Is the UNE Platform the answer to the CLEC's prayers?

Fred Goldstein,  November 2002

The Unbundled Network Element Platform (UNE-P) is one of today's most important avenues for local telephone competition, and represents much of the growth in CLEC line count since 1999. It is also the bullseye in the cross-hairs of the ILEC's policy guns. No other form of competiton is so troublesome to the ILECs. Is it really the solution to the CLEC sector's problems, or is something else afoot?

UNE-P is, in a nutshell, resale of ILEC telephone service that is legally classified as "facilities-based". The Telecom Act specifically permits both "resale" and "facilities-based" competition, but also requires ILECs to make unbundled network elements (UNEs) -- individual components of the network, delivered alone or in combination, but priced a la carte -- available to CLECs. UNE-P is what happens when all of the components needed to resell ILEC service are procured, by the CLEC, as UNEs.

Total service resale is in decline

"Resale", or more specifically Total Service Resale (TSR), is provided by ILECs to CLECs at a price based on the "retail" tariff price, minus a fixed percentage "discount" (typically in the 20-25% range). The CLEC is then responsible for billing and collections. This doesn't leave much of a profit margin for the CLEC.

A more serious question, though, is "why?" Is resale truly competition? I suggest it's not -- it's competition for the back office, perhaps, but not for the service itself. The "discount" is basically a sales commission. A resale CLEC is a sales agent for the ILEC, not a competitor. It's surprising, then, that ILECs even complain about resale. The whole scheme was cooked up in the first place by an ILEC (Rochester Telephone, who called it the "Open Market Plan" in the 1980s); their only real problem with it is the computation of the commissions, er, discounts. Which, naturally, they always wish were smaller.

Resale's value proposition, as it were, is to permit companies to bundle local and long distance service onto one bill. The customer thus saves writing one check and one postage stamp. The reseller gets account control. This of course hasn't caught on; several early resellers, such as USN and, tanked. TSR is in decline, though it still represents over two million lines. It's probably best for specialty applications such as Centrex. The reseller can be the company who provides the desktop telephones -- before the Telecom Act, the ILECs paid commissions to these companies, and TSR "discounts" are larger.

UNE-P and TELRIC pricing

Anything other than TSR is considered to be "facilities-based" competition. CLECs don't have to provide all of the facilities themselves. The Telecom Act requires the major ILECs to provide CLECs with any or all of the unbundled network elements needed to provide telecommunications service, provided that the elements meet certain market tests, which are left to the FCC to determine. These are the "necessary" and "impair" tests -- is access to these UNEs necessary for competitors, and will denying them impair competition?

The Clinton-era FCC originally held that all network elements used to provide basic telephone service met those tests. Thus the UNE menu included local loops (undeniably necessary for a wide range of retail services), dedicated interoffice transmission (needed for the CLEC to build a network out of the loops), operator services, signaling (access to the Signaling System 7 network), and both tandem local switching (use of the ILEC's central office switches). But court battles prevented these from being available in combination until 1998.

A CLEC can, of course, build its entire network from scratch. Cable companies and the fiber-optic trenchers have done just that. But it's frightfully capital-intensive, and the non-cable players have been financial disaster areas. CLECs can also make use of a mix of their own facilities, such as switches, and the ILECs', such as loops. But a CLEC can also order the entire service in the form of combined UNEs. This mainly differs from TSR in the way the ILEC wholesale prices are set.

UNEs are priced, by law, without respect to the retail tariff. This is a Good Thing, because retail tariff pricing (which TSR is based on) is almost entirely arbitrary. Local telephone company pricing is not based on cost; it's an artifact of a monopoly era, when rates were set by state regulators for political as much as economic reasons.

UNEs are based instead on "forward-looking" costs, using a complex FCC formula called TELRIC (Total Element Long Run Incremental Cost). There are many different ways to say what something "costs". In the telephone world, it's possible to use direct historical costs -- what did the network actually cost to build? And it's possible to use "fully distributed" costs, in which direct costs are burdened by the common costs of running the company. Or it's possible to use incremental costs -- what would an additional unit of capacity cost to add? And those have endless variations. TELRIC is a good compromise; it takes into account modern (well, 1996-era) technology, combining aspects of incremental and fully-distributed costing. It's important to note that the TELRIC wholesale prices charged to CLECs also include a profit margin for the ILEC.

A funny thing happens when you compare TELRIC-based pricing to retail tariffs. Some ILEC services turn out to be much cheaper at retail! Rural residential service, for instance, appears to be heavily subsidized -- TELRIC rates for local loops in rural exchanges are generally very costly, while retail rates tend to be lower than in urban areas. On the other hand, urban retail rates are usually well above TELRIC, by a considerably greater margin than the TSR discount. So by ordering the whole service as a set of UNEs, the CLEC can resell ILEC service with higher margins. That's the main reason for UNE-P, and why so many TSR lines have been converted to UNE-P in recent years.

To the ILEC, this is just "tariff shopping", as if that were a bad thing! But its implications go beyond that. UNE-P is actually a valuable public policy tool! In the short term, it's a tool for CLECs to gain subscribers. It's also a way to undo a century of mispricing of telephone services.

UNE-P allows the CLEC to set its own prices without regard to ILEC tariffs. The CLEC can underprice the ILEC for high-markup items like call waiting and caller ID. The CLEC can offer flat-rate local service in measured-rate areas, and can even leave off costly "zone" usage charges that so many subscribers find so annoying. UNE-P thus provides CLECs with a way to provide service differentiation while still using the ILEC's network.

Unlikely to last

The ILECs really, really don't like UNE-P. Neither does their ally, current FCC Chairman Michael Powell. UNE-P is already subject to some restrictions: In the top 50 market areas, ILECs can deny UNE-P for CLEC's business subscribers with more than three lines, so long as the ILECs also provide CLECs with the Enhanced Extended Loop (EEL), a combination of local loop and interoffice transmission. In the current round of UNE review, UNE-P may be further restricted, or even phased out.

From a competitive point of view, this wouldn't be a total disaster. It just isn't that hard for CLECs to provide their own local switching nowadays. While a 1980s-vintage ILEC-style switch like a Nortel DMS-100 or Lucent 5ESS is big and costly, newer switch vendors have created a good selection of less-expensive compact switching systems. And CLECs can share switches -- the ILEC isn't the only one who can sell unbundled switching. Most CLECs with switches have plenty of spare capacity, so they can sell it to each other.

So CLECs who are committed to UNE-P should make hay while the sun shines. It's a quick way to get going, and it has the advantage of covering lots of turf. Worldcom's MCI "The Neighborhood" used UNE-P to roll out a new service to over a million subscribers in dozens of states -- it would have taken years to set up on a UNE-L basis. But I don't advise building a long-term CLEC business plan around UNE-P.

But UNE-P's real value isn't to the CLEC community. It's to the public, in forcing ILEC rates back into line with costs. Because a CLEC can profitably use UNE-P to create a cost-based service, the mere existence of UNE-P creates a sort of unofficial cap on what an ILEC can charge. Look at Ameritech's message-rated residential services, for instance: They introduced flat rate residential service only after UNE-P plans, such as The Neighborhood, led the way. New York City is likewise a mecca for UNE-P. Of course the ILECs will have to make up for those revenues somewhere. UNE-P caps the implicit cross-subsidies available to cover underpriced rural and residential services. This too is not a bad thing -- explicit subsidies, competitively neutral, are the appropriate way to handle high cost areas, and in a competitive market, ILECs have no right to maintain predatory pricing. It would thus be tragic for UNE-P to be shut down before the ILECs were forced to rationalize their rates.