Bringing U.S. Telecom Regs Up to Speed

Recently, the United States Court of Appeals released a sternly worded decision that could unleash a new era of competition and innovation in the telecommunications sector. The Court rebuked the Federal Communications Commission for its stifling regulatory regime, which has hampered investment in critical telecommunications infrastructure and technological innovation. At the same time, the Court upheld recent actions taken by the FCC to shield broadband deployment from much of the regulatory morass surrounding more traditional telephone services. In light of the decision, the FCC is on notice to develop new policies that will promote the real competition envisioned by Congress when it passed the 1996 Telecommuncations Act.

While the court’s decision is good news for consumers, the decision was not welcome in all quarters. In fact, many companies have already criticized the decision as the death knell for competition that will only shore up phone monopolies. But these concerns address a curious form of competition that was created by the FCC, not the marketplace. At the same time, these complaints ignore the very real competition coming from cable and wireless companies in a dynamic marketplace for broadband services. Instead, the managed competition pursued by the FCC established perverse incentives that ultimately drove investors out of the telecommunications sector at a time when critical new investments were required to upgrade the infrastructure for modern technologies.

To understand the current standoff in telecommunications and the importance of the Court of Appeals’ recent decision, it is important to examine the dynamic changes that have taken place in the telecommunications marketplace. In 1996, when the Telecommunications Act was signed into law, the market was 90 percent voice, 5 percent wireless, and 5 percent data. Now it is only 40 percent voice, 30 percent wireless, and 30 percent data. Today’s consumers need high-speed networks that can move vast amounts of information, but regulatory barriers have reduced incentives to build this network.

Today’s regulatory problems stem from the Telecommunications Act of 1996, which was enacted to promote competition in the wake of the break-up of AT&T. Under the 1996 Act, the FCC sought to create competition for local phone service. The Bell companies, or ILECs (incumbent local phone companies), were prohibited from expanding into long distance markets until they could demonstrate that competition existed in their local markets as well. The ultimate goal was true head-to-head competition between competing phone networks. As a first step, the FCC established a transitional phase of competition that introduced new players to the market—CLECs, or competitive local exchange carriers—who would compete to provide local service. To offset the advantage of incumbents and ease entry into local markets, the FCC instituted an era of “managed competition” in which the ILECs were required to share their lines and lease their facilities to their competitors—the CLECs—at prices set by state regulators using a formula created by the FCC.

Pricing has been critical to the whole managed competition market, and the system created by the FCC has been controversial. Known as TELRIC (Total Element Long-Run Incremental Cost) pricing, the problem has been that the prices authorized by regulators are set at below-market rates that do not allow the ILECs to recover their costs. Rather than attempting to set prices based on cost outlays, TELRIC sets prices using a hypothetical network built with the latest and most efficient technologies, something that doesn’t exist in the real world. This arbitrary approach to costs provides wide latitude to regulators setting prices. To add more confusion, the FCC determined that state regulators had authority to identify what components of the network are considered vital—the UNE-P—and therefore must be leased using TELRIC pricing.

This system of managed competition has two significant impacts that make it difficult to complete the transition to a truly competitive market. First, CLECs have little incentive to invest in their own competing networks. As UNE-P options became available, CLECs have decreased investments in new facilities, while increasing their use of ILEC facilities at subsidized rates. In other words, it is easier to free-ride on the existing network rather than build competing facilities.

The other impact of TELRIC has been the disincentives it generates on the part of the ILECs to invest in upgrades to the existing system. Requirements to share facilities with competitors at below-market prices have stymied investment, particularly in the “last mile,” that part of the network that connects consumers to the high speed networks and Internet backbone. As a consequence, deployment of new technologies such as high-speed broadband networks, has been slowed, evidenced by the fact that the United States ranks only 11th in the global Digital Access index, lagging behind countries such as Japan and Korea. Without altering the incentives established by the current regulatory regime, the ILECs are not likely to attract the capital required to boost broadband deployment.

This arcane model of artificial competition is becoming an ever more obvious impediment to true competition in light of the dynamic changes in the telecommunications market. In 1996 the FCC may have viewed its model as the conduit to competition, but in the real world, the advent of broadband technology has brought competition from other sources, most notably cable companies, which today have dominate the broadband market by a margin of 2-to-1 over phone companies. Moreover, the emerging Voice over Internet Protocol (VoIP) allows broadband providers to compete directly with the old wireline phone companies for phone service. Other providers such as wireless, satellite, and even power companies are poised to compete with local phone companies as well.

In light of this history, the CLECs, which have settled into the artificial world of managed competition created by the FCC, have denounced the court’s recent decision. But the decision does not put them out of business. It does, however, force them into a more competitive marketplace. They will now have to either negotiate their own rates to lease equipment from ILECs, or invest in building the facilities themselves. Moreover, the court makes clear that both cable providers are already competing with the ILECs in critical markets. In fact the court goes so far as to say, “More important, we agree with the Commission that robust intermodal competition from cable providers—the existence of which is supported by very strong record evidence, including cable’s maintenance of a broadband market shore on the order of 60 percent … means that even if all CLECs were driven from the broadband market, mass market consumers will still have the benefits of competition between cable providers and ILECs,” (p. 41 http://pacer.cadc.uscourts.gov/docs/common/opinions/200403/00-1012b.pdf).

In short, the old definitions and categories of telecommunications that define the FCC’s view of the world are becoming less relevant in today’s marketplace as new providers and technologies cross old boundaries. The CLECs are regulatory creatures of the old world, with a business model that needs to be updated to current realities. The Court of Appeals made this point emphatically by rejecting the FCC’s regulatory framework. In fact, this is the third time that the courts have rejected the FCC’s approach. Cable companies, wireless companies, and others make the point just as emphatically by going toe to toe with the old phone companies in competition to provide consumers the best products at the lowest rates. In today’s market, with rapidly changing technologies, the FCC would do well to abandon its old model of managed competition in favor of policies that promote true competition and an open marketplace.