Implications of the Supreme Court’s Verizon v. FCC Decision

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Telecommunications deregulation suffered a serious setback onMay 13 when the Supreme Court handed down its eagerly awaiteddecision in the case of Verizon Communications v. Federal CommunicationsCommission and held that federal regulators could continueto force incumbent local telephone companies to share elements oftheir networks with rivals at heavily discounted rates. Although itremains unclear how big a blow the ruling will be to ongoingindustry liberalization efforts, it will certainly make thetransition to a free market in telecom services more difficult thanwas previously expected.

The case was significant because it offered the Court the chanceto rule on the constitutionality of infrastructure-sharing rulesthat the FCC put in place almost six years ago, and in the process,to help bring an end to the constant legal wrangling and litigationnightmare that has followed the passage of the TelecommunicationsAct of 1996. Importantly, this is the second major case to reachthe Supreme Court regarding the FCC's implementation of theinterconnection and network access provisions of the Telecom Act.In its 1999 decision, AT&T Corp. v. Iowa Utilities Board, the Courtpartially overturned the sweeping FCC mandates on the sharing ofunbundled network elements (UNEs) owned by Regional Bell OperatingCompanies, or "Baby Bells."

The Court's latest decision in Verizon v. FCC looked atthe other half of the equation: how to determine just compensationfor the Bells when they are forced to share UNEs with competitors.Specifically, the Court reviewed the pricing methodology the FCCdevised to determine what network "costs" and investments would becompensated. The cost model the FCC invented to accomplish this isknown as TELRIC, which stands for "total element long-runincremental cost." This model is highly controversial because itestimates costs by imagining what it might cost to construct andoperate a hypothetical, efficiently designed network from scratch.Was the FCC's cost model fair? Did it adequately compensate theBells? Did TELRIC encourage enough industry investment? On allthese questions the 7-1 majority for the Court ruled in theaffirmative and vindicated the FCC's six-year effort to divine"costs" through some rather creative regulatory reasoning andcontroversial economic models.

As hordes of economists have pointed out in recent years,however, a fairy tale regulatory model like TELRIC does not meshwith economic reality since it fails to account for the actualcosts of building and maintaining networks. As a consequence,TELRIC poses a threat to industry investment, innovation, andgenuine facilities-based competition. Alfred Kahn, notedregulatory economist and former chairman of the Civil AeronauticsBoard, has referred to the logic behind TELRIC as "regulatoryarrogance" and argued in Cato's 1998 book Regulators'Revenge, "By their meddling, under enormous pressure toproduce politically attractive results, regulators have violatedthe most basic tenets of efficient competition-that it should beconducted on the basis of the respective actual incremental costsof the contending parties; and it is that competition, rather thanregulatory dictation, that should determine the results." Likewise,technology guru George Gilder argued in a Wall StreetJournal editorial last August, "Like any price-control scheme,TELRIC choked off supply, taking the profits out of themultibillion-dollar venture of deploying new broadband pipes." Thatregulatory system, Gilder added, discourages broadband investmentby "privatizing the risks and socializing the rewards." Moreover,he said, "No entrepreneurs will invest in risky, technicallyexacting new infrastructure when they must share it with rivals."In addition to concerns about economic efficiency and investmentincentives, the Baby Bells argued that TELRIC rules represented anunconstitutional taking of their property by forcing them tosurrender space on their networks at generously discounted ratesthat failed to compensate them for their historic investments.

Sadly, only Justice Stephen Breyer gave those arguments anycredence. It should be noted that Justice Breyer was a respectedexpert on the law and economics of regulation long before he joinedthe Court and is the author of Regulation and Its Reform,a standard textbook for students of the regulatory process. Thisexpertise shined through in Breyer's scathing dissent to themajority decision in which he raised the important question ofwhether there was any rational connection between the regulationsthe FCC promulgated and the Telecom Act's stated goal ofderegulating this sector. As Breyer argued: "The problem beforeus-that of a lack of 'rational connection' between the regulationsand the statute-grows out of the fact that the 1996 Act is not atypical regulatory statute asking regulators simply to seek lowprices, perhaps by trying to replicate those of a hypotheticallycompetitive market. Rather, this statute is a deregulatory statute,and it asks regulators to create prices that will induceappropriate new entry." Breyer goes on to correctly note that FCC'sTELRIC pricing rule and UNE requirements, "bring about, not thecompetitive marketplace that the statute demands, but a highlyregulated marketplace characterized by widespread sharing offacilities with innovation and technological change reflectingmandarin decision-making through regulation rather thandecentralized decision-making based on the interaction of freelycompetitive market forces. The majority nonetheless finds theCommission's pricing rules reasonable. As a regulatory theory, thatconclusion might be supportable. But under this deregulatorystatute, it is not."

The majority for the Court didn't buy any of these arguments butdownplayed the negative disincentives posed by such infrastructuresharing and simply deferred to the FCC's "by any means necessary"crusade to encourage new rivals to enter this marketplace. Throughits actions, the agency has essentially proclaimed that a numericalnose count of new entrants is more important than networkinvestment and genuine facilities-based competition. The wisdom ofthat policy has been put to the test by economic theorists and inthe actual business market and has been found wanting.

In a comprehensivesurvey of the Competitive Local Exchange Carrier market,Brookings Institution economist Robert Crandall has found that:"CLECs are best able to produce revenue growth by building theirown networks or significant parts of their own networks. CLECs thatonly resold the establish carriers' services were generally unableto convert investments into revenues, and these companies werelikely to fail." So the Supreme Court's decision cannot change thefact that network sharing has not been a very good business model.On the other hand, the decision perpetuates that model andencourages companies to continue to petition the regulators to rigthe rules in favor of generously discounted access to existing andfuture communications networks and technologies. One cannot helpbut shudder at the thought of years of additional regulatoryproceedings on this matter and wonder what the implications will befor long-term investment and innovation in the U.S.telecommunication sector.

But all hope is not lost. Led by the deregulatory-mindedchairman Michael Powell, the FCC is currently pursuing several proceedings that question the wisdomof some of these rules. With any luck, Powell will receive thesupport of his superiors in the Bush Administration in thisendeavor and begin to roll back the destructive regime of pricecontrols and infrastructure-sharing mandates that threaten the newinvestment and innovation in communications infrastructure thatAmerica so desperately needs.