[Economic Report of the President (1996)]
[Administration of William J. Clinton]
[Online through the Government Publishing Office, www.gpo.gov]

[DOCID: f:erp_c6._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 104-161
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]

CHAPTER 6

Promoting Competition in Traditionally Regulated Industries

AT THE CENTER OF THE SUCCESS OF our economy is the market, and at
the core of the success of the market is competition: it is competition
that drives down costs and prices, induces firms to produce the goods
consumers want, and spurs innovation and the expansion of new markets
abroad.
In stark contrast to the gains from competition are the
inefficiencies that result from monopoly. Monopolists typically set an
artificially high price and restrict output, and often have weaker
incentives to innovate than do competitive firms. The disadvantages of
monopoly are sufficient to warrant government action to ensure
competition or regulate the conduct of monopolies. Part of this
Administration's commitment to strengthen the private sector involves
ensuring that robust competition prevails where competition is possible,
and guarding against the abuse of market power in those limited
instances where it is not.
Powerful market forces, coupled with increased recognition of the
costs of regulation, are strengthening the consensus to reform
regulation in order to promote competition in two of our country's major
regulated industries: electric power and telecommunications. Regulatory
policy needs to respond to the forces of change in these industries, and
important reform initiatives are under way.
At the Federal level the Congress, with the Administration's
support, has recently passed sweeping legislation to rewrite the
Communications Act of 1934 and other rules governing competition in
telecommunications services. The Federal Communications Commission,
which helped foster competition in telephone equipment and long-distance
service, is developing policies for the interconnection of telephone
networks that will promote competition in local telephone service as
well. And the Federal Energy Regulatory Commission is trying to ensure
access to electric utilities' transmission lines for all power
generators. Various States also are moving to promote competition in
intrastate phone service and in electricity. The stakes are high.
Electricity and telecommunications are critical elements of an economy's
infrastructure, and in the United States each sector accounts for over
$200 billion in annual sales or, collectively, over $800 per U.S.
resident.
Regulatory reform enjoys broad support, but disagreement exists over
how best to make the transition from regulated monopoly to competition,
and over the role of government once that transition is complete.
Although the debate is often couched in terms of ``regulation'' versus
``deregulation,'' implying that deregulation by itself will encourage
competition and thus efficiency and innovation, what is at issue is
something far more subtle, namely, the form and nature of regulation,
with profound effects on both efficiency and equity. It cannot be
overemphasized that immediate blanket deregulation is not a panacea.
Well-designed regulations and antitrust safeguards are likely to result,
ultimately, in more competitive markets with more innovation than
immediate deregulation could provide. Moreover, until competition
develops, it is important to maintain safeguards to protect consumers
and to prevent incumbent monopolists from stifling the growth of
competition.
This chapter discusses the challenges facing regulatory and
antitrust policies in the telecommunications (Box 6-1) and electric
power (Box 6-2) industries. It begins by discussing the growing
consensus for increased reliance on competition in traditionally
regulated industries, then provides an overview of the main challenges
to successful regulatory reform. The two subsequent sections elaborate
on these challenges in the telephone industry, which accounts for most
telecommunications revenues, and in the electric power industry.

FROM REGULATED MONOPOLY TO COMPETITION

Public policy has historically taken two approaches to the problem
of monopoly power: antitrust and regulation. The Congress passed the
first antitrust law, the Sherman Act, in 1890. Antitrust policy seeks to
encourage free market competition wherever possible by prohibiting
parties from stifling competition through certain mergers, collusive
practices, or unreasonable exclusion of competitors. Antitrust policy
does not outlaw monopoly or monopoly prices, but instead seeks to
prevent monopoly by promoting competition.
But the main policy approach in public utility industries like
electricity, gas pipelines, and telephones has been regulation of
private monopolies. (Some countries have tried government ownership as
an alternative, but with few exceptions these have proven less effective
than private ownership and regulation.) The first Federal law permitting
regulation of monopoly, the Interstate Commerce Act, dates back to 1887.
Usually the stated reason for resorting to regulation of a monopoly
rather than promoting competition through antitrust is that the industry
in question is believed to be a natural monopoly--an in-

Box 6-1.--The Telecommunications Industry

The boundaries of the telecommunications industry are not clearly
defined. In the broadest sense, the industry spans the entire backbone
of our information economy. Some divide the industry into three
segments: ``conduit'' (including local and long-distance telephone
service; cable television; wireless services; emerging services that
combine data, voice, and image transmissions; and communications
equipment); ``content'' (such as broadcast television and radio and
cable programming); and ``computers'' (computer hardware and software,
and computing and processing services). In this chapter,
``telecommunications'' generally refers to conduits, especially
telephones, cable television, and wireless services.
Telephone service generated about $150 billion in revenues in
1994, television and radio broadcasting almost $42 billion, and cable
television about $28 billion. Cable television, although small compared
with the telephone industry, is an important component of the
telecommunications industry. Almost two-thirds of American households
with televisions--more than 60 million households--subscribe to at least
basic cable service, and the industry employs about 112,000 people.
The telecommunications equipment market includes a vast array of
hardwares, from sophisticated equipment to facsimile machines to public
pay phones. This market is growing rapidly: its sales of more than $63
billion in 1994 are projected to rise to almost $100 billion by 1997.
dustry in which product demand can be supplied most efficiently by a
single firm. Natural monopolies arise mainly from large fixed costs
relative to the size of the market: for example, the cost of running
telephone or video cables to a home, or the cost of electric
transmission lines. Such conditions create large economies of scale;
that is, unit costs drop significantly with the volume of firm's output.
In such cases the judgment may be made that competition is not workable
and that the market is best served by a single monopoly firm that can
fully exploit economies of scale but is prevented by price regulation
from exercising monopoly power over customers.
The last 25 years have witnessed a sea change in attitudes toward
regulating industries on grounds of natural monopoly. Economic studies
have increasingly questioned the extent of economies of scale,
challenging the view that many such industries are ubiquitous natural
monopolies. More important, there has been a growing awareness of the
major inefficiencies spawned by the regime of regulated monopoly.

Box 6-2.--The Electric Power Industry

Four main types of electric utilities operate in the United
States: investor-owned utilities, which are typically privately owned,
regulated monopolies; non-Federal publicly owned utilities, which are
nonprofit State and local government agencies established to serve their
communities and nearby customers at cost; cooperative utilities, which
are owned by and provide electricity to their members; and Federal power
agencies, which are primarily electricity producers, wholesalers, and
transmitters. Although only about 250 out of the 3,204 electric
utilities nationwide in 1994 were investor-owned, they are by far the
most economically significant group, earning almost 80 percent of all
electricity revenues. Over 99 percent of investor-owned utilities'
revenues accrued to the 179 largest utilities.
Total electricity revenues in 1994 were $203 billion, or about 3.2
percent of gross domestic product (GDP). Of that sum, residential users
accounted for almost $85 billion, commercial users for about $63
billion, and industrial users for $48 billion. The electric utility
industry is one of the most capital-intensive in the United States; the
179 largest investor-owned utilities alone had almost $575 billion in
assets in 1994, amounting to almost 5 percent of the gross capital stock
of all industries.
Competition typically offers important advantages over monopoly: it
encourages innovation, which lowers costs and increases the variety of
products available to consumers. And regulated monopolists generally
have weaker incentives than unregulated monopolists to cut costs, to
launch new products, and to respond to changing customer demands. In
addition, there are administrative costs of regulation and, more
important, the potential for losses due to protracted disputes between
the regulated firm, customers, and regulators, which can cause long
delays in adjusting prices or in authorizing new investments.
The bottom line is that competition need not be perfect for it to be
preferable to regulated monopoly. The advantages of competition can
easily outweigh the disadvantage of not fully exploiting economies of
scale.

ADAPTING REGULATION TO INCREASE COMPETITION

Although regulation has been the primary tool for addressing
monopoly in infrastructure industries, these industries have also been
subject to antitrust rules in some aspects of their operation, such as
interconnection in the case of the telephone industry. Regulation and
antitrust have had an uneasy coexistence, given their somewhat
inconsistent thrusts: antitrust encourages competition but for the most
part does not attempt to control a firm's prices, investments, and
technology choices, whereas regulation does attempt to control such
decisions and often restricts entry into the industry as well, thereby
reducing competition. The difficulties in reconciling these approaches,
and the distortions that stem from regulating monopolies, have created
growing support for moving toward a more integrated competition-cum-
antitrust regime.
Regulatory reforms in the 1970s and 1980s demonstrated that largely
unregulated competition yields more efficient performance in such
traditionally regulated industries as air transport and trucking,
natural gas production, and long-distance telephone service. More
recently, technological advances have further increased the scope for
competition in local telephone and cable service and in the electric
power industry. Regulatory regimes should adapt to changing conditions,
to help shrink the boundaries of the regulated sector and rely more on
competition.

