##Ip Intercon Full

8/13/2019 ##Ip Intercon Full

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Prepared For:

GSM Association

71 High Holborn

London WC1V E6A

United Kingdom

Economic study on IP

interworking

Prepared By:

Bridger Mitchell, Paul Paterson, Moya Dodd,Paul Reynolds, Astrid Jung of CRA International

Peter Waters, Rob Nicholls, Elise Ball of Gilbert +

Tobin

Date: 2 March 2007



Page ii

TABLE OF CONTENTS

EXECUTIVE SUMMARY .................................................................................................. 1

1. INTRODUCTION........................................................................................................ 8

1.1. AIM AND SCOPE..............................................................................................................8

1.2. STRUCTURE OF THE REPORT...........................................................................................9

2. IP INTERCONNECTION IN THE CURRENT PUBLIC INTERNET ......................... 10

2.1. INTRODUCTION.............................................................................................................10

2.1.1. Implications of packet switching and circuit switching ................................................ 10

2.2. INTERCONNECTING IP NETWORKS .................................................................................11

2.2.1. Direct interconnection.................................................... ............................................. 11

2.2.2. Indirect interconnection ........................................................ ...................................... 12

2.3. ANY-TO- ANY CONNECTIVITY ..........................................................................................13

3. INTERCONNECTION PRICING MODELS IN CURRENT INTERNET.................... 15

3.1. OPERATOR HIERARCHY WITHIN THE INTERNET ...............................................................15

3.2. B ASIS OF CHARGING .....................................................................................................17

3.3. INTERNET PRICING MODELS FOR DIRECT INTERCONNECTION ...........................................17

3.3.1. Interconnection between Tier 1 IAPs.......................................................................... 18

3.3.2. Interconnection between Tier 1 IAPs and Tier 2 ISPs...................... .......................... 20

3.3.3. Interconnection between Tier 2 and Tier 3 ISPs......................................................... 21

3.3.4. Initiating Party Network Pays (IPNP)................. ......................................................... 21

3.4. WHO PAYS FOR TRANSIT?.............................................................................................22

3.4.1. Multiple charging models applied in a single internet session.................................... 23

3.5. WHAT IS PAID FOR?......................................................................................................26

3.6. CURRENT TECHNOLOGY SHAPES INTERCONNECTION CHARGING MODELS ........................26

4. THE CHANGING WORLD OF IP............................................................................. 29

4.1. INTRODUCTION.............................................................................................................29

4.2. NEXT GENERATION NETWORKS ....................................................................................29

4.2.1. Introduction ....................................................... ........................................................ . 29

4.2.2. NGN architecture................................................................. ....................................... 30

4.3. QUALITY OF SERVICE ....................................................................................................31

4.4. NGN INTERCONNECTION ..............................................................................................32

4.5. IPX .............................................................................................................................33



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5. DETERMINANTS OF EFFICIENT IP INTERCONNECTION FEES ........................ 37

5.1. INTRODUCTION.............................................................................................................37

5.2.

THE MEANING OF ECONOMIC EFFICIENCY .......................................................................37

5.2.1. Components of efficiency..................................................... ...................................... 38

5.2.2. Relationship to consumer welfare and competition .................................................... 39

5.2.3. Market outcomes of economic efficiency........................................................... ......... 39

5.3. WHO SHOULD PAY FOR INTERCONNECTION?...................................................................42

5.3.1. The economic role of interconnection charges............................................ ............... 43

5.3.2. Determining the efficient retail model ....................................................... .................. 44

5.3.3. Efficient direct interconnection ......................................................... .......................... 48

5.3.4. Efficient transit interconnection ............................................... ................................... 52

5.3.5.

The combination of efficient direct and transit interconnection............................... .... 54

5.3.6. Efficient interconnection charges when traffic is balanced ......................................... 55

5.3.7. Quality of service in efficient interconnection ......................................................... .... 55

5.3.8. Welfare consequences of inefficient interconnect charges......................................... 57

5.4. THE EFFICIENCY OF MULTIPLE IP INTERCONNECTION MODELS .........................................61

5.5. CONCLUSION ...............................................................................................................62

5.5.1. The role of interconnection fees in determining market outcomes ............................. 62

5.5.2. Circumstances determining the efficient interconnection fee ..................................... 63

6. ECONOMIC ASSESSMENT OF ALTERNATIVE CHARGING MODELS................ 69

6.1. INTRODUCTION.............................................................................................................69

6.2. EFFICIENCY OF “BILL- AND-KEEP”...................................................................................70


6.2.2. Transit .................................................. ....................................................... ............... 74

6.2.3. BAK in the presence of QoS differentiation ......................................................... ....... 75

6.2.4. BAK imposed by regulation ....................................................... ................................. 77

6.2.5. Conclusion .................................................... ........................................................ ..... 78

6.3. EFFICIENCY OF IPNP....................................................................................................80

6.3.1. IPNP when interconnection price is held constant...................................................... 81

6.3.2. Enhanced performance of IPNP when interconnection fees can vary........................ 84

6.3.3. IPNP imposed by regulation...................................................... ................................. 85

6.3.4. Conclusion .................................................... ........................................................ ..... 85

6.4. EFFICIENCY OF RPNP ..................................................................................................86

6.4.1. RPNP when interconnection fees are held constant .................................................. 87

6.4.2. Enhanced performance of RPNP when interconnection fees can vary ...................... 88

6.4.3. RPNP and regulation......................................... ......................................................... 88

6.4.4. Conclusion .................................................... ........................................................ ..... 89

6.5. EFFICIENCY OF SETTLEMENT-BASED INTERCONNECTION (SBI) ........................................89

6.6. CONCLUSION ...............................................................................................................90



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6.6.2. Transit .................................................. ....................................................... ............... 92

7. POLICY IMPLICATIONS.......................................................................................... 93

7.1. INTRODUCTION.............................................................................................................93

7.2. EFFICIENCY OF IP INTERCONNECTION IN THE INTERNET AND IN NGN..............................95

7.2.1. Current IP Interconnection models................................................. ............................ 95

7.2.2. Future IP Interconnection models.................................................................... ........... 97

7.3. ROLE FOR REGULATORY INTERVENTION.........................................................................98

7.3.1. Risks in Intervention........................................................ ........................................... 98

7.3.2. Risk of increased opportunities for arbitrage ................................................... ......... 100

7.3.3. Any-to-any connectivity ........................................................... ................................. 100

7.3.4. Regulatory certainty ................................................... .............................................. 103

7.3.5. Assessment framework............................................................ ................................ 103

7.3.6. Transition between interconnection regimes ......................................................... ... 105

7.4. CONCLUSIONS ...........................................................................................................105

APPENDIX A: BASIC TECHNICAL AND CHARGING CONCEPTS ............................ 107

A.1 B ASIC CONCEPTS .......................................................................................................107

A.1.1 Interconnection models in telephony ........................................................... ............. 107

A.1.2

Relationship between interconnection models and retail services ........................... 111

A.2 TRANSMISSION OF INFORMATION IN DIGITAL FORMATS ..................................................114

A.2.1 Packetisation............... ........................................................ ..................................... 114

A.2.2 Circuit switching ................................................ ....................................................... 114

A.2.3 Packet switching.................................................................. ..................................... 116

A.2.4 Routing in IP networks .......................................................... ................................... 117

A.3 THE INTERNET............................................................................................................117

A.3.1 Introduction ....................................................... ....................................................... 117

A.3.2 Internet Protocol addresses ..................................................... ................................ 117

A.3.3 Domain name server...................................................... .......................................... 118 A.3.4 Ports............ ........................................................ ..................................................... 118

A.3.5 Internet routing ................................................. ........................................................ 118

A.3.6 Best efforts delivery and Transmission Control Protocol .......................................... 119

A.4 IMPLEMENTING QUALITY OF SERVICE ..........................................................................119

A.4.1 Quality of Service parameters ........................................................... ....................... 119

A.4.2 Labelling for QoS paths...... ........................................................ .............................. 121

A.4.3 Billing models for QoS networks......................................................................... ...... 122

A.5 NGN INTERCONNECTION ............................................................................................122

A.6 NETWORK MANAGEMENT IN FIXED AND MOBILE.............................................................124



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APPENDIX B: THE EFFICIENT UNIT AND LEVEL OF INTERCONNECT CHARGES 125

B.1 WHAT SHOULD BE PAID FOR: THE EFFICIENT UNIT OF INTERCONNECTION CHARGES ........125

B.2

HOW MUCH SHOULD BE PAID: THE RELATIONSHIP BETWEEN EFFICIENT INTERCONNECTIONCHARGES AND COSTS .................................................................................................126

APPENDIX C: THE EFFICIENCY OF MULTIPLE IP INTERCONNECTION MODELS 128

C.1 DIFFERENTIATION BETWEEN ACCESS AND CORE NETWORKS .........................................128

C.2 DIFFERENTIATION OF INTERCONNECTION CHARGES AMONG NETWORKS.........................129

C.3 DIFFERENTIATION OF INTERCONNECTION CHARGES AMONG CUSTOMERS OF A NETWORK130

C.4 DIFFERENTIATION OF INTERCONNECTION CHARGES ACCORDING TO SERVICES ...............130

APPENDIX D: EFFICIENCY OF BAK IN TRANSIT INTERCONNECTION.................. 132

APPENDIX E: REGULATORY APPROACHES TO IP INTERCONNECTION ............. 135

E.1 INTRODUCTION...........................................................................................................135

E.2 GERMANY ..................................................................................................................135

E.3 THE UNITED KINGDOM................................................................................................138

E.4 AUSTRALIA.................................................................................................................139

E.5 HONG KONG ..............................................................................................................142

APPENDIX F: THE AUTHORS..................................................................................... 145

F.1 CRA INTERNATIONAL .................................................................................................145

F.2 GILBERT + TOBIN .......................................................................................................146

APPENDIX G: GLOSSARY .......................................................................................... 147



Page 1

EXECUTIVE SUMMARY

Telecommunications networks are on the verge of profound generational change.

Century-old circuit-based networks are being replaced by packet-switched “next-

generation networks” (NGNs) using Internet Protocols (IP). With quality of service

parameters (QoS) built in, NGNs will be far more reliable than today’s IP-based public

Internet, capable of delivering telephony, television, data and a plethora of new services

at much lower marginal costs than would be possible on today’s networks. Large gains in

efficiency and welfare will be possible; and if captured, they will be immensely valuable to

society.

IP interconnect is a critical lever to achieving economic efficiency. The GSM Association

(GSMA) has commissioned this study to consider the merits of various interconnectcharging models, including the impact of particular models on investment, innovation,

QoS and competition. And in particular, to consider the implications of a QoS environment

where more sophisticated retail and interconnect services both enable and require more

complex commercial arrangements.

Economically efficient interconnect (wholesale) charging depends on efficient retail

charging. Given the large range of services that will be carried by QoS-enabled NGNs, a

wide variety of retail pricing models will emerge. To be efficient, an associated variety of

pricing models will be necessary at the wholesale level.

Consequently, there is no “one-size-fits-all” IP interconnect charging model that willdeliver superior efficiency outcomes in all situations. Each model examined has different

strengths and weaknesses, depending on the situation. Imposing a single model risks

significant harm to efficiency and consumer welfare. Regulators should therefore proceed

cautiously in recommending or favouring any particular model. Regulatory certainty can

be achieved by issuing explicit assessment criteria – based on whether market outcomes

would be advanced – rather than prescribing solutions to interconnect arrangements

when the services to be carried and the networks over which they will be carried are

undergoing significant change.

Large efficiency and welfare gains beckon

IP interconnection is not a new phenomenon – it underpins the public Internet today. But

today’s IP-based networks are burdened with inefficiencies, and offer only “best-efforts”

quality. They send each message as a series of packets, each bearing the destination

address. These packets can take multiple, independent paths, carried by an

indeterminate set of operators, and must be re-compiled at their destination into a

coherent message.



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Interconnection arrangements in the public Internet are somewhat crude. Traffic is

generally only measurable at the handoff points between each successive pair of

networks. Pricing arrangements at each network handoff point are struck largely in

isolation from each other and from the ultimate retail pricing models, resulting in a rangeof payment models: some sending networks pay to send, others receive a payment for

sending packets, yet others treat interconnect as free. In an economically efficient world,

the nature of customer demand would affect the structure and level of retail charges; and

in turn, these retail services would be supported by an appropriate structure and level of

wholesale interconnection charges. But currently, IP interconnection charges are largely

determined by the tier status of operators and the balance of traffic flows between them,

with no ability to attribute an appropriate value at the wholesale level to the contents of a

particular packet or series of packets. This acts to inhibit the efficient recovery of costs.

These inefficiencies are a direct result of the technical limitations of today’s Internet.

But technological changes are transforming IP services and networks. Future NGNs(which will coexist alongside the public Internet) will be able to carry packets at a

specified quality level (or QoS). This will have far-reaching consequences for both the

retail services that can be offered, and the interconnect services that will be enabled and

required. Multiple services will be simultaneously provided with differential, guaranteed

service levels1. Packets with different quality settings will be able to be differently priced.

This brings with it the ability to enhance consumer welfare by matching the type and

quality of services demanded by consumers with the supply of these services in a least

cost manner, or by giving consumers the ability to select the level of service for which

they are willing to pay. For example, voice over Internet Protocol (VoIP) services could

be delivered using a high-priority network “path” to ensure call clarity, while email services

could use a cheap, low-priority path.

The requirements of end-to-end QoS will fundamentally change how IP networks

interconnect. Current IP interconnection does not have to distinguish between different

classes of traffic. But NGN networks will enable a model where one party takes

responsibility for establishing a “QoS path”, maintaining the right quality level through the

various networks between the sender and receiver. This model is consistent with the IPX

arrangements being considered by the GSMA.

1 The International Telecommunications Union defines an NGN as “a packet-based network able to provide

services, including telecommunications services, able to make use of multiple broadband, QoS-enabled

transport technologies, and in which service-related functions are independent from underlying transport-related

technologies. It offers unrestricted access by users to different service providers. It supports generalised

mobility, which will allow consistent and ubiquitous provision of services to users.”



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Interconnect charging arrangements will need to evolve considerably from today’s models

in order to support QoS. The network resources consumed will vary with the quality of

service required, and these costs must be taken into account in interconnect

arrangements if the cost burden is to be appropriately shared between operators and theirrespective customers. Further, because NGNs permit more centralised control over

messages, interconnect charges can be set in light of a coherent view of the end-to-end

service, including who pays the retail charges. As a result, the interconnection model can

be firmly linked to the retail charging model, and where appropriate, applied end-to-end

(instead of each segment applying its own model).

The current “best efforts” interconnection model may continue to apply to retail services

for which QoS is not required. But, as we explain in more detail below, to simply

transpose these models into the NGN world would stifle the development of more efficient

models, and prevent efficiencies from being full realised.

Relatively few network operators have yet committed to full NGN upgrades. Typically,

core networks are upgraded, with upgrades to the access networks to follow at some

future point. Services to take advantage of QoS-based end-to-end IP are still being

comprehended and developed – with supporting wholesale and retail commercial models

as yet uncertain. But the imminent migration of services to NGNs, and the enormous

potential for gains to society, have already sparked a regulatory and intellectual debate

about the charging model that should be applied to IP interconnection.

Capturing gains by efficient IP interconnect

The key IP interconnect models under debate are examined in this report. They operate

on a continuum of who pays whom for the delivery of a message (a phone call, SMS,

MMS, IM, email or a download of a data file, streaming video or a web page). At one end,

the initiating party’s network pays (IPNP) for termination on the destination network; at the

other end of the continuum, the initiating party is paid by the receiving network for having

originated the message (RPNP). At a midpoint between them is a model known as bill-

and-keep (BAK) where no interconnect payment is made at all. A variant of IPNP and

RPNP is known as “settlement-based interconnection” (SBI) where the packets in each

direction are offset before payment is made. Transit interconnection arrangements

(where an intermediate network takes the message part of the way between the

originating and the terminating network) can be classified along similar lines, depending

on which network pays for transit.

An assessment of these alternative interconnection charging models should be based on

criteria of economic efficiency, because efficiency is a precondition to maximising welfare.

In most practical circumstances, consumer welfare is also enhanced by increasing

efficiency. With efficiency gains, prices fall, quality improves (to the extent consumers are

willing to pay for it), costs are recovered (so investment incentives are preserved), and all

messages carried have a value that is no lower than the cost of delivering them.



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Economic efficiency is defined as the best use of resources (allocative efficiency), least

cost production (productive efficiency) and incentives for innovation and investment

(dynamic efficiency). These dimensions of efficiency can conflict so that determining the

optimal charging model may requiring balancing differing impacts.

In this report, we develop the thesis that efficient interconnect pricing can only be derived

in light of the efficient retail pricing arrangements, and an understanding of the costs

incurred by each network (with some very specific exceptions).

Understanding the efficient retail prices for messages brings some special challenges,

because (unlike many services) messages are jointly consumed by sender and receiver.

Efficient retail prices, as well as interconnection fees, must therefore serve the role of

optimally distributing the charges paid by two types of end customers (in addition to the

other economic roles of pricing, such as ensuring that costs are recovered with minimal

distortions to demand).

Hence, the economic role of interconnection fees is to encourage the originating and

terminating networks to charge their retail customers in a way that ensures that the retail

prices faced by each customer sends signals for efficient consumption of messages. If

this is achieved, messages will only be initiated if they are efficient - that is, if their

aggregate value to both customers exceeds the total costs of service provision.

For these reasons, the efficient wholesale pricing model cannot be identified in isolation

from the efficient retail charges. In an NGN world, QoS-based interconnection enables

this link to be established (similar to that which exists in the telephony world today

between wholesale and retail pricing). This is because the technical limitations of today’sIP interconnect – such as the lack of central control or billing information – will be

overcome by more sophisticated arrangements that support the requirements for

guaranteed QoS priorities. Retail services that promise a particular QoS (e.g. VoIP) will

be backed up by wholesale deals that deliver on that promise and charge accordingly.

Because of this close link between wholesale and retail charges in a future QoS

environment, it is not possible to say that one particular interconnect model will always

meet efficiency criteria better than another interconnect model. The large range of

services that will be carried by QoS-enabled NGNs, and the wide variety of retail pricing

models employed, will need to be linked to a similarly wide variety of pricing models at the

wholesale level. As a result, there is no “one-size-fits-all” interconnect model that is most

efficient in all situations. Indeed, it is likely to be most efficient to employ a range of

different IP interconnect models, co-existing for different networks, customers or other

situations.

It follows that consumer welfare will be harmed if an inefficient interconnect model is

imposed (e.g. by a regulator mandating that a perceived ‘winning’ model be applied

across the board). Services may not be provided to their fully optimal extent; investment

incentives can be damaged; and innovation stifled at both retail and wholesale levels. In

other words, inefficient IP interconnect could inhibit the realisation of many of the

anticipated benefits of NGNs, with potentially very large efficiency and welfare gains

simply “left on the table”.



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Examining particular interconnect models

A significant part of the public regulatory debate has been devoted to the question of

whether BAK2 is a more efficient charging model for interconnection than alternative

approaches, and whether it should be imposed as a charging model in at least some

interconnection situations. Based in part on the incorrect assumption that BAK is the

predominant charging model in the current Internet environment, the argument has been

made that as other services and networks converge to an IP standard, BAK could (or

should) become the prevailing interconnection pricing model of the future.

Indeed, we find that BAK is only efficient under a limited set of specific circumstances.

These are:

• where traffic is evenly balanced between peers (that is, networks with similar traffic

levels and geographical diversity), and cannot be taken out of balance by strategicbehaviour (in this situation all models would yield the same interconnect fee as BAK,

that is, zero); or

• where traffic is stable but not evenly balanced and where the imbalance in traffic

generates benefits to the different end-customers that just coincide with the costs

incurred by each customer’s network.

In situations where traffic is not balanced and operators can avoid costs (e.g. by ‘hot

potato routing’ whereby traffic is handed over as close as possible to a network’s own

retail customers)3 the introduction of a zero-fee BAK model tends to distort the operators’

incentives to provide interconnection services, even in the retail situation specified above.This is because the inherent inflexibility of interconnection fees under BAK (they are

always equal to zero) invites strategic behaviour in order to reduce costs. This incentive

would lead to widespread distortions - likely to be amplified in the context of QoS

provision - at the expense of consumers. BAK’s inflexibility is also likely to impede the

development of QoS-based interconnect, as would occur where terminating networks

would require a higher price for terminating a service at a higher quality.

For transit interconnection, some applications of BAK (e.g. in a chain of transit providers)

raise even greater problems as they leave no prospect of cost recovery for transit

providers and will therefore discourage the provision of transit services.

2 While the terms bill and keep and settlement-based interconnection are sometimes used interchangeably, there

is an important difference between BAK and settlement-based interconnection. Settlement-based

interconnection involves an offset of traffic in each direction so that the operator sending more traffic pays for

the net imbalance. BAK involves no payment for interconnection in either direction, irrespective of whether the

traffic is in balance or not. See our discussion on this point in Appendix A.

3 The practical effect of hot potato routing is that a network uses the network of other operators to avoid both the

cost of building its own backbone capacity or acquiring transit services from another operator who provides that

capacity.



Page 6

The problems resulting from applying BAK in the wrong situations can also arise where

IPNP (or RPNP) is applied using a particular interconnection charge that is far from the

efficient charge for that situation. Further, as with BAK, where the level of interconnection

charge is held constant, despite market developments, there would also be a risk thatoperators would engage in strategic behaviour to minimise costs.

Thus, a general advantage of IPNP and RPNP is simply that they encompass a range of

interconnection charges compared with BAK (which implies an interconnect charge of

precisely zero). Accordingly, as general charging models they are more likely to be able

to accommodate the range of interconnection charges that are efficient in particular

situations. Whether a particular level of interconnection charge is efficient will depend on

factors such as how retail customers share in message benefits, whether there are

means by which they can reward each other for initiating useful messages, and their

respective networks’ costs.

In many circumstances, IPNP is likely to be efficient. For a significant share of messages,

the initiating party will be the primary beneficiary and IPNP facilitates those messages

being transported. While there will also be a large share of messages in which both

parties benefit, IPNP can nonetheless support efficient message exchange through

repeated calling arrangements and/or compensation arrangements. IPNP also has the

property of discouraging unsolicited messages (spam) better than any other model by

imposing an economic cost on the network of the customer originating the spam. It helps

to limit the volume of spam through raising the cost of sending messages. IPNP can lead

to termination charges that contribute to not only the cost of the individual message but

also to the receiving party’s general cost of being connected. This provides a means to

efficiently internalise subscriber externalities.

On the other hand, concerns have been raised that IPNP creates a termination monopoly

that results in protracted regulatory inquiries into determining the efficient level of

termination charges. Any market power in relation to the setting of termination charges is

likely to diminish in an IP world, taking into account that there can be a large number of

paths between IP addresses and that content can be multi-homed. Moreover, even

where it is considered necessary for a regulator to continue to be involved in the setting of

termination charges, this would involve a relatively small welfare cost compared with

mandating a zero termination charge in situations where efficiency requires a significant

positive termination charge. The welfare costs of mandating the wrong interconnection

model across the industry are likely to greatly exceed any administrative savings from the

simplicity of BAK.

We also find that there are likely to be other specific situations where RPNP will be

appropriate. In particular RPNP facilitates messages being sent which primarily benefit

the receiver and which may otherwise not occur under BAK or IPNP.

Policy conclusions

Based on our analysis, we have drawn the following regulatory and policy implications for

IP interconnection:



Page 7

• Proceed cautiously : Regulators should be very cautious in mandating IP

interconnection charging models for the unfolding NGN IP environment. While

regulators may be called upon to determine interconnection arrangements in

particular circumstances, at this stage there is no justification for regulatoryintervention to mandate a single IP interconnection model. It is too early to tell what

model or models will prevail commercially and regulatory intervention to prescribe a

particular model, such as BAK, is likely to be pre-emptive and risky.

• Don’t mandate a single charging model. Even if a particular charging model develops

considerable commercial currency, it does not follow that this model would be an

appropriate “one-size-fits-all” model for regulators to mandate. Adopting the ‘wrong’

interconnection model in inappropriate circumstances will lead to significant market

distortions, which ultimately reduces consumer benefit. The evidence is that the

industry is working out appropriate IP interconnection models that correspond to the

variety of market circumstances in the absence of ex ante regulatory intervention.Hence, mandating particular interconnection charging arrangements in the current

environment may inhibit the development of inherently more effective and efficient IP

operating models. It is useful to note that global connectivity was achieved for the

current internet without regulatory intervention.

• Don’t assume bottlenecks will be replicated. The deployment of NGNs has the

potential to change the way many services are delivered. A regulator should not

assume that currently perceived bottlenecks (which in places have led to termination

regulation as well as any-to-any connectivity requirements) will be replicated in an

NGN environment.

• Use existing regulatory frameworks. In any event, existing regulatory frameworks

based on objective tests of market power are likely to be adequate to resolve

problems should they arise. Current sector-specific and competition powers exist

which permit regulators to intervene if bottlenecks emerge in IP Interconnection. For

example, some potential upstream bottlenecks in the access network are already

addressed through requiring the wholesaling of unbundled local loops and bitstream

services.

• Employ consumer welfare analysis. However, in circumstances where regulators

identify market failure or are requested to resolve disputes, their intervention should

be applied only as broadly as necessary to solve the problem. Regulators should

therefore not identify a single charging model that would be the ‘fall-back’ option, but

rather should employ a clearly defined assessment framework that appropriately

reflects the drivers of consumer welfare and broader economic efficiency.



Page 8

1. INTRODUCTION

1.1. AIM AND SCOPE

IP-based NGNs are being developed and deployed by a wide range of

telecommunications network operators to complement or replace existing circuit switched

networks. As a result, the subject of IP interconnection is receiving increasing regulatory

attention in Europe, at the European and Member State level, and in other regions.4

The mobile industry has taken a leading role in the development of NGNs. The IP

Multimedia Subsystem (IMS) core architecture around which NGNs are being designed

was originally developed as part of GSM standards. The GSMA and its members are

currently developing network, operational and commercial models for IP interconnection

(called the IPX).

These developments have led GSMA to commission CRA International and Gilbert +

Tobin to undertake this study to:

• consider the key issues arising out of current regulatory debate about IP

interconnection, focussing particularly on interconnection charging principles;

• evaluate the advantages and disadvantages of various interconnection and service

charging models that could be employed in the market;

•

consider the impact that particular interconnection models may have oninvestment, innovation, quality of service and competition in the mobile industry;

• assess the implications if regulators were to enforce a “one-size-fits-all” approach

to IP interconnection; and

• consider how the European regulatory framework can foster the development of

efficient and competitive IP interconnection technology and its use in the provision

of a range of services across the mobile, fixed telecommunications and Internet

industries.

4 The European Regulator’s group has issued a consultation document on IP interconnection, See ERG Project

Team on IP Interconnection and NGN, Consultation Document on IP Interconnection, ERG (06) 42, available at:

http://erg.eu.int/doc/publications/erg_06_42_consult_doc_ip_interconnection_rev.pdf; the German regulator has

set up an advisory group on the subject of IP interconnection and has commissioned a number of reports;

Ofcom’s consultations on NGNs and its telecommunications strategic review consider issues relevant to NGN

interconnection; and the Hong Kong regulator has issued a consultation on fixed to mobile convergence which

focuses on interconnection charging models.



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1.2. STRUCTURE OF THE REPORT

A description of the basic concepts of interconnection in the telephony environment and in

the internet environment is set out in Appendix A. In that Appendix we also consider theinterconnection models currently used in the provision of telecommunications services.

We describe the way in which messages5 are routed across networks using Internet

Protocol and how individual Internet Protocol networks interconnect together to form the

internet. We also consider the aspects of network management that differ between fixed

and mobile environments.

Section 2 introduces the technology of Internet Protocol networks by using traditional

circuit switched networks as a reference point to describe how data is transmitted in

digital form using packet switching.

Section 3 describes current IP interconnection models and how these models developedwithin the technical and operational constraints of the current internet.

Section 4 considers future technological changes in the IP environment, which will narrow

the differences between switched and fixed networks, without introducing switched

network architecture on IP networks. These impending changes include the ability to

provide retail and wholesale services with different quality of service and to establish

cascading charging relationships at the interconnection level. A more detailed analysis of

the technical requirements for implementing quality of service parameters in an IP

environment is also set out in Appendix A.

Section 5 sets out the economic framework for determining efficient interconnectionmodels.

Section 6 then uses this framework to assess and compare of alternative charging

models (BAK, IPNP, RPNP, settlement-based interconnection).

Section 7 considers the policy implications arising from our analysis.

5 Throughout this report we use the term “message” in a broad sense. A message can, for example, be a phone

call, SMS, MMS, instant message (IM), email or a download of a data file, streaming video or a web page.

While the various types of messages differ in important aspects, all messages included in our definition can be

described as a flow of data between the party that initiates the message and another party, which can be

described as the receiving party.



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2. IP INTERCONNECTION IN THE CURRENT PUBLICINTERNET

2.1. INTRODUCTION

This section lays the foundation for the next chapter, which discusses IP interconnection

pricing principles. In this section we:

• provide an overview of the key differences between circuit switching and packet

switching;

• describe how individual Internet Protocol networks interconnect together to form the

internet; and

• address some key aspects in relation to the concept of any-to-any connectivity.

As further background to this section, Appendix A contains a description of how:

• traditional circuit switch works to provide a reference point for the transmission of

information in digital form;

• information is transmitted in digital form using packet switching compared to

traditional circuit switching; and

• the internet functions and the way in which messages are routed across it using

Internet Protocol.

2.1.1. Implications of packet switching and circuit switching

From our discussion of circuit switching and packet switching in Appendix A, we can

draw three key distinctions between circuit switched networks and packet switched

networks. These are summarised in Table 1 below.

Table 1: Comparison of key features

Issue Circuit switched Packet switched

Path Single path established for the durationof a session or call

Multipath with variable paths for eachpacket

Signalling system Connection-oriented system withsignalling network providing centralcontrol and billing information

Connectionless system with nocentral control and no centralgeneration of billing information

Network interconnectionknowledge

Central control by signalling systemrequires that all networks used for thecall are known to the originating andterminating parties’ networks and havea commercial agreement tointerconnect

Network partners are not known,other than the possible next networkalong a packet’s pathway



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These three crucial distinctions are discussed in Appendix A and in section 3.6 as part of

the analysis of the differences in interconnection of IP networks and circuit switchednetworks.

2.2. INTERCONNECTING IP NETWORKS

As the internet is comprised of so many networks, interconnection arrangements are

fundamental to its success.

Networks comprising the internet may interconnect either:

• directly with each other (often called peering, at least where it occurs between

similar sized networks). In turn, direct interconnection may be achieved over aprivate peering link or by public peering; or

• indirectly with each other by transiting one or more intermediate networks (called

transit).

2.2.1. Direct interconnection

Where networks directly interconnect, they generally use a border gateway protocol

(BGP), and in these circumstances it is an exterior Border Gateway Protocol (eBGP).

The eBGP is a routing protocol used on the edge of autonomous systems (AS). It

calculates loop-free (or direct) paths across the internet by tracking the path in terms of

which AS it passes through. However, it does not track the “route” through individual

routers within an AS. To use eBGP, an operator must have a router that supports BGP

and a registered public AS number.

Routes learned via BGP use associated properties to determine the best route to a

destination. These properties are referred to as BGP attributes, and are used in the

route selection process.

Figure 1 – Private peering



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Private peering involves the two networks establishing a dedicated link between their two

networks (see Figure 1). Public peering involves more than two operators connecting at a

public peering point. Operators connecting at a public peering point are connected by a

shared transmission network (see Figure 2).

Figure 2 – Public peering

The advantage of private peering over public peering is that the two privately peered

operators are in a better position to agree on capacity upgrades needed on the link toavoid congestion, compared with multiple operators that interconnect at a public peering

point.

2.2.2. Indirect interconnection

As there are so many networks comprising the internet, it is impractical for networks to

directly interconnect with each other. As a result, larger networks may choose to offer a

“transit service”. This is a service for the delivery of packets across a network to IP

addresses which that network can “see”. A transit service provider configures the routing

table of the BGP router to advertise the IP addresses of the network to which it is

interconnected.

As set out in Figure 3 below, Network 4 has elected to be a transit network. It advertises

routes to Network 1, which include the IP addresses on Network 4 as well as the IP

addresses on Network 2. This means that Network 1 can “see” the IP addresses on

Network 2 and does not need to directly connect to Network 2 or enter into a commercial

arrangement with Network 2. On the other hand, Network 3 only advertises the IP

addresses on its own network to each of Network 1 and Network 2. Network 3 does not

offer a transit service.



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Figure 3 – IP transit

2.3. ANY-TO-ANY CONNECTIVITY

The internet permits any-to-any connectivity using IP addresses to locate internet users

from time to time. The domain name server system provides for word-based addressing

(for example, email addresses and web addresses), rather than users having to

remember large numbers of IP addresses. However, it is important to recognise that any-

to-any connectivity does not require direct interconnection. The multipath nature of the

internet means that any-to-any connectivity can be achieved without a requirement for

direct interconnection of any particular pair of networks. That is, a combination of direct

interconnection and transit achieves any-to-any connectivity.

