Fair play

Incumbent local exchange carriers and their competitors are locking horns again as they fight over millions of dollars in payments for terminating dial-up calls to ISPs.

It's another round in the long debate over reciprocal compensation. The FCC is expected to rule by the end of the year whether ILECs should pay competitive LECs (CLECs) for completing calls that begin on ILEC networks and end at ISPs that are CLEC customers.

Reciprocal compensation refers to how carriers pay for finishing each other's local calls. When one LEC originates a call and another LEC ends it, the first LEC pays the second one for the cost of completing the call. The Telecommunications Act of 1996 requires such arrangements, which are contained in interconnection agreements.

Thanks to Internet growth and a large ISP customer base, CLECs are raking in more than $1 billion per year in revenue generated by reciprocal compensation, according to New Paradigm Resources Group. Since reciprocal compensation payments are based on minutes, CLECs make more money for longer and more continuous Internet use.

"The theory behind reciprocal compensation is you make as many calls as you receive. But with the Internet, it's all one-way.... The Internet doesn't call you back," said Edward Young III, Verizon Communications' senior vice president of federal government relations. "The issue is worth lots of hundreds of millions of dollars to Verizon."

Reciprocal compensation for all types of local calls totals about $3 billion annually, estimates Steve Pociask of Joel Popkin & Co., a financial consulting firm (see figure).

With so much money at stake, both sides are lobbying hard. A bill in Congress backed by the ILECs, H.R. 4445, would exempt any LEC from paying reciprocal compensation for Internet-bound traffic. However, its success is questionable given Congress's short fall legislative session.

"There's an outside chance we could do something this year, but we stand a better chance next year," said a spokesman for Rep. Billy Tauzin, R-La., the bill's sponsor.

That outlook puts the recip-comp ball in the FCC's court. The main question is whether dial-up calls to ISPs are local - and thus subject to reciprocal compensation - or interstate, with no required payments. Broadband services such as DSL require no payments and are not affected.

CLECs claim the calls are local because they start at the customer premises and end at an ISP's local point of presence. "There would be serious distortions and disruptions if carriers aren't allowed to recover their costs of carrying this traffic," said Jim Falvey, e.spire Communications' senior vice president of regulatory affairs.

ILECs argue that the calls are interstate, ending at points around the globe, and beyond the scope of reciprocal compensation. In addition, CLECs incur little, if any, cost to end calls to ISPs because they aren't hauling traffic back to local calling areas. "It's basically a cash subsidy going to the CLEC industry," said a BellSouth spokesman.

The FCC ruled in February 1999 that Internet calls are "jurisdictionally mixed" but primarily interstate because most of them end not on ISPs' local servers but on Web sites in other states and countries. But the agency also said it would let stand decisions by state commissions - more than 20 of which have found that ISP-bound traffic is local in nature.

The U.S. Court of Appeals for the District of Columbia vacated the FCC rule in March when it found that calls to ISPs are local. It threw the case back to the FCC for further explanation, and the agency in late June issued a public notice asking for comments to help clarify the issue

The FCC could end up having its cake and eating it, too. Observers expect the FCC to reach a contradictory conclusion. ISP-bound calls are interstate, yet carriers still must be paid for ending them.

"The FCC is trying to split the baby," said Craig Clausen, senior vice president of New Paradigm. To wrest control of reciprocal compensation away from the states, the agency must declare that ISP-bound calls are interstate and in its jurisdiction. At the same time, it believes that carriers deserve to be paid for ending the calls.

"I expect the FCC will acknowledge carriers should be compensated for the actual cost of terminating ISP traffic," said Jonathan Askin, general counsel of the Association for Local Telecommunications Services, a CLEC trade organization.

Politics aside, the business of reciprocal compensation is waning, according to executives and analysts. CLECs that once relied heavily on it are weaning themselves as network buildouts yield more customers and other sources of income. Rates for reciprocal compensation have fallen from 1cents to fractions of a cent as interconnection agreements are renegotiated.

"It's definitely becoming less important for e.spire," Falvey said. The Herndon, Va.-based CLEC, which earned 16% of its revenues from reciprocal compensation last year, charges about 1cents to U S West and Southwestern Bell under original contracts, but only 0.2cents to BellSouth under a new contract, he said.

Another CLEC, Chicago-based Focal Communications, got 73% of its revenue from reciprocal compensation in first quarter 1999, compared with 35% in second quarter 2000, said Chief Financial Officer Joe Beatty. Its rates are down from 1cents in 1996 to an average of 0.29cents now, he said.

"It's dropping because reciprocal compensation rates are coming to where they should be all along," Beatty said. Focal serves more ISPs than most CLECs; about 200 of its 1000 customers are ISPs.

Despite its complexities, no one expects 1cents to disappear in the near term. No company is big enough to build and own an entire network, so "carriers will always need other carriers," said Legg Mason analyst Daniel Ernst.