ARCHIVED -  Telecom Decision CRTC 94-13

Telecom Decision

Ottawa, 13 July 1994

Telecom Decision CRTC 94-13

REVIEW OF REGULATORY FRAMEWORK - TARGETED PRICING, ANTI-COMPETITIVE PRICING AND IMPUTATION TEST FOR TELEPHONE COMPANY TOLL FILINGS

I REQUESTS BY UNITEL AND SPRINT

In the proceeding initiated by Review of Regulatory Framework, Telecom Public Notice CRTC 92-78, 16 December 1992 (the Regulatory Framework proceeding), Unitel Communications Inc. (Unitel) requested in final argument that, on an interim basis, prior to the establishment of a new regulatory framework, the current rules governing the consideration of new toll services to be offered by the telephone companies and of rate reductions for their existing services be amended as follows:

(1) Phase II costs should be made consistent with adjustments to Phase III suggested by Unitel in conjunction with its request that there be a 35% reduction in the contribution charges paid by competitors; and

(2) contribution should be included by the telephone companies as a cost of providing the service in question.

Sprint Canada Inc. (Sprint) requested that the Commission immediately adopt a moratorium on further Stentor member targeted long distance discount plans, pending implementation of equal access and a new incentive-based regulatory framework flowing from the Regulatory Framework proceeding.

In making its request, Unitel stated that the telephone companies have aggressively used their dominant position in the long distance market to target their competitors in the limited market segments that are open to competition. Unitel submitted that this pricing strategy would not be possible if these markets were characterized by effective competition. Unitel stated that it is made possible by Stentor's overwhelming dominance, resulting from a number of factors including technical barriers to entry into certain key market segments and a high degree of customer inertia towards changing carriers. It was Unitel's position that the combination of these factors enables Stentor to target massive price cuts in the relatively small market segments where Unitel and other entrants can compete, while maintaining prices well above cost in the segments where there is still a captive market.

Unitel submitted that the problems associated with targeted pricing are made worse by the fact that the telephone companies are not currently required to include contribution as an imputed cost in the Phase II cost studies that they file to justify rate reductions or changes. Unitel stated that this enables the Stentor companies to average contribution over various market segments, recouping more contribution from residential and small business customers and less from discounted toll services and 800 services. Unitel argued that competitors, on the other hand, cannot pursue a similar strategy due to the barriers to entry and customer inertia in high contribution markets.

Unitel submitted that contribution should be treated as a cost for all telephone company services, as is the case for competitors. Unitel's view was that long-run incremental cost plus average telephone company contribution applied at the individual service level would provide a meaningful test for anti-competitive pricing during the interim period prior to the implementation of a new regulatory framework. Unitel's view was that, unless the telephone companies (like competitors) are required to recognize contribution as a cost of providing their services, they will easily be able to price below competitors and squeeze them out of the market. Unitel considered the imputation of contribution to be an essential requirement to prevent the telephone companies from competing unfairly, and stated that, without this type of interim safeguard, many competitors would not survive the transition to workable competition.

Comments regarding targeted pricing, anti-competitive pricing, the imputation of contribution and Unitel's and Sprint's requests were received from various parties, including AGT Limited (AGT); British Columbia Old Age Pensioners' Organization, Council of Senior Citizens' Organizations, West End Seniors' Network, Senior Citizens' Association, Federated Anti-Poverty Groups of B.C. and Local 1-217 IWA Seniors; Competitive Telecommunications Association; the Director of Investigation and Research, Bureau of Competition Policy; Government of Ontario; National Anti-Poverty Organization; Government of Quebec; Sprint; Stentor Resource Centre Inc., on behalf of BC TEL, Bell Canada (Bell), The Island Telephone Company Limited (Island Tel), Maritime Telegraph & Telephone Company Limited (MT&T), The New Brunswick Telephone Company Limited (NBTel) and Newfoundland Telephone Company Limited (Newfoundland Tel); and Unitel.

II EXISTING FRAMEWORK

In Competition in the Provision of Public Long Distance Voice Telephone Services and Related Resale and Sharing Issues, Telecom Decision CRTC 92-12, 12 June 1992 (Decision 92-12), the Commission established criteria for granting interim ex parte approval to telephone company competitive toll filings. Subject to any considerations concerning unjust discrimination or undue preference, those criteria are:

(1) the proposed rates must be compensatory, on the basis that revenues from the service exceed causal costs; and

(2) either:

 (a) the proposed rates must result in an insignificant reduction in contribution; or

 (b) any significant reduction in contribution must amount to the elimination of surplus revenues.

