BEFORE THE WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION ) 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 Additional Reply Testimony of William Page Montgomery for TCG Seattle September 4, 1998 WUTC Docket Nos. UT-960369, et al. Phase II Additional Reply of W. P. Montgomery 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 and reply testimony on August 20 at the request of TCG Seattle. Q. What is the purpose of your testimony in this instance? A. I will discuss three issues raised in other parties’ August 20, 1998 testimony. The first is the staff witness Glenn Blackmon’s proposal to create a “parity pricing” regime for the incumbent local exchange carriers’ (ILECs’) unbundled network elements (UNEs), and to afford the incumbents a high degree of flexibility in pricing UNEs. The second issue is reciprocal compensation. The third is the recovery of interim number portability (INP) costs. Q. Can you summarize your testimony? A. Yes. In effect, Dr. Blackmon simply accepts the prices, exorbitant mark-ups, and revenue guarantee schemes proposed by the ILECs. The Commission should categorically reject the “parity pricing” proposal, which suffers from numerous deficiencies in terms of economics, logic, and competitive principles and most fundamentally, is inconsistent with this Commission’s duties under the Telecommunications Act. “Parity pricing” would deter CLECs from investing as much in Washington as they will do in states where UNEs have been set at economic costs. It is illogical to assume that CLECs would respond to a pricing proposal that raises the cost of doing business in Washington state by increasing their own investment spending in the state. With respect to reciprocal compensation, I note that while the Commission could retain default bill and keep compensation, it would be feasible to have both capacity charge and minutes of use pricing options, as long as the prices were set in relation to their comparable costs. Finally, I discuss why staff witness Griffin’s proposal for INP cost recovery is both discriminatory and not consistent with the FCC’s findings concerning competitively-neutral recovery of such costs. “Parity” pricing Q. Can you summarize the proposal for “parity pricing”? A. Yes. As described by Dr. Blackmon, “parity pricing” means the addition of a mark-up to the cost of a UNE, in particular the loop UNE, to create “parity” between the price of the UNE itself and the price if the UNE were combined in an overall “finished service.” The “finished service” is the wholesale-priced equivalent of the incumbent’s retail service offering. “Parity pricing” would effectively displace the Commission’s deliberations regarding UNE costs in Phase I of this case, and substitute a price ceiling based primarily upon its separate determination regarding the wholesale discount percentages. While the “parity pricing” proposal states that the price of the UNEs, and combinations thereof, not exceed “the resale or wholesale price” of the finished service, the analysis focuses on the ILECs’ revenues, rather than prices. In essence, the “parity pricing” proposal seeks to grant the ILECs fulfillment of their revenue requirement, as determined in a general rate case. In fact, Dr. Blackmon acknowledges this on page 16 of his testimony when he states that the existing retail rates arose from “a public policy objective of promoting universal service (as well as a monopoly pricing objective of revenue maximization).” (Emphasis added.) Universal service funding is being addressed in another docket and should not be used to determine the appropriate prices for UNEs. Q. Would the “parity pricing” proposal create large increases over the ILECs’ economic costs of UNEs? A. Yes. For General Telephone-Northwest (GTNW), the single “parity” price of a loop would be up to 2.1 times the cost determined by the Commission in Phase I. Blackmon Testimony, p. 18. The surcharges would be smaller in USWC’s case, but only because GTNW has proposed a much larger markup than USWC. Dr. Blackmon's calculations do not change either ILEC's own proposals regarding the mark-ups, and he simply accepts those proposals at face value. Dr. Blackmon calculates the “parity” ceiling for both a single stand alone UNE or for a combination of UNEs that the ILEC has “re-assembled.” The recurring monthly surcharge with the ILEC assembled additive is twice as high as the monthly surcharge without assembly. With the “assembly” surcharge the loop price for GTNW would become 3.4 times (340%) of the Phase I direct cost. Blackmon Testimony, p. 19. Q. Would the “parity pricing” have any other effects? A. Yes. The proposal apparently also contemplates that the “parity ceiling” would constitute an upper limit on the price range in which an ILEC would enjoy pricing flexibility for one or more UNEs. This wide range of pricing flexibility was described by Dr. Blackmon only conceptually. Blackmon Testimony, p. 4. He did not provide numerical examples. It is also unclear whether or how the actual dollar amount of the surcharges I noted above would be affected by such flexibility. Such pricing flexibility