Our proposals
A7.179 The LLCC model forecasts the costs of components which make up the TI and AI basket of services. However, BT’s definitions of these cost components are narrow. That is, AI services only use AI cost components and TI services only use TI cost components. 32
A7.180 With the cost components as currently defined, this means that declining services will see an increase in unit costs, since the fixed costs need to be recovered from a reducing volume of services. This then implies a need to increase unit prices. Similarly, growing services will see a decline in unit costs and a stronger need to reduce prices. We think this understates the potential for assets to be re-used as migration occurs, and therefore does not reflect what would happen under normal operating conditions.
A7.181 In the December Consultation we proposed to re-allocate non-marginal costs at the aggregate TI and AI basket level. The purpose of this re-allocation is to allow a greater proportion of the non-marginal (i.e. fixed) costs to be recovered from AI services as volumes grow, and at the same time, avoid rapid increases in TI unit costs as their volumes decline. This follows the recommendation made by Analysys-Mason in their independent review of the LLCC model.
A7.182 Analysys-Mason’s suggested approach is based on an analysis of the marginal costs of components and the attribution of non-marginal costs in proportion to these. This results in a greater proportion of non-marginal costs being recovered from AI services as the volume of these grows and avoids the rapid increases in TI unit costs which would result from a constant amount of fixed costs being recovered from an ever-smaller volume of TI services.
A7.183 In practice, in order to implement the Analysys proposal, we developed a method of re-allocating non-marginal costs at the aggregate TI and AI basket level. This approach was described in detail in Paragraph A9.82 to A9.86 of our December Consultation and therefore not reproduced here. This approach is consistent with the spirit of the Analysys method and is reasonable given that we are calculating the value of X based on the total basket level costs, rather than at an individual service level. This approach resulted in 75% of the fixed costs being re-allocated from the TI basket into the AI basket.
Consultation responses
A7.184 BT expressed concern that this could have a negative impact on the incentive for customers to migrate onto other services. However [BT] accepted, that the extent to which this is offset by a lower control on AI services means that, overall, fixed costs should be recovered across both baskets combined.
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For example a 34/45 Mbit/s local end service uses one 34/45 Mbit/s local end component. This component is not used by any other service. The costs of this component include around 34% fibre, 20% duct and the remainder made up of various other assets (the percentages are based on the proportion of the gross replacement costs of the assets apportioned to this component) and operating costs. In the event of service volumes declining, so will the associated volume of this component resulting in a material increase in the unit cost. However the fibre and duct can be utilised to provide other services and therefore these costs can be recovered elsewhere.
A7.185 Another respondent noted that the proposed re-allocation of fixed costs from TI to AI services would not be required if the charge controls were set using a LRIC + EPMU approach. They therefore strongly encouraged Ofcom to set charge controls on the basis of LRIC + EPMU. However, in the event that Ofcom proceeds with its proposed methodology, they believed that it is necessary to re-allocate fixed costs from the TI services to the AI services.
A7.186 Most other stakeholders agreed with our proposals, whilst some made no comments regarding our approach or our proposals.
Our response
A7.187 A summary of our high-level responses are provided in Section 4 paragraphs 4.254 to 4.263.
A7.188 The need to re-allocate non-marginal costs between the TI and AI baskets arise from the fact that there are no cost components that are common between the AI and TI baskets.
A7.189 As a result, as TI services decrease (see Figure A7.17) the costs are being recovered through a smaller volume of services. Similarly, as Ethernet volumes increase, total service costs are being recovered through greater volumes, leading to a sharp decline in unit costs.
A7.190 We believe in a normal operating environment some of the underlying assets can be, and would be, re-used by expanding services. Without common cost
components, we have to determine the proportion of costs to re-allocate from the TI basket to the AI basket. This implies that non-marginal costs continue to be
recovered from both the TI and AI baskets.
Figure A7.17 Comparison of profiles of costs and volumes for TI and AI baskets without cost re-allocation
0 50 100 150 200 250 06/ 07 07/ 08 08/ 09 09/ 10 10/ 11 11/ 12 12/ 13 06/ 07 07/ 08 08/ 09 09/ 10 10/ 11 11/ 12 12/ 13 In d e x ( 20 06 /0 7 = 1 00 )
Pay opex Capital costs Non-pay opex Volume index
TISBO AISBO
A7.191 We have considered different approaches to cost re-allocation:33
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Source: Office of Fair Trading, “Background to cost allocation”, July 2005.
Table A7.14 Common approaches to cost allocation
Method Description Applicable to LLCC?
Equi- proportional mark-up
Common costs attributed in proportion to the direct and indirectly attributable cost of the service
Yes. Can attribute relative to TI and AI marginal costs as a proportion of total marginal