Up, Down, Across – It’s Still Regulation

In the wake of the recent District Court of Appeals decision rejecting critical components of the FCC’s Triennial Review Order, uncertainty in the telecommunications sector has risen dramatically.(1) Those wishing to preserve the status quo—a system of open access at regulated rates—are urging an appeal to the Supreme Court, while those wishing to move towards a model of market-based competition are calling for commercial negotiations to replace the failing regime of managed competition. Adding to the confusion is a renewed interest in “layered regulation” as an alternative that seeks to promote competition and innovation while targeting regulation to limit market power. Unfortunately, this approach would continue to impose regulatory impediments that inhibit critical infrastructure investment and limit growth in the telecommunications sector.

The layered approach recognizes the failures of the existing regulatory paradigm in the face of converging technologies. In a market where voice, data, and video have converged into a more general demand for information, it makes little sense to regulate separately wireline, wireless, cable, and satellite services based upon the products they were initially established to provide. In an open market, all of these technologies will compete to provide consumers the products they demand; regulations that artificially segregate and divide markets unnecessarily restrict market activity and reduce consumer choice.

While the layered model acknowledges the problem of regulating cutting edge technologies with legacy regulations crafted before many of today’s applications even existed, it offers little to ease the current regulatory impasse. In fact, the current problems that plague the telecommunications sector would persist, if not intensify, in a new regulatory model based on network layers. A more prudent solution to today’s problems would encourage capital investment and the facilities-based competition envisioned in the 1996 Telecommunications Act.

The Basic Layers Approach

The network layers approach is viewed as an alternative to the current regulatory regime of vertical silos, which treat wireline, wireless, cable, and satellite services independently, with specific regulatory mandates for each provider and scant recognition of intermodal competition between providers. Thus, while wireline and cable providers offer similar services and compete for the same customers, wireline remains heavily regulated while cable regulation has been specifically rejected by the FCC.

The most thorough presentation of a new layered model of competition was prepared by Richard S. Whitt for MCI.(2) The Network Layers model envisions four layers—content, applications, logical, and physical—with most regulation reserved for the deepest layer which is the physical connections that comprise the network, including the wireline, wireless, cable, and satellite services that transport information. The physical layer, in essence, would become simply a regulated transport provider, with additional steps taken to ensure that monopoly power is not leveraged into activities that take place in higher layers. Vertical integration would be prohibited or severely restricted.

The network layers model seeks to replace ill-suited legacy regulations with a new regulatory framework that is more compatible with the convergence of voice, data, and video transmission that is currently underway. Instead of independent regulations for various service providers (wireline, wireless, cable, and satellite), the regulatory framework would be adapted to the various layers of telecommunications services. The wires, switches, and cables that move information would be regulated to limit market power and ensure access that allows consumers and content providers to exchange information provided on the higher levels. This physical layer would be further divided into last mile access regulations and Internet backbone regulations. The logical layer, which is just above the physical layer, is the code, or architecture, of the network, such as IP and other protocols, and would engender its own regulations. Above this is the application layer, which is the software that provides users an interface, such as e-mail or a web browser. The final layer is the content layer, which provides the information viewed on the web page, or the video or data stream relayed to the end user.

The layers model raises a number of important issues at all levels, from ownership and access at the physical layer, to debates over open architecture at the logical level, to questions of intellectual property rights at the application and content levels. Indeed, the regulatory regime would need to address virtually all the regulatory issues that currently are before the FCC, from UNE-P access to media diversity. Discussion in this paper, however, will be limited to an examination of regulation of the physical layer upon which the entire network layer model rides.

Smarter Regulation?

Proponents of the layers model suggest that it offers a smarter approach to regulation that ensures a robust and competitive market for content and applications while limiting regulation to cases of excessive market power. In particular, this seems to suggest relegating the physical transport layer, especially the last-mile connections to consumers, to a world of regulation. As Richard Whitt notes, “In the case of local access networks, economies of density and scale, coupled with the sunk-cost nature of network investments, have created a system in which incumbents may have preempted additional entry to serve most end users, including single-family residences, small businesses, as well as large businesses in less densely populated areas.” (3)

Yet in today’s telecommunications market, entry at this level does occur, and the introduction of VoIP will only increase the competition. Wireline is already losing customers to wireless and cable providers, and cable providers are losing market share to satellite providers. To suggest that this physical layer must, in all likelihood, remain regulated is to ignore the current market realities of intermodal, facilities-based competition. As Thomas Hazlett describes these dynamic markets, “All feature entry by companies that own their own infrastructure and now steal customers from the ‘natural monopolies’ that preceded them.” (4)

To be sure, proponents of the layered model claim the regulatory burden on the physical layer would be eased in the absence of market power. However, it is unclear how the physical layer would be able to change if it is initially locked into a static vision of transport based on current conditions. As has happened elsewhere in the telecommunications sector, a regime of regulated prices can drive investment out, leaving few players with the incentives or resources to invest in the physical layer. Consequently, open market competition could be replaced with increased rent-seeking behavior and politically established rates for the use of physical infrastructure.

