The basics of price regulation

In ordinary, non-monopolized markets, companies compete against one another for customers, and this competition theoretically keeps the price of goods and services at reasonably efficient levels. By definition, however, there is no competition in a market that regulators treat as a natural monopoly, as the market for telecommunications was treated for most of the twentieth century. And, if left to their own devices, monopoly providers of any product, including wireline telephone services, can be expected to maximize their profits by raising their retail prices to inefficiently high lev-els. These high prices include monopoly profits that enrich the monopolist at the expense of consumer welfare, artificially reducing the demand for telecommunications services and keeping total output (i.e., sales volume) below optimal levels. In markets without formidable barriers to entry, monopoly profits tend to be a temporary phenomenon, for upstart firms

will enter the market and undercut the incumbent’s prices. Federal and state policymakers have long treated local telephone markets differently, however, because of the traditionally high entry barriers discussed in the previous chapter. In particular, they have relied on rate regulation—and not Adam Smith’s invisible hand—to protect consumers from monopoly pric-ing.

The regulatory compact

Some foreign governments have addressed the problem of monopoly pricing by owning the telephone system outright, an approach that many of them are in the process of undoing.⁸In the United States, by contrast, virtually every telephone network has been privately owned and operated.

At the same time, such networks have traditionally been regulated as pub-lic utilities—i.e., as commercial enterprises charged with providing an essential public service and subject to pervasive regulation to protect the public interest.The Supreme Court explains: “At the dawn of modern util-ity regulation, in order to offset monopoly power and ensure affordable, stable public access to a utility’s goods or services, legislatures enacted rate schedules to fix the prices a utility could charge. As this job became more complicated, legislatures established specialized administrative agencies, first local or state, then federal, to set and regulate rates.”⁹

Like other public utilities, an incumbent local telephone company has made a kind of regulatory compact with the government. In exchange for agreeing to serve consumers at affordable rates as the carrier of last resort, the company is given an opportunity to earn a “reasonable rate of return”

on its overall regulated investment. No similar arrangement exists for long distance carriers or new entrants into the local exchange market. Those carriers face fierce enough competitive pressures, from one another and from the dominant local telephone company, that they already have ade-quate incentives to keep their rates low and their service quality high.

The regulatory mechanisms for setting a dominant local telephone company’s retail rates are baroque in their complexity. To make matters still more complicated, these mechanisms changed significantly in the 1980s and early 1990s, as regulators began moving from rate-of-return regulation to an alternative price cap model for the largest local carriers.

We address these regulatory schemes in turn, beginning with the tradition-al rate-of-return approach.

Introduction to Wireline Telecommunications 47

Under a rate-of-return regime, federal and state regulators give domi-nant local telephone companies an opportunity to charge retail rates suffi-cient, in the aggregate, to cover their anticipated expenses plus a reasonable return on their net investment. As discussed more fully in appendix A, this involves, among other things, calculating a company’s “historical costs”—

the costs it has actually incurred and lists on its books—and making vari-ous judgments about them. Such judgments include (i) the extent to which these costs were “prudently incurred”; (ii) how quickly the telephone com-pany should be able to recover the total costs of given facilities (through its monthly retail rates)—a judgment that in turn depends on estimates of how long those facilities will be in service (“depreciation lives”); and (iii) how much of a return on investment (“cost of capital”) the company needs to continue attracting capital to finance new investment.

Regulatory agencies resolve such issues in long and complex “rate cases.” If dissatisfied with the result, the telephone company can file suit for

“just compensation”—in the form of increases to its retail rates—if it believes that its current rates are so low that they leave the company “insuf-ficient operating capital” or “imped[e] [its] ability to raise future capital.”¹⁰ Although this is an important backstop in theory, courts are unlikely in practice to find that a public utility has suffered such a “regulatory taking,”

as the Supreme Court showed once more in 2002.¹¹ Dual jurisdiction

To this point, we have kept the identity of the rate-setting regulators anonymous. Now it is time to unveil another layer of complexity: the arcane division of labor between the federal government and the states in retail telephone regulation. Since the 1930s, the FCC and the states have shared responsibility for ensuring a “reasonable return” on investment and regulating the retail rates the dominant local telephone company may charge consumers.

