is likely that all categories will comprise of elements of pay and non-pay, the underlying input data used in the off-line analysis was not sufficiently detailed to achieve such an allocation in all cases.

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2.6.2 Size of each area

For each of the identified functional area above, the model includes input for the staffing requirements i.e. the number of staff required for each area and the non-pay costs. The total staffing requirements and non-non-pay items determine the size of each area.

Note that the input to staffing requirements input is strictly based upon head-count numbers. Subsequently, the allocation between the different staffs types: managers, technician and support is made by means of a user defined allocation profile. Distribution to different staff types is done at a later stage in the

calculation, cf. below.

Inputs to each FA are a result of an off-line analysis of various data sources, in particular input data from the top-down model and inputs received during the consultation process on version 1.2 of the hybrid model. The inputs used are based on an evaluation of the requirements for an optimised network with the scope and size of the SMP operator and the actual numbers in Skanova as stated

by the top-down model from TeliaSonera9. As an entry point, the costs in the

hybrid model are based upon the numbers found in the top-down model and figures provided by TeliaSonera. However, these costs have subsequently been analysed and modified where appropriate to ensure consistency with the

underlying cost inputs. In addition, a number of sanity checks have been applied to the off-line analysis to ensure that the cost levels and allocations (between categories).

Generally, three main types of corrections have been made:

1) Technological. The hybrid model has a different network structure than that of TeliaSonera’s actual network. These adjustments arise as a result of a newer switching technology in the hybrid model, and more efficient transmission backbone, due to the extensive use of rings. This has an impact upon the estimates of the switching categories, which have been slightly adjusted to compensate for the enhanced effectiveness of the Ericsson engine concept.

2) Retail. Specific retail costs should not form part of the FA costs. Retail costing has been carefully removed from all costing elements, ensuring the correct input values are used in the model

3) Non-PSTN. Core costs should be input net of non-PSTN, while access FA

costs should include non-PSTN costs. 2.6.3 Cost of each area

The cost of each area is calculated using staffing profile assumptions (%-manager, %-support and %-technical) and the average annual cost of the different staff types.

9_{TeliaSonera has provided PTS with an efficiency study of 8 October 2003, in support of}

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The staff costs include social and pension costs, training and education, fringe benefits, company cars, healthcare etc. and are based on information provided by TeliaSonera to ensure consistency with other FA inputs.

The non-pay costs include e.g. support systems and outsourcing costs. 2.6.4 Allocation of the cost of each area

In order to allocate the costs using the functional area approach to services, the model relies on two different approaches:

• allocation to network elements and since to services; and

• allocation directly to services using a mark-up approach.

Direct network costs are allocated to network elements, while the remaining functional area costs, (overheads costs comprising indirect costs and interconnect and access specific costs) are allocated using mark-ups.

In order to allocate the direct network costs to network elements, the model utilises an allocation table and the operating costs already allocated to different network elements by using operating cost mark-ups in the core and access model. The allocation table consists of zero (do not allocate costs) and one (allocate costs). Using this allocation table and the costs allocated to each network element by using mark-ups, the model calculates the functional area costs to each network element. The formula used to allocate costs is:

∑ ∑

× × × = i j ij opex j ij opex j i j NE NE FA FA α α , where

• FAj = the FA cost of network element j

• FA_i = the FA cost of area i

• NEj = operating cost allocated to network element j using mark-ups in the

core and access model

• αij = allocation key for network element j and area i

This methodology has been developed as an attempt to overcome some of the shortcomings of relying on mark-ups over equipment costs as an estimate of direct network operating costs – shortcomings that were discussed during consultations with the industry but also in the MRP.

The mark-up approaches are discussed in the following section. 2.6.5 Overhead costs

Overhead costs are split into common business costs, costs related specifically to access and interconnection and transit uplifts.

In the model common business costs are defined as: “Costs that are required by an efficient operator with SMP in Sweden, with the scope of services similar to

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TeliaSonera. These costs are common to the businesses of core, access, co-location and other retail services. Note, however, that the inputs used are only those related to wholesale services, excluding any non-PSTN costs.

The costs are indirect non-network costs that are required to make the business function and hence not directly related to the services or the network. Examples are the chairman’s office, recruitment costs, legal department, audit fees etc. Clearly these are required in any business, are common to the entire business and do not vary directly with service or network costs. The costs are allocated directly to the final services using a (multiplicative) mark-up approach, where the total common business costs are calculated as a fraction of the total costs of the core, access and co-location.

