*The views expressed in this paper are those of the author and do not necessarily represent the views of the members of the FCC or other members of its staff.

This is pre-publication version. The final version will be published in Telecommunications Policy, Vol. 24, No. 10 & 11 (November/December 2000).

The global telecommunications service market is undergoing significant change as more countries privatize suppliers, liberalize national markets, and encourage entry. Despite these changes, international settlement rates remain significantly higher than the cost to terminate calls and many carriers reap substantial monopoly profits from the settlement payments they receive. Annual US settlement payments approximate $5 billion. Settlement rates are declining but the progress has been slow. High settlement rates, by raising the cost of international telephone service, result in high calling prices. To accelerate a reduction in settlement rates, the US Federal Communications Commission ("FCC") adopted a set of maximum rates, called benchmark rates, it expects US carriers to use in their settlements with other carriers and created a process designed to insure the implementation of these rates. The FCC benchmark rates vary primarily on the basis of a country’s level of economic development. The ITU took an unprecedented step of proposing an alternative set of settlement rates for its members. The ITU rates differ significantly from the FCC rates, being much lower for economically advanced countries and significantly higher for less developed countries. The ITU rates vary according to a country’s teledensity but the rationale for the ITU categories lacks support. In addition, other, arbitrary categories are part of the plan. Neither the FCC nor the ITU approach to reducing settlement rates address the problem of reforming the international settlement process and replacing it with an economically efficient, market oriented payment scheme.

Keywords:

US Federal Communications Commission (FCC), international settlement rates, International Telecommunications Union (ITU), indicative rates.
 
 

Acknowledgements and Disclaimer

The views expressed in this paper are those of the author and do not necessarily represent the views of the members of the FCC or other members of its staff. I wish to thank Kathryn O’Brien and Douglas Webbink for helpful comments and suggestions.

Pressure is mounting to reform settlement procedures in international telecommunications. The system, which is based on the concept of accounting rates, emerged when monopoly carriers provided international service and seemed suited to bilateral monopoly market conditions.[1] Vestiges of monopoly remain in most countries but market structures are changing in many others. As market structures change, the settlement system is an increasingly inefficient and costly procedure with greater opportunity for abuse. At the same time, continued reliance on the system may actually impede development of competitive markets. The mixture of different market structures around the globe increases the tension between carriers seeking to retain the old settlement system and those who see a need to modify, and perhaps replace it with a system that is responsive to rapidly changing market conditions.

The FCC’s policy in international telecommunications is primarily intended to promote a competitive market environment in the United States while encouraging similar developments elsewhere through privatization, liberalization, and an opening of foreign markets. Reforming the settlement system is a key ingredient in the initiative. If the effort succeeds, consumers around the world stand to benefit from lower prices for international service, a wider array of calling options, more rapid technological change, and an expansion of communications infrastructures that will make service available to a greater portion of the world’s population. Infrastructure expansion supports general economic growth because rapid, reliable, accurate communications service is an essential ingredient in the efficient functioning of business and widespread dissemination of information.

The FCC faces challenges in promoting globally competitive markets.[2] Although no longer under the control of a monopoly, the US market structure in international communications remains concentrated. The United States has a tight, oligopoly market structure reinforced, in part, by FCC policies. A few large carriers dominate the market and, even though entry is eroding the largest carrier’s market share, consolidation is also taking place. Historically, US carriers’ earnings on international service have been high compared to earnings in competitive markets. Prices for international calls from the United States, although low in comparison to prices in most other countries, are generally high relative to US domestic prices and, until very recently, rigid. Rivals tend to match price reductions. Consumer price and service options have been limited.

Complicating the FCC’s ability to alter market structure is the fact that international communication service is jointly supplied. Often ownership in other countries differs from the private investor model of the United States. In most cases, foreign carriers are government-owned and operate under different mandates, procedures, and operating guidelines than US carriers. Indeed, US and foreign carriers are subject to the laws of separate sovereign jurisdictions. Foreign carriers may also have different fiscal incentives that are guided by governmental budget responsibilities rather than the interests of stockholders. Most foreign carriers continue to be monopoly providers of communications service in their countries, although this situation is changing.

US and foreign international carriers must agree to the terms and conditions for providing switched telephone service between countries. A key component of this agreement is the financial arrangement between them. Specifically, the carriers must agree on how they will compensate each other for the facilities, equipment, and personnel used to provide international service. US international carriers negotiate accounting rates with foreign carriers and, by convention, each carrier owes the other one-half of the accounting rate to terminate a minute of service in another carrier’s jurisdiction. This latter rate is referred to as the settlement rate. It varies widely among countries.

Most observers agree that accounting rates exceed the cost of terminating service by a substantial margin. It was recently noted, for example, that "it is widely felt that accounting rate reductions have not moved fast enough to catch up with declining cost trends and that most rates remain significantly above costs."(ITU,1999a,p.31) Accounting rates are bilaterally negotiated but most foreign carriers, being monopolists, have an advantage in their negotiations with multiple US carriers. Indeed, a foreign carrier’s ability to charge a monopoly price to terminate service from the United States is constrained mainly by the FCC’s jurisdiction over US carriers. Nevertheless, settlement rates are the largest cost component of international service so supra-competitive settlement rates raise US carriers’ costs and have a significant impact on the prices charged to US consumers.[3]

After a period of restraint, the FCC recently took action aimed at reducing foreign carriers’ high settlement rates toward cost levels. In its Benchmarks Order,[4] the FCC adopted a sliding scale of maximum rates that US carriers would be allowed to pay foreign carriers to terminate international service from the United States. The rates will be phased in during a transition period that varies primarily on the basis of per capita income levels. Under the plan, economically developed countries have lower benchmark settlement rates than less developed countries. Reductions in US carriers’ costs caused by lower termination charges on growing US international service will lead to lower US calling prices. US consumers will benefit from lower prices as will US and foreign carriers if appropriate demand conditions exist.

