The State of Telecommunications Competition in Canada

Remarks by Gilles Ménard
Deputy Director of Investigation and Research
(Civil Matters), Competition Bureau

The Canadian Institute
Canadian Telecommunications Superconference

June 18, 1996

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Introduction

I would like to thank the Canadian Institute and the Canadian Business Telecommunications Alliance for giving me the opportunity to participate in this important conference.

If you have been following the media lately, you will know that the Bureau has been preoccupied with examining the state of competition in the Canadian gasoline industry. We have also made some public submissions regarding the future mandate of Canada Post and how competition might be introduced into core elements of our postal system.

One thing that I have learned from all my years in the Bureau, is that few things spark more public outcry or media commentary than increases in the price of gasoline, postage stamps, or local telephone service. With this in mind, it will be with some mild trepidation that I will offer you this morning some views on the pricing of local telephone service.

In discussing TheState of Telecommunications Competition in Canada , I have four objectives:

First, I want to step back briefly to reflect on the changes which have overtaken telecommunications markets and why the Bureau is of the view that it is more important than ever to foster competition as the driving force in this industry.

Second, I also want to provide the Bureau's perspective on the progress which has been made to date, particularly in terms of competition in long distance services.

Thirdly, I want to comment on the need for a more efficient rate structure for telecommunications services which we believe is the critical factor to be addressed if we are to successfully open all telecommunications markets to competition.

And finally, I want to highlight some policy prescriptions that the Competition Bureau has advanced in order to encourage competition in the telecommunications sector in Canada.

From Regulated Monopoly to Competition

Technological change and increased recognition of the growing costs and inefficiencies of regulation are reinforcing the view that regulation should give way to market forces and competition wherever possible in telecommunications services. Competition is far more effective than regulation in driving prices towards their costs, inducing firms to produce the goods and services consumers desire, and spurring innovation in new technologies, services and distribution.

For most of its history, however, the telecommunications industry in Canada has been organized on a monopoly basis. For many decades, wireline telecommunications was regarded as a "natural monopoly" in which economies of scale and scope were of such magnitude that services could only be supplied efficiently by a single firm. The corollary of the natural monopoly theory, of course, was that competition was not workable and could lead to inefficient outcomes.

To prevent monopoly firms from exercising market power over captive customers, price regulation was imposed. To preserve the perceived efficiencies available to natural monopoly firms and to ensure that they met social policy objectives such as universality, regulation also served to protect the monopoly service providers from competition.

As we all know, innovation in communications technologies is challenging the notion that these markets are natural monopolies. As a result, there has been a sea change in attitude toward regulating the telecommunications industry on grounds of natural monopoly. These innovations are also making it increasingly difficult for regulators to control the flow of events as new services and means of bypass threaten existing regulatory mechanisms. Instead, regulators everywhere find themselves continually reacting to changed market circumstances.

This rapid technological change has been accompanied by a growing recognition that government regulation of telecommunications has resulted in substantial inefficiencies. Unlike competition, regulation reduces incentives for cost reduction and product innovation. Moreover, the cost of regulation itself can be substantial. This cost includes not only the direct costs of regulation, but also the losses to society from the rigidity and delay in pricing and investment decisions. Regulation can delay the deployment of new services and technologies and hence deprive consumers of valuable products or services that would make them better off.

While the consensus on the benefits of competition over regulation is clear, there continues to be a wide range of views over how best to accomplish the transition from regulated monopoly to competition and the role of government once that transition is complete. There is no choice, regulation must adapt rapidly to changing market forces in a manner which shrinks the boundaries of the regulated sector and relies wherever possible on competition. It should also be understood that competition need not be perfect for it to be preferable to regulation. The advantages of competition, however imperfect, can easily outweigh the costs and inefficiencies of regulation. This is clearly demonstrated by Canada's recent experience in the long distance telephone market.

Long Distance Competition

It has now been four years since the CRTC opened the market for long distance service to facilities-based competition and only two years since the introduction of equal access. In that relatively short period of time, the benefits of competition to business and residential users have exceeded even the most optimistic predictions in 1992.

There has been entry into the long distance sector by facilities-based carriers, including Sprint Canada and Unitel who respectively have forged alliances with Sprint U.S. and AT&T. A host of other companies have also emerged as effective competitors. These new entrants have obtained significant market shares at the expense of the Stentor companies. New and innovative services have been introduced to the market. Reductions in rates for long distance services in Canada have occurred at a pace faster than that observed south of the border after the AT&T divestiture.

