06.03.30 Optus submission ULLS undertaking 2006 Public ver… · PIE 2 model contains fundamental flaws that mean it is not fit for purpose for price setting. ... warrant an increase

Optus Submission to

Australian Competition and Consumer Commission

on

Telstra’s ULLS Undertakings

Public Version

March 2006

Page ii

Table of Contents

1. Executive Summary ............................................................................................... 3

2. Averaging of ULLS prices..................................................................................... 5

3. Appropriate cost recovery method for ULL-specific costs ................................ 6

4. ULL Network Costs ............................................................................................. 12

5. ULL specific cost inputs ...................................................................................... 13 Capital expenditure ............................................................................................................ 14 Operating costs associated with IT projects....................................................................... 17 Costs of the front-of-house connection group.................................................................... 18 Wholesale product management costs ............................................................................... 19 WACC ............................................................................................................................... 20 Period of recovery for capex from between 1999-2000 and 2004-05................................ 22

6. Risk of double dipping by Telstra ...................................................................... 24

7. PSTN related costs ............................................................................................... 24

8. Network modernisation provisions..................................................................... 25

1. Executive Summary

1.1 On 23 December 2005, Telstra lodged an Unbundled Local Loop service (ULLS) undertaking with the ACCC, which proposes to set monthly rental charges for ULLS through to 30 June 2008 at $30 irrespective of the geographic location of the service.

1.2 Optus strongly believes that Telstra’s undertaking should be rejected on the basis that the prices exceed the costs that would be incurred by an efficient, forward looking operator. This undertaking is not consistent with the regulatory criteria set out under s152AH of the Act.

1.3 Optus notes that notwithstanding the fact that Telstra’s December 2004 undertaking proposed de-averaged ULLS prices, an approach that had universal industry support, Telstra has chosen to set prices on an averaged basis. This approach is not reasonable and is entirely at odds with the principles of economic efficiency and cost recovery.

1.4 Optus has concerns with both the cost recovery method that has been adopted by Telstra, and also the cost inputs that it has used.

1.5 In terms of cost recovery methods, when making access pricing determinations the ACCC is required to have regard to the reasonableness criteria (“the criteria”) under the Act. Optus recognises that a variety of cost recovery methods could be adopted that would fulfil accounting principles of cost recovery. However, the extent to which these different methods meet the criteria will differ.

1.6 Optus believes that the access prices that will best promote the criteria are those that will; encourage investment in, and uptake of, the ULL service; encourage competition; and allow Telstra to recover its reasonably incurred costs.

1.7 The approach adopted by Telstra whereby ULLS specific costs are allocated only to ULLS lines does not fulfil the criteria. In contrast, Optus contends that it would be “reasonable” for Telstra to recover ULL specific costs over the broadest category of services – the all fixed lines approach. This would reflect:

• That the ULL is a service that allows all lines to move between Telstra and access seekers. The ULL specific costs were incurred as a result of the natural monopoly characteristics of the local loop. This monopoly led to the service declaration that was introduced to facilitate the emergence of competition benefits which accrue to all end users, regardless of whether or not they take the ULL service.

• That the costs associated with the ULL service are essentially the costs associated with correcting a natural monopoly market failure, and should therefore be borne by all end users of fixed telephony services.

• Competitive neutrality principles, which dictate that Telstra should fund a portion of the ULL-related costs to remove a competitive advantage it would otherwise gain over access seekers.

1.8 In relation to the input costs, Telstra claims that ULL costs are made up of:

• A Network cost component; and

• The ULL specific costs.

1.9 Optus has concerns with the approach Telstra has adopted in terms of estimating these costs. Our primary concerns can be summarised as follows:

• The network cost component based on the PIE 2 model does not reflect the efficient forward looking costs of supply. The PIE 2 model contains fundamental flaws that mean it is not fit for purpose for price setting. Further, since this model was developed the growth in demand for broadband services and likely advances in technology mean that the model is no longer relevant.

• Telstra’s ULLS specific costs are based on actual costs incurred rather than an estimate of efficient costs incurred. An estimate of efficient costs incurred suggests that Telstra has significantly overstated the quantum of these costs.

• The construct adopted by Telstra of charging access seekers for ULL-related ad hoc services, as well as for ongoing monthly costs, appears highly likely to result in double counting of costs.

• The WACC that has been adopted by Telstra significantly exceeds the rate that the ACCC has previously indicated should apply for the ULL service. There have not been any changes in the industry since the ACCC made this decision that would warrant an increase in the WACC.

• Telstra is inappropriately attempting to roll forward its previous ULLS-specific cost losses to be recovered in the period of the current undertakings.

1.10 Whilst Telstra indicates that it has chosen not to include certain PSTN related costs within the cost pool for ULLS, and that it will seek to recover these costs in the prices for PSTN services, it reserves the right to revisit ULLS prices should the ACCC not accept its approach to setting PSTN prices. This condition is unreasonable since it renders the undertaking prices uncertain and largely meaningless.

2. Averaging of ULLS prices

2.1 In contrast to previous ULLS undertakings put forward by Telstra and the ACCC’s model terms and conditions for ULLS, Telstra’s has currently proposed to set ULLS prices on a geographically averaged basis.

2.2 One of the reasons cited by Telstra to justify the move to averaged pricing is the likely burden that will arise from the retail parity obligation recently imposed on it by the Government. Optus has addressed this specific issue in a separate submission to the ACCC. In summary, Optus believes there is very strong evidence to suggest that the retail pricing parity obligation will not impose any burden on Telstra.

2.3 As the ACCC has noted in its discussion paper there are very good reasons to support de-averaged prices. Such an approach will ensure that prices are best aligned to cost, which in turn will promote efficient investment. In addition, such pricing will inherently recognise that copper is not suitable for providing broadband service in many rural areas and that other technologies ought to be promoted.

2.4 In contrast, Telstra’s proposed imposition of averaged prices will only serve only to protect Telstra from the likely impact of future competition in the local loop. Such an outcome would be inconsistent with the LTIE, since:

• It would harm competition. It would not be financially viable for Optus and its competitors to roll-out ULLS-based networks to the same extent as it possibly could under de-averaged pricing. Given that the ULLS service offers a means of minimising the natural monopoly market failure, competition and the LTIE would be harmed.

