Can Public Utility Commissions Save Local Phone Competition?

COMPETITION AT THE CROSSROADS: CAN PUBLIC UTILITY COMMISSIONS SAVE LOCAL PHONE COMPETITION?

TABLE OF CONTENTS

EXECUTIVE SUMMARY ...... 1

LOCAL COMPETITION DELIVERS THE BENEFITS TO RESIDENTIAL CONSUMERS...... 4 THE STRUGGLE TO OPEN LOCAL MARKETS AND KEEP THEM OPEN ...... 4 THE STAKES FOR CONSUMERS ...... 5 WHAT’S AT STAKE FOR THE STATES? ...... 7

THE NATURE OF LOCAL COMPETITION...... 12 OPENING LOCAL MARKETS TO COMPETITION...... 12 THE TIMING OF ENTRY AND COMPETITION ...... 15

INVESTMENT BEHAVIOR CONTRADICTS RBOC CLAIMS ...... 18 UNE PRICES AND COSTS ...... 18 COMPETITION AND INVESTMENT: THE FACTS...... 20 COMPETITION AND INVESTMENT: THE THEORY...... 24

CONCLUSION...... 26

ENDNOTES ...... 27

LIST OF EXHIBITS

Exhibit 1: Residential Market: ILEC Long Distance Compared to CLEC Local...... 6 Exhibit 2: The Importance Of Bundle Competition In Major States...... 8 Exhibit 3: SBC’s Campaign To Raise Une Prices Is Way Out Of Line...... 10 Exhibit 4: Residential CLEC Lines As A Percent Of CLEC Lines: Florida ...... 11 Exhibit 5: Competition In The Local Telephone Market...... 14 Exhibit 6: The Level And Growth Of Competition Before And After RBOC Entry, New York And Texas, All Lines ...... 16 Exhibit 7: CLEC Penetration In Residential/Small Business Market...... 17 Exhibit 8: No Relationship Between UNE-P Rates and CLEC Reliance On UNES...... 21 Exhibit 9: Telecom Capital Expenditures, 1996-2001...... 22 Exhibit 10: Incremental Telecom Sector Investment, 1996 As Base Year...... 23

EXECUTIVE SUMMARY

Introduction

The 1996 Telecom Act was supposed to shake up the telecommunications industry, encouraging competition where there had been monopoly. The Act aimed to allow new companies to spring forward and compete with existing Regional Bell Operating Companies (RBOCs) to provide local phone services. It encouraged RBOCs to enter the long distance market and increase competition there, but only after irreversibly opening up local markets.

The successful opening of local markets and expansion of competition relied heavily upon the state public utility commissions (PUCs) to create conditions that would foster local competition. First, PUCs forced reluctant RBOCs to adopt procedures for interoperating with competitive carriers, allowing for smooth operation and switching of customers. Second, PUCs set reasonable prices for unbundled network elements (UNEs) providing competitive carriers with access to the incumbent local exchange companies’ (ILECs) networks, and sufficiently compensated ILECs for the costs involved with providing UNEs. This system resulted in the emergence of an unprecedented amount of competition for local service, providing 50 million consumers with a choice of service providers and substantial savings.

Earlier this year, the 1996 Telecommunications Act passed a milestone. After seven years, many state markets are open to local competition, and local exchange carriers are now authorized to also sell long distance in well over half the jurisdictions where RBOCs are the incumbent local exchange carriers. By the end of 2003, the Bells are likely to be selling long distance in almost all of their home states. Independent local exchange companies, never part of the RBOC system, have also been allowed to enter into the market for long distance service.

The Stakes for Consumers are High

Markets open to competition are able to offer competitive choices for long distance and local services. More recently, providers have begun to offer bundled long distance and local service at lower rates from a sole provider. Recent press accounts put the number of consumers in competitive markets that have switched to one-stop-shopping “bundles” of services at close to 30 million – 12+ million for the competitors and 18+ million for the incumbents. An additional 18+ million customers have switched local providers to secure better rates. In other words, there are nearly 50 million customers who are the direct beneficiaries of competition – 30+ million who have switched providers and 18+ million who have taken incumbent bundles.

As a result, consumers are reaping sizeable savings. These consumers of bundles are likely to have an average bill in the range of $55-$65 per month for the services that make up the bundle. With bundles selling in the range of $40-$50 per month, the savings of $15 per month is substantial. As a result, the total consumer savings is now in the range of $5 billion per year.

RBOC efforts to delay or halt competition by withholding access to UNEs pose a major threat to these consumer gains. If the RBOCs succeed in forcing regulators to withdraw the unbundled

1 network element platform (UNE-P), or raising the price that RBOCs can charge competitors, they will drive competition from the market and diminish consumer savings.

The Key Battlegrounds

The struggle to open local markets took seven years after the Telecommunications Act of 1996 was passed. Obstacles to fair competitive markets remain in some states and the implementation of the FCC’s Triennial Review Order places the competitive industry, and consumer savings, at great risk. In the major states that are likely to serve as the battlegrounds for the Triennial Review and UNE pricing, the stakes are huge.

The fate of the competitive industry, and consumer choice, will effectively be decided in six states: Florida, California, Illinois, Texas, and New York. These states account for about 10 million CLEC bundles and 13 million ILEC bundles. Losing UNEs in these states would be a devastating blow to the CLEC industry and to consumers. Over $4 billion of consumer savings on bundles in these states could be lost annually.

In Illinois, competitors serve about 19 percent of phone lines in the state. The competition that has developed suggests that as many as 3.5 million customers are taking advantage of bundled savings in Illinois, accumulating savings of over half a billion dollars per year. But, SBC secured legislation, now stayed in court, that would have increased UNE prices and erased these savings. Similar savings are at stake in other states like California, Texas, New York and Florida.

The damage that would result from higher UNE prices or the dismantling of the UNE platform would hurt all consumers, as incumbents would no longer face effective competition in its territory, and would be able to raise prices for all its customers. Premature removal of UNEs or sharp price increases will lead to the re-monopolization of the industry, an end to emerging vigorous competition and cost consumers billions of dollars in the form of higher prices.

Debunking the ILECs’ Claims

The recent progress toward more open and competitive local telecom markets is important but fragile. Although competition has made significant gains, the Bells are working hard to undermine UNE-based competition and force weakened competitive local exchange carriers (CLECs) to build redundant telecommunications networks. A successful result for the RBOCs on this would put a swift end to local competition.

This paper examines three arguments that have been advanced by the Bell companies in support of these anti-competitive aims. In the past RBOCs have employed these arguments to delay opening their local markets to competition. They are reviving them now in an attempt to reduce the availability of UNEs, or to raise UNE pricing to such exorbitant rates that competitors would be forced from the marketplace. This paper examines the current state of competition in 39 of the largest states where public data is available regarding residential competition. Our research shows that, in each case, the Bell’s arguments are both misleading and unfounded.

2 Argument One: The ILECs claim that competition would be stimulated if the Bells are allowed to enter the long distance phone market before new market entrants have real access to the existing telephone network.

CFA Study Findings: This claim is false. The experience of early competition shows that when incumbents are allowed into the interLATA long distance market before local markets are irreversibly open, competition does not take hold. The incumbents quickly capture long distance customers without having to compete on price because barriers to local market entry have not been removed. Incumbents face little real local competition and their hold is reinforced by their unique ability to offer a bundle of both local and long distance services without discounting prices.

Argument Two: UNE prices do not adequately reflect costs, and represent a “subsidy” to competitors.

CFA Study Findings: This paper clearly demonstrates a strong relationship between wholesale costs and UNE prices. Comparisons between UNE prices and a variety of cost and revenue estimates have become the focal debate point. RBOCs insist that their (rejected) estimates of costs are the right numbers. Wall Street analysts and others assume that all claimed costs are legitimate, notwithstanding the history of monopoly inefficiency, and that every penny of lost RBOC revenue reduces investment in the network. After several years of cost proceedings, state public utility commissions established prices for UNEs based on a forward- looking, efficient view of costs.

