WPC 2  BJ Z(urier3|w CG Times BoldX@`7X@HP LaserJet 5Si in 528HPLAS5SI.PRSx  @\!X@CourierCG TimesCourierCG TimesCG Times BoldCG Times ItalicTimes New RomanTimes New Roman BoldTimes New Roman ItalicSymbolTimes New Roman Bold ItalicGaramond AntiquaGaramond HalbfettÍ#Xj\  P6G;ynXP#2B<?T/CourierTimes New RomanCourierCG TimesCG Times BoldCG Times ItalicTimes New Romanx/c81, c PE37P8wC;,|Xw PE37XPD7zC;,EXz_ pi7XSg9xS]?g9xSi+SS88WuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuuxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNA.SSxSSJJSJS+SSSSS8SSSSSSSSS.xJxJxJxJxJorJiJiJiJiJ8.8.8.8.{SxSxSxSxS{S{S{S{SxSxJ{SxSxSxS{S`SxIxSxIqIqIrSrS{dgIiSiSgIxSxSxSxSxS{S{S8.SSSS8Sz]SSuSg/gR>CxxxxxxxxxxCCjݭR[ӭ⭭RCRnxRjxjxjRxxCCxCxxxxR[Cxxxxjs0sR>nRRR>RRRRRRxRxCjjjjjӜjjjjjRCRCRCRCxxxxxxxxxxjxvxxxxjjjjjjjjjjxxxxxRCRxRRRxxC`RRCxxxxxӭRRR[[[eCnxxxxxx⭭jjjxRx[Rx>xxP+PWxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNVVnxRjxxxxxCMxHMxHRRjjxRRxx됶VVņRjxH"x𐋂x됐xz-b81,ub&_ x7XDy.f81,f_ pi7RdW,/d\  P6G;P7jC:,/ynXj\  P6G;XP@|ND,/_|\  P6G;P @ND,?4  pG;\tll@\@\`LCourierCG TimesCG Times BoldCG Times ItalicTimes New RomanTimes New Roman Bold!uX@"i~'^:DPddDDDdp4D48dddddddddd88pppX|pDL|pp||D8D\dDXdXdXDdd88d8ddddDL8ddddX`(`lD4l\DDD4DDDDDDdDd8XXXXXX|X|X|X|XD8D8D8D8ddddddddddXdbdddpdXXXXXlX~|X|X|X|XdddldldD8DdDDDdplld|8|P|D|D|8dvddddDDDpLpLpLpl|T|8|\ddddddl|X|X|Xd|DdpL|Dd~4ddC$CWxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNHxxH\dDXddddd8@d<@d<DDXXdDDxddxHxxHvppDXd<"dxtldpxxd"i~'^FRxxRRRx>R>CxxxxxxxxxxRRx⭞[x⭻𭭞RCRxRxjjRxCRCʆxj[Rxxxj`5`}R>}RRR>RRRRRRxRCxxxxxjjjjjYCYCYCYCxxxxxxxxxxxxxjj}jjjjjxxx}x[C[[R[†}}ClR`Cxxjjj[[[}zR}jjjR[Rx>xxPAPWxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNVVxRxxxxxxHRxHRxHRRxxxRRxxVVņRxxH"x𐎂x됐xd8`SJ8Muu]daqqZZnn{{xu{{M{aZZ5M5M҅P?k2('f :%k%v&",tB^ f ^;C]ddCCCdCCCCddddddddddCCY~~vCN~sk~CCCddCYdYdYCdd88d8ddddJN8ddddYYdYd4dddddCddddddddd8YYYYYY~Y~Y~Y~YC8C8C8C8ddddddddddYdddddsdXdXXXddx|X~d~d|XdddddddC8ddddCdoddd|8|H~d|8|8dtddddHHdlLlLlLkd|H|8~ddddddddXXXd~ddkd~ddxCddCCCWxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNdddCYQQddddddFddddFCChhd44ddxxdddvooChdF"dhd9dCCxCddoddCdYds]xUvdYYCCCCx~oxoY~NYdYC8YooYdYxsdxdd~YYxoxxx~CdxYxxxxCCdddddddxCsdYC\   pxtll\tll@\@\`L(CourierCG TimesCG Times BoldCG Times ItalicTimes New RomanTimes New Roman BoldTimes New Roman Italic ÍX01Í Í#Xw PE37|XP#a8DocumentgDocument Style StyleXX` `  ` 2E)pZ'k'k5((a4DocumentgDocument Style Style . a6DocumentgDocument Style Style GX  a5DocumentgDocument Style Style }X(# a2DocumentgDocument Style Style<o   ?  A.  2+vw)t)a* *a7DocumentgDocument Style StyleyXX` ` (#` BibliogrphyBibliography:X (# a1Right ParRight-Aligned Paragraph Numbers:`S@ I.  X(# a2Right ParRight-Aligned Paragraph Numbers C @` A. ` ` (#` 2. + w, #- -a3DocumentgDocument Style Style B b  ?  1.  a3Right ParRight-Aligned Paragraph Numbers L! ` ` @P 1. ` `  (# a4Right ParRight-Aligned Paragraph Numbers Uj` `  @ a. ` (# a5Right ParRight-Aligned Paragraph Numbers _o` `  @h(1)  hh#(#h 22./a0:1a6Right ParRight-Aligned Paragraph Numbersh` `  hh#@$(a) hh#((# a7Right ParRight-Aligned Paragraph NumberspfJ` `  hh#(@*i) (h-(# a8Right ParRight-Aligned Paragraph NumbersyW"3!` `  hh#(-@p/a) -pp2(#p a1DocumentgDocument Style StyleXqq   l ^) I. ׃  2q5+82c3c44Doc InitInitialize Document Style  0*0*  I. A. 1. a.(1)(a) i) a) I. 1. A. a.(1)(a) i) a)DocumentgTech InitInitialize Technical Style. k I. A. 1. a.(1)(a) i) a) 1 .1 .1 .1 .1 .1 .1 .1 Technicala5TechnicalTechnical Document Style)WD (1) . a6TechnicalTechnical Document Style)D (a) . 2`85Q667a2TechnicalTechnical Document Style<6  ?  A.   a3TechnicalTechnical Document Style9Wg  2  1.   a4TechnicalTechnical Document Style8bv{ 2  a.   a1TechnicalTechnical Document StyleF!<  ?  I.   2>899e=a7TechnicalTechnical Document Style(@D i) . a8TechnicalTechnical Document Style(D a) . PleadingHeader for numbered pleading paperP@n   $] X X` hp x (#%'0*,.8135@8:> lA?!v?Heading 1Centered Headingcal Style 4G Y * à  Bullet ListIndented Bullet List*M0 Y XX` ` (#` heading 3heading 3 heading 4heading 4! 2-B"vU@#v@$vAA%vAheading 5heading 5" heading 6heading 6# heading 7heading 7$ heading 8heading 8% 2)D&l_B'vB(rAC)vCDefault Paragraph FoDefault Paragraph Font& endnote textendnote text' endnote referenceendnote reference( footnote textfootnote text) 2K*e[D+D,F-Hfootnote referencefootnote reference* toc 1toc 1+` hp x (#(#`(#`` hp x (#toc 2toc 2,` hp x (#` (#`` (#`` hp x (#toc 3toc 3-` hp x (#` (#` (#` hp x (#2R.LK/jM0O1vQtoc 4toc 4.` hp x (# (# (#` hp x (#toc 5toc 5/` hp x (#h(#h(#` hp x (#toc 6toc 60` hp x (#(# (# ` hp x (#toc 7toc 71 2Z2NR3lT4V5Xtoc 8toc 82` hp x (#(# (# ` hp x (#toc 9toc 93` hp x (#(#`(#`` hp x (#index 1index 14` hp x (#` (#` (#` hp x (#index 2index 25` hp x (#` (#`` (#`` hp x (#2R^6Z7v]8l]9Z]toa headingtoa heading6` hp x (#(#(#` hp x (#captioncaption7 _Equation Caption_Equation Caption8 1, 2, 3,?@65NumbersO@/"=(1*1÷$t ?.E91.2x`:d^;^<h_=_A, B,t ?@65Uppercase Letters1 ?*1÷$t ?.E: .Default Para6w]Default Paragraph Font8׏ C*g7ȇ׏E;;<endnote refe6w]endnote referenceg78׏ E*g7ȇ׏E<?@footnote tex6w]footnote text=(g78׏ F*g7ȇ׏E=AB2b>o`?a@}aAbfootnote ref6w]footnote reference78׏ G*g7ȇ׏E>CD_Equation Ca6w]_Equation Captiong78׏ U*g7ȇ׏E?_`a1Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7@$ef a2Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7A/gh` ` ` 2^eBbCccDdEda3Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7B:ij` ` `  a4Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7CEkl` ` `  a5Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7DPmn` ` ` hhh a6Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7E[op 2 hFeGOfHgIqga7Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7Ffqr a8Paragraph+g7ȇ1. a. i. (1) (a) (i) 1) a)7=(g78׏ |*g7Gqst a1AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7H%uv*  a2AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7Iwx2jJq=hKqhLqiMqia3AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7Jyza4AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7K{|a5AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7L}~a6AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7M2BlNq3jOqjPkQka7AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7Na8AgendaE+g7ȇAgenda Items'S77=(g78׏ }*g7Oa127 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0P8@   a227 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0QA@` `  ` ` ` 2:oRtlSmTmU{na327 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0RJ` ` @  ` `  a427 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0SS` `  @  a527 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0T\` `  @hh# hhh a627 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0Ue` `  hh#@( hh# 2.rVloW4pXqYqa727 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0Vn` `  hh#(@- ( a827 FE+&Bß-Right-Aligned Paragraph Numbers&8oY 2*&0Ww` `  hh#(-@pp2 -ppp a1OrderX8X X-I.xa2OrderYAp X-xA.` ` 2uZ`r[ s\"t]ua3OrderZJ* X-x` ` 1. a4Order[4 X- I. A. 1. a.(1)(a) i) a) I. A. 1. 1.(1)(a) i) a)I.xannotation rK&7>annotation referenceGw. "7>NGI "\OaOb#Xv P7XP##Xv P7XP#annotation tK&7>annotation textGw/ "7>NGI "]2c(d2=^ u_`YoauȅMACDocument^[     X` hp x (#%'0*,.8135@8:<     #:}D4P XP# T I. A. 1. a.(1)(a) i) a)T,0*ÍÍ,*Í ., US!!!! ! #:}D4P XP#     X` hp x (#%'0*,.8135@8:<     #:}D4P XP# ,0*ÍÍ,*Í ., US!!!! ! #:}D4P XP#Footnote_7.Í#u\4 PXP#č#u\4 PXP#footerinfo'3, '4'46$16c61_$'461L1`4 <DL!T$#<2PP# 4 <DL!(##XN\  PXP#FOOTER؁4_8c6'4iBH|F  '4a  V (##XN\  PXP# R Z bj ##XN\  PXP# 2xbYocȊdNeHEADER؁4_8c6'4iBH|F  '4b4 <DL!T$#A\  PP# 4 <DL!(##XN\  PXP#NORMAL INDEN؁4_8c6'4iBH|F  '4c"    4` hp x (##A\  P'P#   ,JR Z bj ##XN\  P(XP#heading 1 (n؁4_8c6'4iBH|F  '4d&!"  4 <DL!T$#XN\  P)XP#   4 <DL!(##XN\  P*XP#  heading 2 (n؁4_8c6'4iBH|F  '4e##$ , 4 <DL!T$#XN\  P+XP#  4 <DL!(##XN\  P,XP# 2fsghyibody text(n؁4_8c6'4iBH|F  '4f%& 4 <DL!T$ X #XN\  P-XP# 4 <DL!(##XN\  P.XP#heading 3 (n؁4_8c6'4iBH|F  '4g#'(  , 4 <DL!T$#XN\  P/XP#  4 <DL!(##XN\  P0XP# List 4 3 (n؁4_8c6'4iBH|F  '4h)*  `  ` hp x (##XN\  P1XP#  `  R Z bj ##XN\  P2XP#List 1 3 (n؁4_8c6'4iBH|F  '4i/+,    ` hp x (# #XN\  P3XP#   ,JR Z bj ##XN\  P4XP#2jyk_\lmeNList 5 3 (n؁4_8c6'4iBH|F  '4j-.    ` hp x (##XN\  P5XP#   ` hp x (##XN\  P6XP#heading 4 (n؁4_8c6'4iBH|F  '4k/04 <DL!T$#XN\  P7XP# 4 <DL!(##XN\  P8XP#List 2 4 (n؁4_8c6'4iBH|F  '4l/12    ` hp x (# #XN\  P9XP#   R Z bj ##XN\  P:XP#heading 5 (n؁4_8c6'4iBH|F  '4m 344 <DL!T$#XN\  P;XP#  4 <DL!(##XN\  P<XP# 2noxp qList 1.d (n؁4_8c6'4iBH|F  '4n/56    ` hp x (# #XN\  P=XP#   R Z bj ##XN\  P>XP#List 2.d (n؁4_8c6'4iBH|F  '4o/78  `   4 hp x (# #XN\  P?XP#  `  4` hp x (##XN\  P@XP#List 3.d (n؁4_8c6'4iBH|F  '4p"9:    ` 0 hp x (#0 #XN\  PAXP#   ` hp x (##XN\  PBXP#List 4.d (n؁4_8c6'4iBH|F  '4q";<   ` hp x (# #XN\  PCXP#   4` hp x (##XN\  PDXP#2wrIstucList 3d (n؁4_8c6'4iBH|F  '4r/=>7 4  4` hp x (# #XN\  PEXP#  4 #XN\  PFXP#List 5.d (n؁4_8c6'4iBH|F  '4s"?@  h ` <p x (#0 #XN\  PGXP#  h 4 hp x (##XN\  PHXP#Quote.d (n؁4_8c6'4iBH|F  '4t"AB  ` `   hp x (##XN\  PIXP#  ` `  ,JR Z bj ##XN\  PJXP#Page#.d (n؁4_8c6'4iBH|F  '4uCD4 <DL!T$#XN\  PKXP# 4 <DL!(##XN\  PLXP#2vwfWxyzctitle.d (n؁4_8c6'4iBH|F  '4v1EF$ 4 <DL!T$#[\  PMP# }} 4 <DL!(##XN\  PNXP# dd body no inde؁4_8c6'4iBH|F  '4wGH 4 <DL!T$#XN\  POXP# 4 <DL!(##XN\  PPXP#Style 14Stx''F'ơ#Co> PQP##X\  P6G;ɒP#Page Number6?ZFX R(P=()LX R(P=()L><q*"xxxxWWxxxWWkkxxx,?2?2>,H2H2H2H2H2J2J2!2222!2I822F2>>$?2>>J2:J2J2H2H2YHB$B$C26&6&6&62>$>?2J2J2J2J2J2J2^HH2@,@,@,J2?2J262?2H2<!22!!!WddddddddddddddddddddddddddddddddddddddddddddddddxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNHHH222!,))22X222YY2#2222Y#!!442Ydd22<3&8C!C!bC@@>.*(@<[<@85<5x::::::::::::<:C![3[3[3[3[3MY3J3J3J3J3(!(!(!(!eCe@e@e@e@b@b@b@b@W@[3`H:eC::R:W@H<<!!!WxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNWWW<::+33::o:::bb:(C<<:b(!!33:b!!xx::HH[x;sC0,Xs4@ x7XXlT$H(,phHjp P7hP2f ^}Z",tB^ f ^00U``000`000d``````````00FsvdC?vo]x~0d0dd0]`HdH8U`;0d8o]]`N;?hh]YUYdY`4`````0``````d`d;]]]]]~HvHvHvHvHC;C;C;C;o]]]]hhhhY]d]]Y]o]xd`xdXX``xxXv`v`xXd``````D;`d``Cdk``dp8pHv`vCv8ddod`xLxL`dL];dL``pHp8x`hdhhdh`pL~UpLdv`o``x`dx0dd080WxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxNd``4FQQ```YY`CYdd`C00QQ`;;``xxdddhdk0QdC"dYd9dCCx0d`o`d``Y`s]xUvdYY0000xsoxoYvN~YdYC8YooYdYxodxddxYYxoxxxvC`xYxxxx00```````x`sdYC\   pxtll\tll@\@\`Lyxdddy Federal Communications Commission`&(#cFCC 97159 C:\DOCUMENT\4THORD\INTRO  Y4  hhCqpp  *xxX  Y4(a Before the W FEDERAL COMMUNICATIONS COMMISSION 'Washington, D.C. 20554  Y24 ` `  hhCq)  Y 4 In the Matter of hhCq)   Њ` `  hhCq)  Y 4Price Cap Performance ReviewhhCq)CC Docket No. 941  Y 4for Local Exchange CarriershhCq) ` `  hhCq)  Y 4Access Charge ReformhhCq)CC Docket No. 96262 ` `  hhCq)  YL4> FOURTH REPORT AND ORDER IN CC DOCKET NO. 941 AND ă  Y64 SECOND REPORT AND ORDER IN CC DOCKET NO. 96262 ă  Adopted: May 7, 1997; Released: May 21, 1997 By the Commission: Commissioners Quello, Ness, and Chong issuing separate statements.  Y4+ TABLE OF CONTENTS ă  Y4 `(#m Paragraph I. Introduction`"(#1 II. Background and Overview`"(#2 A. Background `"(#2  Y4 B. Overview of Revised Price Cap Plan`"(#7 C. Price Cap Regulation and Access Reform``"(#14 III. XFactor Calculation Issues``"(#16 A. Background``"(#16 "''0*((aao,"ԌB. XFactor Approaches ``"(#19 ` ` 1. Methods for Estimating the XFactor``"(#19 ` ` 2. Direct Approach``"(#27 C. TFP Calculation Issues``"(#29 ` ` 1. Background``"(#29  Y 4` ` 2. TFP Models Placed in the Current Record``"(#35  Y 4` ` 3. Output Index Issues q ``"(#39  Y 4` `  a.Mathematical Construction of Output Indices``"(#39  Y 4` `  b.Number of Output Categories``"(#44  Y4` `  c. Weighting of Output Categories``"(#47  Yb4` ` 4. Input Index Issues q ``"(#49  Y44` `  a. Capital ``"(#49  Y4` `  b. Labor ``"(#77  Y4` `  c.Materials``"(#80  Y4` `  d.Weighting of Materials and Labor Indices``"(#83  Y4` ` 5. Summary hhC ``"(#91 D. Other XFactor Calculation Issues``"(#95  Ye4` ` 1. Input Price Differential``"(#95  YN4` ` 2. Adjustment to XFactor for InterstateOnly Activity`!(#107  Y74` ` 3. Effect of Universal Service and Other (#  Y 4` `  Subsidy Programs on LEC TFP pp `!(#117  Y 4` ` 4. Inclusion of Other Firms in Study pp `!(#120  Y4` ` 5. Consumer Productivity Dividend`!(#122  Y4` ` 6. Effects of Access Reform`!(#128 E. Analysis and Prescription`!(#133 IV. Price Cap Structure Issues `!(#144 A. Overview `!(#144"Q%0*&&aa'"ԌB. Sharing Obligations`!(#147 C. Number of XFactors`!(#156 V. Updating the XFactor`!(#163 A. Background `!(#163 B. Discussion `!(#165 VI. Common Line Issues `!(#168 A. Common Line Formula`!(#168 B. Reliance on Forecasted Data`!(#171 VII. Exogenous Cost Issues`!(#173 VIII. Other Issues`!(#177 A. Application of the New Price Cap Formula to Incumbent LEC PCIs`!(#177 B. Video Dialtone Basket`!(#182 C. Miscellaneous Issues `!(#183 IX. Procedural Issues`!(#191 A. Tariff Filing Requirements`!(#191 B. Final Regulatory Flexibility Act Analysis `!(#192 X. Ordering Clauses`!(#196  Y4 Appendix A  List of Comments and Replies  Y 4 Appendix B  Pleading Summaries  Y!4 Appendix C  Rule Changes  Y"4 Appendix D  Estimation of TFP Under FCC Rules "#0*&&aa%"Ԍ Y4řB8 I. INTRODUCTION ă  Y41. In this Order, we make significant revisions to our current price cap plan for regulating incumbent local exchange carriers (incumbent LECs) as part of our plan to construct a dynamic regulatory framework to further the new procompetitive, deregulatory  Y4paradigm set out in the Telecommunications Act of 1996 (1996 Act).+XN xP'ԍ Telecommunications Act of 1996, Pub.L.No. 104104, 110 Stat. 56 (1996) (to be codified at 47 U.S.C.  xP' 151 et seq.). For clarity, we refer to provisions of the 1996 Act using the sections at which they will be codified.+ In conjunction with  Yw4the Access Reform First Report and OrderwN xP 'ԍ Access Charge Reform, First Report and Order, CC Docket No. 96262, FCC 97158 (rel. May 16, 1997)  xP '(Access Reform First Report and Order). and the Universal Service Order,w@N xPh 'ԍ FederalState Board on Universal Service, First Report and Order, CC Docket No. 9645, FCC 97157  xP0'(rel. May 8, 1997) (Universal Service Order). this Order adopts reforms needed to set the stage for the progressive deregulation of incumbent LECs with the development of competition. We adopt a reasonable, challenging price cap plan that  Y24effectively requires price cap LECs to reduce inflationadjusted prices for interstate access services by approximately 6.5 percent annually. This new price cap reflects a more reliable productivity estimate than in past Orders, one that is based on a careful analysis of the rate of growth of incumbent LEC total factor productivity (TFP) and the rate of change of LEC input prices. We also eliminate the sharing requirements of the current rules, which substantially undercut the efficiency incentives of price cap regulation and retained some of the costmisallocation incentives inherent in rateofreturn regulation. These forwardlooking reforms to our price cap plan for incumbent LECs will allow services to be more readily removed from price regulation as warranted by the development of a competitive marketplace.  Y54.  II. BACKGROUND AND OVERVIEW ă  X4 A. Background  Y42. Price cap regulation seeks to replicate the beneficial incentives of competition in  Y4the provision of interstate access services,XN xP !'ԍ Price Cap Performance Review for Local Exchange Carriers, CC Docket No. 941, First Report and  xP!'Order, 10 FCC Rcd 8961, 900103 (paras. 9096) (1995) (LEC Price Cap Performance Review), aff'd sub.  xP"'nom. Bell Atlantic Telephone Companies v. FCC, 79 F.3d 1195 (D.C. Cir., 1996) (Bell Atlantic v. FCC). ē while striking a reasonable balance between the interests of ratepayers and stockholders. Price cap regulation is intended to encourage growth in productivity by permitting incumbent LECs that increase their productivity to earn" 0*&&aa4"  Y4higher profits, N xPy'ԍ Policy and Rules Concerning Rates for Dominant Carriers, CC Docket No. 87313, 5 FCC Rcd 6786,  xPA'6789 (para. 22) (1990) (LEC Price Cap Order), Erratum, 5 FCC Rcd 7664 (Com. Car. Bur. 1990), modified  xP 'on recon., 6 FCC Rcd 2637 (1991) (LEC Price Cap Reconsideration Order); aff'd sub nom. National Rural Telecom Ass'n v. FCC, 988 F.2d 174 (D.C. Cir. 1993).  while at the same time ensuring that interstate access customers share in the  Y4benefits of productivity growth in the form of lower rates.bN xPJ'ԍ LEC Price Cap Order, 5 FCC Rcd at 6790 (para. 30). b The price cap formula was designed to ensure that "[b]oth carriers and customers will be better off" under price cap  Y4regulation.b@N xP 'ԍ LEC Price Cap Order, 5 FCC Rcd at 6790 (para. 30). b  Y43. The Commission adopted LEC price cap regulation in 1990 because it found that rateofreturn regulation did not create adequate efficiency incentives for incumbent LECs,  Y_4and required administratively burdensome cost allocation rules to enforce.h_N xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 678991 (paras. 2137).h Rather than adjusting prices to allow LECs the opportunity to earn a predetermined return on interstate investment, price cap regulation directly regulates prices and allows earnings to vary. Under price cap regulation, the ceiling or maximum price a LEC can charge for interstate access services is adjusted annually by a measure of inflation minus an "XFactor." A separate adjustment is made for "exogenous" cost changes, which are changes outside the carrier's  Y 4control and not otherwise reflected in the price cap formula.  ` N xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6792 (paras. 4748). For a complete summary of the original price  xP'cap plan, see LEC Price Cap Order, 5 FCC Rcd at 678789 (paras. 520).  Y 44. In the 1990 LEC Price Cap Order, the Commission scheduled a review of the performance of the price cap plan, to begin in 1994, to determine whether any revisions or  Yy4modifications to the plan would be necessary.i y N xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 683435 (paras. 38594).i In the first phase of that performance  Yb4review, completed in 1995,c bH N xP['ԍ LEC Price Cap Performance Review), 10 FCC Rcd 8961. c we made several revisions to the price cap plan. bN xP 'ԍ For a summary of those revisions to the price cap plan, see LEC Price Cap Performance Review, 10 FCC Rcd at 897073 (paras. 1926). We also concluded, however, that we required a more complete record to resolve several important  Y44issues, including how the XFactor should be calculated in the future, 40N xP%'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 896769 (paras. 913). and whether it would"4 0*&&aa"  Y4be possible to develop a price cap plan that did not impose sharing obligations.~N xPy'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 8969 (paras. 1516). ~  Y4Accordingly, we adopted an "interim plan" in the LEC Price Cap Performance Review and  Y4sought comment on additional issues in the Price Cap Fourth Further Notice.WXXN xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 8967 (para. 7), 8968 (para. 14); Price Cap Performance Review for Local Exchange Carriers, Fourth Further Notice of Proposed Rulemaking, CC Docket  xPk'No. 941, 10 FCC Rcd 13659 (1995) (Price Cap Fourth Further Notice). W  Y45. In that Notice, we sought comment on methods for developing an XFactor, the appropriate number of XFactor options, and whether we should represcribe the XFactor periodically or adopt a method for recalculating the XFactor annually. We requested  Y_4comment on sharing, the price cap common line formula, and our exogenous cost rules. We tentatively concluded that the XFactor should have three characteristics. First, it should provide a reliable measure of the extent to which changes in LECs' unit costs have been less  Y 4than the change in level of inflation.X xN xPC'ԍ In the LEC Price Cap Performance Review, we explained that changes in a firm's unit costs come from  xP 'two sources: (1) changes in productivity, and (2) changes in input prices. LEC Price Cap Performance Review,  xP'10 FCC Rcd at 9033 (para. 160). See also Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (para. 54). Second, it should pass through ongoing unit cost reductions to consumers. Finally, the calculation of the XFactor should be relatively simple  Y 4and based on publicly available data.w N xP5'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13662 (para. 16). w  Y 46. In the Access Reform Notice,+X ( N xP'ԍ Access Charge Reform, Notice of Proposed Rulemaking, CC Docket No. 96262, Price Cap Performance Review for Local Exchange Carriers, Third Report and Order, CC Docket No. 941, FCC 96488 (rel. Dec.  xP''24, 1996) (Access Reform Notice).+ we invited further comment on whether and how we should revise our LEC price cap plan as part of access reform. We sought comment,  Y4inter alia, on whether we should adopt a higher XFactor based on the record developed in  Yy4response to the Price Cap Fourth Further Notice or on similar, more recent economic  Yb4studies.^bH N xP['ԍ Access Reform Notice at paras. 23135. ^  X44 B. Overview of Revised Price Cap Plan  Y47. In this Order, we make significant changes to our interim price cap plan and adopt the revised plan as our permanent price cap regulatory regime for incumbent LECs. Incumbent LECs have distributed their interstate services among four groups of access"0*&&aav"  Y4services, called baskets.N xPy'ԍ Our companion Access Reform First Report and Order has added a new price cap basket for recovery of  xPA'marketing expenses. Access Reform First Report and Order at paras. 31725. A price cap index (PCI) limits the weighted average of rate increases for each basket to the rate of inflation minus an "XFactor."  Y48. In the original and the interim price cap plans, the baseline XFactor was based on the average of the shortterm and longterm trends in rate reductions prior to our adoption of the original price cap plan in 1990, plus a consumer productivity dividend (CPD) of 0.5 percent. We selected the XFactor and the CPD so that, at minimum, rates would decline more quickly than they had declined before 1990, and thus would ensure that the first benefits of price cap regulation would flow to access customers in the form of lower rates.  Y14In the LEC Price Cap Performance Review, we tentatively concluded that an analysis that directly measured the growth of LEC productivity and input prices would provide a better  Y 4basis for prescribing an XFactor.s N xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 903132 (para. 157).s In the Price Cap Fourth Further Notice, we invited comment on the total factor productivity (TFP) methodology and other alternatives for  Y 4calculating the XFactor. We also tentatively concluded that we should base our XFactor on  Y 4a TFPbased measure of productivity and an input price differential.@X N xP'ԍ See Price Cap Fourth Further Notice, 10 FCC Rcd at 13664 (para. 25). See also LEC Price Cap  xP'Performance Review, 10 FCC Rcd at 9031 (para. 155).  Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (paras. 5455). @ We find below that the record supports prescribing a single XFactor of 6.5 percent, based on our conclusions regarding a reasonable method of calculating LEC TFP and input prices, our findings regarding the input price differential, and our decision to retain the 0.5 percent CPD.  