• A move to averaged prices at this stage would raise the risk of stranded investments as Telstra’s competitors have invested in ULLS networks in reliance poon the existing de-averaged framework – which Telstra itself has supported in the past.

• Moving away from pricing based upon cost-causation would distort incentives for the efficient use of infrastructure.

• ULLS price averaging would distort investment decisions of both Telstra and its competitors. This is because it would tend to:

i) Encourage inefficient infrastructure duplication in low cost areas; and

ii) Discourage efficient investment in higher cost areas (that is, it would encourage over-use of Telstra’s infrastructure). Indeed, this is a concern that has been noted by the OECD:

Geographic averaging of ULL charges has the disadvantage that it may induce inefficient network duplication in low-cost areas. Entrants will have strong incentives to duplicate existing networks in regions where the incumbent’s charges are above cost and little incentive to build duplicate networks (even when it is efficient to do so) in regions where the incumbent’s charges are below cost1.

• Averaged ULLS prices could potentially lead to cherry-picking. Specifically, as discussed above, averaged pricing could lead to infrastructure duplication in low cost areas that would not have occurred if ULLS prices were de-averaged. This would cause Telstra to lose all revenues from customers switching to the duplicated network. When customers go to ULLS-based competitors, on the other hand, Telstra still retains its ULLS access charges. Infrastructure duplication arising directly as a result of averaged ULLS pricing, therefore, could potentially worsen Telstra’s ability to recover its losses in high cost areas.

• Averaged ULLS pricing could distort incentives for investment in alternative technologies in high cost areas. ULLS may not comprise the most efficient means for delivering high-speed services in some high cost areas. Cost-based pricing of ULLS access will provide the appropriate incentives for access seekers to use the most suitable technologies to deliver these services.

2.5 In any case, as discussed above Optus does not believe that the dual operation of Telstra’s pricing parity obligations and deaveraged ULLS pricing principles would place an undue burden on Telstra.

2.6 Any direct revenue losses arising as a result of increased competition in the market should be seen as a positive outcome to the extent that it likely reflects lost rents by Telstra. Competition of this nature enhances the LTIE.

3. Appropriate cost recovery method for ULL-specific costs

3.1 The ACCC’s discussion paper raises the question as to the base over which the ULLS specific costs should be recovered. There are three options canvassed:

• ULLS services only as proposed by Telstra;

• All DSL capable services; or

• All lines.

1 OECD, Access Pricing in Telecommunication, 2004, page 134.

Allocation

3.2 Optus submits that to determine the appropriate ULLS monthly charge for access seekers, the total efficient costs of supplying the ULLS specific costs should be divided across all customer access network ("CAN") lines and not simply ULLS services purchased by access seekers. Optus considers that this approach is consistent with the Reasonableness Criterion under section 152AH of the TPA as follows:

(a) Promotion of competition: Allocation across all CAN lines promotes competition as Telstra's costs will be more closely aligned to its competitors' prices. The allocation of ULLS specific costs in the manner proposed by Telstra establishes a disparity between the average costs of Telstra and access seekers using ULLS. Applying Telstra's methodology, the average costs of access seekers exceed Telstra's average costs and Telstra is likely to earn supernormal profits. By contrast, the all CAN lines approach leads to an outcome that more closely approximates a perfectly competitive market. As the Commission has previously observed, this promotes competition to the greatest extent2.

(b) Efficient use of and investment in infrastructure: Efficient use of and investment in infrastructure is more likely under the all CAN lines approach as Telstra has no, or little, incentive to ensure efficiency where all costs are borne by the access seeker. In addition, the greater stability in the number of all CAN lines will provide greater pricing certainty.

(c) Legitimate business interests: Restricting recovery of specific costs to ULLS lines only will result in other operators' costs being materially higher than those of Telstra and enabling Telstra to derive a greater than normal commercial return. This is not a legitimate business interest.

(d) Interests of those with rights to use service: The all CAN lines approach reduces the risk associated with the sensitivity of the ULLS price to demand estimates. As outlined above, Telstra has a strong incentive to underestimate demand and thereby increase prices which in turn suppresses actual demand.

(e) Direct costs of providing the service: Telstra's claimed ULLS specific costs are not costs caused by supplying ULLS but are costs caused by the monopolistic nature of the local loop and the need to regulate access to it to correct a market failure.

(f) Economic efficiency: The all CAN lines approach better achieves allocative and productive efficiency by spreading the costs over a broader base since other market participants will benefit from the eventual reduction in prices driven by increased competition.

2 ACCC’s Final Decision “Assessment of Telstra’s ULLS and LSS monthly charge undertaking”, December 2005 pg 49/50.

3.3 Telstra has argued that ULLS specific costs must be charged to access seekers in order to ensure efficient use of infrastructure as well as competitive neutrality between choice of technologies and suppliers. Any such contention could only apply to variable or marginal costs. It cannot extend to fixed and/or common costs, which make up a significant proportion of the ULLS Specific costs claimed by Telstra.

3.4 To encourage efficient use of infrastructure and efficient technology choices consumers (retail and wholesale) should be charged marginal costs. Charges above marginal incremental costs create economic distortions that reduce the efficient allocation of resources and reduce total surplus (or welfare).

3.5 Economic efficiency therefore only requires that access seekers be charged the marginal costs associated with the provision of ULLS. Requiring that access seekers pay the fixed and common costs would reduce (distort) the efficient use of the line sharing service. It would also reduce competitive neutrality. It would do this by artificially raising the costs of a potentially equally efficient competitor to Telstra in the downstream supply of Retail voice and DSL Services.

3.6 There are a variety of economic approaches to the recovery of fixed and common cost which would minimise distortions. These include Ramsey pricing but would generally involve spreading cost across a broad range of services. They would typically not involve allocating costs to a particular customer (such as a wholesale customer) as this would lessen competition in downstream markets. Telstra’s allocation of all fixed and common costs to access seekers could be regarded as a tax on rivals seeking to compete against it in downstream markets. It will therefore not promote the long term interest of end-users in those markets.

