In 1984, as a result of the divestiture of AT&T, state commissions became concerned about the possibility of significant local exchange bypass—the use of alternative
communications facilities or services that circumvent the facilities or services provided by the local telephone company. Many commissioners feared that local exchange bypass would endanger the financial stability of the telephone networks and acted with great energy to address that perceived threat by rebalancing rates—a process in which a commission orders an ILEC to increase local rates55 and decrease the fees (switched access rates) that long distance companies pay to the ILEC for carrying their customers calls over the local telephone network. Following passage of the 1996
Telecommunications Act, the incumbent local exchange carriers expressed similar concerns, yet state commissions, in general, have not acted to rebalance rates. This section explores the differences in regulatory behavior post divesture vs. post Telecommunications Act 1996.
The AT&T antitrust trial began in 1981 and ended in 1982 with the announcement of the Modified Final Judgment (MFJ) agreement between the Department of Justice and AT&T, which required AT&T to divest itself of its local exchange business. The next two years, 1982-1984, spawned a flurry of activity as the various players sought to: 1) implement the terms of the divestiture and 2) come to grips with the impact divestiture would have on the delivery and pricing of telecommunications services. Of special concern to state commissions, and other interested parties, was the impact divestiture would have on the local exchange market. These players “...were determined to maintain at least some of the established revenue flows from long distance service” to the local exchange providers.56
Some state commissions were concerned that an increasingly competitive
telecommunications market would create more opportunity for and instances of local network bypass as major business users sought to avoid paying high charges to the incumbent local providers.57 While state and federal regulators were already starting to
55Of course the objective of rate rebalancing is more than just raising basic local exchange rates. This is borne out by
the fact that there has been substantial rebalancing activity recently of another sort that has not been captured by the trends discussed in this section. That is, state commissioners also are imposing rebalancing as a means to mandate reductions in business and toll access rates. This more recent rebalancing activity occurs because productivity advances and overall revenue growth experienced by the large ILECs in recent years, have enabled state commissions to “buy-down” business and toll access rates without raising local access rates. This type of rebalancing is different from the rebalancing efforts undertaken circa. 1984, which were carried out by raising the price of basic exchange service. The rebalancing activity in that period was performed under the assumption that residential basic exchange service was being provided below its cost of provision; an assumption that, as will be pointed out later in the paper, is of questionable merit.
56Brock, Gerald, W., Telecommunication Policy for the Information Age., Harvard University Press, 1994, p.176
57The local exchange companies defined bypass as “the use of alternative communications facilities or services which
go around or `bypass’ exchange access or distribution facilities provided by the local telephone company.” Maurice Lamb, “Bypass: A Competitive Alternative,” in Changing Patterns in Regulation, Markets, and Technology: The Effect on Public Utility Pricing (East Lansing: Michigan State University Press, 1984), p. 49. For a sampling of debate of the economics of bypass see Lamb’s article as well as, in the same volume, David Brevitz, “A Framework for Evaluating the Threat of Bypass in State Regulatory Proceedings.”
address this issue of bypass in 1980, the divestiture of AT&T added new urgency to these efforts.58 The result was a flurry of rate rebalancing activity as many state commissions sought to safeguard the divested regional bell operating companies (RBOCs) from the potential effects of bypass and ensure that the financial stability of the networks was not undermined by this activity.
As Figure 1 indicates, these increases were quite substantial. The highest period of rate increase activity occurred during 1980-1986, when basic local exchange service rates increased at an annual rate of 10.22 percent.59 This is in striking contrast to the annual rate increase of 0.75 percent that occurred between 1991 and 1997, a period that saw the development and eventual passage of the Telecommunications Act of 1996 (TA96). FIGURE 1: ANNUAL TREND IN BASIC LOCAL SERVICE CHARGE 1980-1997
Source: This graph is derived from data presented in Trends in Telephone Services, September 1999, Service Industry Analysis Division, Common Carrier Bureau, Federal Communications Commission, Table 4.1. Figure 1 represents the trend in the average monthly service charge per household, per year, for those households with telephone service.
Why such a stark contrast between the two periods? After all, as the discussion above illustrates, the passage of (TA96) and the divestiture of AT&T generated similar
58Brock, op. Cit., p. 138.
59During this period the CPI for All Local Charges increased at annual rate of 9.41 percent versus an annual rate of
increase of 4.12 percent in the overall CPI during the same period. So, even taking into account the rate of inflation that was present during this period, charges for local service increased dramatically during this period.
$19.52 $8.74 $16.13 $18.66 $8.00 $10.00 $12.00 $14.00 $16.00 $18.00 $20.00 $22.00 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Year
Price Change for Period 61.32%
Annual Price Change for Period 10.22%
Price Change for Period 14.47%
Annual Price Change for Period 2.91%
Price Change for Period 4.51%
Annual Price Change for Period .75%
Bas
ic
Loc
al Servic
e Charge ( Monthly Servic
e Charges for U n limited Loc al Ser vic e, Taxes , and Subs cr iber Line )
arguments concerning the potential bypass effects of increased competition on the provision of telecommunications services. However, as Figure 1 shows, state commissions have chosen not to increase local rates in anticipation of any possible bypass effects of TA96. This time, commissions are more hesitant about reacting proactively, as they did in anticipation of divestiture and are instead taking a wait and see attitude regarding the effects of (TA96) on the local exchange network.
One explanation for the difference in commission activity is that the ILECs have not exerted much political pressure on state regulators to address the potential bypass effects of the Act. This lack of pressure may indicate that the competitive avenues for entry into the local market created by the Act are causing the ILECs to have second thoughts about requesting state commissions to rebalance rates. More specifically, the ILECs may fear that rate rebalancing would result in a surge of new entrants into the local market.
