8 Lessons from the Telecom Mess

Deregulation simply isn't working. Here's a plan to get the $700 billion industry back on track

Celebrations broke out on Feb. 8, 1996, as the U.S. telecommunications markets were thrown open to competition. A mogul-studded audience in the grand rotunda of the Library of Congress watched a Webcast of comedian Lily Tomlin and local schoolchildren eager to have broadband Internet services. President Bill Clinton signed the Telecommunications Act of 1996 into law using the very pen President Dwight D. Eisenhower used in 1957 to authorize the interstate highways. "We will help to create an open marketplace where competition and innovation can move quick as light," Clinton vowed. Some public officials, however, suspected the plan was a mess. Shortly after the ceremony, one senator who backed the legislation took Federal Communications Commission Chairman Reed Hundt aside. "We gave one side everything they wanted, and then we gave the other side everything they wanted," the senator said, according to Hundt. "Good luck."

Five years later, the telecom industry is a mess. For the first time, industrywide revenues are contracting. Profits are disappearing as prices for service plummet. On July 26, JDS Uniphase Corp. (JDSU ), which makes optical components for the telecom sector, reported a loss of $50.6 billion for its fiscal year, the largest loss ever reported. Such horrific news has investors fleeing the scene. At least a dozen upstarts, from PSINet Inc. (PSIX ) to 360networks Inc. (TSIX ), have filed for bankruptcy protection. Cash-starved companies have laid off 170,000 workers since January, more than any other sector of the economy, according to Challenger, Gray & Christmas and company announcements. And market forces are ripping apart industry giants AT&T (T ), WorldCom (WCOM ), and Lucent Technologies (LU ). "Never before have you seen this kind of bust in telecom," says James Glen, a telecom economist with market researcher Economy.com.

And consumers? They're still waiting for the competition Clinton promised. The local telecom markets remain almost complete monopolies, with Baby Bell rivals controlling just 8.5% of all phone lines. That's one-third of the 25% AT&T's competitors had swiped in the long-distance business five years after the breakup of Ma Bell in 1984. New York has the most competition, with upstarts handling 20% of the local phone business, but most of the customers who have benefited are corporations, not residential customers. Broadband is still a distant dream for most Americans: Less than 5% of U.S. households have any type of speedy Internet hookup. Says Larry Irving, who was Clinton's top communications adviser: The state of the telecom industry is "the worst of all possible worlds."

MAJOR OVERHAUL. As bad as it is, though, there is a way out. After the maelstrom of the past year, it's possible to pick through the wreckage and find crucial lessons about what went wrong--and what went right. After identifying the do's and the don'ts, we picked the brains of more than three dozen industry executives, telecom economists, and Washington policymakers. With all this in hand, BusinessWeek has come up with eight lessons and a series of steps that have the potential to not only stabilize the telecom industry but get it growing again. They also could help consumers get broadband Internet connections more quickly, more innovative wireless services, and better local phone service.

But brace yourself: This blueprint isn't about tweaking an industry. It's about making wrenching changes. Much of the overhaul will come from state and federal regulators, who must remain deeply involved in the industry even though the Telecom Act was touted as "deregulation." The key is to establish rules and regulations that will spur capital investment and spark innovation. In the local residential phone markets, for example, state regulators should slash subsidies and let the Bells raise prices for basic service so that competitors will have an incentive to battle for customers. In rural areas, the government should subsidize the rollout of broadband Net connections to make it profitable for the Bells, cable companies, and others to invest in more expansive networks. And in wireless, Washington should make more spectrum available to companies such as Verizon Wireless Inc. that are ready to invest billions to deliver new services.

The suggested steps are sure to spark controversy. For instance, 50 million consumers would have to let go of cherished telephone subsidies that have been in place for about 60 years. Politicians would have to raise phone rates for half of their constituents. And the laissez-faire Bush Administration would have to take an active role in a nationwide rollout of broadband service. Any chance of the entire plan being enacted? Probably not. But this blueprint for reform could make a big difference even if just a few steps are taken.

CRUCIAL LINK. Why go through such a major revamp? There's a lot riding on telecom's recovery. At $700 billion in annual revenues, the U.S. industry is so big that the economy's fortunes often rise and fall with its health. When telecom players boosted their capital spending by 25% per year from 1996 to 2000, to $124 billion, that helped drive torrid economic growth. What's more, telecom is a crucial link in the technology food chain: Not only do telecom companies purchase enormous amounts of high-tech products and services themselves, but their networks provide the foundation for entirely new industries, including Web hosting and online video. "Telecom is critical to getting the tech sector moving again, and telecom is critical for the U.S. economy as a whole," says William Taylor, senior vice-president at National Economic Research Associates, an economics think tank in Cambridge, Mass.

