Why ADCo? Why now? An economic exploration into the future of industry structure for the "last mile" in local telecommunications markets.

• Author: Beard, T. Randolph
• Position: Alternative distribution company

Editor's Note: A version of this Article originally appeared as Phoenix Center Policy Paper No. 12. (1)

1. INTRODUCTION

   It is now more than five years since the passage of the landmark Telecommunications Act of 1996 (1996 Act), but instead of flourishing competition, the competitive local carrier sector has experienced a financial meltdown. (2) So, what happened?

   Basically, the issue can be narrowed to several fundamental misconceptions about the underlying economics of the telecommunications business by all of the major stakeholders, including Wall Street, policymakers, and would-be entrepreneurs. Namely, it appeared that everybody believed that: (a) entry into the local market would be relatively inexpensive; (b) the market immediately would be capable of sustaining multiple local access networks; and (c) as a result of their desire to enter the long-distance business, incumbents would gladly embrace competitive entry. (3)

   As this paper will discuss, however: (a) entry into the local sector is an extremely expensive business, requiring firms to incur huge sunk costs and achieve scale economies quickly; (b) under current and foreseeable market conditions, local markets will only be able to sustain a few "last-mile" access networks (i.e., high concentration); and (c) incumbents were prepared to--and in fact did--go to great lengths in order to deter entry. (4)

   As such, just as it was prior to 1996, one of the key unresolved issues in telecommunications restructuring continues to be the proverbial "last mile" (5)--that is, the last segment of the network necessary to connect the customer. (6) Indeed, despite the somewhat regular deployment of state-of-the-art national and regional long-haul networks and metropolitan fiber rings by a number of carriers, the deployment of alternative networks comes to a screeching halt when it reaches into the local exchange, leaving dominant control of most switching and transport facilities, and particularly the "last mile" or "last yard" of the local exchange network, to the incumbent local exchange carrier ("ILEC"). (7) In order to bypass the economic bottleneck for local access, therefore, the competitive local exchange carrier ("CLEC") industry has been faced with the core question of transaction cost economics: is it more efficient to buy local access via unbundling, special access, and so forth from the reluctant incumbent, and conduct their transactions in the market, or build their own local access network from scratch, and bring the transaction out of the market and into the firm? (8) Unfortunately, the problem is that under current and foreseeable market conditions, neither option is particularly economically appealing.

   On the one hand, given the incumbents' near-complete dominance of the local access market, there really is no competitive "market" where a firm can purchase local access at just and reasonable rates that will be provisioned on a timely basis. Acquiring needed inputs (i.e., elements) from the incumbents at just and reasonable rates and provisioning intervals is no cake walk either. After all, dominant firms do not typically facilitate the demise of their dominance. This is not an irrational concept, because no firm will ever be enthusiastic about consciously going against its own self-interests by selling its rivals their key input of production (i.e., loops). (9) Indeed, while the 1996 Act requires the ILECs to provide such elements, the Act did little to fundamentally alter economic incentives. (10) So long as this inherent wholesale-supplier/retail-competitor conflict exists between an ILEC and a CLEC, then the ILECs' ability to manipulate prices for elements and to control quality leaves sufficient room for ILECs to sabotage transactions, defined as the ability to increase the cost of a rival's key input of production by nonprice behavior between itself and CLECs. (11)

   On the other hand, as the relative paucity of alternative local networks and rampant bankruptcy in the CLEC industry demonstrates, the economics of self-supply are not particularly compelling either. As explained below, telecommunications is an extremely expensive business, and many CLECs are discovering to their dismay and chagrin that they cannot achieve sufficient economies of scale, scope, or density to warrant the capital required to build various components, even relatively small components, of the local exchange network from the ground up. The large sunk costs required to construct local exchange networks greatly increase the risk of entry and severely limit the number of financially viable alternative "last-mile" networks in most local markets. (12) Simply put, the supply-side economies of the local exchange market prohibit competition among large numbers of network-based firms. The hope for large-numbers competition among network-based firms under current and foreseeable market conditions is sheer fantasy. (13)

