Redefining Public Interest

Finding 6: As new telecommunications technologies and services emerge, the State does not have a systematic way for determining areas of public interest or the extent of government oversight that is necessary.

Put most simply, the PUC's role has been to use regulation to perform price setting and other market functions in the absence of a competitive market. The fundamental issue is: In a competitive market, what regulations if any should the PUC impose? Complicating this simple version of reality is that telecommunications has not changed from a monopolistic service one day into a fully competitive market the next.

Competition has come slowly, to different aspects of the network at different times. Upstart providers have had to gain momentum in order to compete against the incumbents, who are strong from decades of monopoly operation. Incumbent utilities are simultaneously competitive enterprises and monopolies -- creating an enormous task for the regulator of sorting one out from the other.

In new technologies, such as cellular, the PUC's regulatory objectives have been even more confused. The PUC maintained for years that it had rate-setting authority and so established tariff rules, while at the same time asserting that it was relying on the market to set prices.

While the PUC has conducted numerous proceedings in an attempt to fairly usher competition into the market, even its supporters do not believe the Commission has done enough to predetermine when it will stop regulating.

When to Act

The PUC has set out to bring competition into the telecommunications industry, and has expressed an intent to replace government regulation with consumer choice. The PUC is complimented, especially by new entrants, for sticking to its plans to dismantle the monopoly structure that prevents alternative providers from entering the market. The concern arises over the PUC's long-term role and its ability to develop and stick to plans to eliminate regulation when the consumers have choice.

The Public Utilities Commission has taken a two-track approach to the trends: The first are those proceedings, previously described, to usher competition into the telephone network or regulate new services. The second involves the PUC's Vision 2000 process, in which it has attempted to define its role in competitive markets and adapt its internal structure to match its new role. The plan makes two changes directly related to the regulation of telecommunications:

• Creates a Telecommunications Division. As with the other industry-based divisions created by the plan, Vision 2000 consolidates the telecommunications experts into a single office responsible for monitoring the industry, assisting in the development of rules and implementing regulations.



• Creates a Customer Services Division. The PUC's efforts to thwart over-aggressive marketing by long-distance companies helped to convince Commissioners that the PUC will play a major role in policing the markets for unfair business practices and representing customers in disputes against companies.

As part of the Vision 2000 process the Public Utilities Commission prepared "business plans" for each of the industries it regulates. The plans describe long-term market trends and the PUC's attempts to align regulation to the changing industries. The strategies list a number of priorities for PUC action -- including the streamlining of regulations to accelerate the pace of innovation in telecommunications.

The Vision 2000 plan describes what the PUC sees as its role in competitive markets: facilitating the transition by changing regulations to promote competition, acting as a referee between industry participants; and developing rules to create a "level playing field" among competing carriers. Looking ahead to the year 2000, the Public Utilities Commission described its role in telecommunications as "protecting consumers and those with special needs, safety and environmental issues, establishing rules for and monitoring competition."

Missing from the document is a description of when the PUC will cease to regulate participants because competition has developed.

When Not to Act

In the eyes of incumbents, upstarts and consumer groups, it is not clear when the PUC will regulate and when it will not. Without an articulated strategy for forbearance consumer groups and potential competitors are constantly concerned that the Public Utilities Commission will pull back too quickly, allowing incumbents to use their market power to take advantage of customers and fend off competitors. Similarly, incumbents and entrepreneurs venturing into brand-new markets are concerned that the Public Utilities Commission will not let go of its role as an economic regulator.

These are not easy issues. The lesson from deregulation so far is that the presence of more than one provider does not necessarily mean that competition will keep sustained downward pressure on prices. In some cases, the former monopoly may exert market power to keep prices high. But more commonly, the dominant provider maintains higher prices. Rather than try to gain market share by lowering prices, the new entrants are satisfied with the super profits that come by charging just below the dominant provider.

Studies by Harvard and Yale economists both show that the price cap regulation of AT&T has not provided sufficient incentives to hold down costs and lower prices, and the competition from competitors is not enough to force AT&T to lower prices.⁽⁷⁴⁾ Similarly, studies done by RAND and others have shown the ineffectiveness of those controls.