YK49. In its simplest form, total factor productivity is the ratio of a firm's (or industry's,  Y44or nation's) total output to its total input.y4N xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 900809 (para. 106).y A firm can become more productive by producing greater output from the current level of inputs, by producing the same level of output from fewer inputs, or through a combination of both. In TFP calculations, output and input are represented by indices. The output index represents the quantities of goods or services produced, and the input index represents the quantities of capital, labor, and materials used in the production of those goods and services. TFP studies most often develop output and input price indices to adjust output and input quantities for the effects of inflation. The development of composite quantity and price indices, and the weighting of these indices in TFP calculations, raise important issues that we decide in Section III.C. of this Order. In addition to these TFP calculation issues, we also resolve issues about whether to adjust the XFactor for the difference between LEC input prices and input prices for the"N` 0*&&aa&" national economy (an "input price differential"), and about whether to adjust for any difference between interstate and intrastate productivity growth.  Y4 10. Our interim price cap plan permits LECs to choose among three XFactors, two of which include obligations to share certain earnings. Sharing requires incumbent LECs to "share" half or all earnings above specified rates of return with their access customers by lowering the maximum prices LECs may charge during the next year. We tentatively  Y_4concluded in the LEC Price Cap Performance Review that we should move to a system of pure price caps, without sharing, because we found that sharing tends to blunt the efficiency  Y14incentives that we sought to create with price cap regulation.1N xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 904546, 9049 (paras. 18789, 197). We retained sharing in our interim plan, however, because we found that it served three beneficial functions: a "flow Y 4through" function, a "matching" function, and a "backstop" function.(x XN xP 'ԍ The "flowthrough" function of sharing ensures that a reasonable portion of the productivity gains of incumbent LECs are flowed through to access customers. The "matching" function encourages incumbent LECs to select an XFactor that most closely matches their reasonably expected productivity growth in a price cap plan with more than one XFactor. The "backstop" function ensures that rates under price cap regulation do not  xP,'become unreasonably high or low. LEC Price Cap Performance Review, 10 FCC Rcd at 904749 (paras. 191 xP'96). See also Price Cap Fourth Further Notice, 10 FCC Rcd at 1367677 (paras. 11215). These three functions are discussed in more detail in Section IV. of this Order below. ( In the Price Cap  Y 4Fourth Further Notice, we proposed to eliminate sharing if we found a way to replace these three beneficial functions or if we found these functions no longer necessary to the operation  Y 4of our price cap regulatory regime.p N xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13679 (para. 127).p The "backstop" and "flowthrough" functions were necessary in part because we were not certain that the productivity targets established by our XFactors were sufficiently challenging.  Yb4 11. We conclude that, under the price cap plan we adopt today, the beneficial aspects of these functions are outweighed by the benefits of eliminating sharing. As explained in detail below, we consider the XFactor we adopt today to be based on a much more reliable estimate of incumbent LEC potential productivity gains. Therefore, we have substantially more confidence that this XFactor will flow through a reasonable portion of LEC productivity gains to access customers. We also find that, because we establish a price cap plan with only one XFactor, a matching mechanism is no longer necessary. To guard against our new XFactor requiring individual LECs to charge unreasonably low rates, we will retain our current lowend adjustment mechanism.  Y|4 12. In the Price Cap Fourth Further Notice, we sought comment on updating the XFactor annually using a moving average of TFP, or periodically during performance reviews. We decide, in light of the fundamental changes to the marketplace resulting from the new"N( 0*&&aa" competitive paradigm of the 1996 Act, that the better course is to select a new generally applicable XFactor, based on the current record, that will remain in place until we change it in a new performance review.  Y4 13. We also sought comment on how to revise the common line PCI formula and the exogenous cost rules should we decide to adopt a TFPbased XFactor. In our companion  Yv4Access Reform First Report and Order, we are revising the PCI formula for the common line basket to reflect our revisions to common line recovery, and we therefore decline to discuss common line issues further here. We also conclude that our decision to adopt a fixed X Y14Factor precludes the revision of the exogenous cost rules that we contemplated in the Price  Y 4Cap Fourth Further Notice.  X 4 C. Price Cap Regulation and Access Reform  Y 4 14. The rules we adopt in this Order are an essential part of access reform. They are necessary to promote, and plan for, the growth of competition envisioned by the Telecommunications Act of 1996. An XFactor based on TFP and an input price differential provides, with the Consumer Productivity Dividend, a reasonable, challenging target for LEC access prices. Importantly, eliminating the sharing requirement will increase the incentive of incumbent LECs to become more productive and will enable us to deregulate competitive services while noncompetitive services remain under regulation. In addition, eliminating the sharing requirement will remove the incentives that incumbent LECs now have to misallocate costs from services not subject to sharing, such as those no longer subject to price cap regulation, to services that are subject to sharing. A price cap plan without sharing should greatly facilitate our overarching goal of deregulating services that face sufficient competition by making it easier to remove from regulation those services subject to competition.  Y|415. In the Access Reform Notice, we invited comment on increasing the XFactor,  Ye4either on the basis of the record submitted in response to the Price Cap Fourth Further  YN4Notice, or on more recent economic studies.QNN xP'ԍ Access Reform Notice at para. 233.Q In response to the Access Reform Notice, a number of parties have argued that, in light of the 1996 Act, we should move forward to  Y 4reform our current price cap plan.  XN xP)!'ԍ See, e.g., PacTel 1997 Comments at 4142; Aliant 1997 Comments at 8; SNET 1997 Reply at 2324;  xP!'BA/NYNEX 1997 Reply at 3233; CPI 1997 Comments at 2325 (favoring new XFactor). See also, e.g., USTA 1997 Comments at 18; BA/NYNEX 1997 Comments at 60; PacTel 1997 Comments at 43; GTE 1997 Comments at 56 (favoring elimination of sharing).  In this Order, we consider all the comments filed in"  @0*&&aa"  Y4response to both the Price Cap Fourth Further Notice and the Access Reform Notice  Y4pertaining to calculation of the XFactor and other price cap structure issues.6N xPb'ԍ In Appendix A of this Order, we list all the pleadings filed in response to the Price Cap Fourth Further  xP*'Notice in 1996. For purposes of this Order, we refer to these pleadings as "Comment" or "Reply." In  xP'Appendix A of our companion Access Reform First Report and Order, we list all the pleadings filed in response  xP'to the Access Reform Notice in 1997. For purposes of this Order, we refer to these pleadings as "1997 Comment" or "1997 Reply." 6 C:\DOCUMENT\4THORD\INTRO  Y4 !C:\DOCUMENT\4THORD\IIIABC! a}  III. XFACTOR CALCULATION ISSUES ă  Yw4 A. Background  YJ416. Under price cap regulation, the weighted average of the prices for the services in a given price cap basket, or the actual price index (API), must be less than or equal to the aprice cap index (PCI). An incumbent LEC's PCIs are adjusted annually pursuant to  Y 4formulae set forth in our rules.x xN xP.'ԍ See Section 61.45(b) of the Commission's Rules, 47 C.F.R.  61.45(b). x The PCI formula consists of an inflation measure, in this  Y 4case the Gross Domestic Product Price Index (GDPPI),VX N xP'ԍ In the LEC Price Cap Performance Review, we adopted GDPPI as the inflation measure, in place of the  xPo'Gross National Product Price Index (GNPPI) used in the original price cap plan. LEC Price Cap Performance  xP7'Review, 10 FCC Rcd at 9116 (para. 351). V minus the XFactor, plus or minus any permitted exogenous cost changes.  Y 417. In the Price Cap Fourth Further Notice, we proposed to adopt a total factor productivity (TFP) method for deriving the productivity component of the XFactor, as advocated by USTA, but also sought comment on several other possible XFactor calculation methods and invited parties to propose additional methods. For instance, we sought comment on AT&T's Historical Revenue Method, which would explicitly set the XFactor to  Y64produce an industryaverage rate of return of 11.25 percent.v 6( N xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1367172 (paras. 7783).v In addition, we considered the Historical Price Method, which would set the XFactor based on updated versions of the two  Y4studies relied upon in the LEC Price Cap Order. The first, the SpavinsLande study, compared prices for LEC services to price levels for the U.S. national economy between 1929 and 1989; the second, the FrentrupUretsky study, examined the trend in LEC prices  Y4for switched access between 1984 and 1990.v! N xP,$'ԍ See LEC Price Cap Order, 5 FCC Rcd at 6885 (App. C). v Additionally, we sought comment on combining elements of the Historical Revenue Method and the Historical Price Method, or retaining the interim price cap plan on a longterm basis." H !0*&&aa2 "Ԍ Y4ԙ18. In the next section of this Order, we find that the record provides compelling evidence in favor of adopting the TFP methodology. In Section III.C., we address the issues raised by TFP calculations. In Section III.D., we consider XFactor calculation issues other than those raised by use of TFP, such as the input price differential. Finally, in Section III.E., we find that an XFactor prescription of 6.5 percent, including a CPD of 0.5 percent, is a reasonable one. 0  X_4 B. XFactor Approaches  X14 1. Methods for Estimating the XFactor  Y 419. In the Price Cap Fourth Further Notice, we tentatively concluded that we should  Y 4base our XFactor on a TFPbased measure of productivity and an input price differential.@"X N xPe 'ԍ See Price Cap Fourth Further Notice, 10 FCC Rcd at 13664 (para. 25). See also LEC Price Cap  xP-'Performance Review, 10 FCC Rcd at 9031 (para. 155).  Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (paras. 5455). @ 0 In line with a majority of the commenters, including Ad Hoc, AT&T, and USTA, who support TFP in some form, we base our XFactor prescription on productivity growth and  Y 4input price differential, derived on the basis of the TFP methodology.#  N xP@'ԍ As explained further below, Ad Hoc, AT&T and USTA support using TFP to calculate the XFactor, but Ad Hoc and AT&T disagree with USTA over the amount of the input price differential. USTA argues that the  xP'input price differential is zero, while Ad Hoc and AT&T contend that it is at least 2 percent. See Section  xP'III.D.1., infra.  For the reasons discussed below, we conclude that TFP measures productivity growth more accurately than  Yy4the method we adopted in the LEC Price Cap Order and the LEC Price Cap Performance  Yb4Review, and more accurately than any other method proposed in the record before us. In the  YK4LEC Price Cap Performance Review, we noted that we were forced to reject TFPbased productivity studies because they were not specific to the telephone industry, or because they  Y4were based on nonpublic information.:$XN xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9031 (para. 157), citing Policy and Rules  xPf'Concerning Rates for Dominant Carriers, CC Docket No. 87313, 3 FCC Rcd 3195, 340607 (1988) (AT&T  xP.'Price Cap Further Notice).: Pacific notes that the California Public Service Commission has based its intrastate price cap plan on a TFP model. Pacific cites a recent California Public Utilities Commission (California PUC) opinion finding that TFP lies  Y4between 1.8 percent and 2.6 percent.%  N xPy"'ԍ Pacific Reply at 23, 1416, citing Investigation on the Commission's Own Motion Into the Second Triennial Review of the Operations and Safeguards of the IncentiveBased Regulatory Framework for Local  xP $'Exchange Carriers, I.9505047, Decision 9512052 (Dec. 20, 1995) (California PUC Opinion). Pacific  xP$'attaches a copy of the California PUC Opinion to its reply. We now have before us TFP studies that are specific to the telephone industry and rely on publicly available data. Finally, we note that the" %0*&&aaS" Bureau of Labor Statistics (BLS) uses TFP to measure productivity growth in the national  Y4economy.&N xPb'ԍ BLS Handbook of Methods, Bulletin 2285, Productivity Measures: Business Economy and Major  xP*'Subsectors, Chapter 10. ĵ  Y420. Several parties oppose the use of TFP because they maintain that the XFactor  Y4resulting from this method is lower than the XFactors in the interim plan.' N xPu'ԍ LDDS Comments at 34; Ad Hoc Reply at 2 and Att. at 39; MCI Reply at 56; NCTA Reply at 6; API Reply at 12; TRA Reply at 45. We interpret these arguments as opposing USTA's method of calculating TFP, not as objections to the principle of basing the XFactor on TFP generally. Similarly, ICA opposes TFP because it  Y_4anticipates that any TFPbased approach will inevitably raise data availability problems.=(_xN xP 'ԍ ICA Comments at 67.= We find that the record demonstrates that publicly available data can now provide an adequate basis for TFP analysis. We address TFP calculation issues below.  Y 421. We have considered but do not rely on alternatives to our TFP approach. In the  Y 4Price Cap Fourth Further Notice, we sought comment on alternative methods of calculating  Y 4TFP, including an econometric estimation method.R)X N xP'ԍ Under this method, we would develop a "production function," or an equation explaining the mathematical relationship between inputs and outputs, and price cap LECs would then derive TFP from this  xP'equation. Price Cap Fourth Further Notice, 10 FCC Rcd at 13671 (para. 75).R The only parties commenting in the record on the econometric estimation method opposed it. USTA and NYNEX assert that an econometric estimation of productivity growth sophisticated enough to be economically  Y4meaningful would not meet the goal we established in the Price Cap Fourth Further Notice of  Yy4being relatively simple.*y( N xPR'ԍ USTA Comments at 68; NYNEX Comments at 27. See Price Cap Fourth Further Notice, 10 FCC Rcd at 13662 (para. 16). No party to this proceeding has placed an econometric TFP model in the record. Therefore, we have no basis at this time on which to adopt an econometric estimation of productivity growth to measure TFP.  Y422. We also decline to adopt the Historical Revenue Method discussed in the Price  Y4Cap Fourth Further Notice and supported by GSA and TRA.v+ N xP7"'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1367172 (paras. 7783).v The Historical Revenue Method would set the XFactor prospectively at the level that would have, in retrospect," +0*&&aa" produced an industrywide average rate of return of 11.25 percent under price cap  Y4regulation.,N xPy'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9019 (para. 127), Price Cap Fourth Further Notice, 10 FCC Rcd at 13672 (para. 81). Adopting the Historical Revenue Method on a movingaverage basis, as GSA recommends, would create substantially similar incentives to those under rateofreturn regulation, because the XFactor would be explicitly linked to earnings. The Historical Revenue Approach also would recreate many of the administrative burdens of rateofreturn regulation, including a substantial reliance on accurate demand and cost forecasts. In  Yv4addition, in the Price Cap Fourth Further Notice, we expressed concerns that the Historical Revenue Approach might not provide sufficient incentives for productivity growth, to the  YH4extent that increases in industrywide earnings would increase the XFactor.o-H7N xP0 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13672 (para. 81).o No one has adequately responded to this concern. GSA recommends using a moving average to update  Y 4an XFactor developed pursuant to the Historical Revenue Method.8. N xP'ԍ GSA Reply at 8.8 For the reasons set out below, however, we decline to adopt a moving average. TRA supports the Historical  Y 4Revenue Method because it believes that it would help reduce rates to economic cost levels,=/ WN xP'ԍ TRA Comments at 67.= but presents no reasons why a "historical" revenue method better achieves that end than a  Y 4TFP methodology. In addition, in our companion Access Reform First Report and Order, we reject proposals to adopt prescriptive measures at this time to drive access rates to  Y4economic costbased levels.d0N xP('ԍ Access Reform First Report and Order, Section IV.B.2.d  Yb423. We also decline to continue using the Historical Price Method developed in the  YK4LEC Price Cap Order. None of the commenters supports this approach.n1KwN xPs'ԍ See API Comments at 23; Bell Atlantic Comments at 78. n Furthermore, the Historical Price Method bases the XFactor on historical trends in prices of telecommunications prices relative to the economy as a whole, and thus uses price changes as a surrogate for productivity growth. We find that TFP is a more accurate measure of LEC productivity because it is based on incumbent LECs' actual outputs and inputs.  Y424. We also reject MCI's alternative to our TFP approach. MCI asserts that LECs electing the 5.3 percent X-Factor, which entails no obligation to share, must have believed that their unit costs (productivity growth plus decrease in input prices) would decrease by at least 8.54 percent. MCI claims that, otherwise, these incumbent LECs would have earned greater profits by selecting a lower XFactor, notwithstanding the accompanying sharing"e  10*&&aaI"  Y4obligations. Therefore, MCI recommends a fixed X-Factor of at least 8.54 percent.;2N xPy'ԍ MCI Reply at 911.; In response, USTA criticizes MCI's calculations, in part because MCI implicitly assumes that all price cap LECs earned an 11.25 percent rate of return at the time of their 1995 annual access filings. According to USTA, correcting this error results in an XFactor of 2.85  Y4percent.K3XN xP'ԍ USTA 1997 Comments, Att. 7 at 78.K In reply, MCI filed an ex parte statement agreeing with USTA's methodological point, but arguing that USTA erred in basing its analysis on a 13.78 percent return, the  Yv4incumbent LECs' rate of return in 1994.4vN xP 'ԍ Ex Parte Letter from Chris Frentrup, Senior Regulatory Analyst, MCI to William F. Caton, Secretary, FCC, April 18, 1997. According to MCI, the price cap LECs' 1994 rates of return are not the correct starting point because the LECs' expected earnings were  YH4depressed by two exogenous cost decreases required in the LEC Price Cap Performance  Y14Review in 1995.5 1@N xP"'ԍ MCI refers to our decisions to reinitialize PCIs to the levels at which they would have been had we  xP'adopted a 4.0 percent minimum XFactor in the LEC Price Cap Order, and to remove OPEB costs from the  xP'PCIs. See LEC Price Cap Performance Review, 10 FCC Rcd at 906970 (paras. 24550); 909597 (paras. 30709). MCI contends that, after adjusting the LECs' rates of return to remove the effects of these two exogenous cost decreases, its alternative XFactor approach produces an XFactor of 7.9 percent.  Y 425. We conclude that MCI's method is inherently illsuited for prescribing an XFactor, regardless of whether MCI's calculation can be perfected. Fundamentally, MCI's alternative does not estimate expected productivity growth, but instead derives an XFactor based on LEC XFactor choices that depend critically on the LECs' earnings for a single tariff year. It would not be reasonable to base a longterm XFactor prescription, as MCI suggests, on shortterm LEC expectations. Furthermore, the results of MCI's alternative methodology rely heavily on LEC interstate earnings. For example, LECs choosing the 4.0 percent X-Factor under the interim plan are required to share half of their earnings in excess of 12.25 percent, and all of their interstate earnings in excess of 13.25 percent. As a LEC's sharing obligations increase, its gains from increases in productivity decrease. Thus, if an incumbent LEC expects its interstate earnings to exceed 12.25 percent, and also anticipates that it will increase its productivity, it is more likely to choose the no-sharing 5.3 percent XFactor than a LEC that expects the same increases in productivity, but forecasts that its interstate rate of return will be 11.25 percent. As we have said consistently in our  Y4discussions of price cap regulation over the years,6( N xPl$'ԍ See LEC Price Cap Order, 5 FCC Rcd at 6791 (para. 34); LEC Price Cap Performance Review, 10 FCC Rcd at 897374 (paras. 2729). we achieve beneficial incentives by" 60*&&aaA" placing less rather than more importance on LEC interstate earnings. For these reasons, we reject that alternative as a means for prescribing an XFactor.  Y4 26. US West suggests setting the XFactor equal to the GDPPI, and thereby freezing  Y4the PCIs at their current levels as a means of simplifying the price cap plan.T7N xP'ԍ US West Comments at 35; US West Reply 45.T We reject US West's proposal, because it would not provide access customers with any benefits from productivity growth, and so would not strike a reasonable balance between stockholders and  Y_4ratepayers.p8_XN xPh 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13673 (para. 93). p  X14 2. Direct Approach  Y 427. In the Price Cap Fourth Further Notice, we invited comment on replacing the  Y 4PCI formula completely with a formula based on what we called the "direct approach."9 N xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9216 (App. F, equation 7); Price Cap Fourth  xPM'Further Notice, 10 FCC Rcd at 1366869 (para. 61).  Y 4Under the direct approach, the PCI would change by the percentage change in LEC input prices minus the percentage change in LEC TFP. The direct approach eliminates the GDPPI (or any other measure of economywide inflation), nationwide TFP indices, and nationwide input price indices needed to calculate the XFactor in our current PCI formula.  Yb428. We decide not to modify our PCI formula so that the XFactor can be calculated under the "direct approach," as suggested by Sprint and GTE, among other parties. First, for reasons discussed in Section V. below, we adopt in this Order a fixed XFactor until the next scheduled performance review. Adopting a direct approach without also adopting a moving averagebased method of updating the XFactor on an annual basis would result in a PCI formula that reduces PCIs by a certain percentage every year. By definition, a direct approach without a moving average would require prices to decrease by the same nominal percentage regardless of whether the national economy is experiencing high or low inflation. Under a direct approach, with the PCI formula updated only in periodic performance reviews, there is no possible mechanism to incorporate an unexpected increase or decrease in inflation that occurs between performance reviews. Retaining a PCI formula that reflects changes in overall prices is more consistent with our decision to prescribe a fixed XFactor rather than updating the XFactor on a moving average basis. Second, we agree with AT&T that the direct approach does not simplify the PCI formula nearly as much as Sprint claims, because the approach eliminates only noncontroversial terms from the PCI formula, or terms that can be based on publicly available data. !C:\DOCUMENT\4THORD\IIIABC! "@90*&&aa#"Ԍ X4 C:\DOCUMENT\4THORD\IIID _C. TFP Calculation Issues  X4 1. Background  Y429. In the LEC Price Cap Performance Review, we noted that changes in a firm's  Y4costs of producing a unit of output are the product of both changes in the quantity of  Yv4_resources used, i.e., changes in productivity, and changes in the prices paid for those  Y_4resources, i.e., changes in input prices.:_N xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (paras. 