New England Law Review: Volume 48, Number 1 - Fall 2013

Creamskimming and Competition

JIM CHEN*

[48 New Eng. L. Rev. 7 (2013)]

INTRODUCTION

The concept of creamskimming routinely arises in the law of regulated industries. As a rhetorical weapon, the term creamskimming readily conjures images of putatively destructive competition, the precise phenomenon that regulatory commissions are charged with patrolling. As a result, allegations of creamskimming have become a standard weapon in the legal arsenal of incumbent firms seeking to resist competitive entry. At an extreme, incumbent firms will characterize all forms of competitive entry as creamskimming. Sound regulatory responses to these allegations therefore depend on a proper understanding of the creamskimming concept.

This Article proposes a definition of creamskimming that will help state and federal regulatory agencies distinguish genuine objections to proposed competitive entry from reflexive (and often improper) efforts to shield incumbent firms from competition. Creamskimming should be defined as the practice of targeting only the customers that are the least expensive and most profitable for the incumbent firm to serve, thereby undercutting the incumbent firm’s ability to provide service throughout its service area. Moreover, regulatory approaches to this practice should make clear that creamskimming can occur only when a competitive firm proposes to serve only a portion of an incumbent firm’s service area. In other words, when a competitive entrant proposes to serve an incumbent’s entire service area, creamskimming by definition cannot occur.

I. Creamskimming Across the Historical and Regulatory Landscape

In 2008, the Regulatory Commission of Alaska set forth a definition of creamskimming in connection with proposed regulations governing the designation of eligible telecommunications carriers (ETCs) under section 214(e) of the Communications Act of 1934.¹ ETC designations under section 214(e) hold the key to competitive entry in areas where high costs, low incomes, or both prevent carriers from serving all customers in the absence of universal service subsidies.² The Regulatory Commission defined creamskimming as the practice of targeting the customers that are the least expensive to serve, thereby undercutting the incumbent local exchange carrier’s ability to provide service throughout the area.³ The Commission’s proposed definition omitted several crucial details. First, because creamskimming undermines the income stream of an affected carrier, the definition of that practice must include not only low cost but also high profit. Second, a proper creamskimming analysis must focus on the incumbent carrier’s costs and revenues, rather than the financial terms on which a competitive carrier proposes to enter a contestable telecommunications market. Finally, the service area at issue in an appropriate creamskimming analysis is the study area served by an incumbent rural telephone company.⁴ All three of these considerations should be reflected in the Commission’s definition of creamskimming so that evaluations of alleged instances of this practice will accurately identify and remedy behavior that undermines universal service goals. I therefore recommend that regulators define creamskimming as the practice of targeting only the customers that are the least expensive and most profitable for the incumbent local exchange carrier to serve, thereby undercutting the incumbent carrier’s ability to provide service throughout its study area.

Creamskimming emphatically is not synonymous with competition. Whereas competition is a socially desirable and legally privileged economic practice, creamskimming is a very specific behavior with potentially negative consequences. As Alfred Kahn recognized in The Economics of Regulation, a treatise whose analysis of creamskimming remains the definitive scholarly treatment of the subject, parties seeking to ban the practice often use the term cream-skimming to the exclusion of the more accurate term competition, evidently choosing the more colorful designation . . . because it has a more negative connotation.⁵ Regulators must therefore take care to distinguish robust, lawful competition from creamskimming as a special kind of rivalrous behavior that may indeed produce a special kind of undesirable result.⁶

The use of the term creamskimming in legal proceedings apparently originated in Panhandle Eastern Pipe Line Co. v. Michigan Public Service Commission.⁷ Appellant Panhandle, an interstate gas pipeline company, launched a program to secure for itself large industrial accounts from customers . . . already being served by the Michigan Consolidated Gas Company, a local distribution company franchised under Michigan law.⁸ The Supreme Court of the United States refused to grant Panhandle a purported right to compete for the cream of the volume business within Consolidated’s customer base without regard to the local public convenience or necessity.⁹ The Court expressed particular concern that Panhandle’s selective targeting of the local gas utility’s most lucrative customers would no doubt be reflected adversely in Consolidated’s overall costs of service and its rates to customers whose only source of supply is Consolidated.¹⁰

