This article reports some results of a broader review and analysis of the impact of regulation on investment and innovation in the telecommunications sector. It focuses on ways in which traditional and reformed common carrier regulation of telecommunications firms might:
We begin with a discussion of the historic importance of infrastructure development as a goal of telecom policy. Then, we will turn to Congress' recent enlargement of that goal in the Telecommunications Act of 1996. We briefly review the tools available to the Federal Communications Commission (FCC) for encouraging infrastructure and innovation and what the theoretical and empirical literature has to say about the impact of various forms of regulation on innovation and capital formation. The article concludes with some observations about the implications of our overview for development of a comprehensive and coherent policy to encourage innovation and investment in infrastructure. Infrastructure Growth Has Long Been a Telecom Policy Goal
Making telecommunications policy is about making choices -- choices among goals and choices among means. Telecommunications policy in the United States has gradually, but unmistakably, transformed both its goals and the means for achieving them.
For about four decades, the aim of telecom policy, for all practical purposes, had a single dimension. In a remarkable display of consistency, almost every rule and regulation put in place by regulators over that time period took into consideration "universal service" and was rationalized in part as a means of bringing it about. As a practical matter, the universal service goal was transformed into efforts to keep basic residential exchange rates low, despite the fact that lowering rates -- and keeping them low -- had only modest effects on the rate of household penetration.2
Rate structures were designed without regard to the true structure of underlying costs as a way to assure cheap access to and use of local exchange networks for local calling. Imaginative cost accounting rules consistent with the goal of low basic exchange rates -- long plant lives and slow depreciation rates, capitalization of station connection expenses, and creative allocations of common costs among jurisdictions, services, and users -- were adopted. Capital formation by regulated carriers was rationed and technology constrained through facilities authorization processes, but it was always directed toward assuring extension of basic local service to all households -- rural and urban, rich and poor. Entry was foreclosed, earnings were constrained to assure investment sufficient to extend the network to all households, and services were homogenized by regulatory fiat. (Remember the ubiquitous black telephone?) The entire regulatory apparatus was driven by the universal service goal -- a goal named and supported by carriers in the old Bell system and their independent telco partners large and small.
Thus, for over 40 years, rules and regulations of the FCC and their colleagues in 50 state capitals were focused on encouraging investment in infrastructure. To be sure, we did not call it that, even though it was clearly the goal of both the private and public principals to the common carrier social contract. The goal served regulators' interests by giving them a major role in the management of telephone companies, while providing a metric -- the level of basic exchange rates and the number of households connected to the network -- that the public could use to evaluate whether they were doing their jobs. The goal served the interests of the management and shareholders of regulated firms in several ways. Universal service (infrastructure investment policies) assured a large and growing capital stock (the rate base) from which growing and relatively secure cash flows could be generated in a market environment largely insulated by regulators from risks emanating from technological, market or regulatory sources.
A few critics expressed token concern with regulatory neglect of efficiency and progress during the days of pursuit of universal service. Except for a few disgruntled academic economists, the waste and inefficiencies associated with the regulated and protected monopoly were accepted as the modest cost of the larger socio-economic benefits attributable to the pursuit and achievement of universal service.
The policy worked, but it had both unintended and undesired side effects that expanded over time. Competition Introduced into the Policy Mix After having practically accomplished the goal of building local infrastructure sufficient to achieve the goal of universal service, the FCC shifted gears. In a series of controversial and widely-opposed decisions beginning in the late 1960s and early 1970s, the agency began to introduce other goals into the policy mix.
The new goals were multidimensional and involved consideration of various types of economic efficiency, economic progress, productive process and service innovation, diversification of output, improvement of service quality, and the vector of performance variables associated more generally with the operation of competitive markets. The goals were changed and enlarged.
In summary, a reasonable, if simplified, characterization of the goals/means of telecommunications policy before 1996 would include:
The Telecommunications Act of 1996 retained both competition and universal service as goals of policy, but added two new ones. Actually, it added one -- deregulation -- and modified the infrastructure and investment admonitions embodied in the universal service goal so as to encourage investment and innovation in advanced digital, broadband telecommunications facilities. However, by expanding the number of goals, without changing available policy instruments, Congress laid the groundwork for confusion, delay, and uncertainty.