16061) and 921340 (App. F). See  xP 'also Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (para. 54). We tentatively concluded that the XFactor should  YH4include both a measure of productivity growth and a measure of input price changes.;H N xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (para. 160); Price Cap Fourth Further Notice,  xP '10 FCC Rcd at 13668 (para. 54).  In this Section, we consider methods to estimate changes in productivity. In Section D. below, we consider methods to estimate changes in LEC input prices.  Y 430. In general, TFP models measure productivity as the ratio of an index of the outputs of a firm (or industry, or nation) to an index of its inputs over a given period of  Y 4time. <X xN xP'ԍ We also provide overviews of the TFP method in the LEC Price Cap Performance Review, 10 FCC Rcd  xP'at 900810 (paras. 10607), and the Price Cap Fourth Further Notice, 10 FCC Rcd at 1366364 (paras. 2324), and Att. A.  The growth in productivity is simply the amount by which this ratio changes over time. In these calculations, every effort is made to isolate the real change in productivity from the effects of simple price changes. This is why, in a subsequent section, we consider separately the matter of changes in input prices.  YK431. A LEC's outputs are the services it provides, and the output index represents the quantities of services provided. For purposes of constructing the output index, quantities of services can be measured directly, based on such measures as minutes of use or number of access lines, or indirectly, by dividing revenues by an index of output prices. Output indices can be developed to represent changes in the quantity of each individual LEC service over time, or services can be aggregated into one or more categories. The categories are weighted, either on the basis of costs or revenues, to make the output index.  Y432. LEC inputs consist of three major factors of production: labor, materials, and capital services (services provided by plant and equipment). As explained further below,"|<0*&&aa"  Y4TFP analysis assumes capital services are a fixed proportion of the capital stock.= N xPy'ԍ Capital stock in the base year of a TFP study period is the book value of plant. For the second year, the capital stock is derived by reducing the first period's capital stock for depreciation, and increasing it by the  xP 'second period's plant additions that have been deflated by the change in capital stock prices. See Section III.C.4.a.(2). TFP theory and practice estimates the growth in capital services using the assumption that the level of capital services is some fixed proportion of the capital stock available at the beginning of the year. Capital services can be measured as changes in the level of capital stock. Although these factors can be disaggregated further, all the parties presenting TFP models limited themselves to these three input factors. The growth rate of total input index is determined by the growth rates of the capital, labor, and materials input indices, and by their relative by the relative weight given each input index. As discussed below, measuring the growth rate of capital input is a particularly complicated procedure, requiring, among other things, a determination of capital stock and the flow of capital services from capital stock.  Y 4 33. We have reviewed the TFP models submitted by Ad Hoc, AT&T, and USTA in  Y 4response to the Price Cap Fourth Further Notice, the comments received in response to the  Y 4Access Reform Notice, the numerous ex parte filings in both dockets providing additional or updated data or critiques, and the various estimates of TFP and input price differentials. On the basis of our review, we have determined the most reasonable method of performing each step of a TFP calculation. We discuss our conclusions on each of these TFP calculation issues below. We find that no study in the record embodies all the best TFP calculation practices. We then calculate TFP using the most reasonable parts of each TFP study as it was presented by the record. As explained in detail below, we rely primarily, but not  Y4exclusively, on the results of that analysis for our XFactor prescription.U>N xP~'ԍ See Section III.E., infra.U  Y4!34. In Section 2., we summarize the results of USTA's, AT&T's, and Ad Hoc's models. In Section 3., we address output index issues. We address issues regarding the capital, labor, and materials input indices in Section 4. Subsequently, in Section D, we analyze other XFactor calculation issues, such as how to calculate the input price differential, whether to adjust for claimed differences in interstate and intrastate productivity growth, whether to include a CPD, and whether to make adjustments at this time for the  Ye4access charge reforms we adopt in the Access Reform First Report and Order. In Section E. below, we prescribe an XFactor of 6.5 percent, based on our analysis of these issues. "7@>0*&&aa"Ԍ X4  2. TFP Models Placed in Current Record  Y4"35. USTA has submitted its simplified TFP model. That model is a revision of its  Y4original TFP model,?@N xP4'ԍ While the LEC Price Cap Performance Review was pending, USTA made two price cap proposals. The  xP'first, submitted in USTA's 1994 comments, based the XFactor on TFP. LEC Price Cap Performance Review,  xP'10 FCC Rcd at 9008 (paras. 10411). In a January 18, 1995, ex parte statement, USTA submitted its second proposal, basing the XFactor on a moving average of industrywide TFP data, but did not make any significant  xPT'revisions to its TFP calculations. In the Price Cap Fourth Further Notice, we often referred to USTA's original  xP 'TFP study to illustrate the TFP issues on which we were seeking comment. Price Cap Fourth Further Notice, 10 FCC Rcd at 13663 (para. 22). For the purposes of this Order, we will refer to USTA's 1994 TFP calculations as the "Original TFP Model." which was addressed in our LEC Price Cap Performance Review.@N xP< 'ԍ Because USTA has made revisions to the original TFP model, we will not discuss that model in detail here, nor will we discuss in detail whether the data in USTA's original model met the general criteria discussed  xP 'in the Price Cap Fourth Further Notice. See Ad Hoc Comments, Att. at 514, 6061; AT&T Comments at 911, and App. A at 36; USTA Comments at 3233 and App. A; MCI Comments at 911; TRA Comments at 2 xP\'3; LDDS Reply at 5.  USTA supports updating the XFactor annually on the basis of a fiveyear moving average. For the nine LECs included in its original TFP study, USTA claims its simplified TFP model results in average difference between LEC and U.S. national productivity growth of 2.9  Y_4percent from 1988 to 1993, 3.1 percent from 1989 to 1994,HA_ N xP'ԍ USTA Comments, App. A at 3032.H and 2.7 percent from 1990 YH495.KBHN xP 'ԍ USTA 1997 Comments, Att. 5 at 14.K USTA asserts that the input price differential is zero, and makes no adjustment for a  Y14consumer productivity dividend.C 1N xP'ԍ USTA Comments at 26 and App. C at 36; USTA Reply, Att. A at 2325. See also US West Comments at 7, 16; Southwestern Bell Comments at 11; NYNEX Comments at 21; BellSouth Comments at 1416; Bell Atlantic Comments at 1112; Lincoln Comments at 4; Ameritech Comments at 45; GTE Comments at 11 and  xP'App. B, App. F; NYNEX Reply at 5; Pacific Reply at 4, citing California PUC Opinion at 6869.   Y 4#36. AT&T maintains that its TFPbased model corrects errors in USTA's original  Y 4TFP model.UD N xP% 'ԍ AT&T Comments at 2426; AT&T Reply at 3537.U In response to the Price Cap Fourth Further Notice, AT&T recommends a baseline XFactor of 7.8 percent, based on estimates of interstateonly TFP and an input  Y 4price differential, and including a Consumer Productivity Dividend (CPD).E  N xP#'ԍ AT&T Reply at 38 n.78. For purposes of comparison, AT&T would recommend setting the XFactor at 5.42 percent, based on total company TFP and an input price differential, and excluding a CPD. AT&T Reply at 3840. AT&T updated its results to include data BLS released between the time AT&T filed its reply and its  xP%'comments. Compare AT&T Reply at 3840 with AT&T Comments at 29. We discuss" E0*&&aa "  Y4AT&T's interstate TFP adjustment in Section D.2. below. Later, in its 1997 pleadings, AT&T updated its study with 1995 data, and found an interstateonly TFPbased XFactor of  Y49.0 percent from 1985 to 1995, including a CPD.FN xPK'ԍ AT&T 1997 Reply, App. G at 3132. AT&T's calculations would yield a total company TFPbased X xP'Factor, including the input price differential but excluding a CPD, of 6.20 percent. Id.  Y4$37. Ad Hoc also adjusts USTA's original TFP model to correct for alleged methodological errors. Specifically, Ad Hoc recommends adjusting TFP to estimate interstateonly productivity, and including an input price differential in the XFactor. Ad Hoc proposes an XFactor of 9.4 percent, which is composed of an estimated TFP growth of  YH46.0 percent for interstate services, and an input price differential of 3.4 percent.GH N xP 'ԍ Ad Hoc Comments, Att. at 5356. Ad Hoc's recommended adjustments are discussed in more detail below. Ad Hoc states that adopting all its recommendations except its interstate/intrastate adjustment results  Y 4in an XFactor of 6.6 percent.H xN xPC'ԍ Specifically, Ad Hoc proposed an XFactor of 7.1 percent, including a CPD of 0.5 percent. Ad Hoc Comments, Att. at 56. For purposes of comparison, Ad Hoc in its reply based its calculations on data submitted in USTA's comments. Ad Hoc claims that the XFactor would be 7.9 percent, excluding a consumer productivity dividend, from 1989 to 1993; 5.9 percent from 1990 to 1994; and 7.3 percent from 1989 to 1994. Ad Hoc Reply, Att. at 36.   Y 4%38. Ad Hoc submitted its models in the proprietary format of a commercial software program to which we do not have access. The format makes it quite difficult for us to validate its results or to compare them with those of other models in a manner similar to that shown in Section III.E. below. To the extent that Ad Hoc reveals its intermediate results, its input price index appears to suffer some of the same infirmities as USTA's original model, and to exhibit erratic fluctuations. Furthermore, as discussed further below, we find that the revisions Ad Hoc does make to USTA's original TFP model do not improve the model. Specifically, Ad Hoc makes an interstateonly TFP adjustment, recommends making a hedonic adjustment, and does not weight the capital input index on a residual earnings basis. Therefore, we do not give any weight to Ad Hoc's X-Factor estimates. We discuss AT&T's and USTA's models below in greater detail, and we resolve TFP calculation issues on the basis of that analysis. "( H0*&&aaO"Ԍ X4 3. Output Index Issues  X4` ` a. Mathematical Construction of Output Indices  Y4&39. Background. In the Price Cap Fourth Further Notice, we invited parties to  Y4recommend appropriate methods for calculating output price indices for TFP studies.pIN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13994 (para. 26). p As noted earlier, output quantities can be measured directly based on such measures as minutes of use or number of access lines, or indirectly, by deriving quantities by dividing output  YH4revenues by a price index. In the Price Cap Fourth Further Notice, we identified various potentially relevant mathematical techniques for constructing indices: the Laspeyres Price  Y 4Index, the Chained Laspeyres Index, the Paasche Price Index, and the Fisher Ideal Index.hJX XN xP# 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13994 n.52. In Appendix D to this Order, we describe  xP 'the Fisher Ideal Index in more detail. We discussed the Laspeyres and Paasche index forms in the AT&T Price  xP'Cap Further Notice, 3 FCC Rcd at 343536 (paras. 44445).h  Y 4'40. Discussion. USTA and AT&T both use physical output measurements for  Y 4certain access service categories.&KX xN xP'ԍ In its 1996 pleadings, USTA identifies its "end user access" and "interstate switched access" categories. USTA Reply, Att. at 10. In its 1997 pleadings, USTA identifies its "local service" and "LEC toll" categories. USTA 1997 Comments, Att. 6 at 910.& While AT&T's TFP study measures all output directlyHL N xP'ԍ AT&T Comments, Att. A at 7273.H  Y 4using the Fisher Ideal Index method,FM ( N xP'ԍ AT&T Comments, App. B at 56.F USTA advocates indirect measures for certain outputs. For example, USTA uses deflated revenue to measure special access output, arguing that  Y4using special access line counts is too simplistic.DN N xP'ԍ USTA Reply, Att. A at 912.D When it measures output indirectly, USTA divides total revenues by output price indices that are based on an approximation of a chainlinked Paasche method, and then creates output quantity indices using the Tornquist  YK4index method.@OKH N xPD 'ԍ USTA Comments at 1415.@ USTA also contends that using physical measures of output in its local service and toll service categories is inaccurate because it treats each local call identically, and does not capture differences such as the time of day of toll calls, or the effects of vertical services. USTA claims this causes AT&T's study to overstate TFP growth by 0.9  Y4percent.LPN xPx%'ԍ USTA 1997 Comments, Att. 6 at 910.L"hP0*&&aa"Ԍ Y4ԙ(41. We find that, although both methods can be reasonable for calculating TFP growth in most contexts, use of physical output measures is better suited to calculating TFP for purposes of prescribing an XFactor. Use of physical output measures simplifies the analysis, and USTA has not shown that that method yields results less accurate than use of deflated revenues. Specifically, USTA has not explained why a toll call made during the day should count more than a night or weekend call for purposes of determining output in a TFP study. Furthermore, we disagree with USTA's contention that using physical measures overstates TFP growth because they do not adequately reflect vertical services. We expect that the quantities of vertical services will increase faster than the inputs used to provide those services in the future, because the price cap LECs have only relatively recently deployed the SS7 facilities necessary to provide vertical services widely in their networks. Thus, increased output of vertical services reasonably could occur as a result of such recent investment rather than directly requiring further inputs through new investment. To the extent that new investment does occur, we believe it likely would result in further or additional increases in output beyond the output increases generated by the prior investment. At the same time, since the LECs have begun marketing vertical services only relatively recently, demand for these services is likely to grow. Thus, physical measures of services should produce conservative measures of productivity and productivity growth.  YK4)42. In its 1997 comments, USTA claims that AT&T overstates output growth because it measures common line output by minutes of use rather than number of access  Y4lines.SQN xP'ԍ USTA 1997 Comments, Att. 6 at 1011.S USTA also criticizes AT&T's model because it derives common line minutes of use for the period from 1984 to 1985 on the basis of an extrapolation of data for the period from  Y41986 to 1992.MRXN xP'ԍ USTA 1997 Comments, Att. 6 at 2526.M AT&T replies that its extrapolation is necessary in order to create a consistent series from divestiture to the present, because common line data were not recorded  Y4separately from switched access before 1988.JSN xPZ'ԍ AT&T 1997 Reply, App. G at 2930.J We find that where both line and minute data are available, converting all common line output to a perminute basis is not desirable. Therefore, in our staff analysis, we measure end user common line growth on a perline basis, and carrier common line growth on a perminute basis. For the period before 1988, switched access minutes provide a reasonable surrogate for carrier common line minutes. Thus, in our staff analysis in Appendix D, we measure output quantities directly on the basis  Y74of switched access lines,T7xN xP`#'ԍ For the purposes of our TFP calculation, we define "access lines" as business lines, residential lines, and public access lines. special access lines, and switched access minutes of use. " T0*&&aa"Ԍ Y4*43. As a technical matter, our review of the relevant economic literature indicates that the Fisher Ideal Index is superior to the approximated Paasche chain index and Tornquist  Y4Index used by USTA for the construction of deflated revenue quantity indices.UN xPK'ԍ Diewert, Fisher Ideal Output, Input and Productivity Indexes Revisited, 3 J. Productivity Analysis 211  xP'(1992).  For example, Diewert states that the Fisher Ideal Index is the only index that satisfies twenty  Y4welldefined mathematical tests.CV N xPu'ԍ Diewert, id. C We therefore use the Fisher Ideal Index form in our analysis.  X_4` ` b. Number of Output Categories  Y14+44. Background. In the Price Cap Fourth Further Notice, we noted that USTA developed output indices for seven categories in its original TFP study. We sought comment generally on whether USTA's output categorization was reasonable, or whether any of  Y 4USTA's categories should be combined or subdivided.pW N xPM'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13994 (para. 27). p  Y 4,45. Discussion. Both USTA and AT&T base their output categories on ARMIS 4302 reporting groups. USTA uses seven categories, while AT&T uses three. We include three output categories in our analysis of the record: local, intrastate toll plus intrastate access, and interstate access. We find that this categorization is sufficiently disaggregated to provide an accurate measure of output growth, and is easy to implement because we have collected data in ARMIS on this basis.  Y4-46. USTA, in effect, holds that both we and AT&T should have retained miscellaneous services as a fourth category. The three output categories that both we and AT&T use include the services in six of USTA's seven output categories, but exclude those in USTA's miscellaneous services category. USTA claims that, by excluding these miscellaneous services, AT&T's model overestimates TFP growth by 0.4 percent from 198894, and 0.5 percent from 198994, because miscellaneous services output has grown more  Y4slowly than other LEC outputs.IX@N xP 'ԍ USTA 1997 Comments, Att. 6 at 8.I This apparently slower growth, however, is a direct result of USTA's use of GDPPI when it calculates output quantities by deflating revenues by a price index. USTA used the GDPPI because it did not have a specific measure of miscellaneous service prices. Because GDPPI rose substantially over the period while the prices of LEC services other than miscellaneous services fell sharply, it is obvious that miscellaneous output estimated in this manner would grow more slowly. It is not at all obvious, however, that GDPPI is an appropriate price index for miscellaneous services. " X0*&&aa " Furthermore, examining the major components of this category reveals that it is a collection  Y4of highly diverse activities. Many of these, such as White and Yellow Pages operations,KYN xPb'ԍ See 47 C.F.R.  32.5230. K are at best ancillary to telecommunications services. We also note that the composition of this category varies widely from year to year. Because of these characteristics, we do not believe it is feasible to construct a valid quantity measure for this category. Accordingly, we exclude USTA's miscellaneous services category from our analysis. Moreover, because most of the services in this category appear to be produced using a separate production function from that used to produce telecommunications services, it is not unreasonable to exclude miscellaneous services. For these reasons, we exclude the miscellaneous services output category completely from our output index.  X 4` ` c. Weighting of Output Categories  Y 4.47. Background. Regardless of whether output quantity growth rates are based on physical measures or deflated revenues, TFP studies with more than one output category  Y 4must adopt some weighting scheme to combine the categories into a single index. In the  Y4Price Cap Fourth Further Notice, we sought comment on the proper weights for aggregating output quantity categories. We observed that USTA's original TFP study used revenue weights for the output index, and we found that this weighting implicitly assumes that the revenue of a service is a reasonable measure of its value. We questioned whether it is reasonable to make this assumption in an industry where incumbent LECs face different levels of competition for their services, and rates diverge to varying degrees from the costs of producing those services. Therefore, we sought comment on alternative weighting  Y4schemes for output categories.pZXN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13994 (para. 28). p  Y4/48. Discussion. We conclude that, despite the doubts we expressed in the Price Cap  Y4Fourth Further Notice,p[N xPC'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13994 (para. 28). p revenue weights are the best weighting method available. In its  Y4comments in response to the Price Cap Fourth Further Notice, AT&T recommends weighting the output indices on a marginal cost basis, arguing that revenue weights will not approximate more economically meaningful marginal cost weights until competition has  YN4developed further.f\NxN xPw"'ԍ AT&T Comments at 2324 and App. A at 6063; AT&T Reply at 34.f Neither AT&T nor any other party in this proceeding, however, has provided estimates of marginal cost weights. Instead, AT&T uses booked costs as a surrogate for marginal cost weights. BellSouth asserts that using fully distributed costs, such as booked costs, as a surrogate for marginal costs would be unreasonable except in cases" \0*&&aa " where there are no economies of scale, and therefore booked cost weights are inappropriate  Y4for calculating LEC TFP.H]N xPb'ԍ BellSouth Reply. Att. at 2930.H In its TFP model, the Interstate Commerce Commission (ICC) concluded that use of revenue weights was unlikely to bias its output index seriously over  Y4time.'^XXN xP'ԍ Railroad Cost Recovery Procedures Productivity Adjustment, Ex Parte No. 290 (SubNo. 4), 5 ICC 2d  xP'434, 462 (1989) (ICC TFP Order), aff'd sub nom. Edison Electric Institute v. FCC, 969 F.2d 1221 (D.C. Cir. 1989). ' Finally, we note that AT&T has switched its recommendation from costbased  Y4weights to revenue weights._xN xP 'ԍ See Ex Parte Letter from Brian W. Masterson, Government Affairs Director, AT&T, to William F. Caton, Secretary, FCC, April 16, 1997. Accordingly, we agree with the parties that revenue weights are the most reasonable basis of aggregating output indices. .C:\DOCUMENT\4THORD\IIID  X_4 C:\DOCUMENT\4THORD\IIID4 1 4. Input Index Issues  X14` ` a. Capital  X 4` `  (1) Background  Y 4049. The capital input index measures the amount of capital services used by the LEC to produce output. "Capital services" represent the contribution capital makes to the 1production of output. Capital input quantities generally assume that the capital services in a time period are proportional to the stock of capital available in that period. Capital input  Yy4quantities are constructed for a number of asset categories of plant and equipment.