The New Investment Theory of Real Options and its Implication for Telecommunications Economics

273 Pages·2000·3.535 MB·English

by  Lenos Trigeorgis (auth.), James Alleman, Eli Noam (eds.)

The New Investment
Theory of Real Options
and its Implication for
Telecommunications
Economics
Topics in Regulatory Economics and Policy Series
Michael A. Crew, Editor
Graduate School of Management, Rutgers University
Newark, New Jersey, U.S.A.
Previously published books in the series:
Gordon, R. L.:
Kegulation and Economic Analysis: A Critique Over Two Centuries
Blackmon, G.:
Incentive Regulation and the Regulations of Incentives
Crew, M.:
Incentive Kegulation for Public Utilities
Crew, M.:
Commercialisation of Postal and Delivery Services
Abbott, T. A.:
Health Care Policy and Regulation
Goff, B.:
Regulation and Macroeconomic Performance
Coate, M.B. and A.N. Kleit:
The Economics of the Antitrust Process
Franz, R. S.:
X-Efftciency: Theory, Evidence and Applications (Second Edition)
Crew, M.:
Pricing and Regulatory Innovations Under Increasing Competition
Crew, M., and P. Kleindorfer:
Managing Change in the Postal Delivery Industries
Awerbuch, S. and A. Preston:
The Virtual Utility
Gabel, D. and D. Weiman:
Opening Networks to Competition: The Regulation and Pricing of Access
Zaccour, G.:
Deregulation of Electric Utilities
Young, W.:
Atomic Energy Costing
Crew, M.:
Regulation Under Increasing Competition
Crew, M.A. and P.R. Kleindorfer:
Emerging Competition in Postal and Delivery Services
Cherry, B.A.:
The Crisis in Telecommunications Carrier Uahility:
Historical Regulatory Flaws and Recommended Reform
Loomis, D.G. and L.D. Taylor
The Future of the Telecommunications Industry:
Forecasting and Demand Analysis
The New Investment
Theory of Real Options
and its Implication for
Telecommunications
Economics
edited by
James Alleman
University of Colorado at Boulder and PHB Hagler Bailly
Eli Noam
Columbia University
Kluwer Academic Publishers
Boston/Dordrecht/London
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Library of Congress Cataloging-in-Publication Data
Real options in telecommunications : the new investment theory and its implications for
telecommunications economics / edited by James Alleman, Eli Noam,
p. cm.
Includes bibliographical references and index.
ISBN 0-7923-7734-6 (acid-free paper)
1. Telecommunication-Economic aspects. 2. Capital budget. 3. Options (Finance)
I. Alleman, James H. II. Noam, Eli M.
HE7631 .R43 1999
384'.041"dc21
99-052725
Copyright ® 1999 by Kluwer Academic Publishers. Second Printing 2002.
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system or transmitted in any form or by any means, mechanical, photo
copying, recording, or otherwise, without the prior written permission of the
publisher, Kluwer Academic Publishers, 101 Philip Drive, Assinippi Park,
Norwell, Massachusetts 02061
Printed on acid-free paper.
Printed in the United States of America
This printing is a digital duplication of the original edition.
Contents
Preface vii
Randall B. Lowe, Piper & Marbury
Acknowledgements xi
Introduction and Overview xiii
James Alleman, University of Colorado and PHB Hagler Bailly
Real Options: An Overview 1
1. Real Options: A Primer 3
Lenos Trigeorgis, University of Cyprus
2. Real Options Applications in ttie
Telecommunications Industry 35
Sanjai Bhagat, University of Colorado
3. Does Practice Follow Principle? Applying Real Options Principles
to Proxy Costs in U.S. Telecommunications 49
Mark A. Jamison, University of Florida
4. Real Options:
Wtiat Telecommunications Can Learn from Electric Power 77
Todd Strauss, PHB Hagler Bailly
Principles 85
5. Cost Models: Comporting with Principles 87
Richard Emmerson, INDETEC International
6. Ttie Design of Forward Lool<ing Cost Models
for Exchiange Telecommunications Networl<s 95
William Sharkey, Federal Communications Commission
7. Forward Looking Telecommunications Cost Models 119
Timothy J. TardifF, National Economic Research Associates
Implications Of Neglecting Real Options 123
8. An Institutional Perspective on Assessing Real Options
Values in Telecommunications Cost Models 125
Barbara A. Cherry, Michigan State University
9. Real Options Applications tor
Telecommunications Deregulation 139
Greg Hallman, PHB Hagler Bailly and Chris McClain, Vouchsafe, Inc.
