Structural Separation and Universal Service Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” University of Pennsylvania Law School, April 18-19, 2008 Michael Riordan Columbia University

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 2 High cost fund Over 4 billion and growing Duplicative payments to ETCs (ILECS and CETCs)

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 3 Reverse auction NPRM Goals  Market determination of universal service subsidies in high-cost areas  Efficient mix of technologies for provision of supported services  Adaptation to evolving technology Design issues  Single winner?  COLR obligation?  Per line subsidy?  Geographic area?  Frequency?  Maximum subsidy Neglected issues  Access regime  Stranded costs  Structural separation Legal issues  New FCC rules?  Modification of 251(f)?

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 4 Access issues To be a viable or efficient competitor, a CETC might in some geographic areas require access to ILEC network  Backhaul  Interconnection  Resale / UNEs Evolving technology implies shifting access requirements Denial of efficient access puts CETC at competitive disadvantage  Discourages participation  Distorts auction outcome  Dampens innovation

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 5 Structural separation Mandatory unbundling of network elements (UNEs) Netco sells network services  Non-discriminatory access  Regulated terms and conditions  Loops, switching and transport and combinations (UNE-P) Servco sells retail services  Competes in auction  Advanced services  Purchases network services from Netco as required

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 6 Stranded costs Network assets owned by Netco Fair rate of return on historical rate base Embedded cost recovery  Profits from network services  Profits from wholesale advanced services  Distributions from universal service fund

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 7 Simple model ILEC and CLEC compete in reverse auction The winner has a COLR obligation is to provide basic telecommunications service to a community at affordable price  Regulated retail price P ILEC initially requires subsidy to be viable  ILEC has cost is C I > P  Initial minimum required subsidy S o = C I – P

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 8 Simple model, cont’d CLEC requires access to the incumbent’s network in order to provide service at the lowest possible cost  ILEC cost of access is C A  Price of access is P A  CLEC complementary facilities cost is C E  Total CLEC cost is C E + P A CLEC requires subsidy to be viable  Minimum subsidy S E = C E + P A – P

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 9 Simple model, cont’d Open descending auction  CLEC bids down to S E = C E + P A – P  ILEC bids down to S I = C I – P + P A – C A  S o Efficient outcome  CLEC wins if C E + C A < C I and receives S I  ILEC wins if C I  C E + C A and receives S E Equilibrium subsidy exceeds initial subsidy  Subsidy increases with P A  Dual jurisdiction problem: PUC sets P A and federal USF pays subsidy

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 10 Bypass CLEC might bypass the ILEC network with own facilities  Cost of bypass C B > C A + C E  Bypass occurs if P A > C B – C E Bypass makes ILEC more aggressive  CLEC required subsidy S E = C B – P  ILEC required subsidy S I = C I – P = S o Distorts outcome  CLEC wins if C B < C I  ILEC wins if C I  C B

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 11 Stranded cost ILEC embedded cost exceeds the cost of access  ILEC “historical cost” is C H > C A  Initial subsidy is S o = C H – P Above-cost access pricing mitigates stranded cost  If ILEC wins, then stranded cost C H – C E – P A  If CLEC wins, then stranded cost C H – C I + C A – P A Stranded cost recovery might blunt competitive bidding  Promises to leaves ILEC “whole”  Structural separation remedies this problem o Promises to leave NETCO whole o Commits regulator not to “take” SERVCO profits o May fail to reduce subsidies in the short run

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 12 Advanced services Winning ILEC and CLEC have opportunity to earn additional revenue from advanced services  Revenue from unregulated service R  Incremental cost K  Extension to asymmetric revenues and costs Profits from advanced services reduce subsidy requirements  Subsidy less by R – K No outcome distortion unless inefficient bypass occurs Expand USO to include advanced services  What is an affordable price? Comparable price  But don’t exclude CLECs!

04/19/08 Conference on “The Enduring Lessons of the Breakup of AT&T: A Twenty-Five Year Retrospective” 13 Conclusions Structural separation enables competition by enforcing non- discriminatory access to network elements  Efficient mix of dynamically evolving technologies  Low-cost service provider Above-cost access pricing (or access foreclosure) distorts competitive provision of universal service in high-cost areas  Inefficient bypass  Non-participation Reverse auctions may or may not reduce subsidies  “Cross subsidy” from advances services  Avoids duplicative subsidies  Above-cost access pricing  Stranded cost problem