Argument Three: Withdrawing access to Unbundled Network Elements will force the CLECs to make investments in their own facilities and networks.

CFA Study Findings: There is no evidence that reduced UNE availability leads to higher CLEC investment rates. CLECs make investments in those segments where it makes economic sense to do so. This paper details the distinct lack of a relationship between the discount for UNEs and the percentage of CLEC lines provisioned across states. Neither the discount for residential nor business UNEs exhibits a statistically significant relationship to the percentage of lines provisioned.

With the release by the FCC of its detailed Triennial Review order, a new front in the ongoing battle to open and maintain competitive markets is about to emerge. State regulators will soon embark on a series of impairment proceedings in which each public utility commission will evaluate whether UNEs in its jurisdiction can be withdrawn without impairing competition. The outcome of these proceedings will determine the future of local phone competition.

3 LOCAL COMPETITION DELIVERS THE BENEFITS TO RESIDENTIAL CONSUMERS

THE STRUGGLE TO OPEN LOCAL MARKETS AND KEEP THEM OPEN

Earlier this year, the 1996 Telecommunications Act passed a milestone. With a wave of FCC approvals of section 271 applications, the nation passed the halfway mark in the market opening process that began seven years earlier. In well over half the jurisdictions in which Regional Bell Operating Companies (RBOCs) were the incumbent local exchange carriers, markets have been opened to local competition and local exchange carriers are now authorized to also sell long distance. By the end of 2003, the RBOCs are likely to be selling long distance in almost all of their home states. Independent local exchange companies, that had never been part of the RBOC system, have also been allowed to enter into the market for long distance service.

The successful opening of local markets and expansion of competition has relied upon the state public utility commissions’ (PUCs’) ability to effectively create the conditions necessary to foster local competition. 1 First, they forced incumbents to adopt procedures for interconnecting and interoperating with competitive carriers that generally allowed for smooth operation and switching of customers. Second, the PUCs’ set reasonable prices for unbundled network elements, or UNEs, that allowed competitive carriers access to the incumbent local exchange companies (ILECs) network while sufficiently compensating ILECs for the costs involved with providing UNEs. This system, which utilizes forward looking prices known as “TELRIC,” has resulted in the emergence of an unprecedented amount of competition for local service, which has provided 50 million consumers with a choice of service providers and substantial savings.

However, the road to a completely open market is still long, as the ILECs, led by the RBOCs continue to resist competition. The gains that have been made are fragile and vulnerable, especially since many of the competitors are in or near bankruptcy. Regulators must remain vigilant and continue to promote competition, if it is to survive and flourish.

The RBOCs first began their post-Telecom Act assault on competition by claiming that allowing them to enter the long distance market, even before providing their competitors with adequate access to the local telecommunications network, would stimulate competition. They argued that competitors were holding back on entering the local market just to keep RBOCs out of the long distance market. The RBOCs urged policymakers to let them enter long distance sooner, which they claimed would force the new entrants to compete more vigorously. The analysis presented below refutes this claim.

The RBOCs further insist that the UNE rates set by state public utility commissions do not adequately reflect the costs incurred by them to provide wholesale access to the telecommunications network. RBOCs continue their assault on competition by seeking dramatic increases in the price that they are able to charge competitors for UNEs and seeking to withdraw some network elements from the market entirely. These tactics were displayed most graphically in Illinois earlier this year, where SBC, the dominant local phone company, was successful in ramming a bill through the legislature in less than two weeks that would double the price of 4 UNEs. The analysis presented below shows that the UNE prices have been set consistently with forward looking economic costs.

Having been allowed to offer long distance service in most markets, the RBOCs now claim it is time to take away UNEs at TELRIC prices in order to stimulate investment in network equipment. They claim that providing UNEs at reasonable rates acts as a disincentive for competitors to invest in the system infrastructure. Competitive local exchange carriers (CLECs) respond that removal of competitor access to UNEs would put an end to most of the local competition that has sprung up across the country. CLECs argue that the telecommunications network that the ILECs built under monopoly protections, and still control, simply cannot be replicated by new entrants subject to the full force of competition. In fact, analysis shows that investment is stimulated by UNE competition, not deterred.

Meanwhile, the release of the FCC’s detailed Triennial Review Order in August 2003 has opened yet another front in the battle over competition: a state-by-state series of impairment proceedings in which each public utility commission will evaluate whether UNEs can be withdrawn without impairing competition. As a result, state public utility commissions will soon become the focal point of the next phase of the battle to open the telecommunications market to full competition. In response to the FCC Triennial Order, the RBOCs have unleashed a barrage of legal cases against the Commission’s decision to rely on the states to make market-by-market determinations of the need to continue the availability of UNEs. The RBOCs’ goal is simple; to shut down UNE-based competition and force a weakened CLEC industry to build a second telecommunications network. The result would be a swift end to local competition.

Given the billions of dollars in consumer savings at stake, and the speed with which events in the telecom policy arena are occurring at present, there has never been a more important time to understand the nature of competition that has developed in local telecommunications markets. It is also high time that some of the myths propagated by the RBOCs to advance their self-interested, anti-competitive agenda were analyzed and debunked. The analysis presented below refutes these claims and shows that increasing prices, as proposed by the ILECs, would strangle competition and undermine the large savings consumers have finally begun to enjoy as a result of UNE-based competition.

Telecom competition and regulators are coming to a crossroads. The direction that public policy takes in the coming months will determine the telecommunications landscape for years to come, making it essential that policymakers are informed and make decisions that are based on the facts.

THE STAKES FOR CONSUMERS

Before we examine the technical, economic arguments and data, it is important to understand the stakes for consumers. Over the course of the past year, as an increasing number of states have finally put the necessary conditions for local competition into place, the level of national competition has increased dramatically (see Exhibit 1).

5 EXHIBIT 1: RESIDENTIAL MARKET: ILEC LONG DISTANCE COMPARED TO CLEC LOCAL

PERCENT OF 10

RESIDENTIAL MARKET

0 1999 2000 2001 2002 2003

ILEC LONG DISTANCE CLEC LOCAL

Source: Industry Analysis Division, Local Telephone Competition (Federal Communications Commission, various issues); Brogan, Patrick and Scott Cleland, SBC Hemorrhaging Wireline Business (Precursor Group, August 6, 2003), BellSouth’s Hemorrharrhaging Wireline Business (Precursor Group, August 18, 2003), Qwest’s Hemorrhaging Wireline Business (Precursor Group, September 11, 2003), Verisozon’s Hemorrhaging Wireline Business (Precursor Group, September 16, 2003).

For competition to thrive, it was important for competitors to have the ability to acquire a large base of customers to support their cost of operations and create broad marketing programs.2 Competitors need size and reach to really get going. By the end of 2003, CLECs are likely to have won well over 30 million lines or approximately 20 percent of the total lines. In the residential sector, however, their share of lines is closer to 15 percent. At the same time, we must not forget the quid-pro-quo that the RBOCs received for opening their local markets. The RBOCs may have lost some of their local subscribers, but they have also taken a huge bite out of the long distance market, especially in the residential customer market. By year-end, the RBOCs are likely to account for about one-fifth of the national residential long distance market.

Moreover, after the Telecom Act, the RBOCs sought to become larger entities as well. A spate of mergers has reduced the number of large local companies from eight to four (SBC=Southwestern Bell, Pacific Bell, Ameritech and Southern New England Telephone; Verizon=Bell Atlantic, NYNEX and GTE; Bell South and Qwest). The Baby Bells have added more residential long distance accounts and more cellular accounts than they have lost local accounts. With large bases of local service and a third of the cellular market, the RBOCs have developed into huge corporate entities engaged in a range of telecommunications services.