10. Ttie Poverty of Cost Models, ttie Wealth of Real Options 159
James Alleman, University of Colorado and PHB Hagler Bailly
11. Thie Forecasting Implications of
Telecommunications Cost Models 181
Timothy J. Tardiff.NERA
12. Thie Effect of Sunk Costs in Telecommunications Regulation 191
Jerry Hausman, Massachusetts Institute of Technology
Real Options: Evaluations 205
13. Real Options and the Costs of
the Local Telecommunications Network 207
Nicholas Economides, New York University
14. Option Value Analysis and Telephone Access Charges 215
William J. Baumol, New York University
15. Rethinking the Implications of "Real Options" Theory
for the U.S. Local Telephone industry 219
Richard N. Clarke, AT&T
16. Application of Real Options Theory to TELRIC
Models: Real Trouble or Red Herring 227
Michael D. Pelcovits, MCI WorldCom
17. Discussion: A View from Outside the Industry 245
Lenos Trigeorgis, University of Cyprus
18. Rejoinder 249
Jerry Hausman, Massachusetts Institute of Technology
Summary/Conclusions 253
19. Real Options, False Choices: A Final Word 255
Eli Noam, Columbia University
Biograptiies 261
Index 271
Preface
Randall B, Lowe
Piper & Marbury, L.L.R
The issue of costing and pricing in the telecommunications industry has been
hotly debated for the last twenty years. Indeed, we are still wrestling today over the
cost of the local exchange for access by interexchange and competitive local ex
change carriers, as well as for universal service funding.
The U.S. telecommunications world was a simple one before the emergence of
competition, comprising only AT&T and independent local exchange carriers.
Costs were allocated between intrastate and interstate jurisdictions and then again,
between intrastate local and toll. The Bell System then divided those costs among
itself (using a process referred to as the division of revenues) and independents
(using a process called settlements). Tolls subsidized local calls to keep the politi
cians happy, and the firm, as a whole, covered its costs and made a fair return.
State regulators, however, lacked the wherewithal to audit this process. Their con
cerns centered generally on whether local rates, irrespective of costs, were at a po
litically acceptable level. Although federal regulators were better able to determine
the reasonableness of the process and the resulting costs, they adopted an approach
of "continuous surveillance" where, like the state regulator, the appearance of rea
sonableness was what mattered.
With the advent of competition, this historical costing predicate had to change.
The Bell System, as well as the independents, were suddenly held accountable.
Federal regulators wanted to ensure that monopoly rates did not subsidize com
petitive offerings. Otherwise, ratepayers would pay too much and competitors
would be harmed by predatory prices.
As a result, various costing methodologies were devised by all sides to allocate costs
among the dominant carriers' services. The FCC, for instance, came up with a
number of fully distributed costing methodologies (FDC). AT&T proposed its
version of marginal cost pricing, which it labeled long-run incremental costs (LRIC).
FDC, of course, benefited competitors to AT&T because it attempted to spread
costs among AT&T's services based on the historical reasons for incurring those
costs. Under this method, AT&T's competitive services would be saddled with
costs that were not incurred as part of the competitive enterprise, but were associ
ated with more traditional offerings. Eventually, a compromise was reached: al
though LRIC was found to be unacceptable, a "pure" FDC method was used, as
tracked by a more "incremental" FDC method, and was placed in a costing manual
Real Options: The New Investment Ttieory and its Implications for Telecommunications
that AT&T was required to follow. Meanwhile, the states sat back and watched.
