Exhibit ___ (GB-T) Testimony of Glenn Blackmon Docket No. UT-970766 Page 1 Q. Please state your name and business address. A. Glenn Blackmon, Ph.D., 1300 South Evergreen Park Drive Southwest, P. O. Box 47250, Olympia, Washington 98504. Q. By whom are you employed and in what capacity? A. I am employed by the Washington Utilities and Transportation Commission as Assistant Director-Telecommunications. Q. What are your education and experience qualifications? A. I hold Ph.D. and master’s degrees in public policy from Harvard University and a bachelor’s degree in economics from Louisiana State University. I have been employed at the Commission since August 1995 and assumed my current position in April 1996. I previously served as the Commission’s economics advisor in the interconnection case, UT-941464, and the U S WEST general rate case, UT-950200. Prior to working at the Commission, I was a consultant in private practice, where my clients included both regulated companies and consumer advocates, and an analyst for the Washington State Senate Energy and Utilities Committee. I have presented testimony as an expert witness before this Commission, as well as the Illinois and Idaho commissions. I am the author of a book, Incentive Regulation and the Regulation of Incentives (Boston: Kluwer Academic Publishers, 1994). I have authored or co-authored articles on utility regulation and economic theory published in American Economic Review, Journal of Regulatory Economics, Yale Journal on Regulation, Journal of Risk and Uncertainty, and Public Utilities Fortnightly. Q. What is the purpose of your testimony? A. The purpose of my testimony is to: (1) explain the policy and parameters within which this case arose; (2) support the recommendation that no adjustment be made for team and merit awards, and (3) present Staff’s recommendations on rate design and service quality measures. Policy and Background Q. Please explain how this case came about. A. This case had its genesis in discussions between U S WEST and Commission Staff in late 1996 and early 1997, after the Commission’s decision in Docket No. UT-950200 had been upheld by the King County Superior Court. U S WEST appealed that decision to the state Supreme Court, and also asserted that, even if all the adjustments made in that case were upheld by the Supreme Court, the company’s 1996 results of operations would show a revenue deficiency. In March 1997, Staff and the company agreed to an informal review of the company’s 1996 results of operations with the objective of determining whether, with the adjustments ordered in UT-950200, the company in fact was earning less than its authorized rate of return. It was our belief that, if the Commission’ s decision in the last rate case showed an earnings shortfall when applied to the 1996 test year, a rate increase would be appropriate and could be approved without going through a fully contested general rate case. The Commission had concluded a similar exercise with Yelm Telephone Company, and we believed a similar approach was feasible for U S WEST. The informal review was conducted over several months, and Staff regularly apprised interested parties, including Public Counsel, TRACER, and AT&T, of the progress. It was concluded in August 1997. In addition, this case arises from the U S WEST depreciation case that the Commission initiated in August of 1996, Docket No. UT-951425. In August of this year, the company, staff, Public Counsel, and TRACER reached agreement on revised depreciation rates, which were approved by the Commission. Those depreciation rates result in higher depreciation expenses, which are reflected in U S WEST’s request in this case. Q. Does Staff agree with U S WEST that the revenue requirement in this case is $70.3 million? A. Yes. Staff witness Maurice Twitchell, who led the informal review that I just described, provides testimony supporting the $70.3 million revenue requirement amount. Q. Please explain why it is reasonable to limit the scope of this case to the issues raised in the last case, Docket No. UT-950200. A. The results of that case provide a very good framework for evaluating U S WEST’s current request for higher rates. The last general rate case was a very expensive and intensive review of the company’s costs, expenses, and revenues. The Commission described it as “among the longest proceedings the Commission has heard in years… The proceeding generated as much intensity as any other Commission proceeding in recent memory.” 15th Supplemental Order, Docket No. UT-950200, p. 8. In essence, there is no need to relitigate the basic decisions made in that case. The principles adopted were sound and should be used to evaluate the more recent financial results of the company. Q. Does that mean that Staff believes there is no room for dispute about the appropriate revenue requirement in this case? A. No. Staff recognizes that judgments have to be made to apply the principles adopted by the Commission to a new test period. Reasonable analysts may differ about how best to make those adjustments. It also is possible that some adjustments not made in the last case are required because the factual circumstances have changed. It was for this reason that Staff and the company agreed to adjustments for storm damage and right-to-use fees that were not part of the last rate case. Moreover, in some instances applying the principle may require modifying the adjustment. The team and merit award adjustment falls into this category. Team and Merit Awards Q. Please explain the team and merit award and why Staff is recommending no adjustment in this case for that item. A. In the last rate case, the Commission