`yN xP'ԍ For example, USTA based its capital input index on six asset types in its original TFP study. Fourth  xP'Further Notice, 10 FCC Rcd at 13664 (para. 29). The development of the aggregate capital input index requires three determinations: (1) the capital stock for each asset category, (2) the capital input quantities from these capital stocks, and (3) the relative weight that each asset category should have in the final aggregate capital input index.  Y4150. Typically, the "perpetual inventory method" is used to develop a constant dollar capital stock. The nominal dollar level of capital stock in the first period, called the benchmark capital stock, is generally derived by adjusting gross booked investment, either by subtracting the associated accumulated depreciation and amortization reserves, or multiplying by a ratio of market to book value of investment derived from another source. The capital stock for the next period is derived by reducing the first period's capital stock for depreciation, and increasing it by the second period's plant additions that have been"e( `0*&&aa""  Y4deflated by an asset price index.aXN xPy'ԍ The perpetual inventory method is also discussed briefly in the Price Cap Fourth Further Notice, 10 FCC  xPA'Rcd at 13666 (para. 41). A more detailed description can be found in Christensen and Jorgenson, The Measure  xP 'of U.S. Real Capital Input, 19291967, 15 Rev. of Income and Wealth 294 (December 1969).  We discuss this process in detail in subsections (2) and (3) below.  Y4251. Once we have calculated constant dollar capital stocks, we need to measure the  Y4capital services that these stocks generated. In the Price Cap Fourth Further Notice, we sought comment on two measures. One measure assumes capital services are a constant proportion of capital stock, and that the growth of capital services is measured by the growth  Y_4in capital stock. A second measure focuses on "capital consumption," i.e., changes in the  YH4level of efficiency in the capital stock over time.obHN xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 47).o We discuss this issue further in subsection (5).  Y 4 ` `    Y 4352. The aggregate capital input quantity is a weighted average of the input quantity  Y 4of all the capital input categories.c xN xP'ԍ In subsection (4) below, we address the issue of how many asset classes should be used in a TFP study. The weights are based on the price, or "rental value" of the capital services provided by each asset category, or in other words, an estimate of what the rental value of those assets would be in an competitive market, if one existed. We stated  Y 4in the Price Cap Fourth Further Notice that this "implicit rental price" includes the rate of  Y4return, the depreciation rate, and tax rates.xdN xPI'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1366465 (para. 31).x Below in subsection (2), we decide to have only one capital input index. Nonetheless, issues relating to weighting asset categories are still relevant because the method used to develop weights for aggregating asset categories into a single index are also used to aggregate capital, labor, and materials into the final, single input index. We discuss the weighting of the capital input index relative to the labor and materials indices in subsection (6).  X4` `  (2) Capital Stock  Y4453. Background. The capital input index for a TFP study requires the calculation of  Y4capital stock the real (or constant dollar) value of LEC net investment. In the Price Cap  Y4Fourth Further Notice, we invited comment on several issues related to the calculation of capital stock. We asked generally whether the perpetual inventory model in USTA's original model was the best method to derive capital stock quantity indices, and if not, what other  YN4method would be preferable.ueNN xP%'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13666 (para. 46).u In particular, we asked whether the benchmark capital stock,"N( e0*&&aa&"  Y4i.e., the capital stock level in the first period for the study, should be based on the original  Y4cost or current replacement cost of assets.ufN xPb'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13666 (para. 41).u We also noted that USTA used proprietary telephone plant indices (TPIs) to deflate plant additions to constant dollars, and asked several  Y4questions regarding the sources and reliability of USTA's TPIs.ugXN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13666 (para. 45).u  Y4554. In the Price Cap Fourth Further Notice, we also noted that USTA's original model aggregated capital into six asset categories, and then developed a depreciation rate for each category to use in calculating the implicit rental price of capital stocks. We asked whether USTA's six classes were the most appropriate classification scheme, noting that the  Y14Commission prescribes depreciation rates for 30 asset categories.ph1N xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 (para. 39). p  Y 4655. Discussion. Both USTA and AT&T agree that the perpetual inventory model is a theoretically correct and practical method of constructing capital stocks. Therefore, we have decided to use the Perpetual Inventory Model for calculating capital stocks in our analysis.  Y4756. Both USTA and AT&T use BEA asset price indices to deflate their capital stock additions to constant dollars. USTA, AT&T, and Ad Hoc agree that BEA asset price indices avoid the proprietary issues raised by TPIs based on incumbent LEC data. BEA asset price indices measure the movement of asset prices in the U.S. economy. Although BEA asset price indices do not measure precisely the prices of LEC assets, BEA's indices are sufficiently disaggregated that they can be used to develop a surrogate for LEC capital asset prices. Therefore, we have decided to use BEA asset indices.  Y4857. AT&T uses USTA's original six asset categories, but USTA's simplified TFP model reduced the number of asset categories to three. Although USTA and AT&T use different numbers of asset categories, they have not criticized each other's choices, and no one else has criticized either model on the basis of number of asset categories. In our staff analysis, we have used one asset category, and one depreciation rate, because further disaggregation does not appear to provide a more accurate measure of TFP growth, and one asset category simplifies the calculation. "7xh0*&&aa"Ԍ X4` `  (3) Adjustments to Capital Stock  Y4958. Background. In the Price Cap Fourth Further Notice, we treated as separate issues measurement of the accumulated depreciation used in the perpetual inventory model used to calculate the benchmark capital stock, and the depreciation rates in the implicit rental price. Upon review of the record, we find that these issues are interrelated, and consider them together here. For example, USTA emphasizes the need for the starting value of capital in the perpetual inventory equation to be consistent with the depreciation assumptions  YH4used elsewhere in the study.EiHN xP 'ԍ USTA Comments, App. A at 15.E  Y 4:59. In the Price Cap Fourth Further Notice, we observed that the implicit rental price calculation in USTA's original study relied on depreciation rates it characterizes as  Y 4"economic" depreciation rates, developed by an economist named Dale Jorgenson.j XN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 (para. 37), citing Jorgenson , Productivity and  xP'Economic Growth, in Fifty Years of Economic Measurement (E.R. Berndt and J.E. Triplett, eds., 1990), at 19 xP'118. In the Price Cap Fourth Further Notice, we sought comment on depreciation rates in the context of the "implicit rental price." Implicit rental prices are used to weight the indices for different asset categories into one aggregate capital input index. (We discuss the implicit rental price in detail below.)  We questioned whether it was reasonable for carriers to use depreciation rates in TFP  Y 4calculations that differ from the Commission's prescribed depreciation rates.kk N xPw'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 (para. 38), citing Section 220(b) of the Communications Act, 47 U.S.C.  220(b). The 1996 Act subsequently revised Section 220 of the Communications Act so that the Commission is now permitted rather than required to prescribe depreciation rates. We asked whether we should require TFP depreciation rates to fall within the bands established in the  xP'Depreciation Simplification Order, if we were to permit TFP depreciation rates to differ from the prescribed  xP_'depreciation rates. Price Cap Fourth Further Notice, 10 FCC Rcd at 1366566 (para. 40), citing Simplification  xP''of the Depreciation Prescription Process , Report and Order, CC Docket No. 92296, 8 FCC Rcd 8025 (1993)  xP'(Depreciation Simplification Order) (petitions for reconsideration pending). Because we decide below to rely on our prescribed depreciation rates in our analysis of the record, we need not address this issue further. k In our discussion of benchmark capital stock adjustments, we noted that the perpetual inventory model in USTA's original study multiplied the replacement cost of capital by "economic  Yy4stock adjustment factors," and sought comment on economic stock adjustment factors.ulyN xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13666 (para. 43).u  YK4;60. Discussion. Ad Hoc and AT&T contend that we should use the depreciation  Y44rates prescribed by the Commission, and these parties use those rates in their studies.m4hN xPM$'ԍ Ad Hoc Comments, Att. at 20; AT&T Comments at 22; Ad Hoc Reply at 5. See also MCI Comments at 1819. They criticize Jorgenson's "economic" depreciation analysis on which USTA relied in its"m0*&&aa" original TFP study, as well as in its simplified study. Ad Hoc and AT&T state that  Y4Jorgenson's analysis was based on a 1981 article by Hulten and Wykoff,nN xPb'ԍ Charles R. Hulten and Frank C. Wykoff, The Measurement of Economic Depreciation, in Depreciation,  xP*'Inflation, and the Taxation of Income from Capital (Charles R. Hulten, ed., 1981) at 95. which in turn was based on data ending in 1971, and examined depreciation of business assets for the economy  Y4as a whole rather than of telecommunications assets specifically.GoX N xP'ԍ Ad Hoc Comments, Att. at 2021; Ad Hoc Reply, Att. at 33; AT&T Comments at 22, App. A at 4749,  xPT'App. B at 9; AT&T Reply at 3234. But see AT&T Reply, App. B at 4849 ("hyperbolic decay model" used by BLS inferior to "geometric decay model" used by Jorgenson).G USTA explains that it adopted only the depreciation method developed in the 1981 article, and substituted the most  Y4recent BEA data on telecommunications equipment lifetimes to develop depreciation rates.p@N xP~ 'ԍ USTA Reply, Att. A at 1920. See also Bell Atlantic Reply, Att. 1 at 1112; Pacific Reply at 1314.  Y_4<61. Some commenters argue that the depreciation rates should be those prescribed by  YH4the Commission.qHN xP'ԍ MCI Comments at 1819; Ad Hoc Comments, Att. at 20; AT&T Comments at 22; Ad Hoc Reply at 5. Ad Hoc maintains that the prescribed rates are designed to reflect the  Y14actual rate of plant retirement.Hr1` N xPB'ԍ Ad Hoc Comments, Att. at 2223.H MCI asserts that the prescribed rates in fact adequately  Y 4reflect the economic life of plant and equipment.Ps N xP'ԍ MCI Comments at 1819; MCI Reply at 7. P MCI includes a study of depreciation  Y 4rates to support its conclusions.?t N xP4'ԍ MCI Comments, App. A. ? In particular, MCI asserts that the study shows that  Y 4depreciation reserve deficiencies are not excessively high at this time.u N xP'ԍ See, e.g., MCI Comments, App. A at 14. See also NCTA Reply at 78. A number of LECs  Y 4criticize MCI's study.v N xP&'ԍ Southwestern Bell Reply at 1516 and App. A at 12; US West Reply at 2328; NYNEX Reply at 11. USTA Reply, Att. C at 1819, Att. D at 68, 1213.  Y 4=62. We conclude that USTA has not shown that the depreciation rates it developed for its TFP calculations are in fact "economic" depreciation rates, or are reasonable for use in a LEC TFP study. First, although USTA states that it has updated the depreciation rates from the 1981 HultenWykoff article with more recent BEA data, USTA has not shown that the depreciation rates it has developed are applicable to LEC equipment. Ad Hoc notes that the depreciation rates in the USTA study are lower than either the prescribed depreciation rates or the rates advocated by LECs in depreciation represcription proceedings, and argues"v0*&&aa"  Y4that underestimating depreciation artificially reduces TFP and the XFactor.EwN xPy'ԍ Ad Hoc Comments, Att. at 23.E USTA has not  Y4explained why it used depreciation rates lower than our prescribed rates,x XN xP'ԍ In the Price Cap Fourth Further Notice, we stated that our prescribed depreciation rates for the BOCs, GTE, and SNET from 1984 to 1992 was about 7.1 percent, while the depreciation rates in USTA's original  xP'TFP model averaged 5.7 percent for those BOCs over that period. Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 n.59. when in other  Y4comments its members advocate higher depreciation rates.\y@N xP 'ԍ See, e.g., USTA 1997 Comments, Att. 13.\  Y4>63. In our analysis, we have decided to use our prescribed depreciation rates. We find that it would not be reasonable, based on this record, to prescribe a set of depreciation rates for TFP calculations that differs from the depreciation rates currently in place for determining operating expenses. First, there is no sound basis in the record in this proceeding for determining whether and to what extent our depreciation rates differ from economic depreciation rates. Second, developing an additional distinct set of depreciation rates would clearly increase administrative burdens, and the record before us does not reveal  Y 4any countervailing benefits that would justify this additional burden.zx N xP'ԍ USTA asserts that "the ageefficiency trends of assets" are independent of any regulatory depreciation rates, and therefore recommends using the depreciation rates in its simplified TFP model regardless of how the Commission may revise its depreciation rates in the future. USTA 1997 Comments, Att. 5 at 1213. We can think of no reason why incumbent LECs should be permitted to use different depreciation rates for different regulatory purposes. Furthermore, we reject USTA's categorical claim that the Commission's depreciation rates do not and never will reflect the LECs' depreciation costs. We therefore disagree that USTA's depreciation rates are preferable to any depreciation rates we may develop in the future. Third, under our recently established streamlined procedures for determining LEC depreciation rates, incumbent LECs have considerable influence and some discretion in setting their specific  Y 4depreciation rates.2{X N xP'ԍ Under this procedure, proposed depreciation rates are considered reasonable if the rates fall within  xPG'specific bands established for each asset category by the Commission. See Depreciation Simplification Order, 8 FCC Rcd 8025. 2 Commenters in this proceeding have not persuaded us that the depreciation rates we have currently prescribed do not reflect the LECs' depreciation costs.  Yy4?64. To incorporate the effects of accumulated depreciation on its benchmark capital stock level, USTA states that, in its simplified TFP model, it multiplies gross book values by "economic stock adjustment factors" derived by dividing BEA market value measures by  Y44BEA original cost measures for certain asset classes.N|40N xP%'ԍ USTA Comments at 21 and App. A at 16.N For the same reasons we find above that the Commission's prescribed depreciation rates are better suited than USTA's"|0*&&aa" depreciation rates for our TFP analysis, we are not using USTA's economic adjustment factors to adjust the benchmark capital stock level for the effects of depreciation. Instead, we have decided to base the benchmark capital stock calculations in our analysis on net book costs: gross book costs minus the accumulated depreciation reserves associated with our prescribed depreciation rates.  Yv4@65. We note that we are making only limited findings in this Order regarding depreciation: (1) TFP calculations for purposes of determining an XFactor at this time should use the same depreciation rates as those the incumbent LECs are required to use to determine their operating expenses, and (2) USTA has failed to show that the depreciation rates used in its simplified TFP model measure depreciation better than the Commission's depreciation rates. We reach no decision in this Order on the possible use of "economic"  Y 4depreciation methods in general. In the Access Reform Notice, we sought comment on whether some portion of the incumbent price cap LECs' "residual" or "legacy" costs might  Y 4be the result of underdepreciation.U} N xP7'ԍ Access Reform Notice at paras. 25055.U We plan to address this issue in conjunction with the  Y 4other residual cost issues we raised in the Access Reform Notice. Nor are we suggesting that we plan to continue exercising our Section 220(b) prescription authority indefinitely. The 1996 Act amended Section 220(b) of the Communications Act, so that we are no longer required to prescribe depreciation rates. The telecommunications industry is evolving, and this evolution may well require us to revise our prescription methods, or possibly discontinue depreciation rate prescriptions altogether. If we do revise the price cap LECs' depreciation rates substantially, or if we permit them to develop their own depreciation rates, we will determine the effect of the revised depreciation rates on TFP and the XFactor in our next performance review.  X4` `  (4) Hedonic Adjustments  Y4A66. Background. Both AT&T, initially, and Ad Hoc apply "hedonic" adjustments to  Y|4their capital asset price indices, i.e., adjustments to reflect that new equipment differs from the old in technology as well as in price. AT&T and Ad Hoc argue that capital input prices must be adjusted for technological improvements to avoid understating the change in the effective level of real capital stocks. AT&T states that, to the extent that succeeding generations of capital equipment are more productive, a hedonic adjustment increases the computed level of capital stock, increases the flow of capital services, and, holding output constant, decreases measured TFP. AT&T also states, however, that a hedonic adjustment would decrease the price of capital input, thus increasing the input price differential. AT&T"X}0*&&aa!" therefore argues that its computed XFactor is not greatly affected by its hedonic  Y4adjustment.H~N xPy'ԍ AT&T Comments, Att. A at 3435.H By contrast, Ad Hoc asserts that a hedonic adjustment would increase the XFactor, rather than merely result in offsetting changes in TFP and the input price differential. Ad Hoc makes no recommendation at this time, however, as to how to adjust for technological improvements, but asserts that, if this adjustment caused a 10 percent annual decrease in the price indices for the capital input asset categories that include computers, the  Yv4XFactor would increase by about 0.4 percent.<XvoN xP'ԍ Ad Hoc Comments, Att. at 5758. In its reply, Ad Hoc claimed that a 10 percent hedonic adjustment would increase the XFactor by 1.0 when based on data from 1990 to 1994, or 1.1 percent when based on 1989 to 1993, or from 1989 to 1994. Ad Hoc Reply at 4 and Att. at 3637. <  YH4B67. Discussion. We find nothing in the record to suggest that our TFP calculation would be more accurate with a hedonic adjustment. AT&T observes that its hedonic TFP adjustment results in an offsetting adjustment to its input price differential, leaving its X Y 4Factor recommendation unchanged.H N xPC'ԍ AT&T Comments, Att. A at 3435.H In addition, neither AT&T nor Ad Hoc have shown that their hedonic adjustments accurately measure the effects of technological improvements. The hedonic adjustment to the price per unit of capital proposed by AT&T in its TFP model is incompletely documented, and the details on all the components of the hedonic adjustment are not clear and replicable. Ad Hoc's 10 percent per year adjustment to certain asset price indices is not supported, but stated as an assumption. Based on the record before us, there is no need to include a hedonic adjustment.  XK4` `  (5) Deriving the Level of Capital Services from Capital Stock  Y4C68. Background. We invited comment on whether capital services should be  Y4measured by "capital consumption," i.e., the loss of efficiency in the capital over time, or by the level of capital stock. We noted that basing capital services on the level of capital stock assumes that the level of capital services is proportional to the level of the capital stock, and that the factor of proportionality does not vary over time. Alternatively, we sought comment on whether capital services could or should be based on some combination of the amount of  Y4capital consumption and the change in the level of capital stock.qN xPc 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 47). q  Ye4D69. Discussion. Our review of the economic literature on TFP and the pleadings of AT&T and USTA support the view that capital services (the quantity of capital services input) should be measured as proportional to the level of capital stock, and that capital consumption (such as depreciation expense) should be included in the measure of the cost" 0*&&aa"  Y4(price) of the capital stock.pN xPy'ԍ See, e.g., Berndt and Fuss, 33 J.Econometrics at 11. p Further, the parties argue that capital services do not decline over the useful life of a unit of the capital stock. A piece of capital equipment with a tenyear life does not provide 10 units of capital services in its first year and only 3 units in its  Y4eighth year.OXN xP'ԍ See USTA Comments, Att. A at 21.O All the TFP studies submitted in the record of this proceeding measure the change in capital services as the change in the level of capital stock.  Xv4` `  (6) Implicit Rental Price  YH4E70. Background. The weight given to the capital services input when it is aggregated with labor and materials inputs is based on the capital cost, which is the product of the implicit rental prices of the total capital stocks for the asset categories. The implicit rental price represents the hypothetical price of renting the LECs' capital stock in a competitive  Y 4market, if such a market existed.y N xP'ԍ See Price Cap Fourth Further Notice, 10 FCC Rcd at 13677 (para. 48).y In the Price Cap Fourth Further Notice, we observed that the implicit rental price in USTA's original TFP model is based on the rate of return,  Y 4the depreciation rate, certain tax rates, and its TPIs.o xN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 48).o In addition to asking specific questions regarding the rate of return, depreciation, and taxes, we sought comment on whether USTA's method of calculating the implicit rental price is reasonable. We also asked whether data would be available on a timely basis to make these calculations in the future,  Yb4and about alternatives to USTA's method.obN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 49).o  Y44F71. We also asked questions regarding the rate of return component of USTA's implicit rental price. We observed that USTA's original TFP model used Moody's Yield on Public Utility Bonds as the rate of return, and questioned whether it would not be more  Y4reasonable to include the cost of equity as well as the cost of debt in the rate of return.oN xP8'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 (para. 34).o We also noted that we have determined the LECs' rate of return in our past rateofreturn represcription orders, and questioned whether it would be reasonable to allow LECs to use any other rate of return. We also sought comment on how often, and by what method, the rate of return should be updated for purposes of TFP calculations. Finally, we invited" ( 0*&&aa[" comment on whether a represcription of the rate of return applicable to carriers subject to  Y4rateofreturn regulation should also be incorporated into TFP calculations.zN xPb'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13665 (paras. 