2004 International Business & Economics Research Conference Las Vegas, Nevada
Telecommunications Regulation In Europe– Advantages And Pitfalls
Of Price Regulation
Peter Trkman, University of Ljubljana, Slovenia
Abstract
Telecommunications are undoubtedly one of the most important sectors of every economy. In recent years most European Union (and also many other) countries have liberalized this sector and now strive to achieve allocative and productive efficiency in this market. However as the transition from state monopoly to fully competitive market is often slow and hard, certain aspects of telecommunication market are still closely regulated.
The main objective of regulating process is clear: to help to create fully competitive market. However there are different regulating decisions that have to be taken in order to come close to this goal. Different ways of regulation are presented in the paper.
The most widely used method of regulation, namely price regulation, is presented in more detail. Most European countries use this sort of regulation, especially for regulating the prices for interconnection that usually have to be cost-oriented. However some possible problems are identified, such as justification of this approach, proper definition of costs and proper dealing with technological advances.
Another important aspect is the measurement of the efficiency of the market and successfulness of regulation in particular. Different measures and indexes for achieving this goal are presented and their advantages and problems are analysed.
At last the case study of Slovenian mobile market is presented. Slovenia, a new member of European Union, is facing similar challenges as other countries. Its market structure and past developments are compared to other European countries. Currently the market structure is slightly more concentrated than European average, while penetration rate is already above the EU average. Calculation of Herfindahl-Hirschman index and changes in penetration rates are used to illustrate some of the theoretical findings.
Introduction
The main idea of telecommunications regulation is to induce the monopolistic or dominant company to behave similarly as it would on fully competitive market. Consequently prices and cost structures should be similar (Wheatley, 1999). The goal of regulation is to artificially help to achieve such situation on the market where efficient competition will encourage companies to improve productivity and introduce better products and services in order to increase their profits. Over time, the benefits of competition for consumers and society will lead to maximized social welfare and efficiently allocated resources (Uri, 2003). Obviously this is an idealized picture that is rarely fully attained in practice.
From the customer’s points of view the main goal of liberalization is to assure the largest possible selection of cheap, quality services (Bühler, 1998). Usually the liberalization of telecommunications does not mean the abolition of all rules and limitations, since the government still makes market interventions through the regulatory body. Therefore some authors prefer to use the term re-regulation instead (Evaristo, 1998).
The whole regulatory framework obviously cannot replace market forces (and certainly should not try to do it), but should support those forces in giving the right price signals that would encourage efficient investments in telecommunications infrastructure (Schankerman, 1996).
Every external intervention into the market has potential negative side effects and can lead to productive and allocative inefficiency. Therefore in every single case the minimum level of regulation, that can still obtain the desired goals, should be used (Bourreau, 2001).
Regulation is even more important in countries where parts of telecommunication markets are liberalized, while there is still monopoly in some segments. It is crucial to prevent certain companies to prevail with dumping pricing on the competitive market, while covering their losses with high prices on monopoly part of the market. These cross-subsidies can significantly reduce market efficiency.
Possible positive consequences of liberalized, but still regulated telecommunications market include lower prices, reduction of costs, increased offer of different services, increase in quality and greater number of innovations[1] (Preiskel, 1995; Ypsilanti, 1998). The study of 31 companies in 25 countries[2] showed that financial and business results of telecommunications companies in those countries have considerably improved after privatisation. The majority of those improvements can be attributed to regulative changes and not to privatisation itself (Bortolotti, 2002).
Therefore it is obvious that efficient methods of regulation are crucial for realizing the mentioned benefits. While we briefly present other methods of regulation, we mostly concentrate on mobile price regulation that is also the most widely used method of regulation in practice.
The structure of the paper is as follows: in the next chapter we present the main ideas and effects of regulation. Afterwards we concentrate on regulation of telecommunications prices and discuss possible criteria to measure the efficiency of regulation. At last a case study of Slovenian mobile market is described. The main focus of the paper is on regulation of telecommunications in European Union, while reference to USA and other countries is also made.
Regulation and its effects
Almost all developed countries (the situation in 3rd world countries is described in e. g. Evaristo, 1998), especially the countries in the European Union, have liberalized their telecommunications in recent years. However certain aspects of the market are still closely monitored and regulated by independent regulatory organization. This is especially true for interconnection (pricing of calls originating on one and terminating on another mobile or fixed network).
The main goals of this process are clear – to achieve the market situation that will ensure competitiveness of the market and high levels of productive and allocative efficiency and will consequently lead to better quality services at lower prices.