Because every aspect of telecommunications can be characterized as an instrumentality of interstate commerce, Congress could have preempted all state regulation in this area under the Commerce Clause of the U.S.

Constitution and placed the entire industry within the exclusive province of a federal regulator. When it enacted the Communications Act of 1934, however, Congress chose a model of dual jurisdiction—which gave the

newly created FCC plenary jurisdiction over interstate services and, under section 2(b) of the Act,¹² precluded the Commission from intruding on state regulation of intrastate services. Importantly, this particular federal-state division of authority applies only to retail services, such as those addressed in this section, and to the access charges that a long distance company pays the local telephone companies on each end of a long tance call, as described below. Wholesale “local competition” issues, dis-cussed in subsequent chapters, have been governed by a very different jurisdictional arrangement since passage of the Telecommunications Act of 1996.

The federal government and the states divide their traditional retail rate-setting responsibilities roughly as follows. The FCC and the states first allocate a percentage of a telephone company’s total costs into “interstate”

and “intrastate” categories for purposes of ensuring a reasonable return.

The interstate costs are recovered by rates for interstate services regulated by the FCC, and the intrastate costs by rates for intrastate services regulat-ed by the states. The process of dividing up costs this way is callregulat-ed the juris-dictional separationsprocess and dates back to the Supreme Court’s 1930 decision in Smith v. Illinois Bell.¹³The criteria used can be quite arbitrary because many facilities, such as the loop and switch, are typically used for both interstate and intrastate calls. For example, all calls leaving one’s house, whether they cross state lines or not, use the same pair of copper wires. How, for cost-recovery purposes, should the cost of installing and maintaining those wires be divided between the federal government and the states? The general rule, rooted more in political compromise than in technological reality, is that 75% of the cost of that loop is assigned to the

“intrastate” side of the cost ledger and the remaining 25% to the “inter-state” side.¹⁴

Incumbent local telephone companies are entitled to a “reasonable”

rate of return on costs allocated to each side (interstate and intrastate) of the cost ledger, considered independently. The FCC and the states have met this responsibility in similar ways. Each set of regulators enables a tele-phone company to recover costs through a combination of flat and usage-sensitive rates. Subscribers pay two flat monthly fees—one set by the states, the other by the FCC—to receive basic local telephone service, which nor-mally includes unlimited “local” calling. The federal fee, called the sub-scriber line charge, is similar to the monthly “local service” fee set by state

Introduction to Wireline Telecommunications 49

regulators, but it is designed to permit the telephone company to recover the portion of loop costs allocated to the interstate side of the cost ledger.¹⁵

“Usage-sensitive” rates take two general forms. First, a telephone com-pany collects per-minute toll chargesfrom its subscribers for certain types of calls. Second, the company collects access charges from long distance carriers whenever it (i) hands off to thema call placed by one of its sub-scribers or (ii) completes calls delivered by them to one of its subscribers.

Understanding the critical role of access charges in the cost-recovery equa-tion requires some brief background.

Access charges

During the period when AT&T owned most of the local telephone exchanges and the only long distance network, it relied on regulated accounting mechanisms to allocate the costs of long distance calls within the Bell System: i.e., the costs of long distance transport itself and the costs of “accessing” the local networks on each end of the call. When long dis-tance competition developed in the 1970s, regulators had to devise a more formal mechanism—access charges—for allocating these two categories of costs.¹⁶To see how this system works today, suppose that you are an ordi-nary residential subscriber living in Atlanta, your local telephone company is BellSouth, your long distance provider is MCI, and you call a friend served by SBC in Dallas. The call begins with a brief trip through BellSouth’s local network before it hits MCI’s long distance network, and it then ends with a brief trip through SBC’s local network in Dallas en route to your friend. The local companies on each end of the call—

BellSouth and SBC—collect from MCI an access charge for the right to use their respective networks for this purpose. MCI, in turn, passes those charges along to you and the rest of its customers in its long distance rates.

At this point, it is important to understand the distinction between two different types of access charges: those for switched access and those for special access. A long distance carrier pays access charges, and passes them on to its customers, on a per-minute basis for all “switched access” calls:

i.e., calls that pass through the local carrier’s switch en route to the long distance network. As noted above, many business customers place enough long distance calls to justify dedicated lines that bypass the switch and link the business directly to the long distance carrier’s network. If those lines

belong to the local telephone company, it charges the long distance carrier a flat monthly fee for this “special access” arrangement.

