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Statement of Reed Hundt
Federal Communications Commission

Universal Service

Before the
Committee on Commerce, Science and Transportation
United States Senate

March 12, 1997

Thank you, Mr. Chairman, for inviting me here today. The Commission has the important responsibility to address the issues of universal service and access charge reform at a critical juncture in the history of the U.S. telecommunications industry -- a time when the Telecommunications Act of 1996 seeks to open the door to competition among all industry players in all industry segments.

The preamble to the Conference Report summarized Congress' basic vision of the 1996 Act. The Act establishes a "pro-competitive, de-regulatory national policy framework designed to accelerate rapidly private sector deployment of advanced telecommunications and information technologies and services to all Americans by opening up all telecommunications markets to competition." In everything that we have done since passage of the 1996 Act, the Commission has been faithful to that policy.

Our implementation of universal service and access charge reform also will be consistent with Congress' clearly stated goals. We are acutely aware that universal service is about delivering real telephone service in real places across our country to real people -- to people in rural America, to low income people who need help in order to have phone service, to children in classrooms and the whole public in libraries, and to doctors and their patients in rural health care centers. Congress gave us a two part mission: to ensure that universal service continues to be delivered throughout the country, and to do so in a way that "open[s] all telecommunications markets to competition."

The 1996 Act is beginning to bring changes to the marketplace, but not necessarily as fast as many had hoped. An example of these changes is the repeal of the MFJ and the GTE consent decree. As a result of this legislative initiative, GTE gained immediate entry into the long-distance market and has, according to a recent Merrill Lynch report, gained 7% of users in its service territories, and SNET has entered long-distance in Connecticut, gaining upwards of 35% of long-distance users there.

In addition, as Section 271 of the Act states, after the "competitive checklist" has been fully implemented and the Commission finds that entry is in the public interest, the Regional Bell Operating Companies will gain access to the long-distance market. The Bell Companies are at different points in this process. Just last Friday, a hearing examiner in Illinois issued a proposed decision which, if adopted by the Illinois Commerce Commission, would find that Ameritech -- a company known to be seeking early entry into long distance -- has not yet met several parts of the competitive checklist. However, in time there is no doubt that the Bells will enter the long distance market. Ultimately, this development will very likely re-define the nature, marketing, and pricing of all telephone services.

As part of the pro-competitive nature of the Act, Congress also wisely decided that long-distance companies and many others should be allowed to compete vigorously to provide local telephone service. To do this, the Act gave new entrants three basic rights: buying at wholesale, leasing elements, and interconnecting from new facilities. Effective enforcement of all three rights is necessary to expedite the entry of new competitors into the local exchange and access markets. Without specific, enforceable rules that let new entrants bypass or share the existing essential facilities of local networks, there is little chance that Americans will have a choice in local phone service. The creeping pace of competition a year after the law was passed stands as testimony to this fact.

There are a variety of reasons why competition may be moving forward slowly. Certainly it has been a long process for many new entrants, including the long-distance companies, to obtain interconnection agreements. Some in the investment community have also suggested that companies are waiting for the results of the Commission's universal service and access reform rulemakings (see Federal-State Joint Board on Universal Service, CC Docket No. 96-45, Recommended Decision, FCC 96J-3 (rel. Nov. 8, 1996); Access Charge Reform, CC Docket No. 96-262, Notice of Proposed Rulemaking, FCC 96-488 (rel. Dec. 24, 1996)) before committing to the large investments necessary to enter local telephone markets. This is especially true in rural areas, which will be unlikely to see competition until competitors can also receive subsidies.

