Model Reference Paper (rev B)
Guidelines for the LRIC bottom-up
and top-down models
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1 Introduction and background ... 1
1.1 Policy and objectives ... 2
1.1.1 Policy ... 2
1.1.2 Objectives... 2
1.2 Methodology ... 3
1.3 Process ... 3
1.4 Document structure ... 4
Part A: Common guidelines ... 6
2 Long Run Incremental Cost ... 7
2.1 Definition of LRIC... 7 2.1.1 Long Run... 7 2.1.2 Incremental... 7 2.1.3 Forward-looking costs... 8 2.2 Definition of increment... 9 2.2.1 Size of increment... 9
2.2.2 Access and core increment ... 9
2.2.3 Other increments ... 11
2.3 Cost Causality ... 12
2.4 Treatment of common costs ... 13
2.4.1 Allocation of common costs... 14
3 Services modelled... 17
3.1 Core and access services ... 17
3.1.1 PSTN (PSTN/ISDN) and Broadband services ... 17
3.1.2 Leased lines... 18
3.1.3 Other services... 19
3.2 Co-location services... 19
3.2.1 The nature of co-location services... 19
3.2.2 List of co-location services covered by LRIC ... 20
3.3 Demand and growth ... 21
3.3.1 Demand ... 21
3.3.2 Margins for growth ... 21
4 Model outputs ... 22
4.1 Cost types... 22
4.2 Level of detail ... 22
4.2.1 Cost categories ... 23
4.3 Cost of co-location ... 23
4.4 Costs of shared access to unbundled local loop ... 25
4.5 Cost of Bitstream access ... 26
5 General costing issues... 28
Post- och telestyrelsen ii 5.1.1 Annualisation criteria ... 28 5.1.2 Capital charge... 28 5.1.3 Depreciation charge... 28 5.1.4 Annuities ... 30 5.1.5 Guidelines ... 30 5.2 Cost of capital ... 31 5.3 Geographical differentiation ... 31 5.3.1 Geographical differentiation ... 31 5.3.2 Geo-types ... 32
5.4 Other costing issues ... 32
5.4.1 Base year ... 32
5.4.2 Working capital ... 32
5.4.3 Set-up and duration related charges ... 33
5.4.4 Routing factors ... 33
Part B: Specific guidelines for top-down model ... 37
6 Overview of top-down modelling ... 38
6.1 Determine homogenous cost categories (Step 1) ... 38
6.2 Group cost category by activity and network elements (Step 2)... 39
6.3 Re-value assets, calculate GRC, NRC and CCA depreciation (Step 3) ... 39
6.4 Developing cost-volume relationships (Step 4) ... 40
6.5 Cost access and interconnection services (Step 5) ... 40
7 Top-down asset valuation and capital costs ... 42
7.1 Gross asset valuation... 42
7.1.1 Current cost accounting... 42
7.1.2 Revaluation methods ... 43
7.1.3 Asset prices ... 44
7.1.4 New technology ... 44
7.1.5 Land and buildings ... 46
7.2 Utilisation rates ... 47
7.3 Valuation of major asset categories ... 49
7.3.1 Access network ... 49
7.3.2 Core network... 50
7.3.3 Trenching costs, incl. poles ... 53
7.3.4 Poles ... 54
7.3.5 Indirect network costs (buildings, IT, motor vehicles, etc.) ... 54
7.3.6 Co-location... 55
7.4 Annualisation ... 55
7.4.1 Asset lives ... 55
7.4.2 Annualisation of relatively new assets ... 56
7.4.3 Fully depreciated assets... 56
7.5 Capital maintenance... 57
7.6 Net asset valuation ... 59
7.6.1 NBV/GBV methodology... 60
7.6.2 Rolling forward methodology ... 60
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8 Operating costs ... 62
8.1 Operating costs... 62
8.1.1 Cost categories ... 62
8.1.2 Efficiency ... 63
8.1.3 Activity based allocation of operating costs... 64
8.1.4 Documentation ... 65
9 Costing services... 67
9.1 Homogeneous cost categories ... 67
9.2 Service usage ... 67
9.2.1 Trenching and duct... 67
9.2.2 Copper and fibre cable ... 68
9.2.3 Local Exchanges ... 68
9.2.4 Tandem exchanges ... 69
9.2.5 Transmission equipment ... 69
9.2.6 Indirect network costs and overhead costs ... 70
9.2.7 Outsourced costs ... 71
9.3 Assigning costs to services ... 71
9.3.1 Calculating incremental costs... 71
9.3.2 Calculating costs of services within an increment... 71
9.4 Treatment of common costs ... 72
10 Model functionality and documentation... 73
10.1 Model requirements ... 73
10.1.1 Sensitivity analysis ... 73
10.2 Model documentation ... 74
10.2.1 Justification ... 75
10.3 Audit of model ... 75
Part C: Specific guidelines for bottom-up model ... 76
11 Overview of bottom-up modelling... 77
11.1 Measuring demand and establishing unit costs (Step 1&2) ... 78
11.2 Building hypothetical network (Step 3) ... 78
11.3 Determining the cost of network elements (Step 4) ... 78
11.4 Costing services (Step 5)... 78
12 Optimisation... 79
12.1 Scorched node assumption... 79
12.2 Technology ... 80
12.2.1 Switching technology ... 80
12.2.2 Transmission technology... 80
12.2.3 Access technology ... 81
12.3 Requirements of the optimised network... 81
12.3.1 Quality of service ... 82
12.3.2 Service equivalence ... 82
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13 Demand... 84
13.1 Demand in the access network... 84
13.2 Demand in the core network ... 84
13.2.1 Estimation of end-user demand ... 84
13.2.2 Estimation of dimensioned demand ... 85
14 Bottom-up modelling... 88
14.1 Equipment prices and cost data... 88
14.2 Modelling exchanges ... 89
14.2.1 The hierarchy of the exchanges ... 89
14.2.2 Choosing between different nodes ... 89
14.3 Modelling transmission... 91
14.3.1 Transmission hierarchy ... 91
14.3.2 Network configuration... 91
14.3.3 Dimensioning the network ... 92
14.4 Modelling access... 92
14.4.1 Collecting information by geo-types ... 93
14.4.2 Estimation of equipment requirements... 93
14.5 Modelling infrastructure ... 94
14.5.1 Trench in the core network... 94
14.5.2 Costing of trench ... 95
14.5.3 Duct ... 95
14.5.4 Poles ... 96
14.5.5 Cable requirements in the core network ... 96
14.5.6 Cable modularity and length... 97
14.6 Modelling co-location ... 97
15 Bottom-up costing issues ... 98
15.1 Indirect network costs ... 98
15.2 Overheads ... 98
15.3 Operating costs... 99
15.4 Cost allocation ... 100
16 Model functionality and documentation... 101
16.1 Model requirements ... 101
16.2 Sensitivity analysis... 101
16.3 Model documentation ... 102
Appendices... 103
Appendix 1 Summary of criteria ... 104
Appendix 2 Abbreviations used ... 117
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Appendix 4 Detailed list of services modelled or covered by LRIC... 126
A.4.1 Interconnection services... 126
A.4.2 (Wholesale) copper access services ... 126
A.4.3 Bitstream Access... 127
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1
Introduction and background
This Model Reference Paper (MRP) outlines the features and key principles applying to the bottom-up and top-down models to be developed with the purpose of producing a hybrid model and determining LRIC based cost for certain (wholesale) access and interconnection services in Sweden.