Even if all these steps are taken, it's unlikely that telecom growth will return to the scorching levels of the past few years. But the current contraction, in which capital spending is expected to fall 15% or more this year, need not last indefinitely. With the right incentives, telecom companies would begin to pour money back into the local residential market, broadband services, and wireless services. Telecom capital expenditures would rebound to low double-digit growth as soon as 2003, analysts say. That would add up to a rise in capital spending of at least $10 billion a year--hardly pocket change for the ailing communications-equipment makers.

If this plan were to be adopted, the telecom industry would look very different than it does today. The country would have cutting-edge communications services, but the companies providing them would not be the ones that were expected. The upstarts that were supposed to wrest power from the Bells would play only a minor role. The local phone giants would dominate the industry along with the cable operators. And the long-distance carriers with the big brand names--AT&T, Sprint Corp. (FON ), and WorldCom Inc.--would probably be acquired, most likely by the Bells. It wouldn't be a dream world. However, it would be better than what we have today.

Here are the lessons from the telecom meltdown and the steps necessary to get the industry back on track.



Five years after the Telecom Act was signed into law, the biggest disappointment is that most consumers still have only one option for local phone service. According to the FCC, the Bells still control 96% of the local residential phone lines. The reason is simple: The economics of the business as it's currently structured can't support competition. For starters, residential local phone service is less profitable than business service because it costs more to wire individual homes than it does to wire tightly clustered office buildings.

The real culprit is a 60-year-old subsidy system that's increasingly outdated. In the 1940s, AT&T agreed to provide cheap local phone service throughout the country to boost phone penetration, then at 40% of U.S. homes. To subsidize this "universal service," AT&T charged extra for long-distance, business lines, and other features. The pricing system has changed little since. About 70% of local residential phone lines are still subsidized, to the tune of $3 to $15 a month.

Since only incumbents typically can get the subsidies, competitive phone companies chase fat margins in the business market and largely ignore consumers. In New York, for example, basic residential local phone service is priced as low as $6.11 a month while a business next door pays $15.74 for the same service. The companies that have tried to move into the consumer market, including AT&T and WorldCom Inc., have found out that it's next to impossible to make money taking on Bells that often charge consumers less than their own cost. "One of the dirty little secrets in America is that most people pay less for local phone service than it costs to provide," says William E. Kennard, the former FCC chairman and now a managing director at Carlyle Group, a private equity investment firm in Washington, D.C. "You can't have a robustly competitive marketplace unless you have a rational pricing structure."

The solution is to remove most of the subsidies and let local phone companies raise their rates for basic phone service. Subsidies could be kept for the 10 million homes in high-cost regions, the 7 million people considered low-income by state governments, and a few other customers. All told, that's less than 20% of the U.S. population. Limiting subsidies to 20% of consumers, would cut the total subsidy amount in half or more from the current $25 billion to $30 billion a year.

TEMPORARY PAIN. Yes, that means higher rates for half the country's population. No doubt, consumers and politicians would scream bloody murder. But experience suggests that the rate hikes would be modest and that the higher prices would attract a flock of entrepreneurs with capital to invest. In a few years, consumers would have more choice and their telephone bills would be driven back down to the levels that existed during the subsidy days. What's more, consumers should get more for their money in the way of innovative new services and features. "Regulators are caught in this paradox: They want competition, but they don't want to raise the cost of basic telephone service," says Terry Barnich, the ex-chairman of the Illinois Commerce Commission and president of telecom consultant New Paradigm Resources Group. "You have to bite the bullet." National Economics Research Associates estimates that boosting below-cost local phone rates by 10% could lead to competitive phone companies taking 9% to 13% of the market.

The prime example is Massachusetts. State regulators have gradually raised the price that Verizon Communications charges for basic residential local phone service from $8 a month in 1990 to $21 a month today. It's now about $2 above the cost of providing the service. That has helped lure 161 competitors into the market, double the number two years ago. The residential market is one of the most competitive in the country, with rivals like AT&T and RCN Corp. (RCNC ) grabbing 20% of the market, five times the national average.