Removing Legal Entry Barriers

The need for regulatory reform is nowhere more glaring than in
telecommunications, with its blistering pace of technological change.
Several technologies may in the future offer economical alternatives to
today's local telephone network. Cable companies are experimenting with
upgrading their existing lines to deliver telephone service. Wireless
technologies now used mainly for mobile communications might also be
used for ordinary telephone service if costs fall sufficiently.
Fiberoptic lines, now used principally by companies that specialize in
providing access to long-distance carriers, could be extended to homes
and businesses. Mobile telephone service from low-orbiting satellites
could eventually provide basic local service. Similarly, large-scale
competition to cable companies in delivering video services may come
from various sources including satellites, wireless land-based
technologies, or telephone companies upgrading their networks. Meanwhile
the rapid technological change that is blurring industry boundaries in
telecommunications is also leading to the emergence of hybrid services
such as multimedia, which defy easy classification into traditional
industry definitions.
With so much uncertainty about the shape of the communications
networks of the future, and with significant potential for competition,
the best course is to leave their evolution to be determined by the
private sector. Policymakers should not attempt to prejudge the outcome
by assuming that local telephone and cable service are natural
monopolies best provided by regulated franchise monopolists. Attempts to
preserve artificial industry lines for the sake of maintaining
regulation under traditional monopoly franchises become arbitrary,
futile, and counterproductive.
For many years, local telephone and cable monopolies were sheltered
from competition by legal restrictions: States granted monopoly
franchises to local phone companies, municipalities could grant monopoly
cable franchises, and, with some exceptions, Federal law restricted
phone companies' ability to offer cable service. During the past few
years a broad consensus has arisen, both in the Congress and in the
executive branch, that it is desirable to try to eliminate existing
regulatory and artificial technical barriers to competition in these
industries. A number of States have started to open up their local
telephone markets to competition. The recently passed telecommunications
legislation requires immediate removal of all State and local laws and
regulations that unduly prevent entry into telecommunications and cable
services.
In electric power generation, the advent of smaller, more efficient
gas-fueled generators, coupled with falling prices for natural gas, led
to greatly reduced economies of scale. In addition, since the 1980s it
has been demonstrated that independent generators can be successfully
integrated into utility-owned transmission grids. These and other
developments have prompted growing interest in further promoting
competition in electricity generation. Although States now retain
monopoly franchises for electric utilities virtually everywhere moves to
relax legal barriers to competition are gathering steam. Many States are
considering initiatives to permit some competition, and some, like
California, have developed concrete proposals.

Assigning Spectrum Licenses Through Auctions

A major step taken by this Administration to promote competition and
market forces in telecommunications is the recent, highly successful use
of auctions to assign certain licenses for use of the so-called
``spectrum''--the range of electromagnetic wave frequencies used in
wireless communications services, including radio and television
broadcasting, paging, and mobile telephones. The huge sums of revenues
raised in recent auctions have focused attention on budget and equity
issues. Auctions for other parts of the spectrum, if appropriately
designed, could raise billions of additional dollars. When the
government does not auction off but simply assigns spectrum licenses for
free, it is giving away public resources worth billions of dollars. But
more than revenue is at stake. Auctions can help promote economic
efficiency, by ensuring that spectrum is deployed in the highest-return
uses, including emerging growth industries that entail innovative
technologies and services.
Assigning spectrum efficiently has taken on increased urgency as the
value of spectrum has risen with the growth of wireless technologies.
Wireless technologies are among the most promising avenues for
delivering new services and for eventually providing competition to
wireline local telephone and cable monopolies. The exciting potential of
wireless technologies is evidenced by the rapid growth of cellular
telephone systems (Chart 6-1) and of direct broadcast satellite
television service, which since its inception in June 1994 has already
attracted almost 2.5 million subscribers.



The Federal Communications Commission (FCC), charged with managing
spectrum use by the private sector, traditionally assigned licenses
without charge, using hearings to judge which applicants would best
serve the public interest. These trial-like hearings resulted in large
wasteful expenditures by applicants and long delays in assigning
licenses. In 1981 the Congress authorized the FCC to use lotteries in
certain cases. Lotteries reduced the delay in assigning licenses, and
the ability of lottery winners to resell licenses allowed users that
valued spectrum highly to try to obtain licenses in a secondary market.
However, using the secondary market can entail inefficiently large
transaction costs, especially in assembling suitable blocks of licenses.
The lotteries also created windfall profits for lottery winners--
windfalls that became transparent when certain lottery winners resold
their licenses at huge profits.
To avoid such inefficiencies and windfall gains to a lucky few,
economists have long urged the use of auctions to allocate scarce public
resources such as the spectrum. Spectrum auctions have also been
advocated by the National Telecommunications and Information
Administration (NTIA) of the Department of Commerce, the Council of
Economic Advisers, and the FCC. In 1993 the Congress gave the FCC
limited authority to use auctions in assigning spectrum licenses to
provide services for which subscribers pay fees (in contrast to
advertising-financed broadcasting), such as personal communication
services (PCS; these are advanced mobile two-way voice and data
communications services).
Designing good rules for PCS and other spectrum auctions presents
novel and difficult problems. Bidders are often interested not in a
single license but in suitable blocks of licenses, which makes the
values of different licenses interdependent. Interdependence arises, for
example, because aggregating licenses over adjoining regions allows a
PCS device to use the same spectrum frequency over a wider area and
makes boundary coordination easier. Interdependence can also arise
because a bidder may be able to reconfigure its planned network to use a
different set of frequencies as prices for some frequencies increase.
Designing auction rules to help bidders cope with such interdependence
in license values can both promote economic efficiency and bring in
greater auction revenue.
To date, the FCC--in consultation with economists--has developed
innovative auction rules and has conducted very successful auctions. For
example, in the largest auction to date, winners were able to assemble
suitable aggregations of PCS licenses over frequency bands and regions,
as needed to form efficient communications networks. The auctions have
attracted participation by numerous entrepreneurial companies and
promise to speed up the availability of innovative services to
consumers. In the short time since their inauguration in July 1994,
spectrum auctions have raised over $15 billion for U.S. taxpayers.

DEREGULATION IS NOT ENOUGH: CHALLENGES TO REGULATORY REFORM

Removing legal barriers to entry into traditional monopoly
industries, although critical, is unlikely by itself to ensure the rapid
development of competition or an efficient and equitable transition. To
promote these and other goals, regulatory reform must address several
difficult and important challenges, which are outlined below and
discussed further in the later sections on the telephone and electric
power industries.

Promoting and Preserving Competition

Preventing regulated monopolists from distorting competition in
related markets. A common and difficult problem arises in bringing
competition to traditionally regulated industries when, whether for
jurisdictional or technological reasons, a vital ``bottleneck'' segment
will continue for some time under the control of a regulated monopoly.
For example, competition is envisaged in electric power generation, but
for the time being transmission and distribution will remain regulated
monopolies. Similarly, competition is expected to develop more slowly in
certain elements of local telephone networks, notably the final set of
wires to a customer's premises (the ``local loop''), which will
therefore remain regulated longer.
The difficulty posed by such a mixture of regulation and
deregulation is that a price-regulated bottleneck monopolist has strong
incentives to provide its own affiliates in unregulated segments better
access to the bottleneck than it offers to rivals. (This and related
issues are explored further in the section on the telephone industry
below.) Such discrimination can inefficiently exclude rivals from the
potentially competitive segments, harming both the would-be rivals and
consumers. Preventing such access discrimination (and cross-
subsidization, which, as discussed later, also distorts competition)
could be approached in alternative ways, all of which have certain
limitations.
Relying solely on regulation to prevent the regulated monopolist
from favoring its unregulated operations over rivals raises problems.
Firms can devise many clever technological games to circumvent
regulation, such as varying the quality of connections provided to
competitors. An alternative approach is to separate the regulated and
unregulated parts of a monopolist's business into different companies.
This was done in the Department of Justice's landmark case that resulted
in the 1982 consent decree and the 1984 breakup of the American
Telephone and Telegraph Company (AT&T, then the dominant U.S. telephone
services provider). The seven regional Bell operating companies (RBOCs)
created under the 1982 consent decree were allowed to offer regulated
regional telephone service but were barred from the largely unregulated
long-distance market.
Such forced structural separation helps promote level-playing-field
competition in the unregulated markets, but it may sacrifice economies
of scope--efficiencies in joint ownership and operation of related
segments of an industry. How to prevent discrimination without unduly
sacrificing economies of scope is a central challenge in assessing
whether and under what safeguards the RBOCs should be permitted to offer
long-distance service while they still dominate local telephone
networks; and whether electric utilities should be allowed to sell
unregulated power in competition with rivals while they still control
the vital transmission grids.
Preventing monopolists from unreasonably denying interconnections.
One way in which network monopolists can stifle competition is by
denying potential competitors interconnection with their networks. The
telephone industry exhibits strong positive network externalities--a
user's benefit from the network increases greatly as additional users
are connected. This feature marks an important distinction between
telephones and, say, textiles. A new textile producer does not need much
cooperation from other textile producers, but an entrant to local
telephone service needs the incumbent's cooperation to let its customers
communicate with the incumbent's customers. With its much larger
customer base, the incumbent could hamper entry even by efficient
entrants, by denying interconnection or by providing connections of poor
quality or at an exorbitant price. Ensuring suitable and fairly priced
interconnection may require government intervention.
Restricting mergers between likely potential competitors. Regulation
must be forward looking: it must consider the market not only as it is
today but also as it is likely to evolve. In most traditionally
unregulated industries, it is actual competitors--the firms already
present in a market--that largely determine the prospects for present
and future competition. But in traditionally regulated monopolies,
future competition must largely come from the outside. Mergers between
regulated monopolists that are likely potential competitors therefore
can significantly reduce the likelihood of future competition.
For this reason, the Administration opposes excessive loosening of
restrictions on mergers and cross-ownership between cable and telephone
companies in the same local area. Although there are technological
challenges in using telephone wires to deliver video, and cable wires to
deliver telephone service, cable and telephone companies nevertheless
are likely potential competitors because both have wires to the home.
Thus, consolidations among them could delay competition.
Antitrust enforcers could attempt to block such anticompetitive
consolidations, but reviewing and challenging a potentially large number
of transactions in different regions on a case-by-case basis would be
quite costly. Maintaining clear prohibitions may be the better course as
long as such mergers promise no significant economies, and as long as
local cable and telephone companies remain among each other's most
likely potential competitors.

