As 1996 comes to an end, we are struck by the uncomfortable notion that although the Internet as a major commercial medium is almost two years old and we still know very little about the Internet's long-term economic structure. Will access be unlimited? Will we pay for access to certain content? Will we pay for access? Who pays who? How much does it cost? A major piece of the puzzle was unveiled on Christmas Eve when the FCC posted its NPRM (Notice of Proposed Rulemaking) regarding access charge reform. While this proposal is not definitive, it is likely to have a major impact on the eventual decision which is currently slated for May.
Just to make sure everyone is on the same page, we should run through a brief explanation of the current state of the world. Long-distance providers typically pay around 3.25 cents per minute to each LEC (Local Exchange Carrier) for the service of originating and terminating a call. These prices are intentionally high in order to subsidize universal service in the local markets. This allows unlimited local calls in most areas, with the long-distance dialers footing most of the bill. ISPs (Internet Service Providers) who use the exact same physical connections as the long-distance providers, pay absolutely nothing in access fees as a result of a supposedly temporary ruling in 1983.
The NPRM was supposed to address three issues: (1) how do we lower egregious long-distance access fees?, (2) how do we maintain universal service?, and (3) what do we do about ISPs.? The majority of the proposal dealt with the first issue. Two key proposals were made, and it is likely that a compromise solution will endure. With respect to the universal service issue, very little was said, other than the fact that the FCC would like to see universal service extended to Internet access. Lower the subsidy and increase the spending -- yes, the FCC is part of the U.S. government. This leaves the issue with which we are most interested, Internet access.
The FCC's proposals represent an unquestionable victory for Internet users. The FCC has long been a huge supporter of low-priced Internet access and stated definitively that, "information service providers should not be subject to interstate access charges." Therefore, no matter how access charge reform affects the cost of voice long-distance, there is little chance that the LEC (Local Exchange Carriers) will be able to charge ISPs access fees. The FCC also stated that "it must identify those policies that would best facilitate the development of the high-bandwidth data networks of the future." In other words, the FCC is interested in creating artificial incentives that will encourage investments in information service infrastructure.
It is interesting to note that the NPRM did recognize that data services do not belong on circuit switched networks. In fact, they used this difference to launch a separate NOI (Notice of Inquiry), regarding how information services affect the existing circuit-based network. Some of you may be aware of emerging communication technology that separates data traffic from voice-traffic before it reaches the central office switch. The policies promoted by the FCC are unequivocally supportive of the deployment of these types of devices, and appropriately positioned equipment companies may be the biggest beneficiary of the proposed reform.
We see two major inconsistencies with the policies suggested by the FCC. The first issue deals with the soundness of the economic model that will underlie our telecommunications industry. The recent NPRM "includes several proposals for a series of reforms to the existing access charge rate structure rules that are designed to eliminate economic inefficiencies. The proposals are intended to result in access charge rate structures that a competitive market for access services would produce." Fine. We are equally supportive of achieving economic efficiency.
Unfortunately, the FCC forgot its commitment to economic efficiency when it came time to suggest policies regarding Internet access. By instituting such a major discrepancy between the cost of originating and maintaining a long- distance phone call relative to the cost of connecting to the Internet, the FCC is creating an enormous arbitrage gap. Therefore, we can now be assured that companies will invest millions of dollars chasing unnatural market opportunities, created solely by inconsistent governmental policies.
Make no doubt about it, Internet telephony will be a major discussion topic again in 1997. This is despite the fact that the FCC has already determined that data traffic belongs on a packet network and voice on a circuit network. We believe it is dangerous to have a situation where arbitrage opportunities based on government mandated pricing are the catalyst for future investment. No longer is the market dictating the direction, but rather the government.
This leads nicely into our second concern with regards to the FCC's recent issuance. The new NPRM contains sixteen instances of the word "deregulation,." the primary theme behind the Telecommunications Act of 1996. However, the FCC posture with regards to the Internet seems to be one of increasing involvement rather than decreasing; "the Commission sought comment on how it can most effectively create incentives for the deployment of services and facilities to allow more efficient transport of data traffic to and from end users."
Of course, the FCC has ample reason to believe that it has the right to proactively affect the emerging Internet rather than adopting a hands-off policy. According to the NPRM, we should be thanking the FCC for its previous decision regarding information service access charges. "It is extremely likely that, had per-minute interstate access rates applied to ESPs over the past 13 years, the Internet and other information services would not have developed to the extent they have today -- and indeed may not have developed commercially at all." Extremely likely that it may not have developed at all. And we thought Marc Andressen and Vinton Cerf were responsible for the Internet's emergence. Apparently it was the FCC.
Obviously the FCC's proposal is a major win for ISPs. Not only is the FCC implementing a policy that keeps ISPs costs minimized, the tone of the document is very ISP friendly. We have long felt that Reed Hundt, the Chairman of the FCC, views the Internet and ISPs as potential liberators. Of course, without access charges, ISPs will be left to deal with the negative economic realties of unlimited usage pricing on their own. This began two weeks ago when Netcom (NETC, $14) announced that it was abandoning the $19.95 model, an continued last week; an article in the Wall Street Journal suggested that Sprint (FON, $40) might soon move to tiered-usage pricing.
At first glance, the proposed access charge reform seems to be a victory for long-distance providers as well. Reduced costs, even if they are met by reduced prices, should spur overall demand for long-distance service. However, we think this one-step analysis ignores the fact that with access charge inequality (between long-distance and Internet access), there will be an enormous incentive for companies to invest in Internet telephony. Therefore, over the next year, the long-distance companies will be increasingly asked to answer to the threat of the Internet as a medium for real-time voice, despite the fact that the circuit based network may be more economically suitable for this latency dependent application. Voice-based long-distance will be burdened as the sole subsidizer of universal service.
For the cable-companies, we would consider the NPRM to be slightly negative. Had the FCC instituted per-minute access charges on ISPs, the cable companies would have been able to offer lower Internet pricing, largely because their networks are being designed as packet networks as opposed to circuit networks. However, this is a minor issue, and will only be construed as negative by those that expected Internet access charges.
This leads us back to the Regional Bell Operating Companies (RBOCs). Is it just us, or does Reed Hundt have it out for these guys? It seems that each incremental decision is more negative for the local access providers, and no one has sympathy for the "evil monopolists." Even AT&T (T, $44), a famous monopolist in its own time, has taken to tongue- lashing the RBOCs. (Admittedly, the RBOCs have diluted their "the Internet is overcrowded" message by offering discounts on Internet access to consumers who purchase a second-line.)
The one place that the RBOCs will find sympathy is with the local legislature. This has already been proven by the injunction of certain aspects of the Telecommunications Act of 1996. We predict that lower access charges with no compensatory relief will drive the RBOCs to implement usage- based pricing on all calls, just as exists in the rest of the industrialized world. The States are likely to be supportive, being tired of the national government implementing policies (like universal service) and expecting the localities to cover the cost.
Above the Crowd is a bi-weekly publication focusing on the evolution and economics of the Internet. It is distributed through First Call, fax and email. To be placed on the distribution list contact your Deutsche Morgan Grenfell salesperson or send email to atc-request@abovethecrowd.com with the word "subscribe" in the body. As always, feedback is both welcomed and encouraged. ABOVE THE CROWD is a service mark of J. William Gurley.
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