In February of 1999 the Center for the New West and McLean & Brown published a paper titled "America's Telecommunications Revolution: Not Available in All Locations."  This paper provided a basic understanding of the history of universal service, and the status of the efforts underway to implement the universal service provisions of the Telecommunications Act of 1996. Key points made in the paper included:

• Ubiquitous and affordable service in high-cost rural areas has been subsidized by implicit or hidden support from overpriced urban and business services.


• This implicit support will not be sustainable as local competition develops. Congress recognized this, and provided specific guidance for the development of "specific, predictable and sufficient explicit support mechanisms.

Due to a number of factors, including political tensions between low-cost states and high-cost states, the implementation of these new mechanisms has been delayed.

• The FCC's May, 1997 universal service Order called for each state to assume 75% of the cost of supporting universal service within its borders. If this plan were implemented, consumers in states with many high-cost customers and no large urban areas to spread these costs over would face disproportionate surcharges to fund universal service that would threaten the affordability goals of the 1996 Act.


• Concerned citizens, state and local elected officials, business and civic leaders and policy specialists must send a clear and unmistakable message to policy makers and regulators. The FCC must act promptly to implement explicit support mechanisms which meet the intent of Congress and assure affordable and advancing telecommunications services for all Americans.


• NOTE:  This 1999 paper, entitled "America's Telecommunications Revolution Feb. 1999" is available for review on M&B's Special Presentations page, or you can click here to download this report in Adobe pdf format.

The purpose of this Issue Update is to provide a view of the status of universal service -- one year later. As we pass the fourth anniversary of the passage of the Act, the FCC has issued revised Orders implementing a new universal service support mechanism for non-rural LECs. The Rural Task Force, created by the FCC to study universal service solutions for rural LECs, is presently working toward a September 30, 2000 date for its recommendations to the FCC.

Below you will find a brief summary of the status of the new high-cost support mechanisms for non-rural and rural LECs, and following that is a section titled "Policy Recommendations." In the Policy Recommendations section we analyze the important issues surrounding the targeting of universal service support to assure that funds are only used to support the provision of affordable service to high-cost customers. This crucial issue has been largely ignored in the debate surrounding the sizing and distribution of the fund. In this section we offer facts and data that will provide a framework for the analysis of policy options and the implementation of an effective system that will assure affordable and advancing service to all Americans, while furthering the pro-competitive goals of the 1996 Act.

On May 8, 1999 and October 21, 1999 the FCC issued Orders which defined the new explicit support mechanism for non-rural LECs. Initially these Orders appeared to be responsive to the concerns expressed by rural Americans, since they specifically overturned the requirement of the 1997 Order that states be required to pay 75% of the cost of providing support to high-cost areas. However the system that the FCC has put in its place will require most states, including many largely rural western states, to assume 100% of the costs of these universal service support mechanisms.

Key to the FCC's new plan for non-rural LECs is the premise that the primary role of federal high-cost support is to enable reasonably comparable rates among states, while the primary role of each state is to ensure reasonably comparable rates within its borders. Previously, federal support was provided to any company where its embedded cost exceeded a defined benchmark level.

Under the new non-rural plan the FCC made two changes from the present method of providing support. First, the cost standard was changed from embedded cost to forward-looking cost as determined through a proxy model developed by the FCC. Second, the standard for qualification was changed. If the statewide average cost for all non-rural LECs is less than 135% of the nationwide average cost, then no non-rural LEC within that state would be eligible for federal support. If the statewide average exceeded the benchmark, then federal support would be provided for the amount above the benchmark, and that support would be distributed to the non-rural LECs within the state based on a formula specified by the FCC. Current recipients of support who would no longer receive support under the new mechanism would be held-harmless at their present support levels for some transitional period. The Joint Board has been directed to make recommendations on the duration and nature of this transitional mechanism by July 1, 2000.

The FCC Order also specified that the new support amounts, including the hold-harmless support, would be portable to any eligible telecommunications carrier who won a customer in an area receiving support. In addition to determining the amount that each state would receive, the FCC developed algorithms to assign support to specific wire centers. It is notable, however, that the FCC did not provide for the targeting of this support below the wire center level. As will be discussed more fully in the Policy Recommendations section which follows, the targeting of explicit support below the wire center level will be essential to assuring that the universal service objectives of the 1996 Act are met.

As a result of applying the new forward-looking proxy model and the 135% nationwide benchmark, the FCC concluded that a new explicit fund of $255 million would provide support to seven states. In addition transitional hold-harmless support in the amount of $182 million would be provided to non-rural LECs and to 14 states that received support under the old mechanism, but would lose this support under the new mechanism. In January of 2000, the FCC released a notice which cited incorrect data in its earlier model runs. The result of this revision was a reduction in the new explicit funding for Non-Rural LECs to $210 million and an increase in the temporary hold-harmless support to $206 million. States receiving this new support are summarized in the following chart:

Who Will Receive Non-Rural Support?
State	11/99 Model	1/00 Model
AL	$67.7M	$49.0M
KY	$18.0M	$1.6M
ME	$6.3M	$10.2M
MS	$113.6M	$98.6M
MT	-	$1.5M
VT	$12.0M	$13.9M
WV	$34.5M	$30.8M
WY	$3.3M	$4.7M
TOTALS:	$255.4M	$210.4M

As cited in our 1999 paper America's Telecommunications Revolution: Not Available in All Locations, cost-based estimates of the size of the universal service problem ranged from a low of $4 billion to a high of $20 billion. With this as background, the fact that the new mechanism for non-rural LECs will provide a scant $210 million of explicit support is truly frightening.

