Before the

FEDERAL COMMUNICATIONS COMMISSION

Washington, DC 20554

In the Matter of )

)

Access Charge Reform ) CC Docket No. 96-262

)

Price Cap Performance Review ) CC Docket No. 94-1

for Local Exchange Carriers )

)

Transport Rate Structure ) CC Docket No. 92-213

and Pricing )

)

Usage of the Public Switched ) CC Docket 96-263

Network By Information Service )

and Internet Access Providers )

COMMENTS OF MCI COMMUNICATIONS CORPORATION

Bradley Stillman

Don Sussman

Chris Frentrup

Alan Buzacott

Larry Fenster

MCI Communications Corporation

1801 Pennsylvania Avenue, N.W.

Washington, D.C. 20006

January 29, 1997

Table of Contents

Summary i

I. Introduction 1

II. A Prescriptive Approach to Access Reform Is Necessary to Protect the Development of Local Competition and Preserve Long Distance Competition. 7

A. A Prescriptive Approach to Access Reform Is the Quickest and Easiest Route to Economically Rational Pricing and Maximum Competition. 9

B. Reform Requires the Use of Consistent Costing and Pricing Principles. 11

C. The Commission Has an Opportunity to Truly Level the Playing Field with this Proceeding. 12

D. A Prescriptive Approach Creates Certainty for All Parties. 13

III. Executing The Prescriptive Approach To Access Reform 15

A. Driving Access Rates to Cost Requires the Commission to Utilize Existing Price Cap Mechanisms to Replicate Economically Efficient Rates. 15

B. The Commission Should Require Incumbent LECs to Immediately Reinitialize Their Actual Price Indices (API) At Economic Cost. 18

C. The Commission May Use A Combination of One-time Exogenous Changes and a One-time Increase in the Productivity Factor to Reduce PCIs. 24

IV. Constitutional and Jurisdictional Arguments 28

A. Bringing Access to Cost Using a Prescriptive Approach Is Not an Unconstitutional Taking under the Fifth Amendment. 28

B. The Commission Has Exclusive Jurisdiction over Interstate Access Issues. 32

V. A Market-based Approach Is Unworkable, Fundamentally Unfair and Will Undermine the Commission's Interconnection Order. 33

A. A Market-based Approach Fails to Address a Host of Competitive Problems, Including the Cost of Terminating Access. 35

B. The Incumbent LECs Will Have a Greater Incentive to Make the Provision of Unbundled Network Elements Difficult. 37

C. Consumers Will Be Harmed Because Competition Takes Time and Always Develops Unevenly. 42

VI. Pricing Flexibility 44

A. Pricing Flexibility Should Not Be Granted Prematurely 45

B. Incumbent LECs Have Not Exhausted Existing Pricing Flexibility 48

C. Additional Pricing Flexibility is Without Justification and Would Slow the Development of Competition 55

1. Geographic Deaveraging 56

2. Volume and Term Discounts 58

3. Contract Tariffs 59

4. New Services Deregulation 62

D. Deregulation of Incumbent LEC Access Services 63

1. Application of the AT&T Framework 66

2. High-Capacity Special Access Services Should Not Be Removed From Price Cap Regulation 68

VII. Transition Issues 69

A. Separations Reform Belongs in a Separate Proceeding 69

B. Incumbent LECs are Entitled To Recover $1.3 Billion of the $11.6 Billion By Which Their Rates Exceed Economic Costs from their Regulated Customers Once the New Universal Service Fund is Constituted. 71

1. The "Gap" is Approximately $11.6 billion. 71

2. Economic Analysis Does Not Support Permitting Incumbent LECs to Recover But a Small Amount of this $10 billion Gap. 72

3. Legal and Policy Analysis Does Not Support The Notion That LECs are Entitled to Recover the Difference Between the Current and Historic Value of their Plant. 73

VIII. Rate Structure Modifications 75

A. General Principles 75

B. CCL/SLC 76

C. Local Switching 79

D. Transport 84

E. TIC 86

F. SS7 Signaling 87

IX. Conclusion 90

Attachment: Kwoka Affidavit

Summary

In the instant proceeding, the Commission embarks on the final chapter of the competitive trilogy. The three proceedings that make up the trilogy -- interconnection, universal service and access reform -- are each critical to achieving the ultimate goal of a fully competitive local telecommunications marketplace which provides the public with lower prices, increased innovation, and ever-improving service. The access charge proceeding, however, presents an opportunity for the Commission to provide a consumer benefit -- lower long distance prices -- right now. The fact that this action would also help bring competition to the local monopoly market makes any other action both a missed opportunity and a misguided policy.

While the Commission requests comments on a myriad of proposals, it is clear that only a prescriptive approach to access reform can provide immediate benefits to consumers and stimulate competition in local markets. First, as a matter of law, while the Commission should certainly consider the views of state regulators along with other commenters, the Commission has exclusive jurisdiction over interstate access reform. Furthermore, given that this proceeding is the only part of the trilogy that is purely interstate in nature, it can reform the current access regime independent from the scheduled separations reform proceeding.

The Commission can prescribe that access charges, which are currently $11.6 billion too high, immediately be lowered by setting interstate access rates at economic cost, and then reinitializing actual price indices, price cap indices, and service basket indices to 100. A prescriptive approach can be implemented immediately, accelerating competition in both local and long distance markets, and immediately bringing the benefit of lower rates to consumers. The Commission can accomplish this task with a minimal regulatory effort by relying on publicly available estimates of the economic cost of the elements used to provide switched access services. TELRIC estimates made by proxy cost models, such as the Hatfield Model employed by MCI and AT&T, may be used to reach a reasonable approximation of the forward looking cost of services residing in existing price cap baskets.

Bringing down access charges to forward-looking economic cost is not an unconstitutional taking of property. Access costs that reflect forward-looking cost will not deny incumbent LECs an opportunity to earn reasonable profits, and contrary to the financial doom predicted by the incumbent LECs, investors and financial analysts recognize that any financial impact of access reform will most likely be offset by the new opportunities that await the incumbent LECs in long distance, video, and other competitive markets once the incumbent LECs stop erecting barriers to local competition.

As a matter of competition policy, the Commission must set interstate access charges at forward-looking economic cost in order to guarantee just and reasonable rates and reduce the ability for anticompetitive cross-subsidy. If access charges remain above cost, MCI and other long distance carriers will be subsidizing the business of our soon-to-be-rivals, the incumbent LECs. Unless the Commission eliminates these subsidies, the incumbent LECs will be able to use these excessive charges to solidify their control over local markets or subsidize their entry into long distance. Either outcome will seriously undermine the pro-competitive and pro-consumer goals of the Telecommunications Act of 1996.

Similarly, reliance on the proposed market-based approach to achieve access reform, coupled with additional pricing flexibility for the incumbent LECs, will negatively impact both local and long distance competition. Using a market-based approach in a market that remains a virtual monopoly is destined to fail from the perspective of both new entrants and end users, leaving the incumbent monopolist as the only beneficiary. As the attached affidavit of Dr. John E. Kwoka illustrates, premature deregulation of monopoly incumbent LECs and a reliance on "market-based" pricing can lead to adverse effects on consumers, inefficient entry, diminished market competition, and paradoxically, to the need for more -- not less-- regulatory oversight.

While appearing to embrace the pro-competitive thrust of the interconnection order, the Notice ignores the fact that the so-called market approach will permit incumbent LECs to substantially exercise their market power. Reliance on the market approach also subverts the policy goal of maximizing competition by encouraging efficient entry in as many different ways as possible. The market-based approach put forth in the Notice plainly encourages facilities based competition and the use of unbundled network elements to the exclusion of all other means. Resellers would see no access relief and there is no recognition that deploying facilities will take time with access remaining inflated in the interim. Furthermore, while unbundled network elements may eventually represent an important competitive restraint, the Notice places an unwarranted reliance upon these untested devices.

MCI proposes two principles that should guide the Commission when it considers the rate structure for access charges. First, the rate structure must reflect the way costs are incurred. This means that traffic sensitive (TS) costs must be recovered by TS rates and non-traffic sensitive (NTS) costs by NTS rates. This also implies that any TS rates must be assessed on the type of demand that is relevant, e.g., per-minute or per-line. Second, any rate structure must be auditable. The Commission must assure that access customers must be able to verify their access bills. Without this ability, access customers will be find themselves in the situation of having no choice but to trust the LECs, against whom they soon may be trying to compete.

MCI has historically led the way by lowering its long distance prices to consumers well above and beyond the limited access reductions ordered by the Commission. Competition in the long distance industry, with hundreds of companies offering services to consumers, acts as a guarantor that access reductions will be passed through to consumers in the form of lower long distance rates. History proves this to be the case, as long distance prices have fallen twice as much as access reductions. MCI pledges that when the overcharges for access are abolished, MCI will pass on the savings to our customers.

Before the

FEDERAL COMMUNICATIONS COMMISSION

Washington, DC 20554

In the Matter of )

)

Access Charge Reform ) CC Docket No. 96-262

)

Price Cap Performance Review ) CC Docket No. 94-1

for Local Exchange Carriers )

)

Transport Rate Structure ) CC Docket No. 92-213

and Pricing )

)

Usage of the Public Switched ) CC Docket 96-263

Network By Information Service )

and Internet Access Providers )

I. Introduction

MCI hereby submits its comments in the above referenced docket.⁽¹⁾ With this proceeding, the Federal Communications Commission (Commission) embarks on the final chapter of the competitive trilogy. The three proceedings that make up the trilogy -- interconnection, universal service and access reform -- are each critical to achieving the ultimate goal of a fully competitive local telecommunications marketplace which provides the public with lower prices, increased innovation, and ever-improving service.

In the interconnection proceeding, the Commission wisely recognized that the Telecommunications Act of 1996⁽²⁾ mandated rules that foster competition by eliminating impediments and by opening up monopoly network functions to new entrants at rates that allow efficient competitors to succeed in the market. The Commission therefore constructed a system permitting entry through the purchase of unbundled network elements priced at forward-looking costs and

reasonable resale discounts on retail services.⁽³⁾ The Federal-State Joint Board on universal service similarly found that the use of a forward-looking cost model to size a competitively neutral universal service fund was necessary to achieve the important goals of universal service without harming the prospects for meaningful, effective local telephone competition.⁽⁴⁾

The Commission now addresses another fundamental part of the road toward local competition through access reform. The important principles, including the use of forward-looking economic costs, that were the underpinning of the previous decisions and the key to establishing local competition must not be discarded now.

The fact that access charges are far in excess of cost is absolutely clear. In the Notice at issue here, the Commission expressly recognizes this to be the case.⁽⁵⁾ MCI therefore maintains that only a prescriptive approach will eliminate all of the subsidies from access charges and move everyone closer to just, reasonable and affordable rates for all telecommunications services, including access.

