During the time of our review the Chief of FCC's Common Carrier Bureau told us that he recognized that FCC's efforts had focused on establishing AT&T's rate of return and relatively little effort had been devoted to rate base and expense analysis outside of Docket 19129. He said that such an approach was taken because he believed FCC could not conduct a "textbook" rate of return/rate base regulatory program. As a result, he said, the Bureau has focused its attention on the one area which it can address--setting a rate of return--and spent little time on rate base and expense analysis--an area in which he believed FCC's ability to function effectively was questionable. acknowledged that such an approach may create efficiency disincentives for the regulated firm. 1/ However, he believed that, overall, customers were better off under such a program than if regulatory control was eliminated. While he was not optimistic about FCC's ability to substantially improve its rate of return/ rate base regulatory program in the future, he believed that one action which would be worthwhile was an expansion of FCC's audit capability. Another former Bureau Chief also believed that it was impossible for FCC to develop a regulatory program which could effectively substitute for competition. He said, however, that in the absence of a workably competitive environment, FCC had no alternative but to attempt to formulate and carry out traditional rate of return and rate base responsibilities. In addition to strengthening FCC's audit capabilities, he also favored strengthening the Bureau's network analysis program and streamlining its rate of return setting process. Obtaining and managing resources Staff members in the Economics and Accounting and Audits Division, among others, believed that another source of FCC's difficulty in conducting a rate of return/rate base regulatory program stemmed from its inability to obtain, retain, and manage the resources needed to carry out its responsibilities. In this regard, officials believed that the Common Carrier Bureau did not have the trained staff needed to even begin to carry out an effective regulatory program. One factor which was cited as contributing to FCC's staffing problems was turnover among Common Carrier Bureau officials. In this regard, during the 3 years before April 1981, the Bureau had four appointed or acting Bureau Chiefs, five Economics Division Chiefs, three Tariff Division Chiefs, three Chiefs in charge of domestic facilities, and three Chiefs in charge of program evaluation. Given the previously cited difficulty in obtaining a thorough understanding of the problems and nature of the industry, 1/Efficiency disincentives which may result from regulation are discussed in appendix VI. it is not surprising that turnover could greatly restrict FCC's ability to regulate effectively. Officials said that management problems had also impacted FCC's regulatory efforts. One particular problem which was cited was the lack of effective coordination within the Bureau, particularly between the Economics and Accounting and Audits Division. The lack of interdivisional coordination and other FCC management problems were discussed and recommendations concerning overall FCC management effectiveness were made in our July 30, 1979, report "Organizing the Federal Communications Commission for Greater Management and Regulatory Effectiveness" (CED-79-107). Obtaining and processing information Problems in collecting, processing, and analyzing information were also cited by FCC officials as a factor affecting FCC's regulatory efforts. The Common Carrier Bureau Chief at the time of our review, as well as staff members in the Economics, Accounting and Audits, and Domestic Facilities Divisions pointed out information problems which had hampered their efforts. These included obtaining necessary information from AT&T and other carriers, organizing information collected into data bases, and developing reports and analyses which can be used in carrying out regulatory activities and deciding on policy matters. The Common Carrier Bureau Chief told us that he recognized the need for a review of the Bureau's information activities and had initiated a study into this subject. A Program Evaluation Staff official told us in May 1981 that while the effort is not yet completed, some accomplishments have been achieved, including the elimination of certain carrier reports which are no longer needed. Coordination with State public utility commissions A further factor which has inhibited FCC's regulatory efforts is the lack of coordination with State public utility commissions. The responsibility for supervising rate base and expense items for AT&T and other carriers involved in both interstate and intrastate telecommunications is divided between FCC and State commissions, respectively. Consequently, both FCC and the States may frequently be involved in reviewing many of the same aspects of a carrier's activities. However, we were told by officials at both levels that little coordination has taken place, except for work involving Joint Boards and depreciation issues. Both FCC and State commission officials we spoke with believed that increased coordination would be desirable and beneficial. They particularly believed that increased efforts to share information and to discuss problems and concerns at the staff level would be beneficial. ALTERNATIVES TO AND ABANDONMENT OF THE TRADITIONAL REGULATORY PROCESS A variety of proposals and suggestions have been made to modify, replace, or simply abandon the traditional rate of return/ rate base regulatory process. These approaches range from relatively minor alterations in the methods used to determine rates of return to complete deregulation. Most of the alternatives suggested appear to be based largely on considerations of economic theory. We are aware of little empirical evidence to support the changes proposed or to compare their effects to those which have resulted under existing applications of rate of return/rate base regulation. Indeed, such comparisons would be difficult to make with any degree of certainty. Of the approaches which have been formulated, an approach for promoting competition where economic conditions no longer warrant the preservation of an exclusive monopoly franchise and for gradually relaxing rate of return/rate base regulation as markets become workably competitive appears to offer the greatest long-term benefit. 