CORPORATE AND REGULATORY STRATEGY FOR THE NEW NETWORK CENTURY

Eli M. Noam

Columbia University

I. The Challenge of Change

For more than a century, telecommunications around the world followed a classic model: a national monopoly owned or controlled by the state, centrally managed and providing a common public network. By their very nature and tradition, these networks provide a small number of standardized and nationwide services, carefully planned, methodically executed, and universally distributed. But over the past two decades, first in the United States and subsequently in much of the developed world, the forces of centrifugalism began to unravel this traditional system. The driving force behind the restructuring of telecommunications was the shift toward an information‑based economy, which resulted in the accelerated growth and reliability of telecommunications as the medium for the electronic transmission of information. Especially for large organizations, the price, control, security, and reliability of telecommunications became variables requiring organized attention. In a series of steps, each controversial and painful, monopoly began to give way to the "network of networks."

Technology was an enabler of recent change. Looking now forward a decade or two, technology is not likely to be radically different from what exists today, just cheaper, smaller, faster, and more widely spread through society. But these trends, exponential at present, add up to much change. The 1980s and 90s were characterized by a revolution in the technology of information data processing. Historically, transmission was the scarce and expensive resource and its allocation was a political and regulatory matter. But, transmission, too, is now in the midst of enormous developments in optical, wireless, and switching technologies. Soon, a single sheath of fiber strands will be able to transmit petabits per seconds, more than the entire national network capacity of a few years ago. This makes transmission abundant technically, and economically, with infinitesimal marginal costs, which leads to prices that are distance and usage insensitive. As the national backbone networks grew in capacity and reduced price, they forced the upgrade of local networks, whether by the digitalization of ISDN, the frequency expansion of DSL, the coax cable networks, the use of fixed wireless, or the migration of fiber towards the migration to the user. In consequence, networks have been moving from an individualized capacity measured in kilobits, to one of megabits.

The technological opportunities affected the industry structure. Around the world, telecommunications had been defined by first-generation “incumbent” networks, invariably operating as monopolists. Though not always dynamic and efficient, nevertheless they had accomplished to connect most households with affordable service, and their networks had become the nervous system of entire societies and economies. Even after a near-universal connectivity had been achieved, demand continued to grow due to greater usage, the application of computer communications, the Internet, the globalization of economies, and increased personal mobility. In consequence, the telecommunications industry has been growing by leaps and bounds, and annual global spending on telecom services reached $1 trillion in 2001.

Thus by most measures, traditional telecommunications networks companies have been highly successful. And yet they are more challenged than ever. Rival networks have emerged, supported by liberalizing laws, technology that lowered the cost of entry, and the availability of investment capital. In consequence, around the world, “second generation” carriers entered the telecommunications market, operating as common carriers and targeting business and many residents as customers. New facilities-based entry was for the more profitable long-distance service, but on the local level, too. Competitors emerged using various strategies, including the resale of incumbents’ services, the physical facilities of telecom, cable, mobile, and fixed microwave. They also used unbundled network elements and access by way of the existing local loop. Subsequently, a third generation of facilities-based carriers and new-type private carriers emerged that provide wholesale long-transmission to other carriers and service providers. The results of this expansion has been the transformation of transmission into a near-commodity business, with long distance capacity often growing at a 30-40% compound annual growth rate, and markets in capacity emerging. Cheap capacity also enabled various forms of non-facilities service providers such as arbitragers, callback operators, and Internet telephone providers. The next step is for them to become more general integrators that aggregate to various network services into full-service packages.

Overcapacity made the new network environment cyclical in nature. Entrants, in particular, proved these vulnerable cycles are familiar in many other industries, but in telecommunications they are an entirely new phenomenon. One of the functions of a slowdown is consolidation, a reduction in competition and commodification, and a subsequent increase in profitability.

On the supply side, liberalization has resulted in new market participants; privatization enabled foreign ownership of traditional carriers; and international alliances served as a prudent course for both expansion and defense. On the demand side, pent-up consumer needs led developing countries to seek foreign carriers’ investment and expertise, while large users sought global communications services to match the scope of their business operations.

