Background

Today, 95 percent of American households purchase local telephone  service, 85 percent purchase subscription television service (usually from a  cable company or a satellite provider), and about 62 percent purchase  some form of access to the Internet.  Of those with access to the Internet,  about 39 percent have a high-speed—or broadband—connection usually  through either a cable modem or a digital subscriber line provided over a  telephone connection.
Local telephone service has been available since the late 1800s, and, by  1950, over 60 percent of households had telephone service.  Since the early  20th century, certain aspects of telephone service, such as its price, have  been regulated by state public utility commissions and by the FCC.  With  the Telecommunications Act of 1996, the Congress sought to increase  competition in the local telephone market.  Today, incumbent local  telephone companies face competition from a variety of types of  companies.  However, nearly 87 percent of residential local telephone  subscribers continue to receive service from an incumbent, or traditional,  local telephone company.
Subscription television service has been available since the late 1940s when  cable television providers first emerged, and, by the late 1980s, cable  service was available to nearly 90 percent of households throughout the  United States.  Today, according to FCC, about 67 percent of American  households purchase cable service.  The 1992 Cable Television  Competition and Consumer Protection Act took steps to increase  competition to cable providers.  The act prohibited the awarding of  exclusive franchises by local franchising authorities.  Also, as required by  the act, FCC developed rules—commonly referred to as program access  rules—that require cable operators that have affiliated cable networks to  make those networks (if they are delivered to the cable operator via  satellite) available to competitors.  The Telecommunications Act of 1996  also took steps to allow telephone and electric companies to enter the  subscription television market.  In the 1990s, direct broadcast satellite  providers (such as DIRECTV and EchoStar) began offering subscription  television service through satellites.  According to FCC, over 17 percent of  American homes currently purchase satellite television service, and these  providers have become the primary competitors to the cable television  industry.  At this time, competition in the subscription video market from  wire-based providers exists in only about 2 percent of markets nationwide,  according to FCC information.
High-speed Internet is a relatively new service that provides a continuous,  high-speed, high-capacity connection to the Internet.  High-speed  connections to the Internet became widely available in the late 1990s, and,  as of mid-2002, nearly 15 percent of American homes had a high-speed  connection to the Internet.  In recent years, local telephone companies  adapted their networks to provide new services, such as digital subscriber  line service, which is a form of high-speed Internet service.  Through their  digital subscriber line service, telephone companies serve approximately  33 percent of subscribers who purchase a broadband connection.   Similar  to local telephone companies, many cable television companies upgraded  their networks to provide high-speed Internet service through cable  modem service.  Cable modem service is the most widely subscribed to  high-speed service with approximately 57 percent of subscribers  purchasing this service.
Figure 2 provides information on the extent of competition in the local  telephone, subscription television, and high-speed Internet markets.

	BSPs’ Business Strategy Focuses on Providing Bundled Telecommunications Services

Broadband service providers are a new type of telecommunications  provider.  Unlike local telephone and cable television companies, which are  adapting their existing networks to provide additional services, and other  entrants that focus on providing service in one communications market,  broadband service providers focus on a core business strategy of building a  new fiber-optic network over which they can provide local telephone,  subscription television, and high-speed Internet services.
A fiber-optic network requires a long-term commitment to build.   According to the BSPA, companies must first obtain a local franchise that  authorizes them to begin construction.  They then must obtain the rights-of- ways to build the network and work with utility companies to make sure  that they do not disrupt other services.  Once the BSP begins building its  network, construction usually takes between 2.5 to 4 years if the company  (1) has steady access to capital and has no difficulties in obtaining the  necessary local government accommodations and (2) is able to receive  needed information from utility companies.  According to the BSPA, the  time it takes to build a network varies with the size of the market and  whether the BSP can string its cable on poles or if it must bury the cable in  the ground.  Because it takes 4 to 5 times longer for a BSP to build a  network if it must bury the cable, some BSPs target communities that allow  them to string their cable on poles according to the BSPA.  A BSPA  document indicates that BSPs have spent over $6 billion in capital  investments to build 32,000 miles of fiber network.  BSPs’ networks  currently expand across areas that would enable them to service up to   4 million homes as of June 2003; of this possible subscriber base, these  companies have gained over 1 million subscribers.
A representative of the BSPA said that most BSPs have specific targets  regarding the minimum threshold of the potential customers in an area they  need to attract in order to ensure that the large financial investment is  profitable.  Additionally, a common goal is to have most of their subscribers  purchase more than one of the three offered services.  Finally, we were told  that the target average revenue per subscriber each month is about $100.   In order to be able to achieve these goals, BSPs use several marketing  strategies.  First, part of the BSP business strategy is to enter markets that  do not have any wire-based providers other than the incumbent cable and  telephone providers.  That is, BSPs look to become the second major wire- based provider of subscription television and local telephone service in  each of the markets they enter.  Second, BSP officials told us that they  attempt to entice customers to stay with their company in the long term by  building the most modern network in the market, thus enabling the BSPs to  upgrade services as new technologies become marketable.  Third, and most  central to the BSP business strategy, the 6 BSPs we interviewed offer  pricing discounts to encourage the purchase of multiple services. This  business focus allows the BSPs to capitalize on network efficiencies by  generating more marginal revenue on the second or third service that the  subscriber purchases.
In order to illustrate the savings available to consumers from BSPs’  bundled telecommunications offerings, we compared the packaged price of  a certain bundle of communications services offered by BSPs with the  prices that these companies would charge for the same set of services  individually.  While some of the BSPs offered packaged deals on a relatively  low end package of services, we found that to compare a similar package of  services across the 6 BSPs we interviewed, we needed to examine the price  for a higher end package of services that included such items as digital tiers  of video service, premium channels, and higher end speeds of Internet  access.  For the 6 markets with BSPs that we interviewed, figure 3 shows  the average savings a consumer can receive by purchasing this particular  set of telecommunications services in a bundle versus purchasing them  individually.  The average monthly BSP à la carte prices for this bundle of  telecommunications services in the 6 markets is $136.63.  If purchased as a  bundle, the subscriber is able to receive a discount that would bring the  cost for this bundle of services down to $117.28.  That is, a BSP customer  will save, on average, about $20, or 14 percent, if they select three services  as a bundle package rather than buy them individually from the BSP.   Across the 6 markets with BSPs that we interviewed, the additional savings  a consumer could receive by purchasing this basket of services as a bundle  ranged from $11.66 to $28.74 per month.

