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April 09, 2013

America's Real Three-way Digital Divide

By Fred Goldstein, ionary Consulting

Americans are used to seeing things two ways. Elections are usually between two parties. Newspapers like to tell two sides to every story, regardless of how many different sides there really are. And there’s a “digital divide” between broadband-haves and broadband-have nots. But it’s really more complicated than that. Federal policy has “solved” the problem for some of the have-nots, but has been leaving others behind.

Urban and well-populated suburban areas get most of the providers’ attention. They typically have a cable company providing triple-play, and a telephone company providing broadband as well as voice-band telephone service. In some places the telephone company is providing video competition as well. So for the most part, these areas are pretty well served, if not quite up to world standards. And why not? The cost of providing local service, whether copper wire, fiber optic, or coax cable, is largely a function of population density, so these areas are where the profits are made.

The biggest incumbent telephone companies (ILECs) in the US, including the Bells and the biggest ones that used to be called “independents”, now operate under a regulatory model known federally as “price caps”, and sometimes “Alternative Form of Regulation” (AFOR) at the state level. Some states have granted their big ILECs full retail deregulation, so their retail prices aren’t even capped; they can charge whatever they please, even for basic dial tone service. (Broadband service has never been subject to price regulation.) Under AFOR or full deregulation, these companies, which the FCC (News - Alert) refers to as price cap carriers, are allowed to make as high a profit as they can, within whatever price caps remain (mainly for wholesale services to other carriers). If they cut their costs and keep their customers, they make more profit.

Incentives have changed

It hasn’t always been that way. Until the 1990s, telephone companies were treated as regulated utilities, and were all subject to rate-of-return regulation. That set a profit target that the companies were entitled to earn, expressed as a rate of return on the value of their undepreciated plant in service (the rate base). Expenses were just passed along to ratepayers. So the more they invested in their plant, the higher the profit. 

Nowadays, rate of return regulation still exists, but only for small rural carriers, the so-called RLECs, who receive subsidies from the federal Universal Service Fund (USF), and sometimes additional subsidies from state funds. The difference is that they don’t pass along all of their costs to their own ratepayers. They collect typically low rates from their own customers, take more from the dwindling long-distance business, and pass the rest of their costs along to the USF, which until recently had a policy of paying them with almost no questions asked. The USF then taxes all interstate telecommunications services to pay for it; the current rate is over 16%. And unlike a normal tax, the USF “fee” is adjusted quarterly to whatever level is needed to balance its books. Imagine if other taxes were automatically adjusted, without legislative input, to balance the budget. Not going to happen (and shouldn’t)!

Notice the difference in incentives that management has. Under price caps, the incentive is spend less in order to maximize profit margins, not to invest more than necessary, and to only seek out profitable customers. While under subsidized rate of return, the incentive is to maximize investment, seeking out high-cost customers who would add the most to the rate base. So there we are, with a clear two-way divide. Two bad systems to choose from! One spends too little –the Bell company networks are largely in a shameful state of disrepair – and the other spends too much.

Then what’s that about a three-way divide?

Outside of the low-cost-to-serve urban areas, providing telephone and broadband service is simply not profitable, if it is only paid for by the customers. It’s not small towns per se that are hard to serve – many rural towns have as high a density as big cities, just over a smaller area. It’s the countryside, the farms, ranches, mountain cabins, and other spread-out buildings that dot the American landscape. But the telephone companies that serve the small towns also serve the surrounding countryside. Some of these rural areas are served by price-cap carriers, such as the Bells. And some of them are served by rate-of-return carriers, the small independent RLECs. And that makes all the difference in the world.

Small rural carriers have invested the most

If a rural area has a rate-of-return carrier, then odds are it has top-notch service. Maybe even gold-plated, because the incentive has been to invest more. Some of these rural companies provide 100% fiber to the home, and even fiber to the farm and fiber to the ranch. They have modern switching equipment, high-speed fiber-based Internet access, and maybe good multichannel video service to boot. Why not? They aren’t paying for it! Thanks to the wonders of the USF, any investment that is used to provide telephone service – even if it is far more than needed for that simple function, and also provides other services – is an allowable part of the rate base. You can even see which carriers received how much by querying a state, year and month at the Universal Service Access Corp. web site.

But if a rural area has a price-cap carrier, like a Bell, then odds are it has what might charitably be called third-world service. It may have some DSL in town, but maybe not, and rarely in the countryside. Fiber optics are very limited, and only available at top dollar for critical services like cell towers. The wires on the poles or in the ground are likely to be decades old and none too reliable, and repairs may be taking longer than they used to. So two villages near each other may have very different levels of service just based on which ILEC ended up there.

Big carriers were supposed to cross-subsidize themselves

That’s the down side of AFOR and deregulation. The Universal Service Fund was set up in 1996, to replace an even more complicated system of implicit subsidies based on overpriced long distance calling. USF was created for the small carriers with no urban areas to cross-subsidize them. The big telephone companies were then expected to average their costs on a statewide basis. Thus NYNEX New York City’s profits would subsidize NYNEX lines in the Finger Lakes and the Adirondacks, while PacBell in San Francisco would subsidize PacBell in California’s far north. That’s the way it always had worked, after all… under rate of return. 

