The Prerequisites to Competition:
Two Proposals to Reform Universal Service and Interconnection

Eli M. Noam

Tel. 212-854-4222
[email protected]

Professor of Finance and Economics
Director, Columbia Institute for Tele-Information
Graduate School of Business, Columbia University

Presented at the Munchner Kreis Congress on
"Regulation and Competition in Telecommunications - an International Comparison"

September 26, 1995

1. Reforming Interconnection
1.1 The Importance of Interconnection

In 1982, AT&T was split up by the American government. In Japan, the Ministry of Posts and Telecommunication is now considering a similar policy towards NTT. In both cases, the companies have strenuously resisted a massive government intervention pursued in the name of deregulation. But in the future, divestiture may not be state-imposed at all, but rather company-initiated, and it may be in the telecommunications companies' own interest to split themselves up. AT&T did so in September 1995 in a second and voluntary divestiture.

All this is part of the logic of transformation in telecommunications, in which service competition leads to infrastructure competition, which in turn leads to interconnection, unbundling, systems integration, and eventually radical corporate restructuring.

In Europe, of liberalization of unfrastructure is currently the priority. In the U.S. this is also the case for local service, in the new legislation, before the Fcc and in the state utitlity commissions. But the issues are moving beyond liberalization to interconnection and universal service.

With liberalization of entry, multiple networks emerge. They must become linked with each other through various interconnection arrangements. Interconnection, in turn, is fairly meaningless without multiple physical interfaces. If an incumbent network offers an entrant interconnection at a far-off point, little is resolved. Thus, interconnection and unbundling of network functionalities into "modules" go hand-in-hand.

The tension between the integrative and pluralistic forces is most pronounced on the front where they intersect: the rules of interconnection of the multiple hardware and software subnetworks and their access into the integrated whole. As various discrete networks grow, they must interoperate in terms of technical standards, protocols, and boundaries. In the networks of networks, the interconnection of networks becomes critical. This is not a new issue. In the U.S. debate over interconnection go back to the 19th century, once the original Bell patents had expired. Interconnection became a tool for AT&T to bring the independant telcos into its orbit. Similar battles took place in Sweden and Great Britian. In the new round of entrants in the 1970s, AT&T's obstruction against interconnecting its new entrants eventually led to its break-up of the government. Control of interconnection by any entity, whether by government or by a private firm, is the key to the control of the telecommunications system itself. Open and competitive interconnection is the mark of truly open and competitive telecommunications markets.

Today the number and type of entities is great and growing. In transmission, they are:

On the higher levels of applications and content, interconnection becomes an issue of access and interoperability of entities such as:

Given the multitude of entities, their points of intersection are even more numerous and growing, and so is the number of disputes and issues -- technical, financial, operational, regulatory, inter-national, content-wise, etc.

1.2 Why Regulate Interconnection?

The diversity and complexity of the matrix of inter-relations among these participants raises the question why their interconnection should be an issue for public attention, any more than the relation among the various participants in the manufacturing, distribution, and service of automobiles or computers. Need government enter the picture? In a competitive market, it is necessary to mandate interconnection, or to establish markets in intermediate inputs, or to define rights and obligations? There are two major explanations which coexist uneasily.

1. The Anti-Monopoly Perspective.   The most common explanation for the regulation of interconnection is that of monopoly power by an incumbent. Given the incumbent's head start of a full century, a new entrant cannot hope, it is argued, to succeed as a standalone entity. Yet, the entrant must reach the customers of the incumbent and, in turn, be reachable by them. Even if the newcomer is more efficient than the incumbent, the inertia of the latter's customers will keep them where they are, thus giving the incumbent advantages of scale, scope, and positive network externalities. An alternative for an entrant would be to replicate a full-fledged, stand-alone, end-to-end rival network and tough it out until it has caught up with the incumbent in size and scope, but this is a much costlier and riskier strategy than gradual entry and roll-out. Thus, if one wants to encourage competition to a strong incumbent, one must accompany it with an assurance of interconnection. And if the survival of fledgling competition is at stake, this rationale can be expanded to justify interconnection on terms that are favorable to the entrant as an "infant company."

