Telecommunications in the Age of Change Conference and Summit Meeting October 28, 1996 Baltimore, Maryland The Implementation of the Telecommunications Act of 1996 James W. Olson Chief, Competition Division Office of General Counsel, Federal Communications Commission Introduction Good afternoon. First, I would like to thank Barry LeCerf and Jane Lauer for inviting me here to talk with all of you about these exciting and important issues. Before I begin, let me state that anything I say here represents my own views and does not necessarily represent the views of the Commission or the Office of General Counsel. In February of this year, Congress passed the most important telecommunications law in over sixty years. Indeed, it is one of the broadest, far-reaching de-regulatory initiatives of all time -- the de-monopolization of the local exchange business, a $100 billion a year industry in this country. And that is its current size -- not what we may expect it to be as the result of competitive forces. We are gathered here today to talk about the impact that the Telecommunications Act will have on the utility industry and the telecom sector in general. This Act will cause sweeping changes in both the way telecommunications firms do business and the way they are regulated. I will begin by discussing one change that the Telecom Act implemented for your companies that conforms with the policy of opening up all barriers to entry in the telecom industry. I will then discuss in broader terms some of the critical debates that are going on in the wake of the 8th Circuit stay of part of our local interconnection rules. The Telecom Act is About Entry Congress's policy of open entry into all telecom markets is clearly evident in an issue near and dear to your hearts -- the entry of electric utilities. Under the new legislation, registered holding companies may now diversify into telecommunication industries (and therefore need not obtain prior SEC approval before doing so) by acquiring or maintaining an interest in an "exempt telecommunications company." Similarly, exempt public utility holding companies now have available a "safe harbor" from any prospective SEC action if they diversify into telecommunications. There are several compelling policy reasons why holding companies should be permitted to enter the telecommunications industry. Most important, this is America, and people should be free to enter into any lawful business they want to enter. Indeed, in the dynamic world of telecommunications, people should have the freedom to succeed -- and the freedom to fail. In addition, Congress clearly believed that these holding companies are well-situated to provide rival facilities for the provision of competitive telecom and information services. One portion of the Senate Report states: Allowing . . . holding companies to become vigorous competitors in the telecommunications industry is in the public interest. Consumers are likely to benefit when more well capitalized and experienced providers of telecommunications services actively compete. Competition to offer the same services may result in lower prices to consumers. Moreover, numerous competitors may offer consumers a wider choice of services and options. More specifically -- ø Many utilities already have sophisticated systems for internal dispatch purposes. This represents a source of wireless expertise and well-sited antenna facilities. ø Utilities can use their easements to bring newly-configured fiber capacity on-line and use their neighborhood poles as wireless platforms. ø Utilities could use their demand-side management facilities to deliver video programming as an alternative to existing cable service. ø Finally, and perhaps most significantly, utilities can make effective partners for new entrants by providing sufficient capital and facilities to compete for local telephony. In short, public utility holding companies have the potential, alone or with others, not only to provide a new information conduit into our homes, but to provide needed platforms and facilities necessary to augment and expand the existing wireless conduits. Last month, the Commission adopted the final rules necessary to implement the provisions of the Act relating to holding company entry -- some five months ahead of the statutory requirement. Already we are seeing the benefits of holding company entry. For example, ø NU/Mode 1 Communications, Inc., an ETC subsidiary of Northeast Utilities, stated that it intends to construct new fiber-optic facilities along the transmission corridors of public utility affiliates of Northeast Utilities. The project, known as the New England Optical Network ("NEON"), will initially consist of approximately 410 miles of backbone fiber installed along electric utility rights- of-way in Connecticut, Massachusetts, and New Hampshire. This portion of the network will be initially constructed within the current service territory of the operating companies of Northeast Utilities, but will subsequently be extended to encompass the entire New England region of the United States and potentially eastern Canada as well. ø Several ETC subsidiaries of the Southern Company will attempt to operate customer calling centers, which will take calls from new customers for traditional telecommunications, video, utility