Further, any-to-any connectivity does not create a terminating access bottleneck in the

same way that this occurs in fixed line networks. There are four reasons why there is not

a bottleneck problem:

• in relation to content, much content is either multi homed (that is, there is connection

between the web server and more than one IP network connected to the internet) or

the content is “mirrored” (that is, the content is stored in more than one place and

each web server is connected to a different IP network);

• the multipath nature of the internet means that there are a large number of potential

paths between individual IP addresses. Although ultimately each address is

associated with a single network, the multipath routing means that leveraging

termination is practically impossible;

• as set out in the next section, the basic charging model of the internet is pay to

download. This means that a significant change in internet charging would be

required in order to benefit from any ability to leverage termination; and



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• the users of the internet are not restricted to using any one IP network provider to

access services. This nomadicity contrasts with fixed line telephones and means

that users can access applications regardless of their IP address from time to time.



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3. INTERCONNECTION PRICING MODELS IN CURRENTINTERNET

In this section we set out the pricing models currently used in the IP interconnection

arrangements for providing internet services. We begin by describing the hierarchy of

internet access providers (IAPs) and internet service providers (ISPs) that exists in the

internet environment. We then set out the different interconnection pricing arrangements

between each of the participants in the internet value chain and illustrate how these

arrangements come into play to illustrate how costs are likely to be allocated for a

particular internet session.

3.1. OPERATOR HIERARCHY WITHIN THE INTERNET

The internet is characterised by an informal hierarchy of operators. While the technicaland operational arrangements for interconnection are reasonably standardised across the

internet, the commercial arrangements between two operators will depend on where each

of them falls within that hierarchy.

As a result, the direction of interconnection payments can switch as packets move along

the path to their destination.

The hierarchy of internet operators is set out in Figure 4.

This hierarchy is described by reference to tiers of operators:

• Tier 1 IAPs – Tier 1 IAPs (sometimes known as “backbone operators”) are large

telecommunications operators which have internet networks covering large

geographic areas (countries, regions or the globe) and have significant numbers of

points of presence (PoPs). Tier 1 IAPs interconnect with all other Tier 1 network

operators and do not use transit providers.

• Tier 2 ISPs – Tier 2 ISPs host some content and may have peering arrangements

in place with other Tier 2 ISPs. They usually have some network of their own,

although limited to a geographic region (e.g. the east coast of the USA) and they all

rely on purchasing some level of transit from Tier 1 IAPs to exchange messages

with out of region networks and content providers.

• Tier 3 ISPs – Tier 3 ISPs are purely re-sellers of internet access services, they

provide retail services to end customers but do not provide any wholesale internet

services. Tier 3 ISPs rely solely on interconnection arrangements to provide

internet services. They purchase transit from Tier 2 ISPs.



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Figure 4 – The hierarchy of the Internet

Retail customers purchase internet services from ISPs who may sit at any level in the

tiered hierarchy.

Each operator sets the criteria by which it will assess whether another operator

requesting interconnection is a peer. It does this in interconnection and wholesale

arrangements. However, the peer criteria set by individual operators at each level in each

country tend to coincide.

The three main criteria that determine peer status, particularly at the Tier 1 level, are:

• volume of traffic to be exchanged;

• geographic reach of network and number of PoPs; and

• backbone capacity.

Equivalence of traffic volume is not considered enough to treat operators as peers. A

regional operator in an urbanised area may have an equivalent volume of traffic to an

operator with a nationwide network, but if the two were treated as peers, the regional

operator would get access to nationwide transport for no or low charges.



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IP networks, which are directly connected, are not necessarily in the same tier. For

example, a Tier 2 ISP may directly connect to a Tier 1 IAP. However, this does not

elevate the Tier 2 ISP to Tier 1. All Tier 1 IAPs are directly connected to each other.

Separate hierarchies exist at sub-national, national, regional and global levels. Separate

hierarchies will exist within each country for domestic originated traffic to domestic hosted

content. However, for domestic originated content to content hosted in other countries,

which requires global internet connectivity, the national operators will interconnect within

a different hierarchy covering a larger part of the internet. An operator may be regarded

as a Tier 1 IAP in its own country but be considered a Tier 2 ISP within a regional or

global hierarchy.

3.2. BASIS OF CHARGING

In principle, there are three potential bases for charging for IP based interconnection:

• per port – which is a “take or pay” type of interconnection where the interconnection

bandwidth is agreed and the traffic actually transported is not counted;

• per packet – where the port is dimensioned to be greater than the forecast traffic

requirements and the packets which pass through the port are counted; and

• a combination of per port and per packet.

3.3. INTERNET PRICING MODELS FOR DIRECT INTERCONNECTION

The fundamental pricing principle at play in the current public internet environment is ”pay

to download”.

An important difference to interconnection in circuit switched networks is that ”receiving”

refers to packets of data in the internet, whereas it refers to a message in circuit switched

networks. Accordingly, for the purposes of the following discussion:

• “receiving network” refers to each network that pays to receive a packet from the

immediately preceding network along the path of a packet through the internet, and

not to the final network which connects the end user or content server receiving the

message; and

• “initiating network” (as in IPNP) refers to each network that pays to send a packet to

the next network along a packet’s pathway, and not to the network connecting the

end user or content server which sent the message.

As a packet moves forward along the path to its destination, each network that receives

data is charged as illustrated in Figure 5.



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Figure 5 – Receiving Party Network Pays

As we discuss below, the RPNP model is then overlaid with different approaches, which

apply to packets travelling in the reverse direction between the same two operators, so

that:

• between some pairs of operators, a settlement-based model is used to offset the

packets in both directions (usually with an “out of balance” buffer before offset

payments apply);

• between other operators, one operator, as well as paying to receive, also pays to

send in the reverse direction (that is, pays to download and upload); and

• in most cases, regardless of the direction in which the packets are being sent, if

those packets transit over multiple networks, transit will be paid for.

3.3.1. Interconnection between Tier 1 IAPs

The pricing arrangement between interconnected Tier 1 IAPs is usually settlement-based

direct interconnection. Although not entirely accurate, the pricing model applied between

interconnecting Tier 1 IAPs is often referred to as “settlement-free interconnection” on the

basis that it usually involves no payment by either party.

The earliest forms of interconnection between Tier 1 IAPs used BAK pricing, because it

was considered too hard to measure whether traffic was in fact balanced. As discussed

in Appendix A, “true” BAK involves no payments in either direction, regardless of

whether traffic is out of balance.



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Current pricing arrangements between Tier 1 IAPs rely on a measurement of the balance

of traffic between the interconnecting Tier 1 IAPs. This is done by smart routers between

the interconnected parties, which measure the amount of traffic flowing between the two

IAPs per minute. The data is compared at the 95th

percentile of results, to allow forspikes in traffic flow. The per minute data is then aggregated over a calendar month and

traffic is considered to be balanced, if the total traffic flows to each IAP from the other IAP

are equal or within 5% of each other. If traffic is balanced, then no party pays for

interconnection with the other party. If, however, traffic is not balanced, then the IAP that

has downloaded more data from the other IAP pays an amount to cover the cost of the

additional data downloaded, over and above what would otherwise have been a balanced

amount. The interconnecting Tier 1 IAPs also often agree that an additional buffer to

allow for an imbalance of more than 5% before payment will be required.

Effectively the payment obligations between the Tier 1 IAPs are still offset against each

other and payments are only made for the traffic imbalance between the two Tier 1networks. This charging model is illustrated in Figure 6 below.



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Figure 6 - Settlement-based interconnection where imbalance is offset

3.3.2. Interconnection between Tier 1 IAPs and Tier 2 ISPs

In interconnection arrangements between Tier 1 IAPs and Tier 2 ISPs, the Tier 2 ISP will

be able to offset the charge it would otherwise have recovered from the Tier 1 IAP (for

uploading to the Tier 1 IAP) against the amount it must pay the Tier 1 ISP. This is in

effect the same concept of offsetting payments based on imbalances in traffic as is

applied to interconnecting Tier 1 parties. However the difference is that traffic is measured

by counting all bytes, not just any imbalance at the 95th percentile, and no buffer for

differences in traffic flow is applied.

In this scenario, an incentive therefore exists, for Tier 2 ISPs to host popular (andtherefore valuable) content. The more users the Tier 2 ISP can attract to content hosted

on its own network, the cheaper the cost of interconnecting with the Tier 1 IAP becomes.

This, in turn, assists the Tier 1 operator to achieve balance with other Tier 1 IAPs.



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Figure 7 - Tier 1 and Tier 2 interconnection

3.3.3. Interconnection between Tier 2 and Tier 3 ISPs

As between Tier 2 and Tier 3 ISPs, the Tier 3 ISP will always pay for data it downloads

from the Tier 2 ISP. This is the case regardless of the amount of traffic flow, although

data flowing from the Tier 2 ISP to the Tier 3 ISP is always likely to exceed traffic flowing

in the other direction, given that the Tier 3 ISP has no content to host, and merely sends

retail customer requests for data or applications. For this reason, a Tier 3 ISP has no

opportunity to offset charges for any data it uploads to the Tier 2 ISP, against its charges

for downloading from the Tier 2 ISP. However, in the traditional internet environment, the

Tier 3 ISP usually recovers the entire retail charge for the service from the retail

customer.

3.3.4. Initiating Party Network Pays (IPNP)

The IPNP model involves a payment from the network of a party that initiates a message

to the network of the receiving party. The IPNP model is illustrated in Figure 8 below.



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Figure 8 - Initiating Party Network Pays to Send

This interconnection model is only used in the traditional internet wholesale

interconnection environment in the case where a Tier 3 ISP uploads data to a Tier 2 ISP.

However, this model is widely used in data messaging on mobile. In the mobile context,

this model is usually linked to the retail charging model. The initiating party’s network will

pay for interconnection services from the other networks over which a message passes to

reach its destination. This IPNP model also resembles the standard termination model

that applies in the fixed network and between fixed and mobile networks in most

countries.

This model tends to apply between backbone network providers and ISPs providing the

retail internet access service to end users. This model also tends to be used for

interconnection between content providers or content farms and internet backbone

providers. The content providers usually pay a flat capacity charge to connect to the

IAP’s network.

3.4. WHO PAYS FOR TRANSIT?

Transit interconnection is required when packets traverse one network, in order to reach

an IP address hosted on another network. Traditionally, transit providers have been paid

by the sending network. Where there is a chain of transit networks, each network will pay

the next network down the chain.

Settlement-based interconnection and settlement-free interconnection are not widely

applied in the context of transit. Transit will usually be charged even between operatorsthat regard themselves as peers (although some of the largest Tier 1 operators may also

provide domestic transit on a settlement-free basis). International transit is usually

charged, particularly for transit to the US, given the costs operators face in provisioning

international capacity to allow access to US content (which continues to account for most

content on the internet).

The transit network is providing a wholesale IP carriage service. Specialist backbone

providers supply transit services to connect retail ISPs or regional IAPs to content

providers or to other networks.



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3.4.1. Multiple charging models applied in a single internet session

While an end user is engaged in a single internet session, such as browsing the internet,

packets will be flowing in both directions. When the end user clicks on a web link,outbound packets will be sent to the IP address and inbound packets will bring back the

content to display the web page on the end user’s screen. This process occurs as a

series of, what can be referred to as, hops between ISPs and ASPs and is outlined in

Figure 9.

Figure 9 - Paths across multiple operators

It is in this scenario that all of the traditional internet interconnection pricing models come

into play at different stages of the process. Figure 10 further illustrates this point.



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Figure 10 - Current internet charging models

From this diagram it can be seen that the interconnection charging arrangements apply

separately to the outbound and inbound streams. The red arrows show the flow of data

that is sent when the retail customer clicks to download content from a particular source.

The click, being an instruction to send data back to the customer, is itself data consisting

of a minimal number of bytes that must be sent to the content source requesting delivery

of the content. The blue arrows show the flow of data that is sent in response to the retail

customer’s request. That is, the blue arrows indicate the path of the bytes of data

containing the content that the user requested. This will be a larger amount of data than

the original request. While in this specific session this is likely to cause a traffic

imbalance, generally, balancing is done on an aggregate basis. However, this scenario

illustrates how traffic imbalances occur if multiple transactions of this type occur regularly.

The direction of interconnection payments also will change as a packet moves up one

side and down the other side of the internet hierarchy, as depicted in Figure 5 and Figure

8. This is illustrated in Figure 11 for an instruction packet from an end user to a content

server.



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Figure 11 - Payments for a data request in a packet switched environment

This is in contrast to the circuit switched environment, in which, once the retail provider is

identified, interconnection payments all flow back in the one direction up the chain of

interconnected networks to the retail provider, as illustrated in Figure 12. The illustration

is based on an initiating party pays (IPP) model. In a receiving party pays (RPP) model,

the flow of payments would be in precisely the opposite direction.

Figure 12 - Payments for a call in a circuit switched environment



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3.5. WHAT IS PAID FOR?

Where a charge is payable for either interconnection between the originating and the

terminating network or for transit, it may be calculated in a number of different ways.6

The charge may be on a per packet basis, which results in a traffic-sensitive payment.

Alternatively, the payment may be a capacity fee, usually expressed as a port fee, which

in effect is a “take or pay” arrangement. The interconnection fee also may be volume

based.

3.6. CURRENT TECHNOLOGY SHAPES INTERCONNECTION CHARGING MODELS

Applications of settlement-free interconnection (BAK) between the originating and the

terminating network were mainly driven by the technical limitations of the current IP

environment (that is, the internet a decade ago), because early interconnected networks

were operated by research and academic institutions which had no billing systems. As a

result, there was no demand for router manufacturers to facilitate counting of exchanged

packets. Further limitations include:

• as the terminating network is only undertaking to deliver packets on a best efforts

basis, the initiating network is reluctant to pay for a packet that may never be

delivered or is delivered late;

• as the packets comprising a single message are routed over multiple paths, sending

charging records back to the sending operator would be a complex exercise;

• as the pathway for packets is not set up in advance, the sending or receiving

network will not necessarily know which other networks will be involved in providing

interconnection services;

• as the internet only provides for a best efforts service quality, interconnection

charging would involve paying for packets which may be dropped or delayed. TCP/IP

will make several attempts to resend failed packets and BAK means that operators

do not pay multiple interconnection charges fro delivery of the same message

content;7 and

• the internet is not capable of identifying the origin of packets or billing back up the

chain to the originating operator or down the chain to the receiving operator.

6 The regulatory discussion often compares settlement-free interconnection (BAK) to “calling party network pays”,

where two regulated versions of the latter model are considered: Element Based Charging (EBC) and Capacity

Based Charging (CBC). Both EBC and CBC are based on cost-based charging. In commercially negotiated

CPNP agreements, the parties are of course not constrained to use cost-based EBC or CBC.

7 As a practical matter, modern routers (even state of the art routers) count all packets exchanged between

interconnected networks and do not differentiate between packets being sent for the first time and those being

resent because of a failed attempt.



Page 27

Our discussion in Appendix A sets out some of the differences between circuit switching

and packet switching.

Table 2 further summarises the differences between circuit switched and packet switchedenvironments, which are key to understanding the differences in retail and wholesale

services provided in each and to understanding the business models that underpin these

services:

Table 2: Differences between circuit switched networks and packet switched networks

Circuit switched Packet switched

Retail charging

model

Mainly initiating party pays, with some

countries using receiving party pays for

specialist fixed calls (e.g. 800). Receiving

party pays applies to calls to mobiles in

some markets

End user usually pays to upload (initiating

party pays) and pays to download

(receiving party pays).

Basis of retail

charging

Each discrete ”session” by an end user, in

the form of a call or SMS, is charged

separately.

• End users charged on total volume of

packets (e.g. megabytes) over a

period of time, regardless of

individual sessions.

• Some shift to session-based

charging (e.g. rate per 30 minute

usage period).

Type of

interconnection

Direct interconnect with indirect

interconnection/transit most limited to

international services

Direct interconnection between peers but

also substantial use of indirect

interconnect/transit as it is not feasible for

the vast number of networks composing

the global internet to directly interconnect

with each other.

Interconnection

charges

• Mainly IPNP (including settlement-

based interconnection).

• RPNP for some services (e.g. 800).

• BAK for some fixed services and in

some countries for calls to mobile.

Mainly RPNP (downloading charges), with

settlement-based interconnection between

peers.

Interconnection

pathway

Single dedicated pathway comprising

circuit through which signals pass in both

directions

• Inbound and outbound packets travel

in different streams.

• Packets comprising the inbound or

outbound message usually will travel

over multiple inbound or outboundpaths.



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Circuit switched Packet switched

Direction of

wholesale charging

Messages flow in both directions (e.g. two

way call), but interconnection charges flow

in one direction. Interconnection charges

flow up the chain of interconnected

operators to the retail provider of the

service

• The outbound and inbound packet

streams are separately charged for

interconnection purposes.

• Within each stream, there is no

consistency in direction of

interconnection charges. The

direction of charges which apply

between two adjacent networks

along a packet’s pathway will depend

on the commercial arrangements

between the operators (and their

relative positions in the hierarchy of

the internet). When passing a packet

onto a network, some operators

along the packet’s pathway may pay

to send, some may pay to receive

and some may offset against packets

received in the revenue direction. As

a result, interconnection charges not

set are passed back up the chain to

the retail provider of the internet

service.

Charges for transit, on the other hand, have been easier to implement in the current IP

environment. Each network, at its Border Gateway, is able to recognise whether a packet

presented by a directly interconnected network has an IP address that is hosted on its

network or on another network. The receiving network can choose to refuse to accept

packets to IP addresses not hosted on its network, or allow the packets to transit its

network on the way to the ultimate address. If the receiving network does allow transit, it

can charge the network that passed it the packet. This charge is imposed even if the

destination network loses that packet and requests the packet to be resent.

The existence of signalling and inter-carrier billing systems in the circuit switchednetworks avoids many of these problems and provides more options for commercial

charging arrangements between interconnected networks. The original designers of the

internet intended to keep its architecture simple and therefore did not build in similar

signalling superstructure. Therefore, to a large extent, interconnection models which

currently prevail on the internet are shaped by its technical limitations.

While the current architecture of the internet was suited to its not for profit origins, as we

discuss in the next section, technological developments will support the capability to

support differential quality of service offerings and a more diverse range of retail and

interconnection billing arrangements. This raises questions about whether current IP

interconnection models will be appropriate going forward.



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4. THE CHANGING WORLD OF IP

4.1. INTRODUCTION

In this section we describe the features of a stand-alone NGN and then consider how

NGNs may interconnect. The section will draw out the two main differences between IP

interconnection in the current best efforts internet environment and in the future NGN

world, these being:

• the additional demands of IP interconnection to support quality of service (QoS) on

an end to end basis; and

• the capability to support inter-operator billing, that is, tracking and valuing where a

packet travels and linking inter-operator billing to the value of the series of packetssent.

We use the IPX developed by the GSMA as an example of the developing models of a

more sophisticated form of IP interconnection.

The increasing requirement for differential QoS transport arises from the variety of

applications that will be provided over packet switched networks. For example, both

voice and video require higher QoS than email or web surfing. On the other hand, it is

technically inefficient to create networks which are solely QoS transport enabled, if the

users of that network will have some needs which are met by a best efforts solution.

Instead, the network must be responsive and adaptive to the consumer needs and, inmany cases, without consumer intervention. That is, the QoS requirements will, in the

main, be determined by the application and a subsequent consumer decision as to the

service priority.

4.2. NEXT GENERATION NETWORKS

4.2.1. Introduction

The International Telecommunications Union defines an NGN as follows:

A next-generation network (NGN) is a packet-based network able to provide

services, including telecommunications services, able to make use of multiple

broadband, QoS-enabled transport technologies, and in which service-related

functions are independent from underlying transport-related technologies. It

offers unrestricted access by users to different service providers. It supports

generalised mobility, which will allow consistent and ubiquitous provision of

services to users.

The European Telecommunications Standards Institute takes a similar view:



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No single definition of NGN exists so far (and indeed is unlikely ever to exist), but

it is generally acknowledged that its architecture relies on a few general

principles: a shared core network for all access and service types, packet-based

transport technologies, open standardised interfaces between the differentnetwork layers (transport, control and services), support for user-adaptable

interfaces and variable access network capacities and types.

Importantly, the NGN is always a packet-based network and this means that the packet

switched analysis set out in the previous two sections can be applied to NGNs. Further,

an important aspect of the NGN is its support for quality of service enabled transport

technologies.

While NGN will gradually replace circuit-switched networks, the public internet will exist

alongside NGNs – and compete with NGNs for many services.

4.2.2. NGN architecture

NGN architecture supports a range of quality service parameters (discussed in

Appendix A) and consists of four planes which, in order from the end user interface, are

the:

• access plane: this represents the direct interface between end-users and the rest ofthe network;

• transport plane: the IMS forms the core of the transport plane;

• control plane: this is analogous to the signalling system in a circuit switched net-work; and

• service plane: this contains services which can be applied to the lower planes inorder to create products. This plane does not have an analogy in conventionalnetworks but has some comparable functionality to the Intelligent Network.

The access and transport planes form the next generation transport mechanism. Thecontrol and service planes form the next generation services. These are illustrated inFigure 13.



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Figure 13 - Planes

4.3. QUALITY OF SERVICE

The relevance of particular quality of service parameters to specific services is explained

in further detail in Appendix A. The quality of service required in each case will depend

on the application being used and or the consumer’s willingness to pay for increased

priority.

Quality of service is achieved in an NGN through a process depicted in Figure 14 below.

A QoS service path with consistent parameters is created through the network alongwhich packets comprising the message with the QoS commitment then travel (see

Appendix A.4 for a discussion of the key service parameters, such as jitter, latency and

packet loss). This process comprises the following elements:

• packet labelling: packets to which a particular quality of service must attach are

labelled, or assigned a priority. For example, for an IP television service, preventing

jitter and packet loss is key to the consumer’s experience. Packets associated with

this application will be given the highest level of priority;

• service plane and control plane communicating with routers to create QoS

paths: the control plane and service plane in an NGN will create multiple QoS pathsfor packets with similar labels. The service plane provides the path module and the

control plane instructs the routers along the QoS path to prioritise packets according

to their priority labels. QoS paths are not dedicated capacity paths. They are only

created for the duration of the transfer of labelled packets;

• customer premises equipment: the customer premises equipment (CPE) must be

able to respect and apply packet labelling so that it can send packets, and label

packets it sends, with particular QoS priority levels, and so that it can receive

packets labelled a particular priority; and



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• billing for QoS: In an NGN environment, the networks involved in carrying the

prioritised packets along their path are known and it is possible to establish

cascading billing arrangements that support either IPP or RPP charging models and

recompense each network on actual, not estimated, averaged or balanced trafficflow.

Figure 14 - Establishing a QoS path

4.4. NGN INTERCONNECTION

Typically, NGN interconnection will require specific applications to be associated with

QoS parameters, to ensure that they are delivered both within a network and across

networks in a uniform and predictable manner. That is, the mechanisms used to create

QoS enabled transport paths within an NGN will need to be used between NGNs and

respected by interconnecting NGNs to permit effective and efficient interconnection.

In order to provide this level of predictability, IP interconnection will require routing and

prioritisation of packets between networks on a consistent and seamless basis. That is,

interconnected IP networks will need to agree on QoS parameters and also agree on the

way in which they will respect the labelling of packets. The labelling provides the required

parameters for QoS and these parameters will need to be respected by all of the

interconnecting networks. In turn, the interconnected networks will need to agree on an

appropriate billing mechanism for the transfer of those QoS parameters.



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Although the protocols used in IP networks permit and encourage multipath delivery, as a

practical matter there is a strong likelihood that all of the packets in any particular data

stream will, in fact, follow the same route. Indeed, in constructing an IP network, network

operators may seek to achieve this outcome in order to facilitate high levels ofrepeatability in respect of latency and jitter. The use of MPLS described above has also

encouraged this phenomenon. However, this practical outcome does not affect the

requirement to exchange QoS parameters and to respect QoS requirements. Rather, it

indicates that implementation of QoS transport is readily achievable.

The outcome of the establishment of a QoS path across multiple networks is set out in

Figure 15 below.

Figure 15 - Interconnection of multiple networks with QoS path

Creating a QoS path does not determine the direction of charging for wholesale or retail

services. Indeed, it is the implementation of QoS enabled transport services, by way of

labelled QoS paths, which supports calling party pays and receiving party at the retail

level and calling party network pays, receiving party network pays and bill and keep at the

wholesale level. That is, QoS paths permit a range of charging models which are notavailable in the current internet with its differential tiered charging.

4.5. IPX

The GSM Association has developed a series of specifications for a commercially

competitive IP transit network, which will permit the interconnection of IP networks

operated by mobile operators and fixed operators, as well as applications and content

service providers. In order to ensure that the appropriate quality of service parameters

can be associated with traffic crossing this network, latency, jitter and packet

loss parameters are specified. Additionally a security architecture is specified.



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The IPX represents an international QoS transport enabled IP transit network. It is likely

to form the heart of international IP connectivity for many mobile network operators

(MNO). However, it is not the only form of interconnection and is likely to be

complemented by bilateral IP interconnection both between domestic IP networks andinternational partners. Some operators, with a presence in a number of countries, may

interconnect to create an internal network with IPX properties, and this aggregated

connection may then interconnect with the IPX or form bilateral interconnections. These

decisions will be based on appropriate traffic management, based on the services and

applications used by consumers and the QoS parameters that are associated with them.

The form of the IPX is set out in Figure 16 below and this has examples of bilateral, as

well as multilateral, interconnection.

Figure 16 - IPX



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The GSMA conceives of the IPX as being a transit network, built up from IP networks,

provided by competitive suppliers and interconnecting with any operator that wishes to

implement international IP transit at specified QoS levels. It is not expected that the IPX

will replace bilateral interconnection agreements (particularly between operators within asingle country). However, the IPX could also provide very cost effective access to

common content and applications on a global basis. Further, it is likely that smaller

operators will use the IPX as a mechanism to interconnect with legacy services (for

example, circuit switched services) during the migration to all IP networks.

Another way to consider the IPX is that the IPX provider assembles the IPX by acquiring

QoS enabled transport capacity for a number of network operators. Each operator

contracts with the IPX provider (which may also be a network operator). As a result, the

wholesale costs are known for all combinations of quality and quantity of traffic. Further,

the IPX operator can dimension the networks to ensure that the traffic capacity

requirements are met. In effect, the IPX operator functions as a QoS capacity hub and abilling exchange. This is set out in Figure 17.

Figure 17 - Alternative view of IPX



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The IPX is able to provide “cascading billing”. Each of the IPX network providers can

identify the QoS paths created over their network segments. The establishment of the

QoS path gives the connectionless system some of the characteristics of connection-

oriented systems that facilitate the collection of billing data. Each IPX network providerknows the quantity of data (time, volume or events) at each QoS level that it has

transported, and the operators on behalf of which that data has been carried. This means

that the IPX providers can bill on the basis of quantity and QoS colour to each of the

interconnected networks that are sending traffic and recompense the networks which are

carrying traffic based on the quantity and quality of the traffic conveyed.



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5. DETERMINANTS OF EFFICIENT IP INTERCONNECTIONFEES

5.1. INTRODUCTION

This section sets out the economic framework for determining efficient interconnection

fees and for a detailed comparison of alternative charging models which we undertake in

section 6.

The analysis proceeds as follows:

• Section 5.2 explains the tools we will use in our analysis, economic efficiency and its

market outcomes.

• Section 5.3 applies the analytical tool of economic efficiency to the question of who

(if anybody) should pay for interconnection. We describe the role of interconnection

in generating efficiency, the determinants of efficient interconnection – including

considerations QoS context – and the detriments if an inefficient model is imposed.

• Section 5.4 considers the efficiency of applying different interconnection models in

parallel, e.g. applying different models between different networks.

• Section 5.5 provides some concluding remarks.

5.2. THE MEANING OF ECONOMIC EFFICIENCY

Economic efficiency is the touchstone against which we assess interconnect charging

models. This section sets out what we mean by this term and explains how it relates to

concepts of consumer welfare and competition.

By way of summary, economic efficiency has three components: productive efficiency,

allocative efficiency and dynamic efficiency. They can conflict, and must be balanced.

Efficiency is a precondition to maximizing welfare, since it delivers consumer benefits

(such as lower prices and better range of services), producer benefits (such as

investment incentives and the recovery of outlays), market operation benefits (such as the

elimination of inefficient arbitrage) and regulatory benefits (minimising costs of regulation).

Competition is a critical tool to promote efficiency.



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5.2.1. Components of efficiency

Economic efficiency has three components:

• Productive efficiency: Productive efficiency means that goods and services are

produced at least cost. This requires both that the production process be technically

efficient (that is, that the maximum amount of output is produced from a given

amount of inputs using a given technology) and that, among the variety of technically

efficient ways that may be available, the approach employed is that which is

associated with the lowest input costs at prevailing input prices.

If, for example, regulation induced bypass behaviour that involved the use of

technologies or networks which are not the least-cost solution (e.g. taking advantage

of arbitrage implied by regulation in some geographies by routing traffic indirectly),

then productive efficiency would not be achieved.

• Allocative efficiency: Allocative efficiency requires that all resources available to

the economy are employed in the use that generates the greatest value to society.

In an IP interconnect context, this means that the aggregate value to consumers of a

message must exceed the cost of its provision.

• Dynamic efficiency: Dynamic efficiency embodies the inter-temporal (that is,

through time) aspects of efficiency. It requires that firms have appropriate incentives

to invest and to innovate and that the use of resources is allocated optimally over

time. That is, in a telecommunications context, potential investors intelecommunications infrastructure (e.g. NGN) must have an incentive to invest as

long as their investment would generate a positive value to society.

The components of efficiency can conflict. Since allocative efficiency is maximised when

the incremental costs – rather than the average costs – of providing a service are just

covered, this cannot be dynamically efficient in a situation where providers need

additional revenues in order to recover fixed costs. Due to these potential conflicts,

economic efficiency should be evaluated based on a reasonable balancing of the three

efficiency components, in the circumstances of the relevant industry (e.g. existence of

high fixed costs).



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5.2.2. Relationship to consumer welfare and competition

Efficiency is a precondition to maximising economic welfare: a more efficient market

outcome will generate a higher net income to society.

8

Economists typically distinguishbetween the welfare of consumers (of the goods or services in a particular industry) and

producers (in this industry), which in their sum represent total welfare. In many practical

circumstances, policy recommendations based on maximising total welfare will be

identical to those based on maximising consumer welfare, because practices or

circumstances which reduce consumer welfare typically also reduce total welfare.9

Hence, in most practical circumstances, it is reasonable to assume that consumer welfare

is improved when a given market inefficiency is remedied.

The concept of competition is not directly equivalent to efficiency or to welfare. Rather,

competition is a tool to achieve allocative efficiency and to promote productive efficiency.

Similarly, competition can stimulate innovation and investment and hence promotedynamic efficiency. While competition can in many situations assist in improving

efficiency, it is not an end in itself – ultimately market outcomes and policy interventions

must be measured against the criterion of efficiency.

5.2.3. Market outcomes of economic efficiency

Allocative, productive and dynamic efficiency lead to the following tangible market

outcomes, which can be expected to be observed when markets are operating efficiently.

Later in this report (see section 6), we refer back to these factors to test whether

particular interconnection models are consistent with these efficient market outcomes.10

Consumer benefits

1. All customers are served for whom the total benefit of having them on the network is

greater than the cost

8 Economic efficiency does not necessarily imply that all members of the society are better off under a more

efficient outcome. Hence, efficiency analysis gives guidance on models and approaches that maximise the

overall income potential of society. Additional policies can then be applied to alter the distribution of the

outcome if deemed necessary.

9 An exception is price discrimination which can be efficient (and hence maximise total welfare) even if in some

circumstances it reduces consumer welfare.

10 Efficient market outcomes are also reflected in regulatory statutes, for example those of the European Union.

The European Commission requires national regulators within its Member States to take all reasonable

measures which are aimed at achieving the following objectives: [1] promote competition in the supply of

communications networks, electronic communications services and associated facilities and services by inter

alia: (a) ensuring that users derive maximum benefit in terms of choice, price, and quality; (b) ensuring that there

is no distortion or restriction of competition in the electronic communications sector; (c) encouraging efficient

investment in infrastructure, and promoting innovation; and (d) encouraging efficient use and ensuring the

effective management of radio frequencies and numbering resources; [2] contribute to the development of the

internal market; [3] promote the interests of the citizens of the European Union. Article 8 of the Framework

Directive (http://eur-lex.europa.eu/LexUriServ/site/en/oj/2002/l_108/l_10820020424en00330050.pdf).



