THE CONVERGENCE PHENOMENON A CONSUMER …Mr. Larry Frimerman Federal Liaison Columbus, OH Ohio House of Representatives Hon. Priscilla Mead Chair House Public Utilities Committee Columbus,

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THE CONVERGENCE PHENOMENON:

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FINAL REPORT

A REPORT OF THE CONSUMER ENERGY COUNCIL OF AMERICA

CONVERGENCE FORUM

APRIL 2000

Founded in 1973, the Consumer Energy Council of America (CECA) isthe nation’s senior public policy organization focusing on the energy,telecommunications, and other network industries that provide essentialservices to consumers. CECA has a primary commitment to securingreliable and affordable services for all sectors of our nation, with specialregard for residential and small business consumers. CECA is a leadingnational resource of information and analysis on the social andeconomic impacts of energy, telecommunications, and other networkservices. CECA conducts consumer education campaigns nationally toensure a widely informed public constituency. CECA provides a forumfor consensus-building among public and private sector organizations,federal and state regulators, industry leaders, consumer advocates,small businesses, utilities, environmentalists, academicians and othersin furtherance of public policy objectives.

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THE CONVERGENCE PHENOMENON:

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FINAL REPORT

A REPORT OF THE CONSUMER ENERGY COUNCIL OF AMERICA

CONVERGENCE FORUM

APRIL 2000

FOREWORD As we enter into a new millennium, we are witnessing an economic and technological transformation on par with the Industrial Revolution. Fueled by sweeping regulatory changes, technological innovation, and the burgeoning information economy, the merging and overlap, or convergence, of the energy and telecommunications networks will change profoundly the way in which Americans receive essential services like heat, electricity, telephone, and Internet access. Building upon the experience and expertise developed in its landmark Electric Restructuring Forum, CECA convened the Convergence Forum, the highest-level national effort to date to survey the dynamic landscape of converging networks, to measure the progress of these revolutionary market activities, and to anticipate the effect that these novel interrelationships among traditionally unrelated industries will have upon consumers. To achieve the best understanding of the issues underlying convergence, CECA convened the finest thinkers and national leaders to offer their insight, experience, expertise, and concerns in anticipating a converged marketplace. The CECA Convergence Forum included representation from all the major stakeholder groups – state and federal legislatures, regulatory agencies, the energy and telecommunications industries, consumer and community advocacy groups, and the scientific community. The CECA Convergence Forum met bimonthly in Washington, DC between October, 1998 and December, 1999 and debated the complex, contentious issues surrounding convergence. There were diverse points of view, and members worked diligently to reach consensus on difficult issues. The Forum provided illuminating new solutions to the public policy questions faced by policy makers and decision makers across the country. All of the CECA Convergence Forum members gave generously of their time, their knowledge, and their enthusiasm, for which we are extremely grateful. The CECA Convergence Forum thrived thanks to its Chairman George Davidson, CEO of Consolidated Natural Gas during the Forum and Chairman of Dominion since the merger. George’s total commitment to the project and to the issues at hand ensured that the Convergence Forum proceeded with intelligent, constructive debate and in a spirit of cooperation. We are grateful as well for the extraordinary hard work and thoughtful guidance of the CECA Convergence Forum Vice Chairs: Alex Radin, President of Radin & Associates and the former head of the American Public Power Association; Toby Webb, Executive Vice President of Bell Atlantic while serving on the Forum; Jack Gibbons, former Science Advisor to the President; and Charles Curtis, Executive Vice President of The UN Foundation, and the former Deputy Secretary at the Department of Energy. Mark Cooper, Research Director for the Consumer Federation of America, provided the Convergence Forum with an excellent starting point in his background paper, which formed the foundation of the final report. We would also like to recognize Ken Malloy, President of the Center for the Advancement of Energy Markets, and Terry White, Senior Associate at Navigant during the Forum, for their thoughtful white papers, which were incorporated into the final report, as well. Many thanks to CECA Senior Writer/Researcher Julia Holmes for her editorial convergence of discussion papers, recommendations, research and additional writing over the course of the Convergence Forum. Finally, special thanks to Lisa Zifcak, CECA Research Analyst, and the rest of the CECA staff for their assiduous pursuit of excellent research and for their careful administrative oversight, both of which secured the success of the project. Ellen Berman Jamie Wimberly President Vice President

CECA appreciates and is grateful for the valuable assistanceand thoughtful critiques provided by the Convergence Forummembers. An attempt was made to reach consensus on asmany issues as possible in this report. Nevertheless, themembers of the Forum do not necessarily approve,disapprove, or endorse the report. CECA assumes fullresponsibility for the report and its contents.

Chair CECA Convergence Forum Mr. George Davidson Chairman Dominion Pittsburgh, PA Vice Chair CECA Convergence Forum Hon. Charles Curtis Executive Vice President The UN Foundation Washington, DC Vice Chair CECA Convergence Forum Mr. Morrison (Toby) Webb Executive Vice President* Bell Atlantic (*Until December 1999) Harrison, NY Vice Chair CECA Convergence Forum Mr. Alex Radin President Radin & Associates Washington, DC Vice Chair CECA Convergence Forum Hon. John H. Gibbons President Resource Strategies (Former Assistant to the President for Science and Technology) Washington, DC AES Corporation Mr. Thomas A. Tribone Executive Vice President Arlington, VA Alpine Group Mr. Rhod Shaw Consultant Washington, DC American Gas Association Mr. David Parker President and CEO Washington, DC Bell South* Mr. Charles Featherstun Assistant Vice-President Legislative/Regulatory Matters Atlanta, GA (*Until September 1999) Brattle Group Dr. Peter Fox-Penner Principal and Director, Washington Office Washington, DC Cablevision Ms. Lisa Rosenblum Senior Vice President Government Affairs Bethpage, NY

Center for the Advancement of Energy Markets Mr. Ken Malloy President Burke, VA Colorado Public Service Commission Hon. Brent Alderfer Commissioner (Completed term in February 1999) Denver, CO Conectiv Mr. Philip S. Reese Chief Operating Officer Wilmington, DE Consumer Federation of America Dr. Mark Cooper Research Director Washington, DC Council Tree Communications, Inc. Mr. Steve Hillard President Longmont, CO Duane, Morris & Heckscher, LLP Ms. Sheila Hollis Partner-In-Charge Washington, DC Edison Electric Institute Mr. David Owens Senior Vice President Washington, DC Electric City Corporation Mr. Christopher D. Maloney* President and COO (*Served until November 1998.) Lake Forrest, IL K N Energy Mr. Mort Aaronson President and COO Lakewood, CO Exelon Infrastrcuture Services (A subsidiary of PECO Energy) Mr. Gary Murphy Vice President of Operations Philadelphia, PA Federal Communications Commission Hon. Harold Furchtgott-Roth Commissioner Washington, DC Federal Energy Regulatory Commission Mr. Douglas W. Smith General Counsel Washington, DC

Federal Trade Commission Ms. Mary Engle Assistant Director, Enforcement Washington, DC Federal Trade Commission Ms. Gina Schaar-Howard Attorney, Bureau of Consumer Protection Enforcement Division Washington, DC Federal Trade Commission Mr. Roger Boner Economist Bureau of Economics Washington, DC GE Power Systems Mr. Francis S. Blake Vice President Business Development and Legal Operations Schenectady, NY Georgia Public Service Commission Hon. Robert Baker Commissioner* Atlanta, GA (*Until September 1999) Hagler Bailly, Inc. Mr. William E. Dickenson President & CEO Washington, DC Hagler Bailly Consulting, Inc. Mr. Kent Van Liere Director* Madison, WI (*Until March 2000) International City/County Management Association Mr. Mosi Kitwana Director, Research and Development Washington, DC Interstate Natural Gas Association of America Mr. Jerald Halvorsen President Washington, DC International Trade Administration Ms. Barbara Wellbery Special Counsel for Electronic Commerce Washington, DC Kentucky Public Service Commission Hon. Edward Holmes Vice Chair Frankfort, KY Keyspan Energy Mr. Colin P. Watson Senior Vice President Strategic Marketing and E-Business Brooklyn, NY

CECA CONVERGENCE FORUM MEMBERSHIP

Maryland People's Counsel Mr. Michael Travieso People's Counsel Baltimore, MD Montana Public Service Commission Hon. Bob Rowe Commissioner and NARUC President Helena, MT National Association of Regulatory Utility Commissioners Mr. Charles Gray Executive Director Washington, DC Navigant Consulting Mr. Cliff W. Hamal Principal Washington, DC Navigant Consulting Mr. Terry White Consultant* Ashburn, VA (*Until November 1999) New Jersey Division of Ratepayer Advocate Ms. Blossom Peretz Ratepayer Advocate and Director Newark, NJ New Jersey Natural Gas Mr. Larry Downs President & CEO Wall, NJ New York State Electric and Gas Mr. Michael German Executive Vice President and COO Ithaca, NY Niagara Mohawk Power Corporation Mr. Clement Nadeau Vice President, Marketing Syracuse, NY NIPSCO Mr. Gary Neale Chairman, President & CEO Hammond, IN

Northern States Power Company Mr. Larry Taylor President Minneapolis, MN Office of the Ohio Consumer's Counsel Mr. Larry Frimerman Federal Liaison Columbus, OH Ohio House of Representatives Hon. Priscilla Mead Chair House Public Utilities Committee Columbus, OH Ohio Public Utilities Commission Hon. Craig Glazer Chairman Columbus, OH Public Citizen Mr. Charlie Higley Energy Policy Analyst Washington, DC Regulatory Assistance Project Mr. Peter A. Bradford Energy and Regulatory Advisor Peru, VT Renewable Energy Policy Project Dr. Adam Serchuk Research Director Washington, DC Securities and Exchange Commission Ms. Catherine Fisher Assistant Director Public Utilities Washington, DC Statoil Energy, Inc. Mr. Kjell Stautland Senior Vice President Corporate Development Alexandria, VA Swidler Berlin Shereff Friedman, LLP Mr. Steven Agresta Partner Washington, DC Tennessee Valley Authority Mr. James D. Keiffer Senior Vice President Marketing Division Nashville, TN

U.S. Department of Energy Mr. Robert Gee Assistant Secretary for Fossil Energy Washington, DC U.S. Department of Energy Ms. Diane Pirkey Program Manager Office of Energy Efficiency Washington, DC U.S. Department of Justice Mr. Milton Marquis Senior Counsel Office of the Assistant Attorney General for Antitrust Washington, DC U.S. House of Representatives Mr. Wallace Henderson Chief of Staff Office of the Hon. Billy Tauzin Washington, DC U.S. House of Representatives Mr. Timothy Johnson Office of the Hon. Mike Oxley Chairman, Subcommittee on Finance and Hazardous Materials Washington, DC UTC, United Telecom Council Mr. William R. Moroney President/CEO Washington, DC Utility Consumers' Action Network Mr. Michael Shames Executive Director San Diego, CA Wallman Strategic Consulting Ms. Kathleen Wallman CEO (Former Deputy Assistant to the President) Washington, DC Williams Communications Mr. Kenneth Epps Vice President, Strategic Marketing Rockville, MD

CECA CONVERGENCE FORUM MEMBERSHIP

CECA Convergence Forum Final Report April 12, 2000

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TABLE OF CONTENTS EXECUTIVE SUMMARY……………………………………………………………………………………...……I

PART ONE: INTRODUCTION TO THE CECA CONVERGENCE FORUM…………………………………1

I. INTRODUCTION TO CONVERGENCE: A POWERFUL EMERGENT ECONOMIC FORCE ............................................. 1 II. THE CECA CONVERGENCE FORUM ................................................................................................................ 2

A. Why Convergence Matters........................................................................................................................ 2 B. Origin of the Convergence Forum ............................................................................................................. 3 C. Goals and Objectives of the Forum............................................................................................................ 3

1. The Purpose of the Project..................................................................................................................................... 3 2. Goals and Objectives of the CECA Convergence Forum......................................................................................... 4

III. STRUCTURE OF THE REPORT.......................................................................................................................... 4 A. Smart Homes and Offices of the Future: The Technological Drivers of Convergence................................. 5 B. The Market Power Issue............................................................................................................................ 5 C. Consumer Impacts of Convergence ........................................................................................................... 5 D. Regulatory Restructuring and Convergence............................................................................................... 5

IV. BACKGROUND ISSUES OF UTILITY CONVERGENCE ......................................................................................... 6 A. The Underlying Forces of Change............................................................................................................. 6

1. Information Technology ........................................................................................................................................ 6 2. Market Drivers...................................................................................................................................................... 7 3. Deregulation ......................................................................................................................................................... 9 4. Consumer Demand...............................................................................................................................................10

B. The Overall Concept of Convergence...................................................................................................... 10 C. Examples of Convergence Activity (See Also Attached Case Studies) ..................................................... 13

PART TWO: DISCUSSION OF THE ISSUES ................................................................................................ 17

V. SMART HOMES AND OFFICES OF THE FUTURE: THE TECHNOLOGICAL DRIVERS OF CONVERGENCE................. 17 A. Potential Convergence Outcomes............................................................................................................ 20

1. Evolutionary Outcome..........................................................................................................................................20 2. Revolutionary Outcome........................................................................................................................................21 3. Failure Scenarios..................................................................................................................................................21

B. Scalable Technologies............................................................................................................................. 23 1. Fuel Cells ............................................................................................................................................................23 2. Gas Turbines........................................................................................................................................................24 3. Smart Homes and Buildings .................................................................................................................................24 4. Energy-Telecommunications ................................................................................................................................25

C. The Information Economy ...................................................................................................................... 26 D. Technological Catalysts .......................................................................................................................... 26

1. Digitization..........................................................................................................................................................26 2. Bandwidth ...........................................................................................................................................................27 3. Artificial Intelligence ...........................................................................................................................................29

E. Moore’s Law and Metcalf’s Law: The Two Pillars of Change................................................................. 30 F. Important Drivers of Technological Convergence .................................................................................... 32

1. Consumer Demand...............................................................................................................................................32 2. De-regulation / Re-regulation ...............................................................................................................................33

G. Issues: Technology and Convergence...................................................................................................... 33 1. Potential Barriers to Technology Advancement .....................................................................................................33 2. Potential Impacts of Stranded Costs on Technology Development Issues ...............................................................34 3. Promoting and Maintaining Long-Term R&D.......................................................................................................35 4. Establishing Standards for Support Service Delivery .............................................................................................35 5. The Effect of Regulatory Structures on Technology Development .........................................................................35 6. Potential Impacts of Overlaying Additional Services onto a Single Carrier.............................................................35 7. New Training Needs for New Technologies ..........................................................................................................36

VI. MARKET POWER ISSUES ............................................................................................................................. 36 A. Market Power Defined............................................................................................................................ 36 B. Market Power Concerns and Convergence............................................................................................... 37

1. Some Real World Examples of Concerns ..............................................................................................................39 2. The Public Policy Response to Potential Problems ................................................................................................41

C. Market Power and Regulation ................................................................................................................. 43


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1. Regulatory and Other Analytic Uncertainties.........................................................................................................43 a. Partial Deregulation ....................................................................................................................................43 b. Convergence and Overlapping Deregulation ................................................................................................44

2. The Intersection of Regulatory Paradigms and Joint Decisions...............................................................................44 a. Mergers and Antitrust .................................................................................................................................44 b. Regulation and License Transfer .................................................................................................................45 c. Multiple Layers of Review..........................................................................................................................46

3. Paradigms to Speed the Process ............................................................................................................................47 a. Functions Approach to Convergence Activities ............................................................................................48 b. Streamlining Pre-convergence Oversight With Post-convergence Regulatory True-ups By a Single Agency ..50

4. Conclusion...........................................................................................................................................................50 VII. CONSUMER IMPACTS OF CONVERGENCE..................................................................................................... 50

A. The Transaction...................................................................................................................................... 51 1. Pre-Purchase ........................................................................................................................................................51 2. Point-of-Sale........................................................................................................................................................51 3. Post-Purchase.......................................................................................................................................................51

B. The Transition to Competition in Utility Services .................................................................................... 52 1. Pre-Purchase ........................................................................................................................................................54 2. Point-Of-Sale.......................................................................................................................................................55 3. Post-Purchase.......................................................................................................................................................56

VIII. REGULATORY RESTRUCTURING AND CONVERGENCE................................................................................. 56 A. Introduction............................................................................................................................................ 56 B. Convergence and Restructuring............................................................................................................... 56

PART THREE: RECOMMENDATIONS........................................................................................................ 59

IX. SMART HOMES AND OFFICES OF THE FUTURE: THE TECHNOLOGICAL DRIVERS OF CONVERGENCE ............... 59 A. Nurture Research and Innovation ............................................................................................................ 59 B. Streamline the Governance of Technology .............................................................................................. 59 C. Link Technology Development with Community Development ............................................................... 60

X. MARKET POWER ISSUES............................................................................................................................... 61 XI. CONSUMER IMPACTS OF CONVERGENCE ...................................................................................................... 63

A. Consumer Bill of Rights ......................................................................................................................... 63 B. Dispute Resolution.................................................................................................................................. 65 C. Privacy and Exchange of Personal Information........................................................................................ 66 D. Mandatory Information Disclosure.......................................................................................................... 67 E. Billing and Metering ............................................................................................................................... 68 F. Customer Education ................................................................................................................................ 69 G. Universal Service.................................................................................................................................... 70

XII. REGULATORY RESTRUCTURING AND CONVERGENCE .................................................................................. 70 A. The Problem of Incumbents in the Choice Model .................................................................................... 73 B. Social Benefits........................................................................................................................................ 76 C. Utility Assets .......................................................................................................................................... 77 D. Differential Imposition of Burdens.......................................................................................................... 78

XIII. PROCESS OF REGULATION AND CONVERGENCE ......................................................................................... 80 A. State Commission Organization, Decision Making, Resources and Processes........................................... 80 B. Organizational Issues .............................................................................................................................. 81 C. Process Issues ......................................................................................................................................... 82 D. Commission Capabilities and Funding .................................................................................................... 83 E. Patchwork Regulation ............................................................................................................................. 84 F. Federal Role in Assisting/Mandating Change in Retail Policies ................................................................ 84 G. Federal Commission Organization, Decision Making, Resources, and Processes...................................... 85 H. Conclusions and Recommendations ........................................................................................................ 86

PART FOUR: APPENDICES........................................................................................................................... 87

APPENDIX A: OVERVIEW OF TELECOMMUNICATIONS REGULATION.................................................................... 87 APPENDIX B: THE ECONOMIC DRIVERS OF CONVERGENCE ................................................................................ 91

A. Economic Activity.................................................................................................................................. 91 B. Efficiency Gains and Consumer Benefits................................................................................................. 93 C. Sources of Efficiency.............................................................................................................................. 94

1. Economies and Externalities.................................................................................................................................95


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a. Supply-side ..................................................................................................................................................95 b. Demand-side ................................................................................................................................................96

2. Economies of Scope .............................................................................................................................................98 D. Quantification of Potential Savings ......................................................................................................... 99

1. Savings on Transaction Costs From Convergence.................................................................................................99 2. Production and Transport Savings.......................................................................................................................100

E. Constraints On the Gains From Convergence......................................................................................... 101 1. Difficulties In Achieving Efficiency Gains..........................................................................................................102 2. Net Costs ...........................................................................................................................................................102

PART FIVE: CASE STUDIES........................................................................................................................ 104

I. STARPOWER COMMUNICATIONS: PEPCO JOINT VENTURE WITH RCN .......................................................... 104 A. Company Background .......................................................................................................................................104 B. Strategic Opportunity.........................................................................................................................................104 C. Analysis of Policy Decision ...............................................................................................................................105 D. Consumer Impact ..............................................................................................................................................105 E. Outlook .............................................................................................................................................................106

II. MONTANA POWER & TELECOMMUNICATIONS: TOUCH AMERICA................................................................. 106 A. Company Background .......................................................................................................................................106 B. Strategic Opportunity.........................................................................................................................................107 C. Analysis of Policy Decision ...............................................................................................................................107 D. Consumer Impact ..............................................................................................................................................108 E. Outlook ............................................................................................................................................................108

III. CONECTIV COMMUNICATIONS, INC............................................................................................................ 109 A. Company Background .......................................................................................................................................109 B. Strategic Opportunity.........................................................................................................................................110 C. Analysis of Policy Decision ...............................................................................................................................111 D. Consumer Impact ..............................................................................................................................................111 E. Outlook .............................................................................................................................................................112

IV. FRANCE’S VIVENDI ................................................................................................................................ 112 A. Company Background .......................................................................................................................................112 B. Strategic Opportunity.........................................................................................................................................112 C. Analysis of Policy Decision ...............................................................................................................................113 D. Consumer Impact ..............................................................................................................................................114 E. Outlook .............................................................................................................................................................115

V. AMERICAN TELEPHONE & TELEGRAPH (AT&T) ......................................................................................... 115 A. Company Background .......................................................................................................................................115 B. Strategic Opportunity.........................................................................................................................................117 C. Analysis of Policy Decision ...............................................................................................................................118 D. Consumer Impact ..............................................................................................................................................119 E. Outlook .............................................................................................................................................................120

VI. TACOMA PUBLIC UTILITIES....................................................................................................................... 120 A. Company Background .......................................................................................................................................120 B. Strategic Opportunity.........................................................................................................................................120 C. Analysis of Policy Decision ...............................................................................................................................121 D. Consumer Impact ..............................................................................................................................................121 E. Outlook .............................................................................................................................................................122


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EXECUTIVE SUMMARY

I. INTRODUCTION

Recent and ongoing changes in the energy and information industries are transforming the ways in which essential services such as gas, heat, illumination, Internet, telephone, home security, cable, and electricity will be produced, distributed, and selected by Americans. Waves of regulatory liberalization and a series of mergers, acquisitions, joint ventures, and strategic alliances are blurring the lines dividing the traditional public utilities. Electric companies are offering telecommunications services. Natural gas companies are merging with electric companies. Cable companies are merging with telephone companies. Technologies in these industries overlap one another, compete with one another, and are becoming combined in new ways. Many have suggested that information technology and convergence among network industries may produce social, economic, and technological changes as profound and pervasive as those produced by the Industrial Revolution.

The dramatic transformation of all these industries has been popularly referred to as “convergence.” As evidenced by the profusion of “convergence” stories in the popular press, once distinct and disparate industries are combining rapidly and in some surprising ways. The Final Report of the Consumer Energy Council of America’s (CECA) Convergence Forum focuses upon convergence activities that involve one or more historically regulated firms or industries. Convergence has not happened overnight – a unique confluence of factors such as technological innovation, changes in the economics of the affected industries, and regulatory reform have driven convergence ahead in recent years. The post-convergence firm may become an entirely new business model based on competition rather than regulation, the integration of new and old technologies, and, in some cases, a different industry structure, which moves from vertical integration to a horizontal model organized around functional activities. Convergence between the electric, natural gas, and telecommunications industries brings together the largest industries in the world, combining over $500 billion in annual revenue and approximately a trillion dollars in capital. Convergence will affect every sector of our society. There needs to be a clearer understanding of why industries are converging and what these changes will mean for the members of our society, especially small business and residential consumers who depend upon the essential services provided by these network industries.

II. THE CECA CONVERGENCE FORUM

To respond to the fast-moving changes in the market for essential services resulting from the ongoing convergence of the network industries, CECA convened the Convergence Forum in the fall of 1998. Comprised of over 60 of the national leaders in industry, government, and public advocacy, the Forum met for over a year in Washington, DC, to develop recommendations regarding the business, public policy, and consumer implications of convergence. The full report embodies those recommendations. The CECA Convergence Forum report is intended to facilitate informed decision making by addressing several key audiences: industry leaders now struggling to define business strategy;


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public interest advocates trying to protect the interests of small business and residential consumers; and policymakers at the state and federal levels charged with overseeing these industries. Recognizing that there are many types of convergence, the CECA Convergence Forum is particularly interested in convergence of the energy and telecommunications industries given the history of price regulation of these industries as monopolies, the shift towards market pricing and competition, the possibility of companies offering regulated and unregulated services, the need for regulatory change, the essential nature of the “lifeline” or essential services provided by these industries, the capital intensive, infrastructure characteristics of these industries, and the network nature of the industries themselves. Given the size and nature of the industries involved in convergence, and the number of consumers potentially affected, the Forum identified substantial public policy questions which must be addressed with the convergence of the energy and telecommunications industries to ensure that competitive markets develop smoothly and that all consumer classes benefit equitably from the changes in the market for essential services.

III. GOALS AND OBJECTIVES OF THE FORUM

CECA brought together national leaders and stakeholders representing the public and private sectors in order to: 1) Increase awareness and understanding of the convergence occurring between the energy and telecommunications industries; 2) Analyze the consumer impacts of convergence, especially small business and residential consumers; and 3) Make recommendations to policymakers at the state and federal levels of government to ensure that small business and residential consumers benefit from the convergence between the energy and telecommunications industries. The purpose of the CECA Convergence Forum final report is to take a comprehensive, long-term view in crafting public policy that facilitates a market for convergence which is pro-competition and pro-consumer. The public policy developed by the CECA Convergence Forum is intended to balance the interests of market participants (incumbents and new entrants), regulators, and consumers, particularly small business and residential consumers. Consideration of convergence involves many of the issues being debated in regard to restructuring and competition, e.g., market power concerns, state, and federal jurisdictional questions, consumer impacts, etc. The overlapping element of convergence adds a whole new level of complexity, with stakeholders having to learn new vocabularies, new regulatory regimes, and new ways of thinking. Moreover, convergence raises entirely new questions for policymakers. For instance, what are a consumer’s rights regarding bundled service offerings? If a dispute occurs over a phone charge, can the customer’s electricity be shut off? Given that convergence is only possible because of technological innovation, how should public R&D funds be spent to foster the transition to converged services? How should regulatory bodies be structured when traditional industry lines are becoming blurred? The greatest challenge faced by the CECA Convergence Forum was to recognize the uniqueness of convergence, to question the very premises that have governed the public utility sectors for


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decades, and to craft appropriate policy responses that might ultimately mean an entirely new regulatory structure. The ultimate goal for all of the participants of the CECA Convergence Forum is to ensure that consumers benefit from the rapid changes taking place in the market for essential services. If policymakers address the issues presented in this report and incorporate the recommendations made, CECA believes that convergence should be allowed to occur. It should be encouraged through new regulatory structures and incentives, if the proposed recommendations are adopted. CECA further believes that convergence will help to establish workably competitive markets – as providers offer bundled services to consumers, consumers otherwise resistant to switching providers are likely to switch more often and more aggressively. Specifically, CECA recommends that policymakers incorporate two objectives to guide their decision making: Policymakers should ensure that convergence is promoted where the potential for

consumer benefits exists. Policymakers should ensure that benefits from convergence accrue to small

business and residential consumers, as well as to other classes of customers.

IV. BACKGROUND ISSUES OF UTILITY CONVERGENCE

The concept of “convergence” has its origins in the computer and telecommunications industries. Because the economics of the computer/telecommunications industry are different from the economics of the energy utilities, it is important to understand that the causes of convergence likewise differ among industries. Four distinct forces are creating convergent trends in the energy utility industry -- information technology, energy utility economics, deregulation, and consumer demand in information and energy industries. Based on a preliminary review of the literature, we conclude that in general the concept of convergence refers to the joining of two or more previously unrelated economic activities in order to improve the efficiency of the firm through changes in the production process, organizational forms, or market structures. For the purposes of the CECA analysis we add a number of additional stipulations that narrow the scope of the analysis and focus it on utility convergence, with “utility” traditionally meaning a regulated provider of essential services. The convergence activities of primary concern to the Convergence Forum involve joining activities in two industries where at least one of the activities, products or services is provided by a network industry which is traditionally subject to economic regulation and which have, or may have, an impact on the price, quality or nature of the regulated service or of other goods or services provided to the consumer. The requirement that at least one of the firms is regulated is an important one for the present analysis. The industries that the Convergence Forum examined – gas, electric, telecommunications, and cable – historically have been composed of firms that are monopolies with close to 100 percent market share in their local service territories. Regulators and


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legislatures are restructuring these industries, and competition is being introduced at the wholesale and retail levels. It is important to have reasonable assurance that these restructured markets will be effectively competitive during and after the transition to competition. The need for such assurance is heightened in cases in which goods or services viewed as essential are to be provided by an unregulated market rather than by a regulated monopoly. Because regulatory and policy concerns act as triggers, convergence behavior may be facilitated by or inhibited by organizational forms, market structures and government regulations.

V. STRUCTURE OF THE REPORT

The CECA Convergence Forum report covers several areas – technological drivers of convergence, the economics of convergence, consumer impacts of convergence, market power issues in convergence, and regulatory oversight of convergence activity. Part One: Introduction to the CECA Convergence Forum, concludes with “IV. Background Issues of Utility Convergence,” which provides a brief introduction to the trends in network industries that are making convergence possible. This section includes some brief examples of recent convergence activities. For more detailed examples, please refer to the attached case studies in Part Five: Case Studies. Part Two: Discussion of the Issues is organized into the following chapters:

A. Smart Homes and Offices of the Future: The Technological Drivers of Convergence

B. The Market Power Issue C. Consumer Impacts of Convergence

D. Regulatory Restructuring and Convergence Part Three of the report, “Recommendations,” offers policy and decision-making recommendations corresponding to each of the above discussion sections.

VI. DISCUSSION OF THE ISSUES

The discussion section of the report provides an objective, inclusive overview of the convergence issues that most affect consumers and serves as a context for CECA’s findings and recommendations. The areas explored by the Convergence Forum include:

A. Smart Homes and Offices of the Future: The Technological Drivers of Convergence The immense technological potential of convergence should be considered first, as new technologies are making convergence possible and driving the process ahead. This chapter examines the imagined and prevailing technologies driving convergence and describes several possible outcomes from the evolutionary to the revolutionary.

B. The Market Power Issue The powerful supply-side economic forces behind the transformation of so much economic activity will require policymakers to understand and, perhaps, to direct the changes in the market. In the utility industry, where markets have been regulated, decision makers must be able to determine – or establish means to ensure – that the public interest will be furthered by


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convergence. This chapter outlines proposals for capturing and preserving the benefits of convergence, while minimizing the potential costs of convergence.

C. Consumer Impacts of Convergence Industry policies toward consumers and consumer behavior in a converged marketplace are central to the ultimate success or failure of convergence. Consumer reaction in the marketplace will dictate the course of convergence, and consumer impacts will elicit reactions from regulators and policymakers. This chapter presents a “Consumer Bill of Rights” and examines a self-regulatory model for converging industries, government oversight issues, and the transactional costs of new business models.

D. Regulatory Restructuring and Convergence Convergence is promoted by and may further complicate the deregulation and restructuring of utility network industries. This chapter describes the process of regulation at the state and federal levels and identifies current and potential regulatory barriers to convergence. In-depth analysis of each area of discussion corresponds to the findings and recommendations section of the Convergence Forum Final Report.

VII. FINDINGS AND RECOMMENDATIONS OF THE CECA CONVERGENCE FORUM

Taking into account the advice and counsel of the members of the Convergence Forum, CECA offers the following findings and recommendations on a broad array of convergence issues. These recommendations are intended for policymakers at both the state and federal levels of government and for decision makers in all of the affected industries and in all communities. These recommendations are offered after a year of deliberations by all the major stakeholders represented in the Convergence Forum.

A. Smart Homes and Offices of the Future: The Technological Drivers of Convergence CECA believes firmly in the importance of ongoing research and development in the public and private sectors. Innovation, technological evolution, and cooperative work between government and industry are critical to the success of a converged marketplace that will depend upon dynamic, reliable systems to meet changing and growing demand. CECA supports public policy that encourages these strategic partnerships to ensure the improved delivery of services to all classes of consumers while diminishing environmental impacts and maintaining safe, reliable power. As networks converge and traditional single-service providers enter into new markets, technology must enhance interconnection and interoperability standards. Similarly, information and computing technologies should support the physically converging networks by sending accurate, clear, and timely price signals to consumers. CECA recommends sustaining vigorous support of relevant areas of science and engineering research in both the public and private sectors. Research in energy and power, an enormous public as well as private good, has fallen dramatically over the past two decades. It should be restored to a level that assures us technical leadership in both power and information-related areas. Existing public policies should be carefully assessed to eliminate outdated or non-essential barriers or impediments to innovation in technology, market entry, etc.


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In establishing standards for new technologies, industry groups should work to minimize restrictions upon development and innovation. Thus, the standards would allow companies to leverage existing technologies and allow new companies to “leapfrog” those technologies while developing newer ones. This will aid in increasing the pace and effectiveness of technology development. Policies should be devised to encourage new forms of partnerships and consortia aimed at improved delivery of services, lower environmental impacts, and other public goals. Technologies should be shaped to help assure safety, flexibility, and resilience to disruptions such as common mode failures, including those failures due to willful acts of violence. CECA recommends a streamlined regulatory review process that will balance the need for consumer protection with an environment conducive to innovation of products and services. CECA believes that excessive regulatory oversight may inhibit or prevent the development of beneficial technology, improved delivery of services, and the establishment of a fair, stable market for converged services. Furthermore, inconsistent or overlapping regulations in different political jurisdictions will diminish the potential benefits of convergence. CECA advocates credible, accurate consumer education and public outreach raising community and customer awareness of opportunities and risks in a converging marketplace. It is incumbent upon industry to participate in raising consumer awareness and knowledge, just as government funding of R&D and public education should support those companies, technologies, and projects which support the growth of equitable, effective markets for essential services. Additionally, training programs for unemployed or displaced workers should be funded by companies to assist in expanding the pool of skilled resources in the converged industries. Government sponsored financial support of commercial technology ventures (e.g., business income tax relief) should include some requirement for community development by the commercial ventures seeking the relief. The goal of this type of program is to encourage commercial ventures and hiring in areas that traditionally do not serve as employment hubs. CECA recommends that R&D programs should be integrated with long-term basic research conducted by the Department of Energy and other government agencies. To maximize the efficiency and effectiveness of R&D resources, CECA proposes that the following guidelines should be followed when implementing the above recommendations: Stakeholder Involvement: R&D priorities for public benefits energy R&D

programs should be identified through a strategic planning process involving a broad group of public and private R&D stakeholders.

Allocation on Merit: The allocation of R&D funds should be based on merit

and the value of the proposed research. Portfolio Balance: The nation’s R&D portfolio should have a balance of

both near-term and long-term objectives and pursue a mix of technical alternatives defined through a strategic planning process.

Efficient Use of Resources: R&D funds should be leveraged through multi-

party collaboration and public/private partnerships, the existing R&D


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infrastructure should be used where possible; and programs should deliver services in a timely manner with low administrative burdens.

Evaluation of Program Effectiveness: Project and program performance

should be evaluated periodically to ensure that good R&D choices are being made.

Coordination and Integration: Energy technology roadmaps should be

developed through a strategic planning process conducted as a voluntary public/private initiative.

B. Market Power Issues

It has been suggested that policymakers should suspend activity on convergence mergers and convergence activities until more experience can be gained from those which have already taken place. CECA considered but does not recommend a moratorium. Given the scale and scope of the potential benefits associated with convergence, CECA believes the opportunity for consumer gain outweighs the asserted advantages of regulatory caution.

Regulators and policymakers have a broad array of structural, behavioral and regulatory approaches to choose from in dealing with perceived market power issues in convergence mergers. Structural approaches include (but are not limited to): separation of control from ownership of monopoly conduit facilities, partial or complete divestiture of all upstream nonmonopoly assets, and organizational segregation of vertical or horizontal elements into discrete corporations with separate bookkeeping and (partial or complete) separate management. Behavioral approaches include (but are not limited to): functional unbundling and codes of conduct governing inter- and intracorporate relationships and restrictions on the use of name and logo.

After considerable discussion, agreement could not be reached on whether structural or behavioral remedies should be applied by regulators either at the conclusion of an individual case, or as a screening device for preapproved mergers or convergence activities. CECA/RF recognizes that significant pros and cons exist with both approaches.

CECA/RF does believe a hybrid approach shows promise and should be considered by regulators. The hybrid approach, as envisioned by CECA/RF, would allow convergence mergers and activities to proceed using a behavioral paradigm at the beginning. Under this approach, if market power abuse is evidenced, then a strong structural sanction, such as divestiture, would be employed. CECA/RF recommends that the scope of regulatory maneuver be restricted so that the structural sanction serves as a sufficient deterrent to market power abuse.

In those convergence mergers and activities which have passed regulatory scrutiny to date, regulators at the federal and state level have drawn from the various structural, behavioral or regulatory devices available and have tailored the conditions of their regulatory approvals to the specifics of each case.

CECA believes regulators and policymakers might consider in the future a dual track approach to market power concerns in convergence mergers. The first track would establish a set of prescribed conditions which, if met, would promise expeditious approval. The second track would be reserved for hard cases or those instances in which the merger candidates seek


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modification in the pre-approved conditions. If a fast track mechanism is employed, regulators should consider also providing for a post-review “true-up” mechanism to build back in structural, behavioral, or regulatory controls if deemed necessary to correct for unanticipated inimical market consequences or consumer impacts.

Whether or not a fast track or case-by-case path is followed, CECA recommends that regulators should provide market participants with a complaint process to raise concerns about anti-competitive behavior. CECA recommends that regulators also examine carefully how certain regulatory actions or policies could, in turn, become entry barriers to the marketplace.

In determining the market power of a company seeking to enter into a specific market, CECA recommends that regulators examine the core business of each party in determining which party is the incumbent and which party is the new entrant to that market.

CECA recommends that the companies engaged in mergers and convergence activities themselves be involved in setting and being responsible for the mileposts in which the success or failure of such convergence mergers and activities will be judged.

C. Consumer Impacts of Convergence Recommendations on the consumer impacts of convergence are necessarily built upon the assumption that a workably competitive market for essential services exists. CECA believes that competition promotes economic efficiency, new products, technological and market innovation, lower prices, and better customer service. Therefore, the recommendations in this section must be viewed in tandem with the recommendations found above in “Market Power Issues.” A competitive market, in and of itself, is not enough to ensure that consumers are protected from market abuses such as deceptive marketing practices and the misuse of personal information. Moreover, CECA believes that the smooth functioning of the market is dependent on proactive public policies concerning customer information, metering and billing, consumer education, and a “Consumer Bill of Rights.” These policies are not meant to dictate market conditions, but rather to structure the market for maximum consumer confidence and participation. Finally, the market has a difficult time in valuing externalities, such as low-income assistance and environmental impact, that are in the public interest to support. CECA has made recommendations in this section on how to continue support for universal service and other public interest objectives in a convergence market. CECA recommends that a “Consumer Bill of Rights” be developed by state agencies with guidance from federal regulatory bodies such as the Federal Trade Commission. The “Consumer Bill of Rights” should provide consumer information and protection as consumers purchase essential services, particularly as a bundled package. The “Consumer Bill of Rights” should be widely publicized and distributed to every consumer. CECA recommends that the “Consumer Bill of Rights” focus on current and future marketing activities of essential services, with a particular focus on packaging and bundling of those services. The “Consumer Bill of Rights” should include but not be limited to: 1) a summary of current consumer protection laws outlining the rights of consumers in regard to buying essential services; 2) guidelines for buying bundled packages of essential services; 3) a summary of dispute resolution options; and 4) a summary of information disclosure requirements and privacy rules. The ”Consumer Bill of Rights” should be concise and user-friendly.


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In order to ensure that small business and residential consumers are able to compete effectively for the best rates on individual and packaged services, CECA recommends that efforts to facilitate aggregation should be encouraged by local and state officials for all small business and residential consumers residing in areas of retail competition. The Federal government should preempt the right of states to prohibit aggregation by any qualified party, and states should not impose costs or other barriers on aggregation. Aggregation will allow small business and residential customers to exercise market power. Government entities – non-profit or cooperative organizations – should be permitted to aggregate small customers. Aggregation could be offered to default customers, low-income customers, or any other set or subset of the residential and small commercial classes. CECA recommends that consumers should be entitled, but not be forced, to buy essential services such as gas, electricity, or telecommunications as part of a bundled offering. The purchase of one service should not be conditioned upon or tied to the purchase of other services. A la carte offerings of any given essential service should be available. On the other hand, consumers should be provided an opportunity to buy essential single utility services from one or more providers on a bundled or an unbundled basis. For example, with electric service, consumers should be able to buy the different components of that service – transmission, distribution, and generation – from the same company or different companies offering those elements of basic service. Furthermore, consumers should be able to purchase basic service at reasonably affordable rates. Consumers should not be forced or coerced into buying services that they do not want or need. Policies to promote fair marketing and prevent fraud should be both reactive and proactive. Oversight agencies should develop guidelines, rules, and standards for marketing and advertising at the point of sale and should conduct studies to ascertain the state of marketing and sales practices. For example, an aggressive anti-slamming program should be conducted. This would include implementing procedures such as third party verification for preventing slamming (changing service providers without the written permission of the customer). At the same time, consumer protection agencies in the states, which could include public utility commissions, should have the authority and resources to obtain lists periodically of customers from service providers and conduct random samples of those customers to ascertain whether customers have the services and the service providers that they expected. These agencies should also have enforcement authority and a dispute resolution process, as discussed. Companies should be required to provide 800 number services and notification of dispute procedures. The lead state consumer protection agency should also have a centralized dispute handling service. Policies to protect consumers from unfair or rapid loss of service during the adjudication process must be in place. CECA recommends that the federal government immediately develop a “hand-off” policy and mechanism to ensure the timely delivery of consumer complaints to the relevant state agency in charge of complaints. In turn, the relevant state agency should be required to collect records of consumer complaints and transmit that data in aggregate to the relevant federal agency. CECA believes that a new dispute resolution mechanism is needed to resolve disputes between consumers and marketers of a bundled package of essential services. To reduce the costs of dispute resolution, the dispute resolution mechanism could incorporate alternative dispute resolution (ADR) methods, e.g., using an arbitrator initially rather than sole reliance on the


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courts. Consumers should be entitled to representation in these disputes by state consumer advocates or other legal representatives. But this process ought not supplant the opportunity for consumers to get their complaints resolved by a consumer protection agency first. CECA recommends a “one stop” approach to dispute resolution, meaning that consumers should be able to resolve a dispute involving a bundled package of services at one location. Consumers will need a place to go for dispute resolution because relying on courts will be ineffective and inefficient. CECA does not want consumers to be put in a situation that requires them to go to three different locations in order to resolve a dispute over various services provided by a converged utility. CECA recommends that provisions for dispute resolution be as local as possible. CECA recommends that existing consumer protection laws should be vigilantly enforced in regard to the marketing of a bundled package of essential services. As part of any transition to competition, CECA believes that state public utility commissions, in addition to the state attorney general’s offices, state consumer advocate’s offices, and other existing authorities, should be responsible, through rulemaking, for the promulgation and enforcement of utility-related consumer protection laws. After a competitive market for any given essential service has been established, an assessment of the future role, if any, of the state public utility commission in regard to consumer protection should be made. In the long-term and in a competitive market, some believe that divided authority to oversee and enforce consumer protection might be less effective. Others believe that State PUCs should have licensing and consumer protection authority to provide customers with a regulatory dispute resolution process and to permit regulators to weed out bad actors through license suspension or revocation. Within this framework, State Attorney General offices would bring civil enforcement action in State court, seeking civil remedies like damages and injunctive relief. State PUCs and State Consumer Advocate offices should have the resources to hire and train personnel to address consumer concerns and to investigate consumer complaints. Though some overlap may occur during the initial transition to a competitive, converged marketplace, states should work to avoid duplication between public utility commissions and states attorneys general’s responsibilities. Currently different agencies handle consumer complaints – the attorneys general’s offices pursue matters in the courts, while other offices handle non-litigious disputes like shut-offs or billing complaints. In some cases, which process and agency are appropriate for a specific dispute is clear-cut. Allegations of fraud are referred to the attorney general’s office, while complaints about interruption of service are referred to the PUCs. From the consumer perspective, however, resolution of billing disputes in a converged marketplace quickly becomes confusing, as consumers may have to approach different state agencies for charges on a single, bundled bill. In the interest of consumers, states should make efforts to consolidate and clarify recourse for consumers in the converging marketplace, as part of a broader move towards “one stop shopping” for consumers. Consumers are increasingly concerned about the privacy and security of personal information being disseminated for marketing purposes. The bundling together and selling of many essential services as a package could exacerbate people’s fears about how personal information will be used in a convergence market. Dissemination of information about billing, payment history, and consumption patterns must be under the control of the customer. To the extent that exchange of such information is necessary for efficient billing, it should be made available to the parties with whom the customer has contracted for service.


