BEFORE THE WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION In the Matter of Determining Costs for ) DOCKET NO. UT-980311(a) Universal Service ) ) BRIEF OF TRACER ) . . . . . . . . . . . . . . . . . . . . . . . . . . ) Filed: October 7, 1998 Page 1 - BRIEF OF TRACER TABLE OF CONTENTS I. Introduction 1 II. Legal Principles 1 A. State Law 1 1. Ch. 337, L. 1998 1 2. Relationship between this docket and other dockets, including UT-960369 2 a. Can or should the Commission take any action on universal service absent an explicit directive from the legislature? 2 b. Need for consistency between the universal service fund proceeding and the price of unbundled network elements 3 (1) If UNE rates and the USF must be consistent, does this imply that UNE rates must be deaveraged? 5 (2) If there is a need to deaverage UNE prices, must this be done prior to the legislature taking action on the USF issue? 6 (3) If the legislature takes no action on the Commission's report, is there a need to deaverage UNEs? 6 B. Federal law 7 III. Policy issues 10 A. Purpose of the proceeding 10 B. Timing/implementation/competition 11 C. Selection of a cost model 12 D. Benchmark/number of lines to support/geographic level for calculation of costs 15 1. Benchmark 15 2. Number of lines to support 16 3. Geographic level for calculation of costs 17 E. Surcharge 18 F. Impact of FCC activities 18 G. Size of the fund/reliability of fund size estimate 20 H. Should a "wireless cap" be implemented? If so, what is the appropriate investment cap? 21 I. If a revenue benchmark is adopted, what revenues should be included (e.g., should toll revenue be included)? 21 J. Should other sources of support be considered when estimating the size of the universal fund (e.g., revenue from yellow pages, revenue from federal or existing state support programs)? If so, does the record identify the level of support obtained from these other sources? 22 K. Should households or housing units be used to estimate the cost of service? 22 IV. Cost models 23 A. Issues that apply to both models: 23 1. Structure mix (percent aerial, buried, underground) 23 2. Cost of money, depreciation rates 24 3. Should the proxy models' estimates of U S WEST's drop lengths be adjusted to reflect the company's special study? If so, how? 24 4. Should loop length estimates be adjusted to address the concern that the MST < estimated distribution distances? If so, how (e.g., adjust drop distance, apply a route-to-air factor)? 24 5. Should the proxy models' switching investment estimate be used, or should an alternative investment equation be employed (e.g., the equation used by the Commission in the UNE docket)? 26 6. How should expenses be estimated (e.g., role of current/book ratios; adjustment for nonrecurring expenses; estimate of common costs)? 26 7. Pole material and installation cost 26 B. BCPM 3.1 26 1. Arguments in support of model 26 2. Criticisms of model 26 C. HAI 5.0a 37 1. Arguments in support of model 37 2. Criticisms of model 44 V. Cost model inputs 48 VI. Compliance with Commission policies and requirements 48 A. Compliance with Commission guidelines 48 1. Develop costs at wire center level or below 48 2. Study network of single lines, multi-line, and all lines 48 3. Develop forward-looking costs/embedded for rural companies 50 4. Commission-prescribed inputs (cost of cap., deprec., fill factors) 50 5. Actual line counts -- average loop length 51 6. Support the services identified by the Act 52 7. Include shared and common costs separately and provide factual support for each 52 8. Identify costs of administration 52 B. Compliance with Commission orders, including 8th Supp., UT-960369 52 VII. Rural company issues 53 A. Embedded cost estimates and analysis 53 B. Revenue neutrality 53 C. Access charge rulemaking issues 53 VIII. Impact of responses to bench requests and record requisitions 53 IX. Conclusions and recommendations 54 Page 1 - BRIEF OF TRACER I. Introduction The Washington Telecommunications Ratepayers Association for Cost-based and Equitable Rates ("TRACER") submits this brief on issues relating to the determination of the costs of supporting basic telecommunications services for customers of telecommunications companies in high-cost locations in the state of Washington. Legal Principles A. State Law 1. Ch. 337, L. 1998 In Chapter 337, Laws of 1998 (ESSB 6622)("State USF Act"), the Washington Legislature directed the Commission to "plan and prepare to implement a program for the preservation and advancement of universal telecommunications service which shall not take effect until the legislature approves the program." State USF Act, Sec. 1(1). The express purpose of the USF program "is to benefit telecommunications ratepayers in the state by minimizing implicit sources of support and maximizing explicit sources of support that are specific, sufficient, competitively neutral, and technologically neutral to support basic telecommunications services for customers of telecommunications companies in high-cost locations." The act defines the "basic telecommunications