Breaking up the ILECs:  A win-win proposition

Fred Goldstein,  November 2002

In 1982, AT&T agreed to settle a long-standing antitrust suit by breaking itself up eight ways.  Its local Bell Operating Companies were spun off into seven RBOCs, leaving mother AT&T with its long distance and manufacuring operations.  The logic of the split was compelling.  The RBOCs took over the regulated monopoly operations, while AT&T itself was left in competitive markets. This simplified life for both investors and regulators.  The RBOCs were the risk-averse, divident-paying "widows and orphans" stock choices, while AT&T was free to explore growth markets such as computers and enterprise networking.  Never mind that AT&T turned out to be a failure in many of these markets; they were nonetheless freed, for better or worse, from the protections of their older monopolies.

The RBOCs, on the other hand, did not willingly accept the role that they were created to occupy. The "Baby Bells" grew up to seek entry into additional markets, such as long distance. With the historic compromise that became the Telecom Act of 1996, they agreed to accept competition in their core local markets, in exchange for additional freedom to enter new markets.

The perverse result of this deal is that the RBOCs now have the same structural problems that AT&T faced before its own divestiture. They are in both monopoly and competitive sectors, and are essential suppliers to their own competitors.  No wonder local competition isn't working very well!

The obvious answer to this is a second divestiture, one in which the RBOCs are themselves divided again, into monopoly and competitive companies.  Naturally, the RBOCs are aghast at the thought, and will use their political clout to prevent it from happening.  But a monopolist doesn't always act in its own best interest:  Monopoly is a powerful drug, and often leads to irrational behavior. I suggest that not only would breaking up the RBOCs be good for competition, but it would be good for the RBOCs, and especially their shareholders.

Draw the line in the right place

For a "Divestiture II" to work, it must be done right.  The correct model is not, as some have suggested, "wholesale" versus "retail".  Essentially all of the RBOCs' assets are used for "wholesale" purposes; retail operations are only concerned with marketing and billing.  Such a split would be beneficial for resellers, perhaps, but would do nothing to foster innovation or improve efficiency.

The split must recognize the essence of the 1984 split, and divide the RBOCs into monopoly and competitive operations.  That boundary has moved dramatically in the two decades since Divestiture I was agreed upon.  Essentially none of the RBOCs operations are de jure monopolies today.  Competition is technically permitted in all aspects of their operations, but that doesn't make it real.  The RBOCs are beneficiaries of a natural monopoly in certain portions of their operations. A natural monopoly occurs when a single vendor has a preponderant share of a market that has a positive economy of scale, such that their incremental cost is always lower than a smaller competitor's.

The natural monopoly primarily includes the RBOCs' outside plant operations, including the local loop, digital loop carriers, pedestals, manholes, conduits, poles, and the like.  It also includes the central office buildings (wire centers) where the outside plant ends, up to and including the Main Distribution Frames. It also includes the intraLATA fiber optic networks that link these buildings together.  CLECs who wish to reach any but the biggest customers (the few for whom dedicated fiber optic or microwave radio links might be worthwhile) depend on the loop plant, and in order to reach that plant, they are dependent upon the wire centers and bulk interoffice facilities.

All of these today are theoretically available to the CLECs as unbundled network elements. But in practice, the RBOCs, and other like-situated incumbent LECs, use every nuance of the letter of the law to impede them. A true competitive environment for telecom services requires these elements to be available on the same terms to all participants.  Thus these would be spun off into a regulated local loop provisioning company, a loopco.  The loopco would not need any de jure monopoly protection; its natural monopoly would be adequate to protect the bulk of its revenues from competition.

The ILECs' service business, including the customer relationships, switching, and advanced services would remain in a serviceco.  This company would be more like a CLEC than like today's ILECs; it would need residual regulation due to its market power, but, like AT&T in the 1980s, its regulatory status would be eased up as competition expanded.

Switching is competitive

An important network element that is not a natural monopoly is switching.  The ILECs do own central office switches, but many CLECs can, and do, provide their own.  Two CLEC market-entry strategies, Total Service Resale and UNE-Platform, make use of ILEC switching. And these strategies may be useful today, especially to acquire relatively low-revenue residential and small-business subscribers. But that doesn't make switching a natural monopoly.

While the RBOCs were, in theory, more open than AT&T's old BOCs to competitive suppliers, the vast majority of their CO switch purchases came from Nortel and Lucent/Western.  This was understandable in context of the switch to digital switching.  Most of the cost of building a digital switch was in writing the software.  Smaller vendors had fewer customers among whom to divide the cost, so they had a hard time competing.  So by 1996, Lucent and Nortel shared over 90% of the market.  Siemens and Ericsson, huge players elsewhere, had a small share. Mitel and Redcom shared a niche market serving very small rural ILECs.

