In electric power, telecommunications, water, and natural gas, the costs of local distribution make up a significant share of the cost of providing services. For any network or system, the cost of distribution facilities is largely or entirely independent on usage; i.e., such costs are largely invariant to the number of phone calls, kilowatts, British thermal units (BTUs), or gallons that customers use. How these costs are recovered is of critical importance, especially as utilities face increased competitive pressures.ACCESS:
A SERVICE IN ITS OWN RIGHT
Access to any system or network represents a service in its own right. If I own a vacation cabin with telephone, electric, water, and gas services available, I may never use any of these services over the course of a year. However, simply having the option to use these services is of value to me. For each of the utilities, providing me with the option to use these services imposes a substantial cost as well.
In real estate, financial markets, and contracts in general, options are well developed and are
generally recognized to have a separately identifiable price and cost. For example, most businesses leasing office space will also purchase the option to expand to larger quarters if the need arises. For utility customers as well as businesses leasing space, the option to use facilities has a value. Similarly, having the facilities to provide this option has a separately identifiable cost.
Customer Perceptions. Nevertheless, one can easily confuse the perspectives of the customer and the utility, and in so doing, conclude that the costs of the local distribution network/system represent costs incurred by the local exchange telephone carrier (LEC) that are "common" to its production of multiple services (see sidebar for discussion of the term "common costs"), when in fact they generally are not.
Local distribution costs are not common production costs to a portfolio of LEC services simply because the LEC's customers view the services in that portfolio as complements to one another. Instead, local distribution costs are incremental or marginal to the provision of access to the utility system or network.
Think of a telephone company's business customer who offers two products (em fresh fruit sold locally, and canned fruit sold nationally. All of the firm's local telephone calls support its fresh fruit business; its long-distance calls are made specifically for its canned fruit product. The firm pays a monthly fee of $25 for subscriber (end-user) access to the telephone system/network and pays separate charges for local and long-distance calls. This firm may properly consider the $25 monthly subscriber access fee as a cost common to the provision of its two products, fresh and canned fruit. However, a customer's use of local distribution facilities has no bearing on whether the costs of providing the facilities are common to multiple services or directly attributable to a single service for the utility. The utility's cost in providing a service does not become a cost common to several utility services simply because utility customers happen to use one service for their own multiple activities. This distinction (em between cost allocation among the customer's activities and cost allocation for the service provider (em is critical to a sound understanding of utility costs.
The Elasticity Trap. Spill-over or cross-elastic revenue effects and utility costs represent separate economic phenomena. Revenues are a function of customer demand and service prices, while producers' costs are determined largely by input prices. Certainly, in telecommunications, end-user subscriber access service, local usage, and long-distance usage are likely to be cross-elastic to some degree on the revenue/demand side. However, this observation does nothing to change the fundamental nature of the costs of providing the services. Local distribution costs are not common production costs to the LEC simply because customers consider these services to be complements to one another. Consumers may consider bread and jam to be complements, but that does not make the cost of growing wheat a common cost to a company that produces jam.
THREE ALTERNATIVE APPROACHES
Some of the traditional methods of thinking about local distribution costs and recovering them may not be sustainable as utility industries become increasingly competitive. How then, should these costs be recovered?
Three types of charges are possible: a one-time charge; a monthly recurring customer charge; or recovery through increases in usage charges. A one-time service connection charge to the customer could provide recovery of local distribution costs at the time costs are incurred. A monthly recurring charge can be thought of as an annuity payment sufficient to recover the initial one-time expenditure by the utility for local distribution facilities. If local distribution costs are recovered through "usage" charges, the rate per kilowatt-hour, gallon, minute, message, Btu or Mcf must exceed its marginal cost by an amount sufficient to ensure full recovery over time.
The Usage-based Charge. Generally, increases in usage charges represent the least desirable method for recovery of local distribution costs. As noted earlier, local distribution costs are largely insensitive to usage. As a general principle, the structure of prices for services should reflect the structure of costs; usage-insensitive costs should generally not be recovered through usage-sensitive charges.
Recovering local distribution costs through increases in usage-sensitive charges distorts the economic incentives that customers face. In telecommunications, a
significant portion of local distribution costs are recovered through long-distance calling charges (both intraLATA long distance and switched-access charges). These charges climb well above the marginal cost of usage (e.g., long-distance calling) and customers therefore use the system less than the optimal level; i.e., high long-distance rates discourage customers from making calls that carry a higher value than the marginal cost of providing such calls.