The incumbent local exchange carriers (LECs) have overstated the financial effect on them of reducing access to cost. Just as the Commission recognizes that access charges are full of unwarranted subsidies, so does the investor community. In fact, the financial analysts are anticipating access charge reductions.⁽⁶⁾ However, they also realize that the potential impact on the cash flow and revenues of the incumbent local monopolists will be more than offset by the new opportunities that await them in long distance, video and other competitive markets once the incumbent LECs stop erecting barriers to local competition.⁽⁷⁾ Furthermore, forcing one segment of the industry to overpay for a service to protect another segment of the industry is contrary to the spirit, intent, and plain language of the 1996 Act. The Commission should reject any arguments designed to insulate the incumbent carriers from their own poor investments and inefficient operations unless it is also prepared to consider the amount of earnings in excess of the authorized rate of return and scrutinize the financial books of these companies since divestiture.

While the Commission should not be establishing policy based on concerns about stock market reaction, a review of the most recent financial results for the incumbent LECs' extremely strong growth indicate there is no legitimate reason for concern.⁽⁸⁾ The major areas of growth will be largely unaffected by bringing access charges down to their economic cost. Line growth, including second lines which comes with very little incremental cost for the incumbent LECs, has achieved record levels.⁽⁹⁾ Another major growth area which comes at very little cost to the LEC is vertical services. These are services which are being marketed aggressively and provide the incumbent LECs with very large profit margins.⁽¹⁰⁾ Both the facts and the analyst's projections indicate the Commission need not be concerned about the overall financial health of the local monopolies and should not compromise on the appropriate pro-competitive, pro-consumer policy of bringing access charges down to economic cost.

This is the only proceeding in which the Commission is in a position to deliver on the real promise of competition for the public -- lower telecommunications prices. All of the important work that has been done to implement the 1996 Act thus far is premised on the fact that consumers will benefit from increased competition and lower rates. The access charge proceeding, however, presents an opportunity for the Commission to provide a consumer benefit -- lower long distance prices -- right now. The fact that this action would also help bring competition to the local monopoly market makes any other action both a missed opportunity and a misguided policy.

Consistent with our pro-competitive, pro-consumer history, MCI has historically led the way by lowering its long distance prices to consumers well above and beyond the limited access reductions ordered by the Commission. The competition in the long distance industry, with hundreds of companies offering services to consumers, acts as a guarantor that access reductions will be passed through to consumers in the form of lower long distance rates.⁽¹¹⁾ History proves this to be the case, as long distance prices have fallen twice as much as access reductions.⁽¹²⁾ MCI pledges that when the overcharges for access are abolished, MCI will pass on the savings to our customers.

In these comments, MCI will demonstrate why a prescriptive approach to access reform is necessary to provide immediate benefits to consumers and stimulate competition in local markets, both as a matter of law and sound public policy. The Comments will also demonstrate the shortcomings of using a market-based approach to achieve access reform and the negative effect it will have both on local and long distance competition. Then, we will illustrate in greater detail the dangers of the premature and excessive pricing flexibility outlined in the Notice. MCI will also explain the basis for the gap between embedded and forward-looking costs and present a series of steps the Commission can take to eliminate it. Finally, the comments address the proposed rate structure modifications from the Notice.⁽¹³⁾

II. A Prescriptive Approach to Access Reform Is Necessary to Protect the Development of Local Competition and Preserve Long Distance Competition.

In 1984, the Commission established the current access charge regime.⁽¹⁴⁾ The charges were based on the embedded costs of the incumbent LECs and were designed to compensate the local monopoly for use of their facilities. The incumbent LECs have never been forced to show that these charges reflect forward-looking economic costs. With the 1996 Act, the standard has changed. The Commission must require the incumbent LECs to justify access charges based on forward-looking costing principles to send appropriate pro-competitive signals to the local access market.⁽¹⁵⁾

Under the new Telecommunications Act and the rules implementing it thus far, there is absolutely no economic or policy justification for continuing above cost access charges. Approximately 40 cents of every long distance dollar is returned to the local monopoly telephone companies in the form of access charges.⁽¹⁶⁾ The actual economic cost of providing access, using the same forward-looking methodology employed by the FCC in the interconnection proceeding and recommended by the Federal State Joint Board on Universal Service, is only about 5 cents of every long distance dollar.

Interstate access charges are $11.6 billion too high. This includes $6.6 billion in excessive "costs" and about $5 billion in universal service support that should be recovered in a competitively neutral fashion. The result is that the average long distance customer is paying approximately $6.00 per month too much for long distance service, which goes to line the pockets of the incumbent LECs.⁽¹⁷⁾ Any approach to reform that permits the incumbent LECs to continue to receive these uneconomic subsidies would certainly fail the Act's public interest test as well as the requirement that rates be just, reasonable and affordable.⁽¹⁸⁾ To achieve the goal of effective competition in the local market, the Commission must eliminate this excess immediately through the use of a prescriptive approach. Furthermore, the Commission should not even begin to consider whether the competitive checklist has been met until the excess is removed from

access.

A. A Prescriptive Approach to Access Reform Is the Quickest and Easiest Route to Economically Rational Pricing and Maximum Competition.

Bringing access down to forward-looking economic cost is critical both as a matter of competition policy and as a matter of law. The law requires that, the Commission ensure rates are just and reasonable⁽¹⁹⁾ and that all implicit subsidies are made explicit.⁽²⁰⁾ The Commission has recognized that at least some of the excess contained in the access charge regime is being used to fund universal service.⁽²¹⁾ The Commission must identify the economic cost of providing universal service as well as access. Once the competitively neutral universal service fund is established, access charges must be reduced by an amount equal in size to the universal service contribution currently made in access charges. Failure to do so could lead to a double recovery for the incumbent LEC, once through the universal service fund, and a second time through collection of artificially inflated CCL and the completely unnecessary TIC charges.

In addition, to guarantee just and reasonable rates and reduce the ability for anti-competitive cross-subsidy, the Commission must disallow recovery of all access charges above forward-looking economic cost. In the past, an argument could be made that while excessive access charges were unfair, they had no anti-competitive effect because the incumbent LECs could not provide competitive long distance services. Today, however, the competitive threat is clear. If access remains above cost, MCI and the other long distance carriers will be subsidizing the business of our soon-to-be rivals, the incumbent LECs. Unless the Commission eliminates excessive charges, the incumbent will be able to use them to solidify their control over their local markets or subsidize their entry into long distance. Either outcome will seriously undermine the pro-competitive and pro-consumer goals of the law.

Once the hidden subsidies to support universal service are made explicit as required under the 1996 Act,⁽²²⁾ there is absolutely no legitimate reason to permit the incumbent LECs to charge above the forward-looking economic cost for access. As indicated supra, any access charges that remain above cost will plainly violate the Act's requirement that rates be just and reasonable. Only a prescriptive approach to access reform can eliminate these excess charges immediately, delivering benefits to captive ratepayers and clearing another road- block to vigorous competition in all telecommunications markets.

As MCI will demonstrate throughout these comments, the multi-phased market-based approach to access reform outlined in the Notice would not only thwart the development of local competition and force captive telephone ratepayers to continue to subsidize some of the wealthiest corporations in the country, but it would also create an unnecessary regulatory morass. Such an approach would require the Commission to establish general standards for different levels of pricing flexibility, actively monitor the behavior and business practices of the incumbent LECs in both the local and interstate markets, and review claims by the incumbent LECs that they meet the requirements for phase 1, 2, or 3 of access reform.

Using a prescriptive approach, on the other hand, will permit the Commission to fix a very broken system and enable competition to take hold in all markets by removing all subsidies immediately. Once the subsidies are squeezed out of the access system, the Commission can establish a relatively simple and objective measurement of effective competition that can lead to the ultimate deregulation of access charges.

All of the damage that would be done to the development of a competitive local market and the competitive long distance market by allowing the incumbent LECs to retain uneconomic subsidies can be eliminated through a prescriptive approach to access reform.

B. Reform Requires the Use of Consistent Costing and Pricing Principles.

Access reform represents the last piece of the competitive telecommunications trilogy. As the Commission and Federal-State Joint Board have recognized in the interconnection and universal service proceedings respectively, the availability of network elements and services at their forward-looking economic cost is critical to the development of competition. All of the pro-competitive steps taken in the other key proceedings that rely on this basic costing principle, are threatened if the incumbent LECs are permitted to continue to collect huge subsidies from access.

There is no rational justification for permitting the incumbent LECs to continue to collect excessive access charges. Using different costing principles will permit the incumbent LECs to change the source of the unwarranted subsidies currently received from access without taking the monies out of the system as is necessary to allow competition to flourish in all markets. The result may be simply changing which customers at any given time are being forced to pay the subsidy instead of eliminating it.

C. The Commission Has an Opportunity to Truly Level the Playing Field with this Proceeding.

Today, only the incumbent LECs enjoy the comforts of monopoly. One of the primary goals of the 1996 Act was to eliminate this last monopoly and all of the associated benefits in an effort to bring vigorous competition to all markets once and for all. Just as AT&T has learned since 1984, while there are risks in the competitive market, there are even greater rewards. The days of being able to earn great rewards with little or no risk for the incumbent LECs must end under the 1996 Act. An essential part of this process is the elimination of the funds that can and will be used to disadvantage new entrants or are used for anti-competitive cross-subsidy.

The job of effectively monitoring and protecting against cross-subsidy is getting more difficult every day. As the telecommunications marketplace continues to expand and the incumbent LECs enter new business both in and out of the industry, the Commission will have an increasingly difficult time following the money trail. The shared jurisdiction with states makes it possible for the incumbent LECs, especially the Regional Bell Operating Companies (RBOCs), to play a shell game which effectively keeps well intentioned regulators at all levels of government from identifying illegal and anti-competitive cross-subsidy.

The surest way to eliminate anti-competitive conduct and cross-subsidy is to eliminate the funds that make it possible. The $11.6 billion in excess revenues LECs obtain profits from access charges is a major source of these funds. Only a prescriptive approach will squeeze these funds out of the system anytime soon and prevent the anti-competitive effects of these subsidies from skewing competition in a variety of markets.

D. A Prescriptive Approach Creates Certainty for All Parties.

Concern about the financial effect on the incumbent LECs of bringing access down to cost should be irrelevant to the Commission and is, nonetheless, completely overblown. Incumbent LEC claims ignore the new revenue opportunities that are or will soon be available to them. Furthermore, they are based on the assumption that the incumbent LECs are entitled to everlasting monopoly profits. The writing has long been on the wall that the old monopoly regime, with access rates far exceeding costs, would not be permitted to continue. Investors recognize, and have already taken into account, the new risks and opportunities associated with ownership of an incumbent LECs stock.

There are significant benefits to the industry, including the incumbent LECs, from a prescriptive approach as well. Companies will not have to waste resources on legal challenges to Commission actions including necessary access charge reductions and whether or not the requirements for the different phases of relief under a market-based approach to reform have been met. These are funds that MCI would rather use to make investments that help facilitate entry into new markets.

A prescriptive approach also provides certainty for all parties, including the incumbent LECs and their investors, as they make their business plans and take steps to enter in-region long distance and other markets. The elimination of funds which could be used to cross-subsidize incumbent LEC entry into the competitive long distance business will eliminate one hurdle to local entry and should only help the regulators at all levels as they make the required determination of whether the requirements for in-region long distance entry have been met.