The 'LRIC method' refers to a method for the calculation of cost-orientated pricing that is
- based on the long run incremental costs for an efficient operator who makes use of modern technology, and
- includes a mark-up for common costs for an efficient operator under competitive conditions.1
The hybrid model shall be used, together with a pricing methodology approved by PTS, when PTS assesses whether the prices that TeliaSonera applies for
interconnection and LLU, including co-location products, satisfy the requirement regarding cost orientation.
During the years 2002-2003, PTS, together with operators, has produced an LRIC model, a 'hybrid model', for calculating the costs of interconnection in the fixed network and local loop unbundling (LLU). The first version of the hybrid model was approved on 19 December 2003.2 PTS has thereafter updated the hybrid model on an annual basis, resulting in the current version (v4.1) released in December 2006.
According to the PTS Regulations on the LRIC method for the calculation of cost-oriented pricing, PTS shall, at least every three years, review the need to revise the respective hybrid model. PTS shall then take into account, among other things, economic life, required return and the application of new technology. A review of the need to revise the hybrid model for the fixed network means that PTS needs to consult operators regarding a multitude of technical and financial issues. The consultation with the operators confirms that there is a need for revising the hybrid model.
PTS has decided to revise the Model Reference Paper as a prelude to preparing a revised bottom-up model and requiring the SMP operator to prepare a revised top-down model.
The revision of the hybrid model for the fixed network comprises:
- products and services in the access network that are covered by PTS's obligation decision on local loop unbundling: shared access, full access and co-location,
- interconnection services in the fixed networks that are covered by PTS's obligation decision on interconnection.
1 PTSFS 2005:5 PTS Regulation on the LRIC method for the calculation of cost-orientated
pricing.
2 LRIC, The final hybrid model, 19 December 2003.
http://www.pts.se/Archive/Documents/SE/LRIC-final_hybrid_model_191203_2003-45%20v3.pdf
Post- och telestyrelsen 2 The revision also includes the development of the hybrid model to produce cost calculations under the LRIC method for:
- products and services covered by PTS's obligation decision on bitstream access.
1.1 Policy and objectives
1.1.1 Policy
One of the mainprinciples in PTS policy for the access regulation of last mile networks is that infrastructure-based competition should be promoted when replication of infrastructure is feasible.3 To give the right investment signals and promote effective competition, the prices for interconnection and LLU should be based on the long-run incremental cost (LRIC) for an efficient operator. When the prices are determined on the basis of the LRIC-methodology infrastructure-based competition is promoted in those areas where it is efficient to have replication of infrastructures, while service-based competition is promoted in areas where replication of infrastructures is not efficient.
The hybrid model puts the policy into practice by creating neutrality in the choice between building your own infrastructure and paying for access to the SMP-operator’s infrastructure. Conditions for neutral incentives are created since the assumptions underpinning the hybrid model represent a balanced view on what it would cost for an efficient operator of TeliaSonera´s size to build and run a network today. Thus the assumptions take account both of those within the bottom up model, which are by necessity somewhat theoretical, and those in the top down model, that encompass some of the realities of TeliaSonera’s actual network.
1.1.2 Objectives
The objective of using LRIC are to:
• Encourage the use of existing facilities of the SMP operator where this is economically desirable, avoiding inefficient duplication of infrastructure costs by new entrants (incentive to buy);
• Encourage investment in new facilities where this is economically justified by 1. new entrants investing in competing infrastructure
2. the SMP operator upgrading and expanding its networks (incentive to build);
• Increase the transparency of the cost calculations underlying the access and interconnection charges; and
Post- och telestyrelsen 3 • Increase predictability for both the SMP operator and the other operators
with regards to future determination of access and interconnection charges. When access and interconnection charges are based on LRIC they do not distort the build/buy decision of new entrants – they will be encouraged to use existing facilities if, and only if, it is economically desirable to do so. Just as important, LRIC-based access and interconnection charges also mean retaining investment incentive for incumbents to upgrade or extend the existing network when new technology is available.
When charges are set on the basis of LRIC, infrastructure competition is encouraged in those areas where it is efficient to have competing infrastructure, whereas service competition is encouraged in those areas where the investment in competing infrastructure is not efficient.
1.2 Methodology
To send the right investment signals and promote efficient competition, prices should reflect the LRIC of an efficient operator facing the demand of the existing SMP operator (currently this means TeliaSonera)4. The efficient operator is defined as the theoretical operator that would exist if it were in a fully competitive market in Sweden, but with the same scope and demand of the existing SMP operator. This approach ensures that the economies of scale, scope and density are divided equally between the SMP operator and the interconnecting operators allowing the interconnecting operators to compete with the SMP operator on equal terms.
Ultimately, the cost results derived from the hybrid model will be based upon a fair comparison of the costs calculated in a top-down and a bottom-up model respectively.
The purpose of the top-down model is to calculate the LRIC on the basis of the existing network and cost structure of the SMP operator, eliminating inefficiencies and replacing outdated equipment with new, more cost-effective technology. The purpose of the bottom-up model is to calculate the LRIC on the basis of an efficient network using the newest technology actually employed in large-scale networks. In principle, the bottom-up model should model the network that an efficient operator would build today to meet the forward-looking demand of the SMP operator. The costs (if any) for migrating to the efficient operator from today’s operations are not included.
1.3 Process
The review of the hybrid model will observe the principles prescribed by PTS's Regulations.
This revised model reference paper sets out the guidelines and criteria for the modelling work. All guidelines set out as criteria as well as other guidelines should
4 These costs are likely to be different from the costs of an actual new entrant, entering the current
market, as the new entrant will not be able to achieve the same economies of scale, scope and density as the SMP operator when the SMP operator is already in the market.