A usage-based charge also violates the principle of considering access to a network or system as a service in its own right. In some sense, that method expects that each customer's usage will prove sufficient to recover the cost of providing that customer with access to the system. However, when attempting to recover the local distribution costs of an electric power provider (for example) through an increase in kilowatt-hour charges, one cannot guarantee that the customer will use enough energy to allow cost recovery. Customers with high levels of system usage provide high levels of contribution (revenues in excess of the marginal costs of providing access) and/or subsidy, while low-usage customers may provide no contribution at all (they receive a subsidy). The typical result is that not only do usage services subsidize access service, but high-usage customers subsidize low-usage customers.
Even if one mistakenly believed that all local distribution costs represented common production costs, usage charges should not bear the bulk of the recovery burden. The most efficient method of recovering costs that are truly common to multiple utility services is by obtaining the greatest degree of contribution (price exceeds marginal cost to the greatest extent) from services that are the least elastically demanded (those that are the least responsive to price changes). This method is sometimes called Ramsey pricing. It minimizes the degree to which customers substitute away from the efficient quantities of services because prices rise above what is efficient. Ramsey prices are also more likely to be sustainable in the face of competitive pressures. Utility customers are relatively sensitive to usage-based charges (the demand elasticity for usage is generally higher than for recurring monthly access or one-time charges). Recovering distribution costs largely through usage-based charges would prove relatively inefficient.
The Recurring Customer Charge. A second method of recovering the costs of local distribution is through a monthly recurring charge to customers simply for the option to obtain service and use the system. Such a charge offers the major advantage of standing completely independent of system usage. Usage charges can be set to more accurately reflect the marginal costs of usage. This approach will improve economic efficiency and consumer welfare. As a general principle, the most appropriate price structure or recovery mechanism is one that mirrors the structure of costs. Since the costs of local distribution facilities are generally not sensitive to usage, a monthly recurring customer charge (which is not sensitive to usage) is superior to recovering such costs through usage-based charges.
The One-time Connection Charge. A third method involves a one-time assessment for the capital costs of installing local distribution facilities. This method recognizes the franchise obligation as a cost causer and may well prove the most efficient for recovery of local distribution costs.
The costs of local distribution facilities may become largely sunk once facilities are placed; i.e., the facilities have no alternate value if customers choose not to use them. In particular, local distribution costs may be unaffected by the number of customers who actually sign up for service. These costs appear to be caused largely by the provider's franchise obligation to offer service to all potential customers within the service territory on a timely basis. To meet this obligation, utilities must place local distribution facilities well in advance of the time at which customers actually demand service. In some sense, the cost causer is the developer that initially plans and begins construction of homes and businesses. A one-time charge, assessed to the developer for the capital costs of placing local distribution facilities within that development, is probably the most efficient system of cost recovery. The charge need not be a true one-time charge; a commitment to a long-term contract with a stream of monthly payments should suffice. The key aspect is the commitment to payment before facilities are placed.
A one-time connection fee appears consistent with other commercial practices in regulated and unregulated industries, where customer-specific or geographic-specific assets are often purchased outright or provided through long-term contracts.
For example, a company paving a driveway typically will charge the customer at the time the paving facilities are placed. Certainly the paving company does not attempt to recover its costs by charging the homeowner each time the driveway is used. Telephonos de Mexico has utilized a service connection charge to equivalent to over $900 for business and over $500 for residential customers to help recover local distribution costs. For U.S. utilities, "special construction" charges have been used to establish a commitment by the customer for at least partial payment for local distribution facilities. Also, when facilities are placed specifically for a large Centrex or private-line customer with a customer-specific offering, the facilities are recovered completely through a long-term customer contract. Several years ago in U.S. telecommunications, the last few feet of local distribution facilities, inside wire (loop inside the home), was recognized to be sunk after placement. Now when inside wire is placed, the cost is recovered through a one-time charge or long-term contract. (Unlike inside wire, if the utility incurs the franchise obligation to place local distribution facilities to subdivisions, that utility would presumably continue to serve as the sole provider of such facilities and maintain control of the facilities for maintenance purposes.)
