Vertical separation of telecommunications networks: evidence from five countries.

• Author: Crandall, Robert W.

1. INTRODUCTION II. UNBUNDLING AND DISCRIMINATION IN TELECOMMUNICATIONS MARKETS: THE REGULATORY CASE FOR SEPARATION A. Mandatory Unbundling and the Incentive Problem B. Forms of Separation III. MANDATORY SEPARATION AND THE ECONOMICS OF VERTICAL INTEGRATION A. The Economics of Vertical Integration B. Empirical Evidence Relating to Vertical Integration C. Vertical Integration in Telecommunications Markets IV. MANDATORY SEPARATION 1N FIVE COUNTRIES A. The United Kingdom 1. A New Regulator 2. A New Policy: Functional Separation B. Australia C. Italy D. New Zealand E. Sweden V. EARLY EVIDENCE: THE EFFECTS OF VERTICAL SEPARATION ON BROADBAND PENETRATION AND INVESTMENT A. Broadband Growth 1. Broadband Growth in the United Kingdom 2. Broadband Growth in Australia, Italy, New Zealand, and Sweden B. Network Investment and Fiber Deployment 1. Network Investment and Fiber Deployment in the United Kingdom 2. Network Investment and Fiber Deployment in Australia, Italy, New Zealand, and Sweden VI. Is VERTICAL SEPARATION AN OPTION FOR THE UNITED STATES? A. Structural Separation in the U.S. Telecommunications Sector: A Brief History B. Unlike Countries That Have Adopted Functional Separation, the United States Has Virtually Ubiquitous Platform Competition C. Unbundling Existing U.S. Next Generation Networks Would Be Costly, If Not Infeasible VII. CONCLUSION I. INTRODUCTION

   Regulatory regimes that require vertically integrated firms to share hard-to-replicate infrastructures--such as electricity transmission lines, railroad tracks, or the last-mile connections in telecommunications networks--create potential incentive problems, as vertically integrated firms may be induced to discriminate against upstream or downstream competitors. For example, electricity firms might discriminate in favor of their own generation plants against independent generators; railroad track owners might discriminate against competing owners of rolling stock; or telecommunications network operators might discriminate against competing service providers.

   To prevent such discrimination, regulators sometimes adopt rules requiring equal treatment or "nondiscriminatory access" to bottleneck facilities--for example, requiring telephone companies to provision lines for competitors' retail customers as quickly and reliably as for their own. (1) Such regulations are subject to the limitations inherent in all such principal-agent relationships: regulators typically have incomplete information, monitoring and policing compliance is costly, and the results are likely to be imperfect.

   One approach to preventing discrimination is to require some form of vertical disintegration, or "separation," by the regulated firm. In their mildest forms, mandates for "accounting separation" may simply require the firm to maintain separate records for its upstream and downstream divisions, thus facilitating regulators' efforts to monitor compliance. (2) At the opposite end of the spectrum, regulators may force full structural separation, or complete divestiture, of the bottleneck facilities into a separate firm. In between, there is a potentially infinite range of "operational" or "functional" separation alternatives which impose various requirements for "arms-length" dealing, while stopping short of complete divestiture. (3)

   Current proposals for vertical separation are motivated primarily by perceived problems in implementing mandatory access (or unbundling) regimes, which force incumbents to lease portions of their last-mile networks to competitors at regulated prices. (4) While mandatory unbundling has been substantially scaled back in the United States (and was only briefly applied to broadband services in the form of line sharing), it remains a regulatory staple in much of the rest of the world, including the European Union and several Pacific Basin nations. (5)

   By its very nature, mandated vertical separation involves a regulatory decision to alter the degree of vertical integration that market forces have otherwise developed. In telecommunications markets, it is commonplace for network infrastructures to be owned and operated by the same firms that provide retail services directly to subscribers. (6) Economic theory posits that vertical integration is most likely to be economically efficient in industries where there are significant sunk costs (i.e., "asset specificity") and where there are high levels of complexity or uncertainty--all characteristics associated with the modern telecommunications industry. To the extent mandated vertical separation disrupts or reduces these efficiencies, it may discourage the introduction of new networks, thereby reducing economic welfare and harming consumers. Concerns about the potential for such disruptions--combined with recognition that the more extreme forms of separation potentially are irreversible--have led most regulators to back away from mandatory separation, or to view it as a "last resort," to be used only in cases of extreme and otherwise irremediable discrimination. (7)