Most of the day-to-day focus of telecom regulation at the FCC in the United States, and in the courts, has been on matters related to:
The act contains several references to investment and innovation. But, the keystone in this respect is contained in Section 706. It charges the FCC with: [E]ncouraging the deployment on a reasonable and timely basis of advanced telecommunications capability to all Americans by utilizing, in a manner consistent with the public interest, convenience, and necessity, price cap regulation, regulatory forbearance, measures that promote competition in the local telecommunications market, or other regulating methods that remove barriers to infrastructure investment.3 The debate preceding the act's passage was marked by clear expressions of congressional intention to stimulate investment and innovation, as is suggested by the following language: The goal is to accelerate deployment of an advanced capability that will enable subscribers in all parts of the United States to send and receive information in all its forms...over a high-speed switched, interactive, broadband transmission capability.4 President Clinton, on signing the new bill into law, observed that his administration had promoted the bill as a means, among other things, of stimulating investment and providing access to the "information superhighway," a term whose popularity has been, in considerable measure, the result of several speeches by Vice President Gore.
Thus, there is wide recognition and support among the country's political leadership for telecom policy that promotes investment and establishes a regulatory and market environment which encourages risk taking and innovation. Lamentably, much less clear is the extent to which the FCC and state regulatory agencies have been responsive to the call for putting in place a coherent set of policies clearly designed to foster innovation and investment.5 There Are Different Theories of Investment and Innovation Given the commission's statutory obligation to encourage "deployment...of advanced telecommunications capability...," it is reasonable to ask how it might, or should, do so.
The deployment of advanced telecommunications capability requires both investment and innovation from the private sector. A reasonable starting point is to explore the determinants of the level and composition of investment in the telecom sector, and what determines the rate and direction of innovation. While they are clearly related and frequently treated as synonymous, these are two very different questions.6
The literature on the influences and causes of investment and innovation is too broad and diverse to summarize here. Indeed, even a review of the literature would be voluminous. The following simplifies without further apology. Investment Determinants Explanations of the cause of investment are difficult to summarize and even more difficult to comprehend in their full breadth and depth. Dozens of theoretical investment models have been devised and many more have been tested. But, neither models nor empirical explanations have won much consensus, never mind universal acclaim.
An eminent academic investment analyst, Harvard economist Dale Jorgenson, wrote some years ago: There is no greater gap between economic theory and econometric practice than that which characterizes the literature on business investment in fixed capital.7 While the gap has been closed somewhat in recent years, due to the efforts of Jorgenson and others, it is still true that a bewildering array of forces have important and differential effects -- depending on circumstances -- on the rate and composition of investment.
Earnings matter, but are not dispositive. So do interest rates, risk, and prospects for growth. Capital budgeting models built on these variables are instructive, but do not have great predictive power. It seems that other variables -- cost of capital goods, market structure, general business conditions and outlooks, marginal capital to output ratios, durability and replacement cycles, the rate of change of demand, and the state of technology, to name a few from a survey of the models -- are often dominant. In the world of investment models, everything seems to depend on everything else.
This complexity in investment models makes it clear that it is nearly impossible for federal and state regulators to find specific, unambiguous, and incontestable support in the investment literature for any particular approach. The situation is further complicated by the obvious fact that many of the variables important to investment are beyond the control of any regulatory agency. These include:
The complexity of investment determinants implies that considerably more analysis of the structure of specific market opportunities and constraints in the telecom sector must be undertaken. Only then can we begin to determine how the commission can use its limited policy toolkit to encourage investment in the sector. Innovation Determinants We have found no good theory of innovation. No surprise here. The very neoclassical microeconomics that has developed such powerful and policy-robust theorems about decision making within firms and the operation of markets does not help us to understand with any certainty or specificity:
Several theories have been developed and tested, but the findings are not especially robust and are almost always expressed in tentative terms. One scholar informs us that: "The astonishing diversity of the processes and phenomena associated with innovation suggest that the idea of a unified theory to explain it may be a pipedream."9
While innovation studies can have policy implications, they do not generally yield specific and clear-cut policy guidance, particularly in a sector as complex and dynamic as markets for telecommunications.
A recent comprehensive review of innovation concluded:10
These and numerous other expressions of regulatory control over business operations influence the payoff from investing and innovating and thereby the incentives for doing so. That we are unable to determine specific and quantifiable one-to-one relationships between government rules and private market behavior does not negate the power of the influence.
