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The Tyranny of the Low Home Phone Rate
[September 27, 2006]

The Tyranny of the Low Home Phone Rate

ionary Consulting
For many years, the telephone industry was a regulated monopoly, and the regulators were often more than a little friendly with the industry that they were regulating. If they could come up with a common position, then the industry could profit while the regulators could tell the public what a good job they were doing. And for the majority of American consumers, the most visible evidence of that job was the monthly phone bill.
Of course phone rates had to be low enough to allow people of modest means to afford telephones. If home phone rates were too high, then it would not be possible to assume that every home had a phone. Hence the concept of universal service was both public policy and a marketing strategy.

This led to a regulatory scheme known as residual pricing. While it was not always the official stated policy of state or federal regulators, it generally reflected a common point of view. Under residual pricing, the goal of telephone rate regulation was to minimize the “1FR” rate — the monthly charge for basic single-party flat-rate residential local telephone service. Therefore the price for everything else was to be set at profit-maximizing levels, so that their monopoly profits could subsidize 1FR.
This sort of worked when the monopoly was enforced, but competition weakened the whole scheme. For instance, when the FCC’s (News - Alert) 1968 Carterfone decision allowed customers to attach their own terminal equipment (telephones, PBX (News - Alert) systems, answering machines, modems, etc.) to the telephone network, many regulators joined Ma Bell in opposing it because the loss of monopoly profits (i.e., prices much higher than actual cost) could have led to an increase in the 1FR rate. Likewise, many regulators joined phone companies in opposing the opening of long distance competition, because a loss of monopoly profits on long distance calls — the distinction between “local” and “long distance” being largely arbitrary in a modern network — could have led to an increase in the 1FR rate.
The Telecom Act of 1996 should have been the death knell for such obsolete ideas. It opened up local service — the last bastion of a de jure monopoly — to competition, a process which should have led to the end of any expectation of monopoly profits and below-cost rates. Instead, a complex system was left in place that had plenty of room for non-cost-based pricing, monopoly profits, and cross-subsidies from one product to another. And on top of it, a new one, the Universal Service Fund, was thrown on. Competitive free market? Far from it!
The Telecom Act Didn’t Cause the Meltdown
While the first few years after the Telecom Act was passed saw a tremendous growth in competitive investment, it didn’t last. The era of irrational exuberance led to excessive investment in some areas — most of which predated the Telecom Act — and these led to a shake-out and some huge losses. I documented this in my book The Great Telecom Meltdown, noting that the Telecom Act was not responsible for most of the bubble. The Incumbent Local Exchange Carriers, the ones who frankly were best at gaming the rules and had the most residual monopoly power, exercised their political power and improved their position. This was done at the expense of their competitors, their customers, and the economy in general. So now the United States is trailing most of the industrialized world in its telecom development, but the ILECs are the big fish in a shrinking pond.
Wholesale and Retail Rates
It’s important to distinguish between the different portions of the overall telecommunications industry, and between the different types of products and prices charged by local telephone companies. It’s a frightfully complex scheme. The 1FR rate is just one piece of a very complex puzzle, which hardly anyone understands in its entirety. Local telephone networks are extremely capital-intensive, and the same capital assets are used for multiple purposes. Allocating costs between them is more art than science, more politics than math. Indeed, some state regulators have recently complained to the FCC that the phone companies are still allocating too much cost to their regulated side, thereby subsidizing their competitive operations, such as their money-losing ISPs.
A system of price caps replaced traditional rate of return regulation, for all but the smallest carriers, in the early 1990s. Under the price cap system, the prices that ILECs charge for various basic and wholesale services (where they still have monopoly power) are allowed to change by a certain percentage each year, based on a formula that reflects both inflation and expected increases in productivity. Both state-regulated retail telephone rates and federally-regulated intercarrier wholesale rates are usually covered by price cap rules. But not always.
Price caps sound pro-consumer, because they prevent big increases in the 1FR rate. But the cost of delivering most services has actually been decreasing. The Bells have dramatically shrunk their work forces since price caps started allowing them to keep increased profits without reducing rates. Electronic equipment, including switching gear, has tremendously dropped in cost. And fiber optics allow increased call capacity without much new investment. If the Telecom Act had been enforced, and real competition been allowed to develop, then perhaps competitive pressure would have held down rates, and the caps could have been dropped. But since 2001, the FCC and certain courts (notably the Court of Appeals for the D.C. Circuit) have bent over backwards to prop up the Bells and kill their major (and most of their minor) competitors. Only the cable industry still poses a real threat. It is beginning to offer a real choice to more and more consumers, but not everyone has a meaningful choice of local telephone service yet. Indeed there was far more choice five years ago than there is now.