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CECA recommends that the “Fair Information Practice Principles,” developed by the Federal Trade Commission and other government agencies, be applied to the marketing of essential services. The principles are the following: 1) Notice/Awareness – companies should be required to provide consumers notice of their information practices; 2) Choice/Consent – a requirement to offer consumers choices as to how personal information is used beyond the use for which the information was provided for; 3) Access/Participation – a requirement to offer consumers reasonable access to that information and an opportunity to correct inaccuracies; 4) Integrity/Security – a requirement to take reasonable steps to protect the security and integrity of that information; and 5) Enforcement/Redress. CECA recommends that marketers adopt and disseminate a privacy statement on the company’s information practices in regard to the collection, use, and dissemination of personal customer information. CECA recommends an opt-in approach to the release of certain personal account information, whereby consumers would indicate their acceptance of the release of personal information through written authorization. With the restructuring of the electricity markets, some states have required that all retail electricity marketers use a succinct and uniform “label” on electricity bills and promotional materials. Moreover, consumers will be expected to enter into a contract in a competitive market. These labels would include such information as: contract price; basic contract terms; a baseline, regional system default label depicting certain types of emissions of pollutants; justification for any special marketing claims such as “green power”; and fuel mix. CECA is on record as supporting such labels. CECA has recommended that all retail electricity merchants disclose in a standardized format the price, source, and emission profiles of their power. CECA believes that billing clarity and disclosure are important: to enable consumers to make informed and intelligent choices regarding products and services; to educate consumers about rates and charges that may apply on a recurring or one-time basis for each product and service selected; to allow consumers to differentiate the various carrier charges which may appear on their bill; to allow consumers to challenge, in a proper and timely fashion, charges which may be subject to dispute; to enable consumers to identify fraud, such as cramming or instances of slamming, and to address such concerns to both regulatory and industry representatives; to provide for the availability of rate comparisons with marginal transaction costs to the consumer; to identify the costs and benefits associated with a particular product or service, thereby enhancing product value and customer satisfaction; and to differentiate credible carriers from fraudulent carriers. CECA recommends that consumers have the ability to compare basic service options – basic electric, natural gas, local and long distance telephone service – even when bundled together as a menu of options. With a multiplicity of retail service providers offering a multiplicity of promotional claims and products, CECA believes it is essential that state and federal regulators ensure access to comprehensible information from credible sources in a standardized format. Metering and billing services provided to residential and small business consumers represent a convergence point to the end-user. Consumers will increasingly be offered a menu of options for


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the supply of gas, electric, telecommunications, etc., which will mean that consumers will get one bill for a variety of services traditionally provided by a regulated local distribution company. Terms of delivery of bills and billing information should be stipulated by local and state officials. This should include frequency of billing and notice, information and billing detail, format and language requirements. CECA recommends that onerous restrictions (high transaction costs) be avoided for consumers to opt-in or opt-out of a package. Customers must be protected against abusive marketing practices. Federal and state regulations should explicitly outlaw slamming and other fraudulent or abusive marketing practices (unauthorized upgrade of services, pressure tactics, bait and switch tactics, negative options, etc.) Policymakers should enact rules regarding notification of changes in service and the language requirements for such notification. They should set standards for information included in marketing materials. Furthermore, policymakers must prevent a range of marketing practices – slamming, cramming, false billing, fraud in advertising or labeling, unfair collection practices, pressure tactics, and redlining. In a competitive market, consumers should have the opportunity, within certain bounds, to select the means of metering service, to choose the actual metering devices employed, and to have some input on the bill format. CECA recommends that metering and billing services be considered to be competitive and, unless there is good cause, should not be restricted to any one local distribution company. CECA recommends that, following instruction, consumers be allowed, but not required, to read their own meters. Consumers who choose to do so would be required to read their meters within designated time limits. Price and quality information that is understood by and useful to residential customers must be developed and must go beyond mere reliance on the marketplace, especially during the transition period. There are four steps to conducting a successful consumer education campaign. First, the regulators must encourage the development of materials to enable consumers to make effective choices. Initially, consumers should be educated about competition. They must be made aware that new decisions are coming. Consumers must be provided information on price, quality, and features that facilitate comparisons across providers. Apples to apples comparisons are in the public interest, whereas apples to oranges comparisons will make it difficult for consumers to make intelligent choices. Second, outreach efforts should be conducted by state public utility commissions and/or distribution utilities. These should rely on general advertising as well as community-based efforts. Third, each provider should be required to prepare a plan for consumer education. The plan should cover materials, outreach, and monitoring. Fourth, the effects of education efforts should be monitored. Surveys to assess the extent of consumer knowledge and the best means to improve areas of weakness should be conducted. Audits of company efforts should also be carried out. To ensure that convergence benefits all consumer classes, CECA recommends that public and private funds be made available to educate consumers on how the market for convergence of essential services is structured, to educate consumers about how to choose wisely, and to educate consumers on their rights in regard to purchasing essential services. CECA recommends that consumer education on restructuring begin immediately, and that education on convergence begin as soon as convergence services are permitted to be offered by suppliers in a given region.


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CECA believes that consumer education will create a context for change, give small business and residential consumers a voice in the debate around how the new market is structured, and give consumers the tools to make a choice which benefits them and their families. The cornerstone of consumer protection is consumer sovereignty. The ability of consumers to exercise informed choices in the marketplace is essential to the efficient functioning of a market. CECA believes that informed consumers making informed choices drive competitive markets, and that public policy should be pro-competition and pro-consumer. A slight, short-term chilling of innovation may be acceptable in exchange for better-educated consumers. Given the fact that the marketing of gas, electricity, and communications represents essential commodities, and that the vast majority of consumers have access to and rely on these commodities, CECA recommends that universal service – traditionally defined as widespread, easy access to essential commodities or “lifeline services,” at an affordable price – be provided for as the markets for these commodities overlap and converge with one another. CECA believes that universal service should remain a fundamental right of all citizens. Delivering these services under a competitive model on the supply-side does not change its fundamental demand-side characteristics as necessities. Therefore, the broad range of protections for utility services must be preserved. Specific issues that arise in this area include application, credit, deposit, disconnection, collection, dispute resolution, and partial payment. Under no circumstance should convergence diminish any customer’s access to lifeline services or protections in accessing lifeline services. CECA believes that universal service requirements should be technology-neutral. Distributed generation and wireless services, for example, in addition to other emerging and future technologies, may provide economical, reliable, low-impact alternatives for utilities required to serve rural and hard-to-reach customers, provided that safety, maintenance, and quality of the service is not diminished.

D. Regulatory Restructuring of Convergence

As industries converge, a fundamental mission of regulation is to assure that regulatory policy furthers customer choice in former monopoly markets and does not diminish customer choice in all competitive markets, and for regulatory actions directed at one market not to ultimately diminish customer choice in another market. Sound restructuring measures undertaken to further competition are likely to further convergence. CECA recommends disfavoring arrangements providing exclusive access to facilities that are genuinely unique and crucial to the provision of an essential service. Bottleneck facilities, once clearly identified as such, should operate on a nondiscriminatory basis to the extent possible to assure that all buyers of goods and services in the former monopoly markets that were controlled by bottleneck facilities are able to have access to all providers of the services for which they are willing to pay. Regulators should create a streamlined review process that balances consumer protection with the need for timely acceptance or rejection of innovations. Technological advances will play an ever increasing role in the economic viability of the nation and in the lives of consumers. Appropriate levels of governmental review can act to stabilize a market, for example by ensuring


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proper safety for consumers. However, an overload of regulations independently established by the fifty states and the federal government would act to slow technology research and commercialization, thus having a deleterious impact on consumers and the economy. CECA recommends that state, federal, and industry decision makers should acknowledge the need for standardization of certain policy and business rules that facilitate the emergence of competitive markets. CECA recommends further that, while such state/regional/federal collaborative review and regulation should be established initially by permitting states wide latitude to take a leadership role, the federal government, in recognition of the increasing implications to interstate commerce created by the emergence of retail competition, should have supremacy in settling conflicts between state, regional, and federal standards. Policymakers should identify which policies, consumer protections, and rules for businesses will be most critical to enhancing consumer benefits in emerging competitive markets. Convergence, CECA believes, will be a largely adaptive response to both technological and policy change. CECA believes further that convergence will result in significant consumer benefits, and that public policy officials should remove impediments that would obstruct the path to convergence. It is critical that public policy official simultaneously maintain appropriate consumer protections. Companies subject to rate regulation while also selling competitive services will have an incentive to classify costs so that they are recovered as part of their regulated costs, allowing them to undercharge for the competitive services – in other words, have the regulated service cross-subsidize the competitive service. While regulators have been confronted with such problems since the inception of regulation, these cross-subsidy problems will become more difficult with convergence. Regulators have approached this problem with both behavioral and structural remedies. The behavioral approach waits for bad behavior and then corrects it, possibly with severe penalties. The structural approach adopts a “structure” for the operation of markets that eliminates the incentive for bad behavior. Allowing triple damages for price fixing is an example of the behavioral approach. Under the structural approach, incumbent network companies might be prohibited from offering products and services that would provide an incentive for the network company to distort competition. The breakup of AT&T was such a structural approach. Public ownership is also a structural solution. The behavioral approach has been adopted by FERC for gas pipelines that have affiliated gas marketers. If the pipeline abuses its obligation to provide nondiscriminatory network services to independent marketers and such abuse is discovered, the pipeline could be penalized. The application of the behavioral/structural approach also depends on the degree of market power of the incumbent. While the case for incumbents distorting markets by favoring their own services is strongest when the network is needed to deliver an essential commodity, many have raised concerns about incumbents’ ability to distort competition even when network services are not necessarily part of the delivery mechanism for services. CECA recommends that a safeguard be adopted similar to the rule used for telecommunications. A regulated company (including its affiliates) with strong market power should only be permitted to sell competitive services within its service territory if it has first met stringent standards for nondiscriminatory access to third party new entrants. A corollary to this principle is


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that a regulated company with little or no market power over services should be permitted to sell services other than its core business services in competition with independent new entrants. For example, an incumbent electricity company should be allowed to sell electricity within its service territory only if there is open nondiscriminatory access for other suppliers of electricity. However, the same electricity company that sells telecommunications services should be considered as a new entrant. CECA recommends that if the presence of competitive affiliates does create market power concerns, conditions imposed on merger approvals should not differ from those ultimately imposed on comparable businesses, which are not involved in merger proceedings. In establishing policy, regulators must ensure:

Relative fairness between customer classes in both cost and quality of service;

Nondiscrimination within customer classes – similarly situated customers must

be treated similarly – and vigilantly enforced prohibitions against redlining; Subsidies, taxes, and fees should be explicit in policy and purpose.

CECA supports a continuation of policies that would ensure that the needs of low-income people for energy, telecommunications, and other essential services are met. We also acknowledge that the current mechanisms for meeting such needs under traditional utility regulation must be changed to minimize distortions created by such policies in a more open, competitive market. Policy officials should recognize the distortive effects of asymmetric imposition of such requirements on network industries and rectify such distortions. The goal should be to transition to policies and approaches similar to competitive industries, without losing the safety net for at-risk consumers. During the transition, mechanisms should be used to ameliorate the distortive effects of social policies, without losing benefits for low-income consumers and other at-risk groups. It should be noted that policies, such as the federal telecommunications universal service fund, which is “paid for” by carriers on a proportional basis, rather than being supported solely by the incumbent carrier, provide fair, symmetrical choice by basing universal service fund contributions or other social benefit funds on a basis proportional to a particular network provider’s income (or other standard revenue measurement). Incumbent network utilities have been granted certain assets as part of the implementation of the monopoly model, e.g., rights-of-way, customer information, exclusive service territories, etc. Some of these assets can be very valuable in a competitive choice environment. Similar issues arise when seeking the right balance between encouraging entry into the new market and either being fair to the incumbent or ensuring that such encouragement results in efficient decision making on the part of the consumer. CECA recommends that regulated network companies should not be permitted to use “utility assets” to gain competitive advantage in newly opened markets. Rather, mechanisms should be sought that monetize the value of the asset and make it available on an open access basis, e.g. auction or lease to the highest bidder, with appropriate compensation provided to the incumbent to give sufficient incentives to engage in such behavior.


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Some regulatory schemes impose burdens on one technology or competitor that are not imposed on others. Such differential imposition of burdens, or regulatory asymmetry can distort the playing field. Convergence and competition between and within the energy and telecommunications industries has the potential to magnify these distortions. CECA recommends the adoption of an economic standard that requires no increase in market power. Regulators attempt to use methods of redistribution that minimize the distortion to the ongoing operation of markets. It would, for example, be less of a distortion of market efficiency to require, as a condition of a convergence merger involving an electric utility, a lump sum contribution to the development of renewable generation than to require a certain percentage of all generation be out-of-market renewables. At the same time, the economic standard must provide fair treatment to stakeholders in the utility segment of the merged activity: Assets utilized by utility firms to provide converged services should be priced at

fair rates that fully recover all applicable costs and are recorded on the books of the utility as income subject to utility regulation. Such assets should be available for purchase by all interested competitors/companies on a nondiscriminatory basis and be provided by the utility under its designation as a common carrier.

Access to rights-of-way owned by utility companies should be offered without

discrimination under tariff on a first come, first served basis. At least for a transition period, a utility choosing to enter a new market on a

converged basis should be permitted to do so only as a separate subsidiary conducting transactions with the utility company on an arms-length basis.

Traditional public utility regulation by state commissions began around the turn of the 20th century. While there are important differences among commissions—some commissioners are elected, others appointed—the way that today’s commissions carry out their responsibilities for regulating public utilities has been remarkably stable for the last half century, at least until the movement toward reform began in earnest in the last decade. Industry restructuring changes this in fundamental ways and market adaptations such as convergence require even more flexible responses. The report examines how convergence might affect and be affected by: how state commissions are organized; how they make decisions; what processes they use to regulate; and what resources they need to address the massive challenge before them.

Historically, many commissions organized their staff and resources into industry “silos” – staffs were typically organized into gas, electric, and telecommunications sections or divisions, with little or no discussion among the silos. Many commissions have begun to adopt matrix management techniques to deal with the historical silo problem and have begun to organize staff around cross-cutting areas such as customer service, accounting and finance, administration, legal, and, sometimes, research or policy offices.


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CECA recommends that state public service commissions acknowledge that fundamental changes in substantive policy, market structure, and technology require a searching inquiry into how they should be organized to meet future demands and challenges. They should continue to accelerate the trend toward integrated decision making for network industries. Integrated decision making would require that commissions reorganize staff and adopt procedural schedules that coordinate gas, electric, and telecommunications policymaking. While it may be necessary to retain some staff organized by industry, some staff should be organized by functions of regulation across industries, not by industry silos. For example, the same staff might deal with affiliate problems for all regulated industries. Additionally, commissioners should be especially responsive and sympathetic to arguments that traditional organization, process, and procedure are impeding industry adjustment to new economic and technological realities. Commissions should indicate a willingness to change in order to accommodate new forces and realities. CECA recommends that policymakers examine transferring regulatory authority over converging markets to other state agencies, leaving it at state public utility commissions, or creating a dual system, in which regulatory control is vested in state commissions and state attorneys general, who could use their existing consumer protection and anti-trust authority to bring civil actions for damages and injunctive relief against market participants where necessary. Linked to the organizational issues are the processes that commissions use to make policy and decide cases. Current processes are well attuned to the needs of a closed monopoly system. CECA recommends that state public service commissions, consumer advocates, PUC Commissioners and Staff continue to adopt new processes and procedures that are tailored to the customer choice model. These procedures should promote more rapid, less expensive, generic decision making and should be particularly sensitive to the procedural burden on new entrants, while still recognizing the need for consumer protection measures in the new markets. At a time when significant investment should be made in intellectual capital, PUC budgets are under ever tighter constraints. At this critical time of dramatic transition for vital industries, governors and legislators should give special consideration to the magnitude of these challenges when making decisions regarding state commissions and representatives of consumers. While some believe that restructuring is “deregulation” and therefore requires either lower budgets or less attention to the needs of commissions for highly qualified personnel, the opposite is true, at least for the next decade and possibly longer. Implementing a scheme that achieves the right integration of competition and regulation is actually a more complex and time-intensive intellectual and political undertaking than traditional regulation. Training will be necessary in the short-term for staff, commissioners, and consumer advocates. Since regional integration and, increasingly, national integration is more important than in the past, increased travel expenditures may be necessary for the transition. Given the fundamental changes in regulatory philosophy taking place simultaneously across different network industries, CECA recommends that governors and legislatures should give increased and enlightened attention to the needs of state commissions as fundamental managers of these changes when making decisions on appointments to regulatory commissions and when setting the budgets and salaries of commissioners and staff. The same considerations should govern the staffing and budgets of state funded utility consumer advocates for the transition from the monopoly model to the competitive model. The budgets of commissions and the salaries of commissioners, staff, and consumer advocates should, first of all, support the acquisition and


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recruitment of appropriate personnel, the retention of staff, and the cross-industry training of staff. A reallocation of budget dollars and staff training may be sufficient to accommodate this recommendation, but it should be recognized that often a short-term increase in budgets will be necessary to meet the difficult transitional challenges of the next decade. CECA believes that National Association of Regulatory Utility Commissioners and National Association of State Utility Consumer Advocates should take a leadership role in encouraging state commissions to work cooperatively to develop model regulations and coordinate decision making on a regional basis. CECA recommends that the federal government take a stronger leadership role in analyzing comprehensively the implications of state restructuring and convergence and in establishing a program for working cooperatively with states and consumer representatives. The federal government should establish a better understanding of the need for states to work together in an integrated manner, so that consumers can achieve the advantages of restructuring and convergence, while minimizing impediments to interstate commerce. We strongly encourage the exploration of the potential advantages of regional cooperation or integration to develop more symmetrical network policies among states. At the federal level there exists some degree of silo-based decision making. The Federal Energy Regulatory Commission (FERC) sets gas and oil pipeline and electric policies. The Federal Communications Commission sets telecommunications polices. The Department of Energy has responsibility over energy policy and the Department of Commerce has responsibility over telecommunications policy. At the state level, nearly all state commissions set not only gas, electric, and telecommunications policies, but water and sewer policies as well. It is CECA’s belief that, increasingly, policy will have to be set as “network” policy in order to achieve the benefits of restructuring and convergence. Thus greater attention should be given to the organization of these issues by the federal government with an eye toward integrated decision making. Ultimately, we could envision the responsibility for network policy residing in a single agency or department. While some initial steps have been taken by federal agencies to coordinate their efforts, they should identify further opportunities to work together in areas where federal energy and communications regulation have begun to overlap. CECA recommends that DOE, DOC, FERC, and the FCC provide greater leadership on issues relating to organization and cooperation on issues relating to network restructuring and convergence.

VIII. CONCLUSIONS AND RECOMMENDATIONS

The challenge of adopting policies that move our society from the monopoly model of network regulation to the choice model is a daunting, difficult, and in many ways a thankless task. Yet for better or worse, that is the enterprise in which we are engaged. Convergence, we believe, will be a largely adaptive response to both technological and policy change. We believe it could result in significant consumer benefits. We believe that public policy officials should shore up consumer protections, while removing impediments to a competitive marketplace. In general, we believe that there are significant substantive and process changes that must be considered and adopted. Fortunately, many of the recommendations and conclusions we reach are completely compatible with the movement toward reliance on market forces.


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Additional chapters and appendices in the Final Report provide a detailed history and background of utility economics and a convergence-specific overview of the telecommunications industry. CECA has completed and included case studies of convergent activity in the marketplace.


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PART ONE: INTRODUCTION TO THE CECA CONVERGENCE

FORUM

I. INTRODUCTION TO CONVERGENCE: A POWERFUL EMERGENT ECONOMIC FORCE

Recent and ongoing changes in the energy and information industries are transforming the ways in which essential services such as gas, heat, illumination, Internet, telephone, home security, cable, and electricity will be produced, distributed, and selected by Americans. Waves of regulatory liberalization and a series of mergers, acquisitions, joint ventures, and strategic alliances are blurring the lines dividing the traditional public utilities. Electric companies are offering telecommunications services. Natural gas companies are merging with electric companies. Cable companies are merging with telephone companies. Technologies in these industries overlap one another, compete with one another, and are becoming combined in new ways.1 Many have suggested that information technology and convergence among network industries may produce social, economic, and technological changes as profound and pervasive as those produced by the Industrial Revolution.

The dramatic transformation of all these industries has been popularly referred to as “convergence.” The term, however, has different meanings within different industries. “Convergence” has been used to describe networked appliances in “smart” houses. The energy industry talks of “Btu Convergence,” or the ability of a firm to assure the delivery of a unit of energy to end-users who are cost-conscious, risk-averse, and indifferent to the actual source of the energy. The energy industry also uses the term to describe efforts to utilize its fiber optic capacity – over 20 percent of the nation’s total network – to offer telecommunications services. The telecommunications industry first referred to convergence as the bringing together of cable services and telephony. One discussion of convergence in the information industry lists seven different types of convergence – payload, protocol, physical, device, application, technology, organizational.2 Speaking broadly, convergence refers to the merging of business activities within and among network industries, such as telephone, Internet, electricity, cable, and gas.

However one chooses to define the term, convergence is already having a profound effect upon the market. As evidenced by the profusion of “convergence” stories in the popular press, once distinct and disparate industries are combining rapidly and in some surprising ways. For the purposes of the Consumer Energy Council of America's (CECA) Convergence Forum, we will focus upon convergence activities that involve one or more historically regulated firms or industries. Convergence has not happened overnight – a unique confluence of factors such as technological innovation, changes in the economics of the affected industries, and regulatory reform have driven convergence ahead in recent years. The post-convergence firm may become an entirely new business model based on competition rather than regulation, the integration of new and old

1 Jenkins, Dave, “Technological Innovation Spurs New Forms of Convergence,” Electric Co-op Today, June 5,

1998, pp. 2 2 3Comm, 1998.


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technologies, and, in some cases, a different industry structure, which moves from vertical integration to a horizontal model organized around functional activities. Convergence between the electric, natural gas, and telecommunications industries brings together the largest industries in the world, combining over $500 billion in annual revenue and approximately a trillion dollars in capital. Convergence will affect every sector of our society. There needs to be a clearer understanding of why industries are converging and what these changes will mean for the members of our society, especially small business and residential consumers who depend upon the essential services provided by these network industries.

II. THE CECA CONVERGENCE FORUM

A. Why Convergence Matters Recognizing that there are many types of convergence, the CECA Convergence Forum is particularly interested in convergence of the energy and telecommunications industries given the following considerations: The history of price regulation of these industries as monopolies;

The fact that these industries are increasingly subject to market pricing and

competition;

The possibility of the same company offering regulated and unregulated services;

The need of regulatory change to effectively oversee convergence of these industries;

The essential nature of the “lifeline” services provided by these industries;

The capital intensive, infrastructure characteristics of these industries; and

The network nature of the industries themselves.

Like any major transformation, there will be benefits and pitfalls associated with convergence. On the one hand, new services might be offered, prices might decrease through economies of scale or scope, and convergence might lead to new, life-enhancing technologies being integrated into homes and businesses. On the other hand, convergence might result in unregulated monopolies, curtailment of services, increased prices, and the expenditure of a vast amount of capital unproductively chasing the chimera of convergence.

Given the size and nature of the industries involved in convergence, and the number of consumers potentially affected, the Forum recognizes that there are substantial public policy questions which must be addressed with the convergence of the energy and telecommunications industries to ensure that competitive markets develop smoothly and that all consumer classes benefit equitably from the changes in the market for essential services.


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B. Origin of the Convergence Forum To respond to the fast-moving changes in the market for essential services resulting from the ongoing convergence of the network industries, CECA convened the Convergence Forum. Comprised of over 60 of the nation’s leaders in the field, the Forum met over the course of a year to develop recommendations regarding the business, public policy, and consumer implications of convergence. This report embodies those recommendations. The CECA Convergence Forum report is intended to facilitate informed decision making by addressing several key audiences: industry leaders now struggling to define business strategy; public interest advocates trying to protect the interests of small business and residential consumers; and policymakers at the state and federal levels charged with overseeing these industries.

C. Goals and Objectives of the Forum

1. The Purpose of the Project The purpose of the CECA Convergence Forum is to take a comprehensive, long-term view in crafting public policy that facilitates a market for convergence which is pro-competition and pro-consumer. The public policy developed by the CECA Convergence Forum is intended to balance the interests of market participants (incumbents and new entrants), regulators, and consumers, particularly small business and residential consumers. Convergence between network industries represents a new frontier. Rapid and revolutionary changes in technology and a movement toward deregulation have made the convergence phenomenon possible. In CECA’s view, convergence is one of the most exciting developments in the utility industry, and it has created both the potential for immense benefit or harm to consumers, depending on how policy decisions are made today. The CECA Convergence Forum is convening at a time of great fluidity and upheaval in the market for essential services. Increasingly, the retail markets for telephony, data, cable, electricity, and natural gas are being opened to the forces of competition. CECA believes, all things being equal, that competitive markets are superior to regulated markets for dispensing goods and services. If restructuring of these industries is done properly, competition could benefit all consumer classes. Convergence between the energy and telecommunications industries could be a promising answer to the transitional problems now being experienced as these industries move towards competition. CECA envisions that convergence could significantly lower costs and prices, introduce a whole array of new products and services, and greatly increase the chance of establishing a workably competitive market. On the other hand, if not handled properly, convergence could also lead to consolidation without competition, higher prices and fewer options, and confused and angry consumers with little understanding of the changes taking place. Consideration of convergence involves many of the issues being debated in regard to restructuring and competition, e.g., market power concerns, state, and federal jurisdictional questions, consumer impacts, etc. The overlapping element of convergence adds a whole new level of complexity, with stakeholders having to learn new vocabularies, new regulatory regimes, and new ways of thinking.


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Moreover, convergence raises entirely new questions for policymakers. For instance, what are a consumer’s rights regarding bundled service offerings? If a dispute occurs over a phone charge, can the customer’s electricity be shut off? Given that convergence is only possible because of technological innovation, how should public R&D funds be spent to foster the transition to converged services? How should regulatory bodies be structured when traditional industry lines are becoming blurred? The greatest challenge faced by the CECA Convergence Forum was to recognize the uniqueness of convergence, to question the very premises that have governed the public utility sectors for decades, and to craft appropriate policy responses that might ultimately mean an entirely new regulatory structure. The ultimate goal for all of the participants of the CECA Convergence Forum is to ensure that consumers benefit from the rapid changes taking place in the market for essential services. 2. Goals and Objectives of the CECA Convergence Forum CECA brought together 60 national leaders representing the public and private sectors for a year of intensive discussions in order to: 1) Increase awareness and understanding of the convergence occurring between the energy and telecommunications industries; 2) Analyze the consumer impacts of convergence, especially small business and residential consumers; and 3) Make recommendations to policymakers at the state and federal levels of government to ensure that small business and residential consumers benefit from the convergence between the energy and telecommunications industries. If policymakers address the issues presented in this report and incorporate the recommendations made, CECA believes that convergence should be allowed to occur. It should be encouraged through new regulatory structures and incentives, if the proposed recommendations are adopted. CECA further believes that convergence will help to establish workably competitive markets – as providers offer bundled services to consumers, consumers otherwise resistant to switching providers are likely to switch more often and more aggressively. Specifically, CECA recommends that policymakers incorporate two objectives to guide their decision making: Policymakers should ensure that convergence is promoted where the potential for

consumer benefits exists. Policymakers should ensure that benefits from convergence accrue to small

business and residential consumers, as well as to other classes of customers.

III. STRUCTURE OF THE REPORT

Because the effect of convergence upon the market will be profound and the interactions among industries, consumers, and market drivers increasingly complex, the CECA Convergence Forum report covers several areas – technological drivers of convergence, the economics of convergence, consumer impacts of convergence, market power issues in convergence, and regulatory oversight of convergence activity.


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Part One: Introduction to the CECA Convergence Forum, concludes with “IV. Background Issues of Utility Convergence,” which provides a brief introduction to the trends in network industries that are making convergence possible. This section includes some brief examples of recent convergence activities. For more detailed examples, please refer to the attached case studies in Part Five: Case Studies. Part Two: Discussion of the Issues is organized into the following chapters:

A. Smart Homes and Offices of the Future: The Technological Drivers of Convergence The immense technological potential of convergence should be considered first, as new technologies are making convergence possible and driving the process ahead. Given the pervasive nature of the affected network industries and the essential nature of the services they provide, convergence may force dramatic changes in many daily activities. This chapter examines the imagined and prevailing technologies driving convergence and describes several possible outcomes from the evolutionary to the revolutionary.

B. The Market Power Issue The powerful supply-side economic forces behind the transformation of so much economic activity will require policymakers to understand and, perhaps, to direct the changes in the market. Regulators must anticipate that market power may increase as a result of convergence, and that increased market power may lead to abuses of consumers. On the other hand, given how difficult it has been early on to induce competition in the markets for local telephone service, electricity, and cable, convergence could mean more competitors for the provision of individual services. In the utility industry, where markets have been regulated, decision makers must be able to determine – or establish means to ensure – that the public interest will be furthered by convergence. This chapter outlines proposals for capturing and preserving the benefits of convergence, while minimizing the potential costs of convergence.

C. Consumer Impacts of Convergence Industry policies toward consumers and consumer behavior in a converged marketplace are central to the ultimate success or failure of convergence. Consumer reaction in the marketplace will dictate the course of convergence, and consumer impacts will elicit reactions from regulators and policymakers. This chapter presents a “Consumer Bill of Rights” to be overseen by regulators and is designed to provide consumers with the necessary protections while allowing convergence activity to move forward as rapidly as possible. This chapter also addresses: a self-regulatory model for converging industries, government oversight issues, and the transactional costs of new business models.

D. Regulatory Restructuring and Convergence Convergence is promoted by and may further complicate the deregulation and restructuring of utility network industries. This chapter describes the process of regulation at the state and federal levels and identifies current and potential regulatory barriers to convergence. In addition to examining the array of regulatory issues under discussion by policymakers creating restructuring legislation, this chapter addresses convergence-specific regulatory issues such as creating markets, universal service, customer information, cross subsidies, metering and billing, rights-of-way, and treatment of affiliates.


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Part Three: Recommendations offers policy and decision-making recommendations in the following areas:

I. Smart Homes and Offices of the Future: The Technological Drivers of Convergence

II. Market Power Issues

III. Consumer Impacts of Convergence

IV. Regulatory Restructuring and Convergence

IV. BACKGROUND ISSUES OF UTILITY CONVERGENCE

A. The Underlying Forces of Change Although the subject of this report is convergence as it is occurring in and being applied to the utility sector, the concept has its origins in the computer and telecommunications industries. Because the economics of the computer/telecommunications industry are different from the economics of the energy utilities, it is important to understand that the causes of convergence likewise differ among industries. Four distinct forces are creating convergent trends in the energy utility industry – information technology, energy utility economics, deregulation, and consumer demand in the information and energy industries. 1. Information Technology Technologically, the information revolution is at the core of the convergence phenomenon in all of these industries. Digitization3 of all forms of communications “is” convergence in the communications industry, and it is a driver of convergence in other industries. Digitization has been around for some time, but the huge expansion in computing capacity has made digitization increasingly relevant to convergence, as it is now possible to move and store vast quantities of information more efficiently and more quickly than ever before.4 The physical ability to move and store information has been supported by a dramatic increase in programming abilities. The development and implementation of new computer applications makes it possible to utilize the immense capacity of computers more effectively. An important development stemming from the advance in computer hardware and software is the decentralization of information intelligence. The ability to distribute intelligence at various

3 See Section IV. Background Issues of Utility Convergence in this report: “Engineers use the term digital to refer to information representations in which both time and the value being measured move in discrete steps. Thus the process of representing information in binary form, a discrete measure commonly seen as the numbers zero and one, is known as digitization. Although this term is often used to describe the conversion of any type of information to binary, the name digitization refers specifically to the process of converting some quantity, which may be continuous, to a representation that is discrete.”

4 Yoffie, David, B., “CHESS and Competing in the Age of Digital Convergence,” Competing in the Age of Digital Convegence, 1997.


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points in the information network allows the development of new business models and radically new approaches to functionality. On both the supply-side and the demand-side of the market, information technology becomes an enabling technology. The ability to store and manipulate information has enhanced this ability to match supply and demand over larger distances involving more parties. The ability to manage highly complex systems that require real-time decisions, and the ability to move electricity over longer distances has broadened the scope of system design.

The emergence of full-fledged retail and wholesale wheeling (through the establishment of a power pool and numerous types of supporting contractual arrangements) in the electricity market will require enormous amounts of data to be captured, processed, and made available to buyers and sellers of power. As transmission traffic becomes more complex, with many buyers and suppliers making hourly deals, unprecedented scheduling and control of the power flow will be required.5 Distributing the control of information farther out into the network, thereby breaking down the consumption of energy into more granular components of demand, also affects the willingness and ability of consumers to engage in decision making.

Some residential customers and small commercial accounts may want (if not need) high-concept energy management services like on-line customized billing, remote appliance scheduling and control, and appliance energy-usage monitoring. Experiments in providing such services are underway in Walnut Creek, California (a joint venture with PG&E, cable operator TeleCommunications Inc., and Microsoft Corp.), and in Laredo, Texas (a pilot run by Central and South West). Central and South West’s subsidiary, CSW Communications, intends to offer demand-side management services through the network, including automated meter reading, customer messaging, in-home bill estimates, and remote customer billing. It will offer the remaining network capacity to service providers, extending telephony, video, data, and other information services.6 2. Market Drivers Recent, significant changes appear to be moving the utility industry in a direction similar to that taken by the computer and telecommunications sectors. 5 Weiner, Michael, and Nitin Turner, Amanda Hickman, Huard Smith, “Value Networks--The Future of the U.S.

Electric Utility Industry,” Sloan Management Review, Summer 1997, p. 27. 6 Ibid, p. 28.

In “The Next Convergence: Energy, Telecommunications,” (Fortnightly, March 15, 1997, pp. 24.), Vinod K. Dar states:

Each will be empowered by cyberspace retailing to summon all the information needed to analyze and select energy products and services; scroll through and peruse electronic catalogs; solicit, compare, and accept offers; negotiate directly on the screen; record an order for a service or package of services; choose the invoicing format, pricing structure, and payment method; instruct that charges be made to a desired credit or debit card (perhaps an affinity group card from a telecommunications, consumer retailing, or personal financial services company); and enter his or her speech recognition password into the automated and interactive customer service system of the preferred Net merchant.


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First, utilities have reached the limits of economies of scope, and the economic advantages of large, central station power plants enjoyed in the post-war era are gone.7 Changes in generation technology and improvements in transmission economics have contributed to this change.8 Advances in the technology of combined cycle and turbine generation, the declining price of natural gas, faster installation of new capacity, and lower capital requirements have made the technology of choice today small, gas-fired facilities.9 The fact that gas is the fuel of choice creates an immediate interest in convergence between gas and electricity. The preference for gas is, itself, the result of favorable economic developments, and technological progress has supported a continuous increase in estimates of the resource base. Improvements in storage and transport make this larger resource cheaper and easier to deliver.

If the source fuel for electricity is going to be gas and the end-uses remain competitive, the idea of integrating the businesses becomes economically more attractive.10 Economies in purchasing, coordination, transportation, management of demand, and economies in billing (transaction costs) provide potential economic advantages that make “combined” utilities more attractive than ever. General interest in all decentralized technologies is growing, as is particular interest in substituting demand management at the point of purchase for the production of electricity at the point of supply. Whether energy utilities will be subject to the rapid growth in end-user products that the information/telecommunications industry has experienced in the past decade is still uncertain but seems unlikely. Telecommunications has experienced a dramatic growth in products delivered over the traditional infrastructure, including services like call waiting and caller ID. The deployment of second lines into residences to support Internet access will likely represent a very large area of growth in a very high margin product. Telecommunications has also experienced a phenomenal growth of a whole new medium – wireless communications. This service fulfills a new demand, mobile communications, and it has proven immensely popular. Wireless now has approximately 70 million accounts, while 7 Weiner, 1997. 8 Yeager. Kurt E., “Technology: Triggering Structural Change,” Electric Perspectives, January/February 1994,

pp. 23-29. Stahlkopf, Karl E., “Convergence of Utility Services: Technological Challenges and Opportunities,” Electricity Journal, July 1997.

9 Linden, Henry R., “Operational, Technological and Economic Drivers for Convergence of the Electric Power and Gas Industries,” Electricity Journal, May 1997.

10 Burr, Michael T., “Converging Strategies,” Independent Energy, January/February 1998, pp. 18-22.

Burr, p. 19, notes the trend in the international market, where fuel and power projects converge:

Power and fuel infrastructure projects are more frequently being developed in tandem, one supporting and justifying the other… A few fuel companies have historically been leaders in the global independent power business. In recent years, their counterparts around the world have taken a greater interest in developing the power end of the energy chain. This is a logical extension of their fuel marketing strategy, as well as their development strategy.


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wireline has about 165 million. Wireline growth has not slowed, yet a whole new industry has grown up beside it. In the energy sector, new technologies, such as those focused on distributed energy, hold similar promise.

3. Deregulation Regulatory developments inside and outside the affected industries have contributed to the trend toward convergence as well. The Energy Policy Act of 1992 unleashed a flurry of entrepreneurial activity in the generating sector, and many new entities have demonstrated their ability to produce low-cost power. This, in turn, whetted the appetite of large industrial customers interested in purchasing independent power, and willing buyers and sellers representing large economic entities have created the strong movement to restructure the energy utility industry. Faced with changes, considerable pressure has been placed on utilities to adapt. Vertically integrated, monopoly utilities run the risk of being picked apart on the supply-side by non-utility sources of supply and on the demand-side by marketers targeting high volume customers. Even after the tough transitional problems of stranded costs and “codes of conduct” are resolved, the utilities must identify a business model that will allow them to survive. Convergence may be a means for leveraging their remaining assets – distribution plant, relationships to customers, rights-of-way, and potential economies of scope – to become new business entities. Regulatory restructuring in the telecommunications industry is also aiding the transformation. The removal of barriers to entry into local telephony opens another potential market that is both a potential end-user service and a key component of convergent activities. Telecommunications is not only a service that is sold directly to the public. It is used to sell other services or to enhance the productivity of delivering traditional services. Energy utilities are now able to enter the telecommunications business at either the level of wholesale supplier (by renting fiber optic networks to telecommunications companies) or at the level of retail supplier (by becoming a telephone or cable company). Energy utilities may use telecommunications to improve their basic business (of selling energy), or they may become involved in all levels of the telecom business. Deregulation not only opens possibilities, but also creates economic edicts that compel action. Segments of the industry that are actually exposed to competition may experience severe pressures on margins, while substantial assets may be stranded by the introduction of competition. Stranded costs in the electric utility industry and “take or pay” obligations in the natural gas industry come to mind. However, such examples have not been limited to the gas and electric industries. In the decade after the break up of the national telephone monopoly, AT&T and its offspring took restructuring charges and write-offs of over $60 billion (split almost equally between local and long distance segments). In the same period, IBM, suffering through transition from a mainframe to a PC/mini-based computer industry, took restructuring charges and write-offs of over $30 billion. Certain assets held by certain companies will become devalued in the restructuring/convergence process, and market conditions will determine which companies are affected. Some argue that


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generation will be an unfriendly commodity market, but others argue that “commoditization” will take place in other parts of the industry.

Micro-unbundling could cede ownership of the customer gateway to unregulated marketers, allowing suppliers to provide telecommunications, Internet and other services. That is where the energy services industry will make most of its money under restructuring, some say, since commodities will sell strictly on price and carry thinner margins.11

The complex and potent interaction of technological, economic, and regulatory forces is transforming industries. Convergence may be too narrow or too broad a concept to apply in some cases, but it describes the unique and fundamental change that is taking place. In this report, the discussion moves from technology, through economics, and finally to regulation.

4. Consumer Demand Convergence activity is also increasingly driven by consumer demand which, in turn, serves as a driver for the development of new technologies and products. This is especially true regarding information technologies and new web applications to bring bundled services to consumers.

We’re seeing that users are driving innovation, and the power in the marketplace is shifting from supply to demand … from providers to users.12

A recent study by Forrester Research confirms this trend. A survey of Internet users found that of all the factors that cause them to return to the same web site more than once, availability and quality of content were ranked first by respondents.13 The same could be said of a consumer’s perceived value of a bundled package of services. What services are being offered? Can I trust the supplier of those services and thus the quality of the products that they are offering? While much of the consumer demand for bundled service offerings is currently generated by large customers, i.e., a fast food restaurant with many outlets, all consumers expect to have more products available more quickly. This insatiable demand for new products and the need for product differentiation to distinguish one provider from another will continue to grow as a driver in the retail market for essential services. Moreover, when individuals are finding it increasingly difficult to juggle the demands of work and home, the convenience offered by paying one bill and having one company take care of the supply of essential services, often at a substantial discount, will be a very powerful driver of convergence.