Post- och telestyrelsen 4 be followed during the modelling work unless it explicitly appears that the text is of a guiding nature that the responsible modellers may choose to depart from. Other deviations require prior clarification with PTS. Upon finalisation of the revised models, PTS will undertake a thorough review of the two models to ensure that they meet the guidelines set out in this MRP.
TeliaSonera is responsible for developing a revised top-down model while PTS is in charge of developing a revised bottom-up model in co-operation with
interested parties from the industry, including TeliaSonera. A reconciliation of the two models will again be undertaken by PTS and used as the basis for PTS's development of a revised hybrid model on which the final price setting will be based.
A reconciliation report will be submitted to public consultation in order to seek opinions from the industry. The report will identify, quantify and where possible explain the differences between the two revised models. Also the revised hybrid model and PTS’s final proposed pricing methodology will be subjected to public consultations.
1.4 Document structure
The guidelines provided in the MRP are structured in three parts plus appendices:
• Part A includes common guidelines for the two models.
• Part B includes specific guidelines for the top-down model.
• Part C includes specific guidelines for the bottom-up model.
In part A:
• Chapter 2 discusses concepts involved in the definition of long run incremental costs.
• Chapter 3 describes the services that need to be modelled and the services that should be priced according to LRIC.
• Chapter 4 discusses the outputs of the two models including the level of detail. • Chapter 5 discusses a number of general costing issues such as depreciation
methodologies, cost of capital, working capital, and the use of routing factors. In part B:
• Chapter 6 provides an overview of the main steps involved in building a top-down model.
• Chapter 7 discusses the gross and net asset valuation of assets in the top-down model.
• Chapter 8 describes the calculation of working capital and allocation of operating costs in the top-down model.
• Chapter 9 discusses a number of the issues involved in the costing the access and interconnection services including the allocation of costs from cost categories to network elements (using cost volume relationships) and on to services (using routing factors).
Post- och telestyrelsen 5 • Chapter 10 sets out the requirements for the functionality, documentation and
audit of the model. In part C:
• Chapter 11 provides an overview of the main steps involved in building a bottom-up model.
• Chapter 12 discusses the level of optimisation in the bottom-up model including constraints such as the scorched node assumption.
• Chapter 13 describes how demand in the core and access network should be estimated and applied in the bottom-up model.
• Chapter 14 covers issues related to the estimation of equipment prices and specific guidelines for the modelling of exchanges, transmission and access network and infrastructure.
• Chapter 15 discusses a number of other costing issues such as the calculation of indirect costs, overheads, operating costs and working capital, and allocation of costs to network elements and on to services.
• Chapter 16 sets out the requirements for the functionality and documentation of the bottom-up model.
In the appendices:
• Appendix 1 includes a summary of criteria.
• Appendix 2 lists the abbreviations used in the MRP. • Appendix 3 presents a glossary of terms.
• Appendix 4 details the list of services included within the various Reference Interconnect Offers that should where practical be modelled.
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2
Long Run Incremental Cost
2.1 Definition of LRIC
In this section, the concepts involved in the definition of (forward-looking) Long Run Incremental Costs (LRIC) are discussed.
2.1.1 Long Run
Using a long-run measure of costs, such as LRIC, implies a time horizon where all inputs, including capital equipment, may vary in response to a change in demand. This means that the cost models should adapt all input factors to the forecasted demand for services respecting practicalities like minimum size of input and quality of service.
2.1.2 Incremental
Incremental costs are the costs caused by the provision of a defined increment of output given that some level of output (which may be zero) is already being produced. Equivalently, incremental costs can be defined as the costs avoided (i.e. saved) by not providing the increment of output.
For the purpose of interconnection charges, the increments have usually been defined as the entire group of services using the core (or access) network. These services (PSTN,5 Broadband, leased lines, etc.) include those provided by the SMP operator as well as those provided by interconnecting operators using the SMP operator’s network. The costs of the network providing this wider group of services are then divided by the total volume of demand (for example, number of subscribers, calls or traffic minutes, Gigabytes) in the increment to produce the average incremental cost or per unit LRIC6,7.
Figure 1 illustrates the concepts of incremental and average incremental costs:
5 For the purpose of this Model Reference Paper, PSTN should be considered to include both
PSTN and ISDN.
6 The terms LRIC and LRAIC (long run average incremental costs) are often used interchangeably. 7 This averaging does not imply that all the services included in the increment will be attributed the
same costs. It simply means that the costs of using a given network element will be the same for the included services. Services will use the network differently. As discussed in section 5.4.4, this will be taken into account through the use of so-called routing factors. Services may also have different cost drivers, such as subscribers, calls and minutes, or packets. Nor does the averaging imply that prices will need to be the same throughout the day. When setting interconnection charges, costs may also be "de-averaged" to a peak and an off-peak charge.
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Figure 1: Long Run (Average) Incremental costs
Fixed common costs Costs Volume Increment 1
Average incremental costs Incremental costs
2.1.3 Forward-looking costs
Costing systems can be backward-looking, forward-looking, or a mixture of the two. Backward-looking systems are based on the historic cost basis. They may contain outdated technologies and inefficiently incurred costs reflecting, for example, the costs of manpower required to maintain outdated technologies. Forward-looking costs are not the costs in the future but reflect the costs that a network operator, building a network today, looking forward, would incur. Costing measures should be forward-looking to reflect the true economic costs of producing an increment of output. In practice, however, there is likely to be considerable debate about the precise definition of forward-looking. Networks evolve over time with the result that the network of even an efficient SMP operator may look very different from the network design that would be used if starting from scratch (often referred to as a scorched earth assumption).
To make no allowance for the starting position of the operator could result in cost estimates, and therefore interconnection charges, that are too low. Such an
outcome would not provide the right incentives for SMP operators to invest in, and maintain, their networks. Moreover, other operators would have no incentive to invest in their own infrastructure, since they could immediately purchase the interconnection services from the SMP operator when an investment is
successful, while not paying for unsuccessful investments.
Therefore, the scorched node assumption discussed in section 12.1 should be applied. How forward-looking the models should be in their choice of technology is described in more detail in sections 7 and 12.2.
As mentioned, the forward-looking costs are the costs of building a network today, looking forward. "Looking forward" implies that the expected development in prices, first of all asset prices, and expected development in demand will need to be taken into account.
Finally, it should be noted that the models should model this optimised network as if it were already in place. No migration costs (additional costs associated with moving from the existing network to the optimised network) should be included.
