In retrospect, 1997 may well be seen as the year that information technology added dominance in communications to its dominance in computing. The public switched telephone network (PSTN), formerly viewed as voice with an overlay of data transport, is now widely seen as data with a voice overlay. This dramatic transformation is epitomized in the regulatory arena by the emergence of various Internet-related issues, and in the marketplace by the explosion of Internet usage, including a quantum jump in electronic commerce. All the more remarkable is that just four years ago the info-market picture looked quite different, although, in fact, events that year were to spur the rise of the Internet as a mass medium and driver of network evolution.
In a sense, 1993 was the apogee of what might be termed the "Old Information Age" -- the view of an info-future dominated by the television and the set-top converter, with cable and phone rivals racing to deliver broadcast video to the home, epitomized by the abortive 1993 Bell Atlantic/TCI merger that promised a 500-channel universe by 1995. It even gained considerable currency at the highest levels in Microsoft, of all places.1 It was, we now know, wrong.
That fateful year, 1993, saw two other milestones of vast import to the info-future:
The fallout from the events of 1993 is the launching of mass-market Internet access; cyber-surfing might someday overtake channel-surfing as the national pastime. In hindsight, 1993 was the last year that entertainment video could plausibly be regarded as the prime driver of information age marketplace demand.
One measure of the data transport explosion: Forrester Research projects that, by 2005, Internet data bits will represent 99% of global traffic volume.2 Even if the 99 to 1 data-voice level is not reached, clearly, data traffic will vastly predominate under any plausible scenario (few see less than 90% data).3
But regulation of Internet service providers (ISPs) -- especially at the Federal Communications Commission -- may delay and diminish potential dividends consumers reap due to premature imposition of universal access, as well as mis-pricing and inadequate costing rules. After noting the properties of packet networks, this article addresses potential harm to ISP interests that may arise from FCC rules on incumbent local exchange carrier (ILEC) interconnection, availability of unbundled network elements (UNEs), and universal access. Finally, it suggests how proper regulation of packet networks can help the Internet flourish.
Fundamentally, the circuit-switched, voice-oriented PSTN is a physical network that meshes neatly with traditional regulatory and geographic lines; the packet-switched Internet is a virtual network in which geography is an artifact. The "Internet cloud" is, in reality, no more than a set of network nodes configured to handle the TCP/IP protocol suite (a standard for organizing, sizing, and transmitting packets), each node possessing a designated Internet IP address.
The possible regulatory permutations with Internet service are, of course, endless. Permutations were large in number even in the POTS world, but Balkanization was at least geographically defensible, with the variety of traffic in terms of quality levels and content limited essentially to inter- and intrastate voice. Internet traffic is packetized voice, data, image, and video at widely varying quality levels, some chosen by the user and others dictated by network traffic considerations.
Internet calls, unlike traditional voice telephony, frequently involve a single user accessing multiple sites serially; thus, only the call origination point can easily be identified. Further, users often do not know -- or even care -- where the sites are located. And even when the site(s) can be located, packets take diverse paths to their destination, with Internet routers not designed to record sufficient data to support jurisdictional separation of traffic for regulatory purposes.7
Perhaps, the prime example of ILEC network communization is the controversy over the unbundled network element provision by ILECs for use by non-ILEC competitors. The FCC adopted rules requiring ILECs to assemble UNEs in any combination desired by other providers, even including combinations and quality levels not used by the ILEC itself.9 In its initial order on appeal, the Eighth Circuit Court upheld the FCC's rule, making ILECs provide "finished services" by combining unbundled elements, while reversing the FCC on requiring ILECs to offer competitors superior quality elements.10 On reconsideration, the Court clarified itself on finished services, holding that ILECs need only make available unbundled elements and need not combine them for their competitors.11 The Supreme Court has decided to hear the FCC's appeal of the Court's ruling.12
Such fears are hardly theoretical -- the most recent decision of the Eighth Circuit excoriated the FCC for deliberately evading the earlier rulings of the Court denying the FCC authority to impose TELRIC pricing on ILECs nationwide:
This attempt to reassert the vacated pricing rules by imposing them as conditions for entry...does by indirection what we told the FCC...it could not do. The FCC cannot do in an advisory opinion on a section 271 application that which we have expressly forbidden it from doing in its rule-making procedure. A more clear violation of our mandate could hardly be imagined.14
The Court went further, in a rare display of judicial language that is, in the generally genteel world of appellate legal parlance, the equivalent of a body slam onto concrete:
The FCC's choice to promulgate its policy decision not in rules or regulations, but in advisory opinions appended to a section 271 order was, in our view, clearly calculated so as to evade ordinary appellate review.... [W]e suspect that this naked policy statement was added...in an attempt to forum-shop. Having lost its bid to usurp the power to determine intrastate prices in the Eighth Circuit, the FCC now seeks to have another bite at the apple in the District of Columbia Circuit.
