Are regulators forward-looking? The market price of copper versus the regulated price of mandatory access to unbundled local loops in telecommunications networks.

• Author: Hausman, Jerry A.
• Position: The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective

1. INTRODUCTION II. THE DATA REQUIREMENTS FOR FORWARD-LOOKING COST MODELS III. COPPER PRICES AND THE CALIFORNIA PUBLIC UTILITIES COMMISSION IV. COPPER PRICES AND THE NEW ZEALAND COMMERCE COMMISSION A. Biased LL U Benchmark Estimates B. Long-Term Benefits to End Users and Distortion of Investment Incentives C. Benchmark Rates Predicted from a Regression Model D. Benchmark Data That Are Not Forward-Looking E. Subsequent Developments V. REGULATORY OPPORTUNISM AND THE FAILURE TO RECTIFY THE KNOWN DEFICIENCIES OF TELRIC PRICING: THE ILEC's RIGHT UNDER ANTITRUST AND TELECOMMUNICATIONS LAW TO DECOMMISSION COPPER LOOPS VI. CONCLUSION I. INTRODUCTION

   Beginning in 1996, regulators in virtually every industrialized nation started down the path of mandating that the incumbent telecommunications operator offer competitors access to its network at regulated prices that reflect the forward-looking cost of the network, rather than the incumbent's historic cost. In the United States, the Telecommunications Act of 1996 requires that incumbent local exchange carriers (ILECs) provide certain elements of their networks to competitive local exchange carriers (CLECs). (1) Most prominent among these elements is the local loop (the connection between a subscriber and a telephone company's local switch).

   The Telecommunications Act requires that these network elements be priced at cost, with the possible addition of a reasonable profit. (2) In August 1996, the Federal Communications Commission (FCC) issued rules for determining these prices. (3) The agency invented the concept of total element long-run incremental cost (TELRIC) and made it the foundation for the rules for pricing mandatory access to unbundled network elements. The FCC's rules were based on a model of a hypothetical carrier that places switches in the ILEC's existing switch locations but otherwise builds an entirely new network to serve customer locations: "[t]he total element long-run incremental cost of an element should be measured based on the use of the most efficient telecommunications technology currently available and the lowest cost network configuration, given the existing location of the incumbent LEC's wire centers." (4) The FCC's objective in establishing this rule was unexceptionable: to determine the "incremental costs that incumbents actually expect to incur in making network elements available to new entrants" (5) and to adopt a pricing methodology that "best replicates, to the extent possible, the conditions of a competitive market." (6)

   To say that the FCC's pricing rules proved to be controversial both in theory and practice would be an understatement. (7) Between 1999 and 2002, the Supreme Court twice interpreted the rules for mandatory unbundling (8) and thereafter issued two more decisions in 2004 and 2007 construing the relationship of antitrust law to this new regulatory regime. (9) Much of the theoretical debate has focused on establishing proper cost of capital and depreciation values that reflect the risk facing firms owning substantial amounts of capital assets that become sunk upon deployment. (10) Certain components of modern telecommunications networks typically experience steady decreases in equipment prices because of technological progress. For example, the network operator usually can replace a switch or a piece of fiber optic electronic equipment for less than its original purchase price, yet maintain comparable quality and capabilities. The theoretical literature explains how levelized annual cost calculations, widely used by U.S. regulators, can produce economically incorrect cost estimates in these circumstances.

   This article describes another potential source of error in estimating the economic costs of network elements--an error that, despite its great practical significance, has elicited no commentary and evidently has caught regulators around the world unaware. The cost models that regulators use in practice typically require detailed estimates of the equipment and installation prices of the numerous components that are used in a telecommunications network. To represent and estimate the cost of local loop facilities, these models estimate the quantities of components--such as miles or kilometers of copper cable--as well as the purchase and installation prices for these components. Consequently, when there is uncertainty about how these prices will change over the period for which costs and prices are required, the resulting cost estimates used for setting the regulated prices of unbundled network elements can be very inaccurate. (11) Similarly, when regulators in other jurisdictions are considering such rates as "benchmarks," it is necessary to make adjustments to account for such large differences in critical input prices so that the benchmark rates will be representative of the costs that will be incurred by efficient carriers offering unbundled elements in those jurisdictions.

