SBC Shouldn’t Have to Subsidize Its Competitors

Published November 1, 2003

On May 9, the Illinois General Assembly passed and Gov. Blagojevich signed into law legislation dictating to the Illinois Commerce Commission important changes in the way it has heretofore set the rates at which SBC Illinois must make its local services available to would-be competitors at wholesale.

I testified in favor of the bill–without compensation, at my insistence–because the regulatory policies that it attempts to correct are nationwide in their scope and of profound importance to the resumption of investment in the vital telecommunications industry.

For this reason I think the public should understand the logic of Illinois’ courageous action.

One of the primary goals of the 1996 Telecommunications Act was to introduce genuine competition in the local telephone business. To that end it requires an incumbent local company to make available to would-be local competitors, at regulated rates, parts of the network necessary for them to compete.

The Act intended those wholesale charges to recover costs and a reasonable profit.

Instead, the Federal Communications Commission required states to set those rates to recover not the actual costs of the local companies but the hypothetical costs of an ideally efficient new entrant, writing on a clean slate–costs that would be much lower than the cost of running the existing system based on old technology.

The result has been seven years of wrangling about what those hypothetical costs would be. Even worse, by freeing commissions from the obligation to set rates recovering the companies’ actual costs, it posed for regulators an irresistible temptation to produce publicly visible results in the form of subsidized competitors and sharp reductions in local telephone service rates to residential customers.

Various state commissions have used the flawed hypothetical pricing model to drastically reduce wholesale prices. In a race to be the national leader, the Illinois Commerce Commission cut the rate to just over $12 a month. According to Northwestern University Professor Debra Aron, that is either the very lowest among the 50 states or very close to it. Even more striking, she demonstrated that it does not even generate sufficient revenues to cover SBC Illinois’ day-to-day cash expenditures.

That deplorable situation is what the new Illinois statute seeks to correct.

I would not ordinarily regard it as good regulatory policy for a legislature or judiciary to encroach in this way upon the presumed superior expertise of an independent regulatory agency. On the other hand, when a commission sets rates in a way that departs so dramatically from the actual cost of providing the service, without sufficient justification, it has surrendered that presumption, and it is surely a proper function of the state legislature or the courts to call it to account.

In spite of the claims to the contrary, there is no economic reason why retail rates offered by SBC’s competitors will have to go up. What companies like AT&T and MCI will have to do is accept narrower margins–40 percent instead of 60 percent according to the Bank of America–a not unreasonable prospect in light of the fact that AT&T reported to the FCC that competitive carriers in Illinois can currently earn the highest gross margins in the country.

If competitors are as efficient as SBC, there is no reason why they cannot compete while paying SBC its actual costs for the services they buy from it at wholesale.

Subsidizing competitors at the expense of incumbents is a cheap way of getting political credit, but it is not a way, in the long run, of promoting consumer welfare.

Alfred E. Kahn is the Robert Julius Thorne Professor of Political Economy, Emeritus, Cornell University, and was chairman of the New York Public Service Commission from 1974-77. This essay originally appeared in the Chicago Sun-Times, July 22, 2003.