Telecommunications Survey: Extracts

Frances Cairncross
The Economist

A connected world

In many countries, the fixed telephone service is still a public-sector monopoly. By this time next year, the monopolies will, in theory, have been swept away in most countries, as agreed earlier this year in the World Trade Organisation. Its timetable for opening markets at the start of next year parallels an earlier agreement by the countries of the European Union to create a single market for telecommunications services.

But experience in those countries that have already begun to dismantle their monopolies—including the United States, Japan, Britain, Australia, New Zealand and Scandinavia—shows how hard it is to create competition in telephone networks. The old telephone monopolies will almost certainly still be powerful companies ten years from now—though in 20 years’ time some of them may be gone.

Long before then, the industry will have become much more like other industries. New companies are already elbowing into the business. Some come from other industries; some are cheeky upstarts, founded by youngsters. Eli Noam, an economics professor at Columbia University in New York who is also a telecommunications guru, speaks with wonder of one of his graduate students who started a company to resell telephone capacity, and now has 100,000 customers. “The amount of young people going into competition against big companies is remarkable,” he says. “They are not afraid. The advantage of 25 years of experience is irrelevant in such a high-growth industry.”

Already, telecommunications services are starting to be internationally traded—and occasionally dumped, giving rise to a novel sort of trade war. And—another novelty—some telephone companies will go bust (as one or two tiddlers have already done). Many will have foreign owners. No longer will all big telephone companies do more or less the same things; instead, like car companies or banks, they will specialise and diversify, sometimes wisely, sometimes not. And, once there are many providers of communications, government’s role will shrink.

Although regulatory change may be slow, the speed of technical transformation is breathtaking, as information is increasingly handled in digital form and as the capacity of networks soars. As a result, activities that were strictly for nerds one year (say, voice telephone calls over the Internet) are hot commercial prospects 12 months later; and technologies that started as a businessman’s luxury (say, cellular telephones) quickly become a mass-market gadget. No wonder Andrew Entwistle of Analysys, a consultancy in Cambridge, England, confesses: “We’ve gone from clarity about the future to explaining why we can’t answer with certainty.”

Wireless and data sum up the two main uncertainties. Ten years from now, it seems probable that wireless will have become the main conduit for voice conversations, as people come to think of the telephone as a personal, portable gadget rather than a static object which they share with others in a fixed place. Moreover, wireless, including satellite telephony, will eventually be the main guarantee that everybody has a choice of telephone service.

At the same time, telecommunications will be increasingly about carrying data. Some of that data will be the human voice, carried in new ways. Some will be moving pictures, converted into digital form, and some will be information sent from one machine to another. Whereas even the most loquacious humans eventually dry up, machines can go on communicating for ever. Carrying voice calls will remain the industry’s biggest money-spinner for many years—in the time it has taken Internet telephony to become a $2m business, international telephone sex chat has become a $2 billion business. But data will be what fills the pipes.

These changes will transform the industry. “The Internet is just as significant for the telecoms industry as the PC was for the computer business,” says Tim Kelly, head of operations analysis for the International Telecommunication Union (ITU), an intergovernmental body in Geneva. “It brings new companies and cuts margins.” But, he adds, the telephone companies are more entrenched than the mainframe computer makers ever were: they have run a highly effective cartel, they are closely bound to governments, and they usually control the final gate between the network and the user. For all these reasons, change may take longer to come about.

This survey will review the changes that have already taken place, and preview the bigger ones waiting in the wings: in competition and regulation, and in the technologies developing at such a breakneck pace. It will end by giving a few tentative answers to the biggest question of all: how will all this change our lives? A decade or two down the road, will we bless the telecommunications revolution—or wish that it had never happened?

Ready, Steady ....Whoops

“THE more electronic communications becomes the key industry of the economy,” observes Columbia University’s Mr Noam, “the more important it is to have competition.” If you want to see what competition can do, go to Finland. That country almost certainly has the world’s highest ownership of mobile telephones (33 mobiles for every 100 people); the world’s highest Internet (and probably modem) penetration; and more public payphones per head than almost anywhere else in Europe. It also has the second-lowest business call charges in the OECD (after Iceland) and the fifth-lowest residential (after the other Nordic countries). In this country with a population of a mere 5m, many of the largest companies have two network providers. Many people can choose between a fixed-line provider and several wireless services.

Finland’s experience suggests that competition pays, fostering low prices and innovatory service. The country has always had an unusual telephone system: in the 1930s it had more than 600 telephone companies, many of them customer co-operatives. Today it still has 52 local companies, which benchmark their services against each other. Two main groups compete head-on: Telecom Finland (still state-owned) and Finnet (a group of 46 local companies).