This is the type of "evasion" that necessitates mandamus relief. The FCC's advisory opinion is clearly calculated to have a chilling effect on the state commissions' employment of non-TELRIC pricing schemes, and to do so in a way that avoids our review.15
Perhaps the quintessential example of the FCC's confiscatory policies is found in the arena of universal service. Therein, the agency, in rejecting ILEC embedded cost as a benchmark for universal service support, offered two reasons:
As the Joint Board recognized, to the extent that [a carrier's cost] differs from forward-looking economic cost, embedded cost provide [sic] the wrong signals to potential entrants and existing carriers. The use of embedded cost would discourage prudent investment planning because carriers could receive support for inefficient as well as efficient investments. The Joint Board explained that when "embedded costs are above forward-looking costs, support of embedded costs would direct carriers to make inefficient investments that may not be financially viable when there is competitive entry." The Joint Board also explained that if embedded cost is below forward-looking economic cost, support based on embedded costs would erect an entry barrier to new competitors, because revenue per customer and support, together, would be less than the forward-looking economic cost of providing the supported services.16
Thus does the FCC combine, in a nutshell, confiscation with communization: Carriers are denied recovery of embedded cost higher than forward-looking cost; embedded carrier cost lower -- more efficient -- than forward-looking cost must be shared with rivals. Further, the agency declined to recognize legacy cost (with its potential for stranded investment), asserting that no one had presented "specific evidence" that use of forward-looking cost would effect any uncompensated constitutionally-protected "taking" of ILEC property.17
With rapid strides being made in Internet voice, the FCC faces anew the issue of compensation due ILECs for use of their networks. Internet service providers have availed themselves of a 1983 access charge exemption granted enhanced service providers (ESPs) by the FCC. In March 1996, a petition filed by the America's Carriers Telecommunications Association (ACTA) asked the FCC to declare its legal authority over ISP interstate voice transmission, enjoin provision of such services pending adoption of rules, and begin a rulemaking to develop rules for the service. The FCC issued a Public Notice seeking comment, but has not, to date, issued an order.18
The commission has, however, barred ILECs from collecting access fees from ISPs, based upon the ESP exemption.19 Its rationale for extending protection to ISPs was that, like ESPs in the 1980s, ISPs today need "infant industry protection" in order to flourish, and further that in the event ILECs benefit from carrying ISP traffic.20
The Office of Plans and Policy has suggested that the way to prevent perpetuation of potential competitive inequity is to reduce regulation on incumbents rather than impose new rules on ISPs.21 Congress, for its part, has numerous Internet regulation bills pending, but there is also an Internet Protection Act under consideration that would essentially freeze federal regulation of cyberspace.22
The FCC's universal service support for school Internet access covers Internet access and associated software plus inside wire; it does not cover fax machines, modems, and PCs. PCs were excluded because they are not in the agency's view "designed" for communication over distance.24 This is news to the computer industry.25
Since first being announced, the plan has been scaled down -- from a planned $1 billion to $625 million for the first half of 1998; the original plan called for a $9 billion cap over four years. In announcing the reduction, new FCC Chairman William Kennard noted, however, that the $9 billion cap is still in place, and that later this year his agency would re-evaluate the financial needs of the schools.26
The program, however, actually entails far more potential total expense. True, costs may be picked up by private firms helping the schools, but if incurred they must be paid by someone. If all schools participate, the true total cost of implementing the FCC's original schools plan is $75 billion. Although the support total has been trimmed, the original figure stands as an illustration of the extent of license the agency feels itself entitled to under section 254 of the Telecom Act. If this figure startles (it should), the reader might profit from a detailed explanation as to how the $75 billion true total cost figure is attained.
According to a consulting firm cited by the agency, the discount is only applied to 20% of the total cost of implementing the telecom services portion of the program, with the other 80% attributable to items (PCs, servers, maintenance, repair, training, etc.) not subject to the discounted rate.27 The average discount nationwide is 60%.28 This means that the $9 billion four-year cost of the FCC's discount cap equals 60% of the 20% share of total cost to which the FCC's program applies -- i.e., 12%.29 So if $9 billion represents 12% of the total program cost, the remaining 88% comes to $66 billion.30 Hence, the total program cost is $75 billion if all schools apply.
