The Regulation of Network Industries Simon Wilkie. Caltech Lecture for May 7, 2004

2 Overview Policy Goals Interconnection Definitions Pricing Issues Lessons from past problems

3 Interconnection Policy Goals of Interconnection Policy –The terms and rates for interconnection, traffic transfer, and access to network elements should encourage efficient use of the network efficient investment in and deployment of network facilities.

4 Definitions ILEC: Incumbent local Exchange carrier is the firm has owns the legacy network of installed local loops and switches IXC: Inter Exchange Carrier is q firm whose network links other networks rather than the end customers (also a backbone provider) CLEC: Competitive Exchange Carrier os an entrant who does not have a legacy network and leases access on the ILECs network.

5 Definitions Interconnection is a general term for the way in which different networks connect to allow traffic to pass between them; allow a competitor to gain access to an incumbent’s network elements Access is a general term for the way that customers or competing providers use existing networks.

6 Definitions Transport and Termination (or Two-way access): the rates once local carrier pays another to complete a local call One-way Access: the rates an “IXC” pays a LEC to originate or terminate a long-distance call Equal Access is defined where a provider with substantial market power, e.g., an ILEC, is vertically integrated so it is itself a competitor

7 Interconnection Selecting Points of Physical Interconnection –Even with a single provider, different portions of the network are identifiable, based on physical, technological, and engineering differences -- e.g., customer premises/inside wiring, line side of end- office switch; trunk side of end-office switch; line side or trunk side of tandem switch. –Selection of required points of interconnection depends on policy goals, but initial interconnection points reflect “natural” points of interconnection between different portions of the network.

8 Interconnection

9 Selecting Points of Interconnection (cont.) –In introducing competition in the long-distance market, the FCC required interconnection at the end- office and tandem switches. –In introducing competition into local telephone markets, the FCC mandated additional interconnection points, including central office cross- connect points, out-of-band signaling transfer points and points of access to network elements.

10 Pricing Issues -- Overview Rate Structure Issues Access Pricing Issues Past Policy Problems Competitively Neutral Cost Recovery

11 Pricing Issues – Rate Structure Setting efficient rate structures is as important as setting efficient rate levels –Inefficient rate structures cause inefficient use of the network -- e.g., recovering the sunk cost of a loop through per-minute charges leads to under utilization –Inefficient wholesale rates cause retail rate distortion –Inefficient rate structure can ca regulatory arbitrage. General Principle: Rates should recover costs in a manner reflecting the way they are incurred.

12 Pricing Issues – Rate Structure Alternative rate structures –Per-minute charges (most long-distance service and local service in some areas) –Per-call charges (for local calls in some areas) –Flat, monthly charges (most U.S. local service) –Capacity-based charges (certain transport and data services; wireless bucket of minutes plans) –Single, nonrecurring charges (e.g., cost of initiating service or or ordering an additional dedicated transport link)

13 Pricing Issues - Access 3 Types of Access –One-Way Access -- Where one carrier pays for access to another network, but does not receive payment (e.g., IXC pays both originating and terminating LECs) –Two-Way Access -- Where each carrier pays the other to transport and terminate traffic. (Also known as “transport and termination” or “reciprocal compensation.”) –End-User Access -- What end users pay to originate or receive calls –Problem of distinguishing carriers and end-users.

14 Pricing Issues - Access IXC POP ILEC-1 CO ESP/ISP RAS/ GW CLEC CO Circuit Switched Network Packet Switched/IP Network ILEC-2 CO MTSO Cellular Network (3) (2) (1) (5) (6) (7) (4)

15 Pricing Issues - Access Per-Minute Access Rate Levels in the U.S. –One-Way Access -- Interstate Access Charges $0.0055/min. for large price-cap carriers $0.0095/min. for small, high-cost price-cap carriers –Two -Way Access -- Set by State Regulators Range from $0.003 to $0.008, with majority in the range of $0.003 to $ And likely to go lower. ISP Recip.Comp. Option: (1) $ for six mos.; (2) $ for 18 mos.; (3) $ thereafter.

16 Pricing Issues - Access Pricing Termination –Termination charge should recover the traffic- sensitive cost of the facilities used to terminate traffic -- E.g., central office switch. –Question: Should termination costs be recovered from the originating carrier or the end-user being called? –Rate Level -- Should be based on costs Symmetric v. Asymmetric Rates Bill and Keep

17 Pricing Issues - Access Potential for regulatory arbitrage and other problems due to: Inefficient or inconsistent rate levels –Ex ISP reciprocal compensation –Ex Internet telephony Inconsistent rate structures among different access regimes –Ex Where incumbent offers flat-rate Internet access to its retail customers, but not wholesale customers -- Creates potential price squeeze problem

18 Case Study 1:Regulatory Arbitrage ‘96 Act mandated local into local interconnection. Pricing left to states –ILECs asked for high termination fees –Prices ranged from 0.3c to 1.0c minute –CLECs targeted ISPs as customers. Why? Almost all ISP traffic is incoming ISP traffic is “local” By 1999/2000 ILECs claim billions in losses

19 Regulatory Arbitrage Continued FCC’s Interim Solution –ILECs could charge a 0.15c for 1st 6 months, then 0.1c for next 6 months, then 0.07c onwards –If they offer this rate to all CLECs then termination charges are symmetric. –Interim solution still in place.

20 Case Study 2: Terminating Monopoly Problem Only the customer’s carrier can complete the call –Level of retail competition is irrelevant CLECs set fee for IXC access –IXCs legally must interconnect with any CLEC –S254(g) Obligation: IXCs cannot price discriminate regardless of terminating charges –IXC prices based on average costs of initiation and temination fees across all LECs

21 Terminating Monopoly 2 Some Small CLECs charged 9c even10c minute terminating charges! ILECs access charges are regulated and have fallen from 2.5c to 0.55c for large Price Capped carriers. (0.95c for small ILECS) FCC Interim Solution –CLEC prices follow a glide path down to ILEC rates

22 Terminating Monopoly 3 Similar problem in E.U. wireless market Wireless carriers request high termination fees from wireline carriers. Why not a US problem? –Wireless user billed for usage in the US –Symmetry: Wireless carrier pays same terminating fee on the wireline network –Most calls terminate on the wireline network –OFTEL solution in the UK: Price regulation

23 Pricing Lessons In an asymmetric world, Interconnect Prices need to be cost based. “Competitively Neutral” Cost Recovery For two way interconnection, symmetric rates requirements seems to be an important policy tool