Public and Private Interests in Achieving Viable Rural Service: the Role of a Favourable Policy Environment

Andrew Dymond
Director International and Principal Economist
Teleconsult Limited
Vancouver, Canada

Abstract

Some countries are demonstrating that privatization can be harnessed to bring about very significant improvements in the level of telephone and telecommunications services in rural areas. With a liberalized environment and with falling costs from developments in wireless technology, the envelope for commercial supply has broadened considerably. Some policy makers have helped to "push the envelope" by forcing or encouraging privatized operators to include a major rural element in their build programmes, or by offering market entry opportunities for operators who will focus specifically on rural areas. However, the achievements to date are only a fraction of the total needs of rural areas and of the potential market.

This paper argues that the potential for rural telecommunications to develop commercially is much higher than traditionally understood. It has been common to assume that rural and remote services are justified primarily on the basis of their socio-economic rather than financial returns. The paper argues that this is a dangerous strategy if not qualified and complemented with commercial sense. The fact that the public interest - the optimal flow of potential socio-economic benefits - is often not realized unless the operator is motivated and committed to providing a decent level of service, is a pivotal policy issue. It is argued that socio-economic benefits, financial revenues and commercial viability go hand in hand and that the role of policy is to create an environment which will encourage private investment as far as possible.

It is therefore in both the public and private interest to find an enlightened policy mix which will blend commercial incentive and socio-economic demands, in order to bring about further accelerations in rural service investments. In reviewing the achievements thus far, the paper focuses on the role and features of two discrete rural telecom investment models, namely monopoly internal cross-subsidization and special regional operators. Specific policy requirements are addressed and suggestions are made on ways in which rural network expansion can be accelerated on a commercial basis even more.

A new opportunity to serve rural areas

Judging from how rural people have demonstrated a willingness to pay for service, developing country and emerging rural telecommunications markets are potentially worth over $5 billion in equipment sales per year. The beneficial impact of these investments on the lives of people in rural economies would be several times this amount. However, to date the markets remain substantially unrealized.

Policy makers have a unique opportunity. Most are agreed that with sector reform, the provision of services to rural and low income areas must receive special attention, to ensure that rural areas are included in the benefits of sectoral reform. On all continents, the extension of rural telephone service is being stimulated by means of imposed operator obligations, by new entry opportunities and by special licensing conditions. Latin America, in the forefront of emerging market privatization, has led the way in its application of some of the policy tools which can increase service to rural areas. Rural networks are certainly growing faster than during the pre-reform era, but still more can be done to further leverage the benefits of reform.

Leaving old realities behind

The public interest is to secure the social and economic benefits of the telephone and, increasingly, access to information services for all sectors and regions. In the late 1990's, we are no longer asking what these benefits are, but rather how can we be sure they are realized. Despite all the socio-economic studies of the last two decades demonstrating how beneficial - and essential - telecommunications services are to rural economies and to economic growth, the benefits of the telephone are largely non-existent, seriously diminished, or experienced very unevenly if either of the following conditions apply:

• the public infrastructure hasn't reached the majority of rural communities; or
• plans have been made, aid agencies have financed projects, but implementation lags, operator motivation and support is low and service availability is disappointing.

If the first condition is not universally true, the second one is all too common. The important factor to remember is that the socio-economic benefits from telecommunications, just like revenues, are primarily call dependent. For every call made, the user pays a fee and also derives a "consumer surplus" - an economic benefit in the form of cost savings over other ways of communicating, or a social or economic benefit from new opportunities and "connectedness" not enjoyed before.

But if the service is poor, calls are fewer than they could be and operator revenues do not reach potential. The likelihood of financial loss increases, while at the same time the social and economic impact goes largely unrealized, or at least is sub-optimal. Rural telecommunications have endured this unfortunate cycle for too long. They have been labelled as unprofitable and given subsidies, while the organizations responsible to mobilize the subsidized resources have been insufficiently motivated to optimize either their network designs or their operational modalities: "High costs ... low revenues ... financial losses ... subsidies". This rationale has kept rural telecommunications from being operated either profitably or beneficially for too long. Thus, a valid policy objective is learning how to deploy rural services in such a way that they are fully available to the user and recognized as valuable to the investor.