Closely related to the anti-monopoly argument is what might be called the common carriage rationale. A common carrier must provide service to any interested customer, even to its competitor. It must carry all traffic brought to it for carriage, whether from a small user or from a large one that aggregates the traffic of several users. The common carriage rationale is similar to that of the anti-monopoly explanation, but it does not logically permit an infant industry treatment of the entrant that is more favorable than that afforded to other users.

The flip side of the anti-monopoly rationale and its common carriage variant is that if a carrier had no market power, it would owe no interconnection or non-discrimination to anybody. In this case, the carrier is a normal commercial entity doing business as it sees fit. This seems quite reasonable, until one recognizes that this means an asymmetrical arrangement among carriers, because a small carrier can interconnect and reach a large carrier's customers, but not vice versa, because only the large carrier has market power. Similarly, the entrant can use the larger carrier whenever the latter has a service element that is cheaper or better, but when the entrant carrier itself has such superior service, it need not reciprocate unless it has achieved bottleneck power itself. This creates a "heads-I-win-tails-you-lose situation."

Furthermore, not only does this asymmetry skew competition, but also it is unstable. If there are no more interconnection rights when the bottleneck power of the incumbent is gone, then the determination of that point becomes all-important, and will no doubt be fiercely fought over. The question, after all, is not an easy one to answer conceptually or empirically, and may vary by location, service, customer class, and year. For example, suppose that one carrier has a national market share of 60%. Its rival is much smaller, but has 70% of San Francisco, and 80% of inter-airline communications. Who has market power? Who must grant interconnection to whom?

2. The Anti-Fragmentation Perspective.   Next to the anti-monopoly explanation, the other major rationale for the regulation of interconnection might be called the "anti-fragmentation" or the "network of networks" rationale. This view centers on the positive externalities of networks. There is a public interest in permitting customers of networks to link with each other via interconnection. Hence, interconnection is designed to provide an element of integration to the increasingly disparate network environment. Whereas monopoly carriers in the past provided such integration inside their own organizational sphere, now integration must take place across carriers. Information flows across numerous pathways, in a chain of transmission involving half a dozen carriers. Indeed, with packet switched communication, which may be the main-stay of much of future communications (e.g. by fast-packet or cell-based asynchronous transfer mode( ATM) communication), information between two points may travel simultaneously over a wide variety of paths. In such an environment, interconnection rules are a transactioncost reducing arrangement, and as such are similar to transaction cost reducing arrangements in other parts of the economy, such as legal tender for currency, the law governing commercial paper, or the first sale doctrine. The interconnection rules may reduce some freedom of negotiation, but they also facilitate commerce and transactions. They establish symmetry in the treatment of various carriers, and eliminate continuous market power tests.

Today, the anti-monopoly and the anti-fragmentation views coexist uneasily, partly due to fuzzy regulatory thinking, but they have a very different perspective for the future. In the anti-monopoly view, the regulation of interconnection is an essentially transitional task that will fade away with the emergence of competition. Interconnection regulation will, therefore, become less important with time. In contrast, the anti-fragmentation rationale comes to the opposite conclusion. As open entry permits more and more carriers to offer services, the need for basic rules for their interaction becomes increasingly important if the overall network infrastructure is not to fragment into incompatible part-networks. The anti-monopoly view is asymmetric, requiring interconnection by large carriers, but not by their competitors. In contrast, the anti-fragmentation view is symmetrical, applying the principle of interconnection to all carriers.

On balance, the anti-fragmentation issue is more significant in the long term because the anti-monopoly issue is transitional only, and part of large regulatory intervention. How should, then, interconnection be set in the future? Fortunately, a simple solution is possible which I call "Third-Party Neutral Transmission." It will be developed in the context of discussing prices.

1.3 Interconnection under Competition:
The Principle of this Third-Party Neutral Transmission

Interconnection comes with a variety of problems. None is more contentious than its price. The setting of access charges can be a tool for regulators to finance unrelated policy goals, for incumbents to frustrate competition, and for entrants to grab a subsidy. Agreements on price rarely materialize in unregulated markets with unequal bargaining powers because a profit-seeking incumbent lacks the incentives to grant interconnection to a rival unless it can recoup the losses of its monopoly rent. With voluntary agreements not forthcoming, government enters the field. And with government in the picture, access charges become less a mechanism for compensation and more a tool for broader policy. The challenge for regulators becomes setting prices for an intermediate good--access-- so as to encourage entry by newcomers, avoid inefficient entry, and provide an incentive for efficiency and to upgrade.1