The Telecommunications Act in Section 706 sets forth some suggestions for tools the commission might use: [P]rice cap regulation, regulatory forbearance, measures that promote competition in the local telecommunications market, or other regulating methods that remove barriers to infrastructure investment. While the commission is not limited to these tools, they are so broad as to be virtually all-encompassing of the FCC's options.
While competition is an important tool for stimulating investment and may be an important impetus to innovation as well, we want to emphasize that competition policy alone is not sufficient to ensure high levels or an acceptable composition of either. Moreover, given that there are countless specific manifestations of "competition policy," it follows that there is no assurance that the complex vector of federal and state rules constituting current "competition policy" will in fact stimulate total investment (entrant plus incumbent) in the sector. The investment that is stimulated will be "efficient" investment consistent with the requirement that traffic will be awarded by users to the low-cost carrier.
Competition is no doubt necessary to ensure the public interest. However, the commission's competition policies -- embodied in the orders issued to date -- are by no means sufficient to meet the requirements of Section 706 or the needs of the economy for high levels of both investment and innovation in this sector. Studies of Regulatory Links to Investment/Innovation Inconclusive
We have reviewed the available literature on the relationships between various forms of regulation and firm/industry performance related to investment and innovation. The preceding discussion suggests the difficulty of establishing empirically clearcut bridges linking government constraints on market structure and behavior on the one hand and "dynamic" firm or industry performance on the other.
In principle, there are countless ways in which regulation might influence investment and innovation through their impact, for example, on their neoclassical determinants -- expected earnings or cash flow, risk, and growth expectations -- and more specific incentives that operate through these. Regulations and regulatory processes influence private sector expectations about the present value of potential capital formation programs.
Much of the literature on incentive regulation focuses on modifications to the form of the rate-of-return constraint -- the limitation on earnings. Traditionally, earnings of telecom common carriers have been determined by the classical method of setting allowed earnings as a function of the used and useful rate base -- capital stock -- multiplied by a fair rate of return (based on the weighted average cost of capital).
Several variations on this basic monopoly earnings control scheme have been tried. The most common variations can be grouped into three categories: rate change moratoria or freezes, "profit" sharing, and "price caps." Under a pure rate moratorium, the firm agrees to freeze rates for a specific time period in exchange for lessened restrictions on earnings. This gives firms the incentive to become more efficient, since the cost savings can be realized by shareholders. Consumers gain because nominal rates are constant and declining in real terms.
The profit sharing plan allows the firm and the consumer to divide profits earned by the firm in excess of the baseline "allowed" rate. In principle, this opportunity will also induce the regulated firm to be more efficient by permitting it to flow realized cost efficiencies to shareholders, while consumers gain in proportion to their share of the reduced costs that would not otherwise have materialized.
Pure price cap regulatory schemes have similar salutary incentive effects, in principle, since they too permit carrier management to pass cost savings to owners, instead of being obliged to return them to consumers.
Other plans mix the basic features of these, but all are designed to give the firm positive economic incentives to behave in ways they would not under traditional rate-base, rate-of-return earnings regulation. As they say, "The devil is in the details." Thus, to understand the incentives for the firm to invest more or to become more innovative under these plans, it is necessary to understand the specific construction of the plans and the incentives embodied therein.
Efforts to measure the impact of incentive plans addressing carrier earnings prospects have found generally positive impacts. However, existing empirical work does not support the conclusion that incentive regulation plans have produced dramatic changes in key performance indices across the board in the telecom industry. In general, the studies indicate improvements in productivity, quality of infrastructure, level of investment, returns to shareholders, telephone penetration, and the rate of introduction of new services offerings. Prices have been stable or decreasing, and quality of service has not decreased.12 But, the effects are seldom dramatic and almost always contestable, owing either to flaws in study design, inadequate specification of the models, ambiguous data, or other difficulties that plague efforts to measure regulatory impacts.
A handful of studies have specifically addressed the impact of earnings-based incentive plans on capital formation.13 The most comprehensive and rigorous study made to date concludes that incentive regulation, especially price regulation, increases infrastructure investment and innovation.14 This study examined the propensity of local carriers to invest in "innovative" technologies under different regulatory schemes and concluded that direct regulation of prices substantially increased (as much as 100%) the rate of deployment of Signalling System 7, fiber links, and ISDN technologies.
