Assessing the Regulatory Consequences When Content and Conduit Converge A Presentation at the: 25 th Annual Pacific Telecommunications Council Conference Honolulu, Hawaii (January 22, 2003) Rob Frieden Pioneers Chair and Professor Penn State University 308 James Building University Park, Pennsylvania USA (814) ;

Technological and Marketplace Convergence on ICE An integrated information, communications and entertainment (“ICE”) marketplace approaches. ICE convergence results when both technologies and markets intertwine: phone companies become Internet companies and vice versa. An Internet Protocol-centric environment may arise. The basic definitions and assumptions that worked in a pre- convergent environment fail in an ICE convergent one. Legacy regulations offer many opportunities for regulatory arbitrage, i.e., exploiting opportunities to tilt the competitive playing field based on regulatory classifications and the obligations they impose.

The Law of Unintended Consequences Laws and regulations frequently encourage clever and creative approaches that subvert the desired outcome and tilt the competitive playing field. Given its scope, the U.S. Telecommunications Act of 1996 has created plenty of unexpected opportunities for regulatory arbitrage: exploiting inconsistent and asymmetrical regulation to secure cost savings and competitive advantages. The U.S. legal and regulatory system provides countless litigation opportunities: lobbyists who helped craft now challenge its interpretation. Shared jurisdiction creates forum problems. Regulatory asymmetry can properly promote public interest goals, but without review and recalibration it may unfairly disadvantage some and distort the marketplace.

Asymmetric Regulation in Telecommunications Frequently Occurs Many functionally equivalent units of telecommunication service or facility usage trigger significantly different rates, e.g., domestic vs. international; interstate vs. intrastate telephony. The differential results less from variance in demand elasticities or cost and more from regulatory policies. Regulatory agency jurisdiction, state and national boundaries, composition of the carrier and access to the PSTN affect price, but not actual service cost, e.g., the 15 mile, 30 cent call versus the 13,000 mile, 10 cent call. Most nations face this problem, e.g., EU definition and regulation of Internet-mediated telephony.

Regulatory Opportunism Often Results From Classification Dichotomies and Asymmetries Given the dynamics in technological innovation, legislators, courts and regulators often cannot make a regulatory dichotomy stick, particularly when services converge. Basic vs. Enhanced; telecommunications vs. information service; and private vs. common carrier dichotomies generate unfair outcomes by creating arbitrage incentives to qualify for reduced or no regulation while providing functionally equivalent services, e.g., phone-to-phone Internet mediated telephony exempt from access charges and universal service contribution requirements in many nations. U.S. regulatory dichotomies do not differ significantly from those in the EU, Canada, Japan and elsewhere, but the extent of litigation, delay and uncertainty may.

Deregulation Does Not Occur in the Short Run New, ostensibly deregulatory regimes do not terminate regulation. Liberalization changes the rules and assumptions, often providing new market distorting opportunities. Both incumbents and market entrants seek strategic opportunities to qualify for less regulated or regulator- favored status. The U.S. may have started the process of regulatory reform sooner than most nations, but implementation has lagged.

Current Examples of Regulatory Opportunism in the U.S. Jurisdictional brinkmanship--Internet Service Providers create a Competitive Local Exchange Carrier affiliate who qualifies for ’96 Act mandated compensation from incumbent carriers, but offer no return traffic: is the first and last mile of an Internet routing local or interstate? International accounting rate arbitrage--using technology and the enhanced service regulatory classification to evade prescribed and excessive revenue sharing terms. Cable television company vs. telephone company provided Internet access.

The Internet Increasingly Provides Functionally Equivalent Services to What Incumbent Telecom Carriers Offer *Internet facsimile and telephony provide service to end-users for a fraction of the “retail” cost currently available from incumbent carriers--do fairness and “level competitive playing field” arguments obligate Internet Service Providers (“ISPs”) to apply for authority to operate as regulated carriers, to make universal service subsidy contributions and to settle traffic based on the applicable accounting rate? *On one hand, the Internet can deliver cutting edge services to rural locales and ensure that the hinterland has access to the Global Information Infrastructure. *On the other hand, Internet access depends on the availability of a functional, basic telecommunication infrastructure that may not exist, or whose viability depends on subsidies.

The Internet May Fit into One or More Existing Legal and Regulatory Models ISPs and the services they offer do not readily fit within the definition of common carrier, or telecommunication service provider. ISPs enjoy significant freedom from regulation based on the view that they provide enhanced services that need incubation and/or insulation from taxation and regulation. In the United States, ISPs enjoy exemptions from access charges/universal service payments even as those fees support ISP access in schools, libraries, clinics and hospitals.

Internet Mediation Provides Financial and Regulatory Arbitrage Opportunities Heretofore incumbent telecommunication carriers have lacked the technological wherewithal to detect Internet- mediated telephony: a bit is a bit and a packet is a packet. Future packet headers and other applications may distinguish traffic, but facilities-based, telecom carriers of all sorts have embraced IP telephony despite the risk. The arbitrage risk: cannibalization of higher margin traffic offset by more private line leases and the potential for reduction of accounting rate settlement surpluses as well as access charge revenues and universal service fund contributions.

Conclusions While prudent on its face, the desire not to extend “legacy regulation” necessitates ad hoc crafting of new classifications and exemptions. New classifications, which trigger streamlined or no regulation, create incentives for newcomers and incumbents alike to finds ways to qualify. Carriers that cannot so qualify may face competitive disadvantages no longer justified on market dominance or lack of competition grounds. Carriers that do qualify may simply exploit arbitrage opportunities that have outlived any need for incubation or promotion of competition. In many nations, legislators and regulators have anticipated that competition would flourish after a short period of interconnection negotiations; premature deregulation may contribute to the lack of sustainable competition particularly in local first and last kilometer applications.