services" to be supported as: (i) Single-party service; (ii) Voice grade access to the public switched network; (iii) Support for local usage; (iv) Dual tone multifrequency signaling (touch-tone); (v) Access to emergency services (911); (vi) Access to operator services; (vii) Access to interexchange services; (viii) Access to directory assistance; and (ix) Toll limitation services. State USF Act, Sec. 1(7(b)). A "high-cost location" is defined as "a location where the cost of providing telecommunications services is greater than a benchmark established by the commission by rule." State USF Act, Sec. 1(7(c)). In Section 1(2) the Legislature directed the Commission to "[e]stimate the cost of supporting all lines located in high-cost locations and the cost of supporting one primary telecommunications line for each residential or business customer located in high-cost locations . . ." In effect, this provision requires the Commission to estimate the size of the fund that would be required (i) if only one primary line providing basic telecommunications service for residential and business customers located in high-cost locations were supported through the new, explicit USF program (with other lines continuing to be supported through implicit means), and (ii) if all lines providing basic telecommunications service in high-cost locations were supported explicitly. This proceeding arises directly out of these directives and definitions. 2. Relationship between this docket and other dockets, including UT-960369 a. Can or should the Commission take any action on universal service absent an explicit directive from the legislature? The Commission has the statutory obligation to regulate "the rates, services, facilities, and practices of all . . . telecommunications" so as to, among other things, "[preserve] affordable universal telecommunications service. . ." RCW 80.01.040(3); RCW 80.36.300(1). However, it must do so "as provided by the public service laws. . ." RCW 80.01.040(3). It follows that the Commission need not wait for an explicit directive from the Legislature before taking action to preserve universal service. However, at present the Commission does not have the statutory authority to create an explicit USF fund that would require contributions from all carriers or end-users that are unrelated to the services provided by those companies. Washington Independent Tel. Ass'n v. TRACER, 75 Wn. App. 356, 880 P.2d 50 (1994). In that case the Washington Court of Appeals held that the Commission lacked the statutory authority to impose a charge on all access lines, assess the charge against all LECs, and then distribute the funds to other LECs that incur losses through the conversion of toll routes to EAS service. The court stated that the Commission's regulation of rates is limited to the "rates that a utility itself charges its customers for providing services." 75 Wn. App. at 367. The court went on to state: In our judgment, this does not confer power on the Commission, either expressly or impliedly, to impose its own charge on the company or ratepayers. Courts have similarly analyzed the Commission's power as involving the rates that a company charges to subscribers both for the service it provides and to meet its own revenue requirements. . . The charge imposed in WAC 480-120-425 on access lines to fund the CCF is unrelated to service provided by the company. Nor is the charge related to revenue requirements of the LEC against which the charge is ostensibly assessed. It is only related to the Commission's general conclusion that some LECs need to be compensated for lost revenue incurred during EAS conversion, and that sufficient compensation can be gained by charging other LECs. Id. Thus, the Commission must await the grant of express statutory authority from the Legislature before implementing the sort of explicit USF program contemplated in the State USF Act. b. Need for consistency between the universal service fund proceeding and the price of unbundled network elements. There is a clear need for consistency between the calculation of universal service funding and the pricing of unbundled network elements ("UNEs"). This is so for a number of reasons. First, as pointed out by Dr. Zepp, it is an advantage if the same model is used of calculating both UNEs and USF The developers of the BCPM concede that it cannot be used to develop the costs of UNEs., if for no other reason than the fact that the services that comprise “universal service” are a combination of UNEs, plus a reasonable share of service-related costs. In other words, unbundled network elements are the building blocks for the provision of universal service. In order to send consistent economic signals to the marketplace, the same methodology and inputs should be used to calculate the costs for individual UNEs as are used to develop the costs associated with universal service support. By calculating the costs of UNEs and USF consistently, the Commission can help ensure that all potential providers of basic telecommunications services will be