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Regulatory Reality versus Theory

Progress Snapshot
Release 5.5 May 2009

by Barbara Esbin*

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Professor Eli Noam has written a thoughtful piece for the Financial Times entitled "Separating telecoms?[1]" about the "spectre" of forced separation of network infrastructure management from service provisioning that is haunting European incumbent telecommunications companies.  Professor Noam laments that discussion of the pros and cons of "functional separation" "has come to take on some aspects of a religious war, with true believers on each side issuing fatwahs on anyone who strays from their path of redemption."  The truth about forced separation, he continues, "is more complex.[2]"

Noam accepts that incumbent telecommunications carriers often carry significant market power in some essential infrastructure that enables them to charge high prices and engage in discriminatory practices or other gate-keeping behavior.  Recognition of the potential for monopolistic or anticompetitive behavior, however, does not mean automatically that forced functional separation is the best means of addressing the problem.  This is particularly true when the source of the market power is the "underlying economics of network provision, in particular the strong economies of scale and network effects which favour large providers."  Because of "the great importance to society of free flows of information," an "eternal tension" exists between "the efficacy of large scale and the benefits of open competition."

Noam suggests that European regulators seek "negotiated compacts," rather than address the discrimination problem (indirectly) through the imposition of various degrees of functional, structural or full separation (divestiture) of the operations of telecommunications companies or (directly) through additional regulation or legislation. In other words, Noam suggests that regulators offer "the carrot of non-separation" while retaining "the stick" of antitrust enforcement:

The time has come for incumbents, competitors, and regulators to fashion a grand bargain.  In it, they will drop separations – which are not a goal but a tool – in favor of specific incumbent commitments to further the goals that separation tries to achieve:

a.  accelerated network investments, especially for rural areas.
b.  complete neutrality towards any kind of content from whatever source.
c.  terms of non-discriminatory practices towards rival companies' use of their networks.

To ensure that carriers live up to the compacts, Brussels and the European states would stand ready to mount "an anti-monopoly challenge, seeking the full break-up of the offenders ..."  In effect, Noam is suggesting that rather than go at the carriers with guns drawn, regulatory authorities attempt to work out reasonable and mutually satisfactory "social compacts."  This approach was successfully employed by the U.S. Federal Communications Commission's former Cable Services Bureau once it became obvious that the drastic rate reductions imposed on the cable industry by the mid-1990s had halted much needed network and programming investment.[3]

In my recent essay, "Functional Separation, Italian Style[4]," I cautioned against abandonment of the relatively de-regulatory approach the FCC has taken since 2005 in favor of returning to a functional separation regulatory model for wireline access networks.  In view of evidence that the U.S. approach of encouraging platform competition is producing network investment, deployment and increased choices for consumers[5], reversion to a "functional separation regulatory model would require a sudden and extreme policy reversal that would render the telecommunications sector wholly unattractive to investors."

As I wrote, "[e]ven in the European Union where the issue is currently under intense examination and debate, functional separation is generally considered an extraordinary remedy, to be imposed only after a determination of significant market power in the relevant market and where less intrusive forms of regulatory intervention have failed to adequately address the risk of undue discrimination against competitors in retail markets by a vertically-integrated incumbent, and the benefits of its imposition outweigh its costs."  It is recognized that one of the costs of an overly interventionist regulatory policy is a slowing or halt of network infrastructure investment and that aggressive investment decisions in the U.S. have followed forbearance from the imposition of legacy common carrier regulations on new broadband facilities.[6]

Given the importance of extending our national broadband footprint, as evidenced by the broadband provisions of the American Recovery and Reinvestment Act, actions likely to put a damper on private investment in broadband networks would appear to be contrary to the public interest.[7]  According to a recent speech given by Christina D. Romer, Chair, Council of Economic Advisors, entitled "Growth without Bubbles[8]," the keys for sustainable recovery from the bursting of the recent economic bubble are business investment and exports.  Government stimulus spending, while necessary, cannot be the sole driving force for robust and sustainable economic growth, rendering policies that encourage private investment in vital infrastructure that much more important.  The prescription for financial markets, according to Romer, is reliance on market competition as the first line of defense, coupled with oversight to monitor for systemic threats and appropriate regulation for corrective actions.