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Criterion CG 1
The models should be based on forward-looking long run incremental costs. No migration costs should be included.
2.2 Definition of increment
2.2.1 Size of increment
In principle, there are an infinite number of different sized increments that could be measured. However, these increments can effectively be grouped into three different categories:
1. a small change in the volume of a particular service; 2. the addition of a whole service; or
3. the addition of an entire group of services.
The first definition of the increment is equivalent to a measurable version of marginal cost, that is the cost associated with a one-unit change in output. The second definition may apply to services of very different sizes, such as
interconnection, local calls and national calls.
In telecommunications regulation, the third definition of the increment is generally used to set interconnection charges. The use of large increments minimises the amount of common costs and ensures an equal treatment of the SMP operator's internal (on-net) and external (interconnection) traffic8.
2.2.2 Access and core increment
Two main increments are defined9:
• The access increment defined as all (regulated as well as unregulated) services using the access network
• The core increment defined as all (regulated as well as unregulated) services using the core network.
The incremental costs of the core are those costs incurred when adding a core network when an access network is already in place. Similarly, the incremental cost of the access network is the cost incurred when adding an access network when a core network is already in place. The LRIC of co-location is the cost incurred when providing co-location services.
8 When both the internal and external traffic is included, the cost of using a given network element
will be the same for internal and external traffic. This may not be the case if a separate increment is defined for interconnection services.
9 These definitions are consistent with the original definitions offered by the Commission in
Commission Recommendation on Interconnection in a Liberalised Telecommunications Market Part 1 – Interconnection Pricing, 15 October 1997..
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Criterion CG 2
For the core network, the increment should include all services using the core network. For the access network, the increment should include all services using the access network. The LRIC of co-location is the cost incurred in providing co-location services.
These definitions should include the services provided by the SMP operator’s network division to its own retail division as well as the services provided to other operators.
Costs in the core increment are driven by, for example, the volume of traffic, packets or calls, whereas costs in the access network are mainly driven by the number of subscribers. Costs are also driven by the quality of service (QoS), particularly in the core network. Until QoS is specifically charged for separately, it will need to be treated as a minimum requirement.
The access network is typically defined from the first connection point at the customer’s premises up to and including “the line card” (hereafter referred to as the access-core line card). Having said this, current developments in technology are now blurring the borderline between the access and core networks.
For PSTN services, the access-core line card can either be placed as part of the local exchange (often referred to as Host Subscriber Stage - HSS) or away from the local exchange (often referred to as Remote Subscriber Stage - RSS). For leased line services, the access-core line card will be placed as part of the
transmission equipment at the first node (ie the serving node), and for broadband services, the access-core line card placed as part of the DSLAM, which might even be placed in a street cabinet.
For Remote Multiplexers (RSMs) locations the situation is not so clear cut. In some cases, the RSM was installed to replace an old analogue exchange and in others has been used merely as a work-around for a lack of copper in the access network. In either case, there will also be a line card at the RSS/HSS and so there is an option for the access/core demarcation to be deemed to occur at either the line card of the RSM (in which case the RSM would have the access-core line card) or the line card of the RSS/HSS (in which case the RSS/HSS would have the access-core line card). Potentially, therefore, each RSM location needs to be treated on its own merits, with factors taken into consideration including:
• the historical reason for the RSM deployment • the number of connected customers
• the existence (or not) of other equipment at that location (particularly DSLAMs)
• the physical distance from the RSM to the next equipment location
The access-core line card should be included in the access network, as the number (and thus costs) of such line cards are related to the number of lines rather than the amount of traffic (whether minutes, calls, or packets). The cost of the line card should therefore be included in the cost of access services. However, the
Post- och telestyrelsen 11 access-core line card(s) should be excluded from the costs of unbundled local loops, as the line card is not used in the provision of this service.
Criterion CG 3
The access-core line card (typically, though not necessarily, for the PSTN located in the concentrator) should be included in the access network, whereas other equipment related costs should be included in the core network, except where costs are common between the two networks. The access-core line card(s) should be excluded from the costs of unbundled local loops but included in the costs of the access service it relates to (such as telephone line rental for a PSTN line card, broadband access for a DSLAM line card etc.).
2.2.3 Other increments
Other potential increments include a retail increment for the access and core networks; an international increment; an increment for premium rate services; an increment for the mobile network; and an increment for other services:
Retail Increment. The costs referred to for the access network and core network are
wholesale costs. They exclude any costs incurred in packaging and selling services delivered over these networks to final customers, as opposed to wholesale
customers. Such costs include marketing and customer billing costs, customer service costs and retail elements of the finance and human resources departments, land and buildings. These costs belong in the retail increment.
International Increment. This increment covers the costs of the transmission links
between tandem and international exchanges as well as the cost of international exchanges and assets at these exchanges. International calls will typically use both the core increment and the international increment.
Premium Rate Services Increment. Premium rate services include toll free (0800) phone
calls and various information services which can be accessed at premium rate charges. These services may require a separate network of switches (in which additional transmission assets will be required) or may be delivered over existing switches.
Mobile Increment. Assets included in this increment include the base stations,
base-station controllers, mobile-switching centres and transmission links required by the mobile network.
“Other” Increment. The SMP operator may provide a range of other services, such
as the provision of customer premises equipment, and may have investments in other companies either at home or abroad.
These increments will not need to be modelled separately. However, the
associated traffic, using the core and access network, needs to be included in the core and access increment. Also the core and access increment may share costs with these other increments. For example, the international switches and mobile switches will often be co-located with the PSTN switches. Where this is the case, a fair proportion of the building costs (and other common costs) should be allocated to the mobile and international increment respectively. Similarly, the cost
Post- och telestyrelsen 12 of the head office function should have a portion allocated to overseeing any investments in other companies.
2.3 Cost Causality
The definition of the access and core increments set out in section 2.2.2 implies that fixed costs10 that are specific to either the core or access networks are included in LRIC.
To the extent practical, costs (both capital costs and operating costs) should be allocated to services on the basis of cost causality. This might be on either a direct or indirect basis. A good example of how this might apply in practice is to consider the issue of trench, duct, cable and fibre where, as a starting point:
• Trench should be allocated on the basis of duct • Duct should be allocated on the basis of cables
• Cables should be allocated on the basis of system lines (fibre pairs connecting distant items of transmission equipment)
• System lines should be allocated on the basis of usage, where necessary taking account of usage translation techniques (for example, translating voice minutes into Mbps)
The above example assumes that the network is constructed in an efficient manner and does not, without good, justifiable reasons, separate services such that not all services attract a fair proportion of cost.