able to make investment decisions that are economically efficient and consistent with competitive market characteristics. Zepp Response Testimony, Ex. 278-T at 3-4. Second, the FCC clearly intends that consistent methodologies be used for pricing UNEs and for determining USF support. As stated in its Universal Service Order First Report and Order, In the Matter of Federal-State Joint Board on Universal Service, FCC 97-157, CC Docket No. 96-45 (May 8, 1997)("Universal Service Order"). at ¶ 251, n. 669: "Methodological differences such as different geographic divisions or different input assumptions could result in a divergence between the cost calculation for that . . . set of unbundled elements required to provide supported services to a particular customer and the universal service cost calculation for providing supported services to that same customer." Thus, the FCC encouraged states to develop permanent UNE prices as a basis for their universal service cost studies, because this "would reduce duplication and diminish arbitrage opportunities that might arise from inconsistencies between the methodologies. . ." Id. at ¶ 251. (1) If UNE rates and the USF must be consistent, does this imply that UNE rates must be deaveraged? If the USF plan is to be competitively neutral, it is critical that USF support be calculated on the same geographic basis that UNEs are costed and priced. In other words, if UNEs are only available on a statewide averaged basis, USF support should be calculated on the same statewide averaged basis. Conversely, if USF support is calculated on an exchange basis (or on the basis of some geographic unit that is smaller), UNE prices should be set on the same geographically deaveraged basis. If this is not done, significant, distorting, anticompetitive effects will result, particularly in the low-cost areas of the state. For example, if UNEs are only available on a statewide averaged basis but USF support is calculated at the exchange level, the incumbent ETC draws the USF support. That support covers the cost of providing service in the high-cost area. But, the statewide averaged UNE price also covers the cost of providing service in high-cost locations. If a CLEC wants to buy a UNE in a low-cost area and has to pay the statewide averaged price, the incumbent ETC gets a windfall; it double recovers. And, its actual economic cost in the low-cost area is much lower than what its dependent competitor is required to pay. The result is that the CLEC cannot compete and won't buy UNEs from the ETC. Competition will be deterred, or at least dramatically slowed. It is widely recognized that facilities-based competition will most likely come only after the new entrant has established a large enough base of customers (through resale) to justify the investment in facilities. This applies to both the resale of services and the resale of UNEs. Without a correlation of the prices for UNEs and the calculation of USF support, this logical evolution from resale to facilities-based competition will be impeded. See Baker Response Testimony, Ex. 371-T at 15, 16, 25, 35. If UNE prices and USF supports are not calculated on the same geographic basis, urban and other low-cost consumers in the state will be deprived of the benefits of competition. They will get all of the burden of USF support and none of the benefit of competition. Such a result is not in the public interest and is not consistent with federal or state law. (2) If there is a need to deaverage UNE prices, must this be done prior to the legislature taking action on the USF issue? As discussed above, it is critical that UNE prices be deaveraged if USF support is to be calculated and provided on a geographically deaveraged basis. UNE prices must be deaveraged no later than the time at which the Legislature takes action to implement a deaveraged USF program. However, it does not follow that UNE prices cannot be deaveraged before a deaveraged USF program is implemented. In fact, the availability of geographically deaveraged UNE prices will enhance the pace at which economically efficient, facilities-based competition will be able to develop in Washington. As noted in footnote 4 above, the availability of efficiently priced UNEs will enable competitors to accumulate a sufficient base of customers to justify the investment in facilities. (3) If the legislature takes no action on the Commission's report, is there a need to deaverage UNEs? See (2) above. B. Federal law The stated purpose of the federal Telecommunications Act of 1996 Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (codified at 47 U.S.C. § § 151 et seq.). ("Act") is "to promote competition and reduce regulation in order to secure lower prices and higher quality services for American telecommunications consumers and encourage the rapid deployment of new telecommunications technologies." (Emphasis added.) Act, supra, purpose statement, at 56. In section 254 of the Act, Congress also stated that "[t]here should be specific, predictable and sufficient Federal and State mechanisms to preserve