Looking at it another way: The typical school will spend $7.33 on related items, plus its 40% share of the cost of Internet services, for each dollar it would save under the FCC discount. A school eligible for a 20% discount would pay 96 cents per dollar of total cost to save 4 cents -- i.e., spend $24 for each $1 it saves; a school using the 90% discount would still have to pay 82 cents of total cost to save 18 cents -- i.e., spend $4.56 for each dollar it saves.
Thus, the logic of the FCC's program resembles nothing so much as that of Lucy Ricardo telling Desi, in a classic I Love Lucy episode, that she had just "saved" $300. After Desi asks how she managed this, Lucy answers that she went shopping and spent only $500, instead of the $800 she had planned to spend.
Further, the program is being implemented, although many schools -- at least half, perhaps two-thirds -- already have an Internet connection.31 The marketplace is thus well on the way to providing, without added subsidy, what the FCC wants to subsidize. In apparent recognition of this, the FCC has directed the schools fund administrator to collect "only as much as required by demand, but in no event more than $625 million for the first six months of 1998."32 (The Telecom Act, for its part, expressly identifies substantial residential market penetration as one criterion for universal service eligibility.33)
A more modest estimate for the long-term cost of the program comes from a recent report issued by the Congressional Budget Office, which projects a 10-year $20.7 billion total cost, with the FCC's $2.25 billion cap first attained in 2007.34 But CBO projects substantial expenditure by schools to buy new PCs, noting that 17% of PCs now in schools are 20-year-old Apple II PCs.
Universal service coverage, and the Internet generally, are prime issues in the implementation phase of the FCC's universal service rules, which have gone through several reconsideration cycles.35 The commission was directed by Congress to prepare a report on universal service issues to be submitted no later than April 10, 1998, including Internet access by schools and libraries.36
Once added to universal service, an advanced service will stay added forever. Washington is near creating, in effect, a telecom policy version of the "Brezhnev Doctrine" (the USSR's claimed "right" to invade the former Czechoslovakia in 1968 to crush dissent and save socialism -- i.e., once a country goes socialist, it stays socialist): Once a service is socialized as universal, it stays socialized. This "socialized forever" doctrine has proven true for voice telephony, and appears confirmed by the continuing rate regulation of basic cable service post-passage of the 1996 Act. Application of this doctrine to Internet access would permanently entrench open-ended telecom service socialization.
Regulatory policy can dramatically influence how a given technology diffuses in the marketplace. Cellular regulation delayed for more than a decade introduction of what has proven to be an immensely popular service, and the manner in which cellular was regulated has made cellular less successful in the United States than in Europe due to multiple standards, irrational pricing, lotteries, and the like.38 Internet regulation harbors the same potential, albeit there is legislation pending in Congress designed to forestall such an outcome.39
Regulation of packetized services will need to balance legitimate concerns of diverse providers if consumers are to receive the best service. ILECs must recognize that excessive access fees could sink ISPs, and in the event will not be tolerated by regulators. Congestion issues require careful negotiation, with the next (fourth) round of the Network Reliability and Interoperability Council primed to collect congestion data and adjudicate disputes.40 Content liability should be minimal and follow control, goals equally shared by ILECs and ISPs.41
For their part, ISPs should remember that below-cost access to ILEC networks can boomerang, by depriving them of the upgraded network assets needed for high-end Internet services and also undercutting network deployment by carriers entering the local market, who will prefer below-cost usage of ILEC networks over investment in their own expensive new plant.42 And while ISPs may plan to focus on high-end customer markets, it is unlikely that they will completely escape service socialization if their market targeting is perceived as endangering the ability of ILECs to provide basic universal service. Above all, a healthy financial future for ILECs and ISPs is mutually beneficial, with marketplace competition the sole arbiter of which ILECs and ISPs survive.
Toward these ends, federal regulation should recognize in the first instance the incompatibility of TELRIC and other FCC rules with spurring ILEC network innovation -- including the ILEC "last mile" essential for ISP success and Internet growth pending deployment of new local facilities. In addition, regulators should seek to reconcile legitimate ILEC and ISP interests without jeopardizing by regulation the market viability of either. Finally, regulation should be minimal, to foster rapid Internet growth and diversity of services.43
From a broader perspective, the FCC has pursued pure communization of ILEC network assets, grand-scale confiscation of both embedded and future ILEC investment, and platinum-plated expansion of PSTN service socialization -- the latter even to the extent of preempting interstate long distance access price reductions for residential subscribers by increasing universal service contribution amounts.44 There is little -- if any -- reason to believe that Congress enacted the Telecom Act with these ideas in mind, and there is no reason to believe they will aid the Internet.