   Accordingly, the tenuous relationship between a reluctant wholesale ILEC supplier and its retail competitor-consumer CLECs, as well as the substantial scale economies and sunk costs required to participate in the local exchange market, suggest that neither of the two alternatives for facilitating competition offer substantial promise as a long-term solution to monopoly in the local exchange marketplace. So, what to do? How do we go from "one" firm to "many" firms in an economically efficient manner--the raison d'etre of market "restructuring"? This Article will explore the merits of an untapped market-based third option for local access: the alternative distribution company ("ADCo"), which essentially is a wholesale "carriers' carrier" for local network "last-mile" access. (14)

   The "carriers' carrier" is not a new concept to telecommunications. Many long-haul networks, both national and regional, are built and/or operated as a "carriers' carrier." The economic forces that create a wholesale market in the long-distance industry, where about six nationwide and numerous regional networks support well over 500 retailers, are no less present in the local exchange. (15) Indeed, those economic forces--economies of scale, economies of density, and sunk costs--are even more important in the local exchange than in long-distance, where fiber deployment in metropolitan markets is about twelve times as expensive as long-haul fiber networks. (16) As such, the case for a "carriers' carrier" in the local exchange market at this stage of the telecommunications industry restructuring process is compelling.

   More importantly, given its wholesale entry strategy, the ADCo provides for new entrants a viable economic solution to the problems raised by the inherent incentive of an incumbent unduly to discriminate to protect its profits. This issue of incentives is key to understanding the current ills of the market, as it is now clear that policymakers significantly underestimated the significant incentives of the incumbents to unduly discriminate against their rivals, not to mention also underestimating the entry costs of the local market. In fact, it is becoming readily apparent that, given the current and foreseeable underlying economics of the industry, no amount of regulation--with perhaps the exception of total structural separation--can ever fully mitigate the cross-incentives of the incumbents' wholesale-supplier/retail-competitor relationships with CLECs.

   To explore the merits of the ADCo in detail, this Article, using an analysis first set forth in Phoenix Center Policy Paper No. 10, (17) will briefly explain that given the underlying economics of the market, and that much of the entry costs of a telecommunications network are sunk, industry concentration in telecommunications markets is expected to be relatively high. (18) Accordingly, expecting a large number of competitors in local access markets--particularly a large number of network-based competitors--is entirely unreasonable. (19)

   Second, this Article will evaluate in a summary fashion the two primary forms of entry observed since the passage of the 1996 Act:

   Option 1:

   Element-Dependent Entry ("EDE"): An entry strategy where the new entrant relies heavily on the elements of a reluctant incumbent, rather than build its own network, and purchases local access from the incumbent via special access lines, high-capacity circuits (T1's), full resale, individual unbundled network elements ("UNE"), or even the entire UNE platform ("UNE-P"--a combination of the local loop, unbundled switching, and transport elements). This form of entry includes those entrants relying on the elements of the incumbent until their own networks are deployed (i.e., a "smart-build" strategy). As these firms must also sink huge amounts of capital in equipment to enter, however, these firms are certainly "facilities-based" entrants, albeit not "network-dependent" entrants as discussed in the next paragraph.

   Option 2:

   Network-Based Entry ("NBE"): A strategy where a CLEC seeks to build its own local access network from scratch with little or no reliance on the incumbent's network.

   Third, this Article will explore the full impact of the incumbents' incentive to frustrate competitive entry by setting forth a simple economic model that analyzes the incentives of a vertically integrated supplier--one that operates in both the upstream wholesale market and in the downstream retail market--to provide inputs of production to actual or potential competitors. For consistency with the reality of building a local exchange plant, this model assumes that there are economies of scale or density in the downstream retail market. (20) Also assumed for modeling purposes is that services are profitably supplied. As the model reveals, the incentives to supply the "upstream" or "wholesale" market at cost-based prices, thus facilitating competition in the "downstream" or "retail" market, are inversely related to the market share of the firm in the retail...