Looking at the positive experience to date

Some of the policy tools which have been used to date to wring rural investment out of the sector reform process or to entice privatized investors into the rural market include the following:

Are these examples all successful and what difference are they making to the status of the rural telecom infrastructure? By and large, they all represent important initiatives, or stepping stones to better rural service. They can be classified into two broad categories as follows:

Enforced internal cross-subsidization

When monopoly operators or concession holders are forced or enticed to provide a minimum level of rural access or to include a certain percentage of rural lines in their build programme they are, in the eyes of many, being required to absorb and "bury" a loss-making component into their programme. Although telephones are deployed, the service may not necessarily be operated in a commercially optimal fashion if it is perceived to be unprofitable.

In the Latin American "monopoly obligation" cases, national or regional monopolies were essentially expected to pay for their privileged status. They were vital, laudable and very significant requirements, although probably looked upon by the operators as costly but acceptable payments for being able to enjoy national or regional monopoly status for the initial period. The Indian new entrants, the Indonesia KSO operators and the Philippine cellular operators are also required to serve rural areas. Their obligations are another form of enforced cross-subsidization.

The cross-subsidization concept has, of course, provided significant improvements in rural access, though one major limitation is that the obligations may reach the commercially most attractive communities at the expense of leaving the most challenging cases still to be served by other means. In Mexico, the obligations have brought service to more than 20 000 new communities with populations above 500, but there are perhaps 100 000 more communities with lower populations which are still beyond the reach of the existing infrastructure. Similar proportions between served and unserved communities still exist or will remain in Peru and elsewhere in Latin America. The Asian experience (e.g., the Philippines and Indonesia) will most likely have comparable results, while the experience is similar with publicly owned operators which are required to cross-subsidize (e.g., Thailand). On the other hand, Malaysia Telekom is probably carrying out the most aggressive cross-subsidization programme in Asia today, with targets to reach a penetration of 20 lines per 100 rural inhabitants and to provide access to every village by year 2000.

Another problem with most internal cross-subsidization strategies is that little attention may be given to optimizing the operational performance and revenue generating capacity of the rural services. While the operator may have few incentives to optimize the service because other parts of the network provide more lucrative returns, a growing body of data from around the world indicates surprising revenue potential from well operated rural systems, including substantial incoming revenues (from rural to urban calls) which usually go largely unrecognized in the financial reckoning.

Finally, the internal cross-subsidization model may not provide much preparation for the operation of rural services in a multioperator or competitive environment. Mexican authorities appear to be undecided, as yet, on what obligations can reasonably be placed on new competitive basic service entrants, in order to leverage the next stage of sector reform for the benefit of rural areas.

Special rural operators

In several cases - notably in Bangladesh, Czech Republic, Poland, Venezuela, Peru and, in the future, some African countries - policy makers are taking a different, or complementary, approach by licensing operators who will focus primarily on the rural market.

In these cases, the policy environment and terms of interconnection between the predominantly rural operators and the national or urban-based operators is much more critical. The key issues of relative costs and revenues, revenue sharing, and the nature and size of the mutual benefits from both-way call traffic, have to be considered more thoroughly than in the internal cross-subsidization case.

In Bangladesh, a country with less challenging geography and demography for telephone supply than much of Latin America, two special regional operators are, between them, charged with serving more than 400 rural districts and most of the country's 68 000 villages. No special financing has been made available, though the degree of freedom given to the operators ensures that commercial returns are achievable. The companies can decide for themselves how they approach their task, so long as they cover all of the country's districts and meet the expressed demand for both private lines and community public telephones. To date, only one of the two operators has made major progress. A hindrance to growth initially was problems with negotiation of the terms of interconnect and revenue sharing with BTTB, the public sector carrier. Whereas the first of the two companies at least has focused mostly on "high revenue" business and institutional lines, it has made significant progress with creation of a rural infrastructure which can facilitate community access through public payphone businesses as well.

In Venezuela and Peru, the second stage of the rural expansion strategy is based on competition amongst would-be operators to serve the small communities which lie outside of the main operators' obligations. In Peru, the competition may result in licensing of a single rural operator, drawing on financial assistance from the FITEL telecommunications development fund. Chile also offers finance for rural service provision from a telecommunications development fund.

