Phoenix Center Policy Paper Series

 

Phoenix Center Policy Paper Number 8:

 

eEurope Means Nothing Without eEntry:

Regulatory Harmonisation, Subsidiarity and the Realisation of the Information Society

 

Lawrence J. Spiwak 

(October 2000)

? Phoenix Center for Advanced Legal & Economic Public Policy Studies and Lawrence J. Spiwak (2000).

 

eEurope Means Nothing Without eEntry:

Regulatory Harmonisation, Subsidiarity and the Realisation of the Information Society

Lawrence J. Spiwak *
(? Phoenix Center for Advanced Legal & Economic Public Policy Studies and Lawrence J. Spiwak 2000)

 

Abstract: Last year, the European Council set forth an ambitious political initiative: ?eEurope, an Information Society for All.? eEurope will never be realised, however, unless sufficient competitive facilities-based entry occurs. One of the primary barriers to entry in Europe remains the lack of regulatory harmonisation among the various EU Member States. To mitigate this significant barrier, the European Union will be forced to push the limits of subsidiarity. In so doing, this paper does not argue that individual Member States? NRAs should be abolished in favour of some single, pan-European ?ber regulator. Quite to the contrary, this paper submits only that the European Community must undertake more of a leadership (and, by definition, an active oversight) role, rather than continue in its current role of distant legislator and data collection authority. For example, positive steps that the European Commission could take to bring greater regulatory harmony among the various Member States include, inter alia, (1) developing a standard cost model ? complete with a uniform system of accounts ? for all of Europe (including harmonised accounting safeguards for intra-firm transfer pricing); (2) establishing a cohesive and truly standard pan-European reference offer; and, perhaps most importantly, (3) working towards achieving real regulatory transparency within each of the various Member States. As this paper shows, government?s job ? be it local, national, or in this case pan-European ? is to maximise consumer welfare. Thus, eEurope is within our grasp ? it only takes the political will to achieve it.

TABLE OF CONTENTS

I.    Introduction ? eEurope.............................................................................................. 2

II.   The Importance of Entry............................................................................................ 4

III. Understanding the ?Entry Condition?...................................................................... 4

IV. Harmonisation, Subsidiarity and the Information Society ? Creating Conditions for Advanced Facilities-Based Entry on a Pan-European Basis........... 4

A.   Current Economic Environment in Europe......................................................... 4

B.   Positive First Steps............................................................................................... 4

C.   Subsidiarity and the ?Entry Condition?:............................................................ 4

V.   How to Move the Process Forward Constructively.................................................. 4

VI. Conclusion.................................................................................................................. 4

 

I.      Introduction ? eEurope

Last year in Lisbon, the European Council set forth an ambitious political initiative: ?eEurope, an Information Society for All?.[1] According to the Council, the key objectives of eEurope are:

?       To bring every European citizen, home and school, as well as every business and administration, into the digital age and online;

?       To create a digitally literate Europe supported by an entrepreneurial culture ready to finance and develop new ideas; and

?       To ensure that the whole process is socially inclusive, builds consumer trust and strengthens social cohesion.[2]

While the economic performance envisioned by eEurope is noble in its goals, eEurope will not materialise simply by mere proclamation or by creating cute little ?Infotoons.?[3] Instead, the realisation of eEurope requires the European Community to expend the political capital necessary to create conditions conducive for entry by new, advanced facilities-based providers on a pan-European basis.

As explained below, realisation of the Information Society depends on significant investments of fixed and sunk costs. As such, realisation of eEurope will require policy?makers to understand both the economics of new facilities-based entry, and how their regulatory polices directly affect the entry decisions (and, indeed ability) of firms.[4] Once the entry condition is understood, then policy-makers can turn to the concrete tasks of: (a) identifying optional long-term market structure; and then (b) determining the appropriate types of price, conduct and/or structural regulation that will achieve this goal.[5] Without affirmatively promoting new, advanced facilities-based entry as Europe liberalises its markets, however, Europe is in real danger of creating a market characterised by mere ?light handed? regulation over dominant incumbents who have both the ability and the incentive to harm European consumer welfare.[6]