or other services. This will assist, for example, new entrants in the wireless market who may lack many of the facilities needed to establish a local presence, such as Personal Communications Service ("PCS") providers. According to the applications, the calling centers would place an order for the requested service (via computer) directly with the service provider in question. In addition, consumers will have the ability to contact the calling centers to request emergency or repair service for the service ordered. In these cases, the call centers would report (via computer or telephone) the customer problem to the utility or other service provider so that the provider could dispatch work crews. Finally, these calling centers could also process billing and other customer information including preparing and sending bills, or providing "back office" operations. ø Entergy, a major Gulf Coast utility, reported that its ETC affiliates are moving forward with plans to commercialize Entergy's internal 1,000 mile fiber-optic network and offer major telecommunications companies "long-haul" fiber-optic capacity which can be used as part of their national networks. ø In addition, Central and Southwest reported that its ETC affiliate was just awarded a $4.2 million contract to implement a communications-based utility management system for Austin, Texas. This system, based on CSW Communication's Customer Choice & Control Program, will be one of the largest fully automated electric and water utility management systems deployed in the U.S. The Telecom Act is Not Revolutionary But while the Telecom Act certainly opens new doors for your firms, I think it would be inaccurate to consider the Telecom Act as a whole to be "revolutionary." Because while the Act marks a dramatic shift in telecommunications policy in the U.S., all the Act did was bring the telecom industry in line with the rest of the American economy. The old 1934 Communications Act embodied the "natural monopoly" economic theory for telecom regulation. It was a rigid regime that required direct state control over decisions telecom firms made over the means of production. In this old regime, rates were directly regulated by the government, but jurisdiction was split between states and the federal government in a medieval manner. States regulated "intrastate" services and the FCC regulated "interstate" services. As a result, the Commission and the States had to "apportion" costs of certain facilities between them. Now, you know and I know that in an industry of national and international scale such a distinction is untenable. The distinction is also generally irrelevant to consumers. To maintain and control this rate structure, it was illegal to be a competitive local telephone company in many states. I do not think I have to tell you that this type of governmental involvement in sanctioning monopolies is un-American. You know that we generally do not approve of monopolies in America. The history of the Sherman Act and its enforcement is decidedly anti-monopoly and expresses a preference for competition. The landmark Alcoa and Standard Oil cases are evidence of American concern about monopolies. Alcoa, by Judge Learned Hand, was the original articulation of the "price squeeze" doctrine, which is one method by which antitrust law has dealt with a monopolist that sells necessary inputs to its competitors. And indeed, the merger review process -- the embodiment of concern over market power -- is perhaps the single largest source of billable hours for antitrust attorneys. So I do not think that the Telecom Act in unleashing the competitive process in local telecommunications markets is "revolutionary." Far from it -- I would consider it a restoration. It is the industries where the "natural monopoly" theory took hold -- the railroads, airlines, power, and telecommunications -- that are the historical exceptions to the general rule of competition. The Telecom Act of 1996 is designed to bring the local telecom business in line with the rest of American industry, where general rules of corporate law and interaction apply, and where competition, not regulation, is the driving force behind deployment of plant and services. The Telecom Act turns upside down the assumption that telecom is a "natural monopoly" and that government must then regulate entry. Congress told us that regulatory decisions based upon the natural monopoly theory should be abandoned. Congress decided that all telecommunications services should be provided through competitive markets. In August of this year, the FCC took the first in a series of steps to move the national policy framework from statutory text to real-world implementation. Merrill Lynch said that by the August order, "the FCC has smoothed the way for ... local market competition." Morgan Stanley called it "evenhanded," CS First Boston said that "the FCC order hits the mark," and that "the FCC is set on the right course." The order was the talk of the world communications circuit. It was all moving along. Interconnection deals between incumbent carriers and start-up rivals were beginning to take shape. Alex Mandl left AT&T, one of the largest telecom firms in the world, to start up a new wireless local exchange firm. Other entirely new firms with new ideas