Telecom regulatory policies of micromanaged ILEC network communization, confiscation, and socialization collectively constitute the polar opposite policy error committed by regulators with the Savings & Loan industry in the 1980s, when they privatized S&L investment opportunity while continuing to socialize S&L lending risk. In telecom, regulators are increasingly socializing opportunity while privatizing risk. In the former case, the result was to subsidize profligate investments that otherwise, but for the government's largesse (at taxpayer expense), would never have been made. In the latter case, the result -- equally predictable -- is that vital network infrastructure investments that would have been made may well not be made.
Evidence already exists to substantiate the fact that regulation is impeding capital investment. Telecom investment is lagging other industries in the 1990s, a period of dynamic industry evolution, with sub-par performance, vis-à-vis the S&P 500, of telecom stocks during a roaring bull market. Thus, for 1994-1996, one composite index of telecom stocks showed a decline of 25% (63%, 41%, 33%, and 21% declines, respectively for cable, wireless, Big-Three long distance, and local exchange carrier segments).45 In four out of five years this decade for which telecom investment data exist, industry growth was negative.46
True, telecom stocks recently have performed well, but most still have under-performed the market this decade, an enormously counter-intuitive result given the technological dynamism of telecom and information industry sectors. One industry sector whose share prices rose some 25-fold in the 1990s, competitive local exchange carriers (CLECs), was heavily favored by FCC and public utility commission (PUC) regulators -- stark testament to the true market value of federal favoritism.
It is when the government mixes the two strategies that trouble is guaranteed. Combining privatization and socialization of the same services either encourages improvident investment if risky investments are subsidized as with the S&Ls, or discourages prudent investment if it is penalized as is happening with telecom policy. In public policy as in mathematics, changing one side of an equation requires changing the other side as well.
For an industry as potentially dynamic as Internet-driven telecommunications, the opportunity cost of precipitate socialization will be high -- such was the case with cellular regulation.47 The Telecom Act envisaged socialization for services deemed "essential," for which substantial residential market penetration exists, which are being deployed in the PSTN by carriers and serve the "public interest, convenience, and necessity."48 These are cumulative criteria, not alternative.
But FCC policy presses for immediate, broad-scale socialization -- long before market penetration suggests widespread societal acceptance. And this the FCC entwines with a pervasive communization and wholesale confiscation the Congress never envisioned, policies pursed even to the extent of attempting to circumvent an adverse federal appeals court ruling. In this, the agency continues its policy bent prior to passage of the act, during which time telecom industry investment flagged as information age technology and market demand flowered.
Defenders of FCC actions will point to already explosive data on communications growth as evidence that federal policies are in fact successful. In fact, Internet growth to date has piggybacked on the existing telephone network infrastructure, i.e., yesterday's circuit-switched, voice-driven, embedded public network investment. Telecom infrastructure modernization cannot remain a laggard if the full potential of the emerging packet-switched datacom industry is to be realized. Indeed, hardly a day goes by without some Internet denizen bewailing the lack of public network bandwidth for high-speed Internet access. With network risk already privatized, opportunity privatization must follow if telecom market progress is to follow in the footsteps of Silicon Valley.
Even new FCC Chairman William Kennard, while defending FCC policies for implementing the Telecom Act, acknowledges that investment in high-bandwidth plant is lagging: "Our nation has an ever-increasing demand for high-capacity networks. We've got to find ways in this country to increase that capacity."49
Most of this lag is felt in the residential marketplace, where improvement is limited to conditioning in-place copper and jazzed-up modems.50 Business bandwidth -- with local loop bypass -- is exploding, with several recent announcements pushing Internet voice and data tariffs down to 7.5 cents per minute, and fiber systems hitting the market that carry terabit traffic.51 Regulation of advanced services -- including high-speed Internet traffic -- will be the subject of an upcoming Notice of Inquiry covering section 706 of the Telecom Act.52
Interconnection, unbundling, and universal service expanding over time as market conditions and societal needs evolve are integral parts of the vision of competition enshrined in the Telecom Act. But Congress did not write a law aimed at privatizing ILEC risk while socializing their gains for the benefit of their competitors. It is time for the FCC, once and for all, to jettison its perverse juxtaposition of privatized risk and socialized opportunity in favor of a unitary policy: Privatizing both so that the kind of competition Congress envisioned has a chance to flourish. If telecom markets are permitted to emulate the dynamism of the computer marketplace, the winner will be the telecom consumer.