U.S. COMPETITIVE TELECOM MARKETS:
1996 Edition

Northern Business Information

McGraw-Hill Building, 37th Floor

1221 Avenue of the Americas

New York, NY 10020-1095

(212) 512-2900

Ron Cowles

Judith Hellerstein

Steve Koppman

Steve Korba

Meera Singh

February 1997

This report shows that, despite conventional thinking, the incumbent Local Exchange Carriers (ILECs) have already lost substantial telecom market share in regions targeted by competitors such as AT&T, MCI, Sprint, and a host of lesser players. The report also estimates current and future local exchange and long distance phone revenues, reviews the competitive strategies pursued by the local and national telephone companies, and analyzes the potential impact of state and federal regulations and other trends affecting the telecom marketplace.

Two major considerations formed the basis for this report. First, government regulations to implement the 1996 Telecommunications Act may be the most important element in shaping the new competitive telecom marketplace. Second, the conventional method of studying the telecom marketplace on a national basis is no longer valid because the market is not developing that way. Using these considerations, Northern Business Information took the following approach to assess whether and to what extent competition in the major components of the telecom market does exist and to assess how the market will develop in the coming years. U.S. Competitive Telecom Markets: 1996 Edition:

· Profiles the major competitors that currently operate or will potentially operate in the metropolitan areas of New York, Chicago, Los Angeles, and San Francisco (Appendix A).

· Examines the current (pre-full implementation of the 1996 Telecommunications Act) evolution of the local exchange and exchange access markets, primarily in the largest metropolitan areas; explains how these areas have been affected by service bypass, the situation in which a customer moves from one service, such as switched access, to another service, such as dedicated access, in order to save costs, as well as by dedicated and switched facilities' bypass arrangements in competition with the ILEC; and evaluates the evolution of local and toll competition by means of a survey of the top 25 companies in each of the metropolitan areas of New York, Los Angeles, Chicago, and San Francisco as well as a random selection of 25 medium and small-sized companies that operate within these market areas.

- Interviews were conducted with the responsible telecom manager and, in the cases of the smaller companies, the person most familiar with the firm's telecom arrangements and needs. The survey was conducted to identify the primary and secondary carriers (if applicable) for the provision of local exchange services, intraLATA toll, interLATA toll, and dedicated services for each of these companies. In addition, the unit demand of these services and the average monthly revenue by carrier was also identified and used in the calculation of market share relationships. Furthermore, several questions were asked to gain an understanding, from the consumer's perspective, of what changes could be expected after the implementation of full competition (Section 3).

· Offers an estimate of the current and expected developments of the local exchange, carrier access, and long distance markets in the New York City, Chicago, Los Angeles, and San Francisco metropolitan areas. Included are historic (1989-1995) and forecast data (1996-2000) and estimates of current market shares by major carrier, and expected market shares of the incumbent carriers. Section 4 covers local exchange and carrier access, while Section 5 covers long distance, intrastate intraLATA, intrastate interLATA, and interstate. An interactive database and forecast documentation are provided in Appendix B.

· Provides background and regulatory history, including an analysis of the 1996 Telecommunications Act and related regulatory activity of the Federal Communications Commission and the regulatory bodies of the states of New York, Illinois, and California, and an assessment of the impact that these regulations may have on the telecom market--Section 6 (Federal) and Section 7 (State).

Ironically, by not taking account of the substantive inroads that competitors have already made into local markets, the FCC and state regulators may be suppressing rather than stimulating migration to a truly competitive marketplace. This single-minded focus on regulating open markets may only delay their arrival. While competitors indulge in marketing and regulatory strategies to defend their markets, arguing about proper levels of interconnection charges and whether or not there is competition, the customer suffers by continuing to pay inflated rates for long distance services, the incumbent local exchange carriers continue to hemorrhage their more profitable revenue streams to competitive bypass, and the aspiring competitive local exchange carriers continue to lose access to that narrow window of opportunity through which they must enter in order to establish themselves as full service providers. This study also shows that:

· Analysis of the telecom marketplace can no longer be performed at the national level or, for that matter, the state level because competition in these markets is evolving on a local level.

· IXCs and Competitive Local Exchange Carriers have quietly seized significant local exchange, carrier access, and intrastate toll market share in the areas where they choose to compete, particularly in New York City.

