A Brief history of Internet regulation

 
A Brief history of Internet regulation
POLICY MEMO

A Brief History of
Internet Regulation
By Ev ehrlich                                                                                                   March 2014

Executive Summary                                                           From the beginning of “community antenna
Proposals to regulate the Internet are often                                TV” through the 1990s, a parallel but more
presented as “new” solutions to deal with                                   limited effort was made to regulate the nascent
modern problems, but the most significant of                                cable industry. While these regulations had
these proposals, such as “network neutrality”                               some success, technological change quickly
and common carrier rules on unbundling                                      outstripped them—both in the telephone business
and interconnection, are actually vestiges                                  and the emerging field of high-speed data—and
of long-outmoded ways of thinking about                                     a bipartisan consensus formed in the early 1990s
telecommunications policy. This paper explores                              that additional steps were needed to promote
the relevant regulatory history, offering critical                          competition in all these arenas.
context to today’s Internet policy debates.
                                                                            The result was the Telecommunications Act of
From the early days of the AT&T monopoly well                               1996, watershed legislation that marked the end
into the 1990s, regulators, the courts and the                              of the telephone age and the beginning of the
Congress engaged in a lengthy effort to protect                             Internet age from a policy perspective. The Act
consumers and ultimately bring competition                                  embraced and codified the FCC’s distinction
into the markets for local and long-distance                                between traditional telephony/telecommunications
telephone service. This included strict “common                             services and the emerging world of information
carrier” utility regulations and mandatory                                  services, with strict common carrier rules limited
interconnection requirements and ultimately                                 to the former. On the telephone side, this meant
the 1984 Modified Final Judgment, which forced                              a stifling regime of mandatory “unbundling” and
the breakup of AT&T into regional Baby Bells.                               rigid price controls, while giving the private

About the author
Ev Ehrlich is a senior fellow at the Progressive Policy Institute and the president of ESC Company.
A Brief history of Internet regulation
Policy Memo			                                                                    Progressive Policy Institute

sector more latitude to innovate and invest on           Ultimately, three key lessons emerge from this
the “information services” side. The 1996 Act may        policy review. First, information services and
not have specifically contemplated the rise of the       telecommunications services really are different,
broadband Internet (the idea of an “information          and broadband has flourished as an information
superhighway” was in the air, but the exact form         service free from ill-fitting and stifling common
it would take was still unclear as a matter of           carrier constraints. Second, investment and
both technology and policy), but by protecting           capital flow to where regulation (or the absence
information services from the common carrier             thereof) encourages them to flow. And third,
framework, the Act set the stage for the dynamic         technology, business models, and consumer
growth we have seen in American broadband.               behaviors change and, as they change, the
                                                         meaning and effect of different regulatory
The result was a boom in cable broadband                 proposals change as well.
investment that telecommunications providers
attempted to counter by offering DSL services.           Introduction
But any new DSL capability they constructed              An active public policy debate is underway
had to be leased out to competitors at below              regarding Internet regulation. At its core lie
market prices under the unbundling regime,                a series of proposals that address what some
which limited their efforts. When fiber and DSL           advocates perceive as an absence of competition
were relieved of their unbundling obligation in           in the broadband industry. Most important
the early 2000s, however, capital poured in and           among these are the imposition of “net neutrality”
these services flourished as fixed-broadband              rules that would compel all Internet traffic
competitors to cable. In fact, that competition           to travel at the same speed and on the same
drew a competitive response from cable, in                terms; restrictions on usage-based pricing or
turn leading to a virtuous cycle of improvement           other broadband business models, including
and enhancement resulting in the United                   prohibitions on creating a “two-sided” market in
States ascending to the upper reaches of the              which Internet-based business might pay to reach
International broadband rankings.                         network users (much as advertisers pay to reach
                                                          newspaper readers); mandatory interconnection
This background sheds important light on current          rules that would empower regulators to dictate
calls to impose “new” regulations on broadband            prices or procedures for the exchange of data
either through “network neutrality” rules or by           among networks in the Internet’s labyrinth; limits
reclassifying it as a “telecommunications service”        on the participation of selected firms in auctions
subject to common carrier obligations. While              of electromagnetic spectrum; and facilities
advocates suggest otherwise, these proposals are         “unbundling,” which would require providers of
clearly not new, but would represent a return             Internet infrastructure to make portions of their
to the dated—and in the view of this paper                physical networks available to all competitors at
failed—approach that the bipartisan 1996 Act was          prices set or approved by the government.
designed to sweep away. Most of these proposals
for network micromanagement, forced sharing              Some advocates claim that these “new” ideas are
of investments, and government influence on              needed to address new problems; they contend
pricing have been associated with low investment         that Internet service is not provided competitively
and innovation. These rules may have made sense          or that it is too important to leave unregulated.
when the problem was how to protect consumers            In a separate paper, we will argue that there is
in the days of the sanctioned Ma Bell monopoly,          no “competitiveness” problem in the provision
but the business and consumer landscape is               of broadband when conventional yardsticks such
dramatically different today in almost every             as investment, innovation, or prices and profits
regard.                                                  are considered.1 But regardless of the merits of
                                                         the assertion that the provision of broadband is

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uncompetitive, the regulatory proposals that make          Commitment,” under which it would allow non-Bell
up this debate are not, in fact, new ideas. Instead,       local companies to connect to its interstate (long
most of the proposals for Internet regulation are          distance) system. It also made other concessions
the regulatory tools government applied to the             (including divesting Western Union, the second “T”
telephone system during its period as a regulated,         in its name) in return for a government sanctioned
government-sanctioned monopoly decades ago.                monopoly.