Some have expressed concern about the financial position of the new entrants, both carriers and resellers. A number of resellers have left the market or have been acquired by alternative carriers. The alternative carriers have reported losing substantial amounts of money. This situation has resulted in fears that long distance competition may not be "sustainable."

While new entrants have reported poor financial results, a number of them have also reported significant increases in the number of minutes billed and corresponding increases in revenues. The CRTC's open market approach to competition has created a competitive toll market to the benefit of Canadian long distance subscribers. Despite the rocky road for some individual firms in the market, conditions now exist for effective competition in the market for long distance services.

When analyzing the state of competition in markets, the Bureau's test is whether firms currently in the market are subject to effective competition and to what extent the market in question is contestable? In other words, we seek to determine the degree to which incumbent firms are constrained from exercising market power either because they will lose business to existing competitors or because their actions are likely to induce new entry into the market. For a market to be effectively competitive, existing firms or potential new entrants do not necessarily have to seize a large share of the market to constrain incumbent firms from raising their prices. As long as customers have the ability to resist rate increases by turning to alternative suppliers, or increased rates are likely to induce further entry into the market, price increases by incumbent firms to a given set of customers may be rendered unprofitable.

In the context of the Canadian long distance sector, the level of market share held by new entrants may not be the key indicator of the degree of competition in the market. Rather, a more important determinant is the switching and transmission capacity in the hands of the new entrants. In this industry, characterized by high fixed costs and low marginal costs, the ability of competitors to carry additional traffic or to expand that capacity relatively quickly should incumbent firms attempt to raise prices, is a potentially a more important determinant of the adequacy of competition. For once capacity investments are sunk, firms have a strong incentive to use them to their maximum potential.

The Telephone Rate Structure

It is often suggested that the goal of regulation should be to replicate the economic and market results that would be achieved by competitive markets. However, that is in theory. In reality, regulators are asked to achieve social objectives unrelated to competition policy. In pursuing these social objectives, regulators have not attempted to replicate the outcome of competitive markets. On the contrary, regulation has seriously distorted markets leading to economic effects which have been antithetical to competition policy.

Rate and service distortions are not only the source of much of the cost of regulation, but eliminating them, once they have become entrenched, is invariably both socially and politically difficult to accomplish. Whether abandoning railroad track, closing a local post office, discontinuing airline service to smaller communities, or raising local telephone rates, existing regulatory rate structures and service requirements can constitute a major impediment to the scope and pace of the introduction of competition.

The pricing of telephone service is an obvious example. In the past, regulators resisted liberalized entry into telecommunications because of their desire to achieve or maintain affordable 'universal service' through an elaborate system of cross-subsidies. Under these cross-subsidies, a disproportionate share of the costs of local access is recovered from prices for long distance, business local and enhanced local services. Conversely, access rates for primary exchange services for urban residential and rural subscribers are significantly below the cost of providing service.

In their recently published book Talk is Cheap, Len Waverman of the University of Toronto and Robert Crandall of the Brookings Institution have examined Canadian and American telephone rates. They have concluded that rates in both countries are seriously distorted and that Canadian rates bear even less relationship to the cost of providing services than those in the U.S.

In 1992 the CRTC introduced what it referred to as "consumer friendly competition" into long distance service. Facilities-based long distance competition was accompanied by a scheme of long distance "contribution" which was intended to preserve the existing cross-subsidy from long distance to local and thereby obviate the need to raise local telephone rates. Now, as the Commission prepares for the introduction of new entry into local telecommunications services, some parties are proposing new subsidy regimes involving "local contribution", "portable subsidies" and "universal service funds" to perpetuate the existing telephone rate structures and the cross-subsidies which support them.

Introducing effective competition into local telecommunications markets will be very difficult if telephone rates are not based on the underlying costs of providing the service. This is probably the single most important issue which must be addressed to complete the current process of regulatory reform.

Rates must be rebalanced and restructured if the proper signals are to be sent to potential new entrants into local services. As long as the prices of some services are above long run costs, there will be excess entry into those services and diminished revenue available to subsidize local rates. Conversely, as long as the prices of some services are below costs, competitive entry will not occur in those sectors in the absence of some form of subsidy.