The pricing options for interconnection charges are:

  1. Zero-Charge
  2. Stand-Alone Cost
  3. Marginal-Cost Pricing
  4. Incremental Cost Pricing
  5. Fully-Distributed-Cost (FDC) Pricing
  6. Lump-Sum Fee
  7. Per-Unit Charge
  8. Price Caps
  9. Two-Part Tariffic
  10. Ramsey Pricing
  11. Capacity-Based Charge
  12. The Efficient Component Pricing Rule (ECPR)
  13. Unregulated Prices
  14. Wholesale Prices
  15. Wholesale Price Under Third-Party Neutral Transmission.

It would take us too far afield to analyze the pros and cons of each of these options. Most require substantial regulatory resources, as subject entrants to exclusionary prices. A much simpler option is to set the interconnection charge as a wholesale charge, of the kind payable by a large user rather than a retail user. A retail charge will leave no margin for an interconnector to compete for customers.

One should think of an interconnector as a user. Of course, there are some technical issues, dealing with regulating and network management functions. Access to the signaling network and other functionlities would have to be paid for additionally.

Treating competitive networks as ordinary customers greatly simplifies administrative arrangements, classification rules, and disputes over efforts to benefit from different prices for similar services. However, it also creates incentives for incumbents to charge usage prices even for services with costs that are not traffic-sensitive in order to charge a large fee to a competitive network.

Basically one major principle suffices to establish interconnection, set competitive interconnection prices, and thereby maintain integration in the networks of networks, along the line of the anti-fragmental rational discussed above.

The principle, called "Third-Party Neutral Transmission" is as follows: Once a carrier accepts traffic from a customer to transmit, it cannot accept only selected parts of that traffic based on where they originated. It can discriminate against a potential customer by not interconnecting with it. But it cannot discriminate against a customer´┐Ż s customer by carrying traffic only selectively. This principle of TPNT preserves interconnection, access pricing the non-discrimination and free flow features of common carriage that are of major advantage to society, without making private carriers into common carriers as establishing complex regulations..

Thus, if carrier A does not wish to serve B, or at prices that are unfavorable, all that B has to do is find a C or D which are connected to A, directly or indirectly, and thus gain access to A's network. The system is basically one of arbitrage. It is similar to other transaction cost reducing arrangements in society, such as commercial paper at legal tender.

The same principle of Third-Party Neutral Transmission also resolves the need for any regulation of access changes. Under TPNT, arbitrage becomes easily possible, which drives down interconnection charges to the rates offered to large uses. i.e. to wholesale prices. These wholesale prices become the interconnection or access price plus charges for signaling use.

2. Reforming Universal Service

A major problem with the wholesale-retail price approach is that important retail prices are kept for reasons of public policy below cost, such as for many residential and rural customers. Even a competitive cost-based wholesale price hence might not be low enough to permit the interconnector a retail profit on top of it. This is, again, the price squeeze problem, except that in this case it is induced by a well-meaning regulation which giveth residential uses a low retail price but taketh the likelihood for rival entry.

Facing this situation, entrants have demanded to receive a subsidized wholesale price, i.e., a discount from the retail price. But this would (a) require the other customers of the incumbent to subsidize the entrant and its customers; (b) it would distort the high-capacity market, since large users would presumably engage in efforts to obtain such favorable rates, too.

The reform of universal service is an essential component to any rational retail pricing system, which in turn is the prerequisite to a rational interconnection pricing system. To create market-based interconnection therefore requires to reform the system of price supports for residential and rural service. In particular, to move from supporting some carriers (through internal redistribution among its customer classes) to the direct support of benefitted customer classes. This means that retail prices would be set by market forces, based on cost and competitive conditions. Any subsidy to some customers would be extended to the customers themselves, through a system of vouchers, which would be portable among different carriers and service providers. (For low-density regions, some supplementary carrier support might be instituted). This is now discussed.