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2. Full range of services demanded by customers is provided including innovative new

services11

3. Differential QoS is available that matches customer demand

4. Individual messages are sent if and only if the total benefits to the initiating and

receiving customers are equal to or exceed the incremental cost of the messages12

5. Low prices, provided that prices cover the long-term costs of providing services

efficiently13

Network operator impacts

6. Efficiently-incurred operating costs are recovered14

7. Operators have the incentive to undertake efficient investment and innovation15

8. Interconnection arrangements are available which allow services to be provided in

line with consumer demand (e.g. end-to-end QoS)

Market operation benefits

9. Efficient competition is promoted and inefficient arbitrage16 is avoided

11 This also includes that services are available at all locations where consumers are willing to pay for the cost of

service provision. The availability of a broad range of services is usually considered a benefit by competition

authorities and regulators, although situations exist where, from an economic welfare point of view, variation is

excessive. This can occur, for example, where firms excessively differentiate their services in order to avoid

tough price competition.

12 Efficiency is improved if the interconnection regime ‘weeds out’ messages where the aggregate benefit (across

sending and receiving parties) falls short of the resource costs of sending it. For example, in the case of spam

messages that impose a cost on the receiver, an efficient charging regime would ensure that these messageswould not be sent unless the charge to the sender covered the cost imposed on the receiver (in addition to

network costs). Economists refer to this as internalisation of externalities.

13 The price structure might also be relevant for consumer welfare (e.g. it is often argued that consumers prefer

bucket plans), even though the availability of certain price plans might involve higher prices (e.g. a risk premium)

14 Unless operating costs are covered service providers have no incentive to serve customers even in the short

term.

15 Efficient incentives for investment and innovation require appropriate returns. Providing incentives to invest in

networks ensures that services (including new services) are available in the future, and that suppliers make

efficient choices between building and buying, in providing those services. Innovation encompasses process

innovation, which leads to future cost reductions, and product innovation, leading to improved range and/or

quality services.



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10. Costs are minimized by efficient network usage and call routing, including packets

being handed off at economically efficient point

11. Changes in interconnection charging models are made if and only if the benefitsexceed the transition costs

Regulatory benefits

12. If regulation is applied, regulatory administration and operator compliance costs are

minimized

The relationship between allocative, productive and dynamic efficiency, and the tangible

market outcomes listed above, is as follows:

•

Allocative efficiency directly promotes consumer interests, as it ensures thatproducts are available which consumers care about. Another aspect of allocative

efficiency is that markets operate smoothly (e.g. there is no arbitrage, institutions –

such as interconnection regimes – are adopted in an efficient manner and changed

only if the benefit of the change exceeds transition costs) and that operators have

appropriate incentives to provide the services that consumer want (e.g. QoS).

• Productive efficiency ensures that costs are minimised (in production but also

through avoiding unnecessary regulatory costs) and eventually contributes to

consumer benefits (low prices).

•

Dynamic efficiency ensures that consumer interests are optimally served also in thefuture (e.g. available of services at reasonable prices) and that operators have

incentives to invest such that this can occur.

These efficiency effects on consumers, network operators and market operation are

highly intertwined. Some inefficiencies directly generate detriments to consumers (e.g. if

the retail price that is implied by a specific interconnection model may lead to demand for

making particular messages being too high or too low), which then affect operator

benefits and market operation through an inefficient pattern of consumer demand. Other

effects might include distorted investment incentives, which also lead to markets not

operating efficiently and thus ultimately to consumer harm. Consequently, an

interconnection regime that performs poorly with respect to one of the above criteria willtypically also not perform well on several others.

16 Arbitrage occurs when market participants exploit price differentials in the market – for example, to circumvent

levies on some services by switching to other services. Where such switching would be inefficient (that is, the

bypass involves higher resource costs), it would normally be prevented by market mechanisms. However, when

charges (or the lack thereof) are imposed by regulation, then the market loses the flexibility to address inefficient

arbitrage. Hence, regulatory intervention is less effective – and might induce productive and allocative

inefficiency – if it encourages inefficient arbitrage. The net welfare benefit of arbitrage depends on the benefit

that regulation would have if arbitrage were prevented. If regulation were ill-designed or applied without need,

then it would be likely to harm consumer interests. In turn, arbitrage could prevent some of this detriment.



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In the remaining sections of this report we refer to these market outcome implications of

efficiency in describing the consequences of distortions that alternative interconnections

might cause and identify the circumstances in which these inefficiencies are avoided or

minimised. We also employ these criteria in the comparison of IPNP, RPNP and BAK insection 6.

5.3. WHO SHOULD PAY FOR INTERCONNECTION?

This sub-section sets out our analysis of the fundamental question of interconnect: based

on the efficiency criteria above: who should pay ?17 We consider this question both for

direct interconnect (that is, between an originating and a terminating network) and for

transit arrangements.

The analysis below proceeds as follows. We start by describing the economic role of

interconnection fees, which follows from the characteristic that messages are jointly

consumed by the initiating and receiving parties. This consideration implies that efficient

interconnection arrangements must follow from how the costs of providing the service

should be allocated between these retail customers. We then derive the determinants of

efficient interconnection in two steps:

• By first setting out factors that determine an efficient retail pricing model; and

• Then identifying what the efficient retail model, in conjunction with network costs,

implies for efficient direct and transit interconnection charges.

Finally, we discuss the welfare consequences of inefficient interconnection models for

consumer welfare.

The key conclusions from this section can be summarised as follows:

• The question of who should pay whom in direct interconnection, and who should pay

for transit, is determined by two factors: the efficient retail pricing model (which

interconnection charges must sustain) and network costs. Examining the retail layer,

who pays whom is most efficiently answered by how the benefits of the message are

shared, because messages are jointly consumed by both initiating and receiving

parties. Because retail and cost conditions vary across markets and networks, there

is no “holy grail” single interconnection model that maximizes efficiency in all

situations, and dual models may exist for direct and transit interconnection (with

different models each operating in parallel).

17 Two other fundamental questions related to efficient interconnection models – What should be paid for?

(efficient unit of charging) and How much should be paid? (level of cost recovery in interconnection charges) are

discussed in Appendix B.



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• QoS provision does not in principle change how efficient interconnection fees should

be deducted; however, because of the higher costs of providing high quality

services, the distortions associated with applying an inefficient model in a QoS

context will increase. This implies that in a QoS context it will be even moreimportant to optimise the interconnection model to specific cost and retail

circumstances.

• If interconnect charging is inefficient, consumer welfare suffers. If a network’s costs

are not recovered, then network operators will target some customers and avoid

others, and may structure their networks to hand over ‘hot potato’ traffic at inefficient

points of interconnect. There may also be underinvestment in network scope and

quality.

5.3.1. The economic role of interconnection charges

In many markets, economic efficiency requires that the prices, which intermediate and

end producers charge (that is, wholesale and retail prices), are merely reflections of their

variable costs – and, in some cases, reflect the recovery of fixed costs in a way that

minimises distortions to consumption.

However, in the case of message services, efficient retail prices as well as

interconnection fees have the additional role of distributing the charges paid by two types

of end customers: the initiating and the receiving party of a message. This role arises

due to the fundamental character of messages that are jointly consumed18 – and where

all costs are jointly caused – by both the initiating and the receiving party. Hence, the

economic role of interconnection fees is to encourage the originating and terminating

networks to charge their retail customers in a way that reflects an efficient allocation of

retail prices between these customers, so that messages are initiated whenever their

combined value to both customers exceeds the total costs of service provision.

The mechanism through which interconnection payments influence retail charges, follows

from the incentives that interconnection fees imply:

• Interconnection fees paid by an operator represent incremental costs that the

operator will need to recover through retail charges. Hence higher interconnection

fees increase the price that a network has to charge its retail customers in order to

recover its costs.

• Interconnection revenues received by an operator reduce the share of incremental

costs that an operator needs to recover from customers.

18 Point to point messages such as calls, emails or SMS can either generate joint benefits for the sending and

receiving parties or can generate disutility for the receiving party, for example in the case of spam. As a further

example, a data download might benefit the initiating party (access to data) and the receiving party – the content

provider (e.g. through higher advertising revenue).



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The retail charges, which are implied by the recovery of interconnection payments and

other network costs, then set the incentives for retail customers to exchange

messages.Consequently, efficient interconnection fees can be determined in two steps:

• The requirements of efficient usage of message services determine which retail

charging model (the level and structure of retail prices) is efficient;

• The efficient retail model in conjunction with the cost distribution among networks

determines the efficient interconnection fee.19

The determinants of efficient interconnection and the process of deriving the efficient

direction of interconnection payments are illustrated in Figure 18 below.

Figure 18 - Determinants of efficient interconnection

5.3.2. Determining the efficient retail model

The role of efficient retail charges is to generate funds sufficient to cover the resource

costs (including remunerating for investment risks) associated with the provision of the

service, but to do so in a manner that leads to efficient consumption of messages.

Because messages are consumed by more than one consumer, efficient use of

messages (that is, calls, emails, downloads, web searches etc.) requires that retail

charges allocate the resource costs such that customers initiate calls whenever the

aggregate benefit of the call (to the initiating and the receiving party) exceeds the costs of

providing the message. This involves consideration of the joint consumption property, as

well as taking into account whether the message – or subscription decision – also

benefits third parties (that is, parties other than the initiating and receiving party).

19 This implies that the relationship between retail charging models and interconnection models is determinative in

the sense that a given retail charge under a given distribution of costs among networks (and otherwise given

retail market characteristics) implies that a specific direction and level of the interconnection charge is efficient.

However, because network costs, their distribution among networks and retail characteristics of services (e.g.

the relative demand for services) vary across countries, the same retail charging model can be used in

conjunction with different interconnection models across countries or across different services in the same

country.



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Message externalities – the role of joint consumption of messages

From the fact that messages are jointly consumed, by the sending and the receiving

parties, follows that either or both of those parties may derive benefit from the messaging,

with the share of benefit varying between types of messages and groups of consumers 20

In order to achieve economic efficiency, the retail charging model should ensure that

messages are only exchanged when it is efficient – in other words where the aggregate,

shared benefit exceeds the resource costs of sending the message. For this to occur the

benefit to the receiving party would need to be factored into (or “internalised” in) the retail

price paid by the initiating party – otherwise that party may not initiate the message at all.

If this leads to the initiating party paying less then the cost of the message, then the

receiving party must also be charged to ensure cost recovery.

Consequently, the efficient retail model for different circumstances is as follows:

Benefiting party Example Who should pay

Initiating party Telemarketing calls, spam emails Initiating party

Receiving party Toll-free customer order number Receiving party

Both parties (shared benefit) Messages conducting mutually beneficialbusiness transactions or socialinteractions

Both parties if funds reflectingthe willingness to pay of bothparties is required to covercosts. Otherwise, payments byone party may lead to efficientresults, too.

In the last case, where the benefit is shared, there is no single efficient solution to the

question of who should pay. Pricing according to the benefit each party derives from the

message, constitutes one efficient retail price option. Even if the benefit is shared,

efficient market outcomes can be achieved if only one party – for example, the initiating

party – pays for the message. This can occur where a charge levied only on one party is

sufficient to cover all costs but low enough to ensure that beneficial message exchange

occurs.

There are two situations in which the distribution of charges between retail parties does

not influence the market outcome.

First, the allocation of charges does not change incentives to initiate messages, if the

retail parties compensate each other through direct payments (e.g. in the case of a video

download where the party requesting the download pays a fee). These direct payments

between retail parties can be structured in a way to compensate for payments made to

network providers (e.g. the download fee is likely to reflect payments that the content

provider makes to its host for sending the content).

20 Where advertising is involved at the retail level, this could affect the efficient distribution of benefits from the

message between the originating party and the terminating party (e.g. a content supplier who receives a

download request could be receiving advertising revenues for each download). Hence, ‘benefits’ in the main

text should be understood as all benefits (that is, including advertising revenues) that accrue to retail customers.



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Second, retail parties might have non-monetary means to compensate each other. In

many cases, the retail parties’ interaction extends beyond the exchange of a single

message. Repeated interaction can ensure that, regardless of which party initially pays

for a message, benefits will ultimately be balanced through other forms of compensation(e.g. alternating calls or other rewards for beneficial messages) such that messages are

exchanged when it is efficient.

In practice, network operators face the problem that they do not know the precise

valuation of each message to the sending and receiving parties, and these valuations

might vary from message to message. Hence, in reality the best performing retail model

can only be one which is efficient within the dual constraints of limited information and the

need to set low prices to compete effectively.

The retail model that is efficient in this more realistic context, is the model which

generates the greatest welfare benefit through the quantity and type of message traffic itinduces. As a consequence of the fact that messages are jointly consumed, the

distribution of charges between initiating parties and the receiving parties in an efficient

retail model depends on:

• the distribution of benefits between initiating and receiving party relative to the

charges that they bear for typical messages;

• whether and in what message contexts the parties can compensate each other in

other ways for the costs or benefits that that they impose on each other (“negative or

positive message externalities”) via repeated interaction (e.g. alternating who

initiates a message) or other aspects in their relationship (that is, punishment orgratification);

• additional sources of revenue, such as advertising, and which network operator

earns them (i.e., particular 2-sided market effects); and

• customer acceptance – customer aversion against any particular retail pricing model

might reflect a reluctance to adjust to an unknown model; however, it might also

reflect a belief that this model will not “work in their interests” including if the model is

perceived to work inefficiently.

Evaluated against the background of the variety of retail situations, these criteria suggestthat there will not be a one-size-fits-all retail model. Indeed, this is likely to explain why

multiple retail charging models tend to co-exist. In traditional voice calls, payments are

typically made by the initiating party (with the exception of some services and countries

where receiving party payments appear to be driven by the need to accommodate

interconnection regulation), whereas in Internet services payments for download tend to

dominate (with the exceptions discussed in section 3). The variety of retail models is

likely to increase in an NGN environment, where an even larger variety of services will be

offered on a single technology, probably with further variety in the distribution of benefits.

In particular, in an NGN world, payments by the initiating party of calls will be likely to co-

exist with payments for downloading content (which is also a payment by the initiating

party of the message, but involves mostly data transfer from the receiving to the initiating

party, whereas a VoIP call involves data transfer in both directions). This variety is likely



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to constitute an efficient response to the differences in demand characteristics of the

variety of services that will be offered.

Subscriber externalities

A different type of externality, with implications for retail charges, are subscriber

externalities. These exist when an individual’s decision to join a network benefits other

retail customers, who are now able to exchange messages with that individual.

This type of external effect may:

• be limited to on-net subscribers – e.g. subscription to a peering platform where

members exchange content. In this case, benefits generated by new subscribers can

be reflected in an efficient retail charge structure, such as discounts for new

members; or

• apply more broadly - e.g. a new 3G / video calling subscriber benefits all other

subscribers with video calling capability, because they can now have video calls with

more people. In this case, the ideal pricing structure would involve a transfer from all

beneficiaries to the new subscriber. Which subscribers would receive compensation

(by way of lower charges), and which subscribers would have to pay for it, depends

on direction and strength of subscriber externalities.

Economic theory has advanced the examination of the interaction of message (usage)

externalities and subscriber externalities in relation to so-called ‘2-sided’ (or ‘platform’)

markets, which serve two types of customers, for example, users and content providers.21 Whether particular customers join a network, and their willingness to exchange messages

on that network, will be affected by the fixed and variable charges they face. The key

element of 2-sided markets is that the decisions of one type of customer will also be

affected by the decisions of the other type of customers using the network, and these

impacts are not necessarily internalised. For example, a content provider may prefer to

have its content on a network that provides access to more end-customers while an end-

customer may prefer to join a network with more content.

The key insight from the analysis of 2-sided markets is that the structure of prices, i.e. the

extent to which costs should be recovered from each side of the market, is critically

important to achieving efficient outcomes and maximising overall welfare. The

importance of price structure is also recognised in commercial price-setting. As Rochet

and Tirole note:

21 Other examples of 2-sided markets in telecommunications include the situation where readers and advertisers

both use a webpage. In many cases the market will be 3-sided, bringing together users, content providers and

advertisers. A more detailed discussion about the economic implications of 2-sided markets can be found in

J.C. Rochet and J. Tirole, “Two-sided markets: A Progress Report”, the Rand Journal of Economics, 2006.



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“Managers devote considerable time and resources to figure out which side

should bear the pricing burden, and commonly end up making little money on one

side (or even using this side as a loss-leader) and recouping their costs on the

other side”.22

Where the efficient price structure requires one type of customer to bear a greater

proportion of the costs and those costs are spread across multiple networks supplying the

services, then interconnection charges can be crucial to ensuring that retail revenues are

allocated so that each network can cover its own costs, and thereby ensuring the service

can be supplied sustainably.

5.3.3. Efficient direct interconnection

While some messages are initiated and terminated on the same network, many traverse

more than one network. From an economic point of view, this means that no single

network owner can “internalise” the externalities generated among the retail customers of

different networks, because each network can only charge its own retail customers.

Interconnection fees, therefore, have a role in indirectly transferring payments between

the retail customers of different networks in order to compensate for message

externalities and/or subscriber externalities. The alternative models of interconnection

fees – IPNP, BAK, RPNP – represent a continuum of interconnection fees (positive

termination fee, termination fee=0, negative termination fee – that is payment for

origination). The task of determining which model is likely to perform best, therefore is a

task of determining the correct value (or range) of interconnection fee.

Derivation from efficient retail prices and network costs

Efficient interconnection (wholesale) fees result from the efficient retail model and the

distribution of costs among networks. Here we examine some variations of efficient retail

pricing, and consider how they determine efficient interconnection charges in conjunction

with costs.

22 J.C. Rochet and J. Tirole, “Two-sided markets: A Progress Report”, the Rand Journal of Economics, 2006, p.6.



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In summary:

Benefitingparty

Who shouldpay (retail)

Who should pay (interconnect)

Initiating party Initiatingparty

As long as the terminating network incurs some costs of delivering themessage, the initiating party’s network pays termination fee, andpasses cost on to the initiating customer.

Receiving party Receivingparty

As long as the originating network incurs some costs of delivering themessage, the terminating network pays the originating network anorigination fee (a ‘negative termination fee’) and passes this fee on tothe receiving customer.

Both parties(sharedbenefit)

Shared cost,but in manycases,initiatingparty

payment isefficient

Where the efficient retail model is for the initiating party to pay, theinitiating party’s network pays a termination fee. Where the efficientretail model is for the receiving party to pay, the terminating networkpays an origination fee.

Where the efficient retail model is for both parties to pay, efficientinterconnection fees depend on the distribution of retail payments tonetworks in comparison to their costs. No interconnection fee will bean efficient outcome only in specific circumstances.

•

Similarly, where efficient retail model is a bucket plan:

• with limited initiating messages only – efficient interconnection involves a

termination fee;

•

with limited receiving messages only – efficient interconnection involves anorigination fee;

• with a limit on both – efficient interconnection fee depends on the relative

importance of each limit, and on network costs; or

• that has no limits – efficient interconnection fee depends on the distribution of

benefits, and on network costs.

By way of expansion, in the first two cases – where either the initiating or receiving party

gains all of the benefit – it is relatively straightforward to extrapolate the efficient retail

model to derive the efficient interconnect model. In both cases, the network levying the

retail charge pays a portion of its revenue to the other network, ensuring that costs are

covered at both ends. If the retail charge that the customer is willing to pay cannot cover

both-end costs, then the benefit associated with the message must be lower than its cost,

and efficiency dictates that it should not be initiated at all.

In the case of shared benefit, the situation is more complex. If there is repeated

interaction between sender and receiver, then any imbalance of benefits is often

compensated through other means (monetary or otherwise, as described above). But in

one-off interactions, there are no such compensatory mechanisms and inefficient

messages may occur. This is because the initiator is not bearing all the costs of the

message, but offloading some costs onto the recipient (e.g. the cost of dealing with spamemail or receiving unwanted telemarketing calls).



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As set out earlier, this suggests that in many cases the most efficient retail model is for

the initiating party to pay - resulting in matching wholesale payments that is, termination

payments by the initiating party’s network. The ‘match’ arises because the terminating

network can cover its costs without having to charge the receiving party, and theoriginating network can pass the termination charge onto its retail customer (by way of

increased charges per message or by fixed charges). Hence, a termination fee

(assuming it is sufficiently large) creates incentives to adopt the initiating-party-pays retail

model.

In all cases, where both parties benefit, but IPP is not efficient, the efficient direction of

interconnection payments depends not only on the efficient retail model, but also on the

distribution of network costs. For example, if the efficient retail model is a 50-50 sharing

of costs between the initiating and the receiving party, but the terminating network incurs

higher costs than the originating network, then the efficient interconnection model

involves a termination payment compensating for half of the difference in costs (theterminating network would recover the other half from its retail customer).

As we will discuss extensively in section 6, the specific model where no interconnection

fee is paid, is efficient only under very specific circumstances, where the efficient retail

payments by each retail party exactly match the costs of the network that receives the

payment, and where these retail and costs conditions are stable.

If the efficient retail model involves ‘bucket” plans23 – such as are increasingly common

for mobile users – it is necessary to examine the plans in more detail before deriving the

most efficient interconnect model.

If the bucket plan has usage restrictions, the nature of the restriction is important for

example:

• if there are usage restrictions on initiating but not on receiving messages, then the

plan represents a model where the initiating party pays. Accordingly, the efficient

interconnect model would be one with termination fees (that is, IPNP);

• if there are usage restrictions on receiving but not on initiating messages, then the

plan represents a model where the receiving party pays. Accordingly, the efficient

interconnect model would be one with origination fees (that is, RPNP); and

• if the buckets have usage restrictions on both receiving and initiating messages, then

they represent a model where both the initiating and the receiving party pays. The

efficient interconnect model in this case depends on the relative importance of

restrictions on initiating and receiving messages, as well as on the distribution of

network costs.

23 Bucket plans are fixed fee plans, often with usage restrictions. Unrestricted bucket plans are known as “all-you-

can-eat” plans.



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Plans with no usage restrictions are typically offered as an additional option where other,

usage-restricted plans are available to the same customers. Here, the efficient

interconnect model is one that supports the available usage-related retail tariffs.

However, interconnection payments influence market outcomes even in cases where only

flat rates apply. Also in this situation interconnect fees have an important role in

balancing the benefits between retail customers, and if they fail to exert this role,

distortions will result. For example, if only initiating parties benefit, but no termination fee

is charged, network operators would have an incentive to target customers who receive

disproportionately few calls, because these customers trigger fewer termination costs.

Customers would have an incentive to join networks with a large share of originating

traffic, because the uncovered termination costs on those networks are spread over a

larger customer base, thus allowing the fixed fee to be lower. This would lead to market

failure due to business bias – a phenomenon which we discuss in more detail in section

5.3.8.

This shows that one determining factor for efficient interconnection is ultimately the

distribution of benefits between the retail customers – these benefits are often, although

not necessarily (e.g. when prices are flat rates), reflected in retail prices.

Fixed-fee retail arrangements do not mean that interconnect arrangements should

necessarily also be fixed-fee. At the retail level, the decreasing marginal benefit of

messages protects the supplier that charges fixed fees from unlimited usage. There is no

such mechanism to protect suppliers at the wholesale level, so aggregators of retail

demand could exploit an interconnection flat rate (potentially up to the limit of the

network’s technical capacity).

Derivation from subscriber externalities

Subscriber externalities represent another case where interconnection models can be

used to direct efficient consumption decisions.

For example, if adding a subscriber to network A benefits the sum of customers on

network B more than a new customer on network B benefits the sum of customers on

network A, then the presence of subscriber externalities would imply that the efficient

interconnection charge would involve higher interconnection payments from B to A (or

lower payments from A to B). Thus, subscriber externalities have an effect on the amount

and direction of the efficient interconnection fee.

Interconnection fees can help internalise subscriber externalities. However, there are

practical issues in identifying the optimal externality adjustment particularly where there

are different types of networks interconnecting. Subscriber externalities add to the

complexity of identifying the optimal interconnection arrangements.



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Achieving direct interconnection efficiency

In summary, the direction of efficient interconnection payments between the originating

and terminating networks depends on the nature of message externalities, any subscriber

externalities and costs. Variation in any of these elements could alter the direction of the

efficient flow of interconnection payments.

The ability of interconnection payments to match efficient retail charges is subject to two

important practical limits:

• firstly, it may not be possible to design interconnection payments in units which

match efficient retail payments. For example, assume that the efficient retail model

is one in which only the initiating party pays for initiation of a message. As noted

earlier in section 3.6, in the current Internet IP interconnection environment operators

are technically constrained to charging for packets rather than individual retailsessions, because identification of the message to which a packet belongs is not

feasible. Accordingly, technical constraints – at least in the current IP environment –

limit the extent to which efficient retail models can be matched at the wholesale level.

In future, it may be possible to charge by session using elements such as call server

or session border controllers;

• secondly, in some cases it is not possible to differentiate interconnection by service.

Where this applies (e.g. in the Internet and to some degree also in NGN), the most

efficient interconnection fees are those that best meet the aggregated market

characteristics of all of the services to which interconnection applies.

However, throughout the remainder of this section we make two simplifying assumptions

(unless stated otherwise). One is that both retail charging and interconnection relate to

messages, and we distinguish retail parties according to whether they initiate or receive

the message (rather than send or receive data). The second is that interconnection fees

can be set at a service level.24

5.3.4. Efficient transit interconnection

In this section we discuss the question of who should pay for interconnection in the

context of transit arrangements, under which the originating and terminating networks are

not directly interconnected, but interconnection is facilitated through one or more transit

networks.

24 We make these assumptions solely for the purpose of keeping the analysis focused on key economic

considerations. They do not affect the key elements of our result, in particular, they do not affect our finding that

no single interconnection fee is more efficient than alternative fees and that the performance of BAK is

negatively affected by its inherent inflexibility to adopt any level of interconnection fee other than zero.



Page 53

Where transit is required, payments to the transit provider are made by either the initiating

or the terminating network, or both; however, no direct payments between the initiating

and the terminating network occur. Due to the absence of direct payments between the

networks that have the retail relationships, the opportunity to induce efficient retailcharges through interconnection fees becomes less direct. Effectively, the only way to

balance the charges between the initiating and the receiving retail party is through transit

payments, which might take the form of sequential cascading payments along the route

taken by the message.25

For transit charges to be efficient with respect to any particular message, they must (in

their sum):

• induce efficient retail charging models (unless a relationship between the initiating

and the receiving party exists to directly compensate for message externalities and

2-sided market effects); and

• give all network providers in the delivery chain an incentive to provide the

interconnection service.

Because the efficient retail model depends on the situation and transit networks might

differ in their costs, the efficient level of transit charges also depends on the

circumstances. We illustrate this in the context of two different transit models.

In the case where payments for transit are sequential (that is, payments are made only

between subsequent networks along a chain):

• if it is efficient for the initiating party to pay, while the receiving party neither makes

nor receives a payment, then efficient transit payments will be made from the

initiating party’s network to the first transit network, cascading from each transit

network to the subsequent transit network, and from the last transit network to the

terminating network. The payment to the first transit network would have to cover

the costs of all transit networks as well as termination; and so on down the transit

chain so that decreasing sums26 are paid at each stage; and

25 If payments between the originating and the terminating network were possible and practically feasible, then the

transit payment is neutral with respect to the efficiency properties of the interconnection system – as long as the

transit charge is efficient in its level and the interconnection payments between the originating and the

terminating network are derived on the basis that the transit charge is an incremental cost to the network that

paid for it. However, we do not consider this case in the main text, because when transit occurs, direct

payments between the originating and terminating network tend not to occur.

26 Decreasing by the amount of cost incurred by the network making payment. In other words, each network

subtracts its costs and passes on the remainder to the next network.



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• if it is efficient that only the receiving party pays, while the initiating party does not

make or receive a payment, then a similar pattern of payments will be efficient, but in

the opposite direction. The receiving party’s network will pay the last transit network,

and so on up the chain to the first transit network, which will pay the originatingnetwork. Again, the payment to the last transit network would have to cover the

costs of all transit networks as well as origination; with each sequential payment

decreasing in amount.

An alternative transit model is where one network (either originating or terminating) pays

a fee to an intermediary, who organises transit with all transit providers and

interconnection with the terminating network. Assuming the same retail situations as in

the two examples above, the efficient transit payments would be as follows:

• when retail costs should efficiently be borne by the initiating party: The initiating

party’s network makes a payment to the intermediary. This payment would have tocover the costs of all transit networks, termination and the costs of the intermediary.

The intermediary then makes payments to each transit network and to the

terminating network reflecting the costs incurred by that network in providing the

service; and

• when costs should be borne by the receiving party: The terminating party’s network

makes a payment to the intermediary. This payment would have to cover the costs

of all transit networks, origination and the costs of the intermediary. The transit

network then makes payments to each transit network and to the originating network

reflecting the costs incurred by that network in providing the service.

In both transit models just described, the efficient net revenue earned by each network is

the same. Clearly, efficient payments do not depend on whether charging is sequential or

whether a single intermediary organises transit on behalf of the network bearing the

costs.

Practically, though, it is more difficult to achieve efficiency where sequential payments

occur, because a series of transactions is required; whereas in the alternative case a

single party organises transit and pays for it on behalf of a network. This difference is

exaggerated by the constraints of the current technical environment (where the chain of

transit networks involved cannot be foreseen), compared to the options for transit

interconnection in the more sophisticated NGN environment.

5.3.5. The combination of efficient direct and transit interconnection

While both efficient transit and direct interconnection fees depend on efficient retail

pricing, the specific services provided by transit operators and their specific costs will

generally differ from those involved in direct interconnection.

As a consequence, the efficient charging system for direct interconnection will usually

differ from the charging model adopted for transit interconnection.



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Therefore, a dual system – or a range of dual systems that accommodate the variation

between retail markets – differentiating between direct interconnection and transit is likely

to be efficient in general.

5.3.6. Efficient interconnection charges when traffic is balanced

If traffic is balanced (including in the sense that networks are peers and hence have the

same cost structure and customer profile) and this balance is not expected to change

through either evolving market circumstances or deliberate measures taken by network

operators, then the direction of payments (or BAK) is not relevant to efficiency.

Furthermore, in this case of stable balanced conditions, it would not be important whether

the interconnection fee is flexible or set. The reason is that, under stable balance

between peers, any choice of interconnection fee would result in exactly the same (zero)

net payment between networks and ultimately the same market outcomes. Because not

making any payments involves lower transactions costs than making offsetting

payments, BAK is efficient under these circumstances.

In real-world markets these restrictive conditions tend not to hold: Even if traffic between

some networks appears balanced at a point in time, network operators have scope to

influence this balance, and/or the balance is likely to be disturbed by evolving market

conditions. In this situation of an instable balance, alternative choices of the

interconnection model have significant effects on market outcomes, and the efficient

interconnection fee must be derived from considering the retail market as well as network

costs as described in section 5.3.3. Moreover, in the situation of unstable balance – and

regardless of the specific fee that is adopted –flexibility of interconnection fees to reflect

changing costs and market conditions becomes essential in preventing distortions to the

business conduct by network operators.

5.3.7. Quality of service in efficient interconnection

Traffic prioritisation is, in the medium and long term, necessary to cope with demand

growth in order to ensure high quality of service.27 It is expected that there will be a wide

range of services with varying QoS requirements. For example, voice services may come

in many guises (voice with added value services, voice over broadband, voice over

narrowband, etc).

In this section we discuss the implications of quality of service (QoS) provision for the

efficiency of interconnection.

27 See, for example, Hackbarth, Klaus-D. and Kulenkampff, Gabriele „Technische Aspekte der

Zusammenschaltung in IP-basierten Netzen unter besonderer Berücksichtigung von VoIP“. Study prepared for

the Bundesnetzagentur für Elektrizität, Gas, Telekommunikation, Post und Eisenbahnen; 27 July 2006; p 2.



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Implications for who should pay

Retail price differentiation is inherent to any network offering QoS. Without price

differentiation for quality, all customers would have the incentive to request the highest

priority for their packets; all packets would have equal priority and the service would be a

‘best efforts’ service similar to that provided by the Internet today.

Because the efficient retail prices at various QoS levels differ, the efficient interconnect

prices may also differ.

Fees for transit at a higher QoS level must be higher in order to reflect the higher costs.28

Efficient direct efficient interconnection fees for a high QoS level will necessarily exceed

the efficient level of interconnection fees at a lower quality level if the efficient retail model

is that only one retail party pays – in this case the higher fee for higher quality would

reflect the higher cost of the network that receives the interconnection payment. If bothretail parties pay, the efficient interconnection fee at alternative QoS levels may be equal,

although this occurs only in highly specific circumstances.29 The efficient fee difference

may also exceed the cost of the quality differential.30 Interconnection charges may

therefore vary for different QoS levels by more than their cost. If this occurred, it would

not necessarily indicate inefficient charging.

In sum, QoS provision is likely to lead to different interconnection fees for high and low

quality levels, where the extent of the differential depends on how the benefits of high

quality are on average distributed among retail customers and how the costs of high

quality provision are distributed across networks.

28 Some technologies may present greater challenges for QoS than others. For example, as explained in

Appendix A, mobile networks operate on limited spectrum, and customers must share the "last mile" of

bandwidth, whereas fixed network ADSL customers enjoy a dedicated pipe for this segment. Network

management of QoS in a shared environment is likely to more chal lenging as priorities must be traded offacross users. Where this results in greater costs, those costs must be taken into account in interconnection

fees.

