A Discrete Real Options Approach to Access Pricing

Abstract

Traditional cost-based access pricing can be assimilated to net present value (NPV) calculations. Regulated access prices are set so as to allow carriers to recover network asset costs over their economic life plus compensation for the opportunity cost of capital.1 However, NPV calculations do not capture managerial flexibility, viz., the ability to delay, expand or abandon a project. In particular contexts this flexibility is valuable. For instance, when an investment project implies sunk assets and uncertain returns, delaying the investment until more information on profitability is revealed can increase the value of the investment opportunity. Therefore if mandatory unbundling is regulated according to traditional cost-based access prices when capital costs are sunk, returns are uncertain and a network carrier has the opportunity to delay investment, both incumbent and access-seeker decisions are distorted leading, ceteris paribus, to under investment.2 The theoretical underpinnings of this claim are understood by academics and regulators.3 Nonetheless, full acceptance of the approach in regulatory proceedings has not occurred, mainly due to reservations regarding the validity of underlying assumptions (such as uncertainty, sunk nature of assets and ability to wait) and perceived implementation challenges. The underlying assumptions of the real options approach adequately represent investment opportunities for new telecommunication services, especially markets for broadband and next generation networks (NGN). Therefore, the focus of this chapter is to provide a feasible solution to the access pricing problem based on the real options approach.4 An early attempt to apply real options analysis to access problems in regulated industries is undertaken by Hausman (1997, 1999) in the context of TELRIC pricing within the telecommunications industry. Hausman and Myers (2002) also apply the approach to rail regulation, while Pindyck (2005) analyzes vertical services in the telecommunications industry.5