Economics of the telecoms industry

I seem to be in a ranty mood at the moment. Today's rant, however, is not negative - it's an education attempt. In particular, I've dealt with one person too many who doesn't seem to understand how the telecoms industry works in an economic sense, and thus why the price they pay their ISP for a home connection isn't comparable to the price a business pays for "similar" connectivity. On the way, I hope to convince people that different ISPs using the same wholesale suppliers can nonetheless offer radically different levels of service.

To begin with, a quick guide to important terminology:

Capex:

Capex (short for capital expenditure) is the money you have to spend up-front to buy equipment that you'll continue to use. For example, £20,000 on a new car is capex.

Opex:

Opex (short for operational expenditure) is the money you have to spend to keep something going. Using the car as an example again, your insurance costs are opex, as is your fuel costs

Time value of money:

Time value of money is a useful tool for making capex and opex comparable. The normal way to use it is to calculate the present value of your opex cashflow; this gives you the amount of money you'd need up front to do everything from capital, without supplying future cash for opex (or alternatively without needing to allow for opex into your pricing scheme).

Cost of money:

Cost of money is another tool for making opex and capex comparable; whereas time value of money converts opex to capex, cost of money converts capex to opex, by working out how much interest you could have earned (safely) if you didn't spend the money now.

So, with this in place, how does the telecoms industry stack up economically? Well, firstly, there are three activities a telco engages in:

1. Building and owning a telecoms network, whether a small office-sized one, or a big nationwide network.
2. Buying access to other telco's networks.
3. Selling access to their own network.

Of these, the first is dominated by capex; depending on where you need to dig, and who you ask to do the digging, the cost of digging up the roads so that you can run your cables underneath them runs at anything from £20 per metre for some rural areas where no-one's bothered if your trenches aren't neatly filled in afterwards, to nearly £2,000 per metre for parts of London. In comparison, the remaining costs of running cable are cheap - ducting (so that you can run new cable later, or replace cables that fail) is around £3 per metre, expensive optical fibre is around £0.50 per metre (for 4-core fibre, enough to run two or four connections), while traditional phone cable is a mere £0.14 per metre. Even the coaxial cable used for cable TV and broadband is £0.32 per metre.

Once you've got your cables in the ground, you need to put things on the end of them to make them do good things. Using Hardware.com's prices on Cisco gear, and looking at silly kit (plugging everyone into a Cisco 7600 router, and letting it sort things out), you can get gigabit optical ports at aorund £1,000/port for 40km reach, including the cost of 4x10 gigabit backhaul ports from the router to the rest of your network.

Note that all of this is capex; given that your central switching points (phone exchanges, for example) are usually kilometres away from the average customer, you can see that the cost of setting up your network is almost all in building the cabling out in the first place; high quality fibre everywhere can be done retail for £4,000 per kilometre needed (complete with ducting), while your digging works cost you a huge amount more; even at £20 per metre, you're looking at £20,000 per kilometre. The cost of hardware to drive your link falls into the noise.

So, onto the opex of your network. You'll obviously need people to do things like physically move connections around; but most of your ongoing cost is power consumption. Again, this isn't necessarily huge; Cisco offer routers at 50W per port for 10 gigabit use, or 1.2kWh per day. At current retail prices, you'd be hard pressed to spend more than 50p/day on electricity to run the Cisco router, even allowing for needed air conditioning. Reframing that number differently, assuming that the typical customer needs £10/month of human attention, a 10 gigabit link has opex costs of around £40/month, including the 10 gig to other parts of the country.

When you compare this to the capex costs of building your network, you can quickly see that the basis of the telecoms business is raising huge sums of capital, spending them on building a network, then hoping to make enough money selling access to that network that you can pay off your capex, and spend a while raking in the profits before you have to go round the upgrade loop again; your opex costs are noise compared to the money you've had to spend on capex; assuming your network survives ten years, your opex is going to be under £5,000 per port, while your capex for a typical port is going to be over £25,000. Given normal inputs to a time value of money calculation, you can work out that a network has to survive 20 years without change before your opex becomes significant.

So, how do you make money on this? Answer: you sell connections to people; you start by charging some fixed quantity per user, to cover the bare minimum of opex and ensure that no matter how the customer uses the connection, you don't lose money on opex. Then, you add a charge for usage; there are three basic models:

1. Pay as you use of a high capacity link.
2. Pay per unit available capacity.
3. Percentile-based charging of a high capacity link.

The first is the familiar charge per second for phone calls; in this model, adapted for data connections, I pay you per byte transferred. You set the price per byte as high as you think I'll pay, so that you can pay off your capex, make a profit, and prepare for the next round of capex on network upgrades. You may also offer a variable price for usage (as my ISP, Andrews & Arnold do), in order to encourage users to shift heavy use to times when it doesn't affect your network as much. This is also where peak and off-peak phone charges came from; if you use the phone at a time when the existing network is near capacity, the telco charged you more in order to encourage you to shift as much usage as possible to off-peak, where there was lots of spare capacity, and hence allow the telco to delay upgrades.