                                                           The deal hardly held AT&T back. The behemoth
        Most of the proposals for                          still used access to the long distance market as a
        Internet regulation are                            way to disadvantage local competitors. Regulation
        the regulatory tools                               of its acquisitions was lax. And, meanwhile, in a
                                                           different realm, radio was burgeoning. All of this
        government applied to                              combined to create pressure for a new federal
        the telephone system                               framework towards telephone and radio, which
        during its period as a                             led to the Communications Act of 1934 (the “1934
                                                           Act”).
        regulated, government-
        sanctioned monopoly                                The 1934 Act established a framework for telephone
                                                           regulation that would last for half a century.
        decades ago.                                       AT&T’s interstate long-distance lines would be
                                                           subject to federal regulation, and intrastate lines
But the circumstances then were very different             would be regulated by the states. Interconnection
from those we face today. For that reason, a               among these systems was mandatory and regulated,
review of the history of Internet policy, from the         and a system of settlements was created to allocate
formation and break-up of the Bell system to               revenues and costs between and within the long-
the current-day court cases that address many              distance company and local operating companies
of the underlying questions regarding the legal            and to balance accounts. The 1934 Act created
framework for regulation, is in order. Where               the Federal Communications Commission (FCC)
were these policy proposals first raised, and in           to carry out the federal regulatory role in both
what context? And what can be learned from our             interstate telephony and radio.
experience with them? Those are the questions
this paper will address.                                   This system survived for decades, but was
                                                           ultimately undone by technological change,
The next section provides a brief history of U.S.          beginning in the long distance market. Microwave
regulatory policy towards the Internet from                technology created new competitors in the long-
the perspective of telecommunications. 2 That is           distance market, led by MCI. The long-distance
followed by an attempt to identify the roots of            market was particularly ripe for picking, as
leading contemporary policy proposals in that              regulators generally allowed inflated long-distance
history and to apply the lessons learned from this         pricing to cross-subsidize universal service,
review.                                                    emergency response, and other local services,
                                                           especially residential phone service. AT&T
Telecomm Roots                                             fought these competitors in court and through
By the 1910s, AT&T had a commanding                        discrimination in its practices (for example,
position in the U.S. long-distance telephone               requiring competitor long-distance companies to
market, and it used that position to begin                 use a “dial-in” number to get access), but ultimately,
acquiring local companies, often by denying                the pressure of technological progress became too
others interconnection. In 1913, facing a federal          great. In 1982, AT&T and the Justice Department
antitrust suit, AT&T entered into the “Kingsbury           entered into an antitrust consent decree—the

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Policy Memo			                                                                       Progressive Policy Institute

“Modification of Final Judgment” (“MFJ”). While              did not appear until the 1990s) contributed to a
 the name may sound like a panel on the ceiling              backlash that led to the Cable Television Consumer
 of the Sistine Chapel, it actually restructured the         Protection and Competition Act (“Cable Act”) in
 telephone market.                                           1992, which gave the FCC authority to regulate
                                                             cable prices and mandated that content developed
                                                             and owned by the cable companies (e.g., HBO at
        A bipartisan consensus                               that time) be made available to competitors. The
        gradually emerged in                                 FCC soon imposed price rollbacks on cable services
                                                             using its new authority, with disastrous results
        response to these                                    for investment in both the cable system’s physical
        developments that steps                              networks (which limited their ability to emerge as
        were needed to promote                               an important source of telephone competition) and
                                                             cable programming services (which, confusingly, are
        competition in all of                                also commonly referred to as “networks”).
        these arenas.
                                                              Like the 1934 Act, the MFJ and the Cable Act
                                                             “worked” so long as their underlying premises
The MFJ’s major provisions were, essentially,                 regarding technology and market structure did not
three-fold. First, AT&T would divest itself of local          change. But the prospect of greater competition
affiliates and become a long distance company                 in both long-distance and local telephony was
(inter-exchange carrier) in a competitive market.             clear—long-distance rates were dropping and long-
Second, the local telephone companies would be                distance providers were beginning to bypass local
organized into seven regional competitors that                loops in some situations. There was already some
would be barred from providing long distance                  local competition for business communications in
and information services, and whose local services            local phone markets. Meanwhile, Direct Broadcast
would continue to be regulated, predominantly                 Satellite (“DBS”) entered the market and cable
by the states. And, third, the local telephone                companies were experimenting with what then
companies were barred from manufacturing both                 seemed to be futuristic systems involving hundreds
telecommunications network equipment and                      of channels and even “high-speed data,” even
telephones and other so-called “customer premises             as cable investment slowed in response to price
equipment,” buttressing the FCC’s earlier decision            regulation.
to end the Bell System’s monopoly over this
hardware.                                                    A bipartisan consensus gradually emerged in
                                                             response to these developments that steps were
The regulation of cable proceeded on a parallel              needed to promote competition in all of these
track. Today we think of telecom and cable                   arenas—local telephony, long distance, cable,
companies as being in the same business. But their           and even the prospect of “video dial tone,” that
roots were obviously different. Cable was subject            is, television delivered by the phone system. This
to local regulation, but the profusion of inefficient,       consensus culminated in the Telecommunications
disparate regulatory standards and procedures led            Act of 1996. That Act not only addressed that
government and industry alike to embrace the 1984            objective, but—to some extent unwittingly—set the
Cable Communications Policy Act, which imposed               stage for the broadband Internet of today.
some discipline on the process, gave the companies
more latitude to price, and fed a cable investment           The Telecommunications Act of 1996
boom in that decade and afterwards.                          The Clinton Administration brought with it a very
                                                              specific view of the future of telecommunications.
But the increasing prices of cable services and               It saw the potential for an explosion in
then-minimal competition (satellite competitors              “information services” and believed strongly

