Is Phone “Competition at the Crossroads?”: An Analysis of the Consumer Federation of America’s Local Competition Study

Full study available in pdf format.

On October 7, 2003 the Consumer Federation of America (CFA) released a study entitled, Competition at the Crossroads: Can Public Utility Commissions Save Local Phone Competition? The study found that local telephone company arguments for higher wholesale prices for leasing parts of their networks and for reduced access to these so-called unbundled network elements (UNEs) would spell the “end of local phone competition” and “the real savings being enjoyed by consumers across the country.” To support its findings, the CFA study disputed three arguments it said are used by the Regional Bell Operating Companies for raising UNE wholesale prices and for restricting the availability of UNEs. 

• Claim 1 – Competition would be stimulated if local incumbents were allowed to enter the long distance

market before new market entrants have established access to the existing telephone network;

• Claim 2 – UNE prices do not adequately reflect costs, and represent a ‘subsidy’ to competitors; and

• Claim 3 – Withdrawing access to UNEs will force competitors to make investments in their own facilities and networks.

The CFA study concluded that when incumbents were allowed into the long distance market before local markets were irreversibly open, competition did not take hold; that there was a strong relationship between wholesale costs and UNE prices; and that there was no evidence that reduced UNE availability led to higher investment rates by competitors. Competitive local exchange carriers (CLECs) make investments in those segments where it makes economic sense to do so, the CFA study found.

Thus far, the CFA study’s findings and conclusions have not been publicly scrutinized by academics or telecommunications experts. Having previously examined the effects of UNEs in the states, the CEI and NMRC undertook this critique to assess the basis of the CFA study claims. This report presents the views of two telecommunications experts – Solveig Singleton, Senior Policy Analyst for the Competitive Enterprise Institute and Stephen B. Pociask, President of TeleNomic Research, LLC. Each reviews, qualitatively and quantitatively, the CFA study’s assertions, claims, and recommendations and provides insightful perspectives on the role that UNEs play in local phone competition, consumer benefits, and network investment.

Solveig Singleton finds that the CFA study doesn’t address telephone company investment after the telecom bubble burst. Instead, it focuses on capital investment after the 96 Telecom Act. She says those investment levels were unsustainable, that regulators should use price controls sparingly, and that basing wholesale prices on a future hypothetical cost model does nothing to finance the building of today’s networks.

“Regulators must recognize that investment follows incentives, and price controls erode incentives,” says Ms. Singleton. “The essential problem with TELRIC [is that] the super-efficient network is imaginary and quite subjective. TELRIC price controls and unquestioning unbundling of everything under the sun erode incentives to invest in new wireline networks. The FCC’s own data show that CLECs are abandoning their own access lines to piggyback on the old networks.”

“For a stark contrast, look at the rates of growth in less-regulated wireless. This is where the real opportunities for investors are and where the real choices for consumers will continue to spread,” Ms. Singleton says. Regulators should, keeping in mind how they will transition out of them.”

For real competition to occur, Ms. Singleton argues that facilities based competition should be paramount.  “If the networks of the future are to be something other than a twisted reflection of legal complexities, competition in building networks is just as important as competition in marketing, pricing, and packaging…Endlessly repackaging the same service offered over the same network will not end monopoly. Real competition happens between real networks.”

“The idea behind holding the locals out of long distance was to provide a ‘carrot’ to tempt them to open their local markets,” says Ms. Singleton. To get the “carrot,” RBOCs had to open their local markets and were saddled with the “stick” of unbundling, she says. “From a regulatory standpoint, this may have been a necessary transitional measure.  But for consumers, it’s doubtful that the game was worth the candle.” The CFA study, rather oddly, doesn’t recognize the tension between consumer interests and regulatory strategy here, she adds.

In any case, the carrot/stick model the CFA study defends is fast becoming outdated, she says. “The long distance market is looking unhealthy as revenues fall. So the longer we wait to let local companies provide long distance, the more likely they will lose interest and find less regulated opportunities.”

Ms. Singleton also points out that for the CFA study’s argument on TELRIC prices and costs to have any validity at all, the process for measuring costs at the state level should have some kind of integrity. “In practice, wild fluctuations in rates within some states, gross inconsistencies in rates across similar states, and the bizarre technological concepts cooked up in state regulatory proceedings make it unlikely that these costs measures are worth the paper they are printed on. Certainly, investors are not relying on them.”

“The CFA study ignores the lessons of the telecom meltdown; sustainable investment requires stable incentives, not regulatory hand-holding of one market segment,” Ms. Singleton concludes. “It ignores the growth of business competition in local markets from the 1980s, showing that if BOCs do inflate their costs/prices they will be undercut by facilities-based competitors.” The paper employs a simple-minded definition of competition, ignoring the benefits of competition in building networks and access, she says. Finally, the paper pretends that TELRIC yields an objective measure of costs, as opposed to an artificial construct subject to wild manipulation, she notes.

Ms. Singleton recommends that State regulators should recognize that UNE-P and TELRIC regulations hurt consumers more than they help. “It is time to take the next step towards real competition between real networks. UNE-P and TELRIC itself should be phased out, the latter to be replaced first by a more objective measure of costs. Ultimately, both retail and wholesale prices must be deregulated.”