An earlier and related study examined the relationship between network modernization and incentive regulation (related to both earnings and pricing flexibility) using industry-wide data for local exchange companies and concluded that infrastructure deployment is substantially enhanced by incentive regulation.15 A follow-up study indicated that profit incentives alone -- without other pricing incentives -- did not significantly influence the propensity of regulated carriers to invest. Finally, we are obliged to report that one study concluded that incentive plans have no impact on infrastructure investment.16
Most attempts to measure the effect of incentive regulation have found positive impacts on investment of regulatory efforts to reform traditional rate-of-return regulation. Despite serious problems of identification and measurement problems, the principal studies are united in that conclusion.
More specific linkages between regulatory rules and incentive effects on the conduct and performance of firms are very difficult to identify. For example, if the firm's performance in one time period affects its future regulatory environment, the effects are not at all clear-cut. The basic theory of incentive regulation of earnings is that higher earnings will bring about beneficial firm conduct. However, regulators come under substantial political pressure to renege on the original arrangement and to "recontract" when firms report high profits.17
Thus, in determining resource allocation in the near term, firms under these kinds of incentive regulation must take into account how committed the regulatory authorities are to the agreed-upon incentive regulation. Also, they must consider the probability that present earnings will adversely effect the future type of regulation. This not only adds uncertainty and risk to the firm, it also makes it more difficult to achieve either a market solution or a predictable one. The uncertainty invites gaming.18 Regulatory Policies to Encourage Investment and Innovation? There are no silver bullets. It will not be simple or noncontroversial to identify and implement policies that will meet the requirements of the economy for high-speed digital electronic distribution systems. Such policies will have to be woven into a web of existing rules and regulations motivated by entirely different concerns and that developed over a long period of time.
A major challenge, and one that must be met if we are to succeed, will be to overcome the traditional mindset that basically takes technology, technological change, and investment in this sector for granted. It is much too important for that.
Technological change and innovation are indispensable to the economy at large and no less so to telecommunications and the larger information technology sector of which it is a part. Forty years ago, Nobel Laureate Robert M. Solow published research indicating that about 80% of the increase in gross output per worker hour in the United States in the first half of the 20th century was attributable to technological change. While subsequent work has somewhat lowered the estimate, the force of Solow's work is unchanged -- technological change is the primary force propelling growth in productivity and our standard of living. The authors of an important review of markets and innovation summed it admirably: [W]hether technical advance is regarded as a blessing or an evil, we cannot ignore it. Indeed, it is arguably the most important determinant of our past, present, and future.19 Much of the mindset of the regulatory community seems to be focused on matters involving fair competition and fair interconnection, access by favored groups to services, and to the essentially impossible task of "getting prices right." The focus is on fairness and short-run static efficiency. That focus may well be myopic, and we think it is. A recent review of antitrust policy contained what we regard as an efficient expression of the current gap in regulatory performance: We know that many discussions of antitrust policy and efficiency have violated the New Testament injunction against beholding the mote and ignoring the beam. X-efficiency is much more important than allocative efficiency, and dynamic efficiency is almost surely even more important.20 Dynamic efficiency is critical, even more so than more conventional static measures if Scherer is right. Kamien and Schwartz expressed the same sentiment in a slightly different way: Thus, technical advance appears to require the sacrifice of some allocative efficiency at each moment of time for the purpose of greater efficiency in the long run.21 Short-run static efficiency is important, as are efforts by regulators to achieve it. The longer run performance of the economy, however, depends on investment and innovation. These are not necessarily, or even probably, optimized by the single-minded pursuit of policies to ensure equity, fairness, and arbitrary costing and pricing standards -- especially if they are pursued, as they have been, without regard to dynamic considerations.
How can regulatory institutions best contribute to "dynamic" efficiency? Again, there are no silver bullets, and no simple one-shot solutions.
The key is probably found in the complex regulatory behavior that resulted in the successful pursuit of universal service. In retrospect, universal service policy considerations permeated almost every rule-making for several decades. It is very likely that a similar preoccupation with and commitment to investment and innovation will be required by the regulatory community.
Recognition by the regulatory community of the enormous contribution of telecommunications investment and innovation to our overall economic welfare is a necessary first step. Infrastructure policy is just as important as competition policy to the public's well-being. A good second step is a recognition by regulators of their role in fostering -- or discouraging -- investment and innovation. A third is a commitment to making the impact on infrastructure a consideration in all regulatory determinations. Call it "universal service" for the 21st century and the digital age.