The access and interconnection specific costs have been defined as management information/support system, bad debts10, consultancy services, product

development costs, charges to PTS and "other" costs. These are split by access and interconnection services and allocated to these specific services using a

(additive) mark-up approach. That is, costs are calculated a fraction of the demand (per line or min) and simply added to the final service costs. Note that this mark-up is only applied to the specific wholesale services to which they relate, not all the services modelled in the hybrid model.

The transit uplifts have been included to cover costs for the required 2 Mbps interface and the cascading costs (the proportional cost paid to other operators for the leased line between TeliaSonera and the interconnection operator). 2.6.6 Expensed vs. annualised costs

The model calculates the mark-up for common business based on the

annualisation of all costs. Therefore expensed costs are allocated a share of the

common business costs by calculating the common business costs mark-up as if

all costs where annualised and applying this mark-up directly on the expensed unit costs.

This may be regarded as a pragmatic solution to ensuring that expensed costs receive a proportion of common business costs. The underlying assumption is that the total pot of annualised costs, for those cost that are expensed, may be taken as a proxy for the proportion of annual one-off costs.

2.6.7 Number portability (IN/NP costs)

The model includes the costs for number portability (IN/NP costs) These costs are in I_FA_Costs and consist of annualised CAPEX and OPEX. The cost per call is calculated and then added to all calls costs as an additive mark-up. 2.6.8 Billing of transit traffic (kaskadavräkning)

PTS has included costs for maintaining functionality that enables cascade billing and actual billing of cascade transit traffic. It is calculated as an additive mark-up

10_{Note that the costs of bad debt, like any other cost, should be considered in a forward-looking}

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in the Consolidation model and added to IC single transit and IC double transit in C_Services

The mark-up consists of both capital and operating expenses. The CAPEX is the costs for development of the billing system and both external and internal resources are taken into account. The total CAPEX is then annualised with an asset life of 7 years, price trend of 0 percent and a scrap value of 0.

The OPEX consists of pay cost for staff to carry out support of this billing function and a compensation factor for general overhead and management plus non-pay operating costs.

Annualised CAPEX and OPEX is then added and divided by the total number of transit calls to give the final mark-up.

2.7 Other common costs

Common business costs were described above. This section concerns other

common costs such as building related costs and shared costs such as ducts and cables. These are the network costs of shared network equipment that are necessarily incurred if access and interconnection services are provided and are not avoided if interconnection and access services are no longer provided. These costs are not specific to the consolidation model, but are described here because they relate to all models.

2.7.1 Building costs

Building space and common building-related costs are an input in the core model. Common building-related costs (or site costs) include site security, power supply units and air conditioning. Costs related to toilets, storage etc. are captured in the

common cost.

The model attributes each site type (RSM, RSS, LE and TS) a common site cost. This cost is then divided by the average size of these sites to obtain a per square metre value. The average site size is assumed to consist of area used for PSTN equipment, non-PSTN equipment and location. The average site size for co-location is an input value from the co-co-location model (manually entered).

The raw annual building space costs per square metre for each geotype is an input to the model. This value has been derived from publicly available sources.

Common site costs are annualised and added to the annual building costs to achieve a cost per square metre for each geo-type. These values are then

converted to a per square metre value for each site type. This value is also used in the co-location model (manually entered).

Each cost category has a defined accommodation area of occupancy. Thus local exchanges will obtain some building costs, and transmission equipment will also occupy some space. The areas occupied by each piece of equipment are user inputs.

The total common site costs (equipment, operational costs and any allocated building costs) are next allocated to the equipment within the sites. This is done in proportion to the area occupied. Thus the area occupied in a local exchange

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building by a local exchange switch determines the amount of common shared building costs that are allocated to the network element or service.

Accommodation costs remain disaggregated through the individual models into the consolidation model.

2.7.2 Shared facility costs

A number of shared facilities exist (excluding buildings). While it is relatively straightforward to identify the network elements used by services other than PSTN, the potential difficulty is determining the ‘usage’ of the network elements by other services.

The two major categories of shared facility costs discussed in this section are: trench facilities and core network systems.

2.7.2.1 Trench facilities

There are two key sharing aspects of trench:

• The physical amount of trench in km shared with other utilities; and

• The physical amount of trench in km shared with the access network.