This proceeding should lead the Commission to close the doors to unfair and anti-competitive conduct by the incumbents before trying to open the doors to competition and taking a hands off approach to the access charges paid to local monopolies. No matter how hard we try, none of us can wish away the monopoly. Access policy should not be premised on our hopes for a competitive local market in the future. Rather, the Commission should use a prescriptive access reform policy to help achieve this important objective.

III. Executing The Prescriptive Approach To Access Reform

A. Driving Access Rates to Cost Requires the Commission to Utilize Existing Price Cap Mechanisms to Replicate Economically Efficient Rates.

MCI supports the Commission's goal of... "requir[ing] LECs to move prices for interstate access in their service areas to more economically-efficient levels..."⁽²³⁾ MCI advocates the Commission adopt a prescriptive approach to achieve this goal. As our comments demonstrate in Section V infra., a market-based approach is incapable of moving access rates to economically efficient levels, and must be rejected. Since its adoption of price cap regulation, the Commission has sought to set rates for regulated carriers at economically efficient levels by replicating competitive outcomes. The Commission has recognized that setting rates at economically efficient levels will benefit not only consumers of incumbent LEC services, but also the incumbent LECs themselves, by making them stronger and more productive competitors.⁽²⁴⁾ This latter goal has become more important in light of new market opportunities for LECs.

When the Commission adopted price cap regulation for the LECs in 1990, it presumed that rates were at reasonable levels. However, it never determined whether the costs that formed the basis of LEC rates, and ultimately LEC actual price indices (API), were set at economically efficient levels.⁽²⁵⁾ The Commission recognized that these initial rates were not based on economically efficient costs, but were "...the best that rate of return regulation can produce."⁽²⁶⁾

The Commission sought to minimize the risk that LEC interstate customers would pay rates above economically efficient levels by: first, limiting the rate of actual price changes to economically efficient rates of change in prices; and second, adopting a variety of sharing and adjustment mechanisms. The Commission did not explicitly identify a mechanism through which initial rates would be adjusted downward to economically efficient levels, but it believed that the incentives inherent in price cap regulation, including the consumer productivity dividend, would eventually bring rates to economically efficient levels.⁽²⁷⁾

Abstaining from setting initial rates for LEC interstate access services that were economically efficient, while understandable given the lack of reliable economic models estimating efficient costs at the time, has required the Commission to periodically true-up, or reinitialize, LEC interstate rates. The Commission recognized this need when it initiated its Price Cap Performance Review for Local Exchange Carriers.⁽²⁸⁾

In this Notice, the Commission recognized the need to bring LEC access rates to economically efficient levels in a manner compatible with regulations adopted pursuant to its implementation of the 1996 Act.⁽²⁹⁾ MCI demonstrates that a market-based approach will not accomplish this goal, or will do so only at significant regulatory expense and involvement (See V infra.). Instead, the Commission must adopt a prescriptive approach. A prescriptive approach can be implemented immediately, accelerating competition in both local and long distance markets, and immediately bringing the benefit of lower rates to consumers.

Now that the Commission has made reliable estimates of the costs of the elements used to construct an efficient telephone network,⁽³⁰⁾ the Commission has also recognized that existing access rates are far above their economic costs ⁽³¹⁾ Having recognized a significant gap between existing rates and their efficient costs, the Commission must reinitialize existing rates and bring them into alignment with those efficient costs. As MCI explains below, the Commission can accomplish this task with a minimal regulatory effort by relying on publicly available estimates of the economic cost of the elements used to provide switched access services. Total Element Long Run Incremental Cost (TELRIC) estimates made by proxy cost models, such as the Hatfield Model employed by MCI and AT&T, may be used to reach a reasonable approximation of the forward looking cost of services residing in existing price cap baskets.

B. The Commission Should Require Incumbent LECs to Immediately Reinitialize Their Actual Price Indices (API) At Economic Cost.

The Commission seeks comment on whether to require incumbent price cap LECs to reinitialize their price cap indices (PCI) to reflect estimates of forward-looking efficient costs made by a proxy cost model. MCI supports reinitialization of rates on the basis of a forward looking economic cost model, and strongly recommends the Commission reinitialize all indices, APIs, PCIs, and Service Basket Indices (SBIs), to 100.

There are a number of advantages to this approach. First, the Commission would finally be able to ensure that rates would actually be reduced to economic cost. The initial rates under price caps were not set at economic cost. The Commission now has additional, and direct, evidence that rates, even under price caps, remain above economic cost. These excess costs should be immediately removed. The Commission could not be certain that actual rates would decline to economic cost were it to require price cap LECs to reinitialize their PCIs at economic cost, since many price cap baskets are below their "cap."

Second, reinitializing APIs at economic cost would immediately bring access charges to cost. This would hasten the benefits of competition to both local customers and long distance providers, and hasten the entry of the Regional Bell Operating Companies (RBOCs) into long distance.

Third, as discussed above, the Commission has never set actual rates in line with the costs of constructing a forward-looking, efficient, telephone network. Consequently, it is almost certain that initial APIs have always been above economic cost. By requiring price cap LECs to reinitialize their APIs based on economic models that consistently estimate the elements used to construct a complete network, the Commission may subsequently proceed to a pure price cap plan and for the first time be confident that above-normal profits the price cap LECs may earn are the result of their own efforts, and not the transfer of monopoly revenues to their shareholders.⁽³²⁾

The Commission notes the minimal administrative burden imposed by the reinitialization approach. MCI concurs with this assessment. The Commission does express concern that reinitialization might only lower rate levels, and not yield an efficient rate structure. This concern is largely misplaced. As discussed below, it is a relatively straightforward task to use unbundled element costs to develop economic costs for price cap services. Long distance minutes do not utilize switches, make data base queries, etc., differently than do local or intraLATA toll minutes. Therefore, TELRIC estimates can be directly employed to estimate the economic revenues associated with local switching, information, database access, tandem switched transport, voice grade and high cap dedicated access, and signaling interconnection.

It is not surprising that TELRIC estimates readily translate into Total Service Long Run Incremental (TSLRIC) estimates of interstate access services. First, the Hatfield Model estimates are built from the assumption that the network provides local, access, and intraLATA toll services; and includes general overhead, and the wholesale costs of billing. Retail marketing costs are not incurred for wholesale, interstate access services.⁽³³⁾

Reinitializing API's for interstate access services by mapping estimates of costs for unbundled elements from proxy models such as the Hatfield Model is a relatively straightforward and administratively unburdensome procedure. Table III-1 shows the revenues for price cap services and baskets for Tier 1 LECs compared to the forward-looking economic costs of those services and baskets.⁽³⁴⁾ Embedded revenues were used for those services that did not have TELRIC estimates immediately available. Consequently, this table provides a conservative estimate of the gap. Reinitializing the APIs at economic cost would reduce rates by 54%, an amount equal to approximately $11.6 billion ($21.5 billion - $9.9 billion) for price cap LECs.⁽³⁵⁾Table III-1

Existing Price Cap Baskets v TELRIC Baskets

	A	B	C	D	E
Note		Embedded	TSLRIC	Upper Bound	Reduction in Rates
		($M)	($M)	($M)
a	Common Line	10,358.63	5,592.11	5,592.11	46.02%
	Traffic Sensitive
b	Local Switching	3,887.04	843.13	843.13	78.31%
c	Information	331.98	32.42	32.42	90.23%
d	Database Access	122.31	62.83	62.83	48.63%
e	BNA	0.99	0.00	0.00	100.00%
	Total Switched	4,342.32	939.38	939.38	78.39%
	Trunking
f	IC	2,752.39	0.00	0.00	100.00%
g	Tandem Switched Transport	321.00	299.30	299.30	6.76%
h	Voice Grade + High Cap (Switched)	700.87	0.23	0.23	99.97%
i	Voice Grade, etc. (Special)	527.20	n/a	527.20	0.00%
j	Audio & Video	46.48	n/a	46.48	0.00%
k	High Caps & DDS (Special)	2,450.92	n/a	2,450.92	0.00%
l	Wideband	0.05	n/a	0.05	0.00%
m	Signaling Interconnection	0.82	n/a	0.82	0.00%
	Total Trunking	6,799.73		3,325.00	51.10%
	Total Access	21,500.68		9,855.49	54.16%

It should be noted that while rates will be reduced by approximately 50%, LECs will not lose $11.6 billion in revenues by having the "gap" between embedded costs and economic costs eliminated.⁽³⁶⁾ The $11.6 billion in excess access revenues represents a combination of implicit subsidies, unrealized efficiency improvements, and assets acquired in preparation of entry into video and long distance markets. MCI estimates that the interstate portion of implicit subsidies is $1.3 billion, leaving a "gap" of $10.3 billion to account for through rate decreases.⁽³⁷⁾ Nevertheless, the $1.3 billion must be removed from interstate access charges, otherwise incumbent LECs will recover twice for universal service.⁽³⁸⁾

C. The Commission May Use A Combination of One-time Exogenous Changes and a One-time Increase in the Productivity Factor to Reduce PCIs.

In the event the Commission decides to initialize LEC access rates by altering the PCI rather than the API, the record established in the Price Cap Performance Review, the March 1996 Preliminary Rate of Return Inquiry, and the recent Universal Service Docket permits the Commission to order a combination of: a one-time exogenous change in LEC rates of return; a one-time exogenous change removing implicit universal service subsidies; and annual productivity increases to transition PCIs to economically efficient levels.

MCI believes that to conform to the requirements of the Communications Act, it would be best to implement immediate reinitialization of rates. If the Commission chooses a transition approach, it might take 3-5 years before the various price cap mechanisms bring access rates to economic cost. This would deny immediate reductions in access rates to long distance customers, and delay RBOC entry into long distance, since RBOCs would not be able to meet the competitive checklist or the public interest test until access is brought to cost.

MCI submitted evidence in the Preliminary Rate of Return Inquiry that shows that a 10% rate of return will fully compensate LEC shareholders for the risk they have borne investing in LEC financial assets.⁽³⁹⁾ Ex Parte Comments filed by the CARE Coalition in the LEC Price Cap Performance Review support increasing the productivity factor to 10%.⁽⁴⁰⁾ Reducing current rates of return from 13.6% to 10% would reduce LEC interstate revenues by $1.5 billion. Raising the productivity factor to 10% from the current 5.3% would reduce PCI-based charges $4.6 billion over a 5 year period. The gap between embedded revenues and economic costs estimated in Table III-1 amounts to $11.6 billion. Accurately accounting for rate of return, productivity, and universal service contributions would account for $7.4 billion of this $11.6 billion gap, leaving a residual of $4.2 billion, that could be removed by raising the consumer productivity dividend from .5% to 5.2% for 5 years.⁽⁴¹⁾

Table III-2 shows the percentage decrease in the PCI is large the first year, due to the simultaneous transfer of $1.3 billion in implicit subsidies to an explicit universal service fund, the removal of $1.5 billion after reducing the rate of return from 13.6% to 10%, and the removal of $2.13 billion by raising the productivity factor to 15.2%. Revenue changes subsequent to 1996 are due solely to the higher productivity factor.

