The “Last Mile” Problem ADCOs could finally bust open the local phone market

Hal Plotkin, Special to SF Gate
Thursday, December 6, 2001

URL: http://www.sfgate.com/cgi-bin/article.cgi?file=/gate/archive/2001/12/06/adcosbust.DTL

At long last, a promising new group of firms with a sound business model might finally be about to crack open local monopoly phone and Internet-access markets to real competition. That is, if they can find the additional financial support they need.

Dubbed alternative distribution companies, or ADCOs, they’re the subject of an intriguing new research report published last week by the Phoenix Center, a small but well-connected pro-consumer public-policy think tank based in Washington, DC.

Assuming they survive, ADCOs will essentially be carriers’ carriers. In a bold gambit, they aim to generate their revenue by creating new high-speed alternative local telecommunication loops rather than by leasing lines from the preexisting telecom networks owned by incumbent local phone monopolies.

ADCOs are designed to solve what is often called the last-mile problem, which refers to the fact that in most cases telecom customers still don’t have any real choice about which company provides their basic local phone service, including Internet access.

That bottleneck has already played a major role in helping choke off Internet-related innovation and economic growth, particularly in broadband markets. If ADCOs get enough financial support to give the local monopolies a real fight, though, consumers might actually see the long-promised broadband revolution.

Several such firms are already in operation, most notably Maryland-based CityNet Telecommunications Inc. , which uses state-of-the-art robots to crawl through sewers to lay fiber-optic lines. The lines can then be connected directly to homes and businesses without the necessity of tearing up streets or relying on local phone companies in any way. (CityNet’s CEO, it should be added, also serves on the Phoenix CenterĂ•s 12-member advisory board, along with other leading telecom executives and economists.)

Fortunately, ADCOs don’t require any new laws or regulations, which could take years or even decades to implement. Instead, they rely on something ADCO backers say should have been better considered back when telecom markets were partially deregulated in 1996: the basic laws of economics.

In fact, one of the biggest contributions made by the new Phoenix Center paper are the revelations it contains detailing exactly why the 1996 telecommunications deregulation act didn’t open up local phone markets as intended.

According to the study’s three authors, former FCC attorney Larry Spiwak and economists George Ford and T. Randolph Beard, it all comes down to a matter of basic math.

After doing the necessary (and somewhat complicated) calculations, which are contained in the Phoenix Center’s paper , the researchers concluded that the costs of creating a new local telecommunications loop are so significant that a company must have approximately 33 percent market share in most geographic areas in order to make its investments pay off.

According to the data, that means there can usually be, at best, no more than three viably profitable local telecom providers. More important, it also means that to survive, a company must be able to obtain that big chunk of market share before it can stop hemorrhaging money. So far, no nonincumbent local phone company has come close to approaching that mark.

The reasons for that, boiled down, revolve around the costs involved in small telecom companies trying to do too many things all at once.

Take, for example, the shrinking group of financially ailing firms known as competitive local exchange carriers (CLECs), a group that includes, among many others, Santa Clara-based Covad Communications Co., IP Communications Corp., based in Dallas, and Denver-based Internet Commerce and Communications Inc. CLECs have been offering Internet — and in some cases local phone — service since shortly after the passage of the flawed 1996 telecommunications deregulation act.

In most cases, though, CLECs merely resell network access they’ve purchased from the local monopolies, a group of firms such as Pacific Bell, which are known as incumbent local exchange carriers, or ILECs. In addition, CLECs also have significant research, development, marketing and customer-service expenses associated with their various lines of business, which typically include everything from reselling access to leased phone lines to high-end business consulting.

The problems created by that arrangement are legion and well known. CLECs often have contentious relationships with their supplying ILECs, which quite understandably don’t want other firms coming between them and their customers.

New ADCOs could change all that by sticking solely to the knitting of wiring homes and businesses with the fattest optical telecom pipes available. Rather than get bogged down marketing a wide variety of other services in highly competitive markets, such as Internet access, pay-per-view or Web hosting, ADCOs would make their money doing just one thing and doing it well.

