BEFORE THE WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION In the Matter of the Pricing Proceeding ) for Interconnection, Unbundled Elements ) DOCKET NO. UT-960369 Transport and Termination, and Resale ) ) ) In the Matter of the Pricing Proceeding ) for Interconnection, Unbundled Elements ) DOCKET NO. UT-960370 Transport and Termination, and Resale ) for U S WEST COMMUNICATIONS, INC. ) ) ) In the Matter of the Pricing Proceeding ) DOCKET NO. UT-960371 for Interconnection, Unbundled Elements ) Transport and Termination, and Resale ) for GTE NORTHWEST INCORPORATED ) ) REPLY TESTIMONY OF REX KNOWLES NEXTLINK WASHINGTON, INC. September 4, 1998 Reply Testimony of Rex Knowles Page 1 Q. PLEASE STATE YOUR NAME, EMPLOYER, AND BUSINESS ADDRESS. A. My name is Rex Knowles. I am a Director Regulatory and External Affairs for NEXTLINK Management Services, Inc., 111 East Broadway, Suite 1000, Salt Lake City, Utah 84111. Q. ARE YOU THE SAME REX KNOWLES WHO PROVIDED RESPONSE TESTIMONY IN THIS PROCEEDING? A. Yes, I am. Q. WHAT IS THE PURPOSE OF YOUR REPLY TESTIMONY? A. The purpose of my Reply Testimony is to respond to the testimony filed by Commission Staff witnesses David Griffith and Glenn Blackmon. Specifically, I explain why the Commission should reject Commission Staff's apparent proposals (1) to impose the entire costs of interim local number portability on competing local exchange carriers ("CLECs"), and (2) to allow U S WEST Communications, Inc. ("U S WEST") and GTE Northwest Incorporated ("GTE") flexibility in the pricing of unbundled network elements. I. INTERIM LOCAL NUMBER PORTABILITY Q. WHAT IS YOUR UNDERSTANDING OF STAFF'S PROPOSAL FOR RECOVERY OF INTERIM LOCAL NUMBER PORTABILITY COSTS? A. David E. Griffith on behalf of Commission Staff proposes monthly recurring prices for interim local number portability based on the costs established for U S WEST and GTE in Phase I of this proceeding. Mr. Griffith also recommends that these charges be eliminated only when permanent local number portability has been deployed. Q. DOES NEXTLINK SUPPORT SUCH A PROPOSAL? A. No. NEXTLINK's position is that Staff's proposal to impose the entire costs of interim local number portability on CLECs is precluded by the Telecommunications Act of 1996 ("Act") and the FCC's number portability orders, as well as the Commission's prior decisions in individual arbitrations to comply with those federal requirements. The FCC specifically stated that "requiring the new entrants to bear all of the costs, measured on the basis of incremental costs of currently available number portability methods, would not comply with the statutory requirements" of the Act. In re Telephone Number Portability, CC Docket No. 95-116, RM 8535 (FCC 96-286), First Report and Order ¶ 138 (July 2, 1996) ("First Number Portability Order"). The FCC subsequently reiterated this conclusion on cost recovery for interim local number portability solutions in the very order Mr. Griffith cites in his testimony for its provisions governing long-term local number portability: "Shifting all these incremental costs to the competitive LEC would not be competitively neutral, however, because the competitive LEC could suffer a competitive disadvantage when competing with the incumbent LEC for that subscriber." In re Telephone Number Portability, CC Docket No. 95-116, FCC 98-82, Third Report and Order ¶ 43 (May 12, 1998) ("Third Number Portability Order"). Mr. Griffith does not explain why Commission staff apparently believes that imposing the entire costs of interim local number portability on CLECs is appropriate or consistent with federal legal requirements, much less give any reason why the Commission should depart from its consistent position in the arbitrations that it would comply with federal law. The position taken by U S WEST, GTE, and Commission Staff, however, is reminiscent of the unsuccessful arguments AT&T made in opposition to equal access to long distance carriers: Why should customers who choose to remain with the incumbent monopoly provider support the ability of other customers to choose a different carrier? The answer, quite simply, is that all consumers must pay for freedom of choice. Congress and the Washington legislature have made the policy decision that all consumers will benefit from the advent of competition -- whether they change providers or not -- and that consumers thus should have an effective choice of telecommunications service providers for both local and long distance services. The fact that most consumers initially exercise that choice to remain with the existing provider does not mean that only those consumers who want to change service providers must pay the entire costs of making the choice available to all consumers. Q. CAN'T CUSTOMERS CHANGE THEIR LOCAL SERVICE PROVIDER WITHOUT NUMBER PORTABILITY? A. Yes, but requiring a telephone number change -- or a substantial payment to retain that telephone number -- as a condition for changing local service providers imposes a significant and unnecessary burden on the exercise of that choice. Prior to the implementation of equal access in the interLATA long distance market, the existing telephone network configuration allowed customers of carriers other than AT&T to access a competing carrier only by dialing a local telephone number plus an access code (and later just the access