The Bells’ high prices may act as a “price umbrella” to give competitors room to offer lower prices while still making a profit. But it doesn’t always work that way, because the Bells (and even worse, the rural ILECs) can take much of that money back in the form of wholesale charges. Now in most industries, “wholesale” refers to the low price paid by bulk purchasers. But in the topsy-turvy world of telecommunications, “wholesale” refers to charges paid by other carriers to the ILECs. Because the purpose of these charges has usually been to hold down the 1FR rate, they are often set very high.
The Telecom Act did call for Unbundled Network Elements (UNEs) to be set at a cost-based “wholesale” rate, which was a true wholesale offering, the type that might occur in a true competitive marketplace. But since 2003, the Republican-dominated FCC has gutted that requirement, flouting the law with the same sort of regard in which they held the Fourth Amendment’s prohibition against warrantless wiretaps.
So let’s clarify the different meanings of “wholesale” in the topsy-turvy phone world.
“Switched Access” tariffs are “wholesale” rates charged to other carriers for the use of Local Exchange Carrier networks for non-local calls. These were created to extract a share of long distance revenues, back when long distance was very expensive. A long distance carrier is charged this rate at both ends of the call. Since there are fewer and fewer long distance carriers now, a LEC charges this to other carriers when they decide that the call is not “local” enough. Global NAPs, the CLEC carrying most of the modem traffic in Massachusetts, was cut off by Verizon (News - Alert) earlier this year. The pro-Bell state regulators and a deferential court accepted Verizon’s preposterous claim that calls to Global NAPs’ modems were “long distance” because the modems were in Quincy, five miles south of Boston, and most of the callers were elsewhere in the Boston metropolitan area, not “local”, by a very narrow definition, to Quincy. Thus, when Verizon subscribers dialed Global NAPs local numbers, Verizon didn’t owe Global NAPs the pittance (normally $.0007) paid for carrying half of a call to an ISP; rather, Global NAPs owed Verizon a much higher “wholesale” fee for originating “long distance” calls within the state.
“Special Access” tariffs are “wholesale” rates charged to both other carriers and end users for what used to be called private line services. In most areas, these prices are not even capped any more, because the FCC deems this sufficiently “competitive” if there is another carrier who collocates in an ILEC central office anywhere within the same metropolitan statistical area. The cellular carriers are a huge captive market, needing T1 circuits to reach their many cell sites around a city; these typically cost the cellco a few hundred dollars apiece per month. Wholesale? Saudi Arabia may make a higher profit margin on its oil, but crack dealers only wish their illegal business were as profitable.
Competitive LECs are allowed to resell ILEC tariffed services and pay a “wholesale” rate; this is supposed to represent the tariff price minus the “avoided costs” of marketing and uncollectibles. In other words, if the CLEC’s customer doesn’t pay up, it still has to pay the ILEC. This “discount” is usually in the 20% range, and is a small and declining business. And the discount doesn’t apply to other “wholesale” services, such as Special Access. It’s meant to allow CLECs to sell 1FR and similar products without really competing with the incumbents. But this type of wholesale/retail relationship is more like the one between Ford and its dealers than one between competitors.
Reform on the Way? Maybe…
Wholesale rates — formally known as intercarrier compensation — have been on the table for years. The FCC knows that the current system is broken. But it’s afraid to actually do anything meaningful if it offends the rural ILECs whose Access rates are far higher than even the Bells’, and whose 1FR rates still cover only a fraction of their actual costs. Rural state senators like Alaska’s Ted Stevens are very influential on telecom issues.
Several weeks ago, a coalition of rural telephone companies and a few big carriers, including SBC (a/k/a “AT&T (News - Alert) Inc.”), came out with yet another proposal. The Missoula Plan, as it is called, has raised a lot of controversy because it raises the cap on the residential Subscriber Line Charge to $10. This “FCC Line Charge” is often lumped on retail phone bills along with taxes, but it’s just part of the price, above and beyond the price cap, and goes to the telephone company. Essentially it’s a surcharge on the 1FR rate. The Missoula Plan lowers Switched Access charges but does not do away with the system of call classification that so often trips up competitors such as Global NAPs. Supposedly this is to protect the 1FR rate. But wouldn’t a truly competitive market be even more effective at protecting consumers against abuse? Some consumer advocates are upset with Missoula because the SLC goes up, but if there were competition, then this higher ILEC rate (which the ILECs don’t have to charge) would just lead to competitive loss.

Higher residential rates are not per se desirable. But the telecom sector today is a lot more than home phones. In most of the world, wholesale and intercarrier rates are simpler and more rational, home phone rates are still affordable, while “broadband” and other advanced services are more successful. A regulatory mish-mash designed to minimize the home phone rate, and to hell with everything else, is a cure far worse than the disease.

Fred Goldstein is principal of Ionary Consulting. He advises companies on technical, regulatory and business issues related to the telecommunications and Internet industries, especially in areas where they overlap.

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