Absent rate rebalancing, we have the prospect of even more complex cross-subsidy schemes in future involving a multitude of firms rather than just the former monopoly service provider. What regulatory burden will be involved with administering these new schemes? Whose costs would be used to calculate the subsidy? The former monopolist or a potentially more efficient new entrant? Can we look forward to even more costly and prolonged regulatory hearings?

If a subsidy is required, would it not be more efficient to provide the subsidy directly to qualified subscribers and let firms compete for the consumer's business on the basis of the economic costs of supplying service?

If we are going to be serious about telecommunications competition, no one should kid themselves that cross-subsidies which are subsumed in service prices can be maintained. The process of lowering long distance rates through competition and allowing for increases in local rates has, of course, already begun. However, rate rebalancing and restructuring issues continue to be at the core of regulatory reform and transition to competition. There are a number of reasons for this.

First, the provision of access and local service below cost may have been sound public policy in the earlier days of telecommunications services when the objective was to promote universal service. However, with telephone penetration rates in the order of 98.5% of Canadian households, we have long since achieved the goal of "universal service." By comparison, the penetration rate in the U.S. is around 94%. The CRTC in its regulatory framework decision (Telecom Decision 94-19), has recognized that the current level of redistribution of revenue in telecommunications markets is significantly more than necessary in order to keep local service rates "affordable."

Second, economic studies and the experience from other countries which have moved more aggressively than Canada to rebalance rates indicate that the elasticity of demand for basic local telephone service or access is very low. Given the value of local telephone service to Canadians and its relatively low cost compared to other essentials of life such as food, shelter and clothing, all of the evidence which the Bureau has examined indicates rate rebalancing is highly unlikely to result in any significant drop off from the network. In its current Local Service Pricing Options proceeding, the CTRC has received evidence that at household incomes as low as $15,000 per year, depending upon the city, expenditures for local telephone service range from slightly less than 1% to a high of 1.6% per year.

Third, the fact that existing cross subsidies are directed to all telephone subscribers and all telephone lines regardless of their economic need, makes the current system both inequitable and extremely inefficient. For example, someone with three residential lines into the house - one used for telephone, one for a fax machine, and one for access to the Internet - receives the local subsidy on all three. Is this what Parliament intended when it called for "affordable access" and "universal service"?

Fourth, regulatory rate distortions also impose a substantial deadweight loss to the Canadian economy due to the misallocation of resources. Higher than necessary toll rates create incentive to by-pass the public switched telephone network, use foreign facilities or, alternatively, invite inefficient entry.

Finally, these subsidies are a substantial barrier to entry for competition into local telecommunications services. Allowing local rates to more closely reflect the underlying demand and costs of providing telephone service is fundamental to stimulating competitive entry into local markets. To attempt to introduce competition into local markets while preventing prices from moving closer to costs will be very difficult.

If rates are not rebalanced and restructured, competition will place strong pressures on the existing rate structure. As in long distance markets, new entrants will target their efforts at low cost, high margin business leaving incumbents to serve the high-cost sectors of the market. The Commission has already become embroiled in a steady stream of disputes in the long distance sector between new entrants and the telephone companies over pricing, costing allocations and contribution levels. This experience should be evidence that once the decision has been made to have a competitive telecommunications sector, it is very hard and costly to maintain a system of cross-subsidies.

As Dr. Crandall and Dr. Waverman warn:

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"The local telephone companies have accepted a woefully inefficient rate structure as part of a Faustian bargain in which they continue to receive protection from competition. But with wireless costs falling dramatically, this bargain is now crumbling. Competition is coming to the local loop, perhaps very soon. The local exchange carriers and their regulators had better address the issue of rate distortions or face being overwhelmed by this new competition."

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(Talk is Cheap, p. 285)

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Policy Prescriptions

The Bureau is currently addressing issues related to the telephone rate structure in both the Local Interconnection and Network Unbundling and the Local Service Pricing Options proceedings which are currently before the CRTC.

The Bureau has advocated that regulatory rate distortions should be eliminated through the introduction of market-based pricing. Economically efficient pricing will produce a price structure which is more conducive to efficient entry and competition in all markets.

In a competitive environment, where prices are determined by market forces, prices tend toward the long run incremental costs of the most efficient means of providing service. This may or may not be the technologies and marketing methods used by incumbent telephone companies. For example, it is conceivable that wireless technologies may one day prove to be more efficient than wireline technologies in providing telephony and other telecommunications services to rural and remote areas.