were receiving backing from the venture capital markets. And earlier this month, these new entrants, the FCC and U.S. consumers had the rug pulled out from under them. That was when the 8th Circuit issued a stay regarding the pricing provisions of our rules. After 650 pages of FCC reasoning based on a 17,000 page record, the 8th Circuit decided on the efficacy of these policies in a 9-page judicial decision. The 8th Circuit Stay Jeopardizes Local Competition What the 8th Circuit did can be devastating to the development of competition in local telecommunications market. This is because the Telecom Act established an environment in which the process of local competition may proceed. And if there is one thing that Congress made abundantly clear in the Telecom Act, it is that process was to move forward expeditiously. Congress' overriding purpose in the 1996 Act was to get local competition in place as fast as possible. The 8th Circuit failed to grasp the need for speed -- instead, the 8th Circuit stay has interrupted, disrupted, and jeopardized the entire process for what could be years. From a business point of view, perhaps the worst effect of the 8th Circuit decision is the resulting uncertainty. Even if the 8th Circuit eventually rules in our favor -- as I believe it should -- the confusion generated by the stay will slow investment into local telecom competition and could ruin a great many business plans of the new entrants. For a start-up firm, a six month delay in the generation of revenue could mean the difference between getting venture cap financing and not. Under the Act, Congress required the FCC to articulate broad, pro-competition principles necessary to implement the Act. The states are then required to implement these principles by mediating, arbitrating and approving local interconnection agreements. Indeed, states will end up doing the lions' share of the work and will be tailoring the general principles to their specific situations. The direct issue in the 8th Circuit stay is the role of the FCC in setting the rates for interconnection. But nowhere in our rules did the FCC set a specific price -- we left that role specifically to the states. Instead, we adopted a pricing methodology that we believe is mandated by the Act for local interconnection. To understand why the forward-looking pricing methodology is so important, we must first understand the process that Congress established. Competition is a Process Introducing "competition" to the local exchange is more than waving a magic wand and chanting a spell. Competition itself is a process -- a process that occurs in an environment where rival firms duke it out to provide goods and services to customers. Adam Smith described competition as the "independent striving for patronage by the various sellers in a market." In a rivalrous market, sellers are keenly aware of the presence of their rivals. George Stigler called this type of competition "rivalry in a race" -- which is a fitting vision because it implies that individual suppliers and purchasers may be winners and losers in any individual transaction. Competitive rivalry is inherently dynamic, not stationary, and results in tremendous economic change. Rivalry may tend to reduce price to marginal cost, but -- more importantly -- it also encourages the development of newer and better products. Schumpeter called it the process of "creative destruction." Entire firms and industries can get blown over by the gale- force winds of competitive rivalry. Firms not on the cutting edge of technological development and marketing will one day find themselves out of business. But this process does not exist in a vacuum. Among other things, it exists in the environment of public policy. What's important to note is that public policy has a great deal of impact on how the competitive process works in an industry. That is, whether a competitive process is healthy in an industry depends not only on technology and consumer preferences, but also on the rights and duties of firms -- which are derived, for better or worse, from what the government does. For instance, if a government gives an exclusive franchise to a cable operator, then monopoly will ensue. Well, if only one firm is allowed to enter, any investment by a new entrant is socially inefficient -- because he will not be allowed by government to recruit customers. Is that a "natural monopoly"? A "monopoly", yes, but certainly not "natural." There are more theoretical examples as well. For instance, governmental guarantees of property rights are fundamental to free market competition in almost all sectors. The influence of public policy upon the competitive process is particularly true in the telecom industry, where entry was outlawed for many years. It is as if you had a vacant lot where for sixty years you continually destroyed every instance where a plant tried to grow. If you then wanted to restore that plot to a tall-grass prairie, you would have to do more than just walk away and come back in six months to see how it is going. It will require affirmative and extraordinary steps on your part. And the transition from a public policy environment where monopolies were sanctioned and protected to one in which competition reigns will be, by definition, an uncertain and traumatic