Unfortunately, as the European Commission often concedes, perhaps one of the greatest impediments to the realisation of the Information Society is the wide disparagement among Member States in liberalising their respective telecoms sectors, because the lack of regulatory harmonisation acts as a significant barrier to entry for new, advanced facilities-based network investment. That is to say, although entry into a single market is certainly a difficult endeavour, if a firm contemplates a pan-European entry strategy, then ? due to the admitted lack of regulatory harmonisation among the various Member States ? this firm must also revisit these regulatory issues each and every time it seeks to enter another Member State of the European Community. In other words ? under current market conditions ? as a firm seeks to expand across Europe and maximise its economies of scale and scope, the lack of regulatory harmonisation raises exponentially a new firm?s entry costs every time it must jump through each additional Member State?s National Regulatory Authority?s (?NRA?s?) regulatory hurdles.

To its credit, the European Community is proposing steps to bring greater regulatory harmonisation among the various Member States. Although such efforts are certainly welcome, however, given that some Member States were less than effective in implementing past EC directives and recommendations, what makes us so sure that the current round is going to be any different? Indeed, far too often have Member States sacrificed consumer welfare in the face of political pressure.[7]

As such, if pan-European entry is to occur, then the EC is also going to have to face squarely the politically contentious issue of subsidiarity in this process as well. If Europe had not decided to create a single market, then such regulatory failure would be a matter between each Member State and its respective citizens. However, as Europe affirmatively decided by treaty to create a single market (so much so that the European Community went so far as to make a unified offer in the WTO Agreement on Basic Telecoms Services), regulatory failure is no longer is a domestic matter. Accordingly, this paper submits that if individual Member States are unable or unwilling to join the European Community in working towards the goal of eEurope, then the European Union must also be prepared to push the principle of subsidiarity to its limits to facilitate investment in advanced pan-European broadband networks by new firms.

Stating the issue bluntly, the European Community must take more of an aggressive leadership (and, by definition, an active oversight role) ? instead of its current legislative and monitoring role ? to the telecoms restructuring process other then just expecting that individual Member States will obediently correctly and expeditiously implement various EC Recommendations or Directives. As explained below, this leadership can take many forms ? e.g., leadership in establishing long-term restructuring goals; leadership in establishing cost models; and leadership in implementation. Under any scenario, however, if eEurope is ever to be realized, then the Community cannot continue to defer to ?Member State?s rights? or to rely so heavily upon endless industry forums to resolve the complex issues facing the European telecoms sector.

Each issue is discussed specifically below.

II.    The Importance of Entry

If the ostensible public policy goal of the European Community is to move from a market characterised by monopoly (i.e., one firm) to a market characterised by competition (i.e., many firms), then entry of more firms is the sine qua non of this entire exercise. More firms (i.e., facilities-based providers), however, is not the equivalent of more service ?choices.? Indeed, if everybody is simply reselling the same service provided by the dominant incumbent, then the only competitive ?choice? available to consumers is to whom they would like to write their monthly subscription checks out.

Similarly, simply because different access providers? technologies are starting to ?converge? (i.e., they are all starting to provide some sort of broadband Internet access) it does not a fortiori mean that consumers view these various access technology providers as close substitutes. Quite to the contrary, consumers may find that they view these various access technologies as complements instead ? e.g., consumers may have local telephone provider; a cable provider, a mobile provider, and several Internet service providers. Thus, ?convergence? does not automatically mean that various access technology providers have a measurable contestable effect on other firms in the market.

As leading one leading telecoms economist recently observed about the U.S. experience:

One explanation for the failure of the [1996 Telecoms] Act is that an important intermediate step between monopoly and competition has been overlooked. If consumers are to have a choice in local phone markets, the entry of new firms selling local telecommunications services to a broad base of residential and small business consumers is required. ?Choice? in any context implies alternatives. In fact, while the term ?competition? has become somewhat synonymous with the Act, the Act is really much less about competition than it is about competitive entry.[8]