3536). z  Y4G72. Discussion. USTA estimates the rate of return in its implicit rental price calculation by deriving a nationally averaged return on capital from the National Income and Product Accounts. AT&T claims that USTA's implicit rental price introduces unreasonable distortions because it does not reflect price cap LECs' actual payments to capital. AT&T bases its weight for the capital input, or the "cost of capital" in terms of TFP calculations, on  YH4LEC revenues less the costs of labor and materials.XHXN xPQ 'ԍ Specifically, AT&T's proposed implicit rental price is calculated as property income divided by a measure of capital stock, where property income is total revenues plus depreciation less materials and labor payments.  We find that AT&T's residual earnings method is a more accurate estimate of the contribution of capital to the production of output than USTA's method of measuring rate of return, because AT&T's method  Y 4measures the actual flow of funds to capital. In other words, the residual earnings method reflects actual payments to capital. We have decided to use AT&T's approach in our analysis of the record, with the minor modifications discussed below.  Y 4H73. AT&T cites several economic articles supporting the use of residual earnings as  Y4the cost of capital in TFP calculations.cxN xP'ԍ AT&T 1997 Reply, App. G at 2729, citing e.g., Jorgenson and Griliches, The Explanation of  xP'Productivity Change, 34 Rev. Econ. Studies 24980 (July 1967); Christensen and Jorgenson, The Measurement  xPI'of Real Capital Input, 15 Rev. of Income and Wealth 293320 (Dec. 1969); Berndt and Fuss, Productivity  xP'Measurement with Adjustments for Capacity Utilization and Order Forms of Temporary Equilibrium, 33  xP'J.Econometrics 729 (Oct./Nov. 1986) (Berndt and Fuss).c For example, to correct for the potential distortion in the measurement of TFP growth, Berndt and Fuss propose two measures of implicit rental prices as alternatives to the equation proposed by USTA, one of which is similar to the  YK4implicit rental price proposed by AT&T.@K( N xP$'ԍ Berndt and Fuss. @ Dhrymes calculates an implicit rental price in a  Y44similar manner.4 N xP'ԍ Dhrymes, The Structure of Production Technology: Evidence from LED Sample I, in U.S. Dept. of  xPe 'Commerce, Bureau of the Census, Proceedings of the 1990 Annual Research Conference, at 206.  Additionally, AT&T states that Christensen, USTA's consultant, has used a similar construction in a TFP study Christensen presented to the Public Service  Y4Commission of North Dakota on behalf of US West.<N xP#'ԍ AT&T Reply, App.A. < "!0*&&aa"Ԍ Y4I74. USTA and a number of LECs assert that AT&T's weighting of the capital input index replicates the incentives of rateofreturn regulation because it results in limiting  Y4carriers to a particular rate of return.N xPK'ԍ USTA Reply at 2021; Att. A at 17, Att. C at 46; NYNEX Reply at 1516; BellSouth Reply, Att. at 2329; GTE Reply at 910; Bell Atlantic Reply at 3; Southwestern Bell Reply at 10. We disagree. Under rateofreturn regulation, increases in a LEC's earnings lead directly to reductions in that LEC's rates. Under AT&T's capital weighting method, an increase in a LEC's earnings will increase the weight placed on its capital input index relative to its labor and materials indices. This would increase TFP and the XFactor only to the extent that capital is growing less quickly than labor and materials. Also, the XFactor is based on an industry average, and an increase in a particular LEC's TFP has only a limited effect on the industry average.  Y 4J75. In our TFP calculation, we follow AT&T's proposal with modifications. The estimated implicit rental price is measured in terms of gross returns to capital divided by the capital stock. The weight used for aggregating capital services into the overall input quantity index is the share of gross payments to capital in total payments to all factors.  Y 4K76. As a result of our decision to rely on AT&T's rather than USTA's implicit rental  Y4price, we need not determine whether a rate of return based on National Income and Product Accounts, Moody's bond indices, or the Commission's prescribed rate of return would be the most reasonable measure of the rate of return to incorporate into an implicit rental price calculation. We also do not need to address AT&T's contentions regarding USTA's treatment of depreciation or taxes in its calculation of the implicit rental price. Depreciation rates are relevant to AT&T's treatment of capital stock, however, and accordingly, we considered depreciation issues above.   X4` ` b. Labor ` `  Y4L77. Background. Labor is the second of the three factors of the TFP input index. In  Y4the Price Cap Fourth Further Notice, we noted that USTA's original TFP study used two categories of labor: management and nonmanagement. We asked whether labor should be further disaggregated to account for different levels of education and vocational experience in  YN4the work force.oN N xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 52).o We also asked about adjustments for carrier "outsourcing," i.e., replacing  Y74the services of workers employed by carriers with services provided by outside firms.v7N xP"'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 52). v  Y 4M78. Discussion. In USTA's simplified TFP model, there is one category of labor, and the quantity of labor is measured as the number of employees. AT&T's TFP""@0*&&aa " calculations are based on two categories, fulltime and parttime employees. AT&T measures the quantity of labor as number of employees, with parttime employees counted as a fraction of a fulltime employee. No one has suggested a more disaggregated labor input index. In our analysis of the record, we base the rate of growth of labor on total number of employees, to be consistent with our current collections of ARMIS data.  Yv4N79. We agree with USTA that, when outsourcing occurs, the decrease in labor input growth is offset by an increase in expenses for services, and is reflected in the materials  YH4index.?HN xP 'ԍ USTA Comments at 24. ? Because materials expenses are inputs to the TFP calculation, no additional  Y14adjustment for outsourcing is needed. q  X 4` ` c. Materials  Y 4O80. Background. The original USTA TFP study derived materials quantities indirectly. USTA calculated materials expenses by subtracting depreciation and amortization expense, and employee wages, salaries, and benefits, from total operating expenses, and then deflated (or divided) this residual expense by the GDPPI to construct a materials input index. AT&T's TFP study calculated materials expense by subtracting total labor compensation and the change in the depreciation reserve from total operating expense.  YK4AT&T deflated this residual expense by a materials price index. In the Price Cap Fourth  Y44Further Notice, we sought comment on whether it would be preferable or possible to construct a LECspecific price index for deflating materials expense instead of relying on GDPPI for that purpose. We stated that our objective was to measure TFP accurately with data that are verifiable and publicly available. In this section, we address only materials price and quantities index issues. We will address materials index weighting issues below.  Y4P81. Discussion. All the parties use the residual expense method of measuring materials. USTA uses the GDPPI as the materials price index to deflate residual expense to derive materials quantities in its simplified TFP model. We find that USTA has not shown that use of GDPPI accurately measures the prices of LEC materials and, therefore, TFP, because it does not reflect price changes in the narrow range of inputs used by LECs. This significantly affects measured TFP, and it disguises a significant portion of the input price differential.  Y4Q82. The record contains a materials price index created by AT&T based on a subset of categories of national input/output expenditures prepared by the U.S. Bureau of Labor Statistics (BLS) that is more narrowly focused on materials purchases of communications industries than the economywide GDPPI. We have replicated the index using the same"!#X0*&&aa#"  Y4BLS data that AT&T used in an ex parte filing received on April 11, 1996.XN xPy'ԍ AT&T Ex Parte Letter of April 11, 1996. X AT&T's materials price index is a Tornquist index calculation, where the logarithmic percentage changes are replaced by arithmetic percentage changes. Because AT&T's materials price index is more narrowly focused on communications services than GDPPI, we use AT&T's materials price index.  Xv4` ` d. Weighting of Materials and Labor Indices  YH4R83. All the models placed in the record base the weight of the materials index in the final input index on materials expense. Since all the models determine materials expense as the residual expense left after labor compensation and depreciation are subtracted from total operating expense, both the labor and the materials shares of total inputs are affected by the specification of labor and depreciation expense.  Y 4S84. USTA notes that AT&T's materials input index weight is calculated residually on the basis of total operating expenses minus total labor compensation and the change in depreciation reserves. USTA claims that AT&T's treatment of both labor expense and materials expense is flawed, and that those calculations distort the weights placed on the materials and labor input indices. USTA further claims that distorting the weights placed on the materials and labor input indices results in distorting the capital input index as well.  Y4T85. First, USTA claims that AT&T erred in subtracting total labor compensation from total operating expense. USTA claims that the proper measure of current period labor expense is wages, salaries and benefits. According to USTA, total labor compensation includes labor costs that are capitalized rather than expensed in the year in which they are incurred. Each year a portion of previously capitalized labor expense enters the current year total operating expense as part of depreciation expense. USTA claims that total labor  Y4compensation results in some double counting of labor expense,MXN xP'ԍ USTA 1997 Comments, Att. 6 at 1718.M and thus improperly shifts weight from the materials expense index to the labor input index.  YN4U86. Second, USTA claims that AT&T improperly calculated materials expense because it used the change in depreciation reserves instead of recorded depreciation and amortization expense. The increase in depreciation reserves may be less than depreciation and amortization expense because plant retirements draw down the reserve. This issue is different from the depreciation rate issue discussed above. Here, the issue is not to determine the proper rate of depreciation, but to determine materials expense by subtracting the depreciation (and labor) expense components of operating expense from total operating expense. USTA claims that changes in depreciation reserves understate depreciation"!$0*&&aa#" expense, and, thus, overstate materials expense and place too great a weight on the material input index.  Y4V87. USTA claims that these errors result in an understatement of 0.2 percent in TFP for the period from 1988 to 1994, and an understatement of 0.3 percent for the period from  Y41989 to 1994.MN xP'ԍ USTA 1997 Comments, Att. 6 at 1920.M USTA also admits, however, that these errors would have offsetting effects on the calculation of the input price differential in AT&T's model, and, consequently, no  Y_4overall effect on an XFactor that includes an input price differential.J_XN xPh 'ԍ USTA 1997 Comments, Att. 6 at 20.J In its 1997 reply, AT&T states that it has switched to using depreciation and amortization expense, rather than  Y14changes in depreciation reserves,1N xP 'ԍ AT&T 1997 Reply, App. G at 3435. Upon review of AT&T's submitted data, however, it does not appear that it has in fact made this revision to its model. for this calculation.  Y 4W88. Both USTA's and AT&T's models double count some labor costs by basing labor quantities on the number of employees. This doublecounting occurs because capitalized labor expense is reflected in capital stock as well as labor. USTA has not solved this problem by basing labor expense on wages, salaries, and benefits rather than total compensation, because capitalized labor remains fully reflected in capital stock. Instead, USTA's approach merely changes the relative weights placed on the labor, materials, and capital input indices. We have decided in our staff analysis to weight the labor input index in our analysis on total compensation rather than wages, salaries, and benefits.  Y44X89. In summary, we base the weight placed on the materials input on Total Operating Expense, less total labor compensation, as AT&T recommends, and depreciation/amortization expense, as USTA recommends.  Y4Y90. In the Price Cap Fourth Further Notice, we were "particularly concerned" about whether to adjust labor costs for other postemployment benefits (OPEBs) given that we had first permitted price cap LECs to make an exogenous cost increase to reflect these costs, and  Y4then later required those LECs to make an exogenous cost decrease.@@N xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13667 (para. 52). OPEBs are postemployment benefits such as severance pay and other benefits for separated workers, and employee post-retirement liabilities other than pensions, such as retirees' life insurance and medical and dental care benefits. Southwestern Bell Corporation, GTE Service Corporation, Notification of Intent to Adopt Statement of Financial Accounting Standards No. 106, Employers' Accounting for Post-retirement Benefits Other Than Pensions, 6 FCC Rcd 7560  xPl$'(Com. Car. Bur. 1991) (SFAS106 Order); RAO Letter 22, 8 FCC Rcd 4111 (Com. Car. Bur., Accounting and  xP4%'Audits Div. 1993); LEC Price Cap Performance Review, 10 FCC Rcd at 908283 (para. 276), aff'd. Bell  xP%'Atlantic v. FCC, 79 F.3d at 1204.  We decide that no"%H 0*&&aa4" special adjustment of the labor input index is needed to reflect our changing regulatory treatment of OPEBs. The only relevant OPEB issue for purposes of TFP is whether amortizing OPEB expenses over longer or shorter periods can have any effect on the labor index, and thus TFP. We find that it does not because LECs record OPEB costs in their books at their present value, regardless of the amortization period we require. As a result, recording OPEB costs now has no greater or lesser effect on the labor input index than recording those costs in the future.  XH4 5. Summary  Y 4Z91. Total factor productivity (TFP) is the relationship between the output of goods and services to inputs of basic factors of production capital, labor, and materials. A TFP study attempts to quantify this ratio of output to inputs and measure the improvement in the ratio over time. The following outlines the staff TFP analysis, which is presented in detail in Appendix D.  Y4[92. We measured the change in the quantity of output using the change in physical measures such as access lines, messages, and minutes. Output quantities are then converted to index numbers and combined using their relative shares of total revenues as weights.  Y44\93. For inputs, the quantity of labor is measured directly, using the reported number of employees. We create the labor quantity index by taking a ratio of number of employees in a year to the number of employees in the base year, 1985. We measure capital services as a constant proportion of the capital stock. Thus, the change in capital services is proportional to the change in the capital stock. We have no direct measure of the quantity of materials consumed in the production of any period's output. Instead, we calculate materials expense by subtracting from total operating expense the operating expenses attributable to labor, and depreciation and amortization expense. To convert materials expense into a quantity, we deflate materials expense by a price index specifically created to measure changes in materials prices. To combine these inputs into a single index of inputs, we need to calculate weights (or factor shares) that represent the relative contributions of the inputs in the production process. We assume the contribution of each input is proportional to the payments to that factor of production. The weight for each factor is its share of total factor payments. For labor, this is total employee compensation. For materials, we use a number we have already calculated total material expense. The payment to capital is equal to gross return to capital, which is the difference between total revenue and the sum of materials and labor expense.  Y"4]94. Estimating the change in total factor productivity allows us to develop an input price index that measures the change in the unit cost of purchasing basic resources. The labor and capital prices are transformed into indices, and the three input price indices are combined using the factor shares calculated above."Q%&0*&&aa'"Ԍ C:\DOCUMENT\4THORD\IIID4  X4 C:\DOCUMENT\4THORD\IIIE _D. Other XFactor Calculation Issues  X4 1. Input Price Differential  Y4^95. Background. In the LEC Price Cap Performance Review, we noted that changes  Yv4in a firm's costs of producing a unit of output are the product of both changes in the quantity  Y_4_of resources used, i.e., changes in productivity, and changes in the prices paid for those  YH4resources, i.e., changes in input prices.HN xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (paras. 16061) and 921340 (App. F). See  xP 'also Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (para. 54). We tentatively concluded that the XFactor should  Y14include both a measure of productivity growth and a measure of input price changes.1 N xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (para. 160); Price Cap Fourth Further  xP 'Notice, 10 FCC Rcd at 13668 (para. 54).  Specifically, we found that, as a theoretical matter, because LEC unit costs are also affected by the prices they pay for inputs, an input price differential should be included in the X Y 4Factor.o xN xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9222 (App. F). o In general, any TFP study generates an estimate of the change in input prices over the study period, in the price indices used to calculate the input indices. "Input price differential" refers, in the present context, to the difference between the rate at which input prices change in the economy in general and the rate at which LEC input prices change. Thus, when USTA claims that the longterm input price differential is zero, it is saying that the prices LECs pay for the resources they use in producing telecommunications services change at about the general rate of inflation. An input price differential of 2 percent, on the other hand, would mean that the prices LECs pay for the resources they use rise more slowly than the general rate of inflation. A higher input price differential produces a higher XFactor.  Y4_96. Based on data USTA supplied in its comments filed in this proceeding prior to  Y4the LEC Price Cap Performance Review, and in ex parte statements filed in January and  Y4February 1995, we tentatively concluded in the Price Cap Fourth Further Notice that the  Y4input price differential was about 2.7 percent for the period from 1984 to 1990. N xPc 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9222 (App. F). In Appendix F, we referred to the study provided as Attachment 5 to USTA's 1994 comments as the "NERA Study," and the study provided in its  xP!'February 1, 1995 ex parte statement as the "Christensen Study," in reference to the consultants hired by USTA to conduct those studies. In this Order, we will continue to refer to these studies as the NERA Study and the Christensen Study.  We found that USTA's conclusion that the longterm input price differential is zero was theoretically"' 0*&&aa% "  Y4unsound, and unsupported by USTA's data.mN xPy'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9224 (App. F).m In the Price Cap Fourth Further Notice, we also sought comment on whether the input price differential should be based on a longterm trend as USTA suggested, or on a shorter period, such as the period used for the TFP analysis, as Ad Hoc suggested. We invited comment on the data that should be used to  Y4calculate the input price differential.zXN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13668 (paras. 5760). z  Yv4`97. Discussion. USTA and other parties agree that changes in LEC input prices should be reflected in the XFactor if productivity is measured using a TFP method, because TFP adjusts input and output prices to "real" or constant dollar terms to measure "real" productivity. USTA advocates a longrun analysis of input prices, and asserts that, in the long run, there is no statistically significant difference between LEC input price changes and economywide input price changes. Other parties contend the relevant period is roughly from 1984 to the present. AT&T estimates that the input price differential was 2.54 percent per year from 1985 to 1994, using BLS data rather than the data in the Christensen Study  Y 4sponsored by USTA.T N xPW'ԍ AT&T Comments at 1213 and App. A at 1722.T AT&T also estimates that the input price differential between 1985  Y 4and 1995 was 2.35 percent.I xN xP'ԍ AT&T 1997 Reply, App. G at 34. I Ad Hoc claims that the input price differential from 1984 to 1993 is 2.1 percent based on USTA's data, or 3.4 percent based on USTA's data corrected  Yy4for certain errors alleged by Ad Hoc.ByN xP2'ԍ Ad Hoc Reply, Att. at 12.B Sprint compares its price indices for capital, labor, and materials to its economywide input price index, and finds that the fiveyear moving  YK4averages for the period from 1985 to 1993 range from 0.84 percent to 1.64 percent.GKN xP'ԍ Sprint Reply, Att. A at 4143.G  Y4a98. On the basis of the record before us in this proceeding, we conclude, for the reasons discussed below, that shortterm data should be used to select an input price differential for use in prescribing a TFPbased XFactor. All the TFP models in the record include price indices for capital, labor, and materials, and the weights needed to calculate an average input price index. All parties used TFP models that determined an X-Factor by estimating productivity and input prices simultaneously, because both the inputs and outputs must be measured in real, or inflationadjusted, terms. Therefore, any estimate of TFP includes an estimate of an input price differential. If we adopted a methodology that used one set of assumptions and data to measure LEC input prices for use in calculating TFP, and a different set for measuring the input price differential, the calculations would be"N(( 0*&&aa@" inconsistent. We see no reason to calculate TFP using one set of data and assumptions, and then calculate the input price differential using a different set of data and assumptions. Therefore, we do not estimate the input price differential separately from TFP, and we will not make independent prescriptions of the productivity and input price components of the XFactor. Instead, we will focus directly on selecting the appropriate combined X-Factor. Accordingly, in the table in Section III.E. below, we display XFactor estimates which are combined TFP and input price differentials, rather than separate forecasts of TFP and input price differentials.  