******************************************************** NOTICE ******************************************************** This document was converted from WordPerfect to ASCII Text format. Content from the original version of the document such as headers, footers, footnotes, endnotes, graphics, and page numbers will not show up in this text version. All text attributes such as bold, italic, underlining, etc. from the original document will not show up in this text version. Features of the original document layout such as columns, tables, line and letter spacing, pagination, and margins will not be preserved in the text version. If you need the complete document, download the WordPerfect version or Adobe Acrobat version, if available. ***************************************************************** Before the Federal Communications Commission Washington, D.C. 20554 In the Matter of ) CUID Nos. CA0680 (Los Osos) ) CA0706 (Garden Farms) Falcon Cable Systems Company ) CA0707 (Santa Margarita) ) CA0709 (Cambria) ) CA0927 (Templeton) Appeal from a Local Rate Order of the ) County of San Luis Obispo, California ) File No. CSB-A-0589 MEMORANDUM OPINION AND ORDER Adopted: January 25, 1999 Released: January 27, 1999 By the Deputy Chief, Cable Services Bureau: 1. Before the Cable Services Bureau ("Bureau") is an appeal of a local rate order ("Order") issued August 4, 1998 by the County of San Luis Obispo, California, the local franchising authority ("LFA"), filed September 3, 1998 by Falcon Cable Systems Company ("Operator"). In its Order, the LFA disapproves part of the basic service tier ("BST") rate increase Operator sought after upgrading its cable system in the above-referenced communities. Operator argues in its Petition for Review ("Petition") that the LFA erred in disapproving the rate adjustment. The LFA filed an opposition to Operator's Petition ("Opposition"). For the reasons stated below, we deny in part and grant in part Operator's Petition and remand this matter to the LFA for further proceedings consistent with this decision. 2. In its Order, the LFA also disapproves the network upgrade for Operator's cable programming services tier ("CPST"). Under the Communications Act of 1934, as amended ("Communications Act"), the Federal Communications Commission ("Commission") is authorized to review the CPST rates of cable systems not subject to effective competition to ensure that rates charged are not unreasonable. The LFA does not have jurisdiction to review Operator's CPST rates and we find that part of the LFA's Order to be without any effect. 3. Pursuant to the Commission's rules, rate orders adopted by local franchising authorities may be appealed to the Commission. In ruling on appeals of local rate orders, the Commission will not conduct a de novo review, but instead will sustain the franchising authority's decision if a rational basis for that decision exists. The Commission will reverse a franchising authority's rate decision only if it determines that the franchising authority acted unreasonably in applying the Commission's rules. If the Commission reverses a franchising authority's decision, it will not substitute its own decision but instead will remand the issue to the franchising authority with instructions to resolve the case consistent with the Commission's decision. 3. In Implementation of Sections of the Cable Television Consumer Protection and Competition Act of 1992: Rate Regulation and Adoption of Uniform Accounting System for Provision of Regulated Cable Service ("Cost Order"), the Commission concluded that cable operators making significant upgrades should be allowed to establish the upgrade costs through an abbreviated cost of service showing and add an upgrade surcharge to their rates otherwise determined pursuant to the Commission's benchmark and price cap methodology. The Commission concluded that allowing abbreviated cost of service showings and surcharges for network upgrades is an appropriate way to implement the goals of the 1992 Cable Act. Permitting abbreviated cost of service showings could promote the availability of diverse cable services and facilities, encourage economically justified upgrades, and reduce regulatory burdens, while ensuring reasonable rates for regulated services. The FCC Form 1235 (Abbreviated Cost of Service Filing for Cable Network Upgrades) allows cable operators to justify rate increases related to significant capital expenditures used to improve rate regulated services. This option is extended only in cases of significant upgrades requiring added capital investment, such as bandwidth capacity and conversion to fiber optics, and for system rebuilds. Cable operators that incur increases in operating costs associated with a significant network upgrade will be permitted to charge additional rates as justified by their FCC Form 1235 filing. 4. On August 4, 1998, the LFA adopted an Order which adjusted Operator's FCC Form 1235 and which reduced the maximum permitted rate ("MPR") Operator could charge for its network upgrade add on. The LFA based its decision in part on a report generated by the consulting firm Public Knowledge. Operator challenges several of the LFA's adjustments regarding Operator's FCC Form 1235 filing. 5. The first issue raised by Operator is the LFA's disallowance of imprudent and excessive plant construction cost. Our cost of service rules allow operators to recover "[p]rudent investment . . . in tangible plant that is used and useful in the provision of regulated cable services . . . Cost overruns are presumed to be imprudent investment in the absence of a showing that the overrun occurred through no fault of the operator." The LFA does not dispute that the expenditures were actually incurred by Operator or that they benefitted subscribers. Therefore, Operator's investment satisfies our used and useful criterion. The LFA does argue that Operator's upgrade costs were grossly higher than its original estimates and industry norms for construction and attributes the excess to weak construction management practices. Accordingly, the LFA feels that Operator has failed to demonstrate that its construction costs were reasonable. The Operator responds that the LFA has identified no specific areas of imprudent or excessive expenditures. Moreover, Operator claims that it is able to account for all expenditures claimed, that its original budget was based on a 400 MHz rebuild rather than the 750 MHz upgrade actually completed, which explains the large variances to which LFA objects, and that its costs are not outside the normal range. Although weak construction management practices may be a cause of cost overruns, poor budgeting practices could as easily explain the variance. Due to Operator's continued reliance on the 400 MHz budget for a 750 MHz upgrade, the comparison of flawed budgetary data with actual costs does not provide a meaningful basis for demonstrating cost overruns. Neither party has provided significant information regarding how Operator's costs compare with industry norms. Consequently, we find that there is insufficient basis to exclude costs on the basis of cost overruns. 