and advance universal service." As explained in the Joint Explanatory Statement of the Committee of the Conference, Congress intended that, "[t]o the extent possible, . . . any support mechanisms continued or created under new section 254 should be explicit, rather than implicit as many support mechanisms are today." Joint Explanatory Statement of the Committee of the Conference, S. Conf. Rep. No. 230, 104th Cong., 2d Sess. 131 (1996). Section 254(f) of the Act provides that a state may adopt USF regulations not inconsistent with the FCC's rule. A state also may adopt a state USF program that supports additional services or utilizes different standards to preserve and advance universal service in that state "only to the extent that such regulations adopt additional specific, predictable, and sufficient mechanisms to support such definitions or standards that do not rely on or burden Federal universal service support mechanisms." In ¶ 250 of its Universal Service Order the FCC set out ten criteria for forward-looking economic cost determinations: We agree that all methodologies used to calculate the forward-looking economic cost of providing universal service in rural, insular, and high cost areas must meet the following criteria: (1) The technology assumed in the cost study or model must be the least-cost, most-efficient, and reasonable technology for providing the supported services that is currently being deployed. A model, however, must include the ILECs' wire centers as the center of the loop network and the outside plant should terminate at ILECs' current wire centers. The loop design incorporated into a forward-looking economic cost study or model should not impede the provision of advanced services. For example, loading coils should not be used because they impede the provision of advanced services." We note that the use of loading coils is inconsistent with the Rural Utilities Services guidelines for network deployment by its borrowers. Wire center line counts should equal actual ILEC wire center line counts, and the study's or model's average loop length should reflect the incumbent carrier's actual average loop length. (2) Any network function or element, such as loop, switching, transport, or signaling, necessary to produce supported services must have an associated cost. (3) Only long-run forward-looking economic cost may be included. The long-run period used must be a period long enough that all costs may be treated as variable and avoidable. The costs must not be the embedded cost of the facilities, functions, or elements. The study or model, however, must be based upon an examination of the current cost of purchasing facilities and equipment, such as switches and digital loop carriers (rather than list prices). (4) The rate of return must be either the authorized federal rate of return on interstate services, currently 11.25 percent, or the state's prescribed rate of return for intrastate services. We conclude that the current federal rate of return is a reasonable rate of return by which to determine forward looking costs." We realize that, with the passage of the 1996 Act, the level of local service competition may increase, and that this competition might increase the ILECs' cost of capital. There are other factors, however, that may mitigate or offset any potential increase in the cost of capital associated with additional competition. For example, until facilities-based competition occurs, the impact of competition on the ILEC's risks associated with the supported services will be minimal because the ILEC's facilities will still be used by competitors using either resale or purchasing access to the ILEC's unbundled network elements." In addition, the cost of debt has decreased since we last set the authorized rate of return. The reduction in the cost of borrowing caused the Common Carrier Bureau to institute a preliminary inquiry as to whether the currently authorized federal rate of return is too high, given the current marketplace cost of equity and debt. We will re-evaluate the cost of capital as needed to ensure that it accurately reflects the market situation for carriers. (5) Economic lives and future net salvage percentages used in calculating depreciation expense must be within the FCC-authorized range. We agree with those commenters that argue that currently authorized lives should be used because the assets used to provide universal service in rural, insular, and high cost areas are unlikely to face serious competitive threat in the near term. To the extent that competition in the local exchange market changes the economic lives of the plant required to provide universal service, we will reevaluate our authorized depreciation schedules. We intend shortly to issue a notice of proposed rule making to further examine the Commission's depreciation rules. (6) The cost study or model must estimate the cost of providing service for all businesses and households within a geographic region. This includes the provision of multi-line business services, special access, private lines, and