Since Panhandle’s original articulation of the creamskimming principle, judicial treatments of this concept have reached a stable consensus across a wide range of regulatory settings, jurisdictions, and historical periods.¹¹ Federal and state authorities have consistently recognized four distinct and indispensable elements of creamskimming.¹² This practice consists of (1) exclusively targeting only a fraction of customers (2) who are served by an incumbent utility (typically a franchised monopolist) and who are both (3) low in cost and (4) high in profit from the perspective of the affected incumbent. The United States Court of Appeals for the District of Columbia Circuit succinctly summarized these principles in its characterization of the Private Express Statutes¹³ as having been designed specifically to prevent private mail services from ‘cream-skimming’ the most profitable mail services by undercutting the Postal Service on low cost, high-profit routes, thereby leaving the Service with less revenue to fulfill the requirement of providing service throughout the nation at uniform rates.¹⁴ Creamskimming, in postal regulation as elsewhere, consists of [l]imiting entry to lucrative markets, while neglecting low-profit markets, to the detriment of other regulatory goals, such as uniform ratesetting or universal service.¹⁵

Federal and state courts have repeatedly emphasized these same elements—the exclusive or primary targeting of a regulated incumbent’s low-cost, high-profit customers in such a way as to undermine the incumbent’s ability to cross-subsidize other interests or services—in a wide area of other regulatory contexts. These cases span a regulatory spectrum covering waste disposal, cable television franchising, natural gas transmission and distribution, railroad reorganization, maritime transportation, health care and health insurance, and public education.

A. Waste Disposal

In the context of waste disposal, the Ninth Circuit has observed that [c]ream-skimming occurs when an unregulated business offers low rates to attract those customers who are the least costly to service, leaving the regulated companies to service the remaining customers.¹⁶ When this practice takes place within service territories where state regulators attempt[] to ensure universal service at reasonable rates by issuing certificates . . . and by regulating rates,¹⁷ private opportunistic behavior undermines regulatory efforts to ensure that certified carriers remain financially able to serve all of their customers.¹⁸ In this setting, creamskimming disrupts the regulatory strategy of allowing access to more profitable, densely populated areas as a way to subsidize service to rural areas.¹⁹

Along similar lines, a federal district court in West Virginia has observed that [c]ream skimming results when a new entrant provides service ‘to only the users in the high population density [low cost] areas, with the incumbent left to provide service to users in the low population density [high cost] areas.’²⁰ This sort of conduct, properly described as creamskimming, jeopardize[s] the concept of universal service and produce[s] higher rates for the remaining customers of the certified waste hauler.²¹

In A.G.G. Enterprises, Inc. v. Washington County,²² the federal district court for Oregon recognized that creamskimming can take place when a waste hauler targets the most profitable jobs, those for commercial customers, to the exclusion of service [for] less profitable residential customers.²³ Critically, A.G.G. Enterprises recognized that such creamskimming takes place within the[] exclusive territories for which haulers receive certificates of public convenience and necessity.²⁴ Universal service through rate regulation remained the paramount governmental interest: All rates are regulated so that services the County and the City deem essential, such as less profitable residential recycling, are provided to all customers while haulers maintain a reasonable profit margin.²⁵

B. Cable Television Franchising

In City Communications, Inc. v. City of Detroit,²⁶ the City of Detroit expressed great concern over cream skimming, which the Sixth Circuit described as the practice (in its extreme) of installing cable service in affluent subdivisions, where installation costs are low, equipment damage is minimal and customers typically order extra services and pay their bills regularly, and slighting inner-city areas.²⁷ If left unchecked, creamskimming threatened to unravel Detroit’s decision to award a single, city-wide non-exclusive franchise as a means of ensur[ing] that the franchisee could and would provide equal services to all residents.²⁸

Although other franchising cases have recognized that cable operators may be inclined to serve more affluent, and therefore more profitable, portions of the franchise area,²⁹ courts have not consistently concluded that competitive operators have engage[d] in the prohibited practices of ‘cream skimming’ and ‘redlining,’ that is, operating in the most lucrative markets while avoiding the burden of building in less lucrative markets.³⁰ For instance, the Connecticut Supreme Court has acknowledged but ultimately rejected an argument by incumbent cable operators that Connecticut regulators had allowed a competitive operator to engage in creamskimming by operat[ing] first in less densely populated regions where higher incomes prevail.³¹ Likewise, the Ninth Circuit, despite acknowledging municipal governments’ asserted interest[] in preventing ‘cream skimming’—wiring only affluent, and therefore more profitable, portions of the franchise area—ultimately declined to accept that interest [o]n the present state of the record before it.³²

