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B. Addressing network effects: interconnection and collocation
Although section 251(a) requires all “telecommunications carriers” to interconnect with one another on some terms, incumbents alone are sub-ject to a highly specific set of rigorous interconnection obligations. Under sections 251(c)(2) and (c)(6), competing local exchange carriers may demand interconnection with the incumbent’s network at “any technically feasible point,” not just a location of the incumbent’s choosing, and may assert rights to “collocate” (i.e., “co-locate”) their facilities on the incum-bent’s property at tightly regulated rates based on “cost.”
In plain English, this means, among other things, that any competitor may rent space in an incumbent’s central office (the building that houses the incumbent’s switch); place its equipment there to interconnect with the incumbent’s network; and purchase various related services, such as power and air conditioning, from the incumbent. A competitor may also place its equipment in the incumbent’s central office if it has leased some of the incumbent’s loops for purposes of serving the customers at the other end and needs to link all these loops, via a high capacity transport pipe, to its own switch.
For many years, the FCC and the courts engaged in a game of legal ping-pong about the legal limits on the Commission’s authority to impose liberal collocation rules at the expense of the incumbents’ property inter-ests. The ultimate result, reached in 2002, is that competitors may demand room to place necessary equipment in an incumbent’s central office so long as (i) the primary function of the collocated equipment is to allow
intercon-nection or access to an incumbent’s transmission facilities, (ii) any addi-tional functions are logically related to that primary function, and (iii) the additional functions do not increase the relative burden on the incumbent’s property interests.20
The rights described here are those of a competitor to interconnect with an incumbent by placing its equipment on the incumbent’s property (or, in an arrangement known as “virtual collocation,” by directing the incumbent to dedicate some its own equipment to the same task). Under section 252(d)(1), regulators normally limit the rates a competitor must pay for such interconnection to the incumbent’s costs of hosting the rele-vant equipment in its central office. These collocation rights are distinct from the “intercarrier compensation” rules governing how much a carrier that originates a given call owes the carrier that completes it for the latter’s cost of delivering the call from the point of hand-off to the called party. We discuss the latter rules in chapter 9.
C. Addressing scale economies: “network elements” and
“resale”
The interconnection obligations just described go a long way towards reducing any anticompetitive advantage that network effects might other-wise give incumbents in the local exchange market. But, as discussed in chapter 1, these obligations do very little to help new entrants match the overwhelming scale economies that incumbents enjoy by virtue of having built up a ubiquitous network over many decades of regulated monopoly.
The next two statutory rights discussed here, the rights of new entrants (i) to lease capacity on an incumbent’s network facilities at regulated prices and (ii) to “resell” an incumbent’s retail services, are designed to enable new entrants to share in those scale economies—up to a point.
Leasing an incumbent’s network elements
Suppose that you manage an upstart telecommunications carrier and wish to provide both local and long distance service to residential cus-tomers in a suburban neighborhood. Precisely because your customer base is small and your scale economies low, it might well be financially infeasi-ble for you to incur the enormous fixed costs needed to build a complete new wireline network out to your prospective new subscribers. One way
out of that Catch 22, which we introduced in chapter 1, is to lease existing lines from the incumbent, so long as the lease rates are low enough. Over time, if your customer base grows, increased scale economies might then justify the construction of your own network.
In sections 251(c)(3) and 252(d)(1),Congress facilitated this process by giving new entrants a right not just to interconnect with incumbents, but to obtain “access to [the incumbents’] network elements on an unbundled basis”—i.e., to lease capacity on the incumbents’ network facilities—at regulated “cost”-based rates. These unbundled network elements are called UNEs(pronounced YOO-neez). In this context, to say that network ele-ments are available “on an unbundled basis” is simply to say that the com-petitor may, if it wishes, lease them individually at separate rates or in combinations of its choosing. It does not mean, however, that the incum-bent may unilaterally disconnect requested facilities from one another for the purpose of inconveniencing the competitor, a point the Supreme Court confirmed in 1999.21
Although we will often use the phrase “leasing the incumbent’s facili-ties” as an intuitive shorthand for the statutory concept of “obtaining access to network elements,” the latter phrase is sometimes technically more accurate.22What a competitor receives when it invokes rights under section 251(c)(3) is not always a discrete physical “facility” as such—
although it can be, as in the case of a copper loop. Often, the competitor receives only capacityon such a facility, along with its “features, functions, and capabilities.”23 For example, when a competitor leases “dedicated transport” as a network element from an incumbent, it does not normally lease an entire fiber-optic strand; instead, it leases a fixed increment of capacity on that strand. Indeed, the FCC went one step further and until recently permitted competitors to lease, as “network elements,” not just fixedincrements of capacity, but variable(per-minute) increments as well—
as in the case of access to an incumbent’s switch (discussed in part III of this chapter).