29 This occurs when the benefit of the quality differential and its costs are distributed in the same proportion among

retail customers and networks as the benefit and costs for the low quality service. For example, if at two quality

levels the benefit accrued to the initiating and the receiving party is equal and the cost incurred by the

originating and terminating network is equal, then an interconnection fee equal to zero would lead to an efficient

allocation of costs between retail customers at both quality levels. Moreover, this system would give networks

an incentive to charge their retail customers a premium for higher quality so that the high quality service is

requested only where customers are willing to pay for the higher costs associated with the quality differential.

30 For example, the fee increase may exceed the cost increase where (i) increased QoS tends to amplify the share

of total benefit that accrues to the initiating party; and (ii) a positive termination payment would be efficient in the

case of both low and high QoS.



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Which parts of networks will be affected by QoS?

Because quality provision is an end-to-end process, all network components used to

transmit QoS-differentiated messages will be affected. Hence, QoS will affect efficient

interconnection charging across all network elements, for transit as well as for direct

interconnection. QoS standards therefore need to be reflected in interconnection prices

in all network parts where QoS differentiation occurs.

5.3.8. Welfare consequences of inefficient interconnect charges

In addition to supporting efficient retail charging, as explained above, an efficient

interconnection model ensures that the costs of each network are covered (after taking

account of its retail revenues) and that total interconnection charges do not exceed the

costs of efficiently providing interconnection services.

Unless revenues – that is, the sum of retail revenues and interconnection fees –

compensate a network for the provision of interconnection services, the network owner

will have no incentive to provide these services to an efficient degree. For example, a

terminating network that is not able to cover at least its marginal costs from termination

(or which considers that it would earn more profits if it were to originate rather terminate)

would bias its behaviour in the following ways:

• business bias: The network operator would have an incentive to target specific

types of customers (e.g. outbound telemarketers, who initiate more traffic than they

receive) and avoid serving other types of customers (e.g. inbound call centres, who

mainly receive messages);

• network structure bias: The network operator would have an incentive to receive

another network’s traffic as close as possible to its own customers;

• underinvestment in the scope of networks: The network operator’s incentive to

invest in networks (e.g. coverage) would fall short of the socially optimal level; and

• underinvestment in quality: The network operator would lack the incentive to

invest efficiently in capacity or other quality of service aspects which benefit initiating

parties on other networks (with the risk of congestion, or that higher quality services

are not offered at all).



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If interconnection charges exceed the costs of efficiently providing interconnection

services, consumer welfare is also impaired. Above-cost charges by the initiating network

are unlikely to be stable, so long as consumers have alternative sources of network

access. Regulators have been concerned that, by contrast, above-cost charges by thereceiving network could persist, because that network is perceived to have a “termination

monopoly” for access to that consumer. On this basis, regulators have tended to

intervene to regulate the level of terminating interconnection rates in an IPNP circuit-

switched regime. However, as discussed in section 2.3 in relation to any-to-any

connectivity, competition to supply end-user access, multihoming and the ability of end

users to readily switch networks is likely to temper any such power in an IP environment.

As a result, IPNP is unlikely to incur the costs of maintaining regulatory oversight of

termination rates.

Similarly, a network operator who provides origination of a message and who is not able

to cover at least its marginal costs from origination (or who believes that the incrementalprofits from termination are higher) would:

• target customers who tend to terminate more traffic than they originate (business

bias);

• hand over traffic as close as possible to its own customers (network structure bias).

This practice is known in the IP environment as the ‘hot potato’ problem;

• under-invest in the scope of its network; and

• under-invest in quality and capacity that benefits the terminating parties on othernetworks.

Finally, a transit provider who is unable to recover at least its marginal transit costs would

undersupply transit capacity and deploy fewer PoPs (this is similar to a network structure

bias) and under-invest in quality.

In the remainder of this section we discuss the economic incentives leading to these

distortions and the consequences for consumer welfare in more detail.

Business bias

This can occur where the sum of a network’s incremental interconnection revenues and

incremental retail revenues does not cover the incremental costs (including

interconnection payments) caused by some customers.31 For example, if retail payments

are made as a flat rate (that is, if they are not directly related to usage) that does not

differentiate between customer types, networks have an incentive to avoid customer

groups who tend to incur costs that would not be covered by the flat rate. On the other

hand, networks would tend to compete more vigorously for more profitable customers.

31 Business bias can also occur where all customers are incrementally profitable but a network is restricted by

capacity constraints, creating incentives to pick to the most profitable customers.



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If network operators have sufficient commercial flexibility to react to such cherry picking

(e.g. by engaging in similar customer targeting or by adjusting interconnection rates

selectively with respect to some other networks),32 competition is likely to prevent some

of the harmful effects of this customer targeting. Nevertheless, the effort spent incustomer targeting would be socially wasteful, since it does not add value to services

available to consumers and does not lead to any production cost savings. However, in

some situations networks lack the flexibility to deter targeting through adjustments in

interconnection fees (e.g. where regulators require networks to charge equal and

reciprocal termination fees to all other networks) and might not be equally effective in

targeting (for example, due to differing regulatory service obligations or different levels of

public scrutiny and criticism). In these circumstances, targeting can be even more

socially harmful, because:

• selective customer targeting tends to result in some unserved or underserved

customers who are willing to pay for messages in excess of the resource costs ofproviding them. Each message requires origination and termination, a disincentive to

provide one of these services (manifested in avoiding customers that are relatively

high in their propensity to either originate or terminate messages) would tend to

suppress traffic below its socially optimal level;

• as a result of the bias, traffic might shift across networks without proper regard to

which network has the lowest cost of providing certain services, increasing overall

costs and ultimately retail prices; and

• some networks may not recover their long-term costs, creating a disincentive to

invest and resulting in lower availability of services and/or higher prices in the future.

Network structure bias

This occurs where investments in particular network elements are not fully rewarded and

where networks have the option to determine the point of interconnection. For example, if

interconnection fees are imposed by a regulator and these fees do not respond to the

costs that networks incur, this would mean that network owners have an incentive to

reduce their costs, by tilting their network structure.

Where it occurs, network structure bias can lead to inefficient network design (e.g.

underinvestment in the trunk network) and to services being carried in ways which would

result in higher overall costs of communications services (even if the bias enables an

individual network to minimise its own costs). It can also lead to underinvestment in

connectivity, e.g. in high cost areas. The consequence for consumers would be higher

prices and potentially lower availability of communication services.

32 For example, if there was a bias in favour of customers who receive a disproportionate amount of traffic (like

ISPs) increases in termination fees could compensate for the asymmetry of traffic flow and thereby neutralise

the bias.



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Underinvestment in the scope of networks

This occurs when revenues are insufficient to generate an appropriate return to

investment, without necessarily inducing the network structure bias described above. For

example, for technical reasons, messages to mobile customers are typically handed over

to the mobile network at the earliest possibility. Consequently, a mobile operator may not

be able to engage in biasing the structure of its network to the same extent as other

network operators, who can more easily shift POI closer to their customers. However,

insufficient revenues to fully recover investments between the POI and the mobile

customer would nevertheless lead to distortions, which would simply materialise in sub-

optimal network rollout at all levels. This distortion would reduce the availability of

services to customers.

Quality underinvestment

This is similar to underinvestment in the scope of networks: in both cases, expected

revenues are insufficient to cover an operator’s costs of providing a network quality to

socially optimal level. Hence, quality underinvestment implies that consumers end up

being offered lower quality services than they would be prepared to pay for.

Quality underinvestment concerns can also apply to the provision of QoS levels in two

ways. First, not being adequately rewarded for quality differentiation will discourage

operators from investing in systems that allow quality differentiation. Second, unless

operators are adequately rewarded for better quality interconnection, their incentive is to

provide it at low quality. Clearly, both aspects of inefficient QoS provision harm

consumers who do not receive the QoS differentiation that they require and are willing topay for. 33

33

Vogelsang, in his study prepared for the German regulator, argues that quality underinvestment only occurs in asituation where a low-quality network could free-ride the high quality of other networks, that is, if the quality of

the message increases by increasing the QoS standard of any network over which the message is transmitted.

Conversely, he assumes there is no distortion in the incentives to provide quality if the message quality is equal

to the minimal QoS provided any the networks involved (that is, if the “weakest link” determines the overall

quality), because then a low quality network cannot free-ride on the high quality network’s efforts. However, we

believe that the underinvestment problem can also occur in this situation, although through a different

mechanism than free-riding: A high quality network H (whose own customers appreciate quality) might prefer

(and be willing to pay for) high quality on the networks with which it interconnects. However, without receiving

interconnection payments, other networks do not have an incentive to provide quality to a degree which reflects

the benefit to H ’s customers. This would lead to inefficient under-investment, when the additional value that a

given quality improvement would imply for customers on network H, outweighs the costs associated with the

providing the incremental quality. Vogelsang, Ingo “Abrechnungssysteme und Zusammenschaltungsregime aus

ökonomischer Sicht”, Study prepared for the Bundesnetzagentur für Elektrizität, Gas, Telekommunikation, Post

und Eisenbahnen; 28 April 2006; p 141.



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Conclusion

As the preceding discussion demonstrates, the incentives to provide an efficient level of

interconnection services result from the payments that a network operator receives as a

direct consequence of interconnection. In the case of the originating and terminating

networks, these payments potentially include an interconnection charge from the other

network and retail charges from each network’s own customers.34 For the transit

provider, the only potential ultimate sources of payment are the originating and the

terminating network.

Thus, in a situation where networks have to accommodate an interconnection regime that

is imposed on them, they can either adjust the retail model in order to fully recover their

costs – which would almost certainly lead to an inefficient retail model – or, they can try to

avoid some of their costs by biasing their behaviour in the ways described above. As our

analysis shows, these actions are inefficient, because they reduce demand or thenetwork’s future capability to deliver services that consumers want and are willing to pay

for.

5.4. THE EFFICIENCY OF MULTIPLE IP INTERCONNECTION MODELS

Future IP networks will essentially be layered, with a number of services and a variety of

QoS levels. Given the many dependencies described in this section, with respect to the

efficient direction of payments and the additional considerations of the efficient unit and

level of interconnection fees, which we discuss in Appendix B, an efficient

interconnection model will involve different models for different situations:

• interconnection models may differ between direct interconnection and transit. As we

discussed earlier in this section, efficient interconnection is likely to involve dual

regimes for transit and direct interconnection;

• across networks, costs and customer preferences may differ. Flexibility in the

interconnection charging model is an important means of optimisation – for example,

by correcting or preventing inefficient biases;

• similarly, costs and customer preferences may differ across interconnection

customers that connect with a given network. Cost-based differentiation in

interconnection charges encourages the efficient use of resources and avoids

inefficient cost-avoidance behaviour, and price discrimination can ensure that fixed

costs are recovered while minimising distortion; and

34 The possibility of retail payments from the originating customer to the terminating network is excluded as not

being practical.



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• the characteristics of retail services differ. Differentiation of interconnection charges

by service – while not currently possible, because interconnection occurs at lower

network layers which do not differentiate among alternative uses of packets – would

also increase the flexibility of interconnection fees to match a variety of retailcircumstances.

We comment on each of these dimensions of variation of interconnection models in

Appendix C.

Applying a single or a small number of interconnection models across the board, requiring

reciprocity, preventing differentiation of interconnection arrangements among

interconnection arrangements on a single network, or otherwise limiting the flexibility of

interconnection fees, would:

•

reduce the efficiency of interconnection overall, as interconnection fees would bemore limited in reflecting particular retail and cost circumstances; and

• limit the capability of interconnection fees to respond to changes in the type of

product that interconnecting networks supply to each other (e.g. traffic hand-over at

a point closer to its own customers) and therefore bias operator’s incentives. This

would further distort market outcomes against the interests of consumers.

5.5. CONCLUSION

In this section we draw out our conclusions on the role of interconnection fees and

circumstances that need to be taken into account when determining which

interconnection model is efficient in a particular situation.

5.5.1. The role of interconnection fees in determining market outcomes

As outlined in earlier sections, the role of efficient interconnection charges is to ensure

that:

• the efficient amount and type of messages are consumed, taking account of the fact

that messages are consumed by both the initiating and the receiving party; and

• network providers have an incentive to provide the message exchange services

demanded.

Efficient message exchange involves encouraging message traffic for which the benefits

outweigh their resource costs it involves, at low prices and to an appropriately high

quality. It can only occur if the underlying interconnection services are provided to an

efficient extent and quality.



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Unless revenues – that is the sum of retail revenues and interconnection fees –

compensate a network for the provision of interconnection services, the network owner

will have no incentive to provide these services to the degree necessary to meet

consumer demand. Therefore, network operators can be expected to react to the leveland structure of interconnection fees, by adjusting the retail prices they charge and/or by

influencing their level costs.

Where an interconnection model is adopted, without regard to its efficiency implications in

the retail market or on incentives to minimise costs, this will necessarily lead to distortions

to the amount and type of messages being exchanged, the availability of services, and

service quality and prices.

5.5.2. Circumstances determining the efficient interconnection fee

In the following we summarise the implications of alternative circumstances on the

efficient direction and level of interconnection fees. A list of the relevant circumstances

that determine the efficient interconnection fee is presented in section 7.3.5.

Traffic balance

If traffic is balanced (including in the sense that networks are peers and hence have the

same cost structure) and this balance is not expected to change through either evolving

market circumstances or deliberate measures taken by network operators, then BAK is

efficient. However, in real-world markets these restrictive conditions are extremely

unlikely to hold.

The distribution of benefits between end customers and the distribution of networkcosts

As our economic analysis demonstrates, retail market and cost criteria together determine

the efficient direction of payment for interconnection.

The conceptual graph in Figure 19 shows how an economically efficient interconnect

model can be derived, if the distribution of benefits and costs for a specific message are

known. The graph depicts a situation where the total benefit of the message is equal to

the total cost of providing it and both retail customers benefit from the message. This

Figure is drawn based on benefits arising only directly to the particular retail customers,

although the Figure can be modified where the message exchange also needs to take

into account subscriber externalities.



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Figure 19 - Efficient interconnection in response to retail benefits and network costs

• if only the initiating party benefits, but at least some of the costs are borne by the

terminating network, then IPNP is efficient regardless of the distribution of costs

between the originating and terminating network;

• similarly, if only the receiving party benefits but some costs are incurred by the

originating network, then RPNP is always efficient;

• along the diagonal line depicted in the figure, the efficient interconnection fee is

equal to zero (BAK). This line can be derived as follows:

• when only one party benefits and only this party’s network incurs costs, then

the efficient way to recover these costs is for the network that incurs the

costs to charge its retail customer and for interconnection fees to be equal to

zero;

• when both parties benefit equally, and termination costs are equal to

origination costs, then the efficient interconnection fee is equal to zero (point

A in the figure);

• if compared to the situation in A, the initiating party benefits somewhat more,

then the zero interconnection fee maintains its efficiency if the originating

network incurs somewhat higher costs. Similarly, if compared to the

intersection of the 50% lines (which indicate equal distribution), the receiving

party benefits somewhat more, then the zero interconnection fee maintains

its efficiency if the terminating network incurs somewhat higher costs;



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• the area to the left of the zero-fee diagonal represents situations where IPNP is

efficient. The area to the right of the zero-fee diagonal represents situations where

RPNP is efficient.35

If the interconnection fee is chosen in this way, it would be ensured that the message is

initiated, which would be efficient, because the total benefit of the message is larger than

the cost of providing it.

In practice an interconnection model applies to many different messages between many

parties and potentially several service types. Such messages vary in their total value, as

well as in the distribution of benefit between the retail customers. Therefore, the

interconnection model that is efficient in the market is that which strikes the best balance

between messages that would be efficient, but are not initiated, and messages that are

inefficiently made. Deriving the efficient interconnection fee would then require a very

substantial amount of information (e.g. the statistical distribution of types of messagesthat would potentially be made). Given the absence of such detailed information in

practice, the efficient interconnection fee can be thought of as reflecting the ‘typical’

market conditions. Figure 19 can be used as a conceptual aid to represent these typical

conditions.36 Naturally, as these typical market conditions evolve, the interconnection fee

would have to be adjusted in order to maintain the level of efficiency.

In determining the interconnection fee based on the conceptual approach presented in

Figure 19, it is also important to note that the direction of payment of the direct

interconnection fee is mainly relevant to situations where message externalities or 2-sided

market effects are in play, and where the interconnection fee is required as a tool to

allocate the costs among retail customers efficiently in response to these externalities

(that is, where externalities are not otherwise internalised). These are situations where no

direct payments between the retail parties exist and where the typical receiving party

does not have means to reward the initiating party for initiating beneficial messages – or

‘punish’ for damaging messages. In these situations, the interconnection fee has a role of

balancing benefits among retail parties through the way in which network costs are

recovered from retail customers. Hence, the efficient direction of interconnection fees

should be determined mainly based on market situations in which message externalities

and 2-sided market effects are important and not otherwise internalised.

35 With 2-sided market effects the location of the BAK line would shift. For example, if both parties share the

benefits equally and both networks incur the same costs (point A), but also other customers on the terminating

network benefit from the message, then efficient interconnection would involve RPNP (accounting for the fact

that most of the benefits accrue to customers of the terminating network) and BAK would no longer be optimal

(essentially, the BAK line would shift towards the upper left of the graph).

36 The figure would change somewhat for messages whose total benefit exceeds costs. Then, the location of

situations where BAK is efficient would be represented by a channel around the diagonal line depicted in Figure

19. In fact, in this channel IPNP, RPNP and BAK would generate identical market outcomes; however, due to

lower transactions costs, BAK would be preferred. The reason is that the excess of benefit over costs leaves

some headroom to allocate charges between the initiating and the receiving party in different ways without

distorting the initiating party’s decision to initiate the message. The size of the channel would be determined by

the amount by which the total benefit exceeds total costs.



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Two key insights emerge from this analysis:

• first, because retail conditions vary across markets, no single interconnection fee

always generates superior outcomes, compared to alternative fees. The fact that theefficient interconnection model depends on the characteristics of related retail

charging models, as well as on the cost structure of networks involved in providing

the services, underscores the value of flexibility to select interconnection approaches

according to particular circumstances. As we have discussed, differentiating

interconnection schemes according to the networks involved, assists in improving

the fit between interconnection charges and retail conditions; and

• second, the ‘typical’ market conditions might change over time and so might the

distribution of costs between networks (which network operators can actively

influence through their investments). Thus, while efficient interconnect pricing in the

first instance means aligning the current interconnection fee with current marketconditions and costs, the efficiency of an interconnection model needs to be

assessed in light of changes in market conditions and costs. Therefore, the

responsiveness of a charging model to evolving conditions (or in response to

deliberate actions to reduce costs) is as relevant as whether the model best reflects

current conditions.

Overall, preserving the flexibility of networks to differentiate interconnection according to

the situation as much as possible, would ensure that interconnection models support

efficient charging for the variety of services that are available or that will be available in

the future.

In Table 3 we summarise the relevance of traffic balance, cost balance (peer status), thedistribution of benefits and costs as well as the stability of these conditions for the effi-

ciency of alternative direct interconnection (IC) models.37

37 For simplicity of the presentation, the table presents the situation where there are no direct payments (or other

forms of balancing benefits) between retail parties. As we have discussed above, if an interconnection fee were

restricted to the situation in which direct compensation occurs between retail parties, then the direction of the

interconnection fee would not alter market outcomes (e.g. the interconnection fee and the resulting charges by

network operators could be taken into account in the payment between the retail party). However,

interconnection fees typically apply to a variety of retail situations and hence have a role in balancing benefits

between retail parties in situations where no direct payments or other mechanisms of balancing benefits exist.



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Table 3: Comparative efficiency of interconnection models in key market situations

Market situation Model for direct interconnection Generallypreferred model

BAK38 IPNP RPNP SBI

Traffic balancebetween peers,where thisbalance cannotbe changed bynetworkoperators(‘condition 1’).

Efficient, andavoidsmeasurementand billing costs

Efficient (all models lead to the same net payments for IC) BAK

Efficient whenbenefits accrue toinitiating party

only while somecosts are incurredby the terminatingnetwork

Efficient whenbenefits accrue toreceiving party

only while somecosts are incurredby the originatingnetwork

Imbalanced traffic(or trafficbetween non-

peers);

Stable marketconditions; and

Network costscannot beavoided inresponse to ICfees.

Efficient, wherethe efficientpayments by

each retail partyto its networkoperator exactlymatch the costsof the networkthat receives thepayment(‘condition 2’)

Efficient when benefits are shared.Efficient level and direction of IC feesthen depend on distribution of benefitsbetween retail customers anddistribution of costs among networks

Efficient when feefor imbalance ischosen in the

same way as theefficient fee inIPNP or RPNP

IPNP, RPNP orSBI

Unstable marketconditions; or

Network costs

can be avoided inresponse to ICfees

Inefficient due toinflexibility of ICfee, which isalways equal to

zero

Efficient if initial fee doe all traffic (INPN/RPNP) orimbalance (SBI) is chosen efficiently according to demandconditions and costs and appropriately responds tochanging market conditions and costs

IPNP, RPNP orSBI

Direct interconnection vs. transit

Our analysis shows that the principles of deriving efficient transit fees mirror those of

deriving efficient direct interconnection charges, with the added requirement that transit

charges must yield appropriate revenues to transit providers.

38 An argument has been made that in an NGN environment, BAK may become reasonable if the incremental

costs of traffic on a network become negligible. This argument is at odds with the widespread view that traffic

prioritisation in an NGN environment will be required to use capacity efficiently and the fact that capacity

upgrades involve costs suggest that incremental costs of traffic will in all likelihood not be negligible. Moreover,

usage independent retail access charges are unlikely to be commercially viable or economically efficient for

some retail services such that interconnection fees have at least in principle a role in recovering some fixed

costs in addition to incremental costs (see also our discussion about the efficient cost basis for interconnection

fees in Appendix B.2). Finally, as we have discussed in this report, network structure can in generally not be

taken for granted and such that BAK would in many NGN situations imply that network operators have an

incentive to reduce at least their fixed costs by moving interconnection points closer to their end customers.



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Quality of service requirements

QoS requirements do not affect the principles of the approach, although QoS provision

might have an impact on the distribution of costs and benefits and hence on the level of

the efficient interconnection fee. In addition, QoS provision increases the costs

throughout networks and therefore increases the potential disparity between efficient

retail payments and costs that need to be covered. Consequently, applying an inefficient

interconnection model (including one that does not appropriately react to changing market

and costs conditions) either to direct interconnection, transit or both, could have the effect

of seriously impeding the introduction of QoS into the market.

The level and type of costs

Efficient market operation requires that each network involved in providing services earns

revenues sufficient to ensure that incentives are maintained to invest in infrastructure thatmeets customers’ needs. In the case of direct interconnection, these revenues are

derived from interconnection fees and retail payments, whereas in the case of transit,

these revenues only consist of interconnection fees for transit.

The presence of fixed and common costs in telecommunication infrastructure implies that

charging only on the basis of incremental costs will not ensure that network operators

have incentives to invest efficiently. Hence, the efficient revenues that networks obtain

for providing their services should, on average, recover all costs of efficient investment,

including those costs associated with taking risks. Accordingly, the costs taken into

account should generally include an appropriate contribution to fixed and common costs.

If the implications of the circumstances listed above are reflected in the interconnection

model(s) that the market adopts or which is imposed on the market by a regulator, then

the system of interconnection fees would meet the efficiency criteria listed in section

5.2.3.39

39 Regulatory benefits have not been considered in this section as the analysis first sought to establish what would

be efficient, before analysing specific interconnection models (including their potential regulatory benefits) in

section 6.



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6. ECONOMIC ASSESSMENT OF ALTERNATIVE CHARGINGMODELS

6.1. INTRODUCTION

As we have described earlier in this report, telecommunications networks are on the

verge of profound generational change, where many kinds of traffic will be carried and

switched as packets of data in an all-IP environment. The value of efficient IP

interconnection is both high and growing as connectivity becomes more pervasive (e.g.

more devices become connected, for more of the time). This raises the important

question of what will be the most economically efficient interconnection arrangements.

This section uses the economic analysis developed in section 5 to consider the relative

merits of alternative interconnection models that could be applied in an IP context. Whilesection 5 considered how to derive an efficient interconnection model suitable for its

situation, the purpose of section 6 is to:

• identify the type of distortions that might occur if a particular interconnection model

(BAK, IPNP, RPNP) is used in circumstances in which it is inefficient; and

• compare the alternative interconnection models with regard to their benefits and

disadvantages.

We find that no one model will be the single most efficient across a range of real-world

circumstances and point to the importance of flexibility of interconnection fees to react tochanging circumstances.

The approach we adopt in this section is to first illustrate the mechanisms and situations

that can lead to efficient and inefficient market outcomes in the context of one particular

charging model, BAK. It is useful to choose BAK as the starting point, as it has received

considerable attention in the debate to date on IP interconnection. The assessment of

BAK can then be used to highlight the relative advantages and disadvantages of

alternative models.

The analysis proceeds as follows:

• section 6.2 provides an evaluation of the efficiency of BAK (for both direct and transit

interconnection);

• section 6.3 evaluates the efficiency implications of IPNP;40

• section 6.4 evaluates the efficiency implications of RPNP;

40 Throughout this section we refer to IPNP/RPNP in relation to messages (which, as discussed earlier in this

report, are defined broadly, that is, they include downloads web searches etc.). Applying this terminology, the

initiating party’s network is the network of the customer that initiates the message (e.g. sends an email, requests

a download, etc).



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• section 6.5 analyses the implications of settlement-based interconnection; and

• section 6.6 provides concluding remarks.

6.2. EFFICIENCY OF “BILL-AND-KEEP”

In this section we consider the efficiency implications of applying BAK — that is, not

charging for interconnection regardless of any imbalance between networks.41

Imbalance means that the amount of traffic traversing two networks in each direction is

unequal, that the quality attributes of that traffic differ in each direction, and/or that the

costs associated with transporting traffic are different across the two networks.

From our analysis in section 5 it follows that BAK is efficient in two conditions, which are

determined by traffic balance, cost-benefit distribution and the potential for change in

these parameters as summarised in section 5.5.2:

• Condition 1: where traffic is evenly balanced between peers (that is, networks with

similar costs), and cannot be taken out of balance by strategic behaviour (in this

situation all models would yield the same interconnect fee as BAK, that is, zero); and

• Condition 2: where traffic is not evenly balanced (but is stable, and operators cannot

engage in strategic behaviour to avoid costs), and the retail benefit shares of

initiating and receiving customers exactly match the shares of originating and

terminating network costs.

Our assessment of BAK in this section goes beyond identifying the situations in whichBAK is efficient. In particular, the aim of this section is to outline the implications of

applying BAK on other situations, through an in-depth analysis of the distortions that

would occur. In summary:

• outside Conditions 1 and 2, BAK leads to market distortions and damages efficiency.

By setting all origination and termination payments to zero, BAK requires networks to

gain all of their revenues from their own retail customers, which usually leads to

inefficiencies in retail pricing. Moreover, BAK – mainly due to its inflexibility to react

to changing costs – gives rise to network structure bias (‘hot potato’ problem) and

may lead to under-investment in the extent of networks and their quality. Applied to

transit, BAK also leads to similar inefficiencies and, in addition, would discourage the

provision of transit because of the absence of transit payments; and

41 As we discuss in section 3.3.1, in a situation where no interconnection payments are made if traffic is balanced

but there is an understanding that charges will be paid (or the interconnection arrangement be reconsidered)

when the networks are out of balance, the adopted charging model is settlement-based interconnection, not

BAK.



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• these inefficiencies are likely be amplified in an IP-world where QoS differentiation

would otherwise be facilitated to the benefit of end-customers. Applying BAK to

direct and/or transit interconnection could have the serious effect of impeding the

introduction of QoS differentiation.


Because, by definition, BAK prevents the terminating network from receiving revenues

from the initiating party’s network, the only source of revenue to a terminating network are

its own retail customers (including advertising customers). Under a BAK interconnection

system for termination, operators have the following options (individually or in

combination) to generate revenues from their retail customers to cover their origination

and termination costs:

Option 1. The originating network recovers all of its cost from the initiating party; the

terminating network recovers its costs from the receiving party.

Option 2. Each network recovers its costs through retail payments by its subscribers for

unrelated messages, for example:

• the originating network recovers its origination costs by charging more for messages

terminated on its network; and

• the terminating network recovers termination costs by charging more for messages

initiated on its network.

Option 3. Both network operators recover their costs through increasing the price for

bucket plans, fixed access fees or all-you-can-eat plans.

In our analysis below we demonstrate that – except in very special circumstances – all

options involve distortions to market outcomes.

Option 1: The originating network charges the initiating party and the terminating

network charges the receiving party

Charging the initiating and the receiving party each for the costs incurred by their own

network operator would – assuming that charges are sufficiently high – ensure that bothoperators have an incentive to provide services to the degree and quality requested by

customers. While this option solves the cost recovery problem from the perspective of

the networks, its problem lies in its retail implications.

As we demonstrate in section 5.3.2, the distribution of retail charges should reflect the

benefits accrued by each of the parties involved in message exchange. The retail model

of option 1 is efficient only when it appropriately reflects the distribution of consumer

benefits, that is, when each retail party benefits from the message by at least the value of

payment to its network provider. However, as our earlier analysis shows, in many

situations this distribution of benefits is unlikely. In particular, recovering termination

costs from the receiving party can lead to distortions in the following situations:



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• the receiving party does not benefit to an extent equal to at least the termination cost

it bears. For example, a person receiving a request for content from his or her

personal homepage where downloads do not generate advertising revenues, would

be discouraged from providing the content if that person had to pay for downloadsinitiated by some other party;

• both parties benefit from messages; however there is an asymmetry in that the

receiving party usually rewards the initiating party for beneficial messages, but has

less scope to “punish” parties who initiate nuisance messages. As we discuss

earlier, in this case the amount of socially desirable message traffic is maximised by

charging only the initiating party, as this allows socially beneficial messages to be

exchanged, whilst discouraging undesirable messages.

Option 2: Cost recovery through payment for unrelated messages

An operator that does not receive interconnection payments could also try to cover its

costs from charges on unrelated messages (e.g. the terminating network could try to

recover termination costs from outbound messages). Recovering network costs from an

unrelated message sends distorting price signals, because the parties who bear the cost

of the message have not been involved in it. Hence, this retail model tends to lead to an

excess of undesirable traffic, to a suboptimal level of socially beneficial traffic, or a

combination of both.42 These distortions of message traffic would also be reflected in

distortions to subscription decisions wherever subscription fees are relevant: Some

customers would have an incentive to subscribe only because of inefficient messages

they generate, whereas other customers would not subscribe, because they would have

to pay for messages which they neither initiate nor receive.

The disparity between customers who cause costs and those customers who are charged

to recover those costs also results in business bias. While this bias can arise either for

origination or termination (depending on where BAK leaves a gap between retail

payments and network costs), we illustrate it in the situation where BAK leads to under-

recovery of termination costs. In this case the bias leads to targeting of customers that

cause only a small amount of termination traffic and associated costs.

The root of the targeting incentive, is the problem that option 2 involves payments by

customers who do not cause the incremental costs of termination. Therefore, customers

would have an incentive to avoid networks which have a disproportionate amount of

termination traffic, because on these networks they would be charged a higher monthly

fee or pay more whenever they initiate a message. As customers would be willing to pay

a premium to join a network with low termination traffic, network providers would have an

incentive to target customers who originate a disproportionately large amount of traffic.

42 In the event that all messages are identical in origination and termination costs and in their benefits to the

initiating and the receiving party, option 2 could be used to indirectly reinstall efficient retail payments – and

efficient traffic outcomes (e.g. initiating party payments could be re-installed). However, as the costs and

benefits of messages as well as subscriber characteristics on different networks vary significantly, this condition

is extremely unlikely to hold even approximately.



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As we discussed in section 5.3.8, the negative selection process involved in business

bias generally leads to usage which is too low (as some demand for messages is under-

served). Furthermore, the fact that traffic flows reflect a network’s targeting success,

rather than its cost efficiency, and that targeting efforts constitute a wasteful use ofresources, would ultimately lead to higher prices for consumers.

Option 3: Increasing the price for bucket plans, fixed access fees or all-you-can-eat

plans

Because bucket plans and all-you-can-eat plans indirectly involve payments for initiating

or receiving messages, adjusting these prices would be a variant of option 1 (e.g. if the

terminating network recovers costs by increasing the price for buckets on receiving

messages or by imposing additional restrictions on receiving messages on its bucket

options) or of option 2 (e.g. if the terminating network recovers costs by increasing the

price for buckets on initiating messages or imposing additional restrictions on initiatingmessages on its bucket plans). Thus, reacting to BAK by adjusting bucket plans or all-

you-can-eat pricing, leads to the economic outcomes that we discussed above in relation

to options 1 and 2. Therefore, we focus below on the case of introducing (or increasing)

fixed fees, e.g. access fees.

Where a fixed fee is introduced (or increased) relative to traffic sensitive charges as a

reaction to the introduction of BAK, this would distort traffic:

• it leads to excess traffic because the variable charges for messages are below the

costs caused by the message; and

• it tends to distort subscription decisions. Some low usage subscribers who would

have joined a network, no longer do so (because their low usage no longer justifies

the increased fixed fee), whereas other types of subscribers join in excess (those

who disproportionately participate in message exchange that would be discouraged

if the parties of a message had to bear the variable cost of the message, but who

would not have subscribed had only their socially useful traffic be encouraged).