Now Massachusetts residents are seeing real benefits from the competition. Their average local phone bill is about $32, on par with the rest of the country and the same as it was in 1990. Better yet, customers are getting a lot more for their money--including more local toll calls, goodies like caller ID and voice mail, and in about 20% of the homes, second phone lines. Here's how the math works: While the price of basic service has increased threefold, competition has helped push the price of local toll calls and other services such as caller ID down by as much as 75%. "By improving profit margins, more capital is committed to local phone competition," says Paul B. Vasington, a commissioner at Massachusetts' Telecom & Energy Dept.

WHAT TO DO: Eliminate subsidies for all but the truly needy, and let the Bells raise basic phone rates. That will encourage competitors to enter the market, bringing prices back down while improving phone service.



The economics of the local residential communications market are inhospitable to newcomers, and the Bells have done everything in their power to make it worse. Because upstarts frequently use parts of the Bells' networks, they're dependent on the local phone giants to help provide the service they've sold to their customers. Any delay or quality problems by the Bells reflects badly on their rivals. AT&T alleges that 4% to 6% of its new customers in California lose service each month because of Pacific Bell errors. Internet service providers contend that Bells have cut off service to their customers and then tried to win the customers for themselves. "Folks really didn't understand how well-armed the Bells were for a long fight," says Clinton adviser Irving, who is a board member at DSL provider Covad Communications Group (COVDE ) The Bells deny they have engaged in anticompetitive behavior.

What few people outside telecom realize is how helpless regulators are against the Bells. Many state regulators don't have the authority to fine local phone companies. Even those states that can impose financial penalties often have very low limits on fines. For example, Maryland can fine Verizon (VZ ) just $10,000 for each incident of wrongdoing. "Our penalty is a joke," says Joan F. Stern, a state delegate. States need to give their regulators the means to impose substantial fines on the Bells or they will not change their ways. "We don't need the Wild West, we need the sheriff to come to town," says Robert C. Taylor Jr., CEO of the Chicago-based upstart Focal Communications Corp. (FCOM )

A handful of states are leading the charge. New York can penalize Verizon up to $270 million a year for anticompetitive behavior. In Illinois, Republican Governor George Ryan just signed legislation that raises fines for anticompetitive behavior to as much as $250,000 per offense. Since companies often are charged with multiple offenses, the penalties could reach several million dollars. Other states, such as Maryland, are looking at the legislation as a model for their own enforcement efforts.

If tougher financial penalties don't do the job, regulators may have to turn to a more radical alternative. They could push to split the Bells into separate retail and wholesale operations, something known as "structural separation." The retail company would retain the Bell's customers. The other would sell network access on a fair basis to all rivals. Not only would the network company be an impartial wholesaler, but it would have a huge incentive to upgrade its network with new technology so that it could accommodate more traffic. Stern plans to introduce legislation for the structural separation of Verizon in Maryland next year. "I think it's the quickest and most effective way to bring about competition," she says.

Structural separation has been a political nonstarter so far. Verizon defeated Pennsylvania regulators' efforts to split the company and forced Stern to delay her effort in Maryland for a year. "It would cost a lot of money to break these companies apart and build the new systems necessary for these companies to operate," says Thomas J. Tauke, senior vice-president for public policy at Verizon. "We estimate that just in Pennsylvania it would cost us $1 billion to have structural separation." AT&T and other rivals argue such costs are overblown, though they admit it could cost $100 million or more.

Despite the cost, the proposal may be necessary to spur competition, and it may become politically feasible in the next two or three years. If the Bells grow larger through acquisition, and if local competition fails to materialize, public sentiment may favor a breakup of the Bells. "Any time one company wears two hats--supplier and competitor--you don't have a clean relationship," says Dan Moffat, CEO of upstart New Edge Networks. "That's basically an untenable situation."

WHAT TO DO: Give regulators the tools they need to force the Bells to open their markets to competition.



As things stand, many Americans will never have the chance to get broadband Internet service because certain regions of the country are too expensive to wire up. Some 20% to 25% of the population lives in areas that are too difficult to reach for most providers. Why should we care? Because widespread availability of speedy Net connections is good for the economy. Letting people work or shop from home boosts productivity. Consulting firm Eastern Management Group estimates that broadband could add 3.7 billion work-hours to the economy each year as people commute less and drive less to stores. "Like basic phone service, the gains to the U.S. economy are going to be huge," says Taylor of National Economic Research Associates.

The country should improve consumer broadband deployment by creating a fund for network construction in low-profit-margin areas. It could use some of the $10 billion to $15 billion saved by reducing local phone subsidies. If it collected $2 a month from each phone customer, it would have $2.5 billion a year for the fund. That should be plenty to fill out the network in the least profitable areas. Instead of giving all the money to the Bells, let local phone, cable, and satellite companies compete for the subsidies. After determining which regions require subsidies, the government should hold auctions, allowing companies to bid on how little cash they would need to provide service for a defined period of time.

