Are We Deregulating Telephone Services? THINK AGAIN

Robert W. Crandall
Robert W. Crandall Adjunct Senior Fellow - Technology Policy Institute

March 1, 1997

An update of this policy brief is available »


The telecommunications act of 1996 was passed a year ago as the vehicle for promoting competition in the local telephone, long-distance, and cable television markets. The act represents an attempt to open markets to competition, but it also continues and even extends a regulatory framework that is a proven failure. Congress apparently intended to allow cable television companies and long-distance companies to enter the market for local telephone services, the regional Bell operating companies (RBOCs) to enter the long-distance business, and all telephone companies to enter the cable television business, but such entry still seems far away because of the regulatory morass that has developed.

Not only has the act extended the shared regulatory authority of the Federal Communications Commission (FCC) and the states, allowing both sets of regulators to continue their regulatory distortions of telephone rates, but the act has also prescribed a major extension of regulation. At a time when most regulatory regimes are moving away from cost-based regulation because of the difficulties in measuring costs and the strong disincentives for regulated-firm efficiency that cost-based regulation creates, the 1996 act asks regulators to design a new set of cost-based wholesale rates for local telephone companies. It requires regulatory guidance over the technical design of network interconnection, and it even asks regulators to try to ‘allocate’ telephone companies’ plant that delivers both telephony and video services between these two operations.

For decades, the states have generally granted local telephone companies franchised monopolies. The new Telecommunications Act of 1996 brings an end to these protective policies, requiring state regulatory commissions to admit new entrants into local telephone services. Unfortunately, the act also requires that the states, guided by the FCC, be required to allow these entrants to lease any and all required facilities on an ‘unbundled’ basis from the existing local companies at cost-based rates. The FCC has ruled that the proper measure of ‘cost’ for such rates is the cost of the most efficient technology currently deployed in the company’s network, a ruling that is now being appealed in the federal courts. This ruling means that new entrants can simply lease all required facilities from established carriers at prices that are below the owners’ actual costs.

At the same time, the existing local companies are forced by state regulators to offer local services to many of their customers (particularly residences in small towns and rural areas) at rates that are substantially below their own costs while charging others (particularly business customers and residences in large cities) rates that are substantially above costs. Obviously this rate structure cannot survive a competitive assault, particularly from entrants who can lease their capacity from the existing companies at rates that are below the latters’ actual costs. But many state regulators are reluctant to let the below-cost rates rise, preferring instead to fund these subsidies from a ‘universal service’ tax on all telecommunications carriers-a tax whose magnitude may soar as the FCC loads on charges for subsidies to libraries, schools, and medical facilities that are required by the act.

Given the complexity, burden, and uncertainty created by the 1996 act, very little entry has occurred. Cable television, long-distance, and local-telephone companies have scaled back their investment plans. Consumers have few new choices, and they may not have many more until the wrangling between the contesting interests is sorted out by the courts and the fifty-odd groups of regulators. The past year may have been good for the overall stock market, but all groups of communications companies’ equities suffered losses in response to the regulatory controversies that have erupted. At this juncture, it would seem prudent to reconsider major sections of the 1996 act and to simplify the approach to liberalizing entry. Congress should consider amending the act to reduce the amount of regulation immediately and to phase out regulation entirely within five years. Decades of experience in trucking, railroads, airlines, and energy industries has demonstrated that even imperfect unregulated competition is better than regulated competition. It is not too early to reconsider the entire regulatory approach of the 1996 act.


Last year, the 104th Congress passed sweeping new telecommunications legislation that was widely praised by Democrats and Republicans alike. Finally, competition was to replace regulated monopoly in local telephone markets, telephone companies were to be permitted to offer cable television services, local Bell telephone companies would be permitted to enter the long-distance market, and cable rates were to be deregulated. One might have thought that these market-opening initiatives would mark the beginning of the end for telecommunications regulation, but a little reflection on recent events demonstrates that-if anything-the 1996 Telecommunications Act has created a regulatory nightmare that could be tied up in the courts for years. It is not too soon to suggest that Congress consider a fundamental change of course, one that relies on deregulation as the best route to full competition.