process. Just ask the citizens of the former Soviet Union. To have a robust competitive process in local telecom markets, government has to establish an environment in which the competitive process will work. And I believe that the Telecom Act process -- properly implemented -- provides such a policy environment. The Process of Local Competition Adopted by the Act The first thing that strikes me about local telecom competition is that we are faced with more than simply deconcentrating a market dominated by incumbent monopolies. This is not an industry like retail in which an incumbent's 100% market share in a town can be swiftly reduced simply by building a store across the street. If that is all it took to deliver competition to the local exchange, I am sure we would have done it long ago. There are really two things that give the incumbent monopolist an overwhelming advantage in local telecom markets, absent public policy intervention. Economists call them "network externalities" and "economies of density and scope." Any attempt to have a competitive process in local telecom markets must deal with these externalities and efficiencies - - because they make up the incumbent's advantage in this market. "Network externalities" is a fancy way of stating that the value of a network to its users is directly related to its size. If I wanted to start a new telephone company but the only people my subscribers could call were my other subscribers -- how would I even recruit my first subscriber? My business plan is dead before I even begin. As a simple result of incumbency, and not as a result of any superior skill, foresight, or industry, is that the incumbent has essentially all the customers. This means that before an entrant can even begin to offer service, it must negotiate interconnection with the incumbent monopolist. And the incumbent has nothing to gain and everything to lose by negotiating interconnection with the entrant. If the incumbent were to drag out negotiations on termination charges, or make unreasonable demands on termination prices, or on other terms as a condition of being reasonable on termination prices, it would be sitting pretty while the would-be entrant was effectively kept out of the business. Sections 251, 252 and 253 of the Telecom Act deal with this issue by establishing what I like to term a "Competitive Carrier Bill of Rights." In essence, these provisions set forward a list of default conditions -- available nationwide -- to new entrants who commence negotiations with incumbent local exchange carriers. These governmentally-defined and enforced rights can help entrants cope with the great disparity in negotiating power in these interconnection negotiations. Section 251 mandates interconnection between incumbent and rival local carriers at reasonable rates. This prevents the incumbent network form taking exclusive advantage of the current network externality in the incumbent network. Thus, calls originating on a rival network can terminate on the incumbent network at reasonable cost. A policy of mandatory interconnection requires that the rival entrant be allowed to share the existent economies inherent in the incumbent network. Section 251 also requires incumbent local telephone companies to provide "unbundled network elements" to entrants at reasonable rates. The Act also states that incumbents must offer their retail services to entrants at wholesale rates so the entrant can resell those services. These provisions are efforts to deal with the inherent economies of density and scope that incumbents have and that entrants do not. Provisions for unbundled elements and resale can affect the overall process of competition because they permit new entrants to achieve economies of density and scope similar to the incumbent. One reason these tools are important is that they allow an entrant to engage in mass-market advertising in a region even if its network is only in a small portion of the region at that time. Remember, this is how MCI and Sprint began. For a number of years, MCI and Sprint were the largest resellers of interexchange services -- and that was before they had their own national networks up and running. These tools can be used by entrants to fill in a service area and to let the entrants market broadly before they have their own facilities to support that broad reach. It is also important to remember that the incumbents generally often enjoy these efficiencies of density and scope solely because government affirmatively prevented competition. The incumbent's network is ubiquitous throughout a region because the government said it would be unrivaled and ubiquitous. I think it is entirely reasonable for government now to say that the incumbent must share those government-granted efficiencies of density and scope with the new entrants. The general idea behind the Competitive Carrier Bill of Rights is that the incumbent monopolist is to share the inherent advantages of incumbency -- network externalities and efficiencies of density and scope -- with the entrant. The Act effectively provides the entrant a list of rights that both it and the incumbent know the entrant will be able to obtain in the context of an interconnection negotiation. Knowing this in advance of interconnection will speed the interconnection