But economists and other policy experts differ on the appropriate government response in these situations. One economist summarized the dilemma:

One of the greatest challenges confronting regulation today is to know when not to regulate. As competitive forces strengthen, prices should be determined in the marketplace. But at just what point competitive forces are strong enough to permit the end of pervasive regulation is yet to be determined.⁽⁷⁵⁾

Regulators faced a similar problem after the airline industry was deregulated. Dominant carriers charged prices far above costs until a number of low-priced carriers "broke" from the incumbents and offered low fares on heavily traveled routes. Experience in that aspect of airline deregulation, at least, has shown that government forbearance from regulation eventually allowed for the desirable result -- intense competition that has driven down prices and allowed millions more people to travel by air.

While competition is still emerging at the local level, there is evidence that the PUC still may be regulating too much. An analysis published by the Brookings Institution showed that regulators -- including the California PUC -- have been reluctant to separate out those aspects of the market that are competitive to let competition set price. Instead, the regulators impose restrictions with the intent of controlling market power at the expense of delaying or deferring the development of competition.

The analysis concluded that incumbent monopolies usually benefit the most from "half-hearted" reforms: "The regulator should be left to specify interconnection rules, unbundling, an accounting separation between wholesale and retail functions for firms with bottleneck monopoly, and nondiscriminatory pricing for such integrated monopolists."⁽⁷⁶⁾

The PUC faces nearly identical issues when determining its role in new markets where there is no history of regulation and where there is not a monopoly provider -- but there may be concerns about inflated profits. The PUC has asserted that all new telephone companies are utilities under Public Utilities Code Section 216. Some companies have challenged this in PUC proceedings, but so far not in court.

When the first cellular telephone licenses were issued in 1983, the FCC issued two licenses in every market. The "duopoly" arrangement was thought to provide enough competition to thwart the need for government price regulation.

Airtouch, however, was ready to offer services in its first market before its competitor. As a result, the PUC imposed regulations similar to those it had adopted for monopolies, and retained many of the rules even after the duopoly developed.

A number of other states also initiated some form of economic regulation. California's, however, was considered to be among the most rigorous in the nation. While the PUC maintained it would let the market determine the prices, it dampened market forces in a number of ways: It required companies to post tariffs and limited changes that could be made in the tariffs, which encouraged cooperation among competitors. It required a minimum mark-up on services to encourage resellers to enter the market. And it prevented cellular service companies from selling equipment.

The result of these regulations, according to an MIT researcher, was higher prices and fewer people being served by the companies.⁽⁷⁷⁾

In 1993, Congress prohibited states from regulating cellular rates, unless they could show a compelling reason to do so. Eight states, including California, argued their case before the FCC. In 1995 the FCC concluded that California did not have a valid reason for its cellular regulations. And in 1996, to eliminate concerns by PUC Commissioners that the Public Utilities Code compelled them to regulate cellular phones, the Legislature passed a bill specifically exempting cellular phones from PUC rate control.

The dangers lurking behind the PUC's case-by-case strategy for determining when it should intervene depends upon one's perspective. New entrants and consumers are concerned that market power abuses -- and higher prices for consumers -- will be tolerated in the name of encouraging competition. The incumbent monopolies are concerned that the PUC will tie their hands -- letting competitors capture too much of their market before they are truly free to compete. These concerns will heighten as competition is ushered into the local phone business and as more market players -- many of them veterans of the regulatory arena -- use each proceeding to try to gain a competitive advantage.

This problem is as old as modern-day deregulation efforts. By the mid-1980s, the FCC and some state commissions were setting standards for when they would stop regulating. So the good news is that California does not have to stumble down a darkened path.

The recommended solutions depend on one's perspective, as well. Pacific Bell believes the PUC should quickly concede its regulatory role and the Legislature should eliminate a number of "obsolete" statutes, including the PUC's ability to set rates for Pacific Bell.⁽⁷⁸⁾ Other service providers describe a need to eliminate "regulatory underbrush" that complicates proceedings or biases the Commission's decision making in one direction or another.⁽⁷⁹⁾

For Roseville Telephone, the solution was easy: Proposals to lower rates should be approved immediately. As it now stands, the company must submit promotional and advertising material to the PUC before it can receive permission to offer a promotional rate for new services to its customers.

In some cases there are fundamental gaps between where the PUC's decisions are headed and what the law requires of the PUC. Most notably, the code requires the Commission to set fair and nondiscriminatory rates. Not only will the Commission not set rates in the future, but market strategies begin with companies establishing discriminatory rates to capture specific groups of customers.⁽⁸⁰⁾

In other cases, the PUC has chosen to simply ignore regulations or statutes that are no longer meaningful. Among those rules that Pacific Bell complains are obsolete is one for regulating advertising rates in telephone directory yellow pages -- but the PUC has not used that authority in years and it is hardly a roadblock to competition.