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Policy Memo			                                                                     Progressive Policy Institute

that relying on private investment and markets             But, nonetheless, the 1996 Act set the framework
would be the best route to promoting innovation,           within which the high-speed Internet arose and
raising investment capital, and managing the               telephone, cable, and the Internet converged once
uncertainties about the shape these future services        technological change bridged the divisions among
would take.                                                them. The Act did so through two, interrelated
                                                           features. First, the Act embraced and codified the
It applied this perspective widely. For example, it        distinction between telecommunications services and
argued in international fora that the Internet did         information services. The former was essentially
not belong in the province of the International            the telephone system that had evolved through
Telecommunications Union, since it was different           the Kingsbury commitment, the 1934 Act, and
than standard telephony. It made sure that the             the MFJ. The latter, “information services,” would
governance structure of the Internet remained              soon include the cable and broadband worlds, but
in private hands—those of the user community—              at that moment mostly consisted of the private
rather than being moved to government decision             data networks used by larger companies to link
makers. It took steps to facilitate Internet               computers, faxes, and other gear, and the then-
commercialization. And, with the Congress’                 fledgling world of dial-up services like Compuserve
cooperation, the Omnibus Budget Reconciliation             and America Online. Second, the 1996 Act treated
Act of 1993 preempted state and local regulation           those different classes of service very differently.
of entry by and rates for mobile telephone services,       Information services were by law excluded from
even though these were not yet regarded as direct          traditional common carrier regulation, while
competitors to other pieces of the telephone               traditional telecommunications continued under
industry, let alone what we now think of as the            this regulatory frame. Cable systems received some
broadband Internet. And the deregulation of                other limited regulatory relief, such as a sunset on
mobile telephony was accompanied by public                 some pricing regulations by 1999 (although basic
auctions of spectrum to support it (championed             rates remain regulated today unless the FCC finds
and overseen by then-FCC Chairman Reed Hundt),             that adequate competition exists in a given market).
the first of which took place a year later and which       At the same time, the Baby Bells were allowed
resulted in increasing the number of competing             entry into the cable business, from which they had
wireless companies. The burgeoning success                 previously been barred. Yet broader deregulation
of mobile telephony and, subsequently, mobile              of telecommunications, while an aspiration, would
broadband has its roots in this decision.                  await the emergence of expanded competition.

 But the most important manifestation of the
 Clinton Administration’s perspective was the                     The 1996 Act was the
 Telecommunications Act of 1996 (“the 1996 Act” or                watershed event that marked
“the Act”). The 1996 Act was the watershed event
 that marked the end of the telephone age and the
                                                                  the end of the telephone age
 beginning of the Internet age in the public policy               and the beginning of the
 realm.                                                           Internet age in the public
Today, we regard the convergence of telephones,                   policy realm.
television, and the Internet as a fact of life. In
1996, it was considered a futuristic proposition.
The purpose of the 1996 Act was both to promote            The Act attempted to create competition in local
the convergence of these different delivery                telephone markets in three ways still relevant
modes through inter-modal competition—and to               today. First, it prohibited states from sanctioning
foster competition within each of its individual           any local monopoly by the “Baby Bells.” Second,
component sectors (intra-modal competition).               it required the Baby Bells to interconnect with

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Policy Memo			                                                                      Progressive Policy Institute

 emerging competitors on state supervised rates,            The first commercial point-and-click browser was
 terms, and conditions, and created telephone                developed by Netscape, and public awareness of
 number “portability,” allowing users to keep                the Internet boomed. Dial-up services such as
 their number if they switched providers in order           AOL and Compuserve went from being “walled
 to jumpstart local phone competition (a critical            gardens” of content to gateways to the Internet.
 requirement both to get competition started and            The beginnings of a race by investors to fund the
 maintain it in the long run). Third, and most               digital Internet and the enterprises that would use
 controversially, it established that emerging local         it began, setting in motion the dot.com bubble
 competitors to the Baby Bells could get wholesale           of the late 1990s. The 1996 Act was signed on
 connections on the Bells’ existing local phone              February 8 of that year, and only 10 months later,
 networks and then resell that capacity in the retail        Fed Chairman Alan Greenspan soliloquized over
 market—a procedure known as “unbundling”                   “irrational exuberance” in the stock market.
 (since it required the phone companies to separate,
 or “unbundle,” the capacity on their systems that
 supported voice calling and sell it at a below-                   The idea of an
 retail rate). Unbundling spawned a new class of                   “information
“Competitive Local Exchange Carriers” (CLECs)                      superhighway” had
 who availed themselves of this privilege and, to a
 great extent, became the lynchpin of the debate                   caught on, although it
 over implementation and enforcement of the Act.                   was unclear exactly what
As mentioned, the 1996 Act didn’t expressly
                                                                   it would be.
compel the convergence of phones, cable, satellites,
mobile phones, and the broadband Internet.
But, at the same time, the sense that we faced              So, while the 1996 Act addressed the specifics
a dramatically different future was in the air.             of both intra-modal and inter-modal competition
The idea of an “information superhighway” had               for traditional telephone services, it also pointed
caught on, although it was unclear exactly what             towards a radically different future that it could
it would be. The Clinton Administration, and                not define but nonetheless sensed. In 1996, the
Vice President Al Gore and Commerce Secretary               cable and telephone worlds were distinct, and
Ron Brown in particular, were enthusiasts for the           reciprocal interest in competing was guarded.
promise of such innovation—the Administration               While some cable companies showed interest
was busy at work on various policies to facilitate          in telephony, the cable industry as a whole did
the Internet’s commercial development. And                  not race into it, although some began offering
important developments were setting the stage               voice services after the Act was passed and
even as the 1996 Act was being debated and                  others contemplated investments in circuit-
written.                                                    switched phone service. Phone companies had
                                                            experimented with “video dial-tone” trials but
As the 1996 Act was being debated, important                there was no evidence that there would be
technological developments were in motion. The              consistent and adequate consumer demand
switch from analog transmission of signals (in              justifying a permanent commitment. High-speed
which a signal such as your voice is sent as a              broadband (at least by today’s standards) did not
continuous and uninterrupted stream of waves)               yet exist in the commercial market, much less the
to digital communications (in which a signal                residential market. But the Act’s intuition was
is repeatedly sampled at very high speeds and               that, if the markets for the two types of services
converted into 0s and 1s) was proceeding rapidly,           were competitive, and if the two systems entered
driven by cost and efficiency concerns as well as           into facilities-based competition—meaning wholly
the potential product offerings it made possible.           separate systems would connect the household to

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services—long-term inter-modal competition could
be strengthened at the same time. As baseball
executive and savant Branch Rickey is said to have
remarked, “Luck is the residue of design.” Or, as
Louis Pasteur said, “Chance favors the prepared
mind.”