process and hopefully will swiftly deconcentrate the market. But merely stating that entrants "have" these rights is not sufficient. Because you know and I know that the "devil is in the details" -- rights that are too expensive to exercise or that are impossible to enforce are not worth the paper on which they are written. And that is why the 8th Circuit stay can be catastrophic. Because as a result of the stay, it is very possible that the price entrants must pay for interconnection, unbundled elements, and resale will be anti-competitive. A Forward-Looking Cost Methodology is Proper The largest issue in the 8th Circuit litigation is the pricing of these rights. The FCC interconnection order ruled that these prices must be based upon a forward-looking or economic cost methodology. Several incumbent local carriers believe that these rates should be based upon the "historic" cost of their networks. The reason incumbent carriers want to recover their "historic cost" is simple -- under most circumstances, the historic cost of the network, as reflected in current book value, is much higher than the forward-looking value of those networks. If this is true, this is clearly a failure of past regulatory depreciation policies. That is, the incumbents were not allowed to "write-down" the value of their network assets as fast as they perhaps should have been. In a competitive environment, my accountant, my securities lawyer and Wall Street in general would be very uneasy if my firm had a "book value" for an asset significantly higher than the current economic value of that asset. I believe that it is critical that the price of interconnection and unbundled elements be based on forward-looking, economic cost because that is how businessmen in a competitive environment view their assets in making business decisions. In the important antitrust decision in the MCI/AT&T case in 1983, the 7th Circuit discussed this point and stated: [I]t is current and anticipated cost, rather than historical cost, that is relevant to business decisions to enter markets and price products. The business manager makes a decision to enter a new market by comparing anticipated revenues (at a particular price) with anticipated additional costs. . . . The historical costs associated with the plant already in place are essentially irrelevant to this decision since those costs are "sunk" and unavoidable and are unaffected by the new production decision. (708 F.2d at 1116-17, as modified). That statement unquestionably supports the FCC's interconnection pricing methodology. The underlying philosophy of the Competitive Carrier Bill of Rights -- that the incumbent must share its inherent advantage due to network externalities and economies of density and scope -- also necessarily leads us to the forward-looking price structure set out in the FCC's interconnection order. I do not see how it can be applied in any other way. Take the cost of interconnection -- in essence, the cost of terminating calls on the incumbent's network. The cost of terminating calls must be at current economic cost -- not some fictitious function of past investment. Because if customers of competitors can call everyone, but they or their carrier has to pay above economic cost to terminate the call on the incumbent network, the network externality is not being shared. With regard to the pricing of unbundled network elements, remember that the reason network elements are to be available to entrants is so the entrant can share the economies of density that result from the incumbent's ubiquity. The cost of these elements must be based on forward-looking cost, because when the incumbent contemplates using or expanding or rebuilding or selling its network, it is forward-looking cost that it considers. As a result, only forward-looking cost gives the entrant the same opportunities from the density and ubiquity of the existing network that the incumbent gets. To share the benefit of lower economic costs clearly involves pricing at economic cost. Any other price does not meet the goal. Unfortunately, the 8th Circuit stay jeopardizes the swift adoption of forward-looking cost methodologies for pricing interconnection and unbundled elements. However, I hope that when states actually sit down and examine the language and context of the Act, they will also conclude that forward-looking cost is proper and will adopt such methodologies. In the wake of the 8th Circuit stay, I call on all states voluntarily to adopt this pricing methodology and to say so expressly. Any other approach will at a minimum delay, and at a maximum frustrate, Congress' intent that local competition be established. Enforcement Getting the pricing right is critical for the Telecom Act process of local competition to work. Another critical factor is enforcement of those rights. Much as I described earlier, competition is a process, and the enforcement of the implementing statutes and regulations are a critical part of the environment in which that process takes place. As I described above, entrants may be entitled in law to the most wonderful terms and conditions for interconnection or unbundled elements, but if these rights cannot be adequately enforced, they are not worth the paper they are written on. For local competition to take hold, enforcement