Today, both incumbents and competitors are able to offer a uniform package across a large number of markets. MCI initiated the process with its “Neighborhood” program and other companies have followed suit. The ILECs have been forced to match the offers and the resulting consumer savings are totaling huge sums. Recent press accounts put the number of consumers who have switched to one-stop-shopping “bundles” of services at close to 30 million – 12+ million for the competitors and 18+ million for the incumbents. An additional 18+ million customers have realized savings by switching providers without switching to bundled services. In other words, there are nearly 50 million customers who are the direct beneficiaries of competition – 30+ million who have switched providers and 18+ million have taken incumbent bundles.

Recognizing that the bundled service offerings are targeted at higher volume customers who are likely to also take a significant number of extra features (vertical services like call waiting, call forwarding, etc.), we conclude that consumers are reaping substantial savings. These higher volume consumers are likely to have an average bill in the range of $55-$65 per month for the services that make up the bundle. With bundles selling in the range of $40-$50 per month, the savings of $15 per month is substantial. As a result, the total consumer savings is now in the range of $5 billion per year and that does not include savings for others who have switched, but not take bundles.

WHAT’S AT STAKE FOR THE STATES?

RBOC efforts to undermine competition by attacking UNEs pose a major threat to these consumer gains. If the RBOCs succeed under the FCC’s new order in forcing regulators to withdraw the unbundled network element platform (UNE-P), or raising the price that ILECs can charge competitors, they will drive competition from the market, and diminish consumer

7 savings. In the major states that are likely to serve as the battlegrounds for the Triennial Review and UNE pricing, the stakes for competition and consumers are huge.

The fate of the CLEC industry will effectively be decided in a handful of major states. The states identified in Exhibit 2 – Florida, California, Illinois, Texas, and New York – account for about 10 million CLEC bundles and 13 million ILEC bundles. Losing UNEs in these states would be a devastating blow to the CLEC industry and to consumers. Over $4 billion of consumer savings on bundles in these states could be lost annually.

EXHIBIT 2: THE IMPORTANCE OF BUNDLE COMPETITION IN MAJOR STATES

STATE TOTAL BUNDLES CONSUMER SAVINGS (CLEC + ILEC) (Millions of $)

Florida 2.5 450 California 6.0 1080 Illinois 3.5 630 Texas 5.0 900 New York 5.4 970 TOTAL 22.4 4030

Illinois provides a striking case. Despite SBC’s best efforts to stop it, local phone competition is beginning to work in Illinois. Once the Illinois Commerce Commission (ICC) set reasonable price levels for the UNEs in the state, local phone service competition has flourished. According to the Federal Communications Commission, competitors now serve about 19 percent of phone lines in the state, up from 17 percent at the end of 2001 and just 9 percent at the close of 2000. Illinois currently has the fourth most competitive market for local phone service in the country.

The availability of UNEs at reasonable prices has been key to this growth. Analysts place the level of competitive lines available for local service relying on leased UNEs in SBC territory at approximately 75%.

8 Although SBC claims that UNEs are priced too low in Illinois, the evidence indicates that the Illinois Commerce Commission has been effective in setting reasonable prices, as discussed below. However, with the help of their considerable political muscle in the state, SBC rammed a bill to force the ICC to raise these rates through the legislature earlier this year. Under the legislation, the cost of UNE-P in Illinois would approximately double – from around $12 to the range of $22-$24.

According to the most recent data on UNE prices, Illinois has the fourth lowest UNE prices in the country (see Exhibit 3). A recent cost filing at the FCC by the National Association of State Consumer Advocates (NASUCA) indicates that Illinois also has the fifth lowest UNE costs in the country. In other words, Illinois’ current UNE prices (assuming the recently passed legislation is not implemented) are perfectly aligned with SBC’s costs. If the price of UNE-P went from $12 to $22, Illinois’ prices would fall from fifth lowest in the country to 42nd place. Increases like this in wholesale prices at a state level, or the withdrawal of the UNE platform upon which most residential competition is built, would have an immediate and devastating effect on consumers.

The competition that has developed suggests that as many as 3.5 million customers are taking advantage of bundled savings in Illinois. This translates into savings of over half a billion dollars annually. Ultimately, the damage that would result from higher UNE prices or the dismantling of the UNE platform would hurt all Illinois consumers, as SBC would no longer face effective competition in the state, it would be able to raise prices for all its customers.

The stakes in California are even larger, where competitors now serve about 8% of phone lines in the state. While this is up from the 2.1% in January of 2000, it is far from a competitive success story. Even so, nearly 6 million California households are benefiting from access to bundled services saving an estimated $1 billion annually. The state PUC is poised to adopt UNE prices that are designed to stimulate competition for local phone service and will promote more bundling of local and long distance services to the added benefit of consumers

A year ago, SBC asked the PUC to increase wholesale UNE prices to almost $30, nearly equivalent to what they charge for services for retail customers. This would have obliterated competition and robbed California consumers of substantial savings. That effort was rejected by the PUC. Currently, SBC has mounted a new campaign to get legislators to pressure the PUC to raise UNE prices. Again, this effort should be rejected, as an increase in UNE prices would have a negative impact on California consumers.

Although Florida is at the low end of competition among these major states, the development of competition there tells an important story that will be particularly meaningful for states where competition is just getting stated. In Florida, pro-competitive UNE prices were not established until the fourth quarter of 2002. Residential competition increased sharply and has moved Florida much closer to the national average in terms of balance between residential and business in a short period of time (see Exhibit 4).

EXHIBIT 3: SBC’S CAMPAIGN TO RAISE UNE PRICES IS WAY OUT OF LINE

SBC CA UNE PROPOSAL

25 SBC IL UNE PROPOSAL

UNE PRICE: LOOP+ PORT SBC CA CURRENT 10

SBC IL CURRENT

0 0 5 10 15 20 25 30 FOREWARD-LOOKING, WHOLESALE COST: UNE LOOP + PORT

SOURCE: Gregg, Billy Jack, A Survey of Unbundled Network Element Prices in the United States (January 1, 2003); Gabel, David, Robert Loube, Michael Travieso, “Comments of the National Association of State Utility Consumer Advocates (NASUCA),” In the Matter of Cost Review Proceeding for Residential and Single Line Business Subscriber Line Charge (SLC) Caps, Access Charge Reform, Price Cap Performance Review for Local Exchange Carriers, Federal –State Joint Board on Universal Service, CC Docket Nos. 96-262, 94-1, 96-45, January 24, 2002; Ford, George S. and T Randolph Beard, What Determines Wholesale Prices for Network Elements in Telephony? An Empirical Evaluation (Phoenic Center for Advanced Legal and Economic Policy Studies, September 2002).

EXHIBIT 4: RESIDENTIAL CLEC LINES AS A PERCENT OF CLEC LINES: FLORIDA

OF LINES 30 RESIDENTIAL %

0 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02

FLORIDA CLEC NATIONAL CLEC

Source: Industry Analysis Division, Local Telephone Competition (Federal Communications Commission, various issues)

11 THE NATURE OF LOCAL COMPETITION

In markets where UNE based competition has effectively been introduced, consumers are benefiting. The competition in these states is dependent on the provision of the entire UNE-P.3 Recent estimates place the number of competitors lines that rely on UNE-P at 75 percent in the SBC and Bell South regions.4 In the Verizon service area the percentage is somewhat lower, perhaps 60 percent, but still quite important to competition.

However, the RBOCs continue to argue that it is not in the public interest to pursue UNE- based competition. They argue that UNE based competition should be shut down and that CLECs should be forced to build their own facilities in order to compete. The RBOCs claim that competition will continue and this change will simply stop the CLECs from continuing to take the “easy” path. In support of this stance, the RBOCs have worked hard to disseminate three myths:

• Allowing RBOCs To Compete For Long Distance Customers Before Local Competition Takes Hold Promotes Competition

• UNE Prices Do Not Adequately Reflect Costs

• Reducing Availability Of UNEs Will Spur Investment in Infrastructure

This study demonstrates that demonstrates that each of these myths is both misleading and factually incorrect.