At the same time, common carrier telephone
regulation remained in place—and in some
ways was made stronger by the 1996 Act. The
unbundling provision—the requirement that the
historical local phone companies make their parts
of their networks available to local competitors
at government set prices—was controversial and
proved difficult to implement. The problem was
this: the Act was now repealing the incumbent
phone companies’ life-long monopoly franchise,
and theirs was the only telephone infrastructure
in place. The idea that cable and wireless would
supplant them was not yet popular or substantiated
by experience. So the Act included the unbundling
requirement in order to rein in the local phone            wholesale price the FCC and states established for
companies’ (presumably) temporary monopoly                 access to the phone companies’ loops, therefore,
power over local networks and to assist the                was well below the actual historical cost structure
interexchange carriers like AT&T and MCI that              of the incumbents who, predictably, resisted
lacked local network facilities but who faced the          strenuously.
prospect of competition from the Bells in long
distance.                                                  And so, the 1996 Act left behind a trail of
                                                           controversies that have made up most of the
The pricing formula the FCC established                    telecommunications policy agenda since then.
to implement unbundling became a major                     First, where is the line to be drawn between
issue and influence on the development of                  information services and telecommunications,
telecommunications. As opposed to using prices             and would Internet services continue to be
based on actual historical or embedded costs, past         considered deregulated information services
depreciation patterns, and the like, it chose to           or regulated common carrier services? Second,
use a forward-looking method based on what a               where—if at all—should “unbundling” and sharing
theoretical future provider would charge, a provider       of facilities be required? Third, when would we
that had built the most efficient contemporary             decide that competition had developed to the
networks using the best available technology. This         point that market forces could be relied upon to
standard was known as (yet another oppressive              guide it, in lieu of the public utility perspective
acronym) TELRIC—total element long-run                     behind these regulations, and the ultimate goal
incremental cost. The problem was that TELRIC              (as expressed in the preamble of the 1996 Act) of
was about what a prospective, efficient, new               a “pro-competitive, deregulatory national policy
competitor would experience, which was far from            framework” achieved? These questions defined the
the actual situation of the incumbent telephone            broadband policy agenda for much of the coming
companies, who had big, expensive legacy systems           decade.
left over from their previous life as heavily
regulated entities. The long-run, future-oriented

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The World According to Kennard                             because the 1996 Act, in its focu-s on competition
   “I want to create an oasis from regulation in the       within telephone and cable silos, created two
    broadband world, so that any company, using            different playing fields for the two technologies.
    any technology, will have incentives to deploy         Cable systems were heading away from the most
    broadband in an unregulated or significantly           onerous elements of regulation of their business,
    deregulated environment. And that does not             and they were investing heavily. They upgraded
    mean just cable companies. We must have                their networks to handle digital signals after the
    fast and ubiquitous deployment of broadband            1996 Act was made law, and their systems, where
    services and that will only happen if every            available, provided a very high quality of service
    sector of the industry has incentives to provide       to residential users. By the time Kennard spoke in
    it: wireline, wireless and cable.”                     1999, the cable companies were the cutting edge of
                                                           providing broadband, deploying many of the first
   Remarks of William E. Kennard before the United         high-speed Internet access services in the nation.
   States Telecom Association Annual Convention,
   October 18, 1999                                        The response to the cable-based broadband
                                                           offerings by the telephone systems was the more
FCC Chairman Bill Kennard’s statement, made                vigorous deployment of DSL (Digital Subscriber
three years after the 1996 Act, was both a                 Line), a technology that allowed digital data
summary of what had happened since the 1996 Act            services to be provided on the same copper wire
and a statement of what was expected to happen             as voice by using a higher frequency along the line.
soon thereafter.                                           Phone companies began introducing DSL by the
                                                           end of the decade, driven by consumer demands
Chairman Kennard’s vision of the long-term                 and in direct response to cable’s Internet offerings,
future of the Internet, once seen as an over-the-          but they generally lagged behind their cable
horizon issue, was now explicitly one of facilities-       competitors.
based, inter-modal competition, and the center of
that competition was no longer separate markets             The slow response by phone companies to the new
for broadband and telephone (and potentially                interest in the high-speed Internet was probably
video), but their convergence. And it was a                 also driven by the imbalances found in the 1996
deregulated future—an “oasis” from regulation              Act. A cable company, as a provider of information
would be created in order to give “every sector of          services under the 1996 Act, had something closer
the industry” the incentives to invest in it.               to the customary right to deploy its investment as it
                                                            saw fit, although it still had a variety of regulatory
                                                            mandates to fulfill. But the 1996 Act limited the
      An “oasis” from                                       incentives of telephone companies to invest in
      regulation would be                                   Internet improvements by imposing regulatory
      created in order to give                             “unbundling requirements,” which required
                                                            telephone companies to share their copper phone
      “every sector of the                                  lines at the TELRIC price standard. In essence,
      industry” the incentives                              anyone who wanted to pursue it could lease access
      to invest in it.                                      from the phone company and enter the business in
                                                            competition with the phone company at wholesale
                                                            prices, whether used for voice communication or
                                                            broadband connection service. This put the phone
But perhaps the most telling part of this quote             companies in a Catch-22. They had to sell the
is that the deployment of broadband “does not               most important component of DSL service—the
mean just cable companies.” That reflected both             network that conveys it—to their competitors. But
reality and Kennard’s vision. It reflected reality          if they made the significant investments needed