Cost Causation

3.7 Optus considers that that the real cause of the ULLS specific costs, or at least the majority of those costs (including the capital costs), is the need to address the market failure surrounding the natural monopoly status of the local loop. The service declaration was intended to facilitate competition in downstream markets and benefit all users. Therefore, the costs associated with the declaration should be recovered over all lines. The ULLS specific costs should essentially be seen as "unavoidable costs of running the monopoly CAN, not optional costs from providing an incremental service", and should thus be considered common CAN costs3.

3.8 Both ‘private’ and ‘public’ benefits arise from the ULLS. The ‘private’ benefit is the benefit that access seekers obtain in using the ULLS. However, the much greater benefit is the ‘public’ benefit comprising the broader competitive benefits (manifested in lower prices and better non-price conditions) that accrue to all users of fixed-line services as a

3 AAPT quote in ACCC’s Final Decision “Assessment of Telstra’s ULLS and LSS monthly charge undertaking”, December 2005 pg 26.

result of the accessibility of the ULLS. All beneficiaries of the declaration should contribute to the ULLS specific costs because the service was declared in order to enable the broader ‘public’ benefits to accrue, rather than simply the ‘private’ benefits that access seekers obtain. Therefore the costs should be spread over all CAN lines.

3.9 Put another way, ULLS was declared under the Act because the declaration promotes the long-term interests of end-users: s152AL(3)(d) of the Act. The declaration promotes competition (s 152AB(2)(c)) and encourages economic efficiency (s 152AB(2)(e)). It does this by requiring Telstra to provide access to the ULLS to its competitors. By reason of the declaration, that access must be on terms upon which the competitors can compete with Telstra (Standard Access obligations per s152AR(3) of the Act). In these circumstances, it would be a perverse outcome if Telstra’s competitors are required to pay all of the costs associated with their acquiring access to the ULLS. The very object of the declaration, namely, facilitating a competitive market, is undermined (at least in part) if the price of access must be borne wholly by prospective competitors of the monopolist. Such an approach would create barriers to the use of the declared service and would enable the monopolist to retain a competitive advantage.

3.10 Importantly, it should be remembered that, irrespective of whether the ULLS specific costs are allocated to ULLS users only (Telstra’s approach) or the basis proposed by Optus, Telstra recovers those costs4. The issue is: from whom should Telstra recover the costs. Under Telstra’s approach the costs are recovered from Telstra’s competitors. Notwithstanding that Telstra’s customers benefit from the declaration, none of the costs are recovered from them. Whilst this is a convenient commercial outcome for Telstra, plainly, it is anti-competitive. It is anti-competitive because Telstra’s competitors will pay the ULLS specific costs whereas Telstra will not. Under the approach proposed by Optus, Telstra recovers the costs from all persons who benefit from the increased competition caused by the declaration. Not only is this outcome commensurate with a competitive market, it is fair.

3.11 Where the ‘cause’ of the ULLS specific costs is identified as being the declaration of the service to address the market failure of the local loop monopoly (for the benefit of all end users), Telstra's arguments that spreading the ULLS specific costs over all CAN lines would lead to inefficient consumption and investment decisions are invalidated.

3.12 Finally, even if were the case that the spreading of ULLS specific costs over all CAN lines would promote inefficient market entry, a point Optus would strongly contend, Optus submits that in some circumstances inefficient market entry is desirable from a social welfare perspective. In particular, Optus relies on the analysis of White, who shows that the “entry of an inefficient rival could yield price reductions such that the reduction in deadweight loss that this

4 ACCC’s Final Decision “Assessment of Telstra’s ULLS and LSS monthly charge undertaking”, December 2005 pg 47.

causes could exceed the inefficiencies associated with production by an inefficient rival”5.

Promotion of Competition

3.13 Optus submits that it is not in the interests of competitive neutrality for access seekers to be solely responsible for funding the ULLS specific costs as this would allow Telstra to gain a competitive advantage and would harm competition (as outlined above). Although Telstra may claim that it should be able to retain the benefit of being able to provide these services to itself more efficiently, Optus submits that Telstra's cost advantages arise from a market failure and the inefficient supply of ULLS to access seekers, not from any superior efficiencies in supplying to itself6.

3.14 If ULLS specific costs were spread solely over ULLS lines, Telstra would be in a position to set retail prices at a level below those set by competitors (consistent with the competitive fringe model of competition, under which prices are set at the least cost of the competitive fringe). Telstra would then over recover ULLS specific costs and distort the market for consumption7.

Efficient Investment Incentives

3.15 Optus submits that a further benefit of spreading the ULLS specific costs over all CAN lines is the removal of the incentive for Telstra to invest inefficiently in order to raise the costs of its competitors in the downstream supply of Retail voice and DSL Services (cost 'sabotage'). Allowing Telstra to recover ULLS specific costs over any subset of all CAN lines could effectively legitimise the behaviour of sabotage, potentially encourage Telstra to engage in future inefficient investment, and allow Telstra to perpetuate claims about economies of scope through vertical integration where none actually exist.

3.16 Clearly, where the monthly charge for ULLS is calculated on the basis of ULLS demand estimates (as opposed to the all CAN lines approach) there is an issue of circularity, whereby the demand estimate chosen inversely affects the ULLS access price calculation and the calculated price further affects future demand for the service. Therefore, low demand predictions will generally be a self fulfilling prophesy.

3.17 Optus submits that where forecast demand for ULLS is used to determine the unit cost for ULLS Telstra's incentive is to underestimate demand and to thereby suppress demand through higher access charges, because:

5 Optus, Submission to the Draft Decision - Telstra’s ULLS Undertaking, 9 November 2005, p. 4 6 Optus, Optus submission to the Australian Competition and Consumer Commission on Telstra's ULLS undertakings, May 2005, p. 8 7 Optus, Submission to the Draft Decision - Telstra’s ULLS Undertaking, 9 November 2005, p. 6

(a) if actual demand is greater than forecast demand Telstra will over-recoup its efficient costs of supplying ULLS; and

(b) if actual demand is less than forecast demand Telstra's losses are likely to be offset by greater retail and wholesale service revenues – this is because, assuming that the demand for voice and broadband internet services at the retail level is fixed, then end users who do not acquire such services from an access seeker (who would otherwise pay Telstra the monthly ULLS charge) will acquire the services from Telstra directly and pay Telstra the retail price for voice and broadband internet (which exceeds the monthly ULLS charge).