Thus, telecommunications industry, long organized along geographic and product lines that were both a shield and a weapon, is being transformed in different directions: On the one hand, the trend toward global expansion by carriers, and on the other hand, fragmentation and entry in domestic communications. These transformations represent two sides of the same issue: a blurring of market boundaries created through technical innovation, policy liberalization, user initiatives, and entrepreneurialism. The result is a complex web of overlapping network definitions, product and service markets, carrier types, technical standards, government policies, financial arrangements, and cooperative ventures.

II. Strategies for Telecommunications Companies

This environment puts many new demands on management of the traditional networks: meet competition; accelerate the product cycle; lower costs; establish a brand identity for quality and customer orientation; build broadband, packet, and wireless networks; function in the new markets of video entertainment, Internet services, and e-commerce; compete on a worldwide basis; create a new culture—all the while fulfilling traditional public obligations and being subject to many legacy rules. Can all this be done? It is very difficult.

Strategy I: Increase economies of scale. On the supply side, the fixed costs of networks tend to be high, and the variable and operating cost are relatively low—the classic attributes of “natural” monopoly. On the demand side, there are the positive network externalities of large user communities. Put these three things together and there are real advantages to being large in size, reach and capacity. In consequence, incumbent networks have expanded horizontally. In the US the 8 major regional companies have merged into two big and two mid-sized firms. Internationally, similar extensions have taken place.

Incumbent Strategy II: Create global alliances. The quest for scale, and worldwide presence leads to expansion abroad and to alliances with other carriers. There were several approaches: loose marketing alliances like World Partners (AT&T, KDD, Sing Tel et al); operating alliances like Concert (BT and AT&T), facilities consortia like FLAG or the traditional submarine cable groupings; and joint equity ownership like Global One (DT, FT and Sprint).

Many of the alliances were also driven by desire to gain access to closed national markets. But as market access became easier with liberalization and as the coordination of divergent corporate strategies proved difficult, another avenue for globalization emerged: direct investments and acquisitions. Telecom carriers, having historically operated in their home territory only, now became international in their scope. They followed a mixed strategy, partly of specializing geographically, partly following a target-of-opportunity approach. For example, Deutsche Telekom focused on Central and Eastern Europe, while Spain’s Telefonica expanded into Latin America. Most large firms attempted to buy mobile networks and licenses around the world.

The reasons for transborder direct investment varied. They include, still, market access; great growth opportunities at home; liberalization of restrictions; ambitions of empire building; the application of domestic expertise to new markets; risk diversification; the opportunity provided by LDCs’ debt reduction; and the expectation of investors for companies to show activity and dynamicism.

Incumbent Response III: Try to lower the cost curve: For a while entrants had an edge because the accumulated inefficiency of the incumbents slowed them down. But this inefficiency declined with the introduction of competition. A further lowering of cost is more difficult. Almost all new technology is also available to competitors, while the incumbents’ labor costs is often higher than for competitors, its unions more influential, its social obligation greater, and its managerial culture slower.

Incumbent Response IV: Block competitors access to network externalities. Historically, networks have tried to deny and delay interconnection to entrants and to reduce technical compatibility. However, regulators promoting competition increasingly stymie such strategies.

Incumbent Strategy V: Economies of scope. An expansion of activities can be into new but related operations, such as mobile communications, Internet access, cable TV, and network operations software. More ambitious extensions are into Internet portals, transaction platforms, video content, and hardware. There are advantages and disadvantages to vertical integration. Among the former is the potential for extension of market power in one market into other markets, as well as genuine economies of scope. On the other hand, the specialized firm has the advantage of focus, faster product cycles, and the ability to partner with other firms with fewer conflicts.