US carriers enthusiastically support the FCC action while many others criticize it. Some contend that the FCC’s unilateral action on settlement rates will redistribute foreign carriers’ monopoly profits on settlements to US carriers.[5] This loss of revenue may jeopardize investment plans and market structure reform in other countries. They also argue that even if lower settlement rates reduce US carriers’ costs, prices to US consumers will not fall because the US international communications market is a tight oligopoly. In consequence, there will be little change in US prices so US carriers’ profits will rise. Some critics also argue that because US carriers’ costs are lower than the FCC benchmark settlement rates there is an implicit excess profit earned by US carriers on the calls they terminate.[6] In short, the FCC Benchmark Order benefits US carriers at the expense of both foreign carriers and US consumers.

Meanwhile, the International Telecommunication Union (ITU) developed an alternative plan to usher in lower settlement rates, which it terms "indicative rates." The ITU proposal differs from the FCC plan in several important respects, not the least of which is the multilateral approach proposed by the ITU. The ITU approach would have a significantly different financial impact on many countries than the FCC plan because it proposes significantly higher settlement rates with generally longer transition periods for developing countries, and lower rates with longer transition periods for more developed countries. To date, US opposition has prevented the adoption of the ITU proposal. Thus, as the FCC benchmark plan enters its second year, the ITU proposal faces an uncertain future.

Major Features of the Alternative Plans

The FCC plan and the ITU proposal deserve extensive review and detailed examination. Both represent important attempts to deal with settlement rates that exceed competitive market rates. These settlement rates are under growing pressure from market forces at a time when carriers in developing countries rely on the growing settlement payments for many purposes. Increased reliance on settlement payments may lead developing countries to resist attempts to reform the current system because of a concern that a change may jeopardize a significant source of revenue and threaten their economic development plans. Others may resist reform because they may view settlements as a source of revenue to support corporate strategies in an increasingly competitive global market. Still others may see potential savings in settlement payments as means to help finance corporate takeovers, enter new markets, or pursue other ventures. Beyond these pressures and incentives, settlements are the key cost in international calling prices.

Growing pressure on above-cost settlement rates derives from the US experience during the 1990s.[7] Even with high settlement rates, US international calling prices were significantly lower than prices in most other countries so demand for service from the United States grew more rapidly than demand for service to the United States. This growth caused US net settlement payments to rise from $2.8 billion in 1990 to almost $6 billion by the middle of the decade. Rapidly rising payments included growing excess profits as settlement rate reductions failed to match declining costs.[8] The growing disparity between settlement rates and costs lead to greater resource misallocation and growing welfare losses.

A marked change in the distribution of US settlement payments among countries accompanied their rapid growth. The share going to developing countries increased from 70% in 1990 to 85% in 1998. The least developed countries gained more than others as the payments they received sextupled and their share rose from 9% to almost 30%. Other countries saw their payments rise gradually and then level off or even decline toward the end of the period. The rapid rise in payments to less developed countries is particularly noteworthy because the ITU proposal is designed primarily to mitigate the impact of settlement rate reform on these countries. Table 1 summarizes the shifts.

Despite the similarities, there are significant differences in the plans that have an impact on how they will affect countries. A major difference is the rates. Although the rates are not directly comparable because the country classification schemes vary between the plans, the FCC plan has a narrower range of rates that are higher than the ITU rates for high-income countries but lower than the ITU rates for less developed countries, which have lower teledensities. In comparison to the ITU plan, the FCC benchmark rates, for example, are higher for more economically developed countries, particularly for the most advanced group of countries. In contrast, the ITU rates are much higher in the case of least developed countries and those with a low teledensity (see Table 2 for a comparison of the rates). The difference in rates is partially explained by data used to establish them. The FCC benchmark rates are based primarily on unbundled consumer rates for service components that are comparable to the elements of an international call. There are three components: international facility, international gateway, and national extension. The ITU uses a "best practices" approach to set its rates based on a sample of available settlement rates.

In general, countries have a longer transition period with the ITU approach than with the FCC plan. A feature of the ITU approach extends the deadline for adopting its rates. Whereas the deadline for the FCC benchmark rates is the first day of the year, the ITU deadline is the last day of the year. Thus, the ITU rates would take effect on December 31, 2001 as compared to January 1^st in the relevant year for FCC plan. In effect, the ITU indicative rates begin in 2002 whereas the FCC rates begin in 1999 and are phased in over five years so the ITU proposal would start to take effect when the FCC plan is almost completely implemented. By way of comparison, the FCC benchmark rate for high-income countries is 15¢ beginning on January 1,1999 whereas the comparable ITU rate is substantially lower, 5.8¢, and it would not take effect until December 31, 2001. 

