TCS Daily

A Telecom Tutorial for the Heritage Foundation

By Laurence J. Kotlikoff - April 23, 2004 12:00 AM

When competition is allowed to thrive, the results can be nothing less than spectacular. The telecom market is a case in point. Today, we can call long distance for a quarter of the price that prevailed in 1984 -- the year the government ended AT&T's long distance monopoly. And, thanks to the Telecommunications Act of 1996, our phone bills are 25 percent less than several years ago.

Telecom competition has not only lowered the costs of household and business communications. It's also led to tens of thousands of jobs and over a $100 billion of investment that would not have existed had we allowed the Bells to remain protected monopolists.

To bring competition to the local phone market, the government has taken the same tack as it did in de-monopolizing the long distance market -- requiring incumbents to lease to competitors the critical bottleneck infrastructure whose replication would be prohibitively expensive and economically inefficient. Thus, just as AT&T was required in 1984 to provide long distance transmission services and facilities to its long distance competitors, so too are the Bells being required to provide local services and facilities to their competitors. Indeed, the latest entrants into long distance -- the regional Bells -- are using just this entry strategy: making minimal up-front investments, leasing transmission services from established carriers, and then reselling those services to customers.

In the case of local service, there are no significant competitive alternatives to the regional Bell networks that were built with ratepayer funding under government-sanctioned monopoly protection for over a century. Unlike wireless networks that are used for mobile service, these wireline networks cannot be replicated on an economic basis by new carriers because of their scale and scope as well as the lack of rights-of-way.

This is the reality that the architects of TA96 fully understood, and that is why TA96 requires the Bells to lease, at full economic cost-based rates, all necessary pieces of their local voice network. And, the law is working. After being stuck for a century buying local phone service from one and only one provider, close to 20 million households and small businesses have switched their service to a competitive carrier. Many more millions of households and business that have stayed with the Bells have benefited from rate reductions that the Bells have been forced to institute to meet this nascent competition.

This competitive entry has caused the Bells to lose some of their monopoly profits, but this is merely a reality of competitive markets. But while competition has reduced Bell profits, their compensation for network access remains more than adequate. The rates that competitors must pay for such access are required to cover the full economic costs (including a reasonable profit) of providing such access. And these rates are set by independent commissions in each state after review of the Bells' own data. It is hard to believe that they all have gotten it wrong. Furthermore, by opening their local markets to competition, the Bells have been permitted to enter long distance markets throughout the country and are earning new profit streams. By the end of last year, the four Baby Bells had signed up some 35 million customers for long distance service.

That's what the record shows, but recently telecommunications attorney James Gattuso and Dr. Norbert Michel ("GM") in a Heritage Foundation article, "Are U.S. Telecom Networks Public Property?" have challenged my recitation of these facts.

First, GM dispute that the ILECs have bottleneck control over the network, because there is no law barring CLECs from buying copper wire, telephone poles, switches, and physically combining them to form a local network. This observation brings to mind Anatole France's aphorism that, "the law, in its majestic equality, forbids the rich as well as the poor to sleep under bridges, to beg in the streets, and to steal bread." As Congress recognized, scale and scope economies make it unreasonable to expect any CLEC to duplicate the existing network.

GM also claim that "new technologies, such as wireless and Internet telephony, are providing substantial competition to ILECs without burdensome federal rules." But neither wireless nor VoIP (voice over internet protocol), which is in its infancy, are substitutes for wireline service. As SBC Chairman and CEO, Ed Whitacre, observed in 2003, wireless is "never going to be the substitute (for wired service). Reliability is one reason." While VoIP may become an alternative in the future, it is still untested. Right now, only a few hundred thousand Americans are using VoIP as their main residential phone service.

GM are also wrong about the impact of TA96 on telecom competition and investment. In their view, "the FCC's forced leasing rules undercut (competition) by encouraging new entrants to lease network capacity, rather than building their own." This logic is the same as Marie Antoinette's suggestion that depriving the peasants of bread would spur their investment in cake-baking.

First, GM fail to appreciate that the FCC's recent order does not require the Bells to lease access to the broadband capabilities of non-legacy loops (see TRO ¶¶ 247-297). Thus, even if, arguendo, GM's logic is correct, their assumed antecedent is not. Second, close to 20 million CLEC customers would differ with GM's conclusion that competition has been "undercut" by UNEs. Rather, if the network leasing and unbundling requirements of the TA96 were eliminated, the simple result would not be increased facilities-based competition, but no competition. If that happens, the public can say goodbye to the dramatic reductions in phone rates that competition has started to foster. And we can expect long distance and cellular rates to rise, as well.