Another possible reason for the lack of rate rebalancing activity following the passage of TA96 is that most commissions are overwhelmed with work and have not yet had time to consider the impact the Act might have on the local exchanges. This
explanation seems inadequate, however, as commissions were very busy during the divestiture period as well.60 In that period, many commissions were sufficiently concerned about the ramifications of divestiture that they re-arranged their schedules, making the issue a priority item on their agendas.
A third hypothesis is that state commissions have not yet seen how competitive entry is causing harm to ILECs and so are not overly concerned about the issue. Two findings, in particular, support this latter supposition:
With estimates of total competitive local exchange carriers (CLEC) switched lines ranging around 2 to 3 percent of the national total, competition has not currently made major inroads into the ILEC market,61 and so bypass has not been
perceived as being a problem.
Figure 2 lends further support to this perception. The figure shows that the rate of growth in local calling minutes is going up and the rate for toll calls seem to be holding steady or increasing slightly, a sign that the local exchange companies are not currently suffering from any major bypass of their local networks.62
60Carl O. Thorsen and Richard Stannard, “Computer II and Divestiture: A State Regulatory Framework to do the
Impossible in Twelve Months,” in Adjusting to Regulatory, Pricing and Market Realities (East Lansing: Michigan State University Press, 1983), pp. 154-55.
61Local Competition Survey: August 1999, Industry Analysis Division, Common Carrier Bureau, Federal
Communications Commission, p.1, (The report can be downloaded [file name LCOMP99-1.PDF or LCOMP99-1.ZIP] from the FCC-State Link Internet site at http://www.fcc.gov/ccb/stats on the World Wide Web.)
62From the chart it can be observed that local minutes of use is growing at the fastest rate. This is likely due to the
classification of access to ISPs as local traffic. The slow down in the growth rate of interstate toll minutes of use, which is lower than that for intrastate of local traffic, would suggest that some bypass activity may be occurring. This could be due to increased cellular usage, or it could be that some interstate traffic is flowing through the Internet.
FIGURE 2: COMPARISON OF GROWTH RATES IN MINUTES OF USE
Source: This chart was generated from data found in Table 12-1, Dial Equipment Minutes, in Trends in Telephone Service, September 1999. Service Industry Analysis Division, common Carrier Bureau, Federal Communications Commission.
The ILEC’s have earned returns that are greater than the FCC’s authorized rate-of- return of 11.25 percent. If the FCC’s composite rate of return ensures the maintenance of financial integrity, returns in the range illustrated in Table 7 are a strong indicator that the financial viability of the local exchange companies have not, to date, been threatened by any competitive outcomes resulting from the passage of (TA96).
0 5 10 15 20 25 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Year
Growth Rate in Minutes of U
se
Local Intrastate Toll Interstate Toll
TABLE 7: TOTAL AVERAGE RETURN ON REGULATED INVESTMENT FOR THE 150 LARGEST TELEPHONE COMPANIES IN THE US.63
Source: Values in this table were derived using data from the Federal Communications Commissions Automated Report Management Information System (ARMIS) Report 43-01.
The strong ILEC earnings of the past few years, coupled with the low level of CLEC competition in ILEC markets, has apparently convinced state commissions that there is no need to rush to rebalance rates.64 As noted in a recent study of rate restructuring, “…it is striking that a relatively small proportion of states have ordered increases in basic local rates for one or more providers in the last several years, despite the
widespread assumption that basic local rates are below cost. And, of those states with rate increases, a number of these measures are designed to bring the rates charged by smaller independent companies up to the level of the major incumbent local
carrier...rather than to engage in overall restructuring.”65
63The rate-of-return was derived using data from the Federal Communications Commissions Automated Report
Management Information System (ARMIS) Report 43-01. The return is for the combined federal and state regulated operations.
Within ARMIS the federal rate-of-return is calculated by dividing the net return by the net investment. Net return is derived by taking the sum of total operating revenues and other operating income and subtracting from that the operating expenses, federal and other taxes, and non-operating items. Subtracting the reserves from the sum of plant in-service and other investments derives the net investment. This same methodology was applied to the combined state and federal data.
64The FCC recently concluded that the current state of competition at the local exchange level is not placing
sufficiently large competitive pressures on the incumbent local exchange carriers that would require the creation of a large universal service fund. In a May 1999 decision the Commission stated that “...we are hesitant to mandate large increases in explicit federal support for local rates in the absence of clear evidence that such increases are necessary either to preserve universal service, or to protect affordable and reasonably comparable rates, consistent with the development of efficient competition.” Seventh Report & Order and Thirteenth Order on Reconsideration in CC Docket No.
96-45 Fourth Report & Order in CC Docket No. 96-262 and Further Notice of Proposed Rulemaking, Before the Federal
Communications Commission, Adopted: May 27, 1999; Released: May 28, 1999, at ¶69.
65McDowell, Stephen D. and Kostadin Kostadinov, Basic Local Telephone Rates: Comparing Plans for Restructuring,
Paper for the 1999 Telecommunications Policy Research Conference, September 25-27, Section XVII, p.21. McDowell and Kostadinov suggest that re-balancing may come more to the fore when current local-rate freezes expire. These freezes were often adopted as part of an alternative regulatory plan. The plans are due to expire in the next few years. Id.
RETURN ON REGULATED NET INVESTMENT 1996 RETURN ON REGULATED NET INVESTMENT 1997 RETURN ON REGULATED NET INVESTMENT 1998 14.19% 13.24% 14.13