Fine for the Finns

Finland’s success is built on a light regulatory touch. This summer telecommunications licensing was abolished. Anybody who wants to run a telephone service simply notifies the telecommunications ministry, and accepts a number of obligations (such as providing access to the emergency services). The goal, says Harri Pursiainen of the communications ministry, is that telecommunications services should eventually become like any other industry. The government may step in to share out scarce resources such as telephone numbers, and radio frequencies for cellular operators, but in all other respects special treatment should be unnecessary.

Most countries are a long way from this Nordic nirvana. True, businesses can usually lease capacity for private use. A few countries, such as the United States and Japan, have long allowed competition for long-distance calls. And many countries allow competition in cellular telephony. But most forbid it for local voice calls. Finland, Britain, Australia and Hong Kong are among the few exceptions.

That is about to change. New legislation is beginning to liberalise markets. In the United States, the 1996 Telecommunications Act allowed local telephone companies and long-distance companies to compete in each other’s markets. In Japan, the government is breaking NTT, the local giant, into two national companies and a third which will compete internationally. In the European Union, most governments have promised to allow full competition from the start of next year.

In addition, under a WTO agreement reached earlier this year, many developing countries are opening their markets to some degree of competition. These agreements are, at least theoretically, binding and irreversible: a new concept in trade negotiations. “Five years ago,” says David Hartridge, director of the trade in services division of the WTO, “nobody would have thought it possible.” What persuades countries to tear down national monopolies? According to Mr Hartridge, “We told them that industry spends a lot more on telecoms than on oil—and even the oil producers’ cartel has not distorted prices as much as telecommunications prices are out of line with costs.”

But, in an industry with so much distortion, change is bound to be agonising. Private and corporate users will eventually benefit—although some domestic users may lose out at first. But would-be liberalisers face a number of obstacles:

First, the giant government-backed (or -owned) monopolies have skewed prices. They have creamed off revenue from long-distance and international calls and business services to subsidise residential users, who mainly make local telephone calls. The most blatant imbalance is in international voice calls, where tariffs have been propped far above costs. In the long-distance market, profits have boomed as technology has cut the true cost of such calls to little more than that of a local call—but prices have eased only slightly.

A second problem is that the erosion of fat margins often means job cuts in what is usually one of the biggest white-collar employers in the country concerned. Britain’s BT has shed almost half its workforce since privatisation in 1984. Telecom Finland got rid of 40% of its staff in the five years after 1989. Plenty of new jobs spring up in new telecommunications businesses as well, but the headlines mainly record those that disappear.

Third, many countries are in the throes of privatising their telecoms services. The less competition the state-owned giant must face, the more attractive its shares will look, and the more money a government may hope to raise. And even when the national giant has been sold, it may still dominate the local stockmarket.

A further difficulty is the tendency of telephone networks towards concentration. Nowhere has this been more apparent than in the United States. Last year’s Telecommunications Act has been followed not by a burst of competition but by a series of court cases and a wave of merger proposals. The seven large local telephone companies have become five: SBC, the biggest, has acquired PacBell and flirted with acquiring AT&T; and Bell Atlantic is merging with Nynex to form America’s second-largest telephone company.

Go on, Sesame, open up

Still, where competition is encouraged, it fosters new services and lower prices. Such competition takes two main forms: either companies build their own new capacity by laying fibre-optic cables, putting up wireless antennae or launching satellites; or they rent spare capacity on such networks from other companies, including the big telephone monopolists. The most striking new source of competition, the Internet, runs over a network provided by a group of companies separate from those that have developed most Internet applications and services. Eventually, this split between the management of the physical network on one hand and the development and marketing of specialised services for it on the other is likely to be replicated in the telephone industry.

Many of the new entrants come from other industries, and bring new ideas and ways of doing things. In Germany, some are owned by big industrial companies: for example, debitel, which provides mobile-telephone services, is owned mainly by Daimler-Benz and by Metro, a big retail group. Since its launch in 1992, it has captured 17% of the German mobile market, partly by pioneering novelties such as marketing through Mercedes-Benz dealerships and offering a hotline for commuters to reserve parking spaces. As Klaus-Dieter Scheurle, Germany’s newly appointed telecoms regulator, says: “The small companies put pressure on the big ones to be innovative.”