A related provision, section 251(d)(2), directs the Commission to limit the network elements subject to unbundling under section 251(c)(3) by
“consider[ing], at a minimum, whether . . . the failure to provide access to such network elements would impair the ability of the telecommunications carrier seeking access to provide the services that it seeks to offer.”24This statutory mandate is known as the impairment standard.In essence, this provision tells the FCC to identify, at some level of generality, the network Wireline Competition Under the 1996 Act 81
elements that a competitor truly needs in order to compete, and to limit the unbundling obligation to those elements alone. As noted in chapter 5, the FCC construes the “at a minimum” language to give it some discretion to impose or withhold unbundling obligations in the service of larger statuto-ry goals even when doing so may be in tension with the formal outcome of the “impairment” inquiry.
For eight years after 1996, when the FCC issued its massive Local Competition Orderadopting the first rules implementing sections 251 and 252,25 the Commission generally followed a permissive reading of the
“impairment standard.” As this book goes to press, despite this policy’s mul-tiple setbacks in court, a competitor can still sometimes lease from an incum-bent essentially all facilities and network functionalities to provide telephone service, including the loop and capacity on the incumbent’s switches and inter-switch transport links. This arrangement, which the FCC began phasing out in late 2004, has come to be known as the UNE platform or UNE-P.
Alternatively, a competitor might bring some of its own local exchange facilities to the table and lease others from the incumbent. For example, it might lease the incumbent’s loops by themselves and connect them to its own switch. Or it might lease those loops in combination with fixed capac-ity on the incumbent’s transport facilities, again for purposes of connecting its customers ultimately to its own switch.That entry strategy is known as UNE-L, with the “L” (for loop) distinguishing it from “UNE-P.” We discuss the regulatory debates concerning these two entry strategies later in this chapter. In chapter 5, we address the now quite limited circumstances in which a competitor may lease an incumbent’s facilities for the provision of broadband Internet access.
The TELRIC pricing standard. Rights to lease network elements will promote welfare-enhancing competition only if the rates for those elements are set appropriately. Section 252(d)(1) provides that such rates, like the rates for collocation arrangements, “shall be based on the cost . . . of pro-viding” them. As discussed below, individual state public utility commis-sions set actual carrier-to-carrier rates on the basis of the FCC’s rules implementing this “cost” standard.
In 1996, just after the Act was passed, the FCC construed this standard to require states to base network element rates on forward-looking cost rather than “historical” or “embedded” cost. This means that when a com-petitor leases an incumbent’s network assets to provide services of its own, the rates it pays the incumbent are calculated on the basis of what it would
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cost today to obtain those assets or their functional equivalent, not what it actually cost the incumbent to obtain the particular facilities at issue, as recorded on its books. Suppose, for example, that a new entrant seeks to lease capacity on a switch that actually cost the incumbent $10 million to purchase and install five years ago but that would cost only $5 million to purchase and install today. Under the FCC’s approach, which aims to reflect the dynamics of a competitive market, the latter figure would form the starting point for determining how much the entrant must pay the incumbent for leasing that capacity. Because technological innovation has caused many unexpected declines in the value of certain telecommunica-tions assets, such as switches, the conventional wisdom (which may be wrong in various contexts) is that rates would generally be higher under an historical cost methodology than under a forward-looking approach.
Since 1996, the FCC has required the use of a forward-looking methodology it has dubbed “total element long run incremental cost,” or TELRIC. Controversially, this methodology instructs state agencies to base their forward-looking cost estimates not on the incumbent’s network design and technology mix, but on what it would cost a hypothetical “most efficient” carrier to build an entirely new network from scratch today, tak-ing as given only the locations of the incumbent’s existtak-ing switches.26In its 2002 decision in Verizon Communications Inc. v. FCC, after six years of litigation and uncertainty, the Supreme Court finally upheld TELRIC against claims by the incumbents that this methodology necessarily pro-duces network element rates so low that they unlawfully “strand” (deny recovery on) past investments and undermine the incentives of incumbents and competitors alike to invest in new facilities.27
TELRIC’s history and theoretical rationale are complex, and readers interested in a comprehensive exposition will find it in appendix A to this book. Here we emphasize two points, each of which helps explain our abbreviated treatment of the issue in this chapter.