code) in addition to the long distance number they were trying to reach. Some customers took advantage of this "choice," but the vast majority did not, finding that dialing the extra digits was simply too burdensome. Accordingly, the FCC required that incumbent LECs modify their existing networks to provide consumers with "equal access" to interLATA carriers, i.e., using the same 1+ dialing pattern, thus enabling customers to choose a long distance provider other than AT&T without having to dial extra digits. The FCC further required that the costs of implementing equal access be recovered on a competitively neutral basis, i.e., that all interLATA carriers and their customers pay an equal access surcharge on every minute of use. AT&T was not exempted from this requirement -- even though AT&T was the incumbent monopoly provider and its customers did not require equal access -- because the FCC wanted to facilitate effective consumer choice. The FCC's action was based on the policy determination that all consumers ultimately benefit from greater competition -- even if they themselves do not change providers -- so all consumers should pay a proportionate share of the attendant costs. Removing the burdens from the exercise of consumer choice enabled new market entrants to compete for customers on the basis of service price, features, and quality, rather than on whether the customer has to dial extra digits. The market share growth enjoyed by competitors of AT&T in the interLATA market demonstrates the success of this policy. Number portability is the mirror image of equal access. Rather than requiring the customer of a long distance provider to dial extra digits to reach a called party, a calling party must dial different digits to reach the customer of a CLEC. The fundamental issue of burdening freedom of choice, however is the same. Some local customers will change their numbers to switch service providers, but many more will not. INP -- and eventually permanent local number portability -- facilitates consumer choice by allowing the customer to be reached using the same telephone number regardless of whether that customer is served by U S WEST, GTE, or a CLEC. The costs associated with implementing INP (like equal access) should be recovered on a competitively neutral basis from all local service providers and their customers, even though U S WEST and GTE currently serve most local customers in their service areas. This same rationale underlies the FCC orders on number portability. The FCC explained in those orders that a competitively neutral cost recovery standard is a Congressionally-mandated departure from the usual cost causation principles "because number portability is a network function that is required for a carrier to compete with the carrier that is already serving a customer. Depending on the technology used, to price number portability on a cost causative basis could defeat the purpose for which it was mandated." First Number Portability Order § 131; Third Number Portability Order ¶ 41. The Commission, therefore, should establish a competitively neutral mechanism for allowing carriers to recover the costs of interim local number portability that is consistent with the Act and the FCC number portability orders. Mr. Montgomery on behalf of TCG Seattle and I on behalf of NEXTLINK have proposed just such a cost recovery mechanism. Q. WHAT ABOUT STAFF'S PROPOSAL TO ELIMINATE CHARGES FOR INTERIM LOCAL NUMBER PORTABILITY ONCE PERMANENT NUMBER PORTABILITY HAS BEEN DEPLOYED? A. That is precisely the opposite of what the Commission should do. Once permanent number portability has been deployed, CLECs will not need to rely on Remote Call Forwarding and similar interim local number portability technologies to enable their customers to retain their telephone numbers when changing local service providers. In the unlikely event that any CLEC or its customers want to continue using Remote Call Forwarding from U S WEST or GTE after a reasonable transition period following the advent of permanent local number portability, the Commission should permit U S WEST and GTE to impose cost-based charges for that service. II. UNE PRICING FLEXIBILITY Q. WHAT IS YOUR UNDERSTANDING OF COMMISSION STAFF'S PROPOSAL FOR PRICING UNBUNDLED NETWORK ELEMENTS? A. Glenn Blackmon on behalf of Commission Staff proposes that unbundled network elements be priced no lower than their Total Element Long-Run Incremental Cost ("TELRIC") and no higher than the average retail revenues generated from the use of those elements. Commission Staff would allow U S WEST and GTE the flexibility to set prices for individual elements at any point within that range. Q. WHAT IS NEXTLINK'S POSITION ON THIS PROPOSAL? A. NEXTLINK is strongly opposed to this proposal and is deeply troubled that Commission Staff would endorse such a pricing scheme. Adoption of such a proposal would preclude competitive entry into the local exchange markets of U S WEST and GTE using any unbundled network elements and would be a powerful disincentive to any competitive provider to provide local service at all in Washington. Q. WHAT IS THE BASIS FOR NEXTLINK'S POSITION? A. As I explained in my Response Testimony, my perspective is as a business person, not an economist, and from a business perspective, Dr. Blackmon's proposed prices provide CLECs with no opportunity for