Indeed, while there may be multiple firms ?competing? against one another, so long as these firms are scrambling to use the same underlying network facilities (e.g., the dominant incumbent local exchange carrier?s local loop), it does not a fortiori mean that ?more? firms will produce ?more? competition ? i.e., better market performance as measured by lower prices or more services. As such, any Directive or Recommendation from the European Commission:

cannot force firms to compete, but can alter industry structure in such a way as to make entry profitable and, therefore, viable competition more likely. For example, legislation that reduces entry barriers can increase the number of firms in an industry, and the presence of many firms selling similar products and services will inevitably lead to price and quality competition. Without entry, however, competition in the local exchange market will remain nothing more than a fabrication of incumbent monopolists and their representatives.[9]

Notwithstanding the above, however, it is also crucial for policy-makers to understand that competition is not a ?zero sum game? (i.e., the discredited notion that one firm can be made better off only by making another firm worse off?). Quite to the contrary, if eEurope is to be realised, then policy?makers must seek to ?grow the pie? and not ?split the pie? by removing entry barriers and reducing entry costs for new competitive advanced infrastructure wherever possible.[10]

III.  Understanding the ?Entry Condition?

As the European Commission has recognised often in the past, regulation has both costs and benefits. Accordingly, regardless of the merits of any rule or regulation imposed on the market, it does not a fortiori mean that European consumers suddenly will be awash in ?waves? of competition. Entry is an extremely time and capital intensive endeavour,[11] and will only occur if the new entrant believes that entry will be profitable.[12] A firm?s decision to enter any market can be described as the ?Entry Condition? - i.e., entry will only occur when:

(1) Post?Entry Profit (d), minus

(2) Inherent (exogenous) Entry Costs (x), minus

(3) Incumbent or Regulation?Induced Entry Costs (endogenous) (e), plus any

(4) Spillover Effects (s) (i.e., when some firms can enter more cheaply than others can),

(5) Are greater than Zero[13]

This maxim can be represented by the formula:

d ? x ? e + s > 0

Post entry profits might be (loosely) defined as revenues minus average cost (excluding amortised sunk costs). This margin must be sufficient to cover any sunk costs (x, e) the firm must incur upon entry (and, to possibly, exit). Sunk costs are akin to a non?refundable deposit, and as such substantially increase the risk of entry. Sunk costs can be either a results of the capital expenses for technology and marketing necessary to enter a market (exogenous sunk costs)[14] or the result of incumbent behaviour and regulatory decisions (endogenous sunk costs).

One real?world example of an endogenous sunk cost is the cost of physical collocation in a dominant incumbent?s central office/local exchange. That space can, because of regulation, only be used to provide telecommunications services ? once procured, a new entrant cannot readily convert collocation space to a condo or a youth education centre. The incumbent knows this and, absent regulatory oversight, will rationally seek to price collocation in a manner akin to an ?entry tax.?[15]

Accordingly, virtually every decision, past and present, the regulator makes alters one or more variables in the entry equation (with the exclusion, by assumption, of exogenous entry costs (x)).[16] That is to say, if a firm is contemplating the construction of a new pan?European advanced network, what factors does regulation have a direct (or, at minimum indirect) effect on? Obviously, nearly everything. Among other things, the quintessential elements required to construct a new advanced telecoms network ? but whose costs and availability are affected (directly or indirectly) by regulation ? include inter alia:

(1)    Cost?based interconnection rates on a forward-looking basis (domestic and international) at any technically feasible point;

(2)    Effective OSS and standard technical interfaces;

(3)    Timely and adequate collocation;

(4)    Cost?based backhaul, IRUs, and leased lines on a forward-looking basis;

(5)    Access to rights of way, poles, ducts, etc.;

(6)    The ability to dig up streets without a hassle[17];

(7)    Building access/inside wiring;

(8)    Non-discriminatory call origination for Internet access;

(9)    Number portability or, more accurately, number termination flexibility[18]; and, depending on a firm?s particular entry strategy,

(10)  Non?discriminatory and cost-based access to unbundled cooper loops at any technically feasible point.[19]

And, as if the preceding list is not large enough, regulators can, and often do, control post-entry profits (d) (revenue minus variable cost) through regulation. (Indeed both phone rates and collocation prices, loop prices, USF/USO taxes, etc. are direct controls over (d)). Thus, if regulators fail to get their pricing policies right in the first instance, then any contemplated entry decision by a new firm might just become a ?non?starter.?