C. Natural Gas Transmission and Distribution

Contemporary allegations of creamskimming have arisen in the context that sparked the 1951 Panhandle controversy. In the immediate wake of the D.C. Circuit’s 1989 decision in Michigan Consolidated Gas Co. v. FERC (MichCon),³³ which upheld the Federal Energy Regulatory Commission’s issuance of a certificate of public convenience and necessity for direct transportation of gas from an interstate pipeline to an industrial customer,³⁴ similar requests to bypass local distribution companies and their state-law regulators prompted many charges of creamskimming.³⁵ Even before MichCon effectively deregulated direct sales of natural gas by pipelines to industrial customers, the D.C. Circuit anticipated the variety of powers by which state regulators can control the risk of bypass of a local gas distribution company and any resulting effort by pipelines to skim the cream from among a distributor’s customers.³⁶ Persuaded that unrestricted entry of interstate pipelines into [their states] for the purpose of ‘cream skimming’ major industrial customers does significant harm to remaining captive customers,³⁷ state regulators remain committed to the consideration of the economic impact of . . . ‘cream skimming’ operation[s] upon the regulated rate structure in selling only to the most profitable large customers of public utilities.³⁸

Despite the tools available to regulators, bypass and creamskimming continue to pose significant challenges to state public utility commissions. The observations of the Delaware Supreme Court are apt:

It is impossible for the Public Service Commission to monitor and effectively control the extent of competition in the provision of traditionally regulated commodities if an unregulated firm with no obligation to serve all similarly situated customers and without a general obligation to provide service to all who require it in a specific territory can essentially enter the public utility business and cherry pick or cream skim away the existing utility’s highest volume customers.³⁹

D. Rail and Maritime Transportation

Forms of surface transportation with highly variable classes of customers, each with different elasticities of demand, access to alternative modes of transport, and service cost profiles, invite creamskimming—or, at the very least, allegations of creamskimming. The challenges of regional rail reorganization⁴⁰ prompted one special court to opine at length on creamskimming:

The [government parties’] further response to the [terminals’] passenger cases is a variant of their general argument that, so long as substantial profits were projected on the main freight lines, public bodies would have refused to buy any lines on which those profits were dependent. Just as public bodies would have opposed the erection of an artificial firewall between the main freight lines and the predominantly freight lines in the [joint terminals], so would they have resisted the establishment of an inner firewall between privately owned, profitable freight lines and publicly owned, losing passenger lines. Rather than acquiesce in such cream-skimming, public bodies would have sought to persuade the private purchasers of the [terminals’] main freight lines to buy and operate the passenger properties as well. If necessary, public bodies would have offered to raise their passenger service subsidies above the avoidable cost level. If that effort failed, states would have proceeded to petition the ICC to condition approval of a sale of the main freight lines on inclusion of [the terminals’] passenger properties.⁴¹

Maritime transportation poses very similar issues.⁴² As long ago as 1966, one federal court observed, with respect to an order permitting a steamship carrier to double its California-Hawaii sailings, that although States would offer available service for some high profit cargo, there was no basis to conclude that States would (in its increased California-Hawaii service) engage in an extensive ‘cream-skimming’ operation to Matson’s detriment.⁴³ In a dispute over passenger ferries, a Rhode Island court addressed creamskimming allegations in far more colorful but substantively comparable terms:

New Shoreham and Interstate claim that this Court cannot allow Hi-Speed Ferry to cream-skim customers from Interstate with its peak-season, passenger-only ferry. Cream-skimming occurs when common carriers, finding themselves either losing or suffering reduced returns on the profitable part of the business [are] forced increasingly to subsist on a diet of skimmed milk [and] will be unable to carry on in the thinner geographic and seasonal markets, with consequent destruction of service to large areas of the country and bodies of customers.⁴⁴

E. Health Care and Health Insurance

Health care is rife with allegations of cross-subsidization across classes of patients differentiated by their wealth and their willingness or ability to pay. In health care delivery, as in other industries, [c]ream skimming is a common phenomenon in which private providers primarily target good-risk individuals.⁴⁵ The sorting of patients within the health care industry exacerbates itself over time as hospitals, physicians, and insurers are all divided into starkly contrasting camps, pitting relatively healthy and wealthy patients against their sicker, poorer counterparts.

