TELRIC vs. universal service: a takings violation?

• Author: Buck, Stuart
• Position: Total element long-run incremental cost

1. INTRODUCTION

   By longstanding tradition, local phone companies are required to sell their services to customers at roughly comparable prices. (1) This so-called "universal service" obligation is intended to ensure that people who live in rural and residential areas (which are expensive to serve) can buy phone service on terms similar to those offered to urban or business customers (which are cheaper to serve). (2) Under universal service obligations, then, retail pricing is typically averaged across a variety of customers or geographic areas.

   The Telecommunications Act of 1996 ("Telecom Act" or "1996 Act"), (3) however, introduced a new wrinkle into the realm of telecommunications pricing. By law, local telephone companies, known as incumbent local exchange companies ("ILECs"), would be forced to lease virtually all of their equipment and facilities to their competitors, the idea being that the competitors could then offer a competitive product to the consumers. (4) The pricing terms of such leases are to be set by state public utility commissions, who must calculate the theoretical cost of constructing a new network. This system of cost-based pricing is known as TELRIC, which stands for "total element long-run incremental cost." (5)

   While this idea may have had merit standing alone, (6) the combination of universal service obligations and cost-based wholesale leasing is utterly perverse. It simply makes no sense to require the same company to sell its wholesale access at cost, while it must still sell its retail services to all customers at an average price that completely ignores cost. (7) As the California energy crisis of 2001 showed in painful detail, it is absolutely unworkable to attempt to keep below-cost retail regulation in place while creating a system of at-cost wholesale prices. (8) The predictable result in California was to "drive the utilities to the point of insolvency." (9) Some analysts predict a similarly gloomy future for the telecom industry. (10)

   The following analogy might be instructive: Imagine that Ford had historically been seen as a monopoly provider of automobiles. Imagine further that because of a desire for fairness to all customers, the government had traditionally required Ford to personally deliver cars to all customers' homes at roughly the same price, even if some customers were located right next door to a dealership while others lived a hundred miles from any dealership. This system might be workable as long as Ford was able to use its monopoly power to charge all customers a similar price, such that the next-door customers were essentially subsidizing the far-off customers' delivery.

   But then suppose that the government, in an effort to undermine Ford's historic monopoly, ordered Ford to sell all of its automobiles at wholesale, cost-based prices to Chevrolet, who could then relabel the automobiles and resell them immediately. The result would be easy to predict: Chevrolet would buy Ford's autos at the cheap, wholesale prices, and would then target the next-door customers who had historically been relatively overcharged. This, in turn, would undermine Ford's ability to comply with the obligation to deliver automobiles at average prices to rural customers far away from the dealership.

   Current telecommunications regulation is roughly equivalent to this hypothetical I have sketched. Local phone companies are being forced simultaneously to provide service at averaged prices to expensive rural customers and to sell wholesale access at cost to their competitors, who can then resell phone service to urban and business customers. This in turn undermines the local phone companies' ability to comply with universal service obligations.

   To put things more clearly, here is a simplified model of telecommunications service. Imagine that a state consists of 50,000 urban business customers, 50,000 suburban residential customers, and 10,000 rural customers, all of whom purchase exactly the same service package. The business customers cost $20 per month to serve, the suburban customers cost $40 per month to serve, and the rural customers cost $100 per month to serve. Thus, the total cost of service is $4 million per month. As the local phone company is required to charge all customers equal prices for the same service, the price charged to each customer is $36.36 per month (4 million divided by 110,000). Thus, the business customers pay an extra $16.36 per month, the residential customers get a bargain in the amount of $3.64 per month, and the rural customers benefit by $63.64 per month.