3.18 As further support for the legitimacy of the all CAN lines approach, Optus refers the Tribunal to the work of Boukaert and Verboven and their notion of a regulator only allowing additional costs (such as LLS-specific costs) to be partially passed on in access charges according to an 'allowance rate' alpha8. The literature notes that one advantage of a low allowance rate is that it "may reduce the incumbent's incentives to choose artificially high interconnection costs to raise rivals' costs ("gold plating")9.

3.19 Allowing only partial recovery of access-specific costs from access seekers has precedent in regulatory access pricing. For example, the Dutch regulator OPTA has proposed a partial allowance rate for wholesale specific costs incurred by the incumbent KPN. OPTA specifically noted that the proportional allocation of the wholesale specific costs to all traffic using KPN's network "means that the wholesale specific costs will be internalised in KPN's retail cost base, which will give KPN an internal stimulus to bring these costs to an efficient level".

Consistency with ACCC price signals

3.20 In its decision on the model terms and conditions for core services, the ACCC clearly signalled that it would be appropriate to move towards a TSLRIC+ approach to the recovery of ULLS specific costs after the first 5 year period, i.e. post 2005. In practice this means that the ULLS specific costs would be recovered across all access lines. The ACCC has since noted that it was generous towards Telstra in delaying the implementation of this approach:

When the ULLS was first made available, in 2000-01, the ACCC was cautious in its approach to the way specific-costs should be recovered and formed an initial view that these costs could be recovered over ULLS lines. The ACCC has been reluctant to move away from this construct during the expected period of cost-recovery as this was likely to impose unnecessary regulatory risk to both Telstra and other

8 Optus, Submission to the Draft Decision - Telstra’s ULLS Undertaking, 9 November 2005, p. 4 9 Bouckaert, Jan and Frank Verboven. 2004. "Price Squeezes in a Regulatory Environment". Journal of Regulatory Economics, 26(3): 321-351

providers. The ACCC, however, as early as in its model terms and conditions determination in 2003, noted the desirability of moving to a different construct and considered the first real opportunity to do so was at the end of the initial five year investment period…it is a change that has been carefully signposted over several assessment periods and arguably represents a more than generous period of cost recovery to Telstra for the recovery of these costs10.

3.21 It is important that the ACCC now follows through on its proposed move towards a more pro-competitive approach to allocating ULLS specific costs. Not to do so would significantly disadvantage access seekers who have held a reasonable expectation that such a change would be forthcoming from 2006.

4. ULL Network Costs

4.1 The network cost component of the ULLS prices is an output from Telstra’s PIE 2 Model, which it has rolled forward from previous undertakings for the purpose of generating costs to support the current undertaking.

4.2 In its discussion paper, the ACCC has raised a number of specific questions that aim to establish whether the PIE2 Model is capable of producing reasonable TSLRIC cost estimates and whether the output from PIE2 reasonably approximates to TSLRIC costs.

4.3 Optus has not been able to complete a full assessment of the current version of the PIE2 model to meet the deadline for this submission, because the provision of access to this model was significantly delayed. In addition, Optus is awaiting answers to specific questions posed to Telstra relating to the changes it has made to the model to enable us to properly target our work. However, to assist the ACCC in making its draft decision Optus has set out some initial comments on this component of the ULLS prices.

ACCC adjustments

4.4 Optus notes that in previous decisions on ULLS prices the ACCC has proposed a number of adjustments to the network cost component included in Telstra’s ULLS prices.

4.5 Whilst Optus agrees with the ACCC that adjustments are warranted, we do not believe that those proposed by the ACCC go far enough. As a result prices based on those adjusted costs are still above efficient levels.

PIE 2

4.6 Telstra notes that it has rolled forward the PIE 2 model to generate cost outputs for the current undertaking. In its discussion paper the ACCC

10 ACCC’s Final Decision “Assessment of Telstra’s ULLS and LSS monthly charge undertaking”, December 2005 pg 47

indicates that it has previously expressed significant concerns with the PIE 2 model, with the result that it does not accept that network costs based on this model are reasonable.

4.7 Optus shares the ACCC’s concerns. In previous consultation processes Optus has highlighted in detail some fundamental problems with the PIE 2 model, with the result that the model cannot be deemed to be fit for purpose for setting access prices. To evidence these concerns Optus refers the ACCC to:

(a) Section 9 of Optus’ May 2003 submission on Model price terms and conditions for PSTN, ULLS and LCS;

(b) Section 6 of Optus’ March 2004 submission on Telstra’s Undertaking for Domestic PSTN Originating and Terminating Access, Unconditioned Local Loop Service and Local Carriage Service;

(c) The report from n/e/r/a London, Assessment of PIE II – model, July 2003.

4.8 More significantly, the recent explosive growth of broadband services and recent announcements about the potential new deployment of technology in the local loop brings into question the continued relevance of PIE 2. The PIE 2 model does not take account of broadband services, nor does it take account of efficient alternative solutions that are being considered for those locations where the copper network cannot be used to deliver broadband services. Optus recommends that a new model may be required to set genuinely efficient forward looking prices. Such a model would require ACCC and industry input, that is it should not be left to Telstra to produce a PIE 3.

5. ULL specific cost inputs

5.1 The ULL specific cost elements contained in Telstra’s model include:

i) Capital expenditure for the initial IT development;

ii) Capital expenditure for range of recent ULLS-based initiatives, along with the associated operating costs;

iii) The operating costs associated with the front-of-house connection group and wholesale product management; and

iv) The indirect operating and maintenance costs associated with the front-of-house connection group and the product managers.

5.2 Each of the above cost categories are now discussed in turn.

Capital expenditure

5.3 Telstra claims that it incurred capital costs of c-i-c between 1999-2000 and 2002-03 in developing its ULL Carrier Interface System (ULLCIS), and then a further c-i-c was incurred between 2004-2005 and 2005-2006 for a range of subsequent initiatives.

5.4 Before examining the specific capex cost categories in detail Optus believes it is important for the ACCC to re-consider the broader implications of the approach Telstra has adopted in developing the means to supply ULLS.