B. The Overall Concept of Convergence Based on a preliminary review of the literature, we conclude that in general the concept of convergence refers to the joining of two or more previously unrelated economic activities in order to improve the efficiency of the firm through changes in the production process, organizational forms, or market structures. 11 Hoag, John C., and Joseph F. Schuler, “Oasis… (pt/cpt),” Public Utilities Fortnightly, November 1, 1996,

pp. 32-36. 12 “Unclogging the Broadband Pipeline,” Prepared Remarks of Jonathan B. Sallet, Chief Policy Counsel, MCI

Communications Corporation, at the Economic Strategy Institute, April 20, 1998. 13 “Factors Driving Repeat Visitors to Websites,” Forrester Research, 1999.


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For the purposes of the CECA analysis we add a number of additional stipulations that narrow the scope of the analysis and focus it on utility convergence, with “utility” traditionally meaning a regulated provider of essential services over a distribution network. The convergence activities of primary concern to the Convergence Forum involve joining activities in two or more industries where at least one of the activities, products, or services is provided by a network industry traditionally subject to economic regulation, and where the joining of activities has, or may have, an impact on the price, quality, or nature of the regulated service or of other goods or services provided to the consumer. Several observations about this definition are in order. First, it is important to place the firm at the center of the definition of convergence because it is only when convergence becomes important or compelling to economic actors in our society that it begins to matter a great deal.14 A good review of the concept of convergence begins with philosophers and scientists thinking about convergence over half a century ago. The roots of the idea can be traced back to H.G. Wells’ concept of the “world brain.” Those conceptual roots are interesting, but it is only in the past few decades that the concept has taken on profound economic significance. Convergence has been affecting the computer industry dramatically for 20 years, the telecommunications industry for a decade, and the energy utility industry for a couple of years. 15

The onset of the age of convergence in the information industry began in 1981, when the partnership of Microsoft and IBM embedded an operating system into the personal computer. In 1985, when home computers were first listed as a consumer electronic product, they accounted for about eight percent of that category and were about one-sixth the size of the TV product

14 Gaines, Brian R., “The Learning Curves Underlying Convergence,” Technological Forecasting and Social

Change.

Gaines, pp. 30-31. Much of the socio-economic impact of information technology has arisen not through research, development, and product planning targeted on that impact but rather from the serendipitous application of technologies developed for very specific technical purposes to much more widely based social needs… Governments and the computer communications industries have only come to recognize the socio-economic importance of convergence as consumers have come to make technology substitutions that cross traditional market sectors, for example, the substitution of electronic mail for postal and telephone services, the substitution of electronic journal and magazines for paper-based equivalents, the substitution of digital telephony through the Internet for conventional telephone services.

15 Gaines, p. 8.

Our contemporary encyclopedias are still in the coach-and-horses phase of development, rather than in the phase of the automobile and the aeroplane. Encyclopedic enterprise has not kept pace with material progress. These observers realize that the modern facilities of transport, radio, photographic reproduction and so forth are rendering practicable a much more fully succinct and accessible assembly of facts and ideas than was ever possible before.


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market. By 1996, home computers accounted for one-third of consumer electronics and were about 50 percent larger than TV products. By 1996 the digitization of the telecommunications network had passed the halfway point – with more miles of local loop served by digital equipment than analog. Local revenues from non-basic services (which would be driven by sales of services like call waiting) grew from about four percent of revenue in 1986 to about 20 percent in 1996. In the energy utility industry, convergence activity is not yet identifiable in the revenue stream, but it can be seen in organizational changes. The literature indicates almost 200 mergers or joint ventures that are considered part of the “convergence” process. It is also useful to keep in mind the motivations for convergence. The purpose of convergence from the firm point of view is to improve or maintain

long-term profitability.

Consumers benefit from convergence to the extent that their needs are met at lower cost (broadly defined) or with higher quality through, in part, advancements in technology.

The effect of convergence from a societal point of view is to strengthen the

economy.

The interests of the firm, consumers, and society frequently coincide, but occasionally they diverge or come into conflict.

Third, long-term goals must be promoted, because any major shift of business strategy or structure is likely to result in short-term costs. Just as most mergers are “dilutive” of stock value for a few years, transforming economic activity through convergence may be dilutive of profits in the short term. Fourth, convergence is a matter of degree. The term has often been used to describe rather minor changes or fairly routine types of economic and business action. Convergence would not have attracted so much attention if it did not represent significant changes in the way goods and services are produced, sold, and distributed to consumers – all changes that are bound to affect the efficiency of the firm. Finally, the requirement that at least one of the firms is regulated is an important one for the present analysis. The industries that the Convergence Forum is examining – gas, electric, telecommunications, and cable – historically have been composed of firms that are monopolies with close to 100 percent market share in their local service territories. Regulators and legislatures are restructuring these industries, and competition is being introduced at the wholesale and retail levels. It is important to have reasonable assurance that these restructured markets will be effectively competitive during and after the transition to competition. The need


13

for such assurance is heightened in cases in which goods or services viewed as essential are to be provided by an unregulated market rather than by a regulated monopoly.16 Because regulatory and policy concerns act as triggers, convergence behavior may be facilitated by or inhibited by organizational forms, market structures, and government regulations.

C. Examples of Convergence Activity (See Also Attached Case Studies)

So many different activities are now described as “convergence” that the concept may be in danger of becoming too general to be useful for analyzing economic behavior, improving management decision making, or informing the debate about public policy. A remarkably broad range of phenomena appears under the rubric of convergence. All of the following have been called convergence: A simple horizontal merger (one firm buys out its next door neighbor),17

Spreading out price risk and taking equity positions across the energy industry in an

effort to offer fuel contracts that bundle together energy services for sale to customers simply interested in buying the cheapest Btu of energy,18

Digitization of all forms of information (the multi-media, information superhighway),19

The integration of radically different physical phenomena in one network (the intermingling of electrons and bits).20

This array of activities referred to as convergence represents a very complex economic reality. Consider the following example, which is probably familiar to all involved in the energy utility market. Several energy utilities are entering joint ventures with telecommunications companies to provide cable TV or telephone service.21 The description of those activities frequently (but not always) claims that the convergence is driven by the fact that the energy utilities have rights-of-way that can be used to deploy fiber optic cables.22 In some cases, the fiber is already deployed 16 There are, of course, other essential markets, (e.g., food). What distinguishes convergence is that convergence

activities, generally made possible by deregulation, are central to the development of new markets and new market structures. We have little ability, however, to predict precisely how new markets develop.

17 Stahlkopf, 1997. 18 Burr, Michael, “Converging Strategies,” Independent Energy, January/February 1998. 19 Dar, 1997. 20 Nortel’s “Power Line Technology” promises to carry both and is currently being tested in Europe. 21 Stahlkopf:

About 85 electric utilities have established or are planning to offer telecommunications services, using their own private communications networks. Electric and gas companies own a total of 600,000 miles of high-capacity fiber-optic cable, now employed mainly for their own control purposes, but with excess capacity that could easily be used to provide telephone, data or video services to retail customers. Utilities involved in this trend range from such giants as American Electric Power and Duke Power to the small Otter Tail Power Co. of Fergus Falls, Minnesota. (See also the Montana Power Case Study, on p. 111 of this report.)

22 Fenn, p. 3.


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but is underutilized. The joint provision of rights-of-way and the use of high capacity fiber constitutes economies of scale based on capacity utilization in the transportation link of the value chain.23 In some cases, but not all, the convergence proposes to use the information network that will be shared between the energy utility and the telecommunications service providers to deliver interactive, load management type energy services.24 This is an economy of scope that is built on a substitution in the production activity. Two different products will be sold and information is being substituted for energy. Descriptions of such joint ventures frequently note that the energy utility has an installed base of customers who are accessible to the billing system.25 This suggests economies of scale in distribution. Depending on how the marketing is conducted, it may constitute an economy of scope through bundling.26

Texas Utilities bought a minority interest in PrimeCo Personal Communications LP, a Dallas-based consortium of NYNEX, Bell Atlantic, Airtouch, and USWEST owning eleven new federal licenses to operate wireless markets in Texas. In return, PrimeCo gained use of Texas Utilities tower sites… What the utility brings to the wireless company is that they have the right-of-way and siting.

23 Dar and Weiner apply the value chain concept to utilities. 24 Kennedy, p. 2.

Distributed energy control devices located in the utility’s distribution plant on the customer’s premises can be applied to produce three primary actions:

Lower utility operating costs Improve customer service Support new services which increase delivered value

Each of these end-use applications produces incremental positive cash flow with payback periods of less than two years prior to recognizing the cost of two-way communications channels. The real-time pricing, direct load management and automatic meter reading applications produce the largest flows because they are broadly applicable to most customers. Remote on/off outage location and meter tampering offer very attractive ROI if narrowly targeted.

25 Washington Post, “Interview with Henri-Claude Bailly,” August 3, 1998.

The big payoff will be in bundling, if you can use your bill-and-collection customer-care spine to bundle other services to these homeowners… telecommunications services, water services, cable services and other things. You use the same spine, the same core center, the same billing system. The winners in this business are not necessarily the existing electric utilities.

26 Kennedy, p.1.

For example, long distance telephone competition is focused on elaborate market segmentation and hundreds of differently priced calling plans. This is done to differentiate service offerings from the competition and mine the last ounce of profit margin in a narrow margin business. Execution of this strategy is possible because telecommunications technology has the capability to separately track and price each telephone call originated by each subscriber. Retail electric power competition will undoubtedly take a similar form. This is what is driving utility-linked home


15

The fact that these activities have been conducted as joint ventures may flow from regulatory structures which are triggered more by ownership rules than by underlying economic forces or relationships (that is, the rules may have outlived their rationale).27 Energy utilities could lease space on their existing rights-of-way, which are usually subject to tariff rules, thereby limiting the advantage that can be gained. Capturing economies of scale raises other regulatory issues. If electric ratepayers are bearing the full cost of the fiber, using excess capacity for a telecommunications business inevitably raises concerns about cross-subsidy, unfair competition, and inequitable treatment of ratepayers. If the energy utility/telco activity discussed above takes the form of a merger that entails horizontal concentration, it will be subject to substantial antitrust review.28 Because one of the firms engaged in the activity is subject to public utility commission regulation, the convergence activity will be subject to regulatory review. This will involve intrafirm review (to prevent cross-subsidy), and it may involve review of interfirm relations to address questions of interconnection. If joint marketing is involved, consumer protection issues may be raised. These diverse combinations have been observed in the marketplace which suggests two possibilities: 1) economic conditions are uncertain as to which activities make the most sense so companies are trying many alternatives; and 2) different firms have different competencies that they are leveraging.

automation projects at Southern California Edison, Hydro-Quebec, PSE&G, Central & South West Utilities and many other utilities… This process of aligning value chain elements to maintain competitiveness is not a one-way street where utilities reach out to the communications industry to fill technology voids. Increasingly, telecommunications services companies are reaching out to utilities to strengthen their competitive positions. Utilities generally possess superior local presence, field service, and engineering construction capabilities in comparison to telecommunications services companies. In addition, their customer service, information technology, billing, legal and regulatory capabilities may be attractive to some of the new telecommunications company entrants.

27 Van Haste, Clara, “Follow the money: Financial experts weigh in on cross-industry mergers,” Electrical World,

July 1996, p. 32.

Investment bankers point to other, more-specific reasons for the absence of cross-industry M&As. First, no one is sure how the company spawned by such a merger would be structured from a regulatory standpoint. “[Cross-industry] mergers muddy the waters in ways that people haven’t figured out how to deal with yet,” … Electric rates are still set by state regulators, and expense and profits from a business in another field would be impossible to plug into the formulas that the regulators use to calculate them. For utilities that are not affiliates of a holding company, all business dealings with the outside firm would also be scrutinized for possible cross-subsidies.

28 Fenn, p. 4.

“[B]undled services” would be marketed by merged megacompanies or “strategic alliances” of electric companies with telephone companies, cable companies, banks, insurance companies, airlines, and electronic security firms, based on access to the public rights-of-way that reach every American. Such trusts have been illegal under federal anti-trust law since the Great Depression. Tirellos and others are lobbying for repeal of anti-trust laws, such as the Public Utility Holding Company Act of 1935, to legalize such trusts among America’s largest corporations.


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In the information industry, participants are expressing a range of opinions as to which influences and trends are most significant. The only point of perfect consensus is that dramatic change is taking place. This is also true for the electric utility industry, in which participants are voicing widely differing opinions about where the economic future lies for convergence activity. There are two schools of thought:

Stick to your knitting. Find a radically new business model.29

One can also find multifarious views as to whether utility competencies can prevail in the horizontal competition that will take place along the value chain. Each main area in the value chain may support a different business model.

GENERATION Traditional commodity (input efficiency)

TRANSMISSION Regulated wires company

DISTRIBUTION Horizontal convergence

The discussion of convergence in the information industry places most emphasis on horizontal, cross-industry activity that stresses finding new users and uses through convergence in distribution activity. The utility industry, in turn, has identified this model as very promising for the distribution area of their industry. Central to both applications of the model is the ability to do more with the meter or the modem as the key point of contact with the consumer. While acknowledging the potential negative outcomes, many believe that the magnitude of potential gains is immense, which explains the intensity of attention that convergence is beginning to receive. An economic revolution is underway.

29 Van Haste, p. 31.

Some moneymen expect that electric utilities will participate in the convergence of the telecom and computer industries by snapping up telephone and cable companies so they can bundle their energy services with sexy new offerings such as Internet access, interactive home shopping, and movies on demand. Other dealmakers aren’t so sure that that will be the scenario. They say that electric utilities will and should avoid diversifying outside their core competencies, and that power companies would be better off restricting their technical and marketing efforts to what hey know best: offering services related to electricity.


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PART TWO: DISCUSSION OF THE ISSUES

V. SMART HOMES AND OFFICES OF THE FUTURE: THE TECHNOLOGICAL DRIVERS OF CONVERGENCE

Throughout history, innovations in technology have resulted in revolutionary improvements in the way the world lives, works, and communicates. In the last forty years, the development of information technology has had a major impact on the world’s economies. This phenomenon has been variously described as the Third Wave, the Digital Revolution, and the Information Economy. For the past 80 years, government has been active in encouraging the development of technologies to ensure widespread access to lifeline services such as electric, gas, water, and basic telecommunications services. Significant regulation and oversight of these industries has been designed to ensure the widest possible access to these services at competitive prices. Additionally, publicly funded research and development (R&D) has been created to advance cost reductions, environmental quality, and energy efficiency. Most recently, companies working to gain a competitive advantage have embarked on technology development activities that promise to “converge” the delivery of some or all of these lifeline services, as well as to make additional services, i.e., those not traditionally considered lifeline, more readily available. In the not too distant future, consumers – residential, commercial, and industrial – could be offered a wide array of services from companies that have historically sold only one product. For example, it is now possible for: Electric utilities to provide telecommunications over power lines; Telecommunications companies to provide wireless services that monitor and

remotely control heating, cooling, flood, and security alarm systems; Gas companies to provide Internet services that allow its customers to

automatically pay energy and other bills; Utilities to alert customers via voice or pager of a security alarm or to provide real

time video of your residence to your laptop computer; Any company to provide your home an individual fuel cell that generates

electricity and heat.

These examples illustrate “convergence.” This section will describe the key motivating factors behind and impacts of the convergence of the utility industries and is intended to: Provide an overview of the technology advancements that are catalysts of

convergence; Describe how these catalysts are shaping the future consumer marketplace; and Identify the critical issues and questions that must be addressed in the creation of

public policy that creates a positive convergence model for all consumers.

In our discussion, convergence is defined as joint activities in two industries where at least one of the activities, products, or services is provided by a network industry which is traditionally subject to economic regulation and which may have an impact on the price, quality or nature of


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the regulated service or of other goods or services provided to the consumer. In particular, convergence relates to the new potential for gas, electric, telecommunications, and cable products and services to be offered in conjunction with one another. The progressive restructuring of these industries from a traditional monopoly franchise structure to an unbundled, market-based structure has created an economically attractive opportunity for the development of technologies to support this bundling of services and products. Convergence includes not only activities occurring between the energy and telecommunications industries, but also the bundling of various services within the energy industry (i.e., gas and electric) or within the telecommunications industry (i.e., telephony and cable). It includes both conduit and network functions (e.g., using electric power wires to both transmit electrons and digital information). It is evidenced by a single company owning the wires and pipes in a given distribution area as well as owning the content and commodity functions, (e.g., selling both electrons and gas molecules and Internet services under a single billing agent). Due to the numerous variables in areas such as regulation, economics, information availability, and consumer demand, convergence remains difficult to envision. The “Potential Smart Home” below provides one conceptual view of how the convergence of technologies might result in improved services for consumers. The figure is a graphic depiction of how convergence is taking place today in the retailing of utility, information, and telecommunication services. Please

see the footnote below for definitions of terms.30 30 The following definitions are from “http://www.whatis.com/, October 20, 1999.

Potential Smart Home

Applications• Automatic meter

reading• Real time pricing• Time of use rates• Serivce

connect/disconnect• Tamper detection• Outage detection• To Billing System

Broadband HybridFiber Coaxial (HFC)

Network

Broadband

BroadbandAccess Controller

(MAC)

Modulator

Demodulator

VHF/Telephony

VHF/TelephonyMedia Access

Controller (MAC)

Low Earth OrbitLLEO

LLEO MediaAccess Controller

(MAC) Phonelines

Phonelines

TCP/IP

Radiotower

LLEOServiceProvider

WANBB RF

CommunicatioExchange

LAN

User interface

Security system

EntertainmentSystem

Refrigerator

Waterheater

AC or heat pump

HomeLAN

Meter

FuelCell

PowerGrid

Communication Exchange


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BB: (broadband) refers to telecommunication that provides multiple channels of data over a single communications medium, typically using some form of frequency or wave division multiplexing. HFC: (hybrid fiber coaxial cable) is a telecommunication technology in which fiber optic cable and coaxial cable are used in different portions of a network to carry broadband content (such as video, data, and voice). Typically, a local cable TV company might use fiber optic cable from the cable headend (distribution center) to serving nodes located close to business and residential users and from these nodes use coaxial cable to individual businesses and homes. An advantage of HFC is that some of the characteristics of fiber optic cable (high bandwidth and low noise and interference susceptibility) can be brought close to the user without having to replace the existing coaxial cable that is installed all the way to the home and business. IVR: (Interactive Voice Response) is a software application that accepts a combination of voice telephone input and touch-tone keypad selection and provides appropriate responses in the form of voice, fax, callback, e-mail and perhaps other media. IVR is usually part of a larger application that includes database access. LAN: (local area network) is a network of interconnected workstations sharing the resources of a single processor or server within a relatively small geographic area. Typically, this might be within the area of a small office building. However, FDDI extends a local area network over a much wider area. Usually, the server has applications and data storage that are shared in common by multiple workstation users. A local area network may serve as few as four or five users or, in the case of FDDI, may serve several thousand. The main LAN technologies are:

• Ethernet • Token ring • ARCNET • FDDI (Fiber Distributed Data Interface)

LEO: (Low Earth Orbit) A satellite system that employs a large fleet of "birds," each in a circular orbit at a constant altitude of a few hundred miles. The orbits take the satellites over, or nearly over, the geographic poles. Each revolution takes approximately 90 minutes to a few hours. The fleet is arranged in such a way that, from any point on the surface at any time, at least one satellite is on a line of sight. The entire system operates in a manner similar to the way a cellular telephone network functions. The main difference is that the transponders, or wireless receiver/transmitters, are moving rather than fixed, and are in space rather than on the earth. A well-designed LEO system makes it possible for anyone to access the Internet via wireless from any point on the planet, using an antenna no more sophisticated than old-fashioned television "rabbit ears." MAC: (Media Access Control) On a local area network (LAN) or other network, the MAC (Media Access Control) address is your computer's unique hardware number. (On an Ethernet LAN, it's the same as your Ethernet address.) When you're connected to the Internet from your computer (or host as the Internet protocol thinks of it), a correspondence table relates your IP address to your computer's physical (MAC) address on the LAN.

Modem Modulation and Demodulation: Any computer with an online or Internet connection includes a modem. This term is derived by combining the first three letters of the words modulator and demodulator. In a modem, the modulation process involves the conversion of the digital computer signals (high and low, or logic 1 and 0 states) to analog audio-frequency (AF) tones. Digital highs are converted to a tone having a certain constant pitch; digital lows are converted to a tone having a different constant pitch. These states alternate so rapidly that, if you listen to the output of a computer modem, it sounds like a hiss or roar. The demodulation process converts the audio tones back into digital signals that a computer can understand. directly. RF: (Radio Frequency) The term radio frequency (abbreviated RF, rf, or r.f.) refers to alternating current (AC) having characteristics such that, if the current is input to an antenna, an electromagnetic (EM) field is generated suitable for wireless broadcasting and/or communications. Many types of wireless devices make use of RF fields. Cordless and cellular telephones, radio and television broadcast stations, satellite communications systems, and two-way radio services all operate in the RF spectrum. Some wireless devices operate at IR or visible-light frequencies, whose electromagnetic wavelengths are shorter than those of RF fields. Examples include most television-set remote-control boxes, some cordless computer keyboards and mice, and a few wireless hi-fi stereo headsets. TCP/IP: (Transmission Control Protocol/Internet Protocol) is the basic communication language or protocol of the Internet. It can also be used as a communications protocol in the private networks called intranets and in extranets.


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A. Potential Convergence Outcomes

The nature of technological advances is such that no single outcome is absolutely certain to result. Thus it is useful to describe alternative utility industry outcomes that could occur as a result of convergence. We are, by no means, attempting to describe all of the possibilities, but rather to establish realistic boundaries for the range of practical outcomes. The following scenarios describe alternative futures, though the pace of each is clearly predicated upon the pace of development and convergence of technologies. 1. Evolutionary Outcome In this scenario, technology is assumed to advance at a constant or slightly decreasing rate as compared to the pace of change in the 1990s. Products and services are extensions of existing businesses and services. Characteristics of this scenario are as follows: Substantial consolidation of energy markets results in regional duopolies in

generation and distribution, and in retail services for gas, electricity, and water. Energy utility companies enter co-branding alliances or joint ventures with

telecommunications companies to maintain customer loyalty. In addition the energy firms will sell excess fiber capacity or rights-of-way to the telecommunications firms to generate additional new revenues.

Smart phones linked with appliances and home automation processor units via

wireless or wireline telecommunications services control energy metering, environmental control, lighting, audio-visual, security, flooding alert, and outage notification systems (including paging or calling homeowner at pre-set location and notifying utility company).

When you are set up with direct access to the Internet, your computer is provided with a copy of the TCP/IP program just as every other computer that you may send messages to or get information from also has a copy of TCP/IP. TCP/IP is a two-layered program. The higher layer, Transmission Control Protocol, manages the assembling of a message or file into smaller packets that are transmitted over the Internet and received by a TCP layer that reassembles the packets into the original message. The lower layer, Internet Protocol, handles the address part of each packet so that it gets to the right destination. Each gateway computer on the network checks this address to see where to forward the message. Even though some packets from the same message are routed differently than others, they'll be reassembled at the destination. TCP/IP uses the client/server model of communication in which a computer user (a client) requests and is provided a service (such as sending a Web page) by another computer (a server) in the network. TCP/IP communication is primarily point-to-point, meaning each communication is from one point (or host computer) in the network to another point or host computer. TCP/IP and the higher-level applications that use it are collectively said to be "connectionless" because each client request is considered a new request unrelated to any previous one (unlike ordinary phone conversations that require a dedicated connection for the call duration). VHF: (Very High Frequency) 30 MHz - 300 MHz WAN: (wide area network) is a geographically dispersed telecommunications network and the term distinguishes a broader telecommunication structure from a local area network (LAN). A wide area network may be privately owned or rented, but the term usually connotes the inclusion of public (shared user) networks. An intermediate form of network in terms of geography is a metropolitan area network (MAN).


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Consumers use the Internet to gain access to account usage, rate, and billing information and pay via electronic commerce applications. (This is similar to what is currently offered in the banking industry.)

2. Revolutionary Outcome In this scenario, technological breakthroughs occur in a manner that substantially increases the availability of information, products, and services provided by utility industry companies. Characteristics of this scenario are as follows: Consolidation within the energy market results in only a few large companies

with a national footprint in each of the areas of generation, distribution, and retail services.

In addition to very large, national companies, proliferation of niche applications,

with the number of small energy companies increasing, providing generation, distribution, and retail services to regional or local niches for customized purposes.

Energy companies merge with wireless, wireline, and satellite companies and

provide telecommunication services through a combination of existing telecommunication and electric power networks.

Energy companies acquire Internet Service Providers to leverage their

telecommunication networks and become Internet Portals. Consumers use Personal Digital Assistants to control home automation systems

remotely and to access the Internet for account information and to pay bills using a combination of wireless, wireline, and Internet technologies.

Consumers receive one statement electronically from the combined utility

company. Bills will be paid electronically either automatically or after the consumer approves them via the Internet.

Consumers receive telecommunications either through power networks or through

cable modems thus giving most individuals inexpensive access to the Internet via their television link.

3. Failure Scenarios Given the momentum of technological advances, few stakeholders doubt that changes will occur, though there is greater uncertainty as to when they will occur. Certainly, Moore’s Law31 reminds us of the accelerating rate of change in the power, speed, and capacity of computers. In a business world where technology has significantly lowered transaction costs, the use of and dependence upon computing technology will increase. The convergence of technologies in

31 Moore’s Law states that microprocessors double in computing power about every 18 months causing costs for a

given performance to fall by half.


22

support of this new business environment is driven, in large part, by an increased consumer demand for services that leverage these new technologies. However, could these dependencies on technology become vulnerabilities? The potential impact of a catastrophic event, one that results in widespread failures of computers or other technology-based services and products, might demonstrate an “over-reliance” on technology. For example, a severe natural disaster or technological bug could impede or even eliminate a service (possibly a lifeline service) or several interconnected services made possible through the convergence of technologies. As delivery and billing of converged services becomes more reliant upon the Internet, and as more systems become interdependent, reliability issues become increasingly complex. As evidenced by the February 2000 hacker attacks upon several of the largest e-commerce sites (Yahoo, CNN, eBay, Amazon, E-Trade, and others), the vulnerability of the Internet to remote attacks is only beginning to be tested.32 In either the case of a technological bug (or attack), or of a natural disaster, the partial or total loss of services is likely to be a relatively short-term event. The long-term impact of such an event might be a decline in consumer willingness to use the technologies. Consumers might choose to use the technologies less, not at all, or at the same level of use as before, but with a better understanding of the potential risks associated with that service or product. If the failure event were global in nature and of lengthy duration, it might result in a greater decrease in the rate of adoption of new technologies. Following this line of thought, a catastrophic event such as a global economic depression could have a more chilling effect upon both the adoption of new technology and the advancement of existing technology. Advances in technology are driven by the availability of funding for new research and development. During a depression such funds are less likely be available, and a depression will lower consumer spending, thereby reducing overall earnings of companies. This in turn will result in fewer monies being budgeted for research and development of new technologies for commercial applications. The downturn in the late 1990s of the economies of several Asian countries and the economic impact upon the rest of the world is clear evidence of a global economy. With so much of the global economic development dependent on technological development, it becomes critical for governments to implement policies that will encourage commercial research and development of advanced technologies and services, even during economic recessions.

32 “Attacks Leave Internet Denizens Wary,” Washington Post, February 10, 2000.


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B. Scalable Technologies

New technologies will continue to update, improve, and replace existing technologies. The following are examples of how advances in technology might affect consumers. 1. Fuel Cells Fuel cells promise to play a significant role in the future of transportation and of electric power generation and are expected to have tremendous influence in the electric utility industry. Fuel cell technology could allow consumers to have an individualized source of power (e.g., their own mini-power plant) at home or at the office. The underlying chemical process mixes hydrogen (either pure or made from fossil fuels such as natural gas, propane, gasoline, etc.) and air in the cell to produce electricity, water, and heat. Utility companies could install a system (probably the size of a dishwasher) in a private residence to provide the power for that residence. Although customers would still pay for the electricity, savings might be incurred over current rates. In mass production, the units are projected to cost from $3,000 to $5,000, with prices expected to decrease over time. Once widely accepted, individuals could expect to purchase these units at the local appliance store. As a form of distributed generation (which places the source of power closer to its recipient), fuel cells use energy inputs more efficiently. Transmission and distribution losses which normally account for losses of 7-8% are no longer a concern. For a source of backup power,

HOW CONSUMERS MAY REACT TO CONVERGED TECHNOLOGIES

One can anticipate that, initially, the number and variety of applications based on newlyconverged technologies will be much greater than consumer demand. Early adopters of theseapplications will be plagued by unexpected problems such as inconsistent quality and pooruser interfaces. Traditional routes for addressing product liability and lack of performance(e.g., customer service call centers and the legal system) may be less than satisfactory, due inpart to a lack of adequate experience with the technology within the industry and the legalsystem. Moreover, with the emphasis on using technology (e.g., Interactive Voice Responseand Internet sites) to respond to consumer complaints, this less personal touch could causeincreased consumer unease and displeasure with technology companies. During a period of minimal understanding of the technology, consumers will most likely turnto government bodies, both state and federal, to take an active role as a protector of theconsumer. This is particularly important with technologies that could cause significantproperty damage or injury to persons. This governmental role will most likely be reflected inregulations on the sales, advertising, packaging, billing, and redress procedures that newtechnology companies use. All of these will be driven by consumer demands in response toinitial problems that will occur in the introduction of new technology products. Interestingly,the increased speed and diversity of communication, which has been made possible throughadvances in technology, will make it possible for consumers to provide more frequent,detailed, and immediate feedback to service providers and government representatives. Thusadvanced technology will provide the conduit for consumer backlash against advancedtechnology.


24

consumers may elect to remain connected to their local power grid. If connected to the grid, consumers could then choose to sell excess power back to the local utility. Fuel cell technology has important implications for the automotive industry. Gasoline-powered automotive fuel cell systems could soon compete with the traditional internal combustion engine. Within the next decade, consumers will witness the manufacture of a high-performance electric vehicle offering clean emissions, a long utilization range, and fast refueling capabilities. Similar to batteries in size and shape, compact fuel cells could evolve to be the ideal replacement for internal combustion engines in both cars and buses. Several manufacturers are already producing hybrid vehicles, which combine fuel cell and traditional combustion engine technologies. 2. Gas Turbines Gas turbine technology was first utilized around 1930 for jet aircraft. Since then it has been used in numerous other applications including power plants. Efforts are now underway to develop the next generation of ultra-high efficiency natural gas turbine systems for electric power producers. In particular, development of smaller (40MW and less) plants is receiving increased attention. The gas turbine concept consists of a hollow tube with spinning fans at either end that are connected to each other by a shaft. The first fan – the compressor – sucks air in, forcing it into the center of the tube. Fuel is injected at the center and ignited. The burning compressed air-gas mixture expands forcefully and rushes out through the second fan – the turbine – at high speed, causing it to spin. In a power plant, this spinning turbine is used to drive an electric generator. Natural gas-fired, combined-cycle power plants use an efficient gas turbine to produce electricity – both from the spinning turbine and from the hot, relatively clean exhaust gases which generate steam for a conventional steam turbine and spin a second generator to produce more electricity. Today gas-fired power plants are a popular choice for new generation because natural gas is plentiful and the technology is relatively clean, cheap, and efficient. Overall efficiencies are at least 50 percent higher than those of modern coal or oil-fired plants. When compared to a modern coal plant with pollution control devices, combined-cycle gas-fired plants are smaller and cost less than half as much to build. In addition, they produce no solid waste, cut sulfur dioxide and particulate emissions by more than 99%, cut nitrogen oxide by more than 85 percent, and cut carbon dioxide by more than 50 % for the same amount of electricity produced. In the next five years, advanced technology turbines will represent the highest efficiency distributed power system available. Introductions of new turbine technologies will probably outpace fuel cells since the manufacturing and marketing infrastructure is already in place. When fuel cells become available, turbine/fuel cell plants are predicted to have around 80% efficiency. The availability of higher efficiency plants could double the rate of new cogeneration capacity. This could result in substantial annual energy savings and reduction of greenhouse gases. 3. Smart Homes and Buildings Smart homes and buildings are designed to give the consumer the ultimate level of automatic control, convenience, efficiency, and cost effectiveness in managing their environment. These control systems involve the integration of heating, cooling, and lighting management, fire detection, smoke control, smart fire panels, multi-functional sensors, building transport, fault


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detection and diagnosis, and the aggregation of multiple building loads with real time communication with energy providers or other service providers. The control systems could be designed to adjust automatically to meet the needs of each individual in the building, thereby providing better control of energy costs and more options to the consumer. Each individual might be issued special identification card or be recognized by a sophisticated video recognition system. The ID card would allow the smart home or building to monitor the individual’s location and to modulate systems, such as lighting and temperature control, in the vicinity of the individual. By using the lighting and heating and cooling systems only when a worker is present, the energy bill for the building is lowered. The implementation of the technologies could reduce smart building energy usage to half that of conventional buildings. The energy management system could be programmed to operate appliances at the lowest energy price, according to preset preferences. Additionally, the system could speak, e.g., to inform a potential burglar that they have been detected on the premises, and to send real-time video of intruders to a remote central security stations (e.g., the police). While the smart home has traditionally been designated as a hi-tech environment distinguished by its level of interactivity, Amory Lovins of the Rocky Mountain Institute, among others, has advocated a passive smart home, one that relies upon passive systems such as improved efficiencies, better materials, and fewer interactive systems to increase the comfort and efficiency of homes and buildings.33 4. Energy-Telecommunications Recent developments in technology could significantly reduce the cost of energy services for the consumer. For example, a technology capable of sending telecommunications over power lines is being developed. The technology involves superimposing high frequency waves carrying telecommunications onto the typical 60 hertz alternating current passing through the power grid. A special filter box is attached at the home to separate the high-frequency carrier wave, transform it into voice and data, and then send it to the phone, computer, or other devices. The technology has already been deployed in Europe where test cases and initial applications benefit from the advantages of a higher voltage system. Use of this technology in the United States will require the resolution of key issues such as distortion, noise, and the limitations of bandwidth on the low voltage US system, though several European and American companies are working to develop the service in the US. In the area of Transmission and Distribution, new technologies have made it possible for the widespread use of Geographic Information Systems (GIS), Automatic Meter Reading (AMR), and Mobile Data systems. These systems utilize telephone fiber and copper lines, radio, and cellular systems to transmit data to or from remote work sites. AMR systems can use existing phone lines in the home or attached radio transmitters to send a burst of energy-monitoring data to a central data warehousing location, which would eliminate the need to visit each individual meter to verify power usage. Mobile data and GIS systems allow utility companies to manage their field workforce more effectively by providing two-way communication and real-time location information. In the future, satellite communications may be available using Low Earth Orbit (LEO) satellite networks. The advantage of satellite networks is that they provide total coverage of a utility’s service region. This is important since many utility companies have service regions that include remote areas that do not have cellular coverage and are so remote that the installation of radio transmitters is economically infeasible.

33 Please visit the Rocky Mountain Institute’s website, www.rmi.org, for a list of Amory Lovins’ publications.


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The rapid change of multiple technologies will allow industries to converge in order to provide a greater variety of higher quality products and services to both business and residential consumers. The convergence of the technologies used by electric, gas, telecommunication, and possibly by other service providers, and the economic impacts of this convergence in light of the new information economy, may make utility companies the most capable to provide all of these services.

C. The Information Economy The business cycle of the earlier part of this century was one in tune with capital investment. Once capital was available, supply attempted to catch, or in some cases build, demand in an ongoing race that never ended. Supply periodically surpassed demand resulting in excess capacity and overstocked inventories until either demand grew to exceed supply, excess capacities, or inventories. This cycle was built upon a bricks and mortar economy that took five to ten years to complete the cycle.34 In the Information Economy, the swings between such excesses are greatly diminished because we have better data and analysis tools to anticipate and to dampen economic volatility. Like the Industrial and Agricultural Revolutions before it, the rise of the Information Economy will have a profound impact upon the way we live and work. Information technologies are creating new products, obsolescing others, and speeding technology breakthroughs in other areas such as medicine, transportation, and energy. Just as the invention of moveable type forever changed the relationship between people and their governments, the Information Economy will again change people’s relationship with their governments, but the most significant changes are likely to occur in the consumer’s relationship with business. There has been a quantum leap in the capabilities of business and industry to meet (and create) consumers’ various needs for products and services. Additionally, consumer use of information technology is increasing consumers’ access to product information, their ability to influence business, and ultimately affecting decisions on technology development. While the future may be uncertain, consensus is developing as to the causes of this great change. Understanding the fundamental drivers changing our economy as a whole provides a common ground for developing policy recommendations regarding technology convergence. (Please refer to Part Three, Section IX for specific recommendations for the development and management of convergence technologies.)

D. Technological Catalysts

1. Digitization One of the foremost technological advances of this century is the development of digital technology. Engineers use the term digital to refer to information representations in which both time and the value being measured move in discrete steps. Thus the process of representing information in binary form, a discrete measure commonly seen as the numbers zero and one, is known as digitization. Although this term is often used to describe the conversion of any type of information to binary, the name digitization refers specifically to the process of converting some quantity, which may be continuous, to a representation that is discrete. 34 Huber, Peter, Forbes, Dec 14, 1998, p. 136.


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Any type of information can now be digitized quite easily and cheaply. Once the information has been digitized, it can be transmitted and manipulated in ways limited only by human creativity. Therefore, digitization changes fundamentally how business and consumers interact. This is because: (1) digitization either enables some totally new capability or is much better than the one it replaces, and (2) the cost of the new system is reasonably low compared to people's ability to pay. This makes activities such as database marketing, telecommuting, predictive maintenance, and e-commerce feasible. It also blurs the line between perception and reality. Once something has been digitized it is virtually free to be duplicated, transmitted, and manipulated without loss of quality. 2. Bandwidth Bandwidth is a fundamental determinant of the speed at which information can be transmitted. The first major advance in transmission speeds came with the development of digital data transmission. Digital data transmission refers to a generic technology whereby the carrier accepts formatted data from the originating user, regenerates it, compresses it, and decompresses it before delivery to the final user. Compared to analog networks, digital networks are substantially faster and provide signals with significantly higher quality and less distortion. Moreover, digital transmission systems can provide more bandwidth than analog systems over the same access lines. It has become increasingly difficult for digital systems to increase their bandwidth at the same pace at which computing power is growing. Photonics, however, promises to enable bandwidth to increase at a pace similar to that of computing power. Photonics-based data transmission systems use pulses of light to carry data bits down hair-thin glass fibers. For most of the century data transmission has been the realm of the electron and not the photon due to the difficulty of manipulating light and the lack of appropriate materials for economically efficient uses. Now, applied quantum theory, tunable lasers, advanced materials science, and very fast electronics have resulted in the development of practical uses of photonics. The generic process of using light for the transmission of information involves converting electrical signals into optical pulses. Optical systems allow faster and less expensive data transmission than could be provided using electronic switches. At the current pace of development it is projected that prices cuts as high as 30% per annum may occur in photonic network equipment in the next decade.35 One reason for this reduction is the advances in optical transmission equipment used to minimize attenuation of signals and in wave division multiplexing have played a key role in increasing the capacity of fiber transmission systems.36 The Federal Communications Commission (FCC) predicts that the number of households accessing broadband service will more than double by the end of 2000 and quintuple by 2002.37 Some analysts further predict that by 2008, over 66% of all U.S. households could have high-speed data capacity.38 Indeed, an information infrastructure undertaking of this magnitude has not been seen since the construction of the nationwide telephone network in the early 1900s. Increased consumer, business and public access to the multitude of advanced broadband

35 Stuck, Bart, Telephony, Sept 21, 1998. 36 Wave division multiplexing is a method of simultaneously transmitting light of different colors using the same

fiber. This allows for greater transmission capacity. 37 "Technology and Trends," FCC News Release, February 5, 1999. 38 Goldman Sachs Research, cited in "How Much Room in the Fat Pipe?" The Washington Post, September 19, 1999, Page H1.


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communications products such as video-on-demand will depend on the development of a high-speed, digital infrastructure to support them. The new "fat pipes" will use existing cable, telephone, wireless technology and other conduits to connect directly to homes and businesses, often referred to as “the last mile”39 in industry parlance. Thus far, private companies have shouldered the burden of building the broadband network, with an eye towards the upside potential of broadband applications. While the actual size and scope of the market for broadband technology is uncertain due to its infancy, the market perceives these assets as having significant upside potential. Forrester Research, for example, expects U.S. broadband subscribership to grow from 1.5 million in 1999 to 26 million by 2003, and predicts that revenues from consumer broadband spending could reach as much as 9 billion in that year.7 The question of the terms of access to these new broadband networks, once they are built, is of interest to many stakeholders. Currently, owners of cable broadband infrastructure capable of providing high-speed last mile data services may partner with a single Internet Service Provider (ISP)8 to establish Internet9 access capability over the cable plant and may restrict access to their networks. In the telephony industry, some critics believe that local telephone companies, though considered common carriers and required by law to provide all independent ISPs10 with access to their networks, have in practice sought to delay competitive entry to their networks. In this unregulated environment, there is a very real concern that investment and competition may be delayed due to conflict (and, in some cases, litigation) over access to broadband capacity, asymmetric regulation,11 and the ability to provide the next generation of high-speed Internet services. The potential of a nationwide broadband network and all of its advanced capabilities brings together some of the largest communications concerns in the world as telephone, cable, satellite and wireless converge to transform the information superhighway into a high-speed communications vehicle delivering advanced Internet applications.12 For those who have access to the network, broadband technology promises to drastically alter and enhance the way people live their lives and how the nation’s business is conducted. Though broadband services are in the early stages of deployment and lag dial-up services in the Internet access market, some stakeholders have raised concerns over possible ill effects of current access conditions on consumers and the public at large. While it is difficult to substantiate these concerns due to the infancy of broadband deployment, they nevertheless arise

39 See APPENDIX F: GLOSSARY of TERMS for definition of “last mile.” 7“From Dial-Up to Broadband,” Forrester Research Report, April 1999, Pages 4 and 10. (http://som.csudh.edu/cis/lpress/471/links/bband/forrester%20broadband.pdf) 8 The term “Internet Service Provider” technically refers to those organizations that solely provide access to the Internet, and not content. There are a few Internet organizations, however, that do provide both online content and Internet access to subscribers (e.g., America Online). For purposes of simplicity, then, the term “ISP” is used throughout the Findings to refer to all types of Internet Service Providers, with the caveat that the great majority of ISPs do not provide content to subscribers. NOTE: As a regulatory matter, all of these entities are properly classified as ISPs. See APPENDIX F: GLOSSARY of TERMS for detailed definitions of subgroups of ISPs used throughout the Findings. 9 See APPENDIX F: GLOSSARY of TERMS for definition of “Internet,” as it is used throughout the Findings. 10 See APPENDIX F: GLOSSARY of TERMS for definition of “independent ISP.” 11 Some specific issues that relate to asymmetric regulation of the cable and telephone industries are discussed in more detail in Section VIII (C) below. 12 While DSL services currently include only high-speed data delivery, providers intend to eventually deliver video and other advanced technological products. For purposes of the Findings, therefore, DSL is considered broadband.


