Public Utility Research CenterUniversity of Florida

Robert C. Rowe, Esq. rowe@balhoffrowe.comOctober 2005

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Beyond Beyond JarndyceJarndyce(Many of the (Many of the telewartelewar litigants are dead and the assets depleted)litigants are dead and the assets depleted)

Occam’sOccam’s razor versus the Big Bangrazor versus the Big BangBeginning Telecom ReformBeginning Telecom Reform

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“We must not forget that regulatory measures are temporary expedients, not eternal verities.”

Justice Jackson, FPC v. Ohio Gas Co. (1950)

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“How the Internet killed the phone business”

The Economist, headline September 19 2005

“In the long run, we’re all dead.”John Maynard Keynes

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OutlineOutline

Telecom overviewApproaches to Telecom ReformEmerging State RolesTwo High Value Propositions

Telecom Overview

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Telecom Landscape in 2005Telecom Landscape in 2005

Source: FCC and NECA

Telecom Act of 1996Law was ambiguousInterim transition – transition to what?Process has been unpredictable

Telecom is complicatedHalting implementation process

Financial signs of competitionUrban markets—natural competition

Intermodal share shifts occurringWireline losses 4%-5% annuallyWireline MOUs down 10% annuallyCarriers focusing on competition

Rural markets—less competitiveWireline losses about 2% annuallyIntercarrier arbitrage is seriousUSF system is failing

Regulation is showing its agePolicy systems inadequatePolicy analyses are inadequate

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Competitive OutlookCompetitive OutlookCompetition will accelerate

Business competitionPending mergers and competitionCompetitive platforms more stable

Residential competition increasingVoIP and data-centricAsset competitors with cable leadingChallenging policies—software/VoIP

Technology changes are paramountData services are key to futureCost-effective provision of value

Import is fast becoming apparentCustomers gain more cost-effective services in urban regionsCompanies focus on better assets/ broader differentiated servicesCompanies will increasingly rationalize underperforming assetsContent will be one of the major determinants of financial excellenceMajor policy challenges emerging

High-Speed Consumer U.S. Market Share

0%

5%

10%

15%

20%

25%

30%

35%

1999 2000 2001 2002 2003 2004Source: Balhoff & Rowe estimates; Company data

DSLCableSatelliteFixed WirelessTotal

RBOC and Cable Net Adds

200

400

600

800

1,000

1,200

1,400

1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04

(000

s)

0%

10%

20%

30%

40%

50%

60%

DSL Cable DSL % of RBOC/MSO total addsSource: Balhoff & Rowe estimates; Company data

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Wireless and Wireline Demand GrowthWireless and Wireline Demand Growth

Sources: NECA, CTIA, FCC

The Playing Field is Expanding

•Technology advances

•Playing field grows

•Revenue spanning more applications and modes of delivery than ever

Fixed Portable Mobile

Video

Data

Voice

Applications

DeliveryMode

Source: Legg Mason Investment Banking 10

The Ultimate Winner?

Fixed Portable Mobile

Video

Data

Voice

Applications

DeliveryMode

•Clear the competitive overlap between sectors will grow.

•Unclear if or when a sector will be the ultimate winner

ILEC

Cable

Wireless

Satellite

11Source: Legg Mason Investment Banking

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Investor ChallengesInvestor ChallengesEquity and debt investors more risk-averse

Memories of the post-2000 telecom collapseDownsizing of telecom funds and personnelCore analysts on the sell-side and buy-side are fewerFocus on high and more predictable returns

Fundamental analytical viewSimple legacy system

Simple financials—cross-subsidizations based on investment and rate of returnSimple structural system

Intercarrier regimes based on generally well-defined MOUsUniversal service dedicated to COLR-carriers with strict reports on USF investmentJurisdictional distinctions were sharp—states v. federalAn effective supplemental taxation system for state and federal jurisdictions

Multi-variable Telecom Act of 1996Financials now complex—risky investments, rising costs, minimal cross-subsidizationStructural system is disintegrating or preparing to evolve

Intercarrier regime is fraught with arbitrages, including “reclassified” or phantom trafficUniversal service is troubled because of (1) shrinking IXCs and (2) policy in fluxJurisdictional distinctions disappearingTaxation is looming problem because of disparity in treatment of carriers

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Challenges for Regulators Challenges for Regulators Former regulatory systems were relatively simple

Rate regulation and rate of returnEffective system of cross-subsidiesCarrier of last resort

New environment is complex and often intractableIntermodal competition Political issues regarding IP v. TDM (one network or two?)Subsidies—implicit and explicitInvestors drive investment issues

Key insightsInvestment is slowed when capital costs riseCapital costs are significantly raised because of uncertainties

Investors are afraid because of technology changes and competitive turmoilInvestors are seriously concerned about regulatory uncertaintyPolicy investment goals are premised, in part, on regulatory clarity

