Regulatory Politics as Usual

The Federal Communications Commission's long-delayed 3-2 decision of February 20th, purporting to resolve the critical outstanding issues about the obligations of the incumbent local telephone companies (ILECs)--primarily, the Bells--to facilitate the entry of competitors (CLECs), is in one major respect an important reform. Its exemption from regulation and the obligation to share with competitors their costly and risky investments in extending fiber to the home or neighborhood makes excellent sense. These investments, typically in direct competition with the market-leading TV cable, as well as wireless, companies, which are subject to no such obligation, must surely have been discouraged by mandatory sharing--particularly at the FCC's prescribed hypothetical minimum costs.

In another extremely important respect, however, the decision is an abomination, purely political in the worst sense of the term and grounded in neither good economics nor honorable regulatory practice. The one safe prediction is that it will turn out to have resolved little or nothing.1

The Definition and Pricing of Unbundled Network Elements (UNEs)

The blatantly political and unprincipled part of the Decision was to surrender to the states the Commission's statutory responsibility for defining the unbundled network elements (UNEs) of the incumbent companies' systems that they are required to lease to would-be competitors, guaranteeing years and years of additional litigation and regulatory uncertainty.

It is only fair to disclose that my first objection to the UNE-P was aesthetic: "unbundled network elements" combined into a single bundle is an oxymoron.

Shortly after passage of the 1996 Telecommunications Act, an activist FCC--eager to produce quick results in the form of visible competitors and visible rate reductions--proceeded directly to prescribe extremely detailed requirements of the incumbents to make available to competitors essentially every element of their networks at prices conforming with a startlingly novel standard--the lowest costs (with an important exception) achievable by a hypothetical, ideally efficient new entrant. As I had explained in my Economics of Regulation in 1970, that pricing standard was economically incorrect, unless accompanied by extraordinarily high rates of return. It was also dishonorably opportunistic, because it deprived these companies of their previous opportunity to recover their historically incurred costs and dramatically reduced the rate caps that the majority of state commissions had imposed on them only a few years before--ceilings that already incorporated mandated annual reductions averaging about 2.5 percent, reflecting productivity improvements believed to be achievable. Some of the wholesale prices of telephone services now in effect prescribed by the combined charges for the unbundled elements set in compliance with the FCC's instructions called for immediate reductions that would have taken over 20 years to be reached under those ceilings.

The major objectionable consequence of the Commission's new pricing prescription was that no competitor could be expected to construct its own facilities--concededly on all sides the most important and effective competition hoped for--if it could free-ride on the facilities of the incumbents at, by design, the lowest possible costs achievable by an ideally efficient entrant. It would be difficult to imagine an arrangement more hostile to the risky and costly investments in modern telecommunications infrastructure and the development of the new products and services that it makes possible.

How, then, can we explain the tens of billions of dollars that competitors actually did invest annually in constructing their own fiber-ring communication networks in the center of every substantial metropolitan area in the country, serving roughly 23 million local lines? The answer is that these facilities were in their origin the means by which long-distance carriers were able to escape the fees--far above cost--that regulators historically forced the incumbent local exchange carriers (ILECs) to charge them for access to their customers for initiating and receiving calls, using the proceeds to subsidize residential rates. These competitive access facilities then became the basis for the competitive local exchange companies (CLECs) providing the entire range of telephone services, typically to large business users, whose retail rates were likewise systematically set by regulators far above cost in order to subsidize basic residential service--essentially mere cream-skimming of regulatorily-distorted rates. Of the estimated 16 to 23 million lines they serve using their own switches, only 3 million or so are residential. The rate distortions are reflected, correspondingly, in the numbers of customers they serve through mere resales or rebranding of the services actually supplied by the incumbents. Competitive local telephone companies serve approximately 30 percent of all business lines today but only about 9 percent of residential lines, and of that 9 percent almost two-thirds involved no investment on their part in the actual production of the services--that is, they were supplied at wholesale exclusively with ILEC facilities.

This ridiculous policy reached its nadir around 1999 as the FCC confirmed the obligations of the ILECs to include among their "unbundled" elements subject to mandatory provision to competitors at those hypothetical minimum costs the so-called "platform," or UNE-P--the entire combination of network elements (switches and transport facilities) necessary to produce the services, with the "competitor" then having the right to market them to retail customers under its own brand.

It is only fair to disclose that my first objection to the UNE-P was aesthetic: "unbundled network elements" combined into a single bundle is an oxymoron.

More substantively: the consequence of the rapid increase in the use of UNE-Ps, beginning three years after passage of the 1996 Act, was actually to produce a reduction between December 2000 and June 2002 in the number of lines served by competitive local telephone carriers (leaving out the rapidly growing cable telephony) with their own facilities. Small wonder. When every applicant can be a free rider, at prices explicitly intended to recover only the minimum cost of construction, who is going to build the vehicle?