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from trends identified in recent studies both of Americans with and without access to the existing information infrastructure.13 As such, development of the new communications infrastructure brings forth many of the same policy concerns as the original telephone network did in the early part of the century. The following questions are representative of these concerns: Who should be connected and at what cost? Is the new information superhighway an essential service, like telephony, that all Americans should be able to access regardless of geographic or economic circumstances? Would a regulated access environment lead to a decline in private investment and a delay (or curtailment) in network construction? Should there be a national regulatory policy designed specifically to govern Internet access and other advanced technological applications? The underlying causes of the debate over broadband access need to be understood as well as broadband’s implications for policymakers, consumers, businesses, the general public, and other stakeholders. In addition, policymakers need to consider all relevant effects of a given broadband access policy, including economic, social, constitutional and other impacts. Moreover, broadband policies should be implemented with the goal of balancing the property rights of network infrastructure owners with the individual rights of citizens and civic society. 3. Artificial Intelligence Although Artificial Intelligence has been theorized since at least the fifties, it is only now becoming widely available in practical applications. This technology is based upon the concept that human intelligence is centered upon knowledge of particular problems. In other words, for a computer to think like a human, it must first possess the common sense or learned experience of a human (e.g., a cup holding a liquid should be held upright). Recent advances in Artificial Intelligence have focused on identifying the capabilities of human experts to resolve specific tasks and then using this information to develop expert computer systems that can accomplish similar tasks. Software agents will do work autonomously that previously was considered an innately human process. Applications have already crept into common use in business and government to perform critical tasks. However, these applications will continue to increase in power and ease of use. Software agents are used to engineer circuits for the global networks of major telecommunications companies, to process e-commerce transactions, and to patrol a Web site looking for signs of criminal behavior. Within the next five years it is feasible that the more easily adapted engineering professions (e.g., civil engineering) will be largely done by software agents. Since its inception, software has been primarily designed for manipulating information or accomplishing specifically designed tasks. Artificial Intelligence promises to offer software that can make complex decisions based on only the general direction of humans.

13 This phenomenon is commonly described as the so-called “information gap” or “digital divide,” described in more detail in the U.S. Department of Commerce (NTIA) Report, “Falling Through the Net: A Survey of the ‘Have Nots’ in Rural and Urban America,” July 1995. (http://www.ntia.doc.gov/ntiahome/fallingthru.html) The CECA Broadband Access Summit recognizes, however, that there are many factors that contribute to a digital divide, and broadband access policy may or may not be included among these.


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As it becomes more and more important to interact with a world reproduced in digital form, consumers may ultimately become dependent on a variety of smart agents to help meet their most basic needs.

E. Moore’s Law and Metcalf’s Law: The Two Pillars of Change Moore’s Law, named after Gordon Moore of Intel, states that microprocessors double in computing power about every 18 months, causing costs for a given performance to fall by half.40 The widespread application of powerful and inexpensive microprocessors has not only created new industries, but has changed the way almost all organizations do business. Major gains have been recognized in areas such as productivity, quality, environmental impact, and resource efficiency. More recently, Metcalf’s Law has shown itself to be a major driver of the new information economy. This law, named for Robert Metcalf, the inventor of the Ethernet, states that a network’s value grows in proportion to the number of users and information sources connected to it.41 This law is important in assessing a company’s competitive advantage. According to Metcalf’s law, any network has inherent “network” value in addition to the intrinsic “physical” value of its components. A company with an imbedded network (e.g., a detailed database of customers) has a competitive advantage over any company without a network or with a significantly smaller network. Thus businesses with existing networks as part of their current service or product lines are well positioned to be successful in the Information Economy by leveraging the consumers tied to that network. This is an important consideration in creating public policies that encourage a positive form of convergence. While Metcalf’s Law is at work in many businesses, the extent to which it manifests itself in certain situations (e.g., the utility and telecommunication industries) is not well-known and is still open for healthy debate. Consequently, the potential for cost savings by consumers and the extent to which companies could leverage these networks to exercise market power are uncertain. This creates a challenge and concern for convergence policy makers. While it easy to see examples of Moore’s and Metcalf’s Laws, one of their most important effects is less tangible. Taken together, these two laws significantly reduce transaction costs. Generally, transaction costs are the expenses incurred in buyers finding sellers, negotiating purchase conditions, and executing the transaction. In 1937, Ronald Coase first defined the broader economic importance of transaction costs in his article “The Nature of the Firm.” Coase pointed out that transaction costs have a major impact on the structure of firms, the types of products available, and the consumer experience. For example, Coase pointed out that large vertically integrated firms emerged as the dominant form of business largely because it was cheaper to transact business internally than on the open market. Since Moore’s and Metcalf’s Laws have significantly reduced transaction costs, organizations must reinvent themselves in accordance with this new economic reality. Structure designed on the old premise of high transaction costs and regional markets may prove to be obsolete. Just as the reality of transaction costs was a formative factor in the shape of firms and the marketplace, 40 Smith, Raymond, America’s Network, May 1, 1996, v. 100, no. 9, p8. 41 Huber, Ibid.


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the lack of transaction costs will be equally influential in the world consumers will face in the near future. Coase has pointed out that transaction costs have a major impact on the consumer experience. In earlier times, geographic distance was a major driver of transaction costs. Increased computer processor power and increasing bandwidth continue to make distance and political boundaries almost irrelevant to commerce. This effect is tremendously beneficial to consumers in terms of reduced prices and a wider selection of goods and services. The Coase economy emphasizes the strength of the network and related entities, and their combined impact on transaction costs. This is important in that economies of scale and a greater diversity of services can now be reached sooner, thus lowering the barriers to entry to new companies in a market. However, increased competition will often lead companies to make decisions that minimize production costs and total costs of sales. Where consumer power is low, e.g., in areas of little competition such as a rural community or in low-income areas, this can result in limited sets of services being offered. For example, where a bundle of services is sold, it could result in consumers having no choice but to purchase a set of services they do not desire in order to get the service they desire. This can be observed to an extent in how cable television services are sold in a package of multiple channels that must be bought in order to get one “premium” channel the consumer may want. What would be the effect of low consumer choice in local, toll, and long distance telecommunications? What if a power company packages cable and telephone services along with energy? Moreover, these services could have an undesirable degree of complexity but would be offered as a package in order to minimize the company’s costs. When companies that provide services based on converging technologies analyze the costs and the risks associated with installing redundant systems, these companies may be less likely to undertake additional capital investment once less importance is given to providing service at a higher level of reliability. In a business environment of lowered transaction costs where multiple competitors may enter into a market, companies may tend to invest the minimum into infrastructure while emphasizing more “customer facing” activities such as customer call centers and advertising. This reduced spending on capital projects could result in reduced capability to maintain service or to restore service during periods of peak demand or unplanned major equipment outages. The ability to decrease transaction costs and to redefine the most beneficial business structures presents a challenge for the utilities that deliver lifeline services and the regulatory bodies that oversee them. The business structures of these industries were codified in a regulatory framework that was designed to promote access to basic services while maintaining the affordability of these services. As measured by declines in the real price of retail electricity, this structure appears to have been highly successful until about 1970.42 Since 1970 the real price of retail electricity has slowly increased, but utilities, unlike other businesses, cannot arbitrarily change the way they do business. Regulators and legislators must be a part of changing the structure of these industries. Drawing from the experience of competitive industries, many are beginning to see a potential for consumers and, more generally, for society to benefit from changes in the current regulatory 42 EIA, Electric Power Annual, 1997.


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structure which would allow convergence to take place. Utilities see an opportunity to expand their product set, thereby increasing value for their shareholders. Others believe that reducing the costs of delivering these basic services will unlock the capability of utility companies to provide advanced and more desirable services to consumers, albeit with a loss of the market protection provided through regulation.

F. Important Drivers of Technological Convergence

1. Consumer Demand The evolution of the Information Economy has had a profound effect upon the relationship between the consumer and the provider. In the previous era, suppliers typically had much more information than their customers on the cost, functionality, and quality of a given product. In the Information Economy, this has changed. The ever-expanding availability of information and the increased ease of shipping have given consumers more power in deciding to purchase from a particular supplier. Access to information raises the level of consumer expectations of product and service providers. Rapid technological advances have increased both the speed and the capacity at which an industry or an individual business can expand capability while maintaining or decreasing production costs. As propinquity to customers becomes less important, the assumption that companies own their customers (for geographic reasons) has been eroded by a consumer driven economy in which businesses must work assiduously to attract customers rather than simply defending their customer base. Consumers will not pay for items, or for technological advances, that they do not value. Thus new products and services resulting from convergence will have to demonstrate a functional value that encourages a consumer to switch from the current product or service. So the question becomes: how can one spot the next FedEx and not the next Betamax videocassette? The answer in the short run will be a matter of value and cost. For example, immediately after a snowstorm that leaves twelve inches of snow, the value of a snowblower increases dramatically. Consequently, so does consumer demand for this article. Similarly, when there is a large storm that causes power outages for a few days, then the value of a home fuel cell will increase. If fuel cells are ready for deployment at that time, then consumer demand for them will likewise increase. The cost of a product or service is a function of the scale of production. Large investments of the size needed to develop new technologies will be linked to services with mass market appeal. Companies in a converged environment will look for those applications of technology that will appeal to the largest or most profitable segment of their consumer base. Thus, as we have seen with the development of numerous products (e.g., battery powered cars and video-telephones), the technology will be developed far in advance of consumer demand. The direct consumer impact on development will be in product applications, instead of the base technology. Clearly, the consumer will have an indirect impact on the technology developed. Companies will research and develop those products that they believe will have the widest range of applications. It will be the purview of industry groups, competitive joint ventures, and government to identify those technologies that warrant greater investment and then commit the funds. In particular, government bodies may need to take a lead role in funding fundamental technology research for the greater long-term good, rather than for the immediate payback on an investment.


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In the past, companies were driven to meet the demands of shareholders. In other words, the primary objective of most firms was to increase net earnings. While this remains the top priority for firms, the interests of shareholders are now frequently met by decreasing costs and improving quality (both consumer priorities). While consumer protection concerns do not disappear, the Information Economy promises to bring the interests of shareholders and consumers into better alignment. 2. De-regulation / Re-regulation This is the deliberate action by a regulatory authority to restructure an industry so that it moves from being highly regulated to being less regulated. This change in regulatory status is achieved in concert with other regulatory and/or legislative action, so that an industry is better able to operate in a more competitive marketplace. The regulatory changes – which open opportunities for both new revenue generation for incumbents and for new entrants to the industry – create a demand for technological innovations that will maximize economic opportunity. As such, industries in the competitive marketplace will require less regulation overall and will require different regulation than monopolies or duopolies have traditionally.

G. Issues: Technology and Convergence There is good reason to expect that energy/information utility convergence has the potential to provide substantial benefits to consumers in cost reductions, convenience, and the provision of innovative services. However, this concept cannot move forward without changes in public and regulatory policies that govern the delivery of these services. The challenge will be to shape policies that allow convergence to take place without distorting the marketplace and without exposing consumers to abuse by convergence providers. Many unpredictable breakthroughs and rapid advances in technology are driving convergence. The following section identifies some of the issues and questions that surround the creation of policy focused on the relationship between technology and convergence. 1. Potential Barriers to Technology Advancement When technological advances promote revolutionary changes in how businesses and customers interact, new obstacles appear that may hinder the pace of change. While these barriers to a more competitive market are not permanent, they can, like natural selection, allow only the most beneficial changes to survive. Conversely, barriers can be put in place to slow the advancement of technology and subsequently the introduction of competition into a marketplace. Barriers could include: Incumbent power producers could sway technology choices by encouraging the

development of standards that favor the previous technology investments by these companies. Thus consumer benefits due to the new technology may not be maximized because the standards would induce companies to continue using older technologies.

Cultural impediments (e.g., consumers’ reluctance to adopt new technologies and

service delivery processes) could slow the adoption of the new technologies. Thus the pace of technological change might slow until it equaled or nearly equaled the rate of increase in market demand for new services and products.


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Software development needed to efficiently manage and operate various systems

may lag behind the development of the underlying technologies of these systems. Regulatory requirements for access to affordable lifeline services can place such a

significant financial burden on companies that it is too expensive, from an investor risk perspective, to develop the technology necessary to enter into a marketplace.

Governments could slow down business while attempting to improve consumer

safety. In a time of continuous change in technology, the public will expect the government to fulfill its consumer “guard dog” role. In doing so, regulators and legislators could implement practices that restrict new technologies or businesses in order to ensure consumer safety and well-being. For example, multiple reviews and layers of business regulations by various federal and state governmental bodies would create an increased burden for new services and their underlying technologies. This would result in greater risk to those investing in the new technologies and would reduce the amount of available capital to support new technology development.

2. Potential Impacts of Stranded Costs on Technology Development Issues Serious questions surround the fiscal capability and commitment of utility firms to pursue new technologies aggressively while original equipment exists. This is the key underlying issue in the discussion of what level of recovery should be provided to utility companies for stranded costs. Stranded costs are the costs of investment in capital assets prior to deregulation that are no longer deemed to be competitive. Many of these investments were made to fulfill regulatory or legislative mandates and were based a projected future that did not include a competitive energy marketplace. As deregulation gets fully underway and introduces competition to the market, existing utilities will demand some sort of recovery of stranded costs from public regulatory bodies. The amount of cost recovery allowed could aid these companies in their efforts to develop new products and services. Considering stranded costs, regulators can let utilities absorb these losses, allow ratepayers to pay for them, or require the general public to pay for them through taxes. If the utilities absorb all the stranded costs, they could go bankrupt. If consumers are required to pay these costs, then their rates will decrease more slowly, or possibly increase in the short run. Therefore, regulators must balance the financial viability of electric utilities against rate decreases for electric customers. One option being considered as a means of more fairly distributing the burden of stranded cost recovery is securitization. This process refinances stranded utility assets through new public securities. Consumers pay the interest and principal on these securities. Due to the lower costs associated with a publicly assured debt instrument, the difference between the utility cost of capital and that of new security can be used to finance a rate reduction for consumers. However, this may not be the most equitable method of allocating these costs. Securitization sets an irrevocable dollar figure for stranded cost recovery, and does not allow for revision (e.g., downward) of the amount that utilities could recover as circumstances change. The amount of stranded cost recovery allowed will have significant implications for the ability of electric utility companies to compete in the new marketplace. The financial repercussions that


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will be caused by the decisions that each state will make on this issue will influence the level of funding for research and development, particularly for regional or national energy companies, and ultimately will affect the number and variety of services offered to consumers. 3. Promoting and Maintaining Long-Term R&D The competitive marketplace emphasizes the speedy delivery of goods and services. Such an emphasis would seem to discourage product research and development that requires extensive periods of time and investment. However, given a sufficient economic opportunity, businesses may form joint ventures or alliances to pursue such research. Further economic encouragement could come from federal or state governments in the form of:

Low interest loans or loan guarantees to reduce perceived investor risk; Tax credits for technology research and development through the early, high-risk

years of a project;

Regulatory cost-recovery mechanisms that recognize life-cycle cost as a more appropriate determinant of cost effectiveness; and

Effective redistribution of public spending in research and development that

reflects the potential national value of renewable energy technologies.

4. Establishing Standards for Support Service Delivery Critical to expanding technical capabilities is the effort to develop standards, in order to maximize the utility of the technology. In this situation, where the convergence of various technologies precludes relying upon one organization (e.g., IEEE43) to set standards for performance, organizations will need to take on this responsibility jointly. Various original equipment manufacturers should be involved in industry groups to help establish the key standards that will allow the greatest flexibility in developing and interconnecting products and services. Government could play a facilitating role initially, and perhaps serve as an enforcement backstop in the future. The level of standardization necessary to support economies of scale for service delivery remains open for evaluation and determination. 5. The Effect of Regulatory Structures on Technology Development As technology continues to converge, government and regulatory bodies must find ways to adapt to this new environment or be rendered obsolete. Requiring companies to develop technology under the purview of multiple sets of regulations from various organizations could increase the costs of development. This could dampen the level of technology development. 6. Potential Impacts of Overlaying Additional Services onto a Single Carrier The overlaying of services on a single carrier (e.g., laying a fiber optic telecommunications network in the same conduit as an oil or gas pipeline) can increase the return on investment for the companies involved by increasing the potential revenue stream due to carrying multiple commodities. However, this multiple use of a single right-of-way increases the probability of a

43 The Institute of Electrical and Electronics Engineers, Inc.


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common mode failure. In such an instance, it becomes more important for redundant systems to be put in place. 7. New Training Needs for New Technologies The increased level of technical sophistication of services and products will require better trained workers to make best use of new technologies. There is a widespread need for a well-trained and educated workforce. If companies cannot find or train sufficient workers with essential skills productivity will be limited. To address this issue, companies may form joint ventures with educational institutions to address the quality of education provided by the institutions relative to the needs of the companies for their employees. In addition, companies may need to develop and conduct more extensive initial training for new employees. This training will include not just technical subjects but cultural topics, in order to establish common work place principles given the diverse backgrounds of the workforce. Moreover, some companies will rely on outsourcing to fill the need for skilled labor.

VI. MARKET POWER ISSUES

A. Market Power Defined Market power refers to the ability a single firm has (or a group of firms have) in a market to influence the price, quality, or quantity of a product or to hamper competitive entry by others in ways that deviate from competitive levels for a sustained period of time. It should be recognized that most firms have some degree of “market power,” and that consolidation within industry segments is not necessarily bad or good. If market power is substantial, however, and if it is exercised, it can result in efficiency losses, higher prices, reduced levels of output and employment, retarded innovation, and the imposition of barriers to competition, all of which disadvantage consumers who would otherwise benefit from the competitive, deregulated marketplace. Put simply, market power analysis examines whether a small number of suppliers of a product in a given market have the ability to control the price and amount of the product and to keep other suppliers out. Market power analysis determines if there are enough suppliers to ensure that prices and output remain at or near competitive levels. Traditional market power analysis applied to mergers and other joint activities evaluates whether the consolidation of two firms will limit competition and consumer choice in a market. Today, regulators also use market power analysis to establish if a historically regulated product market, such as the electricity market, has sufficient numbers of competitors to give a reasonable assurance that it would function efficiently if the industry were deregulated. Convergence activities create special problems in the way they affect market structure and market power. Methods for properly analyzing potential market power problems associated with convergence mergers and joint activities have not been fully developed, and the application of existing methods requires rigorous examination to avoid making decisions that will ultimately reduce consumer welfare. For example, convergence activities may remain under the scrutiny of regulators, perhaps lessening concerns about the exercise of market power. On the other hand, the products that result from convergence activities may be so complex or new that it becomes problematic to define either product markets or geographic markets with sufficient certainty to allay concerns about the exercise of market power.


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B. Market Power Concerns and Convergence

Market power concerns arise when a corporate transaction - a merger or joint venture - might somehow reduce consumer welfare; thus, concern focuses on the effects of the transaction on the welfare of the (current or potential) customers of the merging parties. Consider "horizontal" transactions, i.e., those for which the parties to the transaction compete in some stage in the production chain. A horizontal merger would naturally eliminate this competition and, depending upon market structure, might harm the commercial interests of buyers in the relevant market by resulting in higher prices, reduced product quality or variety, or a slower rate of product innovation. Related concerns arise when the parties to the transaction are in a "vertical" relationship, which happens when one party supplies the other (so that the latter party is said to be "downstream" of the former). Such transactions, many of which represent examples of convergence, may permit the merged firm to exercise market power in a downstream market by raising the costs of other suppliers to that market.44 Market power concerns may also arise when a transaction might enable the parties to the transaction to foreclose other suppliers in a market or impede entry into that market. In such cases, concerns are expressed in terms of the commercial effects as felt by other suppliers rather than by consumers. Under American regulatory practice, however, regulatory scrutiny is generally higher when potential foreclosure and similar conduct are likely to reduce the welfare of consumers in some market. Concerns regarding potential foreclosure frequently arise in convergence, particularly with respect to transactions involving a regulated supplier. As a rule, regulated firms often control assets that, at least for some markets, represent a natural monopoly bottleneck facility. Local networks (such as power distribution lines, telephone lines, and water lines) are good examples. National or regional networks of bulk power distribution lines, railroad lines, and natural gas pipelines are other examples. Many convergence activities - and certainly mergers and joint ventures involving convergence - are made possible by the (total or partial) deregulation of services that rely upon natural monopoly assets such as these. Deregulation generally proceeds either by separating the natural monopoly assets from other assets (e.g., the breakup of the Bell telephone system) or by devising rules that attempt to ensure that third parties have access to natural monopoly assets. Prominent examples of the latter can be found in each of the utilities considered in this report, including Order 636 for interstate natural gas transmission, Orders 888 and 889 for interstate bulk electricity transmission, and Sections 251, 252 and 271 of the Telecommunications Act of 1996. In these cases, concerns regarding potential foreclosure often ask whether new regulations would permit an incumbent supplier to impede access over networks by other suppliers. If so, the

44 As an example, a proposed merger between PacifiCorp and the Energy Group might have made it possible for the

merged firm to exercise market power in certain bulk electricity markets within the WSCC (encompassing roughly the western United States). In particular, because the Energy Group supplied coal to western power plants competing with PacifiCorp, it might have been possible for the merged firm to exercise market power by raising its coal prices to these plants. PacifiCorp, faced with the resulting weaker competition from these plants, could then raise its prices for bulk electricity. This transaction was ultimately abandoned, due perhaps to opposition from the Federal Trade Commission.


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inquiry then proceeds to examine whether such conduct would have a noticeable effect on the welfare of consumers in these newly deregulated markets. The unique problem that convergence activity presents for market power analysis and policy can be summarized in the following series of observations. Merger activity in any of these industries routinely entails concerns about competitive problems because of the blending of regulated and unregulated activities. These go back to the underlying nature of the regulated activity.

The concerns that typically arise are the leveraging through: The relationship with captive customers; The control over essential facilities; or The potential cross-subsidies that can be used to gain a competitive advantage or

foreclose competitive alternatives.

Convergence activity heightens concerns because it typically entails the union of activity across products within the same geographic market and frequently involves both regulated and unregulated markets. On the other hand, convergence could actually serve as a mitigating factor against market power abuse, providing for new competition to traditional suppliers of goods and services. Convergence activity intensifies regulatory attention for other reasons. The potential for very large economic gains resulting from convergence activity may change the public policy balance. Large telecommunications mergers typically entail projections of gains of ten percent of total costs. Convergence mergers have potential gains several times larger. With larger potential gains, efforts to mitigate potential market power problems are increased. Convergence activities also make the analysis more complex. Because the activity cuts across product markets, market definition becomes more difficult. Because the converged activity is new, regulators lack an empirical base from which to evaluate potential gains and losses or to forecast conduct. For example, it is uncertain what the impact of the unbundling of utility services will mean for competition and consumers, e.g., companies devoted solely to the provision of metering and billing services. Additionally, even if the size of a particular provider is small relative to other national providers and cannot wield unfair market influence at the national level, that provider may still be exercising unfair market influence within its region or market. In short, convergence activities combine very large stakes with very large uncertainties. There is a clear need for more experience in dealing with convergence transactions in order to evaluate their potential impact on consumers. The dilemma for policymakers is how to obtain that experience while protecting the public interest in the short-term.

Convergence attracts a great deal of regulatory attention because it poses special

problems in the leveraging of market power, as regulated industries selling essential services are joined with unregulated activities.

Convergence activity runs a unique risk of being bogged down by multiple layers

of overlapping regulatory oversight – both geographic and institutional.


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Because it crosses industry lines, convergence activity also challenges traditional

economic definitions, and regulators lack experience and evidence on which to base their reactions and projections.

Regulators are already facing several convergence mergers and proposed joint activities. In January, 2000, El Paso Energy Corporation bought Coastal Corporation – a merger that will give El Paso access to a vast natural gas pipeline network serving 70 percent of the U.S. population. El Paso announced its plans to use their expanded rights-of-way to develop telecommunications and electricity networks. El Paso Energy President and CEO William Wise announced that he expected very little trouble getting the merger approved by regulators, because El Paso’s pipeline assets are complementary and without significant geographic or market overlap. The merger will certainly have a dramatic impact upon the energy industry, however, and the merger exemplifies the complexities associated with judging the potential market power of industries converging for the first time. 45

1. Some Real World Examples of Concerns These concerns will not be merely conceptual as the convergence process unfolds. Consider the following examples of predictions in the utility convergence literature about how the market will develop.

A half-dozen or so utilities will likely end up as mega-generators, controlling perhaps 80 percent of the total generation capacity. The remaining 20 percent will be sourced from many niche generators employing advanced generation technologies. In the current vertically integrated industry structure, the largest producer, Southern Co., has only a 3 percent share of the total U.S. market.46

This is a bold prediction that constitutes a radical transformation in the generating sector. The end point is a market structure that will catch the attention of parties concerned about market concentration. Consider the following concern expressed by the Consumer Federation of America about a market that is this concentrated.

The clear danger of a market with a structure equivalent to only six equal sized firms was recognized by the Department of Justice in its Merger Guidelines.47 A market with six equal sized firms would have a HHI48 of 1667. The Department declared any market with an HHI above 1800 to be highly

45 “El Paso, Coastal Converge Into Pipeline Kingpin,” The Energy Daily, ED Volume 28, Number 12, January 19,

2000. 46 Weiner, et al, p. 26. 47 U.S. Department of Justice, Merger Guideline, revised, 1984. 48 From the University of Texas Department of Economics, Website (www.utexas.edu):

The Herfindahl-Hirschman Index (HHI) -- A mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the justice department. If HHI < 1000, a merger will go unchallenged.


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concentrated. Thus, the key threshold is at about the equivalent of six or fewer firms.

Shepherd describes this threshold as follows: Tight Oligopoly: The leading four firms combined have 60-100 percent of the market; collusion among them is relatively easy. One must have many more firms than six to be confident that competition will prevail -- perhaps as many as fifty. In other words, in simple economic markets levels of concentration typified by 10 equal sized firms are high enough to raise questions about the competitive behaviors of the firms in the market. Given the nature of the broadcast media and the special concern about the free flow of ideas, this is a conservative level of concentration about which to be concerned.49

Using these standards, some are predicting a tight oligopoly, which is certain to attract the attention of regulators. The rush to control the meter or the modem will not go unnoticed. The first round will be between competitors, each of whom will seek to gain control. The winner will face a different problem, concern that control over the access point creates market power. Though Microsoft has since undergone highly publicized regulatory scrutiny, consider the concerns expressed by Ralph Nader, founder of Public Citizen, before the Justice Department case:

The Internet is the most successful new platform for publishing and sharing information. It developed in an environment that was profoundly anti-monopolistic, and which embraced open standards. Microsoft ignored the Internet initially, even creating a rival proprietary network architecture for its Microsoft Network… Microsoft, a firm known for its aggressive anti-piracy campaigns, is spending tens (perhaps hundreds) of millions of dollars to develop and promote the Microsoft Internet Explorer, which it gives away. Why? By monopolizing the browser market, and by destroying Java’s promise as a cross-platform language, Microsoft will be in a position to transform the

The HHI is calculated by expressing the market share of each firm in the industry as a percentage, squaring these figures, and adding. Examples: 1. An industry with two firms, each holding 50% market share: HHI = 502 + 502 = 5,000 > 1,000 Therefore this industry is concentrated and a merger will be challenged. 2. An industry with 9 firms, each holding 10% market share, and 2 firms with 5% market share each: HHI = 102 + 102 + 102 + 102 + 102 + 102 + 102 + 102 + 102 + 52 + 52 = 950 < 1,000 This industry is unconcentrated and a merger will be challenged.

49 Consumer Federation of America, 1996.


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Internet radically by moving toward a new set of Microsoft-owned or Microsoft-controlled standards for Internet publishing and electronic commerce. Microsoft is trying to position itself to own the software used by consumers to operate a new generation of cable-TV systems, consumer electronics, and other devices that will be used to connect to the information superhighway. This would extend the monopoly Microsoft has on operating systems for personal computers.50

2. The Public Policy Response to Potential Problems These concerns give rise to a continuing struggle over regulation and organizational forms in converging industries. Table I identifies five areas of regulatory concern to convergent utilities.

TABLE I: REGULATORY ISSUES SURROUND CONVERGENCE ACTIVITIES

INTRAFIRM REGULATION Price Quality Cross-subsidy INTERFIRM REGULATION Interconnection Codes of Conduct Standard Setting Open Access/Common Carriage INDUSTRY BOUNDARIES Cross-ownership Market Exclusion Franchise/licensing Use Restrictions COMPETITION POLICY Market Power Predation Cross-subsidy Discrimination CONSUMER PROTECTION Privacy Transactions Marketing Universal Service

Intrafirm regulation (of price, quality, and cross-subsidy) remains important to utilities as they transform into something else. It may to be imposed on formerly unregulated companies as convergence takes place. Interfirm relations deal with the way firms within an industry relate to one another – how they interconnect, charge, and bill for shared facilities, etc. 50 Nader, Ralph, “The Microsoft Menace: Why I'm Leading a Crusade to Stop Its Drive for Cyberspace Hegemony,”

Slate, October 19, 1997.


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Industry boundaries relate to how firms outside of an industry relate to each other in terms of ownership or market access. Competition policy involves the broad issues of market structure, conduct, and performance. Consumer protection involves the general issues that relate to transactions with the public including use of information (privacy), marketing, and billing, etc.

The restructuring process in the utility industry stops far short of complete deregulation and leaves many of these issues in play.

Concerns about exclusion and foreclosure give rise to extensive codes of conduct

to regulate provider-to-provider relations.

Fear of leveraging and cross-subsidy results in restrictions either in the types of activities into which companies may go, or the rules under which they can provide new services (separate subsidiaries).

Concerns about cross-subsidy give rise to accounting rules and structural

safeguards (separate subsidiaries).

Concerns about price discrimination and cross-subsidy lead to the persistence of price regulation (albeit in a relaxed form).

Concerns about bundling and marketing activity give rise to additional consumer

protection measures (education campaigns, anti-slamming/cramming statutes).

While electric utilities may feel that they are uniquely afflicted by these regulatory burdens as they go through the restructuring process, the measures have been applied to other industries. The Telecommunications Act of 1996 is a remarkably thick regulatory document. Moreover, there is growing pressure to extend oversight to largely unregulated segments of the computer/communications industries. The format is somewhat different, but the imposition of a variety of forms of regulation is happening and promises to increase. Proposed and implemented policies include:

Consumer protection, including privacy regulation and content regulation;

Competition policy, including antitrust actions and even talk of regulating the

computer operating system as an essential facility;

Standards for interconnection and interoperability to ensure compatibility; and

Imposition of open access and common carriage requirements for data services.

The nature and extent of the regulation that will emerge in convergent industries is unclear and is likely to remain in flux for some time. That in itself causes problems for firms pursuing convergence. Convergence activities create several uncertainties about how the activity will be regulated, whether there will be overlapping regulations (since this activity falls in areas that


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formerly subject to several different authorities), and whether the activity will be consistently regulated across geographic boundaries. There is also an important relationship between the organizational form that an activity takes and the way it is regulated. One can find advocates who prefer that transactions be organized on a market (contract) basis, a joint venture basis, and a merger/acquisition basis. These recommendations are frequently based on beliefs about the efficiency of organizational forms. How an activity is organized frequently determines how it is regulated. One often hears the argument that, to the extent that companies choose organizationally inefficient forms because they provide regulatory advantages, a disservice is being done to the industry, consumers, and the economy. At the same time, the potential gains from convergence are so large that regulators have a strong desire to find new approaches that will allow the activity to go forward.

C. Market Power and Regulation 1. Regulatory and Other Analytic Uncertainties

a. Partial Deregulation Broadly speaking, evaluations of market power in regulated and partially regulated markets often depend a great deal upon the nature of the regulations.51 More significantly, deregulation (or re-regulation) is seldom accomplished all at once. Instead, it tends to occur through an ongoing process in which new regulations are periodically introduced at the federal, state, and local levels. Innovative judicial decisions may also contribute to the dynamic process by which regulations are devised so as to encourage - or sometimes inhibit - competition in markets formerly controlled largely by a stable set of regulations. As an example, consider the partial deregulation of bulk electricity markets. Natural gas, an important fuel for electricity generation, underwent deregulation beginning in the 1980s, with the partial deregulation of natural gas transmission. It proceeded at the federal level with the 1992 Energy Policy Act and later in 1996 with Orders 888 and 889. Numerous other regulatory initiatives have been enacted by the states (e.g., formation of the statewide independent system operator in California in 1997-98). If one were to assume that deregulation measures would always be effective - that is, that competition would indeed thrive in newly deregulated markets - then market power analyses involving convergence would seldom sustain concerns about market power. As a rule, suppliers in vibrantly competitive markets cannot exercise market power. However, it is often difficult to foresee the competitive effects of deregulation measures, hence difficult to guarantee that deregulation initiatives will work. As a corollary, it is difficult to predict the form, substance, and effects of future deregulation initiatives. Broadly speaking, uncertainties associated with current and future regulations reduce the predictive value of market power analysis.

51 To illustrate, consider a merger between two electric utilities in a single state. An analysis of potential market

power would not generally examine forms of conduct that are controlled by federal or state regulation. Instead, the analysis would focus on corporate conduct that would respond to competitive pressures. Thus, the scope of the analysis would depend directly upon the scope of regulation by federal, state, and other regulators.


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Other uncertainties, particularly those associated with new, unfamiliar, and potentially useful technologies, also influence the analysis of market power concerns arising in convergence. For instance, over time cellular technologies have become closer substitutes to local telephone service. It is possible, then, that cellular services will provide a significant competitive constraint on the pricing and other conduct of local telephone service providers. On the other hand, deregulation initiatives in bulk electricity must confront the uncertain adequacy of innovative software used for controlling and dispatching electric generation and loads over the bulk power networks. At present, it is not clear to what degree currently available software can accommodate bilateral trades against the need to ensure the reliability of the bulk power network. The availability of effective software may affect the viability of deregulation initiatives in bulk electric markets. b. Convergence and Overlapping Deregulation Considered within the definition in this report, all of the firms involved in utility convergence are regulated to some degree. The term regulated is used here to include any form of regulation that sets prices or limits entry by potential competitors. It includes both traditional and alternative public utility cost regulation, and regulation through the granting of franchises. The latter form of regulation captures cable television and wireless activities, which are both elements in the convergence phenomenon. The term “joint activities” is used to capture a variety of possible convergent activities including: 1) mergers and acquisitions; 2) joint ventures; and 3) and new market entry. In a convergence merger one firm acquires another and at least one of them is in a regulated business. In a convergence joint venture, two firms agree to undertake a combined activity, and the combined activity involves at least one regulated good or service. Presently, mergers, and acquisitions will generally incur greater scrutiny than joint ventures, which will, in turn, incur greater scrutiny than new market entry. Higher levels of scrutiny might be justified given the complexity and newness of the product offered, difficulty in defining the market, jurisdictional questions, and the extent to which the new line of business relies upon or is provisioned over assets owned by the incumbent utility. An important public policy question is whether the factors justifying increased scrutiny are generally associated with the transactions that in fact receive such scrutiny. If transactions that pose the same apparent risk of adverse impact on price, quantity, quality, or ease of market entry are given different levels of governmental scrutiny, it is important to examine whether the scheme of regulation imposes too much burden in some cases or too little protection in others. 2. The Intersection of Regulatory Paradigms and Joint Decisions a. Mergers and Antitrust

Merger activity is highly scrutinized because both federal and state agencies have broad jurisdiction to consider whether the combination of companies would result in competitive harm. Attorneys general in each affected state have authority to investigate under the Sherman Act and, when regulated utilities are involved, there is a tendency to examine such merger activity. Antitrust review centers on actual competition in specific product and geographic markets. Convergence, by its very nature, cuts across traditional market definitions. It frequently involves


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potential, rather than actual, competition, since one of the players has not been in the market. As a result, antitrust analysis of convergence activity can be very challenging.

TABLE II:

AVENUES OF CONVERGENCE AND REGULATORY REVIEW MERGER JOINT NEW (M&A) VENTURE ENTRY ANTITRUST Certain Possible Unlikely LICENSE Certain Light Light COST OVERSIGHT Likely Light Unlikely Because the analysis of the antitrust implications of convergence activity is fraught with uncertainty, enforcement decisions seeking either to block or to allow the activity may be based as much upon ideological preconceptions as upon a clear showing of the presence or absence of competitive harm. Some scholars and regulators come to the issues loathe to frustrate the cost savings, increased choice, and increased quality that can come from convergence activity. Other scholars and regulators believe that smaller is better and, in unknown territory like convergence markets and products, companies should carry the burden to show that such activity is in the public interest. b. Regulation and License Transfer License transfer provokes a notably higher degree of scrutiny than certification of a new entrant in both telecommunications and electricity. Incumbent utilities frequently require modification of their licenses to execute a convergent transaction. The statutes under which the licenses are granted (and transferred) generally have broad “public interest” standards. Because the questions are broader, the need to define and analyze structure, conduct, and performance is more demanding. Technologically dynamic industries present special problems for the regulatory paradigm, both at the moment of convergence (e.g., at the transfer of the license) and in terms of ongoing activities (regulation). Overly restrictive regulation can inhibit progress. A classic, mid-century example of convergence activity that was frustrated by regulation is the refusal of regulators to allow trailer-on-flatcar transportation for years. Regulators had spent decades attempting to manage truck-rail competition to protect the rail industry. Long-haul transportation of trailers for later off-loading and local transport by highway represented a case of convergence that befuddled regulators. Similar end-of-the-century cases of regulators struggling to categorize convergence activity involve high-speed Internet services over cable modems. Is it telecommunications or cable entertainment service? What it is called may affect how it is regulated. Lax regulation can be a problem as well. Diversification in electric utilities and telecommunications companies certainly caused concern about abuse of utility customers by


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non-utility affiliates. Major problems arose in the mid-1980s when utility holding companies diversified into both unrelated and related activities. For example, US West and Pinnacle West suffered severe losses in the real estate market that may have cost utility customers. Similarly, NYNEX was found to have overcharged ratepayers in transactions with an unregulated affiliate that provided services to the regulated subsidiary. There is an ongoing debate over regulation of the Internet facilities and content provider affiliates of local telephone companies. Similarly, there has been a heated debate over the transfer of assets from Boston Edison in a cable television joint venture. C. Multiple Layers of Review Another major regulatory issue that arises through convergence is the federal role in convergence and market structure. Convergence results from granting customers choice. One of the trends of convergence is that many energy and telecommunications functions will spill over the neat state lines that have bounded traditional regulation of utilities. Will the network functions become sufficiently interstate in scope to require federal preemption in order to rationalize the rules of the game? The answer is likely to be “yes” with respect to competition policy. This is certainly the case in telecommunications where any state statutes or policies that created a barrier to competition were preempted. This is the direction of efforts at the federal level with a “date certain” for competition included in many bills focusing on electric utility restructuring. It is less clear whether this preemption will go beyond competition policy and extend to other matters. The first case to the Supreme Court emerging from the Telecommunications Act of 1996 involves just such issues – e.g., whether the Federal Communications Commission went too far in prescribing rates for interconnection and unbundled network elements. The recent Supreme Court ruling overturning a lower court decision places the Federal Communications Commission in the center of market restructuring. Multiple layers of review allow local regulators to impose conditions or extract benefits in situations in which federal regulators have found no anti-competitive threat (e.g., the license transfer from TCI to AT&T). Table III below is an attempt to classify the convergence and concentration activity to date and to further exemplify the types of convergence activities taking place. Any business venture combining any of the activities appearing in the matrix below would be considered convergence.52

52 One of the areas not addressed in this table is the issue of utility companies “spinning off” traditional utility

functions, such as metering and billing, to unregulated subsidiaries. Though it is in many ways the opposite of “convergence,” and perhaps more appropriately called “divergence,” it is the other side of the same coin and invokes the same regulatory concepts.


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TABLE III: EXAMPLES OF CROSS-INDUSTRY CONVERGENCE

WITH MEANS OF ENTRY TARGET Gas Elect Tel Cable Other ORIGIN Gas SEVERAL MERGERS Electric SEVERAL GPU BOSTON ED MERGERS Conectiv (Joint venture) (New Entrant) PUBLIC POWER (New Entrant) Telephone MANY ATT-TCI MERGER MERGERS AMERITECH (New entrant) Cable Cablevision MANY (New Entrant) MERGERS Other COMPUTER BELL COMPANY (Joint venture) 3. Paradigms to Speed the Process Overlapping regulatory reviews and conflicting regulatory standards threaten to frustrate convergence activities. This section seeks to lay the foundation for the discussion of specific issues that confront all the stakeholders in convergence – suppliers, consumers, and society. As the discussion addresses the myriad questions that remain in assessing how deeply convergence will affect these stakeholders, the concepts pinpoint the currency that should be used to determine if producers will prosper, consumers will benefit, and society will progress. The review of the complex process of convergence suggests two fundamental issues confronting stakeholders that should be kept in mind as policymakers address the issue: Specify the costs and benefits precisely; and

Ascertain how much change is actually necessary and in what time frame.

Firms do it formally, when they evaluate the “synergies” they hope to gain from convergence and the “dilution” that results. While firms need to refine this approach in order to identify the


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more complex economics underlying convergence, still other parties need to develop the fundamental metrics to begin the analysis. Recognizing the complex economics of convergence in answering the questions posed by any discussion of consumer protection, regulation, and market power is crucial to preserving the benefits, while minimizing costs. Only understanding the magnitude of change necessary and how best to facilitate that change will serve the purpose of lowering transaction costs. The two alternative solutions for responding to this complex set of factors can be described as follows: Pre-Convergence: Divestiture seeks to isolate the segments of the industry that are the source of potential

leverage – primarily the core network function – from the other activities that are deemed to be competitive or potentially competitive. Once the bottlenecks are segregated and subject to continuing regulation, competition is given free reign elsewhere.

