The Economics of Mobile Interconnection Rates in South Africa

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1 RESEARCH NOTE 15 NOVEMBER 29 The Economics of Mobile Interconnection Rates in South Africa Johann van Eeden (with strategic support from Africa Analysis 1 ) (johann@econex.co.za) The level of interconnection rates, specifically mobile termination rates, in South Africa has recently been highlighted with various parties, both public and private, suggesting these rates are too high and should be lowered. A parliamentary commitee suggested that the peak time interconnection rate be reduced immediately by 65c from its current level of R1.25 per minute. In addition, further cuts of 15c on the peak rate per year for the next three years have been suggested, bringing the eventual rate down to 15c per minute. ICASA and the Department of Communications (DoC) have been more restrained in their recommendations, but still proposed an immediate cut of 3c, coupled with further reductions to bring the peak time mobile interconnection rate to 6c by the end of More recently, MTN and Vodacom agreed on a reduction of 19% on the blended interconnection rate between these two mobile operators 3. This research note will firstly take a brief look at how interconnection rates are determined and their contribution to the revenue structure of the most prominent South African mobile operators. More importantly, however, we will explore whether lower mobile termination rates will neccesarily lead to an increase in the welfare of South African mobile telephony consumers, operators, or both. 1 What are Interconnection Rates and how are they Determined? Simply put, interconnection is connecting a call between two subscribers on different networks. The network with the originating call hands over the call to the other network where the call is terminated at the called subscriber. Interconnection rates are the rates charged for connecting these calls and are often referred to as mobile termination rates (MTR s) in the case of mobile telecommunication operators. In theory, the level at which these tariffs are set should reflect the true cost involved in connecting one subscriber to another subscriber on a different network. However, in practice this is not necessarily the case, both because interested parties differ as to what the true cost of interconnection is and because these costs may change over time as the market matures. This is evident in the South African case, where interconnect rates were set without the expectation that the total number of mobile subscribers would be in excess of 4 million only fifteen years after the launch of mobile services. Interconnection rates are applicable to both fixed and mobile telecommunications operators. However, the focus of this note will be on mobile interconnection rates. 1. Data and helpful comments were received from Africa Analysis, a consultancy specialising in ICT in developing markets ( 2. The recent developments in the determination of mobile interconnection rates is related to the ICASA process that dates back to The blended interconnection rate is the effective average of peak and off peak interconnection rates. The blended rate, therefore, depends on both the level of peak and off peak interconnection rates and the call volumes at these respective times. The focus of the current South African debate has, however, been on the level of the peak mobile interconnection rate. 1

2 Mobile interconnection rates are typically set on a bilateral negotiation basis between the various mobile operators. In these negotiations it is likely that operators with the highest number of subscribers will hold the most leverage, as smaller operators need access to the larger pool of mobile subscribers to make their service offering viable. These negotiations occur under the supervision of the relevant telecommunications regulator as operators are usually obliged to interconnect under their licence agreements. Figure 1: National Interconnection Revenue in Nominal Rand Millions, 23 to Rand Millions CellC MTN SA Vodacom SA 2 Contribution to Mobile Operator Revenue Total interconnection revenue is divided between national and international interconnection revenue. International interconnection revenue is earned when a subscriber of a telecommunications operator outside of South Africa makes a call to a subscriber on a South African network. National revenue is earned when the call is made between subscribers on different South African networks (for example MTN subscriber calls a Vodacom subscriber). In both cases, the level of the interconnection rate is set by way of bilateral commercial negotiation between the different operators. Of primary importance for the current South African debate is the level of national interconnection revenue. Figure 1 shows the national interconnection revenue earned by South Africa s three mobile operators (Vodacom, MTN and Cell C 4 ) between 23 and 28. In 28, national interconnection revenue for both MTN and Vodacom was in excess of 6 billion rand each, while Cell C earned more than 1.5 billion rand through national interconnection. Also evident from Figure 1 is the steady increase in interconnection revenue for all three mobile operators over the time period 5. This is directly related to the substantial growth in subscribers for all 4. Virgin Mobile is not a licensed mobile operator and is a mobile virtual network operator. Virgin only entered the SA market in the third quarter of 26 and had only approximately 25 out of a total SA mobile subsciber base of around 46 million at the end of 28. Virgin Mobile does not receive interconnect revenue as it does not have an interconnect agreement with any of the operators. Cell C pays and receives interconnect revenue for the numbers that Virgin Mobile leases from it. 5. Also of particular interest is the net interconnection payments by various mobile operators, i.e. the difference between interconnection revenue earned and interconnection revenue paid to other mobile operators. In the case of a mobile operator with a relatively small subscrib er base (such as CellC), there are likely to be net payments of interconnection fees as most calls are made to subscribers on other networks. Mobile operators with relatively large subscriber bases (such as MTN SA and Vodacom SA) are likely to receive net interconnection revenue. About ECONEX ECONEX is an economics consultancy that offers in-depth economic analysis covering competition economics, international trade, strategic analysis and regulatory work. The company was co-founded by Dr. Nicola Theron and Prof. Rachel Jafta in 25. Both these economists have a wealth of consulting experience in the fields of competition- and trade economics. They also teach courses in competition economics and international trade at the University of Stellenbosch. Our newest director, Cobus Venter, who joined the company during 28, is also a consultant economist at the Bureau for Economic Research (BER) in Stellenbosch. For more information on our services, as well as the economists and academic associates working at and with Econex, visit our website at 2