The effect of this specialized care delivery model on traditional primary care practices may be to remove some patients and services from the doctor’s office, leaving a sicker population behind.⁴⁶ Whenever physicians engage in ‘cherry-picking’ or ‘cream skimming’ the most profitable patients away from full service community hospitals, those hospitals find it increasingly difficult . . . to cover their costs in providing the community’s full array of needed services, including charity care, emergency services, [and] standby capacity required for community disaster response.⁴⁷ Creamskimming ultimately jeopardize[es] the ability of hospitals to make facility improvements and keep up with new technology.⁴⁸ For similar reasons, nonprofit hospitals, private and public, harbor considerable antipathy toward proprietary hospitals, regarding them as ‘cream skimmers’ who lure away the affluent patients that nonproprietary hospitals need to defray the costs of serving the less affluent.⁴⁹ Primary care physicians likewise perceive ‘cream skimming’ [as] a threat to their revenue, particularly if they rely on income from short appointments for simple cases to subsidize the cost of more time-consuming appointments for more complex cases.⁵⁰

The ultimate expression of creamskimming in health care lies in the market for health insurance. When insurance companies compete by ‘cream-skimming’ the good risks and shutting out the bad risks, they destroy the safety net that insurance is supposed to provide.⁵¹ Though understandable as a natural defensive reaction to adverse selection,⁵² cherry-picking or creamskimming by health insurers threatens inadequate coverage for individuals with poor health, modest means, or both. It is no stretch to describe the landmark Patient Protection and Affordable Care Act, especially its controversial individual mandate that all individuals acquire health care coverage, as an exercise in deflecting the effects of creamskimming on health insurance and on the health care industry at large.⁵³

F. Public Education

The provision of primary and secondary schooling, perhaps the most important function of state and local governments,⁵⁴ has also witnessed its share of creamskimming. In this context, the line of demarcation between haves and have-nots is drawn in terms of race and class:

Bluntly stated, the Tenafly Board has adopted a tuition policy which has the clear effect of enticing white and Asian students away from a nearby public high school already experiencing racial imbalance, thereby contributing to a polarized situation. To accomplish its own ends, the Tenafly Board has instituted selective admissions requirements, including what is tantamount to an income test since only those who can afford to pay are eligible for admission. In what could accurately be called cream-skimming, the Tenafly tuition policy achieves its intended purpose by attracting more highly motivated and academically competent students from its neighboring school district, at the expense of educational quality at DMHS.⁵⁵

In short, definitions of creamskimming in the broader body of regulatory law emphasize a wide range of factors, including both low cost and high profit, often seen from the incumbent utility’s or carrier’s perspective, as indispensable elements of creamskimming. If anything, most authorities regard the incumbent’s revenue as the centerpiece of creamskimming analysis. Against this backdrop, to define creamskimming through an indefinite reference to the customers that are the least expensive to serve is not only substantively misguided, but also exceptionally lazy. Decent regulation deserves better.

II. Creamskimming in Telecommunications Law

A. Creamskimming Controversies Before the Telecommunications Act of 1996

Creamskimming figures very prominently in telecommunications precisely because this industry, by virtue of its economic circumstances and regulatory history, is uniquely susceptible to suppression of competition by incumbent firms. Definitions of creamskimming are consistent with the treatment of this phenomenon in other regulated industries. Creamskimming arguments frequently arose during the decades-long struggle to reconcile conventional rate design with competition for telecommunications services, especially long-distance carriage. Indeed, two of the most important early long-distance decisions by the Federal Communications Commission (FCC) are the celebrated MCI orders that opened the door to facilities-based competition against the original Bell monopoly.⁵⁶ These decisions hinged on the FCC’s characterization of specialized point-to-point, private line carriage over microwave radio systems as permissible and desirable competition, as opposed to unlawful creamskimming.⁵⁷

For much of the quarter-century after MCI, the Bell system contended that its competitors [would] concentrate their intercity services on routes where the volume of business is high and the costs of service are low.⁵⁸ The Bell operating companies alleged that specialized carriers without general service responsibilities would ‘cream-skim’ the [incumbents’] existing averaged rate structure by selectively competing only along the most profitable long distance routes, thus imposing a heavier rate burden on low density and local telephone users.⁵⁹ Competitive entry into these contested markets often proceeded on the strength of arguments that competitive carriers offered new services, proposed to serve all affected customers, and in all events posed no material threat to the core business of Bell affiliates.⁶⁰