This approach did not work. On the assumption that "costs are as costs are de
fined," AT&T was able to use the manual in a manner that, strangely enough,
resembled marginal costs. The FCC next tried structural separation, but that did
not work either. Consequendy, the FCC found itself before Judge Greene of the
Washington, DC District Court arguing that divestment was the only solution.
(Divestment was considered a solution because it separated monopoly services
offered by what became the Regional Bell Operating Companies (RBOCs) from
the now-competitive toll offerings of AT&T. Straightforward in theory, it was dif
ficult to implement and failed to address the intraLATA toll that the RBOCs were
allowed to offer and contained an escape clause that permitted exceptions to the
separation.)
The FCC has relied more and more on market forces as the market shares of once-
dominant companies fall. As new markets open up, such as the market for com
petitive local exchange services, the costing issue has gained strength. This issue is
also now finding its way overseas as those markets open up to competition.
At the risk of oversimplifying, the issue of costs can be summarized as two-fold:
the quantitative determination of the level of costs and the proper attribution of
those costs. Both are fraught with questions. The amount of costs, for instance,
can vary from book costs to marginal costs. The attribution of costs (i.e., incurred
by whom for what service) can vary from those that are directly attributable to
those that are Joint and common. Hence, the need for costing theories and models.
Considering that, in the words of the FCC, costs are at the "heart" of just and
reasonable rates and that such rates lead to universal service and a strong competi
tive environment, the industry is constantly in search of theories and models that
more accurately reflect the underlying costs of service. It is in this light that the
papers have been compiled for this book. Real options theory attempts to consider
management's flexibility in valuation analysis and corrects the deficiencies of the
traditional discounted present value and decision tree analyses. Drs. AUeman and
Noam, as the editors of this compilation, have done a superb job by first setting
forth an introduction and overview of the subject, and then providing the reader
with a primer on real options in articles by Lenos Trigeorgis and Sanjai Bhagat.
Other authors in the volume highlight the controversies that surround the applica
tion of real options in the telecommunications industry; however, the editors have
effectively separated the issues of application from those of interpretation.
It is this type of work and inquiry that can illuminate the issue of costing and cost
modeling for a more refined use in telecommunications. Although we should not,
as one jurist put it, let perfection become the enemy of the good, we should con-
Preface
stantly strive for a better way, especially in the constantly changing world of tele
communications. One can only hope that this book opens that door a little fur
ther.
Acknowledgements
This volume is the product of the encouragement and cooperation of many people
and institutions. First, we would like to thank our home institutions, the Colum
bia Institute for Tele-Information (CITI) of Columbia University and the Inter
disciplinary Telecommunications Program (ITP) of the University of Colorado -
Boulder, which supported the workshop from which this proceeding was born.
Columbia provided the facilities and venue. Both contributed funding, hosted
web sites, supplied mailing lists, and in numerous other ways made the workshop
a success.
The assistance of Hagler Bailly and Putnam, Hayes & Bardett is also gratefully
acknowledged (the firms have since merged and are now known as PHB Hagler
Bailly). In addition to speakers and funding, it offered the support and guidance
to ensure this volume was published.
Of course, it is not the institutions, but the people behind them who contribute
time and effort. From CITI, Caterina Alvarez and later Lynette Mallett ensured
that the workshop was well organized and smoothly run, while Kenneth Carter
oversaw its planning and implementation.
From PHB Hagler Bailly, Lee Bauman added the drive and encouragement to see
the workshop through to completion, championed these proceedings, and came
through in emergencies. Mike Yokell and Bill Zarakas guided us through the pro
cess. A special thanks goes to Wynne Cougill, who edited this volume and Jane
Enright, who laid out the text. They did an outstanding job under tremendous
time pressure.
Last, we would like to acknowledge the speakers who gave generously of their time
and talents to produce an excellent workshop and, as the reader can judge, a sound
volume that initiates the debate on real options application to the telecommunica
tions industry.
James Alleman and Eli Noam