for UNEs makes no sense in light of this Commission’s and the FCC’s goal to encourage competition. Allowing the carriers with dominant market share to flexibly price UNEs, some of which are clearly monopoly elements in some market segments, is a recipe for eliminating nascent competition. ILECs would have every incentive to price UNEs as high as possible wherever CLECs had no other choice in providing service to a customer. The reality is that capital for investment and construction is limited and cannot be deployed everywhere and easily. That is why Congress adopted the provision of UNEs by ILECs to CLECs. The use of UNEs was intended to be a viable market entry strategy; this strategy should not be foreclosed through allowing the ILECs to price UNEs at exorbitant retail rate equivalents. Q. Both Washington ILECs proposed various mark-ups for UNE prices in excess of the TELRIC costs plus common costs. Is the “parity pricing” proposal an analysis of the ILECs’ calculations or justification? A. No, unfortunately, it is not. In effect, Dr. Blackmon has simply accepted the ILECs’ exorbitant markups and revenue guarantees. He correctly rejects GTNW’s “stranded cost” additive, but his own surcharge calculations do nothing more than take the ILECs numbers at face value. He makes no analysis, for example, to explain the great discrepancy between USWC’s proposed surcharge of 18% and GTNW’s proposed 55%. “Parity pricing” would not change either ILEC’s own proposals regarding the markups. Thus, the witness concedes that the proposed loop surcharge for GTNW “could well preclude competitors from using unbundled loops to serve customers in areas served by GTE.” Blackmon Testimony, p.18. Yet two pages earlier, the testimony correctly refers to unbundled loops as “an essential facility.” In other words, the proposal would preclude CLECs from using an essential facility. The effects might be less drastic in USWC’s case, but only because USWC proposed a lower markup. Moreover, the admission that competitors could not use GTNW’s loops does not square with the assertion that “if incumbents fail to provide good service at reasonable rates they are likely to lose significant portions of their current customer base . . . even with relatively high loop prices.” Blackmon Testimony, p. 8. Instead of analyzing the ILECs’ proposals, the witness simply concedes that CLECs may be precluded from using GTNW’s loop UNEs. This stance is not appropriate in view of the Commission’s interests in ensuring fair competition, under both state and federal laws. Q. You noted that “parity pricing” would use each ILECs’ combined wholesale prices as a ceiling. Is this justified? A. No. No justification is provided for the use of the wholesale price ceiling — the essence of “parity pricing.” This failure occurs on two levels. One, this Commission, like every other regulator that I am aware of, used distinctly different cost tests for UNEs and resale. Economic costs were used for the former, but wholesale discounts were calculated from embedded cost data, as the Telecommunications Act contemplates. Dr. Blackmon does not explain why this two-part approach should now be abandoned. Two, any use of a wholesale rate as a price ceiling fails to reflect a condition of which all regulators and their staffs should be aware by now: The earlier proponents of resale have largely abandoned their efforts to sign up new customers after concluding that the national average 22% discount did not permit profitable resale operations. Basing any pricing proposal on the resale rates is destined to fail; those rates have no meaning in the context of purchasing UNEs to be used in conjunction with a CLEC’s own facilities. “Parity pricing” not only fails to address the apparent economic deficiencies of resale, it would actually create a UNE pricing regime based upon wholesale prices that have proven inadequate as a competitive entry strategy. Q. Your reply testimony (page 11) noted that the ILECs’ mark-up proposals created a transfer of access and toll revenues from CLECs to the incumbents. Does “parity pricing” address this issue? A. No. As I showed, the ILECs’ own markup calculations would in effect gut the Commission’s access charge reform decision in Docket UT-970325. “Parity pricing” is based on the same transfer mechanism and would have the same effects on the Commission’s access reform goals. Indeed, the table that Dr. Blackmon included on page 23 of his testimony (which may contain data deemed confidential by USWC) uses the ILECs' gross revenue values. Using these values means, in effect, that the ILECs’ surcharge proposals and “parity pricing” both contemplate shifting contribution from toll and access fees collected by CLECs to the ILECs. Competition cannot operate to reduce originating access charges, and ultimately toll rates — as the Commission contemplated in Docket UT-970325 — if competitors have to turn over contribution from originating access charges to the incumbents. Q. Is this problem limited only to toll and access prices at today’s levels? A. Absolutely not. Any telecommunications service that is priced