Report No. DC-2569 February 22, 1994 EXECUTIVE SUMMARY IMPLEMENTATION OF SECTIONS OF THE CABLE TELEVISION CONSUMER PROTECTION AND COMPETITION ACT OF 1992; REPORT AND ORDER AND FURTHER NOTICE OF PROPOSED RULEMAKING (MM DOCKET NO. 93-215) The Commission today announces its adoption of interim rules to govern cost of service proceedings initiated by cable operators. The Commission anticipates that most cable operators will set rates by applying the revised competitive differential approach announced today, rather than through the cost of service approach. It recognizes, however, that the cost of service approach may be appropriate for some operators. The interim cost of service rules are carefully designed to ensure that subscribers are charged reasonable rates, and that cable operators have both the opportunity for adequate recovery, and incentives to upgrade their systems and introduce new services and capabilities. Cost of service proceedings may be elected by cable operators facing unusually high costs. Those operators will have their rates based on their allowable costs, in a proceeding based on principles similar to those that govern cost-based rate regulation of telephone companies. Under this methodology, cable operators may recover, through the rates they charge for regulated cable service, their normal operating expenses and a reasonable return on investment. Requirements Governing Ratebase Used and Useful, Prudent Investment Standards: To be included as part of "plant in service," the largest component of the ratebase, plant must be used and useful in the provision of regulated cable service, and must be the result of prudent investment. Under these standards, the plant must directly benefit the subscriber and may not include imprudent, fraudulent, or extravagant outlays. (over) - 2 - Modified Original Cost Valuation: Plant in service will generally be valued at its cost at the time it was originally used to provide regulated cable service. In order to permit a simplified method of cost valuation in the case of systems that were acquired by the current operator, plant may be valued at the book cost of tangible assets and allowable intangible assets at the time of acquisition. Excess Acquisition Costs: Acquisition costs above book value are presumptively excluded from the ratebase. The Commission believes that, in most cases, excess acquisition costs such as "goodwill" represent the value of the monopoly rents the acquirer hoped to earn during the period when the cable system was effectively an unregulated monopoly. These monopoly rents would not be recoverable from customers where effective competition exists, the touchstone for rate regulation under the Cable Act. The Commission also recognizes that there may be situations where operators could make a cost-based showing to rebut a presumption of excluded acquisition costs. The Commission will consider such showings under certain circumstances. Additions to Original and Book Costs: Some costs incurred after original costs and some intangible, above-book costs may be allowed. For example, cable operators may have incurred start-up losses in the early years of operating their systems. The Commission will permit reasonable start-up losses to be added to original costs recoverable by the operator, limited to losses actually incurred during a two-year start-up period and amortized over a period no longer than fifteen years. Certain other intangible acquisition costs above book value, including costs of obtaining franchise rights and some start-up organizational costs such as costs of customer lists, will also be allowed. Other intangible acquisition costs will be presumptively disallowed. Carriers may challenge this presumption, however, by showing a direct relationship between the costs incurred and benefits to customers. Plant Under Construction: Valuation of "plant under construction" will use a traditional capitalization method. Under this approach, plant under construction is excluded from the ratebase. The operator capitalizes an allowance for funds used during construction (AFUDC) by including it in the cost of construction. When plant is placed into service, the regulated portion of the cost of construction, including AFUDC, is included in the ratebase and recovered through depreciation. - 3 - Cash Working Capital: The Commission expects to allow operators flexibility in choosing a method of determining the costs of funding day-to-day operations, as embodied in cash working capital. Because cable operators generally bill for regulated services in advance, the Commission will presume zero cash working capital. Operators may use one of several methods for overcoming this presumption, including the Simplified Method for telephone carriers in Section 65.820(e) of the Commission's Rules. Other Costs - Excess Capacity, Cost Overruns, and Premature Abandonment: A cable operator may include in the ratebase excess capacity that will be used for regulated cable service within one year. Cost overruns are presumptively disallowed, but operators may overcome this presumption by showing that the costs were prudently incurred. Costs associated with premature abandonment of plant are recoverable as operating expenses, amortized over a term equal to the remainder of the original expected life. Permitted Expenses Operating Expenses. The Commission adopts standards that will permit operators to recover the ordinary operating expenses incurred in the provision of regulated cable services. Depreciation. The Commission will not prescribe cable system depreciation rates, but will evaluate the reasonableness of depreciation rates submitted by cable operators. Taxes. Corporations may include an allowance for income taxes at the statutory rates in their cost of service showings. Subchapter S corporations, partnerships, and sole proprietorships may also include an allowance for taxes based on earnings retained in the regulated firm. Rate of Return The Commission establishes an interim industry-wide rate of return of 11.25% for presumptive use in cable cost of service proceedings. It solicits comment on whether this interim rate should be made permanent. (over) - 4 - Rate Development and Cost Support Accounting Requirements: The Commission adopts a summary list of accounts, and requires cable system operators to support their cost of service studies with a report of their revenues, expenses, and investments pursuant to that list of accounts. The Commission also decides to establish, after further steps described in the Further Notice, a uniform system of accounts for cable operators. The uniform system of accounts will apply only to operators that elect to set rates based on a cost of service showing. A uniform system of accounts will ensure that operators accurately and consistently record their revenues, operating expenses, depreciation expenses, and investment. In reaching this decision, the Commission notes that accounting records will serve as the principle source of information on cable operators that elect cost of service regulation and a uniform system will, therefore, help keep variations in accounting practices from unduly complicating cost of service proceedings. Cost Allocation Requirements: The Commission adopts cost allocation rules that require cable operators to assign or allocate all costs and revenues identified in the summary level accounting form either to the equipment basket or to one of five service cost categories: basic service