Post-Convergence: Post-convergence oversight allows the convergence activity to move forward with

streamlined pre-approval process coupled with a post-approval review. This approach, which might be called a “regulatory true-up” approach, might commit converging entities to predefined standards of conduct, triggers for review, thresholds for remedial action, as well as specification of post-convergence measures should remediation be necessary.

a. Functions Approach to Convergence Activities One way to look at the issue of market structure as it affects the convergence of the gas, electric, and telecommunications industries is to focus on network functions and content/commodity functions. There is consensus that most distribution network functions will remain regulated, perhaps in a different form than has historically been the case. Even recognizing that there may be efficiencies gained by having large regional “network” companies that remain regulated, it can still be argued that large networks that try to merge will raise antitrust concerns even if regulated. Moreover, if these mergers of network functions (transmission and distribution) were to use new standards of regulation (e.g., incentive regulation that deregulates profit), the concern over convergence mergers would only grow. Additional concerns are raised if regulated distribution or transmission companies are able to control competitive access to their networks. While there would undoubtedly be efficiencies in the operations of larger networks, the most significant efficiencies would be in the lowering of transaction costs to marketers who could reach many millions of customers using standardized procedures, billing, etc. Some argue that there is no reason to be concerned if the same corporate entity owns a combination of the gas, electric, or telecom distribution systems in a given geographic area, even if this geographic area were a multi-state region, the entire US, or all of North America. Clearly, there would be challenges in how to regulate such entities effectively, but, conceptually, such regulation would seek to mitigate any market power abuse in distribution services.


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In the context of regulated dominant firms pursuing economic efficiencies by owning distribution networks in a large geographic area to achieve economic efficiencies, one must deal with the issue of content or commodities that flow through the distribution network. The vast majority of content services is or will be sold in competitive markets by an array of marketing entities. Both the gas and telecommunications content services (i.e., Internet information services) are competitive. Some generation services (such as stand-alone services) would have market power if they were just spun off from existing utilities. Thus regulators should ensure that divestiture of generation assets results in a competitive market structure. Once divested, electric generation should be treated like any other commodity in the US economy, subject to the same scrutiny as the merger of two oil companies, or two hotel chains, as long as nondiscriminatory access to the network is provided to all interested competitors. The vertical market power structure challenge in convergence occurs when a distribution/conduit entity also sells content/commodity services. Obviously there are concerns about using the regulated conduit monopoly in ways that promote the content service and distort competition. There have been essentially two approaches to this problem. The first is applying codes of conduct that attempt to prevent such abuse through a combination of self-regulation and regulatory oversight. The second is to prohibit the conduit company from being in the content business. This approach has been taken by the Congress in preventing railroads from being in the commodities business, and local telephone companies have been prohibited from entering certain lines of business until greater competition exists in their traditional service territories. At present a battle is raging over the combination of content and conduit in the telecommunications/cable/Internet convergence. Many consumer and public advocates, and ISPs such as Mindspring and Prodigy, have been lobbying for nondiscriminatory access to cable broadband infrastructure. Prompted by cable companies’ deployment of broadband networks, telephone companies have upgraded their lines to provide high-speed Internet access. This approach can be crystallized in two principles. Principle No. 1: Require companies to divest regulated services and facilities into stand-alone companies that have no affiliates or subsidiaries. This principle would focus regulation only on regulated services. No longer would there be a need to police affiliate transactions for cross-subsidies and self-dealing between regulated and non-regulated affiliates. It would eliminate "fishing expeditions" by regulators into the activities of non-regulated companies. It would reduce significantly the cost and intrusiveness of regulation. Regulated services or facilities would include the transmission and distribution systems for electricity; the pipelines and distribution systems for gas; local loops for telecommunications; distribution systems for water; cable lines for cable television; and operating systems for computers. Principle No. 2: Require companies to divest ownership of certain facilities if horizontal market power problems arise. For example, a power plant owner should not be allowed to own more than a specified percentage of the baseload power plants, or of the peaking power plants, or of the power plants needed for ancillary services in any geographic area defined primarily by transmission constraints. This principle would ensure that markets had at least the minimum number of competitors needed to create effectively competitive markets. Both horizontal and vertical market power present potential problems. The potential for market power abuse through vertical integration is of particular concern when examining convergence activities.


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b. Streamlining Pre-convergence Oversight With Post-convergence Regulatory True-ups By a

Single Agency A case can be made that the requirement for multistate approval of mergers is an impediment to the development of efficient market structure. Each state wants the benefits to accrue to its state as a predicate to approval. That is unrealistic and a burden on interstate commerce that should not be permitted. How many mergers that make economic sense will not take place as a result of the burden imposed on the approval of such mergers? In addition to multi-state review, there may be problems of multiagency review. Because of the regulated entity involved, it is likely that more than one agency may become involved in approval of the convergence activity. Different agencies may apply different criteria. Even single agency, single state regulatory review can be problematic for convergence activity. Because the legal standard is broader, the absence of experience not only allows convergence to be blocked or allowed based upon ideology, it also creates the opportunity to tax such activity based upon the same ideology. The body of experience necessary to resolve this tension can only be created over time. Given the large potential gains, it is necessary to take some risks at the outset to obtain that experience so long as reasonably adequate after-the-fact remedies are available in cases where experience produces undesirable results. The fundamental promise of deregulation is that its benefits will be provided to consumers through reduced prices, increased quality, and more choice. As a practical matter, the public interest standard is almost always at odds with a competitive market because regulators almost always seek to redistribute the benefits of transactions under their jurisdiction. Finding a new paradigm requires allowing activity to go forward with clearly identified transition rules and a regulatory “true-up” period. 4. Conclusion

While the suggested alternative recommendations in this report differ dramatically, they share a common purpose – to allow a unique form of activity to move forward rapidly. It is interesting to note that these are not necessarily mutually exclusive. The breakup of AT&T involved divestiture and separation of activities (line of business restriction) with an ongoing process to seek waivers of the restriction on integration and a triennial review of the entire separation. The court granted hundreds of waivers and Congress ultimately allowed reintegration of activities subject to strict codes of conduct and ongoing review. While there are widely differing views of the success of the courts’ oversight of the industry and the efficacy of the congressional approach, the uniqueness of both approaches attests to the willingness of the policymakers to seek new paradigms. This willingness reflects a spirit that convergence may require if the public is to reap the benefits of a dynamic new form of economic activity.

VII. CONSUMER IMPACTS OF CONVERGENCE

Building upon the conceptual framework outlined in the overview of convergence, this section presents a scheme for analyzing the magnitude of change necessary to make utility convergence


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(and e-commerce) successful, identifies potential problems, and proposes public policy recommendations. In this section we address only issues that arise when a utility service is sold in new ways. If an electric utility buys a gas utility and simply intends to operate that utility as a separate subsidiary with no change in marketing or billing, there is no convergence-specific consumer impact. For market structure impacts, please refer to Part Two, Section VI, “Market Power Issues.”

A. The Transaction For the purposes of this analysis, we view the transaction from two points of view – the buyer (consumer) and the seller (producer). We view the transaction at three different stages – pre-purchase, point-of-sale, and post-purchase.53 At each stage and from each point of view, something different is happening – a different objective or function is being accomplished.54 A successful transaction (satisfying to the consumer, profitable to the producer) requires a reasonable meshing of the objectives and functions.

1. Pre-Purchase In the pre-purchase phase, consumers seek to identify products that are useful to them in meeting their needs. As potential buyers they are gathering information (conducting market surveillance) on products to meet needs or fill wants. They are seeking the best value, in which lowest cost is one factor. In the pre-purchase phase, sellers are advertising. They seek to make the attributes of their product known and attractive to consumers. They are seeking to convince consumers that their product can meet their needs better than others. 2. Point-of-Sale At the point-of-sale, there is an exchange of values. Consumers order and secure the good or service. They make payment, which tenders value to the seller. The seller delivers the goods, presents a bill and receives payment. In conventional physical or “p-commerce” transactions, the point-of-sale was a highly interactive event. Consumers asked questions, conveyed personal information to describe what they wanted, were given information, and heard representations about what the product would do. The consumer saw the product, took possession of it, was given a bill and tendered payment. The bill described what was purchased, where, when and for how much.

3. Post-Purchase Most transactions involve goods and services that are not consumed at the point-of-sale. In the post-purchase phase, buyers use (consume) the product to satisfy their needs. They may also discover defects or have complaints, in which case they seek to achieve the value they intended (or anticipated).

53 Kalakota, Ravi and Andrew B. Whinston, Frontiers of Electronic Commerce, Addison-Wesley Publishing Co.,

1996, pp. 253-331. 54 Hoffman, et al, 1997.


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In the post-purchase phase sellers provide customer service, frequently hoping to establish and build an ongoing relationship with the customers. The post-purchase phase also includes the opportunity for dispute resolution.

B. The Transition to Competition in Utility Services

The transformation of a utility service with no market alternatives into a commodity is a major change for consumers who have never shopped for these services in the traditional sense. In the past, there was one supplier, and consumers encountered little variation in service offerings. To the extent that competition existed among energy sources, builders, not consumers, made most decisions. The introduction of competition changes the nature of this service and prompts a range of questions. Because these services have been provided by a regulated utility, quality, features, price, and functionality were monitored and controlled. In addition to general concerns about ensuring fair competition in a deregulated market, convergence raises additional concerns when it entails selling traditional services in new ways.

How much uneven service quality is tolerated in the market?

Can consumers learn to evaluate these commodities?

Because these services were regulated in many states, their status under consumer protection statutes may be unclear. In the transition to competition policymakers must ensure that these services are fully covered, not only by general consumer protection statutes, but also by additional consumer protections. To the extent that the legacy of monopoly creates points of leverage and vulnerability, or if the transformation to competition is partial and areas of monopoly or market power remain, there are major consumer concerns. The fundamental need for heightened consumer protection stems from the nature of the service provided and the historical context of its delivery (see Table IV). Consumers are unprepared for the commodification of these services. Regardless of how they are delivered on the supply-side, most of the services affected by convergence are deemed essential. They have a low elasticity of demand. There are few close substitutes, which suggests that consumers will have little bargaining power in the transaction.


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TABLE IV:

FACTORS CREATING THE NEED FOR ADDITIONAL CONSUMER PROTECTION IN THE TRANSITION FROM UTILITY TO COMMODITY

PRE-PURCHASE LOW ELASTICITY OF DEMAND UTILITY HISTORY HOMOGENEITY OF PRODUCT ABSENCE OF MARKETING LACK OF INCENTIVE TO SHOP MONTHLY BILL TIME CONSTRAINT INCUMBENCY ADVERTISING & ADVANTAGE POINT-OF SALE ELECTRONICALLY BILLED TIME CONSTRAINT LACK OF SUBSTITUTES LIMITED PRESENTATION OF INFORMATION BUNDLING OF FEATURES POST-PURCHASE LACK OF INCENTIVE TO COMPLAIN MONTHLY BILL LACK OF TRANSACTION RECORD UNCERTAINTY ABOUT REDRESS MULTIPLE RESPONSIBILITIES FOR SERVICE DIFFICULTIES AND EXPENSE OF RECEIVING REDRESS

This discussion focuses on the initiation/change of service transaction because that is the type of transaction likely to predominate in the short to mid-term of convergence, given the experience with telecommunications restructuring. Ten years after the breakup of the telephone monopoly, almost three-quarters of all consumers had never switched service, and a substantial number of those who had switched had been allocated as part of a balloting process. More than a decade after restructuring, market shares began to move as a result of a major change in the product. MCI’s “friends and family” plan changed the way long distance was billed. It gained about 5 percent market share in a year. When AT&T responded, price competition finally came to the long distance industry. There is a certain amount of churn in the long distance industry, with incentives (checks, frequent flier miles, deep discounts) targeted at a


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small part of the residential market. Fifteen years after the breakup, AT&T still has over half of the long distance market.55 Local telephone service competition in the residential sector has been virtually nonexistent. Even three years after the passage of the Telecommunications Act of 1996, there has been a one percent market share shift. The average household currently spends more on long distance service than on basic local service, reflecting the expansion of the long distance market since the AT&T divestiture in 1984.56 Electricity and gas service have lower elasticity of demand than long distance telephone service. These utility services are likely to be difficult to be differentiated in terms of quality or packaging. Thus, the likelihood of discretionary switching is likely to be smaller than in telecommunications.57 Evidence from the technology adoption58 and e-commerce literature59 supports this interpretation. It indicates early adopters are social shoppers with upscale characteristics. The potential for expansion stems from the fact that high technology goods are “superior” goods (as income rises consumers spend a larger percentage of their income on these goods) with network externalities. The more consumers using the product more often, the greater the value,60 but these are not characteristics of utility services.

1. Pre-Purchase Consumers frequently purchase these commodities under considerable time constraints. Frequently, the need to get service is urgent. People change service only when they have to because they have moved their place of residence. When seeking to reconnect utility service because of a move or to resolve problems or disputes, the customer is likely to be highly motivated and focused, and they are under considerable pressure to make sure that they get connected. The customer needs to make a purchase (rather than the seller needing to make a sale). This reverses the typical roles of buyer and marketer and makes the customer vulnerable to exploitation.

55 “Trends in Telephone Service,” Federal Communications Commission, Industry Analysis Division, Common

Carrier Bureau, July, 1998. 56 Ibid. 57 In Connecticut, the local service monopolist Southern New England Telephone (SNET) was allowed to sell a

bundled long distance/local package. SNET captured approximately 35 percent of the subscribers, but only 12 percent of revenue. SNET clearly captured the low volume residential customers who had switched previously. Rather than switch basic service, they added the more discretionary service – long distance service – to their basic service.

58 Mast, Elizabeth A., Soyeon Shim and George A. Morgan, “In-home Videotex Shopping: Potential Adopters and Non-adopters,” Journal of Consumer Studies and Home Economics, Vol. 15, 1991, pp. 133-146. LaRose, Robert, and Jennifer Mettler, “Who Uses Information Technologies in Rural America?,” Journal of Communication, Vol. 39 No. 3, Summer 1989, pp. 48-60.

59 Lindstrom, Paul B., “The Internet: Nielsen's Longitudinal Research on Behavioral Changes in Use of This Counterintuitive Medium,” The Journal of Media Economics, Vol. 10 No. 2, 1997, pp. 35-40.

60 Peterson, M.J., “The Emergence of a Mass Market for Fax Machines,” Technology in Society, Vol. 17 No. 4, 1995, pp. 469-482.


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2. Point-Of-Sale Conditions of urgency and time constraint diminish the tendency of the consumer to search for alternatives. The ability to distinguish between what must be done without delay to obtain service and what is optional may be limited.61 Consumers have not been subject to marketing pressures at the point-of-sale in the past. Utility incumbents did not do a great deal of promotion or selling. Traditionally, consumers have not been presented with an array of choices for the underlying basic service. Moreover, many of the bells and whistles that will be sold as part of a package have not been bundled before or were easily separable. Now the consumer is faced with packages that are difficult to sort out.62 Recent research into mortgage shopping is interesting in this regard.63 Consumers shopping for a house were less likely to shop for the best interest rate and were less likely to get better deals. For them, the financing was incidental to the purchase of the house. In contrast, consumers who were refinancing did shop more and got better deals. When finance is the purpose of the transaction, consumers do just fine. When it is incidental to a different aspect of the transaction, they do not. Warning messages about a purchase may not be effective in this context. If they require a consumer to react quickly, like hanging up before billing starts, the message may be missed. Since the purchase decision is not focused on the array of products being offered, warnings and cautions are less likely to be heeded.64

The billing pattern for these services is also problematic. There is a disconnection between the purchase and the bill. Many weeks may elapse between the purchase and the bill. Further, the bill may make it difficult to identify exactly what costs how much. The cost itself is a monthly charge, which may appear small on a recurring basis, but over the course of the year adds up. The relatively small size of the monthly charge and the difficulty of sorting the bill out render pre-purchase information gathering and post-purchase follow-up less likely.65 Sellers can definitely exploit a situation of less than effective competition for these services. For many services being offered to consumers, alternatives are being offered for the first time, and they may be hard to find and difficult to evaluate. Exploitation of incumbency and the legacy of having provided a franchise service provide a point of leverage over the transaction. Consumers may have difficulty separating the basic services that they must purchase from the bells and whistles that are optional. Marketers will make this more difficult. Sellers will also exploit their position of authority and expertise.

61 Newman, Newman and Steelings, 1971, 1972; Claxon, 1974; Beaty and Smith, Wilkie, 1982; Funkhouser, 1984. 62 Loken, Barbara, Ivan Ross, and Ronald L. Hinkle, “Consumer "Confusion" of Origin and Brand Similarity

Perceptions,” pp. 195-211. 63 Lee, Jinkook and Jeanne M. Hogarth, “Returns to Information Search: Consumer Mortgage Shopping Decisions,”

Marketing and Public Policy Conference Proceedings, 1998, pp. 80-81. 64 Wilkie, 1987, Funkhouser, 1984. 65 Newman, 1977, Zimmerman and Gesfeldt, Chaiken, Beatty and Smith, 1987.


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3. Post-Purchase As the utility service is transformed into a commodity, the post-purchase phase is not conducive to effective consumer actions. Consumers lack an incentive to complain. With a monthly bill, they tend not to appreciate the size of the purchase. The transaction costs may be high in terms of time and effort to resolve what appears to be a small monetary dispute. Many of the problems that arise occur because the transaction is electronic. Consumers do not have a record of what was ordered. They do not take possession; they initiate service. The bill does not come until some time later. In the competitive environment, there may also be uncertainty about redress and responsibility for service. The former utility will typically be seen as the responsible party, but that may be correct only under some circumstances. Sorting out who is responsible for which part of the total service may be difficult. When three or four companies become involved, transaction costs for the consumer can mount quickly. Please see “Dispute Resolution” in the Consumer Impacts Recommendations further discussion of post-purchase issues.

VIII. REGULATORY RESTRUCTURING AND CONVERGENCE

A. Introduction Network industries are all undergoing fundamental and dramatic change driven largely by public policy reforms and technology, and the attendant market forces unleashed by those changes. Convergence is likely to be one of the adaptive responses to these changes. This section provides an understanding of the role that regulation could play in impeding or facilitating efficient convergence within and between the energy and telecommunications industries. For the purposes of this section, we define “regulation” to mean the public policies carried out by state and federal regulatory commissions to control monopoly power in the gas, electric, telecommunications, cable, and water industries. This includes regulation by local municipalities related to use of rights-of-way and taxation. It does not include policies carried out by antitrust agencies (though antitrust concepts may be used by PUC commissions) or that cover industries more broadly than the utility industries, i.e., generalized consumer protection, preservation of the environment, etc. This section covers the issues by focusing first on substantive issues and second on process issues as an initial organizational theme.

B. Convergence and Restructuring

Traditional utility regulation existed in lieu of customer choice in industries which were thought to operate most efficiently when only one company provided a given service. Such industries involved commerce through a network, typically involving significant capital investment in a fixed immobile asset that required rights-of-way for wires or pipes. Governments either owned these assets (municipals, coops, or federally owned authorities) or comprehensively regulated the companies that owned them. Traditional network regulation typically granted a franchise to the company providing the service and in return controlled the prices and services the company could offer. Typically, the network utility would have to seek permission to change the prices for its services. Serious pricing distortions abounded in regulated industries for a number of reasons, some deliberate but many not.


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There is an inexorable movement away from regulated monopoly toward customer choice. Goods and services that could be sold in competitive markets are being unbundled from network (transport) services that will remain regulated. Thus, some of the wires and pipes are likely to remain monopolies for some time. Regulation is still needed to curb many undesirable results. Regulators will have to face many new questions about their role and impact on the types of markets that are being created. Regulators cannot hope to make perfect decisions. Restructuring and its impact on convergence will inevitably involve considerable trial and error. Convergence is an adaptive response to network industry restructuring in the historically public utility industries. This response may provide competition and offer increased consumer choice throughout these industries. Distinguishing “convergence” issues from “restructuring” issues has been difficult, especially in the area of substantive policy. By and large, sensible policies furthering restructuring and competition will also further convergence. By the same token, policies that retard effective competition are likely to retard convergence. This paper does not attempt to describe all aspects of effective restructuring. Rather, it is intended to highlight those regulatory topics with particular impacts on convergence. Convergence is potentially beneficial for at least two reasons: It enhances competition in former monopoly industries by allowing firms to enter

new lines of business by a process of integration; and It provides new uses for existing network capacity, thereby spreading the costs of

that capacity among more users, potentially lowering prices, enhancing profits and providing additional revenues to mitigate or avoid the problem of stranded investment in some industries.

Though consumers could receive enormous benefits from convergence, CECA believes that convergence should not be a goal of regulation but rather should be an adaptive market response to changes engendered by technology and regulatory change. Within certain limitations, such as those imposed to prevent market power, regulators should “allow” convergence to occur consistently with their overall restructuring mandate and should remove any barriers that would prevent convergence from occurring. The marketplace should have the opportunity to determine the commercial viability of converged providers. Convergence is a challenge to regulators primarily in two circumstances. First, convergence creates new challenges in situations in which a competitive firm gains access to bottleneck facilities that are essential to its competitors. Bottleneck facilities are monopoly network assets that must be used to give value (delivery) to a competitive commodity or service. Two examples would be 1) a merger of electric and gas distribution networks under circumstances in which the gas network is essential to small scale, onsite power plants that might reduce electric distribution profits, or 2) entry of a power company into telecommunications in circumstances in which unique electric monopoly transmission and distribution infrastructure were used to convey exclusive advantages to a telecommunications subsidiary of the electric company. Determining how to regulate bottleneck facilities to permit efficient production and pricing of competitive goods and services is a very challenging enterprise. Complicating this challenge even more is the march of technology. Bottleneck facilities are not static in times of dynamic


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market structure and technological change. Today’s bottleneck facilities may face competition in tomorrow’s technological scenario. It is at least possible to conceive that cellular technology and phone-over-cable could substantially erode the “bottleneck” that the local phone company has on local service. Similarly, it is possible to conceive that microturbines fueled by natural gas might significantly diminish the “bottleneck” that electric companies have on the last mile of distribution wires. In some cases, technology and market structure changes raise questions about whether there remains a bottleneck facility at all, and the answer may have multiple aspects where the facility becomes capable of delivering a multitude of services. An example from cable illustrates this point. Plant upgrades and technological developments now permit cable operators to deliver a variety of services via cable modems – multichannel video services, telephony and high speed data services. With respect to multichannel video services, cable customers typically have only one wireline choice – the locally franchised cable operator – but they can obtain multichannel video entertainment from other sources such as over the air broadcast and satellite video. With respect to telephony services, cable telephony represents a second alternative to the incumbent local exchange company. With respect to high speed “broadband” data services, the question of the cable plant’s status as a bottleneck facility continues to be the subject of heated and robust debate: Should cable operators be permitted exclusive use of the cable plant to deliver such services, or should they be forced to provide access to potential competitors who would like to become providers of Internet service over cable modem? The answer turns in part on definition of the market: Is broadband Internet over cable service a market unto itself, or is it part of a larger market for the provision of narrowband (dial-up) online services, in which it faces heavy competition from numerous established providers? If broadband is a separate market, distinct from narrowband, what is the state of competition in that market, which includes other broadband providers (e.g., DSL, wireless, and satellite)? Will any of these competitors be able to challenge cable modems as the platform of choice for residential broadband services? The debate is unresolved among policymakers who are facing the question at all levels of government. To inform this debate, CECA published the findings of the CECA Broadband Access Summit in March, 2000.


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PART THREE: RECOMMENDATIONS

IX. SMART HOMES AND OFFICES OF THE FUTURE: THE TECHNOLOGICAL DRIVERS OF CONVERGENCE

Steady advances in technology have brought to the market a dazzling array of new capabilities in both the power and information markets. In addition to improvements in efficiency, cost, reliability, and flexibility, the effect of these options is to enable synergistic combinations in terms of improved services and further cost savings. In both the energy and telecom sectors, the state of the art is dynamic and further improvements are possible given sustained support of research and development and an economic and public policy climate favorable to innovation. As we proceed into the new arena of convergence it is important to understand that technical innovation has a way of both creating a need for regulation and forcing obsolescence of older regulatory rules. In a situation of rapidly changing technology, it is especially important to set rules of the road (i.e., regulations) with our eyes on the future. Three broad recommendations follow from these considerations:

A. Nurture Research and Innovation Sustain vigorous support of relevant areas of science and engineering research in both the public and private sectors. Research in energy and power, an enormous public as well as private good, has fallen dramatically over the past two decades. It should be restored to a level that assures us technical leadership in both power and information-related areas. Existing public policies should be carefully assessed to eliminate outdated or non-essential barriers or impediments to innovation in technology, market entry, etc. In establishing standards for new technologies, industry groups should work to minimize restrictions upon development and innovation. Thus, the standards would allow companies to leverage existing technologies and allow new companies to “leapfrog” those technologies while developing newer ones. This will aid in increasing the pace and effectiveness of technology development.

B. Streamline the Governance of Technology Policies should be devised to encourage new forms of partnerships and

consortia aimed at improved delivery of services, lower environmental impacts, and other public goals.

Technical approaches and standards that can help assure broad access and

interoperability in converged systems need to be fostered.

Technologies should be shaped to help assure safety, flexibility, and resilience to disruptions such as common mode failures, including those failures due to willful acts of violence.


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Supporting technologies should be designed to enable accurate, clear, and timely prices signals to the consumer.

In all of the above it is important to avoid inconsistent and overlapping

regulations from different political jurisdictions.

C. Link Technology Development with Community Development

The opportunities provided by convergence and its associated technologies could fall short absent educated and aware consumers. It is incumbent upon the industry to participate in raising community and customer awareness of the opportunities that convergence offers to informed customers.

Government funding of R&D should be emphasized in those industries

where there is substantial commercial support of consumer education and training programs. It is for the benefit of consumers as a whole that governments fund some technology research. This funding needs to be judiciously assigned so that those companies most likely to benefit from the later commercialization of the results of that research have some burden to fund consumer education in this industry. Additionally, training programs for unemployed or displaced workers should be funded by companies to assist in growing the pool of skilled resources in the industry.

Government sponsored financial support of commercial technology

ventures (e.g., business income tax relief) should include some requirement for community development by the commercial ventures seeking the relief. The goal of this type of program is to encourage commercial ventures and hiring in areas that traditionally do not serve as employment hubs.

CECA recommends that R&D programs should be integrated with long-term basic research conducted by the Department of Energy and other government agencies. To maximize the efficiency and effectiveness of R&D resources, CECA proposes that the following guidelines should be followed when implementing the above recommendations:

Stakeholder Involvement: R&D priorities for public benefits energy R&D programs should be identified through a strategic planning process involving a broad group of public and private R&D stakeholders. In general, all types of R&D should involve stakeholders and market participants to enhance the development of practical results and their application. Users of technology (e.g., power producers, distribution utilities, new industry entrants, customers, and public interest groups) should be involved in the R&D process to effectively identify problems and opportunities to “buy-in” to the results and to apply them promptly.


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Allocation on Merit: The allocation of R&D funds should be based on merit and the value of the proposed research. Technical competency, cost effectiveness, ability to deliver results, commercialization capability, and user needs are important attributes to consider in allocating R&D funds.

Portfolio Balance: The nation’s R&D portfolio should have a balance of

both near-term and long-term objectives and pursue a mix of technical alternatives defined through a strategic planning process. Publicly funded programs should address longer-term needs and specific market defects in R&D areas which may not be effectively supported in a restructured industry.

Efficient Use of Resources: To get the most from limited R&D resources, (i)

R&D funds should be leveraged through multi-party collaboration and public/private partnerships (i.e., at the international, national, regional, or multi-state level where possible); (ii) the existing R&D infrastructure should be used where possible; and (iii) programs should deliver services in a timely manner with low administrative burdens.

Evaluation of Program Effectiveness: Project and program performance

should be evaluated periodically to ensure that good R&D choices are being made. Such review would ensure that existing that good R&D choices are being made. Such review would help ensure that existing publicly funded programs are discontinued if markets adequately address them, and that new public needs are addressed, as appropriate, if they develop. In addition, periodic review of R&D organizations by outside experts would help determine their effectiveness and provide guidance for future operations.

Coordination and Integration: Energy technology roadmaps should be

developed through a strategic planning process conducted as a voluntary public/private initiative. The roadmaps could identify the essential societal, economic, and environmental needs, as determined by the stakeholders. The technology roadmaps would help elucidate the most effective participation opportunities among state, federal agencies, the national labs, private industry, and collaborative R&D institutions to guide the efficient use of limited R&D resources.

X. MARKET POWER ISSUES

It has been suggested that policymakers should suspend activity on convergence mergers and convergence activities until more experience can be gained from those which have already taken place. CECA considered but does not recommend a moratorium. Given the scale and scope of the potential benefits associated with convergence, CECA believes the opportunity for consumer gain outweighs the asserted advantages of regulatory caution.

Regulators and policymakers have a broad array of structural, behavioral and regulatory approaches to choose from in dealing with perceived market power issues in convergence mergers. Structural approaches include (but are not limited to):


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Separation of control from ownership of monopoly conduit facilities;

Partial or complete divestiture of all upstream nonmonopoly assets; and

Organizational segregation of vertical or horizontal elements into discrete corporations with separate bookkeeping and (partial or complete) separate management.

Behavioral approaches include (but are not limited to):

Functional unbundling and codes of conduct governing inter- and intracorporate relationships; and

Restrictions on the use of name and logo.

After considerable discussion, agreement could not be reached on whether structural or behavioral remedies should be applied by regulators either at the conclusion of an individual case, or as a screening device for preapproved mergers or convergence activities. CECA/RF recognizes that significant pros and cons exist with both approaches.

CECA/RF does believe a hybrid approach shows promise and should be considered by regulators. The hybrid approach, as envisioned by CECA/RF, would allow convergence mergers and activities to proceed using a behavioral paradigm at the beginning. Under this approach, if market power abuse is evidenced, then a strong structural sanction, such as divestiture, would be employed. CECA/RF recommends that the scope of regulatory maneuver be restricted so that the structural sanction serves as a sufficient deterrent to market power abuse.

In addition, a number of regulatory controls have evolved to address market power concerns, such as:

Open access terms requiring comparable service and price transparency on monopoly conduit facilities;

Price caps combined with incentive and performance-based rates;

Negotiated or prescribed standards of service;

Negotiated or prescribed standards for new facilities investment; and

Non-price allocation of bottleneck facilities.

In those convergence mergers and activities which have passed regulatory scrutiny to date, regulators at the federal and state level have drawn from the various structural, behavioral or regulatory devices available and have tailored the conditions of their regulatory approvals to the specifics of each case.

CECA believes regulators and policymakers might consider in the future a dual track approach to market power concerns in convergence mergers. The first track would establish a set of prescribed conditions which, if met, would promise expeditious approval. The second track would be reserved for hard cases or those instances in which the merger candidates seek


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modification in the pre-approved conditions. If a fast track mechanism is employed, regulators should consider also providing for a post-review “true-up” mechanism to build back in structural, behavioral, or regulatory controls if found to be necessary to correct for unanticipated inimical market consequences or consumer impacts.

Whether a fast track or case-by-case path is followed, CECA recommends that regulators should provide market participants with a complaint process to raise concerns about anti-competitive behavior. CECA recommends that regulators also examine carefully how certain regulatory actions or policies could, in turn, become entry barriers to the marketplace.

In determining the market power of a company seeking to enter into a specific market, CECA recommends that regulators examine the core business of each party in determining which party is the incumbent and which party is the new entrant to that market.

CECA recommends that the companies engaged in mergers and convergence activities themselves be involved in setting and being responsible for the mileposts in which the success or failure of such convergence mergers and activities will be judged.

XI. CONSUMER IMPACTS OF CONVERGENCE

Recommendations on the consumer impacts of convergence are necessarily built upon the assumption that a workably competitive market for essential services exists. CECA believes that competition promotes economic efficiency, new products, technological and market innovation, lower prices, and better customer service. Therefore, the recommendations in this section must be viewed in tandem with the recommendations found above in “Section X. Market Power Issues.” A competitive market, in and of itself, is not enough to ensure that consumers are protected from market abuses such as deceptive marketing practices and the misuse of personal information. Moreover, CECA believes that the smooth functioning of the market is dependent on proactive public policies concerning customer information, metering and billing, consumer education, and a “Consumer Bill of Rights.” These policies are not meant to dictate market conditions, but rather to structure the market for maximum consumer confidence and participation. Finally, the market has a difficult time in valuing externalities, such as low-income assistance, that are in the public interest to support. CECA has made recommendations in this section on how to continue support for universal service and other public interest objectives in a convergence market.

A. Consumer Bill of Rights The market for essential services – electric, natural gas, and telecommunications – is undergoing a historic transformation, moving from a heavily regulated market to one based primarily on competition. CECA recommends that a “Consumer Bill of Rights” be developed by state agencies with guidance from federal regulatory bodies such as the Federal Trade Commission. The “Consumer Bill of Rights” should provide consumer information and protection as consumers purchase essential services, particularly as a bundled package. The “Consumer Bill of Rights” should be widely publicized and distributed to every consumer. CECA recommends that the “Consumer Bill of Rights” focus on current and future marketing activities of essential services, with a particular focus on packaging and bundling of those services. The “Consumer Bill of Rights” should include but not be limited to: 1) a summary of current consumer protection


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laws outlining the rights of consumers in regard to buying essential services; 2) guidelines for buying bundled packages of essential services; 3) a summary of dispute resolution options; and 4) a summary of information disclosure requirements and privacy rules. The ”Consumer Bill of Rights” should be concise and user-friendly. Markets function best when consumers receive credible and comprehensible information. This is all the more true when moving from a regulated market for essential services to one based on competition and convergence. Given some of the problems and confusion surrounding the offering of one deregulated service, e.g., long distance phone service, it is inevitable that the offering of a bundled package of essential services will magnify that confusion if steps are not taken to simplify and clarify the options available to consumers. 66 In order to ensure that small business and residential consumers are able to compete effectively for the best rates on individual and packaged services, CECA recommends that efforts to facilitate aggregation should be encouraged by local and state officials for all small business and residential consumers residing in areas of retail competition. The Federal government should preempt the right of states to prohibit aggregation by any qualified party, and states should not impose costs or other barriers on aggregation. Aggregation will allow small business and residential customers to exercise market power. Government entities – non-profit or cooperative organizations – should be permitted to aggregate small customers. Aggregation could be offered to default customers, low-income customers, or any other set or subset of the residential and small commercial classes. CECA recommends that consumers should be entitled, but not be forced, to buy essential services such as gas, electricity, or telecommunications as part of a bundled offering. The

66 Examples of “Consumer Bill of Rights” documents can be found at the following sites:

Federal Communications Commission, “FCC Chairman Kennard Launches Cable Consumer Bill of Rights Campaign,” FCC web site, March 31, 1999. National Rural Electric Cooperative Association (NRECA), “Consumer Bill of Rights,” NRECA web site, March 10, 1999. Ohio Consumer’s Counsel, “Columbia Gas Customer CHOICE Consumer Bill of Rights,” http://www.webtest.state.oh.us/cons/gaschoice/colbil.html, January 28, 1999. Vermont Department of Public Service, Docket No. 5903, “Vermont Department of Public Services Position Paper on Consumer Protection and Privacy Issues,” http://cit.state.vt.us/psd/cppaper.htm, April 4, 1997. National Association of State Utility Consumer Advocates, “Resolution Urging the Adoption of a Consumer Bill of Rights Applicable to All Consumers of Electricity, Gas and Telecommunications Services,” www.nasuca.org, June 10, 1998. Michigan Public Service Commission, Case No. U-11290, Electric Restructuring, Customer Focus Issues and Recommendations: Electric Consumer Bill of Rights,” http://ermisweb.cis.state.mi.us/mpsc/reports/annual/1997/index.html, October 13, 1997. California Public Utilities Commission, “Consumer Bill of Rights Under Electric Restructuring,” http://www.cpuc.ca.gov/divisions/CSD/GLOSSARY/bil-rght.htm, 1997.


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purchase of one service should not be conditioned upon or tied to the purchase of other services. A la carte offerings of any given essential service should be available. On the other hand, consumers should be provided an opportunity to buy essential single utility services from one or more providers on a bundled or an unbundled basis. For example, with electric service, consumers should be able to buy the different components of that service – transmission, distribution, and generation – from the same company or different companies offering those elements of basic service. Furthermore, consumers should be able to purchase basic service at reasonably affordable rates. Consumers should not be forced or coerced into buying services that they do not want or need. Policies to promote fair marketing and prevent fraud should be both reactive and proactive. Oversight agencies should develop guidelines, rules, and standards for marketing and advertising at the point of sale and should conduct studies to ascertain the state of marketing and sales practices. For example, an aggressive anti-slamming program should be conducted. This would include implementing procedures such as third party verification for preventing slamming (changing service providers without the written permission of the customer). At the same time, consumer protection agencies in the states, which could include public utility commissions, should have the authority and resources to obtain lists periodically of customers from service providers and conduct random samples of those customers to ascertain whether customers have the services and the service providers that they expected. These agencies should also have enforcement authority and a dispute resolution process, as discussed.

B. Dispute Resolution There are four steps in the complaint process -- intake, investigation, resolution, and redress. CECA has pointed out a number of factors that may reduce the willingness and ability of consumers to pursue disputes with former utility service providers, even though they have been wronged. Without effective dispute registering procedures, abusive practices are likely to persist because of the difficulty of pursuing post-purchase remedies. Therefore, it is important to provide support for registering complaints. Companies should be required to provide 800 number services and notification of dispute procedures. The lead state consumer protection agency should also have a centralized dispute handling service. Policies to protect consumers from unfair or rapid loss of service during the adjudication process must be in place. CECA recommends that the federal government immediately develop a “hand-off” policy and mechanism to ensure the timely delivery of consumer complaints to the relevant state agency in charge of complaints. In turn, the relevant state agency should be required to collect records of consumer complaints and transmit that data in aggregate to the relevant federal agency. CECA believes that a new dispute resolution mechanism is needed to resolve disputes between consumers and marketers of a bundled package of essential services. To reduce the costs of dispute resolution, the dispute resolution mechanism could incorporate alternative dispute resolution (ADR) methods, e.g., using an arbitrator initially rather than sole reliance on the courts. Consumers should be entitled to representation in these disputes by state consumer advocates or other legal representatives. But this process ought not supplant the opportunity for consumers to get their complaints resolved by a consumer protection agency first.


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CECA recommends a “one stop” approach to dispute resolution, meaning that consumers should be able to resolve a dispute involving a bundled package of services at one location. Consumers will need a place to go for dispute resolution because relying on courts will be ineffective and inefficient. CECA does not want consumers to be put in a situation that requires them to go to three different locations in order to resolve a dispute over various services provided by a converged utility. CECA recommends that provisions for dispute resolution be as local as possible. CECA recommends that existing consumer protection laws should be vigilantly enforced in regard to the marketing of a bundled package of essential services. As part of any transition to competition, CECA believes that state public utility commissions, in addition to the state attorney general’s offices, state consumer advocate’s offices, and other existing authorities, should be responsible, through rulemaking, for the promulgation and enforcement of utility-related consumer protection laws. After a competitive market for any given essential service has been established, an assessment of the future role, if any, of the state public utility commission in regard to consumer protection should be made. In the long-term and in a competitive market, some believe that divided authority to oversee and enforce consumer protection might be less effective. Others believe that State PUCs should have licensing and consumer protection authority to provide customers with a regulatory dispute resolution process and to permit regulators to weed out bad actors through license suspension or revocation. Within this framework, State Attorney General offices would bring civil enforcement action in State court, seeking civil remedies like damages and injunctive relief. State PUCs and State Consumer Advocate offices should have the resources to hire and train personnel to address consumer concerns and to investigate consumer complaints. Though some overlap may occur during the initial transition to a competitive, converged marketplace, states should work to avoid duplication between public utility commissions and states attorneys general’s responsibilities. Currently different agencies handle consumer complaints – the attorneys general’s offices pursue matters in the courts, while other offices handle non-litigious disputes like shut-offs or billing complaints. In some cases, which process and agency is appropriate for a specific dispute is clear-cut. Allegations of fraud are referred to the attorney general’s office, while complaints about interruption of service are referred to the PUCs. From the consumer perspective, however, resolution of billing disputes in a converged marketplace quickly becomes confusing, as consumers may have to approach different state agencies for charges on a single, bundled bill. In the interest of consumers, states should make efforts to consolidate and clarify recourse for consumers in the converging marketplace, as part of a broader move towards “one stop shopping” for consumers.

C. Privacy and Exchange of Personal Information Consumers are increasingly concerned about the privacy and security of personal information being disseminated for marketing purposes. The bundling together and selling of many essential services as a package could exacerbate people’s fears about how personal information will be used in a convergence market. In a regulated market, public utilities did not usually collect personal information in order to sell that information or use it for their own marketing purposes. With competition and convergence, there will be many more opportunities for the unregulated affiliates of these utilities to use that information for competitive purposes. This is especially true as the transaction costs of


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collecting and sharing that information decrease with the advances made in the use of the Internet as a tool of commerce. Dissemination of information about billing, payment history, and consumption patterns must be under the control of the customer. To the extent that exchange of such information is necessary for efficient billing, it should be made available to the parties with whom the customer has contracted for service. CECA recommends that the “Fair Information Practice Principles,” developed by the Federal Trade Commission and other government agencies, be applied to the marketing of essential services. The principles are the following: 1) Notice/Awareness – companies should be required to provide consumers notice of their information practices; 2) Choice/Consent – a requirement to offer consumers choices as to how personal information is used beyond the use for which the information was provided for; 3) Access/Participation – a requirement to offer consumers reasonable access to that information and an opportunity to correct inaccuracies; 4) Integrity/Security – a requirement to take reasonable steps to protect the security and integrity of that information; and 5) Enforcement/Redress. CECA recommends that marketers adopt and disseminate a privacy statement on the company’s information practices in regard to the collection, use, and dissemination of personal customer information. CECA recommends an opt-in approach to the release of certain personal account information, whereby consumers would indicate their acceptance of the release of personal information through written authorization.

D. Mandatory Information Disclosure With the restructuring of the electricity markets, some states have required that all retail electricity marketers use a succinct and uniform “label” on electricity bills and promotional materials. Moreover, consumers will be expected to enter into a contract in a competitive market. These labels would include such information as: contract price; basic contract terms; a baseline, regional system default label depicting certain types of emissions of pollutants; justification for any special marketing claims such as “green power”; and fuel mix. CECA is on record as supporting such labels. CECA has recommended that all retail electricity merchants disclose in a standardized format the price, source, and emission profiles of their power. CECA has recommended that: Annually, customers should receive detailed information concerning their rights and

obligations under their power contract. A succinct and uniform “label” on electricity bills and promotional material should

convey important information, including: contract price; basic contract terms; a baseline, regional system default label depicting emissions of SO2, Nox, and CO2; justification for any “green power: claims or other special claims if made; and fuel mix. The label should depict the characteristics of any specific products purchased by the consumer.