Improving the Regulation of Remaining Monopoly Segments

As noted earlier, although promoting competition is generally the
preferred approach, some segments of telephone and electric utilities'
operations will continue to be regulated for some time. In those
segments it is important to devise better ways to regulate prices.
Traditionally, utilities have been subject to cost-of-service
regulation, under which prices are set to cover the regulated firm's
costs plus a ``fair rate of return'' on capital. Such regulation,
however, reduces incentives to innovate or to contain costs, because the
firm realizes essentially the same profits regardless of its efforts:
success at cutting costs is penalized by reducing the allowed prices.
Performance-based regulation (PBR) loosens the link between the
firm's controllable costs and its allowable price. For example, pure
price-cap regulation places a ceiling on the firm's price at some
initial level based on estimated cost, then lets the cap change only
with conditions outside the firm's control, such as the rate of
inflation. The firm then has an incentive to cut costs, because to do so
increases its profit. On the other hand, the firm also has an incentive
to cut costs by shading quality, and regulators must guard against such
attempts. Recognizing that suitably designed PBR can often create better
incentives than pure cost-based regulation, ultimately benefiting both
the firm and consumers, many States are moving toward PBR in telephone
service and in the transmission and distribution of electricity.

Protecting Consumers and Investors During the Transition

Protecting consumers. When should an incumbent monopolist's prices
be deregulated? Setting a fixed date reduces investors' uncertainty, but
at the risk that competition may not have developed enough by that time
to substitute for regulation in disciplining prices. For example,
critics of rapid deregulation of cable television rates point out that
substantial actual competition (not merely potential competition) is
needed to discipline prices, and argue that the requisite competition
will develop more slowly than proponents of quick deregulation assume.
In electricity, many economists favor some temporary regulation of the
prices that utilities can charge, even if reforms are instituted to make
generation competitive, because it will take time to build new plants
and reduce existing utilities' dominant share of generation assets.
A complicating factor in deregulating prices is that competition
often develops faster for some customers than others, typically faster
for large business customers than for residential users. It therefore
may be appropriate to deregulate prices on a phased basis, starting with
those customers for whom competition develops earliest. But if the
utility has large (current or past) fixed costs that are common to all
of its operations, which regulators allow to be recovered through
regulated rates, it becomes important to ensure that deregulating one
group's prices will not shift onto others an increased share of these
common costs. One way to prevent this is to deregulate some prices, but
on condition that the utility agrees not to raise prices to its
remaining captive customers. Competition should increase overall
benefits, not be used as a cover for cost shifting among customers.
Protecting investors. Nor should competition be a cover for
unreasonably shifting costs from customers to utility investors. To meet
their obligation to serve all customers in their monopoly franchise
areas, electric utilities have made costly investments in long-lived
generating plant and other assets--with the regulators' implicit promise
of a guaranteed return. Opening up utilities' traditional monopoly
franchises to competition at a time when they have significant excess
capacity would greatly reduce the value of such investments, and subject
utilities to so called ``stranded costs.'' As discussed further in the
section on the electricity industry below, it is important to ensure
that, in the transition to competition, utilities are not saddled with
these stranded costs.

Promoting Universal Service and Other Social Goals

Promoting universal service--reasonably priced access to essential
services for all customers--has been a longstanding goal of regulators
in both the telephone and the electric power industries. Traditionally
this and other social goals (such as assisting certain disadvantaged
customers and reducing environmental pollution) have been pursued by
imposing obligations on and regulating the price structure of utilities.
These regulations, however, have spawned inefficiencies. Moving to
competition and letting prices respond to market forces, so that they
more accurately reflect true costs, are likely to reduce these
inefficiencies and cut the cost to society of providing universal
service by lowering overall costs and prices. But doing so may require
devising alternative ways of funding service to those consumers who
would not be able or willing to pay the prices that might emerge under
competition.

Reassessing Jurisdictional Boundaries

In both the telephone and the electric power industries, State and
Federal regulators share jurisdiction. This can lead to differing
regulatory objectives and inconsistent policies. As is discussed in
Chapter 4, a main advantage of decentralizing regulatory jurisdiction is
to allow States the flexibility to pursue social and economic policies
tailored to different local preferences and conditions. As markets
become more competitive, the scope for pursuing such goals through
regulation may decline, although the States will play a major role in
ushering in an efficient and equitable transition to competition.
On the other hand, decentralizing regulation also has its drawbacks.
Efficient networks in telecommunications and electricity often involve
facilities used to serve several States, which can lead to inconsistent
policies when such networks are regulated at the State level. Multiple
State regulatory regimes also can increase firms' uncertainty and costs
of compliance. For these and other reasons, jurisdictions such as the
European Union have been moving to harmonize the regulation of network
industries. As the United States attempts to increase competition in
such industries, it too will have to reassess what jurisdictional
boundaries are most efficient. In any event, regulators must work across
jurisdictional boundaries to foster cooperative and consistent public
policy goals.

PROMOTING COMPETITION IN TELEPHONE SERVICE

The 1984 breakup of AT&T was a landmark event in fostering
competition in parts of the U.S. telephone industry. As explained
earlier, a regulated monopolist operating in related, unregulated
markets has incentives to stifle competition in such markets. To prevent
such behavior, the breakup aimed to separate local telephone service,
which many viewed as a natural monopoly that would remain regulated,
from manufacturing of telephone equipment and from long-distance
service, which were viewed as potentially competitive and could
eventually be deregulated. AT&T retained its equipment manufacturing and
long-distance service divisions. Seven new regional Bell operating
companies inherited AT&T's regulated local-service monopolies, each
within its region, and were prohibited from entering the less regulated
markets for equipment and long-distance service.
Today the long-distance market is relatively competitive, whereas
local service remains largely a regulated monopoly, in most cases
provided by the RBOCs (Box 6-3). The new telecommunications legislation
aims to increase competition further in equipment manufacturing and
long-distance service and allows the RBOCs back into these markets under
certain conditions. The legislation also aims to introduce competition
in local telephone service, by removing State barriers to entry and by
requiring local telephone companies to grant entrants reasonable access
to their networks. These legislative and related regulatory initiatives,
together with technological advances discussed previously, promise to
foster increased competition throughout the telephone industry.
The terms for allowing the RBOCs to enter long-distance service have
been one of the most contentious issues in the debate over
telecommunications reform and may have the greatest economic
consequences. Telephone service is by far the largest telecommunications
industry (see Box 6-1), and establishing appropriate conditions for
allowing entry by the RBOCs into the other markets is critical to
achieving the legislation's goals.
Allowing immediate, unrestricted entry by the RBOCs while they still
control vital local telephone networks would have been unlikely to
promote efficiency and consumer welfare in the way that unrestricted
entry normally does. To clarify this point, the next part of this
section explains the incentive--and the ability--of a price-regulated
monopolist in local telephone service to distort com

Box 6-3.--The Structure of the U.S. Telephone Industry

The 1982 AT&T consent decree distinguished ``local'' from ``long-
distance'' service by dividing those parts of the country served by the
Bell System into local access and transport areas (LATAs). Each RBOC's
territory encompasses multiple LATAs, but an RBOC may provide service
only within LATAs. For interLATA service it must use the facilities of
long-distance carriers, also known as interexchange carriers. Local
exchange carriers (LECs) are the companies that provide the wire to the
home. There are many independent LECs, especially in rural areas, but
LECs owned by the RBOCs account for about 75 percent of total LEC
revenues.
Although competition has been growing in parts of the local
network, notably in the provision of private lines connecting business
customers directly to long-distance companies, the LECs still have
virtual monopolies over local networks. They receive over 96 percent of
all fees paid to access local networks. Their prices for local calls and
for access to interexchange carriers are regulated by the States and the
FCC.
In contrast, the long-distance market is largely unregulated and
relatively competitive; several carriers provide national service (the
three largest through their own facilities), and many more carriers
provide regional service. Reflecting this competition, the FCC ruled in
October 1995 that AT&T should be reclassified as ``non-dominant.'' Chart
6-2 provides a breakdown of revenues from local and long-distance
service.
petition in related, unregulated markets such as long-distance service
that are dependent on access to the monopolist's bottleneck facilities.
We then analyze further the issues of RBOC entry into long-distance and
of local competition. The final part of this section discusses the
relation between increased competition and universal service.