The contemporary approach to creamskimming in telecommunications regulation builds on foundations laid throughout the law of regulated industries. [P]romot[ing] competition, after all, was the first of many statutory promises made by the Telecommunications Act of 1996.⁶¹ Extensive legislative reform has shifted the focus of creamskimming analysis in telecommunications after 1996 from the regulatory concerns that prevailed before the breakup of the Bell system to modern methods of sustaining universal service.⁶² Any regulatory definition of creamskimming should likewise reinforce the 1996 Act’s emphasis on competition, innovation, and universal service.⁶³

Historic definitions of creamskimming assumed that cross-subsidies within a protected incumbent’s rate structure would finance universal service.⁶⁴ Traditional rate structures extracted a disproportionate share of joint costs from certain customers.⁶⁵ Creamskimming allegations before 1996 hinged on the FCC’s endorsement of national rate averaging in the interest of promoting the goal of universal service.⁶⁶ AT&T blamed creamskimming on the system of rate-averaging that calculate[d] rates on a per-mile basis regardless of demand for service over a particular route, and regardless of differences in costs over different routes.⁶⁷ Until its dissolution, the Bell system contended that competition would harm consumers by raising prices and undermining universal service.⁶⁸

The Bell system’s complaint, if not legally meritorious, was at least factually accurate. National rate averaging at once invited and justified competitive entry. Alfred Kahn recognized that MCI entered long-distance telephone markets in response to national average-cost pricing policies.⁶⁹ To the extent that profitable lines of business, such as backup and interconnection services[,] had previously been subsidized by revenues from the portion of the business that MCI tried to serve, MCI’s decision to enter, far from meriting the derogatory label of cream-skimming[,] represented a healthy competitive reaction to an improperly discriminatory rate structure.⁷⁰

Creamskimming arguments in favor of monopoly-based rate structures persisted beyond the Bell breakup. For instance, the Florida Supreme Court in 1987 upheld toll monopoly areas granting incumbent carriers exclusivity over short-haul intra-LATA (intra-local access and transport area)⁷¹ toll calls within Equal Access Exchange Areas,⁷² ostensibly out of concern that interexchange carriers might ‘cream-skim’ the most profitable, high volume routes while still leaving the LECs [(local exchange companies)] with the obligation to provide uniform service to all customers and to average rates statewide in order to ensure relatively inexpensive local service to all customers.⁷³

B. Creamskimming Under the Telecommunications Act of 1996

Traditional rate design attempted to guarantee universal service by enabling an incumbent utility to cross-subsidize unprofitable services through revenues from creamy customers rendered captive not so much by market forces, but by law.⁷⁴ Creamskimming arguments figured prominently in disputes over competitive entry, particularly in markets perceived to be rich in revenues needed for cross-subsidization. Any diversion of revenue from low-cost customers to competitive carriers would drain the pool of revenue that could be used to guarantee universal service.⁷⁵ But this observation simply restates a larger and more important point: creamskimming is primarily an artifact of rate structures that use internal cross-subsidies to finance universal service and other regulatory goals. The apparent creaminess of disfavored customers is an artifact of conventional rate regulation, a by-product of internal cross-subsidization. This is the sense in which cream-skimming is caused . . . by regulation, and not by greedy, profit-maximizing private companies.⁷⁶

The Telecommunications Act of 1996 fundamentally altered conventional methods of financing universal service in telecommunications.⁷⁷ This transformation of universal service mechanisms in telecommunications alleviated (but did not eliminate) creamskimming concerns. The shift to a universal service mechanism based on a competitively neutral, external source of subsidies demands very close attention to the place of creamskimming arguments in telecommunications law.

Among its crowning achievements, the 1996 Act decoupled universal service from internal cross-subsidies.⁷⁸ The Act dramatically revamped universal service mechanisms that had relied upon a combination of explicit monetary payments to local phone companies and implicit subsidies through rate designs, particularly those imposing uniform rates throughout a company’s service area so that the company [could] charge above-cost rates in urban areas to support below-cost rates in rural areas.⁷⁹ Under the 1996 Act, universal service support must be explicit and sufficient to achieve the [statute’s] purposes . . . .⁸⁰ The requirement that subsidies be explicit effectively bans implicit support.⁸¹ The shift from implicit support through rate design to explicit, competitively neutral subsidies effected tremendous transparency and positive change in the financing of universal service⁸²—precisely what Congress intended in abolishing implicit support mechanisms.⁸³ Even more broadly, the passage of the 1996 Act and the emergence of its model for financing universal service under competitive conditions represents the triumph of competition over monopoly as the economic foundation of telecommunications regulation.⁸⁴ The durability of creamskimming allegations—and regulators’ receptivity to those arguments—is one reason that legal authorities persisted in treating nearly the entire telecommunications industry as a natural monopoly.⁸⁵