That brings us to the worst aspect of the FCC's recent decision. Six years after it required incumbents to unbundle essentially every element of their networks, at ridiculously low rates, its majority has now decided to transfer full and unreviewable authority, so far as inputs for residential and small business services are concerned, back to the state commissions, which are under even more direct and immediate political pressures than it to produce "results"--paper competitors and visible reductions in residential rates. (Of course, it will be the courts, state and federal, not the Commission that will have the final word on that intended "unreviewability.") This transfer includes the authority to continue the permissibility of UNE-Ps, without possibility of overturning by the FCC. Chairman Powell and Commissioner Abernathy, dissenting, would instead have simply abolished the UNE-P, on the unexceptionable ground that it produces the semblance of competition but not its substance.

We have already had a foretaste of the results the politically-minded new FCC majority clearly hopes to achieve, as local incumbent companies lost millions of subscribers within a space of months to such free-riding local competitors as AT&T and WorldCom. Last year the Michigan Commission cut the state's wholesale rates from about $17.50 to $14.44 per line per month. "I really don't care what form the competition takes, so long as companies are in their duking it out and fighting for customers," the Chairman was quoted as saying. Some competitors! Some "duking"!

Similarly, the California Commission last May ordered a 39 percent reduction in combined charges for loops and switching at high levels of usage from $23 to $14 a line. Also, last year, under pressure from the New York Public Service Commission, Verizon entered into a settlement that had the effect of reducing its UNE-P rate from $27.17 per line to $19.14, and the District of Columbia Commission reduced it to around $5!

A year or two ago, I published an article, "Bribing Customers to Leave and Calling it ‘Competition.'" I was referring there to the policy deliberately adopted by some states of forcing local electric utility companies to give rebates to retail customers who deserted them for competitive distributors--that is, the portions of the distribution charges that customers would escape if they left their historical retail supplier--larger than the costs that their departure would actually save those suppliers. In effect, their commissions reasoned: "we estimate that customers who desert their local utility suppliers will save it, say, 3.5 cents a kwh--the cost of the energy it will no longer have to purchase in the wholesale market in order to supply them--but we will make the company give them a ‘shopping credit' of 4.5 cents, in order to encourage them to shift." The Pennsylvania Commission, to cite the outstanding example to date, deliberately prescribed a "shopping credit" large enough to produce something like a 10 percent rate reduction for customers who shifted to competitive marketers; and one of its commissioners then boasted that as a result more customers had shifted in that state than in the entire remainder of the country. Small wonder.

Now the same thing has been happening in the telephone industry and the FCC, overriding its chairman, has left the states free to continue to do so--with the apparent approval of The New York Times, on the ground that "consumers are only now beginning to benefit" from "competition." Some competition!

Line sharing

Paradoxically--perhaps as a sop to the ILECs, perhaps as a consistent accompaniment to its split decision to relieve them of the obligation to lease to their competitors any investments they make in the installation of high-speed fiber, capable of broadband service--the Commission's recent decision rescinds the obligation of the ILECs to permit competitors to use the high-frequency capability of their ubiquitous copper customer-access lines while retaining their use for (low-frequency) voice service. The dissents of Chairman Powell and Commissioner Abernathy remind me of my recognition at the time of the FCC's original decision (in my little book, Whom the Gods Would Destroy) that this capacity of the ILECs' copper networks, exploitable at something close to zero marginal cost, would seem to be the archetypal case for mandatory sharing--a heritage of their franchised monopolies, the sharing of which would therefore not seem to involve any discouragement of future risk-taking investment. I was persuaded eventually to oppose that obligation by the FCC's own conclusion, elsewhere, that the broadband market was already effectively competitive, because of the availability of cable and wireless, so that the ability to share the copper lines of the incumbents could no longer be said to be necessary to competition, under the terms of the Act, and by the incongruity of imposing the sharing obligation on the ILECs but not on the cable companies.

The close to zero marginal cost of this particular form of access, however, would still appear to be a very large competitive advantage of the ILECs that was the product of neither superior foresight nor risky, costly innovation, and might therefore legitimately continue subject to mandatory sharing. True, making that capability of their copper lines available to CLECs at incremental costs would dilute the incentives of those competitors to construct their own broadband transport facilities, but it would do so no more than the difference in the true incremental costs of the two options would dictate: the FCC did not prescribe its hypothetical blank slate price for line sharing. True, also, it would exclude the ILECs from use of those capabilities of their own facilities, as they have complained; but it would appear to do so neither more nor less than the statutorily-mandated leasing of the low-frequency, voice capabilities of those inherited lines when a CLEC has competed successfully for a subscriber--a requirement to which, so far as I know, no ILEC has objected in principle.

My continuing uncertainty, to which I reluctantly confess, springs from the distorting effect of the imposition of mandatory line sharing on the ILECs but not on the cable companies, which have double their market share and, no less than they, enjoy the advantages of the broadband capability of their lines inherited from their franchise monopolies.

Mr. Kahn is the Robert Julius Thorne Professor of Political Economy, Emeritus, at Cornell University and a Special Consultant to NERA. He is also author of Whom the Gods Would Destroy, or How Not to Deregulate.

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