UNBUNDLING POTENTIALLY COMPETITIVE SERVICES FROM REGULATED MONOPOLY
SERVICES

As noted above, traditional cost-of-service regulation sets prices
so as to allow the regulated monopolist a ``fair rate of return'' on its
investment. Under such regulation, a monopolist can gain from engaging
in related businesses that are potentially competitive. As long as
regulation is not too stringent, the more businesses the monopolist is
engaged in, the more likely it is to successfully conceal profits from
the regulators, because overstating costs slightly in many businesses is
more likely to escape detection than overstating costs dramatically in a
single monopoly business. Moreover, by ex-



cluding all rivals from potentially competitive businesses, the
monopolist can prevent regulation of these segments from becoming more
stringent: the exclusion of competitors denies regulators a signal of
the true costs in those businesses.
To promote competition, regulators can mandate unbundling--that is,
they can require the firm to offer the monopoly service separately from
other services, at a regulated price. But problems arise if, as is often
the case, regulators allow the monopolist to offer the potentially
competitive services at unregulated (or less tightly regulated) prices,
on the theory that competition will keep these unregulated prices low.
For example, a local telephone company's access charges to long-distance
carriers might be regulated, but not its long-distance prices to
consumers. Such partial regulation induces the monopolist to favor its
unregulated affiliates over rivals in ways that are difficult for
regulators to prevent. The motive of this favoritism may be largely to
shift profits to unregulated affiliates, but the effect can be to stifle
competition.

Cross-Subsidization and Discrimination in Bottleneck Access

One way that such profit shifting occurs is through misattribution
of costs incurred by a firm's unregulated businesses to the regulated
business. This is sometimes referred to as cross-subsidization. Under
cost-based regulation, shifting costs to the regulated business allows
the firm to argue for higher regulated rates. In principle, cross-
subsidization may be a problem whenever a regulated firm also operates
in unregulated markets; but it is more likely to escape regulatory
detection when the markets are related, since there is more scope for
interaffiliate transactions and for mischaracterizing costs as common to
both businesses.
Discrimination poses an even greater threat to competition. The
monopolist controlling the price-regulated bottleneck facility may try
to evade regulation through what is known as ``tying.'' Suppose that
customers seek to purchase an unregulated service, the provision of
which hinges on access to the bottleneck service. The monopolist can
then require, as a condition of access to the bottleneck, that customers
also purchase from it the unregulated service at a high price. To
implement such tying, the monopolist reduces competition in the
unregulated market by discriminating against competitors in the
technological and other nonprice terms it grants them for access to the
bottleneck.
AT&T's behavior before its breakup is consistent with these
incentives. The monopoly local telephone service was a major customer of
equipment and a vital input into long-distance service. AT&T's prices
for long-distance service and equipment were regulated more lightly than
those for local service, creating incentives for AT&T to favor its less
regulated affiliates. Indeed, AT&T's local affiliates were alleged to
have paid its equipment affiliate Western Electric inflated prices for
possibly inferior equipment. AT&T is also alleged to have discriminated
against long-distance rivals in various ways, including offering poorer
connections to local networks and imposing unnecessary delays in
honoring requests.

Resulting Inefficiencies and Harm to Consumers

When it occurs, cross-subsidization inflates the reported cost of
regulated services, leading to higher prices. For this reason regulators
consistently try to keep the cost accounting of unregulated and
regulated businesses as separate as possible. Prices of unregulated
services--whose costs are underreported--could fall, but need not (for
example, if underreporting involves fixed rather than variable costs).
Even if prices do fall, they will be artificially below cost, and
consumption of unregulated services will be inefficiently high. Also,
sales may be diverted away from more efficient competitors in the
unregulated markets, because the regulated firm attains an artificial
advantage through the cross-subsidies.
Discrimination in access terms raises the prices of unregulated
services, because the excluded competitors might have been more
efficient, and because even equally efficient competitors could curb the
monopolist's prices more effectively than can regulation alone.
Consumers also are denied the variety and innovation that competitors
might have offered. Finally, such potentially more efficient or
innovative competitors are denied profit opportunities. These losses
resulting from discrimination can far exceed the gain to the regulated
monopolist: the monopolist is willing to exclude a rival that would
generate large benefits to consumers (say, by offering a superior
alternative), as long as exclusion yields even a modest increase in its
own profit.

ENTRY BY THE REGIONAL OPERATING COMPANIES INTO LONG-DISTANCE

The Department of Justice sought AT&T's breakup, which separated the
ownership of the regulated-monopoly local telephone service from other
services, because it believed that regulation alone could not, without
imposing undue burdens, prevent the many ways in which AT&T could use
its control of local telephone service to inefficiently favor its
affiliates. (The Justice Department and AT&T at one point tried to
negotiate a settlement without divestiture; the result was a draft
consent decree which for its length and complexity became known as
Quagmire II, or the Telephone Book decree.)
Maintaining the consent decree's prohibition of RBOC entry into
other markets may forgo some economies of scope that could be realized
therefrom, but it is likely to be more effective than regulation alone
in curbing access discrimination by the RBOCs against competitors in
these other markets. The new legislation attempts to achieve the best of
both worlds, by linking the RBOCs' entry authority to the emergence of
competition in their local markets--competition that should reduce their
control of local networks and ability to discriminate against
competitors.

Arguments in Favor of Entry: The Drawbacks of Separation

Consumers could well benefit from one-stop shopping for all their
telephone needs; for example, an integrated provider could offer
simplified calling plans. The RBOCs could provide such one-stop shopping
if allowed into long-distance, although in principle this could be
provided even without RBOC entry. For example, the new legislation
requires all incumbent local telephone companies to sell local service
to other companies at discounted wholesale prices. When authorized,
long-distance or other companies could resell such local service
together with long-distance and other services.
Some economists contend that RBOC entry into long-distance service
is particularly important for lowering prices because the long-distance
industry is far from perfectly competitive. Although there is some
debate about how competitive the long-distance industry already is, the
real issue is why entry would be more profitable for the RBOCs than for
other firms. This could be the case either because the RBOCs could use
such entry to circumvent local rate regulation (a ``bad'' reason), or
because they have special cost advantages in offering long-distance
service (a ``good'' reason).
A clear such cost advantage arises because any RBOC could link its
existing networks to provide long-distance service at lower cost than
could other entrants deploying entirely new facilities. Indeed, the
separation between local area service and long-distance service (see Box
6-3) can be arbitrary and artificial: the boundaries of ``local areas''
at times do not track economic or technological realities. This
highlights a general problem with using structural separation to prevent
a regulated bottleneck monopolist from stifling competition in
potentially competitive markets. Where to draw the boundaries depends on
where the monopoly bottleneck lies, but the bottleneck can shift
location as technology changes. For local telephone networks, most agree
that the bottleneck includes the local loop, but experts disagree over
whether it includes additional upstream elements such as switches. The
issue of where the bottleneck lies is relevant also for policy toward
promoting local competition.