Achieving accelerated network investment is at the top of Professor Noam's list of policy goals that functional separation attempts to achieve.  In his view, the American experience indicates that structural solutions, "while intellectually appealing, create major transaction costs and retard network evolution.  There are better ways to protect users and competitors."  Professor Noam suggests that Brussels, in seeking a "European solution," should make the effort to learn from the American experience with structural separation.  This is an important admonition, especially at a time when many here are urging the FCC to adopt a more "European" style or interventionist approach to broadband network service providers.  If the question is how to get providers to extend or build broadband networks where today it is not profitable to do so, it is highly unlikely that the answer is by increasing regulation that constrains their ability to earn a reasonable return on invested capital.

Professor Noam's recommendations concerning telecommunications policy are significant for several reasons, not the least of which is that Noam, based on his study of the actual performance of telecommunications companies[9], has gone from advocating remedial use of structural separation to strongly doubting its efficacy and wisdom.  Noam compared the post-divestiture performance of AT&T (in terms of growth, prices, employment, market capitalization, equipment, research & development, etc.) to that of carriers in Canada, which did not institute structural separation. 

Twenty-five years later, the US system had less of local competition, of R&D, sectoral growth, employment increases, and growth in market capitalization.  Consumer prices in the US were comparable, and business and wireless prices were lower.  The structural separation may have made in sense in theory, but the numbers do not substantiate the benefits in practice.

The difference between the elegance of a regulatory theory like structural separation and the messy reality of the U.S. approach in segmenting the company along the lines of competitive and non-competitive sub-markets resulted in never-ending regulatory battles and a fantastic expenditure of time and money with little practical benefit.  "Partly as a result, the US telecom sector which was by far the world's advanced a quarter century ago is now just a decent also-ran."

Professor Noam's dispassionate analysis of the source and nature of the problem of companies with significant market power in the telecommunications sector (including cable networks and the Internet) stands in stark contrast to the recent publication by Free Press, entitled "Dismantling Digital Deregulation:  Towards a National Broadband Strategy[10]."  Contrary to Noam's assessment that the forced restructuring of AT&T is at least partly responsible for the U.S. telecom sector's current status as a "decent also-ran," Free Press cites deregulation as the "root of America's broadband decline."  Free Press essentially calls for the reversal of nearly every de-regulatory decision made by the FCC since 1996 and the imposition or re-imposition of pervasive telecommunications regulation, without regard for the costs of such a radical reversal of policy.

First, before we even contemplate going down that route, policymakers should survey the actual (not imagined) landscape of broadband network investment, deployment and services in the U.S. and assess whether the policies and regulation in place today are working.  Although I agree with Free Press insofar as it calls for an evaluation of the regulatory policies of the last decade, I question whether such an evaluation will support Free Press' brief that every deregulatory policy implemented has been an abject failure, that the broadband market today is an "uncompetitive duopoly," and that we are an America in "decline" when it comes to broadband service offerings.  Rather, such an evaluation of regulatory policy is far more likely to demonstrate that the existing approach that encourages network investment and facilities-based competition has produced positive results in the deployment of broadband networks and the provision of voice, video, and data services.  In the words (as best I remember) of former Acting FCC Chairman and long-time Commissioner Jim Quello, "If it ain't broke, don't break it!" 

Second, policymakers should realize that theoretical regulatory schemes based on simplistic economic theory can, and often do, become mired in complexity, bogged down with delay and are subject to political influence in their implementation.  For these reasons, proposals for new or renewed regulation must be subjected to rigorous cost/benefit analyses.  These analyses should address the risks inherent in implementation (and its likely imperfections) and seek verification that the supposed benefits are more likely than not to materialize.  Above all, we must move away from the risks of "faith-based[11]" regulation.