CECA believes that billing clarity and disclosure are important for the following reasons:


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To enable consumers to make informed and intelligent choices regarding

disparate products and services. To educate consumers about rates and charges that may apply on a recurring or

one-time basis for each product and service selected. To allow consumers to differentiate the various carrier charges which may appear

on their bill. To allow consumers to challenge, in a proper and timely fashion, charges which

may be subject to dispute. To enable consumers to identify fraud, such as cramming or instances of

slamming, and to address such concerns to both regulatory and industry representatives.

To provide for the availability of rate comparisons with marginal transaction costs

to the consumer. To identify the costs and benefits associated with a particular product or service, thereby

enhancing product value and customer satisfaction. To differentiate credible carriers from fraudulent carriers.

CECA recommends that consumers have the ability to compare basic service options – basic electric, natural gas, local and long distance telephone service – even when bundled together as a menu of options. With a multiplicity of retail service providers offering a multiplicity of promotional claims and products, CECA believes it is essential that state and federal regulators ensure access to comprehensible information from credible sources in a standardized format.

E. Billing and Metering Metering and billing services provided to residential and small business consumers represent a convergence point to the end-user. Consumers will increasingly be offered a menu of options for the supply of gas, electric, telecommunications, etc., which will mean that consumers will get one bill for a variety of services traditionally provided by a regulated local distribution company. Terms of delivery of bills and billing information should be stipulated by local and state officials. This should include frequency of billing and notice, information and billing detail, format and language requirements. CECA recommends that onerous restrictions (high transaction costs) be avoided for consumers to opt-in or opt-out of a package. Customers must be protected against abusive marketing practices. Federal and state regulations should explicitly outlaw slamming and other fraudulent or abusive marketing practices (unauthorized upgrade of services, pressure tactics, bait and switch tactics, negative options, etc.) Policymakers should enact rules regarding notification of changes in service and the language requirements for such notification. They should set standards for information included in marketing materials. Furthermore, policymakers must prevent a range of marketing practices –


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slamming, cramming, false billing, fraud in advertising or labeling, unfair collection practices, pressure tactics, and redlining. In a competitive market, consumers should have the opportunity, within certain bounds, to select the means of metering service, to choose the actual metering devices employed, and to have some input on the bill format. CECA recommends that metering and billing services be considered to be competitive and, unless there is good cause, should not be restricted to any one local distribution company. CECA recommends that, following instruction, consumers be allowed, but not required, to read their own meters. Consumers who choose to do so would be required to read their meters within designated time limits.

F. Customer Education The vast majority of consumers are unaware of the movement towards retail competition for essential services. A 1998 survey conducted by International Communications Research found that only 38 percent of Americans were aware of efforts to restructure the electricity market. There is a great deal of confusion over billing, service options, and generally what is meant by “customer choice” for the purchase of telecommunications, electric, and natural gas services. Price and quality information that is understood by and useful to residential customers must be developed and must go beyond mere reliance on the marketplace, at least in the transition period. In telecommunications, we have had over a decade of competition and consumers still do not get good information from industry members. Instead, we have confusing and misleading advertising information and elaborate and inadequate “public interest” efforts to develop information. There are four steps to conducting a successful consumer education campaign. First, the regulators must encourage the development of materials to enable consumers to make effective choices. Initially, consumers should be educated about competition. They must be made aware that new decisions are coming. Consumers must be provided information on price, quality, and features that facilitate comparisons across providers. Apples to apples comparisons are in the public interest, whereas apples to oranges comparisons will make it difficult for consumers to make intelligent choices. Second, outreach efforts should be conducted by state public utility commissions and/or distribution utilities. These should rely on general advertising as well as community-based efforts. Third, each provider should be required to prepare a plan for consumer education. The plan should cover materials, outreach, and monitoring. Fourth, the effects of education efforts should be monitored. Surveys to assess the extent of consumer knowledge and the best means to improve areas of weakness should be conducted. Audits of company efforts should also be carried out. To ensure that convergence benefits all consumer classes, CECA recommends that public and private funds be made available to educate consumers on how the market for convergence of essential services is structured, to educate consumers about how to choose wisely, and to educate consumers on their rights in regard to purchasing essential services. CECA recommends that consumer education on restructuring begin immediately, and that education on convergence begin as soon as convergence services are permitted to be offered by suppliers in a given region. CECA believes that consumer education will create a context for change, give small business


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and residential consumers a voice in the debate around how the new market is structured, and give consumers the tools to make a choice which benefits them and their families. The cornerstone of consumer protection is consumer sovereignty. The ability of consumers to exercise informed choices in the marketplace is essential to the efficient functioning of a market. CECA believes that informed consumers making informed choices drive competitive markets, and that public policy should be pro-competition and pro-consumer. A slight, short-term chilling of innovation may be acceptable in exchange for better-educated consumers.

G. Universal Service Given the fact that the marketing of gas, electricity, and communications represents essential commodities, and that the vast majority of consumers have access to and rely on these commodities, CECA recommends that universal service – traditionally defined as widespread, easy access to essential commodities or “lifeline services,” at an affordable price – be provided for as the markets for these commodities overlap and converge with one another. CECA believes that universal service should remain a fundamental right of all citizens. Delivering these services under a competitive model on the supply-side does not change its fundamental demand-side characteristics as necessities. Therefore, the broad range of protections for utility services must be preserved. Specific issues that arise in this area include application, credit, deposit, disconnection, collection, dispute resolution, and partial payment. Under no circumstance should convergence diminish any customer’s access to lifeline services or protections in accessing lifeline services. CECA believes that universal service requirements should be technology-neutral. Distributed generation and wireless services, for example, in addition to other emerging and future technologies, may provide economical, reliable, low-impact alternatives for utilities required to serve rural and hard-to-reach customers, provided that safety, maintenance, and quality of the service is not diminished.

XII. REGULATORY RESTRUCTURING AND CONVERGENCE

As industries converge, a fundamental mission of regulation is to assure that regulatory policy furthers customer choice in former monopoly markets and does not diminish customer choice in all competitive markets, and for regulatory actions directed at one market not to ultimately diminish customer choice in another market. Sound restructuring measures undertaken to further competition are likely to further convergence. CECA recommends disfavoring arrangements providing exclusive access to facilities that are genuinely unique and crucial to the provision of an essential service. Bottleneck facilities, once clearly identified as such, should operate on a nondiscriminatory basis to the extent possible to assure that all buyers of goods and services in the former monopoly markets that were controlled by bottleneck facilities are able to have access to all providers of the services for which they are willing to pay. Another substantive challenge posed to regulators by convergence and restructuring is the need for integration or standardization of policy across state jurisdictional boundaries. The essential policy change that drives both convergence and restructuring is the unbundling of goods and services that can be sold competitively from network elements that may continue to be regulated.


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This policy change is the same in all the network industries and one might expect a high degree of similarity among states implementing such a policy. Such is not the case. Each state has the authority, within broad limits, to adopt a restructuring regime for both energy and telecommunications retail markets. Conceivably, each state could adopt a unique regime for gas, electric, telecommunications, and cable, a potential total of almost 200 different regimes in the continental US. It is already evident that states are adopting very different policies and implementation schedules regarding network restructuring. Even policies within a particular industry, e.g., electric, can be very different from state to state. Indeed, since some states give considerable latitude to individual utilities, the potential number of different paradigms is mind-boggling. Regulators should create a streamlined review process that balances consumer protection with the need for timely acceptance or rejection of innovations. Technological advances will play an ever increasing role in the economic viability of the nation and in the lives of consumers. Appropriate levels of governmental review can act to stabilize a market, for example by ensuring proper safety for consumers. However, an overload of regulations independently established by the fifty states and the federal government would act to slow technology research and commercialization, thus having a deleterious impact on consumers and the economy. Some of the benefit of restructuring to consumers comes from scale efficiencies, i.e., larger networks and larger marketers. Such scale efficiencies may be severely compromised by patchwork regulation. This significantly raises transaction costs to new entrants. Though experimentation is beneficial to promoting innovation and to testing new ideas, some standardization of network policy must take place for interstate commerce to be conducted efficiently through networks. There is too little current effort to rationalize, evaluate, or standardize retail network restructuring policies and protocols.

NARUC has recently taken an important initial step in recognizing the need to develop a better analytical basis for standards by issuing a request for proposal for a study. In its request NARUC stated:

As states begin to introduce retail access, it is becoming increasingly apparent that business rules are varying significantly, state by state. The lack of uniformity, if unchecked, has the potential to be a significant impediment to the profitable market entry and operation of competitive energy service providers. These firms differ from traditional utilities in that they usually do business across multiple service territories and states. The diversity in rules and procedures for providing essentially the same service in different areas may increase the costs to consumers and decrease the profits of such competitive providers. This lack of uniformity could potentially restrict their entry into the competitive market place and subsequently reduce consumer benefits from full retail access. NARUC, accordingly, seeks to promote regional and national consistency in retail access business transaction rules and procedures, where feasible and practical. The emphasis of this project should be on the identification of "best practice" rules governing the transactions between the regulated gas and electric distribution utilities and the competitive energy service providers. These rules, procedures, and associated issues can include, but are not limited to:


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A. Eligibility/licensing/certification/registration requirements for energy

service providers. 1. What information is required (e.g., demonstration of technical ability,

financial ability)? - Are these information requirements uniform for all utilities in the state

or do they vary utility-by-utility? 2. What are the creditworthiness or security requirements?

- Are these requirements uniform for all utilities in the state or do they vary utility-by-utility?

- Is there an ISO that imposes separate creditworthiness or security requirements?

3. Is there a differentiation between energy service providers and brokers? - Is there a difference between the information requirements for providers

of generation services and those for providers of metering and billing services (where applicable)?

4. What actions must an energy service provider take, other than licensing/eligibility/registration, before it can provide service to a customer in a particular utility service territory?

B. Procedures and information required for enrolling and switching

customers. 1. What type of customer authorization must an energy service provider

obtain before enrolling a customer? - What is the utilities’ role in verifying customer authorization?

2. What information must energy service providers give utilities? 3. How is this information provided (e.g., in what format, how is it sent)? 4. What do utilities do with this information? 5. When does service begin? 6. Are there safeguards to prevent slamming? 7. How does an energy service provider terminate generation service to a

customer? 8. What information must energy service providers give customers and

when? 9. Is there a difference, in terms of the procedures and information

requirements addressed in questions 1 through 8, between providing generation service to customers and providing metering and billing services to customers (where applicable)?

C. Requirements for the exchange of current customer usage and billing

information on an on-going basis, between utilities and energy service providers.

1. What information must be exchanged? 2. How is this information provided (e.g., in what format, how is it sent)? 3. When is the information sent? 4 How does competitive metering or billing impact these requirements?

D. Requirements for the exchange of historic customer usage information

between utilities and energy service providers.


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E. Requirements for the exchange of customer payments between utilities

and energy service providers, including invoicing procedures. 1. How are partial payments apportioned between utilities and energy

service providers? 2. How and when is money exchanged between utilities and providers?

F. Billing options available to customers/energy service providers.

1. Is billing a monopoly or competitive service? 2. What are the competitive billing options (e.g. single bill from energy

service provider vs. multiple bills)?

G. Metering options available to customers/energy service providers. 1. Is metering a monopoly or competitive service? 2. What are the competitive metering options (e.g., meter installation,

reading, data management)?

H. Procedures for resolving disputes between energy service providers and utilities.

1. What disputes do the states address (energy service provider/customer; utility/energy service provider)?

2. What specific procedures are followed? 3. What procedures are used to discontinue energy service providers?

In addition to NARUC’s efforts, the Coalition for Uniform Business Rules (CUBR) announced that it had developed a consensus within the marketing community on a set of uniform business rules. They announced that they and the Edison Electric Institute would meet to determine if a consensus could be reached between marketers and utilities. In March, this effort resulted in an interim report for comment, with the expectation that a final report would be completed by summer 2000. CECA recommends that state, federal, and industry decision makers should acknowledge the need for standardization of certain policy and business rules that facilitate the emergence of competitive markets. CECA recommends further that, while such state/regional/federal collaborative review and regulation should be established initially by permitting states wide latitude to take a leadership role, the federal government, in recognition of the increasing implications to interstate commerce created by the emergence of retail competition, should have supremacy in settling conflicts between state, regional, and federal standards. Policymakers should identify which policies, consumer protections, and rules for businesses will be most critical to enhancing consumer benefits in emerging competitive markets.

A. The Problem of Incumbents in the Choice Model In analyzing the substantive issues that affect convergence, CECA found a consistent theme. Many of our issues dealt with the question of how the incumbent network provider should be treated in the choice model. The tension is clear – if incumbent network providers could use their market power over the network to enhance the attractiveness of their competitive offerings, consumers and the economic interests of new entrants would be injured. Conversely, if burdens are imposed on the incumbent’s competitive services that are not imposed on new entrants,


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unfairness results to the incumbent. This is not a new or unique issue. In 1906, Congress prohibited railroads from owning coal and grain in order to ensure that railroads did not discriminate against independent businesses. More recently, both the breakup of AT&T and the antitrust suit against Microsoft involve issues of using network facilities to influence the value of potentially competitive services for which the network facilities are needed. If the incumbent has significant advantages compared to potential new entrants that prevent effective competition, then policies that rectify those advantages are appropriate. At the level of cliché, it is too simplistic to merely assert that the incumbent should not be permitted to abuse its market power and should not have burdens imposed that are asymmetrical with the burdens of new entrants. The issue is a good deal more complicated and inextricably intertwined with restructuring and the different degrees of market power of the network providers. The issue of the incumbent versus the new entrant has two dimensions. The first relates to whether new entrants have an adequate incentive to enter new markets. A significant part of this question revolves around how the incumbent will be allowed to compete against the new entrant. The second dimension is whether the incumbent bears burdens that are not borne by the new entrant. With regard to the first dimension (new entrant burdens), the following issues have been identified as being implicated in convergence analysis: Existence of competing regulated service; Existence of an affiliate doing business in the related utility’s service territory; Customer information; Cross-subsidies favoring affiliate or regulated services; Use of rights-of-way, poles, etc.; Tax advantages.

With regard to the second dimension (incumbent burdens), the following issues have been identified: Social benefits obligations; Cross-subsidies disfavoring the regulated service; Tax advantages.

Companies subject to rate regulation while also selling competitive services will have an incentive to classify costs so that they are recovered as part of their regulated costs, allowing them to undercharge for the competitive services – in other words, have the regulated service cross-subsidize the competitive service. While regulators have been confronted with such problems since the inception of regulation, these cross-subsidy problems will become more difficult in the future, especially where rate-of-return regulation endures. Regulated companies will have incentives to adopt operational rules that, though they have some justification, may disadvantage competitors and give an advantage either to the utility’s potentially competitive non-network services or to the utility’s affiliate. Again, especially where there are seemingly legitimate operational reasons for a given rule, regulators may be reluctant to take the necessary actions to determine if there are other less competitively harmful ways to accomplish the same operational goal, thus erecting additional barriers to new entrants.


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Affiliate questions become more complicated in a convergence context. Air conditioner and furnace contractors have long complained about what they believe to be unfair competition when a gas or electric utility offers air conditioner and furnace repair and replacement services. Propane companies complain that electric co-ops have an unfair advantage in selling propane services in addition to electric services as a result of special legal status and public financing. Independent new entrants believe that utilities, even with codes of conduct imposed on them, still have significant opportunities to tip the playing field against would-be competitors. Regulators have approached this problem with both behavioral and structural remedies. The behavioral approach waits for bad behavior and then corrects it, possibly with severe penalties. The structural approach adopts a “structure” for the operation of markets that eliminates the incentive for bad behavior. Allowing triple damages for price fixing is an example of the behavioral approach. Under the structural approach, incumbent network companies might be prohibited from offering products and services that would provide an incentive for the network company to distort competition. The breakup of AT&T was such a structural approach. The behavioral approach has been adopted by FERC for gas pipelines that have affiliated gas marketers. If the pipeline abuses its obligation to provide nondiscriminatory network services to independent marketers and such abuse is discovered, the pipeline could be penalized. The structural approach is actually much more prevalent in network industries. As noted above, Congress prohibited railroads from being in the grain business (the so-called commodities clause), and the AT&T breakup required divestiture between long distance and local service. The Telecommunications Act of 1996 continues line of business restrictions for Baby Bells until conditions are such that anti-competitive behavior is thought not to be a serious risk (the so-called 14 point checklist). Public ownership is also a structural solution. The government owns highways and airports, the relevant network monopoly, and allows nondiscriminatory access to the network facilities. The structural solution, however, runs the risk of a loss in economies of scope when total costs would be lower if the network company sold both network and non-network services. Many parties object to any solution that prohibits a potential competitor from entering a market. On the other hand, allowing networks into competitive markets may create tremendous transaction costs in regulation, the loss of competitive efficiencies, and the loss of productive efficiencies associated with new entry, innovation, and competition. The application of the behavioral/structural approach also depends on the degree of market power of the incumbent. While the case for incumbents distorting markets by favoring their own services is strongest when the network is needed to deliver an essential commodity, many have raised concerns about incumbents’ ability to distort competition even when network services are not necessarily part of the delivery mechanism for services. For example, some object when local telephone companies offer the sale and installation of customer equipment. The concern is that many consumers view the utility as having a unique competitive position because it has been a reliable supplier of utility services. If competition is to flourish, some believe this unique position must be neutralized. Others are not concerned about the incumbent’s competitive position, arguing that if the utility has competitive advantages emanating from its past services it should be permitted to take advantage of its good reputation.


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CECA recommends that a safeguard be adopted similar to the rule used for telecommunications. A regulated company (including its affiliates) with strong market power should only be permitted to sell competitive services within its service territory if it has first met stringent standards for nondiscriminatory access to third party new entrants. A corollary to this principle is that a regulated company with little or no market power over services should be permitted to sell services other than its core business services in competition with independent new entrants. For example, an incumbent electricity company should be allowed to sell electricity within its service territory only if there is open nondiscriminatory access for other suppliers of electricity. However, the same electricity company that sells telecommunications services should be considered as a new entrant. CECA recommends that if the presence of competitive affiliates does create market power concerns, conditions imposed on merger approvals should not differ from those ultimately imposed on comparable businesses, which are not involved in merger proceedings.

While the discussion above deals generically with the incumbent network issue, the following sections address individual substantive issues.

B. Social Benefits All regulated network industries have policies related to ensuring that regulated utility services are made broadly available. There are two categories of such policies. First, some regulated industries are required to build new facilities to serve new customer load. Second, policies are adopted to lower prices for customers otherwise unable to pay for essential services. In establishing policy, regulators must ensure:

Relative fairness between customer classes in both cost and quality of service;

Nondiscrimination within customer classes – similarly situated customers must

be treated similarly – and vigilantly enforced prohibitions against redlining; Subsidies, taxes, and fees should be explicit in policy and purpose.

These policies can also distort customer choice and competition. Subsidies can make certain technologies artificially more attractive, e.g., natural gas or electricity may be preferred to propane because of cutoff prohibitions. Similarly, subsidies can make certain competitors more economically attractive, e.g., choosing to stay with a regulated service rather than choosing an unregulated new entrant because of cutoff prohibitions; choosing an independent new entrant over a utility service because default provider requirements disadvantage the utility’s service; a utility demand side management program is preferred over an energy service companies product because it is subsidized. Thus the issue has two dimensions. First, how will different social policies affect the competitive market for these services? For example, will prohibitions of gas cutoffs in winter give gas an unfair advantage over oil or propane? Will telephony subsidized pricing policies favor incumbents and discourage deployment of competitive alternatives such as cable or cellular? Will social benefits policies thwart innovation in both technology and service offerings? This dimension is largely an issue of productive and allocative efficiency, i.e., will services be priced


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efficiently such that production and consumption decisions make sense? Will innovation take place? The second dimension is the effect on the competitors. Will competitors have access to the full market if staying with the regulated utility offers state mandated “advantages” that cannot be replicated by unregulated competitors? CECA supports a continuation of policies that would ensure that the needs of low-income people for energy, telecommunications, and other essential services are met. We also acknowledge that the current mechanisms for meeting such needs under traditional utility regulation must be changed to minimize distortions created by such policies in a more open, competitive market. Policy officials should recognize the distortive effects of asymmetric imposition of such requirements on network industries and rectify such distortions. The goal should be to transition to policies and approaches similar to competitive industries, without losing the safety net for poverty level consumers. During the transition, mechanisms should be used to ameliorate the distortive effects of social policies, without losing benefits for low-income consumers and other at-risk groups. It should be noted that policies, such as the federal telecommunications universal service fund, which is “paid for” by carriers on a proportional basis, rather than being supported solely by the incumbent carrier, provide fair, symmetrical choice by basing universal service fund contributions or other social benefit funds on a basis proportional to a particular network provider’s income (or other standard revenue measurement).

C. Utility Assets Incumbent network utilities have been granted certain assets as part of the implementation of the monopoly model, e.g., rights-of-way, customer information, exclusive service territories, etc. Some of these assets can be very valuable in a competitive choice environment. Thus the question becomes: how should a company be permitted to use such rights or assets to create competitive advantage in a competitive business? Under what circumstances should an electric distribution company or cable company be permitted to use its right-of-way to lay fiber optic cable to go into the local telephone business? Should the gas company use employees in its regulated business to sell air conditioning equipment and security services? Is this a cross-subsidy problem? Similar issues arise when seeking the right balance between encouraging entry into the new market and either being fair to the incumbent or ensuring that such encouragement results in efficient decision making on the part of the consumer. A good example of this tension is the issue of shopping credits or price targets for electric services that have been most aggressively implemented in Pennsylvania. The existing utility has a price of electricity that represents its cost and return. The commission establishes a price target for new entrants. Obviously if the price target is high then new entrants will penetrate more quickly. If the target is low then there will be relatively less penetration. Massachusetts has set a low target and had virtually no penetration and Pennsylvania has set relatively high targets and had better penetration. The potential problem is that, if the target price is set above the marginal cost to supply a given market, consumers switch against an artificially high price, thus violating the allocative efficiency goal of restructuring. On the other hand, many of the benefits posited by the advocates of restructuring are productive or innovation efficiencies. One might make a tradeoff


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between allocative and productive efficiencies to jumpstart a market, especially one that has been structured as a monopoly for a century. Georgia implemented an assignment mechanism for its gas consumers. Under the mechanism, once about 33% of the customers have switched to an alternative supplier, then the remaining 67% are assigned to the alternative marketers in the same market share as the switching customers. Interestingly, by the time the assignment mechanism was implemented, about 80% of the customers had already switched, ostensibly to avoid being involuntarily assigned. All Georgia retail customers have been assigned but it is too early to determine the impact of such a radical process. An assignment mechanism was used in the mid-1980s in the long distance market to encourage customers to switch away from AT&T. CECA recommends that regulated network companies should not be permitted to use “utility assets” to gain competitive advantage in newly opened markets. Rather, mechanisms should be sought that monetize the value of the asset and make it available on an open access basis, e.g. auction or lease to the highest bidder, with appropriate compensation provided to the incumbent to give sufficient incentives to engage in such behavior.

D. Differential Imposition of Burdens

Some regulatory schemes impose burdens on one technology or competitor that are not imposed on others. Such differential imposition of burdens, or regulatory asymmetry can distort the playing field. Convergence and competition between and within the energy and telecommunications industries has the potential to magnify these distortions. For example, some schemes require that state officials approve new construction of certain facilities based on whether the new facilities are “needed.” In a regime where companies were granted monopolies over certain geographic territories and were largely guaranteed recovery of costs, it made sense for the regulators to ensure that facilities were not overbuilt. However, in the regime to which we are transitioning, such approval of need can cement-in the incumbent and older technologies against new entrants and technologies. Additionally, the playing field will be tilted to the extent that proponents of one technology have to meet a certification of need test, e.g., gas pipelines, but other technologies that may compete with it do not, e.g., electric transmission. Another example is tax treatment. Nearly all states impose a variety of taxes on utilities and other commodities. The normal method used is to tax a utility based on its gross receipts; that is, on the money it actually receives. The levels of the tax can be as high as 18% or so. Nondiscriminatory access allows a customer to buy some of the services that would ordinarily be bought from the utility from an alternative supplier. The gross receipts tax usually does not apply to these alternative suppliers. Thus, the tax savings alone could afford consumers a “discount” by purchasing from an alternative supplier. Many states as part of restructuring legislation have “normalized” the tax treatment to remove any distortion in consumer demand based on tax treatment. Another aspect of the tax treatment issue is the impact of taxation of rights-of-way by local communities. Local communities have taxed rights-of-way as a revenue-raising device. Convergence raises a number of issues relating to rights-of-way that could have an effect on taxation. Taxation on rights-of-way is a cost that must be borne by the incumbent but may be able to be circumvented by various means of entry, thus disadvantaging the incumbent if the alternative means of entry is not similarly taxed. Some localities may seek to ensure the


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continuation of revenue by taking various regulatory actions that limit entry or needlessly encumber the emergence of convergence opportunities. To the extent that such actions inhibit interstate commerce, federal preemption might be a solution, but a consensus will not develop easily around this option. Some means of replacing the responsibility for the revenue associated with rights-of-way may be more efficacious. This is mostly an issue in telecommunications where competition between different platforms, e.g., wireless, satellite, wire, etc., is possible rather than energy where competition on pipes and wires is less likely. In both gas and electric, there are services performed by governmental entities that would ordinarily be thought of as private sector activities. There are over 3500 gas and electric municipals and member cooperatives (munis and co-ops). While the number of public entities is large, the actual retail market share of public entities is about 23%. On the other hand, the federal government has power marketing entities, such as the Tennessee Valley Authority and the Bonneville Power Administration, that own a significant amount of generation. Many of these governmental entities have tax benefits that may provide an advantage in certain services. Complicating the issue is the fact that many investor owned utilities operate under a regime that grants them many tax and other advantages. This patchwork of governmentally bestowed advantages cannot help but make the emergence of competition and convergence more difficult.

Differential imposition of burdens/regulatory asymmetry raises issues too numerous to resolve on an individual basis in this report. Rather this is a good candidate for a generic rule in favor of adopting policies that impose symmetrical burdens and benefits on all competitors. CECA recognizes that this is often easier said than done. While we are sympathetic with the challenge imposed on public policymakers by this recommendation, it is important to ensuring fair competition that such remnants of both the monopoly model and silo-based decision making be eradicated. CECA recommends the adoption of an economic standard that requires no increase in market power. Regulators attempt to use methods of redistribution that minimize the distortion to the ongoing operation of markets. It would, for example, be less of a distortion of market efficiency to require, as a condition of a convergence merger involving an electric utility, a lump sum contribution to the development of renewable generation than to require a certain percentage of all generation be out-of-market renewables. At the same time, the economic standard must provide fair treatment to stakeholders in the utility segment of the merged activity. For example, utility ratepayers should not be unduly burdened with costs that are shared between utility and non-utility services. Assets utilized by utility firms to provide converged services should be priced at

fair rates that fully recover all applicable costs and are recorded on the books of the utility as income subject to utility regulation. Such assets should be available for purchase by all interested competitors/companies on a nondiscriminatory basis and be provided by the utility under its designation as a common carrier.

Access to rights-of-way owned by utility companies should be offered without

discrimination under tariff on a first come, first served basis.


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At least for a transition period, a utility choosing to enter a new market on a converged basis should be permitted to do so only as a separate subsidiary conducting transactions with the utility company on an arms-length basis.

XIII. PROCESS OF REGULATION AND CONVERGENCE

As described in the previous section, massive changes in substantive network policy will be the order of the day over the next decade. Such substantive changes need to be accompanied by a reevaluation of how regulatory commissions are organized and operate. In May 1995, the National Regulatory Research Institute issued an insightful and prescient report entitled Missions, Strategies, and Implementation Steps of State Public Utility Commissions in the Year 2000: Proceedings of the NARUC/NRRI Commissioners Summit. The report is a product of a unique summit of 60 public utility commissioners held over three days in April 1995. This report is a very useful analysis of the range of issues discussed here. It is especially helpful on the issue of alternative decision-making processes and commission organization. While generally an insightful report on the future of regulation, however, it does not deal with how these issues may impact industry convergence and in fact includes chapters that analyze the future of the electric power, natural gas, telecommunications, and water industries, with very little recognition of the potential for convergence between these industries. The report nonetheless helpfully discusses the challenges of utility affiliates, diversification, and “state/federal jurisdictional disputes.”

A. State Commission Organization, Decision Making, Resources and Processes Some state commissions have been in existence for a century, the oldest being the Rhode Island Public Utilities Commission dating back to 1839. Traditional public utility regulation by such commissions, however, began around the turn of the 20th century. While there are important differences among commissions—some commissioners are elected, others appointed—the way that today’s commissions carry out their responsibilities for regulating public utilities has been remarkably stable for the last half century, at least until the movement toward reform began in earnest in the last decade. In a closed monopoly system, it was possible to deliberate carefully over the prices that should be charged. There was time to have the network company file a detailed rate case and to take nine months or more to give parties an opportunity to debate the assumptions and policies made in the rate case. This also required staff with deep expertise in both the regulated industry and the policies of public utility regulation. Commissions were strong in engineering, legal, and accounting expertise and less so in economics, policy, and dispute resolution. Industry restructuring changes this in fundamental ways and market adaptations such as convergence require even more flexible responses. This section examines how convergence might affect and be affected by: how state commissions are organized; how they make decisions; what processes they use to regulate; and what resources they need to address the massive challenge before them.


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B. Organizational Issues Historically, many commissions organized their staff and resources into industry “silos” – staffs were typically organized into gas, electric, and telecommunications sections or divisions, with little or no discussion among the silos. Many commissions have begun to adopt matrix management techniques to deal with the historical silo problem and have begun to organize staff around cross-cutting areas such as customer service, accounting and finance, administration, legal, and, sometimes, research or policy offices. There is still much evidence of silo-based thinking. Dockets are often still organized by industry. Commissioners sometimes informally split up responsibility and “specialize” in a given industry. Even the regulated industries tend to encourage silo thinking by having their own trade associations and research arms organized by industry. This made sense in a “closed” system where there was little concern that inconsistency would result in competitive distortions. But it almost certainly doesn’t make sense for the future. A silo-based understanding of one network industry does not easily transfer to another silo. As convergence begins to take place, it will be increasingly necessary to develop policy across network industries in order to be assured that regulation presents no impediment to new technologies and policies. On the other hand, it is far from clear what the right organizational pattern is or even if there is one right pattern. The only thing of which we are reasonably certain is that what worked in the past will not necessarily work in the future. Industry restructuring, competition, and convergence are fundamental changes to network industries and require creative and fundamental changes by commissioners and their staff. CECA recommends that state public service commissions acknowledge that fundamental changes in substantive policy, market structure, and technology require a searching inquiry into how they should be organized to meet future demands and challenges. They should continue to accelerate the trend toward integrated decision making for network industries. Integrated decision making would require that commissions reorganize staff and adopt procedural schedules that coordinate gas, electric, and telecommunications policymaking. While it may be necessary to retain some staff organized by industry, some staff should be organized by functions of regulation across industries, not by industry silos. For example, the same staff might deal with affiliate problems for all regulated industries. Additionally, commissioners should be especially responsive and sympathetic to arguments that traditional organization, process, and procedure are impeding industry adjustment to new economic and technological realities. Commissions should indicate a willingness to change in order to accommodate new forces and realities. Another dimension of this issue relates to reconsidering the jurisdiction of state agencies as new issues emerge from industry restructuring. For the most part, utility regulation in a closed system was handled comprehensively by a single agency, the PUC, well-versed in the intricacies of how to regulate monopolies. In the past, some of these agencies had little expertise in competitive markets and how to deal with the problems of competitive markets. Other state agencies (or sometimes the market itself) often had the mandate to deal with a variety of competitive issues that cut across industry lines. However, more recently many state public utility commissions have been integral participants in the transition to competition for gas, electric, and local telephone.


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Restructuring will require the adoption of many different regulatory functions as we transition from the monopoly model to the choice model. For example, consumer protection from deceptive practices or merger analysis involves issues that have greater significance and broader applicability in the choice model than in the monopoly model. These types of issues also occur in industries outside those regulated by the PUC and are historically handled by a different agency of government. For example, the attorney general’s office or the state equivalent to the Federal Trade Commission has expertise in consumer protection outside the context of public utilities. Many state public utility commissions have been actively involved in the transition to competitive markets in industries they regulate. Many states have enacted electric restructuring laws, for example, which vest licensing and consumer protection authority in state public utility commissions for the new market players in the retail electric business. This model establishes licensing, investigation/sanction, consumer protection and dispute resolution authority at the state PUCs. This model is similar to state licensing, investigation and consumer protection laws relating to certain other industries and businesses, such as insurance, consumer credit, health care, real estate, home improvement and to certain professions such as accountants, attorneys, physicians, engineers, and architects. Part and parcel of this issue is the propriety of treating similar issues differently depending on the genesis of the commodity and its regulatory treatment. For example, most states have different policies for home heating oil, propane, and gasoline than they do for gas and electric. This distinction was historically based largely on the different regulatory treatment of these commodities. This raises the question of whether there should be significantly different policies once gas, electric, and telecommunications are sold in markets more similar to propane and oil than to monopoly markets? We think not. CECA recommends that policymakers examine whether transferring regulatory authority over these markets to other state agencies, leaving it at state public utility commissions, or creating a dual system, in which regulatory control is vested in state commissions and state attorneys general, who could use their existing consumer protection and anti-trust authority to bring civil actions for damages and injunctive relief against market participants where necessary.

C. Process Issues Linked to the organizational issues are the processes that commissions use to make policy and decide cases. Current processes are well attuned to the needs of a closed monopoly system. Decision making is very deliberative. Parties are given broad opportunities to raise issues and have those issues decided through a litigation model. Issues are often decided piecemeal, with many important decisions being put off until a fuller record or more expertise can be developed. While many states have used generic approaches in developing restructuring policy, there are substantial opportunities for greater use of a broad policy approach, as opposed to a litigated, issue-by-issue approach. A good example of a broad policy approach is the policy enacted by Georgia regarding assignment of gas customers to marketers. This is not necessarily intended as an endorsement of that policy. Rather, it is an example of an approach that will allow for quick resolution of issues that may take years to resolve in other states. Carrying out recommendations on integrated decision making will require the adoption of new processes for resolution of issues. While recognizing the difficulty of litigating the application


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of generic rulemaking to individual cases, generic rulemaking generally presents a better model than litigation for the kinds of broad policymaking that restructuring and convergence will require. At a minimum, it would seem that greater “regulatory convergence” must take place, i.e., states should consciously link consideration of gas, electric, and telecom restructuring issues in order to accommodate convergence. These observations apply to the setting of generally applicable rules for industries whose offerings are affected by convergence. It is well understood that litigation before state commissions may still be necessary to enforce the rules in the public interest or to resolve disputes among companies. In order to achieve the savings that will motivate many consumers to switch suppliers it may be helpful for network providers to offer a menu of different packages of services, many of which are currently regulated. For example, some posit that there is both convenience and savings to consumers if billing and metering convergence takes place. But if a state commission decides issues by the silo method (thus deciding billing and metering issues for gas, electric, and telecommunications in six different proceedings), it will make such convergence more difficult. Some argue that the data protocols that must be followed by new entrants must be standardized both at the policy and technical level. Deciding these issues in silos makes such symmetry more difficult. The disconnected pattern of reforming network industries on different paths will have a deleterious and procrastinating effect on the services offered to the mass market. If policies are made idiosyncratically by service territory, an additional concern is that current procedures put the burden on new entrants with razor-thin margins to advocate policy changes in every state, and often many times within a state. Each incumbent utility need only defend itself regarding the policies to be applied in its service territory, and in some cases it can recover such regulatory policy costs from customers in rates. Not surprisingly, states seem to be particularly sensitive to claims by incumbent utilities that each service territory needs individually tailored rules to address its “unique” circumstances. Such procedures tip the playing field significantly in favor of non-uniform policies and incumbent sensitive/new entrant insensitive policies. Some states, however, especially in telecommunications regulation, take a more aggressive approach against arguments of “unique circumstances” made by incumbents. CECA recommends that state public service commissions, consumer advocates, PUC Commissioners and Staff continue to adopt new processes and procedures that are tailored to the customer choice model. These procedures should promote more rapid, less expensive, generic decision making and should be particularly sensitive to the procedural burden on new entrants, while still recognizing the need for consumer protection measures in the new markets.

D. Commission Capabilities and Funding The restructuring of the gas, electric, and telecommunications during the first decade of the 21st century will be perhaps the largest industrial transformation in history. The intellectual challenge of public utility regulation over the next decade will be greater than at any other time in the history of such regulation. Similarly, the importance of energy and telecommunications as the central nervous system of the U.S. and global economies will increase, especially in an information and services economy. At a time when significant investment should be made in intellectual capital, PUC budgets are under ever tighter constraints. At this critical time of dramatic transition for vital industries, governors and legislators should give special consideration to the magnitude of these challenges


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when making decisions regarding state commissions and representatives of consumers. While some believe that restructuring is “deregulation” and therefore requires either lower budgets or less attention to the needs of commissions for highly qualified personnel, the opposite is true, at least for the next decade and possibly longer. Formerly regulated commodities are being deregulated, but the network may remain regulated. Implementing a scheme that achieves the right integration of competition and regulation is actually a more complex and time-intensive intellectual and political undertaking than traditional regulation. For example, more training will be necessary in the short-term for staff, commissioners, and consumer advocates. Since regional integration and, increasingly, national integration is more important than in the past, increased travel expenditures may be necessary for the transition. This is a unique moment in the history of regulation of network industries and “business as usual” will not be appropriate. Additionally, as discussed above, greater uniformity among states and regions would greatly facilitate convergence. While admittedly difficult in our system of federalism, we believe that some efforts to overcome parochialism should be made in the decision-making process. Given the fundamental changes in regulatory philosophy taking place simultaneously across different network industries, CECA recommends that governors and legislatures should give increased and enlightened attention to the needs of state commissions as fundamental managers of these changes when making decisions on appointments to regulatory commissions and when setting the budgets and salaries of commissioners and staff. The same considerations should govern the staffing and budgets of state funded utility consumer advocates for the transition from the monopoly model to the competitive model. The budgets of commissions and the salaries of commissioners, staff, and consumer advocates should, first of all, support the acquisition and recruitment of appropriate personnel, the retention of staff and the cross-industry training of staff. A reallocation of budget dollars and staff training may be sufficient to accommodate this recommendation, but it should be recognized that often a short-term increase in budgets will be necessary to meet the difficult transitional challenges of the next decade.

E. Patchwork Regulation

The substantive challenges of “patchwork regulation” are discussed in detail above. We strongly support greater industry and government collaboration in working out the appropriate balance between uniformity and experimentation. But such efforts must begin soon. CECA believes that NARUC67 and NASUCA68 should take a leadership role in encouraging state commissions to work cooperatively to develop model regulations and coordinate decision making on a regional basis.

F. Federal Role in Assisting/Mandating Change in Retail Policies Every policy reform of a network industry that moved from regulation to competition (airline, trucking, telecommunications, railroads, gas pipelines) resulted in a shift in authority from the states to the federal government. As franchises or other entry barriers are reduced, there are greater impacts on interstate commerce. It is entirely predictable that such tensions will exist in

67 National Association of Regulatory Utility Commissioners 68 National Association of State Utility Consumer Advocates


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the ongoing restructuring of retail network markets, yet there is no collaborative effort to bring together state, federal, and private interests in order to forge a new understanding of the federal implications of restructuring and convergence. The federally overseen breakup of AT&T in the early 1980s spawned a period of dramatic change in state regulatory policy. The Telecommunications Act of 1996 was also intrusive into prerogatives that had historically belonged to the states. The electricity industry has not yet experienced a shift in the balance of state/federal authority on the same magnitude as telecommunications. Each state currently undertakes changes in policies relating to retail energy competition with limited influence from the federal government. What is it about such reforms that seemingly require the shift in authority from the states to the federal level? In closed, highly regulated systems, the interstate commerce implications are not nearly as significant as in an open, market-based environment. Indeed, one can already see the pressure building for a federal fix to the electric restructuring patchwork quilt. Each state faces many of the same challenges, and the states’ budgets are constrained. The federal government has an interest in promoting greater coordination among the states and regions on issues that affect interstate commerce, and the federal government is better able to fund and coordinate such efforts. Federal exercise of authority formerly exercised by states is not without its costs both in terms of innovation and insensitivity to important state interests. Clearly, analysis and collaboration would lower the tensions inherent in this transition. CECA recommends that the federal government take a stronger leadership role in analyzing comprehensively the implications of state restructuring and convergence and in establishing a program for working cooperatively with states and consumer representatives. The federal government should establish a better understanding of the need for states to work together in an integrated manner, so that consumers can achieve the advantages of restructuring and convergence, while minimizing impediments to interstate commerce. We strongly encourage the exploration of the potential advantages of regional cooperation or integration to develop more symmetrical network policies among states.

G. Federal Commission Organization, Decision Making, Resources, and Processes At the federal level there exists some degree of silo-based decision making. The Federal Energy Regulatory Commission (FERC) sets gas and oil pipeline and electric policies. The Federal Communications Commission sets telecommunications polices. The Department of Energy has responsibility over energy policy and the Department of Commerce has responsibility over telecommunications policy. At the state level, nearly all state commissions set not only gas, electric, and telecommunications policies, but water and sewer policies as well. It is our belief that, increasingly, policy will have to be set as “network” policy in order to achieve the benefits of restructuring and convergence. Thus greater attention should be given to the organization of these issues by the federal government with an eye toward integrated decision making. Chairman James Hoecker of the FERC has undertaken an impressive effort to reform the agency's decision making for the 21st century in his “FERC First” initiative. Within FERC, the Office of Pipeline Regulation is focused on the natural gas market, and the Office of Electric Power Regulation is focused on the electricity market. FERC's plan, "FERC First," is an effort to


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redesign the way FERC operates and is structured. One of the biggest changes proposed in this plan is to combine the economic regulatory functions of the Office of Pipeline Regulation with the Office of Electric Power Regulation, creating a new office to be called the Office of Markets, Tariffs and Rates. This new office will oversee all of the Commission’s economic regulatory functions in the electric, gas, and pipeline industries. The overall objective of this effort is to recommend ways the Commission could improve its procedures and operations in a rapidly changing regulatory environment. The FCC, in its FCC 2000 Initiative, has also recently announced a comprehensive reevaluation of its processes. The United Kingdom's Office of Electricity Regulation (OFFER) and Office of Gas Supply (Ofgas) are to be combined, as set forth in recent Green Paper entitled, "A Fair Deal for Consumers: Modernizing the Framework for Utility Regulation." The intention is to anticipate changes in the market structure, particularly the integration of the gas and electricity markets, and the growth of multi-utility companies. The proposed UK merger is to further build confidence in the regulatory system by improving the transparency, consistency, and accountability of the process. A primary focus of the UK's plan is to safeguard the interests of all consumers. Nearly all states have telecommunications and energy regulation functions carried out by a single regulatory commission. We are unaware of any ongoing discussions within the federal government to analyze whether such an integration of network policy for telecommunications and energy would be necessary for the 21st century. Ultimately, we could envision the responsibility for network policy residing in a single agency or department. While some initial steps have been taken by federal agencies to coordinate their efforts, they should identify further opportunities to work together in areas where federal energy and communications regulation have begun to overlap. CECA recommends that DOE, DOC, FERC, and the FCC provide greater leadership on issues relating to organization and cooperation on issues relating to network restructuring and convergence.