Different methods of regulation can be used (Wheatley, 1999):
-regulation of market structure (specially licensing to control market entry) ,
-regulation of profit (that is rarely used in practice since it can severely influence the decisions of the operator in an unwanted way and lead to severe allocative inefficiency (Uri, 2001)),
-regulation to promote operational efficiency,
-regulation of service quality,
-regulation to improve public welfare (like universal service obligation that is imposed in many countries)
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Generally the regulatory decisions, that have to be made using the afore mentioned methods of regulation, can be broken into four categories (Cave, 1996):
-structural regulation (licensing, spectrum allocation),
-competition issues (price control, interconnection, number portability, cross-subsidization),
-social objectives (universal service obligation, social welfare),
-technical aspects (number portability, standards).
It is questionable whether the regulation is only needed in the transition period from monopoly to competitive market or some sort of regulation should also be used later. Most authors believe that, due to importance and specifics of telecommunications, at least some aspects should remain partly regulated. One of those areas is e. g. setting prices for call termination on another network (Crocioni, 2001).
Regardless of the method of regulation used, the main principles are (Schankerman, 1996):
-symmetric regulation is generally better than asymmetric, where some companies (usually the incumbent operator) are regulated more strictly. Asymmetric regulation should only be used when there is no suitable alternative.
-the regulating rules should be defined early and the main principles should remained unchanged over a longer time period with slight adjustments in case of technological changes. Due to long-term nature of most infrastructure investments, frequent regulatory changes would bring considerable uncertainty, would increase business risk of all companies involved and would make it harder to evaluate the profitableness of those investments.
Finally and most importantly the regulator certainly should not try to pick winners. Its main role is to help to establish such market conditions where the market will determine which companies, technological solutions and services will survive and help to achieve increased public welfare.
Regulations of prices
The system of price regulation usually includes several prices and defines the maximum price that cannot be exceeded by a specific service (this price can be set for a single service or a basket of services).
One of the possible problems of this sort of regulation with externally set prices is the possible decline in the quality, since the company can easily lower the costs by reducing the service quality (Laffront, 1993). The study of transition to this sort of regulation in UK shows that the quality of British Telecom services has declined considerably (Vickers, 1998). This problem is usually solved in connection with regulation of quality. The company has to assure certain quality of the service in order to charge that price – sometimes this price can be slightly raised for higher quality of services (Norsworthy, 1999). With this combination the regulator can also proactively influence the quality by defining the allowed raise in prices, if the quality of services is improved (Wang, 1997).
Even if the quality remains the same or is even improved, constant revision of regulated prices is important. Due to technological development, increased operator’s efficiency or other reasons, the costs can be significantly reduced. If the prices are unchanged, this can lead to unjustified extra profits and long-term allocative inefficiency – exactly against the main purpose of regulation (Parker, 1997).
The possible approach to changing the regulated prices is to determine the so-called X-factor. The prices then have to be reduced yearly by this factor (adjusted for the inflation rate). Price cap index (PCI) is the difference between rate of inflation and X-factor (Uri, 2003). The operators are therefore stimulated to continuous improvements and reductions of costs – further reductions in costs mean extra profit for them.
The main advantages of price regulation over direct profit or rate-of-return regulation are (Uri, 2001):
-technical efficiency (i.e., short-run cost minimization)
-dynamic efficiency (i.e., long-run cost minimization)
-enhanced service quality and consumer welfare
-reduced costs of regulation.
However there are also certain problems with price regulation. Obviously the main goal would be to set prices that would enable efficient operators to realize profits, while less efficient operators (with higher costs) would either be forced to reduce their costs or abandon that business.
The first problem is the definition of costs: besides the direct costs of a certain service, the operator also incurs significant joint costs. The most important joint costs in telecommunications are obviously the investment into infrastructure (for either fixed or mobile network) and the costs of the licence[3]. Therefore the operator must price some (or all) services over the marginal costs for this service in order to cover joint costs. The prices with lower price elasticity should have higher mark-up for covering those costs (Cost Structures in Mobile Networks, 2001)
Additionally costs tend to change quickly in telecommunications and the current level of costs cannot be taken as good estimation for long run costs, even if we assume that current cost structures is optimal.
Therefore one of the possibilities used by some regulators is to try to calculate the appropriate long-run average incremental costs (LRAIC) and set some prices (like the prices for interconnection) on the basis of those costs (National IT and Telecom AgencyDenmark, 2002).
Even if we assume that it is possible to exactly measure all marginal, incremental and joint costs (obviously not a very realistic assumption)[4], setting the prices on the basis of those costs is questionable. Additionally this approach, if used incorrectly, can basically punish efficient mobile operators that can offer services with low costs. Consequently their regulated prices would also be lower – this does not give much incentive to try to reduce costs.