3 three, shown in Figure 2. Given that the peak mobile interconnection tariff was constant at R1.25 between 23 and 28, additional interconnect revenue had to be generated by an increase in volumes a high total number of subscribers divided between two or more mobile operators will lead to high interconnection revenue, taking as a given that off-net calls increase in proportion to the total subscriber base. Revenue is typically dependent on a mobile operator s own number of subscribers and rises as the Figure 2: Number of Mobile Subscribers/SIM cards, 23 to 28 (quarterly) Millions of Subscribers/SIM cards Q1 23Q2 23Q3 23Q4 24Q1 24Q2 24Q3 24Q4 25Q1 25Q2 25Q3 25Q4 26Q1 26Q2 26Q3 26Q4 27Q1 27Q2 27Q3 27Q4 28Q1 28Q2 28Q3 28Q4 number of calls to that network (from other networks) increases. Cell C MTN SA Vodacom SA A further interesting aspect relating to interconnection revenue is the contribution this makes to the overall revenue of a mobile operator. While nominal interconnection revenue has continued to increase in excess of inflation for all SA mobile operators, the relative contribution made to the total revenue pool of these very same operators has remained constant at around 2%. This reflects not only the total aggregate revenue growth of mobile operators in South Africa, but also their evolving revenue structure. For example, the revenue contribution made by data services (SMS and mobile broadband) increased from 4% in 23 for Cell C, MTN SA and Vodacom SA to 8% for Cell C and 11% for MTN SA and Vodacom SA in Will Lower Interconnection Rates Improve Consumer and Operator Welfare? 3.1 Composition of Mobile Call Charges A popular argument in favour of lower interconnection rates is the suggestion that this will reduce the cost of calls between mobile subscribers, thereby providing consumers with a lower priced service. At the same time producers (mobile operators) are believed to benefit by way of the increased demand stemming from lower call costs - higher call volumes coupled with lower call charges could possibly increase total revenue (the product of call volumes and call charges). While this may be the case in certain circumstances, both the producer and the consumer welfare effects depend crucially on the characteristics of the mobile market in question. An important aspect to consider in the above regard is the fact that the retail price of a mobile phone call consists of a number of elements, designed to recoup the costs incurred in providing the given mobile service. The end user retail price of a mobile phone call consists of, among other things, the call price, connection charge and the interconnection rate (when applicable). The implicit subsidy for mobile handsets is a further element incorporated in the eventual call charge. ECONEX Services ECONEX has extensive experience in competition economics, international trade and regulatory analysis. Strategic analysis was recently added as practice area. We have an established reputation for providing expert economic advice for high profile mergers and complaints that appear before the competition authorities. Some of the more recent highlights include the complaint against British American Tobacco, the merger between MTN and italk, the complaint against Senwes and the acquisition of KayaFM by Primedia. Apart from competition work we have also been involved in trade matters which included analyses of the effects of tariffs, export taxes and anti-dumping tariffs. As a result of our work in competition analysis we have extensive experience in some of the sectors of the South African economy where regulation continues to play a role, e.g. the telecommunications, health and energy sectors. We use economic knowledge of these sectors to analyse specific problems for some of the larger telecommunications, health and energy companies. 3