multiple residential lines. Such inclusion of multi-line business services and multiple residential lines will permit the cost study or model to reflect the economies of scale associated with the provision of these services. (7) A reasonable allocation of joint and common costs must be assigned to the cost of supported services. This allocation will ensure that the forward-looking economic cost does not include an unreasonable share of the joint and common costs for non-supported services. (8) The cost study or model and all underlying data, formulae, computations, and software associated with the model must be available to all interested parties for review and comment. All underlying data should be verifiable, engineering assumptions reasonable, and outputs plausible. (9) The cost study or model must include the capability to examine and modify the critical assumptions and engineering principles. These assumptions and principles include, but are not limited to, the cost of capital, depreciation rates, fill factors, input costs, overhead adjustments, retail costs, structure sharing percentages, fiber-copper cross-over points, and terrain factors. (10) The cost study or model must deaverage support calculations to the wire center serving area level at least, and, if feasible, to even smaller areas such as a Census Block Group, Census Block, or grid cell. We agree with the Joint Board's recommendation that support areas should be smaller than the carrier's service area in order to target efficiently universal service support. Although we agree with the majority of the commenters that smaller support areas better target support, we are concerned that it becomes progressively more difficult to determine accurately where customers are located as the support areas grow smaller. As SBC notes, carriers currently keep records of the number of lines served at each wire center, but do not know which lines are associated with a particular CBG, CB, or grid cell. Carriers, however, would be required to provide verification of customer location when they request support funds from the administrator. These criteria should be used to evaluate the cost models and cost studies produced in this proceeding. Doing so will help ensure that the USF support determinations made by the Commission are consistent with those that will govern federal USF support calculations. Thus, in establishing a state USF program to provide competition-proof support for basic service in high-cost areas of the state, the Commission needs to act to identify high-cost areas and determine the level of support required in strict coordination with federal high-cost support policies and programs. Coordination with federal USF activities and inclusion of the amount of federal support in calculating the amount of needed state USF support is necessary to ensure that the state USF is properly sized and eligible carriers are not permitted to over-recover the costs of providing high-cost services. III. Policy issues A. Purpose of the proceeding The goal of a Washington USF should be to establish a mechanism that, operating with federal high cost support mechanisms, is sufficient to ensure the availability of quality basic telecommunications service at affordable rates in all parts of the state. The purpose of this proceeding is to determine the costs of supporting the services enumerated in ESSB 6622 in high cost areas of the state and the size of the needed USF (i) if only primary lines are supported, and if (ii) all lines are supported. In order to do this, the following subissues must be resolved: (1) the appropriate cost methodology, (2) the geographic level at which costs will be determined, and (3) the benchmark to be used in determining which areas are "high cost" and the amount of USF support required. B. Timing/implementation/competition It is widely recognized that affordable basic service rates have been maintained historically through, among other things, a combination of geographic rate averaging, high rates for business customers, high intrastate access rates, high rates for intrastate toll service, and high rates for vertical features and services such as call waiting and call forwarding. In the case of small, rural LECs, explicit subsidies and above-cost access charges probably provide the largest source of high-cost support, although some is provided by high business rates and geographic averaging. In the case of the large incumbent LECs, more of the high-cost support likely comes from high business rates and geographic averaging. This traditional means of supporting universal service in high cost areas becomes problematical as competition develops. The specific concern is that competition could erode this source of support, thereby jeopardizing the state's ability to achieve its universal service goals. However, in the absence of widespread, effective competition, there is no threat to existing sources of high-cost support. As stated by Public Counsel witness Ben Johnson: Until competition begins to undermine the financial viability of ILECs