Government-led broadband deployments are working elsewhere. South Korea spent $7.5 billion over five years laying the infrastructure for broadband. Now 42% of consumers have DSL service, adding about 1% to economic growth, say government officials. The U.S. government played a crucial role in the deployment of basic local phone service. It will have to play a role in the deployment of broadband, too.

WHAT TO DO: Take the money saved by eliminating residential phone subsidies to pay for a broadband rollout.



What are U.S. wireless companies to do? They can't get their hands on the radio spectrum they need to deploy new voice and Internet services. Earlier this year, Verizon Wireless and others agreed to pay the FCC $17 billion for new spectrum only to find out in June that the commission didn't have the authority to auction it off. "There is a serious spectrum shortage," says Thomas E. Wheeler, CEO of the Cellular Telecommunications Industry Assn., an industry trade group. "We're at a competitive disadvantage compared with the rest of the world."

This is poor public policy. The solution? Politicians need to take spectrum away from some of the most politically connected interests in Washington. Start with the Defense Dept. It holds about 170 megahertz of radio spectrum, about seven times the amount of the average wireless company, and uses less than half of that, according to a wireless executive. Linton Wells II, acting Assistant Defense Secretary, testified before Congress in July that the department needs much of the spectrum to protect the country. "There can be no economic prosperity without national security," he said. But he left the door open to compromise by suggesting the department would give up spectrum if it could move its security operations to other radio bands.

Television broadcasters pulled off the biggest boondoggle. After receiving their original spectrum for free, they got Congress to give them a second slice of spectrum, also for nothing, to roll out high-definition television. Now they can hoard the original and new spectrum for pretty much as long as they want, even though they won't need both in the long haul. Kennard railed against this giveaway, but Congress never had the stomach to take on the companies that give them free airtime during elections. The National Association of Broadcasters says it needs extra time because of the slow adoption of HDTV.

Without spectrum, the wireless players are left sitting on their hands. They may not have enough capacity to offer voice service to all their potential customers. They certainly will be hamstrung in rolling out wireless Internet services. The one sector of the telecom industry that is willing to aggressively invest in new services is being stopped by misguided public policy.

WHAT TO DO: Slaughter the sacred cows. Take spectrum away from the Defense Dept., television broadcasters, and the satellite industry.



The country got a taste of what the Telecom Act was really about the day Clinton signed it into law, on Feb. 8, 1996. Several hours after the ceremony, the three big long-distance carriers filed a lawsuit against Ameritech Corp., now a part of SBC Communications Inc., arguing that the company was erecting roadblocks to keep rivals out of the local market. The litigation hasn't stopped since. The Bells have opposed matters of pricing, network interconnection, and even the fundamental rules of the Telecom Act itself. The effect of the endless litigation? Uncertainty and delay.

Here's how to get the process moving. For minor disputes, there should be a more effective arbitration process. Currently, the FCC is supposed to mediate disputes between the Bells and their rivals that involve federal issues--typically anything involving products or services that cross state borders. But the commission's enforcement bureau is understaffed, so it hasn't been able to arbitrate many issues. Some end up in court. Royce Holland, chairman and CEO of Allegiance Telecom Inc., has testified before Congress that the FCC should have 25 arbitration specialists who can resolve issues before they end up in litigation. "Rather than having a court try something that is very technical, you have experts in the field make those decisions," he says.

For weightier legal issues, a single federal court should be designated to oversee disputes. Take the breakup of AT&T in 1984 as a model. Judge Harold Greene of the U.S. District Court in Washington, D.C., handled the breakup and any appeals. That allowed consistent and speedy decision-making. "Greene had extraordinary power, and everyone knew they couldn't get around him by finding a judge who knew nothing about the case," says former FCC Chief of Staff Blair Levin, now an analyst at Legg Mason Inc. A similar approach now would put a stop to the endless legal disputes and give the industry a dependable legal framework within which competition could flourish.

WHAT TO DO: Streamline decision-making by regulators and courts, eliminating delays that have thwarted the Telecom Act.