Table III-2: Existing Price Cap Baskets v TELRIC Baskets Interstate Switched Access Revenues

	A	B	C
Year	Revenue ($Billion)	Revenue Reduction ($Billion)	Percent Change in PCI
1996	21.50
1997	16.57	4.93	22.93
1998	14.65	1.92	11.59
1999	12.91	1.74	11.88
2000	11.34	1.57	12.16
2001	9.92	1.42	12.52

Column "C" shows the annual change in the PCI required each year to bring existing price cap rates down to economic cost.

Table III-2 shows the amount PCI's would have to be reduced each year in order bring the rates of each price cap service to the average economic cost of price cap LECs. In practice, the Commission should calculate the percent reduction in PCIs for each price cap basket separately for each price cap LEC. This would require:

estimating the difference between each price cap LEC's rate of return and 10%, and exogenously removing this amount from each basket's share of interstate revenues for the first year of the transition;

estimating each price cap LECs minimal universal service subsidy, and exogenously removing this amount times each basket's share of interstate revenues for the first year of the transition;

applying a 10% productivity factor to each price cap basket every year of the 5 year transition; and

estimating an interim consumer productivity dividend specific to each LEC⁽⁴²⁾ that removes the remaining difference between embedded revenues and TSLRIC estimates of each price cap basket.⁽⁴³⁾

IV. Constitutional and Jurisdictional Arguments

A. Bringing Access to Cost Using a Prescriptive Approach Is Not an Unconstitutional Taking under the Fifth Amendment.

The Commission is charged with assuring just and reasonable rates for all interstate services.⁽⁴⁴⁾ For long distance service, the Commission has found that competition achieves this objective.⁽⁴⁵⁾ For interstate access, however, there is virtually no competition and regulation remains essential. In light of the fundamental changes brought on by passage of the 1996 Act, the level of access charges must be brought down to economically reasonable levels and changes should be made to the mechanism for collecting these charges.⁽⁴⁶⁾ Bringing down access charges to forward-looking economic cost is not an unconstitutional taking of property.⁽⁴⁷⁾ The Supreme Court has held that a regulated utility has no right to the maintenance of a particular overall level of return. The Court in Hope explained that, "the mere fact that the value [of the utility's property] is reduced does not mean that the [rate] regulation is invalid." Hope, 320 U.S. at 601.

The Commission has an obligation to balance the interests of the utility and its investors against the consumer interest in and legal obligation of establishing just and reasonable rates, id. at 603. The Takings Clause is only implicated if an agency's regulatory scheme produces overall rates so low as to "jeopardize the financial integrity of the [regulated] companies, either by leaving them insufficient operating capital or by impeding their ability to raise future capital." Duquesne, 488 U.S. at 312. ⁽⁴⁸⁾

Requiring the incumbent LECs to set their access charges at economic cost will not deny them an opportunity to earn reasonable returns. To the contrary, because economic cost includes the cost of capital and a reasonable share of overhead costs, setting access charges at economic cost actually guarantees incumbent LECs an ordinary and reasonable profit on their access services so long as they invest and operate efficiently. Moreover, pricing access at economic cost will not disable incumbent LECs from earning reasonable returns -- or even super-reasonable returns -- on their end user services. In addition, Congress has created new opportunities for incumbent LECs to use their interstate facilities to provide new services and gain new sources of revenue.⁽⁴⁹⁾ For these reasons, reducing access charges to economic cost cannot constitute a Taking.

The claims, if true, that incumbent LECs will suffer short-term losses to the extent that their embedded costs exceed economic cost is immaterial. Firms in unregulated markets routinely risk losses due, for example, to their own inefficiencies and to improvements in technology that cause them to write off outdated assets.⁽⁵⁰⁾ Regulated utilities are not constitutionally entitled to protection against such ordinary market forces.⁽⁵¹⁾

Indeed, for these reasons, the D.C. Circuit recently rejected BOC challenges to Commission regulations comparable to those contemplated here. In Illinois Bell Tel. Co. v. FCC, 988 F.2d 1254 (D.C. Cir. 1993) the court rejected a Takings challenge to a rate order that served to "exclude part of [an] original investment from the rate base." Id. at 1263. Noting that the Commission has no obligation "to include in the rate base all actual costs for investments prudent when made," the court squarely held that, even if the exclusion resulted in a loss of revenues, "there simply has been no demonstration that the FCC's rate base policy threatens the financial integrity of the [incumbent LECs] or otherwise impedes their ability to attract capital." Id. Here, no such showing could plausibly be made. Put simply, even if requiring the incumbent LECs to set access charges at economic cost would cause them losses on past expenditure, a regulation that sets rates at a level which specifically includes the cost of capital will not prevent them from attracting the capital necessary for them to compete and prosper under a new regulatory paradigm.⁽⁵²⁾

B. The Commission Has Exclusive Jurisdiction over Interstate Access Issues.

Interstate access reform, like other purely interstate issues, falls under the exclusive jurisdiction of the Commission. Nothing in the 1996 Act changes this fact. The two other parts of the trilogy, universal service reform and interconnection, required that the Commission, although it has the primary role for establishing the required rules, consult with state regulators. Interstate access reform is different. While the Commission should certainly consider the views of state regulators along with other commenters, this proceeding is the only part of the trilogy that is purely interstate in nature.⁽⁵³⁾ As such, the Commission should bring interstate access rates down to economic cost immediately as an example for state regulators that will be dealing with intrastate access issues in the near future.

Access reform is not contingent on separations reform. While there is an obvious link between the two proceedings, historically access policy has been established and the separations rules have been changed to conform.⁽⁵⁴⁾ The Separations Joint Board is neither designed to, nor should it be making the overarching interstate access reform policy decisions. While it is quite possible that changes need to be made to the interstate allocator, the Commission should establish the appropriate access policy based on forward-looking economic costs and apply it to the current separations regime. This will not prevent the Separations Joint Board from making changes to the Part 36 rules.

V. A Market-based Approach Is Unworkable, Fundamentally Unfair and Will Undermine the Commission's Interconnection Order.

Using a market-based approach in a market that remains a virtual monopoly is destined to fail from the perspective of both new entrants and end users, leaving the incumbent monopolist as the only beneficiary. When combined with increased pricing flexibility proposed for the incumbent LECs, a bad policy becomes even worse. It will create even greater incentives for the incumbent LECs to slow the development of local competition, consumers will be forced to continue to pay artificially high long distance rates to subsidize the incumbent LECs, and it places the already competitive long distance market at risk by forcing today's interexchange carriers to subsidize the activities of their soon-to-be (or current in the case of GTE and SNET) competitors.

While appearing to embrace the pro-competitive thrust of the interconnection order, the Notice ignores the reality that the incumbent LECs will not give up their monopolies without a fight.⁽⁵⁵⁾ It also undermines the policy that recognizes the best way to maximize competition is to encourage efficient entry in as many different ways as possible.⁽⁵⁶⁾ The market-based approach put forth in the Notice plainly encourages facilities based competition and the use of unbundled network elements to the exclusion of all other means. Resellers would see no access relief and there is no recognition that deploying facilities will take time with access remaining inflated in the interim.

A. A Market-based Approach Fails to Address a Host of Competitive Problems, Including the Cost of Terminating Access.

Even if competition could develop overnight for access, half of the access charge problem would remain completely unresolved under the market-based approach outlined by the Commission in the Notice. The market cannot force terminating access charges down to economic cost. This is a problem already being faced by competitive long distance companies. For example, in Arizona, NYNEX is marketing its long distance service by offering lower prices for calls to its home region. The amount of the per minute difference between calls to the NYNEX territory and calls elsewhere is roughly the equivalent of terminating access. This demonstrates a likely price squeeze and, at minimum, a clear price squeeze opportunity. The problem will only get worse if access charges remain inflated and an RBOC is allowed to provide in-region long distance services.

For those territories where the RBOCs are attempting to merge, the potential for this type of price squeeze when a market-based approach is employed will expand even more. One of the primary reasons cited by Bell Atlantic and NYNEX for their merger is the amount of traffic that both originates and terminates in their territories.⁽⁵⁷⁾ For calls within their territories, a market-based approach provides these companies with two price squeeze opportunities, one for terminating access, and a second on origination in areas where local competition has not yet materialized.

A market-based approach may encourage inefficient entry in the access market. As long as access remains above cost, there will be an umbrella under which firms can enter the market to provide access service, even if they are inefficient providers. The Commission should pursue policies that encourage efficient investment and market entry. The market-based approach may permit inefficient competitors to enter the market while the rates remain artificially high, while permitting the incumbent to keep its rates far above economic cost. Ultimately, the inefficient providers will be forced out of the market if prices are eventually driven to cost.⁽⁵⁸⁾

The problems associated with below cost pricing of access also exist under the market-based approach. It too, highlights the important connection between in-region long distance entry and access reform. Now that the Commission has eliminated the lower bands from the current LEC price cap baskets, an incumbent can engage in predatory pricing. Even if the Commission does not allow prices to fall below TELRIC, once an incumbent LEC is providing in-region long distance service, the floor becomes meaningless. If an incumbent LEC can offer a bundled local/long distance service, the Commission effectively loses the ability to protect against pricing access below cost. This opens the door to massive problems from anti-competitive cross-subsidy, many of which would not exist if a prescriptive approach to reform were used.

B. The Incumbent LECs Will Have a Greater Incentive to Make the Provision of Unbundled Network Elements Difficult.

This approach to access reform is premised on the notion that the availability of unbundled network elements will force the incumbent LECs to price access in an economically reasonable fashion or, if they fail to do so, new entrants will be able to bypass excessive access charges through the purchase of unbundled network elements from the incumbent LECs. While MCI strongly supports the Commission's interconnection order -- and believes it is fully consistent with Congressional intent, a fair balance of state and federal authority, and necessary for the development of wide spread local competition -- MCI recognizes that obtaining and assembling unbundled network elements and actually providing competitive local service will take money, time, and the cooperation from the incumbent LECs who still own and control the bottleneck elements. Yet, the market-based approach to access reform will only make the incentives even greater for the incumbent LECs not to provision or price unbundled network elements responsibly because they would be losing excess access as well as a local customer. It is clear that under a "market-based" approach, absent constant and vigorous oversight by the Commission, the incumbents have the power to slow or prevent the development of a competitive local market.

MCI's experience thus far in negotiating terms and conditions for obtaining unbundled network elements, providing local resale, and installing necessary equipment for local market entry, illustrates the difficulties involved in dealing with the incumbent LECs. For example, in California, where MCI is trying to provide some very limited local resale to business customers on a trial basis, there have been numerous problems in dealing with the incumbent LEC, Pacific Telesis (PACTEL). MCI customers have been told by PACTEL employees that MCI is not legally authorized to provide local service; customers have had their service disconnected before their new MCI local service is connected; customers have been forced to wait as much as six weeks for their new MCI local service to be started by PACTEL, during which time PACTEL has tried to recruit back customers that were waiting to be switched; and PACTEL has failed to take steps to make customer switches electronic and seamless.

