Discussion Papers

Marcus Weinkopf

Regulatory Requirements on Cost Accounting Systems within the Framework of ONP

Nr. 84 / April 1992 Summary Costs have traditionally in many ways played a very important role in public utility regulation, especially in the development and approval of tariffs. Regulation, considered as a substitute for competition, uses costs as a benchmark against which prices can be measured. Historically, the prevention of customer exploitation by undue high prices has been the most fundamental reason for regulation of public utilities. The two most common approaches to this problem are, on the one hand, endogenous cost-based approaches, and on the other, exogenous index-based approaches. While the former determine the appropriate tariff levels in each period by analysis of the costs actually incurred in the production of the regulated services, in the latter, the acceptable tariff levels are, after an initial estimation of the future productivity development of the regulated firm, for an agreed number of periods determined by the development of exogenous indices like, e.g. the Retail Price Index. The most common application of index-based price regulation in practice, price cap, is applied in the UK, the Netherlands, and the U.S.. It will be part of tariff regulation in France and is under consideration in Germany. Regulatory concern about prices set by the regulated firm in competitive markets that are deemed to be unreasonably low is, compared to issues concerning monopoly tariffs, a relatively new phenomenon. The importance of regulatory involvement in such cases has, however, risen with an increasing share of the old integrated monopoly markets being opened for competition. In contrast to the problem of tariff regulation in the reserved area where standardized approaches seem appropriate to facilitate the regulatory tasks, in the field of competition policy, standardized approaches sparing careful evaluation on a case-by-case basis would almost necessarily fail to ensure the desired results: As predatory pricing strategies - from an accounting view - strongly resemble to temporary penetration pricing strategies, standard approaches can hardly afford the needed distinction between reasonable and unreasonable prices below a defined benchmark. Though there is a wide variety of possible cost accounting methodologies for application in business and regulatory practice, one can draw a distinction between two basic philosophies underlying most approaches: On the one hand, fully distributed cost (FDC) seeking complete allocation of all costs incurred by a firm to the products/services it supplies, and, on the other hand, incremental costs (IC) analyses seeking comprehensive calculation of the costs that are (respectively: will be, or, have been) incurred due to a particular decision in question. FDC-based calculation means that the decision about an activity to be advantageous or not is made not only based on the costs that are directly influenced by this activity, but also considering the necessity to recover the overhead costs not directly attributable to any specific activity. The revenue requirement for the firm as whole, i.e., to recover (at least) all costs incurred, is thus translated into revenue requirements for each service or commodity, and even for each service element the firm supplies. As an advantage of FDC approaches, it is often cited that prices based on this principle ensure that each service, and thus each group of customers, bears a "fair" share of the overhead costs incurred by the firm. As is shown in our study, however, FDC-based costs can also give simply false signals about the use of scarce resources and thus lead to results that lack efficiency and distributional fairness. The IC concept reverses the viewpoint compared to the "top-down" approach used with FDC. In a "bottom-up" approach, IC analysis seeks identification of the costs that are caused or, respectively, can be controlled on every stage within the firm's hierarchy. As long as one deals with a static environment, this turn-around of the analysis does not necessarily lead to results very different from those obtained based on FDC. The strength of the IC approach is, however, its capability to be applied in decision-making problems of different size (with respect to the cost-categories involved) and different time ranges (with respect to the activity in question). Furthermore, the IC approach is forward-looking: While FDC data are mostly based on historic costs, IC reflects the costs of investments that are currently needed to afford a service respectively a group of services. In particular in an industrial sector as dynamic as telecommunications, it can be assumed that there may be huge differences between historic and current costs in certain cost categories. TOs in the European Community are at present still operating as at least dominant players in most of their businesses. This means that competition policy issues, and thus predominantly pricing issues, will be of major importance for European telecommunications regulation. For these issues, cost studies based on IC analyses seem more appropriate than FDC-based calculations. Concerning cost accounting stipulations in ONP documents, we therefore recommend a language that - encourages the development of procedures appropriate to evaluate individual services' prices against the goals of customer protection and ensurance of fair competition; - emphasizes the need for national regulators' access to all data necessary to ascertain adherence to the ONP principles; - in principle accepts the suitability of generally accepted accounting principles as a basis for further analysis, where required, but avoids to over-focus on any standardized cost accounting data as the determining basis for pricing issues. - does not restrict the flexibility with respect to the development of appropriate cost study methodologies by pre-definition of one preferred system; - states as a binding rule the principle that transfer prices for reserved/monopoly services provided to competitive business units within a TO's organization have to equal tariffs charged to external users.

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