Antitrust regulators evaluate proposed mergers and acquisitions with outdated measures. For example, when WorldCom launched its ill-fated attempt to buy Sprint, regulators were alarmed that the deal would put 80% of the long-distance market in the hands of two rivals, AT&T and WorldCom-Sprint. The merger was rejected. But the decision was made just as the long-distance market was starting to collapse. If WorldCom and Sprint Corp. had been allowed to combine, they might have been able to cut costs fast enough to keep pace with falling prices and revenue. Instead, they are likely to be acquired by other companies during the next year or two, removing once-powerful rivals from the market. The decision ignored the fact that AT&T's biggest competitive threat in the long-distance market no longer came from WorldCom and Sprint. Rather, it came from Verizon, SBC (SBC ), and the wireless industry. "It was a big mistake that the Justice Dept. shot down the WorldCom-Sprint merger," says telecom analyst Brian Adamik of Yankee Group. "Both companies are now struggling for survival."

What to do? Antitrust regulators should evaluate the proposed company's share of the total telecom market. For example, the combination of WorldCom and Sprint would have controlled only 22% of the U.S. telecom market. Already, AT&T and Verizon are both larger. Regulators could stop mergers that would result in 30% of the market in the hands of one company, such as the combinations of Verizon and SBC or Verizon and AT&T. But smaller competitors, such as WorldCom and Sprint or BellSouth and Sprint, should be able to merge to gain the scale to slug it out with the heavyweights.

WHAT TO DO: Regulators shouldn't worry about whether a merged company would dominate one niche, but instead consider its share of the total telecom market.



The biggest mistake AT&T made was to assume that consumers would be confused by technology and that they would pay a premium for the services of a trusted company to guide them into the digital era. As it turns out, most people weren't as confused by technology as AT&T executives thought.

The lesson is that brands, even great ones such as AT&T, must constantly be reinvigorated by new products and services. Deutsche Telekom (DT ) hit on the right strategy a few years ago in Germany. Faced with deadly competition in the residential phone market, DT slashed the price of phone service. Its margins fell apart, but it managed to hold on to its market share. Then it rolled out more lucrative services, such as high-speed ISDN. Now 19.3 million customers, or 38%, take ISDN service, one of the highest penetration rates in the world.

Most communications services, from long-distance to ISDN, eventually turn into commodities. That means companies must constantly develop unique products that can command higher prices. If telecom players fail to develop products at a sufficient pace, revenues across the board decline. The goal of deregulation is not so much to cut the average monthly telephone bill as it is to make sure that consumers and businesses get innovative new products. "Competition in Massachusetts has had a beneficial effect in terms of new services," says Vasington, the Massachusetts telecom commissioner. "The political structure always focuses on price above all else. That is entirely the wrong way to look at it."

The trouble these days is that telecom players tend to promise innovative services, then fail to deliver. Whatever happened to one single phone number for phone, office, and cell phones? What about single mailboxes for voice mail, e-mail, and faxes? If the industry wants to enjoy strong growth, it must stop trying to coast on the strength of its brands and start delivering services that are worthy of premium prices.

WHAT TO DO: If companies want to charge premium prices, they must develop premium products.



One way to speed the arrival of innovative products is for established telecom giants to give up their old proprietary technology. The local networks operated by the Bells and the other incumbents, which handle 91.5% of the nation's telecom traffic, tend to run on technology outdated by the Internet Age. Just try ordering a high-speed business data line from one of the Bells. That can take months, and a line that carries 45 megabits of traffic costs on average $6,400 a month--out of reach for most small and medium-size businesses. To make matters worse, customers can get a 45-megabit line or a 1.5-megabit line--and typically nothing in between.

Local phone networks would perform much better if they were redesigned using the open standards of the networking world. Consider the upstart Yipes Communications Inc. It sells lines that handle 45 megabits of traffic for $4,300 a month, and discounts can exceed 50%. The service can be scaled up or down to suit a customer's needs, from 1 megabit to 1 gigabit, in a matter of hours, not months. The key is that Yipes uses optical equipment based on ethernet, the networking standard of the data world. It's faster and cheaper to operate because it requires fewer pieces of equipment than the older, optical technologies used by the Bells. The local phone giants say they are installing billions in new technology each year, although a total shift to new optical technology is years away.

In the end, it really shouldn't be a surprise that telecom ended up in such a mess. The Telecom Act evolved from political compromise. As the senator admitted to Hunt, lawmakers avoided upsetting their contributors by giving everything to everybody. That may have worked well enough during the long era of telecom monopoly, but if the U.S. really expects to get the competitive market it was promised, it's going to have to make some tough decisions.

WHAT TO DO: Telecom-equipment makers and carriers must accelerate the deployment of new technologies based on Internet protocols and other open standards.

Commentary by Steve Rosenbush and Peter Elstrom

    Before it's here, it's on the Bloomberg Terminal.