The Legislature's PUC Reform Conference Committee struggled with some of these concerns and made some progress toward realigning the Commission's statutory and regulatory framework with the needs of a competitive market. SB 960 requires:

• The PUC to provide the Legislature by March 1997 with "recommendations for changes to regulations or statutes that may be required as a consequence of the changing competitive environment in which regulated and unregulated entities are competitors."
  
  
• The PUC, in consultation with the Law Revision Commission, to submit to the Legislature by June 30, 1997, a report on revisions to the Public Utilities Code that are needed as a result of the restructuring of the electricity, gas, transportation and telecommunications industries.

Sounding Regulatory Retreat

The Legislature's first requirement focuses on one of the most immediate concerns -- the regulations and statutes that might distort the position of competitors in a market that is partly monopolistic and partly competitive. Its second requirement provides a process for a more comprehensive review of the statutes that may minimize the gaming of various competitors, and the Legislature did not leave the task solely to the Commission.

But the heart of the issue is when and how the PUC will intervene in the market, whether it will make those decisions consistently, and whether it will have the self-discipline to let the market function. It will be necessary to allow unique circumstances to influence decision making. But some principles for guiding decision making could benefit the market players, consumers, the PUC and the Legislature, which is often called on to provide relief to whichever participant is unhappy with a regulatory decision.

Standards or guidelines, especially ones crafted by the PUC and approved by the Legislature, could diminish concerns that the State will not back away quickly enough to let competition flourish and reassure those who believe the Commission will retreat before competitive pressures can hold down price in the absence of regulation.

GTE, an incumbent local exchange carrier that also is aggressively seeking to compete in areas where it was previously restricted, believes the Commission should establish a benchmark for regulatory retreat. Specifically, it believes the PUC should forbear from regulating any time that customers can truly chose among service providers. The benchmarks would "assist in assuring that regulation in California was relevant and at the same time assure the standards that customers should expect."⁽⁸¹⁾

Similar to GTE's recommendation is Southern California Gas Company's call for a PUC rule-making order to define when competition is deemed to be adequate -- allowing for case-by-case determinations, but sending a clear signal when the regulator will stop regulating.

It may be that more than one benchmark is appropriate. While the PUC may want to forbear from most regulation when more than one provider exists, it may want to retain a certain degree of regulation until the quality of those consumer choices reaches a predetermined standard.

Since most of these benchmarks would require the commission to stop doing something that it is required by statute to do, GTE believes it would be appropriate for the standards to be approved by the Legislature.

Even more so than with energy, many market players and policy experts see a day when all aspects of the telecom-munications industry are truly competitive, economic regulation can cease, and the State will be left with a few basic functions: public safety and network reliability; administering programs for the deaf and disabled or to subsidize connections to rural areas or low-income residents; registering entrants and monitoring the market to determine when and where competition is failing to control prices.

The PUC envisions itself doing these functions, along with the more activist roles of resolving disputes among market players, resolving disputes between providers and consumers, enforcing unfair business practices and antitrust actions.

In the process of establishing principles or benchmarks for when it will intervene and when it will forbear from intervening, the Commission would necessarily have to detail its ultimate role in a competitive market. The Legislature, in its role of determining what functions state agencies should perform, may not agree that all of those functions are appropriate for the State, or they may find that those functions may be more appropriately done by another state agency.

Recommendations

Recommendation 6-A: The Governor and the Legislature should enact legislation declaring clear standards for when telecommunications services are fully competitive, when they are vulnerable to possible market power abuse or when they are so affected by the public interest that government intervention in warranted.

The PUC should be required to use those standards to establish the scope of its activities and routinely review the consequences of those activities. The standards should include a time line and the PUC should report to the Legislature on the progress or variations from the time line. The goal is to maintain consistent progress in an accountable way toward regulation in line with markets.

Recommendation 6-B: Beginning in the year 2000 and every five years after that, the Public Utilities Commission should undergo a sunset review to determine if the PUC is still needed.

The sunset review will provide at least two benefits. The first would be to make sure that any basic function, such as monitoring for potential market power abuses or registering new entrants, has not outlived it usefulness and those functions or the PUC itself is no longer providing significant value to Californians. The second benefit would be to provide the Legislature with the opportunity to reassess the State's role in telecommunications and the best way to fulfil those roles.