NTT's Lowered Interconnect Fees: The Beginning of the Beginning

As the ink dried on the documents heralding this tectonic shift in Japan's Internet landscape, pundits were predicting that the accord, worked out between American and Japanese trade officials just prior to the July G8 Summit in Okinawa, would help boost Japan's Net economy. "Lower interconnection rates will reduce Internet usage charges, meaning more consumer usage, more competition, and more access -- all pointing to a stronger Japanese economic recovery," says Thomas Logan, vice president of the Tokyo-based American Electronics Association. A Big Bang brought about by enhanced competition could ignite Japan's $130 billion telecom industry, leading to more employment, higher GDP growth, and increased competitiveness in the international arena, added Logan, much of which would spring from the ensuing tsunami of ebusiness in both the B2C and B2B sectors. "The potential for Japan's B2C market is huge, but telecom charges are the biggest barrier. This is the first step: NTT has to understand that lowering charges will benefit them -- it will create more users," says Fujiyo Ishiguro, the president and new CEO at e-incubator Netyear Group.

To see why the issue of interconnect fees has been so significant to Japan's Internet growth, consider that most industry watchers have long pointed to excessive telecom access fees as the biggest drag on Japan's Internet boom.

With NTT's ubiquitous infrastructure, Japan's high construction costs, and an archipelago already criss-crossed with a tangle of utility and telephone wires, new telcos here are not about to put their own lines into each and every Japanese household or office building. Hence most competing carriers' lines cover just the main distance of a voice or data call, and they pay to piggyback on NTT's wires to actually get to the customers' phones or computers. As the former national monopoly telco, NTT owns the nationwide network, including the so-called last mile segments running into households and offices. So other carriers usually pay two interconnect fees, one when the call is picked up at NTT's local switch, and another at the terminating area. Not satisfied with gouging the consumer by billing ¥10 for three-minute local calls, NTT has extorted bucketfuls of cash from its would-be competitors by charging them four times the going rate in the US to interconnect to its lines.

So whether it's a consumer or small business making a voice or Internet dial-up access call, or a competing telco trying to resell bandwidth to its own corporate or individual customers, NTT is the unavoidable gatekeeper who earns a slice of virtually every call made in Japan. The high fees that NTT charges, combined with the expensive monthly fees that ISPs demand, has meant that Japanese surfers have long faced the world's highest aggregate cost of going online. (Ironically, this is a major factor behind Japan's ascendancy in the wireless Net access arena, where the fee structure is significantly more competitive. See "Unwired," page 26, June 2000.) "Higher Internet access charges have thus far hindered the development of information industries in Japan. Lower interconnect rates are central to deregulation measures that will allow Japan to quickly take her place among the leaders of IT-driven economies," maintains corporate communications manager Rowena Kwon of WorldCom Asia Pacific.

Under the agreement worked out in July, NTT will lower its interconnect fees 22.5 percent over three years starting in April 2000, with 90 percent of the cuts to be made by 2002. Additional cuts in local and regional charges are anticipated after that, for total expected cuts of at least 41 percent. Though the media portrayed the 22.5 percent cut as the "Japanese side" and a 41 percent cut as the "US side," in fact these were models A and B as proposed by Japan's Ministry of Posts and Telecommunications (MPT), based on its own studies. The spread between the two proposals highlights the accounting morass involved. "The difference comes from calculating to what extent to include fixed costs," says Shinji Moriyuki, a telecom services analyst at the Daiwa Institute of Research. And this is really the crux of the matter. Depending on which side you're on, NTT is either a bloated behemoth passing on the costs of its inefficient business practices, or a company providing vital national services and therefore in need of public support.

Though the negotiations culminated with an adjusted version of the lower Plan A, international observers and the US government hailed this as a positive first step. In fact, the 2002 cuts will be greater than 22.5 percent, as Japan later agreed to use updated traffic data from FY99 instead of FY98 (such data was used in determining the size of the reductions), leading to an actual reduction of some 28 percent. "These talks were a triumph of substance over form. For them it was important to say, 'Three years, 22.5 percent;' for us it was important to get the biggest reduction possible and the leverage to make sure the rates can change again in 2002," says one US official familiar with the negotiations.