In addition to the physical amount of sharing there is a separate issue, namely how these costs are shared. The model allows for user-definable inputs that specify the amount of shared digging length and other inputs to calculate how the costs are apportioned.

The physical amount of sharing is a technical design factor that is an output of the model calculations. The amount of cost sharing, however, is a more subjective decision, as there is no clear cost driver that can be used to allocate these costs.

2.7.2.2 Core network systems

Core network systems (transmission equipment, switches etc) are shared by many services.

These costs are allocated to the services based on the primary cost driver being:

• capacity (Mbit/s) used by the service for transmission; and

• call volumes for switch equipment.

These allocations are carried out by routing factor techniques or by splitting of the network element’s costs, based on the capacity consumed by the other services. For example, as leased lines are dedicated links, there are no measurable minutes of use of network elements as there are for PSTN calls. As a result, the use of network elements by leased lines must be proxied by other measures such as leased line capacity. That means the costs of shared network elements must be allocated between leased lines and fixed PSTN services on the basis of the capacity of the equipment used to provide the services.

2.7.3 Other shared facilities

The switches are shared by core and access services. The model identifies the line card, MDF and frame unit as all access-related. Although central parts of a core

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switch these costs are clearly not call dependant and are therefore allocated to access accordingly.

2.8 Boundary between core and access

The hybrid model follows the modified scorched node assumption. This implies that the SMP operator’s existing number and location of its nodes are taken as given. However, the mix of exchanges may be changed. For example, a local exchange may be replaced by a remote subscriber stage. Multiplexers or similar equipment with no switching capability may also be placed at a node.

A node is defined as an exchange (including concentrators). This means that the costing boundary between the core and the access network is placed at the exchanges and concentrators in TeliaSonera’s network.

Table 4 Number of nodes (incl. RSM’s) in the hybrid model compared to TeliaSonera’s network

RSM’s* RSS’ * Local

Exchanges Switches Transit Total

Hybrid 5,638 1,615 117 14 7,384

Top-down 1,442 5,049 143 32 6,666

* Number of RSM (RSS) sites where the parent switch is not located at the same site

As can be seen from the table, the number of nodes (incl. RSM sites) used in the hybrid model appears to differ from the corresponding number of node locations in TeliaSonera’s network. Both sets of figures are based on information provided by TeliaSonera. The figures used in the hybrid model are based on a thorough investigation of site and line data provided by TeliaSonera. PTS therefore uses the figure of 5,942 sites or scorched nodes (7,384 -1442) in the hybrid model.

The number of sites used in the current model:

RSM RSS LE TS Total

N. Sweden 861 331 47 4 1243

S. Sweden 3335 1284 70 10 4699

In the case of the 1,442 nodes with RSM equipment in TeliaSonera’s network both the line cards (note that the actual line card is at the RSS) and the de-multiplexing equipment is considered to be part of the access network. In addition, the transmission link from the RSM is considered to be part of the access network. The rationale for this approach is that since the node originally was populated with a RSM in TeliaSoneras network and the RSM does not concentrate traffic, the equipment is dimensioned purely on the basis of the number and type of subscriber lines.

In the case of the remaining RSM nodes, line card costs and MDF (multiplexing) costs are considered to be part of the access network whereas de-multiplexing and transmission costs are considered to be part of the core network. The rationale for this approach is that line card costs and MDF costs would also be in the access network in TeliaSonera’s network. On the other hand, the de-multiplexing and transmission costs would be in the core network in TeliaSonera’s network

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since, for example, the link between the RSS and the LE is part of the core network.

Turning now to RSS equipment, MDF and line cards (and a part of the

concentrator frame cost) are considered to be part of the access network since the quantity required of these items is driven by the number of subscribers. Other RSS costs and the transmission links between the RSS and LE are considered to be part of the core network.

Although the 1,442 nodes with RSM equipment are actually part of the access network these nodes are nevertheless modelled in the core model. The reason for this is that the Access model is designed to measure the costs of plant and

equipment between the customer’s premises and the concentrator or RSM and is simply not suited to measure the costs of RSM equipment and the transmission links and infrastructure from this RSM equipment. By way of contrast the core model already models the equipment in core RSM nodes and the transmission links from this equipment. Therefore, the core model can easily be modified to

cope with the equipment in other RSM nodes.11

2.9 Treatment of other services incl. retail

Other retail services and the retail business are not calculated in the models. Where there are shared networks or facilities, the costs that are driven by these other services are calculated and due portions of network costs are excluded. Thus, leased line transmission costs and common building space costs are calculated and the costs excluded as appropriate.

