Clear Communications vs. Telecom New Zealand

Clear Communications Ltd (CCL) was established as a network operating company in Oct. 1990. In 1987, the New Zealand government had decided to deregulate the telecommunications sector by passing the Telecommunications Act. It imposed a two-year transition period for the removal of state imposed barriers to competition in the telecommunications arena.

CCL had a multi-pronged strategy for entering the telecommunications sector in New Zealand in 1990. The New Zealand government had decided upon a “light-handed” approach to regulation of the sector whereby the incumbent, Telecom and new competitors would be left to negotiate terms for the latter’s entry into the market on their own without any government intervention. CCL entered into negotiations with Telecom under such an understanding. CCL’s first foray into the telecommunications sector was to offer long distance and international telephone service before local service. In order to do this, it had to build domestic long distance network and international transmission capacity. This consisted of fiber optic cables and microwave telecommunication links connecting the main cities in New Zealand. However, since it did not have a nationwide local network, CCL would still have to depend upon the incumbent company Telecom New Zealand for origination and termination of its customers’ calls.

There were certain advantages to CCL’s approach. It made more sense to enter the market by offering long distance service first. Firstly, it was cheaper to do so. As a privately held startup, CCL did not yet have the big pockets to invest in building a nationwide network from the ground up. Such a move would have required the laying of an extensive network of fiber-optic cables in order to be able to offer comprehensive local service, which was a capital-intensive process. Secondly, it also allowed CCL to enter the market much faster than if it had to wait until its network was completed. CCL was able to enter the market quickly by leasing and purchasing fiber-optic cables, which linked the main cities together. A popular notion within the telecommunications industry was that local service was a “natural monopoly”, while long distance was potentially more competitive. Hence CCL would have greater support from any regulatory body in its attempt to enter the long distance market.

The major downside was that CCL had to rely on the goodwill of a competitor in order to get its service up and running. As the incumbent player, Telecom had no incentive to help a new competitor enter its market.

Upon the launch of its long distance and international service, CCL started an aggressive marketing campaign. It started to offer discounts of up to 20% over Telecom’s rates and promised superior customer service. This strategy enabled it to quickly capture market share in the long distance business. In fact, it gained market share quicker than anyone had anticipated. By 1992, CCL had reached the 9-percent market share threshold that was supposed to lead to non-code access. The downside to this strategy however, was that in undercutting Telecom to gain market share, CCL’s costs rose. It also made Telecom much more aware of it as a competitive threat.

As discussed previously, with the advent of competition, CCL had to strike agreements with Telecom in order to gain access to the telephone network. Telecom had no incentive to grant such access to a competitor, since it was in a monopoly position. This situation was made worse due to the fact that there was no regulatory or oversight body to force Telecom to open up its network to competitors. The New Zealand government, unlike others in the industrialized world had decided to open up its telecommunications market to competition, but had declined to set up a regulatory agency to oversee the process, such as the FCC in the USA. This made the negotiations between Telecom and CCL much more skewed in favor of the incumbent.

Thus there were major points of contention between the two companies. These were as follows: interconnection prices, tracking and billing of customers, and non-code access.

Telecom wanted all CCL customers to dial a multiple digit access code in order to make a long distance call. It claimed that this was necessary for it to identify CCL customers so it could calculate billing charges. CCL was naturally opposed to this, since it felt that Telecom was imposing this requirement in order to make the CCL long distance experience as unpleasant as possible. In order words, Telecom was trying to impose switching costs[1]. CCL proposed that Telecom provide non-code access, since it was more convenient. Telecom argued that it would have to make costly changes to its network in order to facilitate this. CCL also wanted Telecom to provide it with the names and billing addresses of all customers who placed calls over the CCL network, or bill its customers on it behalf. Telecom refused to do this.

