Telecom Decision CRTC 2002-34: Regulatory Framework for the Second Price Cap, released 30 May 2002, sets out new rules for regulating competition in the Canadian telecom industry. The Decision capped a process that was launched more than a year ago and saw many different visions of the future presented by consumers, incumbent carriers (ILECs) and new entrants. In this Decision, the Canadian Radio-television and Telecommunications Commission (CRTC) provided a significant win for consumers. At the same time, incumbent and new entrant carriers alike received varying amounts of relief as described below. In this Decision, the CRTC attempted to strike a balance between the interests of business and residential consumers, ILECs and competitors.

Business and Residential Consumers

The Commission determined that there would be insufficient competition to discipline ILEC pricing of local service and optional local features during the next four-year period. As a result, the CRTC has frozen residential rates such that increases in any given year will not be permitted unless the rate of inflation exceeds 3.5%. In addition, ILECs were denied price increases for local service in high cost serving areas, which were proposed in order to eliminate the contribution subsidy. This is a big win for consumers who will likely experience a decrease in residential local service pricing in real terms over the next four years.

The Commission also determined that it no longer requires business local rates to be reduced by a productivity factor. As a result, ILECs will have the ability to increase local business rates by the rate of inflation each year. This will likely put an end to the price decreases experienced by business local subscribers under the previous price cap regime. Previously, business rates in urban areas declined, on average, by 15% in Ontario and Quebec, 11% in British Columbia and 5% in Alberta.

The CRTC endorsed the concept of Consumer Bill of Rights, with rebates if phone companies fail to meet certain service quality standards.

Incumbents

The incumbent carriers, such as Bell and TELUS, will get to recover the CRTC-mandated price decreases won by competitors in this proceeding. As a result, the cost savings for competitors handed down in this Decision will likely not come from ILEC shareholders. Another major improvement from the ILEC perspective is the removal of the requirement for regulated price decreases to local services. Instead, Price Caps are used to keep price increases to constrained levels. Through the removal of the productivity offset for business services and the use of “deferral accounts” for residential services, price decreases for ILEC business and residential customers will only be due to competitive pressures, rather than CRTC intervention. In addition, a significant amount of regulatory reporting has been eliminated, resulting in reductions in overhead costs.

Regulatory Help

As reported in earlier analysis reports, the CRTC has provided certain amounts of relief, contributing hundreds of millions of dollars in financial adjustments to the complex system of cross-subsidies and payments from competitors to incumbents. In fact, more relief is expected in the coming months as the CRTC completes deliberations in its recent Price Cap proceeding.

New Entrants

Effective June 1, 2002, the CRTC has created two classifications of competitor services and a number of new pricing rules for these services. As a result, the major CLECs can expect a reduction in the charges they pay to the ILECs of about 15% to 20% on an annualized basis.

Key price changes include:

1. Reducing the mark-up for certain competitor services from 25% to a 15% mark-up over incremental cost, yielding an 8% decrease in the price for these services;
2. A major reduction in the direct connection cost from $0.003 per minute to a cost-based rate as low as $0.00128 per minute for long distance calls from Bell Canada territory; and
3. The creation of a new interim competitor service tariff for local access circuits providing digital transmission capacity.

The new interim tariff for digital local access circuits (referred to as “competitor-DNA service”) will provide competitors with a monthly rate of 40% off of the equivalent retail service (known as Digital Network Access or DNA), subject to certain limitations. Further Commission processes have been established to determine cost based rates for this service (including a 15% mark-up) based on the banding approach used for unbundled local loops. In addition, the Commission is prepared to hear arguments on broadening the competitor-DNA service to include other types of local channels, such as interconnecting trunks between ILEC central offices and competitor POPs.

Summary

Among the carriers, Bell and Telus executives are likely more satisfied than their competitor counterparts. Still, AT&T Canada will save in the order of $75 million annually as a result of this Decision while Call-Net’s annual costs are reduced by about $50 million. The Price Cap Decision is more than 200 pages and consists of over 1000 paragraphs in setting out many of the business issues for managing the Canadian telecom industry over the next 4 years.

A comprehensive analysis of the Price Cap Decision is being prepared by Mark H. Goldberg & Associates Inc. in conjunction with Decima Publishing, scheduled to be available in late June. For more information about this in-depth report and to get information about special pre-publication pricing, please click here: Report on Price Cap Decision

The Canadian competitive telecommunications market has witnessed at least a dozen significant failures since the global downturn in the sector. The three biggest competitors, AT&T Canada, GT Group Telecom and Sprint Canada have been on a “death watch” for the past year, due to massive debt levels and continuing operational losses. After trimming its money losing operations last fall, Sprint Canada has now broken away from its peers in a massive restructuring of its $2 Billion debt.

Background

In one of Canada’s largest and most disasterous corporate transactions, Sprint Canada’s parent – Call-Net Enterprises – acquired Fonorola for almost $2B in cash and stock in the middle of 1998. Most of Fonorola’s revenue base dissolved within months of being integrated into Sprint Canada and the remaining “goodwill” from the transaction was written off the books in closing out the 2001 year end.

