Cap-sized: how the promise of the price cap voyage to competition was lost in a sea of good intentions.

• Author: Vogt, Gregory J.

1. INTRODUCTION

   The "telecommunications revolution" has moved from cliche, to reality. It is now transforming how people live and work. Telephone service is now available through a computer terminal over the Internet, through wireless handsets, and through good old-fashioned wireline telephones. Service is now available from more providers than ever; competitive carriers now challenge the long-distance, local, and even Internet incumbents with aggressive pricing and innovative products. Thousands of new competitive players have entered the communications arena, an industry that is now worth more than $298 billion annually in the United States alone.(1) This revolution is worldwide, promising to bring the world closer together through communications that are faster, cheaper, and more reliable.

   As this revolution, fueled by amazingly rapid technological advances, transforms individuals' lives, regulators must navigate a difficult course. They must ensure that government rules do not fall behind the swiftly changing currents of technology and the marketplace, lest regulation frustrate these advances that give consumers needed services at reasonable prices.

   Against this backdrop of revolutionary change and regulatory challenge, the Federal Communications Commission (Commission or FCC) has struggled with the regulation of rates, termed "access charges,"(2) assessed by local telephone companies to long-distance carriers needing to interconnect to local networks. All too often, the task has involved an anachronistic regulatory regime that is being rapidly outdated by marketplace developments.

   Eight years ago, the FCC began to discard its largely discredited rate regulation scheme by adopting market-based reforms. It abandoned older style, cost-plus rate-of-return regulation in favor of "price cap" regulation, which focused on prices and created incentives for telephone companies to innovate and become more efficient. Price caps are a system in which regulators set a maximum cap on prices for a certain service, and the cap is reduced each year by a set amount based on estimated improvements in efficiency. Local exchange carriers (LECs) support price cap regulation because it allows them to charge the cap price even if the actual cost of providing the service is substantially lower, thus potentially leading to higher profits. Regulators like the price cap regime because it consistently reduces access charges. Despite eight years of tinkering, the FCC continues to try to get these new price cap regulations "right," while controversy rages among local telephone companies, long-distance carriers, customers, and regulators concerning the scope and necessity of the FCC's regulatory regime.

   This Article analyzes the last eight years of experience under price cap regulation and evaluates what has gone right and wrong. Although price cap regulation has produced reduced rates to long-distance carriers (though not necessarily to long-distance customers) and more efficient pricing than under rate-of-return regulation, it has ultimately fallen victim to incessant tampering and lagged far behind marketplace changes.

   Perhaps the most troubling aspect of the Commission's price cap regulatory regime is that the FCC has not allowed price caps to function free of tampering. The entire premise of the price cap regime is that by placing a cap on prices, local carriers will have an incentive to improve efficiency beyond the levels mandated by the caps themselves because, unlike under rate-of-return regulation, carriers can keep the profits. Although motivated by public interest considerations, the FCC has undermined these very advantages by reinserting vestiges of rate-of-return regulation into the new system and permitting external political factors to impact its price cap decisions. First, the Commission has repeatedly imposed retroactive adjustments to the price cap indices in order to correct underestimates. Second, the Commission has repeatedly revised the productivity factor upwards and maintained a nonefficiency based add-on. Third, the calculation formula for the X-Factor itself has been quite arbitrary, each time generating charges that the changes were politically motivated or result driven. Using high earnings to justify a higher X-Factor is, in effect, back door rate-of-return regulation, a result the FCC said it was trying to avoid. Finally, the FCC has never adopted a "pass through" requirement that would mandate that long-distance carriers pass along price reductions generated by price caps to consumers. Absent such a requirement, the Commission has struggled to broker side deals with long-distance carriers that insure consumers benefit from these reductions.

   Each of these four departures from price cap principles has undermined the fundamental premise of the regulatory program--namely, to permit price cap carriers to keep higher-than-expected productivity gains as profit as an incentive to improve efficiency, while at the same time reducing consumer prices. Instead, the Commission, as if it were still functioning under a rate-of-return regime, has looked to the company's ultimate rate of return, determined that the rate was too high, and then adjusted the price caps to eliminate some of these gains, while struggling to find ways to prompt consumer rate reductions. Although these changes have all been well-intentioned, they have ultimately helped to sink the very ship they were designed to save. If the ship is to be righted and the voyage to full competition resumed, the Commission should return to its original price cap principles by adopting a series of course corrections that will enable all parties to thrive.

   Until the voyage to competition is complete, the Commission should adopt the following reforms to ensure that the public realizes the full benefits of price caps: (1) simplify and maintain X-Factor principles over the long haul to create firm incentives for LECs to become more efficient; (2) refrain from political tinkering with X-Factor or retroactive adjustments in the cap that deny LECs the benefit of their bargain by using a moving historical average to compute X-Factor charges; (3) eliminate the consumer product dividend so that the cap reflects actual achievable efficiency gains; (4) adopt an explicit pass-through requirement that will require long-distance carriers to pass through price cap reductions to consumers; (5) provide pricing flexibility to allow the caps to function more like free markets; and (6) permit new services to be offered outside the caps to encourage innovation and recognize the markets that now exist for these services.

   Only when a consistent and predictable price cap system is in place will the goals of creating market-based incentives for improved efficiency be achieved and the process depoliticized. As set forth below, such a price cap course is consistent with the initial stated goals of price cap regulation and best positions the Commission for the eventual transition to a free competitive market for these services.

   This Article lays out the case for these reforms based on the initial price cap theory and the evolving state of the telecommunications marketplace. Part II presents different models of regulating local exchange carriers, describing the difficulties with the old rate-of-return system and the theoretical advantages of a price cap regime. Part III explains how the FCC's creation of a price cap plan in 1990 contained modifications to address the perceived shortcomings of a pure price cap system. Part IV describes the many subsequent modifications the FCC made to its original 1990 plan. Part V details the experiences of various states with price cap systems, including the progressive reforms by states like California that have been responsive to market and regulatory developments. Finally, Part VI evaluates the current price cap system, discussing both its advantages and shortcomings and sets forth recommendations designed to allow price caps to achieve their full regulatory potential.

2. HISTORY OF LOCAL EXCHANGE CARRIER REGULATION

   To furnish long-distance telephone service, providers such as AT&T need to connect to local networks that are owned and operated by LECs, such as US West.(3) Before the advent of the modern telecommunications revolution, it was widely believed that telephone service was a natural monopoly, especially local telephone service, which required a connection to each individual customer's residence or business.

   Initially, because AT&T had a monopoly in the provision of both local and long-distance services, the FCC relied upon informal negotiated rate making it termed "continued surveillance." In the 1960s, with the advent of some competition in the local market, the FCC turned to rate-of-return regulation, a widely used means of regulating industries with limited competition, in order to control the amount that could be charged by LECs for allowing a long-distance call to go over the long-distance network. More recently, as the idea that telephony is a natural monopoly has been discarded in the face of technological advances, regulators have considered alternative means of regulating rates charged by LECs to IXCs for interconnecting long-distance calls with the local networks. Two of the more prominent and more promising means of regulation are Social Compacts and Price Caps. This section describes the FCC's historical approach to access charges.

   1. The Agency's Early Efforts to Regulate the Telephone Industry Focused on the Rate-of-Return Model

      1. The Commission Attempted to Regulate Effectively AT&T's Monopoly in Long-Distance and Local Telephone Services

         Before the mid-1960s, regulation of the telephone industry was relatively straightforward. AT&T was the sole provider of interexchange services, and thus the only company that the FCC had to regulate. It was widely believed that the provision of telephone services constituted a natural...