Arguments Against Entry: Preventing Access Discrimination

Combining local and long-distance service within a single firm is
likely to offer some economies of scope, but such economies also existed
at the time of AT&T's breakup. The policy judgment then was that breakup
was needed to protect competition in the potentially competitive
segments, given the incentive and ability of local network monopolists
to stifle it, and that the gains from competition would outweigh the
loss of economies of scope. On many counts the breakup has succeeded:
today the equipment and the long-distance markets are reasonably
competitive. Opponents fear that if the RBOCs are allowed to reenter
these markets before they face competition in their core local phone
markets, regulation alone could not prevent them from inefficiently
excluding competitors.
Long-distance service still hinges on access to local networks,
which for now are still largely monopolies controlled by the RBOCs.
Although cross-subsidization by the RBOCs from their regulated local
phone service to their unregulated businesses may be less of a threat
today, access discrimination against other providers of long-distance
service and perhaps of central-office switching equipment remains a real
concern.
Cross-subsidization may now be less of a threat because, in order to
improve regulated firms' incentives, States are replacing pure cost-of-
service regulation of local phone rates with performance-based
regulation. Such regulation also reduces the regulated firm's incentives
to cross-subsidize, because higher costs of the regulated business are
not passed through as fully or as rapidly in higher regulated rates as
under pure cost-of-service regulation. As added protection, the new
legislation requires the RBOCs to manufacture equipment and provide
long-distance service through separate subsidiaries for some time, to
help regulators detect cross-subsidization.
However, preventing RBOC discrimination against long-distance
companies in access to local networks remains a thorny challenge.
Performance-based regulation of local rates leaves intact incentives to
discriminate against long-distance rivals, in order to raise prices in
the unregulated long-distance market. Requiring long-distance service to
be offered through a separate subsidiary does not eliminate
discrimination incentives, because the subsidiary's profits accrue to
common shareholders. Finally, regulators today may be more attuned to
the dangers of discrimination, but preventing through regulation all
avenues of technological discrimination in network access is still
likely to be difficult.
Allowing the regulated RBOCs to provide unregulated long-distance
service gives them incentives to discriminate against long-distance
rivals. Allowing them to manufacture switches and other network
equipment could enhance their ability to discriminate, by making it
easier for them to retain proprietary control of important technical
information needed to interface with long-distance and other unregulated
services that rely on the network. If, as is likely, regulation alone
cannot adequately curb such discrimination, then allowing the RBOCs to
enter these other markets while they retain monopolies over local
networks could reduce prices temporarily in those markets; but it could
threaten rivals' long-run viability, raising the specter of ultimately
reducing competition and causing higher prices and less innovation.

Competitive Safeguards

Local competition can greatly help prevent access discrimination. It
provides alternative ways of reaching some customers. It also offers
regulators a useful yardstick for policing discrimination: claims that
certain network services cannot be provided to competitors will ring
hollow if a local network competitor finds no difficulty providing such
services. Although competition is coming to local networks, the RBOCs'
dominance is unlikely to disappear overnight even if regulatory entry
barriers are relaxed. Potential entrants have encountered technological
problems, for example, in delivering telephone service over cable lines.
Wireless connections may eventually offer alternatives to the local loop
for reaching a customer's premises, but those currently available are
higher in cost, less secure, and of lower quality than wireline
connections.
Since local competition is both critical to safeguarding competition
in long-distance and related markets but is in a nascent stage, the new
legislation not only imposes regulatory safeguards against
discrimination and other abuses but, importantly, links the RBOCs'
authority to enter these other markets to the emergence of local
competition. In broad brush terms, the new legislation provides the
following process for authorizing RBOC entry into long-distance (i.e.
interLATA) service. Such service, as well as the manufacturing of
equipment, must be offered through a separate subsidiary. An RBOC may
offer long-distance service immediately on enactment of the legislation
in any State where it currently provides no local service. But an RBOC
must receive FCC approval to offer service originating in any State
where it does provide local service (and likely controls many local
networks). FCC approval is granted only after the following requirements
are met.
Within 6 months of the new law's enactment the FCC will formulate
rules for interconnection and network unbundling, discussed further
below, that all incumbent local exchange companies must follow in
dealing with new local competitors. At a minimum, an RBOC must offer
terms, including prices, which the State public utility commission
certifies are consistent with the FCC rules. Moreover, if a new local
competitor has requested interconnection from an RBOC, then before being
eligible to offer long-distance service the RBOC must have fully
implemented a binding interconnection agreement with the competitor.
That agreement must satisfy the FCC rules; the competitor must use
predominantly or exclusively its own facilities; and it must provide
local exchange service to both business and residential customers in the
State (pure access providers, for example, do not suffice). In short,
the local competitor is intended to have a significant presence.
Because these requirements help promote local competition but do not
guarantee its imminence or durability, the new legislation provides
further safeguards. Before authorizing RBOC entry, the FCC must consult
with the Department of Justice regarding the likely competitive
implications and give the Department's evaluation ``substantial
weight.'' This procedure offers an important safeguard, given the
leading role that the Department's Antitrust Division has played in
bringing competition to long-distance telephone service through the AT&T
breakup, and given its analytical expertise in competition matters.
Finally, the FCC must determine that RBOC entry would be in the public
interest. Preservation of competition requires that antitrust enforcers
and regulators have the latitude to make judgments of this kind, because
no mere checklist could hope to capture all the relevant contingencies.

IMPLEMENTING LOCAL COMPETITION

As mentioned earlier, in order to foster local competition the new
legislation would require existing local exchange companies to cooperate
with entrants. Even a full facilities-based entrant (one that serves its
customers entirely through its own physical facilities) would still
require interconnection to the incumbent's network--to enable its
customers to communicate with the incumbent's customers, to let
customers keep their telephone numbers if they switch to the entrant,
and to access common signaling facilities and data bases. The new
legislation requires incumbent carriers to provide such cooperation on
reasonable terms.
Other entrants might lease some or all facilities from the
incumbent. A reseller of local services would lease all network
facilities in bulk but undertake all customer-related functions such as
marketing and billing (``retailer'' might therefore be a better term).
It could offer to customers a package of local and other services such
as interexchange service or cellular service. A partial facilities-based
entrant would lease some elements and supply the rest itself; it might,
for example, install its own switches but use the incumbent's local
loops. Both types of entrants require unbundling of the local exchange
carrier's integrated functions. A reseller would require unbundling of
network functions from marketing and other customer-related functions. A
partial facilities-based entrant would additionally require unbundling
of some network functions. To accommodate such entrants, the new
legislation requires incumbents to unbundle their networks and provide
nondiscriminatory access to all the unbundled components.
Inevitably the new legislation provides only a framework and leaves
such ``details'' as the pricing of interconnection and unbundled
services to be determined later by the FCC and State regulatory
commissions. But these details will be crucial. To stay in business, a
reseller must be able to buy the local network services at a sufficient
discount below retail rates, reflecting the fact that it undertakes
costly retailing functions otherwise performed by the incumbent. (The
new legislation requires incumbents to offer their services to resellers
at wholesale rates, defined as retail rates less the costs avoided by
incumbents.) If the discount is too small, even an efficient reseller
will be unprofitable. A partial facilities-based entrant likewise needs
reasonably priced access to the facilities it wishes to lease.
Determining the proper discount to resellers has already raised
controversy, embroiling regulators in defining and measuring the costs a
local phone company could avoid by delegating some retailing functions.
In long-distance there is already an active market in capacity resale,
as multiple owners of facilities compete to provide capacity. But until
competition arrives in local networks, implementing resale of local
service through mandated discounts will be difficult. Mandated
unbundling of physical network elements, as opposed to just retailing
functions as with resale, is likely to be even harder. There are many
joint and common costs, network congestion is important in determining
efficient prices, and unbundling certain elements may pose technical
problems.
In short, introducing competition into local networks will be a
complex process, requiring continued active involvement by State
regulators, the FCC, the Justice Department, and possibly the courts.
Nevertheless, by defining the broad rules and providing for active
government involvement in implementing agreements and refereeing
disputes, the new legislation holds the promise of stimulating
ubiquitous, vigorous competition with potentially enormous benefits to
businesses and

REPLACING CROSS-SUBSIDIES AND PROMOTING UNIVERSAL SERVICE

A longstanding policy goal in the United States has been universal
service: widespread access to telephone service at reasonable prices.
Such a goal can be defended on narrow economic grounds because the
benefits of having a telephone on one's premises accrue not only to the
subscriber but also to others who might be interested in calling that
subscriber. Encouraging telephone subscription by people who would not
otherwise have a phone on their premises can therefore also benefit
others. Support for universal service, however, is based also on broader
social considerations--that all members of a society should be entitled
to a certain level of key services.
Where attaining universal service is thought to require government
intervention, because without it prices would be deemed too high in
certain regions or to certain customer groups, economists generally
advocate the use of targeted, explicit subsidies, financed through
broadly based taxes. Traditional regulatory policy has not taken this
route. Instead, regulators have used the rate structure of regulated
telephone monopolists to promote universal service and other goals. Many
economists believe that this rate structure is inefficient and
incompatible with a move toward increased competition in telephone
service.
The new legislation requires the formation of a Federal-State Joint
Board, representing regulators and consumers, to thoroughly review the
existing system of Federal support for universal service and recommend
reforms within 9 months of the law's enactment. Within 15 months of
enactment, the FCC is to establish a specific timetable for
implementation of reforms. This envisaged reform for the most part
promises to better harmonize the goals of promoting competition and
universal service.

