Universal Service Is Vital To the Economic Development of Rural America

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1 Universal Service Is Vital To the Economic Development of Rural America by Gregory J. Vogt One of the single most important developments in the regulation of telecommunications has been promoting universal service. For decades, federal and state governments have promoted the policy of providing telephone service to all Americans, including those living in hard to reach areas such as on islands, in the mountains, or way out in the sticks. Although there has been discussion and debate about universal service, it is an often-misunderstood concept, and many do not understand its complicated regulatory underpinnings. To complicate matters further, universal service is not the only regulatory concern in telecommunications. An equally important policy, especially in recent decades, is competition for telecommunications services. Reconciling the two policies universal service and competition in services can often be difficult. One thing is certain, however: the resolution of this debate will have profound and longlasting effects on telecommunications service provided by the nations rural telephone companies. Definitions Universal service is the policy that all Americans should have the opportunity to purchase affordable telephone service at prices comparable to urban areas. The policy rests on the understanding that all Americans, both city and country residents, benefit economically and socially from being able to communicate with their fellow Americans. The policy is neutral in that it does not pick and choose which Americans should have priority in receiving service: rich and poor, urban and rural, are all entitled to service. Policy is one thing; creating a workable system to bring that policy to life is another. In ensuring universal service, regulators have recognized that, because it is more expensive to serve customers in particular locations, financial incentives are needed to encourage a telecommunications company to provide service to these more expensive areas. Another policy impacting universal service is often referred to as the carrier of last resort requirement. This policy has been applied mostly by state public utility commissions, 1 the government agencies that most often regulate local telephone service provided by the traditional phone companies. These carriers are known as incumbent local exchange carriers ( ILECs ). The carrier of last resort requirement holds that a telephone company must serve all customers in its area who pay the price for telephone service, subject to a certain reasonableness cost threshold for certain particularly isolated customers. 2 Given differences in terrain and in distances between customers, the 1 United States territories, such as Puerto Rico and the U.S. Virgin Islands, are treated the same as states by federal communications law. 2 The exception is a practical limitation on the laudable goal that the telephone network should reach every last person. It recognizes that a company should not be required to pay exorbitant costs, sometimes in the tens of thousands of dollars per customer, to string wire and provide service to a customer who has intentionally built a house at the top of an isolated mountain, or on a small island away from most people where there is no economical way to string wires to the location. Consider this: if telephone service 1

2 cost to ILECs of providing service to almost all customers can vary markedly. It is ILECs that bear the cost of connecting these expensive customers to the public switched telephone network. History Once Alexander Graham Bell had established that he could communicate with his assistant, telephone companies grew rapidly throughout the country. At first, each telephone company had its own circle of customers because the companies wires were not interconnected with each other. That soon changed as American Telephone & Telegraph ( AT&T ) bought up local telephone companies and established a vast nationwide, interconnected network. Economics and favorable regulatory treatment encouraged rapid expansion and inclusion of more and more households and businesses on this network. In the 1950s, state policymakers met and established the Ozark Plan. That plan set the policy goal of universal service connecting all Americans to the public switched telephone network. To help the telephone company pay for this ambitious project, the Plan determined that long distance revenues should subsidize the cost of hooking up local customers to the network. 3 Thus, long-distance pricing, set to recover more than actual costs, provided a fund to defray the higher cost to provide telephone universal service to all Americans. The policy recognized that there was an average cost to serve most customers and that most of these customers, located in urban and low cost areas, could afford to pay their share of the price of telephone service. Customers in outlying area, however, could not afford to pay the telephone company s cost to provide them with telephone service without a subsidy. Customers in these remote and difficult to reach areas, often rural and insular regions, might not be able to afford the real cost to provide them phone service subscribe to telephone. The Ozark Plan s goal was to provide service to these customers at roughly the same price charged to urban customers. Thus, it was decided that lower cost, urban areas would subsidize higher cost rural and insular areas, creating a more equivalent price for all. As long as AT&T was a single company providing both local and long-distance service, this policy worked rather easily. The company accepted the requirement of providing service in higher cost areas as a small price to pay for protecting its monopoly; the plan imposed no economic burden since the company as a whole recovered its costs. AT&T s lower-cost urban customers, by paying slightly higher long-distance fees, subsidized the more expensive local service to the company s rural and insular customers. This subsidy program worked well only when there was no competing telephone company that could offer lower long-distance prices to the low-cost urban customers without being obligated to provide local service to the higher-cost rural and insular customers. The subsidy favored expansion of service and by 1993, roughly 94 percent of all Americans had telephones in their households, 4 costs $20 per month, a typical price in today s dollars, how can a company justify connection charges of $10,000, when it only earns $240 per year from the customer? 3 See generally, Coll, Steve. The Deal of the Century: The Breakup of AT&T (New York: Simon and Schuster, 1988) ( Deal of the Century ). 4 Universal Service Monitoring Report, CC Docket No , at Table 6-1 (Federal-State Joint Board on Universal Service 2006). 2