A possible solution is to use best practice results from other countries to set the maximum allowed price for the domestic market (Italy for example uses European best practice rates, adjusted for Italy’ s specific factors, to regulate prices for fixed to mobile interconnection (Cost Structures in Mobile Networks, 2001).
This is even truer for newly developed services where the current costs can hardly be used as it is even more likely that those costs will change considerably in the future.
To sum up: the main pitfalls are that accounting data generally involve artificial allocations, historical data reflect prior technological choices, regression estimates give averages not efficient frontiers etc. (Braunstein, 2004).
Therefore we believe that those sorts of regulation should only be used in areas where considerable damage could be done if prices were not regulated. Certainly one of the most important aspects are interconnection prices – without regulation incumbent operator could effectively lock out any new operator by setting too high prices for termination of calls on its network. The basic principles for interconnection[5] are that the price of a mobile operator for call termination from other networks should not be higher for incoming calls than for his own services; and that interconnection prices should be cost-oriented. In most EU countries interconnection price setting is left to the negotiation between mobile operators, while the regulator intervenes if operators fail to reach the satisfactory agreement (Crocioni, 2001).
On the other hand most price settings should be left to the market and certainly all commercial (operative) decisions should be left to every single operator.
Regardless of the methods of regulation it is vital that all regulation rules and practices are well known in advance and strictly adhered to. Any unexpected changes (or even possibility of such changes) can considerably increase the risk for each company, as it is harder to estimate future developments, costs and revenues. Increased risk means lower level of investments, as the requested rate of return for riskier investments is higher.
Efficiency of regulation
Obviously it is important to measure the efficiency of regulation. Since this is a complex process, different approaches to estimate market situation and quality of regulation can be used.
One possible solution is to observe the changes of prices (see e. g. (Oftel, 2003) for an example of study of movements of UK mobile prices or (National IT and Telecom AgencyDenmark, 2002) for similar study of changes of prices in Denmark). One of the main goals of liberalization and regulation is the decline of prices and those studies can show, whether market prices are moving in the desired direction.
Obviously the main problem is that it is hard to establish, whether those changes in prices are due to improved competition and better market structure or due to technological advances, that were made independent (or even in spite) of regulator’s efforts.
Other possibilities for estimating efficiency of regulations are measures of market concentration and measures of the power to influence prices. The most widely used measures of market concentration are:
Herfindahl-Hirschman index (HHI) that is defined as:
where Si is the market share of operator i and n is the total number of operators in the market. Obviously the highest possible value of this index is 10000 (in the case of monopoly). The values above 1000 are regarded as at least moderately concentrated (Wheatley, 1999). However in fixed and mobile telephony slightly higher values of HHI can be expected in practice because there are strong economics of scale that means that we can expect smaller number of companies in market equilibrium.
Entropy index is similar (only the weights are different) and is defined as:
It should be emphasized that HHI should not be studied or observed alone. Market share and market structures alone are not sufficient indicators of market power and power to influence the prices. Regulating decisions that are made based solely on market shares, can reduce the efficiency of the whole branch (Schankerman, 1996). The most important indicator of market power of certain company is demand price elasticity[6] for its services. However in practice even the telecommunications companies rarely have all the data needed for exact calculation of price elasticity, while regulator has even less data.
Nevertheless HHI can provide a quick, easy-to-calculate measure of current situation on a mobile telephony (or Internet access) market. Furthermore it can be useful to make comparison, either among different countries or across time. Obviously it should be combined with other indices or studies before making any decisions on the basis of its values.
Other possible indexes include reach and theta index (the first for measurement of current state and the second for measurement of changes in recent years) (Parker, 1997), index of liberalization, index of competitiveness, index of growth (Elixman, 2000) etc.
Case study – Slovenian Mobile market
Slovenia is a 20.256 square metres large country with 2 millions inhabitants in Central Europe. It is one of the countries that joined European Union in 2004. The challenges and problems are similar to that of other EU countries, so findings from this case study can be compared with the situation in those countries.
Currently there are 3 GSM operators in Slovenia with market shares of approximately 73% (the incumbent operator), 24% and 3% and one retail reseller of GSM services. (Turk, 2003). The larger two mobile operators have been designated with significant market power (SMP) for both retail mobile market and interconnection. While fixed telephony is also legally liberalized, there is still only one operator (which is also designated with SMP). For that reason we are concentrating on mobile services market in this case study.
The comparison of Herfindahl-Hirschman index (Table 1) in recent years shows that the market in Slovenia is still relatively concentrated and that although HHI is decreasing, its value is still above the values of all benchmarked countries. A more detailed analyses and comparison of HHI across different countries can be found in (Trkman, 2003).