Efficient costs vs costs incurred

5.5 Telstra has chosen to develop a stand-alone ordering and provisioning process for ULLS, known as ULLCIS. In developing its undertaking prices it has calculated the ULLS specific cost component by estimating the cost it has actually incurred in developing the ULLSCIS ordering and provisioning system and the ongoing cost it expects to incur to run that system/process.

5.6 The ACCC has previously undertaken a detailed review of Telstra’s claimed systems costs through the work undertaken by CMPI/AAS. Whilst Optus has concerns both about the level of costs Telstra claims to have incurred and the conclusions reached by CMPI/ASS, more importantly we believe that the approach to estimating ULLS specific costs is fundamentally flawed.

5.7 The question that needs to be addressed is what represents an efficient level of costs to perform the required activities to support ULLS ordering. One of the first questions to be addressed in answering this question is whether it was necessary for Telstra to build a stand alone system or whether in fact it could more efficiently have modified its existing systems.

5.8 Optus considers that the latter approach could have and should have been adopted by Telstra.

5.9 The core requirement for a ULLS IT system is for Telstra to ensure that it can meet service activation. The system must be capable of receiving and responding to transactions received from access seekers and checking line availability for allocation. This process is no different from that Telstra would be required to undertake to respond to requests for the provision of telephony or broadband services from retail or wholesale customers. That is to say, systems already exist to perform these tasks and that Telstra would be able to leverage off these existing systems to support ULLS.

5.10 To support ULLS to the ACIF specifications Telstra should have adopted a similar approach. The key development requirement would be to build an interface gateway between itself and access that enables access seekers to perform activities such as pre-ordering availability checks, service qualification and ordering. However, the costs of such an interface should be relatively modest since Telstra should have been

able to fully leverage off its existing operation and support systems (OSS) to support ULLS to current ACIF specifications. For example, the ULLS interface should feed into Telstra’s internal service qualification (SQ) engine. This existing SQ system is used by Telstra to qualify all services it supplies to customers. Hence there was no need for Telstra to build an extra SQ engine to supply access seekers with ULLS. Likewise with respect to ordering, Telstra’s ULLS interface should feed into its existing ordering systems used internally by Telstra to test for the availability, ordering and supply of new services to customers.

5.11 In previous ACCC consultation processes Optus has argued that the costs to develop such an interface should be no more than around $300,000.

c-i-c section

5.12 Each of the above examples indicates that the capital costs totalling c-i-c Telstra has claimed to incur in developing the ULLSCIS are extremely excessive. Optus notes that CMPI/ASS in its report of October 2001 also concluded that Telstra’s claimed costs were excessive and that these should be reduced by more than a half. Whilst Optus shares the conclusions of CMPI/ASS in respect of the unreasonable nature of Telstra’s costs, Optus believes that the recommendation of CMPI/ASS would still leave costs significantly above an efficient level. This is because CMPI/ASS did not start with the premise that Telstra could largely leverage off its existing systems to support ULLS.

5.13 Optus recommends that the ACCC rejects Telstra’s claimed costs and re-visits the issue of what represents a more efficient level of cost to support the ULLS activities.

1999-2000 to 2002-03 capex

5.14 As discussed above, Optus strongly believes that the quantum of capital expenditure costs that Telstra is claiming it should be able to recover in respect of the initial costs to develop its ULLSCIS system is well in excess of that which would be faced by an efficient, forward looking operator.

2004-05 and 2005-06 capex

5.15 Telstra claims that it has incurred further capital costs since 2004-2005, as follows:

(a) c-i-c associated with the new ULLS deployment classes;

(b) c-i-c for ULLS enhancements to deliver operational efficiencies;

(c) c-i-c associated with SSS to ULLS connection processes;

(d) c-i-c associated with the provision of SSS on ULLS upper spectrum.

5.16 The ACIF code changes referred to in the first category above relates to the addition of new ULL deployment classes for ADSL2+ and HDSL. Optus understands that the PCMS is Telstra’s ordering system, and that it needed to be upgraded to allow access seekers to order ULL services in the new deployment classes.

5.17 Optus is concerned that Telstra is claiming that the capital costs associated with implementing this change amount to c-i-c. In reality, the efficient costs would be significantly lower than this amount as it is likely that Telstra needed only to add an entry into a table that sits behind the user interface.

5.18 If Telstra has failed to configure its IT systems in a way that simply enables it to add new deployment classes, then access seekers should not have to fund any incremental work that would not have been required if the systems had been efficiently configured to begin with.

5.19 For the ULLS enhancements, Telstra justifies this expenditure on the need to deliver operational efficiencies to meet current growth forecasts. There are two concerns that arise from this argument. Firstly, it demonstrates that the system Telstra built was not fit for purpose – since it should have been capable of handling significant volumes consistent with mass residential take-up of broadband services. Secondly, if these costs have been incurred to drive operational efficiencies then it would be reasonable to see an overall reduction in ULLS costs consistent with this statement.

5.20 In respect of the remaining two items of capital expenditure, these are explained by changes required to support the inter-working between the Spectrum Sharing Service and ULLS. It is not clear to Optus why these changes have been required nor whether the real beneficiary of these changes will be Telstra Retail, to ensure that it can churn back ULLS customers. If this is the case, then these costs should be discounted.

5.21 Optus also makes the observation that the explanation given by Telstra for this capital expenditure has changed between its undertakings of December 2004 and December 2005. This further reduces the credibility of any statements provided by Telstra to support this expenditure.

5.22 Optus is also concerned about the lack of specific detail Telstra has provided in its submission regarding the nature of costs it has supposedly had to incur (listed above) to enable assessment to be made of their merit. The lack of detail provided in relation to the nature of the IT system changes raises the risk that access seekers will be forced to double-pay for the change. To illustrate, Telstra indicates that it will be implementing changes to its IT system that will facilitate the switching by customers of deployment classes. Telstra is seeking to recover this cost through the ongoing monthly charge. However, Telstra levies an additional fee of c-i-c every time there is a change of

deployment class. It is not clear, therefore, that Telstra is not seeking to double dip on this cost category.

5.23 Further, Telstra has informed Optus during commercial negotiations that if Optus requires Telstra to improve the service in any way, that it will need to fund those improvements through an additional charge, on top of the set monthly charge. If the actual changes that Telstra is funding through this additional capex (and is therefore already factored into the monthly charge) are insufficiently transparent, the situation could arise whereby access seekers are charged an additional fee for the changes that are already factored into the undertaking price. In its current form therefore, the ACCC would need to reject the undertaking or risk exposing access seekers to double payment for changes to Telstra’s IT systems.