Other differences distinguish the two approaches. The FCC plan provides procedures that enable US carriers to seek legal enforcement action of the benchmark rates and that permit foreign carriers to seek relief from the benchmark rates. In contrast, the ITU proposal takes the form of a non-binding recommendation like D.140, which was generally ignored. The proposal provides no remedies if a carrier fails to meet the effective date of the indicative rate. While both plans recognize the need for an extended transition period for countries with a significance reliance on net settlement payments, the ITU proposal provides three extension periods, to the end of 2004. The FCC does not define the extension period. Both approaches link the extension period to the ratio of net settlement payments to total telecommunications revenue. As for interim rates during the transition period, the FCC anticipates a series of proportionate annual reductions in settlement rates whereas the ITU proposal suggests "staged reductions." Finally, the FCC plan applies to service between the United States and other countries. In contrast, the ITU proposal envisions a global application of indicative rates that would be achieved through bilateral negotiations.

Critique of the Alternative Plans

A foundation of common carrier regulation at the FCC is that rates should be based on a carrier’s costs of providing service to consumers. In the era of rate base regulation, the FCC concentrated its regulatory efforts on determining a carrier’s allowed rate of return, assessing used and useful investment, and setting just and reasonable rates. Market forces were ineffective in ensuring the results of a competitive market so regulation was relied on to constrain monopoly prices. Regulation acted as a substitute for promoting the performance expected in a competitive market.

Carriers serving most foreign markets are still monopolists. They are responsible for providing local, long distance, and international service. Although the FCC has no jurisdiction over the operations provided by foreign carriers, it has a responsibility to ensure that the rates paid by US carriers to terminate international service do not exceed just and reasonable levels. The legacy of regulation in the United States suggests that just and reasonable rates should be based on foreign carriers’ costs, including a reasonable return on their used and useful investment.

With its history of cost-based rates, the FCC approach can be criticized because foreign carriers’ costs did not play a prominent role in setting the benchmark rates.[11] This shortcoming is perhaps understandable because reliable data on foreign carriers’ costs are not readily available, even though the FCC solicited cost information in its benchmarks proceeding. Indeed, most foreign carriers are reluctant to reveal even their settlement rates. Lacking cost information, the FCC based its benchmark rates of unbundled rates for comparable service available to consumers on the theory that US carriers should pay no more to terminate international service than foreign carriers charge their customers for similar service. The unbundled rates still incorporate cost inefficiencies, internal subsidies, social objectives, and other ratemaking practices that vary among countries. The FCC acknowledged these problems and recognized the possibility that its benchmark rates exceeded foreign carriers’ cost, but concluded that its benchmark rates were closer to costs than most existing settlement rates.

Access to reliable cost information does not eliminate the difficulties inherent in estimating the relevant costs for terminating international calls. The difficulties are well known. Common carriers provide an array of communications services. They have substantial fixed and common costs. Sunk costs represent a substantial portion of total costs. Generally, there are economies of scale and scope so unit costs may decline over a substantial range of output. Problems associated with cost assignment and cost allocation arise, particularly the potential discretion available to carriers in allocating common and joint costs among service categories. Moreover, the FCC believes forward-looking incremental costs provide the appropriate cost standard for setting rates, but many foreign carriers may not share this view.

The emergence of competing suppliers in the international communications market offers an approach to determining just and reasonable benchmark rates that overcomes the problems created by an absence of reliable cost information. More than one carrier provides international service in several countries other than the United States. Carriers in these countries may engage in a limited degree of price competition in an effort to attract US carriers to terminate their international service. Unfettered market forces do not exist, however, because the number of carriers in most countries is small. Moreover, regulatory policies, like the FCC’s International Settlements Policy (ISP), may impede the operation of market forces so settlement rates may exceed competitive levels.[12] Nevertheless, international carriers negotiate arrangements for terminating service and respond to changing market conditions. Despite the market imperfections, settlement rates determined in these markets may better approximate just and reasonable rates and they are certainly a better indicator of competitive market rates than those derived from consumer prices in monopoly markets.

Information published by the FCC suggests that settlement rates for markets with even a few competitors were in the range of 6¢ to 8¢ cents per minute when the benchmark proceeding was being deliberated. Since that time, many other settlement rates have fallen to this level, which suggests that the benchmark rates do not accurately reflect costs and surely would exceed rates in more open, competitive markets. If the objective is to encourage cost-based settlement rates, then rates that exist in the imperfectly competitive markets should be a better guide for benchmark rates in these markets, and they should provide the basis for determining reasonable benchmark rates for other markets. These market-oriented rates provide a strong incentive for efficient provision of service, foreshadow near-term developments in global markets, and can be adjusted to allow for other concerns.

The ITU proposal suffers from several serious shortcomings. The rationale for the proposal and the underlying studies are flawed. The ITU indicative rates for many developing countries are significantly higher than both the FCC benchmark rates and the ITU rates for more developed countries. The ITU argues that carriers serving less developed countries are saddled with higher costs, which justifies its rates for these countries. The ITU argues that less developed countries have low teledensities, often less than one telephone per 100 inhabitants. According to the argument, low teledensity prevents carriers from providing service at output levels that would enable them to realize economies of scale. The resulting low output levels raise the cost of terminating international calls. Scale economies, however, are not the sole determinant of a carrier’s costs. The cost to terminate international calls also depends on other supply characteristics. There may be a trade-off between scale economies and the state of technology. Carriers in developing countries may have access to technologically advanced equipment and software. The availability of advanced facilities may enable carriers in developing countries to avoid purchasing more costly, older facilities used in more developed countries so they can terminate service at lower costs even though they have smaller networks. A country’s size, its terrain, the population distribution between urban and rural areas with access to the network, prevailing wage levels, and other factors affect a carrier’s costs. The existence of large and small networks around the world raises additional questions about the minimum efficient scale for communications service. If the minimum efficient scale is a relatively low level of output and unit costs are relatively constant at larger output levels, then scale economies are a less important determinant of cost.