The first point relates to the concern, neatly summarized by Judge Frank Easterbrook, that “[p]rices for unbundled elements affect not only the allocation of income among producers but also new investment and innovation: if the price to rivals is too low, they won’t build their own plant (why make capital investments when you can buy for less, one unbundled element at a time?), and the incumbents won’t maintain or upgrade their facilities (why make costly capital investments if you have to sell local loops to rivals for less than it costs to produce them?).”28Although there
is much debate about whether, in application, TELRIC dampens ILEC and CLEC investment incentives in these respects, the more fundamental dis-agreement in that debate often concerns the FCC’s implementation of the underlying impairment standard for unbundling. TELRIC applies to a net-work element only once the FCC decides, under section 251(d)(2), that the element should be subject to mandatory leasing in the first place. And, in making such decisions, the Commission purports to take into account the same types of issues: whether CLECs can feasibly duplicate the element in question and whether subjecting the element to sharing obligations would harm investment incentives. This is not to say that TELRIC’s methodolog-ical details are unimportant to the “price signals” that CLECs and ILECs receive about when it would or would not make sense to build new facili-ties, but rather that those details must be viewed in the larger context of the FCC’s implementation of section 251.
Second, it is unclear how much the theoretical details of any FCC pric-ing methodology matter to the actual rates that state commissions end up assigning to particular network elements. As Eli Noam explains, with only slight exaggeration: “Regulators do not really care about theory but about outcomes, along the lines determined by the political system. . . . [P]rices are the tool; economic theorists merely provide the rationale.”29Or, as one former state commissioner argues, the FCC’s pricing methodology is, in the hands of state regulators, just a malleable means of inviting entry into selected markets by “creating a margin between wholesale and retail rates.”30 To be sure, the FCC’s methodological choices do provide some guidance to the state regulators charged with implementing them. But that guidance is far less outcome-determinative than the rhetoric about TELRIC would suggest.
Reselling an incumbent’s retail services
To address the scale economies problem through another means, Congress added one more entry right to the mix that is ostensibly (though not ultimately, as we shall see) independent of the debate about leasing net-work elements. Section 251(c)(4) permits a new entrant to sign up large numbers of local service customers with the stroke of a pen by reselling an incumbent’s “retail” services under its own brand name. That way, it can build up customer loyalty, develop an established base of customers for a particular geographic area, and only then—when the economies of scale
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are great enough—serve these customers using at least some facilities of its own. Indeed, MCI followed this very strategy while building its long dis-tance business in the 1970s and 1980s.31
Entering the local market by reselling an incumbent’s services would seldom be a very effective tool for a competitor if it had to pay the incum-bent the full retail price for those services. The competitor’s retail rates must cover its own costs of sales, marketing, and billing. But the incum-bent’s underlying rate usually reflects itsown retail-specific costs, so tack-ing on a surcharge for competitor-specific retail functions effectively double-charges the ultimate customer. And, most of the time, customers would be uninterested in paying the competitor more for the same local telephone service that they could purchase instead from the incumbent at a lower price.
To make resale a more plausible entry strategy, Congress entitled com-petitors to obtain, for resale, an incumbent’s “retail” services at retail rates minus the retail-specific costs (of marketing, billing, etc.) that the incum-bent will “avoid” by virtue of no longer providing retail service to the cus-tomers at issue. This pricing formula, found in section 252(d)(3), is known as “retail minus avoided cost” or “the avoided-cost discount.” (Although competitors are separately required under section 251(b)(1) to allow other carriers to resell their services, they need not provide any such discount.) In theory, at least, the avoided-cost discount should permit the competitor to charge its customers no more than the incumbent charges them, and so build up its brand identification and customer base at relatively low risk.
In practice, the attractiveness of this resale option to new entrants dimmed once a regulatory consensus emerged, solidified by a 2000 court of appeals decision,32that incumbents “avoid” only a limited portion of their retail-specific costs when they lose retail customers to resellers. After all, even if an incumbent loses customers to rivals, it still must typically keep all of the same systems in place to serve its remaining customers. So applied, the avoided-cost discount has often proved insufficient to make the resale option a successful entry strategy in local markets.