Operating costs associated with IT projects

5.24 Optus has a number of issues with the component of Telstra’s cost model that deals with IT operational costs.

5.25 Firstly, Telstra claims that it incurred O&M costs of c-i-c between 2004-05 and 2005-06 for the new ULLS initiatives involving changes to the ULLCIS.

5.26 Optus finds it difficult to believe that there would be any incremental O&M costs associated with these capital projects. To give an example, to allow its ordering system to cater for the new deployment classes, Telstra will need to make a minor amendment to the system’s code to allow it to recognise the new services. Optus believes that there would be no costs beyond the capex for doing this, and that this will probably apply also for the other capex cost categories (if they are even justified).

5.27 Further, the costs Telstra is seeking to recover represent its historic costs rather than forward looking efficient costs. The historic costs are likely to diverge considerably from efficient costs due to various inefficiencies that have been built into the ULL specific IT systems.

Operating & Maintenance costs associated with IT systems

5.28 A significant component of the ULLS specific costs relates to the O&M costs relating to the ULLSCIS. These costs total c-i-c over the period 2000-01 through to 2007-08. This category comprises the following groups of costs:

• Mainframe and mid-range production processing

• Maintenance labour

• Maintenance processing

• ULLCIS maintenance costs.

5.29 Optus believes that the costs claimed by Telstra are excessive and likely to well above forward looking efficient levels.

5.30 It highly unlikely, for example that the Mid Frame and Main frame processing costs are necessarily and unavoidably incurred in the provision of ULLS. The inclusion of these systems in access prices appears to reflect an inefficiently high cost structure for the provision of ULLS.

5.31 Mainframes are typically used for voluminous input-output requirements, where there are billions of records, such as for billing. Given the current range of demand forecasts for ULLS transactions, which runs into hundreds of thousands of transactions and not billions, mainframe and mid frame processing requirements are clearly unnecessary. Optus considers that the efficient provision of ULLS requires only personal computers with a high end NT server as the gateway.

5.32 Even if the demand is more than double the estimated demand (which is consistent with overseas experience), the number of transactions required to be processed by the ULLS system would still not require the capacity of a mainframe or mid frame system. Hence the ACCC should treat all costs associated with Midframe and Mainframe processing as 100% avoidable as they do not represent the adoption of efficient best in use technology.

5.33 Further, the ACCC needs to clarify that any maintenance processing and labour costs that are attributable to Midframe and Mainframe processing are omitted from the costing model.

5.34 If the ACCC does not adopt this proposal, then it needs to seek specific explanations into why these costs increase from an average of c-i-c in the 5 years to 2005 to an average of c-i-c in the three years covered by the undertaking. This increase in costs has not been explained by Telstra and hardly seems credible.

Costs of the front-of-house connection group

5.35 Telstra describes the functions of the front-of-house connection group as:

“handles inquiries from access seekers, processes ULLS orders and undertakes related tasks”.

5.36 However, Telstra provides no information to support the claimed costs which are expected to increase to over c-i-c per annum by 2007-08. Optus notes that Telstra’s assumptions on staff requirements was specifically challenged in the 2001 CMPI/AAS report, which was commissioned by the ACCC to review Telstra’s ULLS-specific costs. This report stated that:

Above 25,000 connections, increased automation should lead to further efficiencies so that it would be reasonable

to assume staff numbers should gradually increase to 10 when connections reach 100,000 per annum. Consistent with Telstra’s assumptions, we propose that no further staff increases be envisaged to handle connection rates greater than 100,000 per annum.

5.37 The ACCC should therefore allow Telstra to recover costs associated with no more than ten staff members.

5.38 This is particularly relevant in light of the economies that will arise from bulk migrations – a further and additional efficiency. Staff will be handling inquiries relating to a large number of connections rather than a single connection. Optus also notes that many of the activities that ULLS orders will initiate, are largely covered in the separate connection charges levied by Telstra (both single and mass network migration connection charges).

Wholesale product management costs

5.39 Telstra has attributed the costs of two full time product managers to the ULL service. ULL access prices should, however, only reflect the portion of the product managers’ costs that is attributable to functions that are intended to assist access seekers to gain access to the service, and to improve the quality of service. By corollary, any portion of the product managers’ time attributable to commercial activities that are intended to benefit Telstra, rather than access seekers, should be removed from the pool of costs attributable to access prices. Examples of such tasks include:

• All sales and marketing related activities of the product; and

• Regulatory related activities that are intended to protect Telstra’s ULL revenues.

5.40 In relation to the first point, access seekers are well aware that the ULL service exists. Indeed, access seekers actively sought declaration for the service. The decision of whether or not it would be economic to purchase the ULL service depends very heavily of the situation of the individual service providers. Any additional sales and marketing activities by Telstra will not assist access seekers in informing their investment decisions.

5.41 In relation to the second point, any regulatory-related activities of Telstra’s ULL product managers would likely involve tasks that are intended to protect or grow Telstra’s overall profitability. These would include attempts to keep access prices as high as possible (such as, for example, through assistance in preparing Telstra’s ULL undertakings). Such tasks should absolutely not be funded by access seekers.

5.42 Optus also believes that Telstra’s product managers for ULLS work on other services, such as the Spectrum Sharing Service. It would be not be appropriate, therefore, for attribute 100% of their time to ULLS.

5.43 As a conservative estimate, Optus would suggest that only 50% of the costs that Telstra is currently seeking to recover through ULL product management be attributed to the ULL access price – or alternatively the equivalent of one full time product manager.

WACC

5.44 In its Final Determination for model price terms and conditions of the PSTN, ULL and LCS services, the ACCC stated that a post tax nominal WACC for Telstra’s ULLS of c-i-c would be appropriate.

5.45 Telstra’s ULLS cost model, however, applies a much higher post tax WACC, ranging from 1c-i-c to c-i-c. There have been no changes to the industry that would warrant an increase in the WACC from the time that the ACCC made its decision. The WACC proposed by Telstra is not reasonable.