There is great urgency to reform universal service financing. In the United States, the Administration, Congress, and the Federal Communications Commission have identified the issue as one of priority. The new telecommunications law, if enacted, requires the FCC and the states utility commissions to design a new system. Congress has recognized that the introduction of new competition, especially in local service, and the implementation of interconnection, all require an overhaul of the universal service system. Both chambers of Congress have held hearings. Private sector organizations, (for example, MCI, Teleport, MFS, United States Telephone Association) have advanced proposals. Across the Atlantic, the European Commission has addressed the question in a Green Paper.2 And in Japan, the government has revised the payment system for local access with a consideration for universal service.3

What is universal service? A universal telecommunications service goal, simply defined, is a public policy to spread telecommunications to most members of society, and to make available, directly or indirectly, the funds necessary. In the past this has usually been accomplished through the establishment of a monopoly system in the provision of telecommunications, with the monopolist's profits used to support some of its endusers, especially residential and rural customers. More recently, competitive inroads into segments of telecommunications (and, in the USA, the AT&T divestiture) have limited the ability to generate the funds for such internal cross-subsidies. Since the demands for funds for maintaining universal service have not declined, the old system has been propped up with great complexity. Governments have tried to conduct social policy with the tools of industrial structure policy, and have been less and less successful in either. Similarly, their plans for upgrading telecommunications infrastructure have been affected by the question whether some segments of society would fall behind. For the longer term, therefore, the question must be faced squarely: if we want to continue to assure the electronic interconnectivity of all members of society, how will we pay for it in a competitive environment?

Of course, the greater efficiency of competition, new technology, and a narrower targeting of benefits may reduce the magnitude of the necessary funds. But they will not do away with a core of politically mandated support to the rural population or to the poor. One can disagree about the magnitude involved but not that it will be nonzero. Therefore the question still remains: how do we pay for the necessary subsidy? This question will not go away by the invocation of competition, but is actually made more urgent by it since monopoly profits would no longer be available for funding. Food production and distribution are highly competitive and efficient, and yet we support the food prices paid by the poor, by school children, etc. One should not confuse issues of production and resource efficiencies with those of distributional allocation.

It is often asked, for which services should universal service be extended. It is to those services where

(a) Market demand has resulted in a substantial majority of the population acquiring the service.

(b) A substantial portion of the remainder desires to acquire the service, but its price is a major burden.

(c) Positive externalities exist, i.e., the use by A of the service also benefits B.

(d) There is a significant disadvantage to not participating in the service.

If these conditions are met, a rebuttable presumption is created for the political system to consider policies to spread the service.

In the USA, the elements of financing universal service include a motley collection of contributory elements.4 There are inter-industry transfers such as access charges by interexchange and mobile carriers into local exchange networks. There are high cost funds, toll pools, long-term support, agreements, lifeline contributions, and universal service funds. Major inter-customer transfer mechanisms also exist, such as "contributory" charges on business customer services, special rates averaged across customers and geography, etc. And there are some direct governmental credit contributions, primarily by Rural Electrification Administration loan guarantees.5

These and a myriad of other state and federal pricing and allocation arrangements create a system of bewildering aggregate complexity. Society at large, including its policy-makers, has long lost the ability to see the big picture or to judge the present system by some criteria of fairness of efficiency. As competition increases this system is coming under major strains. It has to change. But how?

2.2 Principles and Options for a Reformed Universal Service.

Any new type of revenue raising measure should meet the following criteria as closely as possible.

  1. Competitive neutrality. A new financing system should not skew the relative market strength of any carrier or of consumers' choice.
  2. Structural neutrality. It should not favor or disfavor integrated or unbundled provision of a service.
  3. Technological neutrality. It should not favor any type of transmission technology over others.
  4. Applications and content neutrality. It should not favor any particular use of telecommunications or type of message.
  5. Geographical neutrality. It should not burden any parts of the country disproportionately.
  6. Transitional Neutrality. There should be no shocks or windfalls to any participants due to transition to a new system.6
  7. Jurisdictional neutrality. The new system should be integrable into the federal-state regulatory system.

Other criteria for a successful revenue raising system are the following five "friendlinesses".

  1. Political friendliness. For acceptability, there should be no rate shocks, windfalls, or unilateral advantages to some competitors.
  2. Collection friendliness. Stability in generating the targeted revenues.
  3. Administrative and user friendliness. Keeping things simple is a key requirement.
  4. Integrability friendliness. Existing universal service schemes need not be overturned first.
  5. Productivity friendliness. Incentives to production efficiencies.