did not allow U S WEST to include in revenue requirement the cost of its team and merit awards. Team and merit awards are part of the compensation package of the company’s employees. They are awarded based on the success of individuals and teams in meeting various objectives. These objectives include quality indicators, profitability measures, and other measures specific to various business units. In disallowing the cost of these awards, the Commission specifically faulted the company for allowing employees to substitute above-target financial performance for below-target service quality. "The service goals were not met and that portion was not distributed. The income-related portion, however, was met and exceeded. What is particularly objectionable about this plan is not only that the financial incentives were independent of the service incentives, but the program was constructed so that, if the Company exceeded the stated financial goals by only 8%, employees could ‘replace’ all of the bonus that they would ‘lose’ for failure to achieve customer service goals.” 15th Supplemental Order, Docket No. UT-950200, p. 48. Staff has reviewed the company’s team and merit award program, which was restructured after the Commission’s decision in the last case. The incentive structure still bases an employee’s bonus compensation on both service quality and financial performance. However, it no longer is the case that an employee or a team can make up for bad service quality by exceeding the target for profitability. Employees’ bonuses are tied to service quality and profits, but employees no longer have an incentive to sacrifice service quality in order to increase profits. Based on that change in structure, an adjustment to disallow these costs is no longer required. Q. Is Staff’s recommendation to include employee bonus compensation based on the company’s service quality performance? A. No. While the company has shown improvement in some areas, its service continues to be less than adequate. Staff therefore recommends that the company’s return on equity continue to be set at the low end of the reasonable range, and the company is not contesting this point. However, the Commission did not disallow team and merit awards because they had caused bad service; the awards were disallowed because they gave employees poor incentives to maintain and improve service quality. Staff believes the incentive program no longer has that defect. Staff believes the most significant factor in the company’s service problems is not the incentives of individual employees or business units but instead corporate-level decisions about how much money and how many employees to dedicate to serving the customer. Implementation of Rate Increases Q. How should the results of this case be implemented, assuming that the Supreme Court has not yet ruled on the company’s appeal of UT-950200? A. Staff recommends that the Commission allow U S WEST to implement any rate changes that are approved in this case and that are not subject to stay under Docket No. UT-950200. Any rate changes that affect rates under stay should be implemented only after the Supreme Court decision is issued. Q. Why do you recommend that some increases be allowed to take effect before the Supreme Court decides the appeal? A. Assuming U S WEST is able to demonstrate a revenue deficiency, it is in the public interest to allow higher rates. Customers and the state as a whole have an interest in maintaining the financial strength of this company. Its ability to provide good service to customers and invest in network growth depends in part on maintaining adequate profit levels. Therefore, in general the Commission should avoid delays in implementing rate increases when they are justified. Doing so will not produce any “yo-yo” effect in customer’s rates, because in no case where a decrease is pending would an increase be implemented. An exception to this general principle should be made for the rates that have been stayed because of U S WEST’s appeal. It would be confusing to customers to have their rates increased in this case only to be decreased when the Supreme Court makes its decision. U S WEST has recognized this “yo-yo” problem and is not proposing to implement increases in any rate subject to stay. Any increases that are approved but not implemented because of the stay would be accounted for in calculating the eventual refund under Docket No. UT-950200, so the company eventually receives full recovery of its revenue requirement. Rate Spread Q. What rate increases should be authorized to meet the revenue requirement supported by Staff? A. Staff recommends the following increases: Service Current Rate Recommended Increase Resulting Rate Residential flat local $10.50 $2.60 $13.10 Residential measured local 7.35 1.82 9.17 Business flat local 25.00 2.00 27.00 Business measured local (rates vary across rate groups) 12.85 - 22.61 2.00 14.85 - 24.61 Business NAR & DSS 14.00 2.00 16.00 Directory assistance 1st call per month 2nd call per month Each additional call Free Free .35 None .60 .25 Free .60 .60 Q. Do these recommended changes produce the revenue requirement agreed to by U S WEST and Staff? A. Yes, assuming no change in the number of units consumed. In its original filing, the company made no adjustment for price elasticity. In other words, it assumed that the number of units purchased by customers will not decrease as a result of the rate increases. To assume no price effect is conservative, and it avoids any disputes about the appropriate elasticity value. Therefore Staff does not object to the company’s use of this assumption in this particular case, even though elasticity