We distinguish here between three types of costs: Directly attributable costs, shared costs and common costs.
Directly Attributable Costs are the costs incurred as a direct result of the provision of
a particular service in a particular increment. These costs fall into two types. Firstly, the costs of some inputs vary with the level of output, so that even if the output of more than one service requires this input, the extent to which a single service causes the costs can be calculated. Secondly, there are assets and operating costs which are fixed with respect to the level of output but which are service specific.
Shared Costs are the costs of those inputs necessary to produce two or more
services within the same increment, where it is not possible to identify the extent to which a specific service causes the cost. Examples of shared costs in the core network include optical fibre, transmission equipment and related overheads, all used by PSTN, leased line and other services
Common Costs are the costs of those inputs necessary to produce one or more
services in two or more increments, where it is not possible to identify the extent to which a specific increment causes the cost. Trenching costs provide a good example of the difference between shared and common costs. The costs of trenching specific to the access network (or the core network) will generally be shared costs since the trenching is likely to be used by two or more services.
Post- och telestyrelsen 13 However, some trenching will be used by both the access and the core network. In these instances, the costs will be common costs. Another example of common costs is corporate overheads.
Figure 2: Cost concepts
Access Network Costs Core Network Costs
Attributable costs in the access network (e.g. line card) Shared costs in the access network (e.g. trench in the access network)
Common costs
(e.g. trench shared by access and core)
Shared costs in the core network (e.g. trench in the core network, ADMs etc.) Attributable costs in the core network (e.g. tandem exchange)
Figure 2 illustrates the relationship between directly attributable, shared and common costs. The first definition of the increment discussed in section 2.2.1 would only include some of the directly attributable costs in the core and access networks. The second definition would include all directly attributable costs. But the variant of the third definition taken to be the increment for LRIC purposes would include all directly attributable and shared costs in the core and access networks. Only common costs would be excluded.
Criterion CG 4
To the extent practical, costs (both capital costs and operating costs) should be allocated to services on the basis of cost causality. This assumes that the network is constructed in an efficient manner and does not, without good, justifiable reasons, separate services such that not all services attract a fair proportion of cost.
2.4 Treatment of common costs
The large proportion of fixed common costs in telecommunications means that setting interconnection charges equal to incremental costs does not allow the SMP operator to recover the costs that span increments, even when those costs are efficiently incurred.
However, setting interconnection charges “based on” (but not “set at”) LRIC permits recovery of efficiently incurred common costs. This can be achieved via the use of mark-ups, where, for example, the LRIC of each increment is marked
Post- och telestyrelsen 14 up by an equal proportion so as to recover (but not over-recover) the common costs.
Criterion CG 5
The models should allow recovery of common costs. These costs should be shown separately.
Criterion CG 6
The models should identify the costs that are common between the other increments and the core and access networks.
2.4.1 Allocation of common costs
As defined above, common costs are the costs of those inputs necessary to produce one or more services in two or more increments, where it is not possible to
identify the extent to which a specific increment causes the cost. The allocation of such
common costs will therefore always be somewhat arbitrary. Otherwise the common costs would not really be common and should instead be allocated directly to the increment. Common costs are therefore typically allocated using some sort of mark-up11.
Before turning to the description of mark-ups, it should, however, be underlined that broad mark-ups should only be used where it is not possible to establish a clear causal relationship between costs and services/increments. In many
instances it will be possible to establish such a relationship by carefully examining the direct and indirect costs drivers12.
Exchange buildings, for example, might at first sight be considered a common cost, as they are used to provide both access and core services. It would however, be inappropriate to allocate the total costs of exchange buildings on the basis of simple mark-ups. The costs of exchange buildings are to a large degree driven by the number of square meters required by the equipment installed in the buildings. Most of the equipment in the exchange building is core related. Only the
distribution frame and part of the subscriber stage are access related. It will therefore be possible to allocate most of the building costs to the core network, e.g. on the basis of the occupied square meters.
Mark-ups can be either additive or multiplicative and similarly be either differentiated or uniform. A (uniform) additive mark-up implies that common costs are divided by the number of increments and the resulting total is added to each increment (thus, if common costs were 2,000, 1,000 would be added to both
11 It may be noted that a price based on LRIC + mark-up for common costs will lie between LRIC
and the so-called stand-alone costs (SAC), which are the costs of producing the increment, assuming no other increments were produced. A price set at SAC would correspond to allocating all the relevant common costs to the increment, whereas a price set at LRIC would correspond to not allocating any of the common costs to the increment.
12 Some underline this point by using the term “residual common costs” instead of common costs
Post- och telestyrelsen 15 the core and access increments). An additive mark-up implies that the allocation of common costs is independent of the costs of the various increments.
A multiplicative mark-up implies that common costs are split in relation to the relative level of incremental costs of each of the increments. For example, if the incremental cost of access is 75% of total incremental costs and the incremental cost of core is 25% of these costs, then the access increment would be allocated 75% of common costs and the core increment 25% of these common costs. This means that if LRIC for the access network is 15,000 and LRIC for the core network is 5,000 and commons costs are 2,000, the mark-up will be 10% (2,000/ (15,000+5000)). Thereby 1,500 (=0.1x15,000) of the common costs are allocated to the access network and 500 to the core increment. Multiplicative mark-ups are sometimes referred to as equi-proportionate mark-ups.
An alternative approach would be to calculate differentiated mark-ups. That is to say the mark-up as a proportion of incremental cost would vary between services. There are at least two potential rationales for using differentiated mark-ups. Firstly, differentiated mark-ups could be used to encourage entry or to ensure that common costs are not assigned to increments that are not prone to competition.13 Having said this, differentiated mark-ups could well be not allowed under
established regulatory practice.
Secondly, differentiated mark-ups may be used to reflect the fact that services have different demand elasticities. So-called “Ramsey mark-ups” are determined on the basis of demand elasticities. Where a service has a high elasticity, the mark-up should be low, because changes in price have a significant impact on
purchasing patterns thereby distorting market signals. The converse is the case where elasticities are low.
From an economic point of view, a Ramsey mark-up is the theoretically correct way to efficiently recover the common costs, ensuring that resources are put to their best possible use. Indeed, it can be shown that a profit maximising company operating in a competitive market would also set its prices in this way.