profitable entry using any unbundled network elements. I explained this issue to some extent in my Response Testimony when addressing GTE's proposals for an "interim universal service charge" and a "competitive transition charge." Dr. Blackmon's Testimony, however, requires a further discussion of the realities of the telecommunications market which Dr. Blackmon apparently does not consider. Q. WHAT ARE THE REALITIES OF THE TELECOMMUNICATIONS MARKET TO WHICH YOU REFER? A. Facilities-based entry into a local exchange market currently dominated by an incumbent monopoly provider is a risky and extremely expensive proposition. Often before a CLEC has a single customer, it must invest millions of dollars to construct an initial backbone network, install a switch, and establish administrative, customer service, billing, marketing and other business functions. The CLEC also must obtain interconnection with the incumbent's network, generally including collocation in several of the incumbent's central offices. Once its network is operational, the CLEC must attempt to generate sufficient revenues to obtain a return on its investments and to justify the additional investments necessary to expand its initial network. CLECs, however, do not have the incumbents' embedded customer base, virtually guaranteed rate of return on investment, or extensive network constructed over the years with ratepayer support. It is little wonder then that most, if not all, CLECs have yet to break even, much less make a profit on their local service operations according to publicly available information. CLECs also face a difficult and uncooperative adversary in the incumbent monopoly provider. U S WEST and GTE have little, if any, incentive to facilitate competitive entry into the local exchange markets they continue to control, and CLECs attempting to gain entry face almost daily obstacles imposed by the incumbents to CLECs' ability to provide local service. As other witnesses have observed, for example, neither U S WEST nor GTE provides CLECs with the same access to the incumbents' operations support systems ("OSS") that they themselves enjoy as the Act and the FCC require. Another example is that the Commission has not established intercarrier service performance standards, measures, and remedies for nonperformance and has repeatedly rejected individual CLEC's attempts to include such standards, measures, and remedies in arbitrated agreements, effectively precluding CLECs from gathering the information necessary to enforce their interconnection agreements or to obtain any meaningful relief if they could provide sufficient evidence of noncompliance. NEXTLINK has not yet interconnected with GTE in Washington but has extensive and largely unsatisfactory experiences in dealing with U S WEST in this state and in other states. U S WEST often imposes unilateral and nonnegotiable rates, terms, and conditions on various aspects of interconnection with, and access to, its network, regardless of its statutory and contractual obligations, including insisting on exorbitant charges as a prerequisite for collocation and providing access to unbundled elements only through technically and financially inferior single point of termination ("SPOT") frames. In some cases, U S WEST has simply refused to provide interconnection, citing an alleged lack of facilities. Although NEXTLINK has not been denied interconnection in Washington, MCImetro and ELI have outstanding complaints against U S WEST challenging just such behavior, and I understand from nonconfidential pleadings filed in the MCImetro proceeding before the Commission that U S WEST's refusal to provide timely interconnection results from an apparent U S WEST policy not to fund construction of facilities needed by competitors. Q. HOW DO THESE CIRCUMSTANCES AFFECT DR. BLACKMON'S ANALYSIS? A. Dr. Blackmon focuses entirely on network element prices, incumbent retail rates, and average retail revenues without considering other economic factors and noneconomic factors that render his analysis inapplicable to the market as it actually exists. Dr. Blackmon's proposal appears to assume that the local telecommunications market is already competitive, that CLECs can be profitable on razor thin or no margins, and that CLECs can exert market pressure on U S WEST and GTE to price unbundled network elements reasonably. Nothing could be farther from the truth. The reality is that the local exchange market in Washington continues to be a monopoly dominated by the incumbent carriers. CLECs will not enter or expand their entry into this market if they do not have the opportunity to recover their enormous initial and ongoing investments in their networks, and as Mr. Montgomery and I explained in prior testimony, they will have no such opportunity if they can compete only by providing more efficient switching and transport while the incumbents continue to recover their monopoly revenues through unbundled loop prices as Dr. Blackmon proposes. CLECs have no ability to exert any effective pressure on U S WEST or GTE to price unbundled network elements reasonably, at least not in the foreseeable future. Q. WHY SHOULDN'T THE INCUMBENTS BE ALLOWED FLEXIBILITY IN THE PRICING OF UNBUNDLED NETWORK ELEMENTS? A. My understanding of Washington law is that pricing flexibility is available to a regulated telecommunications