In structuring a system of contributions towards universal service, these are, broadly speaking, the alternatives:

  1. Protect the system of internal cross-subsidization within the major carriers. This is the traditional arrangement under a monopoly system. In a competitive system it is not sustainable since it exposes the subsidizing customers to cream-skimming entry by new entrants.

  2. Expand above-cost charges for access to the public network. This strategy presupposes access to "the" public network, an increasingly tenuous construct. In a multi-carrier local environment, there would be uneconomic incentives for carriers to avoid interconnection. The access charge approach violates several neutralities, and does not provide much incentive to cost-cutting.

  3. Increase subscriber line charges. All local lines would be assessed a flat charge. The problem here is that what works in the single-LEC world will not work in a future of mobility, portability, band-width-on-demand, private networks, and matrix architecture. The concept of a well-defined "subscriber line" will become quaint and unworkable even if it is extended beyond the LECs, which it inevitably must.

  4. Rate rebalancing. Since a major position of universal service is based on internal distribution within companies, one can target the existing rate structure. "Rebalancing" means to increase residential rates and to lower business-oriented and long-distance services, given a competitive environment with its prices that are cost-based. By itself, rebalancing is not a method of raising revenues for universal service but of shrinking the existing burden. The two are closely related. But whatever universal service subsidy remains must still be raised in some way. Rebalancing is therefore a starting-point rather than a solution to the question of alternative financing methods. Cutting a budget does not answer the question of how to pay for the remainder.

  5. Public financing: general tax revenue. Funds to support universal service could be raised by the income tax, general sales tax, etc. This system would be the most neutral, and be as equitable as the tax which would be levied (progressive for income tax, regressive for sales tax), but in the present budget environment it is not a realistic proposition.

  6. A telecommunications sales or ad-valorem tax. This would be levied on customers telephone bills of LECs and of other carriers. This system, too, would suffer from the political difficulty of raising a new tax. It would have to deal with difficult borderline issues of what and who would be included in the definition of telecommunications -- Equipment? Computers? Software? Information and entertainment services? It would not be neutral with respect to competition, structure and application. And it would not account for already existing universal service mechanisms.

  7. A tax on telecommunications equipment. Such a tax, too, would raise difficult border-line questions: would computer and TV equipment be included? Several neutralities would be violated.

  8. Property taxes on carriers. The advantage would be that they tax fixed rather than variable costs, and therefore distort operations the least. However, the practical problems would be serious and there would be a disincentive to investments and quality.7 This might suggest a Henry George inspired land tax on carrier properties. A land tax excludes improvements on the land, such as structures. But the land tax would have to be fairly high, and it would distort technology choice and inter-carrier competition.

  9. A surcharge on long-distance revenues. By targeting one particular service such a tax would be non-neutral.

  10. A comprehensive telecommunications value-added tax. A telecom-VAT would be levied on all carriers, services (including enhanced services, equipment, etc.). It would be the most neutral of all telecommunications-specific levies, but it would raise the political problem of a new tax, plus border drawing questions and enhanced service issues that will be discussed below.

  11. A voucher system based on a sectoral telecommunications value-added account system. It provides vouchers for customer choice and allocates burdens neutrally on all carriers, integrates existing universal service schemes and provides credits for universal service performance. I call this a NetTrans Account System. It is the recommended system.

2.3 The Net-Trans Account System

At their most basic, NetTrans Accounts are not an additional levy. They are rather a way of keeping score that all carriers pay a proportionately similar share to the maintenance of that type of universal service which the political process has decided upon. Only insofar as some carriers may be contributing less than others would the NetTrans accounting result in transfers to and from the accounts. This system also means, importantly, that one need not (though one could) eliminate or change existing contribution programs. They are simply taken into account and credited in the process.

The system would be initiated at the same time that local competition would be fully permitted, with full interconnection and collocation rights. It would also be tied in with a cost-reduction mechanism of competition, so that inefficient carriers could not shift their costs to more efficient ones.

The system in a nutshell:

Benefitted users receive "virtual vouchers" that are usable at any carrier. The vouchers are financed by a universal service fund, into which carriers pay a flat percentage of their transmission path revenues, and they are given credits for (a) transmission charges paid to other carriers, (b) for certain universal service contributions made otherwise, and (c) for vouchers used for its service.

