Kovacs: No case for special access reregulation

Anna-Maria Kovacs


The Federal Communications Commission (FCC) is conducting two proceedings to examine the U.S. special access market, which is part of the business broadband market.  Various competitive local exchange carriers (CLECs) seek regulation of special access rates, terms, and conditions offered by the incumbents (ILECs).  The ILECs argue that such regulations are not only unnecessary but would in fact distort the market for business broadband in a way that would harm its users. 

I recently published "Business Broadband: Assessing the Case for Reregulation" that looked at the facts underlying this debate. The full paper is available here

Publicly available market and financial data show that the business broadband market is highly competitive.  The ILECs are under attack from both cable operators and traditional CLECs.  The cable operators have leveraged their nearly-ubiquitous networks to expand from the consumer market into the business market.  The CLECs have focused strictly on high-value business customers.  Both have networks that are well equipped to supply the IP over Ethernet services the business market demands.

Gartner Group's blog entry Leverage Declining U.S. Telecom Prices to Control Enterprise IT Spending shows that demand for the legacy TDM (time division multiplexing) services that ILECs provide will evaporate almost completely by 2019, while the demand for Ethernet services will more than double by 2019.  Vertical Systems Group's U.S. Carrier Ethernet Services Leaderboard shows that at year-end 2015, Level3 was second only to AT&T in the Ethernet market, and Time Warner Cable, Comcast, and Cox were all leaders in this high-growth market.  Cogent's overview on its website states that it has become one of the largest carriers of Internet traffic in the world, by building its network independently of the traditional ILEC networks.

As Gartner Group's title indicates, competition in the Ethernet services market has brought sharp price declines, with Ethernet access prices expected to decline by an average of about 9 percent per year from 2014 to 2018.  There are even greater savings opportunities to be gained by switching from TDM to Ethernet.  Zayo, a CLEC that shows pricing trends each quarter, shows that a 100 megabit per second (mbps) Ethernet fast-E link, a 45 mbps DS-3, and four 1.5 mbps DS-1s could be leased at the same price at year-end 2015, providing opportunities for enormous capacity upgrades without additional cost.  Such substitution is even more fruitful at higher capacities, where a Gig-E link providing a gigabit or more of capacity cost only half of a legacy OC-12 link that provided only two thirds the capacity.  Not surprisingly, Zayo's sales of legacy services are falling sharply while its Ethernet service sales are increasing even more sharply. For example, its DS-1 sales are down 37 percent in the last two years, while its sales of fast E are up 18 percent and its GigE sales are up 51 percent.

The CLECs' claim that additional regulation is needed because they are impaired by the ILECs is negated by the CLECs' financial results.  Level3, Cogent, and Zayo compete against the ILECs' wireline networks and report their results publicly.  At 16.1 percent, 19.8 percent and 22.4 percent respectively, their free cash flows are far higher than those of the wireline operations of Verizon and AT&T at 8.2 percent and 11.6 percent.  Investors recognize the CLECs' higher growth prospects and reward them with valuations that are more than twice those of Verizon and AT&T. 

The CLECs' healthy free cash flows combined with their extensive metro networks make it possible for them to build to almost any site that houses potential business-broadband customers.  Birch Communications, for example, plans to connect into a million buildings by the end of this year, over its own fiber or that of its partners.  Level3's 2015 10K explains that CLECs can extend into their customers' buildings cheaply: "Our high fiber count metropolitan networks allow us to extend our services directly to our customers' locations at low costs."  Lowering special access rates might discourage such investments by the CLECs.  

The business broadband market is highly competitive and is naturally evolving away from the ILECs' legacy services to Ethernet services.  Prices are declining, and substitution of Ethernet services for TDM services provides additional opportunities for major savings.  Far from being impaired, the CLECs that report their financial results publicly are doing far better than the Verizon and AT&T wireline operations and their stocks enjoy higher valuations. In such a competitive market, intervention by the FCC is not necessary and may be harmful.

Anna-Maria Kovacs, Ph.D., CFA, is a Visiting Senior Policy Scholar at the Georgetown Center for Business and Public Policy. She has covered the communications industry for more than three decades as a financial analyst and consultant.