Was the UNE Triennial Review Worth the Wait? Part II: The Substance

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Part I of this memo discussed thetroubling procedural issues surrounding the Federal CommunicationsCommission's August 21 release of the its long-awaited final rulingin its massive Unbundled Network Element (UNE) TriennialReview. Although the process behind the UNE Triennial ReviewOrder (TRO) was distressing, the substance of the edict is causefor even more concern.

At its most basic level, the 576-page, 2,447-footnote rulingrepresents an attempt to rationalize and extend the FCC'sinfrastructure-sharing rules for older networks and technologies,while firewalling off new services (fiber in particular) from thosesame rules. Thus, the inherent contradiction of the TRO becomesimmediately clear: FCC officials are smart enough to realize thatthe agency's current infrastructure-sharing regime has wroughthavoc within financial markets, discouraged investment, andthreatened innovation, so they have begun quarantining new servicesand technologies from those destructive regulations. Yet they areeither too embarrassed or stubborn to admit that fact and begindismantling all of the infrastructure socialism that has plaguedthe sector since the passage of the Telecommunications Act of 1996.So a veritable Berlin Wall for telecom is being erected withunrestrained services and technologies on one side and micromanagedservices and technologies on the other.

Containing the Old Industrial Policy. Ofcourse, a regulatory firewall can have benefits for those industrysegments or technologies lucky enough to be on the free side of thewall. This is why many industry analysts have long favored thefirewalling approach; it's the easiest way to limit the damageassociated with the old rules and encourage firms to deployadvanced networks and technologies.

The old industrial policy leans heavily on UNEs and the UNEwholesale platform (UNE-P) scheme the FCC concocted, which requiredincumbent local exchange carriers to unbundle and share virtuallyevery element of their networks at regulated rates and thenreassemble those elements so that rivals could resell the entirepackage of services. The FCC and state public utility commissions(PUCs) have spent the last seven years aggressively subsidizingCLECs via UNE-P. Not surprisingly, that industrial policy workedmarvelously since, if you subsidize something you typically getmore of it, sometimes far more than you really need. Dozens of new"competitors" entered the market and began reselling telecom accessover the lines owned by incumbent firms. Some CLECs built their ownswitches or other systems, but the vast majority opted forinfrastructure sharing via UNE-P over facilities-based investment.Why build when you can borrow, and borrow at rates far below thecost of the good in question?

This game worked for a few years, but the regulatory house ofcards came crashing down a few years ago as telecom stocks tankedand even the most generous infrastructure-sharing rules couldn'tsave companies that hadn't invested a penny in their ownfacilities. The reverberations were widespread and devastating: amassive market meltdown spilled over into adjacent markets andresulted in bankruptcies, heavy job losses, and a slowdown inindustry investment. That explains why the FCC has proposed aBerlin Wall for broadband in the TRO.

Cash Flow and New Investments. But there'salways been one nagging flaw in the idea of broadband firewalling.Freeing up broadband from regulation is a sensible decision thatmay lead to some new investment by carriers. But will thecontinuation of infrastructure-sharing rules on older systems cutinto the cash flow necessary to make significant investment in newnetworks and technologies?

Investment analysts at the Precursor Group rightly label theUNE-P regime "a profit killer" that eats into the operating marginsincumbent carriers need to invest in expensive and risky newhigh-speed systems. And other investment analysts have noted thatbroadband demand remains somewhat uncertain, making high-speeddeployment an even riskier proposition. Incumbents are also losingaccess lines for the first time in decades due primarily to intensecellular competition as consumers increasingly substitute bucketsof wireless minutes for traditional wireline calls. And Internettelephony is finally becoming a credible threat, with dozens offirms (including less-regulated cable firms) deployingpacket-switched voice services over the Internet. The combinationof UNE-P regulation, wireless substitution, and real access lineloss means incumbent operators may find it difficult tosignificantly ramp up capital expenditures in new high-speednetworks in the short term.

The Hyper-Balkanization of Telecommunications.And the cash flow picture won't get better any time soon thanks tothe most unfortunate element of the TRO: the FCC's generousdelegation of UNE authority to state regulators. The word of theday at the FCC is "granular." The term is sprinkled throughout thenew order and reflects the FCC's new infatuation with "states'rights" within telecom markets. Apparently by allowing state publicutility commissions (PUCs) to engage in more granular regulatoryanalysis on a market-by-market basis, 51 PUCs will be able to morescientifically micro-manage telecom competition into existence.

The perils of this approach cannotbe understated. Suffice it to say, there are plenty of other publicpolicy issues for which devolution makes a great deal of sense, buttelecom and broadband regulatory policy is not one of them. If,however, the FCC's intention is to create even more syntheticcompetition and save the resellers, who depend on a steady flow oflow-priced UNEs, then the devolution plan laid out in the TRO maywork. In fact, increased sharing is a virtual certainty under thelanguage of the TRO since the order contains a number ofself-fulfilling tests and triggers that state PUCs can use toretain or expand the use of UNE-P. For example, switching will onlybe removed from the list of shared UNE items if a state finds thatthere are three or more unaffiliated carriers serving customers ina given market using their own switches. (The TRO also lets thestates define "markets" as broadly or narrowly as they want forpurposes of enforcing this rule). But, again, why build a switchwhen you can borrow someone else's at low UNE rates? In otherwords, these rules result in business decisions that cause the veryproblem the rules are supposed to remedy. Worse yet, theself-perpetuating nature of the new TRO state-driven frameworkmeans that "UNE-P may never go away," as a recent Credit Suisse /First Boston investment report argues.

Bottom line: The TRO is one small step forward (the broadbandfirewall), but two or three giant steps back (the retention anddevolution of UNE-P authority in particular). Little in the TROwill likely incentivize the true facilities-based competition sodesperately needed in telecom markets. Instead, the TRO is justmore of the FCC's old infrastructure sharing but this time doledout on a more parochial basis. As Precursor Group analystsconclude, "This order effectively completes the FCC's defacto socialization of the Bells' infrastructure toartificially drive prices down.... [R]esale competition has ceasedto be a transition to facilities competition and become an end initself." Regrettably, it now appears this managedcompetition-infrastructuresocialism game will continue ad nauseam, potentiallyfor many years longer than anyone initially envisioned when theTelecom Act was passed back in 1996.