But the most telling refutation of GM's anti-economic thesis that competition has inhibited investment comes from the basic statistics. Since TA96 was passed, the Bells and the CLECs combined have substantially increased their telecom capital spending, with the cumulative increase relative to trend totaling close to $100 billion. As noted by the U.S. Supreme Court, "a regulatory scheme that can boast such substantial capital spending ... is not easily described as an unreasonable way to promote investment."

Perhaps recognizing the wholly unconvincing nature of their thesis that competition damages economic performance, GM sidestep to an alternate reason the Bells should not have to lease access to their networks: the sanctity of private property. GM argue that, "today's telecommunication networks were not built by the government, but by private investors with private capital. Far from being a legacy of the regulatory past, today's networks are overwhelmingly the product of new investment made long after legal monopolies and guaranteed rates of return were abolished." This statement appears to be in response to my assertion that we the public, not the Bells, own our phone lines, telephone poles, and other local network infrastructure.

I say "our," because our government acting on our behalf granted the Bells a century of monopoly protection and permitted them to charge us phone rates high enough to cover all of the costs (and then some) of these local networks. In 1984, when the Bell System was broken up, these accumulated investments were handed, gratis, to the "Baby" Bells. There was no open bidding for the network that we, the public, had paid for. It was just assigned to the Bells -- but with a protective proviso; the Bells were limited to use this network only for tariff-regulated local telecommunications services. [MFJ Section II(D)(3)]

I never claimed that "legally" the local networks are not the Bells' property. I claim that because of their funding source, their natural monopoly character, and explicit government policy, use of these networks by the Bells is subject to public interest regulation. The Bells do not have the right to wield unfettered monopoly power over local telecommunications. Indeed, this limitation, made explicit in TA96, has been upheld in the federal courts, which rejected the Bells' claim that TA96 was an illegal "bill of attainder."

But perhaps GM's most serious overreach is their assertion that since 1996 the ILECs have, overwhelmingly, replaced their pre-1996 local network infrastructure using their own risk capital. GM support this argument with S&P Compustat data for the property, plant, and equipment investment (PP&E) of telephone holding companies. To quote GM, "with their 1996 gross PP&E as a baseline, the ILECs spent enough to replace over three-quarters of their existing stock of fixed property."

This numerical analysis is specious. First, GM appear to have included capital expenditures for 1996 in their calculations even though these would have been committed prior to the effectiveness of TA96. Second, the Compustat measure of $236 billion cited for cumulative 1996-2002 capital expenditures is not expenditures just on Bell wireline local networks -- but includes vast amounts of capital spent for wireless and international investments. Thus GM's aggregated Compustat data are next to useless for evaluating whether the Bells have largely replaced their wireline local telephone networks in the years since TA96.

Instead of speculating, let's consider the much more detailed data that the Bells are required to report to the FCC concerning their domestic wireline networks. First, the Bells' gross wireline plant was $275 billion at year-end 1996. From 1997 through 2002, the Bell's capital expenditures on this wireline plant totaled $149 billion -- or barely half its value. Moreover, much of this investment wasn't to replace old regulated plant. Rather, it was supplementary investment for DSL and other services. Thus, the fraction of gifted plant that has actually been replaced is substantially less than half. And second, almost all of the funding for these regular replacement expenditures by the Bells come from legacy depreciation flows -- not from new risk capital. Indeed, over the 1997-2002 period, the amount by which Bell wireline capital expenditures exceeded their legacy depreciation flows is just $11 billion. Such a paltry contribution from "risk capital" would scarcely seem to support GM's thesis that current Bell networks are overwhelmingly the product of private entrepreneurship.

Leaving numbers aside, the real issue is whether Americans will be supplied with high-quality, innovative, and fairly-priced local telecommunications services. Experience shows that competitive markets and appropriately-regulated access to bottleneck facilities are the best way to achieve that aim. Monopoly control, whether due to historical legacy or claimed private exploitation rights, is not. Thanks to the recent Court of Appeals decision, the Bells are poised to win their battle to re-monopolize the telecom industry. If this happens, it will impart major and lasting damage on the general public, the telecom industry, and our overall economy. The public needs to understand this issue and protect its right to this critical telecom property before it's too late.

The author is Professor of Economics, Boston University and a consultant to AT&T.


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