Regulatory Arbitrage Strategies and Tactics in Telecommunications

• Publication year: 2003

Rob Frieden⁰

Recently several states have launched investigations of certain MCI telephone call routings based on competitors' claims that the company eliminated or reduced payments it should have made.¹ The MCI investigations may uncover instances of unlawful practices designed to shore up revenues, reduce payments to local exchange carriers for call delivery, avoid tax liability and shift local exchange access payment burdens to other carriers. Perhaps more significantly the investigations may trigger closer scrutiny of numerous strategies and tactics used by telecommunications carriers to reduce payments they make to other carriers. Also, this scrutiny may call attention to how carriers exploit inconsistent regulatory treatment of functionally the same services. A fuzzy line separates lawful efforts to achieve least cost routing of traffic on one hand, and deliberate efforts unlawfully to reduce or avoid financial obligations by deceiving other carriers as to where a call originated on the other hand.²

Regulatory asymmetry occurs when telecommunications service providers offer identical services, but incur different government oversight burdens. More extensive regulation, the duty to pay higher regulatory or legislative fees, and subsidy obligations may apply to carriers based on artificial classifications of services they offer such as geographical scope (intrastate versus interstate) and type (telecommunications as a stand alone service versus one where telecommunications is a minor element of an information service). Additionally, inconsistent regulatory treatment may occur based on carrier classifications using historical market share and perceptions of its market power. Existing "legacy" regulatory classifications³ have established arbitrary dichotomies based on which regulatory agency has jurisdiction, what services qualify for promotion through favorable regulatory treatment, and how carriers and regulators decide to allocate costs.

Regulatory arbitrage⁴ results when stakeholders, such as telecommunications service providers as MCI, exploit differences in legislative and regulatory classifications to accrue financial and competitive advantages achieved by avoiding regulatory burdens, or by foisting payment obligations onto other carriers.

This article will examine tactics designed to exploit regulatory arbitrage with an eye toward identifying areas where inconsistent regulatory treatment distorts the competitive marketplace without offsetting public interest benefits. The article concludes that legislatures and regulators should eliminate opportunities to avoid regulatory burdens through routing and service classification tactics unless compelling reasons persist for maintaining regulatory asymmetry. The Federal Communications Commission and state public utility commissions have established numerous service definitions, territorial and cost allocation policies based on public policy or political considerations that have become unsustainable in light of technological developments. Many of these policies now have costs that exceed the public benefits particularly in light of the competitive distortions they create and the flawed justifications and assumptions underlying the policies.

I. The Death of Distance

Technological developments in telecommunications and information processing increasingly make it unsustainable for operators to charge distance sensitive (mileage based) rates.⁵ Much of the installed plant costs incurred by telecommunications carriers does not vary as a function of usage.⁶ Historically the FCC and state regulatory agencies have encouraged carriers to recover non-traffic sensitive costs on a metered basis⁷ and to recover many types of both non-traffic sensitive and traffic sensitive costs by averaging the different costs triggered by high and low volume users. ⁸ Cost averaging provides a simple "rough justice" solution to complex cost allocation problems,⁹ but it blunts cost differences among carriers, routes and users. Inefficient and inequitable investment recovery would occur if carriers charged usage or mileage based charges to recoup such sunk and embedded costs. High volume users would overcompensate the carrier while low volume users would underpay.

Carriers should not bother to measure the distance between call originator and call recipient if the cost of such metering exceeds the cost differences in handling traffic of different distances. Telephone companies, particularly long distance carriers, typically average long and short haul traffic costs so that they can offer a single, flat rate for all calls. Data communications, including Internet-mediated services, have similar distance insensitive cost characteristics.

Distance and traffic volume insensitivity means that telecommunications and Internet service providers can offer a single per minute or monthly rate for all calls within a wide geographical area, e.g., the entire United States for long distance telephone companies and the entire world for Internet Service Providers ("ISPs"). Such a "postalized" rate averages whatever cost differentials that still exist.¹⁰ Acknowledging the largely sunk investment in telecommunications plant, some carriers now offer a flat monthly rate for unlimited local and long distance calls. Such "All You Can Eat" pricing¹¹ has become standard for Internet access in the United States, and ISPs have never priced access based on the distance separating users and the sources of content, or between senders and recipients of electronic mail.

The death of distance largely erodes the rationale for using geography or political boundaries as the basis for differences in how carriers allocate costs and price services. Indeed many of the reasons for such differences never had a justification on the basis of cost as opposed to other political, social or public policy factors:

[E]fficiency has not been the only goal of intercarrier compensation rules. For example, in order to encourage universal services, . . . [the Federal Communications] Commission and state regulators historically set access charges [paid to local exchange carriers] above cost. By doing so, they hoped to be able to keep local telephone rates low, and thus telephone penetration rates high.¹²

Federal and state telecommunications regulators previously saddled long distance callers, especially ones making intrastate calls, with higher rates than local telephone service consumers. Over-priced long distance call revenues made it possible for local exchange telephone companies ("LECs") to offer possibly below cost local services and to tap into subsidies for achieving universal service objectives including intentionally below cost service to rural residents, the poor and residents of tribal lands.¹³

Distance insensitivity in telecommunications also eliminates the rationale for having different charges for accessing the same local exchange facilities on the basis of whether the call crosses domestic or international borders, originates via a wireless or wireline carrier, or traverses the Internet. Yet LECs continue charging different rates largely because regulatory policies force them to do so, or political factors favor their decision to over- or under-price a particular service.

Set out below is a continuum of LEC access costs from lowest to highest:

• the exchange of traffic between an ISP and a LEC typically triggers no per minute access charge, because the ISP qualifies as an information service provider exempt from LEC access charge payment obligations making it possible for the ISP to receive and terminate calls via metered business telephone lines;¹⁴

• the exchange of traffic between LECs occurs on a reciprocal basis using zero cost, (bill and keep);¹⁵ negotiated, or regulatory-agency prescribed rates typically at a rate several decimal places below one cent;¹⁶

• the exchange of traffic between long distance, i.e., interexchange carriers ("IXCs") and LECs occurs on a uniformly tarriffed basis with rates that have declined substantially, but still significantly exceed the reciprocal rates paid by LECs;¹⁷ New Competitive Local Exchange Carriers ("CLECs") typically charge IXCs higher access fees than Incumbent Local Exchange Carriers ("ILECs");¹⁸

• the exchange of traffic between a wireless carrier and a wireline LEC carrier depends on whether the call appears to be a local exchange of traffic (even if originated at a long distance), or one involving a conventional long distance call making the range variable;¹⁹

• the exchange of international long distance traffic on routes lacking significant competition occurs on a per minute accounting rate,²⁰ ranging from a few cents to more than one dollar which covers long haul and local carriage;²¹ even for routes where an accounting rate settlement does not occur, the rates for call delivery widely varies; and

• the exchange of international long distance traffic with a foreign wireless operator may trigger a termination charge exceeding fifty cents just for using the networks of both the wireline LEC and a wireless carrier.²²

Arguably the costs incurred by LECs do not vary significantly when their networks originate or terminate traffic that traverses the same facilities. Yet even if the traffic types above were to travel the same facilities—and they typically do—the access charges imposed vary substantially. Such cost differentials have little, if any, basis in rational cost allocation and recoupment, but occur as a result of cost attribution: the purposeful loading or unloading of costs onto functionally the same traffic switching and routing functions based on political, social and public policy rationales.²³

The FCC has acknowledged inconsistency in the rates LECs charge:

Interconnection arrangements between carriers are currently governed by a complex system of intercarrier compensation regulations. These regulations treat different types of carriers and different...