In addition to opening the door to competition for all telecommunications services, in rural as well as urban markets, the 1996 Act’s mechanisms for financing universal service enhanced technological innovation. In the related context of using cross-subsidies to promote new industries or to spur technological innovation within an existing industry, Alfred Kahn recognized decades ago that competition may be a much more effective and powerful promoter than monopoly.⁸⁶ He touted external subsidies (a category to which today’s Universal Service Fund belongs) as a far more efficient method than the protection of monopoly for promoting a more rapid industrial development, because they can directly provide such additional incentives as may be required while taking full advantage of the promotional effects of competition as well.⁸⁷

Although the transformation of universal service mechanisms did not totally eliminate creamskimming concerns, the 1996 Act’s creation of a new financial mechanism for universal service did prompt a new approach to creamskimming. Throughout their experience in interpreting and implementing the 1996 Act, the FCC and the Federal-State Joint Board on Universal Service have identified a battery of legal measures that minimize or even eliminate creamskimming concerns.⁸⁸ To receive federal universal service funds, eligible telecommunications carriers (ETCs) must be common carriers and must offer supported services throughout the service area for which the designation is received . . . .⁸⁹ ETCs must also advertise the availability of such services and the charges therefor using media of general distribution.⁹⁰ In concert, these statutory obligations suppress a competitive ETC’s motivation and opportunity to engage in creamskimming.⁹¹ Because eligible carriers receive universal service support only to the extent that they serve customers, they have strong economic incentives . . . , in addition to the statutory obligation, to advertise the[ir] universal service offering[s].⁹²

In regulations governing ETC petitions filed by a common carrier . . . not subject to the jurisdiction of a State commission,⁹³ the FCC has prescribed an examination of creamskimming in connection with its determination of the public interest:

In instances where an eligible telecommunications carrier applicant seeks designation below the study area level of a rural telephone company, the Commission shall . . . conduct a creamskimming analysis . . . . In its creamskimming analysis, the Commission shall consider other factors, such as disaggregation of support to [47 C.F.R.] § 54.315 by the incumbent local exchange carrier.⁹⁴

In the 2005 report and order promulgating 47 C.F.R. § 54.202 (among other new regulations), the FCC discussed a trio of ETC designation petitions affecting rural telephone markets.⁹⁵ The 2005 ETC Order and the trio of rural ETC petitions that it discussed—Virginia Cellular, LLC;⁹⁶ Highland Cellular, Inc.;⁹⁷ and Advantage Cellular Systems, Inc.⁹⁸—warrant close examination.

In Virginia, Highland, and Advantage, the FCC granted in part and denied in part an ETC petition by a competitive wireless provider. Each denial involved the study area of at least one rural telephone company. Using similar language and analysis, these three orders articulated a set of interrelated principles regarding creamskimming:

1. The FCC defined rural creamskimming as follows: Rural creamskimming occurs when competitors seek to serve only the low-cost, high revenue customers in a rural telephone company’s study area.⁹⁹ Notably, the FCC used precisely the same language in the body of each of these orders.

2. The FCC recognized that creamskimming cannot occur when a competitive carrier serves a rural incumbent’s entire study area.¹⁰⁰

3. The Advantage order concluded, [c]onsistent with the Commission’s findings in the Virginia order and Highland order, that it is appropriate to designate a competitive carrier as an eligible telecommunications carrier below the study area level of rural telephone companies when such designation is unlikely to create creamskimming concerns.¹⁰¹

4. As additional support for the FCC’s general policy of requiring a competitive ETC to serve entire communities, Highland observed that a competitive carrier so designated is less likely to relinquish its ETC designation at a later date.¹⁰²

5. Finally, the Virginia and Highland orders observed that a rural incumbent LEC can mitigate creamskimming concerns by invoking 47 C.F.R. § 54.315 to disaggregate universal service support to the higher-cost portions of its study area.¹⁰³ Service area rate averaging, comparable to the ratemaking practices that once made Bell system affiliates vulnerable to creamskimming on a broader geographic scale, is not an inexorable regulatory command. A rural carrier that elects to redirect per-line support according to high- and low-cost areas within its study area as a whole (such as discrete wire centers) can thereby dampen its competitors’ incentive to target high-density areas where per-line support, if averaged over the entire study area, would exceed the real cost of service.