Since 1999, the company has been operating in a retrenchment mode, shedding lines of business, money losing customers, and focussing its efforts on being a smaller, but profitable company.

Debt Restructuring

Call-Net has now announced that it has negotiated a comprehensive recapitalization plan with its major holders of debt and shares that would reduce Call-Net’s debt by more than $2 billion. More than half the debtholders and almost 40% of shareholders have expressed support for the plan. Under the plan, current shareholders will retain only 20% of the company’s equity and shares are to be consolidated on a 20:1 basis.

Regulatory Help

As reported in earlier analysis reports, the CRTC has provided certain amounts of relief, contributing hundreds of millions of dollars in financial adjustments to the complex system of cross-subsidies and payments from competitors to incumbents. In fact, more relief is expected in the coming months as the CRTC completes deliberations in its recent Price Cap proceeding.

Summary

While existing shareholders now have a significantly smaller piece of the Call-Net pie, they are now able to look at more than an empty plate. By cleaning up its balance sheet, Call-Net is far better positioned to successfully compete. If the CRTC continues to provide regulatory relief in the coming months, watch for Sprint Canada and Call-Net to thrive – it now appears certain to be one of the survivors.

Decision CRTC 2001-694, released November 16, 2001, has dramatically lowered the costs of renting local lines for competitive local exchange carriers (CLECs). The CRTC has approved, on an interim basis, the service order charges, incorporating updated costing information from the phone companies. While the rates are still subject to change, it is clear that there are dramatic savings for the few remaining CLECs.

Background

Three years ago, when the CRTC unbundled the parts of the incumbent’s local phone network that competitors rent, it established two types of service order charges: per-order and per-loop (line). The rates varied based on Residential versus Business and these rates were established with one set for Bell Canada, and another set for all of the rest of the incumbent carriers, including Telus, Aliant and MTS. In June, 2000, Bell Canada filed a proposal to significantly lower the retail rates it charges consumers for service connection. The CRTC asked Bell and the other incumbents to show cause why they should not lower the wholesale service connection rates accordingly.

Interim Decision

While the new rates are still subject to change based on revised inputs from the phone companies, the rates are as likely to be adjusted slightly lower as they are slightly upwards. The CRTC has already rejected certain cost elements from Bell that it considered to be more of a “retail” nature and it will not hesitate to challenge significant increases in evidence to be filed over the next two months. The phone companies are unable to charge competitors high service order rates when they are looking at lowering their own retail charges in order to address the slowly increasing level of local service competition. As a result, we expect rates to stabilize at about half of what these rates were prior to November 16. Residential orders benefit even more, with rates set at about 65% of the business rate.

Summary

Sprint Canada, with its residential local service, is the big winner and Futureway has seen its business case improve for its rollout of services based on the C-1 acquisition. Both carriers have been expanding their emphasis on telephone and high-speed data services that use telephone company loops.

The last 18 months have witnessed the collapse of a long list of resale based competitors that would have benefited from this decision. Had the CRTC established interim rates a year ago, when it released its first “show cause” letter to the incumbents on October 3, 2000, the competitive environment in Canada would unquestionably be different.

Despite more than 10 years of competition in telecommunications services, significant levels of profitability for the industry remains in the hands of the regulator – not just in Canada, but in most other jurisdictions around the world. Waiting a year for an interim decision has cost investors real dollars, employees have lost real jobs and consumers paid higher rates with lessened choice.

Axxent Communications will soon become the latest casualty in Canada’s competitive communications industry, following in the footsteps of C-1 Communications, Cannect, Maxlink and Riptide. Some analysts, and even litigious lawyers, have charged that these casualties are due to the evaporation of the communications capital markets over the past 10 months, coupled with jittery vendors holding much of the carriers’ debt load. While it may be technically accurate to blame the foreclosures on now fickle equity markets, in reality all that may have happened is an acceleration of the inevitable failures of flawed business assumptions. No doubt, the carriers’ business plans had called for years of losses before turning cash flow positive, but we believe that none of the failed carriers were able to create, let alone pursue, a sustainable competitive advantage over the incumbents or the other new entrant carriers.

Regulatory Arbitrage

In the case of DSL providers and carriers dependent on telephone company collocation, their business cases depended on what may be termed “regulatory arbitrage.” The companies used telephone company local loops, telephone company buildings and applied technology that is readily available and used by the incumbents at an even lower cost due to better volume discounts. The competitors had a higher cost structure and yet sold their product at a lower price in order to build market share. Their pricing advantage could only be sustained as long as the incumbent chose not to seek regulatory relief. For example, Axxent had become vulnerable to re-pricing by the incumbent, by focusing for too long on resold Centrex and resale of telco loops.

Although Axxent had sought suitors by recruiting financial advisors, it was late in discovering that its customers were too geographically dispersed to be cost optimized and thereby be of value to other new entrants. Further, Axxent had attracted customers that simply were not attractive enough to any other companies. Even the incumbents recognized that there was no need to pay for a customer base that would soon come home on its own.

Blame the regulator?

