Regulatory Karma: The Problem of Legacy Pricing and the Third Price Cap Regime

Cross-subsidization is a bad thing. Some customers pay more, so that others can pay less. In addition to being unfair to the person who is paying the higher price, this arrangement is economically inefficient. Competitors cannot compete with the subsidized price and, consequently, competitive markets are either undermined or prevented from developing in the first place. That being said, there may be situations where cross-subsidization is considered acceptable in order to promote other policy objectives. This was the case for decades in the field of telecommunications. For many years, the CRTC had an express policy of cross-subsidization with respect to residential local service. In order to keep local rates low, the rates for numerous other telecom services were kept artificially high. The public policy objective of maintaining low local rates trumped economics and redefined fairness. Customers paid the approved rates and went on with their lives. But then things changed. In the mid- 1990’s the commission recognized that if it wanted to introduce local competition, it would have to move away from its policy of cross-subsidization. So, it raised local rates. Sort of. Rates went up pretty much everywhere, but in high cost areas the CRTC was unwilling to raise rates to compensatory levels. As a result, the need for a subsidy remained. When the commission introduced the first price cap regime in Decision 97-9, it retained its "contribution" or subsidy levy on interexchange voice services and also kept rates artificially high for many ILEC services – local optional services and Centrex are good examples. In other words, cross-subsidization was intentionally built into the first price cap regime. In fact, not only were the rates for the cross-subsidizing services artificially high going into the first price cap regime, but they were permitted to rise substantially throughout that period. This permitted the contribution levy on interexchange voice services to drop – at the expense, in part, of the customers of the other cross-subsidizing services. But then things changed. In Decision 2000-745, the CRTC scrapped the subsidy levy on interexchange voice services and imposed a new contribution collection mechanism – a general tax on all telecommunications service revenues. In addition, it revamped the subsidy requirement calculation, moving from a Phase III-based calculation that identified the Utility Segment shortfall, to a Phase II-based calculation that focused on the cost of primary exchange services (PES) in high cost serving areas (HCSAs). The new Total Subsidy Requirement (TSR) calculation assumed a $60 per year cross-subsidy from residential non-PES local services in HCSAs (where PES was priced below cost), but that was it. No other cross-subsidy was included in the TSR calculation. Given this change in the subsidy mechanism, one might have expected the CRTC to require an adjustment to the rates for local optional and other ILEC services with artificially high rates – the sole exception being residential non-PES local services in HCSAs which the CRTC had already determined should subsidize residential PES in HCSAs. This type of rate adjustment could have been implemented at the beginning of the second price cap regime and, arguably, should have been implemented if that regulatory regime was to be economically sound. Economic theory says that rates should be cost-based and, over time, should approach long run incremental costs. So, in the absence of any overriding policy reasons, the artificially high rates for the (formerly) cross-subsidizing services should have been forced down toward the Phase II costs of those services. The CRTC did not do this. Instead, at the beginning of the second price cap regimeit let these inflated rates remain at their artificially high levels and, moreover, permitted them to rise even more throughout the second price cap period. Consequently, consumers and other customers paid (and continue to pay) artificially high rates – not to subsidize local service in HCSAs, but for no good reason at all. For example, in 2003, Bell Canada earned more than $800 million in residential local optional service revenues. The monthly cost to provide these services was (and is) a small percentage of the rates charged. In other words, residential customers paid (and continue to pay) Bell Canada hundreds of millions of dollars more than they would if these services were priced on the basis of economic principles. A similar situation exists with respect to numerous other services where, historically, rates were set far above costs in order to subsidize local service. This situation raises two obvious questions. Where is all the money going? And, what should be done?With respect to the first question, it is clear that the ILECs are receiving a huge windfall – hundreds of millions of dollars each year. As to what they are doing with all that money, only the ILECs know for sure, but a few good guesses would include: • the cross-subsidy money is used to enable deep discount bundles and targeted pricing, especially for large business customers who often receive services at or near cost; • the cross-subsidy money helps finance forborne telecom services and other ventures (e.g., long distance, Internet, wireless, broadcasting distribution);• the cross-subsidy money helps finance acquisitions;• the cross-subsidy money boosts corporate profits. As to what should be done, the answer is simple. There is no policy justification for keeping local optional and other service rates artificially high. There is no policy reason why the ILECs should have access to these huge pools of money to cross-subsidize their competitive ventures or boost their corporate profits. Rates that are artificially high and cannot be justified on the basis of economic principle or public policy considerations should be adjusted to the proper level. That means down. A major task for the CRTC in the upcoming proceeding for the third price cap regime must be to adjust these legacy prices to bring them into line with current telecom policy. It is time for consumers and other customers to get the benefit of cost-based rates that reflect economic principles. They should not have to continue paying artificially high rates based on policies that no longer apply. Christopher A. Taylor is an Ottawa communications lawyer. He can be reached at cataylor@cyberus.ca.

Regulatory Karma: The Problem of Legacy Pricing and the Third Price Cap Regime

News | January 18, 2005

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