in excess of its economic costs in the incumbents’ retail markets would be affected the same way. Of course, one of the ultimate goals of competition is to bring prices closer to actual costs. This objective can never be achieved if UNE prices can be set far in excess of the costs as determined in Phase I. Such a proposal would merely lock today’s current rates in place and not allow the market to bring them down. Only after a competitor had built out enough of a network to fully offer alternative services to most customers would those customers begin to see better prices. As I discuss later, “parity pricing” will delay the time when this occurs for Washington customers — not accelerate it. Underlying the Telecommunications Act’s requirement that ILECs provide UNEs is the Congressional desire to facilitate competition in all local markets in conjunction with the recognition that competitors cannot duplicate the ILECs’ network within the foreseeable future. Q. Is there any quantified, relevant economic analysis of the impact of “parity pricing” in the testimony? A. Really there is none whatsoever. The witness speculates, for example, that USWC might have incentives to “price unbundled loops below parity in the business sector.” Id., p. 23. Why would a rational firm ever discount a price so as to help a competitor take away a customer? One is at a loss to understand this statement and the testimony refers to no principle of general economics or industrial organization theory to support the statement. Another example involves price floors and imputation tests. The testimony is completely silent about if or how the “parity pricing” of the loop UNEs would affect the evaluation of the ILECs’ retail rates or the Commission ability to detect and prevent price squeezes. This is, at a minimum, an issue that is quite susceptible to quantified economic analysis, but there is none. Q. Is there any analysis of the impact of “parity pricing” on the economic incentives and competitive strategies of either the incumbents or CLECs? A. Again, no. The testimony refers several times to providing CLECs with incentives to build their own facilities, including loops. See, e.g., Blackmon Testimony, p. 7. But this testimony contains no analysis of this alleged incentive; nor is there a recognition of any possible offsetting disincentives to make facilities investments in Washington State. Making vague assertions of “incentives for investment” is no substitute for reasoned analysis; nor is it sufficient to counter Congress’ very clear determination that unbundled, correctly priced UNEs are required to facilitate local competition. Congress, the FCC and, as far as I know, every state commission accept that competitors must be given access to reasonably priced UNEs as a precursor to more facilities-based competition. This type of consensus cannot be turned aside. Q. Are there, in fact, serious offsetting disincentive effects to the “parity pricing” concept that were not considered in the testimony? A. Yes. To understand the effects, the Commission must realize that every significant competitor in Washington also operates in numerous other states. Thus, the state-level UNE pricing regime fashioned by the Telecommunications Act creates somewhat different investment incentives for CLECs in each state. In effect, the CLEC that operates in multiple states has a portfolio of investment options that differ to some degree in each jurisdiction. Operating in multiple states reduces the firm's risks. However, the portfolio effect cannot justify holding an exceptionally risky or high cost investment. At some point, the portfolio effect becomes insignificant. For example, why would one continue to hold Indonesian bank stocks in light of the current financial crisis in Asia when one could redirect resources to U.S. bank stocks, General Electric, or other investments? A CLEC will continue to pursue any single investment opportunity only if the risks of that investment are reasonable. “Parity pricing” creates this type of unreasonable risk. In the choice among investing in facilities in the incumbent GTE areas of Pennsylvania, Texas and California — where UNEs are priced in close relationship to their estimated economic costs — or investing in Washington State — where, hypothetically, the regulator has adopted “parity pricing” and thereby made GTNW loop UNEs uneconomic for CLECs — the correct investment decisions of the CLEC would divert investment capital away from this state. This is not to say that CLEC investment would cease entirely, but the investments will be more limited and targeted than in the other states. Competition would be slower, not faster. The same effects would also apply to USWC in Washington. It is illogical to assume that CLECs would respond to a pricing proposal that raises the cost of doing business in Washington state by increasing their own investment spending in the state. Q. Would the “parity pricing” concept delay local competition in Washington in any other ways? A. I believe so. I fear that adopting the proposal would lead to still more litigation that has frustrated policy makers who expected local competition to occur much faster than it has. Even the popular press, publications such as USA Today, have begun to depict the efforts to implement the Telecommunications Act as primarily a harvest of court litigation. Adoption of the “parity pricing” proposal likely would create additional litigation and attendant delay because that proposal is inconsistent with the clear language of the Telecommunications Act, and individual states have no ability to ignore such a clear directive. The Telecommunications Act, as noted, states that prices shall be “based on the cost (determined without reference to a rate-of-return or other rate-based proceeding) of providing the interconnection or network element.