In the Czech Republic and Hungary, monopoly licenses have been granted to a number of private operators to serve predominantly small town and rural areas not included within the national operators' respective mandates. In Poland, fifty of the companies licensed to compete regionally and locally with TPSA have predominantly rural service areas, however construction progress is slow because of difficulties in negotiating commercially acceptable revenue sharing and interconnection arrangements with TPSA.

Facing the issues for special rural operators

The licensing of telecom operators which specialize or focus on rural areas carries both unique opportunities for meeting social objectives creatively and significant perils.

The opportunities are as follows:

• the operators are, in principle, motivated primarily by the commercial rewards of rural service provision and their interests are thus to meet the communication needs of rural areas;
• the operators have to learn to serve the market well, to optimize their services, and to survive commercially in the rural environment; and
• if the operators are successful, they can sustain their own growth and develop the market.

The perils, or risks, are related to the following questions:

• what are the limits of commercial service provision? i.e., does commercial viability exist within the rural market to operate profitably and meet the government's reasonable service and access targets?
• on what basis will private investors be interested, as compared to opportunities they might have elsewhere in the telecom sector?
• are policy makers bold enough to create a sufficiently supportive licensing, regulatory and financial environment for rural operators to thrive and grow?

The remainder of this paper will look at the evidence and address these issues. The experience thus far provides mixed signals, but this may be largely because the fundamental policy issues are still only being addressed partially.

Bringing public and private together

As noted previously, because the socio-economic benefits flow from the calls which are made, they can be optimized by maximizing call revenues. In general, it is recognized that medium and large sized businesses and institutions can usually afford private telephone lines and derive significant economic benefit from their use, and increasingly also from information based telecommunications services.

Very small businesses, farmers and individuals in low income groups also derive significant benefits from the telephone on a call-by-call basis, even though they may not be able to afford their own private line and would not therefore derive a net benefit if they had to pay the requisite line rental fee.

It follows that a carefully constructed rural expansion programme which blends relatively "high revenue" business and institutional lines with publicly accessible telephone and information facilities will be most likely to maximize both the financial returns and socio-economic benefits from the investment. In small communities, the most effective commercial arrangement for public call offices or payphones will be for the lines to be operated as franchises or "phone shops". This usually ensures a level of responsibility, accountability and incentive which will maximize service availability to the public. The most attractive scenario for many smaller villages may be for the telephone to be operated by an existing business, since the income from commissions may not at first offer sufficient revenue for a stand-alone business. However, the emergence of innovative "tele-access enterprises" or multipurpose businesses which incorporate a telephone and other communication and office devices is now beginning to set a trend.

Policy makers should encourage tele-access business to emerge. Aid agencies could offer small scale development grants or micro-loans specifically to encourage community level tele-enterprises and to promote additional investment in access applications such as fax, computer and modem equipment, e-mail and other services. Wireless PBX, voice mail, paging, and "virtual telephone" service (where callers can make pre-paid calls and access voice mail from any phone using their own PIN) are some of the concepts which are already emerging as ways of maximizing line revenues and increasing user participation in low/medium income communities.

How much total revenue is available?

Countries spend between 1 and 3 percent of gross domestic product on telecommunication services. This is a more important guide than penetration for rural service provision. People, businesses and communities at all income levels are willing to commit a measurable proportion of their total resources to telephone use. They are at a social and economic disadvantage if they don't. It is therefore in the public interest to encourage the telecommunications market in every region to reach its potential size as soon as possible. As shown by the following graph, countries in the Americas average higher than Asia, Africa and Europe, though all regions are every year increasing the relative amount spent on telecommunications.

Percentage of GDP spent on basic telecommunication services

Rural areas often approximate the national level of expenditure relative to their total income, while some will exceed it because of the high cost of alternative forms of communications. Patterns of trade, services, education, mobility and other communication trends influence the level of need. Hence, with consideration and analysis of the factors which give rise to telecommunication demand, rural communities and regions may be viewed as telecommunications markets representing at least 1 to 2 percent of their gross income.

The affordable level of telecommunications supply can thus be derived from a careful balancing of the total regional market available, the level of access to be provided to the whole community, and the costs per line. Even where access is limited to a single payphone, or a minimal combination of business lines, public telephones and virtual telephone services, a large proportion of a community's revenue potential can be secured if the service provider is sensitive to the cultural and commercial factors which limit or develop the market. Where the potential revenue is not reached, this is usually due less to lack of demand than to a poor level of community access.