Incumbent Strategy VI: The Internet. Hence, the emergence of the Internet created opportunities for high capacity “dumb” networks by low cost competitors, and a threat to incumbents. Carrier costs are lower in an IP system since they can shift many intelligent functions to the users and away from the expensive switching intelligence. Internet transport services are also more homogenous than switched services and this leads to the commoditization of transport. At the same time, the Internet also creates significant opportunities for traditional telecommunications operators to provide narrow and broadband Internet access to end-users, as well as transmission, interconnection, and billing services to backbone networks and local ISP. They can also deploy IP-based technologies for the operation of regular voice service at a lower cost.

Incumbent Strategy VII: restructure the organization. Network companies face decisions about their internal structure. They can operate as a wholesale network selling capacity and network elements to providers of final services, including to their own retail business. As competitors have attempted to build local networks, it became clear how expensive it was to do so. Thus, the provisioning of this local segment is likely to be the main source of competitiveness of telecom organizations and a major profit center unless severely restricted by regulation.

Alternatively, the traditional companies could become a resale and retail network, or a systems integrator. Is that likely? If an entrant, with a low-cost, high-capacity architecture can wholesale for less than the incumbent’s cost, the latter would be making poor business decision if it did not become a reseller. The traditional carrier’s advantage is a nationally recognized brand name; its role is to provide, not to produce. To be successful, integrators must be willing to pick and choose among the lowest-priced carriers. Similarly, the underlying lowest-price carriers cannot favor their own integrators.

In the extreme, the telecom firm would outsource all operations and consist of no more than its top management. The economic advantages of such an arrangement are that the firm can reduce fixed cost and transform it into variable cost. This lowers the cost of entry while raising its speed. A firm thus can also benefit from the specialized providers experience and economies of scale.

On the negative side, the firm becomes dependent on others for critical inputs. It loses the synergies that may come from combining production with application. It may contribute, through a reduced cost of producing the input, to a lowering of costs for its competitors, too. It cannot establish a loyal workforce in whose skills it invests, and it may have less of the corporate culture or institutional memory that would contribute to its long-term operation.

Most likely, networks firms will be a hybrid of functions and network functions. This has structural implications. Firms could become highly centralized and hierarchical, or devolve into fairly independent business units, or break up into separate firms. The structure would depend on different factors: the synergies vs. the diseconomies of scope; the extent of regulation and restrictions; market powers in each segment; different organizational cultures; and turf battles inside the firm.

In the future, re-organization will not be something forced on traditional companies, but will often be adopted in their self-interest once the monopoly status is gone. At the same time they also will acquire and integrate other firms, in the process transforming themselves into organizations, different from those of the past and dissimilar from each other.

Organizational changes, in turn require cultural change. Corporate culture is based on commonality: shared history; values, goals, leadership, processes, and economic interest. For more than a century, telecom organizations operated with a culture shaped by engineering and civil service value systems and operations: clear and specified procedures; clear lines of responsibility; risk reduction; long planning horizon; job security; politicized decision making; public service orientation; national and social perspective; and management that rose slowly inside the organization.

But this traditional culture cannot survive the simultaneous challenges of privatization, competitive markets, globalization, and convergence. The Internet culture, for example, draws from individualism, informality, and risk taking. These two cultures are now clashing. Even where management embraces cultural change, corporate culture is much slower to alter change than organizational structure, top leadership, or strategy. The collective values and the way people do business change much more slowly, because it is the aggregate of many behaviors and routines acquired over a lifetime. This means that the culture is likely to be a drag on an organization in change.

Probably the best structural strategy of cultural change is corporate multi-culturalism. This means the segregation and coexistence of different sub-cultures within separate business units. In practical terms, it means that the traditional organization creates autonomous units whose culture and style can markedly vary from the traditional one. If successful in its realm of activity, a new culture will reinforce itself in its own unit, and might spread to other parts of the organization, this time with the legitimacy of success and in-house origination. And if they fail, the harm is contained mainly to the sub-unit, not to the entire organization.

In such an environment, what is the role of top management? With operational and cultural autonomy of the sub-units, central management becomes essentially a coordination body for existing, newly formed, and acquired companies, both domestically and abroad. In some cases, the centrifugalism might be too strong for the company to hold together, and traditional firms will disappear.