Y14b99. The LECs make four arguments in favor of setting the input price differential equal to zero: (1) the input price differential should be based on longterm studies; (2) shortterm studies do not show a positive input price differential, but rather a temporary effect of divestiture; (3) it is not reasonable to estimate input price changes on the basis of the price indices in TFP calculations; and (4) including an input price differential might make the XFactor volatile in a moving averagebased price cap plan. For the reasons discussed below, we find none of these arguments persuasive.  Yy4c100. We give no weight to USTA's estimate of the longterm trend. Both the Christensen Study and the NERA Study submitted by USTA, and discussed in Appendix F of  YK4the LEC Price Cap Performance Review, base their conclusions on four different TFP studies, each covering different periods of time. Each of these studies was conducted using disparate and inconsistent techniques. For example, different methods of measuring materials input prices, and different depreciation rates, were used to develop capital input prices for different portions of the study period. In addition, the data in the Christensen Study could support a conclusion that the input price differential is either zero or 2.6  Y4percent.pN xP:'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 922425 (App. F).p Although the LECs focus their attention on the fact that zero is within the range  Y4of possible input price differentials supported by USTA's studies,4XN xP'ԍ USTA Comments at 26 and App. C at 36; US West Comments at 7, 16; Southwestern Bell Comments at 11; NYNEX Comments at 21; BellSouth Comments at 1416; Bell Atlantic Comments at 1112; Lincoln Comments at 4; Ameritech Comments at 45; GTE Comments at 11 and App. B, App. F; NYNEX Reply at 5; USTA Reply, Att. A at 2325; Pacific Reply at 4. According to USTA, AT&T places too much emphasis on its estimate and not enough emphasis on the fact that 0 is within the 95 percent confidence interval. USTA Reply, Att. B at 1719.4 none adequately addresses the fact that the data support a wide range of other possible outcomes. Because neither the Christensen Study nor the NERA Study is based on a consistent set of data or methodology throughout the period covered by either study, we find that their conclusions about the longterm trend of LEC input prices are not supported. "7)0*&&aa"Ԍ Y4d101. We agree with the parties who argue that consistency requires us to use data  Y4from the same period to determine both TFP growth and input price differential.N xPb'ԍ Ad Hoc Comments, Att. at 4345; Ad Hoc Reply at 3 and Att. at 1113. See also TRA Reply at 34 (use of longterm data for input price differential hides the effects of divestiture.) Furthermore, our objective here is to prescribe an XFactor that will set a reasonably aggressive productivity goal for LECs for the near future until completion of the next performance review. Given all the changes that have occurred in telecommunications during the 44 years covered by the longterm input price studies that have been placed on the record  Yv4here,#Xv N xPG 'ԍ USTA cites in particular a study in filed prior to our adoption of the LEC Price Cap Performance  xP 'Review, analyzing input price changes from 1948 to 1992. USTA Comments at 2627. See also USTA Reply, Att. A at 2628. # we find that data from a recent, shorter period of time provide a more reliable basis for estimating input price trends for the near future than the longer term data.  Y14e102. Some incumbent LECs contend that any input price differential revealed by an analysis of the data from 1985 to 1994 is a temporary effect of divestiture. According to these commenters, the input price differential appears in 1984, returns to zero in 1989 or 1990, and is likely to continue to be zero in the future. USTA, on the other hand, claims that the input price differential is not related to divestiture at all, and that the input price  Y 4differential started to increase in 1980 and began declining in 1990.E @N xP'ԍ USTA Reply, App. B at 1415.E USTA also contends that the difference in input price differential in the Christensen Study before and after 1984 is  Y4a result of the different methodologies used to generate the pre and post1984 data series.FN xP'ԍ USTA Comments, Att. A at 46. F We conclude that the input price differential is not a temporary effect of divestiture. LEC input prices have grown at a different rate from input prices in the economy as a whole for all the years analyzed in our study. Furthermore, no party making this argument provides any theoretical argument to explain why the input price differential was exclusively a result of divestiture, and therefore could not ever recur. Therefore, we are not persuaded by this record that the observed LEC input price differential was merely a temporary effect of divestiture, or is unlikely to continue.  Y4f103. AT&T argues that LEC input prices for capital and materials in USTA's simplified TFP model are closely related to GDPPI, and thus artificially reduce the input  Y4price differential.E` N xP#'ԍ AT&T Reply, App. B at 2528.E USTA adopts GDPPI as its materials input price index for LECs, and bases its capital input price indices for LECs on National Income and Product Account data. Thus, USTA's TFP study simply assumes away much of the difference between LEC input"e* 0*&&aa<" price growth and U.S. input price changes by basing most of its input price information on data directly related to GDPPI and U.S. input price growth. Using GDPPI to measure  Y4input prices is unreasonable because GDPPI measures output prices, i.e., the prices of final goods and services, rather than input prices, the prices of intermediate goods and services. Therefore, we base our analysis of the input price differential on the input price indices we use in our analysis of the record.   Y_4g104. A number of LECs assert that the design of USTA's original TFP model precludes any derivation of a meaningful estimate of LEC input price changes. These parties  Y14argue further that the Commission erred in Appendix F of the LEC Price Cap Performance  Y 4Review in concluding that the price indices in USTA's TFP study can be used to produce  Y 4reliable results regarding the input price differential for our purposes. N xP| 'ԍ Lincoln Comments at 4; Southwestern Bell Comments at 11; Southwestern Bell Reply at 1113; USTA Reply at 12 n.4. Ad Hoc argues that the Commission's input price differential results are not unreliable simply because USTA did  Y 4not intend its TFP study to be used to derive the input price differential.? N xP'ԍ Ad Hoc Reply at 1314.? We agree with Ad Hoc on this issue. The LECs have not explained why we should assume that the price indices used for their TFP calculations do not reflect their input prices for purposes of calculating the input price differential.  Yb4h105. Several parties assert that the XFactor should represent a prediction of the LECs' achievable future productivity growth, and that including the input price differential in the XFactor would make it too volatile to have any predictive power, and could cause rate  Y4churn.N xP~'ԍ Pacific Comments at 36; Pacific Reply at 4; US West Comments at 16; Lincoln Comments at 4; NYNEX Comments at 22; NYNEX Reply at 6; USTA Reply, Att. A at 2226. As we explain further in Section V. below, we have decided to adopt a fixed XFactor, which will preclude any volatility in the input price differential from being reflected  Y4in the XFactor.  Finally, we reject Southwestern Bell's assertion that the past input price  Y4differential should not be relevant for setting a future XFactor.GN xP'ԍ Southwestern Bell Reply at 15.G Changes in input prices affect incumbent LECs' unit costs, and so should be reflected in the XFactor. We have no more reliable basis for predicting future input price changes than past input price changes.  Y4   Y|4i106. In the LEC Price Cap Performance Review, we defined the input price differential as the difference between the rate of change in LEC input prices and economy"+0*&&aa/"ԫwide input price changes, rather than the difference between LEC input prices and GDP Y4PI.N xPy'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 921516. See also Price Cap Fourth Further  xPA'Notice, 10 FCC Rcd at 13668 (para. 54). We estimate LEC input prices on the basis of the price indices we use to calculate TFP, and we have chosen to use the BLS NonFarm Business Sector Input Price Index as our  Y4measure of economywide input price changes, as AT&T used.E7N xP'ԍ AT&T Comments, App. B at 19.E We have chosen the BLS NonFarm Business Sector Input Price Index for economywide input prices because this is  Y4the broadest index of the prices of nonfarm input goods and services available. It is also produced in conjunction with, and is therefore consistent with, our measure of productivity  Y_4growth for the economy as a whole. We did not choose GDPPI because the input price  YH4differential measures the difference between LEC input prices and input prices in the economy in general, and GDPPI is a measure of price changes for final goods and services. The most recent published data in these series is for 1994. We estimate the 1995 changes using the average of the five most recent years.  Y 4   X 4_ 2.` ` Adjustment to XFactor for InterstateOnly Activity (#`  Y 4  X 4` ` a. Background  Yy4 "Zj107. USTA's original TFP study was based on total company data. AT&T claimed that  xthe LECs' interstate access services have grown faster than LEC output overall, so that interstate  x_productivity growth was greater than total company productivity growth. Thus, according to  xAT&T, reliance on total company data in measuring TFP tends to understate the LECs'  Y4 xinterstate access productivity growth.}N xP'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 901213 (para. 114).} We noted that interstate and intrastate services are  xusually provided over common facilities, and questioned whether it would be possible to develop  Y4separate production functions for interstate and intrastate services.WN xP'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 903233 (para. 159). The "production  xP'function" is the technological relationship between inputs and outputs. Id.  Y4 "k108. In the Price Cap Fourth Further Notice, we invited comment on several issues  x|related to this subject, including whether consideration of total company TFP data might exceed  xour jurisdiction. We also sought comment on whether there was any way to develop  x"economically meaningful" separate production functions for the purposes of calculating  xinterstate TFP, or if not, whether there was any adjustment that could be made to total company  x3TFP to account for any existing differences between interstate and intrastate productivity"N,0*&&aa&"  Y4 xgrowth.sN xPy'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13669 (paras. 6467).s Finally, we asked whether basing the XFactor on total company TFP would require  Y4us to revise our ARMIS or Form 492 reporting requirements.sXN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1366970 (para. 68). s  X4` ` b. Discussion  Y4 "l109. We stated in the LEC Price Cap Performance Review that we would consider  x;making an adjustment to account for differences in interstate and intrastate productivity growth  Y_4 xif including intrastate data created a "systematic downward bias" in the XFactor.-_N xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (para. 159). We discussed a "systematic  xP 'downward bias" in the LEC Price Cap Performance Review because in that context, IXCs argued that measuring TFP on a total company basis understated interstate productivity growth. If an incumbent price cap LEC were to claim that total company TFP overstated interstate productivity growth, we anticipate using the same analysis to determine whether there is any "systematic upward bias." - We also  xDstated that we would prefer to address any such bias "directly," rather than by attempting to  x;construct an interstate factor based on regulatory accounting and other regulatory requirements  Y 4that may not fully reflect economic costs.q N xPc'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9033 (para. 159). q  Y 4 "m110. We find that the record before us does not allow us to quantify the extent, if any,  xto which interstate productivity growth may differ significantly from total company productivity  xgrowth. AT&T argues that interstate productivity growth is greater than intrastate growth  Y 4 xbecause there are greater economies of scale for interstate services.[ ( N xP'ԍ AT&T Reply at 27, App. B at 2934, App. C at 813.[ CCTA assumes that  xDinterstate productivity growth is greater because some state public service commissions have  Yy4 xretained rateofreturn regulation.=y N xP'ԍ CCTA Reply at 1112.= On the other hand, BellSouth asserts that interstate services  x|are more capitalintensive than intrastate services, and that capital inputs have grown faster than  xlabor or materials inputs. On this basis, BellSouth infers that interstate productivity may have  Y44 xgrown more slowly than intrastate productivity.H4H N xP-!'ԍ BellSouth Reply, Att. at 2023.H Neither CCTA nor BellSouth has provided  xany empirical data to substantiate either the effects they describe or their significance. AT&T  x!and Ad Hoc calculate interstate TFP by measuring the growth in interstate outputs, but assume  xthat interstate inputs grow at the same rate as intrastate inputs. USTA argues that it would be  xmore reasonable to assume that interstate inputs grow at the same rate as interstate outputs.  xNone of these parties, however, provides a factual or theoretical explanation as to why its"-0*&&aaz"  xassumptions might be correct. Accordingly, we find no basis in the record for making an  xHadjustment to the XFactor to account for any differences between interstate and total company productivity.  Y4 "n111. Arguing that interstate productivity growth is systematically greater than intrastate  xxproductivity growth, Ad Hoc and API assert that basing the XFactor on total company TFP  xmight give LECs a windfall unless the states also adopt regulations based on total company  Y_4 xHdata.[_N xP'ԍ Ad Hoc Comments, Att. at 4849; API Comments at 5.[ Ad Hoc also asserts that we should require an interstate TFP adjustment because some  xLECs have advocated making some intrastate TFP adjustment before state public service  Y14 xcommissions.E1XN xP: 'ԍ Ad Hoc Reply, Att. at 1011.E Unsupported claims of a potential LEC windfall do not by themselves convince  xQus that there is any factual basis for concluding that there is a systematic difference between  xDinterstate and total company productivity. Ad Hoc's claims that some LECs have supported  xintrastate TFP adjustments in some state jurisdiction does not show that there is a nationwide  xdifference between interstate TFP and total company TFP significant enough to warrant making some adjustment to our LEC industrywide XFactor.  Y4 "o112. Legal Considerations. AT&T and others make various arguments that using total  x}company data to calculate TFP violates Section 2(b) of the Communications Act or the  Yb4 xkrequirements of Smith v. Illinois Bell.IXbN xP'ԍ Ad Hoc Comments at 67; AT&T Comments at 1417; MCI Reply at 8; Ad Hoc Reply at 89; TRA  xP'Reply at 56; LDDS Reply at 45; AT&T Reply at 3031, citing, e.g., Smith v. Illinois Bell Telephone Co.,  xP'282 U.S. 133 (1930) (Smith). I Because we have determined above that the record  xdoes not demonstrate any systematic bias in using total company productivity growth, we need not reach this legal issue at this time.  Y4  X4  iF'v` ` c. TFP Adjustment for Differences in Regulated and Nonregulated  X4Productivity Growth (#  Y4 "p113. Background. We also solicited comment in the Price Cap Fourth Further Notice  xon whether we should measure TFP on any lessthantotalcompany basis other than interstate Y4 xUonly, vsuch as the TFP for regulated services.tN xPL!'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13670 (paras. 6970). t We also asked whether we should exclude the  xxproductivity growth associated with certain specific regulated services or groups of services.  Ye4 xbThe example we used in the Price Cap Fourth Further Notice was video dialtone services. We"e.0*&&aa/"  xnoted that nonregulated services might not share joint and common costs with regulated services  Y4to the same extent as interstate and intrastate services.tN xPb'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13670 (paras. 6970). t  Y4 "q114. Discussion. Ad Hoc claims that the initial investment required to begin providing  xcertain nonregulated services or video services could increase capital inputs, and thus decrease  Y4 xmeasured TFP growth.HXN xP'ԍ Ad Hoc Comments, Att. at 5051.H If we adopted a movingaverage methodology, Ad Hoc's assertion  xmight warrant closer analysis. We are instead prescribing an XFactor based on data from 1986  xto 1995. We find that nonregulated investment during this time period was too small, relative  xto total regulated investment, to have a significant effect on our TFP calculations. We therefore  x@make no adjustment to the XFactor or to TFP to account for the effects of nonregulated activities.  Y 4 "Er115. In its 1997 reply, AT&T asserts that USTA has recognized the legitimacy of  Y 4 xmaking a regulated/nonregulated adjustment by doing so in its TFP analysis.J N xPn'ԍ AT&T 1997 Reply, App. G at 45. J AT&T does not  x;specifically identify the adjustment that it maintains USTA has made to account for differences  xin regulated and nonregulated productivity, but it appears to be in USTA's miscellaneous  xservices output index. As we discuss above, USTA's miscellaneous services output index  xcontains several anomalous results, including negative growth in some years. As a result, we have excluded that output category completely from our output index.  X44` ` d. Reporting  Y4 "Ms116. We sought comment on whether basing the XFactor on total company TFP would  x.require us to expand our ARMIS or Form 492 reporting requirements to collect total company  Y4 xdata.vxN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1366970 (paras. 68). v Below, we decline to adopt a price cap plan in which LECs would be required to  xrecalculate the XFactor annually on the basis of a prescribed method. Instead, we prescribe an  xXFactor that will remain in effect at least until the next performance review. Accordingly, we conclude that we need not expand our reporting requirements at this time. "|/0*&&aa8"Ԍ X4 3. Effect of Universal Service and Other Subsidy Programs on LEC TFP ` `  Y4 "t117. Background. In the Price Cap Fourth Further Notice, we noted that there were a  x;number of universal service or other subsidy programs at both the federal and state levels, and  Y4asked to what extent such programs affect or should affect LECs' productivity calculations.sN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13670 (paras. 7172).s  Yv4 "u118. Discussion. A number of commenters argue that total company TFP captures the  x!effects of any universal service fund or subsidy programs, and thus no special adjustments are  YH4 xneeded.HXN xPQ 'ԍ Southwestern Bell Comments at 1516; GTE Comments at 25; USTA Comments at 3132; US West Comments at 18. BellSouth contends that changes in universal service funding requirements are treated  Y14 xexogenously, and supports continuing this treatment.B1N xP'ԍ BellSouth Comments at 22.B CCTA supports considering universal  Y 4service fund revisions in the Universal Service Order proceeding rather than here.; @N xP 'ԍ CCTA Reply at 21. ;  Y 4 "v119. We have no reason to believe that replacing the implicit subsidies in incumbent  xLECs' current rates with explicit subsidies, as required to meet the 1996 Act's universal service  x@provisions, will affect productivity significantly. The implicit subsidies were designed to  Y 4 xkpromote universal service, and have been generally successful. N xP('ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 8988 (para. 62), citing Telephone Subscribership in the United States, FCC, Common Carrier Bureau, Industry Analysis Division (Nov. 1994). We expect subscribership  x*levels to remain high under our new universal service rules. Thus, there should not be any  xdramatic increases or decreases in incumbent LEC outputs, and so there should be little effect on TFP. Accordingly, we will not take any further action on this issue here.  X44 4. Inclusion of Other Firms in Study  Y4 " w120. Background. In the first phase of this proceeding, Ad Hoc argued that basing the  xXFactor on industrywide moving average data might encourage excessive network investment,  xand thus might lead to "goldplating" incentives similar to those created by rateofreturn  xregulation. Therefore, Ad Hoc recommended including data from other telecommunications  Y4 xservice providers in the TFP calculations.{( N xP#'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 9017 (para. 124). { We invited comment on Ad Hoc's proposal, and"0 0*&&aaW"  x requested parties to discuss whether the data necessary to perform an expanded TFP study would  Y4be available annually in a timely manner.tN xPb'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13671 (paras. 7374). t  Y4 "x121. Discussion. Below, we decline to adopt a methodology for the XFactor on an  x7industrywide moving average. Therefore, we conclude that there is no need at this time to  x!include data from other industries to address the concern raised by Ad Hoc. At this time, we  xalso need not address NYNEX's, GTE's, and US West's arguments against inclusion of such data.  X14 5. Consumer Productivity Dividend  Y 4 "&y122. Background. In the LEC Price Cap Order, we added 0.5 percentage points to the  xXFactor to ensure that the first benefits of the price cap plan are flowed through to access  Y 4 xcustomers. We called this addition the consumer productivity dividend (CPD).4X XN xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6799 (para. 100). We had adopted a similar 0.5 percent consumer  xP'productivity dividend in our earlier Order adopting price cap regulation for AT&T. AT&T Price Cap Order, 4 FCC Rcd at 3001 (para. 248).4 In the Price  Y 4 xCap Fourth Further Notice, we invited parties to discuss whether we should retain the CPD in  xthe longterm price cap plan, in order to, for example, reflect anticipated productivity growth  Y4 x*resulting from the elimination of sharing.oxN xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13673 (para. 95).o We also sought comment on whether the CPD  Yy4should remain at 0.5 percent or be set at some other value.syN xP2'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13673 (paras. 9495).s  YK4 "z123. Discussion. Consistent with our practice in both AT&T and LEC price cap  xregulation, we retain a 0.5 percent Consumer Productivity Dividend in our revised price cap  xplan. We decide below to adopt a single fixed XFactor in our revised price cap plan, based on  xLEC industrywide data. The CPD will act as a mechanism to ensure that price cap LECs flow xthrough a reasonable portion of the benefits of productivity growth to ratepayers. The  ximportance of this purpose in our revised price cap plan is enhanced because we are eliminating  xthe current sharing requirements and we are not adopting a moving average method of updating  Y4the XFactor.N xP!'