Empirical analysis of entry in the local exchange market: the case of Pacific Bell

Contemporary Economic Policy, Jan, 2005 by Trevor R. Roycroft

I. INTRODUCTION

The Telecommunications Act of 1996 marked a major legislative effort to change the structure of telecommunications markets in the United States. While the law affected many aspects of the telecommunications industry, the local exchange market, the last bastion of monopoly remaining after the divestiture of AT & T, commanded special attention. The act specified a new regulatory framework for the local exchange market and removed any remaining state-level legal entry barriers (i.e., grants of exclusive franchise). However, recognizing that legal barriers were not the only impediments to the development of local competition, the act went on to specify changes that recognized the likelihood of lingering technological entry barriers and the scale and scope economies that incumbent firms enjoyed.

Three paths to entry were encouraged by the act: facilities-based entry, local service resale, and unbundled network elements. To encourage entry possibilities associated with these options, the act mandated interconnection of networks, thus opening the possibility of facilities-based local exchange competition. Under this entry format, new competitive local exchange carriers (CLECs) could construct their own local networks and interconnect with the incumbent local exchange carriers (ILECs), thus gaining the network economies of a large local calling scope. The act did not stop with mandates for interconnection. A wholesale market for the ILECs' services and network technology was also created. CLECs could become resellers of the ILECs' services through the act's local service resale mandate. Alternatively, the act specified that CLECs could utilize parts of the ILECs' network, such as local loops (the wires that connect ILEC customers to the ILEC switching centers, switching, and transport), through provisions which specified the unbundling of ILEC networks. The CLEC could then combine the ILEC technology with its own technology to provide the desired local exchange services. Implementation of the Telecommunications Act under the direction of the Federal Communications Commission (FCC) also resulted in combinations of network elements, now known as UNE-platforms (or UNE-Ps), becoming available to CLECs. The combined platform of elements is much closer to a service in that it bundles most technology needed to provide local exchange service at a much lower price than local service resale. UNE-Ps have been widely adopted by CLECs. (1)

While laying out the general framework, many of the details associated with the mandates identified above were not specified by the act. Rather, the FCC and state public utility commissions (PUCs) were charged with the actual stewardship of opening local markets, including developing necessary rules and establishing prices for interconnection, UNEs, and wholesale services. The process of hammering out the details is ongoing because of a series of legal challenges that have wound their way through the courts, with the U.S. Supreme Court having the "last word" on several key issues. However, in spite of these legal delays, the process of competitive entry began in earnest in late 1996 and is continuing through the present period. While ILECs challenged the authority of the FCC to establish rules, the state PUCs, which had the ultimate authority to determine the prices for the components needed by local entrants, oversaw the introduction of competition in the local exchanges in their jurisdictions.

The progress of competitive entry under the provisions of the act, the FCC's rules, and the PUCs' general oversight has been mixed. It is noteworthy that the CLEC industry has suffered considerably in the high-technology bust. A Wall Street Journal article, commenting at the height of the CLEC bust, noted "a broad CLEC index,... reached a peak market cap of $242 billion in March of 2000. By last month (May, 2001), the market cap had dropped to $38 billion--an 83% decline. Of course, the stock market as a whole, and high-tech stocks in particular, also fell over that period, but the tech-heavy Nasdaq, with the CLECs in our index removed, declined 48%." (2) This analysis indicates that CLECs suffered more in the high-tech decline than other high-tech firms, and the flight of capital has influenced the progress of competition in local exchanges. In spite of these difficulties, CLEC market share, as reported by the FCC, has grown slightly over the past 2 years.

Market entry data on the CLEC industry reported by the FCC shows that on a state-by-state basis, lines served by CLECs range from a 3 percent market share in the state of Montana, to a 28 percent market share in the state of New York. (3) Table 1 summarizes the nationwide results reported by the FCC for the period ending June 30, 2003 (Federal Communications Commission, 2003). Overall the FCC reports about 15 percent of access lines nationwide being served by CLECs.

Service offerings by the CLEC industry have not favored all customer classes equally. The FCC reports that CLECs have not gravitated toward residential and small business customer classes. The most recent data show that approximately 62 percent of CLEC lines are associated with residential and small business customers, as opposed to 78 percent residential and small business customers for ILECs (Federal Communications Commission, 2003, Table 2). Entry patterns have not been geographically uniform. The top-10 states, based on CLEC line counts, have about 65 percent of all CLEC lines in service. Average CLEC market share in the top-10 states is about 18 percent, with the balance of the states showing an average CLEC market share of about 12 percent. The slow progress of entry and the apparent gravitation of CLECs toward the business sector have led to widespread criticism of the market environment under the act. (4) Sources as diverse as the Consumer Federation of America and the CATO Institute deem the act a "failure," but not necessarily for the same reasons. (5)