III. The Future of Regulation in the Network of Networks

In the emerging telecommunications environment, will there be any need for regulation? Many people imagine that regulation is based on scarcity. Regulation had been essential to the old system, partly to protect against monopoly, partly to protect the monopoly itself. In the transition to competition, what was left of regulation was seen as temporary, shrinking reciprocally with the growth of competition. In time, it would diminish to nothing. Yet can one expect the new system to be totally self-regulating? In traditional telecommunications, regulation by government existed partly to effect the balance of power between huge monopoly suppliers on the one hand, and small and technically ignorant users on the other hand. It inserted the political and administrative process to alter unconstrained market outcomes. In return, the dominant carriers, whether private or governmental, received protection from competition by other providers. In a network of networks, on the other hand, the imbalance changes drastically. Now, various service providers, integrators, and carriers compete with each other for customers and act as these users' agents toward other carriers. They can protect users against carriers' under-performance and power, and get them the best deal. This would resolve many traditional problems of price, quality, and market power. Thus, assuming that users have a choice among providers and that those have a choice among non-colluding suppliers of underlying services, the need for government control declines drastically. But it does not disappear. Regulation persists not because of bureaucrats who cannot let go. It exists largely as a political response to interest groups. These interest groups will never disappear and new ones will emerge. Thus, what regulatory activities should we expect as a result?

A democratic political system tends toward redistribution. In telecommunications, this has been the underpinning of policies such as universal service and rate averaging. Many people believe that the efficiency of competition will shrink the subsidy to zero. True, the cost of transmission per bit will fall enormously, but the consumption of bits will grow even faster. A larger share of household income will be used for telecommunications than in the past. With telecommunications becoming ever more important, not having full connectivity to the new and powerful means of communication becomes a major disadvantage. That is why, inevitably, the definition of universal service will expand. An early example is the introduction in the US of a favorable “e-rate” for Internet access by schools, libraries, and hospitals. In consequence, universal service redistribution will grow.

As telecommunications become the base for e-commerce and mass entertainment, it is unrealistic to expect that it will be treated differently than the rest of society’s transactions. Which means that it is unrealistic to expect it to be left alone. With electronic commerce, there will be inevitably problems of fraud, misrepresentation, and theft. With entertainment issues of child protection and other harmful content, there will inevitably be public demand for consumer protection regulation to control abuse. Since it is difficult to regulate the electronic parts of a transaction, regulators will go after the physical parts such as transmission networks and the companies offering services. Part of consumer protection may therefore be imposed through telecom carriers and service providers who might be forced to engage in some controls over the transactions on their networks.

Other regulatory issues will involve interconnection. Control over interconnection was used for very different purposes in different stages of telecommunications. Initially, its purpose was to establish monopoly; then, since the late 1960s, it became to open markets to competition; and more recently, to control telecommunications markets themselves. The tension between the convergent forces of technology and the centrifugal forces of business competition is most pronounced on the front where they intersect: the rules of interconnection of the multiple hardware and software sub‑networks and their access into the integrated whole. As various discrete networks grow, they must inter‑operate in terms of technical standards, protocols, and boundaries. In the networks of networks, the interconnection of networks becomes critical.

Privacy, intellectual property right protection, and content standards, of other areas for continuing or expanding regulatory activity. Like it or not, various forms of regulations for telecommunications will remain as control mechanisms on the electronic environment.

In dealing with market power, telecommunications regulation is at a historic cross road of regulatory strategy. Local rival networks for residential customers seem to be difficult to do successfully. In the US, all three major long distance companies are for sale. And the financial community has shifted its financial endorsement from the entrants to the incumbents. All this creates a window of opportunity to major mergers, domestically as well as internationally.

The options for policy are: moving forward, moving back, or moving sideways?

Moving back is to conclude that market power is here to stay, and to regulate it like in the old days, with some modern twists. Moving forward means to push not just competition but competitors, by giving entrants various advantages. This too, also means regulatory intervention.

“Moving sideways” means stepping outside and hoping for the market forces to emerge, even in the face of economies of scale.