We now return to the role of access charges in the recovery of a tele-phone company’s total “costs.” For switched access, the FCC regulates the interstate access charges that local telephone companies may charge long distance companies for calls that cross state lines, and the states regulate the intrastate access charges levied for calls that stay within state lines. The division of authority for the regulation of special access rates is more sub-tle, because the “service” at issue is not the completion of a single call, but the provision of a dedicated line that, like an ordinary loop, can be used for either local or long distance calls. Under a longstanding FCC rule, a special access circuit is deemed interstate in character, and subject to regulation by the FCC, if it is used to carry at least 10% interstate traffic.¹⁷ In recent years, through a policy called pricing flexibility, the FCC has largely dereg-ulated special access charges in a number of urban areas where it has deter-mined that competition has arisen in the provision of direct links to long distance networks.¹⁸

Tariffs

Incumbent local telephone companies are not usually permitted to enter into wholly private contractual arrangements with individual con-sumers in traditional telephone markets. Instead, the basic premise of the incumbents’ common carriage commitment is that each customer should have the same opportunity as any other similarly situated customer to buy the same services on the same terms. Thus, when an incumbent wishes to introduce a new service, it normally must file a tariffwith the relevant reg-ulatory authority, spelling out the terms and conditions of its services and offering them for sale to the public at large. Often, such tariffs are permit-ted to take only temporary effect while regulators conduct an inquiry into the reasonableness of their terms.¹⁹

Once approved, the terms of these tariffs govern the retail relationships between carriers and their customers, even if a carrier offered different terms in a sales call. In theory, thisfiled rate doctrine,which allows com-panies to charge only tariffed rates and (to their great benefit) shields them from litigation concerning the legitimacy of those rates,²⁰ protects con-sumers by ensuring that they receive the prices, terms, and conditions

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approved by the regulators. In practice, however, requiring tariff filings cre-ates significant social costs by slowing down the rough and tumble of free market competition and facilitating collusion between rivals by enabling them to see one another’s prices before they go into effect.²¹As we will dis-cuss in chapter 6, the FCC has thus freed “non-dominant” carriers from tariffing obligations in many markets and has sometimes, over their oppo-sition, affirmatively forbidden them to file tariffs.

Price caps

Up to this point, our discussion of telephone company cost recovery has presupposed the use of rate-of-return regulation, in which federal and state policymakers set their respective retail rates and access charges at lev-els designed to guarantee each local telephone company an opportunity to earn, overall, a reasonable return on the prudently incurred costs attribut-able to its regulated activities. But traditional rate-of-return regulation tends to give any public utility perverse incentives to “gold plate” its assets:

that is, incentives to spend more than is efficient or necessary simply to increase the rate base on which it earns its profits. Rate-of-return regula-tion also can make it easier for firms to engage in monopoly leveraging by over-assigning joint and common costs to its monopoly markets and there-by cross-subsidize its operations in competitive markets—a phenomenon we discuss in part III of this chapter. In the 1980s and 1990s, federal and most state regulators sought to address these incentive problems by adopt-ing a price cap scheme for retail rate regulation of the largest local tele-phone companies.

A price cap analysis starts with the retail rates produced in a given year under traditional rate-of-return regulation. In succeeding years, however, retail rates will be determined on the basis not of new rate-of-return pro-ceedings, but of mathematical adjustments designed principally to reflect (a) expected industry-wide increases in efficiency (known as the “X-fac-tor”) due to technological and other innovation and (b) fluctuations in inflation and other macroeconomic variables.²² A price cap approach, unlike a traditional rate-of-return regime, rewards the incumbents for their efficiency over time by entitling them to keep much of the extra profit they generate as the result of cutting unnecessary costs.²³

Although the size of the X-factor is a source of lively debate and often successful litigation,²⁴ price caps have proven quite effective in balancing

the financial needs of the incumbents against the consumer welfare inter-est in lower retail rates.²⁵The retail rates of the largest incumbent tele-phone companies, as well as their access charges, are now generally subject to price cap rules. Smaller incumbents are often still subject to rate-of-return regulation.