Telecommunications policy debates tend to become polarized, with a false choice presented between regulation versus de-regulation.  The real issue is determining when and how much regulation is actually necessary to protect consumers and preserve competition.  Alfred Kahn is often cited[12] as having said something to the effect that it is not that markets have to work better than regulation; they need only work as well as regulation to be preferable, and it isn't that hard to work as well as regulation.  Regulation inevitably imposes costs and generates unintended and often unhappy consequences.  If a proposed form of regulatory intervention is not likely to work better than reliance on competition, albeit even "imperfect" competition, then we are better off without it.

Professor Noam's thoughtful suggestions about how to strike a grand regulatory compromise on structural separations deserve serious study and consideration by America's regulators.  They may also provide a template for discussion about how to resolve the highly polarized and seemingly never-ending debate over whether we need to impose common carrier or net neutrality mandates on broadband Internet access service providers.

* Barbara Esbin is a Senior Fellow and Director of the Center for Communications and Competition Policy at The Progress & Freedom Foundation. The views expressed in this report are her own, and are not necessarily the views of the PFF board, fellows or staff.

1.     Eli Noam, Separating Telecoms?, FT.com, May 15, 2009, http://www.ft.com/cms/s/0/8b149b84-41a1-11de-bdb7-00144feabdc0.html.

2.     These observations are equally applicable to the lamentable "net neutrality" debate now raging on both sides of the Atlantic.

3.     See, e.g., In the Matter of Social Contract for Continental Cablevision, Memorandum Opinion and Order, 11 FCC Rcd 299 (1995).  The Social Contract was negotiated between Continental Cablevision and the FCC to resolve numerous outstanding cable rate cases without an admission of any wrongdoing; it was designed to provide upgrade incentives for the cable operator and to provide rate stability and increased quality of service for consumers. 

4.     Barbara Esbin, The Progress & Freedom Foundation, Functional Separation, Italian Style, Progress on Point No. 16.9, Mar. 2009, http://www.pff.org/issues-pubs/pops/2009/pop16.9functionalseparationitalian.pdf.

5.     See, e.g., Jeffrey A. Eisenach, Ph.D., The Progress & Freedom Foundation, Broadband Policy: Does the U.S. Have It Right After All? Progress on Point No. 15.4, Sep. 2008, http://www.pff.org/issues-pubs/pops/2008/pop15.14USbroadbandpolicy.pdf; John W. Mayo, Building the Broadband Economy and Society, Oct. 19, 2007, http://www.itif.org/files/MayoPresentation.pdf.

6.     Robert W. Crandall & Debra J. Aron, Investment in Next Generation Networks and Wholesale Telecommunications Regulation, Nov. 3, 2008, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1294910.

7.     American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, 123 Stat. 115 (2009) (Recovery Act).  http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.pdf.

8.     Christina D. Romer, Council on Foreign Relations, Growth without Bubbles, May 12, 2009, http://www.cfr.org/content/publications/attachments/Growth Without Bubbles.pdf.

9.     Eli Noam, Did AT&T Die in Vain? An Empirical Comparison of AT&T and Bell Canada, 61 Fed. Comm. L.J. 119 (2008), available at http://www.elinoam.com/eli/at%26t_bell_canada.pdf.

10.    S. Derek Turner, Free Press, Dismantling Digital Deregulation: Toward a National Broadband Strategy, http://www.freepress.net/files/Dismantling_Digital_Deregulation.pdf (last accessed May 20, 2009).

11.    Kostas Liopiros, The Sun Fire Group, FCC Reform, Jan. 5, 2009,

12.   Barbara Esbin, The Progress & Freedom Foundation, Functional Separation, Italian Style, Progress on Point No. 16.9, Mar. 2009, http://www.pff.org/issues-pubs/pops/2009/pop16.9functionalseparationitalian.pdf.



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