	Consumers Enjoy Lower Rates in Markets with BSPs

In the 12 markets we reviewed, the entry of a BSP appears to induce  incumbent cable operators to respond by providing more and better  services and by reducing rates and offering special deals.  Incumbent  telephone providers have not shown as much of a competitive response to  BSP entry.  The ultimate result of the BSP operations, along with  incumbents’ response, is substantially lower prices for consumers.

		Incumbent Cable Operators Responded to BSP Entry by Lowering Prices and Improving Services, but Incumbent Telephone Operators Show Less Response to BSP Entry

In the 6 markets we reviewed that had a BSP providing service, incumbent  cable operators appear to respond competitively to the presence of the  BSP.  Although cable operators told us they generally viewed satellite  providers as their primary competitors, they indicated that BSP  competition in individual markets can be a significant factor when they  develop their business strategies for that market.  In particular, incumbent  cable providers facing competition from a BSP told us that they responded  to the BSP activity by lowering rates or offering special deals or packages  and, in some cases by providing more local content and advanced services.   For example:    Almost all of the incumbent cable operators we contacted said they  lowered their cable and high-speed Internet prices in the markets where  a BSP was operating in order to be more competitive.  Moreover, we  found that one incumbent cable provider in a BSP market chose to offer  discounts to subscribers who purchased both cable and high-speed  Internet service, thus enabling it to compete directly with the BSP’s  packaged offerings.  In this market, the incumbent cable operator priced  a package combining cable and high-speed Internet services at a 45  percent discount when compared with the same package that the cable  operator offered in the non-BSP matched market.
Two incumbent cable operators also said that exclusive programming  helps them to differentiate themselves from the BSP.  For example, one  incumbent cable operator said that they respond to BSP entry in a  number of ways, including  providing more local programming and  advanced services.  Another cable operator told us that its provision of  local high school sports games, a community-focused talk show, and  city council meetings provides an advantage over the BSP.  However, the  incumbent cable provider said that it provided this programming before  the BSP’s entry into the market.
Some incumbent cable providers also responded to BSP competition by  improving their customer service.  For example, one cable operator  noted that its company initiated door-to-door visits to customers to  ensure good picture reception and answer customer questions.   Similarly, on the basis of the information we gathered from local  franchising authorities, it appeared that in some cases customer  satisfaction with the incumbent cable providers improved after the BSP  entered the market.
The incumbent telephone companies that we interviewed had not generally  taken steps to respond to the BSP presence in their markets.  Incumbent  telephone providers told us that their primary competition comes from  providers other than BSPs.  The telephone companies varied in terms of  which other providers they viewed as providing the most competition to  their services, but this list of important competitors included a variety of  provider types, such as long-distance telephone providers, wireless  carriers, and Internet-based providers of telephony services.
Incumbent local telephone providers we spoke with told us that they do not  perceive BSPs as a significant source of competition because the BSPs  have a very small presence focused only in scattered markets, and because  they face greater sources of competition, such as wireless and long  distance providers. For example, these providers generally did not lower  prices or enhance their services in markets where BSPs provided telephone  service.  However, the incumbent telephone providers told us that their  ability to respond to BSP competition was limited by federal and state laws  and regulations that they view as restrictive.  Regarding the high-speed  Internet market, incumbent telephone providers also noted that they did  not view BSPs as important competitors.  Instead, telephone companies  told us that their most important competitors in the high-speed Internet  market are incumbent cable television providers. Moreover, they noted  that, in their opinion, cable operators were likely to remain dominant in the  high-speed Internet market.  In fact, one incumbent local phone provider  said that it reduced prices for high-speed Internet service to compete with  cable operators’ cable modem service—not because of competition from  BSPs.

