Blocked at the pass

The issue of fees paid by competitive local exchange carriers (CLECs) to incumbent phone companies has become a lightening rod in the wake of the financial squeeze on Canada’s $30 billion a year telecommunications sector that has led to the collapse of many under-funded entrants and accelerated an industry-wide consolidation.

The war of words being waged by incumbent local exchange carriers (ILECs) and smaller CLECs over the state of competition and regulation in the Canadian telecom market has produced both self-serving and valid arguments – on both sides of the debate. Both sides seem to be unanimous, though, in heaping much undeserved blame on the Canadian Radio-television and Telecommunications Commission.

That is partly because the economics of the local telecom market remains inhospitable to newcomers, and CLECs have been dropping like flies. Entering the local telephone business has never been a cakewalk, but the tightening of capital markets has weeded out under-funded entrants much more quickly than a century ago when local telephone competition was previously attempted.

Far from ignoring the plight of alternative providers as some recent industry criticisms declare, the record shows that the CRTC has recognized the fragility of local competition – and has sought to help nascent players.

The reduction to the markup paid by CLECs for using ILEC facilities awarded to competitors in the recent price cap review decision is the fourth such reduction granted to rival service providers in the past 18 months.

Other actions taken by the CRTC that impact CLECs’ relations with incumbent phone companies include:

– A reduction to the monthly fees that incumbent carriers, such as Bell Canada and Telus Communications, can charge competitive carriers to lease network facilities required to complete local loop connections for their customers (Decision 2001-238, April 2001);

– Significant decrease of the contribution fee competitors must pay to subsidize local rates (CRTC Decision 2000-745, Nov. 2000);

– Reducing administrative fees and processes incurred by CLECs; and

– Lowering the prices CLECs pay to Canadian municipalities for access to rights of way.

Price cap relief

The price cap review decision released by Canada’s federal communications regulator at the end of May has been heralded as a victory for local telephone consumers. It also comes at a critical juncture for telecom competitors, who, as the 10th anniversary of open competition was celebrated in June 2002, find themselves struggling to survive.

Early responses to the CRTC price cap decision from telecom industry players have been mostly negative. Both the incumbent telephone companies and their smaller competitors are unhappy with portions of the decision. The CRTC’s landmark decision – one of the most important telecom rulings in the decade since long-distance competition began – has been particularly decried by some CLECs as not going far enough to help them.

Yet the CRTC’s price cap review decision offers CLECs a much-needed financial boost by reducing the markup on the price of facilities leased from incumbents. Although the Commission confirmed its view that local competition should be facilities-based, the CRTC recognizes CLECs will rely significantly on reselling incumbent facilities on a transitional basis.

The 10 per cent reduction to the markup now provided to CLECs is much less than the 50 per cent to 75 per cent savings that two competitive entrants wanted, but more than the telephone companies thought appropriate. Hence both AT&T Canada and Call-Net Enterprises Inc., which had hoped for much larger discounts on competitor services, have expressed disappointment with the CRTC’s decision.

AT&T Canada Corp. has already indicated that it is considering a possible legal appeal of the 232-page ruling. AT&T Canada had the most to lose from the CRTC price cap decision, due to its controversial Facilities Based Carrier (FBC) discount rate proposal.

AT&T wanted the CRTC to grant facilities-based CLECs a 70 per cent discount on the prices charged for all services leased from incumbent telephone companies. The company argued that its FBC proposal would eliminate a significant economic barrier to entry – and yield annual savings of $300 million against the $480 million in charges it paid to ILECs a year ago.

Yet AT&T is hardly a corporation in need of government welfare. The CRTC rejected AT&T Canada’s proposal as unreasonable and declared that cost-based rates are necessary in order to foster facilities-based competition.

“The Commission believes it is critically important to have regulatory rules that make sense from an economic perspective,” David Colville, vice-chairman of the CRTC, said in explaining why that scheme was rejected.

AT&T Canada President John McLennan called the CRTC ruling “a disappointing decision for competition” because it failed to address “the insurmountable cost advantage enjoyed by the former monopolies over new entrant competitors.” McLennan has promised to “explore all options…including a possible appeal.”

AT&T Canada is struggling with deep losses which totalled $157.6 million in the first quarter ended March 31, 2002, $4.7 billion of public debt and tumbling credit ratings. To conserve cash, it has cut its annual capital spending in half to between $200 million and $220 million, is eliminating 1,017 jobs and renegotiated its lending agreements with its banking syndicate in May.

In the wake of the CRTC’s price cap decision, AT&T Canada’s credit ratings were cut to the second-lowest junk grade by Moody’s Investors Service Inc. Moody’s cut AT&T Canada’s senior unsecured debt rating four notches to Ca from B3, and stated its outlook is “negative.” And AT&T Canada’s U.S. based parent, AT&T Corp., announced plans to buy the outstanding 69 per cent equity stake in AT&T Canada that it does not already own one day after the CRTC released the price caps decision. The telecom giant announced on May 31 that it plans to raise US$2.25 billion by selling AT&T shares and convertible warrants to acquire the Canadian shares. (Under a deal struck in 1999, AT&T has agreed to buy the remaining stake by June 30, 2003. If foreign investment restrictions aren’t changed by then, AT&T may put the acquired shares into a blind trust – or put the company up for sale.)

Call-Net, which owns Sprint Canada, has also been harshly critical of both carrier costs and the CRTC.

“The CRTC had an opportunity to balance the interests of all of the key stakeholders consumers, incumbents, and competitors but it has failed to do so,” said President and CEO Bill Linton. “This decision perpetuates that uneven playing field particularly with respect to the provision of local telephone service.”