IV.  Harmonisation, Subsidiarity and the Information Society ? Creating Conditions for Advanced Facilities-Based Entry on a Pan-European Basis

A.    Current Economic Environment in Europe

The ?Entry Condition? outlined above provides a useful way of framing how regulation affects the costs of business decisions. In real life, however, entry decisions involve intangible factors other than a cash-flow positive projected balance sheet. In the case of eEurope, perhaps the biggest intangible is whether European citizens even really want the Information Society to be realised. Indeed, as the European Council conceded, Europe ?must overcome the handicaps that are holding back the rapid uptake of digital technologies? including, inter alia, such basic economic conditions as:

?       An ?insufficient digitally literate on?line population?;

?       The ?lack of a sufficiently dynamic, entrepreneurial, service?oriented culture?; and, perhaps most important of all,

?       A ?public sector that is not playing a sufficiently active role in enabling the development of new applications and services.?[20]

In fact, privatisation in much of Europe is still a relatively new phenomenon, and several Member States still retain an equity stake in their indigenous incumbents as well.[21] As such, we must remember that ?privatisation? (i.e., the conversion of a state-owned monopoly to a privately-held monopoly) is only the first step in the process. Achieving the most important and difficult part ? i.e., the fundamental restructuring of the underlying market conditions to create an environment capable of sustaining competition ? still has a very long way to go.[22]

B.    Positive First Steps

Given the above, therefore, entry into a single market is certainly a difficult endeavour. When if a firm contemplates a pan-European entry strategy, however, then due to the admitted lack of regulatory harmonisation among the various Member States, this firm must also revisit these regulatory issues each and every time it seeks to enter another Member State of the European Community. In other words ? under current market conditions ? as a firm seeks to expand across Europe and maximise its economies of scale and scope, the lack of regulatory harmonisation raises exponentially a new firm?s entry costs each time it must jump through each additional Member State?s NRA?s regulatory hurdles.

Over the last several years, Europe has worked hard towards both liberalising and restructuring the European telecommunications market. Notwithstanding, as the European Commission concedes in its 1999 Fifth Report on the Telecommunications Regulatory Package,[23] there is ? to state it politely ? a wide disparagement of results across Europe. To wit, some Member States have high rates for interconnection, yet low rates for leased lines (Germany, France); yet, on the other hand, other Member States have low rates for interconnection, yet high rates for leased lines (United Kingdom; Sweden).[24] Accordingly, until there is effective harmonisation among the various Member States? regulatory regimes, entry costs will remain unnecessarily prohibitive and the Information Society will remain an ephemeral dream.[25]

So what should we do? For starters, on 12 July 2000, the European Commission proposed an aggressive set of five directives and one regulation that are intended to create a ?new framework for regulation of electronic commerce.? They are:

?       A draft directive on a common regulatory framework for electronic communications networks and services, which seeks to set out the horizontal provisions of the new electronic communications regulatory framework of the European Union[26];

?       A draft directive on the authorisation of electronic communications networks and services, which aims to reduce entry costs by harmonising the rules for authorising provision of electronic communications services[27];

?       A draft directive on access to, and interconnection of, electronic communications networks and associated facilities, which seeks to establish a framework for access and interconnection agreements across the EU[28];

?       A draft directive on universal service and users? rights relating to electronic communications networks and services, which seeks to set out the rights that users have in respect of electronic communications services, in particular in respect of universal service[29];

?       A draft directive on the processing of personal data and the protection of privacy in the electronic communications sector that seeks to update the current Directive to ensure it is technologically neutral and can cover new communications services[30]; and

?       A draft regulation on unbundled access to the local loop, which introduces a requirement for local loop unbundling, designed to enter into force by 31 December 2000, in advance of the entry into force of the rest of the package.[31]

Such proposed directives are indeed a very positive step towards increasing regulatory harmonisation in Europe. Notwithstanding the above, however, an important question springs immediately to mind ? that is, if some Member States were less than effective in implementing past EC directives and recommendations, what makes us so sure that the current round is going to be any different? As such, if eEurope is to become a reality, then the EC is also going to have to face squarely the politically contentious issue of subsidiarity in this process as well.