6. Operator's second issue concerns the LFA's allocation of headend costs. Operator allocated all of its rebuild costs, including headend costs, to the San Luis Obispo County franchises covered in its FCC Form 1235 filing. Operator argues that only San Luis Obispo has been rebuilt to 750 MHz and, therefore, only those subscribers are deriving benefit from the bandwidth expansion and attendant headend costs. The LFA argues that the headend serves the entire system of which San Luis Obispo is a part and, therefore, only a portion of the headend costs are assignable to San Luis Obispo. The LFA also notes that a share of the reported costs relate to relocation of the headend, which was undertaken by Operator on its own initiative, and that additional costs to provide service to system customers will not be required. Because the headend serves the entire system and all system subscribers will ultimately benefit from the expenditures made, it would be unreasonable to impose all of the additional headend costs on San Luis Obispo subscribers. We find that the LFA acted reasonably to allow only a portion of the headend costs proposed by Operator into the rate base. This finding is consistent with the treatment of headend costs in Falcon Cable Systems Company. 7. Third, Operator questions the LFA's finding that Operator is attempting to over recover its actual upgrade investment by reporting only its upgrade additions on FCC Form 1235 while failing to account for assets removed from service pursuant to the upgrade. Operator argues that its baseline rates for San Luis Obispo County were set under the Commission's benchmark methodology, and that it would be inconsistent and inappropriate to reduce benchmark based rates by cost based retirements. Moreover, Operator believes that FCC Form 1235 is intended to account for "total upgrade investment" rather than upgrade investment net of retired assets, and that the FCC Form 1235 instructions do not prescribe an adjustment for retired assets. The FCC Form 1235 Purpose and Filing Instructions provide, in part, that upgrade rate increases are to include "the actual cost of the capital improvement, less any gains realized from the disposition of property, plant and equipment used prior to the upgrades" irrespective of an operator's initial rate setting methodology. The benchmark rate reflects the average cost experience of competitive systems comparable to San Luis Obispo, including those with upgraded networks. The benchmark system presumes that the rate charged allows recovery of capital costs. Therefore, the subtraction of retired assets on an actual cost basis is appropriate. In our Cost Order, we concluded that "the cost of premature abandonments should be a recoverable operating expense rather than an element in the rate base." Operator is permitted under our rules to amortize any unrecovered investment over the remaining original life of a retired asset. Therefore, our rules protect subscribers by "precluding recovery of a rate of return on abandoned plant, while preserving an opportunity for the cable operator to invest in more advanced technology." Although the FCC Form 1235 is a streamlined form, it is still based on cost of service principles. While we do not require operators to recalculate their initial regulated rates when using the FCC Form 1235, the LFA's conclusion that cost increases must be offset by the value of retired assets is reasonable and is consistent with Falcon Cable Systems Company. 8. The fourth issue raised by Operator concerns the LFA's revision of Operator's allocation method. Operator allocated all of its upgrade costs based on the channel lineup resulting from the upgrade. The LFA argues that, in addition to providing improved quality and reliability, the upgrade adds capacity and that more costs should be assigned to added channels than existing channels. We find the LFA's adjustment to be unreasonable because Operator allocated its costs in a manner consistent with the Commission's cost of service rules. We have previously stated that "a straight channel ratio would be a reasonable approach to the allocation of plant costs amongst service baskets." We conclude that the Operator's allocation method is reasonable. 9. The final issue raised by Operator in its Petition is the LFA's treatment of Operator's failure to report on the FCC Form 1235 any additional advertising or home shopping revenues attributable to the upgrade. The FCC Form 1235 Instructions for Worksheet A, Line 10 require the Operator to "[i]nclude the projected annual net increases or decreases in ancillary revenues earned due to the implementation of the upgrade, such as . . . advertising revenues". Although the LFA argues that advertising revenues increased significantly immediately after the upgrade was completed, it has not demonstrated that the increased advertising revenues are specifically attributable to the added channels. In its Petition, Operator agreed to include the home shopping revenues on the CPST but contends that it has not purchased or installed any ad insertion hardware for newly added channels, and has no plans to do so. Because Operator is not able to derive any revenue from the ad avails on the added channels, and does not plan to derive any revenue, we find the LFA's inclusion of projected advertising revenues to be unreasonable. 10. Accordingly, IT IS ORDERED that Falcon Cable Systems Company's Petition for Review, File No. CSB-A-0589, filed September 3, 1998, IS GRANTED IN PART and DENIED IN PART, and the matter IS REMANDED to the County of San Luis Obispo, California for further proceedings consistent with this decision. 11. This action is taken pursuant to authority delegated by section 0.321 of the Commission's Rules. FEDERAL COMMUNICATIONS COMMISSION William H. Johnson Deputy Chief, Cable Services Bureau