TVA Rural Studies

Telecommunications and Rural Development:
Threats and Opportunities

Edwin B. Parker
Parker Telecommunications
May 1996

Appendix A
Current Rural Support Mechanisms and Related Regulatory Issues

Traditionally, the rates paid for residential telephone service have not been directly connected to the costs of providing such service. State regulators allowed telephone carriers to set prices to collect a total “revenue requirement,” based on total costs plus a reasonable profit. Even though total prices related to total costs, the prices for each particular service had no necessary connection to the costs of that service. Consequently, business and long distance rates may be priced well above cost to help maintain lower residential rates.

Regulators in many states required carriers to charge the same price for long distance calls between two rural locations as they did for calls between two urban locations the same distance apart, despite the higher costs on the rural routes. The costs of long distance service fell faster than the costs of local service because of technical advances, but carriers and regulators were slow to lower long distance rates, partly to avoid having to raise local rates. “Access charges” paid to local carriers by long distance carriers to complete long distance calls pay for much of the fixed cost of telephone equipment required for both local and long distance services.

In addition to such support provided by state regulation, a variety of Federal support mechanisms help keep prices low for basic residential service to rural subscribers. The National Exchange Carriers Association (NECA) files average interstate access tariffs at the FCC under which local exchange carriers receive payments from long distance carriers for interstate long distance calls. Long distance carriers pay each local carrier the average rate, but local carriers than pay into or draw from the NECA “pool” according to their actual costs. High cost rural carriers receive extra financial support through this “pooling” mechanism. Currently, Bell Operating Companies pay into this “pool,” but do not draw funds from the pool. This BOC contribution to costs of smaller telephone carriers is called “Long Term Support.” Without this long term support, the average phone bill of rural US subscribers to carriers other than the Bell companies would increase by $3.72 per subscriber per month.

Local exchange carriers serving fewer than 50,000 telephone lines allocate a higher proportion of their switching costs to the interstate jurisdiction for cost recovery through interstate long distance rates. Even though switching costs are largely the fixed costs of the local telephone switch, carriers allocate those costs in proportion to the minutes of use for intrastate versus interstate calls. Local carriers with fewer than 10,000 lines allocate three times the amount of switching costs to the Federal jurisdiction, through a procedure called Dial Equipment Minute (DEM) weighting. Local carriers with 10,001 to 20,000 access lines have a DEM weighting factor of 2.5 and carriers with 20,001 to 50,000 access lines have a DEM weighting factor of 2. In no case can carriers allocate more than 85 percent of the total switching costs for recovery through interstate rates. Without this Federal subsidy through the DEM weighting factor for small telephone carriers, intrastate rates for customers of such telephone carriers would increase by $3.92 per month per subscriber.

The FCC allocates 25 percent of the costs of the “local loops,” the lines between the subscriber’s telephone and the local telephone switch, to the interstate jurisdiction. Carriers recover those costs through the access charges paid by long distance carriers to complete interstate calls. For most local carriers, fewer than 25 percent of the calls are interstate. Some long distance carriers argue that subscribers should pay all of the costs of their lines to the local telephone switch as part of local telephone service. Others argue that the allocation of costs should be proportionate to usage. If interstate long distance calls bore only their proportional cost of local lines, the price to rural telephone subscribers would increase by an average of $9.98 per subscriber per month.

Because some rural telephone carriers have particularly low subscriber densities and consequently high costs per subscriber, the FCC created a “Universal Service Fund,” sometimes called the “high cost fund.” Local carriers with costs greater than 115 percent of the national average are eligible for additional support from this fund. They collect these additional funds from interstate long distance carriers through the access charges long distance carriers pay to local carriers. NECA administers the fund. Without this subsidy, rural telephone subscribers would see an average increase of $6.04 in their monthly phone bills.

Without any of these subsidies, the interstate access charges of rural telephone carriers would still be higher than the access charges of Bell Operating Companies. Currently, under the process of geographic rate averaging, long distance prices on calls to those rural locations are the same as interurban calls of similar distance. If carriers “de-averaged” rates and rural subscribers paid the correspondingly higher costs of their interstate long distance calls, rural phone bills would increase by a further $3.72 per month per subscriber. This does not include any higher costs the long distance carrier may have in its network to reach rural subscribers, merely the amounts paid by the long distance carriers to the local carriers to cover local costs.

The combined effect of de-averaging long distance rates and removing the four main Federal support mechanisms for rural telephony would be to increase the average monthly phone bill for rural subscribers (including both local and long distance charges) by 72 percent, from $43.20 to $74.53 per month. Of course these are only averages. The changes in rural phone bills, without these subsidies, would range from an increase of $4.13 per month for subscribers to one rural telephone carrier in Wisconsin to an increase of $395.93 per month for subscribers to another rural telephone carrier in Texas.

As the level of telecommunications competition continues to increase the FCC will come under increasing political pressures to reduce subsidies so that rates move closer to costs. As a result, carriers and state regulators will be under increasing pressure to find ways to compensate for cost allocation shifts from the Federal to the state jurisdiction and reduced Federal subsidies. These Federal pressures resulting from increased interstate telecommunications competition, will be in addition to the pressures to move intrastate rates closer to costs as intrastate telecommunications competition increases.