C.    Subsidiarity and the ?Entry Condition?:

Under the principle of subsidiarity,

In areas which do not fall within its exclusive competence [e.g., telecoms], the Community shall take action, in accordance with the principle of subsidiarity, only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Community. [However, a]ny action by the Community shall not go beyond what is necessary to achieve the objectives of this Treaty.[32]

Notwithstanding the above,

Subsidiarity is a dynamic concept and should be applied in the light of the objectives set out in the Treaty. It allows Community action within the limits of its powers to be expanded where circumstances so require, and conversely, to be restricted or discontinued where it is no longer justified.[33]

Subsidiarity, when properly applied, can be a very efficient way to address complex issues of telecoms restructuring. Europe is far from homogeneous ? culturally, demographically, geographically and economically ? and therefore attempting to impose a ?one size fits all? approach simply makes no sense. (To wit, the basic economic conditions of Sweden are quite different from the basic economic conditions if Greece.) As such, there are several important areas where local regulation by NRA?s can be far more effective than pan-European enforcement by the Competition Directorate or the Information Society Directorate who sit too far away from the fray to do much immediate good. For example, individual NRAs are well suited to:

?       Resolving issues of universal service given the unique circumstances of their respective Member State;

?       Determining the indigenous incumbent?s underlying costs in order to determine appropriate rates and charges for interconnection, access to local exchanges, etc.;

?       Resolving interconnection disputes; and

?       Working with local authorities to remove such entry barriers as local franchising expenses such as obtaining necessary permits, construction fees, easements, and the like.

This being said, as argued above, just because there are different economic conditions across the continent of Europe (just as there are across the 50 United States), so long as individual Member States perceive they have wide latitude to interpret Recommendations and implement Directives and Regulations, then by definition ? as the EC?s own Fifth Report bears out ? there will inevitably continue to be a sufficient amount of differences among the various Member States (either from legitimate economic theoretical or empirical differences, regulatory ineptitude, regulatory capture, or just plain old nationalistic petulance) to raise the entry costs of new firms.[34] As such, given that the Member States have agreed specifically by treaty to join a common economic framework, then the EC must find a better way to ensure prompt and effective implementation of European Community economic development policies.[35] The issue, therefore, is really nothing more than a question of European Community political will ? i.e., how serious are we really in achieving the Information Society?

V.    How to Move the Process Forward Constructively

Nothing in this paper should be read to stand for the proposition that all Member Country NRAs should be abolished in favour of some single, pan-European ?ber regulator. What this paper does argue for, however, is to have the European Community to step up to the plate and deliver on their promise of eEurope. Stating the issue bluntly, the European Community must take more of an aggressive leadership and oversight role ? instead of its current legislative and monitoring role ? to the telecoms restructuring process other then just expecting that individual Member States will obediently correctly and expeditiously implement various EC Recommendations or Directives.[36] The Community cannot continue to defer to ?Member State?s rights? or to rely so heavily upon endless industry forums to resolve the complex issues facing the European telecoms sector.[37] If the European Community has the political courage to think ?outside the box,? then many positive contributions can be made to the regulatory harmonisation process ? and, by definition, to accelerating entry and the realisation of the Information Society ? within the confines of European Community law.

For example, a constructive first step would be for the European Community to provide greater leadership in the area of price regulation. To wit, the European Community should develop a standard cost model ? complete with a uniform system of accounts ? for all of Europe. In this way, each individual NRA could then plug in the relevant costs for its respective country and Europe can move beyond the current country-by-country disputes of even just how to calculate LIRC.[38] Similarly, the European Community should also develop harmonised accounting safeguards for intra-firm transfer pricing ? especially now that competition is becoming increasingly ?multi-dimensional? as firms vertically integrate various products and services.[39] Merely issuing a vague ?laundry list? of items, such as found in the various Annexes to the 1997 Interconnection Directive,[40] simply will not do the trick.