Perhaps the most troubling aspect of the layered approach outlined by MCI is the fact that it makes no effort to address problems imposed by the UNE-P. Despite the fact that the UNE-P is at the very crux of the current regulatory crisis in telecommunications, it is viewed as “…an important legal mechanism in service of the layers principle.”(5) Rather than eliminating the UNE-P or revisiting the TELRIC pricing formula, it is viewed as “an interesting blend of horizontal and vertical thinking” necessary for promoting intramodal competition.

This view ignores the fundamental problem facing the telecommunications sector in the wake of the high-tech bubble. Namely, the current market provides no incentives to invest in critical infrastructure. The Competitive Local Exchange Carriers (CLECs) find it cheaper to lease equipment at regulated rates, and have abandoned investment in favor of UNE-P access. For example, in December 1999, CLECs relied on UNE access for 24 percent of their lines, while 33 percent were CLEC owned. As of December 2003, CLECs reported providing about 16 percent of their switched access lines by reselling the services of other carriers and about 61 percent by means of UNEs leased from other carriers. The remaining 23 percent of CLEC lines were provided over local-loop facilities owned by the CLECs.(6)

At the same time, the Incumbent Local Exchange Carriers (ILECs) have no incentive to invest in new infrastructure that they must lease to their competitors at rates that do not allow costs to be recovered. Consequently, broadband deployment by ILECs has been slow relative to less regulated providers. Cable companies, which are not subject to open access mandates, have become the dominant providers of broadband, outpacing DSL providers by a 2-to-1 margin. With VoIP bringing voice communications to broadband, cable will expand even further, providing additional competitive pressure at the physical level.

Vertical Lines in the Sand

Beyond a regulatory framework that continues the current regime of open access, the network layers model also includes prohibitions on vertical integration in an attempt to keep monopoly owners of the physical layer from exerting market power in the upper layers, such as applications or content. This proposition is problematic for a number of reasons, beginning with the assumption of monopoly power on the part of the physical layer providers. As noted above, wireline and cable companies compete vigorously at the physical level. Advances in wireless and satellite technology, as well as the potential for broadband over power lines, will only enhance competition and expand consumer choice when it comes to selecting a conduit for broadband.

The proposed ban on vertical integration also threatens economic efficiency in higher layers as well, such as applications and content. For many reasons, from reducing transactions costs to internalizing externalities, vertical integration can be efficient. More than most sectors of the economy, telecommunications and technology are best described as dynamic and rapidly evolving markets. To arbitrarily restrict vertical integration may unnecessarily limit the development of the broadband networks required to provide the video and data content consumers demand.

Moreover, as technology develops, it is not necessarily following the prescripts of the network layers model. There may, indeed, be valid economic and technological reasons for bundling applications or integrating between layers. Allowing businesses to compete in an open market is the best way to identify what combinations of capital can provide consumers the products and services they demand. Adopting another system of arbitrary boundaries, on the other hand, may inhibit innovation while restricting the flow of capital required to build a broadband network.

Conclusion

In the end, it is puzzling that the network layers model would be considered much of an improvement. It does take the important step of abandoning the old functional silos that have governed the telecommunications and technology sectors for the past century. Yet the core problems with the old system remain. The UNE-P determines access and continues to drive incentives to invest (or not invest) in the physical infrastructure. And while the silos may be gone, the new horizontal layers may be just as chafing in a matter of time, with prohibitions on integration across layers reducing innovation and investment. Since the onset of intermodal competition, advocates of open and competitive markets also have sought to eliminate regulatory silos. But instead of a new system of regulation, they envision competition and market forces guiding the development of broadband. The network layers model does not share this vision; it continues to rely on the worst of the old model while establishing a new regulatory framework that will continue to hinder broadband deployment.

This paper originally appeared in “Free Ride: Deficiencies of the MCI ‘Layers’ Policy Model and the Need for Principles that Encourage Competition in the New IP World,” published by the New Millennium Research Council, July 2004. The full study is available at http://www.newmillenniumresearch.org/news/071304_report.pdf.

ENDNOTES
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1 United States Telecom Association v. Federal Communications Commission, U.S. Court of Appeals for the District of Columbia, March 2, 2004, available at http://pacer.cadc.uscourts.gov/docs/common/opinions/200403/00-1012b.pdf

2 Richard S. Whitt, “A Horizantal Leap Forward: Formulating a New Public Policy Framework Based on the Network Layers Model,” An MCI Policy Paper, March 2004, available at http://global.mci.com/about/publicpolicy/presentations/horizontallayerswhitepaper.pdf.

3 Ibid., p. 35.

4 Thomas Hazlett, “The Irony of Regulated Competition in Telecommunications,” Columbia Science and Technology Law Review, vol. IV, 2003, available at www.stlr.org.

5 Ibid., p. 45.

6 Local Telephone Competition: Status as of December 31, 2003, Industry Analysis and Technology Division,
Wireline Competition Bureau, FCC (June 2004).