company only when that company can demonstrate either that the company as a whole or its individual services are subject to "effective competition." The incumbents' provisioning of unbundled network elements is not subject to effective competition. No "market" even exists for unbundled network elements -- either a CLEC obtains an unbundled loop from the incumbent, or the CLEC must construct that loop for itself. There are no market constraints on the incumbents' pricing of unbundled network elements -- the pricing proposals made by U S WEST and GTE amply illustrate that the incumbents will price these elements as high as the Commission will allow. U S WEST and GTE have no desire to provide unbundled network elements to competitors and are doing so only because federal law requires them to do so. The incumbents thus have every incentive to make the use of unbundled elements as unattractive as possible, and overpricing is a very effective way to discourage competitors' use of those facilities. Dr. Blackmon's pricing flexibility proposal, therefore, is equivalent to proposing that incumbents be authorized to price unbundled network elements at the level of their average retail revenues. Unbundled loops, in particular, would likely have the highest mark-up over TELRIC under Dr. Blackmon's proposal. A CLEC that does not rely entirely on its own facilities or resale to provide local service generally has two options: (1) use unbundled loops from the incumbent to extend the reach of the CLEC's own network, or (2) purchase all of the unbundled network elements needed to provide the retail service from the incumbent and recombine those elements. Accordingly, U S WEST and GTE could be most effective in discouraging the use of unbundled network elements by pricing elements other than the loop at or near TELRIC and pricing the loop rate as high as the ceiling will allow. Thus, the total of the unbundled elements would be equivalent to the incumbent's average retail revenues, precluding recombination as a viable entry strategy, while the loop would be priced slightly less than the revenue ceiling, rendering use of unbundled loops economically infeasible. Q. WOULDN'T THE THREAT THAT COMPETITORS COULD BUILD THEIR OWN LOOPS EXERT PRESSURE ON THE INCUMBENTS TO PRICE THEIR LOOPS REASONABLY? A. No, at least not in the foreseeable future. Even if a CLEC had or could reasonably expect to acquire the customer base to support such investment, it would take many years and hundreds of millions of dollars to construct sufficient facilities to provide an effective alternative to the incumbents' existing loop plant. On an individual customer basis, CLEC backbone networks have a limited reach, and for the vast majority of potential customers, it would take more time and expense to construct loop facilities to customer locations on an individual case basis than the customer would be able or willing to endure to obtain service. The incumbents are well aware of these realities, and their actions (particularly U S WEST's actions) demonstrate that they believe they are better off doing everything they can to prevent or delay effective competition -- including requiring competitors to construct their own facilities -- and risk losing all revenue from a customer who changes to a CLEC, than they would be if they provided unbundled network elements at prices that would enable them to generate some revenue from their networks even if the competitor serves the end user customer. As long as these circumstances continue to exist, CLECs cannot restrain incumbents' ability to thwart the development of competition by imposing excessive loop prices. Q. WHY WOULD LOOP RATES SET CLOSE TO THE INCUMBENTS' AVERAGE RETAIL REVENUES BE EXCESSIVE? A. Section 252(d)(2) of the Act requires that unbundled loop rates be "based on the cost (determined without reference to rate-of-return or other rate based proceeding) of providing the . . . unbundled element, . . . nondiscriminatory, and . . . may include a reasonable profit." A loop rate determined by comparison with the incumbent's average retail revenues is not based on cost of providing the loop. Even if such a rate could be considered "cost-based," the GTE loop price of $68.17 that Dr. Blackmon recommends represents a 350% mark-up over the $20.00 cost found by the Commission in Phase I -- not even arguably a "reasonable profit." Dr. Blackmon nevertheless contends on page 9 of this testimony that "[t]o establish preferential pricing for unbundled elements and thereby to place a disproportionate share of the incumbent's common or overhead costs on its retail customers would be discriminatory . . . ." I fail to see how pricing unbundled elements consistent with the requirements of the Act is "preferential pricing" or discriminatory. Even if the Act's use of the term "nondiscriminatory" could be interpreted to refer to retail customers, Dr. Blackmon does not identify any basic retail service that the Commission has authorized U S WEST or GTE to mark-up 350% over the cost of providing the service simply to recover the company's common or overhead costs. Indeed, the revenues from all local and toll services provided by U S WEST and GTE that Dr. Blackmon uses as his price cap recover not only common or overhead costs, but also the direct costs of providing those services, profit, and implicit geographic