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Australia: Encouraging investment August 31, 2006

Posted by Jasper in broadband, Regulation.
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With the recent announcement of the sale of the Governments remaining shares in Telstra, there is been little focus on the prospects for investment in FTTN. This is understandable given the importance of the sales issue, however, with it now a done deal (it would seem) attention should once again shift to ensuring the Australian broadband future.

One of the major critiques raised by commentators is that current regulations are stifling investment and are in need of a major overhaul. While regulation is never perfect, I personally, do not find the regulations governing the telco sector in Australia to be in a particular bad shape or hostile towards investment. None of the evidence that has been presented to me, other than perhaps the current investment morass with Telstra, indicates that there might be a problem.

There is no doubt that investments in fibre will be made – also within the current regulations. If Telstra fails we must put our faith in the ‘Gang of Nine’ (G9). However, Sol Trujillo does not appear to have turned his back completely on fibre investements. So, is there any way Telstra can be encouraged to invest?

One option, could be to give Telstra an access holiday on their FTTN investment. An access holiday would give Telstra the opportunity to recoup their investment over a pre-defined period of time where competitors would have no right to access to the new infrastructure. In a sense this option acts like a patent – it creates an incentive to invest by allowing the investor a period where it faces no access regulation. Note that it would still open for the access provider to negotiate access terms with potential seekers. However, this approach effectively forecloses competition and promotes monopoly pricing in the holiday period.

Another option could be to allow Telstra to recover an additional premium on top of the Total Service Long Rund Incremental Cost (TSLRIC) of access. Conventional wisdom dictates that TSLRIC sends the “correct” signal to the market about building or buying. When a price is set at TSLRIC entrants will be encouraged to use existing incumbent facilities if, and only if, it is economically desirable to do so. And for the incumbent investment incentives are preserved to upgrade or extend the existing network when new technology is available. However, one of the insights of real option theory is that a regulated price equal to TSLRIC might not be enough to provide firms with efficient investment incentives in case the investment is irreversible, uncertainty is present and the firm has managerial flexibility to postpone the investment. As long as these three assumptions are partly correct a firm will require some premium to cover the lost option value associated with investing today instead of postponing the investment decision. [see Holm (2000) for an excellent introduction to access pricing under uncertainty and from whom I have sourced many of the arguments in the following]

As noted by Ofcom:

If the riskiness of a firm’s investment is modelled using the CAPM and Net Present Value (NPV) analysis, then …. the systematic risk faced by investors is taken into account via an estimate of the firm’s Weighted Average Cost of Capital (WACC). Cash flows should be calculated in such a way as to ensure that the rewards from successful investments within the portfolio are expected to be sufficient to pay for the losses associated with unsuccessful investments. This analysis does not, however, explicitly take into account the extent to which risk can be mitigated by the adoption of certain investment strategies (e.g. investing later in order to “wait and see” how a market develops, or investing early in order to gain a first mover advantage). It may not, therefore effectively mimic the signals given by a competitive market with regard to risky, non reversible investments.

However, regarding existing unconditioned local copper loops, already in place, the investment has already been undertaken. An option premium is therefore unnecessary. In option terms one could say that the value of the option to “wait and see” is zero.

Of course, if we accept the option argument, the entrants’ incentives to invest in alternative infrastructure is reduced compared to a situation where the local copper loop is priced above TSLRIC. However, this bias is appropriate because society does not face any opportunity cost when renting the copper already in place. To add a premium to TSLRIC for existing loops and biasing the decision in favour of investing in alternative infrastructure would imply that society incurred otherwise avoidable opportunity costs, duplicating the existing infrastructure. Therefore a price based on TSLRIC alone is appropriate for existing local copper loops.

With regard to new investments and upgrades along the line that Telstra are proposing, however, the option value argument seems to have merit. If the ACCC is not offering Telstra a premium on top of TSLRIC, real option theory would predict (in line with current behavior) that Telstra would postpone the FTTN investment in fibre until uncertainty about demand, investment costs, technology and regulation has been reduced. To the extent that consumers are willing to pay a price for new services that would be result of a FTTN network that exceeds TSLRIC, a welfare loss would be incurred.

So is the answer to allow Telstra to recover a real option premium?

If the FTTN investment is 1) irreversible, 2) involves uncertainty over future net revenues and 3) can be postponed; then the answer is yes: the regulated access price would need to include a premium on top of TSLRIC to compensate Telstra for the lost “wait and see” option.

If the FTTN investment is 1) reversible, 2) involve no uncertainty over future net revenues and 3) can not be postponed; then the answer is no: the regulated access price should not include a premium on top of TSLRIC.

For the FTTN investment the real option argument would appear to be strong. There is certainly uncertainty of demand, the investment will be sunk and it can be postponed as we have seen. Case closed – compensate Telstra for the the lost option value. Unfortunately, it is not that easy. There are a number of potential objections could be made to weaken Telstra’s case. For example:

  • In many cases it will not be possible for a firm to enter or compete effectively within a market unless it already has a presence in the market. Investing therefore, confers real options on a firm, rather than (or possibly in addition to) using them up.
  • By undertaking the FTTN investment Telstra may reduce uncertainty, providing it with valuable information about costs as well as demand for its product. So, while uncertainty will increase the value of waiting until further information has arrived, the opposite is true if investment by Telstra provides it with information that reduces uncertainty.
  • Waiting is associated with costs. Cash flows are foregone and other firms like the G9 may enter. These costs of waiting must be balanced against the benefits of waiting for new information, making it less clear that there is a net cost of extinguishing an option to wait.

All in all, the case for an option compensation is not an easy one to make. And not having a robust methodology to derive its value in a regulatory setting certainly doesn’t make matters easier. In this respect the holiday approach may be the preferred option.

Further reading:

For the Australian perspective on real options see the following submission by AAPT here.

Robert Pindyck (2005), Pricing Capital Under Mandatory Unbundling and Facilities Sharing, NBER Working Paper No. 11225. This paper resulted in part from a study commissioned by Verizon. The paper shows how pricing formulas used to set lease rates can be adjusted to account for the transfer of option value from incumbents to entrants, and estimates the average size of the adjustment for fixed local voice telecommunications in the U.S

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