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Policy Memo			                                                                       Progressive Policy Institute

to offer a better product—for example, by laying           induced DSL competitors, who had built
optical fiber for the “last mile” from the network         broadband businesses based on unbundled
to the home—they could find themselves forced              wholesale access to the Baby Bell’s physical
to resell that improved capacity to competitors as         networks. While still a competitor in today’s
well. As a result, they had little incentive to make       market, Earthlink’s revenues peaked in 2003.
new investments, and were being outcompeted                Covad was valued at $10 billion in 1999 and close
due to regulation of the old ones. They were               to nothing a few years later. These meteoric rises
frozen in place, (a situation that now confronts the       and precipitous falls reflected the nature of these
European Union, which uses a similar system and            companies—they made no investments in their
is falling behind the United States).                      own infrastructure, which limited their ability to
                                                           innovate, and their profitability was a product of
The freezing of the phone companies in this                regulatory privilege, not their own inherent ability
fashion slowed the nation’s overall rate of                to create value.
investment in high-speed Internet via fiber and
DSL. Critics of the industry often seize upon              By the end of the 1990’s, these dynamics
this performance and use it as an argument                 were coming to dominate the debate. Cable
to impose yet-stricter regulation of Internet              was winning the race to provide high-speed
providers. But, as described below, once the FCC           broadband, and telephone competitors were at a
eliminated unbundling requirements for new                 disadvantage due to the unbundling requirement.
fiber networks in 2003, and the courts set aside           The vision laid out by Chairman Kennard in
line-sharing unbundling more generally in 2004,            the above quote was widely understood and had
telco investment in fiber, either directly to the          bipartisan support—in that year, he went further,
home (Verizon) or to neighborhood nodes (AT&T),            and laid out a visionary plan for the FCC’s role
began quickly and earnestly. Unconstrained by              in a competitive, post-regulatory environment. 3
mandatory unbundling, cable companies had                  But the vision still had to be reconciled with the
already responded with new versions of their               questions left behind by the 1996 Act—where was
DOCSIS high-speed data standard that met or                the line between an information service and a
exceeded the speeds of their rivals who, now               telecommunications service to be drawn, and was
similarly treated, responded in turn. As a result,         such a line an eternal fact of life, or a creature of
the United States, driven by new competition               the technologies available at the time? Was the
between the telcos, cable companies, and wireless          transitional device of “unbundling” really just a
providers, now lags only Japan among the                   transition? To whom would it apply, and when
G-7 nations, and only highly urbanized Japan               might it end? The next decade would answer many
and Korea (nations with very high population               of these questions.
densities, a key cost consideration in providing
wired service) in connection speeds. So industry           The Rise of Information Services
critics found themselves in the awkward position           As technology progressed on many fronts, the
of advocating unbundling as the policy needed              convergence of the many sources of broadband
to improve U.S. broadband’s performance, even              connectivity began in earnest, and true
though that specific policy was directly responsible       competition was the result. While this was an
for the lag in U.S. high-speed broadband adoption.         unambiguously good thing, it left an important
The industry sprang forward, both in absolute              issue unresolved—was broadband access in
speed and in international rankings, only once             all cases an “information service” or was it
the policies the industry’s critics advocated were         a “telecommunications service” that should be
abandoned.                                                 subjected to the same type of common carriage
                                                           utility style regulation that applied to voice
The inroads made by cable during this period also          communications?
hurt both the telcos and the telcos’ regulation-

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Policy Memo			                                                                         Progressive Policy Institute

While the original intent of the Clinton                    that would make it subject to common carrier
Administration and the Congress seemed                      regulation.
clear, it was not until after a series of regulatory
pronouncements and court decrees that common                Then on August 21, 2003, the FCC released
carriage was taken off the table for all services           a “triennial review order” that eliminated the
except local phone networks.4 And, through                  unbundling requirement for fiber-to-the-home
these decisions, the regulators and courts made             broadband capacity. (It also eliminated the
important statements about “information services”           unbundling requirement for “hybrid” fiber and
and “telecommunication services,” and the                   copper loops, but allowed that states may find
networks over which they were provided.                     it necessary to re-impose those measures when
                                                            some local competitors would be “impaired” by
                                                            disallowing them wholesale access.) Verizon almost
       The FCC under Chairman                               immediately began formulating and implementing
                                                            plans to deploy fiber into neighborhoods and
       Michael Powell ruled that                            ultimately, to residential premises now that the
       Internet access provided by                          disincentive to do so had been eliminated.
       cable companies should be                             The decision to liberate fiber was not universally
       classified as an “information                         acclaimed. One FCC Commissioner argued
       service” and not a                                    that “today’s decision chokes off competition in
                                                             broadband. Consumers, innovation, entrepreneurs
       “telecommunications                                   and the Internet itself are going to suffer. . . . This
       service”.                                             is not a brave new world of broadband, but simply
                                                             the old system of local monopoly dressed up in
                                                             a digital cloak.”5 In retrospect, it is difficult to
In 2002, after a regulatory process that spanned             defend that prediction. The introduction of fiber-
two Administrations of both parties, the FCC                 to-the-home was both spurred by cable’s entry into
under Chairman Michael Powell ruled that                     broadband and, in turn, produced a competitive
Internet access provided by cable companies                  response from the cable industry that has
should be classified as an “information service”             improved the U.S. absolute and relative broadband
and not a “telecommunications service,”                      performance dramatically, demonstrating the value
removing the specter of wholesale imposition of              of facilities-based competition. Thus, deregulation of
a wide range of common carrier requirements,                “telco” broadband actually spurred investment by
including unbundling. Opponents had claimed                  cable, telco, and wireless competitors, a cycle that
that, even though cable modem service brought                continues today, as Advanced DSL and DOCSIS
consumers the entirety of the Internet (and that             3.1 are readied for market, and 4G LTE becomes
was why consumers purchased the service) the                 ubiquitous. It is hard to imagine that we would
underlying transmission was itself the sale of               have been better off if continued unbundling
telecommunications to the public and thus should             requirements had prohibited fiber deployment,
be classified as telecommunications (i.e. common             much as it would be hard to argue that we would
carrier) services. But, in a March 14, 2002,                 have been better off if providers of cable modems
Declaratory Ruling, Chairman Powell announced                were forced to open their facilities to competitors.
that the FCC had “settled a debate over the
regulatory classification of cable modem service            Over time, the Courts provided clarity on the
and launched a proceeding to examine the proper             nature of the mandates applied to different groups
regulatory treatment of this service” and that cable        of providers. For example, the FCC’s Triennial
modem service did not contain a separate and                Review Order that eliminated unbundling for
distinct “telecommunications service” offering              fiber loops did not provide the same treatment