While the Bureau does not profess to be able to predict the future level of telephone rates with precision, I can offer the following observations. First, very few people believe that local rates will rise to a level which would cover the embedded costs of the telephone companies. Second, some people have speculated that local telephone rates may start to top out in the mid-$20 range as new entrants are attracted to the market.

I am sure that there are many of you at this conference who have your own views and are in a much better position than I am to forecast the level of future telephone rates. However, we do know that rates for local telephone service, or access as some prefer, have started to rise and can be expected to rise even further over the next two or three years. This raises the potentially difficult issue of the effects of these future rate increases on "universality" and "affordability."

"Universality" and "affordability" are relative concepts for which the Commission will have to develop its own standards. In some parts of the world, having access to a telephone within a half an hour walk would constitute "universality." I have already noted that Canada has an extremely high level of telephone penetration and that the percentage of household incomes expended on local telephone service are very small relative to other essential goods and services.

However, if the Commission concludes in its Local Service Pricing Options proceeding that specific measures are required to address concerns over the affordability of local telecommunications services, the Director has encouraged it to adopt measures which are competitively neutral so as to enable local competition to flourish. From a competition policy perspective, a targeted subsidy with vouchers given directly to qualified subscribers is clearly the best approach. This would allow qualified consumers to choose their own service provider based on their own requirements.

The objective should be to eliminate all cross-subsidies and the contribution schemes which accompany them. The alternative is to perpetuate contribution entitlements or expand them as more service providers enter the market. Establishing "universal service funds" and administering them among firms in the industry is likely to distort competition and lead to more, not less, regulation at the very time when the need for economic regulation is quickly eroding.

If penetration rates for a narrow segment of society are in jeopardy of declining below some acceptable standard due to the effects of rate rebalancing and restructuring, it is our position that those subscribers should be identified and compensated directly to ensure that they are able to remain on the network.

In a competitive market, the lowest cost technology will impose a constraint on market prices. Given that the costs of providing telecommunications services are declining rapidly, it may be that in the medium to long term prices will fall back to, or even below, their previous levels. In that case, our concerns about affordability and accessibility should be viewed as temporary and transitional in nature.

Any mandated budget services, direct subsidies or other programs should be introduced as temporary devices. Such programs should be subject to a fixed sunset provision to ensure the transition to market-based pricing is completed.

Irrespective of considerations of affordability, all competitors in local service markets should be afforded the flexibility to offer a variety of pricing options that reflect different packages of services or conditions of use. This will increase consumer choice and foster competition in local telephone markets.

Conclusion

The changes which are taking place in Canada are not occurring in isolation. The dynamic and dramatic transformation of telecommunications is a global phenomena. The challenge is to adapt to this change of environment in a timely manner to ensure that the benefits of competition and technological innovation are made available to Canadians as quickly as possible. Canada has adopted a competitive telecommunications policy and regulatory framework. The task at hand is to implement this policy and framework in the bestpossible manner.

Rate rebalancing is but a part, albeit a fundamental part, of the transition to competitive markets. There are many other important issues which must be resolved if we are to benefit from effective competition in telecommunications markets -- number portability, terms for interconnection, the extent of network unbundling, creating the proper incentives for facilities-based competition and the role of resale to name a few.

There are of course other issues with respect to appropriate competitive safeguards, including the application of the Competition Act. Telecommunications regulation in Canada must undergo continued reform in order to adapt to changing global markets. As we move forward with this process, the roles of the Competition Bureau and the CRTC will evolve. As the role of the CRTC as an industry regulator diminishes, firms in the industry will increasingly become subject to the discipline of the market and, where the circumstances warrant, the application of the Competition Act. Given the structure of the telecommunications industry, there seems little doubt that issues will arise under the merger and abuse of dominance provisions of the Act .

For our part, we are committed to working in a positive manner with the Commission, industry participants and, most importantly, their customers during this period of transition and beyond to ensure that Canada realizes the substantial benefits which telecommunications and telecommunications competition have to offer. We have an obligation to ensure that the application of the Competition Act to this critical sector of our economy is informed, responsible and, above all else, effective in protecting the public's interest in competitive markets. And we count on your assistance.

Thank you.