Demand forecasts

5.46 The prices produced by Telstra’s ULLS cost model vary according to the demand forecasts. Given that Telstra’s approach is to allocate ULLS specific costs over ULLS lines only, the most narrow base of the options available, this results in ULLS prices being very sensitive to changes in demand. This raises a number of concerns for Optus.

5.47 Telstra has strong incentives to understate demand. Low demand forecasts will push up the price of ULLS, thereby reducing the likely demand for ULLS and softening competition to Telstra in the Retail and Wholesale markets.

5.48 Telstra’s current campaign to overturn its past policy of setting de-averaged is causing significant uncertainty for access seekers, which will feed into depressed demand and higher prices. The economics of providing ULLS-based services to customers are very different if a $30 access price is faced relative to a price of, for example, $22. Actual demand, therefore, is very dependent on the price that has been set in the market. Indeed, it is clear that one of the key objectives behind Telstra’s ambit claim to obtain averaged ULLS prices is to depress demand to enable it to continue to monopolise the fixed line market.

5.49 Ironically, the undertaking is structured such that if Telstra’s demand forecasts are exceeded it will also be the beneficiary. As will be discussed below there is no mechanism in the undertaking to prevent over-recovery of costs. If demand exceeds Telstra’s forecasts it will receive a windfall gain. In contrast, if demand is less than forecast then as demonstrated in this undertaking, Telstra will likely seek to recoup its unrecovered costs in later regulatory periods.

5.50 The first best option to address these distortions and ensure that correct incentives are set is to allocate ULLS-specific costs across the entire fixed telephony base. This is because future demand for fixed telephony lines is considerably more certain and any variances

between forecast and actual demand are likely to be fairly minor relative to ULLS demand. Further, Telstra has less ability to affect overall demand in the entire fixed telephony market relative to the ULLS market.

5.51 If the ACCC chooses not to take this first best option then Telstra’s proposed approach will require modification. There needs to be an objective means of setting demand forecasts. There also needs to be a mechanism to prevent Telstra over recovering its costs.

5.52 In its submission, Telstra has indicated that it has developed its demand estimates by looking at organic growth and then extrapolating these results:

“Organic growth is forecast by using historic growth rates and extrapolating these forward to determine future growth. In addition, information is sought from the majority of Wholesale Customer Account Managers to determine whether there are any factors of which they are aware which might influence the rate of organic growth of ULLS”.

5.53 Optus believes that this approach to estimating demand is fundamentally flawed. Firstly, historic take-up of ULLS is unlikely to be at all determinative of future take-up of the service at this point in time. As the ACCC is aware, a number of carriers are in the process of rolling out DSL infrastructure that will see a significant acceleration in ULLS demand. Secondly, this process does not appear to involve any engagement with access seekers. Notwithstanding that Optus is likely to be a significant user of ULLS, Optus was not approached by Telstra to provide its forecast use of ULLS for the period of the undertaking or beyond.

5.54 One approach that would overcome the issues associated with forecasting demand is to adopt a tiered pricing structure such that the ULLS specific cost component is adjusted downwards as ULLS volumes increase. This would remove the need to set demand forecasts. It would also give access seekers an appropriate incentive to drive take-up in order to benefit from lower costs per unit. This approach would necessitate the complexity of rebates to be applied to access seekers once volume tiers were met, but this would be preferable to Telstra simply pocketing any windfall gain.

Recovery of ULL specific capital costs

5.55 This section of Optus’ submission addresses the following topics:

• The period of recovery for the capex incurred by Telstra between 1999-2000 and 2004-05

• The period of recovery for the capex incurred by Telstra in 2005/06

5.56 Each of these is now discussed in turn.

Period of recovery for capex from between 1999-2000 and 2004-05

5.57 The sum of the annual capital costs contained in Telstra’s cost model amounts to c-i-c million for the period between 2000-2001 and 2007-08.

5.58 Optus and other access seekers have previously argued that the appropriate cost recovery period for the ULLCIS was over ten years rather than five years based on this being a better approximation of the useful life of the project11. A longer period for cost recovery would mean that costs on a per unit basis of the service would be lower as the cost base would be spread over a much larger number of SIOs.

5.59 Despite Telstra having previously argued for the position that costs should be recovered over 5 years rather than 10 years in its attempt to keep access prices higher over that time period, now that we have moved beyond 5 years from the first year of costs, Telstra has altered its costing methodology such that losses for the initial 5 year period have been carried forward to the cost pool used to calculate prices out to 2007-2008. Optus does not believe that this method is appropriate.

5.60 In order to determine the level of loss to be carried forward, Telstra calculates the difference between its revenues and costs for each year since 2000-01. In deriving this amount, Telstra uses the ACCC’s ULLS specific cost estimates contained in its indicative prices (that is, $11.42 for 2000-01 to 2001-02, $2.50 for 2002-03 to 2003-04, and $10 for 2004-05 to 2005-06).

5.61 If the ACCC were to accept Telstra’s undertaking, it would effectively be voiding its previous indicative prices by allowing Telstra to recover more from past periods than was envisaged by the model prices. This is because the costs upon which the current and future undertaking prices are set reflect historic costs rather than the ACCC’s earlier forward-looking efficient cost estimates.

5.62 Even if the ACCC did accept that Telstra’s past losses should be carried forward to future regulatory periods, Optus does not believe that they need necessarily be recovered in full during the period of the undertakings. Indeed, the benefits associated with ULLS-uptake could be enhanced by spreading these losses out over a longer time frame.

5.63 Furthermore, as discussed earlier Optus considers that ULL specific costs should be spread over all telephony lines, rather than just on lines taken by access seekers via the ULL service. If this approach was adopted, Telstra is unlikely to have made a loss on the service at all.

5.64 Even if this argument is rejected, it would still be inappropriate to allow Telstra to recover its costs in its proposed manner. Firstly, Optus believes Telstra’s conduct that has hindered uptake of DSL services, and therefore uptake by access seekers of the ULL service, is

11 Submission by Cable and Wireless Optus, Review of Telstra’s ULLS-specific costs, 2001.

largely to blame for some, if not all of the losses it has made. Specific conduct has included:

• Monopoly pricing of DSL services prior to the introduction of competition in the market. To illustrate, Telstra’s entry level DSL package had been priced at $59.95 for some time prior to Optus’ entry into the residential DSL market. Immediately following Optus’ entry, however, Telstra dropped the price of its entry level package significantly to $29.95 per month.