The "compensatory" test established in Decision 92-12 (i.e., paragraph (1) above) excludes any provision for the imputation of contribution and is applied to a service as a whole.

The Commission recognized in Decision 92-12 that the telephone companies' implicit contribution would vary across market segments, stating that "the use of an average measure would likely encourage competitors to target those areas of the market that generate an above average level of contribution. As a result, they might gain a larger proportion of that market, while the respondents would be left with a larger proportion of the low contribution market."

With respect to targeted pricing, the Commission stated that:

(1) "subject to local rate impact considerations, the Commission has found that plans by the respondent telephone companies to introduce targeted rate reductions are in the public interest, particularly in light of concerns about the competitiveness of Canadian business and bypass of Canadian network facilities"; and

(2) "the Commission considers that targeted discounts, such as those proposed by the respondents, represent a reasonable approach to reducing long distance rates."

III TARGETED PRICING, ANTI-COMPETITIVE PRICING AND THE IMPUTATION TEST

A. General

The Commission notes that, as long as the regulatory framework for interexchange services involves something other than complete unconditional forbearance, a test for anti-competitive pricing is necessary, either as a criterion for approval of tariffs (in a tariffed environment) or as a test to resolve complaints (in a de-tariffed environment). There are currently two basic options for such a test: (1) the Commission's current approach, which requires that rates be compensatory in the sense that revenues for each service must recover causal costs, and (2) a test that requires that rates recover not only causal costs, but also contribution (i.e., an imputation test).

The Commission's approach to targeted pricing in Decision 92-12 essentially relied on market forces. In other words, it relied on the assumption that, to the extent that the telephone companies targeted reductions at particular market segments, they would leave other non-targeted market segments exposed to price reductions by competitors and would make competitive entry in the non-targeted segments more attractive. The Commission's approach was also based on the assumption that contribution discounts would be sufficient to offset barriers to entry across market segments. Under such a scenario, competitors could duplicate the pattern of contribution across market segments implicit in the telephone companies' rates by generating a traffic mix similar to that of the telephone companies, or could take advantage of the telephone companies' targeting strategy by entering other, high contribution market segments left exposed by the targeting. In addition, over time, one would expect the telephone companies to respond to entry in the high contribution market segments, with the result that the difference in contribution across market segments would be moderated.

However, based on an examination of the market as it has evolved since Decision 92-12, the Commission considers that the contribution discounts established in that Decision, in conjuction with the current regime for the approval of telephone company tariff filings, are not sufficient to address concerns over targeted pricing, given barriers to entry and customer inertia in the non-targeted market segments. From the perspective of a competitor, contribution represents a tangible, albeit discounted, element of cost. Under a scenario of unrestrained targeted pricing by the telephone companies, competitors could be faced with a situation in which they must compete against telephone company prices that embody a contribution amount that is lower than the competitor contribution cost in that market segment, but where they are unable to generate sufficient contribution in the less competitive (and higher contribution) markets to offset the lower contribution markets.

The Commission considers that, due to their previous status as monopoly toll providers, the telephone companies have an established and generally predominant share in all market segments. As a result, their traffic mix, the presence of barriers to entry and the existence of customer inertia would permit them, on a sustained basis, to recover contribution from the most highly contested market segments at a level below the contribution amount per-minute per-end corresponding to line 10 of the contribution calculations on page 198R of Decision 92-12 (the line 10 contribution amount). Further, the Commission is of the view that, until barriers to entry and customer inertia in all market segments have been reduced sufficiently to provide competitors with an opportunity to compete equally, or until contribution is reduced to levels where potential variations between high and low contribution market segments is minimal, recovery of contribution by the telephone companies in specific market segments that is below the line 10 contribution amount would be inconsistent with a fair competitive environment. Until such time, while recognizing that it will somewhat reduce telephone company pricing flexibility, the Commission considers it necessary in order to ensure such an environment that an imputation test be applied, either at the level of individual services or at the level of each of the basic toll, 800 service and discount toll market segments.

In the Commission's view, the application of the appropriate imputation test will ensure that rates are not anti-competitive. Therefore, there should generally be no additional regulatory concerns with targeted pricing, absent concerns over unjust discrimination, undue preference, or the impact on local rates. As a result, the application of the test will have the additional benefit of permitting the expeditious disposition of telephone company toll filings, provided that adequate information is submitted in support.

However, there are several issues to be considered in the design of an appropriate imputation test. These are:

(1) the level of aggregation at which the test should be applied;

(2) the level of the contribution component;

(3) what exceptions, if any, to the requirement that the test be met are appropriate; and

(4) the specific form of the test and related filing requirements.