Defining the commercial opportunity

The typical cost/revenue situation for many rural areas is illustrated below. Whereas the first lines in remote areas may be unviable or need to be financed under special provisions because of their high cost, a well-planned wide-area supply strategy using the most appropriate technology can often reduce per-line costs to the point where the potential revenues from supplying a limited number of subscribers in each community exceed costs. Profitability can thus exist if the operator focuses on high revenue lines first, and expands service only as marginal costs and revenues allow.

Both the average annual cost of supply and per-line revenue decrease rapidly with the quantity of lines supplied. Hence, a careful balance between demand and supply must be maintained. The cross-over from profit to loss can occur at annual revenues anywhere between US$400 and US$1 500+ per line, depending on income level, population density, terrain, and the resulting capital and operating costs. The revenue line (effectively a form of demand curve) will flatten and move to the right with time as the rural economy and telephone usage grow. Since capital costs are also reducing with time, the profitability zone is expanding and the operator is able to invest in providing service to more and more marginal customers over time, in order to sustain growth and maximize revenue. A motivated operator will seek to serve as much demand as possible.

Policies which could expand the envelope

It was noted that the profitability zone is expanding as costs reduce and people's use of the telephone increases. However, policy strategists are also able to use various forms of intervention to enable rural operators to develop a more positive business case for higher penetration/access levels (e.g., to serve smaller communities or lower revenue subscribers) than would otherwise be viable. The mechanisms could include one or a combination of:

• fiscal and tax incentives;
• import duty relief, based on technology related criteria (e.g., wireless spectrum efficiency);
• differential tariffs (e.g., freedom to charge higher connection fees for initial business and institutional subscribers);
• asymmetric interconnect or toll revenue sharing arrangements with urban based operators;
• "universal service fund" transfers from highly profitable or low cost to high cost operators; and
• soft loan, development funding or other criteria-based financial mechanisms.

For any of these schemes to work effectively, the regulatory body and prospective operators need to be able to assess the cost and revenue situation accurately in order to negotiate suitable licensing terms, conditions and resource flows. The primary policy objective must be to optimize the commercial provision of rural telecommunications using mechanisms internal to the sector as much as possible, so that the administration and expansion of telecommunications fulfils its strong role as a major contributor to economic and social development without becoming a significant drain on the financial resources of the macro-economy. The sector has sufficient internal dynamism to achieve this in most cases.

The importance of interconnect agreements

If all of the income generated by new rural investments are considered, the requirement for resource injections or cross-subsidization would be significantly less than at first appears. The both-way revenues of new investments and their associated comparative costs should be a major focus of interconnect policy design. Incoming revenues are usually not considered in network investment analysis, because outgoing and incoming calls are usually approximately equal throughout the network and attributable costs are assumed to be equal. It is therefore generally not reasonable to "double count" revenues in project appraisal. However, in a multioperator environment where interconnect and revenue sharing agreements must be negotiated, there are strong reasons for looking at incoming revenues as part of the business case for incremental rural investments. The reasons are:

• urban/rural cost-causality is not equal. For urban based operators, the call traffic generated to/from new rural subscribers is usually only a small increment on top of a relatively large inter-urban traffic volume. The incremental cost for an urban based operator to originate rural-bound calls or terminate rural-to-urban calls is therefore considerably smaller than the rural operator's corresponding cost;
• many rural lines experience higher incoming traffic than outgoing, and many payphones have a high incidence of reverse-charging. This is due to urban subscribers having greater financial resources; family members who have migrated to the city often finance both-way calling between themselves and their rural relatives. Any significant imbalance needs to be accounted for;
• in rural areas which have import/export trade or a significant overseas migrant worker population, there might be heavier incoming international call traffic. This generates a positive net revenue settlement for the national or international operator which should be shared with the rural operator.

