TWO YEARS HAVE ELAPSED SINCE CONGRESS PASSED THE Telecommunications Act of 1996 to "provide a pro-competitive, de-regulatory national policy framework designed to accelerate rapidly private sector deployment of advanced telecommunications and information technologies and services to all Americans." %n1%n
Today, however, telephone deregulation has reached an impasse. Few customers enjoy competitive alternatives for local exchange service. Concentration in long-distance markets appears to be increasing.
At its core, the Act still offers its quid pro quo - the Regional Bell Operating Companies would gain interLATA authority (for long-distance service) by allowing entry into their local markets. Nevertheless, that trade has not proven attractive enough to force open the local exchange. The two sets of players, the RBOCs and the interexchange carriers, have fallen into a war of words. Each side (and its paid experts) blames the other for the stalemate that has arisen.
So far, the RBOCs could count themselves fortunate to have found a sympathetic ear at the Eighth Circuit Court in St. Louis in their appeal of the Federal Communications Commission's local exchange market rules, which would have placed competition on a fast track. %n2%n However, the U.S. Supreme Court may not prove so obliging. Recently, it agreed to hear the appeal filed by the FCC and the IXCs challenging the eighth circuit's ruling. %n3%n The FCC's local competition rules may yet rise from the ashes.
The Supreme Court has scheduled arguments for fall 1998, but that may not be soon enough for some. In any case, the potential reincarnation of telephone competition cannot occur at least until sometime in 1999. Given the gridlock, observers have suggested another way out: Divest the RBOCs of their network assets.
Would a second divestiture bear fruit? Many problems have arisen in carrying out the Telecommunications Act. More would arise with a second breakup, as illustrated here in the context of a concrete proposal filed recently at the FCC to separate each RBOC into two business units - a network company to own the lines and a retailer to sell calling services to customers. A forced divestiture might lead only to a rate rebalancing that could boost rates for residential callers while trimming charges for businesses. The broader question remains: Can the telecommunications industry move forward with real technological change that might bring benefits to customers beyond a mere reallocation of current costs?
The Proposal:
"Dismantle the RBOCs"
The Telecommunications Act created a conflict for RBOCs by making them sellers of both wholesale inputs and retail service. However, given that corporate management holds a fiduciary duty to shareholders, it should come as no surprise that the RBOCs have showed a reluctance to forego the large profit margins earned from retail business service to become low-margin sellers of network inputs.
Dividing RBOCs into two business units - one to sell inputs, the other to provide retail service - could eliminate this conflict of interest. Such a separation, in theory, would result in one business unit (the network provider) selling inputs on a wholesale basis to all retail service providers that need unbundled inputs to provide services. The network provider would deal at arm's-length, on a nondiscriminatory basis with the RBOC's retail provider. Rochester Telephone in New York (now Frontier Communications) %n4%n and Southern New England Telephone in Connecticut have pursued such a restructuring. %n5%n
These are the ideas that lie behind a recent proposal by LCI International Telecom Corp. to split the operations of the RBOCs into units that, because of their structural separation, would neutralize the conflict of interest that haunts the 1996 Act. However, the LCI plan does not solve all problems and may introduce a few more.
On Jan. 22, LCI petitioned the FCC for an expedited declaratory ruling that would offer RBOCs "fast track" approval for entry into the in-region interLATA long distance market if they divest their retail local exchange business into two separate subsidiaries within the holding company. LCI deemed these subsidiaries "ServeCo" and "NetCo." %n6%n ServeCo would offer retail services alongside any other competitive LEC. NetCo would be a wholesale provider of unbundled network elements. LCI's proposal includes balloting for the customer's primary choice local service provider. This balloting would be similar to the process that took place after the AT&T monopoly was divested. %n7%n
The LCI proposal requires that the ServeCo, while potentially remaining a subsidiary of the RBOC, must establish "substantial public ownership" of 40 percent or more. %n8%n This outside ownership would, according to LCI, lead to management responsibility to sources other than the holding company. This ServeCo would compete in retail markets while pricing "its retail offerings to reflect the actual prices of the inputs it obtains from NetCo, and demand the best prices and quality for network inputs from NetCo." %n9%n
The LCI proposal would leave NetCo bound by the pricing provisions of the Act as NetCo would remain an incumbent local exchange carrier.