The teledensity categories of the ITU are based on the existence of economies of scale throughout the relevant range of supply and require that teledensity is an accurate measure of scale economies. The ITU argues that low teledensity prevents carriers in developing countries from realizing scale economies, which increases their costs. Indicative rates decline as teledensity increases because economies of scale realized by carriers in developed countries lead to lower costs over the relevant range of supply. Thus, the measure of scale is central to the argument. In order to support the ITU categories, teledensity must be an accurate measure of a network’s capacity to transmit information. Moreover, as capacity increases, a carrier’s ability to handle information increases and its costs decline. Teledensity, however, does not measure capacity, it indicates the relation between the number of people and telephones in a country. A sparsely populated country with few telephones may have a high teledensity but a small network. Conversely, a densely populated country with many telephones may have a low teledensity. The total number of main lines is a better measure of capacity and, therefore scale, than teledensity. In general, teledensity and main lines are not closely correlated. Minimum efficient network scale considerations are also relevant to the ITU argument because they indicate the level of output at which smaller networks can operate efficiently.

Current data show that several less developed countries have a low teledensity, but in many cases the number of main lines exceeds the number in most high-income countries.[13] Carriers serving such less developed countries should realize lower costs associated with large-scale networks. Conversely, carriers in high-income countries with limited main line capacity may be unable to gain the advantage of large scale supply. In short, the ITU proposal is based on the flawed argument that economies of scale occur continuously as teledensity increase, regardless of the actual scale of the network. By proposing discrete teledensity ranges for its indicative rates, the proposal also suggests that there are specific ranges at which unit costs fall.[14] There is no reference to minimum efficient network scale. As an empirical matter, the difference between the lowest ITU rate, 5.8¢, and the highest ITU rate, 44.3¢, seems difficult to justify on the basis of scale economies.

The deficiencies with the ITU proposal cast serious doubt upon its use as an appropriate approach to settlement rate reform. The misplaced emphasis on scale economies to explain cost differences, the flawed measure of scale, the failure to recognize the potential impact of other factors on costs, and the large disparity in rates undercut the foundation of the country groupings based on teledensity. Without a more comprehensive analysis, there is no cost basis for the ITU teledensity categories, the differences in indicative rates, or the size of the rate differentials.

The ITU relies on a sample of cost studies to support its conclusion that costs are higher in developing countries than in developed countries. The studies are flawed. They tend to be based on historical costs rather than estimated future costs. Moreover, different methods were used to estimate the costs so the results are not comparable. There are also questions about the reliability of the cost and other data used in the studies because some carriers lack basic cost accounting systems while others relied on anecdotal cost information. Some studies included costs that do not pertain to terminating foreign calls, for example, marketing and other retail expenses. Other studies did not attempt to separate domestic and international costs and appear to allocate a disproportionate share of common costs to international service. Some studies incorrectly assumed identical costs to originate and termination international service. And finally, one study was based on aggregate cost data for all service provided by the carrier. These problems further undercut the basis for the ITU indicative rates.

Another serious weakness with the ITU proposal is that it represents an attempt to administer global settlement rates in an international communications market that is undergoing rapid change. The indicative rates are computed from a small set of outdated settlement rates that may have excluded the lowest rates between some countries on the grounds that they involve special arrangements between "frontier" countries. Excluding these rates introduces an upward bias into the results. More generally, the indicative rates reflect monopoly conditions in many countries where inefficient operation, inflated costs, obsolete facilities, and X-inefficiencies have raised costs by amounts that cannot be readily determined. By most accounts, settlement rates exceed historical costs, perhaps by large margins. Rather than attempting to provide incentives to improve efficiency, reduce costs, encourage the introduction of cost-saving technology, and promote market-opening initiatives, the ITU is proposing a set of outdated settlement rates. These rates protect monopoly carriers’ excess profits, encourage them to resist change, and increase the obstacles to needed fundamental settlement reform.

Initial Results of the Benchmarks Plan

Now that the FCC’s Benchmarks Order is in the second stage of implementation, the initial results can be assessed to judge whether US settlement rates are moving closer to costs. The order is intended to encourage carriers in other countries to settle their traffic with US carriers at rates no higher than benchmark levels in order to reduce US calling prices. As more foreign carriers agree to benchmark rates, more service will be settled at lower rates. Thus, success in achieving the objective depends upon the number of foreign carriers that agree to the rates and the service with them. Two measures are used to assess progress: the number of countries that have agreed to a benchmark rate and the minutes settled at these rates. The first indicator measures US carriers’ success in negotiating benchmark rates with foreign carriers that take effect according to the schedule adopted by the Commission. The second one measures the proportion of service that is settled at these rates, which may be a more significant indicator of progress because it has a greater impact on US carriers’ costs. The evaluation examines the results for each country category because the benchmark rates are phased in over five years. To date, carriers in two income categories are expected to settle at benchmark rates, 15¢ for high-income countries and 19¢ for upper-middle-income countries. Some carriers in other categories have reached benchmark agreements with US carriers so the results for all categories are included in the evaluation. Table 3 summarizes the results.