Policymakers will increasingly need to establish partnerships with industryTo effect real-world solutionsTo provide a more flexible systems in a world changing rapidly

Approaches to Telecom Reform

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FCC process•Prolonged•Unpredictable•Compromise•Litigated

Legislative process•Possibly shorter?•General principles only•Rural supporters•FCC implements

State process•Generally shorter•More structured•But multiple venues•Incomplete solutions

Cause Problem Reform Approach

Technology changes, especially IP-based services, wireless substitution (access and service)

Inexpensive schemes & methods to mask or reroute IXC traffic (10%-20% annualaccess rev contraction)

Rural policy changes are uneven & often confused, e.g., USF for competitors

Competition from CLECs, IP & alternative access providers (accelerating lineloss)

USF obligations growing due to CETCs, step function increases from e-rate and access-related obligations.

Difficult or impossible to measureIP access MOUs/routing

Principles of competition &USF are not reconciled

Intercarrier comp—intrastate, interstate, reciprocal compensation, special access

Market-appropriate regulation – retail, wholesale, federal and state issues

USF reform—contribution mechanism, ETC threshold, focus on COLR

Virtual NXX traffic and access avoidance (currently reducing approx. 5%-20% of access v. 2003, accelerating in 2005)

USF base shrinking and increasingly inconsistent with market. Must be broadened, future-ready, competitively neutral

Competition from IP & alternative access 2% line loss likely to accelerate. IP and SIP effects on second lines, vertical revenues, and commercial accounts

Multiple reforms concentrated in USF

and intercarrier compensation

Likely a combination of processes, focused

through industry proposals

Iatrogenesis – misdiagnosis leading to wrong prescriptions, potentially killing the ruralpatient

Piecemeal reformsexempting IP and otherbroadband services from network compensation obligations

Industry solution•Shorter process•More financial focus•Vs. strong political forces

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Candidate principlesCandidate principles

Consumers should be better off!Reform should be grounded in sound financial analysis and economics

Massive loss of value across segmentsUncertain investment climate for infrastructure deployment

Networks are high fixed costProvisioning new servicesUpgrading infrastructureTransactions that benefit customersDisruptive effects of IP applications on current business models

IP services depend on high quality broadband infrastructureIP/SIP disrupts traditional revenue streams, including retail voice and vertical services.

Market-based approaches, esp. for large carriers serving more urban areas.Real “carrier of last resort” costs faced by carriers of all sizes serving high cost areas.

Deal expressly with externalities and public policy concerns, e.g. public safety

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Candidate principlesCandidate principles

Reaffirm rural/non-rural policy distinctionDifferent costs, scope and scale economies in rural areas (Rural Task Force paper 2)Acknowledge rural carrier successes in providing access to advanced servicesKey role of rural carriers in their communitiesNote RLEC concerns about transport

Further rationalize federalismMore dispute over extent than direction of reformCould Diogenes find a principled federalist?NARUC policy a good step forward

Recognize technology and market challenges to asymmetry, and substantial “leakages” from regulatory scope (contrast electric distribution)Regulation cedes the field as market advances

Surprising support among many regulators for further retail ratederegulation beyond provider of last resort

Dispute over “rules based” versus broad statutory principles and delegation

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““When you come to a fork in the road, take itWhen you come to a fork in the road, take it””

“Big Bang”Solutions integrated into a coherent whole.All the telecom babies get kissed.No one gets theirs until everyone does.May take years, or – the stars could align.

Occam’s RazorWhat has highest value?What can realistically be done?Who are the necessary parties?

CompromiseDivide legislative and agency tasks.Legislative action on the essentials, directions to the agency on other matters, with deadlines and reporting requirements.Create a clear and enforceable framework, and monitor to ensure agency compliance.

19

Retail Rates*Rate base/Rate of

Return*AFORs *Price cap

CustomerCustomer educationConsumer protectionRetail service quality

Universal ServiceCustomer support – Low IncomeLoop support – High Cost Fund

E911 * Schools & libraries * Rural health care

Wholesale*Rates *Terms *Numbering/LNP *Service quality

*Interconnection/unbundling *Structural/non-structural safeguards

General consumer law*Securities* Uniform Commercial Code*General contract law* Bankruptcy*Anti-trust *Common law (torts/common carriage)

Form•Contested case•Tariff•Rulemaking•ADR•Auctions •Collaboration•Contract•Implicit consensus

Forum•Legislature•Agency•Court•Standards body•Private dispute resolution

“The policy pyramid”

LevelInternationalNationalRegional StateLocal

State of nature – Hobbes v. Rousseau

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Lessons from complexity theory?Lessons from complexity theory?Developed in physical sciences, applied to social sciences and management (compare scenario planning).

Chaos theory a subsetBehind the jargon (and of course lawyers are jargon-free!), provocative and useful ideas.