cross-subsidies. Dr. Blackmon, therefore, like U S WEST and GTE, advocates that prices for unbundled loops be set to enable U S WEST and GTE be made whole for all competitive losses they suffer by generating the same revenues regardless of whether they serve the retail customer. Q. WHAT ABOUT THE POLICY CONCERNS DR. BLACKMON RAISES IF LOOPS ARE PRICED AT OR NEAR INCREMENTAL COST? A. I disagree with virtually all of the "policy effects" Dr. Blackmon enumerates on pages 6-7 of his testimony: (1) Encouraging Inefficient Entry. I see no basis for Dr. Blackmon's fear that inefficient competitors will enter the market if unbundled loop rates are set at or near incremental cost. Competitors who offer the best services at the best prices will succeed, while competitors that cannot match or improve on the incumbents' service quality, availability, and pricing will not. Whether a particular competitor is more or less efficient on one aspect of its operations, such as switching or transport, is irrelevant. The essence of competition is that the marketplace determines winners and losers, and the public interest is not served by effectively eliminating all use of unbundled loops to prevent a theoretically inefficient provider from entering the local market. (2) CLEC Incentive to Construct Loops. The recurring price of the unbundled loop is not the only basis on which a CLEC decides to construct its own loop. Other factors include the quality, capacity, and nature of the facility available from the incumbent, the need to control, maintain, repair or modify the customer's connection to the network, and the related costs to access the incumbent's unbundled loop (such as nonrecurring charges for installation and conditioning and charges for collocation, including Expanded Interconnection Channel Terminations ("EICT") to connect the loop to the collocated equipment). Even if the loop is priced at or near its TELRIC, therefore, CLECs will continue to have significant incentives to construct their own network. (3) ILEC Disincentive to Invest in Loops. The incumbents' incentive to invest in loop plant derives from providing service to retail customers, not competitors. This Commission and other state commissions have repeatedly criticized U S WEST for service quality problems resulting from its failure to invest sufficiently in its network, yet apparently service quality problems continue. The incumbents will have more incentive to invest in their networks and improve service quality if they face the real possibility of losing customers to competitors than if the Commission establishes excessive loop prices that delay the development of such competitive pressures. (4) Erection of Non-Price Barriers. The incumbents already have the incentive to erect non-price barriers to CLECs' use of unbundled loops, regardless of the price they are authorized to charge, and U S WEST (at least) has erected and continues to erect such barriers. I am surprised that Dr. Blackmon would propose that incumbents be allowed to price unbundled loops beyond economically feasible use by CLECs as a way to avoid non-price barriers. If Dr. Blackmon is concerned that the Commission is unable or unwilling to shoulder its responsibilities to enforce the Act or interconnection agreements, he should recommend that the Commission ask the FCC to take over those responsibilities, not suggest that the Commission effectively relieve the incumbents of their legal obligations. (5) Retail Cost Shifting. Any shifting of incumbents' overhead and common costs to an "increasingly narrow retail customer base" is the natural result of any loss of market share to a facilities-based provider. If the incumbent no longer serves a customer, the incumbent cannot recover overhead and common costs from that customer, regardless of whether the competitor now serving the customer uses an unbundled loop provided by the incumbent or the competitor's own facilities. Indeed, if a CLEC serves an incumbent's former customer using only the CLEC's own facilities, the incumbent cannot even recover its direct costs, much less its overhead and common costs, either from that customer or the CLEC that now serves the customer. Dr. Blackmon's concern over cost shifting, therefore, actually undermines his proposal -- the Commission should establish loop rates at or near the geographically deaveraged TELRIC estimates to encourage CLECs to use the incumbents' unbundled loops and thereby enable the incumbent to continue to generate some revenue (albeit indirectly) from the customers it no longer serves. Again, the incumbent's loss of market share is part of a competitive marketplace, and Commission Staff, like GTE and U S WEST, apparently would have the Commission insulate the incumbents from the effects of competition and continue to guarantee that the companies will generate their historic monopoly revenues, regardless of whether they actually serve the retail customer. Such a proposal is fundamentally inconsistent with the pro-competitive policies adopted by Congress and this Commission. Q. WHAT DO YOU RECOMMEND? A. I recommend that the Commission reject Dr. Blackmon's proposal to allow flexibility in the pricing of unbundled network elements and that the Commission adopt geographically deaveraged, cost-based rates as NEXTLINK has proposed. Q. DOES THAT CONCLUDE YOUR TESTIMONY? A. Yes, it does.