THE IMPACT OF NEW GLOBAL TELECOMMUNICATIONS ON TRADITIONAL REGULATION.

Among the issues raised by the globalization of telecommunications carriers and service providers is the effectiveness of the traditional regulatory approaches. Some telecommunications service providers may avoid national regulatory authorities. Other may not be readily subjected to regulatory supervision. Some providers may generate their services from countries where the laws are most favorable. In an attempt to attract business may enact favorable laws, becoming “havens” for particular activities.

The frictions of new industry and old regulation extend in a variety of areas:

Pricing: National price and profit regulation can be undermined by carriers shifting revenues and costs among jurisdictions, either in real or accounting terms.

Investment: Varying policies on foreign investment policy and on the market participation of domestic firms affect international investment flows. Domestic regulatory restrictiveness in one country may lead to investment abroad. Asymmetric foreign ownership provision can lead to countries leveraging their international presence while keeping domestic markets closed.

Content policy: A worldwide harmonization of content policy is undesirable due to divergent national views. Yet when each country enforces its own rules, the most restrictive content regulations may dominate by subjecting distant content providers to liability.

Privacy and Security: The national protection of security and privacy of communications traveling across the globe is difficult. In privacy protection, it is possible to avoid data protection laws by the shifting of data abroad.

Quality: Quality standards are harder to maintain in an international chain of transmission, and uniform or minimum standards may lead to needlessly high standards for poor countries. Network crashes in one country may spill over across borders.

Employment: National labor relations in telecommunications are affected because some employment can be shifted to low-wage, low-union countries.

Standards: Carriers operating abroad may take their domestic technical standards with them, leading to multiple parallel standards.

There are various ways for countries to coordinate regulatory policies if they desire to do so. The spectrum ranges, on the one extreme, from highly centralized arrangements such as supranational agencies with full autonomous powers, to a full reliance on market forces, without any real or potential inter-governmental action, on the other extreme. Even in the absence of formal coordination, countries adjust their policies to each other. This means that some countries, by taking the lead role in a domestic policy reform can nudge other countries to change their ways, too, in order to reach equilibrium. The US, in particular by its fairly unilateral approach to liberalizing its telecommunications sector, and supplementing this stance with the use of reciprocity in determining whether to grant certain privileges to companies from another country, has encouraged other countries to liberalize their telecommunications sectors.

Unilateral adjustments are not necessarily effective, however, for the problems of repelling undesirable activities from other countries or to attract business by becoming a "haven" country. Similarly, a unilateral strictness of one country can become a de facto international standard if it is too risky or burdensome for users to conform to different rules.

As the matrix of international interrelations becomes steadily more cross‑elastic, the overall tendency, in the long term, should lead to reduced regulatory strictness internationally, too. In that sense, liberalization is an expansionary process. It is not so much an ideological choice, but a response to an internal inability to structure a stable equilibrium that serves multiple interests and goals.

IV Conclusion

The present historic stage of telecommunications is the golden age of incumbents. They have become privatized, energized, internationalized, they play a central role in the information economy and in government high-technology policies, they own much of telecommunications infrastructure, and their often minor competitors provide them with a regulatory fig leaf. But this golden age will not last. It will lead to a fundamental restructuring of the traditional carriers themselves. They are now in the midst of the step of vertical diversification, and horizontal expansion. For the traditional telecom firm, will the future therefore be reaction and opposition? Or inspiration, motivation, reorganization, and innovation? We are going through arguably the most creative period in telecom business history. The telecom entrants might not be successful in the short term, but they have created an important legacy. They have forced the incumbents to shape up. They have created a regulatory structure that will enable them to come back, a mechanism for financing entry, and a different mindset and style.

In the process, the new entrants and the traditional networks become the new network economy. Less competitive than many hoped for, more competitive that the monopoly system used to be. Regulatory policy will have to find ways to assure that the major companies become rivals more than partners. In the process, the network industry is being shaken up, and Joseph Schumpeter’s process of creative destruction of capitalism moves to its next level.