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• 6. Compensation

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114. The TSO charge levied on liable service providers for the Local Service TSO is sensitive to the level of retail charges paid by local service customers. If customers in commercially non-viable (CNV) areas pay more line rental in real terms, all other things being equal, liable service providers pay less in TSO levy. Conversely, if customers in commercially non-viable areas pay less line rental in real terms, all other things being equal, liable service providers pay more in TSO levy.

115. The TSO Charge that the Local Service TSO Provider currently receives is of "unspecified amount" and is therefore calculated by the Commerce Commission on an annual basis applying a methodology prescribed in the Telecommunications Act. The "net cost" methodology for the TSO Charge is designed to compensate the Local Service TSO Provider on a hypothetical efficient investment basis.

116. Concerns have been expressed that the level of compensation made to Telecom as Local Service TSO Provider does not reflect the dynamic market economics for supplying local telephone service. The table below sets out the net cost TSO charge determined for the last three TSO financial years to compensate Telecom. Ignoring the increase attributable to WACC due to interest rates rising, the net cost TSO charge is not trending down as would be expected with industry productivity improvements and decreasing equipment costs.

WACC - Weighted Average Cost of Capital

CNVCs – Commercially Non-Viable Customers

117. Several options have been identified to simplify determination of the TSO charge for local service and to ensure it is sensitive to the economic realities of the industry, and recognises the presence of any alternative providers of equivalent service in the relevant market. The options are to:

• Option 1: stay with a TSO charge of an "unspecified amount" and modify the TSO compensation methodology prescribed in the Telecommunications Act for Commerce Commission calculation of the TSO charge;
• Option 2: make the TSO Charge a "specified amount" as part of the requirements in the Local Service TSO Deed without contestability for TSO Provider selection;
• Option 3: abolish the TSO charge for TSO local service and rely only on cross subsidies between TSO Provider customers to fund any cost deficit for the supply of commercially non-viable service; or
• Option 4: make the TSO charge a "specified amount" as part of the requirements in the Local Service TSO deed with contestability for TSO Provider selection.

6.1 TSO Charge of Unspecified Amount

118. A TSO Provider is compensated for services supplied under the respective TSO instrument through a TSO charge. Telecom, as the TSO Provider for the Local Service TSO, recovers the cost for fulfilling its TSO commitments through a combination of trading or sales revenue, together with the TSO levy paid by other telecommunications service providers.

119. The design of the existing TSO net cost calculation methodology for the Local Service TSO was predicated on the assumption that Telecom's ability to cross subsidise within an area, and between areas, could be undermined by entrant service providers "cherry picking" the most commercially valuable customers. The methodology for calculating the "net cost" TSO charge is therefore based on the incremental cost of a notional efficient service provider supplying service to commercially non-viable customers. However, the net cost calculation methodology as currently prescribed does not reduce compensation to Telecom to reflect the extent to which it is earning super normal profits for some commercially viable areas.

120. The TSO charge determination process for the Local Service TSO is complicated by the fact that the charge is an unspecified amount. The Commerce Commission is consequently required to derive a charge by applying methodologies prescribed in the Act which require extensive modelling. If the TSO charge was calculated from a specified amount in the Local Service TSO deed, the TSO charge calculation process would become much simpler, shorter and cheaper.

121. The industry and Commission⁴ incur significantly higher costs for Local Service TSO determinations because the Commission has to derive a TSO charge by cost modelling instead of calculating the TSO charge from a specified amount in the TSO deed. There is a lot of scope for discussion amongst TSO liable persons on the factors and assumptions for calculating a TSO charge of unspecified amount. Some potentially significant cost savings could therefore be realised by both the government and industry if the TSO charge for the Local Service TSO instrument had a specified amount for compensating Telecom as the TSO Provider.

122. Implementation of this option would require minor changes to the Telecommunications Act, but would not involve revising the existing Local Service TSO requirements recorded in the Local Service TSO deed.

6.1.1 Pros of Unspecified Amount TSO Charge

• Enables TSO compensation to be assessed annually by the Commerce Commission relative to other cost recovery areas of the TSO Provider's business.

6.1.2 Cons of TSO Charge of Unspecified Amount

• Complicated and costly process to calculate TSO charge;
• Long length of time taken to calculate TSO charge and effect settlements for TSO charge;
• Uncertainty about liability for TSO contributions hinders efficient budget planning by service providers; and
• Forgo opportunity to test whether alternative provider could offer better value.

6.2 Uncontested TSO Charge of Specified Amount

123. A specified amount TSO charge could be negotiated and agreed between the Crown and Telecom without contestability. Such a specified amount TSO charge could be tied to the movement of the Communications Producer Price Index (PPI) for changes in the cost of resources for the telecommunications industry, and an index for the weighted average cost of capital (WACC) for changes in the cost of money for investment in telecommunications infrastructure. In this way the TSO charge could reflect real increases in the cost of industry inputs used to supply telecommunications services.

124. Implementation of this option would involve revising the existing Local Service TSO requirements by Telecom and the Crown mutually agreeing changes to the Local Service TSO deed. Changes to the Telecommunications Act would not be necessary to implement this option.

6.2.1 Pros of Uncontested TSO Charge of Specified Amount

125. The potential positives of a specified amount TSO charge include:

• Simple and low cost administratively to calculate TSO charge each year;
• Predicable TSO charge each year; and
• Avoids issue of accrued interest on TSO charge to account for delay in calculation of TSO charge.