Cross-Subsidies and the Tension with Competition

Cross-subsidization arises when the price in one market does not
cover the incremental cost of serving that market, and the deficit is
financed by charging a price significantly above incremental cost in
another market. The different markets can be for different products
(e.g., long-distance versus local calls) or different identifiable
customer groups (e.g., residential versus business customers of local
calls). As discussed earlier, cross-subsidies can arise from attempts by
a regulated monopolist to evade cost-based regulation by misattributing
costs of its unregulated business to the regulated business. But cross-
subsidies also can be mandated by regulators.
For many years regulators, with the support of the Congress, used
cross-subsidies between regulated monopolists to pursue universal
service goals. Through a complicated nationwide pooling of telephone
costs and revenues, local telephone companies, especially in high-cost
rural areas, received substantial subsidies to keep their rates low. The
subsidies were financed by setting prices of long-distance calls and of
telephone equipment artificially high. In addition, long-distance rates
were set by geographic averaging: rates for routes of the same distance
were set equal despite different traffic densities and therefore
different costs. There may also have been subsidies from business to
residential customers generally.
This system was administered by AT&T, whose affiliate companies
provided most local telephone service nationwide and virtually all long-
distance service. The system came under strain once AT&T's virtual
monopoly began to erode. The growth of competition in supplying customer
premises equipment (such as telephone sets) in the 1970s and later in
long-distance service reduced the funds available for cross-subsidies.
In response, after the breakup of AT&T the FCC introduced fixed monthly
fees for all telephone subscribers, reducing the need for subsidies; the
FCC and State regulators also instituted explicit access fees for all
long-distance carriers originating and terminating calls on local
carriers' networks. These access fees are still used to finance
subsidies to rural carriers.
The inflated access fees, however, prompted large long-distance
customers to bypass the local exchange and instead use private lines to
connect their premises directly to an interexchange carrier. Such bypass
again threatens the revenue used to cross-subsidize other services. Some
local telephone companies have also alleged that revenue from high-
volume local business customers cross-subsidizes basic local service to
residential customers, so that permitting entry into local service also
will threaten cross-subsidies: entrants will siphon off lucrative
business customers and reduce the revenue available for subsidizing
rates to other customers.
Universal service and other social goals that may be threatened by
competition can be pursued through diametrically different approaches,
as discussed below. One is to try to maintain a broad monopoly charged
with meeting these social objectives, by legally prohibiting entry or by
requiring all entrants to make substantial contributions to cover the
incumbent's cost of providing below-cost services. The other is to
permit widespread competition and develop alternative, market-based ways
of funding legitimate social goals.

Joint Costs, Natural Monopoly, and Cream Skimming

Defenders of retaining monopoly might paint the following picture of
local telephone service. Serving the different markets--be they
different customers or different services--is largely a natural
monopoly, because it entails large fixed and common costs. The markets
are therefore most efficiently served by a single firm, but to cover the
fixed costs, prices in some or all markets will have to exceed the
incremental costs of serving those markets. Entry could then be
profitable but economically inefficient, because an entrant could engage
in cream skimming--targeting only the monopolist's more lucrative
markets where the gap between prices and incremental costs is greatest,
thus saddling other groups with a higher proportion of the common costs.
Charging different price-cost margins, which are vulnerable to cream
skimming, can be efficient if demands in different markets exhibit
different degrees of price sensitivity. The fixed costs are then best
covered by charging higher margins where demands are less price-
sensitive, as this pricing pattern minimizes the inefficiency from
reduced consumption due to prices that exceed marginal costs (economists
call this ``Ramsey pricing''). For example, if demand for local service
were less price-sensitive than demand for long-distance service, it
might make sense to charge higher margins for local calls to finance the
common costs, such as for wires to the home, entailed in providing local
and long-distance service.

Distortions in the Current System

If the view of the industry just outlined--as a ubiquitous,
multimarket natural monopoly that is pricing efficiently to recover
common costs but is vulnerable to cream-skimming entry--were accurate,
policymakers would face a tradeoff: restricting entry would better allow
exploitation of scale and scope economies, but would deny the benefits
of competition and impose regulatory costs. Many economists, however,
challenge this portrait of the local telephone service industry. They
are skeptical about characterizing too many costs as ``fixed and
common'' and the industry as a ubiquitous natural monopoly. Moreover, to
the extent there do exist fixed and common costs, current regulated
prices do not recover such costs efficiently. Rather, the current price
structure sends wrong signals about the true costs, thereby distorting
the decisions of entrants and consumers.
Distorted entry decisions. Access fees charged by local network
operators to long-distance companies far exceed marginal costs. These
high fees cross-subsidize service in rural areas and perhaps basic local
service nationwide, which may be priced below its marginal cost. Such
pricing can distort entry decisions in two ways: artificially high
prices can encourage inefficient entry, and artificially low prices can
discourage efficient entry.
Regarding possibly inefficient entry, inflated access fees may have
provided an artificial stimulus to the growth of so-called competitive
access providers: companies that bypass local networks and link
businesses directly to long-distance companies. Regarding the
discouragement of efficient entry, there may be greater potential for
competition in local services than is currently evident. Artificially
low prices for the subsidized incumbent's services (such as to rural
areas) can make it unprofitable for entrants to compete for providing
such services, even if the entrants are more efficient. This comes about
because under the current system only incumbents are eligible for
certain subsidies.
Distorted consumer decisions. The current rate structure also
distorts consumer decisions. High long-distance rates subsidize
telephone subscription but discourage calling; raising the fixed charge
for telephone subscription and reducing the prices for calls would
stimulate calling. The benefits from lower toll rates and expanded
calling would make many consumers better off even after paying higher
fixed charges. Cross-subsidies from long-distance to local service are
sometimes defended on the grounds that low-income individuals use local
service relatively intensively, but the correlation between income and
long-distance versus local calling may not be strong, and some studies
have indicated that high toll bills often lead to low-income subscribers
being disconnected for nonpayment. Better ways can be found to assist
those with low incomes.
Lack of transparency. A vital ingredient of any sound economic
policy is to make costs and objectives explicit and transparent. The
goals and methods of telephone cross-subsidies are now opaque; as a
result, the true extent of cross-subsidies needed to ensure universal
service or other legitimate social goals remains unclear. In some cases,
cross-subsidies may instead reflect regulatory capture--some groups may
simply be more adept than others at manipulating the regulatory process
so as to procure subsidies for themselves. Competition is likely to
reduce the cost to society of providing universal service by lowering
costs and most prices and by introducing new technologies. It may well
reveal that most people would have affordable access to basic
telecommunications services even without subsidies.

Challenges for Reform

The rapid changes in technology and the accompanying changes in
regulation described earlier imply that protecting universal service by
maintaining regulated monopolies is likely to become both increasingly
inefficient and untenable. Many economists favor giving competition
freer rein and letting prices adjust to better reflect true costs. Any
legitimate social goals served by the current regulated price structure
should be addressed through other means that are more transparent, more
targeted to explicit goals, and do not distort competition. A strong
collaborative effort between Federal and State regulators should be
established in pursuit of these goals.
What should be included in universal service? For many years there
was only one basic service to be universalized or not: a telephone was a
telephone. Today, however, telephone and other telecommunications
networks are evolving to permit a much broader range of enhanced
services. As conditions change, it will be important to review, perhaps
on an evolving basis, the range of services targeted for universal
service and to be clear about what is meant by ``sufficiently
affordable'' prices.
Increasingly, we have realized the potential of modern
communications to affect other aspects of life, from health (via
telemedicine) to education. Access to computers and the Internet can put
at the instantaneous disposal of every child in America resources
superior to those available in even the best schools only a couple of
decades ago. This Administration, through the National
Telecommunications and Information Administration, has been striving to
ensure that all Americans have access to advanced information services,
for example, through public institutions such as schools and libraries.
The new legislation includes the provision of such access as a core
principle to guide universal-service reform.
Who should be eligible for support? For example, should all rural
residents be eligible or only low-income consumers wherever they reside?
And how much should prices be allowed to vary so as to reflect
differences in the cost of providing service? Another reform principle
adopted by the new legislation is that all consumers should have access
to telecommunications and information services that are ``reasonably
comparable'' in quality, variety, and rates to those available in urban
areas. It goes further, however, with regard to interexchange and
interstate telecommunications services (which include, at a minimum,
telephone service), by requiring the rates charged to residential
subscribers in rural areas to be ``no higher'' than those charged in
urban areas. Many economists would hesitate to recommend such a
stringent requirement.
How should universal service be funded? Once the goals have been
clearly identified, funding mechanisms should be devised that do not
distort competition. At present, subsidies to serve ostensibly
unprofitable markets are not offered to all comers on an equal footing
but are largely reserved for incumbent monopolists and financed through
surcharges on long-distance and other services. Alternative financing
methods would be less distorting and more compatible with competition.
An example might be a universal service fund, financed by charges levied
on all telecommunications carriers, or even more broadly. All eligible
consumers could draw on the fund, to help them pay for the provider of
their choice. Alternatively, the right to provide subsidized service to
a designated group could be allocated through competitive bidding among
all qualified potential providers.
In the absence of explicit mechanisms to fund universal service or
other social goals, regulators might feel compelled to meet such goals
by imposing obligations on entrants. Such obligations could easily
stifle competition. For example, regulators might be led to require
entrants to offer a configuration of services, regional coverage, and
rate structure very similar to that of the incumbent local monopolist.
But entry is more likely to occur and to be more valuable if entrants
have flexibility in choosing their technologies and mix of services to
best exploit their comparative advantage. Revamping the funding of
universal service therefore is an integral part of a successful move
toward increased competition in telephone service. Consistent with this
goal, the principles in the new legislation call for making support
mechanisms explicit and predictable; requiring all providers of
telecommunications services to make nondiscriminatory support
contributions; and making all interested carriers eligible for support
to provide service in designated areas, with the exception of any area
served by a rural telephone company.