3 and virtually all Americans had the opportunity to purchase reasonably priced telephone service if they wanted it. In certain areas of the country, however, the percentage of homes receiving service was far lower than the nationwide average. For instance, as recently as 2005 Puerto Rico provided wired telephone service to less than 70 percent of households, 5 and the U.S. Virgin Islands provided service to only about 87 percent of households. 6 Statistics on these and other remote areas are difficult to obtain, because collection of data on these areas is not as rigorous as for states. Competition This system of intra-firm subsidies did not last forever. During the 1960s AT&T began to face competition in the long distance by an upstart company called Microwave Communications Inc. MCI began to pick off lucrative business customers with its wireless links. Although the FCC initially helped protect AT&T s monopoly, the courts eventually put the kibosh on that and opened up the proverbial can of worms that began to unravel many settled regulatory policies that worked well only in less competitive business environments. 7 As the competition grew, AT&T was pressured to reduce long distance prices This reduction in long-distance rates began to erode the source of universal service subsidy. At the same time, the politics of deregulation began to take hold in Washington both at the FCC and on Capital Hill. Instead of regulating a single or small number of providers, opening the telecommunications marketplace to more providers became the goal. The entry of new competitors, especially those taking aim only at more lucrative segments of the market, eroded the subsidy scheme further. This small, but growing, problem for universal service policy was blown wide open, however, not by the FCC or by Congress, but by Judge Harold Greene and the U.S. Department of Justice. The government sued AT&T for monopolizing long distance service and the equipment market. In the settlement of the government s antitrust suit against AT&T the Modified Final Judgment ended the company s near monopoly over telecommunications and the equipment markets. AT&T agreed to spin off its local operating companies from AT&T s long distance business beginning in At divestiture, there were approximately 1500 local telephone companies in the United States, only 24 of which were owned in whole or in part by AT&T. These local AT&T companies were organized in various operating subsidiaries under seven regional holding companies dubbed the Bell Operating Companies or Baby Bells. Although there were only seven regional Baby Bells, they covered over 80 percent of all subscribers, 50 5 High-Cost Universal Service Support, Notice of Proposed Rulemaking, 20 FCC Rcd 19731, 19745, at 31 (2005). 6 Wireless World, LLC v. VI Pub. Servs. Comm., 2005 U.S. Dist. LEXIS 15061, slip op. at 25 (D.V.I. 2005), on remand on other grounds, Order No. 03/2007, Docket No. 526 (VI Pub. Servs. Comm. Dec. 7, 2007). 7 8 See Deal of the Century, note 3 supra. United States v. American Telephone & Telegraph, Inc., 552 F. Supp. 131 (D.D.C. 1982), aff'd sub nom. Maryland v. United States, 103 S. Ct (1983). 3

4 percent of the U.S. land mass, and were enormously lucrative. 9 The independent small telephone companies not owned by AT&T covered mostly the more expensive rural and isolated territories. Although there was a growing trend for some significant mid-sized companies to began to serve medium-sized cities and rapidly burgeoning suburban areas of larger cities, most of these independents served rural territories. The court-enforced separation between local and long distance service had a profound impact on universal service. Even though the government s universal service policy remained unchanged, federal and state regulators had to adjust their rules. Given the break up and spin off of the old AT&T network, using long distance revenues to subsidize local services would no longer work the way it had before the court case. One of the most immediate responses was the FCC s introduction of a system of access charges in The access charges allowed local exchange carriers to receive compensation for the use of their local equipment in the origination and termination of long distance calls placed by customers of other companies. 10 Whereas in the past these charges were intra-company transfer, now, long distance companies began to pay independently owned local exchange carriers for each minute of a call. The second response was that the FCC established a new universal service program. 11 Under this program the long distance carriers, at that time largely AT&T and MCI, paid a flat, per-presubscribed-line fee into the universal service fund ( USF ). The FCC calculated the fee based on the estimated cost of providing the needed funding for universal service and on the number of presubscribed lines. The USF fund was designed to subsidize local telephone companies for providing high cost service. The program received little attention at the time and was not terribly controversial. 12 The perline amount for both elements (access charges and universal service) totaled about 30 cents, representing a total fund of about $300 million. Under the FCC regulations, AT&T was not required to present this charge as a separate line item on its bills; instead the company could simply price its services high enough to recover those costs, together with its other costs. Universal service funds were distributed through a formula, where companies with higher than average loop costs would recover a portion of their higherthan-average costs from the universal service fund. Big companies received relatively smaller portions of their high costs than did smaller companies. High-cost companies, including both some Baby Bell companies and independent telephone companies. relied 9 Consolidated Application of American Telephone & Telegraph Co. and Specified Bell System Companies for Authorization Under Section 214 and 310(b) of the Communications Act of 1934 for Transfers of Interstate Lines, Assignments of radio Licenses, Transfers of Control of Corporations Holding Radio Licenses and Other Transactions as Described in the Application, 96 F.C.C.2d 18 (1983) See, e.g., MTS and WATS Market-Structure, 93 F.C.C.2d 241 (1983). MTS and WATS Market Structure, 2 FCC Rcd (1988). A separate per line amount was assessed for high cost and lifeline assistance. Previous to this time, high cost companies were permitted to recover their higher than average costs by allocations to the NECA common line revenue requirement. 12 By not too controversial I mean that it did not raise political questions. The long distance carriers, however, began to contest the per line contribution amounts almost immediately. Those amounts increased steadily over the ensuing years to about 50 cents per line by the mid 1990s. 4