As in the case of options 1 and 2, these distortions relative to the efficient retail outcome

occur whenever the fixed fee structure, adopted in response to BAK, results from the

need to recover costs (rather than being a result of how the benefits of message

exchange are distributed between retail customers).

In addition to these traffic distortions, option 3 involves business biases similar to that of

option 2. Essentially, with access charges that do not vary among customers or that

imperfectly reflect the differences in costs caused by specific customers (which may be

due to differences in the cost of origination vs. termination or the amount of traffic caused

by customers), networks have an incentive to avoid customer types who cause

disproportionately higher costs. Similarly, prospective customers would have an incentive

to avoid networks with a high-cost customer profile.



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Distortions which are unrelated to the retail model

Bill-and-Keep also leads to distortions that are not related to the specific retail model a

network operator employs in response to BAK.

Importantly, BAK causes network structure bias behaviour (the hot-potato problem). The

source of this problem is that under BAK, interconnection payments are equal to zero and

not variable with the amount of costs a network incurs. Hence, all networks have an

incentive to avoid network costs by locating interconnection points closer to their own

customers. As described earlier in this report, network structure bias would ultimately

reduce the availability of services to customers and/or increase retail prices.

Moreover, where a combination of inefficient retail charges, business bias and/or network

structure bias does not compensate for the investment disincentive associated with the

absence of interconnection revenues (e.g. because some networks may not be able toavoid the ‘hot potato’), under-investment in quality or networks in general would occur,

which will inevitably reduce the future availability and quality of services.

Finally, low or zero interconnect charges, in combination with higher fixed charges, may

risk reducing competition for subscribers.43 When termination charges are below the cost

of supplying termination, marginal customers are less valuable to acquire. This leads to

less intense competition for customers and provides the ability for operators to set

excessive fixed charges. The ultimate result is that the benefit from low call prices is

more than offset by the higher fixed charges so that overall consumer welfare is reduced.

6.2.2. Transit

BAK may also be applied to transit interconnection – potentially either as a result of

specific transit arrangements or as a result of using a BAK model between two networks,

which then applies to all traffic between these networks (that is, to direct interconnection

as well as transit). We analyse the implications of applying BAK to transit interconnection

in Appendix D. As we demonstrate, BAK applied specifically to transit traffic would lead

to more severe distortions than BAK applied to direct interconnection, because transit

does not generate retail incomes.

43 Gans, J. and S. King, “Using ‘Bill and Keep’ Interconnect Arrangements to Soften Network Competition”,

Economic Letters, 71 (3), June 2001, pp.413-420. This result contrasts with earlier research which had found

that networks would cooperatively prefer high termination rates with the aim to soften price competition.

However, these earlier results were derived under the unrealistic assumptions that (i) on-net/off-net price

differentiation was not possible and (ii) retail charges consist only of a fixed charge per unit of service but does

not include a subscription fee.



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6.2.3. BAK in the presence of QoS differentiation

While the Bill-and-Keep model generally leads to a number of distortions, even in the

relatively simple environment of switched voice interconnection, these problems will beexacerbated as quality of service provision becomes technically available. Therefore, as

we discuss in detail below, the speed and scope at which the transition to QoS will occur

will strongly depend on whether BAK is imposed.

For example, where BAK for direct interconnection implies that some amount of

termination costs are unrecovered at no QoS differentiation, then an even higher amount

will go unrecovered for terminating messages at a high quality level. An obvious cost

avoidance strategy for the terminating operator would then be to provide BAK termination

only at a low quality and reserve its network capacity for traffic that both originates and

terminates on its network (that is, for traffic that generates revenues for QoS provision).

Even forcing the operator to provide its highest available quality for termination (or tomatch the quality level at which off-net traffic enters its network) would not avoid the

distortion, because such a requirement would simply reduce the incentive to prioritise

traffic or to invest in other QoS capabilities in the first place. Aside from the distorting

effect of BAK on traffic generally, the result would be that the provision of quality would be

driven by efforts to alleviate the impact of BAK and would not necessarily reflect

consumer demand.

In addition, because QoS would increase costs at all elements of a network, it would

increase a network’s benefit from locating the points of interconnection close to its

customers, thereby aggravating the network structure bias.

Similar distortions would also occur if BAK were to be applied to transit, because – as the

examples discussed in Appendix D demonstrate – BAK applied to transit prevents any

indirect payment between the originating and terminating networks. That is, there would

be no rational firm willing to provide transit services on the basis of a BAK interconnection

model. In addition, not paying for transit even at high quality would further discourage

transit providers from offering services, particularly at high quality.

The additional distortions caused by BAK in the presence of QoS apply to interconnection

at all points in a network, because QoS provision involves costs throughout the network.

For example, prioritising a data packet at any part of a network incurs the cost of the

opportunity to prioritise another packet.



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A recent study44 prepared for the German telecommunication regulator, BNetzA, deviates

from this view. It recommends a dual interconnection system, whereby BAK would be

applied to direct interconnection45, and where CPNP46 (in its Element Based Charging

(EBC) variant) would be adopted for transit where regulation of transit charges isnecessary. The rationale for this recommendation appears to be the following, in the

author’s view:

• BAK is the preferred interconnection system if QoS considerations do not play a

role;47

• CPNP (either as EBC or Capacity Based Charging (CBC)) is the preferred

interconnection system if QoS considerations are relevant;48 and

• QoS considerations are not significant for originating and terminating access.49

Accordingly, the author concludes that, because (in his view), BAK is generally the

preferable interconnection model in the absence of QoS consideration, then it is still

preferable in relation to interconnection for originating and terminating access, even in

networks that adopt QoS standards.

Our analysis in this section has shown that BAK implies several distortions. In the

following sections, after considering alternative interconnection models, we conclude that

BAK is not necessarily preferable to these alternatives even in the absence of quality of

service considerations. In addition, there are compelling reasons to suggest that QoS

plays a significant role for originating and terminating access:

44 Vogelsang, Ingo “Abrechnungssysteme und Zusammenschaltungsregime aus ökonomischer Sicht”, Study

prepared for the Bundesnetzagentur für Elektrizität, Gas, Telekommunikation, Post und Eisenbahnen; 28 April

2006; p 172. It should be noted that Vogelsang’s efficiency analysis is somewhat more limited than the analysis

in this report as he compares only the relative performance of Bill–and-Keep with two specific variants of CPNP

(both of which are cost-based).

45 The study uses the term “interconnection” in the access network to refer to origination/termination.

46 Calling party network pays. The main focus of that study is IP voice traffic.

47 Vogelsang derives this conclusion from his analysis of alternative interconnection charging models in the PSTN

and in NGN (and specifically for VoIP without QoS considerations) with a fixed-line access network, but

concludes that his assessment is valid more generally and in particular applies also to mobile networks.

Vogelsang, ibid, pp 86-87, 118-119 and 129.

48 Vogelsang, ibid, p 148.

49 Vogelsang, ibid, p 142. Vogelsang points out (p. 143) that the BAK approach for origination/termination “could

lead to more problems”, if the possibilities of quality differentiation in the access network (in particular with

regard to termination) are significant.



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• firstly, access networks can be, and in practice sometimes are, affected by capacity

shortages, which constitute the problem that QoS traffic prioritisation attempts to

solve. The reason for capacity shortages in access networks is that adding capacity

to them can be particularly costly, as the elements of the access network at a givenlocation (e.g. a fixed line access network, mobile towers or spectrum) are used only

by a relatively small number of retail customers. Further, mobile network operators

will generally not be able to easily purchase additional spectrum to meet the

increased capacity requirements associated with QoS-free interconnection; and

• secondly, interconnection for originating and terminating access is not restricted to

the first point of interconnection (in the case of origination) or the last point of

interconnection (in the case of termination). For example, interconnection with a

mobile network for call termination typically occurs at the first point of interconnection

with the terminating network, because the geographical location of the receiving

party is unknown. Hence, a terminating mobile call is usually transmitted oversignificantly more elements of the terminating network than just the portion of the

network that provides access to the receiving customer. At every point along this

path, quality of service will need to be ensured for, say, a high quality video call.

Overall, this indicates that interconnection for the purpose of origination/termination

cannot be decoupled from QoS standards. Accordingly, it is essential that the

interconnection regime adopted for origination/termination induces incentives to provide

an efficient level of QoS in the context of both direct interconnection and transit.

6.2.4. BAK imposed by regulation

The results of the preceding analysis can be used to evaluate commonly held perceptions

about BAK in a regulatory context. Proponents of BAK put forward the following benefits

as the rationale for using BAK in IP interconnection arrangements:

• firstly, proponents argue it is simple and certain, both from the perspective of market

participants and regulators. Because there are no interconnect payments,

transaction costs (e.g. billing) are saved and operators can be sure what the cost will

be (which is helpful in the case of, say, retail bucket plans). In addition, regulatory

resources needed to manage a BAK system are low and there is no risk of

regulatory error which might otherwise occur if the regulator attempts to set the ‘right’interconnection fee;

• secondly, in a regulatory context, the BAK model has raised interest as a means for

regulators to overcome what has been called a “termination monopoly”. This refers

to the finding, that because a network controls the access to its customers,

termination charges may not be equal to the economically efficient level even if

networks compete intensively for customers. Because BAK sets the termination fee

to zero, there can be no concerns about over-pricing of termination; and

• thirdly, proponents argue that BAK avoids regulatory-induced arbitrage in which calls

may be routed inefficiently to take advantage of any differences in terminationcharges.



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However, in light of the preceding analysis, none of these arguments in favour of BAK

withstands closer scrutiny.

First, applying BAK efficiently is not simple. If BAK were to be applied efficiently, thenextensive monitoring is required to assess whether the conditions under which BAK is

efficient continue to hold. That is, if BAK is applied in condition 1 traffic balance and cost

balance need to be monitored, whereas if it is applied in condition 2 the cost and benefit

distributions would need to be monitored. Without evaluating whether these conditions

hold (and continue to hold for as long as BAK is applied), applying BAK would risk very

significant distortions in the market place (because, as discussed earlier, it is not suitable

to reflect the variety of retail and cost conditions which are encountered in practice and

which will be even more important with the migration to NGN). The significance of which

will in many cases outweigh the burden of carefully choosing an interconnection model

and monitoring its performance. Thus, applying BAK efficiently does involve potentially

significant transaction costs.

Second, BAK should not be applied as a standard remedy to termination bottlenecks.

There is no guarantee that – in a situation where termination bottlenecks exist and market

based termination rates are excessive (considered within the overall strategy of operators

to recover their costs through various prices)50 – imposing BAK would yield more efficient

market outcomes than imposing any other arbitrary interconnection fee. Indeed, there is

no guarantee that in this situation BAK would lead to outcomes that are more efficient

than those that would be achieved without intervention. The reason is again that, when

applied outside conditions 1 or 2, BAK implies inefficiencies.

Third, regulatory arbitrage is not a failure of interconnection charging models other than

BAK, but a result of inconsistent regulation. Where regulation is applied consistently,

arbitrage is minimised. BAK is not an efficient shortcut to avoid arbitrage, because it

would – outside conditions 1 and 2 – imply inefficient use of services and cost avoidance

behaviour (which eventually will further distort consumption).

6.2.5. Conclusion

In this section we investigated in detail the inefficiencies that follow from applying BAK in

other circumstances other than conditions 1 and 2 listed in Table 3.

Under BAK, network operators must recover their costs from their own retail customers.

Our discussion demonstrates that the most obvious retail charging model which operators

can employ to cover their costs, leads – except in the specific case where the benefit

accrued by each retail party coincides with the cost of its network (as depicted by the

diagonal line in Figure 19) – to inefficient consumption of messages. Alternative models,

which try to recover costs more indirectly, have even more distorting effects (e.g.

business bias). Different operators may have differing abilities to recover costs from their

customers and hence BAK may also impact the relative competitiveness of operators.

50 As discussed in section 7.3.3 in relation to any-to-any connectivity, concerns about traditional termination

bottlenecks may become less relevant in an IP-world.



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Moreover, even in combination with the best performing retail model and under the

assumption that this model efficiently reflects retail benefits, BAK causes network

structure bias (the hot-potato problem). This bias results from the fact that under BAK

interconnection payments are invariably set equal to zero, which creates an incentive foreach network to avoid costs by locating interconnection points closer to its own

customers.

Where a combination of inefficient retail charges and biased business conduct do not

compensate for the investment disincentive associated with zero interconnection

revenues, under-investment in networks and their quality will follow.

BAK applied at the transit level can lead to one or more transit providers not receiving any

revenues. This implies additional distortions, because with no transit payments, transit

providers incur costs but have no means to recover them. As a result BAK would act as a

disincentive to provide transit – an effect that markets could only overcome through costlybypass.

Finally, the distortions generally occurring under BAK are likely to increase in the

presence of QoS, because QoS provision increases the costs throughout networks and

therefore increases the potential disparity between retail payments resulting from an

efficient retail model and the costs that need to be covered. Hence, applying BAK to

direct interconnection, transit or both could have the serious effect of impeding the

introduction of QoS into the market.

In short, unless BAK is applied in a situation of traffic balance between peers, and this

balance cannot be changed through strategic moves, BAK is generally an inefficientinterconnection model with far-reaching consequences, which include distortions to the

amount and type of traffic, unavailability of services and quality levels, as well as high

prices.

Regulators could try to mitigate the disincentives under the BAK model, for example by

preventing the targeting of customers, regulating the location of interconnection points

and mandating network investments to meet quality requirements. However, given the

complexities involved, this would be highly unlikely to be successful. Hence, regulation

alone would not suffice to ensure a mandated BAK would work efficiently.

Our analysis also shows that commonly held beliefs that BAK should be imposed when

markets fail, are incorrect. Applied correctly, BAK is neither a simple remedy nor an

efficient way to respond to termination bottlenecks, where they require intervention.

Table 4 summarises the benefits and disadvantages of imposing BAK with reference to

the efficiency criteria introduced in section 5.2.3.



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Table 4: General assessment of BAK against efficiency outcomes

Type of impact Assessment

1. Consumer benefits • Except under specific circumstances (Conditions 1 and 2), retailprice distortions potentially lead to too few beneficial messagesand too many undesirable messages being sent and tocorresponding distortions in subscription decisions

• Allows some internalisation of positive subscriber externalitiesalthough it may also lead to some customers not being served atall (e.g. those who mainly receive messages and for whom theirown benefit of receiving the messages is lower than the cost)

• In general, impedes the supply of higher QoS-based servicesrequiring interconnection, as the terminating network may not havean incentive to provide the higher QoS

2. Network operator impacts • Where operators are required to accept traffic, BAK may lead to

operators being forced to receive calls without adequateremuneration, deterring network investment (and/or forcing theoperator to adjust its retail charging, which outside Conditions 1and 2 is inefficient)

3. Market operations benefits • The ‘hot-potato’ problem emerges (networks inefficiently hand offtraffic as soon as possible, raising overall cost of supply)

• Potential to soften network competition

4. Regulatory impacts • Avoids regulator involvement in detailed estimation of efficientinterconnection charges; however, strategic behaviour may needto be monitored, and traffic measured to test whether conditions 1or 2 still hold

6.3. EFFICIENCY OF IPNP

IPNP, BAK and RPNP are a continuum of options involving a fee for termination, a

termination fee equal to zero, or a positive origination fee (or, in other words, a negative

termination fee), respectively. For this reason, many of the inefficiencies that can occur

when BAK is applied in an inappropriate situation, can also occur when IPNP (or RPNP)

is applied in (different) inappropriate situations. Therefore, much of the analysis provided

in the previous section is also relevant to the assessment of both IPNP and RPNP, albeit

the benefits or disadvantages of each model appear in different situations.

Efficient interconnect pricing in the first instance means aligning the current

interconnection fee with market conditions and costs. However, because the charging

regime will be in effect for a long time, its efficiency needs to be assessed in terms of

likely changes in these market conditions and costs. Therefore, the responsiveness of a

charging model to changing conditions is as relevant as whether the model best reflects

current conditions. Based on these static and dynamic aspects of the performance

characteristics of charging models, the following analysis focuses on two aspects of

IPNP:



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• firstly, we assume that IPNP is applied by imposing a specific termination fee, which

does not change in response to actions taken by network operators or in response to

other changes in the market. This setting, albeit restrictive, already reveals some

advantages of IPNP; and

• secondly, we consider how the performance of IPNP changes if, rather than

imposing a specific interconnection fee, the fee simply responds to evolving market

developments – for example, by being related to costs that network operators incur.

We demonstrate that in this setting, IPNP has additional potential to outperform BAK.

Our key findings can be summarised as follows:

• in the situation of the fixed interconnection fee, IPNP has the potential to outperform

BAK on efficiency measures in many situations. This is due to the wider set of

conditions under which IPNP is efficient, which follows from the fact that IPNP, unlikeBAK (where the interconnection fee is equal to zero), does not imply a specific

interconnection fee. Moreover, IPNP is likely to be efficient in even more situations,

because payments by the initiating party are often an efficient retail model that is

best complemented by IPNP. Finally, compared to BAK, IPNP can be applied in a

way that covers the costs of transit networks and thereby avoids the distortion of

applying BAK to transit; and

• in the situation where the termination fee is adjusted according to evolving market

conditions, IPNP has the potential to outperform BAK even further, because, by

definition, BAK implies an unchangeable interconnection fee equal to zero.

6.3.1. IPNP when interconnection price is held constant

This section shows that, even in the situation where it is assumed that one specific

termination charge is adopted and not changed in response to market conditions, IPNP

has advantages over BAK. These advantages also hold when a more flexible fee is

adopted, however, they do not result from flexibility.

In this section, we focus on direct interconnection. In relation to transit models, we simply

note that IPNP enables transit providers to cover their costs and so avoids a key problem

associated with BAK in that context.

As we have already identified in section 5.3.2 and summarised in Table 3, IPNP is

• efficient when only the initiating party benefits from a message while some of the

costs are incurred by the terminating network; and

• inefficient when only the receiving party benefits from a message.

When both parties benefit, IPNP may be efficient, depending on each customer’s

valuation of the message and the distribution of costs between networks.



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If the IPNP model is applied in a situation outside these circumstances, then inefficiencies

will follow. For example, if a termination payment is adopted in a situation where the

receiving party should bear the full cost of a message, then traffic will be distorted. The

origin of these distortions is that the originating network incurs the costs of origination andpays for termination, but does not receive revenues under the efficient retail model. As

discussed in section 5.3.8, the originating network could respond by deviating from the

efficient retail model (e.g., by charging its customer for initiating the message) or by

avoiding some or all of its costs (e.g. by targeting customers who initiate relatively less

traffic). In a QoS context this distortion would tend to be magnified, because QoS

provision increases the costs throughout networks and therefore increases the potential

disparity between the retail payments resulting from an efficient retail model and the costs

that need to be covered.

In sum, the type of distortions that can arise under a BAK model (where the termination

fee is equal to zero) can also arise under specific fixed charges for termination. Thus, anassessment of which model is likely to lead to the best market performance needs to

consider the specific market circumstances, that is, how far is the termination charge

(including a zero charge under a BAK) from the efficient level. However, because

adopting IPNP does not limit the choice to a specific interconnection fee, whereas the

interconnection fee under BAK is always zero, the range of circumstances in which IPNP

is more efficient than BAK is large (represented by the comparison of the diagonal BAK

line with the area left of it).

Thus, unlike BAK, IPNP (and also RPNP) does not imply that a specific interconnection

fee is selected regardless of market circumstances. Therefore, IPNP has an inherent

advantage over BAK, as the level of the interconnection fee can be set on the basis of

evidence regarding the typical distribution of message benefits between retail customers,

retail customers’ ability to reward each other for initiating useful messages, and network

costs. If, in addition, the possibility of applying RPNP in some situations is not excluded,

then IPNP and RPNP, unlike BAK, allow the question regarding which interconnection

model should be applied, to be considered without preconceiving market conditions.51

Moreover, the IPNP area depicted in Figure 19 is of particular practical importance.

There are reasons to suggest – and market determination of retail payments appears to

support this – that a model with payments only by the party initiating a message

(commonly understood as the “Initiating Party Pays” (IPP) principle) performs well in

many situations. To see this, consider the consumer welfare implications of a shift

towards higher payments by the initiating party. Raising the price to the initiating party,

and correspondingly decreasing charges to the receiving party, has two conflicting

welfare implications:

51 An assessment of market conditions without preconception may of course result in an interconnection fee that is

equal to zero in specific circumstances. But unlike BAK this interconnection fee would change as market

conditions evolve.



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• a welfare benefit, because some socially wasteful messages (e.g. where the

receiving party does not benefit enough for the total benefit to exceed resource

costs) are less likely to be sent; and

• a welfare detriment, because some socially beneficial messages (e.g. messages that

are socially desirable only because they generate a benefit to the receiving party, in

addition to any benefit to the originating party) are less likely to be sent.

The overall welfare effect, therefore, depends on which effect dominates. If the former,

then moving more of the cost burden onto the initiating party would increase welfare. If

the latter, then efficiency would be improved it the receiving party bore more of the cost.

In many cases, IPNP will result in the overall welfare benefit outweighing any detriment.

First, the detriment is generally likely to be low, because in many situations the initiatingparty can receive appropriate compensation from the receiving party for initiating

messages, which, in part or even mostly, benefit the receiving party. This compensation

may be monetary, such as parents paying their children’s mobile bills, or non-monetary

particularly in repeated calling relationships (e.g. where both parties call each other or

sending a useful message is rewarded through other aspects of the relationship between

sender and receiver).

Second, the welfare benefit of charging only the initiating party may be significant

because, in interactions that are one-off, it may be less likely that a message will benefit

the receiving party, and ‘compensation’ for negative effects on the receiving party (e.g.

for an interruption) is not feasible.

Further, IPNP can lead to termination charges that reduce not only the cost of the

individual message that the receiving party must bear, but can also lead to operators

reducing retail prices to the receiving party (as they become more valuable to acquire).

This can provide a means by which subscriber externalities can be internalised. These

reasons suggest that IPNP has the potential to promote efficiency in many – but not all –

common retail market situations.52

52 The distribution of benefits is to some extent a function of the retail charging model. Charging the receiving

party tends to stimulate messages which exhibit a negative externality (such as spam), which tips the

distribution of benefit to the sender. In other words, the character and pattern of the traffic will change in

response to the charging model. As a result, the benefits of a model which involves charging the receiving party

cannot be assessed on the basis of the typical character and pattern of messages exchanged under a model

where only the initiating party pays. Doing so would lead to the misleading suggestion that charging the

receiving party would improve welfare.



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We note that IPNP mobile markets have traditionally experienced lower average minutes

of use than other markets, such as in the US and Canada where interconnection between

mobile operators is typically on a BAK basis. Making international comparisons of market

outcomes is complicated, however, by the range of factors at play. For instance, prepaidplans (with higher per minute charges) are the most popular form of mobile plan in

Europe, whereas only 11 per cent of US subscribers are on prepaid plans. 53 In addition,

overall mobile penetration rates in North America continue to significantly lag European

penetration, with the consequence that the US market simply does not have many of the

low usage customers that have mobile phones in Europe. There appears to be

increasing convergence in the outcomes between markets -- for instance, prepaid is

growing in the US, while buckets plans are becoming increasingly more common in

Europe. Consequently, IPNP is likely to be relatively more efficient than other

interconnection models in many cases.

Additional advantages of IPNP over BAK arise in the context in which the level of thetermination charge can vary in response to market developments. We consider this next.

6.3.2. Enhanced performance of IPNP when interconnection fees can vary

Adopting an IPNP interconnection model entails the option of allowing interconnection

charges to flexibly reflect market conditions. For example, termination charges could

increase when the costs incurred by the terminating network increase.

The advantage of this flexibility is that it would avoid the distorting behaviour that would

be encouraged by the adoption of a fixed level of interconnection charges. When

interconnection fees do not change, network operators have an incentive to reduce their

costs, as this change will not have an impact on their interconnection revenues or

payments. Specifically, they have an incentive to distort their networks so that

interconnection points are close to their customers (network structure bias). This

incentive can be blunted if interconnection fees change in a way that reflects the change

in the costs. Thus, IPNP – when applied appropriately – also avoids the inflexibility of

BAK with regard to evolving market conditions, including those changes caused by

strategic behaviour.54

Consequently, when IPNP/RPNP are applied in a way that reflects market conditions and

costs and where interconnection fees respond to changes in these factors, then thesemodels have the potential to avoid economic problems inherent in BAK.

53 FCC, Eleventh Annual Report on the State of Competition with respect to Commercial Mobile Services, 29

September 2006.

54 Of course, the potential flexibility IPNP and RPNP does not imply that interconnection fees should change

immediately or frequently in response to evolving market conditions. In an efficient application of IPNP and

RPNP the cost of changes and frequent monitoring will be weighed against the potential benefit of changes.



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6.3.3. IPNP imposed by regulation

At first glance, IPNP appears more complex than BAK, or may result in termination

bottlenecks and regulatory arbitrage, if IPNP is poorly implemented by a regulator.However, as we have demonstrated in section 6.2.4, none of these assertions holds after

closer scrutiny, which weighs the social costs of adopting BAK in situations where it leads

to market inefficiencies, against the cost of adopting a more sophisticated approach to

determining interconnection fees.

6.3.4. Conclusion

The relative merits of IPNP with the flexibility for the level of termination charges to be

changed in response to market developments are summarised in Table 5. This Table

highlights the potential for IPNP to deliver significant benefits where the level of

termination charges is appropriate to the particular market situation (and where the levelchanges in response to changing market condition).

Table 5: General assessment of IPNP against efficiency outcomes


1. Consumer benefits • Helps to discourage unwanted messages (e.g. spam).

• May prevent some beneficial messages from being initiated,although this impact will be minimised by frequent messagingrelationships or other mechanisms which are available whereindividuals interact more broadly.

• Potentially higher subscriber numbers by providing a means tointernalise subscriber externalities.

• Differential QoS supported by means to reward both initiating andreceiving networks for carrying higher QoS.

2. Network operator impacts • With the appropriate level of termination charges and the ability tochange termination charges if costs change, IPNP ensures costrecovery and encourages efficient network investment.

3. Market operations benefits • An appropriate level of termination charges can promote efficientmarket operations.

4. Regulatory impacts •

Regulatory view of ‘termination regulation’ can involveadministrative costs and risk of regulatory error in estimatingefficient termination charges. Nonetheless, these risks are likelyto be outweighed by the cost of instead mandating a zerotermination charge (BAK) regardless of whether the marketcircumstances actually require a significant positive terminationcharge.



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As we have previously noted, while in many situations a positive termination charge will

be appropriate and hence IPNP is likely to be the best model, there will be other

situations when this is not the case. Accordingly, the full range of benefits listed in Table

5 should be understood as relating to the application of IPNP in the right circumstances.However, overall, Table 5 assesses IPNP more favourably than Table 4 summarises

BAK. As we have discussed in detail in this section, the reason is that IPNP implies a

less specific fee than BAK, payments by the initiating party are in many situations efficient

regardless of the distribution of benefits between retail parties and because termination

fees can be adjusted in response to market evolution and cost changes (whereas BAK

implies an invariable fee equal to zero).

6.4. EFFICIENCY OF RPNP

An RPNP model involves a positive origination fee, that is, the receiving party’s network

pays an origination charge levied by the initiating party’s network. For example, a

business may want to offer free calls to its customer service centre. The network to which

the business belongs will then arrange to pay an origination charge to the networks of

customers making calls to the service centre. The origination charges will then be

recovered from the business in the charge for the free call service. Much of the analysis

provided in the previous sections is also relevant to the assessment of RPNP.

As in the discussion of IPNP we consider the static and dynamic performance aspects of

RPNP in two steps:

• firstly, we assume that RPNP is applied by imposing a specific origination fee which

does not change in response to actions taken by network operators or in response to

other changes in the market. This setting albeit restrictive, already reveals some

advantages of RPNP over BAK but disadvantages over IPNP; and

• secondly, we consider how the performance of RPNP changes if, rather than

imposing a specific interconnection fee, the fee simply responds to market

developments – for example, by being related to costs that network operators incur.

We demonstrate that in this setting, RPNP has additional potential to outperform

BAK.

Our key findings can be summarised as follows:

• in the situation of the fixed interconnection fee, RPNP has the potential to outperform

BAK on efficiency measures in many situations. This is due to the wider set of

conditions under which RPNP is efficient (as depicted in Figure 19) which follows

from the fact that RPNP, unlike BAK (where the interconnection fee is equal to zero),

does not imply a specific interconnection fee. At the same time, in most common

situations, RPNP is likely to be inferior to IPNP. Finally, compared to BAK, IPNP can

be applied in a way that covers the costs of transit networks and thereby avoids the

distortion of applying BAK to transit; and



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• in the situation where the origination fee is adjusted according to evolving market

conditions, RPNP has the potential to outperform BAK even further, because, by

definition, BAK implies an unchangeable interconnection fee equal to zero.

6.4.1. RPNP when interconnection fees are held constant

Assuming that under transit models other than BAK the costs incurred by transit networks

will be covered, RPNP consistently avoids a key problem of applying BAK to all transit,

namely that the transit providers do not recover their costs. In the remainder of this

section, we focus on direct interconnection.

As we have already identified in section 5, RPNP is:

• efficient when only the receiving party benefits from a message but some of the

costs are borne by the originating network; and

• inefficient when only the initiating party benefits from a message.

When both parties benefit, RPNP may be efficient, depending on each customer’s

valuation of the message and the distribution of costs between their networks.

If the RPNP model is applied in a situation outside these circumstances, then

inefficiencies will follow. For example, in a situation where the initiating party should

typically bear the full cost of a message, if an origination payment is adopted, then traffic

will be distorted. The origin of these distortions is that the terminating network incurs the

costs of termination and also pays for origination, but does not receive revenues underthe efficient retail model. As discussed in section 5.3.7, the terminating network could

respond by deviating from the efficient retail model (e.g., by charging its customer for the

origination of the message) or by avoiding some or all of its costs (e.g. by targeting

customers who terminate relatively less traffic). In a QoS context, this distortion would

tend to be magnified, because QoS provision increases the costs throughout networks

and therefore increases the potential disparity between the retail payments resulting from

an efficient retail model and the costs that need to be covered.

In sum, the type of distortions that can arise under a RPNP mirrors those that can arise

under BAK and IPNP, again illustrating our earlier finding that, which model is likely to

lead to the best market performance, depends on specific market circumstances.

However, because adopting RPNP does not limit the choice to a specific interconnection

fee, whereas the interconnection fee under BAK is always zero, the range of

circumstances in which RPNP is more efficient than BAK is large (represented by the

comparison of the diagonal BAK line with the area right of it).

Because as discussed in section 6.3.1, recovering the full cost of a message from the

initiating party is efficient in many important situations, RPNP consequently has less

potential to be applied efficiently than IPNP.



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Overall, the type of distortions that can arise under a BAK model (where the origination

fee is equal to zero) can also arise under a specific fixed charge for origination. Thus, an

assessment of which model is likely to lead to the best market performance must have

regard to the specific circumstances under which interconnection is supplied.

6.4.2. Enhanced performance of RPNP when interconnection fees can vary

Adopting an RPNP interconnection model entails the option of allowing interconnection

charges to flexibly reflect market conditions. For example, origination charges could

increase when the costs incurred by the originating network increase.

As noted in our discussion of IPNP, the advantage of this flexibility is that it would avoid

the disincentive for network operators to, for example, distort their networks in a way that

interconnection points are close to their customers (network structure bias). This

incentive can be blunted if interconnection fees change in a way that reflects the change

in the costs.

Thus, similarly to IPNP (in the situations where it is superior to RPNP), RPNP also avoids

the inflexibility of BAK with regard to evolving market conditions, including those changes

caused by strategic behaviour.

6.4.3. RPNP and regulation

When interconnection costs are recovered through origination charges, the question

arises as to whether there would be any parallel “origination bottleneck”, in that the

receiving party who ultimately pays the origination charge, is not the initiating party who

has chosen to join the network on which the message is originated. A concern about

market power in this context would appear to arise only where access to the customers

initiating the messages is in some sense essential, e.g., such as where the viability of the

business is dependent on having access to the large customer base of the incumbent

operator and where there are not alternative means of reaching those customers. As with

access issues more generally, it would also be relevant to consider the incentives of

individual operators to deny access or to set inefficiently high origination charges.

Where interconnection is being negotiated between two networks that are not dominant in

any broader market, it is unlikely that there would be any need for regulation of theorigination charge. For example, if a small network sought to set an excessive origination

charge, companies offering freephone calls could choose not to accept calls from that

network. The loss in revenue from origination charges, as well as potential loss of

customers who would be encouraged to switch away from a network on which freephone

calls were unable to be made, would be likely to lead the initiating network to reduce its

origination charges.

However, even if in a specific situation there were a need to intervene, in order to prevent

inefficiently high origination charges, BAK would generally not be a better solution than

determining an appropriate regulated origination fee for the same reasons discussed in

section 6.2.4.



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6.4.4. Conclusion

We summarise the efficiency outcomes that can result from RPNP in Table 6. In short,

RPNP may have a role in certain market situations, but risks deterring a substantialvolume of traffic if applied more generally.