An important feature of the NetTrans account system, gleaned from the value added tax concept, is to give credit for the cost of inputs. In this case, those are transmission path inputs purchased by a carrier from other carriers. For example, long-distance or mobile carrier reaches its customers, or its customers' called parties, through local exchange companies. It pays for such access through access charges. The carrier's own transmission path value-added are its transmission path revenues minus payments for such services to others carriers. This feature of the plan means that there is no accumulation of tax upon tax, as would be the case with a sales tax imposed at each stage. In consequence, there are no advantages to being vertically integrated across multiple stages.

The logic of subtracting input payments is to avoid multiple payments. But if that input is exempt from payment, there is no reason for a subtraction. For example, if the interconnected carrier is a foreign government monopoly carrier from which no NetTrans payment may be obtainable, then payments to such a carrier should not be subtractable. Similarly, a carrier's use of other ESPs' services, or its equipment input purchases, are not deductible, since these firms do not contribute to NetTrans.

With these steps, we can define and estimate a revenue base for the charging account mechanism. If we know how much of a universal service contribution we must generate in total, we can calculate a debit percentage. That percentage rate, applied to any carriers net transmission path revenues, would then be its debit in its NetTrans account. The percentage would have to be periodically recalculated to keep from over- or underrecovery. In calculating the amount of overall universal service burden, there needs to be a mechanism to keep costs declining. This will be elaborated below.

At present, carriers contribute to universal service in a variety of ways. Some pay access charges that are substantially above cost. Others serve rural areas at prices that are below cost. Etc. These contributions should be credited against the universal service fund debit.

One major advantage of the NetTrans account system is that is does not force an already existing subsidy mechanism to change. Nor is it dependent on such a change. A rebalancing of rates could take place, but one need not wait for it, because NetTrans can accommodate either situation. What it does to credit all these programs within a general calculation of share of burden. If access charges, toll pools, or lifeline contributions have already been made by a carrier, they are taken into account, to the point that high burdens through other contribution programs will lead to net repayment. If the present hodge-podge of contribution programs should, by some miracle, be perfectly equitable in its net financial burdens on the various carriers, no additional transfers at all would have to take place.

It is not necessary here to analyze what types of services might be supported, for how long, what kinds of users might benefit, and whether support ought to be broadbased and expansionary or narrow and means-tested. For example, the mechanism could be used for upgrading of the communications infrastructure, if such is decided upon. What is critical, however, is that the payment system is neutral with respect to carriers. To do so, after defining the benefitted class of users and services, is to provide these users with "virtual vouchers". They would choose carriers freely; and the chosen carrier would then be credited in its NetTrans account for the value of the voucher. The customers' telephone could reflect the credit, which would be fully passed on to them.8

2.4 Universal Service Reform as a Prerequisite

The emerging network of networks will exert competitive pressures on cost and therefore on many prices, thus making telecommunications more affordable to some. But it will be impossible to maintain the traditional redistributive system of generating subsidies and transferring them internally within the same carrier from one category of users to another category. With competing carriers, an internal redistribution is not sustainable once other carriers without redistributive burdens target these subsidizing users as the most likely customers. Furthermore, residential users may end up paying a proportionally higher share than large users, because cost shares in the substantial joint costs may end up allocated inverse to demand elasticity -- the Ramsey pricing rule -- and large users have more options and hence greater elasticity. Thus, the trend which at present is described as a "rebalancing" of prices towards cost would go much further than that, burdening the inelastic customers. Yet this need not spell the end of support schemes. If, for various reasons of policy or politics, one wants to subsidize some categories of service or users, it is still possible to do so, only in different ways. The proper voucher-based NetTrans system is one such way.

The need for change is also true for interconnection. An interconnection that enables entry by competition inevitably raises the question of the impact on universal service, i.e., on the widespread participation of all members of society in telecommunications. For a very long time, the traditional monopoly proclaimed itself as essential to such participation. But this is incorrect. While the internal transfers inside a monopoly system have been instruments of redistribution, other forms of redistribution can be designed within other market structures. An interconnected network of networks hence requires us to look at such alternative methods.

