Handle with care

As vision statements go, ensuring "just, reasonable and affordable rates" to "all regions and economic sectors of the public" sounds like a good one. It's easy to understand, provides direction and, best of all, lays out a laudable goal.

But in a competitive era, achieving that goal is proving more complicated than ever.

For much of the United States, the price of basic local residential phone service has been kept below cost for many years. In some places, particularly rural areas, the real cost of delivering service is much higher than prices reflect.

These low prices primarily result from implicit subsidies-the dollars generated from disproportionately high pricing for business lines or vertical services such as call waiting. Implicit subsidies also comefrom the access charges that local exchange carriers collect from interexchange carriers for originating and terminating long-distance calls.

In the monopoly era, implicit subsidies worked pretty well.

Today, however, this system is vulnerable to the possibility that competitors will undercut pricing on some of these overpriced offerings, eroding the overall revenue base and reducing the dollars available to support high-cost areas. Recognizing this, the crafters of the Telecommunications Act of 1996 mandated an overhaul of universal service support mechanisms, with the directive to make them more explicit. This means that pricing should be more closely associated with costs and any additional funding required should be raised in a neutral manner that doesn't penalize any particular service. An example of an explicit fund is one based on an end user surcharge or that collects a specific percentage of all carriers' revenues.

The FCC's first step toward making subsidies more explicit was not well-received. The commission restructured interstate access charges, hoping to reduce inflated per-minute rates by shifting some of those charges to a fixed monthly fee. This fee, dubbed the presubscribed interexchange carrier (PIC) charge, kicked in on Jan. 1, 1998. Unfortunately, that was exactly when carriers were required to begin making contributions to the new school and libraries fund, an addition to the universal service program designed to bring Internet access to students and citizens (see sidebar on page 34).

IXCs had always passed on regulatory charges to end users-and when charges were exacted on a per-minute basis, these pass-throughs were largely transparent. But this time, IXCs started recovering PIC charges and new contributions to the school and libraries fund as line items on customer bills, labeled with nomenclature such as "federally mandated universal service charge."

To top it off, per-minute access charges did not decrease as much as anticipated because LECs, also required to begin paying into the school and libraries fund, recovered their contributions the only place they were allowed to: through the per-minute access fees.

Consumers were outraged and confused-and some began wondering what happened to all the benefits of telecom competition they had been promised.

The non-rural plan It's against this backdrop that the FCC hopes to implement a new method of funding non-rural high-cost areas beginning July 1. The definition of a non-rural carrier is fairly complex, but in general it encompasses the regional Bell operating company and the larger Independent telcos, including GTE and Sprint's incumbent LEC operations, and puts hundreds of smaller companies in the rural category.

Those high-cost rural carriers, which receive 98.5% of current high-cost funding (Figure 1), will continue to be funded under the existing plan for at least two years (Table 1). That plan helps support 31.4 million of the approximately 170 million total U.S. access lines, according to the Universal Service Administrative Co.

The current high-cost fund is explicit because carriers pay in about 2% of interstate and international revenues to support it (Table 2). But regulators are retooling it because it is not based on forward-looking costs, as required by the Telecom Act.

The task of recommending a plan to fund non-rural areas was given to regulators on the federal/state joint board. The FCC may adopt the joint board recommendations in full or modify them before implementation. Those recommendations, issued in November 1998, contain many gray areas.

"The recommendations are extremely broad-based," says Dennis Weller, chief economist for GTE. "No one could take that document and implement it as is."

One of the joint board's tasks was to develop a forward-looking model that estimates the cost of building the U.S. telecom network today, rather than looking at historical costs as regulators have done in the past. The new model currently specifies things such as feet of wire and man-hours needed, but the inputs to the model-such asthe cost of the wire and labor-have yet to be determined.

"It's by no means a done deal that that model will be ready for something to be done in July," says Weller.

Once the model has been refined, the FCC will use it to calculate a carrier's requirement for funding based on study area. In general, a study area is equivalent to an incumbent carrier's territory within a state.

The first step will calculate each carrier's need by comparing the average cost per line within a study area with a national average. If the average cost for a carrier's territory is somewhere between 115% and 150% of the national average-the exact percentage has yet to be determined-the difference between that amount and the national average is the carrier's need.

The second step will look at the ability of carriers in a given state to cover their own funding requirement. The joint board suggested several means that could be used for that purpose. "The one they seemed to fasten on would look at the dollars needed and determine what percentage of a state's own revenue rate it would have to use to fund it," says Weller.