		Consumers Benefited from Lower Prices for Telecommunications Services in the 6 Markets With BSPs That We Reviewed

Rates were generally lower for the subscription television, high-speed  Internet, and local telephone services in the 6 markets we examined with a  BSP present than in the 6 markets that did not have BSP competition.   However, the extent to which prices were lower in a BSP markets  compared to its “matched market” varied considerably across markets and  services.  For example, in 1 BSP market, the monthly rate for cable  television service was 41 percent lower compared with the matched  market, and in 2 other BSP locations, cable rates were more than 30  percent lower when compared with their matched markets.  On the other  hand, in 1 market, the price for cable television service was 3 percent  higher in the BSP market than it was in the matched market.  Also, we  found that rates for high-speed Internet service were at least 20 percent  lower in the 3 BSP markets compared each of their matched markets, but  for the other 3 market-pairs, high-speed Internet rates were roughly the  same across BSP markets and their matched markets.   The extent to which  rates were lower for one local phone line in BSP markets compared to their  matched market varied considerably:  rates were 4 to 33 percent lower in 5  of the 6 markets with a BSP we reviewed, and the rates for local telephone  service were the same in 1 of the matched-pair markets we reviewed.   See  figure 4 and appendix II for more information on pricing patterns between  market-pairs.
In some cases, the lowest price in the market with a BSP was the BSP price,  however, in other cases, the lowest price was the incumbent’s price.   Specifically, in the 6 markets with a BSP, the BSP price was lowest for cable  television in 4 markets, the BSP price was lowest for high-speed Internet in  2 markets, and the BSP price was lowest for local telephone service in 5  markets.
It is possible that some of the differences in pricing we observed are caused  by factors other than the presence of a BSP in certain markets.  For  example, our earlier study on cable pricing included an econometric model  that showed that several factors, such as the number of cable channels,  direct broadcast satellite penetration, and population density, influence  cable prices.  We attempted to minimize the influence that other factors  would have on price differences across markets by choosing case-study  markets and matched-pair markets that had certain similarities. Because  the number of channels is known to be an influence on cable rates, we  examined channel line-ups of each of the 12 providers.  Our analysis  showed that the provider with the best price in the markets with a BSP also  offered more channels than the provider in their matched market in 4 of the  6 cases and offered the same number of channels in the other two matched- pair markets.  This indicates that the number of channels is not a cause of  lower prices in markets with BSPs.  See appendix I for a discussion of our  methods and appendix II for a more complete listing of the channel line-up  analysis.

	BSPs Consider Specific Demographic, Geographic, and Local Government Factors When Deciding Which Markets to Enter

The BSPs we analyzed considered a variety of factors when determining  which markets to enter.  These considerations were directly tied to the  ability to enter a market quickly and to further their business strategy of  selling multiple services to most of their subscribers.  The primary factors  considered regarding market selection fell into the following three  categories:  demographic factors, geographic factors, and factors related to  the local governments in the communities of interest.

		Demographic Factors Were Considered in Market Selection

Three primary demographic factors were considered by the BSPs we  interviewed when deciding which markets to enter and provide service.  In  particular, the size of the city, the level of income of residents, and the level  of computer use among residents were primary determinants of market  selection.  Despite the commonality in the factors considered, there was  some variation in how BSPs considered each of these demographic factors.
All 6 of the BSPs we interviewed mentioned the size of the market as a key  factor that they considered in market selection.  Only 1 BSP focused its  business development toward larger cities.  This company was the first to  take the approach of competing with an incumbent by offering bundled  service packages; thus this BSP believed that in order to attract adequate  venture capital, it was important to focus its operations in major markets.   This BSP also told us that it believed a large-city focus would have the  benefit of enabling the company to rapidly gain subscribers in high-density  corridors where a greater number of customers could be served with a  given amount of infrastructure deployed.  This BSP further noted that a  downside of entering large markets was that construction in larger cities is  significantly harder and more costly than in smaller cities, which made it  difficult to meet an aggressive construction schedule.  In fact, this BSP was  unable to meet the 4-year construction deadline that was mandated by its  franchise agreement.
Five BSPs built new infrastructure in medium and smaller cities.  They told  us that they took this approach, in part, because they recognized how  difficult it would be to meet construction requirements in a large city.   These BSPs also said that a benefit of entering a smaller city is that  incumbent cable operators are less likely to vigorously compete with them  as would likely, in their view, be the case if they entered a major city.   Representatives from 3 BSPs also told us that they enter smaller markets  because they may be able to leverage customers’ dissatisfaction with the  incumbent—which they believe tend to be more of an issue in smaller  markets.  Similarly, 3 of the BSPs told us that small and medium markets  tend to have old networks, and this provided an opportunity for the entrant  with an upgraded system to successfully compete for subscribers.   Representatives from the 5 BSPs also noted that entering smaller sized  cities allows them to better target markets with favorable demographics,  rather than have to serve the wide array of residents that would live in a  larger market.
Four of the 6 BSPs we spoke with stated that the average household  income in a market was a key criterion in their decisions about what  markets to enter.  However, BSPs took various approaches regarding what  income levels they were targeting.  For example, 2 BSPs told us that they  choose to enter markets with high-income level populations because these  subscribers are more likely to take two or more telecommunications  services.  On the other hand, the other 2 BSPs look more for markets with a  balance of varied income levels.  Representatives of these companies told  us that a mix of income levels among subscribers helps to ensure that each  of the communications services offered by the company has a target  audience.  In fact, 1 BSP stated that higher level income subscribers may be  most likely to subscribe to broadband service, but middle income  subscribers may be most likely to subscribe to subscription television  service.
Two of the 6 BSPs noted that high levels of computer use and Internet  connections among residents of a community are factors they consider  when determining what markets to enter because high-speed Internet  service has a high profit margin.  In particular, these BSPs told us that they  selected markets with a high number of college students because the  academic environment has a large amount of computer ownership and  Internet use.

