A Federal Communications Commission (FCC) order released April 27 may be the first step in tying up a loophole that is lucrative for competitive local phone carriers, such as Pac-West or Focal, but bad for consumers. The order centers around something called "reciprocal compensation."

When a Pacific Bell customer calls a California resident or business that subscribes to a competitive carrier, Pacific Bell must pay the second carrier a per-minute fee for completing the call. And when a call is made in the opposite direction, the competitive carrier must pay Pacific Bell.

The system has been relatively equitable for phone traffic, where calls flow in both directions and payments made between carriers end up canceling each other out. But when applied to Internet traffic, reciprocal compensation is no longer reciprocal.

That’s because Internet calls flow in one direction only. To log onto the Net, a subscriber dials up the phone bank of an Internet Service Provider (ISP), but the ISP never calls the customer back. With the majority of ISPs using the service of competitive carriers, the Bells have been forced to send a heavy, one-way stream of revenue to the competitive carriers for linking calls to the Internet.

Make no mistake, competitive carriers must be compensated for connecting Internet calls. But payments under the government-mandated contracts are set far above cost. According to analysts, it costs a carrier a mere one one-hundredth of a cent per minute to connect a phone call, and even less to connect an Internet call. Under California agreements, however, local carriers must shell out two-tenths of a cent per minute in reciprocal compensation. The system has been a drain on investment, forcing the Bells to pay out more money than they take in.

For example, under the current contracts, a California customer who spends eight hours a day on the Net would end up costing Pacific Bell roughly $30 each month—about $15 more than the company recoups from the customer in payment for his phone line. In the past year alone, the high connection price has caused the Bells to hemorrhage between $2 and $3 billion in payments for Internet calls.

For years, state public utilities commissions have been struggling with inter-carrier compensation policies for Internet traffic. But an FCC order released last Friday will wrench the issue from the states’ authority and place it squarely with the agency.

The FCC has ruled that calls to ISPs are interstate traffic, and, therefore, not subject to reciprocal compensation payments. Under the recent order, the agency will establish a three-year transition plan until it has worked out a more effective approach to inter-carrier compensation.

The order will cap fees on Internet traffic at 0.15 cents per minute for the first six months and at 0.10 cents per minute for the following 18 months. After two years time, the rate will be capped at 0.07 cents per minute.

The caps may help to minimize the risk of regulatory arbitrage in the short run. But if the FCC is wise, it will scrap the lopsided payment scheme altogether and institute a "bill and keep" plan, whereby carriers recover the costs of originating and terminating calls from their own consumers, rather than from each other.

Competitive carriers warn that eliminating reciprocal compensation payments would drive local phone companies to raise connection rates to ISPs, which would be forced to pass costs on to end users in the form of per-minute charges for Internet service. But a recent study by the United States Telephone Association (USTA) reveals a different story.

In states that operate without reciprocal compensation, flat-rate service remains intact and the difference in monthly dial-up ISP rates is minimal. Contrary to competitive carrier warnings, the termination of reciprocal compensation will benefit consumers by reactivating market forces.

To survive the change, local carriers will have to compete on product and price or be pushed out of the market. Instead of sending capital to subsidize competitors, the Bells will be free to invest their resources to boost competition.

The transition may be rough on some local phone companies at first. But in the long run, consumers will benefit from a market in which each carrier’s survival depends upon the goods and services it delivers to consumers, not on its ability to game its competitor through the system.