The litigation in the United States Court of Appeals for the 8th Circuit over the validity of the core rules implementing sections 251 and 252 -- the local competition provisions -- of the Act has also clearly added to the climate of uncertainty. Several members of this Committee -- including the Majority Leader, Ranking Democratic Member Sen. Hollings, Sen. Stevens, and Sen. Inouye, in addition to Chairman Bliley and Ranking Member Markey of the House Commerce Committee -- submitted a brief to the 8th Circuit clearly setting forth Congress' intent for the Commission to issue rules setting a common national understanding of the key terms of the 1996 Act. See Iowa Utilities Board v. FCC, No. 96-3321 (8th Cir.), Brief of Amici Curiae (Rep. Bliley, Sens. Hollings, Stevens, Inouye, Lott, and Rep. Markey) (filed Dec. 23, 1996). We admire their brief a great deal and are grateful for it. As you know, however, others, including other Members of Congress, have presented an alternate view to the court. The court has yet to rule.

What will happen as competition begins? It is predictable that new entrants -- whether local exchange companies, long distance companies, cable companies, or companies formerly called Competitive Access Providers -- will target high volume users in their rivals' markets, especially those in the densest, lowest cost and therefore most desirable areas. For example, we should expect competitive LECs to focus their initial operations in urban America, with a strong focus on business rather than residential customers.

New entry by competitors in the lowest cost, highest profit market segments means that today's pillars of implicit subsidy -- high interstate and intrastate access charges, high prices for business services, averaging rates over broad geographic areas, and high prices for advanced services such as Caller ID or call forwarding -- will be under marketplace attack. These are four of the pillars that have held up universal service until now. Without universal service reform, competition will erode all four pillars.

Congress foresaw these developments and therefore mandated that universal service be reformed. The Act required the Commission, by March 8, 1996, to institute and refer to a Joint Board a proceeding to recommend changes to implement the universal service provisions of the Act, including defining the services that are supported by Federal universal service support mechanisms and a timetable for the completion of such recommendations. The Joint Board was required to make its recommendations to the Commission by November 8, 1996. The Commission must complete rules to implement the Joint Board's recommendations, including rules defining the services to be supported, and establish a timetable for implementation of the recommendations by May 8, 1997.

Section 254 requires the Commission and the Joint Board to base policies for the preservation and advancement of universal service on the following principles:

  1. "Quality services should be available at just, reasonable, and affordable rates."

  2. "Access to advanced telecommunications and information services should be provided in all regions of the Nation."

  3. "Consumers in all regions of the Nation, including low-income consumers and those in rural, insular, and high cost areas, should have access to telecommunications and information services, including interexchange services and advanced telecommunications and information services, that are reasonably comparable to those services provided in urban areas and that are available at rates that are reasonably comparable to rates charged for similar services in urban areas."

  4. "All providers of telecommunications services should make an equitable and nondiscriminatory contribution to the preservation and advancement of universal service."

  5. "There should be specific, predictable and sufficient Federal and state mechanisms to preserve and advance universal service."

  6. "Elementary and secondary schools and classrooms, health care providers, and libraries should have access to advanced telecommunications services as described in subsection 254(h)."

  7. "Such other principles as the Joint Board and the Commission determine are necessary and appropriate for the protection of the public interest, convenience, and necessity and are consistent with the Act."

Section 254 did not assign any one of these principles or objectives priority over any other principle or objective. All have equal importance and urgency.

Section 254 further directs that federal universal service support "should be explicit and sufficient to achieve the purposes of this section." Section 254 also makes clear that a state may adopt its own universal service mechanisms, provided that such mechanisms are "not inconsistent with the Commission's rules to preserve and advance universal service," that such program cannot "rely on or burden federal universal service support mechanisms," and that providers of intrastate telecommunications services must contribute "on an equitable and nondiscriminatory basis" to the "preservation and advancement of universal service in that state."