effects were accounted for in the last rate case. Q. How do these recommended changes compare to the rate increases that U S WEST has recommended? A. Staff agrees with the company that none of the increase should come from access charges, long distance rates, or features. Staff is proposing the same $2.00 increase for business service. However, Staff recommends a smaller increase for residential customers than U S WEST’s proposal of $3.00. Since we agree about the total amount of money that should be collected, a smaller increase in residential rates required additional revenues from some other rate. Staff recommends that the number of free calls to directory assistance be reduced from two to one. The cost of each additional call would be 60 cents, as proposed by U S WEST. Q. Why is Staff recommending no increase in access charges or long distance rates? A. Access charges and, by extension, long distance rates are already too high. Something is wrong when a call from Seattle to the East Coast is substantially cheaper than a call from one side of Puget Sound to the other. This problem arises because access charges are priced much higher, relative to cost, than local service. In the last rate case the Commission used 70% of the available decrease in revenue requirement to lower access charges and long distance rates. The Commission also indicated that even with those decreases, rates were too high and should be further decreased as the opportunity to do so arose. "Because access charges currently are above cost, the magnitude of reductions are primarily a function of the overall revenue requirement in this proceeding and the other rate design changes that must be made.” 15th Supplemental Order, Docket No. UT-950200, p. 111. It would be a mistake to reverse that policy now by increasing access charges and long distance rates. Q. Why does Staff recommend an increase in business rates? A. Business customers should bear a portion of the increase because the services they purchase are in part driving the need for increased revenues. About half the overall increase is due to higher depreciation expenses. The shorter lives adopted by the Commission in the depreciation case were justified by a need to replace equipment more frequently as technology changes and as competition increases. It is generally business customers who demand the latest technology and who are most susceptible to competition. Q. Is Staff recommending an increase in residential local rates because those rates currently are below cost? A. No. The Commission correctly concluded in the last case that residential rates are above cost; U S WEST’s assertion in the last case that residential service is subsidized was rejected on good evidence. Q. Is an increase in residential rates consistent with the Commission’s last order, given that no increase was approved in that proceeding? A. It is consistent. The same principles that led the Commission to maintain residential rates in the last case support an increase in residential rates in this case. While residential rates were found to be above cost in the last case, their contribution to overhead costs was much lower than that for business service or access and toll service. The Commission was dealing with an overall revenue decrease in that case, and in that context there simply was no need to increase residential rates as long as they covered cost. "The appropriate level of contribution is a matter of judgment about how to weigh the public interest, equity among customer classes and groups, the public policy encouraging universal access at affordable rates, and the need to avoid sudden shifts in rates whenever possible. In this proceeding, an important factor is that no overall increase in rates is being ordered.” 15th Supplemental Order, Docket No. UT-950200, p. 100 (emphasis added). Indeed, it is significant that, despite a large overall rate decrease, the Commission did not lower average residential flat local rates in that case and refrained from doing so based on “the long term public interest.” Q. Why does Staff recommend a larger increase for residential customers than for business customers? A. The policy adopted in the last case was to narrow the difference between residential local service and the comparable business local service. In the last case, the Commission accomplished this by lowering business rates substantially and leaving average residential rates unchanged. For reasons of rate stability, it is better to accomplish such long-term objectives over time. A further narrowing of that difference is appropriate in this case, and this can be accomplished by increasing residential rates more than business rates. Even with this increase, business rates would remain substantially higher than residential rates. Q. Please explain the increases in measured service that Staff is recommending. A. For residential service, Staff recommends an increase in measured service equal to 70% of the increase in residential flat-rated service. This maintains the relationship between measured and flat services that was recommended by Public Counsel and AARP in the last case and was adopted by the Commission. Staff recommends that the same increase in business flat-rated service be applied to business measured service. In the last case the Commission did not address the relationship between flat and measured rates for business service. Since there is no decrease in business measured rates that is subject to stay, this increase could be implemented without waiting for the Supreme Court decision. Q. Does Staff propose that rates for multi-party lines increase as well? A. Yes. Any increase in the single-party