Second, the EC should strive to achieve operational harmony among the various Member States. For example, assume arguendo that a firm is contemplating constructing a pan-European advanced broadband network that links all of the major cities in the Community. As part of this business plan, the firm also wants to establish a call-centre somewhere in the south of France or in the Tuscany region of Italy. In order to operate this pan-European business efficiently (i.e., profitably), however, the controller in the call-centre needs to be able to use the same operational and technical protocol from Copenhagen to Athens. Thus, so long as Europe continues to have sufficient differences among the various Member States for technical standards and operational protocols, then transaction costs remain high and entry continues to be delayed if not out right deterred.

Third, although issues of interconnection are obviously best left to private contractual negotiations among the various parties, Europe has recognized correctly in the past that when it comes to telecoms, the respective bargaining power of each of the parties is quite skewed (i.e., the incumbent has virtually 100%, and new entrants have nil.) To remedy this situation, the European Commission again attempts to direct individual NRA?s to develop a standard set of reference offers in the proposed Interconnection Directive[41] and Unbundling Regulation.[42] While this general notion is a step in the right direction, exactly what guidepost does the European Commission provide to NRAs in this area? Again, just as with the complex issue of harmonising cost modelling in the Community, the EC again only provides the NRAs with yet another vague ?laundry list? of topics based upon Annex VII of the Interconnection Directive. As such, if individual NRAs have no common guidepost from which they may all begin, then how can the EC rationally expect these NRAs to formulate any form of cohesive and harmonised policy? Obviously, they cannot.

Accordingly, more is required in this area. If eEurope is to be realised, then the European Union should establish a cohesive and truly standard pan-European reference offer that parties can use in their individual negotiations. After all, the more protracted the negotiations, the more pan-European entry is deterred or outright denied. And, if a dominant incumbent perceives that it can make one Euro more by deterrence than it can by competition, then the incumbent ? as a profit-maximising firm ? will always choose deterrence.

Given the rapid pace of technological change in telecoms, the importance of establishing a cohesive and truly standard pan-European reference offer cannot be overstated. For example, without a standard pan-European reference offer, new entrants will effectively be deterred from constructing networks where the most efficient design might be to place the physical switch outside of one country?s borders and haul the traffic into another?s. Similarly, as IP interconnection technology is deployed across the Community, the lack of a standard pan-European reference offer will further delay or deter competitive entry as it will permit dominant incumbents to dictate the routing of data and IP traffic right at the source without any opportunity for competitive facilities-based competition.

Finally, but perhaps most importantly, the European Community must work towards achieving real regulatory transparency within each of the various Member States. As noted above, the European Commission found in its own Fifth Report that the amount of conflicts of interest between NRA?s and state-controlled incumbent carriers ? as well as outright naked regulatory capture ? was staggering. Until the European Community develops meaningful ways to ensure meaningful regulatory transparency ? for example, developing a standard ?code of conduct? for regulators (applicable to both NRA and European Commission staffers alike) or, more preferably, some sort of pan-European administrative procedures legislation ? European telecoms policy will continue to be formed in large part via ex parte ?backroom deals? with little or no opportunity for public notice and comment ? a result which runs inapposite to the egalitarian goals of eEurope. (To wit, if one side makes an ex parte contact with a NRA or European Commission staffer, due process and fairness requires the other side to know when this contact took place, and the contents of the presentations made therein.)

VI.  Conclusion

In sum, the issues touched upon in this paper are only the tips of the iceberg. As such, this paper does not attempt to critique any of the specific methodological issues raised by the EC?s proposed Directives and Regulation, but seeks instead to attempt to highlight the two macro procedural prerequisites to the realisation of the Information Society: (1) the entry of new, advanced network service providers, and (2) the political courage and resolution to create conditions conducive for this new entry to occur. Indeed, if eEurope is ever to become more than just political rhetoric, then European Community must aggressively take steps to encourage new facilities-based entry. If this means pushing the boundaries of subsidiarity with recalcitrant National Regulatory Authorities, then so be it. Perhaps U.S. Judge Frank Easterbrook summed it up best over ten years ago.

The principle that regulation must extend to catch all substitutions at the margin has a corollary: if you?re not prepared to regulate thoroughly, don?t start.[43]

Government?s job ? be it local, national, or in this case pan-European ? is to maximise consumer welfare. eEurope is within our grasp. It only takes the political will to achieve it.