Table 6: General assessment of RPNP against efficiency outcomes


1. Consumer benefits • RPNP can support initiation of messages which primarily benefitthe receiver and which may otherwise not occur under BAK orIPNP.

• However, general application of RPNP would risk a massivegrowth in undesirable messages being sent, to the detriment of thereceiving customer.

2. Network operator impacts • In situations in which it is appropriate for there to be a positiveorigination charge and origination charges can be changed if costschange, RPNP ensures cost recovery and encourages efficientnetwork investment.

3. Market operations benefits • An appropriate level of origination charges in particular situationscan promote efficient market operations.

4. Regulatory impacts • RPNP avoids regulatory oversight of termination charges.Oversight of origination charges is likely to be desirable only foroperators that have market power in a more general market.

6.5. EFFICIENCY OF SETTLEMENT-BASED INTERCONNECTION (SBI)

Settlement-based interconnection is a special case of either Initiating Party Network Pays

(IPNP) or Receiving Party Network Pays (RPNP), depending on whether the initiating

network or the receiving network pays for the traffic imbalance. This applies in the

context of direct interconnection, as well as to the use of settlement-based

interconnection for transit.

This also implies that the commercial and economic outcomes (including the relationship

between the interconnection model and retail charges) that can be achieved with

settlement-based interconnection where the initiating network pays for the imbalance, can

similarly be achieved with an IPNP model without settlement.55 Similarly, the outcomesfrom settlement interconnection where the terminating network pays for the imbalance,

can similarly be achieved with a RPNP model without settlement.

55 For example, consider two networks, A and B, which apply settlement-based interconnection where A pays B,

because A initiates more traffic (and/or A’s traffic that has on average higher priority and/or its traffic tends to be

sent at peak times) terminating on B than B does in the reverse direction. If the balance changes, such that B

initiates relatively more traffic terminating on A, B would now make a payment to A. The same change would

occur if IPNP were applied: B would, on balance, pay more to A than vice versa. Under both models, if the

traffic balance between the networks changes then the balance of payments also changes, however, the

network making a net payment is the network which initiates the imbalance of traffic.



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The difference between settlement-based interconnection and these two alternative

options seems to be largely a technical one, in which the gross payments between the

parties are lower due the recognition of the balanced traffic.

The operation of settlement-based interconnection is critically related to the concept of

“balance”. The definition of “balance” is not simply the balance of megabits or minutes

that the operators terminate for each other over a specific time frame. The relevant

"balance" is in the long-run costs each interconnected operator incurs to provide the

interconnection. If operators' cost structures and demand profiles are similar, balance in

traffic is a sound and measurable proxy for balance in costs. In this regard, to be

reflective of the operators’ (opportunity) costs of providing termination to each other, the

balance must take into account the time at which services were provided (in order to

distinguish times of high and low network utilisation) and the priority as well as other

quality characteristics of the service provided. Once the definition of “balance” has been

agreed, the parties to settlement-based interconnection then need to identify rules toguide their relationship in the event of either casual or systematic imbalance. Finally, they

need to monitor traffic flows in order to be able to assess the balance.

It is clear that, if the balance between two networks is monitored precisely, then the

complications involved in settlement-based interconnection are likely to be similar to the

transactions costs of negotiating and implementing any other interconnection model in

which (at least under some circumstances) payments are made. However, in many

circumstances setting off payments against each may facilitate interconnection and,

hence, settlement-based interconnection might enhance the efficiency of IPNP/RPNP – in

particular when the charges for imbalance are reflective of market conditions and costs

are revised according to the evolution of circumstances.

In sum, settlement-based interconnection represents a special case of either IPNP or

RPNP, depending on which network pays for the traffic imbalance. Due to the setting-off

of traffic in the reverse direction, gross payments may be lower and transactions may be

facilitated, but settlement-based interconnection generally has the same merits, problems

and dependencies as IPNP / RPNP models.

6.6. CONCLUSION


This section has illustrated the detriments to market outcomes, which might occur if a

specific interconnection fee is adopted under unsuitable circumstances. Where

inefficiencies occur, they are likely to increase in the presence of QoS, because QoS

provision increases the costs throughout networks and therefore increases the potential

disparity between retail payments resulting from an efficient retail model and the costs

that need to be covered. Hence, applying an inefficient interconnection model could have

serious effects on the introduction of QoS into the market.



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The potential inefficiencies are particularly clear in the BAK model, because it involves a

very specific interconnection fee (zero), which cannot be changed. Adopting specific

interconnection fees within an IPNP or RPNP (with or without settlement) model can lead

to similar distortions (although the distortions would arise in different circumstances).However, adopting an IPNP or RPNP model generally implies an advantage over

adopting BAK, as long as the specific interconnection fee in the IPNP or RPNP model is

chosen in correspondence with market conditions.

Adopting an IPNP or RPNP interconnection model also entails the option of allowing

interconnection charges to flexibly reflect evolving market conditions. For example, in an

IPNP regime, termination charges could increase when the costs incurred by the

terminating network increase.

The advantage of this flexibility is that it would undermine distorting behaviour that would

be encouraged by the adoption of unchangeable interconnection fees. Wheninterconnection fees do not change, network operators have an incentive to reduce their

costs, as this will not have an impact on their interconnection revenues or payments.

Specifically, they have an incentive to distort their networks in a way that interconnection

points are close to their customers (network structure bias). This incentive can be

undermined if interconnection fees change in a way that reflects the change in the costs.

Because unlike BAK, IPNP and RPNP do not imply that a specific interconnection fee is

maintained regardless of market circumstances, these models have an inherent

advantage over BAK, especially when no pre-selection between IPNP and RPNP (that is,

about the direction of payments) is made without supporting market evidence. Thus, not

only do these models allow approaching the question about which interconnection model

should be applied, without the preconception with regard to market conditions that is

implicit in BAK, they would also avoid the inflexibility of BAK with regard to evolving

market conditions, including those changes caused by strategic behaviour.56

Consequently, when IPNP/RPNP are applied in a way that reflect market conditions and

costs, then they have the potential to avoid virtually all economic problems inherent in

BAK, which ultimately result from the assumption that the interconnection fee should be

zero regardless of circumstances.

We have identified reasons, why in many practically relevant situations IPNP is likely to

be a well performing model. IPNP, more than RPNP or BAK, discourages socially

undesirable traffic (that is, spam), whereas it is typically unlikely to prevent desirable

traffic to a significant extent. Thus, in many situations, IPNP is likely to be optimal if the

‘right’ level of fees is chosen.

56 An assessment of market conditions without prejudice may of course result in an interconnection fee that is

equal to zero in specific circumstances. The important difference to BAK is that this interconnection fee would

change as market conditions evolve.



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This ‘right’ level of termination fees is not always adopted in a market without the

intervention of regulators. IPNP may in some cases however lead to termination

bottleneck problems, where market equilibrium rates exceed the desirable interconnection

fee. The result is a distortion to market outcomes, such as a relatively low amount oftraffic.

However, the possibility of termination bottlenecks is no reason to impose BAK (or RPNP)

instead of IPNP. First, and generally, intervention should be limited to situations where

distortions would actually arise. Second, our analysis demonstrates that imposing BAK

(or RPNP) would generally not be an efficient remedy of bottleneck market power, but

lead to multiple distortions, which might far outweigh the benefit of simplicity of BAK – and

might even outweigh the distortions originally caused by the bottleneck. Hence,

regulators, where they have reason to intervene in response to bottleneck concerns, are

well-advised to impose a termination fee which is based on careful market analysis, rather

than one which is chosen based on simplicity alone. The costs to society of choosing aninterconnection model that is grossly incoherent with the efficient interconnection model

can be very significant, such that simplicity alone does not appear to ensure market

outcomes that are in the interest of consumers in the short and long term.

6.6.2. Transit

The principles of efficient charging models for direct interconnection and transit fees are

similar to each other. For this reason, our conclusions about the comparative

performance of the alternative charging models in direct interconnection also apply to

transit. Efficiency hinges on applying interconnection models that reflect market and costs

conditions on an ongoing basis.

Transit fees have the added efficiency requirement that transit charges must yield

appropriate revenues to transit providers. For this reason, BAK tends to be even more

problematic when applied to transit, given that BAK between transit providers would imply

that transit costs are not covered. The resulting disincentive to provide transit would

increase the cost of production (e.g. bypass of efficient transit facilities) and ultimately

lead to higher prices.



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7. POLICY IMPLICATIONS

7.1. INTRODUCTION

In the preceding sections of the report, we have outlined the evolution of IP

interconnection and looked in depth at the economic efficiency and consumer welfare

implications of various interconnection charging models. Our key observations from this

analysis are as follows:

• IP interconnection has been around for some time – it is how the public internet

functions as a “network of networks”. Inherent technological features of the way

interconnection works at present mean that today it is only possible to provide a

generic best-efforts grade of IP service. It also means there are quite severe

limitations to the scope for interconnection charging models, in conjunction with retailprices, to be structured to deliver consumer welfare and broader economic efficiency

benefits;

• developments in the IP standard will transform the performance of the internet.

Future IP-based NGNs will, for example, allow multiple services to be simultaneously

provided with differential, guaranteed service levels. These developments demand

more sophisticated IP interconnection arrangements. They also provide greater

scope for IAPs to simultaneously structure retail prices and interconnection charges

to maximise consumer welfare. Consumer welfare is maximised by matching the

type and quantity of services demanded by consumers with the supply of these

services in a least cost manner;

• inherent in any meaningful economic analysis of interconnection charging models is

recognition that consumer welfare is ultimately determined by the structure and level

of the retail prices paid by final consumers, and that any analysis of the consumer

welfare impacts of particular charging models needs to start by identifying the

efficient retail pricing construct for the circumstances being considered. The

efficiency characteristics of different interconnection charging models depend on

their ability to allow the costs of message carriage by network operators to be

recovered and need for new investment to be clearly signalled, without distorting the

efficient structure of retail charges;

• the transition towards NGN has sparked a regulatory and intellectual debate about

the charging model that should be applied to IP interconnection, although how the

industry will move from today's IP interconnection arrangements to those that will

support NGN is subject to substantial uncertainties,. A significant part of the debate

has been devoted to the question of whether Bill and Keep (BAK) is a more efficient

charging model for interconnection than alternative approaches, and whether it

should be imposed as a charging model in at least some interconnection situations;



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• this position is based in part on the assumption that BAK predominates in the current

internet environment, and that as networks are converging to an IP standard, BAK

logically should become the prevailing interconnection pricing model of the future.

This argument is misconceived for a number of reasons, not the least that BAK is thepredominant IP interconnection charging model today – for example essential transit

interconnection services are not exchanged on a BAK basis;

• when the economic efficiency characteristics of the different possible interconnection

charging models – BAK, IPNP, RPNP and settlement-based interconnection – are

considered, it becomes apparent that no one model is superior under all

circumstances in which the model might be implemented. For BAK, there is in fact

only a very narrow range of circumstances under which it would be an efficient

approach to interconnection charging. And while the other possible charging models

are in general more robust in their efficiency characteristics with regard to the

underlying circumstances, no one of these models would be the most efficientapproach in all feasible circumstances. This implies that efficiency, and associated

consumer welfare, would not be maximise by regulators pre-emptively determining

the interconnection charging model that should apply; and

• the success of NGN services will critically depend on delivering different classes of

service quality on an end to end basis, and to differentially charging at retail and

wholesale to reflect these quality differences. This presents both challenges and

opportunities for IP interconnection arrangements. Operators will need to agree on

compatible service classes so that an end-to-end QoS “tunnel” can be created

across interconnected IP networks. This will allow a significantly higher degree of

efficiency in interconnection charging.

From this a number of policy issues emerge, which we address in this section:

• firstly, we apply the welfare/efficiency perspective developed in earlier sections to

the IP world as we know it today and as we expect it to develop (section 7.2);

• secondly, we look at the implications of this analysis for the role for regulators

(section 7.3), covering the risks of intervention, whether the any-to-any

connectivity requirement that underpins access regulation in many jurisdictions is

relevant in an IP world, the assessment framework regulators might use in

considering IP interconnection charging models, how an appropriate degree of

regulatory certainty can be achieved without being simplistically prescriptive, and

the transition issues that would be faced by consumers and operators in moving

to a prescribed interconnection charging regime; and

• finally we draw some overall conclusions (section 7.4).



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7.2. EFFICIENCY OF IP INTERCONNECTION IN THE INTERNET AND IN NGN

In this section we apply the lessons from analysing the characteristics of efficient

interconnection models, in order to assess the efficiency of interconnection in the currentinternet world and to evaluate the anticipated IP interconnection arrangements that will

exist for NGNs.

7.2.1. Current IP Interconnection models

IP interconnection in today’s internet is currently technologically constrained in ways that

limit the flexibility of the charging model to reflect the characteristics of the variety of retail

market. The constraints affecting IP interconnection today include:

• interconnection fees must be cascading (that is, each provider has a billing

relationship only with the next and previous provider in a transit chain), because it isnot possible to identify, and bill, the originator of a packet at points where the packet

traverses two transit networks;

• it is not possible to predetermine the route taken by a particular message; and

• interconnection fees can only be based on the flow of packets, as network operators

are unable to identify the session to which the packet belongs.

These technical limitations impose a number of constraints on interconnection, which

ultimately limit the ability of the current interconnection system to induce efficient retail

charging:

• interconnection occurs on a best effort basis, because quality along a chain of

networks cannot be monitored and because billing the network requesting a high

quality is not possible. Accordingly, the current internet does not realise welfare

benefits which would result from prioritisation of services and other quality aspects

for which there is now – or would be in the future – a market demand;

• the structure of interconnection payments can reflect the distribution of benefits

accruing to the initiating and receiving party only in a very approximate way,

because:

• the interconnection fee between any two parties is negotiated between these

two parties without regard to any specific circumstances – that is, it does not

correspond to the type of service or to the value that a particular network in

the chain adds to the generation of a service to the end customers; and



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• in the current interconnection regime, it is only possible to bill for individual

packets (where separate arrangements apply to packets in either direction)

and not for any other unit, such as a message (that is, a call or a download

inclusive of a request). This implies that the current IP interconnection modellacks the flexibility to closely match retail models that are not based on data

flows. However, efficient retail models are not necessarily based on data

flow, because data flow in many situations does not reflect the value that the

initiating and receiving party attribute to a message (e.g. in a situation where

the initiating party should bear the costs of downloading content, it should

also bear the costs of requesting the download, that is, it should bear the

costs of all data flows related to the download).

In sum, current IP interconnection is a “one size fits all” approach, in the sense that

interconnection arrangements made between any two networks, apply to all of the traffic

between these two networks. This inflexibility is bound to deliver inefficient results in theprovision of some, if not many, retail services.

The limitations resulting from the inability of current IP interconnection to flexibly respond

to the situation of particular retail markets do not, of course, negate the welfare benefits

associated with the flexibility to adopt a charging model (that is, settlement peering, BAK,

IPNP, RPNP) which best reflects the retail characteristics of the (average) traffic between

two networks. Forcing any specific model onto the interconnection in the current internet,

would simply further decrease the flexibility of interconnection models to accommodate

retail market characteristics, and would in many cases be likely to distort the behaviour of

network operators in one or several of the forms discussed earlier in this report (that is,

business bias, network structure bias, network underinvestment, quality

underinvestment). For example, imposing BAK on all interconnection in the internet

would:

• imply a disincentive to provide transit services (as transit providers are not able to

recover their costs from any retail party related to the transit message); and

• could, depending on the relevance of the factors discussed in section 5, distort

network operators’ incentives to efficiently provide their services and/or lead to less

efficient retail charging models, when imposed on direct interconnection between the

originating and terminating networks.

In addition to the limitations in the current internet to reflect the variety of retail markets,

the sequential character of transit payments results in inefficiency, due to multiple margin

setting along the input chain. It is a widely accepted economic principle that price setting

by independent suppliers of inputs and final goods leads to a price for the end product

that is higher than it would be had the production been integrated, as each supplier

charges a margin on all previous inputs.57

57 Because the current internet does not allow charges to vary according to the place of the transit provider in the

supply chain of a particular message, multiple margins are likely to be set on the basis of the average position of

the provider in the vertical supply chain as well as the average characteristics of messages.



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7.2.2. Future IP Interconnection models

In an NGN environment, the technical restrictions characterising current IP

interconnection no longer apply. While the public internet will continue to exist (andcompete with NGN for many services) on NGN, there will be a significantly broader

choice of interconnection arrangements that are technically feasible. This includes, for

example:

• the possibility to charge one network for all services provided along a chain;

• end-to-end quality of service assurance (and billing); and

• the possibility to charge per message or for data flows.

These changes, while not affecting the possibilities available in the best effort internet,

add a technological option that will vastly improve the flexibility of interconnection

charging between two networks, even in situations where no transit is required.

However, the main efficiency improvement is likely to result from the possibility of

streamlining transit. In NGN, providers are likely to emerge who take responsibility for

establishing a QoS path through the various networks between the originating and

terminating networks. These one-stop-shop providers would collect the payment from the

originating network (or the terminating network – depending on how the costs of the

message should be allocated between the retail parties) and organise the transit of

packets between the originating and terminating network at a specified QoS level. The

QoS path provider could then make payments to all transit providers in proportion to theircontribution to customer utility and pay a termination fee to the terminating network (or

pay an origination fee to the originating network).

Therefore, the disadvantage of cascading fees that are unrelated to the nature of a

particular retail service, will become obsolete in NGN, which will result in interconnection

charges reflecting the efficient retail model in a particular situation significantly more

closely than this is possible today.58 In addition, the QoS path model would significantly

reduce the inefficiency due to multiple margin setting along the vertical chain: instead of

each transit provider charging a margin on all previous transactions along a chain, each

transit provider would only charges a margin for its own contribution to the output.

Against this background, locking in any interconnection charging models on the basis of

how IP interconnection currently occurs, would not only further limit the ability of current

IP interconnection to induce efficient retail charges, it would also represent a potential

barrier to the efficient evolution of IP interconnection which is just in its beginnings.

58 As we explain earlier in this report, in circuit switching messages can also be traced back to their source such

that cascading billing is not necessary. However, circuit switching is less flexible than NGN packet switching in

an NGN, because the latter gives the option (although does not imply a necessity) to charge for packet flows

(rather than per minute of a session).



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7.3. ROLE FOR REGULATORY INTERVENTION

In this section we consider the appropriate present role for regulators in the area of IP

interconnection, focussing on the risks in regulator intervention (section 7.3.1), thediminished relevance of any-to-any connectivity requirements in an IP world (section

7.3.2), why regulatory certainty need not and should not lead to a prescriptive ex ante

approach to regulation in this area (section 7.3.4), the assessment framework regulators

should use in considering interconnection charging models (section 7.3.5) and the

transition issues that would be faced by consumers and operators in the shift to a

particular interconnection charging model (section 7.3.6).

7.3.1. Risks in Intervention

It is apparent from the economic analysis in sections 5 and 6 of this report that imposing

any ubiquitous pricing solution for IP interconnection at this stage would risk stifling the

development of IP based services, hampering competition and limiting the consumer

welfare benefits from emerging NGN developments. Many of the operators interviewed

for this report were prepared to shape their services, and develop their plans for

deployment and use of IP networks, on the basis of their ability to recover the costs of

building the network and providing it with the necessary functionality and pricing

arrangements to make the IP network a competitive option. Prescriptive regulatory

intervention at this early stage could prevent market efficiencies developing.

Not only is there no clear view of the appropriate pricing model, but it is also unclear

where potential bottlenecks may lie. As Ofcom has pointed out:

… telecoms is so fast-moving. The dividing line between the bottleneck and the

competitive part of the network might be in one place today, but in a completely different

place tomorrow.59

Some of the current regulated services are likely to remain important in future and may be

sufficient to address bottlenecks. Bitstream policy should seek to deal with network

access issues in the deepest part of the network and not seek to regulate matters at other

levels, at which market forces will determine arrangements. Ofcom has said it may need

to adapt to reflect the changes discussed above such as QoS. Ofcom’s view is that layer

2 and layer 3 bitstream services (called DataStream and IPStream respectively in the UK)

would disappear in an NGN environment, replaced by a bitstream service which provides

access seekers with more flexibility and greater economies while reducing arbitrage risks

faced by BT:

Ideally, a next generation bitstream product would improve on the current situation by

offering the following characteristics:

59 Ofcom, Beesley Lecture - A Strategic Approach to the Economic Regulation of Spectrum, Telecoms and

Broadcasting - 29 November 2005.



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• it would be complementary to LLU, i.e. it would promote broadband competition in

geographies where LLU is not effective. Currently, DataStream [layer 2] does not

fulfil this role, because of the scale economies present with purchasing dedicated

capacity to each DSLAM. To successfully address the geographic issue it seemslikely that a next generation product would need to provide some form of

capability to aggregate traffic across multiple MSANs;

• it would allow all operators to benefit from the increased economies of scale and

scope provided by NGNs;

• it would enable operators to differentiate their services, as this would support

greater innovation and competition in downstream broadband markets.

DataStream currently allows this, but IPStream is less flexible. This suggests a

new bit-stream product may allow sufficient control over, for example, contention

and quality of service (e.g. delay); and

• it would provide an appropriate incentive for operators who deploy their own

infrastructure. The current DataStream charging structure provides a very limited

incentive, and IPStream provides no incentive at all because all traffic is charged

at the same rate regardless of where it is delivered.60

Furthermore, current retail models may remain better suited to similar services delivered

over different access technologies, based on established consumer preferences. For

example, in the case of internet access over a mobile network, timed access charging or

monthly subscription charges have been more widely accepted than bit-consumption

based charging, as consumers can more easily relate to the time-based charging thanwith a charge based on the size of data downloaded during browsing. Mandating

interconnection charging arrangements that would require a shift in this retail model to

allow cost recovery may not be in consumers’ best interests.

In sum, rather than prescribe solutions and risk regulatory errors with potentially profound

negative consequences for efficiency and welfare, regulators should:

• intervene only in the event of demonstrable market failure (and if intervention can be

expected to result in benefits which exceed the cost of regulation);

• intervene only to an extent that is necessary to remedy the market failure; and

• tailor the solution to the specific market circumstances, rather than applying a

standard ”fall-back” option.

60 Ofcom, Next Generation Networks: Developing the regulatory framework , 7 March 2006, p.27.



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7.3.2. Risk of increased opportunities for arbitrage

Regulators also need to remain alert to the fact that a decision to regulate a particular

application or service in an IP environment may increase opportunities for arbitrage. Inthe circuit switched environment, the technical characteristics of the retail service and the

wholesale service are closely tied together and, for example, origination or termination of

a circuit switched voice call can be characterised as "1/2 of a retail voice call".

In the IP environment, the same infrastructure is used to support a broad range of

applications. The nexus between the wholesale and retail characteristics are not as tightly

aligned as in the circuit switched environment. In the NGN environment packets can be

distinguished by whether they have QoS labels or not, and by the level of priority or grade

of QoS attached to the packet. However, the NGN will not necessarily distinguish packets

based on the type of application or content. The network ordinarily will not look inside the

packet to determine whether the packet is carrying voice, video or email data. Thereforeregulating a particular application or service in an IP environment risks subjecting all

packets with the same QoS attributes to the same regulation. For example, because the

network will not distinguish between a VoIP packet with a gold label and any other packet

with a gold label, there will be an arbitrage opportunity to send and receive packets with

the same attributes at regulated rates. The network will have to treat all gold label packets

as though they are for the regulated service. Regulation of an application in this way

becomes akin to regulating an entire band or level of QoS.

As there will be a relativity in value between the different QoS bands, regulating the price

for one band also has an impact on the pricing of the other bands. Therefore, in an IP

environment, the risks of arbitrage may be greater than in a switched environment.Regulation, which is applied to particular services in a circuit switched environment, may

generate arbitrage opportunities if carried forward with those services into an IP

environment. For this reason regulators should be cautious of the potential impact of

regulation of any one particular application.

7.3.3. Any-to-any connectivity

A mandated any-to-any connectivity requirement has in some jurisdictions been seen as

a key policy platform in the introduction of network competition to telecommunications

markets - and in particular, telephony markets. In these countries, policy makers

considered it necessary to formally require the incumbent telecommunications operator to

connect to any new networks that were established, to avoid potential abuse of market

power through denying interconnection with nascent networks, with the objective of

damaging their ability to attract customers.



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However, as competition has evolved, the any-to-any connectivity requirement has

provided an unintended avenue for possible regulator intervention in network

interconnection arrangements in circumstances where substantial market power (SMP)

may no longer exist.61

The internet, on the other hand, has experienced enormous growth in use and achieved

global ubiquity, without any formal any-to-any regulatory requirement. Nonetheless, there

have been suggestions that the any-to-any requirements that were introduced in the

telephony world should carry through to IP interconnection, as telephony as well as other

services move to an IP environment.62

However, the inherent technical and commercial characteristics of the evolving IP

environment mean that a statutory any-to-any connectivity condition is not required to

achieve competitive outcomes in a fully IP world. That is, the competitive need for any-to-

any connectivity is not faced with the potential for originating and a terminating accessbottlenecks in the same way that this is often seen to occur in fixed line networks.

Network operators and IAPs cannot effectively block interconnection by a particular party,

for the following reasons:

1. Much content is either multi homed (that is, there is connection between the web

server and more than one IP network connected to the internet) or the content is

“mirrored” (that is, the content is stored in more than one place and each web

server is connected to a different IP network).

2. The multipath nature of the internet means that there are a large number of

potential paths between individual IP addresses. Although ultimately eachaddress is associated with a single network, the multipath routing means that the

terminating network will be connected to multiple networks, each of which in turn

will be connected to yet more networks. The charging relationship between the

terminating network and each of the networks to which it is directly connected, will

be determined by where the terminating network is in the internet hierarchy,

compared to that other network. Closing off alternative pathways to leverage

higher termination charges or otherwise create anticompetitive harm would be a

difficult, if not impossible, strategy to implement.

3. As set out previously, the basic charging model of the internet is pay to download.

The terminating network is usually the downloading network and, therefore pays

to receive the message.

61 In this regard, European regulators could apply the Art 5 requirement for interconnection (ie a requirement that

applies even in the absence of SMP).

62 See ERG Project Team on IP Interconnection and NGN, Consultation Document on IP Interconnection, ERG

(06) 42, available at: http://erg.eu.int/doc/publications/erg_06_42_consult_doc_ip_interconnection_rev.pdf. In

particular comments on interoperability at p 5 and conclusions on end-to-end connectivity at p 31. Also see

ACCC, internet Interconnection Service, Final Report, 1 December 2004 at p 21.



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4. Under settlement based interconnection arrangements, networks have an

incentive to attract users to their networks to generate more outbound packets to

offset against inbound packets. If the costs of off net parties accessing content

and services on a network is high because of terminating traffic charges, contentproviders and other users may not host on the network.

5. Finally, the users of the internet are not restricted to using any one IP network

provider to access services. This nomadic characteristic contrasts with fixed line

telephony and means that users can access applications regardless of their IP

address.

In short, there is a strong case for no regulatory intervention on IP interconnection, at

least initially. This is because the very nature of IP interconnection and the services which

it underpins raises the potential for the traditional originating and terminating bottlenecks

perceived in a legacy telephony world to be overcome.

If a mandated any-to-any interconnection requirement were deemed necessary, an issue

is whether it should require full interoperability of all IP-based services - that is, access to

technical interfaces and protocols and use of standardised interfaces and protocols at all

IP network layers. The ERG appears to consider that, in order to ensure any-to-any

connectivity, regulation will be required to cover all types of interconnection. From the

perspective of economic efficiency, and assuming this is the ultimate objective of an any-

to-any mandate, intervention should be limited to the network layers at which

interconnection is indispensable to any-to-any connectivity. This implies that

interconnection at one layer may be sufficient if other layers could be substituted by the

access seeker.

Duplicative intervention at several layers is not only unlikely to be necessary, it would also

involve risks:

• consistency of regulatory decisions (inconsistencies could lead to arbitrage); and

• hindering competition in standards and application developments (because

innovators would have to ensure interoperability and would also benefit less from

improving their applications compared to their competitors).

If, on the basis of a mandated any-to-any connectivity requirement, a regulator did see arole for itself as an arbitrator between parties that fail to conclude commercial

interconnection arrangements, all interconnection charging models are in principle

consistent with fulfilment of this role. From the perspective of the regulator, BAK might be

seen as a particularly convenient tool to achieve any-to-any connectivity. However, using

BAK as the default option in arbitration cases would not be warranted, unless there are

strong grounds for generally imposing BAK in the market using regulatory intervention.

This is because, if BAK is the default arbitration option, this would create an environment

where it is unlikely that parties could ever agree on any other charging model than BAK.

In other words, threatening BAK as the model of last resort would induce a tendency to

the adoption of BAK, even in situations where it is disadvantageous from an economic

efficiency perspective and where it would not arise in negotiations were such a default

option not imposed on negotiations.



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7.3.4. Regulatory certainty

Regulators and operators generally ascribe value to certainty with regard to how a

regulator would respond if required to intervene on a particular matter. For IPinterconnection, it could be argued that this is best brought about by regulators indicating

the charging model they would mandate if called into a dispute on such a matter.

However, this is clearly not the only way regulatory certainty can be provided. On the

basis of the analysis in this report, which shows that substantial efficiency costs are likely

to result from ubiquitously mandating one particular charging model, signalling in advance

that it would impose a particular charging model is unlikely to be the most efficient

solution to achieving regulatory certainty.

Rather, appropriate levels of regulatory certainty could be provided by regulators

indicating that their decisions would be guided by a clearly defined framework for

assessing the effectiveness of a range of interconnection charging models in thecircumstances of the dispute. This would give the industry guidance on likely regulator

conclusions on the appropriate charging model to be applied, while minimising the

efficiency-distorting cost of intervention. A proposed efficiency-based assessment

framework for considering interconnection models is described in section 7.3.5 below.

7.3.5. Assessment framework

Where regulators have identified demonstrable market failure (and if intervention can be

expected to result in benefits which exceed the cost of regulation), the interconnection

model imposed by regulation should be identified by comparing the efficiency implications

of alternative charging models. We suggest that the following framework, which is based

on the practical market outcomes of efficiency in an interconnection context, be applied:

A FRAMEWORK FOR ASSESSING INTERCONNECTION CHARGING MODELS

Interconnection charging models should be assessed against the following implications of

efficiency that we identify in section 5.2.3:

Consumer benefits

1. All customers are served for whom the total benefit of having them on the network

is greater than the cost.

2. Full range of services demanded by customers is provided including innovative

new services.

3. Differential QoS is available that matches customer demand.

4. Individual messages are sent if and only if the total benefits to the initiating and

receiving customers are equal to or exceed the incremental cost of the

messages.

5. Low prices, provided that prices cover the long-term costs of providing services

efficiently.



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Network operator benefits

6. Efficiently-incurred costs are recovered.

7. Operators have the incentive to undertake efficient investment and innovation.

8. Interconnection arrangements are available which allow services to be provided

in line with consumer demand (e.g. end-to-end QoS).

Market operations benefits

9. Efficient competition is stimulated and inefficient arbitrage is avoided.

10. Costs are minimized by efficient network usage and call routing, including packets

being handed off to connecting network at technically efficient point.

11. Changes in interconnection charging models are made if and only if the benefits

exceed the transition costs.

Regulatory benefits

12. If regulation is applied, regulatory administration and operator compliance costs

are minimised.

In some cases, there may be a need to trade-off particular criteria so as to determine the

optimal charging model in those cases.

When assessing a particular interconnection charging model against these criteria, the

circumstances in which the model will be implemented need to be identified and taken

into account. We have identified in section 5 that the key aspects that need to be

considered in this regard include:

1. Quality of service requirements:

• Is differentiated quality of service demanded by customers or parties providing

content, applications and services over the network?

2. Traffic balance:

• Is traffic balanced or unbalanced?

• Is there scope for either the initiating party network or the terminating party

network to change the traffic balance?

3. Beneficiaries from message:

• Initiating party only?

•

Terminating party only?



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• Both initiating and terminating parties?

4. Networks involved in message carriage:

• Initiating party network and terminating party network only (direct

interconnection)?

• Transit networks also involved (indirect interconnection)?

5. Network costs:

• Are costs among the networks involved balanced?

As our conclusions in sections 5.5 and 6.6 show, these circumstances are a useful tool to

assess the efficiency performance of alternative charging models.

7.3.6. Transition between interconnection regimes

Regulators should also consider the transition issues involved with requiring a certain IP

interconnection model to be used. The implications for consumers and operators in

moving from one interconnection charging model to another needs to be taken into

account, as the change in the interconnection charging model may drive a change in the

retail pricing approach (e.g. to cover costs) and the retail pricing construct required by the

interconnection charging model may not be efficient.

The evolution from current IP interconnection arrangements to new ones in an NGN willnecessarily impose a variety of “transition costs” on consumers and operators. In

particular, where interconnection charges are currently asymmetric, the transition costs in

moving to BAK are likely to be high.

These transition costs would reduce the appeal of adopting a charging model that is

superior in the long run, unless this model is already adopted.