Other new entrants are big telephone companies from other countries, resigned to losing market share at home and eager to gain it abroad. At present, that almost invariably means a joint venture, such as CEGETEL, run by Générale des Eaux in France with BT, Mannesmann of Germany and SBC to provide a wide range of telecoms services in France. “The fact that we are dominant at home and a new entrant here means we feel a bit schizophrenic sometimes,” admits Fran&ccedillaois Viviers, BT’s regulatory boss in France. Such groupings may be ponderous, but at least their constituent parts will know a lot about manipulating different kinds of regulatory systems.

A third group of competitors is made up of innovators, using novel technologies to leap into new markets. Examples include the various schemes to provide telephone and broadband services from satellites that orbit the earth (satellites that stay in a fixed orbit are already widely used to retransmit conventional telephone traffic). Several newcomers, such as Iridium, a consortium assembled by Motorola, have plans to switch telephone signals from one orbiting satellite to another, allowing people to make long-distance and international calls from a handset in places where local services are overpriced or non-existent. Such projects are feasible because satellites can now be mass-produced. But the initial cost is huge: Iridium, says Robert Kinzie, the venture’s chairman, will spend $5 billion before it earns a cent.

Another group of schemes aims to use satellites to offer high-capacity Internet access anywhere in the world. Teledesic, the venture with the highest profile (and the biggest cost—a mind-boggling $9 billion), has the backing of Bill Gates of Microsoft, Craig McCaw, a pioneer of cellular telephony, and Boeing. Such schemes are a huge technological gamble. And they may be overtaken in mid-development by less expensive ideas, such as using barrage balloons instead of satellites. Luckily for the telecommunications industry, its revolution has unfolded against the background of the longest-ever boom in the American stockmarket. A great deal of money is looking for exciting investments. Once these companies are built and running, their operational costs will be low, so when their capital cost has been repaid they should become hugely profitable. But many will go to the wall long before they reach that point. For their investors, that will be sad, but society as a whole will benefit: the cables and satellites will still be there, but free of the burden of their capital costs.

The magic of competition works just as well in developing countries as in developed ones. In a study published in June, the ITU describes what is happening in the Asia-Pacific region, where more than 80 new companies have entered the industry since 1990:

Asia-Pacific stands out as the realm of new operators. A region burgeoning with new carriers: small and not so small; some backed by powerful international operators, others driven by the adventurous spirit of local entrepreneurs; some concentrating in market niches, others spreading their wings across market segments; some working within the boundaries of one country, others becoming regional operators.

These new entrants have had an unexpected effect. Vigorous competition has sharply reduced prices: for example, in New Zealand the average cost of a national long-distance business call has dropped by a quarter. The resulting stimulus to the market has benefited not just newcomers but incumbent carriers too, even when they have lost market share. In both Australia and New Zealand, the main carriers reported their highest-ever profits in 1996, in spite of increased competition (see chart).

As for the new entrants, they have one huge advantage and face one huge threat. The advantage is simply that they are new: their costs are low, their bureaucracy minimal, their culture entrepreneurial. They have no unions to placate, and their sales force is slim. In all these ways, they differ from an established monopoly. “You could run a hell of a business just on what the Bells spend on golf tournaments,” says Wayne Perry, who worked with Mr McCaw to build McCaw Cellular, a giant mobile business now owned by AT&T. Japan’s fairly new long-distance carriers, DDI and Telecom Japan, have revenues per employee three to seven times as large as those of giant NTT. No wonder BT, Britain’s own giant, is looking at ways to split itself into smaller units, each operating as an independent cost-centre.

The threat is the power of the incumbent monopoly over prices. The new entrants, with their slim overheads, can undercut the giant. But the giant has cash flow, brand and often a largely depreciated network on its side. These are deadly weapons in what has become a commodity business. In addition, the incumbent controls their biggest cost: that of connecting calls to the national network.

So the new entrants usually nestle in under the lee of the giant, making a tidy living, but ensuring that their hefty rival does so too. Over time, the new entrants will help to drive prices inexorably towards costs. But for the moment, look at them as a source of new marketing ideas and new technologies, rather than aggressors in a price war that might well destroy them.

The short arm of the law

AS GOVERNMENTS strip away the rules that have protected telephone monopolies, they will begin to realise that their task does not end there. Without well-designed regulation, competition may falter.

The clearest example is New Zealand, which since 1989 has had no legal entry barrier to any part of its telecoms industry. But until recently, only two companies competed in the fixed and cellular markets. Why? Because when the government liberalised the market, it did not create a special regulatory framework. This omission forced Clear Communications, the new market entrant for fixed services, to take Telecom New Zealand, the incumbent, to court. The dispute took four years to move through the New Zealand courts and up to the Privy Council in London. Clear’s battle discouraged other potential entrants.