The first salvo in the new regulatory wars was fired by the Federal Communications Commission (FCC) on August 8 of last year when it released its new rules that are to guide state regulators in setting the rates among competing local carriers in a massive document of nearly 700 pages. This is an entirely new area of regulation that was created by the 1996 act, and-predictably-these new rules have already been appealed to a federal court by local telephone companies and state regulators. But this is only the beginning of what may be protracted controversy surrounding continuing regulation. The FCC must still establish a new policy for funneling subsidies to rural residences, schools, libraries, medical facilities, as well as low-income subscribers. It must rule on individual Bell company petitions to enter long-distance markets, and it has recently launched yet another proceeding to find a more rational approach to paying for the ‘federal’ portion of the local telephone companies’ costs than the current practice of loading it on long-distance calls. Each of these policies will be bitterly contested, and given the stakes involved, it is possible that the regulatory morass will not be sorted out for several years.

At the same time, each state regulatory commission must begin to set guidelines for the new competitive era. Each entrant into local telephone service must negotiate with the incumbent telephone company in each area over a host of wholesale pricing and interconnection issues. If the entrant and the existing carrier cannot agree, an arbitration of the issues must take place under the state commission’s guidance. The results of these negotiations and/or arbitrations must eventually conform with the FCC’s rules once the rules pass muster in the appellate courts. Perhaps even more important is that the state regulators will soon be embroiled in rulemakings to allow the existing local telephone companies to change their entire local retail rate structures so that these customer rates bear some resemblance to the cost of service.

It is already obvious that the new act creates far too much regulation. Armies of lawyers and consultants are ready to contest every one of the above regulatory changes. The cost of this process and the delays it causes will be enormous. If competition is indeed the goal, the regulators need to prepare the stage and exit the regulation business soon. But they cannot and will not as long as the law requires them to attempt to maintain a large array of subsidies while purporting to turn local telecommunications markets over to the market-to competitive forces that are supposed to drive rates to cost. It is not too soon to consider how the act might be changed to allow these market forces to determine rates, output levels, and service quality.

The Regulated Telephone Industry

No industry has been as ill prepared to move from regulated monopoly to competition as the local telephone industry. The heritage of decades of regulation in which individual rates bear no relationship to costs will prove difficult to overcome, but devastating to the incumbent local companies if it is not changed. In fact, most state commissions did not even try to estimate the cost of individual services before 1996, and many will now be reluctant to allow individual subscriber rates to move towards costs. They simply do not want to try to take on the politics of allowing someone’s monthly local phone rate to rise even if she will now be able to call loved ones in adjacent states at a much lower cost.

The states and federal governments have regulated telephone rates as far back as World War I. Over time, regulators allowed more and more of the cost of the local residential telephone line to be recovered from long-distance calls rather than from flat monthly connection charges. In addition, monthly business rates have been kept at more than twice the residential rates. New services, such as call waiting or voice messaging, have been priced far above cost so that regulators could keep monthly residential flat rates below the cost of providing the line, particularly in rural areas and distant suburbs. The new act does nothing to redress these rate imbalances; indeed, it even mandates that they continue as part of an erroneously named ‘universal service’ policy.

No one knows the true cost of providing telephone service because regulation has both prevented the competitive rivalry that would reveal these costs to us and until recently provided little incentive for local companies to care about efficiency. Only recently, in response to the controversies created by the 1996 act have industry participants begun proffering estimates of the costs of various services. Figure 1 displays one of these estimates-the ‘benchmark’ estimate of long-run incremental costs created by an industry consortium against the average residential and small-business monthly flat rate, arrayed by the length of the line connecting the customer-the ‘loop length.’ Note that the customers with the shortest loop lengths-and therefore the lowest costs of service-pay the highest rates. In the largest cities that have the shortest 10 percent of the lines, small businesses pay about five times the incremental cost of service and residences about double the estimated cost of service. On the other hand, those living in the most rural areas that have the longest loops-shown as the 90th percentile-pay substantially less than the cost of extending service to them. Indeed, they pay less than their big-city brethren even though the cost of stringing lines to them may be five times the cost of providing service near the center of a large city.

FIGURE 1: Average rates vs. incremental cost by length of subscriber line

Source: Benchmark Model; (length of subscriber line by percentile). National Association of Regulatory Utility Commissioners (NARUC), 12/31/94.