6.2.2 Cons of Uncontested TSO Charge of Specified Amount

126. The potential negative aspects of a specified amount TSO charge include:

• Forgo opportunity to test whether alternative provider could offer better value;
• Difficulty of agreeing on the base specified amount to apply initially; and
• Difficulty of agreeing adjustments for industry cost increases/decreases over successive years going forward.

6.3 TSO Provider Bearing All TSO Cost – No TSO Charge

127. Another option is to abolish the TSO charge by removing the TSO charge methodology prescribed in the Telecommunications Act. This option is based on the argument that a TSO charge is not necessary because Telecom customers in commercially viable areas should offset Telecom customers in commercially non-viable areas.

128. The option essentially assumes that super normal profit⁵ for some commercially viable areas will be sufficient to balance against the losses for commercially non-viable areas. As such aggregation would occur at the top level for averaging of costs and revenues across all Telecom customers for local service.

129. Such an approach could only be economically sustainable while the Local Service TSO Provider continued to make super normal profits sufficient to offset loss making areas. However, such profits can be expected to be depleted over time through competition and so TSO Provider profitability would need to be monitored and the approached regularly reviewed to ensure it remained sustainable. If profitability of the Telecom fixed business becomes unreasonably impaired then there would be scope for a line rental increase beyond the price cap level.

130. Implementation of this option would require minor changes to the Telecommunications Act, but would not involve revising the existing Local Service TSO requirements recorded in the Local Service TSO deed.

6.3.1 Pros of TSO Provider bearing all TSO Cost

131. The potential positives of the TSO provider bearing all the TSO cost include:

• Simple to administer and avoids the cost and uncertainty of the TSO charge determination process; and
• Small service providers entering the market with low economies of scale and a smaller customer base are not burdened with recovering this expense.

6.3.2 Cons of TSO Provider Bearing all TSO Cost

132. The potential negative aspects TSO bearing all the TSO cost include:

• Could erode the profitability of the TSO Provider to such an extent that justifies an increase in the standard line rental;
• May reduce the TSO Provider's funding of upgrades to network infrastructure;
• Need for ongoing monitoring of the TSO Provider's financial position.

6.4 Contested TSO Charge of Specified Amount

133. Since the inception of the TSO framework, Telecom has had an uncontested monopoly on access to TSO subsidy funding through the Local Service TSO to supply local residential telephone service.

134. Many in the industry have advocated the introduction of contestability, at least for the commercially non-viable areas which contribute to the net TSO cost, so that it can be tested whether the supply of TSO local service in all areas by Telecom represents optimal value for money. It is argued that the "efficient operator" model currently applied in determining the TSO charge compensating Telecom does not adequately reflect the technology and productivity realities of the industry and relevant markets.

135. Contestability has been suggested as a way to get improved "value for money" in the amount of TSO subsidy funding. The concept of TSO contestability is essentially about using a competitive process to determine who is appointed the TSO Provider and has access to TSO subsidy funding for supplying TSO service.

136. Contestability could potentially be introduced through a variety of competitive methods for selecting a TSO Provider including auction, tendering etc. The preferred service provider awarded the status of "TSO Provider" in this way would be the one who required the least amount of subsidy funding to fulfil the specified TSO requirements.

137. Although internationally contestability has been introduced in a few counties (e.g. Peru and Malaysia) to select service providers who have access to subsidy funding for supplying local service, this has tended to be on a "green fields" basis where there is no existing incumbent provider supplying fixed line telephone service. At this time there is no working international model of contestability having been introduced for local telephone service where there is already an extensive copper cable access network servicing the majority of households.

138. There was an attempt in Australia to make the supply of local telephone service contestable in areas of low population density. However, there was not enough industry interest to make this sustainable at a subsidy cost lower than the compensation to Telstra as the incumbent service provider for these areas. The FCC in the US has a regulatory investigation proceeding into the potential of contestability to assist achieving US regulatory goals.

139. Contestability in the supply of TSO local service may be feasible for some areas of New Zealand where there already exists network capability which could be suitably adapted to supply a fixed telephone service equivalent of the Telecom copper cable based telephone service. For example, the Vodafone cellular network, the Woosh wireless network and the Kordia Extend network could potentially be used to facilitate the supply of fixed telephone access in certain parts of some commercially non-viable areas.

140. Contestability would give other service providers the opportunity to access TSO subsidy funding so they could expand their customer base and build economies of scale. To maximise the opportunity to receive the greatest number of bids from service providers to supply TSO local service it would be desirable to define the TSO service requirements in a technology neutral manner.

141. Implementation of this option would involve revising the existing Local Service TSO requirements by Telecom and the Crown mutually agreeing changes to the Local Service TSO deed. Changes to the Telecommunications Act would not be necessary to implement this option.

6.4.1 Pros of Contested TSO Charge of Specified Amount

142. The potential positives of contestability in relation to status quo include:

• More efficient supply of service through the deployment of technology solutions with higher productivity than current service solutions tied to the Telecom wireline telephone network;
• Lowering the TSO subsidy cost for the supply of local telephone service in commercially non-viable areas;
• Giving other service providers the opportunity to harness TSO customers for bolstering their economies of scale; and
• Motivating the incumbent TSO Provider to "lift its game" above merely complying with explicit TSO service standards.

6.4.2 Cons of Contested TSO Charge of Specified Amount

143. The potential negative aspects of contestability, depending on the model introduced, include:

• Possible lack of industry interest in bidding for TSO business;
• Business failure by a new TSO Provider and the consequent potential disruption of service to customers;
• Cost of implementing and administering a contestability scheme;
• Lost economies of scale without a single service provider supplying service to all areas; and
• TSO subsidy spending on a premium factored into bids for "asset stranding" where the provider is exposed to under recovery of capital asset costs for service infrastructure.