LCI's proposal would potentially avoid legal implementation problems by making the "fast track" optional to the RBOCs. Whether any RBOC would voluntarily adopt such an approach is unknown. However, given recent activity by a federal district court concerning the legality of the Act's exclusion of RBOCs from the interLATA business, a policy of watchful waiting might suit RBOCs best. %n10%n
The Result: Another Monopoly
LCI's plan serves as an admission that economies of scale in the local exchange market remain too pervasive to allow for meaningful facilities-based local competition. Yet under its plan, NetCo would remain a monopoly and would have no incentive to move its prices toward cost or to invest in new technologies. %n11%n NetCo would require regulation of prices, service quality and infrastructure investment and deployment, introducing five distinct problems.
First, technology deployment would become more complicated in the environment envisioned by LCI's "divestiture." Infrastructure deployment might require a higher level of regulation with NetCo than with today's RBOCs, which have market incentives to invest in new technology and offer new services. New services have received more lenient regulatory treatment by regulators and thus offer the potential for increased profit margins. %n12%n
This link would be broken with the structural separation of the network facilities and service providers and would require regulatory oversight of conflicts that would likely arise.
For example, if new switching technology were offered by switch manufacturers that introduced new calling services, the customers of NetCo (i.e., ServeCo and other retail providers) would need to convince NetCo to make the necessary investments to deploy this technology. Regulators might need to decide whether the deployment was justified and who should bear the risk of the deployment (i.e., NetCo or the retail providers). A regulatory requirement for NetCo to offer the new technology at "economic cost" might not be sufficient to induce investment from NetCo's shareholders. Thus the regulator would need to select compensatory wholesale pricing, which in turn would affect the ability of the retail providers to experiment in pricing the new service.
Given its continuing monopoly position, NetCo might also force unwanted (or unmarketable) technology on its customers (i.e., the retail providers). NetCo might use technology in its network in a way that proves most profitable. Through its monopoly position, it could then try to force the retail customers to purchase unwanted network upgrades. %n13%n
Second, national pricing standards would not govern prices for unbundled network elements offered by NetCo under LCI's plan. Rather, states would continue to have jurisdiction over these prices (absent action by the U.S. Supreme Court that might reinstate the FCC's local competition rules). Thus, the development of local competition may still be subject to a quilt of regulation that leads to an uneven development of local competition nationwide.
Third, LCI's proposal would introduce "rate rebalancing" between residential and business rates. The plan would require NetCo to offer unbundled network elements at "economic cost." Economic cost studies do not distinguish between business and residential customers. Thus the cost structure of the retail service provider (i.e., NetCo's input prices) would provide pressure for a "balanced" rate structure between business and residential rates. LCI suggests that the retail providers would not be subject to regulation. %n14%n
Unregulated retail providers could introduce "rate shock" for many residential customers. LCI's proposal would also require that issues relating to subsidizing universal service to either high-cost areas or to low-income customers be established and functional before the transition to an unregulated retail service environment.
Fourth, LCI's proposal ultimately does not compel the desired behavior from the RBOCs. The RBOCs would not have to accept the optional fast track. AT&T's divestiture was successful only because it voluntarily agreed to strip itself of its BOC assets. Absent some mechanism to force the RBOCs to break up their retail operations into a network provider and retail service provider, it may be a long wait. %n15%n
Fifth, easy access to, and reliance on, NetCo's facilities would not encourage deployment of alternative network infrastructure. Competition on a resale basis in the local exchange will not offer the benefits of facilities-based competition. This imbalance would exist regardless of whether retail providers are reselling the services of an integrated RBOC or of a NetCo as proposed by LCI.
The Question:
More Sellers or More Lines?
What would have happened to the long-distance industry if competition had been on a pure resale basis? Competitors depending solely on AT&T would not have offered innovative technology, such as the emphasis on fiber optics pursued by Sprint and then emulated by all other carriers. Also, innovative billing, such as MCI's "Friends and Family" would have been more difficult to set up if MCI had not controlled its own network facilities and had instead relied on AT&T's.
