Out of Control

Conventional wisdom says rural areas cost so much to build out, and offer so little return, that enterprises beholden to shareowners will see no profit in extending broadband infrastructure to remote towns and regions.

Penetration is indeed higher in urban and suburban areas than rural areas. But while rural penetration lags, it’s not declining or even flatlining. From 2001 to 2007, according to the Pew Internet and American Life Project, rural broadband penetration increased from 5 percent to 30 percent.

Hence rural grew six times—from 1 in 20 households to 6 in 20. Over the same period, city and suburban broadband grew five times, from 1 in 10 to 5 in 10.

Despite this growth, broadband penetration in rural areas could be better. But to set conventional wisdom on its ear, it could be that rural penetration is at only 30 percent because of government programs, not due to a lack of them.

If you listen to those who suggest we adopt broadband subsidy programs similar to those in Europe and Asia, you’d believe the federal government is doing nothing. That’s not true. There are numerous government programs, run by several cabinet level agencies, geared toward funding telecommunications infrastructure and applications in high-cost areas.

This starts with the $6.8 billion Federal Universal Service Find (FUSF), amassed from a federal surcharge on all wireline, wireless, and Internet phone lines. And there are numerous other programs, such as the Department of Agriculture’s Rural Utilities Services, loans and block grants from the Departments of Commerce, Education, Homeland Security, and Housing and Urban Development, and several federal-state partnerships.

The real question, then, is how well they are being administered. Economist Thomas Hazlett calculated you can take the $7 billion the FUSF spends in one year and buy a satellite phone for every household without a phone and have plenty left over.

The FUSF is an easy target, but it’s not the only program that raises questions. The core problem is that huge subsidies are flowing to large rural companies who have a vested interest in maintaining expensive, older facilities in order to extend depreciation periods. This is leading to a dangerous dependence on a business model that requires subsidies, as opposed to real equity, to bolster company value.

This table shows some of the top telephone holding companies that serve rural areas. The biggest, Embarq, a spin-off from Sprint, did $6.3 billion in revenues in 2006. Of those revenues, $228 million came from the state and federal USF funds. Embarq had net earnings in 2006 of $784 million.

Do the math and you’ll see 29 percent of its profit came from government USF receipts. Move down the list and you see how USF simply pads the bottom line on most of these companies. Is the government subsidizing broadband or shareowner equity?

With the exception of one company in the chart (Consolidated Communications Holdings, a situation that raises questions in and of itself), if the subsidies were taken away these firms would still be profitable. Maybe not as profitable, but profitable. And then, maybe, they would start looking for ways to grow revenues in line with the actual market appeal of their services.

And therein lies the point. Government subsidies are inherently misallocated capital. Generally, the rationale for a subsidy comes when the government decides that an essential product or service can’t be delivered by market mechanisms. It is an intentional diversion of capital to fill a gap between what a service costs to provide and what an average citizen can afford to pay.

In doing so, the government takes available capital away, either as tax, or a loan at below-market interest, from investments that, in a totally free market, would yield more productive returns in the long term. That’s the societal trade off, but the loss in productivity gain is often not calculated into the subsidy equation. Policymakers should think about it, however, especially in telecommunications, where the pace of technological change makes business models particularly prone to disruption.

By all signs, in three to five years the market stands to deliver much greater value from the investor dollars government leaves, than what it can deliver from tax dollars it takes. We already have examples, reported on here and here.

Technologies such as WiMax and Broadband over Power Lines aren’t commercial yet, but established patterns suggest when they are these technologies will eclipse the cost and capabilities of conventional wireline and DSL in rural areas—and deliver profit for investors. But government must be careful not to confuse the protection of rural consumers with the protection of rural holding companies.

If, as the worriers say, the U.S. risks losing global leadership in broadband growth, then less government, not more, is the answer. In the IT and telecom sector, only transport companies are regulated and subsidized. All other segments compete freely.

In each of the competitive areas, the leader is a U.S. company—software: Microsoft; search engines: Google; IP infrastructure Cisco; e-commerce: eBay; Web-based media: Apple; Internet servers: HP, Sun, Akamai, and IBM.

Look at what this industry, when left unregulated and driven only by their need to attract willing investors, has accomplished. Isn’t it time we extended the same freedom to the service provider sector?