flat rate should be equally applied to multi-party lines. There are few customers still subscribing to multi-party lines, but for reasons of equity it is important to include them in any increase that is approved. Q. Why does Staff recommend an increase in network access register (NAR) and digital switched service (DSS) rates? A. Increasing these rates in the same dollar amount as the business flat rate will maintain parity between business service and private line service, which is essentially unbundled business service. Similarly, rates for other business lines and trunks that in the last case were set at $25 should be increased by the same dollar amount as flat business service. Q. What is Staff’s recommendation regarding directory assistance charges? A. Staff supports U S WEST’s proposal to increase the rate for charged calls from 35 cents to 60 cents. Unlike most other optional services, directory assistance provides a relatively small contribution to overhead and common costs. Even at the 60-cent rate, U S WEST’s directory assistance rates would be among the lowest in the market. In addition, Staff recommends that the free call allowance drop from two to one. These changes to directory assistance represent a substantial overall increase in the rates for this service, and Staff recommends that the service be restructured so that customers pay for directory service only when they get the information they are seeking. Q. Please explain the restructuring of directory assistance that Staff is recommending. A. Currently, U S WEST applies the directory assistance charge (or counts the call against the customer’s free call allowance) even if no listing is found or the listing is non-published. Directory assistance is an information service. It would be more reasonable for customers to be charged only when they get the information they are seeking. Just as callers are not charged when the line is busy, consumers would get better value if they are charged only when the call produces the information requested. This is particularly important if the rate for directory assistance increases and the free-call allowance is reduced. Q. But couldn’t an argument be made that U S WEST incurs the cost of searching for the number even if no listing is produced? A. Yes, that argument can be made. But there are many unconsummated business transactions where costs are incurred but no sale is made. Airlines expend costs checking on availability of seats only to find the plane is full. A retail store incurs costs assisting a customer only to find that the desired product is not available. It is particularly important that U S WEST charge customers only when service is received when one considers the incentives of the company to maintain complete and accurate directory databases. If U S WEST can charge customers only when it succeeds in providing the requested information, it will have a better incentive to maintain its database. Q. Did Staff consider eliminating the free call allowance entirely? A. Yes. The advantage of eliminating the free call allowance is that doing so would allow for a smaller increase in the basic rate. If every directory assistance call were charged at 60 cents, the increase in residential service could be about 30 cents smaller (assuming that the business increase remained at $2.00). Over time, it may be appropriate to eliminate the allowance and require that each call pay for itself. In the interest of gradualism, Staff recommends that one free directory assistance call be retained at this time. Q. The Commission asked parties to recommend a rate design for only the depreciation portion of U S WEST’s request. What is Staff’s recommendation? A. Staff recommends that the company be allowed to implement the directory assistance increases that I just discussed and recover the remainder with an equal increase in all lines. The only exception is that residential measured service should receive 70 percent of the increase to residential flat service. The necessary increase would be $1.10 per month. Washington Telephone Assistance Program Q. U S WEST is proposing not to increase rates for Washington Telephone Assistance Program (WTAP) customers. Does Staff agree with this recommendation? A. Staff agrees that rates for WTAP customers should not increase simply as a result of this filing. However, that result is a function of the WTAP mechanics and does not require any special treatment of those customers by the Commission. The WTAP provides for basic monthly service at a rate established by the the program. That rate is currently $9.25 and applies in all areas of the state, regardless of the company providing service or the rate they charge for local service. The WTAP pays the local telephone company the difference between its standard rate and the WTAP rate of $9.25. Thus, an increase in U S WEST’s basic residential rate will increase the costs incurred by WTAP, but it does not change the rate paid by WTAP participants. WTAP is funded by an excise tax on all switched access lines in the state, which is capped by state law at 14 cents per month. Therefore an increase in basic local rates by U S WEST would, in the absence of any other offseting events, require some combination of an increase in the excise tax rate, which is currently at 13 cents, and an increase in the monthly rate paid by WTAP participants. Q. What do you understand U S WEST to be proposing for WTAP? A. Rather than bill WTAP for any rate increase approved in this case, U S WEST would recover that cost from its non-WTAP other customers. In other words, the company’s rate design proposal collects the full revenue requirement amount without