· Regulation may be the most important element in shaping the new competitive telecom marketplace, and existing regulations may have created artificial markets. Many of the current bypass arrangements are a product of regulatory mandates that require the pricing of many of the ILEC services to achieve regulatory policy goals rather than to achieve economic efficiencies. Over-restrictive regulations will hinder natural competition in all markets and for all competitors.

· While a key issue seems to be why aspiring competitors in the local exchange markets should pay interconnection charges at close to RBOC costs when the RBOCs have almost no entry costs to enter the long distance markets, the real issues are:

- Interconnection may cause additional costs. In fact, the FCC's perception that the avoidable costs associated with unbundling and interconnecting ILEC network elements should enable lower interconnection charges is erroneous. New methods of doing business must be undertaken by the incumbent local exchange carriers' operational groups. This includes the ILECs' network planning for interconnection, network design, network monitoring, maintenance (e.g., coordinating the testing of a network connection, the elements of which may be partly owned by the ILEC and partly leased or purchased by the CLEC), customer service, billing, etc. Also, the carriers are not just after POTS service, they want intelligent network services, which need SS#7 capability and create additional engineering and capital expenditures by the ILECs.

- Paying interconnection charges at what the ILECs calculate is their costs is merely a cost of entering the market. It is not a barrier to entry as it reflects the ILECs' own cost. If the ILECs were to include all of the additional costs that interconnection will cause, rates based on those costs might be a barrier to entry.

- The RBOCs do have expensive entry costs. The cost of entering the interstate market is the market share that is presently being lost while competition is being held in abeyance and the additional market share that will be lost by the time regulators authorize in-region long distance service provisioning (even though during this time the RBOCs will have continually leaked out their most lucrative business profit streams to bypass).

- These high barrier-to-entry costs will continue unless competition is accelerated. Only by competition occurring can the initial costs be overcome and team-size efficiencies take place. New methods of doing business must be undertaken by the operational groups in each entity. For the ILECs it's the network planning for interconnection, network design, customer service, network monitoring, billing, and maintenance functions. For the CLECs, IXCs, and other competitors, it is actually building their facilities and developing sufficient team sizes so that costs will drop.

- The idea that one can lower entry costs into new markets at the outset is erroneous, non-economic, and harmful to the development of naturally competitive markets. Artificially lowering interconnection charges just harms the ILECs; further erodes their market share through continual uneconomic bypass; and encourages resale over facilities-based competition, which is contrary to the intentions of the 1996 Telecommunications Act. All sides must admit that there will be entry costs, agree to pay those costs, and enter into the markets. Eventually the costs will come down.

· What's stake is who will wrest control of the $100 billion local telephone market and the $75 billion long distance market. The local exchange and toll markets in the subject metro areas are being fought over in increasingly diminishing margin markets.

· The real opportunity lies in becoming a large, full-service provider who can weather early investment costs--profit will be in large-volume, small-margin services such as local and toll. The bigger profits lie in data, on-line services, and future broadband offerings, which should go to the large or dominant full service providers. Competitive Access Providers and Competitive Local Exchange Carriers may be things of the past as phenomena of regulatory mandates.

· A review of the events in Connecticut reveals that in less than one year (in most cases in just six months), local exchange competitors have been able to garner nearly 20% market share in the local exchange marketplace in the areas where they choose to operate, and that it took the incumbent Local Exchange Carrier three years to make the same inroads into the interstate long distance market.

· Incumbent LECs stand to lose over 30% percent of their respective markets to competition by the year 2000 (a much higher rate in high-rate urban areas), and the IXCs will lose 20% of their share of interLATA toll to the RBOCs. NYNEX has already lost 20% of its local exchange business market in New York City.

· When AT&T enters the local exchange market, it will likely initiate a campaign of short-term discounts, bundled with toll offerings designed to attract customers. This will set off a flurry of offerings from the other competitors and will create a small price war. In other words, AT&T will be the market leader in these promotions, and the success of these campaigns will set the stage for changes in market share for the various competitors. AT&T itself could obtain additional market share, due to its name recognition and to confusion in the marketplace.