These results suggest that carriers in many countries across the economic spectrum support lower settlement rates and, while they may not all agree with the FCC benchmarks plan, many have agreed to the rates. It is particularly the case for the upper income countries. A close examination of these countries suggests that other forces are putting additional pressure on settlement rates. The rates with several countries, 12 to be precise, met benchmark levels before the FCC ordertook effect and several rates were in the range of 6¢ to 8¢. A low settlement rate with a carrier puts pressure on carriers in neighboring countries with higher rates. As a result, countries with benchmark rates tend to be clustered geographically. Monopoly carriers are under pressure to accept rates below benchmark levels because re-routing, refiling, and hubbing of traffic, along with the wider availability of international simple resale (ISR) and the rise of IP telephony enable US carriers to avoid high settlement rates. Carriers in these situations that refuse to reduce high rates risk bypass. This development means that markets for terminating international minutes are no longer defined by geographic boundaries. In short, FCC action may add to growing market pressures on settlement rates in some areas and act as a catalyst in other areas.

Several rates below 15¢ indicate that the benchmark rate for high-income countries still exceeds a reasonable level. The Commission acknowledged that the rates adopted in the Benchmarks Order exceed costs, but it may have underestimated the size of the difference. Benchmark rates are intended to be price caps US carriers pay to terminate service in other countries, but current settlement rates for one-third of the high-income countries fall in the range of 6¢ to11¢. Market forces are primarily responsible for these low rates. The existence of rates at these levels lends support to the ITU argument that the FCC’s rate for high-income countries is too generous and should be much lower than 15¢. Thus, even though the rates for almost all settled minutes in the high-income category satisfy benchmark levels, they may be significantly above termination costs.

Emerging market forces in the international telecommunications market may threaten the ability of less developed countries to insulate their high settlement rates. Just as carriers in high-income countries are forced to reduce settlement rates, other carriers will come under the same pressure. As Table 3 suggests, many developing countries anticipate growing market pressures and have negotiated benchmark rates. In fact, some carriers in developing countries have negotiated settlement rates with US carriers that are lower than benchmark levels while others have agreed to implement benchmark rates ahead of schedule. The growing list of developing countries adopting settlement rates that are at or below benchmark levels raises serious questions about the reasonableness of the ITU rates for such countries and their sustainability in an environment of rapidly changing market conditions.[17] Moreover, the concern that settlement rates at benchmark levels will jeopardize infrastructure investment appears overstated because recent US experience shows that payments to many developing countries increase after settlement rates decline.[18]

Settlement Rates, Calling Prices, and Flow-through

In the past decade, falling settlement rates have contributed to lower US carrier costs to terminate international telephone service in other countries. Other costs have also fallen and further reductions will occur. In fact, the average US settlement rate fell from 64¢ in 1990 to 18.5¢ in mid-2000. As settlement rates continue to decline, US costs of providing international telephone service will also decline. By declaring AT&T to be a non-dominant, international carrier, the FCC increased its reliance on competitive market forces to control international calling prices. As rival carriers’ costs fall, market forces should operate to bring down prices and US consumers should benefit as the savings from lower settlement rates are passed through to calling prices.

It has been alleged that US carriers rather than US consumers benefit from the FCC’s Benchmarks Order (See Melody 2000; and Utsumi 2000) According to the argument, the US international market structure is highly concentrated. Three firms provide virtually all international service in the United States, in fact two carriers account for 85 percent of the market. These market conditions are unlikely to stimulate competitive pricing behavior. Lower settlement rates reduce US carriers’ costs, but because the market is so concentrated US carriers are not under pressure to pass the cost savings along to US consumers. Instead, it is claimed that US carriers maintain their prices and increase profits as falling settlement rates reduce their costs. Excess profits that flowed to foreign carriers at higher settlement rates are redirected to US carriers.

If the allegation is correct, it is a serious criticism of the FCC’s long battle to reform the international settlement process because this FCC effort rests on the belief that US consumers ultimately benefit from cost-based settlement rates. The charge may also lend support to the allegation that FCC actions only benefit US carriers. Because of these charges, US international calling prices bear close scrutiny.

A related criticism is that US carriers earn greater excess profits on calls that terminate in the United States because US costs are lower than foreign costs but service is settled at the same rates in the United States as other countries. As a result, margins on calls that terminate in the United States exceed margins on calls that terminate in other countries. In effect, the netting process used to calculate settlement payments involves an implicit transfer of excess profits to US carriers.

Historically, international switched telephone service has been a highly profitable business.[19] When rate base regulation was the method used to control US carriers’ earnings and AT&T was a monopoly supplier of international service, it repeatedly reported earnings on international service that far exceeded its authorized rate of return. High earnings continued after the AT&T break up. When price cap regulation replaced rate base regulation in the United States, the FCC ruled that it was unnecessary to require AT&T to reduce its international calling prices as settlement rates declined because market forces would exert pressure on international calling prices.[20] Despite entry, the FCC remained concerned about the persistence of high earnings on international services. When the FCC ruled that AT&T was a non-dominant international carrier in 1996, AT&T entered into a voluntary commitment that included a provision temporarily restricting its ability to raise prices for international residential telephone service. AT&T also agreed to file reports so the FCC could monitor international prices, but excess profits seem to persist. There are suggestions that net settlement payments may account for as much as 50% of the cost international telephone service. If the figure is accurate, then 40¢ of every dollar from international service represents profit.

At issue is the relationship between changes in settlement rates and US international calling prices. Do US carriers flow-through reductions in settlement rates to US calling prices and, if they do, what portion of the cost savings do US consumers realize? Critics seem to suggest that changes in US international calling prices should match changes in settlement rates. Economic theory postulates that a firm, even a monopoly, will reduce prices as its costs fall. In general, the magnitude of price reductions depends upon supply and demand elasticities, but prices tend to decline less than costs. A larger portion of a cost reduction is passed on the more responsive consumers are to price changes and the more sensitive a firm’s cost curve is to a cost reduction. Conversely, a reduction in settlement rates leads to a smaller reduction in prices if demand is inelastic.