The second is also simple. I pay you for a link with a given communications capacity, and I get that capacity whenever I use it; paying for unlimited phone calls is an example, as is an unlimited Internet connection. In this model, the telco is playing a complex game; if they make the price for the capacity too low, people will use enough capacity on the "unlimited" link that you have to bring forwards a high-capex network upgrade. If you set it too high, people will go to your competitors; a median position, used especially by consumer telcos, is to offer "unlimited with fair use", where you will be asked to reduce your usage or disconnect if you use enough that a network upgrade is needed to cope with you. This position can cause a lot of grief; people don't like to be told that, actually, this good deal for their usage level isn't for them, and that they're "excessive" users.

The third option (percentile billing) is the most common option used in telco to telco links. In a percentile billing world, there is a high capacity link that neither end expects to see fully utilised. Instead, the current utilisation is measured repeatedly (e.g. once per second). The highest measurements are ignored, leaving the percentile behind. Payment is then made based on the peak utilization in the percentile. A very common version of this is monthly 95th percentile; as used by ISPs, you measure once every second. You sort your month's measurements, and discard the highest 5% (e.g. in September, a month with 30 days, you have 2,592,000 seconds; you discard your highest 129,600 readings to get your 95th percentile). You then charge for the highest remaining measurement. For a simplified example; imagine that I measured a day's usage, and charged you 75th percentile. In February, you used 5 units a day for the first week, 1 unit a day for the next 20 days, then 50 units on the last day. 75th percentile of 28 periods involves discarding the highest 7 measurements, so I discard the 50, and 4 of the 5s, to get a measurement of 5 units peak use. I thus charge you for 5 units/day for the entire month. Had you been able to keep the last day at 1 unit, your bill would have fallen to just 1 unit/day; you can thus see how percentile billing avoids charging for rare peaks, but doesn't let a user get away with lots of heavy use cheaply.

I hope this has piqued some interest; as you can see, running a telco, especially at consumer prices, is much more akin to running a mortgages bank than a shop.

A dangerous "benefits trap"

I'm feeling compelled to write this post, because I don't see any evidence that the current Chancellor understands this trap, and I see otherwise intelligent friends not understanding just why this is a dangerous trap for a government to fall into; often, they're letting themselves be blinded by an ideological view.

The trap in question is one where increasing my taxable income decreases my net income; there are two ways for this to happen. The first is obvious - if the tax rate applicable (once you combine income tax, national insurance, and any other taxes paid on income) is above 100%, increasing your pay decreases your net income. The second is more subtle; if you are paid income-linked benefits, and the increase in net pay is offset by a greater decrease in your income-linked benefits, you lose out.

Why is this so bad? There are two reasons:

1. You set things up such that I could pay more tax, but I'll be worse off than if I pay less tax. This results in things like someone refusing a pay rise that takes them into higher-rate tax, until it's enough to make up for the loss of child benefit; the government is thus losing out on tax revenue, and paying out in benefits.
2. You encourage people to depend on benefits rather than earned income, because they're better off that way - this is bad enough when people are depending on benefits because they value their free time above their possible earnings, but becomes utterly crazy when they're doing it because they could get off benefits, but then they'd work as hard for less money in the bank.

I have set up an example spreadsheet on Google Documents to illustrate this. My hypothetical benefit is £1,000/month (housing costs, say), paid to people who earn £12,000 per annum or less. To set up the trap, we've excluded people who earn £24,000 per annum from claiming the benefit at all, and we've decided that you'll lose benefit linearly as you earn more (e.g. people on £18,000pa get £500/month benefit). I've also simplified taxation - instead of multiple taxes on income, I've got a single rate, and a personal allowance. We could add higher rate tax, and more personal taxes, but it doesn't seem worthwhile for a simple example.

You will notice that in my simple example, anyone who earns between £12,000 and £28,000/year is worse off than someone earning less than them. A rational actor will handle this by refusing to accept any job where they're paid in that range; the result is that (for example), instead of taking a job at £24,000, and paying a net £354.17/month in tax, someone sane will take a job at £12,000, and receive a net £895.83/month in benefits after tax is allowed for. It's obvious how this is bad for the government.

It's also not all doom-and-gloom; in this case, by increasing the upper threshold for £24,000 a year to £28,000 a year, people earning between £12k and £28k simply don't take home more; increase the upper benefit threshold a bit further (say to £30k), and although you don't take home much more as you increase your pay, you do take home more money, and thus escape the trap. You can also escape the trap by limiting benefits; this has other, deeper, social implications, as it can result in the benefit not helping the people it's supposed to assist.

So, how do governments end up in this trap accidentally? The usual route is to link the level of a benefit to something different to the thresholds for being permitted to claim the benefit; for example, in the example, I could have tied the benefit level to rents in London. When it started, I was paying £300/month maximum benefit; at that point, there is no trap. As rents rise, I don't review my thresholds, nor do I limit the benefit level; once rents exceed a certain threshold (around £750/month in my example), the trap appears. Capping the benefit just forces people out of an area completely, and creates "ghettos" of poor people kept out of the way of the rich, making it easier for the genuinely rich to be ignorant of what it's like living in a world where £10,000 isn't just the cost of a good night out, but is a sigificant sum of money.