RECOMMENDATION TO THE CHAIRMAN, FCC

We recommend that the Commission establish within the Common Carrier Bureau an industry analysis section, whose analyses should provide a framework for future Commission decisions for regulating dominant and nondominant carriers in light of changing market conditions and would enable the Commission to measure the effectiveness of its policies designed to foster and encourage competition.

CHAPTER 3

PRICE/EARNINGS REGULATION-

ITS APPLICATION BY FCC

To carry out its responsibilities for regulating telecommunications common carriers under the Communications Act of 1934, FCC has used a form of price/earnings regulation which relies on rate of return/rate base regulation. Under this system a regulatory agency attempts to simulate a competitive outcome by limiting a regulated firm's revenues to its cost of service, including a reasonable return on investment. This involves determining the firm's reasonable costs of plant (rate base) and expenses and the prices which it should charge for its products and services to cover its costs and provide a fair return to investors.

FCC's administration of rate of return/rate base regulation has focused on establishing rates of return. However, rate of return proceedings have been long and complex, leading some critics to suggest the possible use of modified procedures.

FCC has, on the other hand, paid relatively little attention to carrier investment costs and expenses. Apart from one large, formal investigation of AT&T's rate base and expenses, conducted in the mid-1970s, FCC has reviewed these items only on an informal "continuing surveillance" basis. Little effort, however, has been devoted to carrying out this surveillance. As a result, FCC has exercised little control over rate base and expense items and has not addressed many of the problems raised in the one formal investigation.

While we believe that FCC can take certain actions to improve its administration of rate of return/rate base regulation, we also recognize that because of the nature and magnitude of the tasks involved no such regulatory approach can ever be expected to fully simulate a competitive outcome. Further, while alternative regulatory approaches have been proposed, and some tried by State commissions (see app. IX), no one approach has yet emerged which seems clearly more effective than rate of return/rate base regulation.

As the industry becomes more workably competitive, relaxation of price/earnings regulation needs to be vigorously pursued. However, in the interim FCC will still need to continue its application of rate of return/rate base regulation to services not subject to effective competition and provided by dominant carriers.

To better enable FCC to carry out its regulatory responsibilities as a more competitive environment evolves, we believe that FCC can take several actions including:

--Initiating a proceeding to explore changes needed to facilitate and improve its process for setting a rate of

return.

--Increasing the scope of its audit program.

--Coordinating with State regulatory commissions.

In addition, we believe the Congress needs to clarify FCC's regulatory authority by amending section 214 of the Communications Act of 1934 to give FCC explicit authority to require carriers to submit for approval plans for the construction of any facilities subject to its jurisdiction and to allow FCC to require carriers to file long-term facilities construction plans.

CONCEPTS OF PRICE/EARNINGS REGULATION

In industries where one firm has been able to achieve monopoly power, economic theory has suggested that the firm be subject to some form of price/earnings regulation. Without such regulation, the firm's natural profit-making incentives would be expected to lead it to charge higher prices and produce less output than if it were subject to effective competition. Regulatory intervention, thus, attempts to simulate a competitive outcome by restricting the firm's prices which should, in turn, lead to increased production.

Some form of price/earnings regulation has been frequently applied to firms which are considered public utilities--those which produce gas, electricity, water, and communications. regulation is often mandated under Federal or State law.

Such

Such an approach is contained in title II of the Communications Act of 1934 which gives FCC the authority and responsibility for carrying out a price/earnings regulatory program for interstate communications common carriers. For example, title II contains a variety of provisions which may be used to constrain market power through control over prices charged; control over construction; prohibitions on discrimination in charges, practices, or services; and requirements dealing with terms of services.

The Communications Act does not explicitly set forth a specific price/earnings regulatory system which must be used by FCC. It does, however, contain the basic elements of a rate of return/rate base regulatory system, such as is frequently used to regulate public utilities. It is this system which FCC has used to regulate domestic common carriers.