If the percentage of revenues required were to exceed a certain threshold, a federal fund would make up the difference between the amount the state could afford and the amount of funding required. This is a departure from the existing program, which only considers cost and does not take into account the fact that some states may have a higher level of offsetting revenues than others.

"Regulators want some money to go to square states in the West, and they're looking for a calculation that will produce that," says Weller.

The joint board also recommended a "hold harmless" clause that seems designed to address the concerns of carriers that traditionally have used a historical approach to determine costs: No carrier will receive less funding under the new program than it does under the current historical cost-based program.

"Forward-looking costs are not appropriate for the purpose of sizing the fund," says Lawrence Sarjeant, vice president of regulatory affairs and general counsel for the United States Telephone Association. "If you spent $50 on [a piece of equipment] and you could get it today for $30, does that change the fact that you spent $50? State commissions and the FCC have only allowed [carriers] to recover costs over a very long period of time."

Others argue, however, that incumbent carrier claims about embedded costs are exaggerated.

"Some of these [telcos] have recovered their investment several times over," says Gene DeJordy, executive director of regulatory affairs for Western Wireless. His company has submitted a wireless cost model to the FCC to make the case that some areas-particularly rural areas where people are spread out rather than clustered together-can be most effectively served by wireless.

"If you're going to establish a subsidy system, you should establish an efficient subsidy system," DeJordy says. "Wherever [wireless] is most effective, [regulators] should use that model as a basis to determine the subsidy. It would significantly reduce the size of the fund."

A final gray area about the non-rural recommendations is whether the fund will continue to be collected as a percentage of interstate and international retail revenues, or whether it will also include intrastate revenues.

The advent of competition Some have charged that the joint board proposal does not do enough to encourage competition in high-cost areas. These charges stem from two specific concerns: the size of the study area and the state's responsibility in funding its portion of the high-cost universal service requirement.

The joint board recommendation determines an incumbent carrier's need for funds by comparing the average cost-across its entire study area-with the national average.

Some argue that this doesn't mesh well with the Telecom Act's directive that all explicit universal service support should be portable to competitors willing to serve high-cost customers: A competitive LEC could serve only the lowest-cost customers within a study area and collect a disproportionate amount of high-cost support. Alternatively, regulators could require a CLEC to offer service throughout the entire study area. The difficulty there is that sometimes an incumbent serves pockets throughout a state, rather than a single contiguous territory.

States do have the option of using a smaller unit of measurement for apportioning funds. The state of Washington, for example, plans to distribute non-rural federal funds on a local exchange level, says Commissioner Bill Gillis of the Washington Utilities and Transportation Commission.

Under that plan, competitive carriers will be required to offer service throughout an exchange and will receive a higher level of funding per line for the highest-cost exchanges and a lower level per line for lower-cost exchanges.

However, some question whether all states will take the initiative to refine the joint board plans as Washington has.

Another concern is that because most high-cost support is implicit, the amount of explicit funding a CLEC could pick up for serving high-cost areas may not provide sufficient incentive to serve those areas. An analysis of GTE's current support mechanisms reveals that only a small fraction are explicit (Figure 2), and the joint board's recommendation does little to change that. The joint board leaves it to the states to determine how and when to move to more explicit means of covering the state's portion of high-cost support.

The idea behind that, says Gillis, is that "states are closer to the ground and are in a better position to know when and how fast to move to an explicit [fund] for their state."

"If a state lacks competition, rate averaging may be adequate," according to Gillis.

But others argue that as long as residential rates are kept artificially low through high prices on business services and access, a lack of competition-particularly for residential customers-will be a foregone conclusion.

"It's troubling when I hear regulators talk and they say there's no competition in these areas yet so we don't have to eliminate implicit subsidies," says Western Wireless' DeJordy. "Of course there's no competition, and it's because of the subsidies."

Weller has conducted an analysis of GTE's rates in Texas that supports this point of view.

That analysis considered what would happen if GTE were to lose all its residential business to competition (Figure 3). It assumed competitors' costs would be equal to the cost of all requisite unbundled network elements, that customers would continue to buy all the local services they do currently, and that the competition would be able to continue to charge GTE's existing rates.

Even though that scenario tends to underestimate costs and overestimate revenues, Weller found it would be unprofitable for competitors to serve 78% of all existing residential customers. Revenues collected from the other 22% and from business customers currently support low pricing for the vast majority of residential customers.