OPENING LOCAL MARKETS TO COMPETITION

As the 271-application process reaches completion, it is important to recall why it was instituted in the first place. Section 271 was instituted in 1996 when Congress determined that in order to establish a level competitive playing field, the RBOCs would have to open their networks for local competition before they were allowed to sell long distance. Although long distance competition had become familiar to most Americans by 1996, local competition was unheard of. The century old Bell monopoly on local telephone service was essentially untouched. Competitors were denied access to the existing telephone network and it was impossible for anyone to build a duplicate telephone network to compete with or displace the ubiquitous public switched network that had been built behind a wall of monopoly protection over the course of a century. Moreover, if the local telephone monopolists were allowed to sell long distance service too, they would immediately be able to sell bundles of local and long distance service with little competition, as their competitors would be unable to offer the local part of the bundle.

Therefore, section 271 of the 1996 Telecommunications Act required that RBOCs make all elements of the telephone network – on an unbundled basis – available to competitors. All elements that are necessary to or would impair competition if not made available, must be offered on a nondiscriminatory basis – at parity with the way the incumbents provided those elements to themselves. Upon satisfaction of these requirements, RBOCs were allowed to enter

12 into the long distance marketplace. The initial section 271 proceedings have taken far longer than anticipated, largely because the RBOCs have put up stiff resistance to sufficiently opening their local markets. The nature and extent of existing competition has been a central concern in evaluating section 271 applications from the outset. The Department of Justice concluded that the level and extent of actual competition is an important indicator of the openness of the market. In the recent Order in the Triennial Review, the level of competition is a touchstone for evaluating the need to continue to make the incumbent networks available to competitors on an unbundled basis. 5 Because the state of competition is so important to the policy analysis, we developed a multifaceted approach to analyzing local competition including three characteristics – intensity, extensiveness and balance (see Exhibit 5).

The intensity of competition is defined as the percentage of residential customers who have switched local carriers. The average level of penetration of CLECs in the residential market is just under 10 percent and the median is just under 9 percent. Three states are in excess of 20 percent.

Two factors are used in determining the extensiveness of competition. The first is determining the percentage of zip codes in which there are no CLECs. This indicates the lack of geographic spread of competition. On average, about one quarter of the zip codes have no competitors available. However, these tend to be the least populous areas of the country. In the aggregate, less than six percent of the population resides in zip codes with no CLECs.

On the other side, the percentage of zip codes with six or more CLECs indicates the availability of competition. The Department of Justice defines a market with 6 or more equal- sized competitors as moderately concentrated. Approximately 20 percent of American zip codes have six or more CLECs. However, these tend to be the most populous areas. In the aggregate, approximately 50 percent of the population resides in zip codes that have six or more CLECs.

The third factor is balance. Balance is calculated as the ratio of residential to business customers for the competitors compared to the ratio for the incumbents. If the CLECs are disproportionately attracting business customers, that would be a major concern for residential competition. Although business customers were the initial targets, as UNE prices have come down, balance has improved. In the top five states there is good balance between residential and business market penetration.

New York serves as a good example of what happens when local markets are genuinely opened to competition. Consumers in the Empire State have switched companies in droves (2.7 million local and over 1.5 million long distance) since the start of true competition. Companies have engaged in “tit-for-tat” competition, matching each other’s price and service offers. As a result, prices for both local and long distance service have dropped substantially (approximately 20 percent for those who shop). 6 Innovative new products, like flat rate service in markets where it had not previously been offered immediately materialized. Later, competition around large “bundles” of services developed.

13 EXHIBIT 5: COMPETITION IN THE LOCAL TELEPHONE MARKET

STATE INTENSITY EXTENSIVENESS BALANCE CLEC RES NO CLECS 6 OR CLECS RES RATIO MKT SHARE IN ZIP CODE IN ZIP CODE CLEC%/ILEC% % RANK % RANK % RANK RATIO RANK

New York 23.6 1 5.0 7 52.6 2 0.93 7 Rhode Island 21.2 2 2.8 5 0.0 34 0.97 6 Michigan 20.6 3 8.8 10 39.6 8 0.99 5 Illinois 19.2 4 32.6 27 22.8 13 1.04 2 Nebraska 16.7 5 66.9 38 0.0 38 0.93 8 Kansas 14.6 6 58.6 36 0.9 33 0.82 12 Iowa 14.3 7 36.3 30 0.0 35 1.10 1 Massachusetts 13.4 8 1.0 1 41.5 6 0.77 13 Colorado 13.3 9 26.4 20 19.2 20 0.84 9 Utah 13.1 10 32.3 26 10.9 25 0.83 10 Virginia 13.0 11 21.9 17 21.7 15 1.00 4 District of Columbia 12.6 12 11.1 12 44.4 4 0.76 14 Texas 12.4 13 17.9 15 47.3 3 0.70 23 Georgia 11.6 14 23.5 19 41.5 7 0.74 16 New Hampshire 11.4 15 3.2 6 1.4 32 0.74 17 Minnesota 11.1 16 33.7 28 8.8 26 0.59 32 Pennsylvania 10.7 17 19.5 16 28.9 11 0.61 30 Wisconsin 10.0 18 35.5 29 3.5 29 0.72 20 Arizona 8.9 19 27.5 22 28.9 12 0.71 22 New Jersey 8.6 20 1.5 3 41.7 5 0.83 11 California 8.3 21 10.1 11 37.3 9 0.72 21 Florida 7.7 22 6.7 8 60.9 1 0.58 33 Oklahoma 6.9 23 56.9 35 8.3 28 0.61 31 Arkansas 6.9 24 61.1 37 0.0 37 0.64 28 Ohio 6.9 25 30.0 25 19.3 18 0.73 18 Missouri 6.8 26 48.8 34 11.0 24 0.67 25 Washington 6.2 27 29.8 24 21.8 14 0.58 34 Oregon 5.9 28 17.4 13 2.1 30 0.67 26 Louisiana 5.7 29 26.8 21 20.9 17 0.75 15 Maryland 5.6 30 1.6 4 31.7 10 0.73 19 Mississippi 5.6 31 8.0 9 1.6 31 1.01 3 Indiana 5.4 32 39.8 32 0.0 36 0.70 24 Alabama 5.0 33 36.9 31 8.4 27 0.63 29 Connecticut 4.9 34 1.1 2 21.0 16 0.49 35 Nevada 3.7 35 22.4 18 11.2 23 0.32 37 South Carolina 3.2 36 29.0 23 17.5 21 0.45 36 Tennessee 3.1 37 42.2 33 16.3 22 0.31 38 Kentucky 2.9 38 79.1 39 0.0 39 0.67 27 North Carolina 2.2 39 17.7 14 19.2 19 0.27 39

US TOTAL 10.2 NA 31.0 NA 21.0 NA 0.74 NA

SOURCE: Industry Analysis Division, Local Telephone Competition: Status as of December 31, 2002 (Federal Communications Commission, June 2003)

14 Overall, New York presents a good standard by which to judge the quality of competition. The New York marketplace ranks high on all three characteristics that taken together help determine the competitive nature of the market. CFA supported the early New York model for opening competition because it was consumer-friendly and CFA hoped that it would serve as the basis for other state models.7 Since New York’s markets were opened, however, the stringency of market opening conditions has been relaxed and the results have been less spectacular. If the New York model had been applied to the rest of the nation, the competitive residential market would be at least twice as large.

After New York, some section 271 applications were approved with very low levels of competitive penetration in the residential sector. This has occurred primarily as the result of analyzing the marketplace of multiple states together, even where there were differences in the conditions in the states. The Bell South states stand out as having very low levels of competitive penetration in the residential sector. The Ameritech states have relatively high levels of competition for markets in which entry has not been allowed. The corporate change in the Ameritech region and some bitter disputes with regulators may have slowed entry in that region.

THE TIMING OF ENTRY AND COMPETITION

The experience of early competition provides an important lesson. When incumbents are allowed into the interLATA long distance market before local markets are irreversibly open, competition does not take hold. Similarly, if UNEs are withdrawn before they can be supplied at a reasonable price in the local market, local competition will be undermined and long distance competition will not be vigorous. The incumbents can capture long distance customers without having to compete on price because barriers to local market entry would exist. Incumbents would face little real local competition and their hold would be reinforced by their unique ability to offer a bundle of services without discounting prices.