The FCC was able to achieve this reduction largely through the use of statewide cost averaging, the use of nationwide average cost data in the proxy model, and its use of the 135% of nationwide average cost benchmark. In reality, the averaging of costs is nothing more than a continuation of the reliance on implicit universal service support mechanisms, as described in our 1999 paper. Congress called for the elimination of these implicit supports since they will no longer be sustainable in the new competitive marketplace. This deliberate under-funding of rural areas served by non-rural LECs will create incentives for these carriers to exit rural markets. This in turn will create new and additional universal service funding requirements.

The FCC's 1997 Order established a separate track for the development of the new explicit funding mechanisms for rural LECs. The rural LECs were not to be considered for any type of new funding mechanism until 2001, at the earliest. To analyze the needs and requirements of the rural LECs, the Universal Service Joint Board established the Rural Task Force (RTF). The RTF is composed of a diverse group of experts from both incumbent and new-entrant carriers, as well as spokespersons for rural consumers. The RTF is charged with identifying the issues unique to rural carriers and determining how the model and funding plans determined for non-rural carriers should be modified for rural carriers. The RTF must deliver its recommendations to the FCC by September 30, 2000.

At the January 2000 meeting of the RTF, Task Force member Bob Schoonmaker of GVNW Inc. presented a study that quantified the impact of applying the non-rural model to the rural LECs. If the proxy model, inputs and funding calculations used in determining the non-rural fund were used for the rural companies, annual funding to rural LECs would decrease from around $1.5 billion to about $500 million Ò a reduction of about $1 billion. Mr. Schoonmaker identified the statewide averaging of cost as one of the primary contributors to this funding reduction.

Fortunately for rural America, the reaction to this data was swift and positive.

In a February, 2000 speech to the National Telephone Cooperative Association FCC Commissioner and Joint Board Chairman Susan Ness stated:
"Clearly some of the criteria that define the forward-looking mechanism for non-rural carriers will not work for rural carriers. For example, the large carrier mechanism is based on statewide average costs. I highly doubt that a statewide average would be appropriate for rural carriers." Regarding the applicability of a proxy model for rural LECs she said:  "I will not vote to apply any model to rural carriers unless and until I am convinced that it makes sense for rural America."

Among the items that the RTF must still decide are how to determine the new explicit support amounts for rural LECs, what role (if any) a proxy model should play in determining and/or distributing support, and how explicit support should be made portable to new market entrants.

There are also two important universal service funding issues pending before the FCC. Several years ago the FCC capped the total size of the Universal Service Fund from which rural LECs continue to draw support. A request is pending before the FCC to remove this cap. Also, current FCC rules provide that a carrier purchasing an exchange from another carrier will receive the same amount of funding as the original owner received. As mentioned in the previous section, the fact that the FCC refused to recognize the needs of rural exchanges served by non-rural LECs in its recent Orders will cause many of these carriers to consider exiting their rural markets. The public interest may indeed be better served by having these areas served by carriers whose primary business plan is serving rural markets. However this will require the repeal of the current rule, and the provision of sufficient explicit funding to support the provision of affordable and advancing service in these exchanges.

What is clear from the experience of the last four years it that there is little appetite in Washington for any large increases in the amount of explicit high-cost funding. What this will mean is that any funds that are made available for high-cost support must be carefully targeted to benefit customers living in the remote and sparsely populated areas.

When dealing with high-cost support, particularly in an environment where support payments are portable to new market entrants, averages can be very dangerous. Averaging, by its very nature, implies implicit support. Indeed, by relying on statewide averages of support, the FCC was able to greatly reduce the size of the non-rural fund. The non-rural Order also provides that support will be targeted to high cost wire centers based on wire center average costs, and will invite arbitrage of support that will waste valuable support dollars. This element of the FCC's plan must be modified, or at least not perpetuated in the plan that will be developed for the rural LECs.

The cost of providing basic telephone service is most heavily influenced by two factors -- distance and density. The farther from the central office a customer is located, the more costly will be the feeder plant necessary to reach the customer's neighborhood. Also, the more dense the population in the neighborhood, the less costly will be the distribution plant to connect individual customers to the network. To create the most efficient network, the central office is located so as to minimize the overall cost of outside plant. This usually results in the central office being located in the middle of a town. Even in wire centers with very high average costs, there are customers who cost very little to serve because they are located close to the central office. An arbitrage situation could occur if a new market entrant chose to serve the less costly customers on Main Street, but received support based on the average cost for the entire wire center.

