The Telecom Act’s Phone-y Deregulation

On Monday the U.S. Supreme Court issued its ruling on the most important regulatory dispute in the wars over local telephone competition. At issue was the degree to which the old-line local companies, such as Bell Atlantic or Ameritech, would have to lease their networks to their prospective rivals and the prices to be charged for the leased facilities.

The court upheld the Federal Communications Commission’s authority to dictate the approach states must take in overseeing the rates the local companies charge their new rivals. But it told the FCC to reconsider just how far it should go in requiring the local companies to offer their networks for their rivals’ use.

If this sounds strange, it is. In the 1996 Telecommunications Act, Congress for the first time required states to allow competition in local telephone service. Before 1996 all but a few states had protected their local telephone monopolies. State regulators allowed these companies to overcharge business and long-distance customers and use the excess charges to subsidize residential local service, particularly in rural areas.

Congress was not satisfied simply to permit competition, as it had in airlines, trucking and railroads nearly 20 years before. It wanted to grease the skids of entry by requiring the incumbent local phone companies to make their facilities available to new entrants. The idea of forcing firms with monopoly facilities to make them available to rivals is not new. It has been part of U.S. antitrust policy for 60 years and has existed in the regulation of railroads and pipelines.

But the 1996 act was new in its breadth, dividing up the incumbent local companies’ networks into many piece-parts—local wires, switches, transmission lines and network intelligence—for newcomers to use. The assumption was that the new entrants, including giants AT&T and MCI WorldCom, would not be able to afford to build their own networks anytime soon. The FCC’s approach to pricing these pieces was revolutionary, for it required that the newcomers be able to lease them at prices that reflect today’s most efficient technology, not the company’s actual cost of building these networks under efficiency-suppressing regulation.

The FCC issued its rules reflecting this “pro-competitive” view in August 1996, and before you could crack open the 600-page text, the states and the incumbent local companies had sued the FCC, scoring a victory in the Eighth U.S. Circuit Court of Appeals. But in Monday’s opinion, written by Justice Antonin Scalia, the Supreme Court upheld the FCC’s authority to prescribe the leasing formula and the commission’s rules that require local companies to provide the unbundled network pieces to their rivals in a single, integrated package.

But the local companies got something, too. Justice Scalia’s majority opinion and Justice Stephen Breyer’s dissent both seriously question the FCC’s interpretation of the 1996 act as requiring the local companies to make every part of their networks available to their rivals. Justices Scalia and Breyer asked why it is necessary for local companies to lease out all facilities, particularly those that can be duplicated easily. By analogy, railroads may have to let rivals use their “bottleneck” tracks in areas where there is only one line, but they do not have to lease them locomotives, warehouses or fork-lift trucks.

There is an even more crucial difference between old-style industrial networks like railroads and the modern telecommunications network. The monopoly rail facilities built a century ago are still there, using the same steel, wooden ties and ballast. By contrast, the modern telecommunications network is nothing like its counterpart of just 20 years ago. The local companies are constantly updating the network to carry far more information at ever-higher speeds. Today’s network piece-part may be discarded next year because the optimal network design has changed.

But whose network is it? What if the original local company wants to adapt it to new technologies or modify it to deliver new services, but these changes are incompatible with the new lessee’s operations? The railroad would not alter its track gauge or rail size, but a telephone company is constantly upgrading its plant to accommodate new technology. Will this upgrading simply have to stop or be negotiated with the other companies leasing its facilities? Who decides?

The impact of the court’s opinion on the value of telecom equities was dramatic. The value of most large local companies, including the former Bell companies and GTE, fell 4% to 10% in the first few hours after the opinion was handed down. The long-distance companies and newer local entrants, such as RCN and Winstar, generally rose 2% to 4% during the same period. The market clearly assumed that the established local companies were now going to be forced to offer their networks to their rivals at deep discounts.

Given that these companies are the suppliers of much of the country’s basic telecommunications infrastructure, the market’s reaction is surely cause for concern. Why should these firms invest in new, often risky technology for delivering advanced, high-speed services if they are to be required to offer any such new facilities to their rivals at cost? Interestingly, the FCC’s first response to the court’s ruling was to delay its imminent decision on when and how to forbear from regulating new services.

As Justices Breyer and Scalia both note, the FCC has not made it clear why all network parts must be made available to rivals. Why not simply limit this cumbersome, controversial process to just those facilities that would be prohibitive to duplicate, such as that last mile of copper wire to a customer’s house? Or is even this necessary? There are now at least six or seven different owners of wireless telephony licenses in every major market in the country, and more could enter at any time. Why not let them provide the last mile?

Of course, the FCC and the courts may eventually agree, after another two or three years, that the 1996 law requires substantial unbundling of these parts and that they should be offered to rivals at prices that are lower than the local companies’ embedded costs. If they do, how can the courts allow the states to continue to set the final, retail rates that the older companies must charge, while the new entrants’ rates are unregulated? Could it possibly make sense for a state to tell one of these companies with embedded costs of, say, $25 a month per customer to charge businesses $40 a month, to charge residences $15 a month, and to lease its entire networks to rivals at $20 a month? It is hardly surprising that new entrants are rushing in to serve business customers, ignoring residential customers, and hiring expensive lawyers to argue the wisdom of such a regulatory scheme.

In earlier, simpler times—say, the 1980s—deregulation meant eliminating state controls on pricing and letting anyone build his own business by buying airplanes or trucks to compete with United Airlines or InterMountain Express. The 1996 Telecommunications Act is not deregulation but a vast new regulatory program designed to mold and shape competition through mandatory wholesale leasing of pieces of an incredibly complicated network at prices that are based on regulators’ imperfect understanding of costs.

Justice Breyer has it right when he opines that “rules that force firms to share every resource or element of a business would create, not competition, but pervasive regulation, for the regulators, not the marketplace would set the relevant terms.” Justice Scalia doesn’t go quite this far in his criticism of the FCC, because he finds that “the Telecommunications Act of 1996 is not a model of clarity. It is in many respects a model of ambiguity or indeed even self-contradiction.”

The FCC has gone too far in implementing this act, but the true problem lies in the act itself. Congress should revisit the matter and provide the FCC with a new law that provides for true competition and deregulation, much as it did with airlines, trucking and railroads 20 years ago.