The 2005 ETC Order embraced many of the principles articulated in the Virginia, Highland, and Advantage orders. The ETC Order explicitly ruled out the possibility of creamskimming when a competitor serves an entire rural study area: When a competitive carrier requests ETC designation for an entire rural service area, it does not create creamskimming concerns because the affected ETC is required to serve all wire centers in the designated service area.¹⁰⁴ Mindful of [t]he potential for creamskimming that arises when an ETC seeks designation in a disproportionate share of the higher-density wire centers in an incumbent LEC’s service area, the ETC Order endorsed a creamskimming analysis that examines the extent to which an ETC applicant would be serving only the most densely concentrated areas within a rural service area, and whether the incumbent LEC has disaggregated its support at a smaller level than the service area (e.g., at the wire center level).¹⁰⁵ The 2005 ETC Order recognized the ability of rural incumbent carriers to mitigate creamskimming concerns through disaggregation of universal service support.¹⁰⁶ Finally, the Order reasserted the FCC’s belief, first stated in the Highland . . . Order, that requiring a competitive ETC to serve an entire wire center will make it less likely that the competitor will relinquish its ETC designation at a later date and will best address creamskimming concerns in an administratively feasible manner.¹⁰⁷

One of the earliest decisions by a state commission in response to the creamskimming analysis that the FCC began formulating in Virginia, Highlands, and Advantage confirmed this understanding of the 2005 ETC Order. In the 2005 case of American Cellular Corp.,¹⁰⁸ the Kentucky Public Service Commission analyzed three factors bearing on the prospect of creamskimming.¹⁰⁹ First, the Kentucky Commission recognized that an entrant seek[ing] to be designated within its entire FCC-licensed service area is not intentionally creamskimming.¹¹⁰ Second, [t]he risk of unintentional creamskimming has been virtually eliminated by the FCC’s implementation of the disaggregation mechanisms set forth in 47 C.F.R. § 54.315.¹¹¹ Finally, the Kentucky Commission applied the FCC-endorsed method of population density analysis as a proxy to assess the risk of unintended creamskimming.¹¹²

One point of agreement firmly connects all four of the FCC’s creamskimming orders, from Virginia to the 2005 ETC Order. The FCC has consistently limited creamskimming analysis to instances in which a competitive carrier would not serve an incumbent’s entire study area. In proceedings for the designation of eligible telecommunications carriers, and in other settings where controversies over alleged creamskimming may arise, regulators should declare that creamskimming cannot occur when a competitive entrant would serve the entire service area of the affected incumbent. Indeed, the Regulatory Commission of Alaska rejected a contrary argument by rural local exchange carriers and accordingly acknowledged that a commitment by a competitive carrier to serve an entire study area does effectively address . . . creamskimming concerns.¹¹³

Rather remarkably, however, neither the 2005 ETC Order nor the creamskimming regulation it promulgated¹¹⁴ defines creamskimming. The FCC left this task to the Virginia, Highland, and Advantage orders. In the body of each of these orders, the FCC defined creamskimming: Rural creamskimming occurs when competitors seek to serve only the low-cost, high revenue customers in a rural telephone company’s study area.¹¹⁵ In each of the orders, the FCC then appended an immediate footnote that recast the definition in different language: ‘Creamskimming’ refers to instances in which a carrier serves only the customers that are the least expensive to serve, thereby undercutting the ILEC’s ability to provide service throughout the area.¹¹⁶

The definition of creamskimming that appears in the bodies of the Virginia, Highland, and Advantage orders differs from the definition that appears in the footnotes of those orders in two significant respects:

1. The body definition refers not only to low-cost but also to high revenue. By contrast, the footnote definition omits any mention of high revenue or profit, referring solely instead to customers that are the least expensive to serve.¹¹⁷

2. The body definition refers expressly to customers in a rural telephone company’s study area, as opposed to the footnote definition’s more general phrase, service throughout the area.¹¹⁸

In each instance, the body definition is more complete than the footnote definition—and, critically, more consistent with the understanding of creamskimming that regulatory authorities developed in communications law and in the broader law of regulated industries. Both cost and revenue, from the incumbent carrier’s