H. Conclusions and Recommendations The challenge of adopting policies that move our society from the monopoly model of network regulation to the choice model is a daunting, difficult, and in many ways a thankless task. Yet for better or worse, that is the enterprise in which we are engaged. Convergence, we believe, will be a largely adaptive response to both technological and policy change. We believe it could result in significant consumer benefits. We believe that public policy officials should shore up consumer protections, while removing impediments to a competitive marketplace. In general, we believe that there are significant substantive and process changes that must be considered and adopted. Fortunately, many of the recommendations and conclusions we reach are completely compatible with the movement toward reliance on market forces.


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PART FOUR: APPENDICES

APPENDIX A: OVERVIEW OF TELECOMMUNICATIONS REGULATION

Adapted from Peter W. Huber, Michael K. Kellogg & John Thorne, Federal Telecommunications Law (Aspen Law & Business 2d ed. 1999): For most of this century, telephony was viewed as a natural monopoly. The high cost of fixed plant, the steadily declining average cost of service, and the need for all customers to interconnect with one another, made it seem both sensible and inevitable to have a single, monopoly provider. The Bell System was born on that premise, and with it an elaborate body of regulation designed to reconcile private monopoly with the public good. The old regulatory paradigm had three basic pillars. First, the protected franchise: would-be competitors were barred from competing or even interconnecting with the enfranchised carrier; natural monopoly thus became a self-fulfilling prophecy. Second, the quarantine: the monopolist was restricted to its regulated sphere and barred from exporting its expertise (and the corrosive influence of its monopoly) into adjacent competitive markets. Third, cradle-to-grave regulation: prices, terms, and conditions of the monopolist’s services had to be sold to regulators before they could be sold to customers. The old regulatory paradigm served the country adequately for over half a century, permitting the Bell System to deploy the best, most technologically sophisticated telephone system in the world. Bell also deployed Bell Labs and funded it with the enormous profits of the Bell System. And Bell Labs, apparently unfamiliar with regulatory paradigms, developed new technologies that made competition in telephony inevitable. Today, the two overarching technological trends in the industry are fragmentation and convergence. There are, on the one hand, more switches, more lines, more networks, many more levels of interconnection – the old integrated, centralized media are being fragmented into many smaller, more autonomous, parts. On the other hand, interconnections are proliferating as never before: direct interconnections between competing, wireline phone companies, and also interconnections between different media that never used to connect at all. Television is leaving the air in favor of wires; the telephone is leaving the wires in favor of the air. Copper and coax, wired and wireless, terrestrial and satellite: digital data networks are rapidly emerging as the new, universal, universally-interconnected standard for the transmission of everything – voice, data, video, the lot. These industry-transforming developments are not, of course, unconditionally welcome on all sides of all the industries involved; every invention, as Joel Mokyr has noted, is born into an uncongenial society, has few friends and many enemies.69 Precisely the same technological developments support new competition by the phone company and against it, and incumbents on opposite sides of traditional regulatory fences have quite different views about which kind of competition should come first. Thus, television broadcasters want to contain phone and cable companies, just as radio broadcasters once hoped to contain television, and just as newspapers once hoped to contain radio. Cable companies want to contain phone companies and vice versa. Providers of Internet services would prefer to contain both. Landline phone companies see a real threat in wireless services, which provide far more convenience; wireless carriers see a real threat in the landline system, which still provides the dominant hub for ubiquitous

69 J. Mokyr, The Lever of Riches 183 (1990).


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interconnection. Much of the time, for many of the protagonists, the paramount regulatory objective is to preserve the status quo, and so to fend off the instability of untrammeled new competition. The dynamics of the new technology have forced regulatory change regardless. The protected franchise has disappeared. The quarantine was eliminated in its entirety by the 1996 Telecommunications Act. Pervasive regulation of prices and terms of service is now rapidly giving way to prices and terms set by competition. These changes have in turn wrought fundamental changes in the nature, purpose and complexity of regulation. The 1982 AT&T breakup antitrust consent decree had assumed that the local telephone business was a natural monopoly and therefore left that monopoly intact. Many state regulators, however, concluded otherwise and began to embrace local competition. By 1996, Congress was ready to finish the job with a sweeping reform of U.S. telecommunications regulation. For better or worse, the Telecommunications Act of 1996 will likely be remembered as the most important piece of economic legislation of the twentieth century. It runs some 100 pages of impenetrably dense and convoluted prose. Its overarching objective is to transition the entire industry from regulated monopoly to unregulated competition. Completing the process will take a decade or more, but the transition is already well under way. The 1996 Act broadly preempts most state laws to the extent that those laws explicitly bar competitive entry.70 It specifically affirms the right of cable operators to compete head-to-head against local telephone companies.71 The legal path has been cleared to allow electric utilities and gas companies to build communications networks, too.72 But the 1996 Act does not stop there, by clearing away the obstacles to new entry. It also requires incumbent carriers affirmatively to assist the new entrants in three distinct ways. The 1996 Act allows a competitor to construct its own network and “interconnect” with the incumbent telephone company “for the transmission and routing” of traffic between the two networks.73 Such interconnection is crucial to competitive entry because it allows customers on the new network to place calls to, and to receive calls from, customers on the incumbent’s network. Congress required incumbent telcos to offer competitors “access to network elements on an unbundled basis at any technically feasible point” and “in a manner that allows requesting carriers to combine such elements.”74 Congress added this provision because it recognized that some key parts of the incumbents’ network would be difficult to reproduce immediately. For instance, Congress understood that cable television companies planned to use their existing door-to-door networks to carry telephone calls as well as TV signals, but lacked the switches needed to direct calls from one customer to another. Conversely, some interexchange companies might have the necessary switches but lacked the loops to the customers’ premises. By requiring access to parts of the incumbents’ network, Congress allowed new companies to enter local markets as facilities-based carriers without reproducing the incumbent’s complete network. 70 See 47 U.S.C., 253(d). 71 Telecommunications Act of 1996, 302(b)(1) (repealing 47 U.S.C., 533(b)). 72 The 1996 Act authorizes the Commission to permit registered holding companies to offer telecommunications

services through a separate, single-purpose telecommunications subsidiary. See Telecommunications Act of 1996, 402(b)(2)(A) (to be codified at 15 U.S.C., 79 et seq., amending PUHCA Section 34(a)(1)).

73 47 U.S.C., 251(c)(2). 74 47 U.S.C., 251(c)(3).


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The 1996 Act requires incumbent telcos “to offer for resale at wholesale rates any telecommunication service that the carrier provides at retail to subscribers who are not telecommunications carriers.”75 Resale permits entry by potential competitors who have no facilities of their own. The flip-side of these obligations placed on incumbent telcos is supposed to be a new freedom to compete. The two remaining pillars of traditional regulation – the quarantine, and end-to-end price regulation – are not long for this world. The 1996 Act sets in place an express mechanism for eliminating the long-distance restrictions on Bell companies. A number of those restrictions, on wireless and out-of-region services, have already been removed. Others are due to sunset. The main ones will be eliminated when state and federal regulators conclude that incumbent local phone companies have opened their networks sufficiently to put competition on a robust trajectory. As for pricing regulation, the new statute calls for the elimination of all implicit subsidies and their replacement by a new explicit universal system funded in an equitable and non-discriminatory way by all providers of telecommunications services.76 And Congress called upon the FCC to forbear from regulating, consistent with the public interest, wherever such regulation is not necessary to ensure that charges are just and reasonable or to protect consumers.77 As competition spreads at all levels of the network, traditional price regulation should be its first victim. In order to implement these new regulatory requirements, the 1996 Act has substantially increased regulatory authority – but whose regulatory authority? The FCC’s or the states’? The FCC believes that the 1996 Act has fundamentally changed the balance of power between state and federal regulators. According to the Commission, the “1996 Act moves beyond the distinction between interstate and intrastate matters that was established in the 1934 Act,”78 and grants the FCC authority “without limitation” to regulate local telephone service.79 As the FCC’s then-Chairman declared in plainer terms, the 1996 Act threw the states’ traditional intrastate authority into “the trash can of history.”80 Not surprisingly, the states have taken a different view, finding in the 1996 Act a large area of still exclusive state regulatory authority and a much more limited role for the FCC in opening local markets to competition. After winning some initial battles in the courts, however, the states have lost the war. According to the Supreme Court, the Maginot line between intrastate and interstate matters has not merely been bypassed; it has been obliterated by the 1996 Act.81 Even where the States retain explicit powers under the 1996 Act, they now are subject to detailed supervision by the FCC which may “prescribe such rules and regulations as may be necessary in

75 47 U.S.C., 251(c)(4)(A). 76 47 U.S.C., 254. 77 47 U.S.C., 160. 78 Implementation of the Local Competition Provisions in the Telecommunications Act of 1996, First Report and

Order, 11 FCC Rcd 15,499, 15,513 � 24 (1996) (Local Competition Order), modified on recon. 11 FCC Rcd 13,042 (1996), vacated in part, Iowa Utils. Bd. v. FCC, 120 F.3d 753 (8th Cir. 1997), cert. granted, sub nom. AT&T v. Iowa Utils. Bd., 118 S. Ct. 879 (1998).

79 Local Competition Order, 11 FCC Rcd at 15,559-60 � 115. 80 Hundt Looks Toward �Radical� Overhaul of Regulatory Regimes, Major Business Moves, Telecommunications

Report, July 15, 1996, at 6. 81 AT&T Corp. v. Iowa Utils. Bd., 119 S. Ct. 721 (Jan. 25, 1999).


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the public interest to carry out the provisions of this Act.”82 Where the FCC has issued standards and methods, the States merely get to “apply those standards and implement that methodology, determining the concrete result in particular circumstances.”83 The 1996 Act gave the FCC an additional weapon in its battle with the states. In keeping with the 1996 Act’s goal of encouraging competition through the opening of local markets, section 253 of the 1996 Act preempts in sweeping terms state and local barriers to entry: No State or local statute or regulation, or other State or local legal requirement, may prohibit or have the effect of prohibiting the ability of any entity to provide any interstate or intrastate telecommunications service.84 The Act also contains other express preemption of state authority over such services as mobile radio services,85 payphone services,86 cable telephony,87 telco-supplied video programming services,88 intraLATA toll services,89 Internet and data services,90 and direct-to-home satellite services.91 States do still retain regulatory authority to impose competitively neutral regulations necessary to preserve and advance universal service, public safety and consumer protection.92 States may regulate rates for intrastate services, supervise service quality, and oversee telco investment decisions.93 States and local regulators also may manage the public rights-of-way and charge “fair and reasonable compensation” from those who want to run their wires above or beneath the city streets, provided such management is performed on a competitively neutral, nondiscriminatory basis.94 Whether at the FCC or in the states, open entry is now the norm in telecommunications markets. The old and simple regulatory principle of exclusive franchise has given way to a new and complex set of rules governing interconnection among competitors. The principle underlying the 1996 Act, however, is still a simple one: carriers sell carriage, and their obligation to do so does not depend on whether the customer is itself a competing carrier.

82 47 U.S.C., 201(b). 83 AT&T Corp. v. Iowa Utils. Bd., 119 S. Ct. at 732. Justice Breyer, in dissent, noted that the FCC’s rules approved

by the Court leave the States little or no freedom to choose among reasonable rate-determining methods according to the State’s policy-related judgments, assessing local economic circumstances, or community need. 119 S. Ct. at 751.

84 47 U.S.C, 253(a). 85 47 U.S.C., 332(c)(3). 86 47 U.S.C., 276(c). 87 47 U.S.C., 541(b). 88 47 U.S.C., 571. 89 47 U.S.C., 271(e)(2)(b). 90 47 U.S.C., 157 nt. 91 47 U.S.C., 152 nt. 92 Id., 253(b). Any state universal service regulations must also be consistent with universal service provisions of

47 U.S.C., 254. Id. 93 47 U.S.C., 152(b). 94 47 U.S.C., 253(c).


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APPENDIX B: THE ECONOMIC DRIVERS OF CONVERGENCE

In order to provide the best analysis of the complex and novel interrelationships, or convergence, of the formerly regulated network industries, this appendix focuses first on the individual economic components of the definition (economies of scope, efficiency gains, etc.), describes current economic activity, and, where possible, delves into convergence-specific measures being implemented in the marketplace.

A. Economic Activity

The concept of a value chain is used most often in both economic and management literature to describe firms engaged in convergence behavior.

Value chain analysis is a method for decomposing the firm into strategically important activities and understanding their impact on cost and value.95

The original value chain concept dealt with production of goods. It tracked the commodity from its raw materials through to its sales to the public.

We propose that the value chain models a long-linked technology, where value is created by transforming inputs into products. The product is the medium for transferring value between the firms and its customers. Raw materials and intermediate products are typically transported to the production facility that transforms the inputs into products which are shipped to customers. Marketing serves two complementary purposes. The first is the development and refinement of the chain by producing product specifications and volume estimates. The second is to stimulate the required levels of demand for the chain’s output to ensure stable operation and capacity utilization. Post-purchase service is performed to ensure proper use of the product by the customer, to remedy defects or to increase the life span of the product.96

More recently, as service industries have taken a more prominent role in the economy, the value chain concept has been expanded to include value networks to deal with other types of economic activity that are more service oriented.

The term value ‘network’ underlines that a critical determinant of value to any particular customer is the set, or network, of customers that are connected… The linking can be direct as in a telephone service, linking two or more parties in a call, or indirect as in retail banking where one customer is not linked directly to another customer, but a group of customers is linked through a common pool of funds.97

95 Stabell and Fjeldstad, p. 413 . See also Porter, 1985, 1990. 96 Stabell and Fjeldstad, p. 416. 97 Stabell and Fjeldstad, p. 427.


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The industries that we are generally dealing with (telecommunications, gas and electric) all share the network characteristic. The energy utilities are unique in the sense that they are (or have been) more heavily involved in traditional value chain activities. They have produced a product, so they represent both value chains and value networks. That is, they transform inputs into products, and they link customers. One of the primary impacts of convergence may be to separate out the value chain activities from the value network activities.98 For purposes of describing these industries, it is useful to define the value chain as divided into three vertical stages – production, transportation, and distribution. This is roughly equivalent to the generation, transmission, and distribution phases of the electricity and natural gas industries. Distribution is frequently divided into two main functions – marketing (particularly account acquisition) and customer services (particularly billing, but also complaint handling and service). In the telecommunications/computer industries it is more complex. It is roughly equivalent to content, conduit, and applications. Production of content is fully separable from the transmission of content in digitized form (bits), which is separable from applications at the end-user location (customer premise).

TABLE I:

CATEGORIZATION OF ECONOMIC ACTIVITIES IN VARIOUS INDUSTRIES INDUSTRY PRODUCTION TRANSPORT DISTRIBUTION VALUE CHAIN Inbound logistics Outbound logistics Marketing, sales, Service ELECTRIC Generation Transmission Distribution UTILITY CABLE DATA ISP, ICP Satellite, Cable modem, TV Coaxial cable TELEPHONE ISP, ICP Copper/fiber Modem, PC DATA INFORMATION AGE COLLING ET AL Content Transmission Terminals Packaging 3COMM Payload Physical Device Applications Protocol Technology

98 There is a minority who argues that integration of production and distribution will remain the preferable

form.


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For example, consider the current competition between cable and telephone companies for high-speed data and multi-media business. Content is provided by Internet Service Providers (ISPs) and Internet Content Producers (ICPs). The telephone company conduit is copper wire and fiber optic cable. The cable company conduit is satellite and coaxial cable. Telephone company applications will access a modem and be displayed on a PC. Cable company applications will access software in a cable modem and be displayed on a TV.99

B. Efficiency Gains and Consumer Benefits

Although utility convergence is only one aspect of a much larger phenomenon, it shares central characteristics with all convergence phenomena. To the extent that utility convergence involves telecommunications or cable TV,

the utilities will be drawn into the broader area of convergence which is known as e-commerce.

In its most significant forms, convergence requires consumers to change their purchase and behavior patterns in similar ways.

A significant part of the economic efficiencies that are anticipated from all forms of convergence are transaction cost savings.

One of the greatest expectations for convergence is a revolution in the nature of transactions.100 The most immediate goal is for consumers to buy different types of goods and services in a single transaction, or pay for them on a single bill. Convergence in the information industries and utility convergence certainly share this goal of consolidation of purchases. Bundling of goods and services in one stop shopping is only the first step, however. It is also hoped that the form of the transaction will change. Physical commerce (p-commerce) will become electronic commerce (e-commerce). Not only will the transaction be electronic, but it will take place over the Internet, with consumers self-billing, self-ordering, and even providing customer service themselves though interactive programs. Convergence in the information industries and utility convergence could well share this transformation. If the most efficient way to manage accounts is electronically, particularly where there are ongoing relationships and monthly transactions, then utility convergence will be deeply affected by the e-commerce transformation. Yet a higher level of transformation will take place when the manner of consumption is altered. Instead of buying a magazine, consumers will click on a specific article (and pay for it on a per use basis). Instead of calling a travel agent, they will make reservations online and pay for the service from an existing account or with a direct debit to their bank account. The physical nature of the transaction will shrink and be replaced by virtual reality. In the electricity and gas industries, this final transformation is less likely to have an impact on the supply and delivery of services – electrons and gas molecules will still have to flow to produce the service. 99 There is constant speculation that parts of the two competing systems may converge, or that one

approach will prevail over the other. However, the speculation that a one-wire world will prevail is at least four decades old and the actual competition between the two wires is at least one decade old (see Consumer Federation of America).

100 Choi, et al, 1997.


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The potential direct consumer benefits of this transformation are readily apparent.

Consumers gain a much more convenient means of shopping and purchasing

goods and services. For e-commerce, early adopters in e-commerce appear to be more sensitive to

non-price competition101 and the primary gain is in information gathering 102which ultimately results in more efficient search.103

At a minimum, utility convergence and e-commerce will deliver new bundles of

goods and services. They may also deliver entirely new products.104

To the extent that the transformation affects firms and market structures, there are

additional benefits. Production costs may be significantly lowered by better coordination and

reduction of transaction costs within the production process.105 Sellers expect substantial cost savings in advertising106 and information

dissemination,107 reduced transaction time 108 and distribution109.

Reduced production costs and more efficient search should produce bottom line price savings for consumers in two ways: Under competitive conditions, cost savings translate into lower prices for

consumers.110 There is also a belief that markets will become more competitive as a result of

these transformations.111

C. Sources of Efficiency

Economies of scale and scope and network externalities are the focal point of convergence economics. The extent and capture of these economic forces are crucial to convergence. These

101 Gupta, 1995. 102 Gupta, 1995; Hoffman, et al, 1996. 103 Wallace, 1995. 104 Jones, 1995. 105 Wigand and Benjamin, 1997; Radosevich, 1997. 106 Berniker, 1995; Cuneo, 1995. 107 Magi, 1995; Sharples, 1995. 108 Kline, 1995. 109 Michalski, 1995; Jones 1995; Wigand and Benjamin, 1998 110 Choi, et al, 1997 111 Hoffman et al, 1995


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concepts have received a great deal of analytic attention in the past several decades, particularly in the computer and communications industries.

1. Economies and Externalities The central factor in understanding network externalities is the economic efficiencies inherent in achieving a large installed base of users with technologies that are said to be networked. As the number of users grows, economic benefits are created on both the supply-side and the demand-side. Firms seek to capture these positive externalities and accomplish technological “lock-in.” a. Supply-side On the supply-side, certain industries like computing and network industries tend to have high fixed and front-end costs. By increasing the number of units sold, the cost per unit falls dramatically112 [Economies of Scale: Capacity Utilization]. Size itself may lower costs by making volume discounts available on the purchase of inputs [Economies of Scale: Size]. This trait is exhibited in varying degrees by the electric utility industry in its value chain aspect. Transmission and distribution exhibit strong economies of scale, while the reduction of economies of scale in generation is contributing to the restructuring of the industry.

The cost savings apply not only to the initial production costs, but also to the service and maintenance costs113 [Externalities: Personnel, Management Effort]. As the installed base of hardware and software deployed grows, learning and training in the dominant technology is more valuable as it can be applied to more users and uses114 [Externality: Training and Learning].

112 Arthur, 1990, p. 92 - 93.

Conventional economic theory is built on the assumption of diminishing returns. Economic actions engender a negative feedback that leads to a predictable equilibrium for prices and market shares. Such feedback tends to stabilize the economy because any major changes will be offset by the very reactions they generate… The parts of the economy that are resource-based (agriculture, bulk goods production, mining) are still for the most part subject to diminishing returns… The parts of the economy that are knowledge-based, on the other hand, are largely subject to increasing returns. Products such as computers, pharmaceuticals, missiles, aircraft, automobiles, software, telecommunications or fiber optics are complicated to design and manufacture. They require large initial investments in research, development and tooling, but once sales begin, incremental production is relatively cheap… Increased production brings additional benefits: producing more units means gaining more experience in the manufacturing process and achieving greater understanding of how to produce additional units even more cheaply. Moreover, experience gained with one product makes it easier to produce new products incorporating similar or related technologies…

113 Katz and Shapiro, 1993, p. 55.

Network externalities also arise when a large installed base allows manufacturers of complementary goods to exploit economies of scale, leading, for example, to a higher density of repair facilities for more popular automobiles or a greater variety of software to run on more popular computer hardware platforms.

114 Shilling, p. 275.


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There may also be certain pooling benefits on the supply-side.115 As the customer and geographic base spreads, the load on the system can be balanced, achieving higher overall utilization rates [Economies of Scale: Composition]. For example, a system with many residential users who tend to place demands on the network in the early evening could be balanced with business users who are more likely to use the network during the workday. Spreading the customer base across geographic areas would allow time zone differences to balance load as well.

b. Demand-side On the demand-side, as more consumers use a particular technology, each individual consumer can derive greater benefit from it. The classic case is the telephone network (or the Internet) in which each individual derives greater benefit by being able to contact other individuals directly.116 This is a communication externality117 [Externalities: Direct].

The size of the installed base and the availability of complementary goods will be highly correlated because the variables have powerful self-reinforcing effects. A technology’s installed base will influence the choice of manufacturers of complementary goods. Assuming there are increasing costs associated with supporting multiple technologies, complementary goods providers face a technology adoption choice similar to that of consumers. Supporting a technology with many users will be more valuable to them than supporting a technology with few users and, thus (with the possible exception of a few niche providers) complementary goods providers are likely to support the technology with the largest installed base.

115 Stabell and Fjeldstad, p. 432.

When network externalities are present, the value of the service provided is affected by the character of the customers that join the network… In the value network there is reciprocal interdependence across primary activity categories due to the need for synchronization and dimensioning of simultaneous activities. Both geographical coverage and capacity must reflect the composition of customers who are members of the network. Adjustments must be done on a continuous basis.

116 Church and Gandal, p. 241.

The benefits received from the consumption of a particular good often depend on the aggregate number of consumers who elect to purchase compatible goods. This positive consumption, or network, externality can be direct or indirect. If it is the former, the utility of a consumer depends directly on the total number of subscribers to the same network. For instance, the value of access to a telephone network depends on the total number of consumers with similar access.

117 Katz and Shapiro, 1993, p. 55.

Installed bases are important, and network externalities arise, when buyers wish to “communicate” directly with each other, such as when files are transferred from one computer to another or software is shared among users. Network externalities also arise when a large installed base allows manufacturers of complementary goods to exploit economies of scale, leading, for example, to a higher density of repair facilities for more popular automobiles or a greater variety of software to run on more popular computer hardware platforms.


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There may be indirect benefits in which two consumers never actually come face-to-face, or computer-to-computer. Larger numbers of users seeking specialized applications create a larger library of applications that become available to other users.118 Markets may be created for used hardware and software119 [Externalities: Indirect].

The fact that convergence discussions have their deepest roots in the information and computer industries is particularly important. These industries have unique and powerful economic features that appear to give a distinct flavor to the discussion. The orders of magnitude of change which underlie the convergence in the computer/information industries are enormous.

Information technology is characterized by high rates of growth in performance parameters sustained over long periods. The number of devices on a chip is growing at 60% a year and has grown by some nine orders of magnitude in 37 years. Clock speeds of computers have grown by some six orders of magnitude over the same period. The number of computers connected through the Internet is growing at 100% a year and has grown by seven orders of magnitude in 27 years. The volume of traffic on the Internet is growing at over 100% a year… The number of transistors on a chip has seen a 1,000,000,000 times increase in less than 40 years, whereas other high-technology industries have typically seen less than 100 times performance increase in 100 years.120

What sustains the rapid development in the computer industry is positive feedback loops, or virtuous circles. Advances in computing technology support more advances in computing technology. This is the purest form of an emergent phenomenon.121 The feedback phenomenon

118 Church and Gandal, p. 241 (see also Chou and Shy).

Examples of goods where the network externality is indirect include many consumer durables such as televisions, videocassette recorders, compact disc players, and personal computers. To be of value these durable hardware goods require complementary software.

119 Arthur, 1990, p. 93.

Not only do the costs of producing high-technology products fall as a company makes more of them, but the benefits of using them increase. Many items such as computers or telecommunications equipment work in networks that require compatibility; when one brand gains a significant market share, people have a strong incentive to buy more of the same product so as to be able to exchange information with those using it already.

120 Gaines, p. 20. 121 Gaines, p. 21.

This improvement depends on the capacity of silicon to support minute semiconductor logic circuits, but this capacity could not have been fully exploited over nine orders of magnitude performance improvement without the use of the computer to support the design and fabrication of such circuits. This is one example of a positive feedback loop within the evolution of computers, that he computer industry has achieved along a learning curve that is unique in its sustained exponential growth because each advance in computer technology has been able to support further advances in computer technology. Such positive feedback is known to give rise to emergent phenomena in biology whereby systems exhibit major new phenomena in their behavior. The history of computing shows the emergence of major new industries concerned


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in economics is more of a “reinforcement mechanism” and not as “powerful” as that identified in computing, but it is said to account for much more dynamic economic development than simple efficiencies.122 The difference between positive externalities in computing and other sectors has been aptly summarized as follows:

If automobiles had developed at the same rate as computer microprocessors over the last twenty years, a typical car would cost $5 and get 250,000 miler per gallon.123

2. Economies of Scope The efficiencies that have been described in terms of economies of scale and externalities also apply to economies of scope. A firm can enjoy a dramatic increase in capacity utilization by doubling the sales of its product. It can enjoy a similar gain by adding a second product and spreading costs between the old and the new product. Many analysts believe that economies of scope are where the greatest potential for convergence lies. Economies of scope entail more complex questions and more dynamic potential than economies of scale. For example, is the product that is being added a substitute or a complement?124 If it is

with activities that depend upon, and support, the basic circuit development, but that are qualitatively different in their conceptual frameworks and applications impacts from that development: for example programming has led to a software industry, human-computer interaction has led to an interactive applications industry, document representation has led to a desktop publication industry, and so on.

122 Arthur, p. 93.

Self-reinforcing mechanisms… work in international high-tech manufacturing and trade. For example, in the early 1970’s Japanese automobile makers began to sell significant numbers of small cars in the U.S. As Japan gained market volume without much opposition from Detroit, its engineers and production workers gained experience, its costs fell and its products improved. These factors, together with improved sales networks, allowed Japan to increase its share of the U.S. market; as a result, workers gained still more experience, costs fell further and quality improved again. Before Detroit responded seriously, this positive-feedback loop has helped Japanese companies to make serious inroads into the U.S. market for small cars.

123 Sampler, p. 345. 124 Oxenfeld identified this key characteristic on the demand-side over thirty years ago. Collis, et al, describe this as

follows: Two products converge in substitutes when users consider either product interchangeable with the other… There are two ways that products converge in substitutes (can be used interchangeably). First, a given set of users may be willing to use the two products as substitutes in an increasing number of tasks. And second, an increasing number of users might begin to think of the products as substitutes in a given set of tasks… Two products converge in complements when the products work better together than separately or when they work better together now than they worked together formerly… As with convergence in substitutes, there are two ways in which products converge in complements (can accomplish more together than separately). First, a given set of users can find


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a substitute, the potential is limited by the reduction in sales of the original product (cross-elasticities) [Economies of Scope: Substitute]. If it is a complement, there is a potential to stimulate additional demand for both products [Economies of Scope: Complement].

D. Quantification of Potential Savings

1. Savings on Transaction Costs From Convergence It is useful to gauge the potential savings that could result from convergence. The most frequently identified potential savings involve transaction cost savings, which are most readily available in both e-commerce and utility convergence. Because of the way restructuring has occurred in the telecommunications industry, companies have been forced to estimate the transaction costs and make them public. The telecommunications industry provides a useful frame of reference, since potential local service competitors have been forced to put their economic analysis on the table in debates over the pricing of bottleneck elements. When companies argue about whether or not entry would be profitable, they identify the costs in Table II as the transaction costs of customer acquisition and service.

TABLE II: GAINS FROM CONVERGENCE IN TWO INDUSTRIES

DOLLAR PERCENT PRICE VALUE FINAL TELECOMMUNICATIONS TRANSACTION COST SAVINGS PRE-PURCHASE CUSTOMER ACQUISITION $100 10 POINT OF SALE BILLING $6 -10/mo. 10 - 15 POST-PURCHASE CUSTOMER SERVICE $6 - 10/mo. 10 - 15 PROVISION AND MAINTENANCE $6 - 10/mo. 10 - 15 TOTAL (20 MONTH CUSTOMER LIFE) $460 40 - 65 VALUE ADDED CHAINS IN THE SHIRT INDUSTRY UNIT: PER SHIRT PRODUCTION $20.45 39 WHOLESALER $11.36 22 RETAILER $20.91 40 . TOTAL $52.72 100 POTENTIAL COST SAVINGS $32.27 62 (Wholesale + Retail)

SOURCES: Telecommunications: Sprint, 1999, Stentor, 1996. Shirt: Wigand and Benjamin, 1997.

While these are only order of magnitude estimates, they give a good sense of what is at stake because they are not purely hypothetical. Companies are actually making investments or

that two products work together better for a larger set of tasks. Second an increasing number of users can find that two products are complementary for their specific purposes.


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complete transactions on the basis of these estimates, and they indicate that the size of the potential savings through convergence is quite large. Half of the total revenue per customer appears to be devoted to transaction costs. The repeat purchase, ongoing nature of the relationship between the customer and the seller accounts for the largest part of these transaction costs. The potent ial savings ident ified in Table II can be thought of as simple consolidation -- the savings for a company that can combine two services while still largely engaging in p-commerce. It would:

Acquire a customer for two services at one time, instead of having to acquire two

customers separately,

Deliver one bill instead of two, and

Have one transaction for customer service, and

Utilize fewer resources for provision and maintenance (have a smaller fleet, better coordinate truck use, etc.).

Another way to view this is the potential gain from one-stop shopping. Integrating electricity and telephone companies could clearly save substantial customer acquisition and billing costs. This supports the strong interest in bundling, even if the p-commerce part of the transaction remains substantial. There are other potential gains from transforming the transaction in addition to consolidating it, although these savings are less certain. Additional savings can be had if the one paper bill is replaced with an electronic bill. In telecommunications, for example, most “Internet” long distance companies actually are regular p-commerce long distance companies who have replaced the phone bill with a charge on the consumer’s credit card. Because they save on billing costs, they offer lower prices. The consumer loses the billing detail, however. The savings would appear to be approximately half of the billing costs. The ability to use electronic systems to provide customer service and self-maintenance appears to offer potential savings of a similar order of magnitude – half of the p-commerce costs.

A recent example from the e-commerce literature supports this view and uses the delivered price of a shirt to discuss several relevant areas where companies can realize opportunities to economize along the industry value chain. Wholesaling and retailing costs are approximately 60 percent of the delivered price. 2. Production and Transport Savings Utility convergence also holds the promise of significant savings at other stages of the value chain. Infrastructure costs are substantial in these industries. Access to right-of-way is a scarce commodity.


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When Regional Bell Operating Companies proposed video dialtone projects, which were intended to integrate voice and video over single systems, they identified 50 to 60 percent of the costs of deploying these networks as common or shared costs with local telephony. In theory, substantial cost savings could be achieved if one network is deployed instead of two. In telecommunications these costs represent over one-third of the cost of delivering service. Potential cost saving would be in the range of one fifth of the final price. This is over and above the transaction cost savings discussed above. Combining the overall cost savings in the value chain analysis, the potential is as large as 60 to 70 percent of final delivered costs. If anything even close to that were achieved in the utility industry, it would constitute a major economic accomplishment.

TABLE III:

THE COST OF A MULTIMEDIA VOICE, VIDEO, DATA NETWORK INVESTMENT TOTAL COMMON COST COST DISTRIBUTION Customer Premise $100 – 126 Drop Wire 50 – 125 Distribution Plant 110 – 165 110 – 125 TRANSMISSION Feeder Plant 35 35 ELECTRONICS Remote Distribution 150 – 200 150 – 200 Unit Central Office 100 – 200 TOTAL 500 - 750 295 - 360 Sources: Bell Atlantic, In the Matter of the Application of the Chesapeake and Potomoc Telephone Companies of Maryland and Virginia for Authority Pursuant to Section 214 of the Communications Act 0f 1934, As Ammended to Construct, Operate Own and Maintain, Facilities and Equipment to Provide a Commercial Video Dialtone Service Within a Geographic Territory Defeined by Maryland and Virginia Portions of the Washington Local Access Transport Area (LATA), Exhibit 3A, and Bell Atlantic Response to Inquiries, December 16, 1994, Exhibit 3. U.S. West, In the Matter of the Application of U.S. West Communications Inc., Under Section 214 of the Communications Act of 1934, As Ammended to Construct, Operate Own and Maintain, Facilities and Equipment to Provide a Commercial Video Dialtone Service in Portions of the Colorado Springs Service Area, Exhibit 3A,

E. Constraints On the Gains From Convergence

The previous chapters have outlined a glowing model of economic progress, but there have been concerns expressed about the end point of the process. For each potential positive economic factor, there is a potentially negative economic force or outcome. With the powerful forces driving convergence and large economic gains to be made, convergence may look easy, but it is not. Even though the forces underlying convergence and


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the economic efficiencies appear to be strong, there are constraints. We may observe constraints on either the supply-side or the demand-side, and the transformation may not come as quickly as anticipated for two reasons. 1. Difficulties In Achieving Efficiency Gains Potential barriers to transformation are consumer resistance, the privacy125 security of transactions,126 and consumer rights.127 Producers appear to be ahead of consumers in their use of technologies,128 and major changes in consumer behavior will be required. Consumers are being asked to change the way they buy an essential service, which they have not actively shopped for before, and to make the purchase in a way that is unfamiliar to them.129 A second concern, particularly for former utility services being restructured into commodities, is that governments might so encumber the new transactions that they will be prevented outright, or be so constrained as to lose their economic attractiveness. Concerns about abuse of transactions, invasion of privacy, and loss of essential services may result in regulation that negates the benefits of convergence. This is a “particular” problem for utilities being transformed into commodities because two powerful forces intersect in the new transaction. On the one hand, it requires fundamental changes in behavior. On the other hand, utilities are necessities that, compared to other products and services, have been only marketed very lightly. Market structure is of special concern to policymakers.

2. Net Costs Even the economic gains, were they achieved, would not all be net benefits to society.

For utility convergence, the customer acquisition costs are not pure savings for

former utility services. Because of the monopoly franchise nature of these services, companies have not had to spend heavily to acquire customers. There are new costs that result from the fact that customers now have to be acquired.

125 Rohm and Milne, 1998; Milne and Borg, 1998 126 McKnight, et al, 1997, Neuman 1997, Lai, 1997 127 Kolloman, 1997 128 Bellau and Summer, 1997 129 Change creates fear and slows adoption. As one author recently put it (Higgind and Shanklin, 1992):

After our literature search and countless conversations over the years with experienced sellers of high-technology products and services, we identified four predominant types of technological fear that can act as barriers to purchase: 1. Fear of technological complexity 2. Fear of rapid obsolescence 3. Fear of social rejection 4. Fear of physical harm


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One cannot assume away all wholesaling and retailing costs. Consumers will have to be informed about and convinced to buy the product. The transaction is transformed; it will not disappear.

Second, these potential savings will not materialize overnight.

Consolidating transactions takes time.

Transforming transactions from p-commerce to e-commerce takes more time.

Third, consumers are not driven only by cost savings, nor will they necessarily “minimize” their costs.

To the extent sellers can, they will emphasize non-price factors and consumers

may respond.

Empirical research shows consumers do not optimize shopping efficiency.130

Even with these constraints, the potential gains of convergence are large, which supports the intensity of interest in convergence.

130 Daellert, et al, 1998.


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PART FIVE: CASE STUDIES

I. STARPOWER COMMUNICATIONS: PEPCO JOINT VENTURE WITH RCN

A. Company Background PEPCO provides retail service to over 692,000 customers in a service area with a population of approximately 1.9 million and includes all of the District of Columbia and major portions of Prince George's and Montgomery counties in suburban Maryland. The Company serves 78% of the population and 51% of the geographic area of Prince George's County and 94% of the population and 61% of the geographic area of Montgomery County. The Company also sells electricity, at wholesale, to the Southern Maryland Electric Cooperative, Inc. (SMECO), which serves an area of 1,150 square miles in Calvert, Charles, Prince George's and St. Mary's counties in southern Maryland. The area served by PEPCO is unusual because it does not include large industrial customers. About 30% of the Company's revenue is derived from residential customers, 63% from sales to commercial and government customers and 7% from sales at wholesale. Presently, about 16% of PEPCO’s revenue comes from sales to the federal and local governments. In 1998, about 59% of PEPCO's revenue was from Maryland sales (including wholesale) and 41% from sales in the District of Columbia. The Company operates its facilities as part of the Pennsylvania-New Jersey-Maryland Interconnection Association (PJM). PJM serves approximately 23 million people in a 48,700-square mile territory with Jersey City, New Jersey; Washington, D.C.; and Johnstown and Erie, Pennsylvania, as perimeter points. Included in this area is the vital Southern leg of the northeast corridor which includes Washington, D.C., Baltimore, Maryland, and Philadelphia, Pennsylvania.131

B. Strategic Opportunity In June, 1998, PEPCO embarked on a joint venture with RCN Corporation to offer bundled local and long distance telephone service, cable and Internet under the entity Starpower Communications. Under the terms of the venture, both partners invest up to $150m over three years. Starpower undertakes to build a fiber optic network in and around Washington DC with plans to expand into Maryland and Virginia. The proposed venture represents PEPCO’s recent focus on its transmission and distribution segments with a simultaneous downsizing of its generation holdings. To effect this change in strategy, PEPCO divided itself into three distinct business units: generation, transmission, and distribution. Of the three, generation will receive the least focus as PEPCO finds these assets too small (approx. 6000 megawatts) to compete in this market in the long term. Instead, the Company will seek to expand its transmission and distribution units whose markets offer much larger growth potential. The venture with RCN allows PEPCO to diversify its revenue stream as it moves away from sole reliance on a commodity for income and into a focus on deliverable services.

131 Source: PEPCO homepage—www.pepco.com.


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C. Analysis of Policy Decision The Starpower deal capitalizes on deregulation opportunities in the telecommunications arena. PEPCO’s brand name and existing customer base make it a viable competitor in the market for bundled services. Research continues to indicate that brand name is key to customer interest in bundled services. PEPCO’s longstanding reputation with customers will allow it to successfully enter the telecommunications and cable markets on an equal footing, especially in the cable arena where studies indicate a 50% dissatisfaction with existing providers. While the Baltimore-Washington area represents just 4% of PEPCO’s geographic sales base, the area has twice the Internet usage of any other geographic area in the United States and accounts for 28% of the total telecommunications dollars spent.132 RCN’s recent acquisition of Erols Internet is now included in its current customer base of 500,000 in the Northeast. Of these, between 180,000 and 200,000 customers are in the Pepco service area for Starpower.133 Disadvantages of the venture include the high cost of building video networks to meet cable access demand and butting up against Bell Atlantic’s formidable fiber optic mileage (approximately 36,000 miles in the DC metropolitan area compared to PEPCO’s current network of just 350 miles)134. But PEPCO/RCN plan to use its $300 million investment to augment this network and make Starpower’s fiber optic capacity competitive. Starpower will also need to obtain approval from the FCC and weather the effects of certain initial operating losses. D. Consumer Impact Customers of the new Starpower entity may benefit from the convenience of a single bill for phone, cable, and Internet service which savings is estimated at 1/3 of current cost. Prices are estimated at 5%-10% lower than current providers and represent the first major competitive offering for such services following deregulation. Initial feedback from Starpower’s customers has been positive. Educating consumers after years of monopolistic service appears to be Starpower's biggest challenge. This includes publicizing competitive if not lower rates, guaranteed two-hour blocks for service calls and night calls, and other advantages. In a related case, Somerville, Mass., was the first city in the country to sign up with Starpower parent company RCN, letting it go head-to-head with Time Warner for the city's 35,000 homes last December. The result has been enhanced services and stable rates, according to Somerville officials who noted that the competition has impacted the city in a very favorable way. By example, one month before the RCN deal, Time Warner announced an across-the-board 10% cable rate hike. Time Warner exempted Somerville residents from the hike, however, to better compete with RCN. Their rates actually decreased slightly, and the company also offered rebate coupons and free pay-per-view promotions.

132 MegaWatt Daily, August 7,1997, Vol. 2, No. 152, “Pepco Teams With RCN to Provide One—Stop Telecom

Shop.” 133 Buskirk, H. “Derrick: Pepco Sees Profit, Opportunity In Bundled services,” The Energy Daily, June 9, 1998,

Vol. 26, No. 108, p. 3. 134 “Pepco Plans Phone, Web, Cable Service,” The Washington Post, August 6, 1997, p. A12.


