Reed Hundt's Last Stand: Did You Say Reform Or Deform?

"It's the same old story; Same old song and dance - my friend." --Aerosmith

Just last week, Reed Hundt announce d that he will resign as chairman of the Federal Communications Commission despite the fact that his term was not expected to end until June 30, 1998. We should not be surprised by this resignation, as Mr. Hundt was assuredly exhausted. Not only did the FCC recently work through new policies on access charge reform, but this work came on the heels of the passage of the massive Tele c ommunications Act of 1996. Moreover, Reed Hundt had just completed his fait accompli: assuring that libraries and schools would have access to low-cost Internet connections, at the cost of a measly $2.5 billion increase to the universal service fund.

We here at Above the Crowd have taken a less-than-favorable view of the recent decisions at the FCC, and the responses from our readership community have not always been favorable. After all, readers claim Mr. Hundt is a friend of the Internet community, not a foe. He has fought long and hard against per minute access fees on Internet access, based on the belief that there is no need to add regulation to this new and exciting branch of our communications network. Additionally, he has fought the noble cause of making sure that school children would have access to the vast resources on the Internet. Who can argue with that logic.

It is our impression that Reed Hundt and the FCC finagled the support of the Internet community solely to accomplish their own objectives. For starters, consumer Internet access costs will rise anyway, as the proposed access charge reform simply allocated universal service costs to fixed line charges, as opposed to per minute fees. The bigger issue, however, is that the FCC operated in a very cavalier manner without regard for the long-term ramifications of their decisions or a dedication to one of the predominate goals of the FCC: to encourage competition in all communications markets. What's more, the real problems have simply not been addressed.

Let us start with a look at the current architecture of the consumer ISP market. ISPs currently purchase a single business line for each modem port installed at their POP (point-of-presence). The cost of these lines can range from $35-$50 per month which equates to a cost of $3.33-$5.00 per customer, depending on the customer-to-port ratio. What everyone is about to discover is that the RBOCs (as well as selected competitive access providers with co-location status) have a huge cost advantage in delivering Internet access. The cost of this business line, which represents 15%-25% of revenue from $19.95 access, is totally absent if the POP is located within the central office.

Over the next 12 months, watch for (1) the RBOCs to become very aggressive in the ISP business, and (2) the ISPs to cry foul. The ensuing 100-yard dash to the central office will end with a recognition of the cold reality that there is only a limited amount of real estate. Charles Ferguson of Vermeer fame noted this problem in a recent essay on telecommunications policy. In the synopsis he notes, "The 1996 Act and FCC policy fail to give Internet and/or Enhanced Service Providers (ISPs/ESPs) sufficient interconnection and collocation rights with respect to monopoly local exchange telephone carriers (LECs), which creates entry barriers, retards technical progress, and may cause network congestion." Expect this problem to end up in the courts, while the wait for high-speed access continues.

Perhaps the main problem with the FCC policies of the past twelve months is that they fail to acknowledge that the current implementation of the universal service program is inherently contradictory with a competitive free market. By applying a cost to one aspect of a network to fund another aspect of a network, you create huge incentives for arbitrage. You also obfuscate the underlying "real costs" of the service, which should be exposed if we expect competition and capitalism to arrive at the optimal solution. Universal service subsidies should be taxed on a national basis and then paid to the company that provides the service. This would be a more direct result and would allow for faster competition in rural areas through means like wireless. However, the FCC chose to spread the universal service "tax" across three places instead of one. These fees will be entwined deeper into the system, almost insuring that they will never be properly removed.

Along similar lines, B o b Metcalfe takes issue with the implementation of the school and library subsidies. Rather than offer subsidies directly to the ISPs that provide these services, the current plan calls for the ISPs to beg telecommunications regulators for reimbursement, giving huge control to the current monopolies. If we really want to fund Internet access to schools, why don't we add this to the national budget and pass a bill through Congress. Then we could pay the ISPs that provide the service directly, once again allowing for a de minimus invasion of the capitalist market system that we all know and love.

We cannot help but wonder if Reed Hundt's push for low-cost Internet access to schools and libraries is motivated more by him securing a place in history than optimizing the goals of the FCC. Is it not hypocritical to proclaim that the FCC is in favor of deregulation while it simultaneously increases the mandate of the universal service fund? Additionally, allowing agencies to finance multibillion initiatives could be slippery slope. What initiatives can be funded and which can't? Where do you draw the line? Princeton profes s or John DiIulio, in writing for the Wall Street Journal suggested that the FCC has crossed a similar line before, "The FCC's action is at odds not only with the textbook understanding of how a bill becomes law, but with the first principles of limited government and American constitutionalism."

Another major problem is that the current universal service policies do a very poor job of identifying exactly what qualifies as a "data service," and therefore, which services and vendors are exempt from the hefty per minute access charges. Let's suppose that one day someone implements an IP network that is capable of handling high-quality voice calls. Now, let's also assume that the fully-loaded cost (including opportunity costs) of this call is two cents per minute. What if the "real" cost of placing that same call over the traditional circuit network is actually one cent a minute, but access fees of two cents per minute on each side of the call drive the actual costs up to five cents a minute. Every service provider in the world will have a huge incentive to build the higher cost network in an attempt to arbitrage access fees (nice use of capital, heh?). Moreover, customers will have huge incentive to switch to these higher cost implementations which will place a serious drain on the funds that were needed for universal service in the first place. Where will the schools turn to when the universal service fund goes insolvent?

In summary, we have three major issues with the FCC policies to date:

•  Bureaucrats have pushed through policies based on ideals without thinking through the long-term implementation issues. These decisions should be made in a similar fashion to the moves of a great chess player. You must look several moves deep and make assumptions about the changing mindset of the other player. You cannot simply make a move because on the surface it appears to be the most helpful. Reed Hundt spent his entire career in the legal profession, not in either business or technology.

• Allowing government agencies to dictate multi-billion dollar expenditures is a slippery slope. This is not a knock against spending on education. It is simply an argument that decisions regarding the welfare of the nation should be made in Congress, not at the FCC. Reducing costs in one program should be tantamount to an increased agency budget. It will be tough to balance the budget if this is the case.

• Lastly, the FCC has suggested that one of its major objectives is deregulation. We believe this means changing the telecommunications industry such that pure competition is enhanced and the government influence is minimized. This is simply not the case. As witnessed in the broadening of the universal service fees, the theme here is proliferation (by the way, the FCC recently doubled its budget).

We apologize to our readers for the overly-political nature of this column. However, high-tech investors should understand that policy decisions can have serious implications on the types of services that are deployed and the timing of the deployment of those services. Companies need an economic incentive to invest. However, based on the current policies of the FCC, the drivers of these economic decisions may be political, obscure, and potentially temporary.

J. William Gurley 1997-8. All rights reserved. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Hummer Winblad Venture Partners (HWVP). HWVP and its affiliated companies and/or individuals may, from time to time, have positions in the securities discussed herein. Above the Crowd is a monthly feature focusing on the evolution and economics of high technology business and strategy.