Negotiations notwithstanding, until 2002 the interconnect fees charged to other carriers here will still remain substantially higher than in the rest of the world. "In the US, local interconnect fees are well under a half-cent per minute, and a lot are down to 0.1 cent per minute. Long distance is down to 0.55 cents per minute," claims the US official. By comparison, Japan's local fee in FY99 was ¥5.57 (5 cents) for 3 minutes, and the regional fees were an astronomical ¥10.64 (10 cents). According to one source, some new carriers spend 80 percent of what they charge their users just to cover NTT's exorbitant interconnect rates. "NTT's too expensive, and it's been funded by our taxes," complains Aoki Daiichi, head of marketing at the ISP PSI Net. American trade officials agree and have for years claimed that the fees are just one more non-tariff barrier to foreign competition.

Not surprisingly, a major issue in the negotiations was NTT's methodology for calculating its interconnect fees, which it currently does by adding a "reasonable" margin to the cost of service. But as a member of the World Trade Organization, Japan has committed to the Agreement on Basic Telecommunications, which advocates the pro-competitive Long-Run Incremental Costing (LRIC) model. The WTO agreement says that interconnect rates shouldn't be based on the historical cost of building existing infrastructure, but on the LRIC model instead. The distinction is an important one. If a competing telco wants to lay fiber optic cables to a consumer's house, does it have to reimburse NTT for having placed the telephone pole in front of the house back when the national network was built, or can it assume that the pole is there and already paid for, and so only pay to add one more cable?

For most of NTT's competitors, the fee methodology is the heart of the issue. Of course, NTT doesn't feel especially compelled to make the details of its calculations public. "The most important thing for us is that NTT disclose its financial information. It's like a black box. We cannot do a cost analysis of NTT's access charges; we can't say whether they're appropriate or not," complains Haruhiko Maeda, PR chief of international long-distance carrier KDD (scheduled to merge with major long-distance and mobile carrier DDI later this year). This opacity keeps anyone from knowing how the giant allocates costs to services, and so NTT is free to set access charges as high as it wants. What's NTT's response to complaints like Maeda's? "We calculate these charges according to the MPT's guidelines," spokesperson Testuro Ushimaru says.

The interconnect fees also have a symbolic significance for foreign enterprises and governments, and, perhaps more importantly, domestic entrepreneurs. "If NTT won't allow competition in this area, why would Japan allow it in any other area?"

Which raises the question of the relationship between NTT, the regulated industry giant, and the MPT, the government regulator whose objectives are not always apparent. While US regulations set out to encourage competition, in Japan the situation is quite different, having been described as "overregulation of new entrants, underregulation of the dominant carrier." New carriers are burdened with requirements for official permission from the MPT for seemingly inconsequential aspects of operations. "The MPT should have a mandate to promote competition, and it should have the authority to make these decisions, even if they're hard," says a source requesting anonymity. "We're finding in Japan that the MPT doesn't have either. It doesn't seem to have the clout; it can't force NTT to set certain rates. The care and effort that the MPT takes over NTT's profitability is not regulatory independence." Adds a US embassy official also requesting anonymity: "The MPT thinks its job is to protect NTT. The MPT looks at us and says, 'If we do this, NTT will lose money. We can't do that.'"

During the recent negotiations, the US side rooted for an earlier implementation of Plan B (41 percent cuts), but the Japanese side countered that such a move would cost NTT ¥700 billion in foregone revenue and force it to lay off thousands, sentiments that were echoed by NTT's political friends in Japan's ruling Liberal Democratic Party. Unfortunately for NTT and its political cronies, NTT's two regional carriers reported generous profits for the year ending March 31, and the government became worried that the dispute would mar the G8 Summit. When the telecom negotiations stalled in the final week before the summit, deputy US trade representative Richard Fisher successfully tapped political connections outside the MPT to get the ball rolling again.