… The staff proposal would base UNE prices on the Commission’s most recent rate-of-return cases for USWC and GTNW — where the ILECs’ current retail rates were established. To adopt UNE prices that are in parity with retail rates would directly contravene the Telecommunications Act. Dr. Blackmon expresses concern over discriminatory rates and cites subsection 252(d)(1)(ii). Blackmon Testimony, p. 9. He has seriously misread the Telecommunications Act. The referenced subsection speaks to discrimination among purchasers of interconnection and network elements and between ILECs and CLECs, not discrimination between UNEs and retail rates. Competition will bring about different rates for different types of customers. Although the Commission should be concerned about ILECs gouging one set of customers in order to cross-subsidize offering a lower price to another set of customers, this can and should be handled through imputation and other pricing rules, not through artificially inflating the prices of UNEs. Q. Are there any other examples in the testimony that appear to mis-characterize incentives and other effects of “parity pricing”? A. Yes. Dr. Blackmon speculates that the failure to adopt “parity pricing” will have several negative results, including weakened ILEC incentives to invest in the network and the risk that retail customers will be burdened with untoward cost shifts. Blackmon Testimony, p. 7. These speculations apparently rest upon absolutely no analysis of the state of the overall telecommunications industry and the overall market. It is common knowledge that USWC and GTNW and all telecommunications providers are today facing lower costs, improved productivity and very robust increases in demand. See Montgomery Reply Testimony, pp. 22-23 ILECs would be irrational to forego business opportunities by failing to make new investments. USWC’s aggressive effort to deploy ADSL technology, a new market that will confront competition, belies the notion that pricing UNEs at economic cost somehow creates poor incentives. By the same token, cost shifting will be much less of a problem if those costs are declining as they are. These speculations are also troubling in two other ways. First, they reflect a lack of contextual knowledge about growth in demand and connectivity as well as declining costs in the global telecommunications market — as well as in Washington. Second, the underlying theme of this list of horrors seems to be the notion that this Commission’s telecommunications regulation should or can run on auto pilot. Claims that ILECs would erect non-price barriers and shift costs if “parity pricing” were not adopted Blackmon Testimony, p. 7. completely discount this Commission’s continuing oversight role. It’s the Commission job to prevent any service provider from erecting anti-competitive non-price barriers to competition, but there is no magic bullet that would automatically do the job. Likewise, if “cost shifting” were ever to be perceived as a real problem in the future (highly unlikely though that is), this Commission has ample tools to deal with it and even prevent it. See Montgomery Reply Testimony, pp. 25-26. The Commission does not need to adopt competitively-harmful pricing policies merely to assuage hypothetical events or conditions. Q. Does “parity pricing” as proposed correctly address any costs associated with a “assembled service”? A. No. Although the issue is somewhat trivial in comparison to the other problems with “parity pricing,” the proposal for recovering the costs of “assembling” UNEs is also wrong. The proposal would recover the “cost” of assembly month after month in the form of a recurring surcharge. The surcharge would be $3.02 per month for USWC and $24.08 per month for GTNW. Blackmon Testimony, pp. 19 & 24. Even assuming that there were such a cost in the first place, it would be only a one time cost that would be recovered in a non-recurring charge. Under the proposal, then, a CLEC holding an “assembled” UNE set for 18 months would pay an extra $54.36 to USWC and an extra $433.44 just for assembly. Therefore, the “assembly” issue merely magnifies the anti-competitive tax on CLECs that “parity pricing” represents. Reciprocal compensation Q. Can you summarize the issues with respect to reciprocal compensation? A. Yes. A number of the parties to this proceeding favor replacing the Commission’s current “bill