Furthermore, transition costs are likely to place a higher burden on the market (e.g. in the

form of inefficient arbitrage, or complicated or lengthy processes to prevent arbitrage)

when the new model is imposed by regulation, as this takes away flexibility from the

operators to time the transition in a way that minimises arbitrage.

Finally, transition costs will differ depending on the current termination charge situation.

For example, transition costs to a BAK regime would be less significant in a country with

currently lower termination rates and in jurisdictions such as the US where the regulator

currently requires that interconnection rates be reciprocal.

7.4. CONCLUSIONS

Our key policy recommendations are as follows:



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• Proceed cautiously : Regulators should be very cautious in mandating IP

interconnection charging models for the unfolding NGN IP environment. While

regulators may be called upon to determine interconnection arrangements in

particular circumstances, at this stage there is no justification for regulatoryintervention to mandate a single IP interconnection model. It is too early to tell what

model or models will prevail commercially and regulatory intervention to prescribe a

particular model, such as BAK, is likely to be pre-emptive and risky.

• Don’t mandate a single charging model. Even if a particular charging model develops

considerable commercial currency, it does not follow that this model would be an

appropriate “one-size-fits-all” model for regulators to mandate. Adopting the ‘wrong’

interconnection model in inappropriate circumstances will lead to significant market

distortions which ultimately reduce consumer benefit. There is no evidence that the

industry will not be able to work out appropriate IP interconnection models in the

absence of ex ante regulatory intervention that correspond to the variety of marketcircumstances. Hence, mandating particular interconnection charging arrangements

in the current environment may inhibit the development of inherently more effective

and efficient IP operating models. It is useful to note that global connectivity was

achieved for the current internet without regulatory intervention.

• Don’t assume bottlenecks will be replicated. The deployment of NGNs has the

potential to change the way many services are delivered. A regulator should not

assume that currently perceived bottlenecks (which are the basis for termination

regulation and any-to-any connectivity requirements) will be replicated in an NGN

environment.

• Use existing regulatory frameworks. In any event, existing regulatory frameworks are

likely to be adequate to resolve problems should they arise. Current sector-specific

and competition powers exist which permit regulators to intervene if bottlenecks

emerge in IP Interconnection. For example, some potential upstream bottlenecks in

the access network are already addressed through requiring the wholesaling of

unbundled local loops and bitstream services.

• Employ consumer welfare analysis. However, in circumstances where regulators

identify market failure or are requested to resolve disputes, their intervention should

be applied only as broadly as necessary to solve the problem. Regulators should

therefore not define a single charging model that would be the ‘fall-back’ option, but

rather should employ a clearly defined assessment framework that appropriately

reflects the drivers of consumer welfare and broader economic efficiency.



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APPENDIX A: BASIC TECHNICAL AND CHARGINGCONCEPTS

A.1 BASIC CONCEPTS

In this section, we outline the basic interconnection models that we use throughout the

analysis of this report. While our focus is on interconnection, it is necessary to relate the

models to retail charging approaches. This is because:

• market outcomes are ultimately achieved by retail purchasing decisions; and

• the costs of all of the interconnected networks eventually need to be recovered from

retail charges.

Therefore, this section also discusses the inter-relationship between retail and wholesale

models.

The relationship between the interconnection and retail services requires an

understanding about the nature of the retail service. We define the retail services as a

“message” in a broad sense. A “message” can, for example, be a phone call, SMS,

MMS, IM, email or a download of a data file, streaming video or a web page.

Although this report is concerned with IP interconnection, we use switched telephone

calls examples in this section to illustrate interconnection and retail charging models, for

two reasons. First, these models were initially developed in the traditional, and simpler,PSTN environment. Second, understanding the differences between circuit switched

networks and packet switched networks will help explain how IP interconnection has

developed and will continue to evolve.

A.1.1 Interconnection models in telephony

We distinguish between two types of interconnection:

• direct interconnection, which refers to interconnection between two networks

where the message originates from a network address (e.g. a telephone number or

an IP address) hosted on one network and terminates at a network address hostedon the other network; and

• indirect interconnection, which refers to interconnection between two networks

through one or more transit providers.



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Direct Interconnection

There are two forms of direct interconnection: Initiating Party Network Pays (IPNP)63 and

Receiving Party Network Pays (RPNP). As illustrated in Figure 20, IPNP involves the

initiating party’s network operator (the originating network) directly connecting with the

called party’s network operator (the terminating network).

Figure 20 - Initiating Party Network Pays

In this model, the originating network usually will pay the terminating network an

interconnection charge for the termination service, being the right and ability to connect a

call to the called party on its own network. As traffic is usually being exchanged in both

directions, the termination services each provides to the other, may be netted-off and the

operator which sends more traffic than it receives will make a balancing payment to the

other operator (which we call settlement-based interconnection).64 Because each time

a call is connected, capacity is dedicated to that connection, there is no measurement of

traffic flow within a session, traffic is measured between interconnecting circuit switched

operators on a per call or per session basis only.

The IPNP model applies to most fixed network switched telephone calls. The IPNPmodel universally applies for calls from mobile phones to fixed telephones and in most

countries, for calls from fixed telephones to mobile telephones.

63 In the traditional circuit switched environment, IPNP is also termed calling party network pays. We have used

the term “initiating” rather than “calling” to accommodate a broader set of messages, such as a mouse click to

request a download from a website.

64 See discussion below of the distinction between settlement-based interconnection and BAK arrangements.



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RPNP involves the called party’s network directly connecting with the called party’s

network. The called party’s network (the receiving party network) acquires originating

access from the other network. The RPNP model applies to specialist fixed network

switched telephone services where the direction of the retail charging is reversed (seeFigure 21below). The RPNP model applies in Hong Kong to calls from fixed telephone to

mobile telephones, although the regulator, OFTA, is currently reviewing these

interconnection arrangements.

Figure 21 - Receiving Party Network Pays

A third direct interconnection charging model is settlement-free interconnection or BAK.

As illustrated in , each network provides the connectivity required to originate or

terminate the call within its own network, without charging the other operator. Instead,

each operator recoups its costs of originating calls on its network and/or terminating calls

from the other operator’s network out of its own retail charges for outbound and, if a retail

charge applies, inbound calls. BAK may apply to calls in both directions between

networks or only in one direction.

Figure 22 – Bill and keep



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Some commentators use the term BAK to describe settlement-based IPNP

interconnection in situations where the traffic between two networks is “balanced”.

However, in “true” BAK, charges will not apply even when the traffic flowing to one

network exceeds the traffic flowing in the reverse direction (“out of balance” traffic). Inthis report we use the term BAK to describe settlement-free interconnection regardless of

traffic balance.

Hybrid models combine elements of BAK, settlement-based interconnection and IPNP.

For example, in New Zealand local calls are exchanged between fixed networks on a

BAK basis to a threshold of 20% imbalance (that is, the volume of traffic in one direction

is 20% higher than in the other direction) after which termination changes are payable by

the originating network. The New Zealand regulator, the Commerce Commission has

recently extended this model to calls between the incumbent fixed network and a mobile

network when the mobile subscriber is using a fixed geographic number in a home

zone.65

Indirect interconnection

When no direct interconnection between the originating and the terminating network

exists (that is, when at least one additional network is involved in transferring a message

from the originating to the terminating network), then interconnection has two aspects, as

illustrated in Figure 23.66 First, one party pays the transit provider for providing the transit

service. Second, payments are made between the originating and the terminating party

(e.g. a termination fee may be paid). In the switched environment, the transit party

usually acquires the termination or origination and bundles it with the transit fee in to a

single wholesale carriage charge.

65 Vodafone New Zealand Limited application for a determination under section 20 of the Telecommunications Act

with respect to interconnection with Telecom’s fixed PSTN designated access service, 28 September 2006,

www.comcom.govt.nz.

66 The diagram illustrates an IPNP transit arrangement where the transit and termination fees are paid by the

originating network. Indirect interconnection also can apply under an RPNP model, for example where the

receiving network provides an 800 service, which requires universal access from the subscriber base, but the

receiving network does not have direct interconnection arrangements with all local networks.



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Figure 23 - Indirect interconnection

A.1.2 Relationship between interconnection models and retail services

As at the interconnection level, retail charging models can involve a retail charge paid by

either the initiating party or the receiving party or, less commonly, by both.

Most fixed network telephone calls are initiating party pays (IPP), such as local calls, long

distance calls and international calls. As noted above, some telephone services involve

only the called party paying the call charges (RPP), such as reverse charge or collect

calls and calls to toll free numbers (typically numbers which begin 0800 or 1800).

In some markets, RPP applies to calls from fixed telephones to mobile telephones,

usually combined with the calling party also paying a retail charge. Examples include

Singapore, the USA and Canada. In Hong Kong, only the called mobile party pays a

retail call charge.

An emerging retail model in traditional RPP markets is the “bucket plan”. End users are

charged a flat fee for a maximum number of minutes, packets or messages, whether

inbound or outbound. Bucket, or “all you can eat” plans applying to uploading and

downloading volumes are also increasingly common in the internet environment.

As the European Regulators’ Group (ERG) notes:

although it is not possible to establish clear cut causalities between billing regimes on the

wholesale and the retail levels, they are closely related.67

67 European Regulators Group, Consultation Document on IP Interconnection, ERG (06) 42 at p (iii). Available at:

http://erg.eu.int/doc/publications/erg_06_42_consult_doc_ip_interconnection_rev.pdf.



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If the IPP model applies at the retail level, the matching IPNP model will usually apply at

the interconnection level, as illustrated in Figure 24. In the absence of a retail charge, the

terminating operator uses the interconnection charge to recover its costs from the retail

revenue collected for the originating operator.

Figure 24 - Interconnection charges where retail model is Initiating Party Pays

In the fixed switched environment, use of RPP at the retail level is usually matched by an

RPNP model at the interconnection level. In those markets where the initiating fixed ormobile party and the receiving mobile party each pay for calls to mobile telephones, BAK

tends to apply at the interconnection level. illustrates how fixed to mobile calls are

charged at the retail and interconnection level in Singapore. In this situation, both RPP

and IPP exist at each end of the call.

Figure 25 - Charging model for fixed to mobile calls in Singapore



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The same retail charging model is supported by different interconnection models across

countries or across services in the same country (although the direction of interconnection

remains the same). Local calls and long distance calls use an IPP model at the retail

level in most countries. However, in markets such as Australia and the UK, an IPNPmodel applies to termination services of all voice services, while in countries such as the

US, Canada and New Zealand, a settlement-based interconnection or hybrid model

applies to termination of local calls and an IPNP model applies to termination of long

distance calls.

However, in these cases, the underlying interconnection continues to remain the model in

which the initiating network acquires termination payments, but in the case of local calls

the termination charges are netted off, whereas they are not in the case of long distance

calls.

There are some limited examples where the same retail charging model attractsfundamentally different interconnection models between countries. In both the US and

Singapore, the fixed originating party and the mobile receiving party pay for a retail

charge for fixed to mobile calls. However, at the interconnection level, BAK applies at the

interconnection level in Singapore (as illustrated in Figure 25), while an IPNP model can

apply at the interconnection level in the US, under a principle called “reciprocal

compensation” (see Figure 26). This term means that the termination charges in both

directions are equal.

Figure 26 – Reciprocal compensation



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A.2 TRANSMISSION OF INFORMATION IN DIGITAL FORMATS

A.2.1 Packetisation

Internet Protocol (IP) is a standard for the transmission of data in digital form. IP is a form

of packet switching and is the protocol used to interconnect the individual networks that

comprise the public internet.

Information, which travels over the internet or over any other computer network, is

represented in the form of digital data. Digital data consists of a series of binary digits (1s

and 0s) that carry information. Each binary digit in a stream of digital data is known as a

“bit” and has a value of either one or zero. By convention, a series of eight bits is referred

to as a “byte”. A byte may represent a character such as “a” and a group of bytes may

represent a word or a message.

Digital data travels over the internet by breaking the data up into “packets”. A packet of

data consists of a certain number of bytes of data and a series of numerical identifiers.

The numerical identifiers contain information as to where the packet is destined to go and

where the packet has come from. In addition, information as to the number of bytes of

data in the packet travels along with the source and destination numerical identifiers.

The process of moving packets through networks is called “packet switching”. A

comparison of packet switching with circuit switching will help explain how IP networks

differ from traditional voice networks and, therefore, how the interconnection models

described in Section 1 of this Appendix apply differently in an IP environment.

A.2.2 Circuit switching

The public switched telephone network (PSTN) over which traditional voice services are

provided, operates by means of “circuit switching”. A call is transmitted between two

points along a dedicated path (circuit), which remains in use for the entire period of a call.

The path is selected by the originating network on the basis of what network transmission

capacity is expected to be available for the anticipated duration of the call.

Consider a telephone call across town illustrated in Figure 27 below. The circuit is

established for the sole use of the parties for the duration of the call, irrespective of

whether a conversation is taking place. The circuit must be set up prior to the call

proceeding. If the call is tariffed at a timed rate, then the circuit needs to be monitored.

At the end of the call, the circuit needs to be disassembled or “torn down”.

Figure 27 - Circuit switched connection



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The entire process is controlled centrally by a dedicated digital signalling network that is

overlaid on the physical transmission path set out in Figure 28. Each switch has a signal

switching point (SSP) associated with it, which connects with a signal transfer point

(STP). The A-party, by lifting the handset, completes a circuit to his or her localtelephone exchange (LS1). The SSP associated with LS1 relays the signals generated

by the dialled number to the STP. The STP liaises with the SSP associated with local

exchange connecting the B party (LS2) to determine where a circuit to the B Party is free

(e.g. the B Party is not on the phone). The STP determines what paths are available

between LS1 and LS2, decides the most efficient path through the intervening switched

(there may be more than one transit switch depending on how far apart the calling and

called parties are) and directs the relevant switches to form the end-to-end connection

once the B Party picks up the receiver. Once the circuit is set up, the call is released by

LS1 and the analog signals flow through the circuit in each direction conveying the

conversation.

Figure 28 - Signalling aspects of circuit switched connection

The signalling system is responsible for establishing and tearing down the bearer path.

As a result, the signalling system collects information as to the:

• calling party;

• called party;

• call routing; and

• call duration.





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A further implication of packet switched networks using a connectionless system, is that

the packets will traverse any network that indicates that there is an available path to the

packet’s destination. This means that packets may cross networks with which the

originating network has no commercial relationship.

A.2.4 Routing in IP networks

The rules of IP networking dictate that any time a host has an IP packet to transmit, it

must first determine whether the destination IP address is on its own network or another

network. If the address is not on its own network, the host must send that packet to a

router. The host determines this by comparing the network portion of its own address

with the network portion of the address with which it wants to communicate, or the

destination IP address.

Each packet is routed from its source to its destination through a series of routers, and

across multiple networks. The router “looks” at the destination address of an IP packet

and then forwards the packet to another router or, if the destination address is on its own

network, to a directly connected host.

Each router “advertises” the range of IP addresses to which it has connectivity. This

information is held in a routing table. The routing table is dynamic, meaning that it is live

and continually updates to reflect the connectivity from time to time (this ensures that

routes which are faulty are not advertised). As all of the routers in a network are aware of

the paths advertised by adjacent routers, eventually all the devices connected to a

network will be advertised.

A.3 THE INTERNET

A.3.1 Introduction

The internet is a series of interconnected packet switched networks, established on a

global basis, that allow businesses and individuals access to information. The internet

comprises hundreds of thousands of individual networks. In order for all of the users of

the internet to be able to exchange information, a common method is required to provide

a recognisable address for each user on each network and to specify the formats and

protocols associated with the transfer of information between users. This is the role ofInternet Protocol.

A.3.2 Internet Protocol addresses

The most common version of IP addressing is called “IPv4” (Internet Protocol Version 4).

An IPv4 address consists of four numerical identifiers separated by full stops. Each

number must be between zero and 255. For example, 212.100.246.162 is the IP address

of the GSM Association’s “GSM World” website. These IP addresses can be compared

to telephone numbers except that they do not contain geographic information. It is not

possible to identify the physical location of a computer from an IP address alone.



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A.3.3 Domain name server

Similar to using a telephone directory, the internet has a directory service called the

Domain Name Service or DNS. This service matches IP addresses with physicalcomputers. DNS means that users do not have to remember a large volume of numbers

in order to attempt to retrieve content from the servers of Web content providers. The

DNS system allows a Web content provider to specify an address using a form known as

“Uniform Resource Locator” (URL). The addressing structure of a URL is:

protocol://server.subdomain.top level domain/directory/filename.

For example: http://www.gsmworld.com/news/statistics/index.shtml

This is the “GSM Facts and Figures” web page of the GSM Association. Here “http” is

Hypertext Transfer Protocol, a web communication protocol, the server is “www”, the

subdomain is “gsmworld”, the top-level domains is “com”, the directory is “news/statistics”

and the file name is “index.shtml”.

A.3.4 Ports

A server makes its services available to the internet using numbered ports, one for each

service that is available on the server. For example, if a server machine is running a Web

server and a file transfer protocol (FTP) server, the Web server would typically be

available on port 80, and the FTP server would be available on port 21. Clients connect

to a service at a specific IP address and on a specific port.

Thus, ports are often associated with specific applications and this is particularly the case

for “traditional” internet applications. The association of ports with specific applications

provides a potential basis for specifying quality of service paths associated with a specific

application.

A.3.5 Internet routing

There are special protocols to deal with routing at the borders of interconnected networks

in the internet. These protocols are known as border gateway protocols (BGP). BGP

routers also advertise IP addresses, but here the network operator has a choice of what

to advertise depending on the interconnection arrangements between the operators.

Typically, the BGP router always advertises the IP addresses on the interconnecting

network. It may also advertise addresses on a further interconnected network. However,

this only occurs where there is an agreement for the network to provide “transit services”

which are described in more detail below.



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A.3.6 Best efforts delivery and Transmission Control Protocol

As discussed above, packet switching allows packets which comprise a single message,

to be routed over different non-dedicated pathways. Circuit switching can maintain qualityof service across interconnected networks because the networks work together to set up

a single dedicated circuit. However, in the current internet, multipath routing across

multiple networks means that a guaranteed quality of service is not achievable.

Multipath routing allows for very little coordination in the control over the movement of

packets. There is no central database of what traffic is moving where, or when. The

packets know where they have to go but not how to get there. Breaking information into

packets means that each and every packet must be treated exactly the same way. There

is no memory of the paths or addresses from the directions it has given previous packets.

As David Isenberg noted, the internet is a stupid network.68 For this reason, the internet

is described as a “best efforts” delivery system.

However, some control is required for the internet to provide reliability. Transmission

Control Protocol (TCP) and the higher layer protocols provide this reliability by managing

a local connection between the routers involved in each hop of packet transmission.

Managing the local connection involves a set-up process and a series of

acknowledgements as packets are received and checked for fragmentation or errors.

The set-up process is a “handshake” arrangement between the two routers in which they

identify themselves by means of sequence numbers. As the packets are forwarded from

one router to the other, the receiving router compares the checksum field on the packet

header (which is akin to a representation of the total bytes, together with other informationabout the group of packets) with a checksum that it has calculated for the packet. If there

is a variation, the packet is discarded and a TCP packet is sent back to the sending router

asking for the packet to be resent. If the checksums are equal an acknowledgement is

returned to the sending router, and the next packet is forwarded.

A.4 IMPLEMENTING QUALITY OF SERVICE

A.4.1 Quality of Service parameters

In the future world of NGN, IP-based services are likely to be built around different serviceclasses, with different quality of service, features and functions. Triple play services are

critically dependent on packet labelling to prioritise capacity in an efficient manner based

on consumer needs. This means that there will need to be mechanisms which permit

quality of service parameters to be associated with transport of various services.

In an IP environment, service quality is affected by three parameters:

• latency;

68 The Rise of the Stupid Network , at http://www.isen.com/stupid.html, updated 22 April 1999.



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• jitter; and

• packet loss.

Latency is a measure of delay between a packet being originated and its termination.

Jitter is the variation in latency and packet loss describes the effect of packets being

dropped (usually because of congestion). These parameters are described graphically in

Figure 30.

Figure 30 - QoS parameters

Certain services require different levels of service for each of these parameters as set out

in Table 7.

Table 7: Services and QoS parameters



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Data transfer and web browsing are highly sensitive to the basic level of bandwidth

available, but less sensitive to other factors. The quantity of data that can be sent and the

speed at which it is sent is very important, but whether the data can be sent in real time

(latency) and whether packets arrive at regular intervals or in bursts (jitter) is notimportant, providing the packets arrive eventually. Packet loss is, of course, moderately

important, but if packets are lost, and resent, they at least still arrive, and time frames or

sequences are not critically important.

For interactive services such as instant messaging, small amounts of data are sent,

quantity (bandwidth) is not important, but real time transfer of complete sets of data are

important. The ability to ensure the passage of certain packets over the internet in a

corridor that shelters them from the vagaries of bursts and troughs (jitter), factors which

may slow the speed at which they travel and packet loss, means that if these packets can

be sent down a fairly narrow, but high quality, clear path, the end service is optimised.

Again, this is a problem which bandwidth and broadband access speeds alone cannotsolve, which is why prioritisation is inevitable.

A.4.2 Labelling for QoS paths

The level of quality of service required for the transport of a particular message depends

on:

• the application being used; and/or

• the willingness of the consumer to pay for increased priority.

As a result, the customer premises equipment (CPE) must be able to respect and apply

labelling for carriage across an NGN. One implication of this is that the CPE may select

the QoS required by reference to the application. For example, if the application is using

internet port 80, it is likely to be web browsing. This is relatively tolerant of jitter, latency

and packet loss and might therefore be assigned a priority “bronze”. That is, the packets

associated with this application are given a bronze label.

On the other hand, if a content provider is delivering an IP television service, this form of

video delivery is highly intolerant to jitter and packet loss. These packets may therefore

be assigned a priority “gold”. That is, the packets associated with this application are

given a gold label. In a similar fashion, VoIP services might be given a silver label.

The NGN creates multiple paths for packets with similar labels. It does this by using the

modules in the service plane and the control plane. The carriage of gold packets requires

a QoS path from the router nearest to the consumer to the service that requires gold QoS.

The service plane provides the QoS path module that is established by the control plane

which instructs the routers along the QoS path to prioritise the gold labelled packets.



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The QoS paths are only created for the duration of the transfer of the labelled packets

and the capacity over which the QoS path is created is not utilised on a dedicated basis.

This means that the efficiencies of packet switched networks over circuit switched ones

are maintained. However, the network needs to be dimensioned such that there issufficient bandwidth to allow the passage of gold traffic (the highest class of QoS traffic)

with minimal packet loss at peak load times.

A.4.3 Billing models for QoS networks

In a QoS network, the QoS path is, in general, established by the initiating party

regardless of the direction of the flow of packets. This means that in circumstances

where the initiating party is the party who determines the quality of service for the

session, regardless of the network on which the initiating party is located, one approach

would be for that initiating party to bear the retail charge for the QoS parameters. This

model works well with the internet model of “downloading party pays”. That is, the

initiating party establishes a QoS path for the duration of the session (and has thus

expressed a willingness to pay for that level of quality for the session) and will also pay for

content that is downloaded during the session.

The key difference between this type of QoS path and the internet examples set out

above, is that each of the networks across which the path is established are known. As a

result, it is possible to establish a cascading billing arrangement, whereby either the

initiating party or the receiving party pays. The economic analysis in sections 5 and 6

demonstrates that the benefits of IPP or RPP models in this context differ, depending on

the particular circumstances of the transaction. However, it is likely that in many

situations, payments by the initiating party will achieve the best market performance.

A.5 NGN INTERCONNECTION

Typically, NGN interconnection will require specific applications to be associated with

QoS parameters to ensure that they are delivered, both within a network and across

networks, in a uniform and predictable manner. That is, the mechanisms used to create

QoS enabled transport paths within an NGN will need to be used between NGNs and

respected by interconnecting NGNs to permit effective and efficient interconnection.

In order to provide this level of predictability, IP interconnection will require routing andprioritisation of packets between networks on a consistent and seamless basis. That is,

interconnected IP networks will need to agree on QoS parameters and also agree on the

way in which they will respect the labelling of packets. The labelling provides the required

parameters for QoS and these parameters will need to be respected by all of the

interconnecting networks. In turn, the interconnected networks will need to agree on an

appropriate billing mechanism for the transfer of those QoS parameters.



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Although the protocols used in IP networks permit and encourage multipath delivery, as a

practical matter there is a strong likelihood that all of the packets in any particular data

stream will, in fact, follow the same route. Indeed, in constructing an IP network, network

operators may seek to achieve this outcome in order to facilitate high levels ofrepeatability in respect of latency and jitter. The use of MPLS described above has also

encouraged this phenomenon. However, this practical outcome does not affect the

requirement to exchange QoS parameters and to respect QoS requirements. Rather, it

indicates that implementation of QoS transport is readily achievable.

The outcome of the establishment of a QoS path across multiple networks is set out in

Figure 31.

Figure 31 - Interconnection of multiple networks with QoS path

Creating a QoS path does not determine the direction of charging for wholesale or retail

services. Indeed, it is the implementation of QoS enabled transport services by way of

labelled QoS paths which supports calling party pays and receiving party at the retail level

and calling party network pays, receiving party network pays and bill and keep at the

wholesale level. That is, QoS paths permit a range of charging models which are notavailable from in the current internet with its differential tiered charging.



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A.6 NETWORK MANAGEMENT IN FIXED AND MOBILE

One of the major differences in the implementation of network management between

fixed and mobile networks is that mobile networks are constrained by the spectrum thatthey have been allocated. In mobile networks the spectrum constraint is effective at all

times, but is particularly difficult to manage once a network has been rolled out and is

expanding to accommodate an increasing user base. In this case, the process of “cell

splitting” and increased frequency reuse means that the infrastructure used to deliver any

particular call type will change and evolve as the network expands the number of

subscribers which it serves. There is no directly analogous effect that occurs in fixed

networks, other than those that use shared spectrum, such as hybrid fibre-coaxial

networks. In fixed networks a single access network solution can be maintained. The

only slightly similar issue is that a copper pair can be shared for the delivery of both DSL

services as well as voice. However, this is not a spectrum constraint even though only

one DSL provider can share each copper pair line.

The constraint on mobile services is limited by the scarce resource of spectrum and no

comparable constraint occurs in fixed access networks. Indeed, the expansion of

potential capacity of optical fibre, by techniques such as dense wavelength division

multiplexing, indicates that capacity constraints barely exist in fixed networks.



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APPENDIX B: THE EFFICIENT UNIT AND LEVEL OFINTERCONNECT CHARGES

The main focus of section 5 in this report is to assess the efficiency of various

interconnection charging models from the perspective of who should pay for

interconnection. With the exception of settlement-free interconnection (that is, BAK),

interconnection models involve charges and this raises the question as to how the

charges should be determined to promote efficiency. In this Appendix we provide a brief

summary of key determinants for what should be charged for and how much should be

charged.

B.1 WHAT SHOULD BE PAID FOR: THE EFFICIENT UNIT OF INTERCONNECTION CHARGES

In this subsection we compare two models: Capacity based charging, under whichinterconnection capacity is purchased; and element based charging, under which

payment depends on the volume of traffic that is, minutes or data volumes.

The question of whether capacity or volume-based charges are more efficient arises in a

commercial as well as in a regulatory context. In a regulatory context, both charging

models are tied to cost measures.

In element-based charging, interconnection fees are typically proportional to minutes for

voice and bits for data. These measures have not, traditionally, reflected network

utilisation. As a result, they can lead to inefficient utilisation, because they do not reflect

the higher opportunity costs of using capacity at peak times and lower costs outside thesetimes.

In a capacity-based charging model, interconnecting users no longer face variable (per-

minute or per-bit) interconnect charges. Rather, once the capacity is purchased, they

incur the opportunity cost of usage.

Capacity-based charging can increase or decrease the efficiency of capacity utilisation:

• it can improve utilisation of capacity once the capacity charge is paid, because the

purchaser and the owner of capacity then have similar incentives to increase traffic

(largely due to the fact that the lessee of capacity incurs costs which perfectly reflectthe current network utilisation and because it does not make variable payments

which involve any contribution to fixed and common costs). The efficiency outcome

could be improved further if a spot market for unused capacity existed (although the

costs of organising such a market would have to be taken into account); and

• it can be detrimental to efficient network utilisation. Having different “owners” of

dedicated interconnect capacity increases the total amount of capacity required to

carry a particular peak load of traffic at a certain QoS standard, because managing

large volumes of capacity together reduces the probability of capacity shortages.

Hence a trade-off exists between economic efficiency and technical efficiency, with the

net situation indeterminate.



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Because the efficiency comparison between element and capacity based charging

depends on the circumstances of a network and on each network owner and its

customers’ costs to bear the risk of capacity not being fully utilised, no model is strictly

preferable to the other.

If prioritisation is available through QoS standards, capacity-based charging appears less

attractive, because customers can buy the services at their required priority level. The

network operator ensures that the QoS level is met by increasing the price for high priority

if the demand for high priority increases, so that high-priority traffic is not delayed. Hence,

leasing capacity where high priority services are available would no longer generate the

benefits of having the assurance of available capacity, but would still imply the downside

of inefficient network usage.

B.2 HOW MUCH SHOULD BE PAID: THE RELATIONSHIP BETWEEN EFFICIENT

INTERCONNECTION CHARGES AND COSTS

In determining prices, it is relevant to consider the types of costs a network incurs in

providing interconnection (that is, incremental costs and fixed costs), as well as the

presence of fixed and common costs.

The interconnect models discussed in this report, such as IPNP and RPNP, determine

how the network cost should be efficiently allocated to retail parties, what the basis for

these costs should be. They do not imply any particular cost methodology; nor even that

costs should be recovered in full.

However, efficiency requires that the cost basis underlying interconnection payments

covers incremental costs that operators incur, as well as provides sufficient incentives to

invest.

In the short term (assuming no additional investments are necessary to provide services)

efficiency requires that marginal costs be covered. In telecommunications, actual

operational expenses are typically low once infrastructure is built. However, if network

utilisation is high, there can be significant marginal opportunity costs of capacity usage.

This implies, for example, that the cost basis for determining interconnection fees must,

on average, reflect the opportunity costs of capacity usage.

But telecommunication networks are not static. As demand grows, service range is

extended, and technology develops, network owners expand their capacity and, over

time, replace networks entirely. This has at least two implications for efficient recovery of

costs.

First, incremental costs of adding capacity can be large. For example, if expanded

network capacity is required to support interconnecting entities, then network owners may

spend significant amounts on, for example, improving network software, lighting fibre in

existing cables, and adding or replacing cables in the core network; or in upgrading

cables and adding base stations in the access network. These incremental costs must be

recovered through retail and interconnection prices.



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Second, investment incentives need to be preserved, not only for incremental capacity,

but for entire networks. Recovering only incremental costs will not allow a network to

recover its total costs where incremental costs are decreasing (that is, scale effects),

large fixed costs exist or some costs are common between network services. Thepresence of decreasing average costs suggests that prices should cover the total cost of

a service in the long term.

One way to efficiently recover fixed costs is to charge retail customers a fixed access

charge (e.g. subscription fee). Where access charges are possible and incremental costs

of traffic are relatively independent of the amount of traffic, efficient interconnection fees

typically would not exceed incremental costs. However, incremental costs will often

decrease through scale effects and in many retail markets for IP services, recovering

fixed costs only through fixed fees from a network’s own customers may not be

practicable or economically efficient.

Consequently, interconnection fees will in many situations have a role in generating

contributions to fixed and common costs.

The most efficient way to recover common costs is to spread them across users in a way

that minimises the distortion to consumption (that is, affects traffic), a principle which is

reflected in the economic concept of Ramsey pricing. Accordingly, recovering more than

the long-term average costs from a particular service is not necessarily an indication of

efficiency, because it may be caused by the need to efficiently recover common costs.

Ideally, the principle of recovering fixed and common costs where the distortion is the

least, should guide price setting in commercial as well as regulatory practice. BecauseRamsey-pricing is complex, regulators do not generally apply it (that is, they do not

typically differentiated mark-ups for fixed and common cost recovery according to the

price sensitivity of demand for services that use the regulated service as an input). As a

result, there is a potential divergence between regulated interconnection rates and

efficient rates. Efficient rates may be higher than regulated rates for some services and

lower for others.



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APPENDIX C: THE EFFICIENCY OF MULTIPLE IPINTERCONNECTION MODELS

As discussed in the main part of this report, IP networks will enable a variety of services,

a variety of QoS levels and comprise a number of layers at which interconnection could –

at least theoretically – occur.

This raises the question whether a variety of IP interconnection charging models

(including alternative direction of payments, alternative units of charges and/or alternative

levels of the interconnection charge) could – or even should – coexist. In this Appendix,

we discuss the efficiency advantages of differentiating interconnection charges between:

• access network and the core network;

• networks that interconnect;

• interconnection customers of a given network; and

• retail services.

C.1 DIFFERENTIATION BETWEEN ACCESS AND CORE NETWORKS

Some commentators have considered the efficiency properties of different interconnection

models applied to the access and core network. According to this view, the efficient

interconnection model might differ for interconnection at the access network (origination,termination) and for transit. Specifically, a recent report69 prepared for the German

regulator proposes that a BAK interconnection model be mandated by the regulator at the

access network, whereas IPNP be adopted for transit.