There have also been problems and time delays when MCI has attempted to negotiate terms for both physical and virtual collocation of equipment. From the middle of 1994 until the middle of 1996, it was taking, on average, between six and nine months to obtain a collocation agreement. In September of 1996, MCI made 72 collocation requests. By January 1, 1997, MCI had only taken delivery on five. For many, the regulatory clock had not even begun to run because applications were wrongly rejected by the incumbent LECs, numerous questions were asked consecutively giving the incumbent LEC 30 days to answer each one as a means of further delay, and excessive prices were demanded. The incentives for this kind of anti-competitive behavior will only be heightened under a market-based approach to access reform.

As each of the RBOCs begins to seek permission to provide in-region long distance service, the incentive to cooperate in the provisioning of unbundled elements will end. Allowing incumbent LECs to provide in-region long distance service is the only "carrot" that the Commission has to force the incumbent LECs to minimize their anti-competitive conduct and open their local markets to effective competition. MCI expects all incumbent LECs to try to hold on to as much excess revenue from access charges as possible while at the same time trying to enter the in-region long distance market. A market-based approach to access permits them to do so. If access is not brought to cost before in-region long distance entry is permitted, it will be very difficult, if not impossible, to squeeze out the unwarranted subsidies.

The market-based approach also exacerbates the problems of in-region entry into long distance before there is meaningful competition for all consumers. Once it can provide one-stop-shopping for local and long distance services, the incumbent LEC's primary interest will be to remain the only provider that can effectively provide combined local and long distance service for as long as possible. That way it can continue to collect inflated access from customers with no competitive alternative while maintaining a significant marketing advantage. One need only witness the behavior, with respect to court challenges of GTE which already provides both local and long distance services, to see these anti-competitive incentives in action.⁽⁵⁹⁾

There is also the serious problem of interim rates. In light of the fact most states have only established interim rates for both resale and unbundled network elements, it is altogether unclear whether and when competition using these means of entry will be viable. The absence of permanent rates makes reliance on the market to deliver access reform even less likely to succeed. Only 13 states and the District of Columbia have established a permanent resale rate⁽⁶⁰⁾ and only one state, Florida, has established a permanent rate for unbundled network elements. While the presence of permanent rates does not, by itself, lead to a finding that the competitive checklist has been met, the uncertainty created by interim rates would certainly foreclose the Commission from finding that the competitive checklist has been met.⁽⁶¹⁾

The experiences of new entrants thus far and the potential windfall for the incumbents illustrates the link that must be made between bringing access down to cost, establishing permanent forward-looking rates for unbundled network elements, and entry into in-region long distance. The bottom line is that even in places where the right pro-competitive laws are on the books, the ability of new entrants to actually provide competitive services is constantly under attack by the incumbent. Making access reform contingent on the effective operation of these rules will serve only to make the competitive situation worse.

If access charges are not at cost when an incumbent LEC gains entry into the in-region long distance market, the inevitable result is discriminatory access prices. When a LEC buys access for itself, through its affiliate, it incurs only the economic cost. Competitors, however, are forced to pay the inflated costs. When the LEC was not permitted into the long distance market, it was unfair, but less of a competitive problem because everyone in the long distance industry was forced to pay too much. If the LEC gains entry before access is brought down to economic cost, it gains an unfair competitive advantage.

C. Consumers Will Be Harmed Because Competition Takes Time and Always Develops Unevenly.

Local competition is going to take longer to develop than new entrants, most regulators, and consumers would like. A market-based approach to access reform ignores the time it will take and the financial realities faced by new entrants as they try to enter the local market.

Of course, even with multiple means of market entry, a new entrant will not be able to enter all places at once. MCI, for instance, has spent over a billion dollars on local network investments while maintaining the finest long distance network in the world. We currently have local facilities in 17 markets and plan to have facilities in 25 cities and 20 states by the end of the first quarter of 1997. Still, the presence of limited facilities in a market is only the first step toward widespread, effective competition.

MCI believes that over-priced access is essentially a tax levied on consumers for the benefit of the incumbent LECs that the long distance carriers are forced to collect. A market-based approach not only leaves the tax in place, but makes things even worse for the vast majority of consumers. Instead of forcing everyone who uses access services to pay the tax, this approach, particularly when combined with the increased pricing flexibility discussed in the Notice, gives the incumbent LECs an opportunity to pick and choose which customers or market segments will be forced to continue to pay for overpriced access services. The perverse result of such a policy is to force those consumers with the least choice -- those that are the least likely to see competition in the near term -- to continue to subsidize the business of their local monopoly telephone company.

Since competition generally takes root first in areas with the greatest concentration of traffic, those consumers that local competition has not yet reached will remain subject to the continuation of unwarranted excessive access charges while they wait for competition to develop. As indicated supra., while the 1996 Act recognizes that competition will have to come in many forms, this approach to access reform does not. The market-based approach disproportionately penalizes customers of certain entrants, which runs counter to the plain language of the Act and the Commission's previous position.⁽⁶²⁾

For example, in places like California where MCI has some facilities but is, at least initially, providing local service as a reseller, excessive access charges will not be avoided. If the incumbent LECs are able to shift costs to the least competitive segments of the market, as would be the case under a market-based approach with significant pricing flexibility, it will do so and the development of local competition for all customers will be seriously impeded.

This approach is not only unfair to those consumers without a facilities based alternative, but to new entrants as well. It allows the incumbent to continue to build up an anti-competitive war chest which can then be used in a variety of ways. Of greatest concern, the incumbent LEC can target the most lucrative customers by cross-subsidizing its long distance business once in-region entry is permitted, grabbing customers they would otherwise be unable to win.⁽⁶³⁾

VI. Pricing Flexibility

As part of its "market-based approach" to access reform, the Commission proposes to afford the incumbent LECs additional pricing flexibility. This pricing flexibility would be granted in phases as the incumbent LEC demonstrated pre-defined, specific transition points or "competitive triggers." Phase I pricing flexibility would be permitted under conditions of "potential competition," while Phase II pricing flexibility would be permitted under conditions of "actual competition." The Commission justifies this additional pricing flexibility on the grounds that it would "permit LECs greater ability to price economically and therefore bring more competitive pressures, including lower prices, in areas and for services where we expect competitive forces initially to be the strongest."⁽⁶⁴⁾

There is no evidence that the proposed grant of further pricing flexibility would have the effect of intensifying access competition and driving access to cost. In fact, it is more likely that the proposed pricing flexibility would enable the incumbent LECs to preempt the development of access competition. Premature pricing flexibility would permit the incumbent LEC to reduce access charges selectively in order deter new entrants, while continuing to charge above-cost access charges in areas and for services where there are no competitive forces. By slowing the development of competition, the pricing flexibility proposed by the Commission would only exacerbate the flaws inherent in the market-based approach.

A. Pricing Flexibility Should Not Be Granted Prematurely

As is outlined below, and discussed more thoroughly in the attached affidavit of Dr. John E. Kwoka, premature deregulation of monopoly incumbent LECs and a reliance on "market-based" pricing can lead to adverse effects on consumers and on efficient entry, to diminished market competition, and paradoxically, to the need for more -- not less-- regulatory oversight.

First, as Dr. Kwoka points out, while price cap regulation theoretically encourages cost efficiency and product innovation, results in "second-best" prices, blunts incentives for cross-subsidization, and is easy to administer, in actual practice nothing in price caps in any fashion alters the firm's incentives to maximize its private profitability at the expense of social objectives (e.g., cost minimization, product innovation, and cost-based pricing). Moreover, price cap regulation is not designed to foster competition, and in fact, allows for anticompetitive behavior by a dominant firm and actually can enhance its ability to deter entry and handicap rivals. With the decoupling of price from cost and with the unilateral ability to alter price, price-capped dominant firms have a greater ability to take actions that deter new entry.

Price caps may also result in a greater degree of unpredictability to prices, with potentially adverse effects on consumers and competitors alike. Since prices are no longer tied to costs or any other benchmark, the dominant firm may set and change prices for any reason it chooses (e.g., market perceptions, strategies, etc.). This unpredictability may be disruptive to consumers seeking nothing more than simple low-cost service and to competitors and new entrants striving to make rational investment decisions.

The ability of a price-capped firm to deter entry is nowhere more apparent than in the case where a monopoly firm supplies services needed by companies that are its competitors. Under price caps, the monopoly LEC has every incentive, and ability, to disadvantage rivals and undermine the evolution of competition by raising the price and/or lowering the quality of the necessary (bottleneck) service supplied to its rivals. As has previously been pointed out by the Commission, raising rivals' input costs or degrading input quality cripples those rivals and can force them out of the market. Nothing in the structure of price caps exists to thwart such actions.⁽⁶⁵⁾

For these reasons, Dr. Kwoka concludes that the Notice's assertion that the market-based approach "creates incentives for incumbent LECs to act quickly to open up the local exchange and exchange access market to competition" (para 142) is based more on "hope than reality." The LECs have no incentive to promote competition --not inherently, not under price caps generally, and not as a result of the market-based approach proposed in the Notice. Granting the LECs enhanced pricing flexibility would allow them to distort the entry process. The proposed "market-based" approach would likely preserve continued market power for the LECs, require renewed regulatory oversight of various unresolved and contentious relationships between the LECs and its customers and competitors, and increase the difficulties prospective entrants into the access market will encounter.

Deregulation should be deemed appropriate only at the point that competitive forces can and predictably will constrain a firm with market power as well as regulation itself. The competitive forces must in actual fact be approximately equally constraining over such anticompetitive behavior as excessive prices that injure customers, strategic pricing and related conduct that inhibits competition, and undue discrimination. Unbundled network elements may in time represent an important competitive constraint, but the Notice places unwarranted reliance upon these untested devices.

B. Incumbent LECs Have Not Exhausted Existing Pricing Flexibility

Given the dangers inherent in premature pricing flexibility under price caps, the Commission should not grant additional pricing flexibility unless there has been a clear demonstration that existing pricing flexibility is inadequate to respond to the level of actual competition. The incumbent LECs, however, have generally failed to utilize their existing pricing flexibility. Even in the market for switched transport services, where there is nascent competition in some markets, the incumbent LECs have made little or no use of price cap rules that permit geographic deaveraging of transport rates and term and volume discounts.

In response to emerging competition, the Commission offered price cap LECs targeted and measured pricing flexibility which would increase in response to actual competitive conditions. In the expanded interconnection proceeding, price cap LECs were afforded the flexibility to price their switched trunking facilities differently in up to three zones, within existing service categories and subcategories.⁽⁶⁶⁾ The zone subcategories have upper pricing bands of 5 percent and lower bands of 10 percent. LECs are permitted to price below band with proper cost support, pricing their transport facilities at average variable cost. In a later order, price cap LECs were afforded the additional flexibility to offer volume and term discounts on switched transport.⁽⁶⁷⁾

Density zone pricing, however, has not yet been implemented for access services in the areas serviced by RBOCs in 13 states⁽⁶⁸⁾ and by GTE in 13 states⁽⁶⁹⁾ even though such pricing flexibility is permitted. In many instance, even where density zone pricing has been implemented, pricing flexibility has not been used. For instance, Bell Atlantic has implemented density zone pricing structures throughout its region for certain services, however, rates are either the same in all zones or vary by a de minimis amount.⁽⁷⁰⁾ Similarly, SWBT has zone density pricing structure in place in Arkansas, Oklahoma, and Kansas, but the rates are identical in all zones.