5 upon access charges and universal service subsidies to recover their costs of providing local service in high cost locations Telecommunications Act In the 1980s and 1990s, a growing consensus developed in industry and in policy circles that telecommunications policy was outdated and needed to be modernized. 13 The 1996 Act was forged out of that consensus. This law radically transformed a number of regulations governing competition, universal service, and the ways newer carriers interconnected with the existing monopolists. First, the Act eliminated the local monopoly or franchise, which protected local telephone companies from competition by wiping away state laws that gave local telephone companies the protection against competition. 14 Even though this federal legislation permitted competition in the state and local telecom market, the Act did nothing to eliminate the complex legacy of state regulation applied to existing ILECs, particularly the carrier of last resort requirement. After the 1996 Act, this requirement applied only to the ILECs, not to any new companies entering the market. The Act instituted a number of detailed interconnection requirements that were designed to help new entries into local markets obtain services from ILECs, particularly interconnection with the ILECs existing equipment network to serve the competitors customers. 15 The Act set up three different classes of interconnection, one for the large telephone companies (at first, mostly the Baby Bells) a second class for all other local exchange carriers, including smaller telephone companies and the competitive wireline competitors, and a third for every other type of telecommunications carrier, including long distance, wireless and satellite companies. Second, the Act adopted Section 254, the universal service requirement. 16 Section 254 obligated the FCC and a new Federal-State Joint Board, to implement the statute. That section established a number of universal service policies that must be followed. These policies included an FCC-defined minimum level of universal service provided in order to receive funds and a requirement that all interstate telecommunication service providers contribute to the universal service fund. The section expanded the scope of universal service support to ensure that subscribers in insular and high cost areas could obtain service (and at prices) comparable to urban areas. Section 254 also ensured that universal service funding was explicit, predictable, and sufficient. In addition to these basic principles, the Act required the FCC to ensure that all Americans had access to advanced services, such as broadband Internet. In addition the USF funds could now be used to provide advanced services to schools, libraries and rural health care facilities received universal service support funds. Section 254 permitted state or federal governments, to designate eligible telecommunications companies to receive universal 13 These changes also included cable and mass media regulatory reform, but those changes are beyond the scope of this paper U.S.C U.S.C U.S.C

6 service support if the companies agreed to provide all of the elements of universal service as defined by the FCC. 17 The FCC and state agencies have been implementing the universal services provisions for the past eighteen years, but to date the program still has not been fully implemented. Instead of settling universal service, section 254 created more controversy. Moreover, several new issues have arisen since the Act was passed. The FCC has been criticized for using a private company to administer the fund instead of doing so itself. 18 While spending years establishing a $2.25 billion fund for educational institutions, the FCC has failed to address reforms to the fund for insular, high cost, and rural companies. 19 Criticism has focused on the size of the fund, which rose from a little over $1 billion under the Act, 20 to over $8.8 billion dollars and growing. After over thirty-five Commission rulemaking Orders, four Joint Board referrals, and at least six appellate decisions, as well as numerous Bureau-level clarification orders, Congress is again considering a total rewrite of the universal service portions of the Communications Act, although prospects at this time are extremely uncertain. 21 Service to Remote Areas Hangs in the Balance There is no question that the demands now placed on the Universal Service Fund go far beyond those that originally envisioned in the 1950s Ozark Plan was initially or the first USF established by the FCC in the 1980s. The original needs giving rise to the USF still exist, since providing service to high cost areas is still more expensive that service to urban areas. Subsidies have been instrumental in providing needed funds to build out and modernize networks in high cost areas to provide quality service to all Americans. There is no doubt that services in high cost areas would be inferior by today s standards if not for these subsidies. These facts have been recognized by government policymakers 22 and U.S.C. S 214. Letter from General Counsel, General Accounting Office to Honorable Ted Stevens, United States Senate (dated Feb. 10, 1998). The FCC eventually made changes in response to these criticisms, after Congress required the FCC to file a report with them, in Changes to the National Exchange Carrier Association, Inc., 13 FCC Rcd (1998). 19 Federal State Joint Board on Universal Service, Tenth Report and Order, 14 FCC Rcd , Dissenting Statement of Commissioner Furchtgott-Roth, at 1 (1999). 20 See, e.g., Remarks of FCC Chairman Kevin Martin at Meeting of Federal State Joint Board on Universal Service, Washington, D.C., (Feb. 21, 2007), published at 21 A number of Congressmen and Senators introduced bills in 2006 that would have substantially changed Section 254 of the Communications Act. See, e.g., S (109th Cong., 2d Sess. 2006)(Sen. Stevens, sponsor). All of these bills died in the 109th Congress. The House of Representatives has solicited a series of comments on reform of the Communications Act, including universal service. See Energy and Commerce Committee, House of Representatives, Universal Service Policy and the Federal Communications Commission (rel. Aug. 22, 2014), available at date/ white%20paper-usf.pdf (last viewed Jan 19, 2015). 22 See, e.g., Statement of Sen. Inouye, Hearing of the Senate Commerce Committee on Universal Service (Mar. 1, 2007), published at 6