PROMOTING COMPETITION IN ELECTRICITY

The Nation's major electric utilities have historically been
vertically integrated, engaged in both the generation and the delivery
of electricity. Delivery is over high-voltage transmission lines from
generators to substations, and from there over local distribution lines
to users. The Federal Energy Regulatory Commission (FERC) regulates
interstate transmission services and interstate wholesale power
transactions (sales to utilities for resale), whereas the States
regulate their investor-owned utilities' retail sales. In the past the
supply of electricity within a given geographic area was seen as a
natural monopoly, and State public utility commissions awarded utilities
exclusive franchise areas. They required utilities to serve all
consumers in their franchise areas at regulated, bundled rates, covering
generation and delivery, based on cost of service.
A major crack in the vertically integrated structure of the industry
came with the Public Utilities Regulatory Policy Act (PURPA) of 1978,
which required utilities to buy power from nonutility generating
companies that employed renewable energy sources or co-generation (co-
generation uses steam both to generate power and to heat adjoining
buildings). Although its primary goals were to reduce dependence on
imported oil and encourage renewable energy sources, PURPA played a
major role in promoting competition in power generation. By giving rise
to a class of nonutility generating firms, PURPA created momentum for
efforts to unbundle generation from delivery. Moreover, experience with
PURPA demonstrated that independents could build generators on time and
on budget and could be reliably integrated into the transmission grid,
subject to utilities' control. Nonutility generating firms have grown
rapidly since PURPA's enactment. Their share of nationwide generating
capacity has doubled from 3.6 percent in 1987 to 7.2 percent in 1995;
since 1990 they have contributed over half of all new investment in
generating plant.
An obvious reason for some independents' growth is obligations
imposed on utilities to purchase power from PURPA-qualifying facilities.
Although PURPA required purchases at prices that were supposed to
reflect utilities' expected costs were they to supply power from their
own sources, regulators in a few States calculated these prices in ways
that led to artificially high purchase prices. But technological change
also played a major role in the growth of independents. The advent of
small, efficient, natural gas-fueled generators, coupled with falling
gas prices, drastically reduced the capital cost and minimum efficient
scale of generating plants, making it easier for independents to finance
plants (because of shorter construction lags and lower financing needs)
and to build plants under contract to serve a particular utility. Market
innovations in the financing of power plant construction by independents
also were important.
Asymmetrical regulatory treatment also contributed to the
independents' growth. Independents had stronger incentives than
utilities to cut costs, because only they were exempt from cost-based
regulation. The Energy Policy Act of 1992 expanded this exemption to a
broader class of independents than PURPA had covered, allowing such
independents to enter the wholesale power market, where they could sell
power to utilities at unregulated market rates (unlike PURPA, however,
the 1992 Act did not oblige utilities to purchase from the
independents). In addition, some utilities may have refrained from
building their own plants, fearing that regulators would later reject
some of the costs when it came to resetting their rates. And regulators
in some States required utilities to look first elsewhere, to nonutility
generating firms or to other utilities with excess capacity, to supply
their incremental generating capacity needs before building more plants
themselves. In this the regulators' intent was to foster competition, as
part of an effort to curb the rise in electricity prices following the
oil shocks of the 1970s.
These changes expanded wholesale competition among generating firms
to sell power to utilities. Pressure is growing to allow retail
competition as well: for generating companies or utilities to sell
directly to final customers in the franchise area of a different
utility, paying regulated rates to use the utilities' existing
transmission and distribution lines. This pressure comes mainly from
large customers, who, among other things, can credibly threaten to
bypass their local utility by generating their own electricity using
small natural gas plants, or through municipalization (discussed later
in this section). Promoting increased wholesale competition and
introducing retail competition present three major challenges, which are
discussed below.

UNBUNDLING GENERATION FROM TRANSMISSION AND DISTRIBUTION

To deliver power to final consumers, generating firms require access
to the transmission and distribution facilities that utilities own and
operate. These facilities appear to be natural monopolies, likely to
remain subject to price regulation. This gives rise to a by-now familiar
problem: if utilities are also permitted to generate their own power and
sell it at unregulated rates, they will have an incentive to evade
regulation by favoring their own generators and realizing profits
through unregulated power sales. Such favoritism could involve cross-
subsidizing the unregulated power generation business from the regulated
transmission and distribution business or, more important,
discriminating against outside generators in providing access to
transmission and distribution networks.
If there were no significant economies of scope between generation
and other functions, an obvious way to prevent discrimination would be
to require separate ownership of regulated transmission and distribution
assets and of unregulated generation assets. However, as discussed
below, transmission and generation may be subject to important economies
of scope. The challenge to policymakers and market participants is to
devise solutions that balance potentially conflicting goals: preventing
access discrimination, but without comprising the reliability of
electricity supply, sacrificing economies of scope, or imposing
excessive regulation.
The technological relationship between the generation and
transmission of electricity is more complex than that between production
and transportation in most other industries. Modern alternating-current
transmission networks require tight and rapid balancing between power
generated into and power withdrawn from the transmission grid. Storing
electricity in significant volumes is generally impractical, and failure
to balance power inflows and outflows can result within seconds in
serious deterioration of system operation and widespread damage to
equipment. The system is much less tolerant than, say, gas pipelines,
which can accommodate imbalances for longer periods through external
storage and by changing the degree of gas compression within the
pipelines. Moreover, electricity flows cannot be easily routed within an
integrated transmission network; rather, power flows automatically and
instantaneously along the path of least impedance. Imbalances at one
point on the grid therefore can have widespread and unpredictable
consequences throughout the network.
Although network operations are largely computerized, unforeseen
contingencies can require central intervention by the grid operator:
transmission constraints may result from unforeseen demand surges or
equipment failures, requiring some generating sets to be unexpectedly
dispatched and others turned off. In addition, there are common costs in
operating a transmission network, such as maintenance of reserves, and
charging individual generators for such costs requires a central
authority. Operating such a complex system therefore requires the grid
operator to have substantial control over at least some generating
assets, and over some network functions that entail common costs.
Until now such complications have been addressed within the context
of a vertically integrated industry, and through regional power pools
and other voluntary associations. However, moving to a more competitive
regime may require devising alternative institutions. Vertical
integration opens the possibility that utilities would use their control
of transmission to discriminate in favor of their own generating plant.
And, as explained below, reliance on voluntary cooperation to resolve
regional transmission issues may be more difficult in a competitive
environment.
The FERC has addressed the issue of expanding transmission access by
requiring utilities situated between one utility seeking to purchase
power and another utility or independent power producer seeking to sell
power to allow use of their transmission lines to complete the sale. At
first efforts to expand access were episodic; for instance, approvals of
utilities' merger requests were made contingent on their granting
transmission access. The 1992 Energy Policy Act explicitly authorized
the FERC to require wholesale transmission access upon request. The FERC
is in the midst of an important rulemaking to establish a comprehensive
framework for implementing open, nondiscriminatory wholesale
transmission access: a utility would have to grant access to outsiders
seeking to consummate wholesale transactions on the same terms as to its
own generating facilities.
Important as these initiatives are, some observers believe that more
will have to be done. Defining and policing against discriminatory
access may be difficult when an integrated utility runs the grid. In
addition, increased competition will strain the current system of
informal coordination between utilities, each operating transmission
facilities that are connected into regional grids. Connecting such
systems offers important advantages: it provides alternative
transmission paths and economizes on redundant facilities, and it
facilitates power sales to resolve temporary local imbalances between
supply and demand or to benefit from differences in the cost of power
over a wider region. Such informal coordination worked reasonably well
in an era when utilities had exclusive franchises, but may become
increasingly frayed in a competitive environment.
To address these concerns, some observers have proposed, and
California regulators have recently endorsed, the formation of an
``independent system operator.'' Investor-owned utilities and
independent nonpublic generating companies would bid competitively to
sell power into a regional grid. Utilities would retain ownership of
transmission facilities but would turn over their operation under
contract to an independent entity, which would manage the system on a
regional basis. The operator would have authority over decisions such as
how to respond to unforeseen contingencies and, under FERC oversight,
how to price certain network services and allocate certain common costs.
Although promising, this model also raises some questions. Can an
operator be truly independent of utilities while they retain ownership
of transmission and distribution? And will such a system cope well with
coordinating investments in transmission and generation, given that
different generating firms that rely on the grid can often have
diverging interests?
In short, moving toward a more competitive market in electric power
generation will require innovations in both regulation and market
institutions. Maximizing the benefits from competition will also require
implementing pricing policies that more accurately reflect transmission
congestion and the costs of generation at different times (peak and off-
peak). Finally, the gains from increased competition beyond those
already being realized from today's wholesale competition may be modest
in the short run, because much of utilities' expenses are associated
with past investments, and with fuel expenses, which cannot be greatly
reduced.
Nevertheless, some efficiency gains could materialize even in the
short run: from increased utilization of excess capacity, from superior
operation and maintenance of existing plants, and from boosting labor
productivity. In the longer run the gains may be greater, since
generation accounts for about half of the cost of electricity to the end
user, and increased reliance on competition rather than regulation could
allow both better operating decisions and better investment decisions
regarding the amount, mix, and speed of construction of new plant.