activities, cable programming service activities, other programming service activities, other cable activities, and noncable activities. To the extent possible, costs must be directly assigned to the category for which the cost is incurred. Where direct assignment is not possible, cable operators shall use allocation standards incorporated in current Section 76.924(e)(f) of the Commission's rules. Affiliated Transactions: To keep cable system operators from engaging in improper cross-subsidization, the Commission adopts rules governing transactions between cable operators and their affiliates. Procedural Requirements Threshold Requirements for a Cost of Service Showing: There are no threshold requirements limiting the cable systems eligible for a cost of service showing, except for the two-year filing interval described below. - 5 - Historic Test Year: Cost of service showings shall be based on a historic test year, adjusted for known and measurable changes that will occur during the period when the proposed rates will be in effect. The test year should be the last normal accounting period. In the case of new systems for which no historic data is available, a projected test year may be used; the assumptions on which the projected test year are based will be subject to careful scrutiny. Cost of Service Filing Interval: After rates are set under a cost of service approach, cable operators may not file a new cost of service showing to justify new rates for two years absent a showing of special circumstances. Cost of Service Form: The Commission adopts a form to be used by cable operators making cost of service showings. The Commission states that this form will be made available electronically as soon as possible. Hardship Showing: In individual cases, the Commission will consider the need for special rate relief for a cable operator that demonstrates that the rates set by a cost of service proceeding would constitute confiscation of investment and that some higher rate would not represent exploitation of customers. The operator would be required to show that unless it could charge a higher rate it would be unable to maintain the credit necessary to operate and would be unable to attract investment. The operator would also be required to show that its proposed rates are reasonable by comparing them to the rates charged by similar systems. In considering whether to grant such a request, the Commission will consider the overall financial condition of the cable operator and other factors, such as whether there is a realistic threat of termination of service. Small Systems The Commission adopts an abbreviated cost of service form for use by small systems, to reduce the administrative burdens of cost showings for small system operators. The information must be certified by the operator as correct subject to audit by the Commission. The Commission solicits comments on the possibility of exempting small systems from uniform system of accounts requirements. (over) - 6 - Streamlined Cost Showing for Upgrades The Commission adopts a streamlined cost showing for upgrades. Under this showing, operators would be permitted to adjust capped rates by the amount of the net change in costs on account of the upgrade. Operators must reflect in rates any savings associated with upgrades and must apply cost allocation rules applicable to cost showings generally. The Incentive Upgrade Plan The Commission announces an experimental incentive plan that provides subscribers with assurances that rates for current regulated services will not be increased to pay for upgrades that are not needed to provide their current services and provides cable operators with incentives to upgrade their systems and offer new services. Specifically, operators will be given substantial rate flexibility for some established period of time in setting rates for new services. Operators that elect to operate under this plan will commit to maintaining rates for their current regulated services, including the basic service tier, at their current level. Operators also will commit to maintaining at least the same level and quality of service, including the program quality of their current regulated services. Operators must seek Commission approval before setting rates for new services pursuant to the plan. New service tiers comprised of new programming as well as new functions that can be used with existing tiers are eligible for this plan as long as they are available and chargeable on an unbundled basis from existing services. The plan seeks to give cable operators a strong incentive to invest in their networks and increase the services they offer to customers. This incentive is generated by giving the operator broad flexibility in setting the rates for these added services and capabilities. If the operator invests wisely and introduces services that meet customer needs, it gains the opportunity to achieve higher profits. The plan is intended to help achieve the Cable Act's goals of setting rates similar to those in competitive markets. As in competitive markets, customers are protected from monopoly rates for established services, but entrepreneurs who successfully introduce new products or improve the efficiency of their operations are rewarded through higher profits. - 7 - The Commission will entertain requests from operators seeking to use the plan on an experimental basis, and seeks comment on whether the plan should be made permanent. The Commission will accept proposals from operators as of the effective date of its cost rules. Further Notice of Proposed Rulemaking Pending completion of cable system cost studies and the development of experience through the case-by-case evaluation of complaints, the Commission is adopting the current rules on an interim basis. The Commission seeks comment on whether the rules should be adopted as permanent. Among other issues, the Commission seeks comment on whether 11.25% is an appropriate rate of return and on whether it should adopt an average cost schedule approach for small systems, and possibly for larger systems as well. The Commission delegates authority to the Cable Services Bureau to obtain detailed cost information from cable operators to help examine this approach. The Commission also seeks further data, analysis, and comment on whether to include a productivity factor in addition to an inflation factor in the benchmark/price cap formula. Based on the current record, the Commission proposes a 2% productivity factor. The uniform system of accounts proposed by the Commission in the Further Notice is derived in part from the system currently used by the Commission for telephone companies (see Part 32 of the Commission's rules), but the Commission seeks to simplify those rules and adapt them to the cable industry. The Commission requests that industry groups work with Commission staff to develop a proposed uniform system of accounts, with a view towards completion of a tentative proposal within 180 days. The Commission will then solicit comments from interested parties on the proposed uniform system of accounts before adopting a final version. Action by the Commission February 22, 1994, by Report and Order and Further Notice of Proposed Rulemaking (FCC 94-39). Chairman Hundt, Commissioners Quello and Barrett, with Commissioner Barrett issuing a separate statement. - FCC - News Media contacts: Karen Watson or Susan Sallet at (202) 632-5050. Cable Services Bureau contact: Patrick Donovan at (202) 416- 0856.