Ramsey pricing, however, has a number of weaknesses when implemented in practice. First of all, price elasticities are very difficult to estimate and verify. This is of special concern since an operator operating in both competitive and
regulated markets will have a strong incentive to attribute a disproportionate amount of the common costs to the regulated products. Price elasticities would also be likely to vary over time, with price, and be dependent on the level of competition in various segments of the market. Also multiple price elasticities could occur depending on the intended use of the product. The method therefore faces a number of operational difficulties14.
13 See footnote 11 in the Commission's recommendation on interconnection in a liberalised
telecommunications market (98/C84/03) and point 696 in FCC's "First Report & Order in the Matter of Implementation of the Local Competition Provisions in the Telecommunications Act of 1996".
14 Proper Ramsey mark-ups would also take into account the impact of cross-elasticities and
externalities. This could significantly improve the allocative properties of the resulting prices, but would also add to the complexity of the analysis and the associated data requirements
Post- och telestyrelsen 16 Secondly, it may seem unfair that consumers should bear a larger burden of the costs just because they are so dependent on provision of the services or have so few alternatives that their demand is not very sensitive to the price. Finally, it is not always clear how to estimate demand elasticities for access and
interconnection services, since these services are sold to other operators reselling and re-packaging the services to end-users with very different demand elasticities.
Criterion CG 7
As far as possible, common costs should be allocated to increments and services using appropriate (direct or indirect) cost drivers. Only common costs, for which it is not possible to identify the extent to which a specific increment or service causes the costs, should be allocated via mark-ups. The starting point should be equi-proportionate mark-ups. The models should allow for equi-proportionate mark-ups to be used for all cost categories. It is possible that there could be instances where there might be good reasons for departing from equi-proportionate mark-ups. However, if this is the case, it must be properly justified in the model documentation.
Post- och telestyrelsen 17
3 Services
modelled
Telecommunications operators typically carry a wide range of services across their networks. In addition to the traditional voice services, operators provide leased lines, broadband and other data services, and other services such as cable TV. The models need to account for all of these services. To exclude some would result in an under-dimensioned network and increased costs for the remaining services as costs, such as ducts, would be allocated to fewer services. Therefore more services need to be modelled than the actual number of services that should be priced on the basis of LRIC. Appendix 4 includes a detailed list of the RIO (Reference Interconnect Offer) services.
The models should include and categorise services under the following headings: • Core and access services
− PSTN/ISDN services
− Broadband services (including Bitstream access) − Leased lines; and
− Other services • Co-location services
3.1 Core and access services
3.1.1 PSTN (PSTN/ISDN) and Broadband services
PSTN services include standard call services that originate and terminate on exchange lines, whereas broadband services include both retail and wholesale (Bitstream) services.
Post- och telestyrelsen 18
Table 1: List of standard PSTN/ISDN and Broadband services
Core Access
National calls PSTN Line Rental
- FO15-internal calls ISDN 2 Line Rental
- FO-external calls ISDN 30 Line Rental
International calls – Inbound Wholesale Line Rental**
International calls – Outbound Shared Access**
International calls – Transit Full Access**
Fixed to mobile calls Other Access (including fibre and wireless
technologies)** Mobile to fixed calls
IN services Broadband
Mass call services
Internet dial-up (network product) Retail broadband Interconnection - double segment (double
tandem) Bitstream access
Interconnection - region segment (single tandem)
Interconnection - metro segment Interconnection - local segment Interconnection - single transit Interconnection - double transit Interconnection - international call Operator Services
Other calls
** Where the demand for these services has not been included in other categories, such as PSTN or ISDN line rentals. The purpose is to estimate demand for all access lines, avoiding double counting.
Criterion CG 8
The models should include all standard PSTN/ISDN and Broadband services.
3.1.2 Leased lines
To ensure that the volume information in the top-down and bottom-up models is consistent, the leased lines should be defined in a uniform way ensuring
compatibility between the models.
Leased lines may thus be classified in the three following groups:
15 Förmedlingsområde, or transit area. An FO internal call covers calls up to and including those
using a single transit switch, whereas an FO external call covers calls using more than one transit switch.
Post- och telestyrelsen 19 • retail customers, usually requiring leased lines to provide a permanent connection
between customer premises;
• other operators, usually requiring leased lines to provide a permanent connection between networks;
• network operators, requiring leased lines for internal use.
In addition to this, SMP operators may carry data or other services over leased lines. Such services should be modelled and shown separately.
Criterion CG 9
When dimensioning the network, the leased lines traffic volume should include leased lines provided to retail customers, to other operators and to the network operator itself.
The models will not need to calculate the costs of leased lines explicitly. Leased lines should only be included for dimensioning the network and for ensuring that a fair amount of the costs shared with PSTN and Bitstream services are allocated to leased lines services.
3.1.3 Other services
Demand for other services using the core and access networks should also be included to ensure that the core and access increments are dimensioned properly. Inclusion of this demand will allow a fair distribution of shared and common costs. Cable television, Virtual Private Networks (VPN) and packet-switching technologies such as frame relay are examples of these services.
Criterion CG 10
Where possible, the models should categorise the “other services” into two major groups:
• one category comprising for example cable TV services, IP TV
services and other services using their own “non-telecommunications” electronic equipment.
• one category comprising non broadband data services (by type) using
the core network.
It is not the purpose of the models to calculate the LRIC of these services, but only to ensure that a fair proportion of costs is attributed to these services.
3.2 Co-location services
3.2.1 The nature of co-location services
Co-location enables the placement and operation of telecom equipment in buildings housing technical plant. Co-location services provide access to the infrastructure of these buildings such as power supply, cooling, ventilation, security, and common amenities.
Post- och telestyrelsen 20 From a modelling point of view, no network modelling is required in order to model co-location services. What has to be modelled is the cost incurred by producing the co-location services.
Co-location may be relevant in relation to switched interconnection, access to unbundled local loop, or for other purposes. However, only the co-location services related to access to the unbundled local loop are to be priced on the basis of LRIC.
Despite this, the co-location services to be modelled in the top-down and bottom-up models may include more services than only the services which are to be costed according to LRIC principles. The reason behind the inclusion of more services is that some of the costs that make up the LRIC-specific co-location services are shared with other co-location services (i.e. co-location in relation to switched interconnection or "tele hotels"), services in the access network, and services in the core network. Examples of such shared costs may be the cost of accommodation, power supply, cooling/ventilation, and also the cost of administrative and technical staff.
On the other hand, some co-location services include only co-location specific cost categories, such as racks and cables. In this case, only the services related to access to the local loop (that are to be costed according to LRIC principles) have to be modelled.
Last, the costs of power consumption used by electronic equipment and
cooling/ventilation can be attributed directly to relevant co-location services on the basis of the unit price paid to the power supplier.