These rate distortions have been amplified by the curious division of regulatory responsibilities between federal and state regulators. The fixed (non-usage-sensitive) costs of our local lines has been divided between state and federal jurisdictions on an arbitrary basis. Today, approximately one-fourth of these costs must be recovered from the federal (interstate) jurisdiction. Because Congress has limited the FCC’s ability to require that these costs be recovered on a per-line basis, the Commission has been forced to require that interstate long-distance calls bear a large share of these costs even though these costs do not vary with calling volumes. As a result, every time we pick up the phone to make a long-distance call, our long-distance carrier is charged an average of almost 3 cents per minute on each end of the call by the local telephone company even though the cost of providing the connection is no more than 0.5 cents per minute, even during peak calling periods. The excess 5 cents per minute (two × 3 cents – 2 × 0.5 cents) goes to defray the costs of providing local lines to high-cost areas while clearly suppressing calling volumes. The cost of this regulatory ‘cross-subsidy’ in terms of reduced economic welfare is at least $4 billion per year and probably much more.

These distorted rates are a particular problem for the established local carriers as they prepare to meet competition. They are more vulnerable to entry than they would be if regulators had allowed rates to reflect costs. Entrants will obviously pounce on customers whose rates have been kept far above cost, particularly small business customers, heavy long-distance users, or urban residences. Entrants will happily cede the existing local carriers the rest of the market where rates are generally below cost, particularly the residential markets in small cities. Add to this handicap the fact that regulation has traditionally provided little incentive for efficiency, leaving the incumbent local carriers with a cost structure that will burden them for years. One might conclude that their new competitors are anticipating the future with glee, but even these entrants may have to proceed with caution.

Will Anyone Enter the market?

The 1996 act essentially mandates a flash cut from this morass of distorted regulated rates to a brave new world of competitive rivalry, but this cut is to be achieved by the exceedingly dull knife of regulation. State regulators must now allow long-distance companies, cable companies, wireless (cellular or the new PCS) companies, and perhaps even electric utilities to begin to offer local telephone service. The long-distance market was opened to competition more than a decade ago-except for short intrastate calls in most states. Now many of the long-distance carriers may try to enter the local telephone business, and others may not be far behind.

Competition could be risky, both for the entrants and for the established local companies. First, the new entrants would have to spend perhaps $600 to $1,000 per subscriber line to build facilities that duplicate the facilities of existing companies, which were built at an average cost of about $2,000 per line over the past decade or more. Entrants could target just the densely concentrated areas at a lower cost per subscriber, but even these investments could prove to be very large. No one expects entrants to be in a hurry to spend the $85 billion to $140 billion to replicate the country’s existing local telephone lines with new wires. As a result, the 1996 act requires that the existing carriers lease some or all of their facilities, called ‘network elements’ to the entrants on an ‘unbundled’ basis. This means that the entrants may lease the line that connects the customer, the switching services that direct the calls to their recipients, the transmission links between these switching centers, or even the advanced signaling and database management services, or any combination of these facilities. Alternatively, the entrants could simply become retailers-‘resellers,’ in industry parlance-of the existing local companies’ services by paying them a wholesale rate. The 1996 act also requires that the entrants be permitted to interconnect with their competitors at negotiated rates. No one can possibly offer telephone service without being able to send calls to and receive calls from subscribers of other companies.

Unfortunately, the 1996 act provides a set of complicated and even confusing regulatory requirements for managing the process of setting the rates for leased facilities, wholesale discounts, and interconnection. And the act does nothing to require regulators to straighten out the existing rate structure before unleashing the competitive hurricane. For both reasons, an intense regulatory and legal battle has been unleashed that will not be resolved soon nor without considerable acrimony. The federal court appeal of the FCC’s August interconnection rules is only the first shot in this war.

Rates, Costs, and ‘Universal Service’

Most of the controversy over the 1996 act thus far has centered on the method of setting the rates for leased facilities and the terms for interconnecting new entrants and existing carriers. This controversy is in some ways misplaced-the local companies should be placing most of their emphasis on getting the regulated retail price structure to conform to costs.