These traditional methods of supporting rural telephone service are increasingly vulnerable to the pressures of competition. It will not be possible to retain all of the traditional support mechanisms in their present form indefinitely. (The FCC has begun a proceeding to revise the subsidy mechanisms of the Universal Service Fund. ) States should minimize the risks of catastrophic change later by starting a gradual transition to a system of support for rural telecommunications services they can maintain in a competitive environment.

State regulators and policy makers have the particularly difficult task of protecting the interests of rural users during a long and difficult, but inevitable, transition to competition. New technologies offer great promise for both urban and rural telecommunications users. Devising policies for transition to competition that help rather than harm rural economies will be a challenging task.

Local Rates, Access Fees, Depreciation Rates and Universal Service

In most states, state regulators have kept local rates low by recovering much of the cost of local lines and switches from intrastate long distance users. They permit local carriers to charge high “access fees” to intrastate long distance carriers. They also allow carriers that offer both local and intrastate long distance to recover a large portion of their local line and switching costs from the intrastate long distance charges. They also keep current local rates low by requiring long depreciation rates, so that carriers charge current users a smaller percentage of capital investment costs. (Long depreciation rates actually cost users more because they pay over a longer period of time and pay more cost of capital charges, the carriers’ return on investment, in the process. The process is analogous to deferring current payments for consumer goods by putting them on a credit card: consumers must pay the total bill sometime and deferring the payments adds substantial interest charges.)

The policy goal served by keeping local rates low was the laudable one of “universal service.” The regulatory theory was that low local rates would make telephone service affordable to more people. Some commentators now suggest that the task of achieving universal service is largely finished and state policy makers should therefore abandon that goal. They suggest instead that policy makers focus on the newer goals of stimulating new competitive services and ensuring that the competition is fair.

The facts do not support abandonment of the policy goal of universal service. The latest FCC study of telephone subscribership showed that, in November of 1995, 93.9 percent of US households had telephone service. This level of telephone penetration is not evenly distributed across the country. In many rural counties throughout the country the telephone penetration rate is below 85 percent.

Achieving or even approaching universal service with the remaining six percent of US households without telephone service will not be easy. The percentage of US household with telephone service is currently less than the peak of 94.2 percent achieved in 1993. Maintaining local rates at their present levels will not be sufficient to achieve the goal. If it were, those households would already have telephones. Lowering local phone rates sufficiently to create a significant increase in penetration rates is not a plausible alternative. Keeping telephone rates low for everybody with subsidy mechanisms built into the rate structure is no longer the best strategy to achieve universal service. Specific policies aimed at removing the particular barriers for the remaining six percent of households without telephone service are preferable to maintaining rates below the underlying costs for the 94 percent of US households that do have telephone service. Targeting subsidies at those most in need will be more effective than distorting the rates away from economic costs for those who can well afford to pay.

Several years ago, when the FCC proposed increasing local rates by a flat $3.50 per month per subscriber interstate access fee, many complained that it would reduce the percentage of US households with telephone service. In fact, telephone penetration continued to rise during the time those charges were being phased in. This was partly because the FCC concurrently introduced a targeted subsidy called “lifeline service” to provide a way for low income households to continue to afford telephone service.

Intrastate Long Distance Rates and Access Charges

The major telecommunications barrier to rural economies becoming competitive in this “information age” is not the price of local telephone service—it is the high price of intrastate long distance service. High long distance toll calls are both a financial and a psychological barrier that blocks potential customers from reaching rural businesses. The rationale of high intrastate toll rates and low local rates does not make sense for rural users. FCC studies have shown that rural users, who are poorer than urban users on the average, spend a higher proportion of their income on telephone service. Rural users make more intrastate long distance calls than urban users because rural users can reach a much smaller number of rural businesses and residences with a local call. That system of high toll and low local rates may be attractive to urban users who do not have as much need for toll services. However, it does not make political or economic sense to have poorer rural users subsidize richer urban users. That was not the intent of the current subsidy mechanism.

The current situation is an anachronism dating back to days when toll calls were a luxury used by the rich and a necessity for the rest of us only in emergencies. The US economy has changed since then. Intrastate toll calls have become necessities for rural residents and rural businesses. Complaints about intrastate calls being priced significantly higher than out of state rates are not just an absurdity to laugh at. They are legitimate complaints from people concerned about their local economy. Keeping business in state that would otherwise go out of state should be one of the first concerns of state economic development in the age of the “information superhighway.”

Arguments pointing out that the FCC $3.50 per month access charge is the primary cause of the differential are irrelevant. (That Federal monthly access charge resulted in lower per minute long distance charges for out of state calls.) The Federal access charge exists. State actions cannot change it. No amount of explanation will take away the obvious fact that intrastate toll calls are more expensive than interstate calls for comparable distances. Blaming the FCC and wishing they had not done it will not change the facts on the ground and in people’s minds. State regulators should deal with the problem, instead of pointing fingers elsewhere.