		Geographic Factors Were Considered in Market Selection

We found that BSPs consider certain geographic factors when deciding  which markets to enter and provide services.  In particular, BSPs looked for  markets that were in close proximity to other markets that were served by  a parent company or in proximity to other key facilities, such as the BSP  headquarters or network, or other needed infrastructure.
Officials of 2 BSPs that are subsidiaries of energy companies told us that a  key factor considered in market selection was proximity to the parent  company’s service area, which they said helps to leverage the parent  company’s name brand, infrastructure, and human capital.  For example, a  BSP representative told us that his BSP chose to enter one of the markets  we studied because it was close to its parent company, and the BSP was  thus able to benefit from the parent company’s good reputation within the  community as a power provider.  The local franchising official in that  market agreed that the community’s positive relationship with the parent  power company gave citizens confidence in the BSP’s proposal and to trust  that it would fulfill its infrastructure construction requirements.  In  addition to name recognition, another BSP official said that entering cities  where the parent company has a presence allows the BSP to take  advantage of the parent company’s workforce to assist with the  construction of the new infrastructure.
Two BSP representatives said that their BSP chose to enter markets on the  basis of close proximity to their BSPs’ headquarters or physical network.
For example, 1 BSP that we interviewed chose markets that were close to  the BSP headquarters.  Another BSP told us that choosing cities in close  proximity to its existing physical network was important in order to  minimize the cost of fiber connecting any new market to the company’s  network.  In fact, some markets that this BSP chose not to enter were too  far from existing infrastructure and would have been very costly to  connect.

		Characteristics of Local Government Were Considered in Market Selection

We found that when deciding which markets to enter, BSPs considered the  receptivity of local government officials to new entrants.  Moreover, the  degree to which government officials took steps to reduce administrative  requirements—which BSPs told us could be considerable—was a key  factor for some BSPs when considering market entry.
Representatives from 5 BSPs indicated that specific markets were selected  because the city government officials had a positive attitude toward  competition, were easy to work with, or invited the BSP to provide services  in their market.  Similarly, one BSP told us that they avoided entering  markets that had local franchising officials who showed limited interest in  their services.
During our interviews, BSPs mentioned that they needed to overcome a  variety of administrative issues before market entry.  Gaining access to  rights-of-way, fulfilling costly franchise requirements, and obtaining  access to apartment buildings that have exclusive contracts with the  incumbent cable operators were a few of the varied administrative issues  that were mentioned by the BSPs.  Representatives from 2 BSPs told us  that when government officials are welcoming to the new entrants, the  officials often take steps to mitigate administrative costs and requirements.   For example, one local franchising authority, which was eager to have a  BSP offer services in its market, presented a franchise agreement with  reduced-fee payments for rights-of-way access and construction permits.   Also, 2 different BSPs told us that the timeliness for gaining approvals for  various required applications often were directly influenced by the  receptivity of the regulators.  We were told that two enthusiastic local  franchising authorities took only 120 days to approve a BSP’s application  for a franchise.  In contrast, another BSP told us that it was unable to  obtain a franchise after 2 and 1/2 years of working with a local franchising  authority that was not receptive to competition, and the BSP did not  succeed in entering that market.
Five of the 6 case study markets that do not have a BSP competitor had  companies express interest in entering their cities, but, according to local  government officials, these companies decided not to enter for several  reasons.  For example, one local official told us that the level-playing-field  law in his state—which are laws that require any new cable franchiser to  agree to the same terms and conditions that the incumbent cable provider  must meet—was a factor in an interested competitive cable company’s (not  1 of the 6 companies we studied) retracting a franchise application.   Another factor that may cause BSPs to choose not to enter a market is the  local government’s lack of administrative resources.  Specifically, one local  official said that the lack of administrative resources to process  applications quickly caused some BSPs to withdraw their applications and  seek more receptive markets.

	BSPs Are Gaining Market Share, but a Variety of Factors May Hinder Their Success

BSPs are gaining market share in the service markets they have entered,  with varying success.  BSPs we interviewed said that certain factors, such  as difficulty in gaining access to certain programming, can create obstacles  to their ability to compete effectively.  Moreover, BSPs may be finding that  these telecommunications markets are more competitive than they had  expected when they first developed their business strategy.  Currently, all  of the BSPs we interviewed are having problems with access to capital and,  thus are struggling to continue expanding their market presence.

		BSPs Are Having Varied Success in Gaining Subscribers

On the basis of statistics provided by the 6 BSPs we interviewed, these  companies appear to be having varied success in gaining subscribers for  their television, local telephone, and high-speed Internet services.  The 6  BSPs have made significant inroads in gaining market share in the three  service markets.  In particular, for the 6 cities with BSPs we interviewed,  the average BSP market penetration for subscription television service was  25 percent, the average penetration of subscribers for local telephone  service was 29 percent, and the average subscriber penetration for high- speed Internet service was 17 percent.  As figure 5 shows, there was  substantial variation across the companies in the penetration rates for each  service—ranging from a low of 6 percent penetration for high-speed  Internet in 1 market to a high of 63 percent penetration in telephone service  in another market.  We found that entering smaller markets may be  associated with an ability to gain greater market penetration.  For example,  we found that in the 3 smaller markets we examined, the BSPs were able to  attract a larger share of the potential subscribers—that is, to achieve a  higher level of penetration—than was the case for BSPs that entered the  medium and the larger markets included in our case study.