"Right now we're selling to millions of customers and we're not getting [sufficient] dollars from those customers but from other implicit sources," says Weller. "There are millions of customers no one would want to serve, and until that's fixed there will be no competition for those customers."

Of course, Weller's analysis only looked at intrastate service revenues and, to the extent that some customers in the unprofitable group may have a high volume of interstate calls, a competitor offering local and long-distance service might find some of them worth serving. But that is exactly the kind of "cherry-picking" most regulators hope to discourage.

Whenever a move is made from implicit to explicit support mechanisms, Weller argues that any CLEC receiving explicit funding should be required to serve customers who want only basic local service. Such a CLEC should be prohibited from offering local service only as part of an $80 a month package that also includes long-distance, Weller says.

Pioneering states A few states, including Washington and Nebraska, have begun to undertake rate rebalancing to correct the sort of situation GTE has encountered in Texas.

The Nebraska plan, due to take effect by mid-year, had its genesis two years ago, when the public service commission got approval from the state legislature to undertake rate rebalancing and create a universal service fund. The PSC then created two study groups-one to look at universal service and the other to look at access charge reform.

Adding a sense of urgency to the process was an AT&T initiative to reduce access charges, which went to voters in the state. The IXC succeeded in getting a proposal on the ballot to reduce the intrastate access charges it was required to pay Nebraska LECs. States control access charges on toll calls within a state, while the FCC controls access charges on interstate calls. Although the AT&T initiative ultimately was defeated, partly as a result of counter-efforts by Nebraska LECs, that initiative likely helped regulators realize that reforms were needed-and needed soon.

In the spring of 1998, the PSC decided it would be better to look at rate rebalancing and access charge reform together and combined the two study groups. In October 1998, the PSC issued a preliminary order; a final version was issued this past January.

That order establishes an explicit universal service fund to cover much of the state's portion of the subsidies required to support service to high-cost areas. Carriers will collect from the fund if their costs, calculated on a local exchange basis, exceed the average. Another requirement is that they move toward a residential price benchmark of $17.50 per month and a monthly business rate benchmark of $27.50. In some cases, LECs will have to raise their rates to meet these benchmarks.

End users will pay into the fund via a surcharge on their total bill. Initially, the surcharge was targeted to be about 5% of interstate and intrastate revenues. But in response to complaints from telemarketing companies that handle a high volume of interstate calls, the PSC decided it would look only at intrastate revenues, says Gene Hand, director of communications for the Nebraska PSC. The commission is currently working out whether it will exact a higher percentage of intrastate revenues or whether it will adjust the scope of the program to reflect a lower overall funding level, says Hand.

Will consumers accept the program?

Hand points out that the average Nebraska consumer has 69 minutes of intrastate toll traffic a month. Anticipated changes would reduce per-minute intrastate toll charges by about 10 cents a minute. For many customers, he says, those savings will outweigh the new charges.

"Nebraskans have always been very willing to support infrastructure in rural areas," adds Joe Schuele, government relations manager for Aliant Communications, a Nebraska LEC that supports the new program.

Aliant expects to collect some explicit high-cost funds under the new program, for which it was never eligible under the old program, says Schuele. The problem was that although the company served some very high-cost exchanges, it also served a lower-cost metropolitan area. "We were subsidizing our rural exchanges through access charges and we felt great vulnerability on the access side," says Schuele.

The concern was that new competitors would steal business by undercutting inflated access charges-a concern that the new plan helps to alleviate.

The USTA supports the Nebraska plan, says Sarjeant, adding, "It's astounding to find that the states are getting ahead of the FCC in implementing universal service programs."

The rural plan-and other reforms A rural task force, chaired by the WUTC's Gillis, has begun work on a plan for high-cost rural areas. The rural task force likely will want to refine or replace the non-rural cost model and the study areas upon which the model is based.

"The nature of operations for small companies is quite different," says Gillis. "They don't have economies of scale and the assumptions you might make about the appropriate technology to build outmight be different for a large company than a small one. For larger companies, the law of averages tends to overcome mistakes. For a small company, a mistake could be huge."

The rural task force recommendations are due within nine months of when the non-rural plan is implemented, but they won't go into effect until 2001 or later.

Considering that most high-cost support is implicit, however, the impact of these recommendations may be minimal compared with the potential impact of federal and state implicit support reform. With the exception of a few states that have undertaken reform programs, neither of those events seems imminent.