Estimating the impact of lower settlement rates on prices is a difficult process for several reasons. There are problems in estimating the cost savings from reductions in settlement rates. Each country is a separate market with its own settlement rate and several countries are served by more than one carrier, each with a different settlement rate. The rates do not decline simultaneously or in equal amounts. Most settlement rates take effect on a retroactive basis. Many rates are denominated in "Special Drawings Rights" (SDR) but payments are made in US dollars so the impact of settlement rate changes on costs may be offset by currency fluctuations. Many settlement arrangements have surcharges for particular types of calls, some which vary with the settlement rate and others that are constant. Other arrangements introduce surcharges in conjunction with settlement rate reductions. Carriers’ ability to refile, re-route, and hub service through other countries may conceal the actual settlement rate owed by one carrier to another carrier. Also, the impact on costs of a reduction in a settlement rate may be partially offset by a change in the traffic balance.

The FCC proportionate return policy adds a unique element to the flow-through issue. This policy, which is a component of the ISP, requires US carriers to receive traffic from a foreign carrier in the same proportion as they transmit to the foreign carrier. As a result, US carriers’ settlement costs depend upon the return traffic they receive and their market share. The effect of the proportionate return policy is that a change in the settlement rate changes US carrier’s settlement cost but the change in costs is less than the rate change. As a result, reductions in US international calling prices should not be expected to equal reductions in the settlement rate.

US international calling price structures further complicate attempts to estimate the flow-through of cost savings attributable to lower settlement rates. US calling prices vary among countries and carriers, and price changes are not always uniform. Calling prices are also different among consumer groups. For example, non-discount plan, basic rates are different for residential and commercial customers. There are also a variety of optional, discount calling plans offered to different customer groups. Optional discount prices tend to be significantly lower than basic rates and are aimed primarily at customers who make a large number of international calls. Some options have a fixed monthly charge and a charge that varies with use; others may not have a fixed charge. Customers may also be entitled to volume discounts as usage increases. Combined domestic and international call volume may determine the size of the discount. List prices, therefore, may differ from actual prices. In addition, low-priced international calling plans are becoming available. Finally, hubbing, refile, and ISR distort the connection between US calling prices and settlement rates.

While recognizing the difficulty associated with estimating the impact of cost savings on calling prices, an examination of general trends in overall US calling prices and settlement rates reveals significant changes in the 1990s and sheds some light on the flow-through issue. Average revenue per minute (ARPM), which is an estimate of the average US billed international price, is the basis for examining calling price trends. ARPM figure is the annual billed revenue of US facilities-based carriers divided by annual US minutes. A comparable figure for settlement rates is the average net settlement payment per minute (ANSM), which is calculated by dividing annual US net settlement payments by annual US minutes. The difference between ARPM and ANSM is the revenue available to US carriers, after settlements, for other operating expenses and profit.

Average prices and settlements both declined in the 1990s, particularly after 1995, as shown in Table 4. Lower settlement rates reduced US carriers’ settlement costs, particularly toward the decade’s end. Reductions in other costs may have contributed to further lowering the cost of providing international service. A fall in the average revenue per minute accompanied the cost reductions, which suggests that some portion of the cost savings attributable to lower settlement rates was passed on to US consumers. Several other changes may also contribute to the apparent decline in average prices. These changes include lower calling prices, the introduction of new service options, customer migration to lower-priced service options, a change in the distribution calls among countries, a shift to off-peak calls, a decline in operator-assisted calls, and other factors. Indeed, prices for some services may increase as the average price declines. 

Overall, the average US price declined during the 1990s at a more rapid rate than the US average settlement payment per minute. The margin between average price and average net settlements also declined. These results suggest that US consumers benefit from lower settlement rates and that the reductions did not merely result in a redistribution of monopoly profits from foreign carriers to US carriers. [21]A more extensive analysis, however, is required to estimate more precisely the cost savings attributable to lower settlement rate reductions that were passed on to US consumers.

If US carriers retain the cost savings from lower settlement rates, as alleged, then a decline in ANSM should not be accompanied by a lower ARPM and the margin should increase. The results in Table 4 indicate that overall prices are declining more rapidly than average settlements so the margin is falling. Reductions in the ARPM and ASNM indicate US carriers are flowing through some portion of the savings they realize from lower settlement rates and that US consumers benefit from the reductions. The trend will continue as market forces grow, the remaining phases of the Benchmarks Order take effect, and the pressure on settlement rates and calling prices increases. [22]

As noted, there is a related allegation that US carriers earn excess profits on service they terminate in the United States. The argument rests on the assumption that US costs are lower than foreign costs. If carriers have different termination costs but the same settlement rate is used, then the profit per minute on calls that terminate in the United States is greater than for calls that terminate in other countries. This argument overlooks the fact that US service to virtually every country is significantly greater than service to the United States. In general, the imbalance is most pronounced with less developed countries. Because of the traffic imbalance, excess profits included in US net settlement payments to foreign carriers are far greater. Service between the United States and Bangladesh provides an example. If the settlement rate is 80¢ and termination costs are 7¢ and 55¢ respectively, then the profit per minute is 73¢ for service terminated by US carriers and 25¢ for service terminated by the Bangladesh carrier.[23] Service to Bangladesh was 52.7 million minutes while service to the United States was 4.7 million minutes. The net settlement payment to Bangladesh on this service is $38.4 million. Even if 55¢ is an accurate estimate of the cost to terminate a minute in Bangladesh, excess profits are $13.2 million on service to Bangladesh and $3.4 million on service to the United States. Based on these levels of service and the assumptions about termination costs, the net excess profit realized by Bangladesh is $9.7 million. Here is an indication of the potential impact high, above-cost settlement rates may have on US consumers.