7 statistically demonstrated in study after study commissioned by companies that serve these territories. 23 Some commenters have concluded that universal service has been achieved in most of the country. Since 1993, penetration rates overall have hovered around 94 percent. Although there is much debate about whether the overall percentage should be higher, the gap is no doubt caused by a combination of personal choices and low income. 24 But, as indicated earlier, penetration rates are far below average in some higher-cost insular areas, such as Puerto Rico and the U.S. Virgin islands. In the past, both of these territories received universal service subsidies. When a large portion of Puerto Rico s USF was reduced in 2002 due to nationwide FCC policy changes, penetration rates on the island stagnated. Although the exact cause is difficult to isolate, the elimination of a huge subsidy appears to have coincided remarkably with a set back for universal service policy. 25 Although the U.S. Virgin Islands continue to receive universal subsidies, these subsidies are shrinking, in part because of the FCC-imposed cap on rural high cost funds. 26 And even these funds are threatened by some reform proposals, throwing company finances, and telephone service, into doubt. 27 Islands by their very nature are poster children for universal service. The cost of living, and the cost of providing telephone service, on an island can be over 50 percent higher than on the mainland due to the isolated nature of the island and the need to ship most products, including network infrastructure equipment, over seas. Costs are also substantially increased because of the harsh island climate, with unrelenting very hot periods, continuous exposure to salt breezes from the ocean, windstorms, hurricanes, and torrential rains. Although many view islands as paradise, one need only live on one for a year to discover the rest of the story. What is more, per capita income of island residents is substantially below that of the mainland. All of these factors combined mean that the higher cost of telephone service can deter customers from affording telephone service. These factors underscore the need to provide sizable universal service funds to ensure that telephone service is affordable See, e.g., Organization for the Protection and Advancement of Small Telephone Companies, Keeping Rural America Connected: Costs and Rates in the Competitive Era (1994). 24 Low income alone cannot explain the remaining 6 percent of subscribers because lifeline funds subsidize over half the price of telephone service. Although government statistics demonstrate that households with less than $10,000 in income had only an 86 percent penetration rate in 2005, households with over $40,000 in income still had only a 96 percent penetration rate. Because these statistics ask households whether a telephone, include a wireless handset, is available in the house, the penetration statistics clearly account for wireless substitution. Why four percent of higher income households do not have a phone is unknown, but probably is due to personal preferences. 25 See High-Cost Universal Service Support, Notice of Proposed Rulemaking, 20 FCC Rcd 19731, 19745, at 31 (2005). 26 Federal State Joint Board on Universal Service, Fourteenth Report and Order, 16 FCC Rcd , at 37, et seq. (2001) ( USF Fourteenth R&O ) See note 21, supra. See, e.g., High-Cost Universal Service Support, Notice of Proposed Rulemaking, 20 FCC Rcd , (2005). 7

8 Rural areas of the country face similar difficulties because the distance between customers defeats the economies of scale possible in urban areas. Moreover, difficult terrain increases the costs of network set-up and maintenance in many rural areas. The problems encountered by companies serving rural high cost areas have been detailed in testimony submitted to the FCC s Federal State Joint Board. 29 Although critics of the fund complain about the its size, they rarely dispute the cost differential betweens providing service to urban versus insular and rural areas. Current Universal Service Scheme Administration. The FCC has established the Universal Service Administrative Company ( USAC ) to collect and disburse universal service funds in accordance with the FCC s rules. USAC is a wholly owned subsidiary of the National Exchange Carriers Association ( NECA ), a local exchange carrier private company that was chartered by the FCC to help ILECs file and recover access charges, among other duties that it has taken on over the years. USAC is required to keep its facilities and staff largely separate from NECA, although NECA still provides some services to USAC pursuant to negotiated contract. 30 NECA has adopted a number of its own requirements for company contributions to and disbursement of USF funds. 31 Although USAC is not technically part of the government, its actions are often judged by government laws and regulations. Decisions of USAC can be appealed to the FCC and USAC staff often seek direction from FCC staff both formally and informally. 32 Contribution. The FCC requires all telecommunications carriers to contribute to the universal service fund. 33 The FCC bases contributions on a percentage of interstate and international revenues received by companies from end users. This assessment is based on filings by the companies, specifying details about their revenues. 34 Each quarter, the carrier predicts its telecommunications revenues. The estimates are, trued up in April of every year. 35 Based on these projected revenues figures, USAC divides projected disbursements by projected revenues to derive a percentage assessment figure. The FCC adopts that assessment figure and applies it to projected revenues for the upcoming quarter. The percentage contribution factor has varied from about 5.5 percent 29 See Remarks of Brian Staihr, Embarq, at Meeting of Federal State Joint Board on Universal Service, Washington, D.C., (Feb. 21, 2007), published at 30 See Changes to the Board of Directors of the National Exchange Carrier Association, Inc., Third Report and Order, 13 FCC Rcd (1998) Many of these requirements are listed on its website, See 47 C.F.R , et seq. Telecommunications carriers and other equivalent providers are also required to contribute to three other public interest funds, for telecommunications relay services for the hearing impaired, local number portability, and number administration. Although the bases for these contributions all vary slightly, their percentage pales in comparison with the universal service percentage, the total of the other three funds being about 0.5% The form for final telecommunications revenues is Form 499-A. Quarterly filings are made on the Form 499-Q. 8