ԍ A moving average could result in flowing through productivity gains to access customers. LEC Price  xP"'Cap Performance Review, 10 FCC Rcd at 9030 (para. 153).  Y|4 "{124. Parties arguing in favor of eliminating the CPD are not persuasive. Several  xincumbent LECs maintain that it is arbitrary and capricious to transfer any productivity gains"e1 0*&&aa<"  xto access customers. In a competitive market, however, competitors will continuously provide  xxfirms with incentives to lower their unit costs more quickly than they have in the past so that  xthey can lower their prices and win customers from their competitors. By this mechanism, a  xcompetitive market passes cost reductions on to customers in the form of lower prices. By  xVrequiring incumbent LECs to transfer at least part of their productivity gains to access  xcustomers, the CPD tends to replicate the results of a competitive market. Therefore, we find  xthat it is reasonable to use a CPD to require incumbent LECs to transfer some portion of their  xUunit cost reductions to their customers. USTA asserts that the price cap plan properly balances  YH4 xshareholder and ratepayer interests without the CPD,:HN xP 'ԍ USTA Reply at 26.: but does not explain why we should not continue our established practice.  Y 4 "|125. Some contend that the CPD was adopted because of uncertainty regarding the X xFactors in the original price cap plan, and our experience under price cap regulation should have  xalleviated this uncertainty. We disagree that the passage of time by itself has eliminated the need  xofor a CPD. The CPD remains necessary to require LECs to transfer some portion to their unit  xcost reductions to their access customers. Also, the CPD was, in a sense, an expression of  x certainty that LECs would respond to the incentives provided by the price caps plan by becoming  xmore productive, and that there would be productivity gains that could be shared between  x|ratepayers and shareholders. The passage of time has not altered the need to strike this balance between ratepayer and shareholder interests.  Y4 "_}126. BellSouth and GTE argue that there was no principled basis for selecting 0.5  Y4 xQpercent as the CPD. We explained in the LEC Price Cap Order that setting the CPD at 0.5  xopercent would ensure that access customers share a portion of the productivity benefits of price  Y4 xcap regulation.aXN xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6796 (para. 74).a Although GTE broadly asserts that including a 0.5 percent CPD would cause  x&the XFactor to be excessive, we believe that a 0.5 percent CPD, with the elimination of sharing, continues to be necessary to ensure that access customers receive benefits.  Y|4 ""~127. We are mindful that, while some incumbent LECs have achieved high earnings  xUunder price caps, others have not always done so. We therefore retain the lowend adjustment  xmechanism for LECs with substantially belowaverage earnings. The lowend adjustment  xmechanism permits incumbent price cap LECs with rates of return less than 10.25 percent to  Y 4increase their PCIs to a level that would enable them to earn 10.25 percent.f N xP"'ԍ LEC Price Cap Order, 5 FCC Rcd at 6804 (paras. 14749).f " 2x0*&&aa"Ԍ X4 6. Effects of Access Reform  Y4 "128. In the Access Reform Notice, we invited comment on the potential effects of access  Y4 xreform on TFP.QN xP4'ԍ Access Reform Notice at para. 233.Q Some parties argue that replacing the perminute carrier common line charge  x.with a per line charge will depress measured TFP because access lines have historically grown  Y4 xmore slowly than access minutes.XN xP'ԍ US West 1997 Comments at 55; Aliant 1997 Comments at 68; USTA 1997 Reply at 4041 and Att. 3 at 910. USTA argues that if either competition or regulatory action  xreduces the pricemarginal cost margin on rapidly growing services, measured TFP will fall.  xUSTA concedes it has no direct evidence of the expected magnitude of this effect and makes no  YH4 x% specific prediction of the size of the reduction in TFP growth.KHN xP 'ԍ USTA 1997 Comments, Att. 5 at 78.K USTA estimates, however, that  x2 its access reform proposal, holding everything else constant, would reduce measured TFP growth  xfor the period from 1990 to 1995 by 0.4 percent by changing the revenue weights of perline  Y 4 xand perminute common line services. @N xP'ԍ USTA assumes that carrier common line charges are billed on a presubscribed line basis, and that the transport interconnection charge is collected on a bulkbilled basis. USTA 1997 Comments, Att. 5 at 89. USTA claims support for its assertion that measured  xTFP growth will be affected by restructuring the collection of common line costs from two  Y 4 xarticles from the literature of economics.  N xP'ԍ USTA 1997 Comments, Att. 5 at 7 nn. 10, 11; citing Crandall and Galst, Productivity Growth in the  xP'U.S. Telecommunications Sector: The Impact of AT&T Divestiture (The Brookings Institution, February  xP'1991) (Crandall and Galst); Fuss, Telecommunications Growth in Canadian Telecommunications, Canadian J. Econ. (May 1993). On the other hand, AT&T anticipates that access  xreform would increase productivity growth, because reducing rates to costbased levels would  Y 4stimulate demand.B N xP'ԍ AT&T 1997 Reply at 3536.B  Yy4 "129. We find that USTA has not sufficiently considered the effect that moving prices  xtowards marginal cost will have on LEC efficiency. Under our current access rate structure  YK4 xrules, before the revisions adopted in our companion Access Reform First Report and Order,  xincumbent LECs are often unable to offer access services at rates that reflect the manner they  xincur costs and therefore are faced with artificially depressed demand. The implicit cross xsubsidies in our current access rate structure rules have resulted in increased demand for certain  xtservices and decreased demand for others. When demand for services is distorted in this  xZfashion, incumbent LECs must provide those services at levels that do not enable them to  xminimize their perunit costs. When prices reflect marginal costs, however, consumers increase  xtheir purchases of services previously priced above marginal cost, and reduce their purchases"30*&&aad"  xof services previously priced below marginal cost. The net result of such a change in rate  xstructure will allow LECs to minimize the perunit cost of producing their total output. Based  xoon the current record, we find that access reform will have at most a very modest effect on the  xrevenue weights used to aggregate output and that this effect will be offset at least in part by  xchanges on the input side of the TFP equation as LECs adjust inputs to produce a more efficient mix of outputs. Thus, it would be speculative to attempt to adjust our TFP estimates now.  Y_4 "t130. The articles cited by USTA are consistent with this analysis. They provide support  xonly for the proposition that, if everything else is held constant, adjusting the weights of each  x*category of LEC outputs for the margin between price and marginal cost reduces measured  Y 4output, measured TFP, and TFP growth.K N xP 'ԍ Crandall and Galst at 2829.K  Y 4 "131. Some parties contend that measured TFP will decrease under competition because  xxincumbent LEC output will fall as new entrants successfully compete for existing customers.  xUSTA asserts that a one percent reduction in LEC output growth will reduce LEC TFP growth  xby 0.3 to 0.5 percent. We are not persuaded that we should reduce our baseline productivity  Y4 xestimates we are using here to set an XFactor that will apply to all incumbent price cap LECs  Yy4 x^and all their access services. We are not deciding what, if any, changes to the XFactor we  x/should make with the lowering of barriers to competitive entry or the development of  YK4competition.NKXN xPT'ԍ See Section IV.C., infra.N  Y4 "I132. In summary, we find that the parties have not shown it reasonable to reduce the  x|measured TFP growth of incumbent LECs in light of the overall effect of the rate restructuring  Y4adopted in the Access Reform First Report and Order. C:\DOCUMENT\4THORD\IIIE  X4 C:\DOCUMENT\4THORD\IIIF E. Analysis and Prescription  Y4 "133. Above, we have examined several individual issues regarding TFP calculation,  xdetermination of the input price differential, and other XFactor calculation issues. On the basis  xof the record in this proceeding, we have determined the best available methods to perform each  xof the calculations necessary to conduct a TFP study, and we have developed a reasonable  x;prediction of the future input price differential. We recognize that the results of any study are  xreliable only to the extent that the data used in the study is taken from a consistent series, and  x|that the methods used in the study are internally consistent. We conclude that our staff analysis  xrelies on consistent data sources and methods, and that our input price differential findings are based on consistent and reliable data. " 40*&&aa("Ԍ Y4 "t134. For reasons discussed in Section V. below, we have decided not to adopt a moving  Y4 xaverage mechanism to update the XFactor. In the Price Cap Fourth Further Notice, we sought  Y4 xcomment on the best time period for studies used to calculate a fixed XFactor.tN xPK'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13675 (paras. 10406).t Ad Hoc  xcontends that we should use all the data since 1984, arguing that the divestiture of the Bell  xSystem in 1984 creates a "break" in the data, and that comparing data from before and after that  Y4 xtime could yield anomalous results.EXN xP'ԍ Ad Hoc Reply, Att. at 2526.E AT&T also uses postdivestiture for its TFP study.  xUSTA recommends basing the XFactor on a fiveyear moving average, and includes post1988  x data in its TFP study. USTA also contends, however, that the relevant period for the input price  xdifferential is from 1948 to the present. No other party commented on this issue. As discussed below, we base our analysis on data from 1986 to 1995.  Y 4 "135. USTA criticizes AT&T's model because it includes data only from the Bell  xOperating Companies (BOCs), while USTA's model includes data from GTE, Sprint, SNET,  Y 4 xand Lincoln.M N xPn'ԍ USTA 1997 Comments, Att. 6 at 2829.M USTA also finds, however, that including nonBOC data results in only a 0.1  xpercent difference in the XFactor for the period from 1988 to 1994, and no difference from  Y 41989 to 1994.M xN xP'ԍ USTA 1997 Comments, Att. 6 at 2930.M In our analysis of the record, we rely only on BOC data, as AT&T does.  Yy4 "136. Parties have presented a wide range of XFactor recommendations in our two  Yb4 xbproceedings. On the basis of its model, USTA proposes XFactors ranging from 2.7 to 3.1.ubN xP'ԍ See USTA 1997 Comments, Att. 5 at 14; USTA Comments, App. A at 3032.u  xUAt the other extreme, AT&T and Ad Hoc propose XFactors between 8.0 and 10.0, in part on  Y44 xthe basis of adjusting TFP for interstate productivity.4N xP}'ԍ Ad Hoc proposes 9.9 percent and AT&T proposes 8.5 percent. Ad Hoc Reply, Att. at 36; AT&T 1997 Reply, App. G at 32. As discussed above,Q4 N xP'ԍ See Section III.B.1., supra.Q MCI proposes  xan XFactor of 8.5 percent based on a nonTFP methodology. Recently, a number of parties  Y4 xfiling a joint ex parte statement have advocated an XFactor of at least 7.5 percent, based largely  Y4on MCI's and Ad Hoc's recommendations.m  N xP #'ԍ On April 16, 1997, the American Petroleum Institute, Consumer Federation of America, Consumers Union, International Communications Association, Michigan Consumer Federation, Oregon Citizens' Board, and  xP$'the National Retail Federation filed a joint ex parte statement in CC Docket Nos. 9645 and 96262. Ex Parte Letter from Brian R. Moir, Counsel to the International Communication Association, to William F. Caton,"x%0*&&%"  xP'Acting Secretary, FCC, April 16, 1997 (Joint Ex Parte Statement). m "5X0*&&aa"Ԍ  Y4 "t137. The table in this Section presents the yearly XFactor estimates (TFP plus any input  xprice differential) submitted by USTA and AT&T, and the results of our analysis of the best  xZmethods and data available in the record of this proceeding, as well as various multiyear  xaverages of total company productivity derived from the AT&T model and our own analysis.  xoIn its model, Ad Hoc does not present comparable yearly estimates, but only average estimates.  xHWe find that, for the 198595 period, the average annual growth in TFP estimated by USTA's  xsimplified TFP model are about 0.2 percent less than our estimates. Based on more recent  xperiods, the differences are somewhat greater. As discussed above, however, USTA has not  xprovided any reliable estimate of the input price differential. For that reason, we cannot give  xany weight to its X-Factor estimates. Also as discussed above, Ad Hocs model relies heavily  Y 4 xon methodologies USTA employed in its original TFP model reviewed in the LEC Price Cap  Y 4 xPerformance Review and discussed in the Price Cap Fourth Further Notice. Ad Hoc's  xadjustments to the USTA original model do not adequately address the problems we found with  x that model, so we also give no weight to Ad Hocs XFactor estimates. We also place no weight  Y 4 xUon the joint ex parte statement's recommendation, which relies, without further analysis, on the  Y4 xMCI, Ad Hoc, and AT&T interstateonly proposals..xXN xP'ԍ The joint parties cite MCI's XFactor proposal of an 8.5 percent XFactor, Ad Hoc's proposal of 10 percent, and AT&T's interstateonly TFP proposal of 8.5 percent, and argue that the XFactor should be at least  xP)'7.5 percent on the basis of these proposals. Joint Ex Parte Statement at 1718. We explained in Sections III.B.1. and III.C.2., above, why we do not rely on MCI's and Ad Hoc's XFactor calculations. In Section  xP'III.D.2., we conclude that we can place no weight on AT&T's interstate TFP adjustment. The Joint Ex Parte  xP'Statement relies on MCI's, Ad Hoc's, and AT&T's comments without providing any further analysis, and therefore provides no basis for reconsidering this conclusion. . Our analysis does incorporate a number  xQof the methods advocated by AT&T, but AT&T's estimate of the X-Factor relies as well on  x.methods that do not provide the best estimates of productivity from this record. Thus, we will  xaccord some weight to AT&T's estimates of the X-Factor, but will rely primarily on our own  xbanalysis, which is a synthesis of the most persuasive treatment of TFP suggested by the record. The results of our analysis are displayed in the table below."60*&&aaP"Ԍř Y ddx!(7I aY  1 +  SUMMARY OF XFACTORS11YEAR$+FCC$+AT&T$+USTA111986E+-0.5%E+0.2%E+N/A1141987v+5.0%v+4.1%v+N/A11e1988+5.0%+6.4%+N/A111989+7.9%+8.8%+2.1%111990 +8.8% +11.0% +4.0%111991: +5.8%: +6.0%: +3.0%11) 1992k +3.4%k +4.1%k +2.0%11Z 1993 +4.7% +6.0% +3.1%11 1994+5.4%+5.9%+1.8%11 1995+6.8%+9.4%+3.5%3DZ D^ D^ D^ D^ 311Ave (86,95)/+5.2%/+6.2%/+11Ave (87,95)`+5.9%`+6.9%`+11OAve (88,95)+6.0%+7.2%+11Ave (89,95)+6.1%+7.3%+2.8%11Ave (90,95)+5.8%+7.1%+2.9%11Ave (91,95)$+5.2%$+6.3%$+2.7%1+  Y4 "#x6X@`7X@##Xw PE37|XP#138. The upper portion of the Table shows the year-by-year estimates of the X-Factor.  xThe lower portion shows a series of averages of the annual X-Factor estimates derived from our  x!analysis of the record and from the AT&T model. The first average includes all the years for  xwhich estimates were made. The next average excludes the oldest estimate. Each subsequent  xaverage drops the next oldest estimate until the average includes only the most recent five years,  x from 1991 to 1995. Taken as a whole, this series of averages gives the least weight to the oldest  xestimate, because that estimate only appears in the first average, and the most weight to the most  xrecent five estimates, because these estimates appear in every average. We find that these  xaverages, rather than the yearly estimates, provide the most reliable basis in the current record  x^for estimating incumbent LEC productivity targets (including input price differential) for the  ximmediate future. The "trimming" of the averages yields a range of possible productivity outcomes based on progressively more current sets of yearly estimates.  Y$4 "139. Focusing on the staff estimates, we note that the middle four averages are closely  xgrouped around 6.0 percent. The first and last averages are 5.2 percent. We conclude that it"%70*&&aad&"  xis reasonable to place less weight on these two averages. The first average is heavily influenced  xby the improbably low 1986 estimate of -0.5 percent. The estimate for 1986, the first period  xfor which we have data, is improbably low in comparison to all the other estimates: the next  xHlowest estimate is +3.4 percent and seven of the ten estimates are +5 percent or higher. The  xlast average (1991-95) is the average most affected by the low 1992 estimate. The decline in  xkthe measured X-Factor in 1992 appears to be an artifact of a one-year jump in the measured  xproductivity of the national economy as economic activity increased, rather than a change in the  xgrowth rate of LEC productivity or input prices. The measured TFP of the U.S. economy  xappears to be more sensitive to the business cycles than the measured TFP of LECs.  x7Furthermore, we note that, although there are years in which incumbent LECs were able to  xachieve measured X-Factors that exceed 6 percent, there is no extended time period over which  xthe measured X-Factor remained substantially above 6 percent. We also note that from 1993  xonward there has been an upward trend in the X-Factor, with the 1995 estimate being 6.8  xpercent. The estimates provided by AT&T are somewhat higher than our analysis, but show the same pattern.  Y4 "140. Based on this analysis, we conclude that a reasonable, challenging productivity  xoffset for incumbent LECs lies within a range whose lower bound is 5.2 percent. If we were  xorelying exclusively on our own analysis, we would conclude that the upper bound of our range  xof reasonableness is 6.1 percent. As a result of our reliance to some extent on AT&T's results,  x^however, we have increased the upper bound of the range of reasonableness slightly, to 6.3 percent.  Y4 "&141. Because the averages listed above tend to show that the incumbent price cap LECs  xhave fairly consistently achieved productivity growth near or at the upper end of the range of  xreasonableness, and because there appears to be a strong upward trend in productivity growth  xfrom 1992 to 1995, we determine that the most reasonable course at this time is to set the X x3Factor in the upper portion of this range, 6.0 percent. AT&T's estimates reflecting total  x*company productivity rather than interstate productivity alone, which range from 6.2 to 7.3  xpercent, also suggest that we should prescribe an XFactor near the upper bound of the range  xHof reasonableness. As discussed elsewhere, in order to ensure that increased benefits from the  xincreased productivity we expect from incumbent LECs flow through to price cap customers,  xwe also adopt a CPD of 0.5 percent, bringing the overall X-Factor prescribed for use in price  xbcap PCIs to 6.5 percent. We are confident that an X-Factor of 6.5 percent can be achieved by  xthe incumbent price cap LEC industry, yet provides a substantial increase over our current price cap plan in the benefits flowed through to price caps customers.  Y!4 "I142. We expect the price cap LEC industry to be able to meet this target, for several  xxreasons. First, price cap regulation seeks to replicate the incentives of a competitive market,  xbut it is clearly not a substitute for competition. As a result, measured LEC TFP may not  xmeasure the actual productivity growth that incumbent LECs can achieve, but rather reflects the  xproductivity growth LECs were encouraged to achieve under our original and interim price cap"Q%80*&&aa'"  xplans. Under price cap regulation, LECs are required to reduce their prices only to the extent  xthat their PCIs have been lowered by application of the price cap formulas, and are permitted  xHto keep the rest of the cost reduction in the form of higher earnings. To the extent that a price  xccap LEC has not reduced its prices as much as it has reduced its costs under price cap  x7regulation, and to the extent that lower prices would have led to demand stimulation, higher  xoutput growth, and the realization of additional scale economies, then measured LEC TFP  xunderestimates the productive growth the price cap LECs could achieve with the right incentives.  xTo the extent that LEC anticipated earnings would fall in the sharing range, LECs had less  xincentive than a firm operating under competition to realize all the possible productivity gains.  xIt is not clear how great this underestimation is, given that not all price cap LECs set their prices  xso that their APIs are equal to their PCIs. On the other hand, many LECs were subject to  Y 4 x!sharing obligations under the original price cap plan.X  xP| 'ԍ In the LEC Price Cap Performance Review, we found that, from 1991 to 1994, the cumulative effect of savings due to belowcap filings was $1.14 billion, and the cumulative net effect of sharing obligations and low xP 'end adjustments was $152 million. LEC Price Cap Performance Review, 10 FCC Rcd at 8987 (para. 60).  On balance, we believe that measured  x|LEC TFP may somewhat understate achievable gains in TFP. A second reason that we believe  xthat LECs can achieve our 6.5 percent XFactor is due to the actions we are taking in our  Y 4 x!Access Reform First Report and Order, which should greatly stimulate usage. We expect this increase in usage to lead to more efficient use of the LEC network.  Yy4 "143. In summary, we retain our existing formula for adjusting price cap PCIs. We  Yb4 xdecline to adopt a PCI adjustment formula based on a direct approach, i.e., a PCI formula  x|excluding any economywide measure of inflation, because we have decided to prescribe an X xUFactor at this time rather than adopt rules to calculate a new XFactor each year and update the  xXFactor using a fiveyear moving average. In addition, we find that the XFactor should  xinclude LEC TFP and an input price differential. For the reasons discussed above, we find that  xTFP should be based on the Commission's prescribed depreciation rates. We have decided  x|against adopting any interstate TFP adjustment, hedonic adjustment, or any adjustment based on  xthe productivity growth of other industries. We also find that USTA has inadequately supported its contention that the input price differential is not significantly different from zero. C:\DOCUMENT\4THORD\IIIF  Xe4 C:\DOCUMENT\4THORD\IV _  IV. PRICE CAP STRUCTURE ISSUES\  X74 A. Overview  Y 4 144. We are today substantially revising the structure of our price cap plan to reflect the procompetitive, deregulatory paradigm established by the 1996 Telecommunications Act _as well as the enhanced methodologies and data available for estimating incumbent LEC productivity gains. By eliminating sharing, we are removing a major vestige of rateof"90*&&aa("ԫreturn regulation and eliminating the strongest LEC incentives to shift costs between  Y4services. xPy'ԍ This assumes of course that the XFactor continues to be calculated on an industrywide basis. We also establish a structure conducive to the growth of competition and to progressive deregulation of incumbent LEC interstate access services as competition  Y4develops. o xP'ԍ According to NYNEX, Congress identified price cap regulation as a mechanism to encourage infrastructure investment when it adopted the 1996 Act, and eliminating sharing would further encourage  xPk'infrastructure investment. NYNEX Reply at 21, citing Section 706(a) of the Telecommunications Act of 1996, 47 U.S.C.  706(a).  