Cap-Sized: How the Promise of the Price Cap Voyage to Competition Was Lost in a Sea of Good Intentions

I. INTRODUCTION The "telecommunications revolution" has moved from cliche, to reality. It is now transforming how people live and work. Telephone service is now available through a computer terminal over the Internet, through wireless handsets, and through good old-fashioned wireline telephones. Service is now available from more providers than ever; competitive carriers now challenge the long-distance, local, and even Internet incumbents with aggressive pricing and innovative products. Thousands of new competitive players have entered the communications arena, an industry that is now worth more than $298 billion annually in the United States alone.(1) This revolution is worldwide, promising to bring the world closer together through communications that are faster, cheaper, and more reliable. As this revolution, fueled by amazingly rapid technological advances, transforms individuals' lives, regulators must navigate a difficult course. They must ensure that government rules do not fall behind the swiftly changing currents of technology and the marketplace, lest regulation frustrate these advances that give consumers needed services at reasonable prices. Against this backdrop of revolutionary change and regulatory challenge, the Federal Communications Commission (Commission or FCC) has struggled with the regulation of rates, termed "access charges,"(2) assessed by local telephone companies to long-distance carriers needing to interconnect to local networks. All too often, the task has involved an anachronistic regulatory regime that is being rapidly outdated by marketplace developments. Eight years ago, the FCC began to discard its largely discredited rate regulation scheme by adopting market-based reforms. It abandoned older style, cost-plus rate-of-return regulation in favor of "price cap" regulation, which focused on prices and created incentives for telephone companies to innovate and become more efficient. Price caps are a system in which regulators set a maximum cap on prices for a certain service, and the cap is reduced each year by a set amount based on estimated improvements in efficiency. Local exchange carriers (LECs) support price cap regulation because it allows them to charge the cap price even if the actual cost of providing the service is substantially lower, thus potentially leading to higher profits. Regulators like the price cap regime because it consistently reduces access charges. Despite eight years of tinkering, the FCC continues to try to get these new price cap regulations "right," while controversy rages among local telephone companies, long-distance carriers, customers, and regulators concerning the scope and necessity of the FCC's regulatory regime. This Article analyzes the last eight years of experience under price cap regulation and evaluates what has gone right and wrong. Although price cap regulation has produced reduced rates to long-distance carriers (though not necessarily to long-distance customers) and more efficient pricing than under rate-of-return regulation, it has ultimately fallen victim to incessant tampering and lagged far behind marketplace changes. Perhaps the most troubling aspect of the Commission's price cap regulatory regime is that the FCC has not allowed price caps to function free of tampering. The entire premise of the price cap regime is that by placing a cap on prices, local carriers will have an incentive to improve efficiency beyond the levels mandated by the caps themselves because, unlike under rate-of-return regulation, carriers can keep the profits. Although motivated by public interest considerations, the FCC has undermined these very advantages by reinserting vestiges of rate-of-return regulation into the new system and permitting external political factors to impact its price cap decisions. First, the Commission has repeatedly imposed retroactive adjustments to the price cap indices in order to correct underestimates. …