• The creation of delays and uncertainty about pricing of DSL access services, including ULL and wholesale DSL. It took Optus some 18 months to negotiate acceptable terms and conditions for access to wholesale DSL.

• The well publicised problems with Telstra’s initial DSL services.

5.65 Secondly, it is reasonable to expect Telstra to share with access seekers the risks associated with the ULL service. A firm operating in a competitive commercial environment would never gain full immunity from risks of under-recovery of costs.

5.66 In the absence of the service declaration, Telstra would act on its incentives to restrict wholesale supply of the service to enable it to extract monopoly rents from its retail customers. The service declaration was intended to correct this market failure, and provide for conditions that better mimic the operations of a competitive wholesale and retail market. If this were the case, then we would expect Telstra Wholesale to be providing these wholesale services following a commercially competitive model, and therefore facing the associated risks.

5.67 Finally, if the ACCC did make the decision to allow Telstra to recover past losses through future access prices, in determining the size of the loss, the ACCC would need to have regard to the rents that Telstra has received from access seekers in the form of other additional ULL charges. The following list provides a number of examples of ULL-related services where prices are likely to be above cost:

• Order withdrawal charge of c-i-c: This charge is excessive given that it applies where Telstra is unlikely to have commenced any work on the initial order.

• Change of deployment class fee of c-i-c: This service requires Telstra only to update its internal records. The fee applicable to change of DSL speeds is only c-i-c.

• Late order withdrawal/ retarget charge of between c-i-c and c-i-c: The charge for this service applies only where work has been allocated and not where work has commenced. It is clear that Telstra will not incur costs of anywhere near the amount that it is charging for the service.

• Call diversion: Telstra charges Optus the same price for the wholesale service that it charges to its retail customers. This provides a fairly good indication, therefore, that Telstra must be receiving rents from the wholesale supply of this service.

5.68 Optus submits that it would be appropriate to reduce the size of the losses by the rents received on these services. This is justified because if the ULL was not a declared service, Telstra would not receive these monopoly revenues.

6. Risk of double dipping by Telstra

6.1 Optus remains concerned that, consistent with Telstra’s past practice, many costs associated with the provision of ULLS fall outside the scope of the undertaking. There is a real risk that, if these costs are not also subject to assessment by the ACCC, double dipping may occur.

6.2 In considering the undertaking, the ACCC also needs to be cognisant of the fact that Telstra charges access seekers a wide range of other once-off costs for performing various ULL-related services, as set out in the table below:

Service Price

Call Diversion c-i-c

Invalid request c-i-c

Service qualification c-i-c

Order withdrawal c-i-c

Late order withdrawal/ re-target

c-i-c

Change of deployment class c-i-c

Incorrect call-out c-i-c

Category D Port c-i-c

Reversal of Category D Port c-i-c

7. PSTN related costs

7.1 In previous ULLS undertakings Telstra has sought to include costs related to the PSTN, specifically a contribution to the access deficit through the ADC surcharge and a contribution to the maintenance of the IEN. The ACCC has correctly rejected the inclusion of these costs on the basis that inclusion:

• Is unlikely to promote the LTIE, as they will not promote competition and will not encourage the economically efficient use of, or investment in infrastructure;

• Will result in Telstra recovering more than is necessary to promote Telstra’s legitimate business interests;

• Will harm the interest of access seekers, and the persons who have rights to use the service would be limited in their ability to compete; and

• Will exceed the direct costs of providing access.

7.2 For the purpose of the current undertaking, Telstra indicates that it has not included a contribution towards these costs in ULLS prices but will instead include the full contribution in prices for PSTN OTA and the LCS services. However, it indicates that if the ACCC does not accept the prices for these latter services “then Telstra reserves its right to increase the ULLS prices to allow for full cost recovery of long run efficient PSTN costs”.

7.3 For the reasons articulated above it would not be reasonable for such costs to be included in ULLS prices. Further, this condition renders Telstra’s proposed undertaking as being fundamentally uncertain, with the result that it should be rejected.

8. Network modernisation provisions

8.1 Optus considers that the clauses relating to network modernisation are inconsistent with the reasonableness criteria of the Act.

8.2 Whilst Optus recognises that retaining an ability to upgrade its network would be in Telstra’s legitimate business interests, such a claim would need to be balanced against the other reasonableness criteria. In particular, regard must also be had to access seekers rights to continued use of the ULLS service in addition to the broader issues relating to the promotion of the long term interests of end-users.

8.3 Telstra’s proposed provisions are unreasonable since they elevate its own legitimate business interests above all other criteria. In essence, Telstra’s proposed condition allows it to push through changes to its network with no due regard to access seekers rights to use the ULLS. Whilst, it commits to provide some ill-defined notice period for any changes, those changes would go ahead regardless of the impact to the access seeker at the expiry of that notice period. Telstra ultimately reserves the right to cancel an existing ULLS service.

8.4 This clause is contrary to the interests of access seekers rights to use the declared service. Further, Optus strongly contends that it breaches the LTIE criteria since it gives Telstra an unfettered right to contract out of its obligations to supply the declared service. Use of the proposed provisions is likely to undermine competition which would not promote the LTIE.

8.5 Optus contends that any network modernisation provisions should seek to ensure continued supply of the ULLS. In making any change to its network, Telstra should be required to take all steps necessary to ensure continuity of service. If this is not possible, then alternative access services ought to be made available. In addition, the provisions should indicate that network modernisation should only be undertaken where this is “absolutely” necessary to meet Telstra’s legitimate interests. This would rule out any changes implemented for the purpose of sabotaging access plans to use the service.

8.6 Optus notes that this issue has been somewhat overlooked in the assessment of past undertakings. This probably reflects the “blue skies” nature of network modernisation plans at that time. However, recent developments such as Telstra’s announced Fibre to the Node strategy and developments overseas means that this issue needs to be given due attention in the current consultation process.

Documents

06.03.30 Optus submission ULLS undertaking 2006 Public ver… · PIE 2 model contains fundamental flaws that mean it is not fit for purpose for price setting. ... warrant an increase