In this report we have used the term “direct interconnection” for interconnection at the

access network (that is, for origination/termination). Having set out the determinants of

both efficient direct and efficient transit interconnection, we conclude in section 5.3.5 that

the efficient interconnection regime is highly likely to involve a dual system – and

potentially several dual systems according to specific market situations – where the

interconnection model for direct interconnection differs from that for transit.

The specific proposal made to the German regulator is discussed in section 6.2.3 of the

report.

69 Vogelsang, Ingo “Abrechnungssysteme und Zusammenschaltungsregime aus ökonomischer Sicht”, Study

prepared for the Bundesnetzagentur für Elektrizität, Gas, Telekommunikation, Post und Eisenbahnen; 28 April

2006; p 172. It should be noted that Vogelsang’s efficiency analysis is somewhat more limited than the analysis

in this report as he compares only the relative performance of Bill and Keep with two specific variants of CPNP

(both of which are cost-based).



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C.2 DIFFERENTIATION OF INTERCONNECTION CHARGES AMONG NETWORKS

There are many reasons why interconnection charges may differ. They include:

• costs may differ between networks – for example, if there are scale differences or

geographic factors that impact the cost structure; and

• demand factors may differ between networks – for example, geographically separate

networks may have customers with very different preferences as to which sports

they wish to see on IPTV.

An efficient interconnection regime does not necessarily establish a single set of

interconnection rates applying to all networks which might interconnect.

Flexibility that allows each network to negotiate its interconnection fee independently of

fees charged on other networks, can improve efficiency by undermining behaviour that

would take advantage of a non-variable interconnection fee (which does not respond to

market circumstances) or an interconnection fee that does not respond to incentives in a

particular interconnection relationship. For example, even where two networks are

identical in relation to their current costs and coverage, the interconnection charging

model must have the flexibility to be non-reciprocal, because this can prevent business

bias and network structure bias. In other words, the threat of non-reciprocal rates is

required to maintain market equilibrium where both networks charge symmetrical

interconnection rates. Being able to resort to non-reciprocal rates is particularly relevant

in cases where one network is more effective in targeting customers and such that the

targeting itself cannot be fully reciprocated.70

As a direct consequence, imposing BAK on a group of traffic-balanced networks would

not be efficient. Prior to BAK being imposed, their true arrangement is really a form of

settlement-based interconnection, with the (explicit or implicit) understanding that

payments would be made if an imbalance occurred. If BAK is imposed in this situation,

this would alter incentives in ways that would almost certainly lead to a move away from

efficiency. This is because targeting of customers and network structure bias may

become profitable and/or network and quality underinvestment might occur. Even if these

biases could be avoided through adjustment of the retail charging model, and even if

traffic balance were to be maintained in the market equilibrium, the change in retail

charging structure that would be required to avoid biases and disincentives to invest

would not be efficient.

70 Reciprocal termination rates imposed by the FCC in the US had the effect that entrants cherry picked ISPs as

their customers which lead to a large termination deficit incurred by incumbents. See Hermalin, Benjamin E.

and Michael L. Katz, “Intercarrier compensation with all-you-can-eat retail pric ing”, working paper, 14 March

2006. Hermalin and Katz illustrate the incentive that entrants had to bias their business towards customers that

mostly terminated traffic in a theoretical model. The authors conclude that, under the requirement of a

reciprocal termination fee, and within the limitations of the model they investigate, BAK would be at least equally

efficient as any positive or negative termination fee. The paper by Hermalin and Katz does, however, not

analyse whether the removal of the reciprocity requirement could achieve the same or a better efficiency level

as BAK.



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C.3 DIFFERENTIATION OF INTERCONNECTION CHARGES AMONG CUSTOMERS OF A

NETWORK

Efficient interconnection charges on a given network may also differ depending on whothe interconnection parties are (e.g. some operators might pay a higher termination

charge than others for terminating traffic on a given network). This could occur due to

different interconnection products being provided (which might involve different costs),

reflect reactions to a specific interconnection customer’s cost avoidance conduct, or

simply be the outcome of separate negotiations. Interconnection charges may also reflect

price discrimination among different types of network customers (reflecting the

characteristics of their retail business and their costs). In summary:

• clearly, differentiation according to cost differences is efficient as it encourages the

efficient use of resources;

• as we discussed in the previous section, being able to specifically respond to

inefficient cost-avoidance conduct enhances efficiency; and

• price discrimination at the level of interconnection charges is more ambiguous: it

may increase or decrease efficiency depending on the specific market conditions.

For example, in the presence of large fixed costs, price discrimination is a tool to

recover these fixed costs with the least possible distortion to consumption decisions.

Overall, differential conditions which networks secure for interconnection services on a

given network are not an indication that some of these charges would be inefficient.

It may even be efficient to differentiate interconnection arrangements to an extreme

degree where one network refuses to interconnect with another network. This can be

efficient if, for example, the network which is refused interconnection only enables a low

QoS standard, which would undermine the other network’s quality proposition to its retail

customers (as retail customers may not be able to realise the source of a lower than

expected quality).

C.4 DIFFERENTIATION OF INTERCONNECTION CHARGES ACCORDING TO SERVICES

Interconnection occurs at layers 1 and 2 of an IP network at technically feasible PoIs in

the transport plane and the access plane. Interconnection at these layers enables the

provision of all retail services which are currently provided.

While IP interconnection could – in theory – also occur at higher network planes (e.g. at

the service plane) this has not been commercially trialled to date. Consequently,

differentiation of interconnection models according to whether it occurs at the transport or

service plane would only become relevant if and when the technical requirements for

interconnection at the service plane are developed and retail services are brought to the

market for which service plane interconnection would be required.



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At the lower network level at which interconnection currently occurs, differentiation of

interconnection charges according to the nature of the retail service is not possible,

because all information is transported in packets, which are only labelled with their

origination, destination and priority.

Should, in the future, interconnection also occur at the service plane, then interconnection

charging models that differentiate according to the nature of the retail service are likely to

arise at the service plane. Our analysis of charging models earlier in this section

suggests that the nature of a commercially viable and economically efficient

interconnection charge at the service plane for each service (in isolation) would – absent

traffic balance between peers – depend on two elements:

• the costs of providing interconnection, including the cost of providing the service

element as part of the interconnection product; and

• the distribution of benefits associated with the service among initiating and receiving

party.

In addition, commercial viability and economic efficiency would require that the sum of

interconnection arrangements avoids inefficient arbitrage between services (as well as

between interconnection at the service plane and lower network levels). Setting

consistent interconnection charges will become more complex for each interconnected

network; the consistency requirement would also substantially increase the burden on a

regulator attempting to regulate charges at any level. To operate efficiently all charges at

one network level would have to be consistent with all other charges. Even sophisticated

regulation would then tend to induce arbitrage opportunities, because networks differ intheir topology and the services they offer, such that a set of regulated charges may be

consistent when applied to one network but not with regard to other networks.



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APPENDIX D: EFFICIENCY OF BAK IN TRANSITINTERCONNECTION

In this section we discuss the efficiency of applying BAK to transit interconnection –

where BAK could potentially be applied either as a result of specific transit arrangements

or as a result of using a BAK model between two networks, which then applies to all traffic

between these networks (that is, to direct interconnection as well as transit). As we will

demonstrate, BAK applied specifically to transit traffic would lead to more severe

distortions than BAK applied to direct interconnection, because transit does not generate

retail incomes.

No rational firm will provide transit services under a BAK interconnection model. The

analysis presented here is for completeness only.

As we have discussed earlier in this report, the economic principles applying to transit

interconnection mirror those applying to direct interconnection. Specifically, the economic

role of transit interconnection involves two elements:

• balancing the interconnection costs incurred by the originating and the terminating

network in order to induce them to balance the retail charges efficiently between the

initiating and the receiving party; and

• recovering the transit networks’ costs.

When BAK is applied to transit, neither the originating nor the terminating network

receives any interconnection payment; and therefore each network can recover costs only

from their own retail customers. Unless this distribution of retail payments is an efficient

retail model, BAK at the transit level will lead to distortions similar to those discussed in

the main text with regard to direct interconnection.

However, BAK applied at the transit level in a way that leaves any transit provider without

revenues, leads to another distortion, because with no transit payments, transit providers

incur costs, but have no means to recover them. Hence, BAK applied in this manner will

discourage transit services.71 A number of market responses to the under-recovery of

transit costs could occur, depending on the specific market conditions. For example,

transit over shorter distances could be vertically integrated into the networks thatoriginate/terminate traffic, such that more of these networks interconnect directly.

Another alternative would be that transit is diverted through paths where BAK does not

apply (that is, networks on which BAK is not imposed for transit). Because these

71 The empirical fact that in the current internet a significant amount of transit – namely transit between tier 1

providers – is transmitted without payments does not contradict this prediction. Firstly, as we point out

elsewhere in this report, this practice represents technical limitations of the current internet. The technical

limitations imply that the recovery of transit costs does not necessarily occur from customers who cause the

costs; however, on an average basis, transit costs can be recovered. Secondly, this form of transit occurs only

between peers with an approximate traffic balance. Each of these providers can then factor in transit costs

when negotiating charges with lower tier providers.



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alternatives would be driven by a need to bypass the distorting incentives set by BAK and

would not reflect the efficient way to provide services, costs would increase; and this

would ultimately result in higher end-user prices.

We illustrate these inefficiencies in two examples involving a simple message (e.g. email).

The first example, where neither the originating nor the terminating network makes any

payments for transit, is illustrated in Figure 32 below. While the figure shows only one

transit provider, it can also be interpreted as depicting the relationship between the

originating/terminating networks and a transit provider that may result in NGN, whereby a

single provider manages an end-to-end delivery of the message and pays the providers

who contribute to the physical transit.

Figure 32 - BAK for transit

The inefficiency of BAK in this situation arises from

• The inability of achieving an efficient interconnection balance between the originating

and the terminating network, such that each network must charge their own retail

customer to recover costs; and

• The fact that the transit provider(s) would be expected to provide a service without

compensation.

The second example, illustrated in Figure 33 below, depicts a situation where sequential

transit providers receive payments from either the originating or the terminating network,

but BAK applies for transmission of the message between transit providers. Provided that

the payments from the originating and terminating network fully cover the costs of transit

(including those associated with higher quality of service), at least the transit providers

that receive these payments from the originating and the terminating network have an

incentive to provide their services. However, the BAK element between both transit

providers (or, more generally, BAK somewhere in the chain of transit providers) prevents

any indirect payment between the originating and terminating networks.



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Figure 33 - BAK between transit providers with sequential transit

Overall, the specific retail and cost conditions under which BAK is an efficient

interconnection model (namely, the efficient retail model involves payment by both retail

parties equal to the costs of providing “their side” of the service, or – alternatively – traffic

balance between peers), apply similarly to direct interconnection and to transit. Where

these conditions do not hold, the zero fee for interconnection, which is implicit in BAK,

induces either the adoption of an inefficient retail model and/or distortions due to cost

avoidance behaviour. In addition, the adoption of BAK in a manner that one or more

transit networks are not paid for providing the transit service, discourages the provision of

transit, a disincentive that the market could only overcome by costly bypass.



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APPENDIX E: REGULATORY APPROACHES TO IPINTERCONNECTION

E.1 INTRODUCTION

In this section we consider regulatory developments on the issue of IP interconnection in

various jurisdictions. The jurisdictions covered in this section are Germany, the UK, Hong

Kong and Australia. These are all jurisdictions in which the national regulators have given

some consideration to the development of NGNs and the potential regulatory implications,

or have otherwise given detailed consideration to the issue of interconnection charging

models.

E.2 GERMANY

The German regulator, Bundesnetzagentur (BNetzA) has set up a working group of

industry representatives with the aim of advising the BNetzA on technical and economic

aspects of IP interconnection. To assist the working group, the BNetzA commissioned

three studies related to IP interconnection charges.72 These developments suggest that

the BNetzA is considering imposing an interconnection charging model as ex ante

regulation of NGNs.

The economic analysis commissioned focuses on the economic outcomes of alternative

charging models for telephony in fixed NGN networks and makes some references to

mobile termination. However, because currently and over the near future IP

interconnection does not distinguish between services, adopting the recommendations of

the report would have consequences for all NGN services. The conclusions arising out of

the economic analysis commissioned by BNetzA include:

• that BAK is a better charging model than element based charging or capacity

based charging, for IP networks that do not offer quality of service differentiation;

• that the preferred long-term interconnection regime in a QoS context is BAK in

the access network and element-based charging in the core;

• that within a core network, element based charging is optimal, as long as

interconnection regulation continues to exist in the PSTN;

• that with the switch to NGNs, commercial solutions for interconnection in the core

network may be adequate and these may be based on element based charging,

but need not be;

72 An economic study: I Vogelsang, “Abrechnungssysteme und Zusammenschaltungsregime aus ökonomischer

Sicht”, Study prepared for the Bundesnetzagentur für Elektrizität, Gas, Telekommunikation, Post und

Eisenbahnen; 28 April 2006; a technical study and a study in relation to UK and US interconnection regimes: JS

Marcus, “Framework for Interconnection of IP-Based Networks – Accounting Systems and Interconnection

Regimes in the USA and the UK”, 27 March 2006.



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• that minute-based charging may not continue in an NGN environment, as the

costs of providing NGN network capacity depends on the type of data and

number of packets; and

• that having bill-and-keep charging for access networks and element-based

charging for core networks does not mandate a change from calling party pays

models at the retail level to a receiving party pays model, especially if bill and

keep is restricted to the access layer.

Based on these conclusions, the report recommends the adoption of BAK between the

last PoI and the customer (that is, BAK would replace termination payments), whereby

the location of the PoIs is monitored by the regulator, and the network sending the

message has to commercially negotiate delivery of the message to the Pol at which BAK

applies. If the regulator were to mandate interconnection for transit, the report

recommends the EBC approach.

With regard to mobile networks, the report concludes that for reasons of technological

neutrality, fixed-to-mobile termination should adopt the same charging model as

termination in a fixed network.

The economic analysis in the main text of this report suggests that adoption of BAK in this

way would be burdened with inefficiencies:

• the retail model that is implied by BAK model will – except in extraordinary

circumstances – not be efficient. This is because, under BAK each network must

recover costs from its own retail customers, and in all but specific cases, this form ofcharging does not correspond to the distribution of message benefits between retail

customers (and to the distribution of costs between the network).73 Indeed, our

analysis in section 6.3 concludes that in many situations, payment by the initiating

party (and a corresponding IPNP interconnection regime) is likely to be efficient; and

• if operators attempt to cover their interconnection costs by imposing charges for

unrelated messages (options 2 and 3 discussed in section 6.2.1) – for example,

because they might face customer reluctance to accepting a retail model where the

receiving party pays at least some of the costs (charges might be variable or take the

form of buckets) – then this would lead to business bias, whereby operators attempt

to establish a low-cost customer base. As discussed in section 5.3.8, business bias

implies that too few messages are sent. In commercially negotiated interconnection

systems, business bias can be prevented, because operators have the option to

adjust interconnection fees in response to evolving circumstances (e.g. changes in

the relative importance of terminating and originating traffic on each network).

However, in a mandated BAK model this is not possible, because, by definition, the

interconnection fee is zero and cannot be changed;

73 Condition 1 (stable traffic balance between peers), which represents the only other situation in which BAK would

be efficient, is highly unlikely to hold in practice. In particular, it is unlikely to hold in the context of

interconnection between alternative fixed networks or between fixed and mobile networks.



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• regulatory oversight over the location of PoI at which BAK is suggested to be applied

would mitigate the hot-potato problem (that is, the incentive to locate PoIs close to a

network’s own customers). However, such a regulatory intervention in network

design is likely to involve high costs, in particular if the application of BAK were to beextended to non-fixed networks;

• mandating BAK, instead of positive termination fees, may change the incentives to

invest in networks and their extension, in particular in relation to locations where the

cost of coverage is higher (BAK would prevent residential customers and businesses

in other areas contributing to the cost of connecting high-cost customers through

payments of termination fees). Suboptimal network coverage would be the

consequence of this distortion;

• while imposing BAK would ensure that termination fees cannot be excessive, there is

no guarantee that the market outcomes resulting from imposing BAK are at leastpreferable to the outcomes that would have been achieved absent intervention; and

• the distortions associated with BAK are likely to be exacerbated in a QoS

environment, because ensuring QoS typically implies that the efficient

interconnection fee must be higher for services with a higher QoS standard (see

section 5.3.7). BAK has therefore the potential to prevent the adoption of QoS – with

serious consequences for the availability of services that rely on end-to-end QoS

provision (such as high-quality VoIP). Moreover – as discussed in section 6.2.3 – we

do not agree with Vogelsang’s view that interconnection for origination/termination

can be decoupled from QoS standards. Access networks can be, and in practice

sometimes are, affected by capacity shortages, which constitute the problem that

QoS traffic prioritisation attempts to solve. Moreover, while in the fixed network

traffic hand-over under BAK conditions could be limited to the last PoI on the way to

the receiving customer, this is not practicable in mobile termination, where traffic is

typically handed to the terminating network at the first PoI. Hence, a terminating

mobile call is typically transmitted over large parts of the terminating network. At

every point along this path QoS will need to be ensured.

The final report74 by the IP interconnection working group, which was released for public

consultation in December 2006, shows that the group members’ support for the dual

charging model proposed by Vogelsang is mixed, with some members of the working

group considering “some” balance of traffic between networks and similar cost conditions

as key preconditions for BAK to be a viable interconnection model. Moreover, the report

notes that even those supportive of the dual system proposed by Vogelsang agree that

determining a time path for the transition appears to be impossible from today’s

perspective.

74 Berg, A and others “Rahmenbedingungen der Zusammenschaltung IP-basierter Netze”, 15 December 2006.





Page 139

service specific wholesale regulation and a greater focus on generic access and

interconnection remedies.80

Ofcom’s approach to the developments in IP interconnection is epitomised by thisstatement from the second consultation on NGNs:

We do not think it would be appropriate for Ofcom to become involved in

increasingly detailed management of the transition to NGNs and specification of

new products. We believe the most effective role we can take, and the purpose of

this consultation, is to establish a clear policy framework and ensure that robust

industry-led processes are in place to take forward the issues.81

Ofcom has noted that NGN deployment may result in more efficient interconnection of call

termination traffic at a central location, but that these arrangements would need to be

consistent with existing call termination obligations for those with substantial marketpower.82

In response to Ofcom’s statements encouraging industry led co-operation and solutions to

ensuring that NGNs reach their full potential for the benefit of investors and consumers,

BT has established the Consult 21 program as a forum for consulting with its wholesale

customers on these issues.

E.4 AUSTRALIA

In May 1998, the Australian regulator, the ACCC, issued a competition notice in which it

found that the incumbent fixed network operator, Telstra, had acted anti-competitively by

not entering into sender keeps all (SKA)83 peering arrangements with 3 other backbone

providers, because:

• interconnection between different IAPs is essential for end users to obtain complete

global access to all content providers and other end-users. Hence, such

interconnection is fundamental to the effective operation of the internet;

• the terms and conditions upon which interconnection between different IAPs is

arranged will also affect the terms and conditions upon which IAPs are able to

provide Access Provider Services to ISPs;

80 Ofcom, Next Generation Networks – Future arrangements for access and interconnection, Consultation

published 13 January 2005, pp 22.

81 Ofcom, Next Generation Networks – Further consultation, Consultation published 30 June 2005, p 2.

82 Ofcom, Next Generation Networks – Further consultation, Consultation published 30 June 2005, p 26.

83 In the ACCC competition notice it is unclear whether the ACCC is referring to sender keeps all or a settlement

based interconnection arrangement, however, the arrangements struck as a result of the competition notice

seem to be settlement based.



Page 140

• Telstra, because of its market power, is able to charge other IAPs for the supply of

Access Provider Services, while not paying or otherwise compensating for Access

Provider Services supplied by other IAPs; and

• in a competitive market, Telstra would either pay for Access Provider Services

supplied to it by other IAPs or enter into reciprocal financial arrangements with

other IAPs for Access Provider Services supplied to Telstra by those other IAPs.

The ACCC subsequently conducted an inquiry into IP interconnection to determine

whether it should become a regulated access service, which would require all IP

operators, not only Telstra, to provide the service on terms and conditions which the

ACCC could determine. The ACCC ultimately decided not to proceed with the

designation of IP interconnection, because it did not have sufficient information to

determine whether the designation would or not meet the long term interests of end users

test, which guides decisions about access regulation. The ACCC reiterated its concernunderlying the peering competition notice, that peering between major ISPs could have

anti-competitive effects:84

The nature of the internet interconnection service means that while there is some

scope for product differentiation on pricing, the range of options for

interconnection models remains limited to either a peering or transit relationship.

The preponderance of transit relationships between the major ISPs and those

ISPs with less investment in infrastructure leads the Commission to consider that

there may be monopoly rents being extracted by the larger players, particularly

since the major ISPs have a lower cost base than their smaller competitors by

virtue of the peering relationships they have amongst each other.

This circumstance may result in the large ISPs being able to raise their rivals’

costs, and perhaps free-ride on the infrastructure and other investment of the

smaller ISPs. Whilst there may be a number of contributing factors, limited

market concentration figures indicate that the number of ISPs in the market is

shrinking, despite the low barriers to entry at the low end of the market, and a

market that has not yet reach saturation.

The existence of peering relationships among the major ISPs and the static

nature of the identity of these ISPs does not necessarily imply that there is

collusion among them. However, the Commission remains concerned that the

standardisation of internet interconnection arrangements into peering or transit

may have the same effect. This is because the major ISPs are aware that each

other has access to a substantial number of routes for near-zero cost, and is able

to ‘onsell’ this access to other ISPs. There is no incentive for any of the

beneficiaries of these arrangements to explore other interconnection models that

may reduce the revenue gained from onselling access to peered routes.

84 ACCC, Internet Interconnection Service, Final Report, 1 December 2004, p 12.



Page 141

While the ACCC is clearly uncomfortable with “oligopolistic” SKA peering arrangements, it

is equally clear that the ACCC also is not inclined to ubiquitously apply SKA peering. The

ACCC rejected the ubiquitous application of SKA peering because of the adverse effects

on incentives to invest in IP backbone infrastructure:85

A number of submissions to the inquiry’s Discussion Paper suggested that the

Commission mandate interconnection at IXs, with some stakeholders favouring

the exchange of traffic on a ‘Sender Keep All’ (SKA) basis. Aside from doubts as

to whether the Commission has the power to mandate such a model, it is not

certain that this model offers greater benefits than others, and may result in

inefficiencies in routing and investment. Notwithstanding these concerns, it may

be possible for IXs to become the preferred means of interconnection without

being required by regulation.

Although the ACCC noted that QoS was impossible to guarantee given the state of theinternet at the time of its final IP Interconnection report, it noted that:86

Internet markets generally are in a state of transition. As such, the Commission

believes that it should proceed with caution in deciding whether or not to regulate.

In particular, there is a shift from dial-up to broadband access, the retail market is

continuing to grow, and applications that drive the internet’s growth continue to

develop and evolve. It is not certain that market power is constrained by this

dynamism, or whether requirements for quality of service associated with

newer applications may act to reinforce existing market power .

The ACCC made more extensive comments on QoS in its draft report:87

However, while QoS considerations may force some ISPs to accept a higher

price than others, the product they are acquiring is no different to that acquired by

other ISPs. It may be more likely that the necessity of reaching the popular IP

addresses via the most direct path places the provision of access to those

addresses in a separate market. At this point in time, the Commission considers it

to be unclear whether quality of service considerations may diminish the

substitutability of alternative interconnection services for interconnection to be

one or more of the larger ISPs. The Commission expects that this will become an

issue of greater importance, demanding further consideration, in future.

….

85 ACCC, Internet Interconnection Service, Final Report, 1 December 2004, p 22.

86 ACCC, Internet Interconnection Service, Final Report, 1 December 2004, p 20 (emphasis added).

87 ACCC, draft Internet Interconnection Report, pp 47-48.



Page 142

Quality of service issues are becoming increasingly important in line with the rise

of sophisticated internet services, such as VoIP, video and audio-streaming and

advanced e commerce. These services can require ‘real-time’ transmission, and

therefore ISPs supplying these services may be unable to meet end-userdemands for quality of service without directly connecting to ISPs with large

proportions of popular IP addresses, to reduce latency. The Commission has

received anecdotal evidence that large corporate clients require their chosen ISP

to obtain wholesale internet interconnection from Telstra in order to maximise

quality of service.

The quality of service differences between the different types of internet

applications suggests that different product markets may exist for these

applications. However, the nature of the internet is such that it is operationally

inefficient to examine packets to determine the application of their payload. As a

result, ISPs whose customers demand low latency have no choice but tointerconnect with those networks that host IP addresses of importance to their

retail customers.

E.5 HONG KONG

The Hong Kong regulator, OFTA, is currently considering changes to the existing

interconnection regime between fixed and mobile operators for voice calls made in each

direction. While OFTA’s focus is voice calls, it has developed its proposals with the

transition to IP-based NGN networks in mind.

Currently, calls between fixed networks and mobile networks are dealt with as follows:

• calls from mobile to fixed networks: the calling mobile subscriber pays for the

end to end call (IPP). The mobile operator (as IPNP) pays the fixed operator a

termination charge. The termination charge to the fixed incumbent’s network is

calculated on a fully distributed cost basis. Charges for termination by fixed

competing networks to the fixed incumbent’s network are calculated using an

incremental cost standard, LRAIC. Other than in respect of the charging standard,

these interconnection arrangements are fairly typical; and

• calls from fixed to mobile networks: the called mobile customer pays for

inbound calls, although most subscribers are on bucket plans covering inbound and

outbound calls. The fixed calling party (unlike in Singapore) does not pay a per call

charge to originate the call. The mobile operator pays the fixed operator an

originating access charge. The charge payable by the mobile operators to the fixed

incumbent is calculated applying the LRAIC standard. This charging arrangement

(as well as the LRAIC standard) is unusual amongst countries in which the RPP

model applies to calls to mobile services.



Page 143

OFTA has proposed that a BAK approach should apply as a fallback between fixed and

mobile networks.88 The BAK approach was recommended by OFTA’s consultants,

Ovum, who identified the following benefits:

• it eliminates the current problems associated with fixed termination charges;

• it substantially reduces the transaction costs of negotiating/determining

interconnect charges for all operators, both fixed and mobile;

• it substantially reduces transaction costs of billing, reconciling and collecting

interconnect charges for all operators;

• it focuses the efforts of the operators on competing in the supply of retail services

to Hong Kong citizens rather than competing through regulatory arbitrage and

gaming;

• it gives operators a greater pricing freedom at the retail level. At the moment an

operator offering services for a flat monthly fee at the retail level pays interconnect

charges on a per minute basis and risks a margin squeeze. Moving to BAK

removes this problem;

• it is future proof. Operators using IP and circuit switch technologies can

interconnect with each other without needing to negotiate complex interconnect

charging arrangements;

•

it gives an operator stronger incentives for cost efficiency than other interconnectcharging arrangements. Under BAK the operator must recover all its costs from its

customers. In a competitive market this gives it strong incentives to minimise its

unit costs. Under a traditional calling parties network pays model the operator

receives a substantial portion of its revenues from call termination prices which are

set by negotiation or determination and where incentives for regulatory gaming

rather than cost efficiency dominate. The same argument applies to current FMIC

arrangements in Hong Kong;

• it eliminates any need to consider the “terminating access monopoly” problem,

which gives even the smallest operators’ substantial power over calls that

terminates with their customers

• it reduces the role which OFTA plays in competitive interconnect in Hong Kong and

so represents a substantial withdrawal of regulation and of regulatory costs; and

• it costs virtually nothing to implement.

88 Regulation for Fixed-Mobile Convergence, Second Consultation Paper, 14 July 2006.



Page 144

Appropriate interconnection arrangements between directly connected networks for voice

calls is beyond the scope of this report. As we discuss in sections 5 and 6, BAK can be

efficient in some circumstances and not efficient in others. Factors such as the retail

charging models and the impact of interconnection on competition betweeninterconnected operators in downstream markets needs to be considered.

However, the view that OFTA and its consultant seem to share, that BAK is the approach

which should prevail in an NGN environment, is too single-dimensioned. As we have

discussed in this report, transit has a much more significant role in IP interconnection than

in circuit switched interconnection. The transit provider will not have access to retail

revenues out of which to recover its costs in providing transit.



Page 145

APPENDIX F: THE AUTHORS

F.1 CRA INTERNATIONAL

CRA is a leading provider of economic and business consulting services to clients in the

public and private sector. Founded in 1965, the firm has over 700 consulting staff in its

offices in Europe, North America and Asia-Pacific. CRA has very substantial experience

in telecommunications competition, technology and other industry issues. We have

telecommunications experts located in Europe, North America and Asia-Pacific, with a

substantial dedicated Telecommunications/Media team of consultants in Australia.

Bridger M. Mitchell, Vice President, is the director of CRA’s Palo Alto office. He is an

expert in competition and pricing in the telecommunications industry and is the author of

five books and numerous articles in professional journals. He has researched regulatoryissues involving the theory and practice of telecommunications pricing, competition, and

equal access in local telephone markets, interconnection of wireless and wire line

telecommunications networks, international telephone rates, and broadcasting and cable

television.

Paul Paterson, Vice President in CRA’s Sydney office has significant commercial and

government experience in industry research, corporate strategies, and policy

development, as well as senior executive experience in the telecommunications industry.

Prior to joining NECG, Dr Paterson was with Telstra Corporation Ltd, where as Director,

Regulatory, he held one of Australia’s most influential regulatory positions.

Moya Dodd, Vice President in CRA’s Sydney office, brings with her a wealth of expertise

in strategic decision-making, business development, legal and regulatory issues

management, advocacy, and negotiation. Ms. Dodd’s former experience includes senior

strategic development, management, and regulatory roles in media and

telecommunications firms.

Paul Reynolds is CRA’s key expert in European telecommunications, advising on

competition law and regulatory issues. Paul has over 10 years’ experience assisting

lawyers and companies in responding to investigations by national competition and

regulatory authorities, the EC Commission under Articles 81 and 82, and the EC Merger

Regulation, in court proceedings in EU Member States and Australia and in international

arbitrations. Paul has particular expertise in relation to the telecommunications

interconnection issues and has advised telecoms operators, industry associations and

regulators in Europe, the Asia Pacific, Africa and Latin America.

Astrid Jung specialises in industrial economics and econometric applications to

competition analysis and antitrust. Her interests lie in the areas of empirical testing of the

effects of regulation on firms’ competitive behaviour and of industry influence on

regulation.



Page 146

F.2 GILBERT + TOBIN

Gilbert + Tobin is an internationally recognised firm in telecommunications law and was

intimately involved in the deregulation process in Australia. From this base, Gilbert +Tobin has expanded its client base throughout Europe, North America and with a

particular focus on the Asia Pacific Region. With this depth of experience Gilbert + Tobin

have built up specialised knowledge of best practice telecommunications regulatory

design, implementation and management.

Peter Waters is a partner in Gilbert + Tobin specialising in communications and

technology. Peter is recognised as one of the leading communications lawyers in Asia

Pacific. Chambers and Partners Global report for 2006, commenting on China/Hong

Kong telecommunications sector, says Peter Waters is "the first choice lawyer for

regulatory work bar none." He completed his Master of Laws at Harvard Law School on a

Fulbright Scholarship. Peter spends his time between Sydney and Hong Kong, where heis a consultant to Arculli Fong & Ng (in association with King and Wood).

Rob Nicholls is a consultant at Gilbert + Tobin and has worked in the communications

field for over 25 years business, focusing on strategy in the telecommunications and

broadcasting sectors. He delivers strategic direction and associated solutions. Rob brings

commercial, finance and analytical abilities based on an extensive technical and

regulatory background.

Elise Ball is a lawyer in Gilbert + Tobin’s Corporate, Communications and Technology

Group. She has acted in many intellectual property disputes, including those relating to

copyright enforcement, trade mark infringement and domain names. She also hasexperience managing intellectual property registers for domain names and business

name registrations. Elise completed an internship at the Brussels office of Freshfields

Bruckhaus Deringer, where she was involved in European competition law, specifically

clearing mergers and takeovers with the European Commission.



Page 147

APPENDIX G: GLOSSARY

AS – autonomous systems

BAK – bill-and-keep

BGP – border gateway protocol

CDR – call data records

CPE – customer premises equipment

DNS – domain name service

DSL – digital subscriber line

eBGP – exterior border gateway protocol

FTP – file transfer protocol

IAP – Internet access provider

IMS – IP multimedia subsystem

IP – Internet Protocol

IPNP – initiating party network pays

IPP – initiating party pays

ISP – internet service provider

MNO – mobile network operator

MPLS – multi protocol labeling system

NGN – next generation network

PoP – point of presence

PSTN – public switched telephone network

QoS – quality of service

RPNP – receiving party network pays

RPP – receiving party pays

SBI – settlement-based interconnection

SSP – signal switching point



STP – signal transfer point

TCP – transmission control protocol

URL – uniform resource locator

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