In a multioperator environment, rural operators could be compensated for their higher cost structures and for a fair proportion of their total revenue generating potential by means of an "asymmetric interconnect agreement" which establishes differential cost-based network access fees or a differential revenue sharing formula between the urban and rural operator. The rural operator should receive a higher payment for terminating incoming (urban-to-rural) traffic than the urban or national carrier receives for connecting outgoing traffic. Because this means of revenue redistribution is cost-based, it is well-suited to a liberalized environment. It has been used historically, in one form or other, in the USA, Canada and other multioperator environments. It should ideally form the basis of differential revenue sharing agreements in any multioperator environment involving rural and national or urban-based operators.

Based on cursory estimates of relative costs and traffic volumes, it is projected that an asynchronous interconnect agreement should yield approximately 30 to 40 percent additional revenues to the rural operator, compared to the usual form of revenue sharing agreement or simple "sender-keep-all" arrangement. Whereas the urban operator's share, although smaller, would still be sufficient to cover costs and provide a fair return, the rural operator's larger share would extend the commercial viability zone for rural investments by a wide margin, providing higher returns for potential investors, increased geographical reach, higher penetration levels and more optimal socio-economic impact.

Policy management

One of the main challenges for policy makers is to incorporate commercial realities into a coherent framework. Viable operations are able to attract private equity and loan finance. However, rural telecommunications provision has had a hard time because the business case has appeared to be unattractive. Rural service can be profitable within a certain envelope, though the limits of the conventional business case must be recognized. The limits will be less constraining to investment and growth if the regulatory machinery is present to:

• identify and calculate the true incremental revenues and costs attributable to a range of different rural operations (identifying both the rural and urban segments of call completion), setting appropriate and affordable access/penetration obligations accordingly;
• facilitate and monitor the interconnect agreements, revenue splitting or analytical framework (including justification for other incentives such as tax breaks, loans and development fund support) which will provide the enhanced revenue flow operators need if they are to be attracted to invest and to be viable over a wider geographic-economic envelope;
• enforce rural investment targets on monopoly operators which at least correspond to the limits justifiable on the basis of the bothway revenue analysis (i.e., the true financial flows generated).

Even in a single operator environment, operators could be required by financiers to apply a cost-causality and both-way revenue analysis to determine the true financial benefit-to-cost relationship of rural network investment. This would shift the basis for rural investments from the traditional cross-subsidization argument to one of distributing the full incremental revenues and costs and would be much more palatable to financiers, including development banks.

Whereas the provision of basic service to the most remote and low income communities and regions could still need concessional "development fund" support or cross-subsidization from the more highly profitable services, these situations should be identified and financed as required. It is important to recognize first the full extent of the commercial envelope and to create an environment which provides a non-subsidized and dynamic investment climate to the maximum extent possible.

Conclusion: the sector's responsibilities

When we consider the needs of rural areas today, the issue is not whether the telecommunications sector can compete with water, agricultural, health or education projects for aid finance. There is little need for this question to be asked, because telecommunications is a potentially healthy sector in virtually every country. With some policy boldness, the sector can meet almost all of its own service coverage challenges through a combination of creative mechanisms. In doing so, it can benefit every other sector of economic and social activity along the way, without burdening the economy for scarce resources. Demand exists, costs are reducing and innovation brings new possibilities continually. But the lowest cost, lowest risk urban and international markets will attract all of the investments unless the scales are tipped to attract investors into rural service provision. Policy makers have the opportunity and responsibility to influence the investment parameters and create an environment which is favourable to rural telecommunications.

Whether rural areas are served monopolistically or competitively, there are strong arguments for the licensing of special rural operators who will focus specifically on the needs of rural communities. On balance, this is most likely to create a responsive mode of service. In cases where the blend of costs, calling pattern and preferred tariff structure do not allow profitability on a strictly rural basis, regional operators having within their territory both urban and adjacent rural markets can be viable so long as the terms of the interconnect agreement with the national carriers are fair.

In order to assist with attracting and channelling investments into rural areas on a priority basis, policy makers can also use the prize of future market opportunities (in basic or value added services) as an enticement. For example, the offering of rural operating licenses or concessions as a means of enabling foreign operators to gain a foothold into the basic services market prior to expiry of the dominant national operator's monopoly would provide a means for them to position themselves for more profitable ventures further on.

All operators should have clear obligations to meet, and should be offered carefully crafted interconnect agreements and incentives which facilitate commercial viability and, wherever possible, long term market sustainability. If this can be achieved, then rural and remote telecom investments could accelerate significantly.