of the Competitive Carrier Bill of Rights must be swift and certain. And if there is one thing that is clear from the Telecom Act, it is that Congress wanted the FCC and the states to create as soon as possible an environment in which local competition could develop. The statutory deadlines in the Act make this clear -- the FCC was directed to issue local interconnection rules in 6 months and the states are to resolve interconnection negotiation arbitrations within 9 months of the commencement of negotiations. Congress also changed the FCC's complaint procedure to require us to resolve complaints within 5 months. To deal with this new environment, the FCC must improve upon our traditional enforcement procedures. We are faced with the possibility of having to confront hundreds, if not thousands, of instances where the Commission may be petitioned to "do something." Not only will resources have to be directed at these issues, but both the states and the FCC need to think about how our procedures should be established so that we can provide the swift and certain enforcement responsibility that is needed. We are investigating various formal and informal techniques to help establish an environment in which the entrant's rights are enforceable in a swift and certain manner. This process involves a critical assessment of our traditional means of enforcement -- most notably, complaints filed under Section 208 of the Act and requests for declaratory rulings. In addition to those traditional means, we are exploring some additional tools that Congress provided the FCC in the Telecom Act. Section 253 of the Act says that state and local governments can no longer prevent "any entity" from providing "any telecom" service and requires the Commission to "preempt the enforcement" of state and local actions that have the effect of erecting a barrier to entry. Section 271(d)(6) provides an expedited mechanism for the Commission to resolve issues of BOC continuing compliance with the "competitive checklist" once they are in the long distance market. Other tools to consider are informal ones similar to those the Commission has used successfully in several recent matters where broad guidance was necessary. One idea that has been presented to us is a process in which the Commission would issue letter rulings or advisory opinions on particular topics upon request. This approach was used very successfully in the PCS auctions and I am sure were very useful in clearing up unnecessary confusion. Informal actions like this may help speed up and make more certain formal enforcement processes such as 208 complaints and court processes. If any of you have any additional thoughts about how the Commission can better fulfill its obligation, I would certainly appreciate your insight. Conclusion I would like to wrap up my comments today by taking you back to 1844 in this old and historic city. In that year, Samuel Morse made the first telegraph message from Baltimore to Washington. It was the beginning of the modern communications revolution. And, I would note -- the telegraph was actually the first digital service! The first words that were transmitted in real-time between two people outside of shouting distance still resonate today. Those first words asked a haunting question: "What Hath God Wrought?" It was an eloquent and rather prescient statement on the unpredictability of technological change and regulatory development. Essentially, we as a society have been trying to answer that question ever since. It took another technological advance -- the telephone -- and a state-sanctioned monopoly -- the Bell System -- to remove the teeth from the Western Union monopoly. Now, if we do our job correctly, the local telephone monopoly is in its last stages. Will we see the development of rivalrous, interconnected broadband networks, consisting of a myriad of technologies, all vying for customers? Perhaps. Or will we see data communications completely migrate from the telephone network in favor of parallel broadband networks -- in which case, the telephone network would look a lot like Western Union today? Perhaps. Most importantly, what decisions will be in the forefront of telecommunications consumers ten years from now? I confess that I don't have the foggiest idea. But I am convinced that the services available through existing and new information conduits to the home and office will be of a nature that will amaze us when we view the present retrospectively. The computer industry has undergone rapid waves of transformation that have virtually turned the industry upside down. The power of IBM's mainframes was swamped by networks of networked PCs. Now even that structure is being encompassed by the Internet. If rivalrous competition flourishes in the telecommunications industry, I do not think that we can even begin to estimate the pace or direction of change. The one thing I can tell you is that competition is not always a pretty process. To wit, (dramatically show transparency here for maximum comic effect) And I can also say that the end result will be cheaper, higher quality and more innovative telecommunications products and services offered to consumers by vastly more efficient companies. Thank you for your kind attention. I would be happy to take your questions.