Competing in the telecoms business is different from competing in candyfloss or cornflakes. The dominant telephone companies start with big advantages—100% of the local market, a familiar brand, a network that has largely been paid for, and a good cash flow. They usually are also have strong relations with government: their executives may have spent careers in and out of the telecommunications ministry, or they may know a great deal about lobbying. In any industry, these would be formidable challenges for a new entrant.

To add to these challenges, this business rewards size. The more people and businesses a network connects, the greater the value of being plugged into it. Without regulation to sustain competition, the telephone network might naturally revert to a single giant. Even if services remained competitive, the network probably would not.

So regulation is probably inevitable to ensure competition. But the lesson of the past decade has been that regulation is extremely difficult to get right. And bad regulation can impose big costs. MIT’s Mr Hausman reckons that regulatory delays in allowing full-fledged competition in cellular telephony in the United States cost about $50 billion a year in lost consumer welfare. He fears that mistakes in implementing the 1996 Telecommunications Act will delay the building of broadband fibre networks to allow high-speed access to the Internet and other services from homes, and thus impose even bigger costs.

At present, regulation’s toughest tasks are licensing new services and dealing with interconnection. Regulators have to decide whom to license (for instance, should foreign companies be allowed to own a new telephone service? Should there be a limit on the number of competitors?) and on what conditions (should newcomers have to guarantee a certain quality of service or level of investment?). In the past, governments have tended to give licences for a particular technology or type of service. Now some are moving towards more broadly defined licences. When Malaysia recently switched from service-specific to full-service licences, new investment boomed.

Even harder questions arise with interconnection. A telephone is virtually useless unless it can reach the other 800m or so telephones around the world. So the new entrant has to be able to interconnect with the main national network—which means doing a deal with the dominant company. Almost every new entrant complains that the interconnection charges bear no relation to their true cost. Many grumble that interconnection charges account for around 40% of their operating costs.

Count us out

Governments are understandably unwilling to become embroiled in these disputes. “Every day companies ask us to intervene,” says Mr Pursiainen of the Finnish communications ministry. “We usually refuse. Our companies have been negotiating interconnection agreements with each other since the 1920s.” In Finland, which has never had a single local monopoly, and whose main telephone companies are more evenly matched in size than in most countries, this relaxed approach may work. Elsewhere it may not. Germany’s new telecoms regulator, Mr Scheurle, says that would-be new entrants are supposed to negotiate with Deutsche Telekom first, but can ask the regulator to step in if that fails. Newcomers point out that Deutsche Telekom has skilfully dawdled, leaving them fearful that they will have no agreement in place when the market opens at the start of January.

The terms of interconnection cause arguments when a company (such as Cable & Wireless’s Mercury in Britain or Sprint in the United States) wants to sell its long-distance services to the local customers of another company (BT, say, or Bell Atlantic); or when a new local network (such as those of Ionica or WorldCom) wants to connect with an existing one. In the United States, an even trickier problem has arisen: over the terms on which a company (such as MCI) should be allowed to sell local telephone services to the customers of a former monopoly without building its own physical network.

Congress has allowed for three options to create local competition. One is to build new local networks. In Britain, policy has been designed to encourage this option. Under Margaret Thatcher’s government, an asymmetrical regulatory system was created that was less favourable to BT than to its rivals, to promote the building of a second, parallel network by the cable-television companies (and, later, fixed-wireless companies such as Ionica).

But Reed Hundt, chairman of the FCC, regards this as wasteful. “It’s like building two train tracks to every town,” he says. “To tell the cable industry that it has to build an alternative telephone system or it can’t come into your country is dirigiste. It’s better to use the economies of scale in this business.” Oftel, Britain’s regulator, now worries that the two-track policy will be undermined by the new rules the European Union is developing. These are likely to mimic America’s emphasis on kickstarting competition in services by allowing competitors to offer them over the existing network, rather than encouraging the construction of a second wire. Oftel fears that the result—tough competition not in the local market but for more profitable long-distance business over BT’s network—may damage both the cable companies and Ionica.

America’s attempts to implement that strategy over the past year have been discouraging. The aim was to give new competitors two options: to buy services from existing local incumbents and resell them under their own brand, or to buy “unbundled” components—the use of the lines and switches that make up local service. But neither side has been happy with that choice. One problem has been with the way prices are set. This differs enormously under the two schemes, creating huge potential for arbitrage. Moreover, the local incumbents protest that the pricing regime for “unbundled” parts of the network makes no allowance for overheads and “embedded costs”, and that Congress is confiscating their assets. They intend to fight the rule all the way through the courts.