Diverging Price Trends

In general, the average price of US international telephone service has declined significantly in recent years but the trend camouflages a disconcerting and growing disparity in the prices charged to different consumer groups.[24] Although average US international prices are declining, all consumers are not experiencing lower prices. International prices of many, perhaps most U.S consumers are rising at the same time that others are charged steeply lower prices. Since settlement rates do not vary for service provided to different consumers groups, the growing disparity in calling prices raises questions about equitable treatment of US consumers as settlement rates decline.

Optional discount calling plans were introduced during the 1990s at prices significantly lower than non-discount basic rates. As these options became available, international callers were also divided into two categories: residential and commercial. Subsequently, non-discount, basic rates for commercial and residential service increased dramatically as the rates for the optional discount plans drifted downward and then declined sharply. Occasional users, who constitute a majority of international telephone customers, tend to pay basic rates. Due to their small demand for international service, occasional users tend to be less sensitive to price changes. Frequent and large volume customers, on the other hand, are more sensitive to price levels and more likely to migrate to low cost calling options that become available. The growing disparity between basic rates and option plan rates is summarized in Table 5.

Settlement rates are generally the same for all service classifications. US carriers do not negotiate one rate for commercial service, another rate for residential service, and a third rate for optional calling plans. As a result, reductions in settlement rates apply equally to all service categories. All users share in cost reductions from lower settlement rates. And yet prices charged to US consumers vary, rates move in different directions and by different amounts. As the indices in Table 5 indicate, the savings from settlement rate reductions are passed along to frequent and large volume users who benefit the most from the discount option plans while occasional users realize no benefit from the savings. In fact, their international rates are increasing.

The international market is subdivided and occasional users are charged higher prices, which are then increased as costs decline. Discriminatory pricing and cost shifting among services should concern the FCC as it presses forward on accounting rate reform. These practices may also concern other countries planning to rely on unfettered competition as they liberalize their communications sectors. Increases in the rates of most international consumers at a time when frequent and large volume users reap the benefits from settlement cost savings seems inconsistent with the argument that cost-based settlement rates redound to the benefit of US consumers.

Conclusion

Recently, significant progress has been achieved in reducing settlement rates from the very high levels that existed in the early 1990s. Most rates, however, continue to exceed levels in currently more open markets and are well above rates that would occur in truly competitive markets, so additional work remains to solve the problem. To date, two serious plans exist that seek to reduce settlement rates even further. Both plans are flawed and should be viewed as interim steps to real reform of international settlement arrangements. The FCC took the first step with its benchmark plan. The negative response by many countries that are accustomed to the revenue they derive from the traditional settlement procedure with its high rates and slow progress is to be expected. Even the FCC plan, however, does not offer cost-based settlement rates and attempts to accommodate the special concerns of less developed countries. Nor did the FCC plan incorporate the low market-oriented settlement rates that existed when it adopted the benchmark rates. Instead, the FCC plan relies on monopoly retail prices as the basis for its benchmark rates. The result is a set of benchmark rates well above market rates and costs. Nevertheless, the FCC’s benchmark rates marked a significant step in the direction of market-based rates at a time of rapidly changing global communications markets. Concerns about US calling prices, however, must be addressed so that all US consumers benefit from the progress made to reduce settlement rates.

Following the FCC action, the ITU developed another plan. Coming on the heels of the FCC proposal, the ITU had an opportunity to propose much-needed fundamental reform of the international settlement process. Instead, the ITU plan is better characterized as a reaction to the FCC proposal that is intended to protect monopoly carriers serving less developed countries. If the FCC plan is viewed as progress in the effort to bring settlement rates closer to cost-based levels, the ITU plan generally moves away from this effort. With higher rates for most countries, particularly for less developed countries, the ITU plan, if implemented, would continue to shield carriers from settlements at cost-based rates and arrangements driven by market forces. These same carriers have strongly resisted settlement reform efforts since the early 1990s when ITU D.140 Recommendation was being discussed. Ironically, these countries stand to benefit from fundamental reform of the international settlement process that is compatible with more competitive markets for international telecommunications service.

Now is the time for fundamental reform of international settlement procedures. Further delay makes the transition more difficult for less developed countries because global communication is changing at a rapid pace that will not wait for countries that continue to rely on outdated, inefficient settlement practices. Current transactions between countries in which international communications services are provided in relatively open competitive markets provide a point of departure in the reform process because they foreshadow the direction of future transactions.
 