As the Nebraska experience demonstrates, implementing a statewide reform program can take at least two years-and although the FCC is scheduled to make federal access charge reforms in July, some question whether it will make any major changes. Some say the commission would prefer to let competition drive access charges down, even though that has been slow to happen. Concerns about negative reaction to potential new pass-throughs on consumer phone bills also may cause the FCC to move slowly.

Meanwhile, some have advocated substantially reducing high-cost support (see sidebar).

Local competition, like universal service, is a laudable goal. Like branches of a rose bush, the two are intertwined-and achieving either goal will require a difficult, and potentially painful, process of untangling the two.

Implicit subsidies: Dollars generated from disproportionately high pricing for business lines, vertical services or access charges that support artificially low pricing for residential services or areas that are expensive to serve.

Explicit subsidies: Dollars for high-cost areas or other programs that are collected without penalizing any particular service, typically through an end user surcharge or a fund to which carriers contribute a percentage of revenues.

In addition to mandating an overhaul of the universal service system, the Telecommunications Act of 1996 expanded the definition of universal service to include a program to provide Internet access to schools and libraries. That program has had a rocky history, drawing criticism from various quarters and possibly even tainting other universal service programs-and the controversy isn't over.

Carriers were required to begin paying into the schools and libraries program in January 1998 as a percentage of total retail revenues. Before anyone could see any benefits of the fund, interexchange carriers started recovering their new contributions as line items on customer bills, which generated a barrage of customer complaints.

The program was not off to a good start.

Carriers had another concern: Because schools and libraries were allowed to use money from the fund to pay Internet service providers for hooking up the schools, shouldn't Internet service providers be required to pay into the fund?

This debate just happened to gear up right when Internet protocol-based telephony was experiencing numerous technological advances. Some ISPs were beginning to offer lower-cost, subsidy-free alternatives to conventional long-distance voice service. By stealing voice business from conventional carriers, IP telephony providers were also reducing the size of the universal service fund-and that ultimately could threaten the nation's ability to provide service to high-cost areas, conventional carriers argued.

"If the hype was real, I could completely appreciate their arguments," says Jeff Pulver, president of Pulver.com and IP telephony advocate.

As of December 1998, Pulver says, IP telephony providers generated 50 million minutes a month of worldwide traffic, compared with 400 billion total minutes. He argues that the amount of funds regulators could collect from IP telephony providers would not cover the administrative costs that would be required to collect them.

"We're asking to be levied at a time and place that makes sense," says Pulver, adding thatthe efficiency of IP telephony and packet-based phone service ultimately could reduce operating costs for all carriers. "The industry is in its infancy. We still have yet to see interoperability and we still have yet to see the promise [of IP telephony]. To regulate it at this point could stifle the growth."

In early 1998, the FCC said it would not require ISPs to contribute to universal service but that it reserved the right to regulate some forms of IP telephony in the future. Around that same time, the commission reduced the size of the schools and libraries fund and made some modifications to the way the fund was administered.

But criticism continues.

"The FCC has levied an unconstitutional tax on telephone companies," says Ken Johnson, press secretary to Rep. W.J. "Billy" Tauzin, R-La. "If anyone challenged it and won, the schools and libraries program would be in disarray."

Tauzin will re-introduce a bill he tried to get passed last year that would abolish the federal excise tax currently collected on phone bills and would add a smaller charge to cover the schools and libraries program.

Some say the issue of whether ISPs should contribute to universal service isn't dead yet. Pointing to ongoing challenges in the courts, George Reed-Dellinger, senior vice president for HSBC Washington Analysis, says, "A lot of current ISP exemptions could be thrown out."

Some industry observers argue that government should look at how to serve high-cost areas in a totally different manner. They argue that any subsidies should be based on economic need and not on geographic location, as high-cost funding dictates.

Under the current plan, there's no way to subsidize poor rural customers in high-cost areas of Kentucky without giving money to wealthy horse breeders, says Lawrence Gasman, a senior fellow in telecom and technology studies at the Cato Institute.

Some have suggested that subsidies should be given only to end users who cannot afford to pay by instituting the telecom equivalent of food stamps. The current universal service program already includes a fund that picks up part of the cost of a low-income customer's bill. Some parties would like to see that fund revamped and the high-cost fund reduced or eliminated.

Others would undertake even further reforms.

"We already have poverty programs," says Gasman. "Why can't we put everything in one program? Why do we need a separate administration?"