4 To illustrate this, Figure 3 shows the revenue structure of a mobile operator, MTN SA, for 28. While airtime and subscription revenue was by far the major contributor to revenue in the 28 financial year, both interconnection revenue and the reselling of cellular phones and accessories made substantial contributions to income earned. At the same time, the expenditure side of a mobile operator also consists of a variety of cost elements. Figure 4 uses the expenditure composition of MTN SA for 28 to illustrate this. However, an important aspect of a mobile operator s cost framework is not present in Figure 4, namely the cost of expanding network coverage. In order to expand their geographical coverage and the level of service provision, mobile operators have to continually invest in physical infrastructure. Additional strain is put on existing infrastructure both by the number of subscribers on a network at a given time, but also the nature of their activities. For example, as the demand for mobile broadband internet increases so too does the pressure on mobile operators to upgrade their existing network to provide improved access speeds and penetration by way of technologies such as HSPA (High Speed Packet Access). 3.2 The Waterbed Effect The assumption that reduced interconnection charges will necessarily result in lower call charges and gains in Figure 3: MTN SA Revenue Composition (28) 21.4% Figure 4: MTN SA Expenditure Composition (28) 29.4% 9.6%.1% 9.8% 7.% 1.8% both consumer and producer welfare has been challenged in what some have dubbed the waterbed effect. This term is used to describe a situation where pressure to reduce one element of the final retail price of mobile services may lead to an increase in the other elements and even to an increase in the final retail price. A study into the existence of the waterbed effect in 24 developed 1.6% 23.6% 67.% 19.7% Airtime and subscription revenue Interconnection revenue Connection revenue Cellular telephones and accessories Other Direct network operating costs Costs of handsets, SIMs and vouchers Interconnect and roaming costs Employee benefits and consulting costs Selling, distribution and marketing costs Other expenses (general and administration) countries found that a decrease in mobile interconnection rates lead to an increase in the final retail price of these services 6. Similar to current developments in South Africa, the European Commission (EC) published a recommendation in May 29 7, suggesting a framework that would lead to significant cuts in mobile interconnection rates under Source: MTN Annual Report 28 Source: MTN Annual Report Genakos and Valletti (28) Testing the Waterbed Effect in Mobile Telephony. CEIS Tor Vergata Research Paper Series Vol. 6, Issue 2, No European Commission (29) Commission Recommendation on the Regulatory Treatment of Fixed and Mobile Termination Rates in the EU. C(29) 3359 final, 7 May 29. More Information ECONEX regularly publishes Research Notes on various relevant issues in South African competition, trade and applied economics. For access to previous editions of Research Notes, or other research reports and published articles, go to: If you want to add your name to our mailing list, please send an to iris@econex.co.za. 4

5 the assumption that this would lead to an increase in consumer welfare. However, other reports on the matter (such as the one by Frontier Economics) show that lower interconnection rates could actually harm consumers if other charges increase as a result of loss in interconnection revenue 8. Using the costs involved in acquiring a mobile handset as an example, they show that if subsidies on handsets are reduced, then mobile penetration could decrease. The Frontier Economics report also compares the types of pricing plans applied in the US (where mobile interconnection rates have been lowered) with those in Europe and finds that while certain categories of users would be better off under a situation with lower interconnection fees, others would not 9. More specifically, low and medium mobile users would be worse off with lower interconnection rates, while users that make a high number of calls would benefit from lower interconnection rates. So, while high volume users could benefit from lower per minute charges, access could be reduced through a reduction on, for example, handset subsidies. South Africa is in some regards faced with a similar situation to that in Europe, with a high mobile penetration rate, but relatively few high volume users, as is evident from the prepaid/post paid mix of subscribers shown in Figure 5. While one should not be too quick to compare the South African mobile market with that of developed settings such as Europe or the US, it is definitely worthwhile to take note of the composition of the market in question and what this could imply Figure 5: Number of Pre- and Post paid Mobile Consumers in South Africa, 23 to 28 Number of Subscribers (millions) for the welfare of different categories of consumers when interconnection rates are lowered. Another factor to take note of in the South African context is the effect that lower total revenues may have on the expansion and upgrading of network infrastructure. This holds not only for the geographical reach of mobile networks, but also the array of services provided by these networks. 4 Conclusions and Policy Implications This research note provided a brief overview of mobile interconnection rates in South Africa in light of recent developments to have these rates significantly reduced. The contribution that these rates make to the total revenue of mobile operators as well as their relationship to the total number of subscribers in the market was highlighted. More importantly, it was shown that interconnection rates are only one element used in the determination of retail mobile prices and that a reduction in interconnection rates could lead to an increase in other elements of the final retail price of mobile telephony services. This effect is also known as the waterbed effect. If the final retail price of mobile calls is regulated to the same extent as interconnection rates, the waterbed effect could manifest itself in increased costs of, for example, acquiring a mobile handset. Another important consideration in the South African context could be the effect that a reduction in total revenue could have on the expansion and upgrading of network infrastructure. All these factors call for a thorough economic analysis of the proposed changes to mobile interconnection rates to ensure that aggregate welfare is increased rather than reduced through changes in telecommunications policy Prepaid Post paid 8. Frontier Economics (28) Assessing the Impact of Lowering Mobile Termination Rates, July Assuming that the final retail prices of mobile phone calls are reduced in proportion to a cut in interconnection rates. If final retail prices are not regulated in conjunction with interconnection rates, this is of course not a given. 5