III. The Effects of Regulatory Policy in Michigan

Chart 2: Changing Market Share in Local Calling
Chart 2

Assessing the Competition

Competition in local telephone service was the principal policy goal of the Telecommunications Act of 1996. Assessing whether the statute has achieved this objective in Michigan requires measuring the level of competition that has emerged since its passage.

Regulators have made the measurement of competition maddeningly complex. How the measurement is conducted depends on how the results will be applied. For example, federal law provides a 14-point checklist of competitive conditions that must be met before incumbent wire line companies are allowed to provide long distance services.

Most of the telephone services billed by competitors are actually provided by SBC.

But even when a market is declared “open” based on the competitive checklist, an incumbent service provider can still be forced to provide subsidized access to its network. In other words, the market can be both “open” and uncompetitive at the same time.

By any measure, Michigan is a national leader in the number of local lines billed by competitors. Some 99 percent of Michigan zip codes now are served by at least two local providers.[20] More than 190 companies are currently licensed to offer local service.[21]

As illustrated in Chart 2, local service market shares have shifted dramatically in recent years. In 1999, SBC served 81 percent of all Michigan lines, but that share fell to 62 percent by the close of 2002. SBC’s losses have been competitors’ gains. The market shares of Verizon and small independents have remained virtually unchanged, but competitors’ shares of the market grew from 4 percent in 1999 to 22 percent in 2002.

As of March 2003, some 74 local service companies were competing in SBC’s service territory, up from 66 in 2002.[22] Chart 3 illustrates the rapid increase in lines billed by competitors.

Were competitors serving customers through independent facilities, such numbers would indicate robust market competition. But it would be a mistake to conclude that federal policy has succeeded in spurring local competition in Michigan.

The reality is that most of the actual telephone service billed by competitors in Michigan is actually provided by SBC facilities. According to MPSC data, an astonishing 89 percent of the lines billed by competitors in 2002 actually were serviced in whole or in part by an incumbent network, up from 62 percent in 1999.

As Chart 4 illustrates, there also has been a corresponding decline in the proportion of lines served by independent facilities. Competitors utilized their own facilities to service a mere 10 percent of their customers in 2002, down from 29 percent in 1999.

Northwestern University economist Debra J. Aron also has found that between March 2002 and March 2003, for every (net) new line competitors serviced via independent facilities, they added three lines dependent for service on an incumbent network.

This reliance on incumbent networks has largely failed to stimulate new products or services, or even lower rates — the hallmarks of competition. Local telephone rates, which held steady in Michigan in the years preceding the 1996 telecom act, actually increased thereafter.

That competitors have shunned investment in independent facilities is hardly surprising. It would be economically irrational for any business to assume the capital expense and associated risk when a competitor such as AT&T can simply demand subsidized local network access for $14 a month, bundle in its long distance service, and resell the package for $49.95 retail.[23]

(See Chart 5 and Chart 6.)

As explained by Verizon’s John Thorne: “No company will invest billions of dollars to become a facilities-based broadband services provider if competitors who have not invested a penny of capital nor taken an ounce of risk can come along and get a free ride on the investments and risks of others.[24]

Taken together, the evidence demonstrates that federal and state regulation of the wire line network has failed to produce the market competition envisioned by Congress. As the appeals court charged in striking down the FCC’s impairment standard, ubiquitous access subsidies only produce “completely synthetic competition.”

Summing up this failure, economist Robert Crandall of the Washington, D.C.-based Brookings Institution said: “Simply allowing other carriers to deliver the same service over the same facilities to the same customers at a greater social cost will not promote competition. The UNE platform is not stimulating the development of new local services. Nor are the companies offering local service over the UNE platform using this network strategy to gain a toe-hold before moving ahead to build their own networks.”[25]

The Costs of Failed Policy

One measure of the success or failure of a public policy is whether specific goals have been met. Just as important is assessing the costs of success or failure. In this case, regulations have imposed enormous economic and social costs that far exceed marginal benefits.

As stated earlier, a multitude of factors contributed to the precipitous decline in telecom stocks beginning in 2000. But the regulatory actions of Congress and the FCC are among the factors most often cited by Wall Street analysts, economists and industry experts.

The essential problem is that the forced access regime is a money-losing proposition for incumbent wire line companies. According to Merrill Lynch analysts, “Regional Bell Operating Company profitability would be much improved if [they] were not required to resell local exchange service at TELRIC rates.”

In the case of SBC, Michigan’s largest local service provider, the access rates established by the MPSC are among the lowest in the nation. Consequently, for every line SBC is forced to subsidize, the company posts a loss.

In a 2002 study of Michigan rates, investment bank UBS Warburg concluded that SBC operating expenses exceeded access payments by more than $8 per line per month.[26] Merrill Lynch analysts pegged the loss at $6.10 per line per month.[27]

According to Stephen Pociask, president of TeleNomic Research, a Virginia consulting firm, incumbent service providers lose more than 50 percent of line revenue when a rival signs a customer, but shed only 20 percent of the service cost. Explains Pociask: “This divergence between price and costs leads to an absolute decline in cash flow and earnings for incumbents.”

SBC’s loss of operating revenue — totaling $416 million between 2001 and 2002 alone — has eroded the company’s ability to invest in network upgrades and product innovation. And it has put downward pressure on its stock price, as Chart 7 shows.

SBC is not alone in hemorrhaging operating revenue. Four of the five largest telecom carriers have lowered capital expenditure targets as a result of revenue losses from forced-access subsidies.[28]

Securities analysts with the Precursor Group, a Washington, D.C.-based investment research firm, aren’t shy about assigning blame. “The wire line telecom sector,” they note, “has fundamentally decoupled from the rest of the tech sector and from the economy, in large part because regulators managed competition policies. In contrast to the rising tide of tech enterprise demand, wire line telecom equipment capital expense budgets are sinking.”

Investors see little benefit in providing new telecom capital so long as the government continues to require that incumbent service providers subsidize their rivals. Total capital spending declined from $100 billion in 2000 to less than $40 billion last year, according to Brookings Institution economist Robert Crandall. And in testimony before Congress in February, he warned that continued declines in capital spending could undermine the reliability of the telecom network.

“This decline in capital spending is clearly the most alarming aspect of the current telecom malaise for it portends a slowdown in the deployment of new technology and even the possibility of a degradation of traditional services if it continues,” Crandall said.

Competitors, too, are strapped for cash in the wake of enormous losses in market capitalization — which declined from $80 billion in 2000 to $1 billion last year.[29]

Researchers Larry Darby, Jeffrey Eisenach, and Joseph Kraemer suggest that investors may have been overly optimistic about the benefits of subsidized access.

“There is little support for the notion that more aggressive regulation could have ‘saved’ the [wire line competitors] ... but some indication that firms and investors may have been influenced in their behavior by excessive reliance on regulatory incentives.”[30]

The economic adversity has not been confined to telecom service providers. To the extent capital expenditures have been restricted, the entire chain of technology supply has been rattled, including software firms, chipmakers, fiber optic manufacturers and even Internet Service Providers.

As FCC Chairman Powell declared in his opposition to continuation of the forced-access regime: “Such regulatory calculus impedes the proper functioning of a market.”