To maintain competition it is necessary to reform interconnection, and to reform the financing of universal service. Conceptually, and even politically, the time is right. The NetTrans and the Third-Party Neutral Transmission, both discussed in this article, provide the foundation for a telecommunications system that is competitive, interconnected, and socially responsive.

Appendix: A
Numerical Example for Net-Trans Accounts.

Let us look at a simple numerical example of NetTrans, using arbitrary numbers.


  1. an LEC with two customers service, which cost 30 each to provide, and whose price is regulated at A=10; B=40. Cost of providing access to an interconnecting carrier is 5.
  2. a competitive IXC interconnecting into an LEC, with an operating cost of 5 per customer, a regulated access charge to the LEC of 15.
  3. a rival local ALT, also with a cost of 30, and a freely set price of 30 for its customer D.9

Under the Present System:

Customer A is being subsidized at a price that is 20 below cost. The revenue comes from two sources: (a) customer B, who pays 10 above cost; and (b) long distance customer C, whose call generates an access contribution of price minus actual cost of 15 - 5 = 10. In such a system:

(a) the ALT will have an over-incentive to serve customer B. It will to be prevented from offering that service to B, or else the contribution by B to A would be lost. B thus has no choice among local carriers.

(b) ALT will try not to serve customer A, who thus has no choice among local carriers.

(c) IXC has an incentive to link up with ALT rather than LEC. It will be prevented from doing so to maintain the subsidy from C to A. (If it is permitted to bypass LEC, to maintain the subsidy to A, the rates on B would have to be increase from 40 to 50, thereby increasing the pressures on B to try to switch to ALT.)

(d) Customers C and B call less than otherwise, because their rates are above cost, while customer A calls more than otherwise.

(e) LEC has no incentive to reduce cost of operations.

Under NetTrans:

Local competition and pricing flexibility is instituted. Assume that the price for subsidized customer A remains at 10.10

Total net transmission revenues are:

IXC: customer C 20 - 15(access charge to LEC) 5
LEC: customer A 10
customer B 40
access charge from IXC: 15
ALT: customer D 30
Total net revenues 100

To support A's universal service out of the aggregate net revenues of the entire telecommunications system of 100 requires these revenues to be charged at a NetTrans debit rate of about 28.6%. We assume that customer A's rates remain at 10, requiring a subsidy of 30 - 10 = 20, plus NetTrans on that amount, i.e. A does not pay the NetTrans debit charge on the subsidized part of the cost. The formula for the debit percentage can be calculated as % = (C-P)/(R-P), where C is the cost, P is the subsidized price, and R are the total of net revenues. In our example C = 30, P = 10, and R = 100, for a debit percentage of about 28.6 %.11

This would mean debits on the various carriers net revenues of about:

IXC: -.286 x 5 -1.4
LEC: -.286 x 65 -18.6
ALT: -.286 x 30 -8.6

For a total of 28.6, the required subsidy amount (20 + NetTrans on 30) of a voucher.

1. Scrapping the Old System

Let us also assume for the moment that the previous subsidy schedules are abolished, and competition is free. What happens?

(a) Customer A gets a voucher enabling him to get service at the previous rate.12 However, since he receives a subsidy of 28.6 directly, such as by voucher, he has a choice among carriers.

(b) with the contribution in the access charge to LEC abolished, access charges would be at cost (5), plus NetTrans charge. Also, because of competition in the long-distance market, and since all other IXCs would have the same reduced access charge costs, the IXC cost to serve customer C would drop (to 12.8, comprised of IXC's operating cost of 5, plus its access charge payment, now at a cost-based 5, plus NetTrans on the access of 1.4, instead of the subsidizing of 15, plus the universal service contribution of 1.4 on its net revenue). IXC can use both LEC and ALT for access to customers. It pays either of them only cost based access charges. IXC customer C contributes to universal service only its pro-rata share, whereas before it paid above average.

(c) LEC lowers its contributory price to customer B, since it now faces competition for that customer from ALT. (The price would drop to 30, plus NetTrans of 8.6, i.e. to 38.6.)

(d) LEC can charge A the market price, i.e. 38.6, against which A can use their voucher of 28.6.