The regulator is often seen as a convenient scapegoat for the woes of the competitive industry. In recent months, the CRTC has ruled in favour of competitive industry interests in virtually every decision, including its removal of the so-called “Sunset Clause” for near-essential facilities (see our update of March 1, 2001). The change in the collection mechanism for the universal service fund (Contribution) gave wireline carriers a significant windfall. The CRTC’s failure to accept and understand the real cash flow concerns affecting RSL Canada during the transition period (see CRTC Order 2001-300) is among the few black marks on a regulatory scorecard that otherwise has recently been creating an increasing number of opportunities for new entrants to succeed.

Technology versus Service Based

Too many of the failing companies focused on specific technologies instead of the services enabled by these technologies. Riptide sold DSL access technology; Maxlink focused on wireless access; C-1 was primarily an IP play.

Maxlink’s wireless focus, like that of Winstar in the US, created too little flexibility in servicing their customers. In each case, the companies lost sight of the fact that customers don’t buy technology, customers buy services. Technology is an enabler and should only be seen as one of the tools in the solutions kit. Voice over Internet Protocol has often been cited as a service that customers are demanding. No customer really wants VOIP any more than customers are screaming for DSL or cable modem based service. This is the same trap that carriers fell into when trying to sell ISDN in the past decade.

Customers want low cost, reliable voice communications and high-speed data access. VOIP, DSL, Cable Modems and ISDN are methods for delivering service – they are not services themselves.

Since local competition was opened four years ago, the CLEC industry has professed to be targeting the so-called “under served small and medium enterprise market.” The small and medium business market is hardly under served: it is sorely under serviced. Yet the focus has typically been based on price, not service. It is a real challenge to launch a broad geographic marketing campaign while promising to overwhelm customers with personal service.

Success Factors

Management pedigrees are simply not enough. Losing sight of customer centric services and focusing too much on technology and unprofitable revenue has brought down communications carriers on both sides of the border. Companies such as Group Telecom are building value through construction of tangible assets and customers that are served on its own facilities.

Norigen has pulled together a complete communications portfolio, and its alliance with Compugen signaled a focus on being able to put together a complete servicing strategy for its clients. Through its building-centric focus and technology agnosticism, Norigen is building a concentrated and well-bundled customer base. Its primary challenge will be to survive on the backs of its private equity backers until the markets are ready to face a communications industry Initial Public Offering.

Successful companies will avoid the seduction of reporting top line revenues at any cost. In the long run, demonstrably building a sustainable difference and profitable business will be rewarded by both the customers and the financial markets.

Order CRTC 2001-184, released March 1, 2001, has determined that the level of local competition is not yet where the Canadian Radio-television and Telecommunications Commission (“CRTC”) had hoped when the market was opened up in May of 1997. As a result, the CRTC has ordered the incumbent local exchange carriers (“ILECs”) to continue to provide “near-essential” facilities for an indeterminate period, until the CRTC finds that competition has reached a level that warrants lifting the designation.

Background

On May 1, 1997, in Decision 97-8, the CRTC determined that certain facilities (such as local loops and signaling) belonging to ILECs were limited in supply and as such, mandated that the ILECs make such facilities available to the competitive new entrants (“CLECs”) at a rate based on the ILEC cost plus a 25% mark-up. The near essential designation was originally set for a five-year period – after which, a sunset was supposed to take effect and CLECs were expected to have built their own networks. CLECs had been concerned that due to the slow rollout of Local Number Portability and other pre-requisites for competition, there had been insufficient time for competition to evolve to the point that alternate supply of facilities were available.

What’s a Near Essential Facility?

Under the original decision, to be considered essential, a facility must meet all three of the following criteria: (a) it is monopoly controlled; (b) a CLEC requires it as an input to provide services; and (c) a CLEC cannot duplicate it economically or technically. As a result, central office codes, subscriber listings and local loops in certain high cost bands met the definition of an essential facility. Other “near essential” facilities did not meet all three criteria, but were found to have limited competitive supply: local loops in low cost bands, transiting of switched local traffic and signaling networks (i.e., common channel signaling system 7 (CCS7) transiting), and extended local area delivery of CLEC-originated traffic. These were to be provided until May 1, 2002 under the same terms as essential facilities.

Summary

Almost all carriers recognized the inevitability of an extension to the so-called sunset clause. However, certain CLECs, such as Group Telecom and Futureway, had joined the ILECs in opposing an open ended period for the extension. Resale based carriers and those investing significantly in collocation space, such as Axxent and AT&T Canada, are major winners.

Much of the original Local Competition decision in 1997 was elegantly prepared to set in place a regime of the industry regulating itself. By leaving the sunset period in place indefinitely, the CRTC is looking for the industry to continue to evolve to be more self-governing. Opportunities exist now for the ILECs to recognize the under utilized potential of their loops as a revenue opportunity – collocated CLECs, regardless of their size, are channel partners to exploit the sunk cost of existing local loops – and advance the removal of the “near-essential” designation. Although this approach may seem counter-intuitive, the sooner the ILECs respond, the sooner the sun will finally set.