STRANDED COSTS

Allowing competition would put pressure on utilities' prices and
customer base, threatening to create stranded costs. Stranded costs are
those unamortized costs of prior investments that are scheduled for
recovery through regulated monopoly rates but would not be recovered
under competition. Stranded costs for the industry as a whole have been
estimated at $135 billion--well over half the total equity value of all
investor-owned utilities. Many of the vulnerable utilities are
concentrated in California, New York, New England, Pennsylvania, and
Texas (Chart 6-3 provides a breakdown by region). Many of these
utilities would be threatened with bankruptcy if unfettered wholesale
and, especially, retail competition were allowed without providing
utilities assistance in covering stranded costs.



One source of stranded costs is past investments that turned out
differently than expected. In some cases nuclear power proved more
expensive than projected, and gas prices much lower; therefore some
investments in nuclear generators led to higher generating costs than
those of modern gas-based plants at today's gas prices. Second, in many
regions utilities overestimated power demand, leading them to build
excess generating capacity. If this capacity were fully used under the
pressure of competition, it would drive the price of power down to the
short-run marginal cost, and thus well below average cost (which
includes sunk capital costs). Although such pricing promotes short-run
efficiency, it would impose large losses on some utilities. Finally,
stranded costs also arise from regulatory obligations imposed on some
utilities but not on other suppliers, including requirements to buy
power from PURPA-qualifying facilities at prices above today's market
prices, to invest in pollution control equipment, and to fund demand
conservation programs.
In unregulated markets the possibility of stranded costs typically
does not raise an issue for public policy--it is simply one of the risks
of doing business. However, there is an important difference between
regulated and unregulated markets. Unregulated firms bear the risk of
stranded costs but are entitled to high profits if things go
unexpectedly well. In contrast, utilities have been limited to regulated
rates, intended to yield no more an a fair return on their investments.
If competition were unexpectedly allowed, utilities would be exposed to
low returns without having had the chance to reap the full expected
returns in good times, thus denying them the return promised to induce
the initial investment. A strong case therefore can be made for allowing
utilities to recover stranded costs where these costs arise from after-
the-fact mistakes or changes in regulatory philosophy toward
competition, as long as the investments were initially authorized by
regulators.
The case for allowing recovery is even stronger where stranded costs
arise from regulatory obligations imposed on utilities. Several States,
notably California, required utilities to purchase power from qualifying
facilities under PURPA at long-term contract prices based on high
estimates of future oil and gas prices, even after utilities resisted
purchasing all the capacity offered at the high prices. Utilities also
were required to fit coal-fired generators with costly pollution control
equipment, again with the expectation that costs would be recovered
through regulated rates. Utilities should be allowed to recover such
costs mandated by regulation.
To be sure, utilities should be granted recovery only of costs
prudently incurred pursuant to legal and regulatory obligations to serve
the public. Investments made after utilities are notified that
competition is coming and are relieved of their obligation to serve
should not qualify; and utilities must try to mitigate their losses. But
recovery should be allowed for legitimate stranded costs. The equity
reason for doing so is clear, but there is also a strong efficiency
reason for honoring regulators' promises. Credible government is key to
a successful market economy, because it is so important for encouraging
long-term investments. Although policy reforms inevitably impose losses
on some holders of existing assets, good policy tries to mitigate such
losses for investments made based on earlier rules, for instance, by
grandfathering certain investments when laws and regulations change.
Because stranded costs are sunk, economic reasoning suggests that
they should be recovered through mechanisms that do not artificially
reduce power consumption. One possibility is a charge levied on
transmission, but as a fixed fee rather than a marginal charge:
customers would be required to pay specified amounts, based perhaps on
their past consumption, regardless of their future use of electricity.
Since stranded costs reflect policy decisions, recovery should be
borne broadly by all parties on whose behalf the stranded costs were
incurred, including customers that switch to other suppliers. Consistent
with this principle, the FERC proposed that wholesale customers
departing a utility be assessed a contribution toward stranded costs.
Although the FERC proposal would directly apply to stranded costs
resulting only from increased wholesale competition, it could also serve
as a model for States contemplating retail competition, and serve as the
FERC approach to recovering stranded costs resulting from retail
competition in the unlikely event that the State lacked authority to
address the issue.
Most State discussions of initiatives to foster retail competition
in fact have included, as an integral part, mechanisms to recover
stranded costs. But some retail customers threaten to bypass this
process, for example, by resorting to ``municipalization.'' A municipal
utility within the franchise area of an investor-owned utility may
generate none or only some of its required power, and as a power
reseller it qualifies for FERC-mandated wholesaler access to outside
suppliers. Although municipal utilities typically serve legitimate
functions, they might at times provide a loophole for avoiding fair
sharing of stranded costs. A municipality might extend its boundaries to
encompass the premises of a large industrial customer served by the
investor-owned utility; that customer becomes eligible to buy power from
outside suppliers, using the municipal utility as conduit. Such actions
raise important issues of equity and cost-shifting, both for the local
utility and for other customers in its franchise area that may be stuck
with a larger share of stranded costs. The FERC has stated that
municipalization should not be a vehicle to escape responsibility for
stranded costs.

COMPETITIVE PARITY, UNIVERSAL SERVICE, AND ENVIRONMENTAL PROTECTION

For competition to work well, it must take place on a level playing
field: competition will be distorted if producers are given selective
privileges, or subjected to selective obligations imposed to further
even legitimate social goals. This principle raises several issues as we
move toward increased competition.
As competition grows, increasing distortions may result from some
entities having access to special privileges such as federally tax-
exempt bonds or other preferential treatment. Accordingly, reexamining
special privileges of various entities may become more important.
On the other hand, producers should not be subjected to selective
obligations. New ways must be found, as in the telephone industry, to
address universal service, assist low-income consumers, and meet other
social goals currently addressed through obligations on regulated
monopoly utilities. Continuing to impose such requirements only on some
producers would place them at a competitive disadvantage and imperil
their ability to meet these obligations. Accordingly, these obligations
would be better financed through more broadly based mechanisms.
Increased competition in electricity can also affect the
environment. To reap the advantages of more efficient electricity
markets and a cleaner environment, environmental policy will need to
respond to any risks that restructuring may pose for environmental
quality. But policy toward restructuring should also recognize those
risks and, where possible, facilitate appropriate responses. For
example, the burden of funding renewable energy sources or energy
conservation programs to reduce pollution should be shared broadly, not
placed solely on vertically-integrated utilities. Symmetrical treatment
of all players will address environmental concerns more effectively and
provide competitive parity.

CONCLUSION

Our telecommunications and electricity sectors are undergoing
sweeping transformations, which hold the promise of increased reliance
on market forces and competition, with potentially large dividends for
consumers and business. To facilitate such transformations, regulatory
and competition policy must adapt. Unnecessary legal restrictions on
entry must be removed, and regulation must be reformed to better address
those industry segments where monopoly power will persist. But blanket
deregulation will not ensure an equitable, efficient, and durable
transition to competition. To ensure a successful transition and protect
important social goals, government will have to play an evolving but
ongoing role.