The more integrated, soup-to-nuts telecom strategy is the failing idea employed today by most of the firms trying to compete, usually with very limited success, with local phone monopolies. By staying clear of all those other lines of business, the economic reasoning goes, ADCOs would have the ability to stay focused on providing something consumers and businesses really want, need and would be willing to pay for: an alternative high-speed digital pipeline into their homes and businesses.

Years ago, there were hopes that cable would fill that void. But an FCC decision granted cable firms a virtual monopoly on providing online services through their lines, which effectively eliminates cable as a friendly staging ground for the competitive forces needed to unleash a new generation of broadband online services.

ADCOs would take the telecom industry in a far more promising direction.

In fact, ADCOs would provide a much more effective economic stimulus, particularly in Silicon Valley, than anything else now being considered, including the incredibly misguided huge corporate tax rebates recently approved by the GOP-controlled House of Representatives.

Unlike corporate tax rebates, which merely reward companies for being big, fixing the last-mile glitch would actually do something real to restore economic growth in the tech sector, especially at firms working to develop new broadband-related products, which include hardware, software and services.

ADCOs will have only other telecommunications carriers — CLECs, for starters — as their customers. Unlike local phone monopolies, they would have no incentive to sabotage or undermine any of the businesses that generate their revenue. Instead, ADCOs would have an incentive in the other direction — that is, to continue to build out their physical networks so they can achieve ever-greater economies of scale. Over time, that would make ADCOs even more effective rivals to incumbent local phone companies.

By focusing on building out the last mile and the last mile only, wholesale only — i.e., carrier to carrier — ADCOs would also not be burdened with the considerable expenses related to marketing other lines of business to retail customers, creating, in theory at least, a cost structure that helps make the ADCO business model viable.

Consumers, in turn, would get new freedom to pick and choose among competing local telecommunication suppliers.

The study’s authors even contend that it’s possible local phone companies will eventually choose to voluntarily divest their local phone monopolies if at some point competitive pressures from ADCOs make it more profitable for them to focus on distributing higher-margin products and services to larger groups of target customers.

When AT&T was broken up, for example, the company eventually decided to spin off its research and components business, Bell Labs, which it renamed Lucent Technologies. That decision enabled Lucent to sell its products to other carriers rather than just to AT&T. Although Lucent has fallen on hard times lately, it’s undoubtedly in much better shape than it would be if AT&T were still its only customer.

Phoenix Center study coauthor Larry Spiwak says the same thing could happen in the local telecom loop. Right now, for example, Pacific Bell’s ISP customers come almost entirely from the large but still limited ranks of PacBell’s phone customers. Take away all the power that comes with owning an unchallenged local monopoly, though, and PacBell might well discover that it could make more money by focusing on its other lines of business, such as selling its ISP and other telecom-related services to new customers in markets where it does not now compete.

Spiwak, who is also president of the Phoenix Center, is a knowledgeable and shrewd insider, having served as a senior attorney with the FCC’s Competition Division from 1994 to 1998. He says forcing local phone companies to give up their monopolies is, given the power they wield in Washington, DC, and elsewhere, a “political nonstarter.”

“It hasn’t happened, and it won’t happen,” he adds.

Spiwak also says that’s why it would be far wiser to encourage ADCOs to flourish, which would create economic conditions that would make voluntary divestments of local phone monopolies more likely.

“ADCOs,” he says, “are an idea whose time is coming.”

Spiwak, however, won’t offer any predictions as to when that future might arrive.

It might take a while. At the moment, it appears that very few Silicon Valley venture capitalists are looking for new telecom-related investment opportunities.

But, as President Clinton was fond of saying, insanity can be described as doing the same thing over and over again and expecting different results.

If nothing else, Spiwak and his colleagues at the Phoenix Center deserve credit for providing the best proof yet that the main tactic being used to open local telecom loops, which involves leasing lines from just one incumbent supplier, is not just wrong.

It’s insane.

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