CFA’s earlier market analyses focused on comparisons of market shares and competitive strategies in New York and Connecticut. Not only is Connecticut a neighbor of New York, but also it is one of only two states where customers are overwhelmingly served by a company that was not part of the Bell system. This means that the local phone service provider in Connecticut was allowed to offer long distance services without being subjusC to the requirements of irreversible opening of local markets.

If the local market is not open, long distance companies cannot compete to deliver bundles. The incumbents do not have to compete vigorously to win market share. They just bundle local and long distance and use their name recognition to gain market share. This is exactly what happened when companies like Southern New England Telephone and GTE were allowed to enter the long distance markets in the states of Connecticut and Hawaii before they opened their local markets to competitors. In those markets the companies offered uncompetitive long distance rates and consumers got virtually no benefits.

Thus the RBOC claim that competition will be stimulated if the RBOCs are allowed to enter the long distance market, even before permitting competitors adequate access to the local telecommunications network is wrong. The flip side of that claim, which is their current

15 argument, that competitors would stay in the market if UNEs are withdrawn or made much more costly, is just as incorrect.

The evidence presented in Exhibit 6 shows the pattern of development of residential competition across time. It strongly suggests that the claim that CLECs would only compete after long distance entry was granted to the RBOCs is not supported by real world experience.

EXHIBIT 6: THE LEVEL AND GROWTH OF COMPETITION BEFORE AND AFTER RBOC ENTRY, NEW YORK AND TEXAS, ALL LINES

STATE PERCENT OF LINES SWTICHING TO COMPETITOR

Year Before Entry Year After Entry TEXAS 10.1 9.8

NEW YORK 8.0 14.7

Industry Analysis Division, Local Telephone Competition: Status as of June 31, 2000 (Federal Communications Commission, December 2000); Analysis of Local Exchange Service Competition in New York State (New York State Public Service Commission: 2002); Texas PUC Competition., 2000.

The levels of competition on the date of RBOC entry into the long distance market in each jurisdiction is all over the map. If the RBOCs ‘claim that letting them enter the long distance market is what makes competition work, we would expect to find that the longer they have been in the market, the higher the level of competition. A statistical test of the relationship between the date of entry and the level of competition is not statistically significant.

More detailed tests of the argument also fail to turn up statistically significant results. Thus, if we contrast the growth in competition in the six months before entry to the growth that occurred six months after entry, for which there are comparisons possible in the data, the relationship is not significant.

Because Texas and New York were the earliest states to open their markets, we examined their records of competition based on state PUC data, which can be used to construct a longer- term series. Exhibit 7 demonstrates once again that we do not find a consistent pattern between entry and competition. In the year before entry, competitors took about 8 percent of the lines in New York and in Texas they took over 10 percent.8 In Texas, competition leveled off after entry, while in New York competition increased.

16 EXHIBIT 7: CLEC PENETRATION IN RESIDENTIAL/SMALL BUSINESS MARKET

(% of residential/Small Business Lines Served by CLECs, Ranked by Current Market Share; penetration at entry in bold)

STATE RBOC O1/OO O6/OO O1/O1 O6/O1 O1/O2 O6/O2 O1/O3 New York VZ 8.50 14.55 19.20 22.49 23.79 23.36 23.61 Rhode Island VZ * * * 8.83 14.12 16.18 21.22 Michigan SBC 2.11 1.29 1.89 5.92 9.86 15.99 20.62 Illinois SBC 3.72 2.88 5.01 9.34 11.96 14.39 19.15 Nebraska Q * * * * * 13.98 16.67 Kansas SBC * 1.43 1.98 1.97 5.13 9.66 14.59 Iowa Q * 6.57 7.71 7.87 7.94 7.14 14.34 Massachusetts VZ 4.01 4.21 5.89 8.77 10.40 11.57 13.39 Colorado Q 3.37 5.05 7.26 7.62 9.31 10.32 13.29 Utah Q * 0.00 3.68 6.03 7.87 9.14 13.09 Virginia VZ 1.53 3.91 5.55 7.56 9.45 10.18 13.03 District of Columbia VZ 3.04 0.24 3.89 5.33 6.26 9.02 12.59 Texas SBC 3.02 3.87 7.88 9.92 11.99 13.04 12.42 Georgia BS 2.62 1.97 4.37 5.14 7.04 9.40 11.60 New Hampshire VZ * * 3.63 5.40 6.86 8.75 11.42 Minnesota Q 2.89 2.55 4.13 5.03 6.12 6.80 11.13 Pennsylvania VZ 3.22 2.98 5.48 8.93 9.37 10.28 10.71 Wisconsin SBC 2.20 3.60 3.59 3.97 5.13 6.46 10.00 Arizona Q * 2.42 2.79 3.70 5.74 7.34 8.87 New Jersey VZ * 1.57 1.62 0.85 1.20 1.78 8.65 California SBC 2.10 3.16 3.63 3.38 4.52 5.41 8.27 Florida BS 2.15 2.19 2.25 2.68 2.94 3.87 7.74 Oklahoma SBC * * 2.07 2.07 3.75 6.15 6.89 Arkansas BS * * * * * * 6.88 Ohio SBC 0.63 1.77 1.21 0.68 1.60 3.51 6.87 Missouri SBC 0.87 0.94 1.27 1.71 2.52 3.19 6.75 Washington Q 1.67 1.99 2.85 2.78 4.62 5.43 6.21 Oregon Q 1.07 1.71 2.17 2.68 4.38 5.33 5.87 Louisiana BS 1.10 1.48 1.25 0.60 1.22 2.36 5.65 Maryland VZ 0.72 0.70 0.68 2.08 1.70 2.80 5.64 Mississippi BS 2.60 * 2.66 2.21 2.81 1.98 5.59 Indiana SBC 0.75 1.94 1.68 1.39 2.01 3.09 5.41 Alabama BS 0.51 0.40 0.46 0.46 0.77 1.13 5.01 Connecticut SNET 1.84 1.49 3.12 3.52 3.95 4.58 4.93 Nevada SBC * * * 4.79 * * 3.71 South Carolina BS * * 1.80 0.27 0.65 1.81 3.21 Tennessee BS 0.76 1.34 1.40 1.57 2.05 2.36 3.14 Kentucky BS * * 2.71 * * * 2.86 North Carolina BS 0.82 0.59 0.65 1.67 1.20 1.06 2.23

SOURCE: Industry Analysis Division, Local Telephone Competition: (Federal Communications Commission, various issues).

17 There are few longer-term comparisons possible in this data set because FCC data prior to January 2000 was reported on a different basis. Two of the three states for which a year- before/year-after comparison can be made, exhibit a slow down in competition after entry (PA and MA), while one experienced a speed up (MO). Thus, there is no support for the RBOC claims in these states were markets have been open for some time. These five states for which we have year-before/year-after comparisons represent almost one-quarter of all the lines in the nation.

The lesson we draw from this pattern of competition is that the conditions for market opening are of paramount importance. The root cause of the success is not, as the RBOCs assert, the mere fact of entry by incumbents into long distance. The cause of the success is the irreversible market opening that took place prior to allowing the company entry into long distance. The implications of this conclusion for the current situation, in which the RBOCs are likely to be allowed into all markets, are that it is critical to continue to keep markets open. Prematurely removing the market opening conditions – reversing irreversible opening – would doom competition.

INVESTMENT BEHAVIOR CONTRADICTS RBOCCLAIMS

Now that the RBOCs have lost the legal and regulatory arguments against procompetitive UNE prices, they have threatened to go on strike. Declaring that UNE prices do not adequately reflect costs and represent a “subsidy” to competitors RBOCs have declared their unwillingness to invest in the network. They have further argued that competitors will not make significant investments unless UNEs are withdrawn, or sharply increased in price. The evidence supports neither of these claims.