The second problem has been the sheer difficulty of making this sort of competitive co-operation work. “Getting the companies’ computer systems to communicate is a huge job,” says Anna-Maria Kovacs of Janney Montgomery Scott, a Philadelphia brokerage. It would be hard enough between two willing parties. But it is being undertaken and largely financed by unwilling Bells. As even the FCC’s Mr Hundt admits: “The incentives for the incumbent to co-operate are nil.” Not surprisingly, the Bells have found any number of ways to throw sand in the gears.

“We’re spending tens of millions of dollars on legal fees trying to fight this out in 50 states,” growls Bert Roberts, chairman of MCI, whose proposed merger with BT has been jeopardised by potential losses as it tries to enter the local market. For example, MCI has permission to provide local telephone services in Texas, using SBC, the local Bell, as supplier. To persuade customers to switch, MCI first needs to know what services they are currently receiving, in order to offer something better. MCI complains that, when SBC is asked for that information, it rings those customers and attempts to “plant seeds of doubt in [their] minds about MCI’s ability to provide local services.”

So either competition may wither, or the incumbents may see precious little reason to make new investments in the local network. If that holds back the development of new services, then people will rightly blame enforced competition.

What is the alternative? Southern New England Telecom (SNET), which provides telephone services in Connecticut, is about to embark on an interesting experiment. The company is splitting itself in two—a wholesale operation, which will own the network and sell services to all comers; and a retail operation, which will deal directly with customers. But SNET will not be allowed simply to transfer its customers to its new retail arm. Instead, next year, the Connecticut state regulator will ballot all the state’s 2m telephone customers, asking them which local telephone company they want. Ms Kovacs reckons the company will lose about 20% of its retail market. But, because the wholesale network will continue to carry most of the traffic in the state, the overall net loss of revenue may be much less—perhaps only 5%. If the scheme works, it may be the answer to a regulator’s prayer: it will provide a genuine incentive for local competition, but protect the main asset base of the local incumbent.

The price of competition

If regulation is difficult for rich countries, it will be desperately hard for poor ones. Part of the problem is cultural: not many developing countries have good antitrust regulation, or are used to the idea of regulating to promote competition rather than to restrain it. A further problem is the sheer demand for skilled manpower. “If you need to create a body with autonomy and expertise, you are quickly talking about 50 professionals,” says Bj&odierisisrn Wellenius, telecommunications adviser at the World Bank. “That is a big problem for countries with limited human and institutional resources.”

All the same, the Bank is keen to encourage competition and to promote foreign investment, both of which will help bring the telephone to many more people in poor countries. One shining example is Chile, which privatised its main carriers back in the late 1980s and now has one of the developing world’s most open telecommunications markets. But many Chileans live in places that do not even have a public telephone. So in 1994 the government set up a fund with a four-year life, offering a subsidy to any company willing to provide these places with telephone services. The bids it attracted have so far allowed half the places to be served without any subsidy at all. The fund has spent only $2m—half its budget—and drawn in private investments of $40m, which will pay for the installation of 1,285 rural public telephones at an average cost of $1,634 a telephone. Compare that, says Mr Wellenius triumphantly, with the bad old pre-competition days of the 1980s, when the government paid $6m to the incumbents to install a mere 300 rural payphones, at an average cost of $20,000 apiece.

But, if competition is to achieve more such triumphs in the developing world, then new models of regulation must be devised. The Bank sees two main options. One is to create private property rights—for instance, to designated bands of radio spectrum, which will be in hot demand for wireless local loop. The private owners would thus take over part of the licensing task of a regulator, deciding whether spectrum should be used for cellular, fixed wireless, broadcasting and so on.

A second suggestion is to contract out more regulatory tasks. Why not allow a global accountancy firm such as Price Waterhouse or Arthur Andersen to monitor compliance with licences, for instance, or even to set up procedures for resolving those dreaded disputes about interconnection? The regulators might then confine themselves mainly to setting the rules in advance—which would inspire confidence among investors.

If poor countries do not want to push outsourcing so far, plenty of rich countries are keen to help train their regulators. Even before the WTO agreement takes effect, many developing countries are opening the door to foreign investors who will want to see fair and reliable regulation before parting with their money. The best-regulated markets will get the most investment.