We have compiled a chart (titled "Distance from Central Office" and available with ordering a hard copy of this paper)....
that illustrates the impact that distance from the central office has on the cost of service. This chart represents a compilation of data from all households in the United States. It also illustrates the relative distribution of household distances from the central office: Well over half of all households are located within 15,000 feet of their serving central office. Costs are relatively low in close proximity to the central office, but grow geometrically as distances exceed 40,000 feet. This is due largely to the fact that the distant customers generally are located in sparsely populated areas also. The Appendix provides similar charts for a number of high-cost wire centers as determined by the FCC's Hybrid Cost Proxy Model. These wire centers, as would be expected, tend to have a much higher percentage of their lines located far from the central office. These offices also tend to be smaller, which further increases cost since the fixed costs of the switching equipment must be spread over fewer lines.

The potential for arbitrage with wire center targeting is very real and potentially dangerous. If a wire center's average cost qualified for a support payment, a carrier serving primarily below-average downtown customers could receive a substantial windfall. However that windfall would be at the expense of the above-average customers in the outlying areas. To the extent that funds are removed from the system through arbitrage, then additional funding ultimately must be provided to support the costs of serving the remote customers. This would hardly seem to be good public policy or efficient use of scarce support dollars.

A more precise targeting of support would also serve to further the FCC's pro-competitive goals. Competition can be expected to develop naturally in the lower cost areas, and throwing governmental support money into this mix would likely do more harm than good. The greater benefit, however, would be to the remote rural consumers. With support payments more nearly approximating the cost of reaching the remote customer, it is more likely that competing carriers would vie for their business, thus providing these consumers the prospect of greater choice and lower prices.

But how should high-cost support be more efficiently targeted to achieve these benefits?

In their 1999 publication A Compilation of Best Practices to Implement the Telecommunications Act of 1996, the National Regulatory Research Institute (NRRI) included a suggestion submitted by McLean & Brown for the establishment of a no-support zone within each wire center that qualifies for high-cost support. This zone would be defined as an area within close proximity of the central office, and carriers would receive no support payments for serving customers within this zone. Any support that is provided to the wire center would be uniformly distributed to customers outside of the no-support zone. The following example illustrates how this redistribution would work:

ASSUME: Average support = $100/line 1000 lines in the wire center 600 lines inside the "no-support" zone 400 lines outside the "no-support" zone receiving support 1000 Lines X $100 _______________         =         $250/supported Line 400 Supported Lines

By redistributing the support to those lines that actually need it, no more support money is required, but the funds are distributed far more efficiently.

There are many ways in which the no-support zone could be defined. City limits, a tariff defined Base Rate Area, or some other pre-defined distance from the central office would all be possibilities. Looking at the cost distribution chart, above, it is possible that a simple definition such as all lines less than 15,000 feet from the central office could achieve the policy objectives of not providing support for serving lower cost customers and targeting support to the higher cost customers. Multiple support zones within a wire center would also be a policy option if it could be demonstrated that the additional cost of administering multiple zones would be more than offset by efficiencies in the targeting of support.

It has been suggested by some parties that support should be targeted to the UNE (Unbundled Network Element) zone. FCC guidelines call for three UNE zones within a study area for the pricing of unbundled loops. Under most UNE zone schemes, the lowest cost zone is assigned to a few very dense urban wire centers with large numbers of business customers. The second zone generally contains wire centers serving smaller metropolitan areas and nearby suburbs, and also generally has a significant number of business customers. The third, and highest cost, zone is defined as the rest of the study area.

If support were targeted to the UNE zone, it stands to reason that all of the wire centers receiving support would be in this third zone. This would create several problems. First, the amount of support per line would be small, since the support would be spread over all lines in this zone. Second, not only would carriers be paid support for serving low-cost customers, they would be also be paid for serving low-cost wire centers within the third zone. Finally, with the per-line payment so low, carriers would have little or no incentive to make the significant investment necessary to serve customers in remote high cost areas. Wire center targeting, with all of the problems described above, would actually be a better solution than UNE zone targeting.

The UNE zones could, however, be useful in making high-cost support portable to new market entrants who use the unbundled loops of the incumbent LEC. Since the price for the unbundled loop is based on the average forward-looking cost for the entire UNE zone, it would make sense to offset this price by the average per-line support within the UNE zone. This would avoid the need to devise Rube Goldberg type schemes to divide the support between the UNE purchaser and the provider of the underlying loop when the support amount exceeded the UNE price. It would also avoid the unthinkable arbitrage scenario proposed by some parties, that the purchaser of an unbundled loop receive the entire amount of support, even if it exceeded the UNE price.

Four years after the passage of the 1996 Act, we are still struggling to implement the critical explicit universal service support mechanisms. The minuscule explicit fund for the non-rural LECs would appear to suggest a de-facto industrial policy that large LECs should consider exiting rural markets. This will place additional upward pressure on the funding needs for rural LECs. It will be imperative that the cap on the current fund be removed, and that the new mechanism to be recommended by the RTF provide sufficient support to assure affordable and advancing service in rural areas. Finally, since the amount of support dollars available will be finite, it is essential that these dollars be specifically and effectively targeted to achieve the twin objectives of competition and universal service.