UNE PRICES AND COSTS

At the heart of the issue is the Bell complaint about the price–cost relationship for UNEs. After several years of cost proceedings, state public utility commissions established prices for UNEs based on a forward-looking, efficient view of costs. Comparisons between UNE prices and a variety of estimates of costs and revenues have become the focal point. The RBOCs continue to insist that their (rejected) estimates of costs are the right numbers. Wall Street analysts and others simply assume that every penny of claimed costs is legitimate, notwithstanding the history of monopoly inefficiency. They also claim that every penny of lost RBOC revenue reduces investment in the network.

On the other hand, some analysts have argued that the estimation of costs used by the state PUCs under the guidance of the FCC is too generous. A recent rigorous analysis of the actual revenues paid by CLECs and cost data filed by RBOCs challenges the claim that the TELRIC regime is “confiscatory” or amounts to “subsidized competition.”9 This analysis finds that “using actual payment by a representative CLEC and publicly available ARMIS expense the wholesale business, taken alone, is profitable for the BOCs.”10

18 Similarly, NASUCA raises questions about the cost levels that have been modeled in the state proceedings under the guidance of the FCC’s TELRIC methodology. It points out that its estimate of costs is inflated because of certain assumptions imposed by the FCC on the TELRIC methodology.

UNE rates are based on configurations that assume more expensive materials for the provision of advanced services, such an additional fiber optic cables and universal digital carrier systems, which are not necessary for basic voice services. Therefore, without such assumptions, the cost of providing a voice only network would result in lower UNE loop and port rates.11

Others argue that as applied, TELRIC “has been modified in practice to allow price increases that compensate the seller for a portion of retail margins.”12 Some have pointed out that the legacy of the mandated, vertically integrated monopoly affects the cost structure of the industry and the regulatory oversight of costs leading to the conclusion that “the existing vertical structure of incumbents is characterized by likely inefficiencies.”

The incumbents’ cost data is based on a vertically integrated market structure. Market-based examples, such as with OSS, strongly suggest that this structure leads to inefficient operations… In other words, the cost data of incumbents are not representative of what would emerge if… ‘market fundamentals that provide proper incentives for long term, sustainable competition,’ were to be implemented.13

Not only is the underlying cost structure inefficient, but the allocation of costs is also strategic. Regulated monopoly incumbents “typically manage the upstream operating (network) as a cost-based entity supplying the profit maximizing downstream entity (retail).”14 This strategic allocation of costs is part and parcel of the regulatory process, but it takes on an even more critical role with the introduction of competition. 15

There is also the problem of monopoly profits. The fundamental purpose of unbundling network elements at forward-looking pricing like TELRIC is “[to] minimize the monopoly rents the vertically integrated monopoly receives over and above what it would get through competition.” NASUCA makes a similar observation, pointing out that the profits earned by the RBOCs in the interstate jurisdiction are quite high, a twenty percent return on equity.

In one sense, the extent to which embedded inefficiencies and excess profits have infected the data underlying the TELRIC exercise is irrelevant. As Willig, et al., point out, “the question of whether or not UNE pricing compensates ILECs for past such investments may be of interest in other contexts, it is not relevant to the ILECs’ current or future investment incentives… TELRIC by its very definition allows the ILECs to recover their full economic costs, including a risk-adjusted cost of capital and forward looking depreciation lives that reflect both technological and economic obsolescence.”16

Exhibit 3 above shows the estimate of the relationship between forward-looking costs and UNE prices that reflect the above concerns. It uses the TELRIC costs minus the $5 retail margin that is embedded in the results of state-by state applications of the TELRIC model. It compares 19 the forward looking wholesale cost of access to the UNE loop plus port revenue. The 45-degree line in the Figure identifies the point at which the UNE prices exactly equal the NASUCA costs.

Three clear points emerge:

• First, there is a strong relationship between wholesale costs and UNE prices.

• Second, revenues are aligned with costs.

• Third, the analysis shows how outrageous SBC’s recent effort to legislatively raise the price of UNEs in IL was and how outrageous their demands in California are.

COMPETITION AND INVESTMENT: THE FACTS

The Bells have long argued that they are unable to afford to make investments in upgrading the network, goods and services because prices are set such that costs cannot be recaptured. Kill two birds with one stone, they suggest, by withdrawing access to the unbundled network elements, which will force the CLECs to make investments in their own facilities and networks.

There is no evidence that reduced UNE availability leads to higher CLEC investment rates. CLECs make investments in those segments where it makes economic sense to do so. Exhibit 8 shows the relationship (or lack therefore) between the discount for UNEs and the percentage of CLEC lines provisioned. If the availability of UNEs is supposed to be a disincentive to investment, we would expect to find the larger the discount the higher the portion of lines provisioned as UNEs. There is no such relationship observed. Neither the discount for residential nor business UNEs exhibits a statistically significant relationship to the percentage of lines provisioned.

Exhibits 9 and 10 show the investment made by four types of entities involved in or reliant upon the telecommunications network to deliver their services to the public. Exhibit 9 shows the total market investment. Exhibit 10 shows the increases in investment above 1996 levels. In 1996, the incumbents accounted for about half of all capital expenditures in the network sector. Over the ensuing five years, their share of investment declined sharply, to less than one-third of the market total. The ILECs account for only about 40 percent of total investment over that 5 year period and less than one-quarter of the increase in investment that occurred after the 1996 Act. The idea that the availability of unbundled network elements undercut the incentive for competitors to invest is flatly contradicted by these figures.

Z-Tel (a CLEC offering national phone service) examined the question of the relationship between the availability of UNEs and investment decisions using a natural experiment, which was created when the FCC changed its policy on the switching UNEs (the part of the network made up of switches). Z-Tel notes that “the UNE Remand Order provides a textbook framework for analyzing whether the availability of UNEs disincents CLEC deployment of network facilities,” because “the FCC restricted access by CLECs to unbundled local switching in the 50

EXHIBIT 8: NO RELATIONSHIP BETWEEN UNE-P RATES AND CLEC RELIANCE ON UNES

40 % OF UNES IN CLEC LINES

0 0 20 40 60 80 100 120 140 160 UNE RATE AS % OF BASIC RATE

RES BUS

SOURCE: Industry Analysis Division, Local Telephone Competition: Status as of December 31, 2002 (Federal Communications Commission, June 2003); Gregg, Billy Jack, A Survey of Undundled Network Element Prices in the United States (January 1, 2003).

21 EXHIBIT 9: TELECOM CAPITAL EXPENDITURES, 1996-2001

100

60 ISPS CLECS 50 IXCS

DOLLARS ILECS BILLIONS OF 40

0 1996 1997 1998 1999 2000 2001

Source: Eisenach, Jeffrey and Thomas Lenard, Telecom Deregulation and the Economy: The Impact of “UNE_P” on Jobs, Investment and Growth (Progress and Freedom Foundation, January 2003), Table 2.

22 EXHIBIT 10: INCREMENTAL TELECOM SECTOR INVESTMENT, 1996 AS BASE YEAR

40 ISPS CLECS

IXCS

DOLLARS ILECS BILLIONS OF 30

0 97>96 98>-96 99>96 00>96 01>96

Source: Eisenach, Jeffrey and Thomas Lenard, Telecom Deregulation and the Economy: The Impact of “UNE_P” on Jobs, Investment and Growth (Progress and Freedom Foundation, January 2003), Table 2.

23 largest MSAs…” which “precludes entry using the UNE platform… to serve giant swaths of access lines in those MSAs.”17 Z-Tel tested both of the aspects of the RBOC argument. Withdrawing UNEs restricted competition and reduced CLEC investment. The impacts were large.

According to the analysis “the restriction on unbundled local switching has resulted in substantially less competition for residential and small business customers in states where the restriction applies. On average, the switching restriction reduced competitive entry for these customers by 54% in affected states…the restriction has reduced CLEC switch deployment in affected states by 19%.”18

The evidence indicates that CLECs are making investments in those segments where it makes economic sense to do so. While investment is lower in residential markets, this is because the residential sector is much more difficult to penetrate and population densities and revenues per line are much lower.