Disputing the CFA study’s contention that competition is in trouble, Stephen Pociask finds that competition is developing at a robust pace and more regulation is the last thing the industry needs. “There are over 153 million wireless subscribers, a number rivaling the total traditional telephone lines provided by the Regional Bell Operating Companies (RBOCs).” Competition is also taking shape in the form of tens of million of high-speed connections from cable operators and other broadband providers, he says. “These high-speed services permit voice communications, as well as data and video transport services, making them far superior to traditional telephone service.”

Mr. Pociask also points out that the CFA study ignores this competition and focuses on only the market for traditional local voice telephone services. Even given this limited focus, the traditional local telephone market is irreversibly open to competition, he says. “This is not, as the CFA would lead one to believe, an ILEC view or an RBOC view, this is the view 48 of 48 state commissions that have independently judged the ILECs to have sufficiently and irreversibly opened their markets to CLECs in terms of interconnection and nondiscriminatory access of the ILECs’ facilities.”

Mr. Pociask also disputes the CFA study’s three main arguments.

Claim 1. – Mr. Pociask notes that the RBOCs have never been allowed to enter an in-region long distance market before that market was fully opened to competitors. “The Section 271 competitive checklist requires markets to be irreversibly opened first and requires nondiscriminatory access for CLECs before ILECs can enter that long distance market…In all 48 states where Section-271 process could be applied, the ILECs’ markets were found to be irreversibly opened.”

He also says there is evidence that ILEC entry into the long distance market did increase competition in the local exchange market, after Section 271 approval. And in the opposite case, Mr. Pociask finds that there is evidence that ILEC entry into the long distance market did increase competition in that market. “Where local telephone companies have been permitted to provide long distance services, the increase in competition has been sufficient to lower consumer prices,” he says.

If consumers are benefiting from competition, why does the CFA study argue for more regulation, Mr. Pociask asks. “Several studies have shown that the potential benefits from long distance competition exceed the potential benefits of local competition by more than 4 to 1. Oddly, holding back long distance entry, a position that the CFA study appears to favor, harms consumers.” He concludes there is overwhelming evidence that consumers are saving as a result of the elimination of long distance entry barriers. “The CFA report has selectively ignored the studies and facts cited here.”

Claim 2. – Mr. Pociask notes the CFA study attempts to prove something different than the ILECs supposedly claim. The ILECs’ claim that UNE prices do not fully recover their costs, including investment costs. “If, for example, UNE prices only recovered 40% of the ILECs’ costs, then the ILEC claim would be true,” states Mr. Pociask. “However, if every state set prices this way (recovery of only 40% of costs), then the CFA study response – that there is a strong relationship between wholesale costs and retail prices – would also be true.”

Evidence suggests that UNE prices are set so low that they represent a corporate subsidy for the CLECs paid for by the ILECs, he says. “One study calculated that TELRIC costs (the formula used to price network elements) would need to be marked up 3.3 times in order to recover the ILECs’ sunk costs and risks.”

“In contrast, regulatory commissions estimate that ILECs can shed only 19 percent of their cost when the ILECs’ retail customers are replaced by the ILECs’ wholesale services,” says Mr. Pociask. This divergence between price and cost leads to an absolute decline in cash flow and earnings for ILECs, he notes. “The CFA study retort for this is

that these earnings are based on historically embedded costs, while TELRIC estimates are based on future competitive costs.” TELRIC models are full of assumptions that may not reflect real-world realities, such as hurricane damage, network redundancies for security and reliability, and human error, he says. “Economists have criticized TELRIC models and their assumptions for years.”

Still, the CFA study believes that UNE prices are reasonable. The CFA study’s evidence is also weak, says Mr. Pociask. “They offer data showing that TELRIC costs are roughly aligned to UNE prices. The CFA study shows FCC data on what is supposed to be residential CLEC lines. What the CFA study does not tell the reader is that the FCC does not publish residential CLEC line data separately – it combines residential and small business lines.”

Accepting that error, the CFA study shows only that TELRIC costs are similar to UNE prices, he notes. “Both price and TELRIC costs can be too low and be correlated. Therefore, the CFA study has not provided any evidence to support its conclusions.”

Claim 3. – The CFA study finds no relationship between current UNE price and UNE use by CLECs, defying even the laws of supply and demand, says Mr. Pociask. “To support this claim, the CFA study pairs and plots, for each state, UNE prices (as a percent of residential retail price) against the percent of total UNE lines in use by CLECs, and not the percent of residential UNE lines in use by CLECs. Similarly, the CFA study pairs and plots, for each state, UNE prices (as a percent of business retail price) against the percent of UNE line use by CLECs, and not the percent of business UNE lines in use by CLECs. Therefore, not one of the seventy-eight data points in the CFA study finds the correct point on both the horizontal and vertical axes.” The result is a confusing, meaningless scatter plot that the CFA study uses in finding no relationship between UNE discounting and UNE use by CLECs, he finds.

There is ample evidence that consumers benefit from competition. For this reason, the CFA study should support fair competition and resist efforts (by some) to give an advantage to one competitor over another, he concludes.