Privatesector P U B L I C P O L I C Y F O R T H E The World Bank January 1996 Note No. 65 Regulating Telecommunications Lessons from U.S. price cap experience Jeffrey H. Rohlfs Regulatory shift case) to recoup those lost profits.1 In addition, price cap plans usually allow the firm substan- Rate-of-return (ROR) regulation has been used tial flexibility—within the price cap constraints for many years to regulate telecommunications —to restructure rates, with minimal regulatory carriers in the United States. This regulatory delays. approach has important desirable features: it limits monopoly rents, and it provides a stable The primary drawback of price caps is that they environment to attract investment. But it also create incentives for firms to cut costs by has serious flaws. Like cost-plus procurement, degrading the quality of service. Many price ROR regulation provides limited incentives for cap plans deal with this problem by imposing firms to cut costs or otherwise to improve effi- penalties for quality degradation. Another ciency. As markets become more competitive, drawback is that price levels may become in- the incumbent may overprice monopoly ser- appropriate over time as a result of unexpected vices to subsidize competitive services. All firms changes in demands or in real costs. Shorten- may use the regulatory process strategically to ing the term of the plan helps ensure that rates undermine rivals’ ability to offer better value do not drift too far out of line, but it also re- to customers. duces efficiency incentives. (A firm faces the prospect of earlier unfavorable adjustments to For these reasons, many U.S. telecommunica- prices if it improves efficiency.) U.S. regula- tions regulators have recently replaced ROR tors have generally opted for terms of three to regulation with price cap regulation. Price cap five years. Longer terms will become appro- regulation uses a formula, set in advance, to priate as regulators gain more experience with determine the price increases for a firm’s ser- price caps and uncertainty is reduced. vices for a period of several years. During this period, the firm may keep all the benefits of its This Note reviews the U.S. experience with incremental productivity gains. Customers can price caps, focusing primarily on federal regu- also benefit, in several ways. The price cap for- lation. It then briefly discusses the lessons of mula may cause prices to rise less rapidly dur- this experience for developing countries. ing the period than they did historically. The sharpened incentives created may encourage Competition and the regulation of AT&T the firm to offer innovative new services. And after the period ends, regulators may order price AT&T has been subject to competition in long- reductions that reflect productivity gains dur- distance services since the 1970s, though the ing the period. competition intensified substantially after equal access was implemented in the mid-1980s. In Another advantage of price caps is that they this more competitive environment, federal reduce firms’ incentives to cross-subsidize. regulation of AT&T has been reformed and re- Cross-subsidy generally reduces a firm’s prof- laxed. The Federal Communications Commis- its, and during the price cap period the firm sion (FCC) began granting AT&T pricing has no opportunity (as it would in an ROR rate flexibility shortly after its breakup into the seven Industry and Energy Department ▪ Vice Presidency for Finance and Private Sector Development Regulating Telecommunications regional operating companies in 1984. In the sumers over the 1990–93 period. 2 Estimates by early 1990s, the FCC streamlined regulation of Schmalensee and Rohlfs show that 90 percent AT&T’s large-business and 800-number services, of the gains from price cap regulation went to and it has just streamlined regulation of AT&T’s consumers and 10 percent to AT&T stockhold- remaining services. Thus, although AT&T still ers.3 Consumers enjoyed real price reductions has to file tariffs with the FCC, its prices are no as the price cap declined (in real terms) and longer subject to regulatory review. AT&T has from AT&T’s voluntarily pricing below the cap, generally responded to regulatory freedom by and they also made greater use of discounted competing more aggressively for large customer pricing plans. accounts. Its competitors have stopped gain- ing market share at AT&T’s expense, but re- For AT&T, the most dramatic gains were reduc- main prosperous. tions in its real noncapital expenses (figure 1). The rising trend in AT&T’s real noncapital expenses was reversed in 1989. In 1988, the company took a US$6.8 billion write-down of antiquated analog equipment and started to FIGURE 1 REAL NONCAPITAL EXPENSES OF AT&T, 1985–91 replace it with digital equipment, primarily Billions of U.S. dollars fiber-optic systems, to thoroughly modernize 6.2 its network. Transition to competition 6.0 Competition, rather than price caps, was un- doubtedly the primary impetus for AT&T’s mod- ernization effort. When Sprint began to advertise its all-fiber network in the mid-1980s, AT&T per- 5.8 ceived an urgent need to improve its network to maintain the company’s reputation for qual- ity. But price caps have eased the transition to streamlined regulation. Under ROR regulation, 5.6 a detailed cost allocation manual would have had to be developed to ensure that prices in markets not subject to streamlined regulation covered the costs allocated to those markets. 5.4 1985 1986 1987 1988 1989 1990 1991 By contrast, under price caps, the FCC simply had to order streamlined regulation for some Source: Richard Schmalensee and Jeffrey H. Rohlfs, “Productivity Gains Resulting from services, leaving the formulas for price cap regu- Interstate Price Caps for AT&T,” filed with U.S. Federal Communications Commission, lation of other services unchanged. Docket 92-134, September 3, 1992. Because of the altogether favorable experience with the price cap regulation of AT&T, the FCC renewed AT&T’s price cap plan without change The FCC began to use price cap regulation for in 1994. AT&T in 1990—though AT&T had started to act in anticipation of price cap regulation even Regulation of local exchange carriers before then. The FCC’s 1993 review concluded that the price cap plan was working well. After implementing price cap regulation for According to the FCC’s calculations, price AT&T, however, the FCC backslid, adopting a caps yielded US$1.8 billion of gains to con- hybrid of price cap and ROR regulation for local exchange carriers. This hybrid plan allowed the The drawback of this