NTT still maintains a market share exceeding 90 percent of all regional voice and data communications, translating to nearly 60 million subscribers. The other 7 percent is all the other competitors -- an astonishing 8,000-plus enterprises -- put together. Nonetheless, throughout the negotiations, NTT loudly lamented the enormous losses its two regional carriers (NTT East and NTT West) would incur if the interconnect rates were slashed -- about ¥242 billion by 2002, according to NTT's Ushimaru. NTT's mathematics seem intended to inspire terror in the hearts of its stockholders (including, quite significantly, the Ministry of Finance -- see sidebar), but some say the company's calculations are simplistic -- as in, a 22.5 percent cut in interconnect fees equals a 22.5 percent decrease in revenues. The law of supply and demand points to lower costs stimulating demand, and analysts generally agree that the increased traffic on NTT's lines will absorb the shortfall. Meanwhile, NTT's recent record-breaking gains and aggressive overseas acquisitions have hardly gained it a sympathetic audience.

At the behest of all parties concerned, the MPT is now deliberating revision of the NTT Law, created in 1987 when the former monopoly was privatized. The dominant carrier says it asks for just two things in any revision: first, a discussion of "universal service," under which NTT is obliged to provide uniform telecom services to every resident in the country. NTT blames this ambiguous clause -- devised before the advent of data transmission -- for slowing its pursuit of new data communications and broadcast media business opportunities. In the future, says NTT spokesperson Ushimaru, voice services will probably remain universal, but Internet and other services may vary according to location. Industry watchers here point out, however, that the company already offers flat-rate high-speed ISDN access to urban centers only.

The telecom giant's second request is less government control and more access to international capital sources. The NTT Law stipulates that the Japanese government must hold more than one-third of the company's shares; non-Japanese may hold no more than 20 percent of the company; and the MPT must approve any new stock issues. Wielding its majority interest, the government appoints NTT officials and restricts the company's global competitiveness against US and European telecom giants, which were deregulated in the early 1990s to promote growth. "If NTT were a private company, it would be easy to manage; we would be free to sell stock, manage, and raise capital," Ushimaru says.

At this stage, how the revised law will turn out is anyone's guess, though the expectations and stakes are high. "The discussions on revising the NTT Law should be fair," says Mitsuhiro Kurano, PR head of Japan Telecom, one-third of which is held jointly by AT&T and British Telecom. We are asking that we be able to use the local network, gain access, and use facilities under the same conditions as NTT." He concedes, however, that this is unlikely to happen.

Interconnect fees and the NTT Law are just the tip of the iceberg for an industry that by almost all accounts is in desperate need of a massive overhaul. Deregulation would result in lower rates, faster data transmission speeds, and a wider range of services, which in turn would promote greater expansion of the entire IT market. Despite appearances, the US has not been a lone voice in the woods bullying Japan to revamp its telecom industry. Communications analyst Takayuki Tsutsumi from Tokyo Securities notes that everyone from DDI, Japan Telecom, Keidanren, and Softbank to foreign embassies and telecom interests have been lobbying for change.

To his credit, in late July MPT Minister Kozo Hirabayashi requested that the ministry's advisory Telecommunications Council consider a complete restructuring of the regulatory framework, boding a monumental shift in policy. At present, MPT regulations are centered -- somewhat puzzlingly -- around whether a telecom carrier owns their own lines (Type 1) or rents them (Type 2). In the US market, by contrast, carriers regularly mix and match lines (owned or rented) to best suit the market, business phase, or demographics. In Japan, the MPT is making some voluntary adjustments, but carriers must still toe the red tape line, and get its approval about how their network is put together.

There is talk of the MPT further splitting NTT to help break its vise-like grip on Japan's telecom industry. But even if this occurs, with the worldwide trend toward mega-companies, some ties between the progeny are likely to be permitted in the name of international competitiveness. On the other hand, Japan Telecom's Kurano alleges that regional carriers NTT East and NTT West are seeking a merger, which his company adamantly opposes for fear of a new monopoly.

