--Initiate a proceeding to explore changes needed to facilitate or otherwise improve FCC's rate of return setting process for dominant carriers including: (1) opportunities for coordinating its rate of return determinations with those of State public utility commissions, (2) the possible use of formats for presentations of cost of equity capital, and (3) methods which could be used to adjust carriers' rates of return between formal rate of return proceedings. -Initiate a project within the Common Carrier Bureau to examine dominant carriers' efficiency and productivity. This inquiry should explore possibilities for linking carriers' rates of return to efficiency and productivity gains. --Resolve the issues relating to AT&T's 1978 apparent excess earnings by completing the October 1979 Notice of Inquiry. --Reestablish within the Common Carrier Bureau's Economics Division a group with clear responsibility and adequate resources to: (1) develop methods for testing the reasonableness of carrier investment costs and expenses, (2) identify and investigate deviations by carriers from cost standards and recommending corrective action, and (3) monitor rate base components and recommend action in those cases where amounts appear unreasonable or inappropriate. This group's activities should be fully coordinated with those of other groups within the Bureau that have related functions. --Increase the scope of the Common Carrier Bureau's audit --Establish a program within the Common Carrier Bureau to improve overall coordination between the Bureau's regulatory activities, including its rate base and expense analysis functions and those of State public utility commissions. RECOMMENDATION TO THE CONGRESS We recommend that the Congress clarify FCC's facility authorization authority by amending section 214 of the Communications Act of 1934 to explicitly authorize FCC to require carriers to: --Submit to it for approval applications to construct any new facilities or extensions thereof which are subject to its regulatory jurisdiction. CHAPTER 4 COSTING PRINCIPLES AND METHODOLOGIES TO PREVENT CROSS SUBSIDY--FCC'S FAR FROM SUCCESSFUL 20-YEAR STRUGGLE The introduction of competition has brought with it the need to allocate costs among various telecommunications services to prevent the cross-subsidy of competitive services by monopoly services. FCC has struggled with this issue for over 20 years-the first 15 in determining appropriate costing principles, the last 5 in attempting to implement these principles. FCC was unsuccessful in implementing the costing methodology it adopted in 1976 and in December 1980 FCC adopted an Interim Cost Manual which used a sharply different methodology than the one adopted earlier. This manual is intended to provide a way to allocate costs until a more complete approach can be developed; however, FCC's long-run approach is still unclear. The potential for cross-subsidy remains strong and this issue must be addressed more comprehensively than it has been to date. We are recommending certain improvements in the Interim Cost Manual as a near term approach and look forward to a longrun solution based on the development of a new Uniform System of Accounts and certain noncost approaches to preventing crosssubsidy. We are also recommending changes in the Communications Act to facilitate FCC's obtaining cost data from dominant carriers. THE IMPORTANCE OF COSTING METHODOLOGIES IN A COMPET ITIVE ENVIRONMENT Before competition was introduced, regulation was concerned with the overall costs of the monopoly firm. Even though the carrier provided multiple telecommunications services and equipment, because it had no competitors the prices charged for these services and equipment were not a major issue. With the introduction of competition the focus of regulatory concern expanded to the appropriateness of the prices of individual services and equipment. Where a firm operates in two markets--one monopolized and one populated by new competitive entrants--it has an incentive to cross-subsidize the competitive markets by undercharging for services in the competitive markets and overcharging for services in the captive monopoly markets. The effect of such pricing behavior can nullify or restrain the development of competitive markets. The potential for cross-subsidy is compounded in telecommunications by the nature of the telecommunications plant. The dominant firm provides all telecommunications services via a single, integrated network involving extensive use of common facilities, personnel, management, and marketing resources. use and value of these common resources are misallocated between If monopoly services and services subject to competition, and among classes of competitive services, then cross-subsidy can exist. The misallocation may be accidental or intentional. For example, given that the highly monopolized MTS/WATS services constitute the overwhelming proportion of the dominant firm's revenues and costs, errors which over allocate joint and common costs to these services can be expected to have little impact on these services or on the firm's overall revenues. These same errors, however, will under allocate costs to competitive services thereby reducing their price with corresponding negative implications for competitors. In addition to inadvertently misallocating joint and common costs, a regulated firm facing competitive entry in particular markets may have an incentive to classify as much cost as possible in categories which are not directly attributable to a specific service and also design its plant to be joint cost in nature. As a result, the directly attributable costs of producing competitive services appear "low" and the firm can then justify to the regulator low prices based on these apparently low costs for services facing competitive entry. With the introduction of competition, developing costing principles and methodologies to guide in determining the appropriate rate level for monopoly and competitive services has bea critical issue and has occupied FCC's attention for over 20 years. This attention has focused in two areas--(1) establishing the underlying costing principles and (2) implementing the principles in determining prices for monopoly and competitive services. ESTABLISHING COSTING PRINCIPLES- THE ROAD TO FULLY DISTRIBUTED Establishing costing principles came to a head in October 1976 when FCC issued its decision in Docket 18128 endorsing Fully Distributed Cost (FDC) Method 7 as the appropriate method for allocating costs among services. This decision had its roots in the origin of competition in long distance, interstate telecommunications. In its 1959 Above 890 Decision FCC permitted the construction of interstate, microwave communications networks by private (noncommon carrier) businesses. In response to this decision, AT&T filed the TELPAK tariff in February 1961, which provided for drastically reduced private line rates for bulk lease of channels. TELPAK directly challenged the economic viability and potential growth of these private microwave systems. The TELPAK tariff was reviewed in a series of proceedings which began in 1961. As these proceedings evolved, they produced evidence which suggested that cross-subsidy was a potential problem. 1/ As a result, the investigation of the TELPAK tariff broadened into a proceeding to establish basic costing principles. Two basic costing approaches became the focus of Docket 18128-Long Run Incremental Cost and Fully Distributed Cost. What are Long Run Incremental Cost and Fully Distributed Cost? Long Run Incremental Cost and FDC differed in two major respects--how common costs were distributed and how cross-subsidy was determined. In the area of common costs under the long run incremental costing approach, AT&T proposed to FCC that it would forecast the incremental investment and expenses directly attributable to the particular competitive service. The service would be priced to cover these incremental costs and make some contribution to the common costs associated with providing this and other services. The magnitude of this contribution to common costs would depend on the prevalent competitive conditions and how high a price AT&T thought it could charge. The portion of common costs not recovered by the revenues from the competitive services were to be recovered by the monopoly services so that in the end AT&T would meet its total revenue requirement (i.e., it would collect revenues from all its services to cover its total costs). This was known as the "basic service" philosophy. The net result was AT&T was afforded considerable latitude in the assignment of common costs to various services, and through common costs' impact on total costs considerable latitude in setting prices for services. The FDC approach sought to reduce this latitude. 2/ After attributing to each service its direct costs, the FDC methodologies, unlike the incremental cost approach, sought to distribute 1/As part of its investigation of TELPAK, FCC ordered a study to ascertain AT&T's interstate investment, revenues, expenses, and net earnings for seven categories of service. The resulting "Seven Way Cost Study" submitted in September 1965 showed returns for MTS and WATS were above the overall systemwide rate of return and returns for competitive services significantly below the overall systemwide rate of return. 2/Seven FDC methods (FDC-1 to FDC-7) were initially proposed |