9 to a high of 17.9 percent. For the first quarter of 2015, it has been set at 16.8 percent. 36 Telecommunications carriers are permitted, but not required, to recover the universal service fee from end users as long as the percentage does not exceed the carrier s contribution to the USF, i.e., a carrier cannot recover more money from the USF fund than it has contributed. 37 Size of Fund. Total universal service distributions are currently set at over $8.8 billion. 38 As noted previously, the goals of the USF have expanded over the years and there are several categories of USF recipient that have been added to the original providers of telecom services to high cost rural and insular telephone customers. Of the total fund amount, $4.5 billion goes to support companies that serve insular, high cost and rural areas of the country, collectively referred to as high cost support ; 39 $2.4 billion goes to schools and libraries; 40 $1.7 billion goes to companies who provide service to low income subscribers; 41 and less than $242 million supports services to rural health care providers. 42 About $613 million of the high cost support goes to subsidize competitive carriers that are not ILECs, but who have been designated as eligible telecommunications carriers ( ETCs ) by states or the federal government. 43 The vast majority of those competitive ETCs are wireless carriers. High Cost support. The FCC adopted significant reform of the universal service program in 2011, refocusing support to promote availability of broadband services, and retitling it the Connect America Fund ( CAF ). 44 Because at the same time it reformed USF it began phasing down all intercarrier compensation to zero, it has fundamentally shifted the method of recovery of costs for all carriers. Broadband services were initially defined as 4 Mbps upload speeds and 1 Mbps done. The broadband service speed was increased in 2014 to 10 Mbps download and 1 Mbps upload, leaving open the possibility that the speeds could be increased at a future date when greater adoption of the higher speeds occurred in urban areas See Public Notice, Proposed First Quarter 2015 Universal Service Contribution Factor, DA No (rel. Dec. 15, 2014) C.F.R (a). Federal-State Joint Board on Universal Service, Universal Service Monitoring Report for 2014, CC Docket No (Fed.-St. Jt. Board USF, rel. Dec. 4, 2014) ( 2014 USF Monitoring Report ) Id. Id. Id. Id. Id. See also Remarks of FCC Chairman Kevin J. Martin, supra, note 22. Connect America Fund, WC Docket No , Report and Order and Further Notice of Proposed Rulemaking, 26 FCC Rcd (2011), aff d, Direct Communications Cedar Valley v. FCC (Universal Service Issues), 753 F.3d 1015, 1054 (10th Cir. 2014) ( USF/ICC Transformation Order ). 45 Connect America Fund, WC Docket No , Report & Order, FCC , 15 (rel. Dec. 18, 2014) ( USF December 2014 Order ). 9

10 First, the FCC reformed high cost support. When adopting its reforms, the FCC made distinctions between price cap and rate-of-return companies. High-cost support was phased out for price cap companies and replaced with temporary funds designed to specifically target areas unserved by subsidized broadband competitors. Initial outlays in 2015 will be based on a cost model during Phase II of CAF, including special provisions for non-contiguous areas of the country, such as Alaska, Hawaii and the territories. After this program is more fully implemented, funds will be distributed based on a reverse auction for unserved areas. The FCC is continuing to explore ways to modernize high cost support for rateof-return companies. The FCC limited per-line support to $250 per line, added new restrictions on recovery of corporate overhead expenses, and phased out older USF programs targeted at smaller rate-of-return companies. In 2011, the FCC began to limit certain company receipts based on statistical formulas, called quantile regression analyses This methodology was widely criticized as arbitrary, and was ultimately terminated by the Commission in after vocal congressional disapproval. Although support levels have generally decreased, the FCC added a broadband mandate in exchange for receiving support if such requested service is reasonable. The rural portion of the high cost fund was capped, adjusted for inflation and line changes, 47 but has been resized once since the cap was initially applied in The FCC modified this rule in 2014 to prevent companies with costs that were just over the national average loop price from falling off the cliff because of substantially increased costs from higher cost carriers. 49 In 2011, the FCC eliminated its identical support rule that gave ETCs the same per line support as that received by ILEC competitors, regardless the ETCs costs. 50 The amount of support was phased down in equal five-year increments, subject to a temporary pause, pending establishment of permanent support for mobile providers. The FCC also capped the amount of support that a carrier could receive if it charged local rates to end users below the average urban price. 51 Although the FCC estimated at that time that the rate would be about $15.47, its eventual methodology and survey led to the adoption of a rate floor of $ Because this much higher rate floor 46 Connect America Fund,WC Docket No , et al., Report and Order, Declaratory Ruling, Order, Memorandum Opinion and Order, Seventh Order on Reconsideration, and Further Notice of Proposed Rulemaking, 26 FCC Rcd , 127, et seq. (2014) ( USF April 2014 Order ) USF/ICC Transformation Order, 126. The FCC re-based the rural portion of the high cost fund based on the rural carrier s actual USF claims for the year Then the FCC increased the cap each year thereafter by the rural growth factor, which equals annual inflation plus the annual change in the lines of rural carriers. USF Fourteenth R&O, at (2001) USF December 2014 Order, 106, et seq. USF/ICC Transformation Order, 502. Id.,

