Rules for sharing local telephone networks would make more sense if they accounted for constitutional concerns

By Randolph J. May
Legal Times, October 8, 2001

I understand. It's not easy to get excited about a case involving TELRIC. Yes, TELRIC-Total Element Long Run Incremental Cost, an arcane cost methodology devised by the Federal Communications Commission to set the prices at which incumbent local telephone companies like Verizon must share parts of their networks with such new competitors as AT&T, MCI, or Allegiance Telecom.

But the outcome of Verizon Communications Inc. v. FCC , which considers the legality of TELRIC and will be argued before the Supreme Court on Wednesday, likely will have a significant impact in determining the future of local telephone competition. At the same time, it illustrates how a regulatory agency would have reached a sounder policy result if it had been more sensitive to the spirit-even if not necessarily the letter-of the Constitution.

In my view, TELRIC frustrates a key objective of the Telecommunications Act of 1996-encouraging new entrants to construct their own facilities, and incumbents to modernize what they've already built.

That's why I hope the incumbents win the case, either on the basis that the FCC lacks statutory authority to require TELRIC, or because TELRIC violates the Fifth Amendment's takings clause. But it won't be easy for the incumbents to prevail.

Hopelessly Complex

The 1996 act did not prescribe a specific methodology for setting sharing prices-it merely states that the rates shall be based on the "cost" of providing the network elements. In the context of what the Supreme Court in Duquesne Light Co. v. Barasch (1989) characterized as "often hopelessly complex" ratemaking proceedings, the courts usually give regulators wide berth to interpret such nebulous terms.

And all that is required to pass constitutional muster is that the rates not be so "unreasonable" as to confiscate the incumbents' property, according to the Supreme Court's century-old formulation in Smyth v. Ames (1898). This simply means that a "company is entitled to ask . . . a fair return on the value" of its property employed in providing service. There is enough ambiguity in terms like "unreasonable" and "fair return" that the Smyth Court felt comfortable suggesting that the constitutional inquiry in ratemaking proceedings "will always be an embarrassing question."

But even if the Court upholds TELRIC's legality, the FCC would have reached a sounder policy result-one more consistent with the 1996 act's vision of competing infrastructures-if it had acted with more sensitivity to the property rights concerns that animate the incumbents' taking claim.

To see why, look at the context of Verizon. Because local telephone service historically had been provided on a monopoly basis, Congress recognized in the 1996 act that it had to take additional measures, beyond declaring the end of exclusive franchises, to promote competition. It knew, for a transitional period, at least, that new entrants might need some access to the incumbents' facilities to that end.

The first case under the 1996 act to reach the Supreme Court was AT&T v. Iowa Public Utilities Board (1999). There, the Court determined that the FCC had acted unlawfully by promulgating rules giving the new entrants virtually unlimited access to the incumbents' networks, even though the statute provided that sharing would be required only if "necessary," and if the ability of the new entrant to compete would be "impaired" without it. Therefore, the Court remanded for the agency to develop meaningful restrictions on the sharing requirement.

Justice Stephen Breyer's concurrence is a pithy lesson in regulatory economics that captures the unsoundness of the FCC's rules. "It is in the unshared, not the shared portions of the enterprise that meaningful competition would likely emerge," he wrote. "Rules that force firms to share every resource or element of a business would create not competition, but pervasive regulation, for the regulators, not the marketplace, would set the relevant terms." Unfortunately, two and a half years after Iowa Utilities Board, the FCC has yet to place any meaningful limits on the sharing requirement. And TELRIC only exacerbates things.

Economists generally agree that, in transitions to competitive markets, it is forward-looking (or incremental) costs, not historical costs, that matter most. This is because incumbents and new entrants alike don't consider sunk costs in making entry, pricing, and investment decisions. Instead, they consider the costs of producing an additional increment of the service. While TELRIC is a forward-looking methodology, it is too extreme, tilting the balance in the direction of subsidizing inefficient competition.

It achieves this undesirable result by basing prices on unrealistically low estimates of what it would cost today to build almost an entirely new network using only the most up-to-date, least expensive technology. In the decision now under review by the Supreme Court, the 8th Circuit found the statutory term cost sufficiently ambiguous to give the FCC leeway to choose some form of forward-looking, rather than historical, cost methodology. But it held that such discretion is not broad enough to allow the FCC to require sharing rates based on TELRIC, which it characterized as "the cost some imaginary carrier would incur by providing the newest, most efficient, and least-cost substitute for the actual item or element which will be furnished."

This assumption that the incumbents will replace virtually their entire networks at any one time with the latest least-cost technology is indeed fantasy. As noted Cornell University economist Alfred Kahn has explained, "In a world of continuous technological progress, it would be irrational for firms constantly to update their facilities in order completely to incorporate today's lowest-cost technology, as though starting from scratch, the moment those costs fell below prevailing market prices."

The upshot is that the existing excessive sharing requirements, together with TELRIC prices, discourage new facilities construction by the new entrants and incumbents alike. The new entrants lack incentive to invest in their own facilities when they can lease the incumbents' more cheaply than they can build. And the incumbents are discouraged from undertaking investments necessary to innovate when they know that any competitive advantage derived from their investments will be dissipated by the sharing requirement.

Why has the FCC pursued such a course? The best explanation is that the agency, however well-intentioned, became fixated on creating competitors, rather than competition. In his book, You Say You Want A Revolution, former FCC Chairman Reed Hundt, who led the agency at the time the TELRIC and sharing rules were developed, stated that he "aspire[d] to provide the new entrants . . . a fairer chance to compete than they might find in any explicit provision of law." Hundt boasted that he had created 250 new local telephone companies.

The problem is, as we have learned in the financial distress now gripping the telecom sector, that most of these companies were induced to enter the market on a vastly overextended basis. They relied predominantly on reselling the incumbents' facilities. So when the downturn hit, they had less ability to respond flexibly to the new economic conditions.

Second Chance

Given the judicial proclivity to avoid arbitrating what the Supreme Court in Duquesne politely called the "economic niceties" of ratemaking, the FCC may escape a second high court rebuke regarding its implementation of the 1996 act. But in regulating with an eye toward deliberately giving the new entrants a "fairer chance" to compete, the commission made the competition less fair for incumbents.

And there's the constitutional rub-a less fair chance to compete necessarily impacts the ability to earn, in the Smyth formulation, a "fair return" on property in a way that implicates the Fifth Amendment.

I wouldn't bet my house that the incumbents will prevail in Verizon. But I'd bet all the living room furniture that, in devising its network sharing rules, a greater appreciation by the FCC for the spirit suffusing the Fifth Amendment's takings clause would result in policies more consistent with the competitive vision of the 1996 act.

Randolph J. May is a senior fellow and director of communications policy studies at the Progress & Freedom Foundation in Washington, D.C. The views expressed are his own and do not necessarily reflect the views of the foundation.

© 2001 Legal Times. All rights reserved. This article is reprinted with permission from Legal Times.