These issues are addressed below.

B. Level of Aggregation

As noted above, the Commission's view is that achievement of a fair competitive environment requires that the imputation test be applied at the level of either individual services or market segments. Recognizing the above, in the Commission's view, there are two primary options for the imputation test:

(1) a requirement that revenues (or the average revenue per minute) for each service equal or exceed the sum of Phase II causal costs and contribution; or

(2) (a) a requirement that revenues (or the average revenue per minute) for each service equal or exceed Phase II causal costs; and

(b) a requirement that revenues (or the average revenue per minute) for each market segment as a whole equal or exceed the sum of Phase II causal costs and contribution.

Option 1 entails the application of the imputation test at the individual service level, while Option 2 entails the application of the test at the market segment level. The Commission considers that there are two key considerations bearing on the question of which option is preferable.

The first consideration is the degree of pricing flexibility that the test would permit. A service-specific imputation test (Option 1) would provide less pricing flexibility to the telephone companies, because they would not be able to offset recovery of lower contribution from one service with rates that would recover more contribution from other services in the same market segment (as they would be able to do under Option 2). The Commission notes, however, that the trend, particularly in the discount toll and 800 service market segments, is to define services more broadly, grouping together what would previously have been considered separate services. Thus, any restriction on pricing flexibility resulting from service level imputation, as opposed to market segment imputation, may not be significant and may decline over time.

The second consideration is the regulatory burden associated with the test. In this regard, the Commission notes that service-specific imputation would require that only one test be performed, i.e., that the service recover both its causal costs and the imputed contribution. Market-segment imputation would, in the Commission's view, require that the telephone company demonstrate that two tests were met, i.e., that each service recovers its causal costs and that the market segment as a whole recovers its costs plus aggregate imputed contribution.

In addition, the information that would be required in order for the Commission to have confidence in the results would be much greater in the case of the market-segment imputation test, since, in the Commission's view, the market-segment test results would be more sensitive to assumptions concerning relative levels of demand for the various services within the market segment and the degree of migration of demand from one service to another in response to changes in relative prices for services within the market segment. Assumptions such as these are difficult to verify in a rapidly changing competitive market. Current information requirements for toll filings making use of estimates of migration between services and competitors are extensive, and require the use of complex and highly judgmental models and sensitivity analyses involving the various assumptions. As a result, they can give rise to controversy and delay. Consequently, from the perspectives of practicality and regulatory streamlining, the Commission considers that the service-specific imputation test is preferable as a means to support tariff filings.

On balance, the Commission is of the view that the service-specific imputation test (Option 1) is the preferred option. Given the trend towards more broadly defined services, the Commission considers that this option provides a reasonable balance between pricing flexibility and practicality of application.

In light of the above, effective the date of this Decision, the Commission will require that the service-specific imputation test be applied to all applications for toll rate reductions or new toll services on the part of AGT, BC TEL, Bell, Island Tel, MT&T, NBTel and Newfoundland Tel, in place of the current requirement that proposed rates be compensatory on the basis that revenues from the service exceed causal costs. Since the application of the imputation test represents a change in Commission policy, the requirement that the test be met will apply only to rates approved after the date of this Decision. Thus, the Commission does not, as a result of this Decision, envisage increases to toll rates that have already been approved.

Some parties suggested during the Regulatory Framework proceeding that a service-specific imputation test would force price increases for off-peak basic toll service. As noted above, the imputation test is to apply only on a going-forward basis and, for this reason alone, would not force such price increases. In addition, intra-company off-peak basic toll is not a service for the purposes of service-specific imputation; rather, the service for the purposes of the imputation test is intra-company basic toll in total. Specifically, the service definition to be used for the purposes of the service-specific imputation test is the tariff definition (for example, Advantage Preferred, Teleplus Subscription Service, Between Friends, Advantage 800, Advantage Vnet, etc.).

C. Level of the Contribution Component

In Decision 92-12, the Commission found it appropriate to establish contribution discounts as a means of achieving competitive equity. Consistent with that approach, the Commission considers that the undiscounted contribution amount (i.e., the line 10 contribution amount) is the appropriate amount to be included in the imputation test, rather than the discounted contribution amount that would have been paid had a competitor carried the traffic.

A further issue with respect to the contribution component of the imputation test relates to direct access lines (DALs). Pursuant to Decision 92-12, competitors do not pay contribution on traffic originated or terminated on DALs. In Decision 92-12, the Commission stated that directly applying a contribution charge to traffic carried on DALs would be administratively difficult, if not impossible.