Call-Net, which recently emerged from a restructuring that eliminated more than $2 billion of debt, had said that the estimated $240 million it will pay this year to the incumbents is excessive. The new price-cap regime will provide it with a reduction of about 15 per cent – or $36-million – off those charges, Linton estimated.

The magnitude of his chagrin at the lower-than-expected savings is no doubt related to Sprint Canada’s previously announced strategy to quadruple its number of collocation sites this year. Call-Net plans to build 40 more collocation sites to attain its goal of acquiring over 150,000 new local residential customers this year in Canada’s seven largest urban markets.

Call-Net recently disclosed that it is reviewing its strategic business plan and suspending its most recent guidance to the financial community because the amount of relief from the price cap decision is below the “minimum expectation.” Linton added that Call-Net will “consider our options.”

Estimates from CRTC staff peg the financial impact of the reduced markup at about $75 million a year.

Not all competitive players are upset by the CRTC decision, however.

Primus Telecommunications Canada’s President and Chief Operating Officer Ted Chislett applauded the financial benefits of the ruling. He estimates the CRTC price cap decision will produce $2 million of additional annual profit for Primus alone. “Our business plan was not based on obtaining gifts from the CRTC,” he added.

Group Telecom also applauded the CRTC’s decision and stated the commission’s regulatory framework “continues to foster facilities-based competition.”

Despite Group Telecom’s financial struggle, the company opposed any major cuts to ILEC fees during public hearings, arguing that any large-scale reduction would simply drive down prices, and worsen the industry’s plight.

Contribution charges fall

The price cap review decision also left rural telephone rates unchanged after a decade of price increases to further the public policy goal of eliminating the century-old subsidy of local prices by long-distance rates.

“We think the subsidy level is now at an adequate level,” said Ottawa-based Shirley Soehn, executive director, telecom branch of the CRTC, pointing to other recent CRTC decisions that have substantially reduced those so-called long-distance contribution charges.

The overall amount of subsidy required to support local services in remote, high-cost areas has been slashed by the CRTC to about $300 million annually from $1 billion – starting this year – by a ruling issued in late 2000.

Any assessment of the financial impacts of the price cap review must also consider the $700 million benefit to competitors from lower subsidy charges – as well as the gains from other beneficial rulings. This nuance should not be overlooked by Canada’s two largest CLECs – AT&T Canada and Sprint Canada – both of whom also happen to be the country’s first and second-ranked alternative long-distance carriers.

When those reductions are added to the lower fees set in the price cap decision and to other savings, competitive entrants will see the annual cost of all charges to incumbents fall between 30 to 35 per cent.

Canada’s largest phone company, Bell Canada, will incur the lion’s share of those reductions, prompting BCE Inc. boss Michael Sabia to declare, “The pendulum has swung far enough, perhaps too far,” in reaction to the price cap ruling.

At the heart of the change in contribution collection methodology is a process called “rebanding,” which involves a re-examination of how local exchanges are classed based on measurements of their costs, population and line density, and local loop length. Those changes mean that local rate subsidies will be paid out to fewer areas than previously, and more precisely targeted to high-cost areas in greater need.

Only 1.3 million residential lines in Canada now receive a contribution subsidy – or 15 per cent of Canada’s NAS lines, compared with 11.3 million lines or 95 per cent of the total under the previous system. A further significant change to the previous regime is that no subsidies will be received for business services in high-cost areas.

The CRTC’s rebanding decision of April 2001 also reduced the local loop charge by almost one-half – to less than $10 per line per month from almost $20. That reduction changed the economics of supplying local services, according to Call-Net’s analysis – and prompted it to aggressively re-target the local market in 2002 and beyond.

Reduced fees

The economics of local competition was further improved by the unbundled local loop decision of Nov. 2001 that reduced the one-time administrative fee paid by CLECs when it acquires an incumbent’s customer. That fee was reduced by more than one-half to $42.50 from $87.50 – yielding Call-Net alone an estimated saving of $5-million this year.

The need for those changes was attributed by the CRTC to both technological advances and the fact that the previous method “severely hampered” the pricing flexibility of service providers.

CLECs will also benefit – albeit slightly – from yet an other provision in the price cap decision that has reduced the floor space rental charge paid to ILECs when equipment is co-located in a phone company switching centre. The monthly floor-space rental fee has been reduced to $14.90 per square metre per month plus a 15 per cent markup, compared to the previous charge of $16.20 per square metre plus a 25 per cent markup. Restrictions on the growth of rental space in ILEC-owned facilities where the CLEC connects its network with the telcos – a previous source of contention – were removed by the CRTC a year ago.

Most recently, the CRTC resolved a conflict over service intervals and ordered the phone companies to supply local loops to rivals as quickly as they provide them for their own customers. No sooner was that complaint dispensed with then a similar proceeding was launched by CLECs seeking a shorter mean repair time to four hours from the current 24 hours.

Despite the CRTC’s best efforts, disputes will continue to plague relations between the CLECs and ILECs, particularly as competition intensifies.

It may be an exaggeration to assert, as AT&T Canada’s McLennan has, that a duopoly looms. But the recurrent theme of the financial obstacles facing would-be entrants in both the 19 th and 21 st centuries gives rise to a harsher conclusion of economics. Local telephone service may indeed be a ‘natural monopoly.’

Surtees is director of telecommunications research at International Data Corp. (Canada) Ltd. in Toronto. He can be reached at