The New Investment Theory of Real Options and its Implication for Telecommunications Economics, 1999 Topics in Regulatory Economics and Policy Series, Vol. 34

Randall B, Lowe Piper & Marbury, L.L.R The issue of costing and pricing in the telecommunications industry has been hotly debated for the last twenty years. Indeed, we are still wrestling today over the cost of the local exchange for access by interexchange and competitive local ex­ change carriers, as well as for universal service funding. The U.S. telecommunications world was a simple one before the emergence of competition, comprising only AT&T and independent local exchange carriers. Costs were allocated between intrastate and interstate jurisdictions and then again, between intrastate local and toll. The Bell System then divided those costs among itself (using a process referred to as the division of revenues) and independents (using a process called settlements). Tolls subsidized local calls to keep the politi­ cians happy, and the firm, as a whole, covered its costs and made a fair return. State regulators, however, lacked the wherewithal to audit this process. Their con­ cerns centered generally on whether local rates, irrespective of costs, were at a po­ litically acceptable level. Although federal regulators were better able to determine the reasonableness of the process and the resulting costs, they adopted an approach of "continuous surveillance" where, like the state regulator, the appearance of rea­ sonableness was what mattered. With the advent of competition, this historical costing predicate had to change. The Bell System, as well as the independents, were suddenly held accountable.

Real Options: An Overview.- Real options: A primer.- Real options applications in the telecommunications industry.- Does practice follow principle? Applying real options principles to proxy costs in U.S. telecommunications.- Real options: What telecommunications can learn from electric power.- Principles.- Cost models: Comporting with principles.- The design of forward looking cost models for local exchange telecommunications networks.- Forward looking telecommunications cost models.- Implications of Neglecting Real Options.- An institutional perspective on assessing real options values in telecommunications cost models.- Real options applications for telecommunications deregulation.- The poverty of cost models, the wealth of real options.- The forecasting implications of telecommunications cost models.- The effect of sunk costs in telecommunications regulation.- Real Options: Evaluations.- Real options and the costs of the local telecommunications network.- Option Value Analysis and Telephone Access Charges.- Rethinking the implications of “real options” theory for the U.S. local telephone industry.- Application of real options theory to TELRIC models: real trouble or red herring.- Discussion: A view from outside the industry.- Rejoinder.- Summary/Conclusions.- Real options, false choices: A final word.