Lucent and Nortel did not ignore CLECs.  Lucent led with its smallest 5ESS, the VCDX.  Nortel adapted its DMS family into a multifunction CLEC special, the DMS-500.  Both featured the same "big iron" 1980s-vintage hardware that the ILECs loved, and offered wide feature arrays, albeit at a high entry cost.

The Telecom Act, though, spurred a burst of innovation in switching.  New venture-funded switch vendors popped up like mushrooms after a summer rain.  And these vendors had a lot in common.  Their switches were physically small, used less power and cooling, and provided flexibility for customers or third parties to develop their own features.  Disregarding voice over IP, which has gotten negligible traction in local switching, CLECs were blessed with a choice of new vendors.  Alas, many did not have mature products until after CLEC funding dried up, and their future prospects are often uncertain, but several of these vendors are likely to live on.  Salix and Tachion have already gone to that great switchroom in the sky, and Unisphere's circuit-switching division was merged back into parent Siemens. But survivors so far include Sonus Networks,  Convergent Networks, Taqua, Coppercom, Metaswitch, Santera, and Telica. (Not that there aren't others, and I'm omitting pure "softswitches" that don't have circuit switching hardware.) Not all of them are capable of serving every LEC's requirement, but their existence proves that it's a different world from 1996.

Current rules permit the ILECs to limit what CLECs can put into their collocation spaces. CLECs do not have the right to collocate switching systems in ILEC wire centers.  They can only collocate remote modules and multiplexors, unless the actual switching capability takes up no more space.  Thus a little Redcom, Coppercom or other new switch might be allowed in, but a 5ESS is verboten. Under a divestiture II scenario, the "inside plant" ILECs, or "servicecos"  themselves would merely become collators in the "outside plant" company's wire center, so CLECs wouldn't be treated differently. In 1999 this might have been a problem, because collocation space was at a premium.  But the failure of many CLECs has left many ILEC collocation rooms almost deserted.  So an outside plant company might look at its buildings as assets, open to CLECs, ISPs, whomever.  The "carrier hotel" business was largely created because the ILECs, who had the natural advantage, refused to sell space to companies they perceived as competitors.

And CLECs can sell each other switching capacity.  One CLEC with a multiplexor or switch can sell its capacity, wholesale, to other CLECs.  The ILEC is not the only potential source of unbundled switching.  It's also quite conceivable that in a Divestiture II scenario, the serviceco would recognize the revenue opportunities in selling its own switch capacity wholesale, even without the current legal mandate.

The ILEC's serious debt burdens would be relieved

Why should the RBOCs, and other large ILECs such as Broadwing and Citizens, willingly submit to this type of division?  The answer lies in the fiscal meltdown of the new decade. Divestiture I seemed to create low-risk RBOCs and a moderate-risk AT&T.  The RBOCs and other major ILECs today are more diversified, with overseas holdings, wireless holdings, and other ventures. They are saddled with debt, and are not the safe investments that they once were.  

Divestiture II would assign most of the debt to the outside plant companies, the loopcos, whose natural monopolies would assure a steady income. These companies would even be good candidates to return to old-fashioned rate-of-return regulation.  The remaining service companies would be free to pursue new markets, to compete on an even footing.  Some shareholders, and it seems many senior managers, want this type of deregulated freedom.  With most of the debt elsewhere, they would have new freedom to explore new business opportunities, while keeping control of the bulk of their customer base and revenue.

Broadband would be facilitated

But if the outside plant were owned by a separate loopco, access to DLC-served customers could be provided on a competitively-neutral basis.  Any bona-fide request by any LEC would be fielded by the loopco, so a CLEC could ask the loopco to provide DSL to any subscriber, anywhere in its service area.  The loopco would of course have the right to charge a cost-based price for its services.  If public policy dictated subsidies, they would be available to the loopco, and thus to all LECs. 

The loopco and the various LECs, including the serviceco and CLECs, would have a common interest in being competitive with cable, wireless and satellite providers. The loopco could even offer its fiber-optic services to the cable companies.  While facilities-based competition between Hybrid Fiber-Coax cable networks and LEC networks is frequently beneficial, the economics just don't work as well everywhere. Loopcos would not be allowed to become cable service providers; their charters would, unlike those of the RBOCs, be limited to prevent them from becoming their own customers' competition.

Perhaps this plan is too idealistic to gain traction where it is needed, but the policy decisions being made in Washington today do not seem to be a long-term solution to anything.  Rather, today's plans are made entirely on the basis of short-term benefit to one side or another.  Structural reform was beneficial in the 1980s and it would be even more beneficial in the 2000s.