3.2.2 List of co-location services covered by LRIC
According to Skanova’s co-location agreement, co-location includes the following services:
• Fee for tenders
• Location of equipment • Transportation of equipment
• Installation and mounting of equipment • Station wiring
• Placing
• Power, cooling and ventilation • Demonstration of co-location node
In Skanova’s co-location agreement, a number of service variations are listed for each of these services. The variations are associated with different prices. The reason may be that different costs are incurred for the different service variations. The models should model the cost of all service variations set out in Appendix 4.
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3.3 Demand and growth
3.3.1 Demand
Although costs should be allocated to the total amount of traffic using the network, the network should be dimensioned to carry the traffic in the "busy hour" subject to the required QoS. The busy hour may vary between the different parts of the network.
Criterion CG 11
The models should identify busy-hour information for traffic. The models should be flexible enough to allow for changes in these figures.
3.3.2 Margins for growth
The modelled network should be able to meet the demand not only in the base year but also in the foreseeable future. It will therefore be necessary to develop forecasts for the development in demand. The network dimensioning should correspond to what an efficient operator facing these forecasts would do. Whereas margins for growth will typically be implicitly incorporated in the top-down model via the existing network, margins for growth will need to be modelled explicitly in the bottom-up model. The models may use different planning periods for different parts of the network. Forecasts for growth should be specified for each set of services.
Criterion CG 12
The network dimensioning should correspond to what an efficient operator facing the forecasted demand would do.
The models should show the anticipated Cumulative Annual Growth Rate (CAGR) for each service for a five year period, following the base year, 2006. The models should allow for a change in the margins for growth.
The models should use the following planning horizons as a starting point: 5 years for the access network and infrastructure in the core network; 3 years for exchange equipment; 3 years for transmission
equipment; 3 years for backhaul broadband equipment (core routers etc); and 1 year for DSLAMs. For line cards a 1-year planning horizon should be used as the starting point. If different planning horizons are used, this will need to be justified.
Post- och telestyrelsen 22
4 Model
outputs
This chapter outlines the types of outputs that both models should provide and sets out the level of detail for which costs should be shown. The treatment of co-location, shared access and Bitstream access receives particular attention.
It is important that the top-down and bottom-up models produce comparable results at different levels. The reason for this is twofold.
• First, in order to compare the cost of network elements and ultimately the cost of interconnection, access and co-location services; and
• second, in order to go beyond the network elements to compare variables such as utilisation rates, volumes, direct network costs and operating costs. If this objective is realised, it will lead to a more efficient reconciliation process.
4.1 Cost types
Costs should be broken down into three types in terms of the way they relate to the network:
• direct network costs, such as processors, ports, multiplexers, duct, and fibre; • indirect network costs, such as power, accommodation, network management and
maintenance; and
• overheads, such as the personnel department.
Network costs measure the costs of those inputs necessary for the network to run. They can be divided between direct and indirect network costs. A direct
network cost is defined to be one where the level of inputs, and therefore the cost,
depends on factors exogenous to the network, such as the level of demand. For example, the number of line cards, and therefore their total cost, will depend on the number of subscribers. In contrast, an indirect network cost is one where the level of inputs and hence cost depends on choices made concerning other inputs, and therefore only indirectly on external factors such as the level of demand. An example is racks, since the number and size of necessary racks will depend on the choices made concerning ports and line cards.
The types of network costs included in the models will depend on the technology and configuration modelled. Therefore, it is not possible to provide a complete list. A top-down model can determine these costs explicitly as can the bottom-up model, although the bottom-up model may in some cases need to estimate them by using mark-ups.
Overheads (also referred to as common business costs) cover those costs that are
not necessary for running a network, but must nevertheless be incurred by the company running the network in order to function.
4.2 Level of detail
Some aggregation of costs is desirable to make the models manageable, but this aggregation should be limited to ensure that the models provide a detailed
Post- och telestyrelsen 23 breakdown of costs. This is important, since the reconciliation process requires the models to be transparent.
4.2.1 Cost categories
The cost categories that fall under the heading of direct network costs should be sufficiently disaggregated so that each cost category has only one cost driver. For example, a local switch consists of both ports and processors, and thus, its costs depend on call minutes and call attempts. Therefore, there should be two cost categories, the costs of ports and the costs of processors, instead of a single cost category measuring the cost of local switches.
Criterion CG 13
Cost categories should, as far as possible, be identified to obtain only one exogenous cost driver for each category.
The models should identify operating costs and asset costs separately. Only those operating costs necessary to bring an asset into working for its intended use, such as transport, installation and commissioning should be capitalised. Other
operating costs should be included in separate cost categories.
Criterion CG 14
Costs related to assets can include capitalised operating costs when there is a rationale for it. These costs should be shown separately in the
documentation.
As stated in the previous section, it is difficult to provide a complete list of cost categories to be modelled without knowing exactly the technology and
configuration modelled.
4.3 Cost of co-location
Experience shows that the costs of co-location services produced in top-down and bottom-up models respectively may be difficult to reconcile. There may be three main reasons for this difficulty. First, cost categories may be different. Second, the models may apply different units of measurements, which are not easily convertible for reconciliation purposes. Finally, costs may be expensed in one model, whereas the same costs are annualised in the other model and vice versa.
Reconciliation of co-location costs may be eased if modelling guidelines are more precise on these main issues – the cost categories, units of measurement and whether costs should be expensed or annualised.
Hence, this MRP provides detailed guidance on these issues.
The cost categories which are regarded common to both co-location and other services in the core and access network are:
• Land and buildings (annual costs);
Post- och telestyrelsen 24 • Security systems, fire surveillance, etc. (one-off and/or annual costs);
• Power supply (annual costs); and • Cooling/ventilation (annual costs).
The above cost categories, which are common to both co-location and other services, may be distributed among the relevant services once the costs are estimated. Costs should be distributed according to an appropriate cost driver. For the cost categories that relate to space, an appropriate driver will be the number of square meters occupied by the equipment associated with particular services. For the cost categories that relate to power, an appropriate key may be the power and cooling/ventilation requirement measured in Watts. The power and cooling/ventilation requirement may be too difficult to estimate, however. A proxy could be the number of square meters occupied by the equipment
associated with particular services.
Where appropriate, costs in the common cost categories should be allocated between services according to square meters occupied. The SMP operator should co-ordinate with PTS to ensure that the common cost categories are allocated using the same principle in both models.