More rumors are flying about whether NTT Corp. will sell some of its NTT DoCoMo shares (it holds a 67 percent interest in the wireless operator) to cover its interconnect losses. The humongously profitable cell phone company makes up more than 80 percent of NTT Corp.'s profit base, according to Tokyo Securities' Tsutsumi, who notes that the MPT and the Liberal Democratic Party have called for NTT to reduce its stake to less than 50 percent. In early June a study group of the Japan Fair Trade Commission made the same recommendation, saying it would encourage competition in the cell phone services industry. Somehow these appeals have fallen on deaf ears. "DoCoMo is one company, NTT West is one company, and NTT East is another. It would be difficult for tax reasons," NTT's Ushimaru avows. "People have been talking about it, but there has been no formal proposal made to NTT."

With other major telcos -- Japan Telecom, DDI, WorldCom -- talking about entering the local market with cut-rate prices, landline Internet use is poised for explosive growth. The promise of fairer competition is likely to invite increased investment in Japan's telecom and e-business sectors, which means more services becoming available at more competitive rates, and a faster-growing community of ISPs and Internet backbone providers like Level 3 and Global Access. This is big news in the land of the rising sun; here, despite a dizzying plethora of new entrants into the market, unfavorable market conditions have seen investment in telecom services decline each year since fiscal 1997 -- a phenomenon unmatched in the rest of the industrialized world.

Lowered access charges mean that the ISP fees can also come down, crucial for Web users to spend more time online, explains Internet analyst Thomas Rhodes at Nikko Solomon Smith Barney. "It takes time to find what you want to buy online, and to buy it. If you have an expensive meter running while you're online, you're not likely to do it." He cites the quantum leap in Internet usage that took place in 1996 when America Online switched to its flat-rate charge structure as a portent of what could happen here. "People went from spending 14 to 16 minutes online a day to two hours a day. Basically, people went from using email to surfing the Net." (In Japan, email remains the most effective online marketing tool, as this magazine pointed out in its July issue. See "Meru Maga Mania," page 33, July 2000.)

The lower access rates also bode well for free ISPs that, like Freebit.com, have struck revenue-sharing deals with NTT: with the lower interconnect rates, NTT is watching its revenues go down for every three minutes of time spent online. To make up for this, it needs to make traffic go up, or get more people to go online. How to achieve this? With free ISP service, maintains Rhodes. ISP operating costs consist of the access rates they have to pay to NTT, and their revenue is online advertising. With lowered access rates, ISPs' operating costs will go down, and their path to profitability is clearer.

For every three minutes of online time that the ISPs create, NTT still gets its 10 yen basic charge, out of which it notionally pays the ISP about three yen. "That basically covers the new, lower access charges. So now the ISPs have revenues and costs that almost match. The advertising is gravy." So far NTT is sticking with less threatening, smaller companies, says Rhodes, rather than with any potential competitors. Naturally, other carriers are trying to strike the same type of deals. "But the Japanese haven't got their minds around the fact that free ISPs can be money-makers."

Why is it taking so long for NTT to figure out that cheap, fixed-rate charges could make business boom? "Monopolists are never good at understanding the elasticity of demand. Basically, they're not good at pricing," Rhodes deadpans.

Sure enough, NTT's fixed-rate ISDN service was introduced in limited parts of Tokyo and Osaka a year ago for a pricey ¥8,000 a month, though in May it was lowered to a just-bearable ¥4,500 a month in those two cities. NTT East and NTT West have also introduced two typically overcomplicated plans ("i-aiplan") that combine a fixed rate with volume usage, to offer more than 50 percent savings on telephone charges for 15 or 37.5 hours a month of Internet usage. This may be small change compared to the price slashing going on in the rest of the world's telecom sectors, but for Japan's long-suffering Web surfers, it's a respectable start.

Related Stories:
Unwired, June 2000
Meru Maga Mania, July 2000