· Overly aggressive interconnection rates and policies could harm the incumbent LECs by promoting bypass and delaying their entry into the in-region long distance markets.

· Both the interstate toll and local markets are at their peak growth rates for the foreseeable future. Prices will not stimulate big growth in the local exchange market and interstate margins are getting smaller. Package discounts of some kind could offset this somewhat. The fact that in many areas local exchange rates are priced below their embedded costs and that certain states (and the FCC in the case of the federal Subscriber Line Charge) have limited local exchange rate increases could block certain competitors from entering the local exchange markets because the margins are not there.

· The FCC and certain state regulators are likely to walk away from certain public policy determinations concerning the pricing of toll and carrier access services and capital recovery that have been in place for the past 60 years. This will cause the incumbent LECs to enter new markets and/or seek new affiliations to recoup the loss of an estimated $20 billion revenue stream nationally.

· Any delay in entering the local exchange market may turn out to be a tactical mistake, even for AT&T. Market share opportunities lost initially may be lost for ever. Conversely, overly aggressive interconnection rates and policies could harm the incumbent LECs by promoting bypass and delaying their entry into the in-region long distance markets.

· Niche opportunities exist because, in low margin areas, by concentrating in one area costs could be driven down.

Local Exchange revenues will continue to rise, while prices will be kept relatively constant. This is mainly due, for residence customers, to: (i) continued demand for online and data services; (ii) additional line growth to meet the needs of telecommuting and home businesses, access to online services and the Internet, and other second-line needs (which will soon taper downward because the population growth in the studied areas is low); and (iii) growth in optional features and functions, CLASS services, and ISDN services. For business customers, the cause is continued demand for multiline service, including centrex.

Switched Access revenues will decline briskly once full competition enters the market. This will occur for two major reasons: first, the FCC will allow the market to transition interstate access charges to cost, but will not make long-term provisions for cost recovery of the subsidies currently in the rates, if at all; and second, while revenues are expected to increase initially, the influences of the market and discounted interconnection prices will cause revenues to decrease over time.

Intrastate Long Distance revenues will begin declining nationally in 1998 due to price competition from new entrants. This will take place sooner in the more competitive markets, such as New York City and possibly Chicago.

Interstate Long Distance revenues will continue to rise until the RBOCs enter the market. This will be the result of initial price increases in domestic long distance services and an increase in international calls brought about by the expanding global economy. International long distance rates will begin coming down as settlement rates are renegotiated.

Report_Title: U.S. Competitive Telecom Markets: 1996 Edition

Connecticut passed legislation deregulating its telecom market in 1994, almost two years before the Federal government acted. This historic act has catapulted the Connecticut Department of Public Utility and Control (CtDPUC) and its actions into world view. Connecticut has become the leader in intrastate telecom competition. Its actions and rulings have the potential to serve as models for many states in their efforts to introduce competition in telecom and create a level playing field.

This section examines how Connecticut deregulated the local exchange market and thus opened it up to competition and consumer choice. This analysis will focus on some of the issues and concerns encountered by the Department of Public Utility and Control, the State's Public Utility Commission (PUC), and how the CtDPUC's experience with competition can provide guidance to other State PUC's in their efforts to open up local exchange markets. The "Connecticut experience" is also used as input to the development of the local exchange and toll market forecasts and conclusions found in Sections 4 and 5 below.

In 1994, the Governor of Connecticut assembled a telecom task force composed of representatives from government, the business community, and telecom providers and charged it with investigating how best to bring competition into Connecticut. Their report and recommendations formed the basis for what became Public Act 94-83, or the Telecom Deregulation Act. One of the primary objectives of the Act was to provide the public with a wide variety of choice among telecom products, prices, and providers through the development of effective competition.

At the core of the Act are the following goals: to (1) ensure the universal availability and accessibility of high-quality telecom services to all residents and businesses in the state; (2) promote the development of effective competition by unbundling all network elements and setting fair and transparent prices for these elements; (3) encourage shared use of existing facilities and joint development of new facilities where possible; (4) modify regulatory oversight of incumbent telecom providers; (5) provide needed incentives for telecom providers to build advanced telecom infrastructure, with open networks; (6) promote the economic development of the region; and (7) ensure that telecom providers provide high-quality customer and technical service.