approach—indeed, the local exchange carriers to keep all their mar- problem with benchmark regulation generally ginal productivity gains until their rate of re- —is that one size does not fit all. Price reduc- turn reached a certain level. Above that level, tions that are not onerous for some firms may the carriers had to share further efficiency gains cause financial distress for others. The FCC dealt equally with their customers, which reduced with this problem by offering a range of op- their efficiency incentives by 50 percent. At a tions. Firms could opt for smaller annual price still higher rate of return, the plan reverted to reductions but would then have to share most pure cost-plus regulation. of their productivity gains with customers. Or firms could opt for pure price caps (with no Despite this declining incentive structure, lo- sharing of gains with customers) but would then cal exchange carriers have significantly in- have to agree to larger annual price reductions. creased their efficiency under federal price cap Several large local exchange carriers chose the regulation. To ensure that consumers did bet- second option. ter under price cap than under ROR regula- tion, the FCC included in the plan a “consumer Lessons for developing countries dividend” of 0.5 percent a year. But local ex- change carriers have still been highly profit- For developing countries, which generally lack able. Their rate of return on capital averaged strong regulatory institutions, creating and staff- about 10 percent a year in 1991–94,4 compared ing a regulatory agency that can perform ROR with the yield on short-term U.S. Treasury regulatory functions competently would be securities of less than 5 percent a year. The improved efficiency of the local exchange Developing countries are well carriers is only partially attributable to federal regulation: many states also adopted price cap advised to avoid rate-of-return regulation or one of many variants of incen- tive regulation during the period. Because lo- regulation altogether and cal exchange carriers were so profitable under price caps, the FCC made adjustments when it to leapfrog to price caps. renewed the plan. Rates have to be reduced and will decline more rapidly than under the original plan. costly and take considerable time. Furthermore, ROR regulation is subject to abuse—especially Hybrid drawbacks in the absence of judicial precedents. For these reasons alone, price cap regulation may be The FCC applied the same percentage adjust- more feasible than ROR regulation for newly ments to all price cap–regulated local exchange privatized telecommunications companies. carriers—a form of “benchmark” regulation, often used in industries with many regulated But the U.S. experience suggests that even firms. Thus, the adjustments to each firm’s rates where regulatory capacity is strong, price cap were largely unrelated to its productivity gains, regulation may be better. Price cap regulation so each firm was able to retain most of the in the United States has been highly success- incremental benefits of its productivity gains, ful—the theoretical benefits of price caps for even after the end of the price cap period. As industry performance appear to have been a result, the plan provides much greater effi- realized in practice. Moreover, because price ciency incentives than one that makes adjust- cap regulation is simpler and more transparent ments for each firm based on that firm’s than ROR regulation, it may be less subject to productivity gains. abuse. And the U.S. experience in long-distance Regulating Telecommunications telecommunications suggests that price cap regulation works well during an industry’s tran- sition to a competitive structure. Price cap plans have the additional advantage of being indexed to inflation. But even though they adjust automatically to unexpected changes in inflation, as occur often in devel- oping countries, the adjustments do not fully compensate for the effect of inflation on capi- tal costs. Thus, where inflation is unstable, an additional adjustment factor may be desirable. This comparison of regulatory performance suggests that developing countries are well advised to avoid ROR regulation altogether and to leapfrog to price caps. By doing so, they can benefit from the greater efficiency incen- tives of price cap regulation while avoiding the administrative costs and difficulties of ROR regulation. Hybrid regulation incorporating formal mechanisms for sharing efficiency gains with consumers is a third alternative. But hy- The Note series is an open forum intended to brid regulatory plans require having ROR regu- encourage dissemina- latory institutions in place, offer weaker tion of and debate on efficiency incentives than price caps, and pro- ideas, innovations, and best practices for vide less protection against cross-subsidy. Thus, expanding the private pure price caps are the best alternative. sector. The views published are those of the authors and should 1 not be attributed to the For the same reason, price caps increase the firm’s losses from World Bank or any of its providing subsidies mandated by regulators—for example, subsi- affiliated organizations. dies of residential services in rural areas. Consequently, regulated Nor do any of the con- firms may carry out subsidized programs with less vigor under clusions represent price caps. 2 official policy of the U.S. Federal Communications Commission, “In the Matter of Price World Bank or of its Cap Performance Review for AT&T,” CC Docket 92-134, adopted Executive Directors June 24, 1993, released July 23, 1993, at para. 9. 3 or the countries they Richard Schmalensee and Jeffrey H. Rohlfs, “Productivity Gains Re- represent. sulting from Interstate Price Caps for AT&T,” filed with U.S. Federal Communications Commission, Docket 92-134, September 3, 1992. Comments are welcome. The Schmalensee-Rohlfs estimate, unlike the FCC’s, includes the Please call the FPD customer benefits from greater use of discounted services. 4 Note line to leave a Derived from U.S. Federal Communications Commission, Prelimi- message (202-458-1111) nary Statistics of Communications Common Carriers (Washington, or contact Suzanne D.C.: U.S. Government Printing Office, July 7, 1995) and Statistics Smith, editor, Room of Communications Common Carriers (Washington, D.C.: U.S. Gov- G8105, The World Bank, ernment Printing Office, various editions). 1818 H Street, NW, Washington, D.C. 20433, or Internet address Jeffrey H. Rohlfs, Strategic Policy Research, ssmith7@worldbank.org. Bethesda, Maryland 9 Printed on recycled paper.