		Certain Factors in Local Markets Can Hinder BSPs’ Ability to Compete

All of the BSPs we interviewed noted that various barriers arise that can  hinder their ability to effectively compete in the markets that they have  entered.   Although a host of issues were mentioned during our interviews,  the greatest concern surrounded issues related to an inability to gain  access to certain cable networks, an inability to serve certain apartment  and condominium complexes, and restrictive local regulatory  requirements.

			Program Access Concerns

In 4 markets, BSP officials said they have experienced problems obtaining  certain cable networks—such as regional sports, weather, and local  informational channels—that the incumbent cable provider of that market  owns or holds exclusive rights to within that market.  Of the 4 BSPs that  expressed concern with program access, 2 specifically told us that they  were unable to gain access to regional sports networks because the  incumbent cable provider, which owned that network, provided the  network to its own facilities terrestrially—that is, not via a satellite.   Similarly, the third BSP stated that it could not obtain access to a popular  local news network because the incumbent cable provider partially owned  it.  The incumbent, however, explained that FCC ruled that program  exclusivity in this case was in the public interest and therefore FCC granted  it an exemption to the program access rules.  The last BSP stated that even  though the incumbent cable provider had not produced a local sports  network, it still could not obtain access because the incumbent had  secured an exclusive deal with the producers of that network.  The BSP  was able to gain access to that cable network only after the network was  sold from one owner to another.
While 4 of the BSPs said they had a problem with program access, only two  cable operators we spoke with said that they were aware of program  access issues in the markets we reviewed.  Moreover, one incumbent cable  provider told us that producing or having access to exclusive content can  be a good marketing strategy for it and that without the ability to develop  exclusive content, the incentive to produce innovative programming is  minimized.  Regarding the market where an incumbent cable provider had  exclusive rights to certain programming, the incumbent’s view was that it  created the concept for the programming package and the BSP was  unwilling to make such a commitment on an unproven product.

			Multiple Dwelling Units

Three of the BSPs we interviewed expressed concern about being  prevented from providing service to large segments of the population that  live in apartments or condominiums, which are generally referred to as  “multiple dwelling units.”  We were told that owners of multiple dwelling  units often enter into exclusive contracts with one cable provider, thereby  limiting a competitor’s access to that building.  Also, even when BSPs have  gained access into a building, we were told that the building owners may  not allow them to lay additional wires because of the associated costs and  disruptions.  In fact, 1 BSP we spoke with estimated that it could not  provide service to 20 percent of subscribers in 1 of our case-study markets  because of problems gaining access to multiple dwelling units.  The  incumbent cable operators we interviewed said that in some cases they had  exclusive contracts to serve multiple dwelling units.  However, in 3 of the  markets, these providers noted that the BSPs also had exclusive contracts  with some multiple dwelling units.
Recently, FCC reviewed issues related to access by telecommunications  companies to multiple dwelling units.  In a January 2003 order, FCC did not  establish federal access requirements or preempt state regulation of these  matters.  Likewise, FCC continued to permit exclusive or perpetual  contracts for subscription television service in multiple dwelling units  because, according to FCC, it found that it was not clear that there are  anticompetitive effects from exclusive and perpetual contracts, and, as  such, FCC could not support government intervention in privately  negotiated contracts.

			Burdensome Franchise Requirements

Some of the BSPs also told us that certain franchise requirements can be  burdensome.  As we previously noted, BSPs told us that the administrative  requirements of local jurisdictions can influence the markets they enter,  but we were also told that these requirements could affect how quickly  they can begin providing service in markets they have chosen to enter.  For  example, we were told that required construction time frames often burden  new entrants, even though these rules are generally designed to create a  “level playing field” by ensuring that new providers must meet all of the  same requirements that incumbent providers have had to meet.  These  construction rules can require extensive capital, reprioritization of the  business plan, or the provision of service in areas that are not economic to  serve.  In some cases, BSPs have changed their legal status in order to  avoid costly and labor-intensive construction requirements.  One BSP  noted that the incumbents effectively receive a longer build-out schedule  because they were able to grow with the communities they serve.

		BSPs May Have Underestimated the Level of Competition in Telecommunications Markets

One of the most significant factors that may hinder the BSP’s marketing  success is that the communications markets BSPs seek to serve may be  more competitive today than these providers envisioned when they first  developed their plans.  We found that BSPs avoid markets where another  new wire-based operator had entered the market, but this avoidance does  not ensure that there are not other new competitors providing service in  the three service markets.  For example:      Regarding subscription television service, direct broadcast satellite  service (such as DIRECTV or EchoStar) service is available nationwide  and, thus, represents a second and third formidable competitor in every  market that a BSP may choose to enter.  As the number of direct  broadcast satellite subscribers continues to grow, it will be even harder  for the BSPs to achieve the penetration rates that are necessary for  profitability.
Competition in the market for local telephone service has been  emerging.  Incumbent local telephone companies noted that consumers  are increasingly turning to mobile telephones as their sole telephone  line in lieu of a wire line connection.  If more consumers replace their  wire line telephone service with wireless service (which is not  traditionally provided by BSPs), such action will also have the effect of  decreasing the number of potential subscribers to which BSPs can  market their services.  Also, incumbent local telephone providers view  the large established cable operators as their primary competitive threat  in the future.  In fact, some established cable operators are increasingly  providing telephone service in markets around the country.
In the high-speed Internet market, BSPs already compete against cable  and local telephone providers.  In addition, new platforms for the  provision of Internet service may erode the market for all wire-based  companies.  For example, one incumbent local telephone company  noted that the presence of a large university that provides free high- speed Internet service to its students and faculty reduces its potential  high-speed Internet market.  Other new means of Internet access, such  as through wireless modes, are also becoming more widely available.