View legal and policy structures as coexisting, complex adaptive systems.

Limited ability to achieve specific outcomesInstead, influence over (unpredictable) trajectories of performance.

Goal: Design policies more suitable for interactions with, interpretations of responses to sector over time –sustainability.

Don’t seek “best” policy, but rather policies robust across a range of possible outcomes.Shift from static optimization to emphasis on adaptability.Economic viability + political feasibility.Acknowledge path dependency

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Lessons from complexity theory?Lessons from complexity theory?

Economic constraints on policy – policy must generally support private investment, enforceable transaction rules (property rights), limits against arbitrary government action/expropriations.View federalism as a “patching algorithm” with adaptability through diversity and coupling of jurisdictions.

Stability plus experimentation as way to develop sustainable policies.Evolution over timeRequires flexibility in sharing, plus new tools to develop adaptive policies.Contrast complete preemption from conditional preemption.

From Barbara Cherry, PhD, The Telecommunications Economy and Regulation as Coevolving Complex Adaptive Systems: Implications for Federalism (delivered to TRP)

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Regulatory glide path in converged IP-based world?

Emerging State Roles

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Old word: Dual federalism.“One big company,”

two regulators, and a “horse high fence.”

New world: Broken fences, lots of “borders” – technology, layers, jurisdictions, etc., but nobody can find the property lines.Many issues happen on the borders.

Alternative 1: Preemptive federalism. Efficiency, consistency, scope of markets require national action. (“Withering away of the states.” Strongly top down.

Alternative 2: Subsidiarity. “Bottoms up.” EU/Articles of confederation.

Alternative 3: Cooperative federalism. Both federal and state authorities charged with implementing federal law within a federal structure. Less top down.

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Five buckets of policy?Five buckets of policy?Function Needed or

not?Who does it and how?

Infrastructure support (e.g. 254, 706)

“Bugsy sent me”(Enforcement)

“Can’t we all get along”(Mediation and facilitation)

Information

Consumer protection

Which functions are needed? How are they best performed? By whom? Do some conflict? (E.g., would a strict Sec. 252 filing requirement for services not required under Sec. 251 discourage voluntarily negotiated or mediated outcomes?)

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State rolesState roles

Regional approaches.Minimize inconsistent requirements.Better harmonize with market scope.More efficient for regulators and market participants.

Wholesale.Implementation and monitoring of wholesale regimes.

Qwest QPAP Audit – Liberty Consulting.Follows on 13 state Section 271 collaboratives.

Phantom traffic – under-billed as well as unbilled.State rulemakings and enforcement.Coordination within NARUC.

“Facilitation” of facilities deployment and access.Progress and Freedom Foundation suggests new role reviewing cost allocations for municipal broadband projects.

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State rolesState rolesRetail.

Lead implementation of “market-appropriate” rate and service regulation.Numerous states moved ahead on reduced retail regulation, while no outcomes yet in Congress.

Significant state-telecom rewrites in ’05.NY PSC Competition III proceeding recommends reduced regulation of Verizon and Frontier, finds significant competition at least in more urban areas.

Need to consider regulator costs to small companies as wellWill the regulatory “hammer stay in the closet”?

Intercarrier compensation.Largest portion of ICC is intrastate.In absence of more direct FCC leadership, NARUC convened ICC Forum.

Almost ADR-lite.Direct exchange among stakeholders.Developed better understanding of numbers, issues, and positions.Participants’ positions evolved.

States participate in shaping federal policyICC principles“Straw man” proposal

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State rolesState rolesUniversal Service.

ETC Certification.Opposite of “public choice” expectations – states often tougher than FCC, not treating as “free money.”FCC rules advisory to states.NARUC ETC workgroupMontana and Missouri ETC rulemakings.

States participate in shaping federal policy.Joint Board10th Circuit

State block grantsArguably inefficient and unpredictable.Prefer rules-based to adjudicated allocationMay constitute impermissible sub-delegation“Punts” tough issues in USF.

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State high cost and ICC fundsState high cost and ICC funds

By 2002 about half states had or were implementing USF.More states required wireless contribution than did notMost states supported through a percentage surcharge on intrastate, some assessed all, some used line chargesMost had third party administratorMost had some version of federal ETC regimeIncreasing number have some broadband componentAccess reform an increasing concernNebraska activity especially detailedNew Mexico most recent to adopt legislation

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State funds State funds –– common issuescommon issues

Legal authorityCovered servicesEligibilityPost-designation review (e.g. annual certification)Earnings test or “make whole” all revenuesContribution sourcesFund administrationRole of PSC or other public entities

Two High Value Propositions

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Two high value propositionsTwo high value propositions

Procedural reform of FCCDebate over continued independent commission, single decision-maker or reassignment to an existing department within governmentMy preference – meaningful modifications to existing structure, based on systems that are working elsewhere (private and public sector models).

