Capacity access in telecommunication networks: evaluating the symmetry of cost-based access prices using option pricing theory

Abstract

The search for an appropriate approach to pricing capacity access in telecommunication capacity networks has evolved variously in the literature through rate of return regulation, the Efficient Component Pricing Rule, price-cap regulation (RPI-X) and cost-based regulation, based on efficient forward-looking costs - all in search for an approach that would send signals for efficiency to the users of the access infrastructure and thereby facilitate the longer-term efficient development of access networks. In some literature and indeed in practice this search has for the time being settled on FL-LRIC,1 a cost-based access price, which has been widely advanced as an e¤ective instrument for incentive regulation. An emerging debate in the literature questions the versatility of FL-LRIC from the standpoint of option-theoretic considerations. An issue at the centre of the debate is the versatility of FL-LRIC in responding to the stochastic processes that de�fine downstream value. More speci�cally, whether, in view of the option-theoretic considerations, FL-LRIC is distortionary and whether such distortions, if any, are sufficiently material to adversely affect competitive outcomes. This thesis contributes to this debate, which sits at the interface of the theories to access pricing and option pricing, by taking it beyond the qualitative conjectures in literature and makes contributions on the following fronts. First, it develops a framework for valuing the flexibility of adapting to downstream value, and tests the neutrality of FL-LRIC as an approach for pricing capacity access, based on evidence from the analogue and ADSL platforms, using numerical methods. Second, it develops closed-form option-theoretic generalizations of the value of such flexibility, in the two platforms. The theoretical framework underpinning this thesis is option pricing theory. This theory is used because of its capacity to conceptualize and quantify the value of flexibility. This study uses data from the analogue and ASDL capacity access platforms in the UK. Maximum Likelihood Estimation is used to calibrate the stochastic differential equations describing downstream value and the value of the underlying contingent claims are estimated using risk-neutral valuation measures. From the standpoint of option pricing theory and based on UK evidence we �find that: (i) FL-LRIC is distortionary; and (ii) the level of the distortions, imply the existence of a strong incentive for inefficient entry