Because UNEs are covering the forward-looking economic costs of the network, we do not expect to find the capital flight that the ILECs claim. Several researchers have already conducted a state-by-state investment analysis that is similar to the approach taken in this report. They did not find that the increase in prevalence of UNEs in a state reduces the investment by the incumbents in the state. In fact, they found exactly the opposite effect.

A recent report for the Phoenix Center for Advanced Legal and Economic Public Policy studies conducted an analysis using the number of UNE-P lines as the measure of competition. It found that the higher the number of UNE lines, the higher the RBOC investment. The study concluded, “UNE-P competition increases BOC net investment, with each UNE-P line increase net investment by $759 per year… implying UNE-P competition translates into about $5.2 billion in additional investment.”19

Willig, et al., conducted a similar analysis that was specified in terms of UNE prices. Since the RBOCs claim that low UNE prices dissuade them from investing, we would expect to find that the higher the UNE price, the higher the investment. Willig, et al., found exactly the opposite. In their findings they conclude, “the estimated elasticity is –2.10. An elasticity of – 2.10 means that if UNE prices were increased by 1%, the regression results estimate that ILEC investment would decline by 2.1%.”20

COMPETITION AND INVESTMENT: THE THEORY

The story the numbers tell may seem counter-intuitive at one level. If RBOCs were losing market share, why would they invest more? If competitors can rent the piece parts of the network, why would they want to invest? This is the main RBOC argument, which has been called the Investment Deterrence Hypothesis.21 This argument is contradicted by the empirical facts for a simple reason – it ignores the power and multifaceted impact of competition.

The whole idea behind the 1996 Act was to decentralize investment decisions and stimulate investment through competition, or what has been called the Competitive Stimulus Hypothesis. 24 ILEC investment will be encouraged both to meet the growth in ILEC retail demand and to serve the growing demand for wholesale services from CLECs. If access to UNEs encourages CLECs that would not otherwise exist to form, their non-UNE investments also constitute a net increase attributable to unbundling.22

Entrants invest where they believe they have an advantage. ILECs respond, sometimes to defend market share or lower their costs, sometimes to provide wholesale inputs for new entrants, and sometimes to innovate more quickly in the competitive environment.

In essence, the heightened threat of loss of business to rivals impels the ILEC facing competition to lower prices, to produce more, to improve quality and range of services, to innovates, and to invest more in order to accomplish these goals. The result is that incentives for investment and production of output are greater under the pressures of a competitive environment, and predictably, the firms invest more.23

Nor is price the only dimension along which increased competition will benefit consumers. As they compete, both ILECs and CLECS will have the incentive to use quality of service improvements and innovation as competitive tools to protect their own market share and to lure customers away from their rivals. Because most of these improvements must be embodied in network infrastructure, competition provides an added spur to increased investment.24

At the same time that the defenders of the vertically integrated monopoly assume that the incumbent is more efficient, they also discount and disregard the benefits of innovation that entrants bring. The most obvious examples, on which the consumer benefits calculations rest, are the customer-oriented products and marketing strategies of the new entrants.

These authors, like all the authors who argue in favor of asymmetrical regulation between facilities and services-based competition, essentially ignore the value added a competitor contributes through steps such as definition, marketing, sales, and support of commercialized services, all dimensions around which competitors seek to compete and innovate….

In the case of UNE-P, for example, competition is keen in pricing, brandings, markets, customer service, etc… [T]hose activities constitute real competition that results in true economic efficiency.25

Although the marketing innovation of the new entrants is most obvious, they have also made substantial contributions to the production side of the industry. They have driven innovation in operating support and back office systems, rights of way and collocation, and the provisioning and use of fiber.

One of the lessons from the recent competitive era is that new entrants and competitors can be quite ingenious and innovative in tackling the challenges that they face. One of the most impressive innovations was the use of old pipelines to create a national backbone fiber network… More generally entrants have been 25 very successful in addressing the right-of-way problem where they were at an enormous disadvantage….

Entrants innovated in almost every dimension of the business from use of rights- of-way, to becoming early adopters of net technology. Entrants innovated at the OSS/BSS level by working closely with new vendors that were developing modular off-the-shelf elements that would support a plug-and-play strategy. While incumbents were selling their real estate because of the miniaturization of equipment and complaining that there was not enough space for collocation, entrepreneurs created the telehouse, where myriad service providers could collocate and interconnect efficiently. Fiber became commercialized under a growing diversity of formats – dark or lit, by strands or lambda. While ADSL had been developed by Bellcore in the late 1980’s, the CLECs were the first to push for its large-scale deployment. In all, entrants brought a new standard of innovation and efficiency to the marketplace.26

Thus, the key to understanding the behaviors of the incumbents and the CLECs is to recognize that the incumbents approach the advent of competition as monopolists. The legacy of the monopoly and the willingness of incumbents to leverage it to protect their market position, as well as the inefficiencies and strategic misallocation are deeply embedded in the incumbents costs structure create the need for regulatory intervention that reduces the barriers to entry. The solution is unbundling at forward-looking costs.

Given the legacy industry structure, the regulatory objective of achieving sustainable competition in local access services requires the regulator to disaggregate the integrated production of local access into meaningful component processes and establish sustainable market activity in each, or establish substitute prices consistent with a competitive model. Both dis-aggregation and proper pricing are critical to regulatory success and that fact has been chronically under appreciated.27

CONCLUSION

Since the telecommunications act of 1996 was passed, there has been an ongoing struggle to open local markets and keep them open for local and long distance telephone service. Many state commissioners have facilitated competitive markets – and thus consumer benefits - by effectively setting prices that allowed competitive carriers access to the RBOCs’ network, while sufficiently compensating the RBOCs for the costs involved with providing UNEs. In those states, consumers are beginning to realize substantial savings.

However, while substantial progress has been made, obstacles to fair competitive markets continue to arise. By seeking dramatic increases in the price of UNEs, and lobbying for the withdrawal of network elements from the market entirely, the RBOCs have continued their assault on competition.

The next hurdle on the long road to open competition will be the implementation of the FCC’s Triennial Review Order. This process places the competitive industry, and consumer 26 savings at great risk, especially for residential customers. In the major states that are likely to serve as the battlegrounds for the Triennial Review and UNE pricing the stakes are huge. The fate of the CLEC industry will be effectively be decided in about a half a dozen major states that account for about 10 million CLEC bundles and 13 million ILEC bundles. Losing UNEs in these states would be a devastating blow to the CLEC industry and to consumers.

Premature removal of UNEs or sharp price increases will quickly lead to the re- monopolization of the industry, an end to emerging vigorous competition and cost consumers billions of dollars in higher prices.