That is what we are doing. The Commission issued its notice of proposed rulemaking on universal service on March 8, 1996, seeking comments, convening a Joint Board, and referring the matter to that Joint Board for recommendations. The Joint Board issued its recommendations November 8, 1996. The Joint Board voted unanimously (Democrats and Republicans, state and federal commissioners, and the consumer advocate) on all of the following recommendations:

Principles --
Rural, Insular and High Cost Areas --
Low Income Subscribers --
Schools and Libraries --
Rural Health Care Providers --
Administration --

The only issues on which the Joint Board split was the issue of the appropriate collection base for universal service support, and the subscriber line charge. By a 6-2 vote, the Joint Board recommended that support for schools, libraries and rural health care providers be collected from both interstate and intrastate revenues of all providers of interstate telecommunications services, and the Board made no recommendation as to the funding base for rural, insular and high cost support or for low income support. Two members of the Board, Commissioner Ken McClure (Vice-Chairman, Missouri Public Service Commission) and Commissioner Laska Schoenfelder (Member, South Dakota Public Service Commission), disagreed, stating that all schools, libraries and rural health care funding, and all funding for rural, insular and high cost areas and for service to low income subscribers should be collected only from the interstate revenues of providers of interstate telecommunications services. On the issue of the subscriber line charge, the Board recommended by a 7-1 vote that the SLC for primary residence and single line business should be reduced according to a specified formula if funding for federal support to high cost areas and low income subscribers were collected from both the interstate and intrastate revenues of providers of interstate telecommunications services. Commissioner Chong dissented from the conditional recommendation to reduce the primary residence and single line business SLC.

An Approach to Universal Service

a. In General
When properly implemented, universal service reform should, through a combination of federal and state efforts, make it possible for an efficient carrier, existing telephone company or new entrant, profitably to provide affordable universal service in high cost areas and to low income persons, and for schools, libraries and rural health care providers to be able to afford to use advanced telecommunications and information services. Under the 1996 Act, universal service is not achieved simply by ordering carriers to provide below cost service to some customers or areas, and to make up the difference through rates charged for other services or in other areas. To the contrary, the statute requires that support for universal service be "explicit" and "sufficient," and that contribution to universal service be obtained from "all providers of telecommunications service on an equitable and nondiscriminatory basis." The Act clearly contemplated that there could be more than one provider of universal service in any given area, so that carriers may be competing even to provide universal service.

This approach both ensures that universal service will continue to be provided even as competition enters the marketplace, and it maximizes the opportunity for competition to develop to provide universal service to rural, insular and high cost areas, to low income persons, and to schools, libraries and rural health care providers. Through the combination of federal and state efforts, a carrier should receive enough money to cover the costs of efficiently providing service to a particular customer at an affordable retail price. This will ensure that universal service continues to be provided, even in the most remote parts of our country. Moreover, as long as subsidies are portable from universal service carrier to universal service carrier, new entrants can develop business plans that embrace, rather than shun, rural America.

The Joint Board recommendations provide the outline for the Federal Communications Commission and the state public utility commissions to build such a universal service system. Such a universal service system would have various benefits.

First, as competition arrived in the cities, especially for business customers, the universal service provider would have reduced concern about the impact of competition on the subsidy base. Business rates, interstate and intrastate access rates, vertical feature rates, and even some urban residential rates, might approximate cost without threatening universal service.

Second, to the extent that more than one provider sought to provide affordable universal service and to compete for the opportunity to receive a subsidy, rural consumers could benefit from innovative service and product packages. The universal service system would not preclude clever entrepreneurs from finding ways to make a business out of providing universal service in rural America, as is the case today.

Third, because any carrier can become eligible to receive a subsidy for serving high cost areas, there will no longer be a subsidy-based regulatory incentive for large carriers, such as

U S West, to sell exchanges to small carriers.

The universal service fund also acts as a "market-maker" with respect to service to schools, libraries, and rural health care providers. The Joint Board recommendations with respect to schools and libraries, for example, define the product that needs to be provided -- connection between the student in the classroom and the Internet -- and define the price discount to be funded by universal service. The exact combination of technologies used to provide that service is left to competitors in the marketplace to determine.