1/ However, other approaches--particularly those which attempt to affect the firm's incentives--also offer some potential for improving regulation in those markets which are not workably competitive. Modifications of rate of return/rate base regulation Perhaps the most noteworthy proposals to modify the existing rate of return/rate base regulatory system are those which involve the use of automatic rate adjustment clauses and incentive plans. In general, automatic adjustment clauses aim at facilitating the regulatory process while incentive plans focus on a firm's incentives to perform efficiently. Automatic rate adjustment clauses are designed to expedite adjustments to changes in economic conditions. This may be done, for example, by indexing utility rates or certain utility costs, to a general economic indicator such as the Consumer Price Index, so that they would automatically go up or down by the same percentage as the percentage change in the indicator. 2/ The primary advantages of using such clauses are that (1) they may make it easier for utilities to deal with inflation and (2) regulatory agencies might be required to conduct fewer rate hearings and, thus, they could devote their time to other areas needing attention. 1/This is further discussed in chapter 2. 2/Automatic adjustment clauses may also allow utilities to simply pass along certain cost increases to customers. Among their disadvantages are that they may reduce efficiency, they may not be tied to appropriate indicators, and they may be subject to manipulation. Incentive plans attempt to provide firms with reasons to increase efficiency and, consequently, to overcome a primary weakness of rate of return/rate base regulation. Such plans are often predicated on the concept that a firm should be given the opportunity to earn above its cost of capital if it does so through efficiency improvements. One of the methods aimed at improving efficiency is simply allowing a range in the firm's rate of return, the top of which would be above the firm's cost of capital. This would theoretically provide the firm with an incentive to reduce its costs, since by doing so it could increase its profits. 1/ While this approach appears to offer promise, a primary problem with it lies in establishing procedures to ensure that extra profits result from cost efficiencies rather than some other factors. 2/ FCC has taken some action to explore the possibility of using these or other modifications in its regulatory program for domestic common carriers. In 1974 Horace J. DePodwin Associates submitted a report to FCC under contract FCC-0071 in which it outlined an alternative to rate of return/rate base regulation. The proposed alternative used an incentive approach which would allow the regulated firm to increase its profits if its performance improved, in accordance with a performance index to be established by FCC. An FCC official involved with the contract said that nothing was ever done to attempt to implement the proposal since it was believed to be unworkable. In 1976 FCC also held a 2-day conference in which a number of experts in regulatory theory were to discuss alternatives to and improvements in rate of return regulation for the common carrier industry. In his concluding remarks at the conference, the then Common Carrier Bureau Chief noted that while much information was presented on the theory and deficiencies of rate of return/rate base regulation, little was said about alternatives. Nevertheless, he believed the conference was "a good beginning" and, hopefully, would stimulate further research on the subject. 1/As discussed on page 37, FCC set forth such an approach in two of its rate of return proceedings for AT&T. 2/A more detailed discussion of modifications of rate of return/ rate base regulation and examples of their use is contained in appendix IX. Abandonment of rate of return regulation Because of the problems which agencies such as FCC have experienced in formulating and implementing a rate of return/rate base regulatory program or some alternative to it, questions have been raised by some economists and regulatory theoreticians concerning whether regulation makes a difference or whether it is worth its costs. Some parties have argued that society would be better off if rate of return/rate base regulation were abandoned and some other form of government intervention were mandated, as necessary. While it appears that rate of return/rate base regulation can and has made a difference in that agencies, including FCC, have, among other things, ordered rate reductions, disallowed items from firms' rate bases and limited rates of return, it has been argued that such actions do not necessarily prove that such regulation is effective. Rather, the argument continues, such actions may have been in error or may have led to service degradation or may have resulted from exaggerated requests made by the firm, which was aware that any full request would not be granted. Thus, it has been suggested, the ultimate result may have been close to that achieved without regulation. Proponents of deregulation have also cited the costs to society which rate of return/rate base regulation may create. The regulatory process imposes administrative costs on the agency, the firm and other parties to regulatory proceedings-much of which is passed on to the ratepayer and taxpayer. However, it has been argued, even greater costs to society may result from the effects of rate of return/rate base regulation on the firm. For example, such regulation may distort the firm's pricing behavior and inhibit its desire and ability to innovate. It has been argued that the need to promote innovation is particularly acute in the telecommunications industry where the rate of technological advance is high. Because of these costs, certain studies on the subject have concluded that rate of return regulation is likely to be more harmful than beneficial and, therefore, should be abandoned. Instead, it has been suggested that alternative forms of intervention such as opening the right to operate a public utility to competitive bidding at specified intervals (franchise bidding) or taxing excess profits could be used, if necessary. While recognizing the validity of some of the problems raised in these arguments, other studies have argued against the overall conclusion that rate of return/rate base regulation should be abandoned under any circumstance. Among the counter-arguments which have been made to such broad deregulatory proposals are: --They tend to be based on simplistic analyses. --They tend to minimize the power and incentives of an |