2.10 Allocation of costs to services

For access and core services, service costs are calculated using the routing / allocation tables, using information on the attribution of cost category to network element. For co-location services the allocation is done directly without any allocation table.

However, before costs are allocated to services they are annualised (or expensed as appropriate). Annualised equipment costs and installation costs together with annual operating and indirect costs are added to derive a single annual cost. To allocate costs to core services the model offers two possibilities:

• busy hour; or

• minutes of traffic.

Using a busy hour allocation, each service’s share of minutes in busy hour is used as the cost allocation key. Using minutes of traffic the allocation key the service’s average use of a network element is divided by the total volume in minutes through the element.

11_{In fact, the model contains a specific section C_Transmission Section 16, which is designed for}

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2.10.1 Allocation for core services

The busy hour allocation uses cost weights derived in the core model used to dimension the network. These costs weights (CW) are calculated using the following formula: j i ij ij capacity BH BHT rf CW = × , where

• rfij = routing factor for service i and network element j

• BHTi = busy hour traffic (BHE or BHCA) for service i

• BHT_i = busy hour capacity through network element j or i

i ij BHT rf ×

∑

. Note that

∑

=1 i ij CW .

The model uses a conversion factor to convert the annual call minutes into busy hour erlang. This conversion factor is: BHE = annual minutes/52/6/10/60. The factor of 52 reflects the number of weeks in the year while the factor of 6 is used to convert into daily values (weekend traffic is assumed to be the same as one weekday). The factor of 10 implies that 10% of traffic occurs in the busy hour. Finally, the factor of 60 is to convert from minutes to hours, cf. section 3.3.1 for more information on how this figure is used.

In the case where the conversion factor is the same for all services the results of using a busy hour allocation will be the same as using a minute allocation –the cost weights will be the same, i.e.

∑

× × = × i i ij i ij j i ij Traffic rf Traffic rf capacity BH BHT rf

2.10.2 Allocation for access services

For the access network, costs are allocated to services using the allocation table. For each network element, allocation factors are attributed to each service using the network element in question. The allocation factors reflect the relative usage of the network element (cost causation principle). These factors are weighted against the volumes of each service.

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3 Core

model

This section describes the main features and rationale behind the core model.

3.1 Definitions and assumptions

3.1.1 Increments

The core model is a bottom up model of the equipment and systems required to carry the services defined in the MRP with the required level of service quality. It therefore calculates the cost of both wholesale (interconnect) and retail PSTN increments.

The core network model is defined to include all systems and equipment contained in scorched nodes, including links between the nodes. It does not include links from the node to the customer (these links are in the access model), except in the case of customers located on islands with no scorched node and no overland connection to the mainland (these are re-allocated to the access network in the consolidation model). The core network (c.f. core model) does not include line cards and the MDF. The core model includes additional costs required to give the extra capacity needed to support other services than those defined in the MRP. These other services, or non-PSTN increments, include leased lines and datacom services. The costs of servicing and supply of dedicated equipment for these increments are not included. The transmission capacity required to support the non-PSTN increments is included and a portion of the total transmission cost is later taken out of the calculation. This portion represents the cost of the non-PTSN increments.

Non-PTSN increments are therefore not calculated, but the capacity effect on the PSTN increments is taken into account. Due to the effect of cost-volume

relationships, increased capacity reduces the average cost per unit. 3.1.2 Network structure - switching

The network is based on the traditional three-layer network but uses Modern Equivalent Assets, as described in further detail below, rather than traditional switching technologies. In addition, there is a further equipment class of Telephony Servers:

The three traditional layers are:

• Remote subscriber switch (RSS) layer although, as discussed below,

Engine access Ramps are used instead of RSS’. The RSS is sometimes referred to as a remote concentrator. RSS’ concentrate traffic that is then sent back to a parent Local Exchange (LE). The LE completes a call by sending it to another RSS or to another core switch. The RSS has access line cards that link to the customer.

• Local exchange (LE) layer although, as discussed below, Multi-Server

Gateways (in combination with telephony server functionality) are used instead of traditional local exchanges. One LE may parent many RSSs. It is assumed that RSS are located at scorched node sites and that an LE does not have access line cards. An LE scorched node site may have one

Hybrid Model Documentation