On average, every dollar of universal service funds spent for service to classrooms and libraries will generate matching funds of 67 cents -- just for the covered services. Although telecommunications providers will pay at most $2.25 billion per year, they have the potential to receive at least $4 billion per year by collecting their tariffed rates for these services to schools. Plus, demand can be expected to grow as educators learn to use these new tools to teach. In total, according to estimates by McKinsey & Co., the universal service funds will account for at most 9% of the costs of connecting students in every classroom to the internet.

On the topic of universal service, many members of the Joint Board supported a combined interstate and intrastate fund. I believe the Commission has the jurisdictional authority to do so. The Board wisely agreed that a combined fund is clearly the superior policy option. In the absence of a unified fund, both the effective contribution rates and the basis of assessment could also vary between the federal and state jurisdictions. Thus, carriers may have artificial regulatory incentives to classify their revenues as inter- or intrastate, or otherwise to minimize their universal service contribution burden.

However, many states, including Alabama, California, Colorado, Georgia, Illinois, Iowa, Kansas, Kentucky, Maryland, Missouri, New York, and Utah, have argued that the Commission does not have the authority to base contributions on intrastate revenues. As I said in a recent speech to the National Association of Regulatory Utility Commissioners, I am very reluctant to precipitate another jurisdictional war in civil court. We should be mindful of the value of comity toward the states. Those states that seek high cost support only for costs assigned to the interstate jurisdiction surely have their own plans for how the state could use its own authority to ensure affordable rates for universal service. It would be presumptuous to assume that these state representatives are ill-informed, misguided, or unwilling to meet their obligations under section 254. Indeed, they have every motivation to meet their obligations.

It is also important to recognize why it is important to avoid a jurisdictional battle over universal service. If these rules were stayed, especially in an area as critical as how to collect universal service contributions, our country could be left with no universal service program. A lengthy litigation could truly threaten universal service, because competition may eventually arrive in urban America.

The Commission, in setting its final universal service rules and establishing a timetable for the implementation of the universal service system, will also have to decide other fundamental questions about high cost support that continue to challenge us. The cost proxy models -- which the Joint Board recommended form the initial basis for determining high cost support for large telephone companies but not smaller rural telephone companies -- have only just now arrived at the FCC and are still undergoing revisions by the parties, turning them into moving targets for assessment by FCC staff, state joint board members (who were supposed to weigh in by March 1st) and other commenters. (Just running one of the models took 40 hours of computer time.)

I am increasingly concerned whether a workable, reliable model will emerge in time for our decision on May 8, or whether we will need an interim step in our implementation timetable to permit us to further refine how to determine the cost of providing universal service. I also have doubts about whether models, rather than studies of the forward-looking costs of actual providers, are a better way to determine the level of support in the longer term. These and other complexities that we are grappling with may warrant a phased approach to our decision on high cost support for large telephone companies.

I believe we can, by May 8, set in place the universal service support mechanisms for schools and libraries, rural health care and low income users. Those steps can be taken now, on the basis of the Joint Board's recommendations, and are not affected by the complexities of cost proxy models.

b. Rural Telephone Companies
As previously stated, the Joint Board's recommendations made special accommodations for small, rural telephone companies. First, the Joint Board recognized that a proxy-based universal service support system that was adequate to determine support for a large telephone company may not be well-suited to address the needs of small telephone companies. Such a model would have to be much more precise before it could be applied to small telephone companies. To permit greater refinement of any proxy-methodology, the Joint Board recommended that proxies not be used to determine any support for a rural telephone company before January 1, 2001. Beginning on January 1, 2001, rural companies would begin a three-year transition to proxy-based support.

Second, the Joint Board recommended that a rural company be permitted to elect to move to a proxy-based support mechanism at any time. The Board recognized that a rural company would only do so if it could get greater support than under the interim transition plan.

Third, while the Board recommended that present high cost support to rural companies be converted to a per-line subsidy, the recommendation would allow a company's total subsidy draw to grow as the number of subscribers also grows. This avoids penalizing companies facing growth during the transition period.