Neither the RBOCs nor GTE are fully utilizing their ability to offer switched facility volume and term discounts to their access customers. For example, SWBT in some states has not implemented volume and term switched transport discounts even though they have met the Commission-designated threshold.⁽⁷¹⁾

As the table below illustrates, even though virtually all of the RBOCs continue to price their traffic sensitive, trunking, and carrier common line baskets as high as possible ("at cap"), the RBOCs have neither depleted nor extensively utilized the pricing flexibility already afforded to them within the specific service categories. Currently, all of the RBOCs have failed to utilize between 62 and 100 percent of their downward pricing flexibility in the local switching and voice grade service categories, and in the areas where incumbent LECs claim they face the most significant competition (zone 1 DS1 and DS3 transport), the RBOCs have still failed to used over 65 percent of their downward pricing flexibility in most instances.

Table VI-1: Unused Incumbent LEC Downward Pricing Flexibility⁽⁷²⁾

Local Voice DS1 DS3

Switching Grade (Zone 1) (Zone 1)

Ameritech 71.5% 88.2% 28.7% 38.8%

Bell Atlantic 66.7% 77.7% 66.6% 66.8%

Bell South 62.3% 71.1% 64.5% 71.4%

NYNEX 66.3% 100.0% 93.8% 92.1%

Pacific Tel 64.3% 80.9% 71.7% 60.2%

SBC 66.1% 68.5% 49.3% 73.5%

US West⁽⁷³⁾ 79.2% 93.6% 83.1% 79.4%

The incumbent LECs have not yet taken advantage of the pricing flexibility that the Commission already permits, presumably because they currently face no significant competitive threat for access services. Therefore, no valid reason exists for the Commission to grant, or even contemplate offering incumbent LECs more pricing flexibility.⁽⁷⁴⁾

Moreover, evidence suggests that the RBOCs and GTE have not been harmed in the marketplace because of the current level of pricing flexibility afforded them. Examination of recent incumbent LEC actions, growth, and profitability clearly illustrate that their ability to retain current business, as well as secure new business, has not diminished. As is illustrated in table VI-2, in a year-over-year comparison, the incumbent LECs continue to increase local service and network access revenue significantly.

Table VI-2. Revenue Growth⁽⁷⁵⁾

Percentage (%) Change

Year-Over-Year 3Q95 v 3Q96

Network Local

Access Service

Revenue Revenue

Ameritech 5.6 5.8

Bell Atlantic 3.3 5.2

Bell South 6.2 11.0

NYNEX 4.3 0.1

Pacific Tel 5.3 6.5

SBC 5.0 10.9

US West 2.3 9.3

GTE 8.0 4.2

Simple

Average 5.0% 6.6%

Furthermore, access lines continue to grow at an increasing rate as several RBOCs set records for lines added during 3Q96. The main growth driver continues to be the strong demand for second access lines.⁽⁷⁶⁾ As depicted in table VI-3 below, access line growth (year over year) averaged 4.6 percent in 3Q96 for the RBOCs and GTE, matching 2Q96 for the highest growth in the last five quarters.

Table VI-3. Access Line Growth⁽⁷⁷⁾

Year over Year Growth

Absolute

Percent Change Lines

3Q95 4Q95 1Q96 2Q96 3Q96 3Q96

Ameritech 4.4 4.5 4.5 4.2 3.8 19.6m

Bell Atlantic 3.3 3.4 3.7 3.5 3.7 20.4m

Bell South 4.7 4.5 4.8 5.0 4.9 21.9m

NYNEX 3.0 3.4 3.6 3.8 3.9 17.6m

PacTel 2.7 3.2 3.9 4.7 4.4 16.3m

SBC 4.2 4.5 4.9 5.3 5.2 14.8m

USWest 3.5 3.6 4.2 4.2 4.0 15.3m

GTE 5.3 6.2 6.6 6.7 7.4 19.5m

Simple

Average 3.9% 4.2% 4.5% 4.6% 4.6% 18.2m

Clearly, the RBOCs and GTE have not been harmed under the current price cap regime, and conditions do not exist which warrant increased pricing flexibility at this time. The Commission has never determined that interstate access services face significant competition, and has determined that, distinct from the rest of the country, only certain services offered by NYNEX in LATA 132 in Manhattan uniquely face "special circumstances," and therefore, warrant increased pricing flexibility.⁽⁷⁸⁾ No LECs have offered evidence that demonstrate that the "special circumstances" which warranted a waiver of the Commission's pricing rules in LATA 132 are present elsewhere.

The Commission has already set conditions, which when met, and when combined with the pricing flexibility already provided in price caps, allow the incumbent LECs substantial pricing flexibility. Until incumbent LECs demonstrate that they do not maintain monopoly control over essential bottleneck facilities, that they are significantly restrained or harmed by a lack of pricing flexibility, and that effective competition exists for access services, the Commission should not even contemplate extending increased pricing flexibility to the incumbent LECs.

C. Additional Pricing Flexibility is Without Justification and Would Slow the Development of Competition

Not only have the incumbent LECs failed to use their existing pricing flexibility under current competitive conditions, but there is no indication that existing pricing flexibility would be inadequate under the "potential competition" conditions described in the Notice. The Notice generally fails to enumerate specific restraints that current price cap rules place on the LECs' ability to reduce their access charges to cost or to respond to new entrants under conditions of potential competition. As discussed in the attached affidavit, the two-phase approach to granting additional pricing flexibility lacks a coherent theory relating the competitive triggers to the specific regulatory relief proposed.⁽⁷⁹⁾

At the same time, there is every indication that incumbent LECs could use the proposed pricing flexibility in an anticompetitive fashion. The Phase I proposals would permit the incumbent LECs to lower access prices selectively. They could offer discounted rates only to important customers, or in areas where there was competitive entry, while continuing to charge above-cost rates in other areas. Thus, instead of increasing competition and thereby driving down access charges, the pricing flexibility proposed by the Commission would slow the development of competition and leave above-cost rates largely untouched.

On balance, then, the proposed pricing flexibility does not make the market-based approach to access reform any more viable. The two-phase scheme does nothing to encourage the competitive entry that might put downward pressure on LEC access rates. Rather, it would allow the incumbent LECs to preempt competitive entry. Moreover, the dangers inherent in the Phase I pricing flexibility proposals are exacerbated by the potential for BOC entry into the in-region interLATA market. In particular, the Commission's proposal to deregulate new service offerings and to permit contract tariffs would create an opportunity for the incumbent LEC to tailor access offerings for its interLATA affiliate.

1. Geographic Deaveraging

In the Notice, the Commission suggests that, where unbundled network elements are deaveraged, continuing to require access rates to be averaged across a study area would foreclose the incumbent LEC from meeting competition from unbundled network elements in low-cost areas. However, there is no indication that geographic deaveraging under conditions of potential competition under the market-based approach would accelerate the movement of access charges to cost. The essential problem with geographic deaveraging is that it would allow an incumbent LEC to lower access charges in only those markets where it faced competitive entry.⁽⁸⁰⁾ This would handicap entrants and rivals there, without jeopardizing LEC profit elsewhere -- and may even induce the LECs to raise charges in other markets.⁽⁸¹⁾

Further, there is no cost basis for geographic deaveraging of switching rates. No negotiation or arbitration conducted under Section 252 of the Act has yet resulted in geographically deaveraged local switching or tandem switching rates. Therefore, geographic deaveraging of switched access charges is not required for incumbent LECs to be able to respond to new entrants providing access using unbundled network elements. Deaveraging of local switching rates would permit the LEC to engage in selective access charge reductions in order to respond to competition, while maintaining inflated local switching rates in other areas.

2. Volume and Term Discounts

The Commission suggests that volume and term discounts for switched access elements may enable an incumbent LEC to reflect its actual costs more accurately. However, there is no evidence that there is a cost basis for volume discounts for access services other than transport. No studies have demonstrated substantial economies of scale associated with switching capacity. Likewise, it is highly unlikely that there is a cost basis for volume discounts for the CCL charge, whether assessed on a per-minute or per-line basis. Accordingly, lifting the restrictions on volume discounts for these services would not in any way permit the incumbent LEC to compete more effectively. Volume discounts would simply be a mechanism for the incumbent LEC to discriminate between different classes of access customers.

Similarly, term discounts represent a tool with which the LECs can lock in customers and prevent even efficient entrants from securing an adequate customer base.⁽⁸²⁾ "Potential competition" is not, as the Notice seems to suggest, sufficient to prevent the incumbent LEC from attempting to lock in customers before competitors have had the chance to establish themselves in the market. Indeed, the incumbent LEC has the greatest incentive to do so during the period of potential competition. This is especially true when the incumbent LEC can influence, through the provision of unbundled elements, how and when a "potential competitor" can enter the market.

The proposal to permit term discounts under conditions of potential competition is not consistent with Commission precedent. In the Switched Access Expanded Interconnection Order, the Commission permitted term discounts for transport services only when competitors had taken 100 cross-connects in the incumbent LEC's zone 1 offices. As the Commission noted, satisfaction of this condition provided "marketplace evidence that the LECs' expanded interconnection tariffs provide a viable competitive opportunity."⁽⁸³⁾ The Commission has provided no rationale in the Notice for now proposing to permit term discounts with absolutely no "marketplace evidence" that the Phase I checklist is sufficient to allow competitive entry. The Commission should require that competitors have taken some reasonable minimum number of unbundled network elements before permitting term discounts. Further, the Commission should require a "fresh look" provision that would enable an IXC to terminate a term arrangement once some threshold number of unbundled elements had been taken at a particular end office.

3. Contract Tariffs

The Commission's proposal to permit incumbent LECs facing potential competition to offer contract tariffs is completely without justification. The Commission suggests that the availability of contract carriage should lead to lower prices for those customers using contract tariffs. However, a significantly greater level of competitive entry is necessary to prevent the use of contract tariffs strictly for entry deterring and predatory purposes.⁽⁸⁴⁾ Contract carriage provides the incumbent LEC with unfettered pricing flexibility, giving it the opportunity to disrupt competition in the access market.

The Commission's proposal to grant contract tariff authority to incumbent LECs as soon as they have met the "potential competition" checklist is contrary to Commission precedent. As the Commission pointed out in its November 29, 1995 Order rejecting SWBT's attempt to afford itself increased pricing flexibility through the issuance of a Request For Proposal section of its FCC tariff,⁽⁸⁵⁾ even in cases where the Commission allowed AT&T to offer some of its long-distance services pursuant to contract carriage rates, the Commission has determined that "AT&T...may include in its contracts only those services the Commission has found to be substantially competitive."⁽⁸⁶⁾(emphasis added) Under the substantial competition test, the potential for strategic pricing is reduced because a competitor has invested substantial sunk costs.⁽⁸⁷⁾ Only a year ago, the Commission proposed to apply the "substantial competition" test to incumbent LECs as well.⁽⁸⁸⁾

Now, with little or no explanation, the Commission proposes to abandon the "substantial competition" test and require only "potential competition." The Commission's suggestion, that certain interconnection arrangements negotiated under Section 252 may be substitutable for access services, and thus place greater pressure on prices for incumbent LEC access services at an earlier phase in the development of competition than existed for AT&T, is without foundation. Pursuant to the Local Competition Order, Section 252 interconnection arrangements are only to be used for transport and termination, not access.⁽⁸⁹⁾

Even if an incumbent LEC met the substantial competition test, however, it should not be permitted to offer contract tariffs. Contract tariffs provide a mechanism for the incumbent LECs to discriminate in favor of their own interLATA affiliates. The requirement that a tariff must be "generally available to similarly situated customers under substantially similar circumstances" is insufficient. It ignores the fact that tariffs are easily constructed so that only one user is positioned to adopt them, even if ostensibly offered to all.⁽⁹⁰⁾ At a minimum, the diversity of contracts and contract terms would make it impossible for the Commission to enforce the nondiscrimination requirements of Section 272(e)(3).