		BSPs Serving the Markets We Reviewed Are Now Struggling to Obtain Adequate Access to Capital

The BSPs we spoke with gained financial capital to construct their  infrastructure and operate their business in a variety of ways.  Two BSPs  that are providing services in the markets we reviewed were wholly owned  subsidiaries of large power companies and were able to receive all of their  investment capital from their parent company.  Two other BSPs providing  service in the markets we reviewed are, or had been, part of larger  telecommunications companies and received their startup financing from  these parent companies.  The remaining BSPs serving markets we reviewed  were funded through venture capital or a mixture of venture capital and  money obtained through a partnership with an energy company.
Despite these sources of capital in the early stages of their business, the 6  BSPs we interviewed are currently experiencing some level of financial  problems.  In particular, they told us that their difficulty in obtaining access  to necessary capital is threatening their ability to construct their networks  and market their services.  None of the 6 BSPs we studied are aggressively  expanding their operations.  Two of the BSPs are still completing  construction within their current markets in order to comply with their  agreed-upon schedule, but another BSP was currently unable to complete  construction.  Beyond their current markets, all of the BSPs we reviewed  have had to put expansion plans on hold until the market conditions  improve.  Additionally, 2 BSPs told us that they do not have enough capital  to advertise their service offerings to their current base of potential  subscribers, and 1 BSP reorganized through a Chapter 11 bankruptcy  proceeding.  BSPs told us that, to a large extent, these financial problems  are the result of the economic problems that have affected the entire  telecommunications sector.

	Conclusions

Although our study indicates that there are measurable consumer benefits  in markets with BSPs compared with markets without such competition,  the degree to which the BSP model is replicable throughout a broader set  of markets remains unclear.  For example, the majority of BSPs we spoke  with stated that they avoid entering large metropolitan cities because they  believe serving such markets might prove difficult.  Moreover, even in the  markets that they have successfully entered, the companies are struggling  to achieve their key business targets.  As a result, nationwide, BSPs serve  only about 1 percent of the subscription television market and even less of  the local telephone market, although BSPs do serve about 2 percent of all  high-speed Internet subscribers.  Nevertheless, at this time, with the  telecommunications sector struggling to recover from diminished capital  investments, it is difficult to determine the long-term prospects for success  of BSPs as new telecommunications providers.  The problems BSPs face  may be mitigated as the current economic downturn of the  telecommunications sector subsides, but the long-term viability of these  providers is not clear.

	Agency Comments

We provided a draft of this report to the Federal Communications  Commission and the Antitrust Division of the Department of Justice for  their review and comment.  The Department of Justice did not provide  comments on this report.  The FCC provided technical comments that we  incorporated.