Finally, in any instance in which the rules recommended by the Joint Board would severely constrain investment, the Commission retains the ability to waive the rules to reflect a particularly compelling investment need.

Many small companies presently receive a larger share of revenue from interstate access charges than do larger companies. These funds, in part, contribute to the costs of providing universal service. Some of the money small companies currently collect through access charges -- for example, switching subsidies currently funded by tripling the interstate share of switching cost -- referred to as the "DEM Weighting" program -- would explicitly be collected and disbursed through universal service. This is a transfer, not a reduction, of this universal service support.

As further discussed below, the Commission has not proposed, at this time, to alter the methods rural telephone companies use for calculating and collecting interstate access charges, except for certain changes relating to the TIC and the common line rate structure.

An Approach to Access Charge Reform
Access charge reform is the "flip side" of the universal service coin. Local Exchange Companies (LECs) as a group collect approximately $23 billion annually in interstate access charges. At present, $7.1 billion is collected by LECs directly from end user customers in subscriber line charges. The remaining $16 billion is collected by LECs from interexchange carriers as follows:

Per-Minute Switched Access Charges

Carrier Common Line $ 3.7 billion

Transport Interconnection Charge $ 2.9

Local Switching (and other traffic sensitive charges) $ 4.2

Total Per-Minute Switched Access Charges $10.8

Transport (Facilities) $ 1.1

Special Access $ 3.1

Information $ 0.3

Miscellaneous $ 1.0

The existing access charge system was adopted at approximately the same time that AT&T divested its local exchange operations and established the seven regional Bell companies pursuant to the Modification of Final Judgment (MFJ). Like the MFJ, the existing access charge system assumed that local exchange networks are and would continue to be monopolies. As a consequence, the rules were designed to promote efficient competition for long distance service, but were not designed to accommodate or even contemplate competition for local service. To a significant degree, pre-existing implicit support flows from long distance service to local service were incorporated into and mandated by those rules. These subsidies are caused by, among other things, rate structure rules that require LECs to assess per-minute usage charges to recover costs that do not vary with the usage of the network and to average their access rates across a state, and separations rules that allocate to interstate access services costs unrelated to the provision of those services. In other words, per minute access charges are set at artificially inflated levels significantly above the economic cost of providing access services in order to support local service. Through these charges, high-volume interstate toll users as a group pay a portion of the costs of providing telephone service to low-volume customers, regardless of ability to pay.

As the local competition provisions of the 1996 Act are fully implemented by incumbent local exchange carriers with enforcement by federal and state utility commissions, the competition that will be created will render the current access charge system unsustainable. Once competitors have the option of bypassing LEC access services by using their own facilities or unbundled network elements purchased from the incumbent LEC, the competitors will be able to offer lucrative high volume customers equivalent service at significantly lower overall charges than those offered by LECs today, even if the competitors are no more efficient -- or are less efficient -- than the incumbent LEC. Without access and universal service reform, as local markets become genuinely competitive, the implicit subsidies contained in today's access charges will be competed away and the support they provide for universal service will disappear. Conversely, the current access charge pricing structure also reduces competition for low-volume customers since these customers are now being subsidized by high-volume customers. Competitors must not only beat the incumbent LEC's costs, but also the implicit subsidy in order to serve less-desirable customers.

Section 254(e) requires that all federal universal service support mechanisms be "explicit." Interstate access, as it currently stands, is the largest federal universal service support mechanism, and it is entirely implicit. Because these subsidies are implicit, they are hard to estimate.

With respect to access charge reform, I think that our target is clear: over time lowering traffic sensitive interstate access charges to forward looking cost and restructuring access prices to reflect the way in which costs are incurred by LECs. That is what would happen in a competitive market and thus we should seek to emulate this result in the absence of such competition. Where and when the market for a particular access service is workably competitive, access prices should be set by the market. A key question in access reform is not the target, but how -- and how fast -- we get there.