Universal service/intercarrier payment reformChairman Martin providing effective leadership on key issues.

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Bad results likely from bad processBad results likely from bad process

Non-process process makes it terribly difficult for FCC to reach deliberative, judicially sustainable decisions on many complex, contentious issues.

Good people stuck in a bad processPaper process supplemented by permit-but-disclose not conducive to reasoned decision-making or judicial review

Qwest v. FCC (2-23-05): FCC must return with “empirical findings supporting its conclusion,” and utilize its expertise to craft a support mechanism “taking into account all the factors that Congress identified.”

Nothing resembling contested case, but alsoNothing resembling ADR/negotiated rulemaking.No deliberative meetings of all commissionersDifficult for this not to be perceived as “political”

In this setting, for example, pre-TRO parties often fell back to extremist positions.

Reasonable ideas for reasonable discussion were attacked rather than discussed.Delay and uncertainty ultimately hurt all.

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Modest but achievable procedural reformModest but achievable procedural reformAre those who don’t learn from history likely to repeat it?

Intercarrier compensationUniversal ServiceFurther work on competition rules?Media?

A better way?Federal models – FTC or FERCFCC Enforcement Bureau State models –

Negotiated rulemakingWell managed quasi-adjudicationADRROC multi-state

Business modelsScenario planningFinancial options analysis

Require deliberation by decision-makersSet deadlines for final agency orders, including rulemakings and actions on petitions.

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Universal service/intercarrier paymentsUniversal service/intercarrier paymentsIdentify necessary partiesDevelop common data setIdentify parties’ core interests, and alternate strategies to meet themWon’t happen through paper process alonePossible combination of legislative and agency actions to implementUniversal service – key issues now on the table

Stabilize and broaden contribution baseRefocus on core support purposes

Support networks, not servicesHigh fixed costs to serve disbursed and distributed areas

IP services disrupt current business model and support system, but do not change the need to support networks

Aim high! Producing value to customers“No barriers” to advanced service deployment over supported networks

Rigorous ETC certification and reviewMinimize moral hazard from liberal certifications

Support based on own costsRLEC support based on embedded, as forward looking cost model has not been reformed

Can keep FLEC as an optionDevelop wireless support model

Do not discourage rationalization of rural ownership and serviceRecognize successes of rural providers

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Still seeking the “sunny upland.”

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About Balhoff & RoweAbout Balhoff & RoweBalhoff & Rowe, LLC, is a specialized professional services firm focused on providing financial-regulatory advice. The principals

have nearly 30 years of experience in advising investors and regulators on complex investment issues. They have provided services to a wide range of communications companies, including incumbents, competitive carriers, wireless operators and cable operators. Additionally, the firms has expertise in energy and other utility services.

The services of Balhoff & Rowe include research, think-tank projects, professional facilitation, advocacy efforts, financial and restructuring advice for various companies, carriers and policymakers. The company offers an unparalleled combination of experience, credibility, strategic insight and access in a rapidly changing environment.

Michael J. Balhoff, CFA, Managing PartnerMichael J. Balhoff, CFA, is managing partner at Balhoff & Rowe, LLC. Previously, Mr. Balhoff headed for 16 years the Telecommunications Equity Research Group at Legg Mason, which advised investors about equities in media, cable, wireless, telephony, communications equipment and regulation. Prior to joining Legg Mason in 1989, Mr. Balhoff taught at both the graduate and undergraduate levels. He has a doctorate in Canon Law and four master’s degrees, including an M.B.A., concentration in finance, from the University of Maryland. A Chartered Financial Analyst and a member of the Baltimore Security Analysts Society, Mr. Balhoff has been named on six occasions as a Wall Street Journal All-Star Analyst for his telecommunications recommendations. His coverage of telecom was named by Institutional Investor as the top telecommunications boutique in the country in 2003. He has also testified multiple times before congressional committees, is regularly a featured speaker at conferences for investors and policymakers, and is widely quoted in the media, including television, newspapers as well as communications and business journals.

Robert C. Rowe, Esq. , Senior PartnerRobert C. Rowe, Esq., is a senior partner at Balhoff & Rowe, LLC. Previously, Mr. Rowe served as the Chairman of the Montana Public Service Commission which was responsible for regulating telecommunications, electricity, natural gas, water, and some transportation services. Mr. Rowe also served as President of the National Association of Regulatory Utility Commissioners, Chairman of the NARUC Telecommunications Committee, member and state chair of the Federal-State Joint Board on Universal Service, member of the Federal-State Joint Conference on Advanced Services, chairman of the thirteen state Operations Support Systems Collaborative working with Qwest and its competitors to achieve compliance with Section 271 of the 1996 Federal Telecommunications Act, and member of various advisory boards for university-affiliated programs.