Under the needlessly complicated 1996 act, the local companies’ unbundled facilities are to be priced at some measure of cost that is ‘ . . . determined without reference to a rate-of-return or other rate-based proceeding.’ Many observers read this requirement as mandating some hypothetical ‘long-run incremental cost’ measure, not the actual costs now on the books. Unfortunately for the owners of these facilities, engineers can surely show that the incremental costs of using today’s technology are substantially below the carriers’ actual costs that reflect a mix of investments in necessarily older technology and a heritage of regulation-induced inefficiency. But who is to determine the precise level of these incremental costs?

Ironically, most state regulators, who have been responsible for controlling the local carriers’ costs for decades, have little information on these incremental costs, or even actual embedded costs of the various network elements. They must now convene regulatory proceedings in which a variety of parties will tender their engineers’ estimates of costs. Indeed, the process has already begun, and the engineering consulting firms with expertise in this area are overloaded. Until they complete this process, however, the FCC’s new rules would have the regulators bound to the FCC’s ‘proxies’ for these costs, a requirement that is at the heart of most of the incumbent telephone companies’ court appeals of these rules. The companies contend that these proxies are simply too low in many states because they are based on the most modern technology, not the company’s actual costs, and no company has the latest technology deployed to every subscriber on its network. The potential entrants understandably feel that they should not be charged for all of the inefficiencies induced by decades of regulation.

The local companies also fear that the FCC’s proxy rates might be the basis for setting these rates far into the future, particularly in states where regulators have difficulty in making their own cost determinations. And if entrants can simply lease the existing companies’ facilities at prices that reflect the best of current technology, why should these entrants even consider building their circuits’ Indeed, AT&T’s new president recently told reporters that AT&T will rely heavily on leasing incumbents’ facilities rather than risking large investments in competitive facilities, and the country’s largest cable television company has suspended indefinitely its previous plans for converting its systems to offer both television and telephone services. Thus, the FCC’s wholesale pricing rules may have already discouraged facilities-based entry into local telephone service by allowing entrants to lease facilities at rates that are based on ‘forward-looking’ costs.

The FCC’s new rules also require that the rates at which entrants lease the various portions of the telephone companies’ facilities be allowed to vary with population density because costs increase with declining density, but that the rates not be different for businesses and residences because there is no difference in the cost of similarly-situated residential and business lines. This would require state commissions to establish a wholesale rate structure that reflects differences in costs in a regulated environment in which retail rates bear no relationship to costs and are often even inversely related to them.

Further complicating the regulators’ problems is the coming implosion of the system of imposing large connection charges on long-distance calls to cross-subsidize residential connections. These interstate and intrastate connection or ‘access’ charges now account for $20 billion of the local carriers’ $100 billion in revenues. Were these charges reduced to some approximation of the cost of handling these calls, these revenues would fall to about $5 billion even after accounting for the greater long-distance calling volumes that lower charges would clearly stimulate. Once the states approve interconnection agreements between new entrants and existing local telephone companies, however, the long-distance carriers will find ways to avoid these access charges if regulators do not act to reduce them. The new entrants into local telephony-a number of whom will be long-distance carriers-will avoid paying the charges of 3 cents per minute on each end of the call by simply funneling their long-distance calls through their own local networks first and then sending the calls as ‘local interconnections’ at 0.5 cents per minute or less. Competition has a marvelous tendency to push prices towards costs!

Unfortunately, there is little inclination among state regulators to immediately resolve the dilemma they now face. If they are required to price interconnection and leased local network facilities at some measure of incremental cost, they will either be forced to align retail rates with costs or to allow new entrants to take away the highly profitable business and urban customers and the heavy users of long-distance, leaving the unprofitable residential customers and light long-distance users to the existing local companies. If access charges fall and highly profitable customers leave, how will the local companies defray their losses on the remaining customers?

To most regulators and even to some industry participants, the best way out of this dilemma is to plead a ‘universal service’ necessity for keeping monthly residential rates low and to fund the resulting deficits from a universal service fund. The 1996 act requires this result, mandating that the FCC and the states reach an accord on the size of a universal service fund that is to be raised in a manner consistent with the ‘public interest.’ Indeed, the solution now being proffered is the imposition of a substantial tax (‘universal-service contribution’) on telecommunications firms to subsidize rural and low-income subscribers. This tax would then be passed on discreetly in the carriers’ charges, perpetuating the very rate distortions that one would hope would be eliminated by competition.

