Special Access and the FCC’s Regulatory Revival…

Tuesday, October 20th, 2015

There is a Chinese proverb, though some call it a curse, which says “May you live in interesting times.” For those involved in telecommunications policy over the last few decades, I think it’s safe to say we are now living in interesting times. Since before and certainly after the 1996 Telecommunications Act, the communications industry has undergone a competitive and deregulatory revolution. Twenty years ago the cross-entry of phone companies into video markets and video companies into phone markets was a running joke, but no longer. It’s a reality. Video regulation, which was a disaster even under monopoly conditions, has long been abandoned. Most states do not even regulate basic phone service today. A few years back, industry insiders expected a continuance of these competitive and deregulatory trends.

Then … a Regulatory Revival.

Over the past five years the FCC either has, or has sought to, undermine a large part of the bi-partisan deregulatory achievements of the past two decades. Last Friday, the Commission added on more item to this growing list when the Wireline Competition Bureau issued an Order launching an investigation into the contract terms of Special Access services offered by the nation’s largest phone companies (including AT&T, Centurylink, Frontier and Verizon) (hereinafter the “Investigation Order”). At the heart of the matter are claims by the large phone company customers (e.g., Sprint, Level 3, Windstream, BT Americas, XO, and so forth) that they are no longer happy with the terms of their contracts, including the terms for volume discounts that require the buyers hold relatively stable their purchases over the contract horizon.

The FCC’s Investigation Order formalizes its intent to delve into such terms, seizing upon the arguments by some that the contract terms are among other things, anticompetitive.  Specifically, some of the buyers of Special Access services contend that the quantity discounts contained in the contracts they signed “lock up” their demand and thereby shrink the market for potential entrants, an argument that, unlike most of the arguments in the Special Access debate, has some theoretical support (see ft. 54 of the Investigation Order for a long list of published articles), at least when the seller is dominant. Of course, quantity discounts are not evil in and of themselves. Contracts that offer lower prices for longer terms and quantity commitments are ubiquitous: from renting a car, signing a lease, or getting a hotel room, a willingness to guarantee the seller a minimum term or bulk purchase gets the buyer an often hefty discount. The reason is obvious: by assuring, for example, the seller of a certain term of use, the buyer in effect indemnifies the seller against the risk of having the property unused and unremunerated. In contrast, short-term, at-will rentals command high prices, even in the most competitive markets such as lodging. Quantity discounts operate similarly. In the communications industry, where sunk costs abound and many costs are transaction-specific, there are plenty of good reasons to discount services in return for quantity and time commitments.

Ostensibly, the FCC’s investigation aims to assess, among other things, whether or not the particular details of these quantity discounts in Special Access agreements are, in fact, entry barriers or just rational discounting options. While the FCC claims “[n]othing has been decided on the merits,” a read of Investigation Order, and this Administration’s documented history of regulatory proclivity, strongly suggests that the Agency is likely to see a lot more of Hyde than it does of Jekyll. It’s a favorable environment at the FCC for using regulation to get a leg up against your rivals, which is why those wanting lower Special Access prices are now pushing so hard for the attention of FCC Chairman Tom Wheeler.

But let’s be clear. This investigation is not really about the contract terms and it’s not about entry deterrence. It is, as always, about price. In fact, a few years ago AT&T submitted a request to eliminate some of the conditions and terms that the Commission now seeks to investigate. You’d think the complainers would be happy, but no. The buyers—the same ones now calling for the FCC investigation—went nuts in opposition because, they claimed, “AT&T’s elimination of the discount plans effectively results in substantial price increases for special access customers.”  And the FCC’s response? Heeding such complaints, the Commission suspended those very tariffs and launched an investigation.

The opposition to AT&T’s proposal says a lot about the present investigation. We can break this issue down like this. Say a regulated communications firm offers a rack-rate of $100 for a service. This service can be acquired without any special terms. Alternately, the regulated firm offers the same service for $75 if the buyer agrees to a set of terms, which I’ll just label X for convenience. Assume, for argument’s sake, that the regulator decides that the term set X is unreasonable and forbids it. If so, the most obvious result would be that the buyer would be stuck with paying the no-terms price of $100 for the service.