   Nevertheless, since 2002, five nations--Australia (2005), Italy (2002, 2008), New Zealand (2007), Sweden (2008), and the United Kingdom (2005)--have adopted some form of mandatory vertical separation, (8) and the European Parliament is on the verge of embracing functional separation as a potential remedy for use by European Union (EU) national regulators (albeit only as an "exceptional measure"). (9) As the International Telecommunications Union (ITU) noted in 2008, "[t]here has been a tremendous amount of interest around the world recently in functional separation as a regulatory remedy in the telecommunication sector." (10)

   In this Article, we examine the arguments for and against mandated vertical separation in telecommunications. Section II discusses the regulatory case for mandatory separation in telecommunications markets and describes the types of separation regimes typically advanced. Section III explains relevant economic theories of vertical integration and their application to telecommunications markets, concluding that telecommunications possesses many of the characteristics economists associate with the presence of strong efficiency effects of vertical integration. Section IV describes the separation regimes that have been adopted to date--in Australia, Italy, New Zealand, Sweden, and the United Kingdom--and briefly summarizes the market circumstances in each country at the time separation was implemented. Section V presents the available empirical evidence on the impact of mandatory separation in each of these countries, focusing specifically on broadband adoption and infrastructure investment. Section VI briefly examines the appropriateness of mandatory separation for the United States. In Section VII we summarize our central conclusion, which is that the available evidence fails to support the proposition that mandatory separation improves market performance, but this evidence does suggest that such a policy leads to reduced levels of innovation and investment. Adoption of mandatory separation in the United States would represent a radical departure from current policies, which would be extremely disruptive and likely to produce few, if any, benefits while imposing extremely large costs.

2. UNBUNDLING AND DISCRIMINATION IN TELECOMMUNICATIONS MARKETS: THE REGULATORY CASE FOR SEPARATION

   Mandatory unbundling policies for telecommunications networks were first adopted in Hong Kong in 1995, rolled out aggressively in the United States after passage of the 1996 Telecommunications Act, and adopted in most other Organisation for Economic Co-operation and Development (OECD) countries between 1999 and 2001. (11) Beginning in 2003, the FCC--prompted by the courts--began reversing course, initially by forbearing from imposing unbundling for broadband services delivered over optical fiber, hybrid-fiber-coax (HFC) and through line sharing over traditional copper networks. (12) In 2004, it eliminated the so-called "UNE-Platform" (UNE-P), a requirement that incumbents offer the entire local telecommunications platform at low, wholesale rates. (13) In 2005, the FCC essentially deregulated telephone companies' DSL services by declaring them to be "information services." (14)

   In contrast to the United States, most OECD nations have continued to pursue mandatory unbundling of local loops for both voice and broadband services. (15) Hence, regulators in these countries continue to grapple with the incentive problems created when mandatory unbundling regimes are imposed on incumbent carriers, and to explore the role of vertical separation requirements in addressing those problems.

   1. Mandatory Unbundling and the Incentive Problem

      When regulators force vertically integrated incumbents to lease access to their networks to competitors at binding maximum prices, incumbents may have incentives to engage in non-price discrimination in favor of their own retail services. (16) Such discrimination, in principle, could take any number of forms, from providing competitors with slower installation times to failing to provide adequate interfaces for operations support systems (OSS) necessary to coordinate the ordering and billing of services. As the FCC explained in its 1996 Order implementing the unbundling provisions of the Telecommunications Act,

      [w]e are also cognizant of the fact that incumbent LECs have the incentive and the ability to engage in many kinds of discrimination. For example, incumbent LECs could potentially delay providing access to unbundled network elements, or they could provide them to new entrants at a degraded level of quality. (17) In this context, the challenge for regulators is to devise mechanisms for detecting and policing potential discrimination. In principle, regulators have two choices: they can impose behavioral rules on incumbents, requiring them to meet various regulatory metrics for providing service on a nondiscriminatory...