11 would cut off the level of previous benefits, it delayed implementation of the phase in of the floor, but did not reverse its policy. 52 With the adjustments identified above, today rural companies receive high cost loop support based upon the same formula used by the Commission adopted back in the days of its pre-1996 USF support. This formula is based on the carriers accounting costs, which must exceed the national average loop cost. As stated previously, the formula provides only a portion of the actual costs, and larger rurals receive relatively less than smaller rurals. 53 The annual rural budget for USF payments, including the high cost loop program, is about $2 billion today, and has been roughly the same for a number of years. Second, companies receive interstate access charge replacement funds that contain implicit universal service money. The FCC found that interstate access charge levels contained implicit subsidies of local rates because the rates exceeded the costs of providing the service. In order to implement that portion of the Act requiring that USF subsidies in interstate rates be made explicit, the FCC established a universal service fund mechanism to replace interstate access charge support. Telephone companies that are regulated under price cap rate regulation at the interstate level receive access support from the Interstate Access Support ( IAS ) fund based on their forward-looking economic costs. 54 The IAS fund was initially targeted at about $650 million pursuant to FCC rule This means that if IAS support exceeds that level, all carriers will receive a proportionate decrease in IAS funds. 55 Such support was phased out in the USF/ICC Transformation Order and will be superseded with refocused CAF II funding. Telephone companies that are regulated under rate of return regulation at the interstate level receive access support from the Interstate Common Line Service ( ICLS ) fund. ICLS is basically the difference between a carrier s interstate costs of regulated services and the amount of subscriber line charges they assess. The revenue requirement is based on the carrier s accounting costs, not hypothetical forward-looking assumptions. 56 ICLS was about $1.6 billion in In 2013 ICLS was about $910 million, although this amount is not comparable to the 2009 figure because a sizable amount was transferred (based on rate-of-return carrier conversions to a system of price caps) to a category entitled frozen support. 57 The FCC is in the process of examining whether to phase out ICLS funding, but has not initiated any action to do so. Although some non-rural carriers are rate-of-return regulated companies, rurals and rate-of-return carriers are largely the same class of carrier USF April 2014 Order, C.F.R , et seq. 47 C.F.R , et seq. 47 C.F.R The IAS fund was about $720 million annually. First Quarter 2007 USAC Report, at C.F.R , et seq. Federal-State Joint Board on Universal Service, Universal Service Monitoring Report (2014), available at (last viewed Jan. 19, 2015). 11

12 The 2011 reforms mandated that phased-out intercarrier compensation be replaced partially through monthly charges on end users, called access replacement charges, which are strictly limited by FCC regulation, and partially through a new high cost fund called CAF intercarrier compensation support. This ICC-CAF support is different from either IAS or ICLS support. Schools and Libraries. Non-profit elementary and secondary schools and not-forprofit libraries may receive funds for telecommunications and internet services and some related equipment, such as inside wiring and Internet routers, at discounted rates. The discounts are paid for out of the schools and libraries fund, also termed the e-rate program. The discounts vary from 20 percent to 90 percent depending, on the number of children participating in the federal school lunch program and on the rural nature of the district. Funds are provided with priorities given to the poorest districts and the types of service funded, but thereafter are decided on a first-come, first-served basis. Schools and libraries must identify the services and equipment needed, must include their plan for deploying the services and equipment, and must put out the request for competitive bid pursuant to the FCC rules and applicable state bidding regulations. 58 If these schools and libraries are found to have violated the rules their applications may be denied If the rule violation is discovered after money is paid, the party at fault may have to refund the money to the government. 59 In 2014, the Commission refocused the e-rate program to support broadband, in particular WIFI connections, and increased the budget by $1.5 billion, from the previous level of about $2.25 billion. 60 The Commission also substantially modified, and complicated, a number of the technical rules for computing contribution amounts, as well as application requirements. Low-income fund. The FCC has established a lifeline program which permits an low-income residential customers to receive assistance to cover part of the cost of local telephone service and installation. The lifeline program pays for a portion of the federal subscriber line charge, and a portion of the state subscriber line charge, or its equivalent. The amounts of recovery vary depending on the level of state participation. 61 The program has been widely implemented at the state level; however only about onethird of eligible subscribers have participated. 62 Only low-income customers receiving state or federal public assistance are eligible for this program. 63 Carriers waive charges for eligible customers and, in turn recover the waived amounts from the lifeline fund. The FCC established special rules for subscribers in Native American territories C.F.R , et seq. Federal State Joint Board on Universal Service, Order on Reconsideration and Fourth Report and Order, 19 FCC Rcd , 10 (2004). 60 Modernizing the E-rate Program for Schools and Libraries, WC Docket No , First Report & Order and Further Notice of Proposed Rulemaking, 29 FCC Rcd (2014) ( E-rate 1st R&O ); Second Report & Order & Order on Reconsideration, FCC (rel. Dec. 19, 2014) ( E-rate 2d R&O ) C.F.R Lifeline and Link-Up, 19 FCC Rcd. 8302, at 1 (2004). Id. at