Resale-based local exchange competition will not offer customers the benefits of facilities-based competition for similar reasons. This lack of facilities-based competition points to a major difference between development of competition in long-distance and local exchange markets. In the long-distance industry, new technology (microwave transmission) lessened economies of scale enjoyed by the incumbent AT&T. MCI was leading regulation in its efforts in both the private line and message toll service markets. MCI had the network facilities deployed and was ready to offer the services before regulatory approval was granted. %n16%n
On the other hand, in the local market, regulation is being asked to find a solution to a technological problem. Outside high-density urban areas, no evidence exists of alternative technology deployment in the local exchange. Competitors (and incumbent RBOCs) have asked regulators (and legislative bodies) for help in overcoming the technological barrier by unbundling incumbent networks. Congress obliged with the Telecommunications Act, which superimposes a regulatory framework over a market that is not technologically ready for competition. If competition will continue to depend on the facilities of the incumbent LEC, either on an integrated or NetCo basis, local competition will not lead to significant downward pressure on prices because the underlying technology will be similar for all providers.
Simply put, a second divestiture to correct the perceived deficiencies of the post-Act environment does not appear to offer a means of achieving the benefits of competition anticipated by Congress when it passed the 1996 legislation.
The issue of rate rebalancing remains a particularly thorny question for the states. If raising residential rates and lowering business rates was the ultimate goal of Congress, it could have achieved this outcome much more directly simply by legislating its own rate rebalancing. By contrast, competition should bring tangible benefits (read "lower prices") to all customers. Raising residential rates to encourage "resale" competition is undesirable as public policy.
Granted, if it were mandated for the RBOCs, LCI's proposal for a divestiture of assets would likely increase the pace of local exchange choice, especially for residential customers. However this divestiture plan might lead only to a rate rebalancing that could boost rates for residential callers while trimming charges for business. And the price paid by residential customers for the ability to choose between local carriers may be high if rate rebalancing results.
Until technology allows for the delivery of local service in a way that is better and cheaper than that currently available from incumbent LECs, most local exchange customers will not see the benefits that Congress hoped the Telecommunications Act would deliver.
Trevor R. Roycroft, Ph.D., is assistant professor at the J. Warren McClure School of Communication Systems Management at Ohio University.
1 Peter W. Huber, Michael K. Kellog, and John Thorne, "Joint Explanatory of the Committee of Conference" in the Telecommunications Act of 1996 - Special Report, 1996 (p. 277).
2 Seth Schiesel, "Court Sets Back F.C.C. Efforts to Open Local Phone Markets," New York Times, July 19, 1997.
3 "Supreme Court to Hear Petitions on FCC's Interconnection Order," Telecommunications Reports, TR Daily, Jan. 26, 1998.
4 "Rochester Tel Debuts 'Frontier' Corporate Identity," Telecommunications Reports, Oct. 24, 1994.
5 "Connecticut DPUC OKs SNET Restructure Plan," Telecommunications Reports, TR Daily, June 25, 1997.
6 In the Matter of: Petition for Expedited Declaratory Ruling, Petition of LCI International Telecom for Expedited Declaratory Rulings. Filed at the FCC Jan. 22, 1998, p. 3.
7 LCI petition, p. 29.
8 LCI petition, p. 28.
9 LCI petition, p. 28.
10 SBC Communications Inc. (formerly known as Southwest Bell) filed a motion for summary judgement with a federal district court July 1997 seeking relief from the Act on the grounds it discriminates against RBOCs. A favorable ruling in this case would gut the quid pro quo by immediately allowing RBOC interLATA authority. At the time of this writing, the outcome of this request is unknown. (See, "SBC's Challenge to Telecom Act Could Hinge on Ruling that Separate Treatment of Bells is Punitive," Telecommunications Reports, July 7, 1997).
11 The LCI petition, p. 32.
12 While states often retain jurisdiction over new services, they are likely to treat these services as "discretionary" and to allow for large margins. For example, the cost of providing call waiting or caller ID is typically a few cents per month. These services are often priced (with regulatory blessing) with mark-ups of several thousand percent.
13 This possibility is further complicated by the Act's enabling of the RBOCs to re-enter the equipment manufacturing business. The Act does require that the RBOCs establish a separate subsidiary for equipment manufacturing, however, the potential NetCo and the potential "EquipCo" would remain wholly owned subsidiaries of the RBOC. 47 C.F.R. ยง273(d)(3).
14 LCI petition, p. 21.
15 Initial RBOC response to LCI's "fast track" proposal has been negative. See, "BOCs Say LCI's 'Fast Track' Plan Conflicts with Act," Telecommunications Reports, TR Daily, March 24, 1998.
16 See, Gerald R. Faulhaber, Telecommunications in Turmoil: Technology and Public Policy, 1987.
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