The ‘universal service’ fix to the problem is now being debated within the FCC, guided in part by a recommendation of a Joint Board of FCC and state commissioners. The Joint Board recommendation calls for federal payments of up to $7 per month for low-income consumers, plus a payment to carriers in ‘high-cost’ areas based on some engineering model of their costs for their given population density. In addition, the 1996 act requires that the Joint Board consider extending subsidies through this ‘universal service’ fund to schools, libraries, and medical facilities. Finally, another dollop of universal service funds might be given to local companies in return for a reduction of long-distance access charges. The unspecified requirements to fund such schemes would require a tax on virtually all telecommunications carriers that might have to reach $20 billion or $30 billion per year-or as much as 30 percent of the industry’s total costs-if it is to cover all of these requirements. This tax would be visible and therefore unpopular, but it might be more popular than simply letting below-cost customer rates rise to market levels.

Fortunately, there simply is no real economic need to maintain and expand the ‘universal service’ policy that has been invoked in defense of all of the regulatory rate distortions. We do not have ‘universal’ housing, clothing, or food policies, those who live in high-cost areas pay more for each of these necessities. The average residential customer pays about $20 per month for his flat-rate local telephone service. Rural residences pay less, but would probably have to pay $40 to $50 per month to cover the full cost of stringing wires to them unless wireless connections of equal quality were to prove to be cheaper. Thus, the full cost of local service is no more than $600 per year, or about 1.2 percent of average household disposable income. Even poor households in rural areas making, say, $10,000 per year would have to spend no more than 6 percent of their income to be connected to the network. One might make a compelling case for some assistance to the latter, poor families, but should regulators make sure that households with average or above-average incomes not pay even as much as 1 percent of their incomes to be connected to the telephone network when they live far from an urban center? Were state regulators to decide that telephone service-like food, automobiles, or gasoline-should be priced at its cost, the introduction of competition would be less problematic.

The Telephone Industry One Year Later

It is now one year after the passage of the 1996 act. The FCC and state regulators are tied up in a large number of complicated proceedings. It is very likely that the federal Court of Appeals will send a substantial part of the FCC’s first ruling (on interconnection and wholesale pricing) back for reconsideration this spring. There has been little actual entry into local telephone markets, in no small part because the stock market has treated most of the potential entrants badly. As figure 2 shows, virtually all of the major groups in this sector have fared poorly since the 1996 act was passed, a period in which the average equity price rose briskly. The local telephone companies’ performance is perhaps understandable because these regulated entities are now vulnerable to market entry and even to the prospects of having to lease their facilities below their embedded costs. But why should the long-distance companies and cable television companies have fared so poorly? Perhaps the explanation is that all of them are being threatened by new competition: the long-distance companies from the potential entry of the RBOCs, and the cable companies from the new direct broadcast satellites. The long-distance companies, which generally appear supportive of the direction that the FCC is taking in enforcing the new law, have lost more on average than the RBOCs. The cable television companies have been the biggest losers despite cable-rate deregulation, probably because of the growing competition from direct broadcast satellites. The smaller independent local companies ‘only’ under performed the market by 22.5 percent in 1996, perhaps because they own many of the rural companies that are protected from competition by the act.

FIGURE 2: Shareholder returns, 1996

Source: Donaldson, Lufkin, and Jenrette.

It is not surprising that the stock values for these incumbent companies would be depressed by the prospects of competition, but it is ironic that these values are falling while competition is being postponed by the regulatory wrangling. It is unlikely that most of the companies thought that they would be so punished by the equities market and some-such as the RBOCs-may have even thought that they had ‘won’ in Congress. It may therefore be a propitious time for them to reconsider and even to support a fundamental change in direction, such as a movement to less regulation and greater dependence on the marketplace to set rates.

Consumers should also be concerned that the new act will not deliver to them the benefits of competition as long as the act’s many regulatory requirements are being bitterly contested before the FCC, the states, and in the courts. It could easily take five years or more for the new competition to begin to develop. The RBOCs are only now beginning to file for the right to enter long-distance services; it could take several more years before the required regulatory proceedings and legal appeals are complete. Similarly, the complex negotiations between prospective entrants into local telephony and the old-line local companies over interconnection and wholesale facility rates could take years to complete. The only beneficiaries of this process are the lawyers and consultants who square off again and again before the FCC, the state commissions, and the courts.