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Policy Memo			                                                                         Progressive Policy Institute

for hybrid loops of fiber and copper under some                of the difference between telecommunications
circumstances. But when industry groups appealed               and information networks discussed above have
that part of the order, the U.S. Court of Appeals              centered on their essential character. But as the
for the District of Columbia Circuit in March 2004,            last decade progressed, the debate soon moved
essentially rescinded any unbundling requirement               on to their engineering and logistical nature.
save for a minimal level of access—64 kbps,                    In particular, two policy proposals moved to
enough for voice service, reflecting the original              the fore—“net neutrality” and the regulation of
intent (to preserve telecommunications services)               network interconnection—each of which seeks
of the 1996 Act. And in June 2005, the Supreme                 to have broadband networks behave like their
Court ruled in what is known as the Brand X case.6             telephone antecedents. These have become
In that case, a small Internet service provider in             perhaps the most loudly debated, if not most
Santa Monica, California, argued that the cable                important, aspect of policy toward the Internet
modem ruling of 2002 was in error, that the data               today.
communication portion of a cable modem service
was a telecommunications service, and that it was              “Neutrality” first: The telephone system of a
therefore subject to common carrier regulations                 generation ago was “dumb”—it did little more than
requiring (among other things) cable companies                  to set up an electrical circuit between a calling
to unbundle it for competitors. But the Court                   party and a called party. In the analog world, that
ruled that the FCC’s determination that cable                   voice signal was a continuous wave carried without
broadband was an “information service” was                      interruption from one destination to another—that
reasonable and could stand.                                     was the only way the system could work. If the
                                                                system was overloaded, the caller got a busy signal
After Brand X (and follow on proceedings at                     and came back later.
 the FCC), the basic questions regarding the
 application of the 1996 Act structure to emerging             By contrast, under the protocols that now govern
 Internet technologies and innovations appeared                not just voice transmission but all data, image,
 resolved (although controversies remained                     video, or other streams on the digital Internet,
 as the FCC worked through the implications                    all messages are broken down into “packets” that
 of the decision for DSL, wireless broadband,                  find their way across the Internet individually and
 and other services). The Courts and the FCC                   are reassembled when they arrive, a technology
 had converged around one view—that simply                     that lies behind the increases in speed, network
 because an “information service” contained a                  utilization, quality, and declines in cost of the
“telecommunications” component that did not                    past decades. That means that networks can be
 make it a “telecommunications service” subject                managed to optimize their performance—they’re
 to public utility common carrier regulation. This             not “dumb,” as was the old phone system.
 was the logical interpretation of the 1996 Act’s
 provisions in light of dramatic technological                 This difference emerged as a policy issue in
 change, which was ratified immediately by                     the mid-2000s. In 2005, for example, the
 capital markets that poured vast investment into              FCC fined Madison River, a North Carolina
 companies and technologies when it became clear               telecommunications company, for blocking
 the common carriage regime (and, therefore, the               Vonage’s VoIP traffic, which potentially competed
 possibility of unbundling) would not apply. In this           with Madison River’s own telephone service.
 context, at least, the policy intents of the 1996 Act         The question of limiting certain types of traffic
 and of Kennard’s 1999 vision had finally been                 became more nuanced in 2007, when Comcast
 achieved.                                                     began to manage traffic that used BitTorrent, a
                                                               program used for very high volume applications
Net Neutrality and Network Management                          like peer-sharing music, video, or other large
The various regulatory and legal considerations                files. To some, the decisions to limit BitTorrent

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                                                          11
Policy Memo			                                                                         Progressive Policy Institute

 during periods of Internet congestion could be                ignores the reality that different Internet traffic
 analogized to a grocery store deciding how many               can have different needs for speed and reliability.
 registers to open and how many lanes should be                Because the broadband network has intelligence,
 devoted to those customers with a limited number              it could readily offer different levels of service,
 items. But critics raised the possibility of Internet         allowing some content to move more rapidly (for
 providers editorially managing the traffic on their           instance, by keeping their packets together instead
 system—deciding what traffic would move and at                of distributing them—thus eliminating “buffering”
 what speed based on what the providers “liked”                as they are reassembled). This would be one way
 or “didn’t like.” Perhaps this would be editorial             to resolve congestion, and the ability to use a
 control, perhaps they would quash traffic that               “premium” service would greatly assist innovations
 competed with their own (for example, blocking                that require such an unbuffered connection,
 Netflix because it potentially competes with a                such as remote medicine, distance learning,
 provider’s video-on-demand). These advocates                  entertainment and gaming, and the like.
 ultimately petitioned the FCC to prohibit the
 practice as applying to BitTorrent, and the                  Net neutrality opponents argue that allowing
 episode became an emblem for the policy of “net              content to pay for the higher quality of their
 neutrality” (which postulates that all traffic should        signal (much as we allow households to pay for the
 move across the Internet under identical terms               higher speed of their connection) could reduce
 and conditions, much as telephone calls did under            the share of network costs borne by end users. An
 the regulated, analog voice system). In essence,             analogy can be made to a newspaper—it charges
 neutrality advocates wanted the broadband                    advertisers to reach its readers, and readers to
 network to act the way the old phone system                  see its advertisements—it is a “two-sided market.”
 did. Moreover, they argued that the Internet                 If a newspaper were prohibited from charging
“always worked that way,” and that this equality of           advertisers for space, the cost of the newspaper
 treatment of all data was essential to its character.        to readers would be much higher. Not charging
                                                              content (websites) for premium access, therefore,
                                                              potentially increases costs to users, who end
        The idea that all traffic                             up subsidizing content, including content they
        must be treated equally                               may not use and that others in the market would
        sounds democratic, but                                readily support.