The main reason intrastate toll rates are so high is the access charges intrastate toll carriers pay to local exchange carriers to cover much of the fixed cost of the local telephone lines and switches. Regulators can take several approaches concurrently to reduce intrastate toll rates. The goal should be to reduce rates to the point where intrastate toll rates are no higher than interstate rates for comparable distances.

The first step is that regulators should apply any rate reductions resulting from previous over-earnings to reduction of intrastate toll rates. Credits on local phone bills or other adjustments to local rates are an inappropriate place for those adjustments, given the magnitude of the rate rebalancing necessary to prepare the economy for the onslaught of telecommunications competition.

The second step should be the use of competition as a tool to reduce rates. The best way to ensure lower intrastate toll rates will be to encourage further competition in intrastate long distance services. The next step in stimulating such competition will be to require equal access (1+ dialing) for all intrastate toll calls. With equal access, customers could preselect a long distance carrier of their choice for intrastate services, just as they do now for interstate services. It is likely that local exchange carriers, especially those that now provide intrastate calling on an exclusive basis, will suggest that the expense of converting to intrastate equal access will be prohibitive. Carriers made similar arguments before the FCC ordered equal access for interstate toll calling. Any state order for equal access should include as a condition a bona fide request from a qualified competitor and should provide a reasonable amount of time for the upgrade of facilities. (The FCC allowed three years.) In special hardship cases, if any, state regulators could consider waivers of the general requirements.

These two steps are unlikely to be sufficient to get intrastate toll rates down to the level of interstate toll rates for comparable mileage. To meet such a goal, state regulatory commissions also will need to take a third step. They should rebalance toll and local rates, perhaps by instituting an intrastate subscriber access charge similar to that used by the FCC for interstate subscriber access. It will be difficult to get intrastate rates down to the level of interstate rates if local carriers charge long distance carriers a higher carrier access charge for intrastate access than they do for interstate access. To ensure that the benefits of lower access charges to long distance carriers reach users, regulators should obtain agreements from major long distance carriers that they will lower prices to users by the amount of the resulting cost reductions.

Competition, Interconnection and Carriers of Last Resort

Since the FCC controls licenses for wireless services and has preempted most state authority to regulate such services, increased local telephone competition from cellular and PCS service providers is inevitable. Federal legislation now permits cable television companies to compete for local telephone service. This is a quid pro quo for letting telephone carriers enter the cable television business. States will be unable to prevent local telephone competition. States should use the regulatory power they do have to put in place rules for competition and interconnection that take advantage of the transition to competition to achieve their policy goals.

The rules concerning interconnection of competing networks into a transparent switched network of networks will be the main area of state control. States may be able to stimulate investment in advanced telecommunications infrastructure and services throughout the state by encouraging competitive entry and establishing fair rules for competition and interconnection. Establishing the rules of the game early may provide incentives for carriers to invest in their state before making investments in other states that have not established clear rules encouraging competition. Both incumbent carriers and new entrants are likely to make investments. Equal access rules, including equal access for intrastate toll carriers, as discussed in the preceding section, will be an important part of the “level playing field” necessary for the competition to be fair for all participants.

The trickiest part of the transition from monopoly to competition will be revision of rules with respect to carriers of last resort. In a truly competitive industry there would be no barriers to entry or exit. Carriers unable to remain profitable in a competitive environment could go bankrupt or otherwise stop offering service. Historically, states regulated both entry to and exit from the business of providing telecommunications services.

Traditionally, local exchange carriers had a monopoly franchise in a geographically defined service area and, in exchange for that monopoly franchise, accepted responsibility to serve all qualified customers within that territory. The standard argument of monopoly incumbents against permitting competitive entry is that the new entrant will not be required to serve all customers within the territory of the current carrier. Therefore the new entrant will engage in cream-skimming, that is, serving only the most profitable customers. Furthermore, new entrants may not face the same barriers to exit from the business should they fail to achieve the level of profitability desired by their owners. Regulators, acting to protect the public interest, have a responsibility to ensure that at least one provider is willing to continue to serve. Rural telephone subscribers depend on their regulatory commission to protect their right to continue to receive service. For subscribers in larger urban markets, the issue is a hypothetical one unlikely to arise in practice. However, rural subscribers may still need this regulatory protection.

State regulators might choose to require new entrants to define the geographic territory within which they propose to offer service. Given such a definition by the competitive entrant, the regulatory commission could require that they provide service at their standard rates to all qualified potential customers requesting service within the territory defined by the new entrant. New entrants would thus be defining for themselves the areas in which they are willing to be carriers of last resort. When such territory only partially overlaps the territory of an incumbent with pre-existing carrier of last resort responsibility, regulators could permit the incumbent to propose withdrawing from carrier of last resort responsibility for part of its territory. Such proposed withdrawal should include an offer to sell all of its facilities in the territory it no longer desires to serve, at a pre-determined price (possibly the depreciated book value of those facilities). Since carriers rarely like to give up franchise territory, such a mechanism may never be needed. Nevertheless, the availability of such a mechanism may be necessary as a safety valve to protect vulnerable rural customers.

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Contents, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, (App A), Endnotes

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