On average, interstate per minute access charges are just under 3 cents today and carriers' estimates of the forward looking economic cost of access service range from .4 to about 1.2 cents. This means that access is priced somewhere between 250-700 percent too high. This inefficient pricing discourages broad entry by new entrants (because revenues are concentrated in high volume users) and deters usage of long distance (because it is priced artificially high).

To get from where we are today to where we would like to be, the Joint Board suggested moving some traffic sensitive charges to flat rate charges imposed on IXCs by the LECs. This flat rate access charge is plainly the subject of state and federal consensus, as stated by the Joint Board, and should be implemented as part of our access reform proceeding.

But we still have to decide how much usage-based charges should be reduced on what we call Step One, the effective date for the changes in our access reform order, and how long we should take to phase in the rest of the reduction required to get to forward looking cost. Plainly, as the usage charges go down, the flat rate access charge will have to be phased in. But how closely should these two processes be tied together? Should the transition processes be on the same track or would staggering them in some way be better?

Nor is it obvious that the flat rate access charge ought to be imposed equally on all access lines. There is some rationale for imposing the new flat rate charge more quickly or to a greater degree, at least initially, on multiline businesses and residential second lines than on single line residences. This technique would be beneficial for low volume toll users and yet still would broaden the distribution of revenues and hence encourage wide competitive entry.

In terms of rate levels, we may wish to have different approaches for originating and terminating access charges. There seems to be broad consensus among economists that originating access rates will experience significantly more downward pressure from market forces than terminating access. This idea is fairly intuitive: the calling party chooses the originating carrier but doesn't select the terminating carrier. Thus, we suspect that the better method favors smaller initial reductions and a more market-based approach for originating access, and more significant initial reductions and a more prescriptive approach on terminating access.

The combined effect of the changes I am discussing here today is to take a significant step toward getting access charges to cost immediately, with the bulk of additional reductions coming later, over time. There's also sound economic reasoning behind this phased approach: a significant but partial step in reducing usage-based access charges to economic cost-based levels has disproportionately large positive effects.

As to future access reductions, it will be critical to set in motion a predictable process in our order that will reduce access to forward looking economic cost within a reasonable time period. Of course, the market may drive change faster or give us new information over time.

The Historic Cost Issue
As we observed in the Access NPRM, we also intend to address the question of LEC recovery of historic costs. We recognize that there may be some costs that the incumbent LECs should rightfully be able to recover, but which will be difficult to recover in a competitive market. This is a classic problem of transitioning from monopoly-based regulation to a competitive market. Some of these costs may represent under-depreciated assets or investment.

I do not believe, however, that we should begin the inquiry into the historic cost issue with the supposition that the LEC is necessarily guaranteed as a matter of law a complete certainty of recovering all such investment. Takings is certainly one of our concerns here, but we must not forget "givings." Let me mention three: first, giving the LECs cellular licenses worth billions; second, giving LECs yellow pages publishing opportunities (also worth billions); and third, giving LECs the opportunity to enter long distance, where they can leverage their regulated local asset.

Like high cost support, historic cost recovery is a difficult analytical task and in our Order, we may wish to provide guidance for a joint Federal-State effort, akin to the Joint Board process, to address this question.

In conclusion, Mr. Chairman, I thank you for the opportunity to testify on these important topics.

Our country has a telephone network that today is the envy of the world. It delivers real service to real people in real places in a way that is unsurpassed. But we can do more and can do better.

That's what the 1996 Act was all about: creating a telecommunications system that is better, faster, and more powerful throughout our country, and bringing our country the economic and social benefits that even better telecommunications will bring. And Congress wisely chose to rely on competition as the primary means to make that happen.

The changes we have discussed today are about making sure that those benefits reach rural Americans, low income Americans, children in classrooms and libraries and rural health care providers. This is what you told us to do, and we will do it.

These are not easy issues. The Commission and its staff are working hard, with states, industry, and consumers, to find solutions. We will continue to do so, both up to our decisions this May, and beyond.

I look forward to your questions.