Given that finding, the Commission considers that, for the purposes of the imputation test, contribution should not be included for telephone company traffic originated or terminated on DALs (a telephone company DAL would be an access line dedicated exclusively to a service or services in the Competitive Toll or Competitive Network Phase III categories). In the Commission's view, an imputation test that imputed contribution on the telephone companies' DAL traffic would be inconsistent with competitive equity.

D. Exceptions to the Test

The Commission considers that below-cost pricing in the case of market trials and promotions is generally not anti-competitive. Accordingly, market trials and promotions will be exempt from the application of the imputation test, on the condition that sufficient information is provided by the telephone companies to demonstrate that the offering is a legitimate market trial or promotion of limited duration. The Commission's general policy will be not to permit other exceptions to the requirement that the imputation test be met.

E. Specific Form of the Test and Related Filing Requirements

AGT, BC TEL, Bell, Island Tel, MT&T, NBTel and Newfoundland Tel are directed to provide, effective immediately, imputation test information with all tariff applications for toll rate reductions and new toll services, as a replacement for item (4) of the Appendix to Information Requirements for Competitive Toll Filings by the Telephone Companies, Telecom Letter Decision CRTC 93-12, 30 July 1993.

The Commission considers that the application of the imputation test approved in this Decision should involve the use of the appropriate Phase II study (excluding cross-effects), as modified to reflect the imputation of contribution as a cost. The Commission will require that the test be applied for each company, unless all revenues (both intra-company and non-intra-company) associated with the service in question are subject to settlement, in which case a single Stentor study is appropriate.

The telephone companies are directed to identify the imputed contribution component separately and to describe and justify their assumptions concerning the proportions of telephone company traffic originating and terminating on DALs.

The Commission notes that, given the sensitive nature of cost information for competitive toll services, the information filed to demonstrate whether or not the imputation test is met will likely be filed in confidence. In general, the Commission considers this appropriate. However, in general, the Commission considers that, at a minimum, the following should be placed on the public record:

(1) a statement as to whether or not the imputation test is met and, if not, the justification for the proposed rates; and

(2) details of the method used to perform the imputation test.

AGT raised the concern that Phase II does not represent an appropriate incremental cost test for the purpose of determining whether or not a competitive service is compensatory. AGT indicated that the costs produced by Phase II studies would be acceptable if the variable common cost factor (VCCF) currently employed in the analysis were removed. AGT was of the view that the inclusion of variable common costs is inconsistent with the estimation of service-specific causal costs.

The Commission notes that the purpose of the Phase II costing methodology is to estimate causal costs for individual services and that the VCCF is intended to estimate costs causal to a service that it would be impractical to estimate through some other means. In any event, the Commission is of the view that the Regulatory Framework proceeding is not the appropriate forum in which to consider the details of the variable common cost estimation methodology or the appropriateness of the inclusion of such costs in the estimation of causal costs for individual services.

IV OTHER MATTERS

With respect to part (1) of Unitel's request, the Commission notes that, in Review of Phase III, Telecom Public Notice CRTC 94-16, 16 March 1994, it denied Unitel's requested interim 35% reduction in the contribution charges paid by competitors. However, the outcome of the Phase III review may have an impact on the costs calculated for the purposes of Phase II. Therefore, AGT, BC TEL, Bell, Island Tel, MT&T, NBTel and Newfoundland Tel are directed to provide a report on any such impact, as well as any consequential changes to their Phase II manuals, within 30 days of the Commission's decision in the Phase III review, detailing:

(1) any changes to Phase II methodology or costing models resulting from the Phase III review decision; and

(2) plans for the implementation of the above.

In the Commission's view, this Decision addresses the concerns related to targeted pricing underlying Sprint's request for a moratorium on further Stentor member targeted long distance discount plans. Accordingly, the Commission denies that request.

V STATUS OF THIS DECISION

In light of other determinations to be made in the Regulatory Framework proceeding, this decision is interim and is subject to change in the Commission's decision on the other issues in that proceeding.

The Commission notes that Manitoba Telephone System (Manitoba Tel) was not subject to the Commission's jurisdiction when Public Notice 92-78 was issued and was therefore not made party to the Regulatory Framework proceeding. The Commission's preliminary view is that it would be appropriate to apply the imputation test to Manitoba Tel. Manitoba Tel is therefore directed to show cause, by 12 August 1994, why it should not be made subject to this Decision. The company is to serve copies of its submission on parties to the Regulatory Framework proceeding by the same date. Parties may comment on Manitoba Tel's submission by 2 September 1994. Manitoba Tel may file a reply by 19 September 1994.

Allan J. Darling
Secretary General