4. New Services Deregulation

The Commission proposes to deregulate new services for which a core offering would still be available, suggesting that this could create incentives for incumbent LECs to introduce services using new technologies. However, it is unclear how this pricing flexibility would help drive rates for core services to cost. In fact, the continued provision of "core" services in no way prevents strategic manipulation of price cap provisions to the disadvantage of customers.⁽⁹¹⁾ As noted in the AT&T Price Cap Order,⁽⁹²⁾ the price capped firm can offer a scarcely different "new" service outside the cap at a price that attracts most customers from the original capped service. This results in a very low demand weight on the latter, so that its price may thereafter be increased without much adverse effect on other capped prices. That, in turn, allows the price of the unregulated service outside the cap to increase to near-monopoly levels.

The Commission should not consider deregulating new services until there has been several years experience with LEC provision of interexchange services. As with contract tariffs, the deregulation of new service offerings would create the opportunity for an incumbent LEC to tailor access offerings for its interLATA affiliate. Enforcement of the Section 272(e)(3) requirement that a BOC charge its long distance affiliate an amount that is no less than the amount charged to unaffiliated interexchange carriers would be almost impossible and would do nothing to guard against the anti-competitive effects of tailoring services to meet the specific needs of the incumbent LEC's affiliate.

D. Deregulation of Incumbent LEC Access Services

It is premature for the Commission to consider removing incumbent LEC access services from price cap and tariff regulation. The basic legal framework for local competition, established by the 1996 Act, has existed for less than a year, and many steps remain to be taken before the local competition provisions of the 1996 Act are fully implemented. Even in the narrow market for transport services, where the Commission's expanded interconnection rules have been in place since 1993, the LECs' physical and virtual collocation tariffs remain under investigation. By contrast, when the Commission initiated its inquiry into the state of competition in the interexchange market in 1990, the rules governing long distance competition had been in place for several years and tested fully. In particular, as the Commission discussed in the Interexchange Notice, the BOCs had been subject to equal access requirements for six years, and over 95 percent of BOC lines had been converted to equal access.⁽⁹³⁾

In addition, by 1990 there was clear evidence that the rules governing interexchange competition were sufficient to encourage competitive entry. In the Interexchange Notice, the Commission noted that there were over three hundred competitors offering competing interexchange service, and that two of these carriers competed with AT&T in every state.⁽⁹⁴⁾ These competitors also offered virtually every service that AT&T offered.⁽⁹⁵⁾ By contrast, the incumbent LECs' only actual competitors are the Competitive Access Providers (CAPs), which provide only high capacity services to a limited number of customers in a limited number of buildings in the largest cities.⁽⁹⁶⁾

Finally, at the time that the Commission released the Interexchange Notice, there was clear evidence that new entrants were competing successfully. In the Interexchange Notice, the Commission cited AT&T's market share, which had declined substantially during the preceding five years, from 84.2 percent of switched interstate access minutes to 64.4 percent.⁽⁹⁷⁾ With respect to exchange access service, there is no clear evidence that the existing rules or industry structure allow for successful entry in the market.

Thus, measured by the standards of the Interexchange Notice, it is premature for the Commission to begin examining whether competition in certain exchange access markets is "substantial." Moreover, the Commission must preserve price cap and tariff regulation for the foreseeable future in order to safeguard competition in the interexchange market. As the Commission has noted, "[b]ecause interstate access services are a critical input in the provision of interstate interexchange service, [the Commission] also define[s] competitive harm to include LEC actions that could affect adversely competition in the interexchange market."⁽⁹⁸⁾ Because continued market power would allow the incumbent LEC to discriminate in favor of its own long distance affiliate, stringent standards would have to be met before the Commission could consider removing an incumbent LEC access service from price cap or tariff regulation. In particular, the Commission should preserve these regulatory tools until there has been considerable experience with BOC provision of in-region interLATA services.

1. Application of the AT&T Framework

The Commission seeks comment on whether the analytical framework that was used to streamline AT&T's services should be applied to incumbent LEC access services. In particular, the Commission seeks comment on which of the factors that it used in examining AT&T's pricing behavior could be used to determine when to remove incumbent LEC access services from price cap regulation. It cites demand elasticity, supply elasticity, market share, and the pricing of services under price cap regulation as relevant factors.

As noted above, it is premature to establish the criteria for evaluating the competition faced by incumbent LECs. The Commission need not and should not reach a decision regarding these criteria at this time. No one can predict how the access market will evolve, or even if competition will ultimately be successful. The Commission should not limit its options by deciding this issue today. Moreover, there are at least two reasons why the AT&T criteria should not be applied to the incumbent LECs. First, the economic model of a dominant firm -- presumably that used as a framework for developing criteria for competition -- does not contemplate a multiproduct dominant firm that is both supplier to and competitor of the same other firms. Second, the economic costs of premature deregulation are far greater in the case of the incumbent LECs than for a company without bottleneck control of any service.⁽⁹⁹⁾

To the extent that the Commission applies a supply elasticity test to evaluations of incumbent LEC requests for regulatory flexibility, the Commission should find that substantial supply elasticity exists only when there is facilities-based competition.⁽¹⁰⁰⁾ In the Interexchange Order, the Commission's finding that AT&T faced substantial competition rested in large part on the existence of national facilities-based competitors, and the further demonstration that these competitors stood ready to accept considerable additional traffic in the relatively short term.⁽¹⁰¹⁾ Because a purchaser of unbundled elements remains dependent on the incumbent LEC, and the ability of new entrants to use unbundled elements remains untested, the Commission should not adopt its tentative conclusion that the ready availability of unbundled elements indicates a high elasticity of supply. The Commission should also reject the incumbent LECs' assertion that the fact that they have relatively few access customers makes the interstate access market highly demand responsive. This view fails to recognize that the IXC controls only the selection of transport services, while the rates for other access elements purchased by the IXC, including switching and common line, are determined by the end user's choice of local service provider. Thus, the relevant measure of demand elasticity for these access elements is that of the end user, not the interexchange carrier customer. Studies show that demand for local service is quite inelastic.⁽¹⁰²⁾

2. High-Capacity Special Access Services Should Not Be Removed From Price Cap Regulation

The Commission asks whether high-capacity special access services should be removed immediately from price cap regulation. Applying the criteria used in the Interexchange Order, it is clear that the Commission should not take this step. Even in areas where a CAP is present, businesses that are not located in buildings served by the CAP cannot easily substitute the CAP's services for the LEC's services. As a result, the LEC could exercise significant market power over customers not on the CAP's network. Removing special access services from price cap and tariff regulation at this time could permit the incumbent LEC to discriminate unreasonably between users. Moreover, any examination of competition in the special access market should be undertaken in a separate proceeding. This would allow the development of the type of comprehensive record that supported the Commission's streamlining of AT&T's services.

VII. Transition Issues

A. Separations Reform Belongs in a Separate Proceeding

In this Notice, the Commission seeks comment on the extent to which interstate rates exceed economic costs due to a misallocation of costs to the interstate jurisdiction.⁽¹⁰³⁾ While there are no doubt misallocations that result from the existing separations rules, MCI recommends that the Commission consider separations reform independently from access reform, as it has traditionally done.

Jurisdictional separations deals with the allocation of direct and joint and common costs between jurisdictions. There are no generally accepted allocation methods capable of ensuring that rates based on separated costs will settle at the economic costs caused by each jurisdiction. Consequently, it is not correct to portray separations reform as a means to establish more efficient rates. Proceeding with separations reform first, or giving it priority over bringing access charges to cost, is simply a means to delay access charge reform, and deny access charge reductions to end users.

The Commission is currently able to use a proxy cost model to determine the economic cost of unbundled elements, and as explained above, set rates for interstate access services close to economic cost by mirroring the economic cost of unbundled elements. Including separations reform with access charge reform will introduce a greater amount of arbitrariness than would exist if the Commission limited its attention to access charge reform.

The Commission has historically treated separations changes as secondary to other policy issues.⁽¹⁰⁴⁾ Policy changes designed to promote competition have been implemented, and then it becomes necessary to adjust separations to conform to those policy changes.⁽¹⁰⁵⁾ That is how the Commission should presently proceed. By proceeding immediately with access charge reductions, the Commission will permit all interstate access charges to be reduced to economic cost, including the SLC, because it has linked access reform with an open price cap proceeding. This will bring immediate benefits of competition to consumers. If separations reform is completed first, and costs are transferred to the intrastate jurisdiction, it may delay the reform effort unnecessarily and there may not be mechanisms in place in every state that require immediate reduction in local rates.

B. Incumbent LECs are Entitled To Recover $1.3 Billion of the $11.6 Billion By Which Their Rates Exceed Economic Costs from their Regulated Customers Once the New Universal Service Fund is Constituted.

In its Notice the Commission raises a variety of issues connected with the recovery of the gap between the economic cost of access and the current amount incumbent LECs are charging their customers. In particular, the Commission asks parties to address the following issues: the amount and make-up of the difference between these amounts, whether recovery of the remaining interstate-allocated costs should be permitted, the lawfulness of a denial of such recovery, and possible recovery mechanisms.⁽¹⁰⁶⁾

1. The "Gap" is Approximately $11.6 billion.

As presented in Table III-1, price cap LECs interstate access revenue was approximately $21.5 billion in 1996, and the economic cost of that access was approximately $9.9 billion, leaving a gap of $11.6 billion. Incumbent LECs are entitled to continue to recover the universal service subsidy funds currently included in access charges to fund Long Term Support and other interstate universal service mechanisms -- though that $1.3 billion should not be recovered through access charges. Consequently, approximately a $10.3 billion interstate revenue gap remains after removing the interstate share of universal service.