   The viability of this universal service pricing system depends on being able to charge the urban business customers more and the rural customers less. But then enters the 1996 Act, with the requirement that the local phone companies lease their lines and equipment to competitors at cost. Thus, if a competitor comes to the local exchange company and announces that it has signed up all 50,000 urban business customers at some retail price under $36.36 per month, the incumbent must lease 50,000 lines to the competitor at the actual cost of $20 per month. This then leaves the incumbent serving all the 50,000 suburban customers and the 10,000 rural customers at a per-customer loss of $3.64 and $63.64 per month, respectively. (Obviously, the competitors will have little interest in leasing rural lines at the actual cost of $100 per month and then selling retail service at $36.36.)

   Clearly, this is a highly stylized and simplified model because conditions are much more complicated in the real world. Still, this model shows just where the problem lies for the incumbents. On one hand, they are required by law to serve rural customers at prices that do not cover the costs of service. On the other hand, they are now being required to lease lines to competitors at actual cost, who then skim off the most profitable urban business customers (11) who made the entire system of universal service work in the first place. (12) As telecom lawyer and scholar Peter Huber recently wrote, "Ordinarily, imperfections in the price-regulating machinery tend to cancel each other out; here, competitors buy wholesale where wholesale is cheaper than retail, and consumers buy retail where retail is cheaper than wholesale. One way or another, incumbent companies end up with sharply lower revenues." (13)

   But in fact, the problem is even worse than I have suggested thus far. In most states, regulators base retail rates on "value-of-service" calculations, by which rates are actually higher in dense urban areas on the theory that service is more valuable in areas where there are many people to whom one can make local calls,j4 According to one estimate, businesses are charged at rates of up to four times those charged for the same service in residential areas. (15) In Rosston and Wimmer's recent analysis of nationwide data, they found that "residential rates are equal to less than one-half the rate paid by business users, holding costs constant," (16) and even that "rates across states are inversely related to costs." (17) To go back to my analogy, this would be as if state law required Ford to charge twice as much for a cross-town delivery as for a cross-country delivery. The incentive for distorted competitive entry would be obvious.

   There is little hope for legislative or regulatory relief from this dilemma. Changing the retail rate system is generally thought to be a political nonstarter. (18) As Robert Saunders pointed out in a recent essay, raising residential rates to market prices

   is not an option any company can lobby for without engendering a massive backlash. Although almost any industry analyst would tell you that Aunt Tilly is simply not paying enough for the telephone services she currently enjoys, it's nigh impossible to convince a lawmaker or regulator of this. No ratepayer wants to pay more, and the PSCs are beholden to powerful folks who listen when large lobbies like the AARP speak. (19) Milton Mueller agrees, saying that in the debate over costs,

   the ultimate trump card is the level of local telephone rates. If basic service rates go up, the FCC will look bad and the new law will appear to the public to be a failure. Thus, the commission's temptation to maintain implicit universal service subsidies or to structure the subsidy program in a way that prevents a cost-based rebalancing of telephone rates is probably irresistible. (20) Economists confirm that "regulators are mostly influenced by political considerations," primarily "cross subsidization to politically influential user groups." (21)

   In order to combat the obvious irrationality of this system, local phone companies may find it necessary to file lawsuits alleging a violation of the Takings Clause of the United States Constitution. Such a suit would claim that the current combination of an averaged retail rate structure and cost-based UNE prices creates a "confiscatory" rate that effectively "takes" their property without just compensation. (22) Though modern courts are not always in agreement on how to apply the "confiscatory rate" doctrine under the Takings Clause, all agree that the Constitution requires that a company's investors be able to achieve a rate of return reasonably comparable to rates achieved by similar firms with similar levels of risk. (23)

   As a famous scholar once commented, "The Supreme Power who conceived gravity, supply and demand, and the double helix must have been absorbed elsewhere when public utility regulation was invented." (24) The recent history of telecommunications regulation does not give much cause for hope, as it attempts to combine two inherently contradictory requirements--universal service retail pricing and cost-based UNE pricing. Because a federal judge would hopefully be isolated from the conflicting political pressures that affect the rationality of decisions by legislators and bureaucrats, a takings lawsuit...