As with a monthly recurring customer charge, a one-time service connection charge offers the advantage that the usage-insensitive capital costs of providing local distribution facilities are recovered through a usage-insensitive charge. Such a one-time charge (or long-term contract) has the additional advantage that it reflects the true underlying nature of the capital costs of placing local distribution facilities: It occurs at a single point in time (as a commitment with a long-term contract), not on a recurring basis.
THE SERVICE FRANCHISE
Although generally more efficient than recovering local distribution costs through usage charges, often the practical disadvantage of a one-time service connection charge is that facilities are either placed with a lag after customers desire service, or the charge occurs after facilities are already in place and sunk.
The duty to serve has led to the traditional placement of local distribution facilities before customers actually demanded service. On the other hand, a relatively high service connection charge, established after local distribution facilities are sunk, may actually discourage some customers from ordering service and paying the connection charge. Unfortunately, if facilities are placed in advance of an order for service connection, the service connection order does not cause the capital costs of providing local distribution facilities (other connection expenses can occur). The utility cannot avoid these capital costs if the customer decides to forego service connection.
Should local distribution facilities be placed (sunk) in advance of customer commitment to pay for the facilities? Charging developers for local distribution facilities offers the major advantage of commitment of payment before facilities are placed, but without delay in providing service to the final customer.
Going forward, a one-time service connection charge to developers is appealing as a method for recovering the capital costs of local distribution facilities. Ongoing maintenance costs caused by customers subscribing for service should be recovered through a monthly recurring charge. However, in recovering the capital costs of existing facilities, the choice between a one-time charge and recurring monthly charges is more difficult.
The choice should be based largely on how price- responsive customers are to each charge. It may well be that customers are more sensitive to a one-time charge; if this is the case, a monthly recurring charge is preferable to a one-time charge.
AND GEOGRAPHIC DISPARITIES
The problems of local distribution cost recovery are exacerbated by the fact that costs of providing customers with access to the distribution system can vary substantially across customers and/or geographic areas. For all utilities, distribution costs per customer are lower in densely concentrated urban areas. In addition, costs are often lower for customers that are near certain facilities (large mains, central offices, transmission lines, and so on).
A single jurisdiction-wide charge (regardless of whether it is a one-time, usage-based, or recurring monthly charge) cannot properly reflect the differentials in local distribution costs across geography and customers. An economically proper charge should reflect the major differentials in the costs of local distribution across geography and customers. The historical use of "outside the base-rate area" (OBRA) charges in telecommunications gives an example of an efficiency-improving rate structure that can appropriately reflect geographic cost variations. Customer-specific offerings employ customer-specific costs, rather than some measure of jurisdiction-wide costs to form the basis for sound pricing and cost recovery.
THE COMPETITIVE FUTURE
As the issues of interconnection, alternate service providers, bypass, and relaxation of franchise protection come to the fore in utility industries, local distribution costs and the methods of recovering them become more important.
Moreover, the very concept of the traditional franchise obligation (em to provide all customers, regardless of the circumstances, with service in a timely fashion (em is placed in question.
Viable solutions should allow incumbents to recover costs and encourage entry only by efficient competitors, preferably in a way that minimizes damage to franchise obligations. t
Steve Parsons is a regulatory economist at Southwestern Bell Telephone Company, in St. Louis, MO. The opinions expressed here are those of the author and do not necessarily reflect the opinions or business plans of SBC Communications or any of its subsidiaries.Common Costs, Common MisconceptionsIn telecommunications, the term "common line" refers to the local distribution facilities (and some "feeder" and central office investment) connecting subscribers to local and long-distance networks. The term "common line" was traditionally employed because the same line was "used" by customers for both local and long-distance calls. In part because of this terminology, many people have improperly characterized the cost of local distribution as a cost common to the services that use the local distribution network or system. Instead, a true common cost is one that is incurred regarless of the volume of each service or even the number of services provided; it is a cost common to the production of multiple services.Access Drive CostsEconomics literature provides clear guidance on the proper treatment of the costs incurred to provide access to a network or system for telecommunications subscribers. Two important points can be derived:
. These costs are generally not sensitive to the volume of use of the network or system to which they provide access. They are sensitive to the number of customers served and the nature of the franchise obligation to provide service.
. Second, these costs are not common to the production to the production of multiple services provided by the local carrier. Rather, they are directly attributable to the services that cause them; the "access" characteristic of private line, special access, Centrex, and basic local exchange service.
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