Principles of rate of

return rate base regulation

Under the Communications Act of 1934, FCC has attempted to limit the profits and review the operations of telecommunications common carriers through a system of rate of return/rate base regulation. Under this system, FCC tries to limit a regulated carrier's revenues to those necessary to cover its cost of service, including funds needed to pay reasonable interest payments and dividends to investors. The amount of funds which a carrier

is allowed to take in during a given year is called its revenue requirement.

A carrier's revenue requirement may be broken into two primary elements: (1) its legitimate business expenses--operating expenses, depreciation, and taxes--and (2) a fair return on the property which is used in providing services to the public. This latter amount can be computed by multiplying the net or depreciated valuation of the carrier's property (rate base), times its cost of securing capital (rate of return).

To determine a firm's revenue requirement, a regulatory agency must, therefore, be involved in two major activities. First, it must determine what constitutes a fair rate of return. Second, it must oversee rate base and expense items to ensure that they represent only those costs which the firm needs to incur to provide service.

The rate of return which a firm is allowed to earn should be equivalent to that earned by other firms with comparable business risks. In determining this return the agency must take into account three main factors--the firm's cost of debt, its cost of equity and its capital structure. Establishing the firm's cost of equity--the return which should be paid to stockholders--is generally the most difficult task.

Determining a fair rate of return will, however, not alone ensure that a firm's rates are reasonable. The agency must also determine which investments and expenses incurred by the firm are actually necessary to provide service to the public. (See app. V.)

After the firm's revenue requirement is determined, rates for the various services offered by the firm must be established to realize the total amount of revenue required. These rates are, in the case of telecommunications firms, contained in tariffs which are filed with FCC. To protect all of the firm's customers, the agency must examine these rates, otherwise the firm would be free to price discriminate--i.e., to price its services to arbitrarily favor one class of customer over another. The incentives for a firm to engage in such price discrimination are enhanced when it faces competition in certain market sectors. (See ch. 4.)

Problems with rate of

return/rate base regulation

Although rate of return/rate base regulation has been widely used by regulatory agencies, questions exist concerning whether it can ever come close to achieving its goal of keeping rates at a competitive level or even whether the benefits of such regulation outweigh its costs. For a rate of return/rate base regulatory system to function effectively, the regulatory agency must supervise the firm's costs as well as constrain its profits.

In

addition, the agency must pay attention to the firm's quality of service as well as its performance--for example, its innovation and efficiency--since the firm may lack the spur of effective competition in all markets.

Given the size of many monopoly firms, particularly one as large as AT&T, the task confronting the agency is formidable especially since costs and market conditions change over time as the result of technological change or change in consumer demand, for example. Also, the imposition of profit constraints on a firm may cause its incentives to differ from those of a competitive firm, thus, exacerbating the need for regulatory supervision of its activities. Among the undesirable incentives which economists have attributed to limiting a firm's profits are the following:

--The firm may excessively expand its rate base.

--The firm may be less cost conscious.

--The firm may be less innovative.

--The firm may try to evade regulation and enter unregulated or loosely regulated markets.

These incentives are discussed in appendix VI.

FCC's EFFORTS TO ESTABLISH

AND MONITOR RATES OF RETURN

In administering its rate of return/rate base regulatory program, FCC is responsible for establishing rates of return for carriers under its jurisdiction and for monitoring carriers' actual rates of return between formal rate proceedings. Through these efforts, FCC attempts to ensure that a carrier has the opportunity to obtain the revenues which it needs to cover its cost of service without allowing it to earn excess profits. FCC's efforts in this regard have focused primarily on the interstate operations of AT&T. Carriers' intrastate operations are regulated by the States.

Establishing rates of return--a complex, lengthy

and costly process

Since 1965, FCC has been involved in four proceedings to establish a fair rate of return for AT&T and its associated operating companies' interstate and foreign operations--each of which involved the use of trial like evidentiary hearings. These proceedings--Dockets 16258, 19129, 20376, and 79-63--were initiated