I can assure you that this is not the scenario Sprint and its companions are after. As the Investigation Order states, those complaining about the terms are arguing that “the incumbent LECs’ non-discounted, month-to-month rates are too high to allow them to compete (¶ 32).” It seems plain that what these guys want is the $75 price (if not a lower one) for the service without any terms attached. This debate, once the distractions are set aside, is primarily a squabble between large companies over the price of doing business in the marketplace. Sprint simply wants to lower its costs by regulatory fiat, because lower costs will increase its profits. The truth doesn’t make for a terribly good policy argument, so it was replaced with the colorable alternative of “entry deterrence,” a diversion of boilerplate cleverness for communications policy.

Parts of the Investigation Order portend to this eventual turn from contract terms to price. For example, in relation to the penalties associated with a breach of the agreement by the buyers, the Commission asks for “a narrative description of the methodology for calculating the level of the overage penalty (¶ 83).” Also, the FCC wants “a narrative explanation of the basis for the term discounts, including any cost or efficiency justifications supporting those justifications (¶ 90)” and “the incumbent LECs must also produce all relevant cost data related to the setting of the early termination fees (¶ 101)” and “an identification of and explanation for any instances in which an early termination fee exceeds either the price or the cost of deploying the facilities used in providing the service (¶ 101).” Such data are obviously intended to assess whether term set X is really worth $25.

When this debate turns from entry deterrence to “price,” which it inevitably will, a number of interesting issues will arise. First, we must ask the question, “the price of what?” Prices for term or bulk rentals are not the same as those for “spot” rentals. Second, based on the FCC’s and the buyers’ depiction of the market for Special Access service, the regulatory manipulation of price has no upside. We demonstrated the impotence of Special Access price regulation in our 2009 paper Market Definition and the Economic Effects of Special Access Price Regulation (and subsequently published by CommLaw Conspectus in 2014). If the Commission continues to adhere to a geographic market that is “location specific,” which is the same position of those calling for renewed regulation of the services, then price regulation cannot improve economic welfare, and may well reduce it, even if the service is sold by a monopolist. Admittedly, this is a seemingly odd result to the layman, but it flows directly from defining the geographic market as location specific. If the market is monopolized and location specific (or point-to-point), then not only is the seller a monopolist but the buyer is likewise a monopolist (or, to use the term of art, a “monopsonist”). When one seller negotiates with one buyer for the sale of one item (e.g., a circuit), the standard welfare losses from monopoly are no longer present. If there are gains from trade, then the item is sold and whatever surplus is available from the transaction is divided between the buyer and seller depending on their relative bargaining power. There is no loss of quantity to render a reduction in welfare.

Certainly, regulation may alter the balance of power between the two parties, but the costs are doing so exceed the benefits. If the seller has more power, the effect of regulation in such settings is mostly to transfer profits from seller to buyer (which has no welfare consequence). But, every $1 of transfer imposes a cost on society because it alters the common incentive of both parties to reach an agreement. Thus, the price regulation of special access services in location-specific markets unambiguously reduces welfare. As such, as we note in our paper, the special access debate appears to be largely a “quibble over rents.”

In textbooks, regulation is used to protect consumers from market power. In reality, regulation is more often used by one set of firms to disadvantage another, say by handicapping a competitor or by altering bargaining positions. In many ways, the Special Access debate smells of the latter. Yet, it’s hard to get a real good feel for what’s up in Special Access services because of a lack of quality evidence and good theoretical frameworks. The earlier FCC data request on pricing was, in the end,so limited that it will shed little light on the service. This new investigation will eventually reach its own dead end—it’s targeted to a diversion and the deals it will study are too complex for regulatory control. What the Commission’s Investigation Order does do is signal once more to investors that this Administration is committed to shifting value out of the network core. As a result, investors will increase their assessment of risk in the sector with predictable consequences—less competition and less investment.