(e) ALT can now contest customers A and B. (Its price would be 30 plus NetTrans of 8.6 for 38.6.) If ALT's cost would be 29 instead of LEC's 30, it would gain both customers. ALT and LEC would, in effect, compete for A's subsidy voucher, by lowering their price.

(f) LEC customer B contributes to universal service only its pro-rata share, whereas before it paid above average. ALT customer D contributes to universal service its pro-rata share, whereas before it was below average.

(g) LEC would have major incentives to reduce its cost. First, because it could keep the cost savings. Second, because if it does not reduce costs, it will lose its customers to ALT. Third, because a built-in productivity improvement factor, the virtual voucher to A would be lowered for Period 2 as prices drop, and LEC would be credited less for each universal service customer served.

2. Keeping the Old System

It is likely that not all previous contribution elements would be abolished. The NetTrans accounting would accommodate elements of the old system. If access charges, for example, would not be reduced, NetTrans could simply account for it. (If IXC would still have to pay LEC an access charge of 15, including a contribution of 10, to a universal service fund that goes to LEC, the contribution would be credited to IXC's account against its debit of 1.4. IXC would then be owed a net of 11.5. LEC, on the other hand, would have to add 10 to its debit of 18.6, for a total of 28.6.)


Note 1 : Tirole, Jean, "Interconnection Charges," (talk delivered at Idate), November 18 1994, unpublished. Back

Note 2 : COM (93) 543 FINAL. Communication from the Commission to the Council, European Parliament and The Economic and Social Committee Developing Universal Service for Telecommunications in a Competitive Environment, 15 Nov 1993. Back

Note 3 : Hayashi, Koichiro. Universal Service. Chuokoron-Sha: Tokyo, 1994. Back

Note 4 : It should be noted that no two participants in the communications environment can seem to agree on the nature of the financial flows, including their size, direction, or beneficiaries. It is not the purpose of the present article to settle those questions, but rather to reform them out of existence. One quantification is Weinhaus, Carol, Sandra Makeeff and Peter Copeland et al, "Telecommunications Industries Analysis Project: What is the Price of Universal Service? Impact of Deaveraging Nationwide Urban/Rural Rates," Cambridge, MA: Telecommunications Industries Analysis Project, July 25 1993. Back

Note 5 : The Rural Electrification Division of the Department of Agriculture provides three types of loans. 1. Standard (3 subscribers or less per sq. mile): 5% interest loan. 2. Higher Interest (greater than 3 subscribers per sq. mile): 5% plus premium based on ability to pay. Local service provider must have 1.5 interest coverage ratio or better to qualify. 3. Guaranteed loans by Federal Financing Bank: Serves remainder of rural LEC's. Interest rates vary depending upon financial condition of rural LEC. Back

Note 6 : This should not suggest a commitment to protect the status quo on prices and revenues. Such changes, e.g. price rebalancing, are possible, but are a separate matter. Back

Note 7 : Einhorn, Michael A., Recovering Network Subsidies Without Distortion. Columbia Institute for Tele-Information Working Paper Series, Working Paper #690, 1994. Back

Note 8 : See also Gail Garfield Schwartz, "Universal Service Assurance Via Equal Access to the Subsidies." Thinking points by the Teleport Communications Group. September 21, 1993. Back

Note 9 : We assume in this example, for numerical simplicity, that no ALT access charges exists. There is no problem in dropping that assumption. Similarly, the assumption that cost to serve customers A, B, and D, is in each case 30 is made for computational simplicity and transparency. There is no problem in assuming that costs are different from each other. Also, the example has no high-cost rural LEC that would receive low-density support. Back

Note 10 : We assume here that the NetTrans assessment on A's payment would not be passed on to A. However, there is no problem in A's absorbing this charge. It would make the calculation simpler, but would mean a net increase in A's actual payment. The "benefitted service" of A would still be subject to a NetTrans debit, but it would not be paid by A, even on the portion he is paying. LEC would both be debited for the NetTrans and credited for it, so it would be a wash. One could therefore leave it out entirely from the NetTrans system. But in so doing, one creates unnecessary accounting and administrative problems, since the LEC (and ALT) would have to segment their revenues between different customer classes. Back

Note 11 : If to A's price at 10, would be added a NetTrans charge, the equation becomes % = (C-P)/(R-C+P). In this case, it would be 25%. Back

Note 12 : See previous note. Back

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