The most problematic issue was the problem of interconnection pricing. Interconnection is the single most contentious issue to crop up when a telecommunications industry is opened up to competition. The existence of a network externality[2] in telecommunications gave Telecom of New Zealand, the incumbent, enormous power since it owned the network. In this situation, a network was only as valuable as the number of users who were connected to it. Any startup network would be of limited value, because it would only be able to offer a small number of connections to its customers. The network Telecom controlled had large economies of scope and it would be prohibitively expensive for CCL to try and duplicate this scope by building its own network. Also, network externalities would make it unattractive for a user to switch from Telecom’s network to the one CCL built, unless everyone switched to CCL’s network. This is because the customer would have to maintain subscriptions to both systems in order to maintain access to all users. Thus, established networks have market power because they are established, not because of price or quality of service. Hence, there is a strong need on the part of any new entrant for interconnection with an incumbent’s network, and CCL had no choice but to do so. However, Telecom had little to gain by interconnection as it had all the customers and all the economies of scope, and wanted to maintain its monopoly position. CCL was the party who had all to gain as a result of interconnection. By interconnecting CCL would gain access to all users, without having had to incur the costs of creating the network. It was also free from any regulatory constraints such as the Kiwi Share Obligation, which Telecom had to obey. Thus CCL would be able to gain some of the economies of scope provided by the network, but without incurring the costs. This is the problem of appropriability.

Telecom and CCL differed on the issue of what CCL would have to pay in order to be connected to Telecom’s network. The two companies were able to reach agreement on this issue when CCL entered the long distance market, but had to resort to litigation when it tried to enter the market for local service. Interconnection pricing was a big issue, and in New Zealand, there was no regulatory agency to compel Telecom to set the price at a level agreeable to CCL. This made reaching an agreement between the two companies difficult.

Telecom offered terms similar to those for long distance interconnection – i.e. use of access codes and pricing based on retail rates that enabled it to finance its obligations under the KSO agreement. CCL strongly opposed these terms, fearing that using an access code for local service would make its service too unwieldy for its users. Relations between the two companies came to a head when CCL attempted to purchase Telecom’s direct dial-in service in order to meet a contractual obligation to provide local service to the Wellington courts. Telecom refused, and CCL took the matter to court, accusing Telecom of violating the Commerce Act by using its dominant market position to stifle competition.

There are a few similarities between the conflict in New Zealand and the USA, but also some striking differences. Superficially, the situation seems similar – an incumbent monopoly telephone company seeks to maintain its market dominance to the fullest extent possible, by using its ownership of the nationwide telecommunications network to erect barriers to entry for the new entrants. For example, since the 1996 Telecommunications Act freed up local telephone market, the Baby Bells[3] have been able to do this for local telephone service, and more recently for broadband service, with the result that many independent upstart DSL providers have gone out of business, partly due to high interconnection costs imposed by the incumbents[4].

On a more fundamental level, however, the similarities end. Firstly, New Zealand decided to open its telecommunications market to competition with minimal regulatory oversight. In the US, the Federal Communications Commission has regulatory powers over the telecommunications industry. Thus it could intervene in any dispute between incumbent and entrant companies, such as the conflict over interconnection. Secondly, when the market was first opened to competition in the USA, the incumbent phone company AT&T was divested into two parts – a large long distance company and smaller Regional Bell Operating companies (RBOCs). This action broke the monopoly AT&T had over existing access connections, especially in long distance. For example, it could not dictate interconnection terms in long distance, since it no longer had control over termination and origination of calls, but had to negotiate terms with the RBOCs like any new long distance entrant would have to do. However, it can be argued that it led to the creation of entrenched monopolies in local service, as can be seen by the resistance of the Baby Bells in resisting competition in that market.

In November 1991, CCL filed suit against Telecom, alleging that it had violated Section 36 of the Commerce Act by using its dominant market position to stifle competition and erect illegal barriers to entry into the local telephone market. The case was brought before the High Court, and the court had to decide whether Telecom’s proposed interconnection agreement for local service constituted a violation of Section 36 of the Commerce Act. Specifically, CCL claimed that Telecom had violated the act in these three respects: by delaying interconnection negotiations for five months, refusing direct-dial service and lastly by charging excessive rates for local interconnection.
In order to defend its position on interconnection pricing, Telecom engaged the services of two notable American economists, Baumol and Willig, authors of the BW Efficient Component Pricing Rule. According to Baumol and Willig, the charges should be enough to make the incumbent indifferent whether it provided local service itself, or by a combination of its services and that of CCL. Thus, Telecom should set interconnection prices at a level high enough to recover all incremental costs created by serving CCL plus the opportunity cost created by loss of business to it.