This historic act has catapulted the Connecticut DPUC and its actions into world view. Connecticut has become the leader in intrastate telecom competition. As a result, all eyes are on the Connecticut DPUC. Under Public Act 94-83, the CtDPUC is charged with creating a detailed plan for opening up the market to competition, taking into account the continuation of consumer safeguards.

Public Act 94-83 requires all new market entrants to gain certification from the CtDPUC and also to commit to serving all customers (both business and residential) in their certified service areas, within three years.

· Intrastate toll competition was authorized in advance of interstate toll competition, which gave AT&T and the other IXCs a slight advantage over the incumbent state toll provider, SNET. In addition, with the margins contained in state toll rates, full service providers can afford to offer local service at wholesale rates in excess of retail rates (see Section 2.2, above) and still provide attractive competitive packages. Any universal service support in state toll rates as well other competitive rates must be eliminated to the extent possible to create an effective competitive environment.

· SNET's loss of market share in the intrastate toll market (dominated by SNET until 1993) has not been offset by the amount of market share acquired in the interstate toll market (dominated by AT&T prior to being opened to competition in 1994). On the other hand, AT&T's share of the intrastate toll market has nearly offset its loss of market share in the interstate long distance toll market.

· The Connecticut experience demonstrates that long distance competition is evolving quite rapidly. In 3-4 years of open competition, AT&T is the major carrier in the long distance market, garnering a 40% market share. SNET, once dominant in the intrastate toll market, comes in a distant second at 30%. It takes nearly twice as long for SNET to acquire a level of market share in the interstate toll market as it takes for competitors to gain the same level of market share in the local exchange market.

· AT&T will likely gain additional market share of the inter/intrastate toll market when it enters the local exchange market and initiates a campaign of short-term discounts, bundled with local service offerings and designed to attract customers. This will set off a flurry of offerings from the other competitors and will create a small price war. In other words, it is expected that AT&T will be the market leader in these promotions, and the success of these campaigns will set the stage for changes in market share for the various competitors.

· The first year of open competition in the toll and local markets following the completion of negotiations/arbitrations of the terms and conditions of interconnection will establish the winners and losers in the market in Connecticut. AT&T's choice not to actively participate in the local exchange market until arbitrations are complete in December 1996 may turn out to be a tactical mistake--extensive delays will cause the loss of valuable market share. Late arrivals in this game cannot make up lost ground.

· The rapid growth in inter/intrastate toll use that was experienced in the 1980s and early 1990s due to large carrier access rate reductions may not be available going forward. Therefore, it is not expected that the state/interstate toll markets will grow nearly as fast as they have in the past, even with more extensive competition.

· British Telecom's purchase of MCI will, if approved, combine BT's sizable financial resources with MCI's market-driven culture and marketing savvy. However, because it may take over a year to complete, this merger may prove to be inconsequential in improving MCI's position in the Connecticut long distance marketplace.

· Section 254(k) of the Telecommunications Act of 1996 prohibits the subsidy of competitive services. By the same token, to promote fair competition, competitive rates should not bear large contribution levels to promote public policy goals through regulatory mandates. Regulators must recognize that public policy goals cannot be financed through competitive rates because to do so will artificially benefit one competitor over another.

· Because of the proposed merger between MFS and LDDS Worldcom, MFS can divert the $2 billion it had earmarked to build long distance networks throughout the U.S. to expand its present city networks, including those in Connecticut. This will make MFS/LDDS Worldcom a more formidable competitor.

· Only full-service providers will be successful in this market, and the more "beneficial" services a carrier offers, the more successful it will be. In addition, carefully bundled service offerings will prove to be successful in attracting and retaining consumers. Regulators must recognize this and not restrict certain competitors through unnecessary regulations and structural separations requirements (see Section 6).

· As with local exchange service, from the incumbent local exchange provider's standpoint, it is advantageous to cooperatively interconnect with its competitors following successful negotiations. Any partial delivery of a service by the incumbent is preferred to total bypass of the incumbent's network by the competitor. For example, if SNET's competitors fully bypassed its network, its market share of carrier access service would be much less than the 80-85% range it currently enjoys.

Report_Title: U.S. Competitive Telecom Markets: 1996 Edition