and keep” rule for the transport and termination of calls on another carrier’s network. Some have suggested that the bill and keep method might be displaced only when traffic exchanges exceeded a “collar,” See Hydock (MCI) Reply Testimony, p. 43. or eliminated outright. However, some disagreement exists about how a new compensation plan should operate. Staff witness Blackmon agreed with my direct testimony concerning the advantages of capacity charges for reciprocal compensation. Blackmon Testimony, pp. 25-29. WorldCom witness Gary Ball, on the other hand, supports minutes of use charges; he states that the capacity charge concept I discussed should not be the only form of reciprocal compensation. Ball Testimony, p. 14. Q. What is your opinion of these positions? A. As I stated in my direct testimony, the Commission has sufficient information to retain bill and keep as a default compensation mechanism, and any replacement form of compensation must comply with the Act’s “additional costs” pricing standard for the transport and termination of calls. I believe, however, that the Commission could reasonably retain bill and keep and allow CLECs to have either minutes of use prices or capacity charges. In this instance, multiple pricing options would be consistent with the Telecommunications Act’s general preference that carrier interconnection arrangements can best to defined by bilateral agreements. I noted in my direct testimony that the Commission’s ability to oversee and approve interconnection agreements would be much more difficult if each agreement contained, in effect, a “customized” set of basic price terms. Montgomery Direct Testimony, p. 21. If there were an unfettered range of prices, for example, it would be quite difficult for the Commission, or other competitors, to detect a potentially preferential set of prices offered by an incumbent to a particular CLEC, in exchange, perhaps, for the CLEC’s agreeing to concessions in other areas. The creation of price squeezes against certain CLECs, particularly as retail prices begin to decline under competition, would be especially hard for the Commission to uncover. However, having the capacity charge and minutes of use charge options would not create any particular confusion about prices and would not make it appreciably more difficult for the Commission and the various competitors to understand and evaluate the prices being paid by other competitors for the transport and termination of traffic. Q. Can you explain why the two reciprocal compensation pricing options would be readily understandable to market participants? A. Yes. As I explained in my direct testimony, the costs for transport and termination are driven by the same factors regardless of whether the cost is recovered via a capacity charge or a minutes of use charge. Minutes of use cost calculations primarily reflect peak network utilization costs after they have been “spread” over the usage periods to which the prices will apply. Because the underlying cost driver is the same, the capacity charge or minutes of use prices will be comparable and can be compared easily. Of course, as I said, capacity charges should be more economically efficient, both because of the closer correspondence to how the underlying costs are, in fact, incurred; and because capacity charges can avoid the deadweight cost of measuring individual minutes of use in real time. A CLEC, however, should have the option to elect a minutes of use charge, as long as these relatively small differences in economic costs are properly identified and recovered in the minutes of use charge itself. In Tables 1 and 2 of my direct testimony, I used USWC’s own minutes of use cost estimate to establish the USWC capacity charge, removing only limited costs of measurement. Therefore, the calculations I prepared are entirely amenable to having both pricing options in place in Washington. Pricing of interim number portability Q. Should the Commission adopt staff witness Griffith’s proposal for pricing of interim number portability? A. No. Mr. Griffith’s proposal is contrary to the competitively-neutral pricing recommendations described in the FCC’s Third Report and Order on Number Portability and in my direct testimony. Not only does Mr. Griffith adopt a per line charge to be assessed only on CLECs, he recommends a rate that covers all INP costs, including common costs plus an additional mark up of 18% for US WEST. Griffith Testimony, pp. 4-5. Mr. Griffith claims that since interim number portability will only be needed for a short time longer, that we can disregard such recommendations and go ahead and adopt artificially high prices based on the ILECs’ recommendations. His assumptions, however, are not correct. There will be areas where INP will still be used and, more important, there are likely interconnection agreements that call for true-up pricing of INP once the Commission adopts final prices. For these reasons, the Commission cannot ignore the real financial impact of adopting non-cost based rates that are not competitively neutral. Q. Do you have any additional testimony at this time? A. No.