	Industry Association Comments and Our Evaluation

We also invited representatives from the Broadband Service Provider  Association (BSPA), the National Association of Telecommunications  Officers and Advisors (NATOA), the National Cable & Telecommunications  Association (NCTA), and the United States Telecom Association (USTA) to  review and comment on a draft of this report.  The USTA did not provide  any comments.  The BSPA and NATOA provided some comments that we  incorporated as appropriate.
NCTA officials provided extensive comments on the draft.  These officials  expressed concern with certain summary statistics on price differences in  BSP markets compared with markets without BSPs that appeared in the  draft of this report that they reviewed.  We modified the presentation of the  data on these price differences. In particular, rather than providing  summary statistics on price differences across the markets with BSPs  compared to the markets without BSPs, we provide information on the  price difference between each BSP market and its match. Additionally,  NCTA made the following points:  NCTA officials note that a case study of 6 markets with and 6 markets  without a BSP competitor is a very small sample of the roughly 10,000  cable systems in operation in the United States.  They view the study as  thus having no statistical significance.  In particular, NCTA official  express concern that our draft “implies vastly broader conclusions  regarding the effect of BSPs on cable pricing than are warranted by the  limited case studies.”  They also note that, as we reported, the larger  pricing differences were found for the 3 smaller city-pair case studies,  while smaller price differences were found in the medium and larger  city pairs.  The officials stated that, as such, for the larger percentage of  subscribers covered by the study, the differences were much smaller.
GAO response:  We agree that our approach in this report—a case study  analysis—is not generalizable to the universe of cable systems.  We  have stated this several times in the report, and have added more  discussion of this in response to NCTA’s comments.   However, as  stated in the report, our BSP sample represents more than 20 percent of  the households nationwide that are in areas where BSPs currently offer  the three-service package.  Given the caveats we place on our own  work, we do not believe that our conclusions imply a broader  interpretation than is warranted.
NCTA officials note their concern that just 4 months after we released a  report on cable pricing that was based on an econometric analysis, we  would provide new information on cable pricing in competitive and  noncompetitive markets that are based on a different methodology.
GAO response:  We do not believe there is a problem in conducting a  second study on cable rates and competition that analyzes the issue  using an alternative methodology.  The two studies used different data  and different methods to examine an overlapping issue.  The  fundamental findings of both studies were similar, but the specifics  were different—as would be expected given the different methods  used.  While our October 2003 study examined the issue of cable rates  broadly, the current study focuses on 12 markets and compares rates in  the 6 with a BSP to the 6 without such a competitor.  The findings from  this study relate to those 12 markets.
NCTA officials note that the reported pricing differences between  markets with BSPs and those without BSPs could be misinterpreted as  implying that BSP entry engenders a substantial price response by  incumbent providers, when in fact, for cable pricing, the BSP (not the  incumbent) offered the lower price in the BSP market in 4 out of the 6  case-study markets.  Moreover, NCTA officials note that to the extent  that incumbents are responding to competition, this response may be to  competition from DBS providers, rather than competition from BSPs.
GAO response:  We agree with NCTA that price differences in cable  rates across the BSP markets compared to those without a BSP do not  necessarily mean that the incumbent providers lowered their prices  entirely in response to BSP entry.  We added some discussion in the  report to clarify this point.  Also, we note in the report that incumbent  cable providers told us that their most important competitors are the  two DBS providers.  However, almost all of the incumbent cable  providers also told us that when faced with wire-based competitors in  particular local markets, they tend to lower their prices.
NCTA officials also note that any observed price difference between  markets with and without BSPs could be related to other factors not  controlled for by the case-study analysis.  For example, they noted that  the number of channels in a cable system’s line up is a key factor that  may drive pricing differences across locations and providers.
GAO response:  We agree with NCTA’s point that some of the  differences in cable rates across our case study locations with a BSP as  compared to those without such a provider could be caused by factors  other than the presence of the BSP.  We have added language to that  effect in the report.  However, after receiving NCTA’s comments, we  also examined the number of channels provided in the case study  markets—which NCTA specifically cited as a possible cause of rate  differences—and found a similar number of channels available in the  markets with a BSP when compared to its matched market.  Moreover,  when we asked incumbent cable operators why their prices differed  across the markets in our sample, they usually cited the presence of the  BSP as the primary cause.
NCTA officials note that the draft report did not adequately address the  possibility that in markets with BSPs, prices are uneconomically low  and are unsustainable.  That is, they noted that the low prices available  in markets with BSPs may be of a transitory nature only.  The officials  noted that this seems particularly possible in light of the fact that we  found that all BSPs interviewed in the course of the study were facing  various degrees of financial difficulty.  NCTA officials also said that we  did not fully describe the extent of financial problems currently  experienced by the BSPs.
GAO response:  We did not evaluate the long-term sustainability of the  BSPs in the markets we reviewed.  However, to address this to some  extent, we only selected markets where the BSP had been in operation  for at least a year.
NCTA officials note that they believe that BSPs have overstated claims  that certain local conditions (e.g., related to program access concerns,  multiple dwelling unit access, and local franchising conditions) may  hinder BSPs’ ability to compete.
GAO response:  We did not evaluate BSPs’ concerns about the effect of  local market conditions on their entry and success.  Similarly, we did  not evaluate the veracity of incumbent providers’ statements on these  issues.  In this section of the report, we are simply reporting the views  of these providers.
As agreed with your offices, unless you publicly release its contents earlier,  we plan no further distribution of this report until 30 days after the date of  this letter.  At that time, we will provide copies to interested congressional  committees; the Chairman, FCC; and other interested parties.  We will also  make copies available to others upon request.  In addition, this report will  be available at no charge on the GAO Web site at http://www.gao.gov.  If  you have any questions about this report, please contact me at (202) 512- 2834 or goldsteinm@gao.gov.  Key contacts and major contributors to this  report are listed in appendix IV.

Scope and Methodology

We employed a case-study approach in gathering information in responding  to our four objectives.  In particular, this report provides information on (1)  BSPs’ business strategy; (2) the impact of BSPs’ market entry on incumbent  cable and telephone companies’ market behavior and consumer prices of  subscription television, high-speed Internet, and local telephone services;  (3) the key factors BSPs consider when making decisions about which  local markets to enter; and (4) the success of BSPs in attaining  subscribership and any key factors that may limit their success. The case  study consisted of 6 matched pairs of cities (12 total) that shared certain  key traits except that 1 city in each pair has a BSP providing service and the  other does not.
In selecting the cities with BSPs, we considered several factors.  We  selected cities in various parts of the country with BSPs that met some  basic criteria.  To be considered for selection in our case study, a BSP had  to provide subscription television, local telephone, and high-speed Internet  services in the city for more than 1 year; had to have constructed its own  network (rather than having purchased an existing network); and had to  have a network that was nearly completed.  We also analyzed population  data to ensure that our case study included markets of varying sizes.  We  selected 3 small cities (with populations under 100,000), 2 medium-sized  cities (with populations of 100,000 to 200,000) and 1 large city (with a  population over 200,000).  The 6 cities chosen for the case studies  represented more than 20 percent of the households to which BSPs  currently offer the three-service package.  See appendix III for a detailed  listing of the BSPs and areas of service.
To choose cities without BSPs for our analysis, we matched the 6 BSP  cities with cities that were similar in terms of size and demographics.   Where possible, we matched each BSP city with a city that did not have a  BSP in the same state to avoid any possible differences caused by state  laws or regulations and to help ensure reasonably similar demographic  characteristics across the city-pairs.  However, in the case of the only large  city in our sample of BSP cities we selected a city in another state— Seattle—to match with Boston because there was no city in Massachusetts  with similar size and demographics, and no other large cities had extensive  BSP presence. Each city-pair also has the same incumbent local telephone  and cable television providers, although in one case two incumbent  telephone companies served different parts of a city.
We conducted semistructured interviews with a variety of industry and  local government participants for each of the selected markets.  Our  interviews included questions about telecommunications competition in  each city, the price of telecommunications services, and the factors that  favor or discourage competition in each city.  We interviewed the BSPs (in  the 6 cities where they existed), the incumbent cable companies, the  incumbent telephone companies, the local franchising authorities, and the  public utility commissions.  Table 1 provides the details of the cities we  chose and the primary companies and local representatives we  interviewed.  In addition, we interviewed officials from the BSPA and the  Mid-American Regional Council (a support organization for local  governments).
Our analysis provides details on the competitive status of markets with  BSPs.  However, because we used a case-study method, our results are not  generalizable to all markets with such providers.  We performed our work  between May 2003 and December 2003 in accordance with generally  accepted government auditing standards.