 

Endnotes

1. Ende (1975) has a discussion of the international settlement process in the early stages of development.
2. Trebing and Estabrooks (1995) describe the changes occurring in international telecommunications markets and the challenges that confront regulators.
3. Harris (1996) advances this argument but the contention is sharply disputed by Sullivan (1997).
4. See FCC (1996 and 1997) for the decisions proposing and adopting the benchmarks policy. Cowhey (1998) and Stanley (1997) assess the potential impact of settlement rates and the benchmarks policy in a changing global environment.
5. See ITU (1999) for this position.
6. Trotti (1993) and Melody (2000) advance this argument.
7. Early recognition of the potential problem presented by international settlements is described in Stanley (1991) and Alleman, Rappoport, and Stanley (1989).
8. It is alleged that net settlement payments from U.S. carriers to foreign carriers are as much as seventy percent higher than the cost to terminate service from the United States. See In the Matter of International Settlement Rates, Report and Order, 12 FCC Rcd 19806 (1997) at ¶ 13.
9. The income categories are the World Bank’s classification scheme, which is based on GNP per capita. When the FCC adopted its benchmark scheme, high income countries had a GNP per capita greater than $8,956, upper-middle income countries had a GNP per capita between $2,896 and $8,955, lower-middle income countries had GNP per capita between $726 and $2,895, and low income countries had per capita income less than $726. The ITU defines teledensity as the number of main telephone lines per 100 inhabitants.
10. The ITU "Least Developed Country" category has fifty-one countries, more than any other category. LDC’s and small island states received $410 million in settlement payments from U.S. carriers in 1985 and $2.5 billion since 1998. The transition period for LDC’s may be extended beyond 2001. If the ratio of a country’s net settlement payments to its total telecommunications revenue in a year exceeds 10 percent but it is less than 20 percent, then the indicative rate takes effect at the end of 2002. If the ratio exceeds 20 percent but it is less than 30 percent, then the indicative rate takes effect at the end of 2003. If the ratio exceeds 30 percent, then the indicative rate takes effect at the end of 2004.
11. Spiwak (1999) reviews the FCC’s Benchmarks Policy as well as other FCC international policies.
12. Several papers analyze various aspects of the FCC’s International Settlements Policy. They include Alleman and Scorce (1997), Galbi (1998), Thuswaldner (1998 and 2000), and Wright (1999).
13. Both China and India, for example, have a large number of main lines but they have low teledensities. Only the United States has more main lines than China, and India has more main lines than over one-half of the high-income countries. Pakistan, which has a teledensity between one and five main lines, has almost as many main lines as Norway and Finland, which both have a teledensity greater than fifty main lines. See ITU, 1999b.
14. The categories proposed by the ITU overlap and this introduces another source of confusion into the plan. Seventy-five countries or territories fall into two categories so that more than one indicative rate could be used for settlements. In several cases, there is a significant difference in the indicative rate that could be used, 5.8¢ versus 36.0¢. Six countries or territories fall into three categories so three different indicative rate are candidates for the appropriate settlement rate. Here again, the differences in indicative rates are not insignificant. In the case of three countries, for example, the rate could be 28.5¢ or 36.0¢ or 42.3¢.
15. The calculations for settled minutes are based on 1998 figures because the data for 1999 are not yet available.
16. Other changes in FCC policy may also contribute to the impact on settlement rates. The FCC recently adopted an order that tied ISR approval to benchmark rates. The same order also linked a waiver of the ISP to benchmark rates, and eliminated filing requirements for settlement rate changes with non-dominant foreign carriers. These changes are intended to reinforce the role of market forces in determining settlement rates. See FCC (1999).
17. The relevance of the ITU "indicative rates" is called into further question by updated information. The "indicative rates" decline significantly if current U.S. settlement rates are substituted for the rates used by the ITU in its calculations. Current U.S. rates produce the following comparative figures: 16.8¢ vs. 36.0¢ for small island states, 31.7¢ vs. 42.3¢ for least developed countries, 32.6¢ vs. 44.3¢ for TD<1, 20.1¢ vs. 34.0¢ for 1<TD<5, 21.2¢ vs. 28.5¢ for 5<TD<10, 17.5¢ vs. 22.0¢ for 10<TD<20, 12.2¢ vs. 16.0¢ for 20<TD<35, and 10.9¢ vs. 11.9¢ for 35<TD<50. By the end of 2001, when most "indicative rates" would go into effect, the disparity will be greater.
18. Abelson (2000), for example, presents results showing that many countries experienced an increase in the net settlement payments they received from U.S. carriers following reductions in settlement rates.
19. Early earnings on international message telephone service are presented in Stanley (1981), while Madden and Savage (1999) report more recent earnings.
20. The FCC advanced this argument when it adopted price caps. See FCC (1989). Subsequently, the FCC declared AT&T to be a non-dominant carrier in the provision of international service. See FCC (1996).
21. study by Ford (2000) supports a conclusion that reductions in settlement rates have led to lower calling prices for international service in the United States.
22. FCC has taken additional steps to promote accounting rate reform. It has, for example, approved asymmetric settlement rates, allowed ISR on many routes with benchmark rates, encouraged departures from the ISP, reformed the ISP, and allowed flexibility on transition paths to benchmark rates.
23. The figures are taken from Melody (2000).
24. U.S. international calling prices are generally significantly lower than prices charged by foreign carriers for calls to the United States. The Common Carrier Bureau conducted a study of calling prices to and from the United States and found wide disparities in prices. See FCC (1992). The disparity in prices apparently continues. See Peters and Donavan (1998). Significant price differences help to explain the surge in U.S. demand for such services like call-back, which has both increased the overall demand for international service and aggravated the U.S. traffic imbalance. Of course this type of service adds to the U.S. net settlement payments to other countries. And, of course, foreign carriers may lose some customer billings (that are partially offset by increases in the settlement payments they receive) as U.S.-billed calls are substituted for foreign-billed calls. Callback service is gaining in popularity, however, because foreign carriers charge monopoly prices that U.S. consumers can avoid by having their foreign-originated calls billed at U.S. carriers’ prices.

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