functioning as carriers of last resort, the support mechanisms currently in place may continue to be adequate. . . . . . . . . Until competitive pressures build and the market evolves towards a pattern of deaveraging, competitive "cherry picking," and the like, the incumbent carriers can continue to function under the existing system. A USF mechanism is primarily needed as a response to competitive pressures rather than as a device to promote competition. Johnson Rebuttal Testimony, Ex. 387-T at 20. Exhibits 276 and 277 accompanying Dr. Zepp's Supplemental Direct Testimony demonstrate that the three non-rural companies involved in this proceeding (U S WEST, GTE, and Sprint/United) currently generate sufficient average revenues per line from their residential customers to cover the cost of providing service to residential customers in all areas. The same is true for their business customers. Thus, until competition develops at least to the point where the average revenues per line for each customer class fall below the average cost per line for those customer classes, it cannot be said that universal service is in jeopardy in this state. There is no evidence in this proceeding that shows that local competition has developed to the point that there has been any appreciable impact on the existing sources of support for services in high-cost areas. See also Order No. FCC 98-160 (July 17, 1998), extending the implementation date for the new federal high-cost USF program, in which the FCC stated at ¶ 8: "No convincing evidence has been presented to the Commission to show that circumstances such as the development of local exchange competition, will significantly affect the support flows before the revised implementation date." This does not mean that the Commission should not move forward in trying to develop an appropriate USF program; however, it does mean that the Commission has time to move carefully so as to avoid inequitable, adverse, and unduly disruptive effects on end-users, on carriers, and on the development of competition. C. Selection of a cost model Cost models should be evaluated against the ten criteria set out by the FCC in ¶ 250 of its Universal Service Order. See Section II.B. above. In addition, Dr. Zepp discussed six important principles to which cost proxy models used for determining USF support levels should adhere. These principles are: (1) Costs should be calculated in a way that reflects—at a disaggregated level—the operating territory and demand characteristics of each incumbent local exchange carrier (“ILEC”), but be independent of the ILEC’s embedded network configuration and operating procedures; (2) Costs should be for a long run period, a period long enough to vary all inputs required to provide the elements or services under study; (3) Costs should be the forward-looking costs of serving demand efficiently, using the least-cost technology that is generally available; (4) To the maximum extent possible, costs should be consistent with the principles of cost causation; (5) The increment of demand used in the model should be the entirety of the service or network element under study; and (6) The model should be open and well-documented permitting the Commission and all parties to fully explore (and alter, if warranted) all of the key inputs, assumptions, and algorithms used in the model. Zepp Response Testimony, Ex. 278-T at 1-2. Adherence to these criteria and principles is important and will ensure that cost-based prices for unbundled network elements and the costs used to calculated USF subsidies will reflect the economic costs of providing basic local exchange service efficiently. Id. at 2-3. However, as Dr. Zepp explains, the BCPM does not satisfy these principles. The BCPM (1) fails to provide universal service because it does not build plant to all occupied households in Washington; (2) uses faulty assumptions to locate and cluster customers that cause the model to understate the need for distribution plant; (3) does not include the effects of growth in the denominator of its calculation of cost per line even though it constructs plant to provide for future growth; (4) does not use preprocessing that is sufficiently open--this is a particular problem with respect to the feeder/subfeeder design assumptions which are not modifiable; and (5) uses data and assumptions in the development of both the default and state-specific inputs that are not available for verification. Id. at 4-5. If the Commission decides to go forward with a recommendation that the Legislature authorize the creation of a state USF at this time, TRACER recommends that the Commission adopt one model only and work to improve it over time as the results of the FCC's efforts to select a model platform are known and as improved data on customer location, line counts, revenues, and other data inputs become available. Given the available evidence and serious flaws in the BCPM discussed by TRACER's witnesses Brian Pitkin and Dr. Zepp, AT&T's witness Dr. Robert Mercer, and Public Counsel's witness Dr. Johnson, TRAC