Technical Difficulties

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

November 8, 2007

European investment in high-tech infrastructure has been lagging behind American spending for years now, with direct consequences for the Continent’s economy as a whole. Yet next week the EU commissioner for telecoms, Viviane Reding, is expected to announce a radical new policy that will severely hamper future investments in that sector and put Europe even further behind its peers.

The policy that Ms. Reding has been preparing for months now is known as “functional separation.” She wants to force owners of the old-line telephone companies to separate their operations into distinct wholesale and retail divisions, with a Chinese wall between the two. This drastic measure is necessary, Ms. Reding claims, because there is an absence of strong competition for the owners of these networks. Allowing new entrants to offer broadband (DSL) service over the incumbents’ existing networks will supposedly spur retail competition, since firms won’t have to build an entire new network before they can go into business.

There’s one huge problem with Ms. Reding’s approach. Unlike in the water or natural-gas sectors, telecom networks are not simply unchanging pipes in the ground that require only occasional maintenance. Rather, the typical telecom network is already somewhat obsolete, offering circuit-switched voice services when much lower-cost packet-switched (Internet) telephony is pushing the price of voice calls down to virtually zero. Even broadband and video signals, often haltingly delivered over current telecom networks, are gravitating rapidly to hand-held devices offered by Nokia, RIM or Apple, potentially over a variety of wireless networks.

So network operators must spend billions of euros each year to update their facilities, often replacing assets that were deployed only five or ten years ago. If these carriers are forced to sequester their network assets in separate wholesale divisions, offering access to both rivals and their own retail operations at regulated wholesale rates, their incentives to spend the money needed to modernize these facilities will be substantially reduced.

What’s more, it will be difficult for their network managers to make specific investment decisions in this unusual environment, because they will have many retail-service providers who will lobby the regulators over the very design of these networks. This is precisely what happened in the U.S. in the late 1990s when the incumbent telephone operators tried to replace some of their copper-wire facilities with fiber optics. Their downstream competitors used the regulatory process to frustrate these investments, eventually causing the carriers to cancel or severely delay their investment plans until the regulatory policy was changed. This bickering tends to occur because once competitors have adapted to the old network, they become opponents of changes in that network that do not comport with their business plans — particularly if these changes allow others to offer innovative services that the existing competitors cannot offer to their customers.

The U.K. has led the way here, imposing functional separation on its national carrier, British Telecom, in 2005. Ms. Reding apparently approves of the result. But U.K. broadband subscriptions were already growing more rapidly than the average rate for the EU when the U.K. regulator chose this path. If anything, U.K. broadband growth has slowed slightly since the separation policy was imposed.

If there was a problem in the U.K., it was its dormant cable-television sector, which provided only modest competition for BT in the broadband sphere. The new policy won’t stimulate cable competition, and it discourages cable companies from deploying their own broadband services. What’s more, it will surely slow U.K. telecom network investment in the next few years. BT is not likely to announce an aggressive roll-out of fiber to homes, emulating Verizon in the U.S. or NTT in Japan. Indeed, there is little interest in such deployments in most of Europe, a disinterest that will only grow if Ms. Reding proceeds with her proposed initiative.

Ms. Reding should investigate the developing literature on high-tech investment and growth. Several studies have shown that in the last few years of the 20th century, the U.S. enjoyed strong productivity growth thanks to its investment in information and computer technology. Recently, Professors Melvyn Fuss (University of Toronto) and Leonard Waverman (London Business School) showed that the EU has suffered a substantial stagnation in productivity growth because it has not invested in these high-tech products and services as intensively as the U.S. or even Australia has.

In fact, Ms. Reding’s own office funded a study of EU-15 investment in the communications sector that showed the EU invested far less in 2001-04 in fixed-wire, wireless and cable television infrastructure than did the U.S. in the same period. In 2004, the most recent year for which data are available, EU-15 investment in these sectors was only two-thirds of the U.S. level, even though the EU-15’s population is 30% larger than America’s. There is no evidence that the EU has begun to close that gap in the last three years, and now Ms. Reding seems hell-bent on expanding it.

There is precedent for the current policy direction in Europe. The U.S. tried to stimulate competition by breaking its national telecommunications company, AT&T, into separate “local” and “long distance” operations in 1984. The experiment worked for a while, but when the network technology had to adjust to wireless competition and the demands of the Internet, the experiment crumbled. The carriers became mired in endless disputes over such questions as whether Internet communications is local or long-distance. The long-distance carriers collapsed despite various attempts by the regulators to save them from the inevitable decline of voice calling rates. By 2005, the telecom sector had become vertically integrated once again, and the structural separation of local and long distance became a distant memory.

Ms. Reding appears unaware of this failure. She even suggested in April of this year that full structural separation may eventually be required of “dominant” telecom carriers. She should ponder whether flourishing competition over isolated and increasingly antiquated telecom networks would serve EU consumers. How much farther behind the U.S., Canada, and Australia should EU high-tech investment be induced to fall?