13 Because telephone service penetration is so low in these areas, subscribers are eligible for up to the entire cost of telephone service less $1. 64 The low-income fund was changed to substantially increase the income level qualifying as low income. At the same time, the Commission permitted wireless providers to participate in the program. The FCC has also begun to explore providing low-income support for broadband. 65 Rural health care. The USF also provides assistance to not-for-profit rural health care providers to defray a portion of their telecommunications and Internet services costs. The fund subsidizes that portion of the cost that is in excess of the equivalent urban rate for similar services in its state. 66 Major Current Universal Service Issues Administration. USAC has been saddled with controversy from its beginning and has attracted many vocal critics. The Congressional Budget Office has taken the FCC to task for establishing USAC as an integrated part of a carrier company, which it believed compromised USAC s ability to be impartial. 67 Moreover, the FCC has been criticized because it appeared to delegate its statutory policy-making authority to USAC. 68 USAC has been denounced for, on the one hand, providing money to companies that have engaged in waste, fraud, and abuse, and on the other hand, for creating red-tape delays in and restrictions on deserving applicants. USAC often is attacked for enforcing rules arbitrarily and for failing to follow requirements for governmental rulemaking. For example, although FCC rules require that USAC have sufficient receipts on hand before it obligates funds, 69 it has not always done so. The FCC has made modest modifications to USF administration by increasing document retention policies from recipients, as well as implement further audit requirements. The FCC has modified its appeals process by requiring initial appeals to be filed with USAC, not the FCC. 70 It is unclear whether such steps will improve USAC s processing of applications or the efficiency of any appeals. Contribution. The FCC concluded in 2001 that the funding source for the USF was not stable enough. In particular, it was concerned that, even though overall telecom revenues were increasing, the revenues for interstate communications subject to the USF U.S.C (a)(4). Lifeline and Link UP Reform and Modernization, WC Docket No , 27 FCC Rcd. 6656, 321, et seq. (2012) ( Lifeline Reform Order ) U.S.C , et seq. See Letter from the Office of General Counsel, General Accounting Office, to the Honorable Ted Stevens, United State Senate (dated Feb. 10, 1998). 68 The FCC responded to this criticism in Changes to the Board of the Directors of the National Exchange Carrier Association, Inc., Third Report and Order, 13 FCC Rcd , at 16 (1998). 69 GAO, Telecommunications: Application of the Antideficiency Act and Other Fiscal Controls to FCC's E-Rate Program, Testimony before the Committee on Commerce, Science, and Transportation, U.S. Senate, GAO T (Washington D.C., Apr. 11, 2005). 70 E-rate 1st R&O,

14 levy were declining. 71 In response, the FCC has raised the contribution factor. In the fourth quarter of 2014 the factor was 16.8 percent, 72 and is likely to go even higher in later quarters. The agency is in the process of exploring alternative funding sources to stabilize the fund. FCC Chairman Martin was interested in assessing telecommunications providers based on working telephone numbers. Business services that do not employ numbers, such as private line or special access services, would contribute based on capacity equivalents or revenues. Estimates of possible revenues based on per-number assessments range from $0.90 to $1.25 per month, hardly a radical change when considering that it is less than a quarter to fifty cents per month higher than what the lowest volume subscribers pay today. The vast majority of the industry has supported this type of numbers-based system; 73 however, consumer groups oppose the move to a per-line charge because it requires low volume users to contribute the same amount as high volume users, and these groups assume that carriers will flow through the number-based charge to consumers. 74 Several companies have proposed to begin assessing broadband connections, given that broadband is now the focus of high cost and e-rate programs. However, the ability to increase contributions by broadband services is in substantial question. Currently there is much debate surrounding new open Internet rules 75 and many have challenged the notion of raising costs on broadband users. Because of the lengthy passage of time since 2001, it is not clear when or if the agency will reform contribution requirements. Without FCC action, the ability of carriers to make contributions to the USF solely from interstate telecommunications revenues will steadily erode as this revenue base continues to decline. Distribution. The FCC in 2014 was still in the process of completing its reform of distribution mechanisms adopted in the 2011 USF/ICC Transformation Order. The FCC is just now finishing work on a cost model, including targeted reforms for non-contiguous areas of the country, to distribute support to price cap companies. The agency is still in the planning stages of a system of reverse auctions for areas where price cap companies decline to accept cost model-based support. The cost model does not seem to appeal to most companies in non-contiguous areas, which appear to prefer to elect to receive support frozen at previous levels. This preference reflects a recognition of the FCC s failure to make acceptable cost model changes. It is still too soon to tell how much such reforms for price cap carriers will advance broadband availability in rural and insular areas of the country. 71 Federal State Joint Board on Universal Service, Notice of Proposed Rulemaking, 16 FCC Rcd (2001), Second Further Notice of Proposed Rulemaking, 17 FCC Rcd (2002). 72 Public Notice, Proposed First Quarter 2015 Universal Service Contribution Factor, CC Docket No , DA (Man. Dir., rel. Dec. 15, 2015). 73 See, e.g., USF by the Numbers Coalition, The Consumer Benefits of a Numbers-Based Collection Mechanism to Support the Federal Universal Service Fund (Jan. 30, 2007) See materials at See generally comments filed in Framework for Broadband Internet Service, GN Docket No and Protecting and Promoting the Open Internet, GN Docket No (commonly referred to as Net Neutrality dockets). 14