collecting any increase from WTAP or its customers. Q. Why is it preferable to apply any increase to WTAP instead of spreading it among all other customers? A. Charging the same rate to all customers, including WTAP, is more consistent with legislative intent when it created WTAP, and it results in a more equitable distribution of the costs of supporting service for low-income customers. WTAP was created by the Legislature as an explicit mechanism to fund telephone assistance. The Legislature was specific about the services that would be supported and the limits that would be applied to payments by other customers. The Legislature could have ordered each company to offer service to low-income households at discounted rates, but it chose instead to authorize a statewide program funded by an excise tax on all lines, not just the lines of the individual company. Q. Would it be reasonable for U S WEST to delay implementation of any increase for the WTAP? A. Yes, it would. U S WEST and all other parties share an interest in maintaining affordable service for low-income families. An unplanned increase in local rates by U S WEST would be very disruptive to WTAP finances. Were this case to proceed on a schedule that used the full 10-month suspension period, any increase would not take effect until after the next fiscal year begins on July 1, 1998. The WTAP administrator would have an opportunity to revise the excise tax rates and/or customer rate levels to keep the program in financial balance. Doing so may well require legislative changes, particularly since the program is scheduled to sunset on June 30, 1998 if the Legislature does not renew it. Parties also need to work together to make sure that the program is structured so as to maximize our ability to receive federal matching funds. Accomplishing these changes is simply not possible on the current schedule for this case. A reasonable solution would be for U S WEST to begin charging WTAP any higher rate effective July 1, 1998. However, the uncollected revenues should not be recovered from other U S WEST customers; they should be absorbed by the company and considered as an unavoidable consequence of the accelerated schedule. Customer Service Measures Q. How should the Commission address the issue of customers who have service problems with U S WEST? A. Customer service should be addressed at two levels, the overall performance of the company and the experience of individual customers. At the overall level, the rate of return adjustment ordered by the Commission in the last case should be maintained. U S WEST’s service quality performance has not improved sufficiently to justify eliminating that adjustment. The prospect of having that adjustment removed provides at least some incentive to the company’s corporate management to make good service a priority. It is at the individual customer level, however, where customer service measures should be most emphasized. In the last rate case, the Commission ordered U S WEST to compensate customers directly when they do not get adequate service. Those measures are more important, because they directly compensate the customers who are harmed by inadequate service. A rate of return adjustment, by contrast, gives a small saving to every customer, including many who have not been harmed. Q. What is Staff’s proposal on individual-level customer service measures? A. Staff proposes that the “customer care” measures ordered in the last rate case be made a permanent part of U S WEST’s tariff. These provisions, as set out at pages 23 and 26 of the 15th Supplemental Order, directly compensate customers whose lines are not installed on time. In addition, the Commission should order U S WEST to provide a customer credit for missed appointments and commitments. Q. How should the customer credit for missed appointments and commitments be structured? A. The credit provision recently adopted for Puget Sound Energy in Docket No. UE-960195 serves as a good model. PSE’s tariffs now provide that if the company misses a guaranteed appointment or guaranteed commitment, it will credit $50 to the customer’s account. The guarantee includes reasonable exceptions for instances in which events outside the company’s control cause it to miss an appointment or commitment. The same credit provision should be added to U S WEST’s tariff. Q. Do any other regulated companies offer similar service guarantees? A. Yes. General Telephone of the Northwest, the second-largest local exchange company in the state, has a service performance guarantee in its tariff which provides for a credit of $25 for residential customers or $100 for business customers if GTE-NW fails to meet a repair or installation commitment. Another example is McDaniel Telephone Company, which gives a credit equal to the monthly rate if the company misses a commitment, fails to restore an outage within 24 hours, or fails to make a change in service after one request. The relevant tariffs for these companies are included as Exhibit ____ (GB-1) to my testimony. Q. If the company’s service quality levels improve enough to justify eliminating the rate of return adjustment, should the customer care measures then be dropped as well? A. No. The reason for putting these measures in the tariff is that they should be a permanent part of the company’s service. Some delays in installing service are inevitable. Even if the overall levels are not excessive, the individual customers who experience these problems are still inconvenienced. It is reasonable to compensate these customers, at least in part, when they do not get adequate service. Q. Does this conclude your testimony at this time? A. Yes.