   The precipitous rise in the price of copper since 2003 exemplifies this need to reevaluate the inputs used by regulators in their cost model, as well as the inferences drawn from those models. (12) The large increases in copper prices differ from the type of constant annual expected input price growth (or decline) situation that some cost models used outside the United States have accommodated with "tilted annuity" methods. Rather than a gradual anticipated price increase, copper prices escalated rapidly and are likely to remain well above the levels that regulators used to set existing loop rates.

   The global financial crisis that began in the summer of 2008 does not change the fundamental point that we raise. The price of copper fell sharply in mid-2008; yet, as of this writing, that price is still roughly twice the level that is built into the regulatory models. Indeed, this wide fluctuation in the price of copper demonstrates why the use of a fictitious network with current prices introduces a great amount of variability into the prices. Should a regulator change regulated rates each time the price of copper changes? Can a network provider or access seeker do rational business planning when facing this amount of variability?

   Part II of this article explains the data that TELRIC models require if they are to achieve their purpose of producing valid estimates of the forward-looking cost of an efficient telecommunications network. Part III documents the rapid rise in copper prices since 2003 and how accounting for such evidence would change the forward-looking costs of a hypothetically efficient ILEC network that one of the most prominent U.S. state regulatory commissions--the California Public Utilities Commission (CPUC)--established in 2006. (13) Part IV explains how the Commerce Commission in New Zealand has similarly employed a benchmarking methodology for the pricing of unbundled loops that fails to account for the increased price of copper. (14)

   Part V asks whether a global trend is emerging among telecommunications regulators to ignore the input requirements of their own forward-looking cost models. Such a trend would be consistent with a version of regulatory opportunism in which regulators are forward-looking only when doing so produces lower regulated prices over time. The risk of regulatory opportunism and the high price of copper together create a strong incentive for an ILEC to replace its copper loops with optical fiber. Although some CLECs could be adversely affected by such a decommissioning of copper loops, an ILEC has no duty under U.S. antitrust or telecommunications law to keep copper loops in service for the benefit of its competitors.

2. THE DATA REQUIREMENTS FOR FORWARD-LOOKING COST MODELS

   To attain the FCC's objective for TELRIC of determining "incremental costs that incumbents actually expect to incur in making network elements available to new entrants," (15) the results produced by the TELRIC process must be consistent with the forward-looking business decisions that those incumbents make in designing the network that produces both the network elements provided on a wholesale basis and the incumbent's retail services. (16) In competitive markets, such investments are made with the expectation that prices will be sufficient to recover the investments in long-lived assets (typically with "lumpy" capacities over their economic lifetime) to earn a normal return, and to recover the associated direct expenses along with some portion of the joint and common costs of the enterprise. (17) The competitive prices that are the basis for such decisions are also the economically efficient rates for any unbundled elements provided to other carriers.

   Accordingly, evaluating whether the results produced by TELRIC approximate such efficient prices involves an assessment of the extent to which the TELRIC assumptions that constrain the network design to existing switch locations--but otherwise assume that the network operator has complete freedom to design a new network instantaneously--depart from the economic decisions that produce real networks. In fact, previous analyses have identified at least two significant ways in which the TELRIC process departs from reality. (18)

   First, because of the long lives of network assets and the fact that demand can change over both space and time, network components are built over time, not instantaneously. Second, investments in assets with long lives are made in the face of uncertainty about output prices and volumes, input prices, and interest rates. Therefore, these departures from reality imply that the costs and rates produced by the TELRIC process will differ--potentially substantially--from economic costs and prices. (19)

   A simple example of the bias introduced by the first factor is that the routing of loop facilities from switches to customer locations is very likely longer in the real world than what typical cost models based on TELRIC produce, because the network was built to...