Is There a Better Way?

No one knows how all of these Rube Goldberg schemes that are designed to encourage competition while keeping local retail telephone rates from being pushed towards costs can work. Clearly, competition will depress rates where they are now substantially above costs. But with regulators unwilling to let the below-cost retail rates rise substantially, the incumbent local companies will be forced to rely on transfers from funds created by the federal and state authorities’ taxes on telecommunications carriers. The imposition of such taxes will not go unopposed, of course, nor will they necessarily be distributed in a way that is fair or efficient. And if the taxes are assessed in proportion to revenues, they will simply be passed on in the form of usage charges on long distance calls, Internet connections, or new services, extending the unfortunate regulatory errors of the past. This attempt to pay for the fixed, non traffic-sensitive costs of the network through long-distance charges now costs the American economy at least $4 billion in annual losses of economic welfare. It is ridiculous for the industry to spend the next four or five years in court battling over complicated new regulations largely to maintain an inefficient status quo.

Congress could have decided on a much less complicated and more sensible approach to introducing competition into local telephone markets. It should consider an early change in course, composed of the following elements. First, it should develop some mechanism to induce or require state regulators to let all retail rates move towards the cost of providing the service from existing facilities, subject to the requirement that rates be sufficient to cover all current costs. Second, Congress should abandon all ‘universal service’ subsidies except those directed at needy subscribers. It is neither necessary nor desirable to subsidize telecommunications services for all rural residents and all libraries, schools, and hospitals. If subsidies are sought for the latter institutions, they should be general subsidies that the institutions can spend in a manner that meets their individual needs, and they should be funded by something other than a tax on telephone service.

Third, Congress should mandate interconnection of all networks at rates based on some measure of incremental costs-even forward-looking costs-so that entrants and incumbents can deliver traffic to each other. (There will be only minimal debate over the level of these costs as long as other rates are based on actual costs.) Fourth, Congress should only require that incumbents lease those facilities that are arguably ‘bottlenecks,’ (such as the line that connects the switch to the final subscriber), not all of the incumbents’ facilities. Even this mandate should be limited to the period of time required for entrants to build their own circuits.

Finally, and perhaps most important, Congress should require that all regulation be eliminated within, say, five years while ending either the federal or the state role much sooner. Costly jurisdictional battles over regulatory authority should be eliminated even before all remaining regulation is abolished. Any risk of unleashing some remaining monopoly power by deregulating after five years would surely be offset by the gains to the economy from ending the distorted rate structure and the very legal and regulatory battles that the 1996 act has only begun to unleash. Moreover, given the rapidly declining costs of wireless services and the FCC’s recent auctions of four more wireless bands to create at least six wireless (cellular and PCS) competitors in every part of the country, wireless competition will surely limit rate increases in rural areas in which wire-based entrants will fear to tread.

Such an approach would surely be challenged in the courts by some state regulators, who would view it as an incursion on states’ rights, but the incentives for most of the incumbents or new competitors to resist the new order would be reduced substantially. There would be some debate about how to measure the carriers’ current incremental costs and how to recover any shortfall between these incremental costs and full costs. But once these debates are resolved, the incumbents would have much less to fear from competition than they do now with their distorted rates. Moreover, the likely entrants would be induced to build most of their own facilities rather than simply leasing the current local companies’ plant.

Were Congress to require that retail rates be based on the regulators’ best estimate of incremental costs, it could have limited its ‘universal-service’ requirement to low-income subscribers. ‘High-cost’ assistance that subsidizes all rural subscribers, regardless of income, may seem worthwhile to Alaskans. But it costs residents of Los Angeles and New York-even those in Watts and Harlem-and heavy long-distance users in Alaska far too much and needlessly complicates the introduction of much-needed competition into local telephone markets. The regulatory complexities that Congress continues and even supplements with the 1996 act have more to do with concealing the true nature of these subsidies than with promoting efficient competition. Now that the chairman of the Senate Commerce Committee from the 104th Congress has been defeated for reelection, there is a much better chance for correcting the errors in the 1996 act. Congress would be well advised to attempt to do so before we spend billions of dollars in legal and regulatory battles that result in preserving far too much of the current status quo in telephony. Deregulation has served us extremely well in other industries; it could work just as well in telecommunications.

An update of this policy brief is available »