        can be costly and                                     This debate over neutrality rages today. The
        inefficient in practice, and                          purpose of this paper is not to resolve it, but to
        ignores the reality that                              place it in historical context.

        different Internet traffic                             The debate first flickered to life in D.C. policy
        can have different needs                               circles when Chairman Powell spoke on
                                                              “Preserving Internet Freedom” at the February
        for speed and reliability.                             2004 Silicon Flatirons conference. The following
                                                               year, the issue was joined in earnest when the
                                                               FCC issued its “Internet Policy Statement,” an
To neutrality’s detractors, these arguments missed             attempt to identify general principles that might
the point. The Internet that “always worked that               guide the management of network traffic. That
way” was one that delivered files and mail to                  statement said that consumers were entitled to:
users, not data-intense video files and other large            access the lawful Internet content of their choice;
claimants to bandwidth. Moreover, the idea that all            run applications and services of their choice
traffic must be treated equally sounds democratic,             subject to the needs of law enforcement; connect
but can be costly and inefficient in practice, and             to any device that does not harm the network;

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Policy Memo			                                                                         Progressive Policy Institute

and a competitive market for all components of                 had to be mandatory because otherwise any of the
the Internet “package”—connectivity, devices,                  system’s sanctioned monopolists (in either long
services, applications, and the like. Although the             distance or local service) could try to jack up the
Commission did not adopt rules in this regard, it              price of interconnection to the other by holding
said it would incorporate those principles into its            the system hostage, and all heck would break lose.
ongoing policymaking activities.
                                                               But the Internet works differently. Websites
But at the same time, it recognized that those                 generally take their content (either on their own
principles were subject to “reasonable network                 or through a contacted service provider) to one
management,” which left situations like the                    of many “backbone” networks that make up
Comcast/BitTorrent instance in a regulatory                    the Internet, which in turn take it to the local
grey area. The FCC ordered Comcast to make                     networks in your neighborhood. There are many
its network management practices transparent.                  of these backbone providers—not just ISPs, but
But what gave the FCC the right to regulate the                also such more specialized companies as Cogent,
way information services were managed? If a                    Tata, and others—and they move data across
telephone company in a prior age had created                   the network to minimize cost and maximize
a system that allowed some users to bypass a                   speed and efficiency through a flexible system of
busy signal, the FCC would have prohibited it,                 arrangements. If these backbone providers billed
as part of its mandate to regulate a sanctioned                each other every time a message jumped from
monopoly. But broadband (an information,                       one of their lines to the others, they’d go nuts
not telecommunications, service) exists in a                   processing the transactions. So, instead, when the
competitive environment funded by investors.                   two parties are roughly the same size in terms of
What gave the FCC the authority to regulate                    volume of data transferred, they set up a peering
network management practices in that world the                 relationship, which says that they will trade data
way it did in the first?                                       without billing so long as the volume moving both
                                                               ways is “roughly” in balance. If their traffic falls
Comcast took the FCC to court over the BitTorrent              out of balance, they settle up and figure out how
order and, in 2010, the U.S. Court of Appeals for              to manage the imbalance. When two networks’
the D.C. Circuit found that the FCC had failed to              traffic exchanges are dramatically different in
show that its decision was reasonably related to               size, other “settlement based” or commercial
its statutory authority. Taking this authority unto            arrangements allow this exchange to occur.
itself, the Court found, would “virtually free the
Commission from its congressional tether,” giving              “Peering” and other arrangements, therefore, are
the FCC the ability to impose regulations on                    the Internet’s effective free-market substitute
Internet service providers that were not based on               for mandatory and regulated interconnection, a
Congress’ expressed intent. A second and more                   system that makes the competitive backbone
basic legal challenge to the FCC’s ability to impose           “market” work just as the old system made the
neutrality on the Internet will be discussed below.             prior-day, regulated monopolies work. The
                                                                system has been tested, several times, most
A second regulatory proposal would recreate                     publicly in an instance involving Level 3 and
 the old phone system’s practices regarding                     Comcast. Level 3 and Comcast had a settlement-
“interconnection.” The old phone system, as                     free peering agreement, one that required that
 mentioned above, had both long distance and                    traffic exchanges be roughly in balance, per the
 local carriers. Regulation required all of them to             companies’ respective published peering policies.
 interconnect at a specified “price.” “Price” is set in         Then Level 3 entered into an arrangement to carry
 quotes because what was really being set was the               huge amounts of Netflix’s movies on its network,
 way in which revenues would be divided among                   which resulted in the balance of traffic between
 the system’s participants. And interconnection                 Level 3 and Comcast falling far out of balance.