2. Economic Analysis Does Not Support Permitting Incumbent LECs to Recover But a Small Amount of this $10 billion Gap.

Approximately $1.7 billion of this amount is attributed to incumbent LEC rate of return (13.6%) being 3.6% above the competitive 10% level. Approximately $3.2 billion in revenues is attributed to strategic investment in plant in preparation for LEC entry into video and long distance markets.⁽¹⁰⁷⁾ Research submitted by MCI in the Local Competition Proceeding showed that approximately $.21 billion of the gap can be attributed to under-depreciation.⁽¹⁰⁸⁾ Table V-1 summarizes the sources to which the gap is attributed:

Table V-1 Sources of the Gap

Source	Annual Revenue ($Billion)
Universal Service	1.3
Excess Profits	1.7
Overbuilt Plant	3.2
Depreciation Reserve Deficit	.2
Residual/Operational Inefficiencies	5.2
Total Gap	11.6

Under-depreciation accounts for approximately 2 percent ($.2 billion) of the difference between existing interstate access revenues and the economic cost of interstate access services. LECs' claims that Commission-prescribed depreciation rates are too low and have overvalued their assets have not withstood serious scrutiny.⁽¹⁰⁹⁾ The Commission has recognized this point, and only seeks comment on whether there is under-depreciation as a result of a "...decline in the economic value of plant already in service that occurs when the replacement cost is less than the cost of older equipment....some portion of the deployed equipment is arguably under-depreciated by an amount equal to the difference between the current net book value and the forward-looking replacement cost of the depreciable plant."⁽¹¹⁰⁾ MCI's discussion below shows that if this form of depreciation exists, LECs should be required to recover revenues for this form of under-depreciation from its customers of unregulated businesses.

3. Legal and Policy Analysis Does Not Support The Notion That LECs are Entitled to Recover the Difference Between the Current and Historic Value of their Plant.

There is no basis in policy analysis that would justify permitting LECs to recover this form of under-depreciated plant. In competitive markets, firms routinely write off plant made obsolete by more efficient competitors. For the Commission to allow LECs to recover the value of their plant lost by the entry of more efficient competitors, would simply indemnify the LECs against all competitive inroads and directly contravene the intent of the 1996 Act.

Neither is there a good argument for permitting LECs to recover this type of under-depreciation for plant purchased prior to the enactment of the 1996 Act, as the Commission inquires at para. 255. LECs have been preparing for entry into new lines of business since the day after divestiture, but certainly since the Commission adopted its price cap regulatory regime for the LECs, largely at the urging of the LECs that they be granted more flexibility to innovate against potential competitors. It strains belief to think LECs have been caught off guard at the possibility of encountering local competitors.⁽¹¹¹⁾

More importantly, as made clear in Sec. IV supra, eliminating the gap is not a taking. Rather, it is an obligation under the Act. The Commission inquires what standard of proof LECs should be required to meet in order to be permitted to recover plant claimed to be under-depreciated. If the Commission permits such proceedings to take place, the burden of proof must be placed on the LECs. LECs should be required to show that: a) they have not already written the asset in question off of their financial books⁽¹¹²⁾; b) that the purchase of the asset was prudent by showing that the revenue the company expected to realize from the asset providing regulated services during the first 3 years of its useful life were greater than the cost of the asset; c) that the asset can not be expected to earn revenues during the 3 years following initiation of the under-deprecation proceeding sufficient to cover the amount of claimed under-depreciation.⁽¹¹³⁾

VIII. Rate Structure Modifications

A. General Principles

The Commission seeks comment on several issues related to the access charge rate structure. MCI addresses infra, specific issues raised by the Commission. There are two principles that MCI believes should guide the Commission when it considers the rate structure.

First, the rate structure must reflect the way costs are incurred. This means that traffic sensitive (TS) costs must be recovered by TS rates and non-traffic sensitive (NTS) costs by NTS rates. This also implies that any TS rates must be assessed on the type of demand that is relevant, e.g., per-minute or per-line. However, in some limited cases, it may be impossible to identify what portion of TS costs vary per minute or per call, and thus a single per-minute rate may be reasonable.⁽¹¹⁴⁾

This leads to the second consideration that should guide the Commission. Any rate structure must be auditable. The Commission must assure that access customers must be able to verify their access bills. This implies both that access customers should be able to confirm the amount of costs associated with each rate, and should have the information they need to confirm that they are being charged correctly. Without this ability, access customers will be find themselves in the situation of having no choice but to trust the LECs, against whom they soon may be trying to compete.

B. CCL/SLC

The Commission tentatively concludes that the current common line rate structure does not reflect the manner in which loop costs are incurred.⁽¹¹⁵⁾ MCI agrees with this conclusion. The current split of common line into End User Common Line (EUCL) and Carrier Common Line (CCL) rates was adopted when access charges were instituted. Even though the Commission acknowledged that loop costs were non-traffic sensitive (NTS), it retained recovery of part of loop costs through the CCL charge. The recovery of NTS loop costs through usage-sensitive charges does not reflect cost-causation, and should not be continued.

The Commission offers several options for recovery of the NTS loop costs that are currently recovered through CCL charges. One option is to charge a flat, per-line rate to the interexchange carrier (IXC) to whom the line is pre-subscribed. This option has the advantage of being cost-causative, as the per-line cost would be recovered on a per-line basis.

The Commission's other proposed options do not have this feature, and should therefore not be adopted. The proposed "bulk billing" option, where IXCs are charged based on their relative minutes of use, retains the current usage sensitive recovery of NTS costs.⁽¹¹⁶⁾ The "capacity charge," assessed on carriers based on the number and type of trunks that IXCs purchase from incumbent LECs, is not based on the number of loops that the IXCs use, and would allow those IXCs that pack more loops onto their trunks to avoid paying the cost of the loops they serve. The "trunk port charge" and trunk port and line port charge" options also share this problem.

There are two issues with regard to the per-line charge option that the Commission must address. First, this method would allow companies that use dial-around access to avoid paying for their use of the loop. This could be solved by assessing the TELRIC per-minute cost on each dial-around minute, and reducing the loop costs to be recovered in per-line charges by the amount of revenue recovered in these charges. Second, to allow verification of access bills, the LECs must be required to provide the IXCs with a list of ANIs that are pre-subscribed to that IXC.

The Commission also seeks comment on giving rate structure flexibility to the LECs in their recovery of interstate common line costs from IXCs. Specifically, the Commission seeks comment on the effect of the requirements of Section 254(g), that IXCs are required to charge geographically averaged rates, on the ability to give LECs rate structure flexibility in their recovery of interstate common line costs from IXCs. This requirement of the Act, combined with incumbent LEC pricing flexibility, will have a substantial effect on the ability of local competition to discipline access charges.

If competition comes to local service, all LECs will be trying to capture the end user customer. If the LECs have full flexibility to structure their common line charges to IXCs, and to set their rate levels for those charges, they will seek to charge low end user rates to obtain the end user customer, and charge high access rates. If the IXC is able to charge different rates for long distance service to customers who choose the LEC that charges higher access charges, the end user will be required to consider the full cost of his local service provider, and will allow the market to discipline access charges. However, if the IXC is prevented from reflecting the LEC's access charges in its rates, the market cannot control LEC charges, and the Commission must prohibit geographic deaveraging of access and continue to regulate access rate structure and levels.

The Commission seeks comment on several issues regarding the EUCL. MCI believes that, if the loop costs are determined by economic costs, as they should be, the Commission's proposed increases in the EUCL cap will be moot, as the economic cost of the loop is well below the current cap. However, MCI wishes to make specific comment regarding the question of allowing or requiring the LECs to deaverage EUCL charges.

If the Commission adopts the Joint Board's recommendation in the Universal Service docket, LEC lines will be supported based on the difference between a benchmark rate and the cost of the loop. That being the case, there will be no necessity for the LEC to charge a different EUCL rate for lines whose cost exceeds the benchmark. On the other hand, some EUCL reductions may be justified for those lines that are below the benchmark. Thus, it is highly unlikely that higher EUCL rates need to be charged, because the higher cost loops will be subsidized by the Universal Service Fund. Therefore, deaveraging of the EUCL should be prohibited.

C. Local Switching

The Commission seeks comment on the proper local switching rate structure. Currently, LECs charge per-minute rates for local switching. However, the Commission notes, there are some aspects of switch costs that do not vary with usage. The switch consists of line and trunk cards, and a switching system which connects one line or trunk with another. The line cards, which connect subscriber lines to the switch, are dedicated to an individual subscriber line, and thus do not vary with usage. Similarly, the trunk cards, or ports, which connect interoffice trunks to the switch, are dedicated to individual trunks, and thus do not vary with usage. It is the switching system, which routes calls between trunks and lines, whose cost varies with usage. The Commission seeks comment on the best rate structure for these components.

MCI agrees that, in principle, the line card portion of the switch is, like the loop cost, non-traffic sensitive. In addition, those trunk cards that connect dedicated trunks are also non-traffic sensitive. Trunk cards that connect common transport trunks are traffic sensitive. Given these cost characteristics, it would appear reasonable to recover the costs of these items as the Commission proposes. However, as the Commission notes, identifying the TS and NTS costs separately is not a simple, straight-forward process.

As the Commission recognizes, the NTS and TS costs must be separately identifiable to implement the proposed rate structure. The separate identification of these costs must not be based solely on "special studies" performed by the LECs. These studies will necessarily require allocations of costs, as switches are not priced by their manufacturers in this manner. Identification of the NTS and TS costs of the switch will require data from the switch vendors regarding the cost of the individual parts of the switch. Analyses of this data can be performed to determine the relative amounts of NTS and TS elements of the switch.⁽¹¹⁷⁾

The Commission has considered the traffic-sensitive nature of switching costs in the past. Based on the Joint Board's recommendation in CC Docket 80-286, the Commission dropped the distinction in separations between non-traffic sensitive and traffic sensitive costs of Category 6 Central Office Equipment.⁽¹¹⁸⁾ The Joint Board and Commission determined that changing switching technology, especially the introduction of digital switching systems, rendered the distinction between NTS and TS costs difficult to calculate and justify.⁽¹¹⁹⁾ Given the age of the then-existing studies allocating cost, the Joint Board recommended that the distinction be dropped for purposes of separations.

Since it would be theoretically ideal to implement a rate structure such as the Commission proposes for local switching, the Commission should adopt its proposed structure, as long as the cost studies allocating cost between TS and NTS can be easily performed. The Commission should adopt the methodology described supra, and examine very closely the studies provided by the LECs. These studies must be performed on the public record, to allow all parties opportunity effectively to examine the basis for the allocation of costs.

The Commission also asks whether the TS portion of the local switch should be recovered in per-call or per-call attempt charges rather than per-minute charges. Even if the TS portion of a switch can be identified, it is not clear what part of the TS portion of a switch is sensitive to call attempts and what part is sensitive to minutes. The central processor of a switch is only engaged when the call is attempted. However, there is a physical connection within the switch, between the lines and trunks, which is in use every minute of the call. Therefore, for the TS portion of the switch, there is some portion which may be sensitive to the number of calls, the central processor, and some portion which may be sensitive to the number of minutes, the switching matrix. Dividing the TS portion of the switch into those two pieces might require arbitrary assumptions. Only if the costs of the central processor and the switching matrix can be separately identified should the Commission adopt this rate structure. Given all of these problems, it is not clear that the TS portion of the charge for local switching should be changed from its current per-minute rate structure.

If the Commission does adopt a per-call rate element, it should be assessed only on calls, not call attempts. If the LECs are able to charge for every call attempt, they will be compensated even if their switches are blocking calls. Thus, the LEC will have less incentive to ensure that its network is providing quality service. For this reason, the current structure, w