Price and Channel Information in Six Market Pairs

The following table provides additional data on the price patterns between  the matched pair markets.  The percentage price difference between each  matched market pair was calculated by subtracting the lowest price in the  BSP market from the incumbent’s price in the non-BSP market, and then  dividing that difference by the incumbent’s non-BSP market price.

Broadband Service Provider Association Member Markets as of February 2003

Minnesota: St. Cloud  California: Concord, Contra Costa County,  and Walnut Creek Kansas: Lenexa, Overland Park, Shawnee,  and Merriam Missouri: Kansas City and Kearney Texas: Austin, San Marcos, Corpus Christi,  Midland, Odessa, San Antonio, and Waco Alabama: Huntsville and Montgomery Florida: Panama City Georgia: Augusta and Columbus South Carolina: Charleston Tennessee: Knoxville Iowa: Lakeside and Storm Lake Minnesota: Luverne, Marshall, Pipestone,  Slayton, Tracy, and Worthington South Dakota: Canton, Coleman,  Flandreau, Madison, North Sioux City,  Watertown, and Yankton California: Gardena and San Francisco Illinois: Chicago New York: New York Massachusetts: Boston Pennsylvania: Philadelphia Washington, D.C.
Several changes in the membership of BSPA have taken place since we selected our case-study  markets in early 2003.

GAO Contacts and Staff Acknowledgments

	GAO Contacts

	Staff Acknowledgments

In addition to those named above, Julie Chao, Michael Clements, Andy  Clinton, David Dornisch, Etana Finkler, Bert Japikse, Sally Moino, and  Carrie Wilks made key contributions to this report.

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Summary:
Why GAO Did This Study

One of the primary purposes of the Telecommunications Act of 1996 was to promote competition in telecommunication markets, but wire-based competition has not developed as fully as expected. However, a new kind of entrant, called broadband service providers (BSP), offers an alternative wire- based option for local telephone, subscription television, and high- speed Internet services to consumers in the markets they have chosen to enter. This report provides information on (1) BSPs' business strategy, (2) the impact of BSPs' market entry on incumbent companies' behavior and consumer prices for telecommunications services, (3) the key factors that BSPs consider when making decisions about which local markets to enter, and (4) the success of BSPs in attaining subscribership and any key factors that may limit their success. We developed a case-study approach to compare 6 cities where a BSP has been operating for at least 1 year with 6 similar cities that do not have such a competitor. The 6 markets with a BSP presently account for more than 20 percent of the households nationwide that are in areas where BSPs currently offer the three-service package, but the results of these case studies are not generalizable to all markets.

What GAO Found

BSPs' primary business strategy is to build a fiber-optic network to provide consumers with a bundle of services, including subscription television, high-speed Internet access, and local telephone. To entice consumers to purchase more than one service of the three services they offer--a key marketing goal--all of the BSPs we reviewed offer substantial savings to consumers who buy more than one service. The rates for telecommunications services were generally lower in the 6 markets with BSPs than in the 6 markets without a BSP. For example, expanded basic cable television rates were 15 to 41 percent lower in 5 of the 6 markets with a BSP when compared with their matched market. The 6 BSPs we interviewed said that demographic factors, such as city size, income, and computer use were important factors in their decision to enter a market. For example, most of the BSPs avoided entering large cities. Location of the markets to key facilities and receptivity of local government officials were also considered when deciding which markets to enter. The 6 BSPs we interviewed have gained significant market shares for the services they provide, but they have also faced a number of obstacles that may be hindering their success. For example, the BSPs we spoke with are experiencing some financial difficulties and are putting off network expansion. Two of these companies also currently lack the resources necessary to adequately market their services within their existing markets. We provided a draft of this report to the FCC and DOJ. The DOJ did not provide any comments, and FCC provided technical comments that we incorporated. We invited the Broadband Service Provider Association, the National Association of Telecommunications Officers and Administrators, the National Cable & Telecommunications Association (NCTA), and the United States Telecom Association to comment on a draft of this report. We summarize and discuss NCTA's detailed comments in the report.