Lately I'm reading up on the new Telecommunications Act. Last week I printed a copy from the Internet and stuffed it in my briefcase. Each night on the train I give it a go and skim a few sections.

The new law unabashedly favors competition over regulation, but appoints state commissions (PUCs) to certify when that competition may be deemed effective enough to open markets. Thus, the PUCs will take at least one last shot at managing markets before they relax regulation for competitive services.

But what if this "relaxation" actually makes some rates higher (em to the advantage of the incumbent, which still exerts monopoly power? That result sounds counterintuitive, but read on.

The Incentive

Back in 1989, the California Public Utilities Commission (CPUC) imposed a "new regulatory framework" for incentive pricing for Pacific Bell and GTE California, the state's largest local exchange telephone carriers (LECs). As the plan evolved it imposed price caps, allowing rates to float as long as they did not exceed a price ceiling. The CPUC would adjust the ceiling periodically for inflation and other factors. Also, the CPUC would offset inflation by productivity gains in telecommunications. In essence, the productivity offset served as the ratepayer's friend. As new technology shaved costs, rising productivity would protect ratepayers from inflation-driven price hikes. The CPUC tabbed this offset the X Factor.

Meanwhile, growing competition took a bite out of LEC earnings. Competitive access providers (CAPs) siphoned off some business traffic. Cellular boomed. Market barriers fell for intraLATA toll. Finally, in July 1995, the CPUC announced it would open up the PacBell and GTE local calling areas to other facilities-based carriers, starting in January 1996. Reseller competition would follow by March. Other small and mid-sized LECs would face local competition in 1997. Then President Clinton signed the Telecommunications Act of 1996.

But timing is everything. Now, and during the transition that will come, the incumbent LECs find themselves engaged simultaneously in competitive and captive markets. Keeping both ends honest remains a full-time job for the state PUCs.

That Worked So Well

Last Winter, on December 20 (the date of its final order in the "Blue Book" electric restructuring case), the CPUC killed off the X Factor. No longer would productivity gains offset inflation in setting the price ceiling for LECs. The reason? The X Factor was working too well.

The productivity rate had grown to exceed inflation. The X Factor was driving rates down for local telephone services (em so far down, in fact, that the CPUC felt it threatened PacBell: "We conclude that in an era in which the price cap formula is producing price reductions, the resulting declines in revenues can jeopardize a firm's ability to finance capital investments."

In fact, PacBell and GTE offered evidence of losses in market share in the intraLATA toll market during the first six months of 1995 (6 percent for PacBell; 7.5 percent for GTE). The CPUC proved receptive: "It is clear that the market share loss in California is both extraordinary and unprecedented. ... [I]t took at least three years for GTE to lose the cited levels of traffic in Texas and Florida."

Other evidence (though disputed, see below) showed that PacBell's return on equity was falling during the first half of 1995. The CPUC found that PacBell's revenues grew at a 2.8-percent compound annual rate from 1984 to 1989 (before the price cap), but only 0.2 percent for 1990-94 (when the price cap and the X Factor held sway).

The CPUC even questioned the worth of productivity: "The forced reductions lock the LECs into a constricting internal cost constraint." And although PacBell had cut its workforce, the CPUC voiced second thoughts: "The record shows that Pacific had 13,915 fewer employees at the end of 1994 than at the beginning of incentive regulation (em a reduction of over 20 percent ... [We] wonder whether such reductions in labor force [can] continue without threatening the state's infrastructuring of skilled workers."

The CPUC found support from the Communications Workers of America: "[T]he efficient competitor will just as directly threaten the security of our jobs as does the productivity factor."

It Had to Go

On the day it killed the X Factor, the CPUC set interim rules for facilities-based carriers to compete for local calls. Two months later, it certified 59 resellers to compete against PacBell and GTE in the local market (see, Decision 95-12-056, Dec. 20, 1995; Decision 96-02-072, Feb. 23, 1996). Yet the CPUC's earlier price-cap case acknowledged no proof of effective local competition. That perception of a phantom competition led the CPUC to relax regulation (lifting the X Factor), opening the door for PacBell or GTE to keep local rates high.

One clue to the CPUC's motive may be gleaned from testimony offered by the U.S. Department of Defense (among other federal agencies), which intervened in favor of retaining the X Factor: "The DOD sympathizes with the ... 'double hit' ... from having to reduce prices for competitive services in the face of growing competition, and then also having to reduce overall prices in response to the price cap."

To learn more, I talked with Regina Costa, a telecommunications analyst at TURN (Toward Utility Rate Normalization, a ratepayer advocacy group from San Francisco), and with Jerry Kimata, a spokesman for Pacific Bell.

Kimata emphasized the recent CPUC decisions allowing resale and facilities-based competitors to enter the local market in California. "Competition is here," says Kimata. "It's not appropriate that PacBell should be forced to lower its prices just as competition is entering the market."

Kimata adds that PacBell's local residential rates are already very low, "among the lowest in the country." He points to the CPUC's order of March 13, setting rates for bundled local exchange service sold by PacBell to resellers. Kimata says that commissioners Henry Duque and Josiah Neeper dissented over the 10-percent discount on bundled residential local service sold at wholesale to resellers, arguing that PacBell already priced its retail service below cost.

Back at TURN, Regina Costa faults the evidence for killing the X Factor. Costa claims that the proposed decision issued by Administrative Law Judge Jacqueline Reed not only found no reliable evidence of local competition, but cited errors in data that PacBell witness Dr. Laurits Christensen presented on market-share erosion and revenue-loss comparison with other LECs. (PacBell's cellular spinoff made these comparisons invalid, says Costa.)

In fact, Costa "couldn't think" of a single major telecommunications player in California that did not oppose the PUC's move to kill the X Factor. She noted that MCI, Sprint, AT&T, Time-Warner, large users, and even cable television firms had all joined with TURN to save the X Factor.

"You cannot act as if these guys are facing competition," says Costa. "Even the cable television guys don't like this decision."

Editor

Articles found on this page are available to Internet subscribers only. For more information about obtaining a username and password, please call our Customer Service Department at 1-800-368-5001.