In the Matter of the Pricing Proceeding for ) DOCKET NO. UT-960369 Interconnection, Unbundled Elements ) Transport and Termination, and Resale ) In the Matter of the Pricing Proceeding for ) DOCKET NO. UT-960370 Interconnection, Unbundled Elements ) Transport and Termination, and Resale ) for US WEST Communications, Inc. ) In the Matter of the Pricing Proceeding for ) DOCKET NO. UT-960371 Interconnection, Unbundled Elements ) Transport and Termination, and Resale ) for GTE Northwest Incorporated ) PHASE II Reply Testimony of William Page Montgomery for TCG-Seattle August 20, 1998 TABLE OF CONTENTS Introduction --3-- Non-cost markups to TELRIC --5-- "Transition Cost" Recovery --26-- "Costs of unbundling" certain loops --38-- Conclusion --44-- Reply Testimony of William Page Montgomery PHASE II August 20, 1998 Introduction Q. What is your name and business affiliation? A. My name is William Page Montgomery. I am the principal of Montgomery Consulting in Laguna Beach, California. I submitted Direct Testimony in this proceeding on July 9, 1998 at the request of TCG Seattle. TCG Seattle is now part of AT&T Local Services. Q. What is the purpose of this submission? A. TCG asked me to review the testimony submitted by other parties and to comment on that testimony as necessary. I will discuss primarily the testimony submitted by the two main Washington incumbent LECs (ILECs), US West Communications, Inc. (USWC) and GTE Northwest Incorporated (GTNW). Q. Can you summarize your reply testimony? A. Yes. In its Eighth Interim Order in this proceeding, the Commission formally determined as a matter of law that “[t]he proper cost standard for Phase I is total element long run incremental cost [TELRIC] and the cost for unbundled network elements should be based upon the cost of the total demand for the elements.” Eighth Order, Para. 509. A substantial amount of the testimony presented by USWC and GTNW in this phase seeks to obviate the Commission’s conclusion and to effectively render the Phase I proceeding null and void. This includes the testimony presented on the ILEC’s cost markup proposals and on the “recovery” of so-called “stranded costs.” USWC proposes a mark up factor of 18% over and above the costs approved in the Eighth Order and an allowance for reasonable common costs. GTNW proposes a uniform markup of 55% and sets forth a mechanism for recovering so-called “stranded costs” that would increase UNE prices even more than the uniform markup. I will discuss these proposals, and demonstrate that they should not be adopted by the Commission. The ILEC proposals bear no relationship to how competitive firms behave when faced with an increase in competitive rivalry. Q. Will you address any other proposals put forth by USWC? A. Yes. USWC also seeks for a second time to recover from CLECs part of the “transition costs” it says it will experience because of local competition. USWC testimony of Dean Buhler. These costs for Operational Support Systems (OSS) are part of the costs USWC tried to recover through its Interim Cost Adjustment Mechanism, or ICAM, which the Commission rejected. USWC apparently continues to overlook or to minimize the serious policy and factual issues raised by the proposed recovery of “transition costs.” I will discuss these issues and show why ILECs should not be allowed to recover these costs through a “tax” on CLECs. Q. Do you comment upon any other proposals set forth by GTNW? A. Yes. GTNW has submitted a new cost study that purports to identify the “cost of unbundling.” GTNW testimony of David Tucek. However, this study fails to reflect several key determinations made by the Commission in the Eighth Order in this proceeding. The Order discussed the costs of integrated digital loop carrier systems at some length. GTNW’s cost study is not consistent with the TELRIC standard. It is not filed in the proper phase of the proceeding, either. GTNW’s study completely overlooks more efficient arrangements, both as part of the company’s own processes and practices as well as in other options for offering unbundled loop to CLECs. These other technical arrangements would significantly reduce or eliminate the “unbundling” cost. GTNW’s proposal should, accordingly, be rejected. Non-cost markups to TELRIC Q. You stated that the ILECs’ direct testimony in this phase of the proceeding was an attempt to overturn the Commission’s conclusions about the propriety of the TELRIC cost standard. Can you elaborate on that point? A. Yes. When the Commission endorsed the TELRIC standard, it effectively set the bar higher for the ILECs in this phase of the proceeding. Not only were GTNW and USWC required to modify their cost studies as required by the Eighth Order, the order held them to the standard of showing how and why prices based upon TELRIC, plus a limited additive for the forward-looking common costs that may not be captured in the TELRIC value, would result in unreasonable UNE rates. The