Application of real options theory to TELRIC models: real trouble or red herring

Abstract

Since the inception of policy debates on opening local markets to competition, the incumbent local exchange carriers (ILECs) have argued against any costing methodology that would erode their monopoly level of revenue and profits. Real options issues were introduced to this debate at a time when the FCC was considering adopting TELRIC models to set rates for interconnection to the local exchange. The ILECs’ goal was to use these real options issues to undermine the credibility of the TELRIC methodology, leaving the FCC with no choice but to rely on embedded costs.

Although the theoretical issues raised by real options are legitimate and intriguing, they do not apply to the case at hand. The competitors’ use of the local network does not expose the ILECs to more risk than the typical customer. Customers of the ILECs have always had the option to use or not use the ILECs’ network, and the ILECs have never imposed a premium for option values on those customers. Indeed, the customers that imposed the greatest risk on the ILECs — the Centrex customers — frequently paid the lowest rates.

An attempt to measure the upper bound of the option value effect also shows that the ILECs will be fully compensated for the use of their network when prices are set at the levels estimated by the TELRIC models. The risk to the ILECs of a failure to recover the costs of sunk investments is greatest for portions of the local loop plant. Yet, this plant is shown to exhibit very large economies of scale, and the ILECs’ option to build a smaller-scale network is essentially valueless. The conditions that would render the real options theory as a killer critique of the use of the TELRIC models simply do not exist.