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Policy Memo			                                                                       Progressive Policy Institute

Comcast asked to move to “settlement based”                 prohibit differentiated service (so long, of course,
peering but Level 3 refused to pay and escalated            as it didn’t violate antitrust or other consumer
its argument to the FCC, insisting that Comcast’s           protection statutes), or regulate interconnection,
demand that they renegotiate their peering was a            because of the difference between information and
violation of an “open” Internet and the FCC’s oft-          telecommunications services, the same distinction
stated principle of “net neutrality.” FCC Chairman          the FCC cited when freeing the latter from
Julius Genachowski, in remarks before Congress,             common carriage requirements.
leaned toward Comcast’s view, arguing that
peering disputes were private business matters,             The Court’s decision in this case was delivered
and expressed the hope that companies like Level            in January 2014. While it acknowledged the
3 and Comcast could work out their differences              FCC’s role in promoting the Internet, it found
as was routinely done in the marketplace. (The              that the FCC, having classified broadband ISPs
companies did in fact work out an agreement,                as information service providers, could not
without regulatory intervention.)                           impose common carrier-type regulations on
                                                            them. In response, many advocates for neutrality
A similar dispute is now underway with Cogent—              and similar regulation now suggest that the
yet another conveyor of Netflix content—and                 FCC identify (or “reclassify”) the Internet as
Verizon. (Note that video plays a role in both these        a telecommunications service rather than
examples.) And, again, advocates for regulating             an information service, thereby undoing the
network interconnections see this dispute over              distinction first made in the law in the 1996 Act,
traffic exchange among networks—a dispute                   and undoing the Clinton Administration’s guiding
resolved by regulation under the rules of the old           intent.
phone system—as an example of the need for
regulation of the new broadband system, even                What Are the Lessons?
though the vast bulk of Internet traffic moves              Different analysts will take different lessons from
through these market-based arrangements without             this history. This review sees three of primary
incident.                                                   importance. They are:

Thus, the debate over regulation of the Internet            •   information services and telecommunications
has moved from the issue of common carriage                     services really are different;
to the issue of network management. But,                    •   investment and capital flow to where regulation
paradoxically, the resolution of the second                     (or the absence thereof) encourages them to
question could lead us back to the first. In                    flow; and
December 2010, the FCC issued its “Open Internet            •   technology, business models, and consumer
Order,” which prohibits Internet service providers              behaviors change and, as they change, the
from “discriminating” against any legal content                 meaning and effect of different regulatory
among other requirements, subject to reasonable                 proposals change as well.
network management requirements. This is often
assumed to prohibit ISPs from offering “tiered”             The rest of this section examines these three
services to Internet content providers, although            propositions.
it may be argued that allowing content providers
to pick a service tier at posted prices is no more          The 1996 Act codified the distinction between
discriminatory than letting consumers choose                information services and telecommunications
among “good,” “better,” and “best” from Sears.              services, and expressly limited common carrier
                                                            regulation to telecommunications. The Internet
Verizon, in response, appealed the Open Internet            has flourished as this distinction was put into
Order in the courts, claiming that the FCC lacked           practice and, critically, common carriage status
the authority to impose the neutrality requirement,         and unbundling requirements were either lifted

                                                       14
Policy Memo			                                                                      Progressive Policy Institute

or were never placed on the various information           would have been outrageous. Imagine, for instance,
service providers that offer high-speed broadband.        that we applied unbundling to peanut butter,
                                                          and Peter Pan had the legal right to use Skippy’s
                                                          manufacturing facilities at a price determined
        The 1996 Act codified                             by what Peter Pan’s processing costs would be if
                                                          they had built a new, state-of-the-art plant (which
        the distinction between                           they did not and had no intention to do). That
        information services and                          is exactly what unbundling does. The 1996 Act,
                                                          therefore, imposed common carriage in a narrow
        telecommunications
                                                          area to correct for a historical fact, but it spared
        services, and expressly                           new forms of innovation and investment from this
        limited common carrier                            burden.
        regulation to                                     The differences between telecommunications
        telecommunications.                               services and information services recognized by
                                                          the 1996 Act have been extended significantly
                                                          since then, in part because of the way the 1996 Act
One of the intentions of the 1996 Act was to              treated them, and in part because of technological
preserve the commitment made to the public in             progress. The old phone network addressed by the
the 1934 Act—that they would have access to local         1996 Act was built by sanctioned monopolies that
telephone service at affordable rates, including          traded the market power the government ceded
emergency services such as 911. Cable was still           to them for a regulated return and the ability to
subject to a variety of regulatory mandates—its           invest in facilities with minimal risk. But Internet
basic tier was subject to price regulation, and it        access has been provided by competing private
was still subject to certain carriage and tiering         parties who have risked their own investments—
requirements—but the Act asserted a basic                 over a trillion dollars’ worth since the 1996 Act—
difference between telephony and cable television,        without government guarantees. This extends
data communication, or other information                  the original basis for the distinction between
flows, as had past FCC regulatory practice and            the two systems—information services were
the perspective of the Clinton Administration.            financed by risk capital, in contrast to their legacy
The distinction made in the 1996 Act between              telecommunications counterpart.
telecommunications and information services
reflected genuine and significant differences in          The system of sanctioned monopolies also gave
the nature of the two services—differences in             rise to mandatory interconnection and settlement
functionality, in engineering characteristics, in         policy regarding shared revenue (for instance, the
their potential for innovation and improvement.           division of dial tone revenues to local versus long
The differences and distinctions between the              distance calling). The system needed mandatory
two made in the 1996 Act were not political or            interconnection to work, and required a method
semantic, but real.                                       for allocating revenues and costs among long
                                                          distance and local traffic (which essentially
The distinction between the two types of services         determined what the price of that interconnection
was made so that there would be a guideline               was) to determine profits as well as to subsidize
for determining where regulation and common               many local services. The Internet, in contrast,
carriage status were needed. It was imposed on            is a “network of networks” comprised of many
providers of telephone services because these had         different companies’ facilities. As opposed to their
been local monopolies and, therefore, had the only        regulated predecessors, these companies are in the
telephone infrastructure in place. Had this not           business of interconnecting. Occasional cases such
been the case, the imposition of common carriage          as Level 3 and Comcast, or Cogent and Verizon

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