WAVE Report

The Broadband Economy
By Amanda Rogos
(October 26th)

WAVE Issue #0147


The debates on telecommunication regulation or deregulation have been fierce both before and since the passage of the Telecommunications Act of 1996. The evolution of circuit to packet switched data, merging data and voice services and cable television with Internet services in addition to the mergers between companies in all the aforementioned markets have only further complicated this situation. Columbia Business School's Institute for Tele-Information (CITI) was the latest forum for discussion on these topics and the WAVE Report was present for the day of debate.

Unfortunately, there was not much debate. The view, most often heard (at least in our offices) of the CLEC (Competitive local exchange carrier) demise being a direct result of ILEC (Incumbent local exchange carrier) discrimination, was strangely absent. There was evidence of a similar argument in several papers on the CITI Web site (written by James Glassman and William Lehr) but neither individual was present at the conference.

The day was one-sided - focusing on the view that there has not been enough deregulation. Yet, the arguments presented were intriguing and by the end of the day, we were wondering what was wrong with deregulating some of the ILEC market? Why shouldn't incumbents be allowed to invest in their infrastructure without sharing it? And why was asymmetrical regulation (regulating DSL but not cable broadband) deemed a fair play by the FCC (Federal Communications Commission)? After a weekend of further study, the arguments towards decreasing the ILECs regulatory burden seemed weaker than when advocated at the conference. However, we found that the conference presented an interesting view of the telecommunications world and therefore more than merit this article.

The theme of the conference was the condemnation of asymmetrical regulation (and subsequently the FCC). The Telecommunications Act of 1996 identified the Bell companies as monopolies and therefore regulated them such that they must follow basic rules forcing them to unbundle certain elements of their network to competitors, setting the wholesale rates they can charge, restricting their services between LATA (local access and transport area) and restricting entry into long distance. Cable on the other hand, has been put under less restriction (until the recent open cable push) and is therefore, according to the participants, allowed to have free reign in the market. The theory is that this environment has lead to a 70% market share for cable in the broadband market, compared to DSL's 30%.

The root cause of this distortion can be related to investment in infrastructure and facilities. The Bell network was faced with a situation in which their large investments in fiber, broadband routers and switching fabric, would benefit their competitors as well. Because broadband was a risk and not a guaranteed success, the Bells were reluctant to accept all the risk and then share their profits with companies that had not made the same type of investments, but shared in theirs. Essentially, as Economist Alfred Kahn put it, the regulations basically mandate that, "If you [Bells] are successful, you have to share. If you aren't you eat your investment."

John Thorne, Senior VP and Deputy General Counsel at Verizon, compared the DSL market with wireless as an example of its potential for unregulated growth. Initially, the use of wireless technology was regulated by the FCC. When the FCC granted regulatory parity to all carries and removed interLATA restrictions on Bell companies, wireless services began to have explosive growth with SMR (Nextel) becoming the first successful application. Thorne believes that given the chance to invest without regulation, DSL would have similar growth and success - benefiting the Bells, but also consumers as well.

Jerry Hausman, from MIT's Department of Economics took a slightly different tack, although still blaming the FCC, and said that the Commission was guilty for not only their asymmetrical regulation but for their implementation of those policies. According to Hausman, facilities-based competition is the only real competition. Therefore, when the FCC set pricing for UNEs (Unbundled network elements) and encouraged network sharing, it was not competition - it was sharing. Instead, when the FCC set these rates, using a system called TELRIC, they should have been set higher (higher than retail pricing as opposed to under) as an incentive for CLECs to build out their own infrastructure. Hausman believes that because the CLECs depended entirely on the ILECs for their livelihood, there was no future in their business - and that was their downfall.

For example, in Korea, where broadband deployment is completely unregulated the connections per 100 inhabitants are four times as high as the US, with 4.32 million broadband connections (9.2 per 100 inhabitants - November 2000). Canada falls into second place with a 4.5% penetration. The US has a 2.2% penetration per 100 inhabitants. As another example, Korea has three ADSL providers Korea Telecom (the incumbent) and Hanaro Telecom (the startup competitor) are the two largest with 46.8% and 24.8% of the market respectively. There are no unbundling, pricing or network sharing regulations in Korea and Hanaro uses its own fiber network. Hausman compared these figures with the US broadband market in which ILECs (DSL) have 24.6% of the broadband connections and CLECs (DSL) have only 4.5% (cable modems have 70%).

When some brave soul in the audience suggested that without CLECs competition would cease to exist in the DSL market, the panel voiced their opinion that there is no need for competition within DSL. Instead the entire broadband market should be considered, i.e. competition between cable, DSL, wireless and satellite should be sufficient to satisfy competition standards. The FCC, which received varying amounts of negative attention within each panel, due to their competitive posture vis--vis its regulation, instead merely counts players, not actual competition, as if to say, "See, competition is alive, we have 9 players in the DSL market."

The talk turned briefly to cable, which although not regulated per se, has not been completely untouched by these policies either. Operators currently offer only a small channel for broadband and use most of their bandwidth for television - even to the extent that they are showing small channels like the 2nd golf channel and 4th football channel. This, according to participants, was due to the fear, that if a large broadband investment was made, they too, could be party to the same type of unbundling and regulatory structure. This may be happening with the push for Open Cable and most operators, excluding AT&T, are not happy with the entrance of this debate. Satellite may be in for some regulation as well - especially due to the pending acquisition of DirecTV by EchoStar, which was recently announced.

Now, there are certainly counterpoints to all the aforementioned debates, most of which we have covered in previous WAVE Issues. For instance, one could argue that if the Bells would agree to separate their retail and wholesale operations, they would have a lot more freedom to invest as they chose. In essence, regulation has attempted to help them unburden themselves from the risk of which they complain. Plus, if this is a competitive market, and the incumbents have a monopoly position, don't they have the upper hand? Why have they fought the DCLECs so hard, instead of using their business as an added revenue stream?

On the CLEC side, perhaps it is true that they had an incentive (initially) to co-locate instead of build their own facilities. But when the ILECs began to stall the co-location efforts, wouldn't that be incentive enough for the CLECs to construct their own networks? Actually, build-outs were started by Covad, Level3 and IXC but instead of instant facilities success, they have been rewarded by falling investment from funding partners, ILEC anticompetitive price decreases and in the end, bankruptcy. Certainly not the result that was hypothesized above.

Were CLECs to become truly facilities based and compete with the ILECs they would have had to implement a much smaller footprint - that is, smaller geographic coverage. They would have no option but to carefully pick the areas where broadband would have had a very high attach rate in order to have a chance of paying back the investment. In fact, one company had this strategy in the cable side, (RCN) and they are having problems like all the others. So in our minds, the CLECs were really in a no-win situation.

The telecommunications market and its regulatory structure are indeed a difficult tangle of issues. CITI's conference was an excellent forum for a discussion that was unusual in its bias. It presented a very different picture than is usually seen in Washington, where competitors and consumer advocates have been committed to fight the ILECs and any effort to deregulate them, almost to the death. This dichotomy of conclusions, which does not often surface in Washington or in the Trade Press made for an interesting set of debates. Bravo Columbia!

The next WAVE Issue will present another viewpoint, this one from Ken Zita of Network Dynamics Associates, asserting that the broadband revolution is already upon us, with business-based broadband. Zita believes that too much emphasis has been put on consumer broadband, an interesting theory indeed.