ENDNOTES

1 The framework was substantially defined in the rejection of the first two applications, as discussed below including Michigan Public Service Commission, In the Matter of the Commission’s Own Motion to Consider Ameritech Michigan’s Compliance with the Competitive Check List in Section 271 of the Telecommunications Act of 1996, Case No. U-11104; Federal Communications Commission, In the Matter of Application by Ameritech Michigan to Section 271 of the Telecommunications Act of 1996 to Provide In-Region, InterLATA Service in Michigan, CC Docket 97-1; Federal Communications Commission, Memorandum Opinion and Order In the Matter of Application by Ameritech Michigan to Section 271 of the Telecommunications Act of 1934, as amended, to Provide In-Region, InterLATA Service in Michigan, CC Docket 97-13, August 19, 1997 (hereafter FCC Michigan). Oklahoma Corporation Commission, Cause No. PUD 97-64); Federal Communications Commission, In the Matter of Application of SBC Communications, Inc., Southwestern Bell Telephone Company, and Southwestern Bell Communications Services, Inc., d/b/a Southwestern Bell Long Distance for Provision of In-Region InterLATA Services in Oklahoma, CC Docket No. 97-121 (hereafter FCC, SBC, Oklahoma). 2 Mark Cooper, Lessons From 1996 Telecommunications Act: Deregulation Before Meaningful Competition Spells Consumer Disaster (Consumer Federation of America, February 2000) 3 National Association of State Utility Consumer Advocates, The Unbundled Network Element Platform: Essential for Local Telephone Competition for Residential Consumers, January 2003. 4 Brogan, Patrick and Scott Cleland, SBC Hemorrhaging Wireline Business (Precursor Group, August 6, 2003), BellSouth’s Hemorrharrhaging Wireline Business (Precursor Group, August 18, 2003), Qwest’s Hemorrhaging Wireline Business (Precursor Group, September 11, 2003), Verisozon’s Hemorrhaging Wireline Business (Precursor Group, September 16, 2003). 5Evaluation of the United States Department of Justice, Federal Communications Commission, In the Matter of Application of SBC Communications, Inc., Southwestern Bell Telephone Company, and Southwestern Bell Communications Services, Inc., d/b/a Southwestern Bell Long Distance for Provision of In-Region InterLATA Services in Oklahoma, CC Docket No. 97-121, May 16, 1997 (hereafter, DOJ, SBC), p. 26. Without specifying a precise standard, DOJ concludes that competition must be meaningful, real, nontrivial, substantial, and irreversible. At the key point in its response, DOJ uses the term “substantial competition.” DOJ, SBC, pp. 41-42. The public interest in opening local telecommunications markets to competition also requires that the Commission deny SBC’s interLATA entry application. SBC does not presently face substantial local competition in Oklahoma, despite the potential for such competition and the expressed desire of numerous providers, including some with their own facilities, to enter the local market... SBC’s failure to provide adequate facilities, service and capabilities for local competition is in large part responsible for the absence of substantial competitive entry. If SBC were to be permitted interLATA entry at this time, its incentives to cooperate in removing the remaining obstacles to entry would be sharply diminished, thereby undermining the objectives of the 1996 Act.

In performing its competitive analysis, the Department seeks to determine whether the BOC has demonstrated that the local market has been irreversibly open to competition. To satisfy this standard, a BOC must establish that the local markets in the relevant states are fully and irreversibly open to the various types of competition contemplated by the 1996 Act -- the construction of new networks, the use of unbundled elements of the BOC’s network, and resale of BOC services... In applying this standard, the Department will look first to the extent to which competitors are entering the market. The presence of commercial competition at a nontrivial scale both (1) suggests that the market is open; and (2) provides an opportunity to benchmark the BOC’s performance so that regulation will be more effective. 6 Comments Of The Consumer Federation Of America, In the Matter of Application of New York Telephone Company (d/b/a/ Bell Atlantic – New York) Bell Atlantic Communications, Inc. NYNEX Long Distance Company and Bell Atlantic Global Networks, Inc., for Authorization To Provide In-Region, InterLATA Services in New York, Before the Federal Communications Commission CC Docket No. 99-295, November 8, 1999. Telecommunications Action and Research Center, A Study of Telephone Competition in New York, September 6, 2000; Consumer Federation of America and Consumer’s Union, Lessons From 1996 Telecommunications Act: Deregulation Before Meaningful Competition Spells Consumer Disaster, February 2001. 7 In the Matter of Application by Bell Atlantic Inc., Pursuant to Section 271 of the Telecommunications Act of 1996 To Provide In-Region, InterLATA Services In New York, Federal Communications Commission, CC Docket No. 99- 404 (hereafter FCC New York), 2. 8 It should also be noted that the competition in Texas includes CLECs offering pre-paid service, which does not represent a genuine alternative to local exchange service because of the restrictions on its use, Texas PSC Competition, p. 34. 9 p. 1. 10 Beard, T. Randolph, George S. Ford and Chrisopher C. Klein,”The Financial Implications of the UNE-Platform: A Review of the Evidence,” Comlaw Conspectus: Journal of Communications Law and Policy, Fall 2003. 11 Gabel, David, Robert Loube, Michael Travieso, “Comments of the National Association of State Utility Consumer Advocates (NASUCA),” In the Matter of Cost Review Proceeding for Residential and Single Line Business Subscriber Line Charge (SLC) Caps, Access Charge Reform, Price Cap Performance Review for Local Exchange Carriers, Federal –State Joint Board on Universal Service, CC Docket Nos. 96-262, 94-1, 96-45, January 24, 2002, p. 25 12 Beard, Ford and Klein, p. 8. 13 de Fontany, Alain Bourdeau, Bruno Chaves and Brian Savin, Why Inefficient Incumbents Can Prevail in the Marketplace Over More Efficient Entrants: An Analysis of Economies of Scale and Scope, Transaction Costs and the Misuse and Data, February 2003, pp. 58-59. 14 de Fontenay, p. 24. 15 de Fontenay, p. 42, Our conclusion is that incumbents can manipulate the costs of transactions in the production domain to undermine competition… To the extent that firms have sufficient market power to manipulate those transaction costs that in their strategic interest, what might be viewed as economies of scale and scope of the vertically integrated firm would include variables that are decision variables for the dominant firm…. The power and incentives of dominant firms to manipulate requires the intervention of government directed at facilitating efficient transactions and capturing available economies for society. 16 Willig, Robert D., William H. Lehr, John P. Bigelow and Stephen B. Levinson, Stimulating Investment and the Telecommunications Act of 1996 (October 11, 2002). This paper comes as part of an ongoing dialogue between expert witnesses representing the ILECs and competitors. See notes 40-45 for the key pieces in the debate. The October version thoroughly refutes the criticism of the analysis. 17 Z-Tel, Does Unbundling Really Discourage Facilities-Based Entry? An Econometric Examination of the Unbundled Switching Restriction(February 2002), p. 2. 18 Z-Tel, p. 2. 19 Competition and Bell Company Investment in Teelcummunications Plant: The Effects of UNE-P (Phoenix Center for Advanced Legal and Economic Studies, July 2003), p. 13. A subsequent exchange and respecification of the model reaffirms the basic conclusion, see UNE-P Drives Bell Investment: A Synthesis Model (Phoenix Center for Advanced Legal and Economic Studies, September 2003), responding to “Declaration of Thomas W. Hazlett, 28

Artheru N. Havener and Coleman Bazelon on Behalf of Verizon Communications Inc., Reply Comments of Verizon Telephone Companies in Support of Petition for Expedited Forebearance from the Current Pricing Rules for the Unbundled Network Element Platform, In the Matter of Petition for Forebearance from theCurrent Pricing Rules for the Unbundled Network Element Platform, WC Docket NO. 03-157, September 2, 2003, “Declaration of R. Carter Hill on Behald of Z-Tel Communications Inc., In the Matter of Petition for Forebearance from theCurrent Pricing Rules for the Unbundled Network Element Platform, WC Docket No. 03-157, September 18, 2003. 20 Willig, Robert D., William H. Lehr, John P. Bigelow and Stephen B. Levinson, Stimulating Investment and the Telecommunications Act of 1996 (October 11, 2002). This paper comes as part of an ongoing dialogue between expert witnesses representing the ILECs and competitors. See notes 40-45 for the key pieces in the debate. The October version thoroughly refutes the criticism of the analysis. 21 Willig, et al., p. 5, According to the Investment Deterrence Hypothesis, mandatory unbundling discourages ILEC investment by rendering it less profitable than it would be in the absence of unbundling…. Unbundling rules compel the ILEC to lease portions of its local exchange network to CLECs at returns that are lower than it can earn when it uses this network to provide retail services to customers. The combined return accruing to the ILEC from its local network investment is, therefore, diminished and with the ILEC incentive to invest. 22 Willig, et al., p. 7. 23 Willig, et al., p. 6. 24 Willig, et al., p. 7. 25 de Fontenay, p. 27. 26 de Fontenay, et al., p. 37…59. 27 de Fontenay, et al., p. 59.