The cost categories which are regarded as being specific to the co-location services related to unbundled local loop - and therefore should be costed according to LRIC principles - are:
• Administrative staff (one-off costs and annual costs); • Technical staff (one-off costs);
• Racks (“ETSI-skåp”) (one-off and annual costs);
• Co-location specific power supply inclusive power consumption (one off and annual costs);
• Co-location specific cooling/ventilation (one-off and annual costs); and • Cables (one-off and annual costs).
Note that power supply and cooling ventilation are included in the co-location specific cost categories as well as the common cost categories. The reason is that some of the costs associated with power supply and co-location are only incurred for specific co-location agreements.
Criterion CG 15
The modelled co-location services should include the following cost categories common to both co-location and other services in the core and access network:
• Land and buildings (annual costs);
• Site preparation and fit-out of buildings (one-off and/or annual costs); • Security systems, fire surveillance, etc. (one-off and/or annual costs); • Power supply (annual costs); and
Post- och telestyrelsen 25 • Cooling/ventilation (annual costs).
The specific co-location services to be costed include:
• Administrative staff (one-off costs and annual costs); • Technical staff (one-off costs);
• Racks (“ETSI-skåp”) (one-off and annual costs);
• Co-location specific power supply inclusive power consumption (one
off and annual costs);
• Co-location specific cooling/ventilation (one-off and annual costs);
and
• Cables (one-off and annual costs).
Each cost category should include one-off and annual costs as shown above.
4.4 Costs of shared access to unbundled local loop
Shared access to the unbundled local loop implies that the other operator gains access to the high frequency band of the copper pair whereas the SMP operator continues to use the lower frequency band for providing PSTN services16. A large amount of the costs, in particular the costs of the copper pair, will be shared between the PSTN and shared access service. It is important that the models distinguish between these shared costs and those which are directly attributable to the two services.
Criterion CG 16
The models should distinguish between the costs that are specific to PSTN services, costs that are specific to shared access, and the costs that are shared between the PSTN services and the shared access service. The additional cost of shared access (compared to PSTN) should be shown as a separate output of the models.
Shared access, full access, PSTN subscription and Bitstream access (discussed below), are naturally closely linked together. It is important to ensure consistency between the included network element costs. The total annualised cost of the actual copper pair might be considered to be the same whether it is used for providing PSTN services, full access, shared access or PSTN services plus Bitstream access. On the other hand, a case might be made for separating out copper pairs that are too long for broadband or those on nodes that do not contain a DSLAM from the remainder of the copper pairs.
How the shared costs are allocated between the services for the final price setting is a different issue. Costs that are specifically caused by full access, shared access
Post- och telestyrelsen 26 or Bitstream access, such as frequency planning, should be allocated to these services.
Raw copper used for xDSL and other services may need to be of a better quality than copper used for PSTN services. Where this is explicitly considered in the models, other differences such as a shorter average loop length would also need to be taken into account
Criterion CG 17
The total annualised cost of the actual (raw) copper pair should as a starting point be the same whether it is used for providing PSTN services, full access, shared access or Bitstream access plus PSTN services. If it is decided to cost Bitstream capable copper pairs separately from non-Bitstream capable copper pairs then this must be justified and documented.
.
4.5 Cost of Bitstream access
The models should be capable of calculating the cost of Bitstream access.
Bitstream access allows other operators to provide Internet access to end-users by using ADSL transmission on the existing copper pair used for PSTN services. Instead of installing their own equipment, operators use the existing DSLAM equipment of the incumbent (SMP) operator.
The Bitstream access service will normally include:
• Lease of capacity on the copper (similar to shared access);
• Lease of capacity in the SMP operator's DSLAM;
• Transport of traffic from the DSLAM to the nearest point in the SMP operator's network available for Bitstream interconnect.
The service might also include installation of the ADSL filter at the customer's premises. In order to use the service, the other operator might also need to have a separate agreement regarding connectivity between the first available interconnect point and the other operator’s required interconnect point (e.g. using a Virtual Private Circuit or VLAN). Figure 3 provides a schematic illustration of Bitstream access. The figure is only included for illustrative purposes and relates to ATM-based DSLAMs rather than those with Ethernet-ATM-based backhaul.
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Figure 3 Bitstream access
ADSL modem NTP Line PSTN ADSL filter MDF Splitter RSS/HSS DSLAM PSTN ATM network Other operator premises Leased line ATM VPC POI Data Exchange building Customer premises Criterion CG 18
When modelling the cost of both shared and full Bitstream access, the models should be able to distinguish between the costs of: Capacity on the copper; capacity in the DSLAM; and transport of traffic from the DSLAM to the nearest point in the SMP operator's network available for Bitstream interconnect. The costs of the modem at the customer's premises, and any costs related to installation of a filter at the customer’s premises, should not be included in the cost of Bitstream access and, if included within the modelling, should be shown separately. The
additional cost of Bitstream access (compared to PSTN) should be shown as a separate output of the models.
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5
General costing issues
This chapter discusses a number of general costing issues relevant for both
models, such as annualisation, cost of capital, geographical differentiation of costs, working capital, base year, distinction between set-up and duration related costs and the use of routing factors.
5.1 Annualisation methodologies
5.1.1 Annualisation criteria
Three criteria should guide decisions on the appropriate approach to modelling the annualisation charges for the various assets:
• Accuracy; • Consistency; and • Tractability.
An accurate annualisation charge should have a profile which reflects the expected levels and changes in replacement costs, obsolescence, operating costs, output levels, asset productivity, the cost of capital and the asset life.
Consistency requires that annualisation charges should be set in such a way that
there are no arbitrage opportunities available for purchasing assets at certain stages of their lives. Where the output produced by the asset is constant,
consistency requires that the sum of the annualisation charge and operating costs of an asset purchased in Year t will be the same in Year t+1 as if the asset had been purchased in Year t+1.
Tractability means that there is sufficient information to calculate the annualisation
charge using the chosen approach.
The annualisation charge consists either of a capital charge and a depreciation charge or alternatively a combined annuity charge.
5.1.2 Capital charge
The capital charge is simply the cost of capital (the required rate of return on capital) multiplied by the average value of the asset for the year being reviewed. It reflects the costs of having capital tied up in the fixed assets, thereby not being able to use it for alternative purposes. Assuming the cost of capital is 10 per cent, the capital charge for an asset worth 1000 at the start of the year and 900 at the end of the year would be 95.
5.1.3 Depreciation charge
The depreciation charge should reflect the change in the asset value during the year being reviewed.
The depreciation can be determined using a number of different methodologies:
• Economic depreciation;