The New Zealand High Court released a decision in December 1992. In the ruling, the High Court endorsed the BW rule as the appropriate basis for resolution of the interconnection dispute. CCL did not agree with this ruling, and took the decision to the Court of Appeal. A year later, the Court of Appeal reversed the High Court’s decision. The court rejected the Baumol pricing rule, and also Telecom’s attempt to make CCL share in the burdens imposed by the Kiwi Share Obligation. The judge then ordered the two companies to resume negotiations on a new agreement.

Neither company was entirely satisfied with the Appeals Court decision. Consequently the case ended up before the Privy Council[5]. The Privy Council took four months to deliberate the case, and eventually ruled in favor of Telecom. It ruled that the Baumol-Willig pricing rule was appropriate in determining the price of interconnection in a fully competitive market, and that the Appeal’s court had overreached in its interpretation of the Commerce Act as having the purpose of eliminating any advantage Telecom may have by virtue of a dominant market position.
In my opinion, the High Court and Privy Council made a correct ruling under the current law at the time, although the spirit of the ruling was wrong. The problem is that there are fundamental flaws in New Zealand’s telecommunication policy framework, in so far as engendering competition and opening up the market for competition. New Zealand opened up its telecommunications market and at the same time deregulated the interconnection arrangements whereby competition is to be engendered. A “paradox“ of opening up previously regulated markets is that regulatory oversight needs to be maintained, so as to prevent an incumbent monopoly from erecting barriers to entry for entrant companies. New Zealand’s attempt to deregulate interconnection arrangements ran into problems because there was no basis for a market transaction between Telecom and new entrants. The Baumol-Willig pricing rule was inadequate to solve the problem of interconnection pricing in the absence of proper conditions for the operation of a free market. The government’s hands-off approach to regulation of the telecommunications sector was simply inadequate in encouraging Telecom to open up local markets to competition. The Appeals Court ruling was more in concert with the spirit of opening up the telecommunications sector. It highlighted the fact that the Commerce Act by itself did not provide an adequate framework for bringing about true competition in telecommunications.

After the Privy Council ruling, CCL CEO Andrew Makin contemplated three options for the future of the company. One option was to abandon its attempt to enter the local call market. Alternatively, it could try to build a local network from the ground up in major markets. A third option would be to try to lobby for a favorable change in New Zealand’s regulatory framework that would make it easier for new entrants to offer local call service. In the long term, the third option may be the most viable. Building a network up from the ground up would be prohibitively expensive, and even if CCL could raise enough capital to do it, its network would suffer from externality effects, as previously discussed. Abandoning the local market would limit its growth prospects. Lobbying for a change in the regulatory regime offers the greatest prospect for change, especially since such laws are often dependent upon the political philosophy of the party in government. CCL could embark on an advertising blitz, for example, appealing to consumers for them to pressure their representatives to enact regulatory laws with teeth that would open up the local telephone call market. Examples of this abound in the US, where AT&T was divested of its local business when the telecommunications sector was opened up to competition. The threat of divestiture would surely force Telecom New Zealand to open up its local loop to new competitors. A less drastic example from the USA would be the Telecommunications Act of 1996, which has a carrot and stick approach. In that act, local companies are prevented from entering the long distance market unless they open up their local loops to competition. New Zealand could adopt a similar law whereby Telecom is prevented from entering new market segments such as wireless unless it opens up its local loop.

In conclusion, this case highlights what happens when the telecommunications sector is opened up to competition, regulation is completely abandoned, and issues of competition are resolved by market transactions alone. The incumbent monopoly will inevitably act in its own self-interest and erect barriers to entry for the new entrants, and the advent of true competition will be delayed.