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‘Special access’ shouldn’t be fixed

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‘Special access’ shouldn’t be fixed

George S. Ford and Lawrence J. Spiwak at the Phoenix Center conclude in a new paper that government intervention is not warranted in the market for special access services purchased by businesses and institutions (which I discussed most recently here).
They note that the rates of return a prominent study estimated AT&T, Qwest and Verizon are currently earning either are similar to or less than the rates of return these companies used to earn when the market was fully regulated.

NRRI bases this analysis on ARMIS rates of return, a perplexing approach once one calculates ARMIS rates of return from the period in which all special access services were price regulated. In 1999, for example, the average rate of return for special access computed using ARMIS data was 32% for Qwest, 37% for AT&T, and only 4.5% for Verizon. For Qwest and AT&T, the returns under complete price regulation are not much different than the “adjusted” returns computed in the NRRI Study. The conclusion, then, is the pricing flexibility has had no effect. For Verizon, its rate of return prior to the Pricing Flexibility Order was substantially lower than the other Bell companies and even below any reasonable estimate of the firm’s cost of capital. One interpretation, then, is that a more deregulatory approach has provided for more reasonable returns on investment for the firm. (footnote omitted.)

There is always a high risk well-intentioned regulators will fall victim to lobbyists or simply guess wrong. Ford and Spiwak point out that in the current environment the risk is heightened due to the impairment of credit markets.

In the current financial and economic crisis, [the] costs and risks of regulation are even more pronounced, particularly with regard to rate regulation. At the most basic level, one cost of rate regulation is the risk that regulators will establish an incorrect rate. If regulators set a rate too high, then they might redirect investment inefficiently and also whittle away any prospective welfare gains by that intervention. If regulators set a rate too low, then investment will be squelched and entry will be deterred. It is important to note that not only would investment by incumbents be squelched and deterred, but that investment by entrants might be similarly affected. With fixed and sunk costs, regulatory-mandated reductions in prices or profits may very well dissuade new entrants from offering service.
The risk of a regulator setting a rate incorrectly is particularly acute in the current environment, because any form of rate regulation requires the regulator to examine and establish a cost of capital. In a normal rate case, a regulator can obtain reasonably valid estimates of the cost of capital by observing borrowing and equity costs for other firms exhibiting “comparable” risk characteristics.
But today, the Federal Reserve Board of Governors and the Department of the Treasury have concluded that the financial markets are currently so dysfunctional that the public authorities must step in and recapitalize banks, large insurers, and so on. Future taxpayers are being used as a source of capital-of-last-resort for many of these institutions, a process that is necessarily distorting the standard methods in which a regulator may establish a cost-of capital for the industry. Stated simply, if it is true that even economically worthwhile projects are now unable to obtain funding under any conditions, what is the true cost of capital? Once credit is being rationed, the risks of establishing an incorrect rate for a service are very high, and policymakers ought to take this into account when reviewing proposals for immediate regulation of special access rates, at least until the financial markets return to normalcy. (footnotes omitted.)

The paper confirms that re-regulating the special access market would be both unnecessary and highly risky.
Related post:Don’t believe ‘special access’ hype” (6-23-2009).