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.

Decision CRTC 2001-23, released January 25, 2001, reaffirms broad constitutional authority for the CRTC to supercede municipalities in the regulation of telecommunications carriers and their access to municipal rights of way. Repeatedly in the Decision, the CRTC rejected limitations on the Commission’s jurisdiction under the Telecom Act and, in doing so, the CRTC is blocking the ability of municipalities to collect so-called “market-based” fees for access to municipal rights of way.

Background

In March of 1999, Ledcor Industries (now 360 Networks) asked the CRTC to intervene in a dispute it was having with the City of Vancouver over the ability to install, operate and maintain fiber optic cables on municipal rights of way. Vancouver had sought fees that exceeded the cost of providing access, an ongoing percentage of revenues, and a donation of four fiber strands to the City among other requirements. The regulatory proceeding grew to include other municipalities and all of Canada’s national carriers as well as building owner and manager associations believing that the Decision could have implications on other property access agreements.

Municipal Implications

The CRTC re-affirmed that carriers should be negotiating access with municipalities, while clarifying the terms that it considered to be reasonable. Among others, the CRTC will permit cost based allocations of direct costs with a factor to account for indirect costs. The CRTC rejected an allocation toward fixed costs, because of the nature of municipal governments being completely paid for by a tax base.

Building Owner Implications
In rejecting Vancouver’s “market based pricing” with recurring fees, the Commission rejected this scheme because there is no free-market for municipal land. The CRTC expressly contrasted this with private property, which seems to indicate the Commission would look more favourably upon private landlords charging market-based fees.

Summary
Certain statements in the Decision could be interpreted to imply that the Commission will not permit interference with its authority to exercise jurisdiction over telecommunications services. At the same time, the Commission stated clearly that it is not, at this time, prescribing terms and conditions related to further construction by other carriers applicable in Vancouver or elsewhere. However, the principles used are expected to be helpful in negotiating future access agreements and resolving disputes.

The Commission explicitly rejected the populist claim that taxpayers have been subsidizing carriers by providing free access to rights of way. The Commission noted that much of the value of adjacent land derives from the fact that the land is serviced by utilities such as telecommunications carriers. “The benefits of a competitive telecommunications market and greater access to modern high-speed networks… provide generalized benefits throughout the municipality, attracting industry, creating jobs [and] increasing tax revenue.” Carriers, cities and building owners alike will mutually benefit as they begin to view telecom infrastructure deployment as a partnership.

Since opening Canada’s long distance market to competition in 1992, the CRTC has held in place a system whereby long distance service providers paid a per-minute contribution (which varied by province) to subsidize local services. With precipitous drops in retail rates, competitors found that marginal costs frequently outweighed their marginal revenues for off-peak traffic. On November 30, 2000, in Decision CRTC 2000-745, the Commission determined that the market would be better served by a revenue tax to be applied across a broader range of services and service providers, most notably including cellular services companies. The new collection mechanism will be effective 1 January 2001 and will apply to companies with annual telecommunications services revenues greater than $10 million.

Background

In the proceeding leading the Decision, parties provided technology and marketing arguments questioning the sustainability of the old regime, which applied to traffic considered by the local incumbent to be long distance. This limited flexibility in defining local calling areas on the part of CLECs. From a technology perspective, telecommunications networks are no longer easily separable into local and long distance traffic segments. As a result, the ability to count and report long distance minutes is becoming increasingly difficult. In some cases, service providers may have to adopt inefficient network designs, acting as an impediment to technological advances. Other parties argued that the current per-minute mechanism could not be applied to modern converged networks, where traffic flows over packet-switched networks and cannot be measured in minutes.

After reviewing a variety of mechanisms, the Commission determined that a revenue based mechanism across a broader range of services, will be most sustainable in that it is insensitive to technology changes, removes regional differences in rates, accommodates administrative efficiency and spreads the burden of the subsidy most fairly.

Details

The new contribution imposes a 4.5% tax on total revenues from Canadian telecommunications services, less certain deductions, effective January 1, 2001. The tax applies to all telecommunications service providers, such as: ILECs, competitive IXCs, CLECs, resellers, wireless service providers, international licensees, satellite service providers, Internet service providers (if a telecommunications service is provided), payphone providers, data and private line service providers.

Deductions apply for a number of types of revenues. Retail internet and retail paging service revenues are exempt. However, any revenues generated by internet and paging service providers from the provision of any other telecommunications services will be contribution-eligible. Revenues associated with sales or rental of terminal equipment is contribution exempt. Telecommunications service providers are entitled to a deduction for contribution revenues received. If service providers bundle exempt services with contribution eligible services, the entire bundle becomes contribution eligible.

Finally, a service provider is entitled to a deduction for inter-carrier expenses incurred for those services purchased from other telecommunications service providers (for example, Centrex, private line services, settlement, switching and aggregation, transiting and unbundled local loops) to the extent that the service is used to provide contribution-eligible telecommunications services. In this way, the contribution tax applies, in effect, to the value added by the service provider. There is no deduction for contribution payments and inter-carrier expenses incurred for telecommunications services internally.

To ease the administrative burden for small carriers, the Commission will only require carriers with total Canadian services revenues in excess of $10M (before deductions) to file reports and funding to the pool.

Summary

The CRTC has clearly listened to CLECs and competitive IXCs in trying to find a mechanism to break the linkages between incumbent definitions of long distance and local services. This will lead to increased service flexibility and increases in the types of flat rate packages to be expected from national providers. For example, because the Decision eliminates traffic sensitive payments, cable companies may be expected to introduce unlimited free calling to other “on-net” telephone customers, thereby encouraging friends and families to sign-up for service en masse.

The Decision brings significant financial relief to Canada’s fragile competitive long distance industry, but it comes at the expense of the wireless industry and Bell Canada. As a result of the new national equalization pool, Bell will find itself subsidizing the rest of Canada, including its rival Telus. It is likely that the Decision will be appealed to cabinet by an interesting coalition of disgruntled new taxpayers, but it is unclear that the Cabinet will agree to intervene.