But AFOR changed that. Without the incentive to increase the rate base, and little or no USF support, price cap LECs had no incentive to invest any more than necessary That led to focusing their remaining investment in the most profitable areas. The only thing that kept dial tone going in rural areas was their Carrier of Last Resort Obligation (COLR), a rule that requires ILECs to provide basic service on request anywhere in their service area. Now, guess which rule the Bells have pushed to get rid of? That was easy. Some states have already abolished COLR. Technically it still exists in federal law, but the FCC doesn’t enforce it unless USF money is involved. AT&T (News - Alert) has petitioned the FCC to abolish it nationwide, except for areas that receive USF subsidies. Without COLR, the price-cap LECs can average-down their costs and thus boost their profit margins.

Walking away from their networks

AT&T’s plan is to let the old copper plant in high-cost areas deteriorate and, when it’s no longer profitable, tell subscriber to use its wireless affiliate’s network. The price may differ and the service may not be comparable, but it’s more profitable than supporting a wireline network in a rural area. Besides, in lots of African, Asian, and former-Soviet bloc countries, most people only have a cell phone, if that, so why should the rural USA be any different?

Verizon’s (News - Alert) plan is essentially the same as AT&T’s, though they have already sold off most of their rural turf. CenturyLink doesn’t have a wireless company any more, but they have a resale agreement with Verizon Wireless, so they have a place to dump their unprofitable subscribers. Qwest (News - Alert), before selling out to CenturyLink, had already sold off many of its rural exchanges to small rate-of-return carriers, but caps on USF limit future use of that approach. 

Indeed, buyers of Verizon’s properties haven’t had a good record so far. Fairpoint bought three states and soon went bankrupt, and Hawaiian Telephone went bankrupt for its leveraged-buyout fund buyers. Frontier has managed to stay above water with the extensive ex-GTE turf that it bought from Verizon, but it’s hoping for more money from the FCC’s new Connect America Fund, the restructured USF, which will allow some new funds for price-cap ILECs.

So that’s about where we are now, with very distinct lines through rural America. Subsidized rate-of-return ILECs provide high-end service at low-end prices, probably even better and cheaper than what urban customers can get from what passes here for competition. But the outlying Bell and other unsubsidized price cap areas often get third-world service.

Will the Connect America Fund ride to the rescue?

But is this where things will end up? The National Broadband Plan called for making “broadband” service available to everyone. The FCC responded in late 2011 with its Connect America Fund (CAF) plan for restructuring the USF. CAF promises to leave no areas “unserved”.  It eventually replaces the old USF, though the final rules are not complete and the whole thing is bogged down in court. Still, the outline is pretty clear.

Under the old USF, dial tone was subsidized, though the telephone plant could be used to provide other services such as broadband Internet access. Under CAF, broadband is subsidized, though the broadband plant can be used to provide dial tone. Just the opposite. The real difference is that there is no longer a requirement that the subsidized services be common carriage, so it ends up with a monopoly subsidized ISP. But it does put some limits on the rate-of-return carriers. In fact it says that if an unsubsidized competitor offers telephone and broadband service across their entire turf, then their subsidy will be phased out. And the subsidies will only be to bring their rates down to something above the urban average, not below. Rural rates will thus rise for the first time in well over a decade.

They also have to worry about new FCC caps on total subsidies, and new subsidy formulas based on what a computer suggests that a rural carrier should be spending, not what it actually is spending. An option apparently off the table: Having actual regulators rationally look at a carrier’s actual requirements and determining what they should be getting. That would be just so last century! So the blank check era for the small rural carriers may be ending, but most, by now, have already modernized their networks. What really remains to be seen is whether they’ll be able to pay off the Rural Utility Service loans.

But it’s still pretty hard for an unsubsidized competitor to compete with a subsidized one. And most other vestiges of rural competition are gone. There will be no support for competitive carriers, and subsidized carriers will not have to provide wholesale services to competitors. So rate-of-return carriers won’t have to worry much about competition. 

Just how CAF brings broadband to rural price cap carrier areas remains to be seen. Again, forcing them to invest is not on the table. It’s all carrot, no stick. Price cap carriers will become eligible for CAF subsidies, but the total money in CAF is capped near current USF levels. Awards for bringing broadband to in “unserved” price-cap carrier areas, the areas worst served today, will be given to the low bidder in a reverse auction. It may or may not ne the incumbent. But since the goal is to control cost while providing a minimum level of broadband service, it won’t be comparable to the blank-check networks already built by the rate of return ILECs, an probably won’t even be as good as cable service. CAF should raise the minimum bar, perhaps even subsidizing someone else to compete with a price cap ILEC that doesn’t serve a given census block with any broadband yet. But the process will take several years to play out – even if the auction takes place this year, it will take a few years for the build-out to occur.

So rural telecommunications is in for a bumpy ride. The rate of return carriers have to worry about keeping the subsidies. Price cap carriers are abandoning rural areas but somebody might be subsidized to serve them. And who knows how long it will take the FCC and courts to actually settle the rules and get that process started?   In the meantime, the three-way digital divide grows deeper.

Edited by Peter Bernstein
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