15 The FCC has seemingly made little progress on reforming high cost distribution for rate-of-return companies, and has rejected at least one consensus reform proposal. Per-line limitations and excluded high cost support based on the urban rate floor policies have continued to general controversy. Delay and confusion surrounding the agency s efforts at reform have sharply limited high-cost company support and the FCC has been very stingy with granting waivers of the rules to permit greater support. 76 Such limitations have curtailed broadband build-out plans in rural areas, a consequence that the FCC had denied would result from its reform policies. 77 In the meantime, FCC-mandated reductions in intercarrier compensation is seriously eroding carrier revenues, further undermining the ability of the carriers to extend broadband deployment in rural territories. Concerned about low lifeline participation levels, Federal and state regulators have raised eligible income levels to increase the pool of eligible end users and have increased the number of eligible providers. 78 These changes, however, caused problems of their own, as customers received multiple subscriptions in clear violation of the FCC one-connection per household rule. In response, the FCC established a national data base which providers must use to verify eligibility. The agency adopted other reforms, which have saved the fund some money, but controversy about program fraud continues. 79 The Commission is currently conducting an experiment on subsidizing broadband use by lowincome individuals, but with previous evidence of program fraud and serious pressures on fund size, it is unclear whether or in what time frame a new broadband low-income fund will be initiated. Schools and Libraries. The e-rate fund has had its own share of controversy, including several high profile cases of waste, fraud and abuse. To provide an incentive for schools and libraries to police fraud, the FCC considered requiring them to pay a higher percentage of costs. 80 The FCC, however, has never adopted meaningful modifications. Despite these publicized cases of fraud, the e-rate program remains politically popular with most members of Congress and thus is in no danger of being terminated or scaled back. Rural Health Care. The FCC continues to expand ways in which rural health care providers can qualify for assistance under the USF rules. 81 It has also begun an experiment designed to promote use of telecommunications for rural diagnostic and 76 See, e.g., Adak Eagle Enterprises, LLC and Windy City Cellular, LLC, Petitions for Waiver of Certain High-Cost Universal Service Rules, WC Docket No , 28 FCC Rcd (Wir. Comp. Bur. & Wir. Tel. Bur., 2013) USF-ICC Transformation Order, 285. Lifeline Reform Order. Id., 182, et seq.; Lifeline & Link Up Reform and Modernization, WC Docket No. 1-42, 26 FCC Rcd (rel. Jun. 21, 2011) ( Deenrollment Order ). 80 Schools and Libraries Universal Service Support Mechanism, Third Report and Order and Second Further Notice of Proposed Rulemaking, 18 FCC Rcd , (rel. Dec. 23, 2003). 81 (2004). See, e.g., Rural Health Care Support Mechanism, Second Report and Order, 19 FCC Rcd

16 treatment purposes. 82 Although the FCC has committed to promote rural health care improvements through telecommunications, very few rural health care entities have signed up for USF support. This reluctance might be due to the high cost of such diagnostic and treatment equipment, costs not subsidized by the fund, or to the lack of staff qualified to use such equipment. Until there is a source of funding for needed medical equipment, this fund will continue to be under utilized. Fund size. One of the most important flashpoints in the USF debate is the sheer size of the fund, estimated at over $8.8 billion for This amount will grow with recent increases in e-rate funding. Large, urban states that contribute more to the fund, such as like New York and California, are adamant in their attempts to scale back the fund. Carriers who are large contributors, such as Verizon, or who are net contributors, such as many wireless and VoIP providers, want to cap or scale back the fund. On the other hand, rural carriers, who rely on USF for a significant portion of their revenues, oppose efforts to cap the fund. Policymakers are concerned with the size of the fund overall because it could make the program politically unsupportable, especially if it rises above the current 16 percent. And since all customers, including those in high cost areas, inevitably have to pay the fee if it becomes too high, rural customers may drop service, and the fund could become self-defeating. USF Reform May Adversely Affect Rural Telephony USF reform for rural rate-of-return carriers is extremely uncertain, with inaction at the FCC eroding the ability of some companies to obtain adequate support. The recent increase in broadband speed to 10/1 Mbps, and the need to update the network have increased the financial burden on rural carriers. The FCC defends its actions by claiming that rural carriers only have to provide broadband if the request is reasonable, 84 but no one will know how burdensome this requirement is until the FCC is faced with a specific complaint alleging noncompliance with the broadband mandate. With the relentless phase-out of intercarrier compensation, and no adopted permanent reform for USF payments, the continued economic viability of some rural companies looks questionable. Although most in Congress recognize the fundamental need for the USF program, there are powerful lobbying forces at work that could undermine congressional commitment to rural and insular telecom customer. Some House members, particularly Republicans, are highly skeptical of the universal service system, even for rural telephone companies, because they believe subsidies for corporations are no longer needed. Even the once sympathetic Senate Commerce Committee members are beginning to voice concern about the size of the fund and are not as quick to support rural companies. It is questionable that Congress can forge a consensus plan on how to change the current system, given the splintering of the telecom market and their competing interests in any reform proposals. 82 Rural Health Care Support Mechanism, Order, FCC No , 21 FCC Rcd (rel. Sept. 29, 2006) Universal Service Monitoring Report, at Table USF December 2014 Order,