FCC addressed these very issues in its First Interconnection Order. I quote the FCC language at some length below, because the FCC’s statement underscores what USWC and GTNW have not attempted to rebut in their testimony in this phase. While the FCC’s points are not now legally binding on the Commission, USWC and GTNW had the duty to address these points by virtue of the Commission=s broad endorsement of TELRIC, and because the FCC’s commentary also constitutes clear factual statements with which few if any economists would disagree: Section 252(d)(1) states that rates for interconnection and access to unbundled elements "may include a reasonable profit." We find that the TELRIC pricing methodology we are adopting provides for such a reasonable profit and thus no additional profit is justified under the statutory language. We note there are two types of profit. First, in plain English, profit is defined as "the excess of returns over expenditure in a transaction or a series of transactions." [Footnote: Webster's New Collegiate Dictionary 931 (10th ed. 1994)]. This is also known as a "normal" profit, which is the total revenue required to cover all of the costs of a firm, including its opportunity costs. Second, there is "economic" profit, which is any return in excess of normal profit. Thus, for example, if the normal return in an industry is 10 percent and a firm earns a return of 14 percent, the economic profit for that firm is 4 percent. Economic is also referred to as "supranormal" profit. We conclude that the definition of "normal" profit is embodied in "reasonable profit" under Section 252(d)(1). The concept of normal profit is embodied in forward-looking costs because the forward-looking cost of capital, i.e., the cost of obtaining debt and equity financing, is one of the forward-looking costs of providing the network elements. This forward-looking cost of capital is equal to a normal profit. We conclude that allowing greater than normal profits would not be "reasonable" under sections 251(c) and 252(d)(1). Thus, contrary to the arguments put forth by several incumbent LECs, we find that adding an additional measure of profit to the risk-adjusted cost of capital in setting the prices for inter-connection and access to unbundled elements would violate the requirements of sections 251(c) and 252(d)(1) of the 1996 Act. Possible accounting losses from the sale of interconnection and unbundled network elements using a reasonable forward-looking cost-based methodology do not necessarily indicate that incumbent LECs are being denied a "reasonable profit" under the statute. The use of a forward-looking, economic, cost-based pricing methodology, including a reasonable allocation of legitimate joint and common costs, will permit incumbent LECs the opportunity to earn a reasonable return on their investment in network elements. ... Based on the current record, we conclude that the currently authorized rate of return at the federal or state level is a reasonable starting point for TELRIC calculations, and incumbent LECs bear the burden of demonstrating with specificity that the business risks that they face in providing unbundled network elements and interconnection services would justify a different risk-adjusted cost of capital or depreciation rate. These elements generally are bottleneck, monopoly services that do not now face significant competition. We recognize that incumbent LECs are likely to face increased risks given the overall increases in competition in this industry, which generally might warrant an increased cost of capital, but note that, earlier this year, we instituted a preliminary inquiry as to whether the currently authorized federal 11.25 percent rate of return is too high given the current marketplace cost of equity and debt. On the basis of the current record, we decline to engage in a time-consuming examination to determine a new rate of return, which may well require a detailed proceeding. States may adjust the cost of capital if a party demonstrates to a state commission that either a higher or lower level of cost of capital is warranted... We disagree with the conclusion that, when there are mostly sunk costs, forward-looking economic costs should not be the basis for pricing interconnection elements. The TELRIC of an element has three components, the operating expenses, the depreciation cost, and the appropriate risk-adjusted cost of capital. We conclude that an appropriate calculation of TELRIC will include a depreciation rate that reflects the true changes in economic value of an asset and a cost of capital that appropriately reflects the risks incurred by an investor. Thus, even in the presence of sunk costs, TELRIC-based prices are an appropriate pricing methodology. In the Matter of Implementation of the Local Competition Provisions in the Telecommunications Act of 1996; Interconnection between Local Exchange Carriers and Commercial Mobile Radio S