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E. Outlook As PEPCO seeks to remake itself from an electricity provider to a supplier of energy, telecommunications and video, the emphasis will be placed on delivery of services. Revenue from this type of business is likely to have higher margins than their historically low-margin, commodity product. It remains to be seen, however, how consumers who purchase Starpower’s bundled package are impacted. These consumers have come to expect a level of reliability and price stability for these services which are associated with the PEPCO name. It is too soon to know whether such benefits will be realized in a converged market.

II. MONTANA POWER & TELECOMMUNICATIONS: TOUCH AMERICA

A. Company Background The Montana Power Company (“MPC”) is a broadly diversified energy and telecommunications company with three main business units: Energy Supply, Energy Services, and Telecommunications. The company has assets of $2.9 billion, consolidated revenues for the 12 months ended December 31, 1998 of approximately $1.25 billion, net income of $162 million, and 2,900 employees. Based in Butte, Montana, the company was formed in 1912 through the merger of four small regional electric companies. Through an evolutionary expansion into related businesses, the company now operates or invests in businesses worldwide, supplying energy -- electricity, natural gas, oil and coal -- and providing energy and telecommunications services. The company's core utility business in the western two-thirds of Montana is transmission and distribution of electricity and natural gas, serving 285,400 electric customers and 148,000 natural gas customers.135 In the early 1990s, MPC began to grow a subsidiary telecommunications division known as Telecommunications Resources Incorporated (“TRI”) which provided communications engineering, consulting, and network installation nationwide. Eventually, TRI purchased a small long-distance reseller based in Missoula, Montana and acquired its name, Touch America. By 1997, MPC began aggressively expanding the Touch America subsidiary beginning with a purchase from the FCC of personal communications services licenses in 12 markets along its fiber optic network between Minneapolis and Seattle. License acquisition continued into 1998 with the acquisition of licenses for 24 more markets. MPC’s Touch America has grown from 3,000 miles in late 1997 to about 10,000 route miles of fiber-optic network today. In 1998, MPC achieved the second highest revenue increase in the industry and in early 1999 the Company captured the Edison Electric Institute’s top award for financial performance over the past five years. By delivering a 200.09 percent total return on investment between Jan. 1, 1994 and Dec. 31, 1998, Montana Power won the EEI Index Award for the industry’s best financial return during that period.

135 Source: MPC web page: http//mpc.in-tch.com:30080/about/welcome.


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B. Strategic Opportunity The seeds of MPC’s decision to grow its telecommunications arm into a major business division were planted broadly by industry deregulation and specifically by a FERC decision to provide non-discriminatory access to transmission lines. This development, coupled with the restructuring of the Montana utility industry to allow increased competition and customer choice resulted in MPC’s reevaluation of its corporate strategy in the early 1990s. Faced with the prospect of competition, thin margins, and low generating capacity, MPC decided to de-emphasize its core generating business. By the end of 1998, MPC had sold its generating assets to PP&L Global, a subsidiary of the former Pennsylvania Power & Light, for $988 million,136 and planned to utilize these proceeds to invest in its growing nonutility operations. Specifically, these funds (upwards of $650 million) may be used in the coming years to reduce MPC debt, buy back stock and make additional investments in existing businesses such as its network communications. Concurrent with such a divestiture was the decision to exit the business of trading and marketing electricity. MPC’s strategic focus now shifted to expanding its fiber optic network to build a vast, continental network and achieve a long-term objective of moving beyond regional recognition. MPC plans to utilize its growing national fiber network to market and sell energy and energy-related products and services to business, residential, and large industrial customers as well as to other utility companies. The Company also plans to increase its broadband wireless communication business with a low-cost strategy built upon transmitting telecom products over its infrastructure at the lowest cost to consumers. Meanwhile, MPC’s traditional electric and natural gas transmission and distribution, as well as revenues from coal production, combine to provide a stable earnings base with which to balance its telecommunications growth business.

C. Analysis of Policy Decision MPC’s strategic evolution into a telecommunications focus was driven by the realization that an increasingly competitive electric supply business would require huge volumes and a sizable balance sheet, both unattainable for the Company in the long-term. MPC’s low production capacity coupled with the inherently risky, volatile nature of electric commodity trading and marketing led MPC to diversify its revenue stream. Crucial to MPC’s fundamental strategic transformation, however, was its history of utility integration. The company’s vast telecommunications infrastructure as well as extensive experience with fiber optic and digital technology provided a strong foundation for its horizontal strategic shift into the telecommunications business. As far back as 1939, MPC created its own communications system which helped manage 13 hydroelectric plants, scores of electrical substations, and high-voltage transmission lines in a vast service territory of over 100,000 square miles. By the 1980s, communications activities increased and those lines were upgraded to accommodate high-voltage transmission capacity. With demonstrated knowledge and experience in analog, digital and fiber optic technology, MPC was able to cut its costs and expand profit margins by reorganizing the telecommunications arm into a nonutility company. As early as 1990, by example, Touch America (known then as “TRI”)

136 Source: Remarks by Robert P. Gannon, Houston, TX, 2/24/99.


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built a 510 mile fiber optic line for a large customer along MPC’s existing electric transmission lines. The project was highly successful and provided valuable lessons and a foundation for future expansion into the telecommunications arena. The nature of MPC’s entry into the telecommunications business lies in sharp contrast to the scores of other like-minded utilities who currently seek entry into this potentially lucrative market but lack the technical capacity and expertise to compete successfully. For this very reason, these companies often choose to enter into strategic alliances or joint ventures with established telecommunications companies as a preferable means to diversify revenue. Finally, MPC’s solid reputation and associated brand name strength allows it to gain credible access to telecommunications customers. The result has been an ever-increasing contribution to the Company’s bottom line: MPC realized record earnings of $125 million in 1997. Of this, over half the total came from nonutility earnings (approximately $66 million).137 In 1998, revenues in telecommunications alone were nine times the level of 1996 revenues.138 D. Consumer Impact Although Touch America has been in business for fifteen years, the total scope of its impact on consumers is debatable. While it is clear that customer choice for telecommunications has been positively impacted by Touch America’s presence, many argue that MPC and other similarly-minded utilities are merely focusing their attention on high margin, commercial accounts. Currently Touch America’s customer base is composed of approximately 60% business customers.139 These accounts represent a genuine profit skimming opportunity for Touch America and other utilities and it is likely that rural areas will continue to be served by traditional carriers (e.g., rural cooperatives). So while Touch America is positioning itself as a competitive alternative to the traditional carrier, it is uncertain the nature of their long-term commitment to residential customers. Touch America has, however, succeeded in building a fiber optic network with a digital communications system that connects all major population centers in the Northwest. Overall, the nature of benefits accruing to residential customers of Touch America remains unclear.

E. Outlook Despite the remarkable financial success of Touch America and MPC’s related telecommunications expertise, the Company’s new emphasis on telecommunications represents a significant departure from MPC’s core utility business and, as such, there is uncertainty about whether the current profit levels will be sustainable in the long term as the industry continues to evolve and the impact of convergence is felt. Such uncertainty may be minimized, however, by the earnings base MPC continues to glean from its traditional energy business units. Certainly, companies like Touch America which are linked with an established brand name and well regarded utility such as MPC possess significant advantage in gaining access to a broad base of customers. It is still unclear, however, whether MPC and other entrants into the telecommunications arena intend to target residential consumers in the long term or concentrate on the more lucrative business customers. 137 “Gannon: Montana Power Planning to Enter Local Telecom Business,” The Energy Daily, May 14, 1998, p.4. 138 Speech by Robert P. Gannon, Houston, TX, February 24, 1999. 139 Source: Touch America corporate headquarters.


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III. CONECTIV COMMUNICATIONS, INC.

A. Company Background Conectiv (NYSE: CIV and CIV A), is headquartered in Wilmington, Delaware and has 3,400 employees. The company had operating revenues of $3.1 billion in 1998. Conectiv established itself as a major regional provider of energy and energy-related products and services with the 1998 merger involving Delmarva Power and Atlantic Energy. The merger that created the company provided Conectiv with a base of more than 1 million electric customers and over 100,000 gas customers in five states. Conectiv is the holding company for regulated utilities in four states -- New Jersey, Delaware, Maryland, and Virginia, each of which has taken steps to give electricity customers a choice of suppliers. In addition, Pennsylvania’s move to customer choice has provided an opportunity to attract additional customers. The company has several operations providing a variety of services to residential and business customers throughout the Mid-Atlantic region including: electricity and gas; heating, ventilation, air conditioning and plumbing products and services; steam and chilled and hot water; and integrated local, regional and long distance telephone and data services. Like other utilities facing industry “deregulation”/restructuring, Conectiv has examined several strategies for the future: concentrating on T&D [transmission and distribution]; purchasing certain kinds of power plants, establishing an international presence; and/or changing focus substantially in order to broaden its offerings and become a new kind of company. Based on primary customer research and competitive assessment, Conectiv believes that it must concentrate on becoming a provider of multiple vital services under a common brand. The following areas comprise the foundation of Conectiv’s growth opportunities in its vital services focus and allow Conectiv to concentrate on deepening customer relationships within its growing region: The regulated electric and gas delivery business. The energy business. The facilities-based telecommunications business

Conectiv has elected to become a new kind of company able to serve the over six million homes and 500,000 businesses within a 100-mile radius of its Wilmington, DE headquarters. In order to improve Conectiv's financial flexibility and position it as a growth-oriented investment, Conectiv's Board of Directors intends to reduce its CIV common stock dividend and recapitalize its balance sheet. The company is targeting a dividend payout ratio of 40% to 60%. This ratio is more consistent with companies operating in a competitive environment, and transitions Conectiv away from the traditionally higher payout ratios typical of the regulated utility industry.


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B. Strategic Opportunity Conectiv Communications, Inc. is a facilities-based telecommunications provider offering a full portfolio of voice, data, and integrated voice and data services to business and residential customers in Delaware, Maryland, Southern New Jersey, and Southeastern Pennsylvania. Conectiv Communications owns and operates its own SONET fiber optic network, stretching more than 600 miles through southern New Jersey, southeastern Pennsylvania, Delaware and Maryland. Conectiv Communications introduced its new telecommunications service in November 1997, offering local, long distance, international, toll-free and data communications service. Today Conectiv has more than 50,000 access lines. It has 40 connections – known as co-locations – with Bell Atlantic central offices. By the end of 1999 Conectiv Communications expects to have 60 such connections, many in New Jersey where the company is aggressively adding fiber. Conectiv Communication’s recent alliances with Intermedia Communications and Cisco Systems, Inc support its strategy of taking advantage of the many high growth opportunities including Internet, high speed DSL (Digital Subscriber Line) and advanced data networking products. By offering Intermedia’s Frame Relay products, Conectiv Communications provides business customers with coast-to-coast data connectivity. The DSL technology from Cisco Systems will allow Conectiv’s customers to have much faster access to the Internet on a cost-effective basis through a high-speed modem that is past of the new DSL offering. Conectiv Communications has qualified as a Cisco Powered Network provider by meeting stringent network quality requirements. This highlights the company’s focus on using intelligent broadband networking to deliver enhanced connectivity and network-based applications to its customers. Conectiv is testing its new DSL service and expects to make it available this summer (1999) to both residential and business customers. Conectiv Communications will be one of the first major CLEC (Competitive Local Exchange Carrier) providers of DSL access to businesses and consumers throughout the Mid-Atlantic region. Conectiv is furthering the region’s growth of advanced communications services and high-speed data communications to meet the surging demand for integrated voice and data services over communications and Internet networks. These new services are particularly suited to businesses with multiple locations and substantial data processing needs, such as financial institutions, insurance companies, and healthcare providers, offering businesses in the mid-Atlantic region the ability to transfer information faster, more affordably and with coast-to-coast data connectivity. For both residential and business customers, DSL technology means faster access to the Internet. In a related development, Conectiv recently purchased Communications Consulting, Inc., an independent Internet service marketer. CCI (known as “iNet”) currently offers both dial-up and dedicated Internet service, and such related services as consulting, data security, and web service for more than 2,500 Delaware and Pennsylvania residents. The new acquisition should give Conectiv local access points in 150 cities, including all major cities in Conectiv’s mid-Atlantic service territory.


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C. Analysis of Policy Decision Conectiv’s utility operations have used communications technology for many years to support energy management needs. In recent years, fiber optic technology, in addition to wireless-microwave technology, has been deployed across the utility’s service area. When the Telecommunications Act of 1996 opened the gates of competition Conectiv began serious consideration of how to participate. Conectiv evaluated the options available to utilities for entering the local telecom business: 1) form a partnership with a local competitor; 2) acquire a local competitor; 3) resell service; or 4) offer facilities-based service. Making the decision to go into telecommunications was relatively easy since Conectiv saw it as an expansion into another vital service that would add to a set of regional offerings to business and residential customers. Conectiv had familiarity with the technology and had fiber optic assets already in place. In addition, a customer survey indicated that 17 percent of the customers in the target area said they would switch from Bell Atlantic if they had a good alternative. By bundling local with long distance Conectiv would have something that customers said they want. Based on an analysis of its competencies and of the economics and competitive landscape of the telecommunications business in the Mid-Atlantic region, Conectiv chose to enter the business using its facilities-based capabilities and got the necessary regulatory approvals to transfer these utility assets to a subsidiary to provide retail service. Conectiv decided to create competitive advantage by owning, managing and maintaining its entire network. By controlling all points on that network, and because the facilities are already in place, Conectiv believes it can create cost-effective solutions that meet unique requirements. D. Consumer Impact Customers in Delaware, Maryland, Southern New Jersey, and Southeastern Pennsylvania can do something most business and residential customers across the country still can't -- choose among competing local as well as long distance phone companies. Competition has produced additional service options and lower rates for Conectiv Communications customers. Conectiv Communications offers customers the convenience of getting local, regional toll and long distance service from one company, on one bill. A new Consumer Federation of America (CFA) study shows just how unique it is to have a choice of phone companies, especially for local service. The CFA study concluded that the Telecommunications Act of 1996 has not produced the widespread competition among local and long distance telecommunications providers that it was intended to promote. Most customers, the study concluded, pay more rather than less for phone and cable service than they did before the federal law was passed in 1996. In part, the study blamed the higher rates on a dearth of actual competition among companies offering local and/or long distance phone service. Conectiv Communications provides an alternative to Bell Atlantic for local, regional, and long distance phone service. It offers all those services, and more, at lower rates. The CFA study suggests that most customers nationwide do not enjoy such competitive options.


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E. Outlook "Conectiv's rate of progress continues to meet our expectations," said Howard E. Cosgrove, Chairman and CEO of Conectiv. "While our competitive businesses continue to grow, the biggest news for Conectiv is the successful completion of our efforts to bring customer choice to the states in our territory. Since January [1999] we have seen electric restructuring legislation passed in New Jersey, Delaware, Maryland and Virginia. The successful completion of the legislation provides us the rules we need to go forward. We feel that all of the mandated rate reductions and freezes are manageable, and Conectiv is ready to become a major regional player in the new world of the non-regulated utility business. Strengthening our telecom business is a key component of our strategy to be a growth company offering a full array of vital services to residential and business customers throughout the Mid-Atlantic region.”

IV. FRANCE’S VIVENDI

A. Company Background Founded in Paris in 1853 as Campagnie Generale des Eaux (“General des Eaux”), Vivendi began as a water supplier to major towns and cities in Europe and later expanded its business to include waste management, transportation, energy, construction, property and communications. Vivendi, whose primary shares trade publicly in Euros and as American depository receipts in the U.S. (OTC ticker symbol:VVDIY), currently operates in 90 countries and employs 235,000 people.140 The Company provides water treatment services to more than 80 million people worldwide and operates over 7,000 wastewater treatment systems.141 With its recent acquisition of U.S. Filter (see below), Vivendi became the largest U.S. water treatment company and the dominant player in the emerging municipal privatization market, in which cities contract with private firms to provide water and wastewater treatment to residents. In the past decade, Vivendi has focused its convergence strategy on two primary markets: utilities and communications. Of greatest significance in the context of this strategy are 1) the purchase of 23 U.S. thermal power plants from GPU, Inc. under the subsidiary Sithe Energies, and 2) Vivendi’s acquisition of Cendant Corporation’s software division through its publishing subsidiary Havas. These acquisitions, along with the U.S. Filter purchase, are discussed in detail below.

B. Strategic Opportunity 1. Utilities Following the onset of utility deregulation and restructuring in the U.S., Vivendi realized an opportunity to diversify its revenue and add shareholder value by increasing its presence in this newly deregulated industry. The 1998 acquisition of 23 coal, oil and hydroelectric generating stations from GPU, Inc. was the most significant step taken in this direction. Owned and operated by subsidiary Sithe Energies, these facilities are located throughout Pennsylvania, New Jersey and Maryland. The acquisition also included several generation sites and service support

140 Vivendi Home Page: www.vivendi.com 141 AquaAlliance homepage: http://aquaalliance.com


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centers as well as a chemistry and materials laboratory. The purchase of assets from GPU for $1.7 billion142 is the largest sale of power plants ever to occur in the U.S. 2. Communications With the purchase of the consumer software division of PC giant Cendant Corporation, Vivendi gained control of a company that is a leading player in games software, ranks second worldwide in educational software and third in lifestyle software. The Cendant division will be operated by Vivendi media subsidiary Havas. The software acquisition will give Havas a much larger share of the lucrative U.S. software market which figures to broaden with the proliferation of inexpensive (<$1000) PCs. Inside France, meanwhile, Vivendi has begun competing with France Telecom through its subsidiary, Cegetel. The company has no current plans, however, for entry into the U.S. telecommunications market as this would require heavy capital investment. Michel Avenas, president of Vivendi North America explains that “for the time being, our strategy in the telecom business is to focus our efforts in France.”143 3. Water In March of 1999, Vivendi bought U.S. Filter for $6.2 billion in cash; the largest French acquisition ever made in the U.S.144 The purchase of U.S. Filter nearly doubled the revenues of Vivendi’s water treatment business, to about $12 billion.145 U.S. Filter, based in Palm Desert, California, has operations ranging from the retail sale of bottled drinking water through its Culligan subsidiary to the construction and operation of large water treatment plants for U.S. cities and factories. Under the terms of the agreement, US Filter becomes a wholly owned subsidiary of Vivendi. C. Analysis of Policy Decision Since the mid-1990s, Vivendi has continued to redefine itself as a multinational corporation with a diversified portfolio of products in water distribution, utilities, and communications. This convergence strategy has been accomplished primarily through the acquisition of U.S. companies in all three industries. The cornerstone of Vivendi’s convergence strategy has been large scale entry into the utility industry. Vivendi is increasing its utilities assets in order to position itself as a major player in the recently deregulated U.S. market where financial success is increasingly dependent on generating capacity. Subsidiary Sithe Energies now has over 11,000 megawatts of energy producing capacity in 40 power plants and plans to expand to a combined capacity of 20,000 megawatts in the near future.146 All told, Sithe plans to invest over $1 billion in new energy facilities in the next 3 years and to become one of the ten largest generators of electricity in the U.S.147 The GPU acquisition makes Sithe the leading independent power producer in the northeast United States. This region is characterized by several positive attributes including high demand for electricity, a large, concentrated population (70 million residents), and a market which is rapidly moving towards deregulation. In addition, Sithe has over seven years of

142 Rosenberg, M. “The Europeans Are Coming,” Utility Business, January 1999, p.34. 143 “The Europeans Are Coming,” p. 34. 144 FOX Market Wire, “French Conglomerate Buys Southern California-based U.S. Filter, 5/19/99. 145 Engineering News Record, “Vivendi to Buy U.S. Filter,” 3/22/99. 146 “The Europeans Are Coming,” Utility Business, January, 1999, p. 32. 147 “Sithe Energies Fact Sheet,” Demand Clean Air


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experience dealing with local regulators, who have a history of encouraging deregulation and competition. Vivendi has also made substantial inroads in the communications industry. Of greatest significance is the Cendant purchase. The Cendant software acquisition will raise Havas’ input to Vivendi’s profit in the coming years as the consumer PC retail software market is estimated to average 15% growth each year from 1998-2002.148 Cendant’s strong proprietary brands coupled with its dominant presence in existing distribution channels should also provide Havas with substantial competitive advantage. In water distribution, passage of the Safe Drinking Water Act in 1996 greatly influenced Vivendi’s evolution as the world’s largest water company. The Act significantly raised legal standards for water quality. Municipalities, which currently supply about 85% of all U.S. residents, were required to renovate vastly outdated and deteriorating systems in order to be in compliance with the new law. Such renovation often proved extremely costly and led many cities to contract with private water companies to either run these facilities or purchase them. Vivendi has successfully capitalized on municipal privatization in Europe and is positioned to do the same in the U.S. as this process gradually takes hold. With the increase in size and resources afforded by the U.S. Filter purchase, Vivendi is assured of positioning itself as the low-cost water company with worldwide brand recognition. Notably, Vivendi competitor Suez Lyonnaise des Eaux SA is simultaneously undertaking a similar convergence strategy. Suez has made several key U.S. acquisitions including the recent purchase of Nalco Chemical Company, a U.S. water treatment group, and Calgon Corporation, a Pittsburgh-based water-treatment company. Both purchases are designed to secure a greater share of the U.S. market as municipal privatization takes hold. Like Vivendi, Suez also has major energy holdings and intends to expand these positions as convergence continues in U.S. markets. Thus far, the financial impact of Vivendi’s convergence strategy has been positive. The stock price has risen in the past year from 51,5 Euros to the present 71,5 Euros. Net sales are up 25% ($31.7), as is net income which has increased by 36% to $1.12 billion, with each business sector making an operating profit.149 Importantly, Vivendi’s core water business provides a steady revenue base with which to leverage its current convergence strategy.

D. Consumer Impact In the Northeast and other U.S. regions, consumers may now choose their energy providers from an increasingly broad array of local suppliers. As Sithe competes with other local power companies in a newly deregulated marketplace, the full effect of Vivendi’s convergence activity in this industry remains to be seen. Over the past five years, for example, increased competition from new entrants has led to significant declines in the level of wholesale electricity prices in the Northeast. If Vivendi’s activity continues to be limited to the wholesale market, tangible impact on consumers is probably minimal. Historical industry data indicates, however, that lower wholesale prices usually lead to lower retail prices.

148 Company financials, “Recent Acquisitions,” http://finance.vivendi.com 149 Company financials, www.vivendi.com.


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One risk of Vivendi’s increasing market share in utilities is the possibility of more stringent environmental regulations which may impact Vivendi’s position. Sithe (and parent Vivendi) has publicly stated its overarching concern for the environment; including a plan to build cleaner, state-of-the-art gas-burning generating plants. Sithe is faced with an important dilemma, however, as such “green” facilities are much costlier to build and operate. Competitors and environmental groups are concerned that Sithe’s new utility holdings in the Northeast currently include several older plants which burn either coal or oil and emit more pollutants. In Massachusetts, for example, some of Sithe’s competitors have complained to the EPA, urging the agency to adopt stricter regulations.150 Some of Sithe’s competitors (known collectively as “New Generators”) own and operate newer, more environmentally-friendly plants, which tend to be more costly to operate. These higher costs make it more difficult for these companies to compete with older plant owners such as Sithe. As a result, even though the company publicly claims its concern over the environment, Sithe may be less inclined to update its old plants with costly emissions technology. While it is evident that deregulation has led to increased competition it has also eliminated the guaranteed profit of the formerly-regulated market. As such, plant owners feel pressure to reduce costs (including costs associated with emissions controls), which may lead to harmful environmental impacts. E. Outlook Through its recent acquisitions in water, utilities and communications, Vivendi is gaining sizable clout in these U.S. markets. It has evolved from a traditional French water supply company to its present status as a multinational firm with numerous, diverse enterprises. President Michel Avenas characterizes the company as a “growth company…committed to growth internationally.” Judging by the size and scope of Vivendi’s recent convergence activity, the Company appears headed for a dominant role in each of its worldwide business enterprises.

V. AMERICAN TELEPHONE & TELEGRAPH (AT&T)

A. Company Background American Telephone and Telegraph Company (“AT&T”) was incorporated on March 3, 1885, as a wholly owned subsidiary of the American Bell Telephone Company. Its original purpose was to manage, and expand, the burgeoning toll, or long distance, business of American Bell and its licensees. It continued as the "long-distance company" until December 30, 1899, when in a corporate reorganization, it assumed the business and property of American Bell and became the parent company of the Bell System. Today it is the largest telecommunications company in the United States with its main businesses comprised of long-distance services, AT&T Wireless Services, AT&T WorldNet® services, AT&T Solutions consulting services, and the AT&T Universal Card. Until divestiture, on January 1, 1984, AT&T was the parent company of the Bell System, the regulated enterprise that formerly provided the bulk of telecommunications in the United States. From 1984 until 1996, AT&T was an integrated provider of communications services and products, network equipment and computer systems.151 150 Utility Companies Joust for Power,” CNN Financial News, 6/4/99. 151 AT&T Homepage: www.att.com


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With the purchase of McCaw Cellular in 1993, AT&T entered the wireless communicationsmarket in a serious way. This was of particular importance as it gave the Company a significantchunk of the now exploding wireless market which is currently estimated to be growing at more than $1 mill new customers per month. On September 20, 1995, AT&T announced its intention to split into three companies over thesubsequent fifteen months. These companies are: today's AT&T, which provides communicationservices; Lucent Technologies, a systems and technology company, which providescommunications products; and NCR Corporation, in the computer business. NCR was largelyunsuccessful and was spun off at a cost to AT&T of $2 billion. AT&T serves more than 80 million customers, including residential consumers, businesses and government. With annual revenues of more than $53 billion and 109,000 employees, the Company is a leading supplier of data and Internet services for businesses and the nation's largest direct Internet service provider with 1.2 million customers.152 On March 9, 1999, AT&T completed its merger with Tele-Communications Inc. (TCI). TCI became AT&T's newest business unit, now known as AT&T Broadband & Internet Services. TCI’s status as one of the leading cable television companies in the country gives AT&T- for the first time - a direct wire connection to 33 million U.S. homes on lines that the company now owns and operates.153 AT&T plans to deliver bundled packages of telephone, entertainment and high-speed Internet access services as well as an extensive menu of new communications products to customers. In early May, 1999, in what CEO C. Michael Armstrong called “our last big acquisition,” AT&T purchased MediaOne for $58 billion in cash and stock plus an additional $4.5 billion assumption of liabilities related to Comcast Corp. of Philadelphia. Comcast had also seriously bid for MediaOne and despite losing the bidding war was able to purchase 40% of the cable subscribers it wanted (750,000 customers) for $3.5 billion. With that, Comcast also agreed to allow AT&T eventually to use its cable television lines to sell telephone service to Comcast customers, expected to total 8 million. As a result of the MediaOne acquisition, AT&T becomes the nation’s biggest provider of cable television with a customer base of 16 million.154 Following closely on the heels of the MediaOne acquisition, AT&T announced a deal with Microsoft in which Microsoft agreed to invest $5 billion in AT&T to use its software to deliver an array of electronic services via a box on top of the television set. The box acts as a central switching device and can handle telephone, Internet and cable all in one place. AT&T plans to launch these electronic boxes in select U.S. cities, including San Francisco, Chicago, Dallas, St. Louis and Seattle.155 AT&T’s new strategic direction has positively affected its revenues. For the fiscal year ended 12/31/98, net income rose 23% to $5.24 billion and revenues rose 3% to $53.22 billion. All told, there have been four consecutive quarterly increases in revenues. The results from first quarter, 1999 have also been impressive with profits rising 39%. Shareholders are experiencing

152 CNN Financial Network, “AT&T Rings Up TCI Deal,” 6/24/98. 153 Ibid. 154 “AT&T Chief’s $120 Billion Plan Capped by Deal for MediaOne,” The Washington Post, May 6, 1999, Page E1. 155 Schiesel, S., “At Last, a New Strategy for AT&T,” The New York Times, 1/20/99.


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significant, consecutive gains as the stock is up 60% (from $0.69/share to $1.00/share).156 AT&T’s recent financial success may best be understood in terms of a determined, strategic redefinition as described in more detail below.

B. Strategic Opportunity The transformation of AT&T from a traditional telecommunications provider to a worldwide provider of telephone, Internet and television services was engineered by its new Chief Executive, C. Michael Armstrong. A highly regarded turnaround specialist and innovator, Armstrong was selected in 1997 to revitalize AT&T during a time of declining revenues and diminishing market share. Armstrong succeeded in orchestrating the Company’s most important strategic shift in decades. This transformation has been accomplished primarily through more than $82 billion in acquisitions and alliances.157 Armstrong’s goal is to engineer a reentry into the $90 billion local U.S. telephone market158 that the Company had been forced to abandon under deregulation. Reentry will be accomplished by repositioning AT&T as a full service communications provider, thereby capitalizing on the value chain of the Internet. Successful reentry into this market, however, requires a markedly different approach than AT&T’s prior attempts which have proved unsuccessful. The local telephone market is currently the exclusive domain of the Regional Bell Operating Companies (“RBOCs”). To successfully compete, AT&T will shift from a product re-sale strategy in local telephony to one that is facilities-based. In other words, the Company now owns the telephonic infrastructure necessary to transport its communications products. This enables AT&T to offer more value at a competitive price because ownership is less costly than purchasing space on an RBOC network and re-selling those products.159 The long term goal is an extensive broadband network utilizing cable wires to transport digital products. These cable wires will be utilized to deliver a new, digital product over a “broadband” network. Specific aspects of this strategy are described below, including its relation to the macro communications market. The U.S. communications industry is characterized by 8%-10% growth per year (3 times as fast as the macroeconomy). Within this context, Internet access is a significant growth area. By 2002, it is estimated that there will be 250 million Internet users.160 In order to access Internet and other entertainment consumers (e.g., cable television) AT&T intends to focus on broadband technology to accomplish this goal. The company intends to develop its cable telephony to provide bundled, communications services to consumers via a digital, broadband network. To accomplish this, AT&T will shift from its present local/analog/regional structure to a national/digital one. By the end of 1999, over 80% of AT&T’s infrastructure will be digital.161 The established infrastructure will enable AT&T to access customers’ homes via “box” technology; a term that refers to an electronic switching box that will house cable, telephone and Internet selections based on individual consumer preferences. Technically, use of IP (Internet protocol) technology will allow the different systems to speak to each other electronically. 156 AT&T News Release, “AT&T’s Fourth Quarter Operational Profits Were $1.00 Per Share, an Increase of 45%,”

1/25/99. These results also include the effect of large scale personnel reductions. 157 Reuters News: “Armstrong at the Helm Guides a Rejuvenated AT&T,” 4/27/99. 158 Ibid. 159 Speech by C. Michael Armstrong, “Networking: The New generation Comes of Age,” Washington, DC, 1/26/99. 160 Armstrong speech, 11/5/98. 161 Armstrong speech, 1/26/99.


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AT&T’s cable access strategy is utilized in conjunction with two other strategic areas: long distance calling plans and global alliances. First, concurrent with infrastructure ownership and development is AT&T’s decision to drop its unprofitable long distance customers in order to target more desirable ones. This has been accomplished by marketing calling plans like “One Rate Plus” which bundle telephone services together. The plan rewards high volume usage and charges a minimum monthly fee for low volume users who do not select a long distance calling plan.162 Second, AT&T has begun to concentrate on the domestic communications market and limit its global direct sales. In fact, global product strategy has become almost exclusively limited to strategic alliances as a means for diversifying revenue. AT&T’s recent service ventures with British Telecommunications, P.L.C and Japan Telecom Corporation, for example, were forged in preference to prior plans to build extensive networks in countries such as Germany and France.163 C. Analysis of Policy Decision AT&T’s convergence strategy has been successful. The Company may now compete in the local telecommunications market by using cable lines that are directly connected to customers’ homes. In the industry, ownership of these lines is considered a scarce asset because access by competitors is not regulated in the same way as traditional phone lines. AT&T may refuse, for example, to allow rival Internet service providers such as America Online or EROLS to access its wires. This will prove particularly advantageous as the Internet industry evolves from a dial-up (analog) network to broadband (digital).164 AT&T’s brand name may also contribute to the continued success of its convergence strategy. In a recent study by the Yankee Consulting Group, AT&T was selected by a majority of consumers as the preferred provider of bundled communications services. In the Pacific regional market, for example, AT&T was selected by 38.6% of consumers compared to the 26% who selected the dominant RBOC, Pacific Bell.165 Such strong consumer brand preference gives the Company a significant competitive advantage over regional (and national) competitors. AT&T’s new convergence strategy is not, however, without weaknesses. Analysts warn that the Company has insufficient understanding of the local phone business. In addition, AT&T may have to spend billions more dollars to transform existing cable lines from “1-way” capacity to “2-way,” in order to enable the transmission of both voice and data traffic. Costly new computer systems are also necessitated by the Company’s new broadband cable network and sophisticated communications products. 166 Other limiting factors include competition from the RBOCs which is likely to be formidable. As a group, these companies possess significant financial wherewithal, as well as more customers and political influence than AT&T. Government response to AT&T’s convergence activity is also an important issue. While FCC response to the recent Microsoft alliance and the Media One 162 Associated Press, “AT&T Long-Distance Customers Hit With New $3 Fee,” 4/7/99. 163 Snyder, K., “Globalization of the Telecommunication industry Players, the AT&T Strategy,” New York

University, 1998. 164 “AT&T Chief’s $120 Billion Plan Capped by Deal for MediaOne,” The Washington Post, May 6, 1999, Page E1. 165 “Yankee Group Survey Finds AT&T is Top Choice for Consumers Interested in Single Communications

Provider,” Boston, MA, 1/20/99. 166 “AT&T Rings Up TCI Deal,” 6/24/98.


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acquisition appears to be positive, subsequent acquisitions and/or monopolistic practices could invite another breakup. This appears unlikely, though, as the Federal government’s long term goal has been to engender local telephone competition and AT&T’s entry represents a significant step in that direction.167 Finally, AT&T is betting more than $120 billion168 that consumer demand for the types of bundled, digital services it plans to sell will materialize. It is possible, however, that a majority of consumers may not want to pay for such sophisticated products. As a result, it remains unclear whether AT&T’s heavy investment in cable technology will ultimately pay off.

D. Consumer Impact It is premature to gauge the consumer impact of AT&T’s broadband convergence strategy as many of these products won’t be available on a large scale basis until 2004 or 2005. In the meantime, however, some positive and negative aspects may be observed. Consumers may experience much faster Internet access speeds, and have the opportunity to select satellite, cable or telephone to access the Internet. Perhaps most beneficial is that AT&T’s cable wire strategy represents the best chance for local phone competition.169 In Phoenix, Arizona, for example, Cox Cable has now begun offering local service and Internet (just as AT&T plans to do), as an alternative to regional provider US West. US West has responded by countering with a discounted, bundled product. In this market, consumers may select from at least two different providers instead of only one.170 On the other hand, AT&T’s aggressive acquisition strategy may result in numerous drawbacks for consumers. Simply put, the new strategy undisputedly eliminates major cable competitors from the communications marketplace. AT&T is now the largest cable television company and its size and technical resources may beget the monopolistic behemoth that was dismantled only fifteen years ago. If its recent behavior in the long distance market is any indication, consumers’ fears may be justified. In January 1998, for example, federal legislation substantially cut the fees that RBOC’s are permitted to charge for access to their telephone wires. Consumer groups protested that long distance consumers of AT&T, Sprint & MCI/Worldcom have not benefited from the substantial cost savings realized by these companies. These groups maintain that long distance carriers have pocketed this savings and realized greater profitability as a result. Consumers’ experience in the market for long distance telephone service may provide valuable insight into the potential behavior of dominant broadband providers.171 Perhaps most important, it is unclear whether the digital broadband and other bundled communications services in AT&T’s new product line will be affordable to a majority of consumers. Because of the high cost of developing and maintaining an adequate network infrastructure, it is possible that AT&T’s new product line may only be accessible to wealthy

167 Schiesel, S., 1/20/99. 168 Fitzgerald, M. & Kane, M., “Broadband Game Just Beginning,” Yahoo! News, 5/6/99. 169 Mehta, S., “Consumers Fear Results of AT&T Consolidation,” The Wall Street Journal, 5/6/99. 170 Adamik, B., The Yankee Group, Boston, MA, quoted in The Wall Street Journal, “Consumers Fear Results of

AT&T Consolidation,” 5/6/99. 171 Consumers Union Press Release, “Consumer Groups Challenge FCC On Phones: Time to Engineer Long

Distance Phone Rebates & Stamp Out Hidden Fees,” 8/13/98.


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customers and/or densely populated customer centers such as apartment houses.172 In this case, rural or low spending consumers may be disregarded. E. Outlook The long term success of AT&T’s bold, innovative strategy is uncertain. Of particular importance to the success of this new strategy is AT&T’s bet on the ability of digital technology to eclipse analog (dial-up) systems. The Company’s heavy investment in developing the requisite infrastructure to support such a product offering hinges on consumers opting for digital. This appears to be at least an even bet, though, as most analysts agree that the broadband market is expected to grow to $200 billion by 2005.173 Clearly, consumer impact is uncertain, although a return to AT&T’s historical, monopolistic position as the sole provider of communications services to the home is a distinct possibility. These fears may be exacerbated by the recent alliance with Microsoft, a continuing target of federal antitrust litigation. Ironically, though, these same consumers consistently select AT&T as the provider of choice for bundled communications products (see Section III above). It appears that consumer preferences for quality and reliability may take precedence over low prices. It may turn out that this mindset, along with the brand name preferences of consumers themselves, will be a significant barrier to desirable competition in this converging industry.

VI. TACOMA PUBLIC UTILITIES

A. Company Background Publicly owned since 1893, Tacoma Public Utilities (TPU) is the largest department in Tacoma’s city government and operates entirely from service revenues, not from taxes. TPU has three main subsidiaries: Tacoma Power, Tacoma Water and Tacoma Rail, covering a service area of 180 square miles on total 1998 assets of $543,235,204.174 TPU serves over 140,000 customers, 90% of whom are residential. TPU has undertaken several important projects in the past five years, including large-scale convergence activity into the communications business. This new strategic direction required a substantial upgrade of its fiber optic infrastructure undertaken by its subsidiary, Tacoma City Light. TPU’s wires now have the capability to carry Internet, cable and telephone service to residential customers. B. Strategic Opportunity In 1995, TPU began looking for ways to offer cheaper, more efficient power and became particularly interested in developing technology that would enable its customers to control their own energy consumption. Examples of such innovative products include “smart” meters that can track household energy consumption and are accessible to electricity customers. To accomplish this, TPU upgraded its fiber optic lines which led to an important realization: not only could the new wiring accommodate the latest monitoring technology, but there would be substantial room left over to accommodate high-speed Internet access, cable television and telephone service. In 172 Mehta, S., 5/6/99. 173 Knox, N., “Microsoft, AT&T Form Alliance,” The Washington Post, 5/6/99. 174 TPU home page: http://www.ci.tacoma.wa.us


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order to discover how best to utilize its improved infrastructure, TPU commissioned a marketing survey and learned that most of its residential customers were unsatisfied with incumbent cable provider TCI. The situation had deteriorated so dramatically, in fact, that most Tacoma cable subscribers customers were receiving as few as 20 channels as compared to the 60 or 70 typically available in larger markets. A key impetus to TPU’s decision to pursue this market also occurred in 1997 when it learned that US West and TCI had no immediate plans to upgrade their networks to accommodate the new technology. With no formidable competitive response, TPU decided to undertake the modernization effort and pursue the convergence opportunities available in the communications business. In 1998, TPU launched the Click! Network through subsidiary Tacoma City Light. Click! offered Tacoma residents an inexpensive cable television, Internet and telephone alternative. Besides cable and Internet service, the Click! offering also includes remote metering services and additional scheduling and informational services. The total cost of TPU’s infrastructure upgrade is estimated to be $100 million dollars but it should be able to recoup a sizable chunk of this outlay from revenues derived from its new communications products. While TPU has not expressed an interest in establishing its own ISP, the company is utilizing a strategy that includes “renting” space to other ISP companies on TPU’s newly expanded and upgraded wires. Tacoma city manager Steve Klein explains: “We’re interested in being a public highway other businesses will ride on.”175 C. Analysis of Policy Decision TPU’s convergence strategy has been successful thus far as evidenced by the growing presence of its Click! Network, the first alternative cable TV service in Tacoma. Over 25% of Tacoma’s households have signed up with Click! and with all the new services that TPU plans to offer on its new fiber optic system, the company expects to recoup its initial investment within 10 years.176 As previously noted, a key contributor to the success of TPU’s venture was the decision by its close competitors (US West and TCI) to decline a fiber optic upgrade. TCI has since reconsidered its initial decision and has upgraded its cable offering from 37 channels to 75 channels.177 To balance this convergence activity, TPU has further developed its core utility business so that it now has the ability to engage in selling electricity on the open market. This has resulted in millions of dollars more revenue a month that allows TPU to both fund its new cable venture and keep its rates low. In 1997, for example, energy trading on the open market increased TPU’s revenues by about $1 million a month.178

D. Consumer Impact The impact on Tacoma consumers of TPU’s convergence strategy has been wholly positive. Not only do cable television customers now have a choice of suppliers, the rates are considerably lower than those charged by incumbent provider TCI. Consumer choice has also increased 175 McLennan, D., “The Little City That Could: A Tacoma Power Company’s Move to Provide Net and Cable

Service Counters the Trend Toward Megacorporate Control of Telecommunications,” Salon Magazine Online, 2/3/98.

176 McLennan, D., “The Little City That Could,” p.3. 177 McFadden, K., “Tacoma Cable Experiment Fills In Where Market Failed,” Seattle Times, 9/17/98. 178 “Energy’s Uncertain Future,” The News Tribune, Tacoma, WA, 9/7/97.


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dramatically with most customers moving from an average cable package of approximately 20 channels to one a Click! offering that includes between 50 and 70 channels. For example, customers may even select a minimal channel package of 17 channels for only $5.95 a month. Perhaps most important, however, is that the Click! Network has offered a viable alternative to what had historically been a market monopolized by a single provider. E. Outlook In March, 1999, TPU’s Click! Network began offering broadband services (which allow companies to move large amounts of data very quickly) to Tacoma businesses. This level of communications service ranges from the approximate capacity of 24 telephone lines at the low end, to the equivalent of 32,256 telephone lines at the highest level of service offered.179 TPU promotes the new service as yet another important element in its long term strategy to expand customer choice and introduce competitive pricing to Tacoma’s telecommunications market. Debra Stewart, Click! Network general manager further explains that TPU sees broadband service as “a significant economic development tool for the City of Tacoma because it will make customized broadband services available…”

179“Click! Offers Commercial Customers Broadband Services,” Click! Network News Release, 3/3/99.

Documents

THE CONVERGENCE PHENOMENON A CONSUMER …Mr. Larry Frimerman Federal Liaison Columbus, OH Ohio House of Representatives Hon. Priscilla Mead Chair House Public Utilities Committee Columbus,