Y4145. Based on the limited information then available, both the original and the interim LEC price cap plans included multiple XFactors, ranging from 3.3 percent to 5.3 percent, many with sharing obligations that provided LECs in sharing zones with rateofreturnlike incentives. Today, as discussed above, we prescribe a 6.5 percent XFactor based on a total factor productivity analysis of the impact that LEC productivity growth and the change in LEC input prices have had on LEC industry unit costs over a tenyear period. Both the methodology and the data used in this analysis more accurately reflect price cap  Y 4carriers' ability to reduce perunit costs than previous studies used to set the XFactor. W xP'#Xw P|XP# I. A. 1. a.(1)(a) i) a) I. A. 1. a.(1)(a) i) a)#c P P#э See LEC Price Cap Order, 5 FCC Rcd at 68856941 (App. C, App. D.); LEC Price Cap Performance  xP'Review, 10 FCC Rcd at 915995 (App. D).  #X P|XP#To ensure consumers share in all increases in LEC efficiency, and to provide efficiencyenhancing incentives to those LECs whose past performance has exceeded the industry  Y 4average, #X P|XP#we are adding a 0.5 percent CPD to the XFactor.  Yy4146. #Xw P|XP#In light of these changes, we here eliminate sharing as part of our overall strategy to devise a more deregulatory and efficiencyenhancing regulatory framework. The elimination of sharing removes a major vestige of rateofreturn regulation Additionally, the elimination of sharing facilitates progressive deregulation as services become subject to competition.  X4 B. Sharing Obligations  Y4 147. Background. In the LEC Price Cap Performance Review, we found that  Y4sharing blunts the efficiency incentives that we sought to create with price cap regulation.w xP !'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 904546 (paras. 18789).w  Y4Therefore, we tentatively concluded that sharing should eventually be eliminated.p?  xP#'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9049 (para. 197).p We also  Y|4noted in the LEC Price Cap Performance Review and the Price Cap Fourth Further Notice, however, that sharing served a number of purposes in the price cap structure we then"e: 0*&&aa<" adopted. One such purpose was a "backstop" function, which helped ensure that any errors in the XFactor did not lead to unreasonably high rates. A second purpose was a "flowthrough" function, which helped ensure that LEC reductions in unit costs were passed  Y4through to their customers. We also found that sharing served a useful "matching" function in a price cap plan with two or more XFactors by encouraging LECs to adopt an XFactor  Y4that most closely matched their internally expected rate of productivity growth. xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 904749 (paras. 19396). See also Price Cap  xP'Fourth Further Notice, 10 FCC Rcd at 1367677 (paras. 11315). In the  Yv4Price Cap Fourth Further Notice, we proposed eliminating sharing if other mechanisms could be found to serve these functions, and we solicited comment on whether it might be possible  YH4to eliminate sharing from the price cap plan without replacing the three functions.pH  xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13679 (para. 127).p  Y 4148. Discussion. In the LEC Price Cap Performance Review, we established the goal of eliminating sharing completely from price cap regulation. For the various reasons set out below, we conclude that we can and should now adopt a price cap structure without  Y 4sharing. As discussed in the LEC Price Cap Performance Review, sharing severely blunts the efficiency incentives of price cap regulation by reducing the rewards of LEC efforts and decisions. These reduced incentives, we argued, can be expected to generate lower LEC  Y4efficiency, which in turn would reduce the benefits of price caps to consumers.p xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9045 (para. 187).p The removal of sharing also removes a major vestige of rateofreturn regulation that created incentives to shift costs between services to evade sharing in the interstate jurisdiction. When a price cap LEC anticipates earnings will fall in the sharing range, every dollar of cost misallocated from services not subject to regulation decreases the LEC's interstate sharing obligation and increases recorded earnings on those other services.  Y4149. We find that a price cap regulatory structure without sharing best serves the public interest now even though we have not so found in the past. We have selected an achievable but significantly more demanding XFactor than we have in the past that will give customers their greatest assurance ever of real reductions in interstate access charges. We also believe that our XFactor selection is a more reliable estimate of actual LEC productivity than in the past. In particular, we have based our previous XFactors on a very indirect measure of productivity changes in output prices and used a very limited range of data. We are basing our XFactor prescription on a detailed direct analysis of productivity that applies a welldeveloped Total Factor Productivity methodology to publicly available data measuring ten years of incumbent LEC industry productivity. As a result, we find that sharing is no longer necessary to ensure that price cap customers benefit from price cap regulation, or to deal with uncertainty in selecting a reasonable XFactor. ";@0*&&aa "Ԍ Y4ԙ150. We also conclude that our new price cap structure better suits the advent of competition that lies at the heart of the 1996 Act. Subjecting incumbent LECs to a price cap structure that better replicates the discipline of a competitive marketplace is warranted as we move toward competition itself. Furthermore, we conclude that we should adopt a price cap structure that readily lends itself to the further regulatory changes we anticipate will be warranted as competition develops for access services in various geographic areas. Finally, we find that reducing our regulatory reliance on earnings calculations based on accounting data is essential to the transition to a competitive marketplace, where forwardlooking costs are central to decisionmaking.  Y 4151. Several carriers advocated eliminating sharing, either without regard to the  Y 4purposes of sharing listed in the Price Cap Fourth Further Notice, or because they expect  Y 4increased competition to replace one or more of those functions.<X  xPe 'ԍ USTA Comments at 3839; Southwestern Bell Comments at 2931; Bell Atlantic Comments at 24, 67; GTE Comments at 3940; Pacific Comments at 9; SNET Comments at 1213; Ameritech Comments at 9; USTA Reply at 23 and Att. C at 1921; NYNEX Reply at 19; Bell Atlantic Reply at 11.< Certain commenters in this proceeding have argued that the existence of sharing would unreasonably complicate the removal of some services from price cap regulation as those services become sufficiently  Y 4competitive so as to no longer warrant regulation.  xP@'ԍ NYNEX Comments at 10; NYNEX Reply at 20; USTA Comments at 39; Ameritech Comments at 910; GTE Comments at 40. We agree that sharing might be a serious impediment to deregulation. Therefore, our goal of eventual deregulation provides an additional reason to seek to eliminate sharing. Not only is sharing inconsistent with the general competitive paradigm that was established in the 1996 Act, but sharing might make it more difficult to deregulate services that become subject to substantial competition by creating an opportunity for LECs to misallocate costs from deregulated common carrier services to services that remain subject to sharing requirements. As more and more incumbent LEC services become subject to competitive pressures, the public interest detriments of the crosssubsidy incentives inherent in sharing become worse as the costs that can be misallocated to services that remain subject to sharing requirements increase. Without the elimination of sharing, it might become necessary to adopt new structural or nonstructural safeguards to prevent or limit these misallocations. Rather than consider adopting such administratively burdensome requirements, we conclude that eliminating sharing is the more reasonable course.  YN4152. Finally, elimination of sharing reduces our reliance on, and thus the importance of, jurisdictionally separated embedded costs. The sharing obligation is triggered when a price cap carrier reports interstate earnings above a specified level. Reported earnings are calculated on the portion of embedded investment and expenses that are allocated to the interstate jurisdiction by Part 36, the jurisdictional separations manual. Interstate rate base"<@0*&&aa " and expense levels, and thus reported earnings, are also directly affected by accounting depreciation rates, which we prescribe for most incumbent price cap LECs. By contrast, in a competitive marketplace, decisions are governed by economic costs and economic depreciation rates. Reduced reliance on accounting costs thus facilitates our transition to the competitive paradigm of the 1996 Act.  Yv4153. Parties recommending that we continue to impose sharing obligations on price cap LECs do not make a persuasive case. MCI argues that sharing replicates a competitive market by permitting carriers to retain the benefits of increased productivity for a time, and  Y14then passing those benefits through to consumers.<1 xP 'ԍ MCI Comments at 20.< On the contrary, competition forces a firm to pass through its cost reductions when other competing firms also enjoy the same cost reductions. Thus, a firm is compelled to pass through a reduction only when the industry as  Y 4a whole experiences the same reduction. An XFactor without sharing replicates these incentives. A firm that is more efficient than its competitors in a competitive market has the option of not lowering its price and reaping higher margins on the units it sells at the prevailing market price. Sharing would eliminate such an option. Furthermore, as we found  Y4in the LEC Price Cap Performance Review and reaffirm here, unlike a competitive market,  Yy4sharing severely blunts a firm's efficiency incentives.syX xP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 904546 (para. 188).s We also find that our new XFactor prescription of 6.5 percent adequately ensures that access customers benefit from the efficiencies resulting from price cap regulation.  Y4154. We also disagree with parties that argue that we must retain sharing to serve as either a backstop or a flowthrough mechanism. The backstop function ensures that rates under the revised price cap plan do not become unreasonably high. The flowthrough function ensures that ratepayers receive a reasonable portion of the productivity gains that incumbent LECs make pursuant to the incentives of price cap regulation. Both mechanisms were necessary in part because we were not certain that the productivity targets established by our XFactors were sufficiently challenging. We conclude that, under the price cap plan we adopt today, the need for the beneficial functions served by sharing are outweighed by the benefits of eliminating sharing. First, we consider the XFactor we adopt today, based on the TFP and input price differential calculations we discuss in Section III and Appendix D, to be a much more reliable measure of incumbent LEC potential productivity gains than the  Y 4approach we used in the LEC Price Cap Order and the LEC Price Cap Performance Review. Therefore, we have substantially more confidence that the XFactor we adopt in this Order will flow through a reasonable portion of LEC productivity gains to consumers. Second, our price cap plan retains the CPD. In light of our significantly increased productivity estimates, we find that the CPD serves an enhanced flowthrough function by guaranteeing that access" =0*&&aa"" customers receive the first benefits of increased productivity under our nosharing price cap plan.  Y4155. For reasons discussed in the next section, we are adopting a price cap plan with one XFactor, and therefore no longer need an alternative to fulfill the last purpose that sharing served under our previous price cap structure the matching function.  X_4 C. Number of XFactors  Y14156. Background. In the Price Cap Fourth Further Notice, we expressed concern that a price cap plan with one XFactor might not adequately reflect legitimate differences in the economic conditions faced by each LEC, but that establishing an individual XFactor for each LEC would not encourage LECs to improve their productivity. Therefore, we invited comment on whether to establish one XFactor or multiple XFactors in a longterm price  Y 4cap plan.y  xP7'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1367576 (para. 109).y In the Price Cap Second Further Notice, we asked for comment on the extent to which competition might affect productivity growth, and whether we should permit carriers to use different XFactors in different parts of their service areas in which they face different  Yy4levels of competition.uyX xP'ԍ Price Cap Second Further Notice, 11 FCC Rcd at 93031 (paras. 15962).u We invited parties to discuss this issue in conjunction with the  Yb4issues we raised in the Price Cap Fourth Further Notice.b xP'ԍ Price Cap Performance Review for Local Exchange Carriers, Order on Motion for Extension of Time,  xP'CC Docket No. 941, 11 FCC Rcd 1153 (Com.Car.Bur. 1995) (First Extension of Time Order).  Y44157. Discussion. In the LEC Price Cap Performance Review, we tentatively concluded that we should establish more than one XFactor because we were concerned that a single XFactor might not reflect the heterogeneity in the economic conditions faced by individual LECs, and because we had little experience with price cap regulation. Based on the additional information available to us now, however, we have less concern about the impact of heterogeneity on the XFactor component of the PCI formula, and conclude that mechanisms other than a multiple XFactor price cap plan with sharing as the matching mechanism will better serve the public interest. Based on our recent price cap experience, it is not so clear that LEC heterogeneity should be a major determinant of how we should structure our XFactor component of the price cap formula. Widespread heterogeneity among LECs has not been manifested through XFactor elections. Substantially all mandatory price cap LECs have, for some portion of the time under the interim plan, elected  Y 4the highest XFactor available under the interim plan.x @ xP%'ԍ GTE has consistently selected the 4.0 percent XFactor for certain study areas.x In addition, the studies undertaken  Y 4in response to the Price Cap Fourth Further Notice make use of more postdivestiture data," >0*&&aa " including data from four years of price cap regulation, and are more sophisticated than the  Y4studies on which we relied in the LEC Price Cap Performance Review. The new studies provide us with more hard evidence regarding price cap LECs' ability to reduce perunit costs. The analysis we have undertaken, as well as those placed in the record, allows us to conclude that the XFactor target we set is attainable by most if not all price cap carriers, including those price cap LECs with belowaverage earnings in a given year. If a particular LEC is unable to meet the 6.5 percent XFactor target in a given year, the lowend adjustment mechanism prevents price cap regulation from becoming confiscatory. We conclude that the lowend adjustment mechanism is sufficient to address any heterogeneity that may exist among price cap LECs.  Y 4158. Furthermore, the record contains no convincing proposals that would allow us readily to identify any characteristics by which we could assign individual XFactors to different price cap carriers, so that there could be multiple "nosharing" XFactors. Absent such a proposal, the only available approach is attaching differential sharing obligations to different XFactors and allowing carriers to select from those options. This approach brings with it all the problems associated with sharing. We therefore conclude that a single XFactor plan is likely to improve economic efficiency. Because our previous price cap rules included multiple XFactors and different sharing requirements for each plan, LEC incentives differed according to the plan under which they were regulated. By eliminating sharing, all LECs will now face the same efficiency incentives, which eliminates any heterogeneity caused by our regulatory framework.  Y4159. We also find that a single XFactor plan will significantly simplify our rules.~ xPh'ԍ See Price Cap Fourth Further Notice, 10 FCC Rcd at 13678 (paras. 12023).~ Importantly, the use of a single XFactor eliminates the need to adopt rules to limit or  Y4prevent carriers regulated by price caps from "gaming the system," i.e., preventing LECs from increasing their profits without improving their productivity growth by shifting between different XFactor options. Finally, we note that a single XFactor does not force all LECs to charge identical prices for access services, but only requires all price cap LEC rates to decline by the same percentage over time. Thus, heterogeneity in the price levels between LEC services remains embedded in our new price cap plan, as it was in our earlier plans.  Y 4160. We find that other aspects of our new price cap structure sufficiently address issues raised by heterogeneity among LECs. Our new XFactor should deal adequately with situations in which incumbent LECs may have aboveaverage opportunities for productivity enhancement. At the other end, we find, contrary to the arguments of Sprint and US West, that multiple XFactors are not necessary to be fair to LECs with productivity growth less  Y!4than the industry average_!X xP%'ԍ Sprint Comments at 10; US West Reply at 1314. _ because the lowend adjustment mechanism provides adequate"!?0*&&aa#" protection for those LECs. We also note that basing the XFactor on industry average data is not inherently unreasonable. The rail cost adjustment factor (RCAF) established by the Interstate Commerce Commission (ICC) was based on the industryaverage level of productivity growth in the rail carrier industry. The court found that the ICC's use of the industry average was reasonable. "It is not arbitrary, . . . for an industrywide regulatory  Y4scheme to use industrywide average cost data." xP'ԍ Edison v. ICC, 969 F.2d at 1226, citing Permian Basin Area Rate Cases, 390 U.S. 747, 80506 (1968);  xP'1 Alfred E. Kahn, The Economics of Regulation 4546 and n.62 (1970).  Y_4161. A number of price cap LECs suggest that we permit LECs to use a lower XFactor once they meet certain competitive criteria. NYNEX, for instance, recommends that we do so based on the first six items listed in the "competitive checklist" identified in the  Y 4Price Cap Second Further Notice.  xP 'ԍ NYNEX Comments at 1112, citing Price Cap Second Further Notice, 11 FCC Rcd at 906 (para. 108). (a) Competing providers of local switched telephone service have been authorized and have become operational; (b) local loops and switches have been unbundled; (c) intrastate expanded interconnection is available through tariff or contract; (d) service provider number portability is available; (e) compensation arrangements have been established for the LEC and its competitors to complete telephone calls originated on the other carrier's  xP'networks; and (f) competitors have access to directory assistance, 911, and other databases.  NYNEX contends that we should permit a LEC to use an XFactor of 75 percent of the baseline XFactor if it has met the checklist criteria in 75 percent of its service area, and at least one competitor is operational in the region. NYNEX would permit a LEC to use an XFactor of 60 percent of the baseline XFactor if there is a "competitive presence" in areas representing 40 to 50 percent of the LEC's business access  Y 4lines.?  xP'ԍ NYNEX Comments at 11. ? SNET and Ameritech make similar proposals.bX (  xP'ԍ  SNET Comments at 69; Ameritech Comments at 1012. In addition, Pacific argues that it has already removed barriers to entry in its region, and argues that it should be permitted to choose a lower XFactor now rather than delaying while it goes through some certification process. Pacific Comments at 89.b Southwestern Bell argues that a competitive checklist should be the test to determine whether to remove services from price  Yy4cap regulation rather than to permit a LEC to use a lower XFactor.MyH  xPr'ԍ Southwestern Bell Comments at 2728.M We plan to address  Yb4these proposals in a subsequent Order in our Access Reform proceeding, where we will set out in detail our marketbased approach to access reform.  Y4162. Finally, we note that the issues raised by Lincoln and Cincinnati Bell related to optional incentive regulation for small and midsized LECs are beyond the scope of this proceeding. C:\DOCUMENT\4THORD\IV C:\DOCUMENT\4THORD\V "@0*&&aa7"Ԍ Y4 V. UPDATING THE XFACTOR ă  X4 A. Background  Y4163. In the LEC Price Cap Order, we established XFactors that remained in effect  Y4for the initial fouryear period of price cap regulation.b xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6835 (para. 394).b In an ex parte statement filed on January 18, 1995, USTA proposed updating the XFactor annually, based on a moving  Y`4average of past productivity.`X xPi 'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 902931 (paras. 15054). We tentatively concluded in the LEC Price Cap Performance  YI4Review that there were a number of benefits to adopting a moving average XFactor. This approach would eliminate the need to review and revise the XFactor during periodic performance reviews, which consume substantial public and private resources. We also found that a moving average might allow us to reduce or eliminate sharing by flowing  Y 4through unit cost savings to customers on a lagged basis.w  zP'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9030 (para. 153). w  Y 4164. We invited comment on several issues related to this topic in the Price Cap  Y 4Fourth Further Notice. We asked whether a moving average would be an adequate replacement for performance reviews, and whether it would flow through unit cost reductions  Yz4to consumers.ozz xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13674 (para. 97).o We also noted that there was disagreement in the record in the first phase of this proceeding regarding whether basing the XFactor on an industrywide moving average would encourage productivity growth, or whether it was possible for an individual LEC to lower the XFactor by limiting its productivity growth. We invited comment on this issue. We also noted that resolution of this issue might turn on the extent to which there are  Y4mergers between price cap LECs.o  xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13674 (para. 98).o Finally, we solicited comment on the administrative burdens of updating the XFactor annually, specifically asking whether it would be necessary or desirable to establish a procedure to true up data reported in prior periods. We also asked whether it would be reasonable or preferable to update the XFactor less frequently than  Y4annually.o xP!'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13674 (para. 99).o  X}4 B. Discussion "fA* 0*&&aaI"Ԍ Y4165. We have decided not to adopt a moving average at this time. First, adopting a moving average in lieu of periodic performance reviews would represent a commitment to base changes in the XFactor on a mechanical formula driven solely by the LECs' historical productivity growth over the previous five years. We have based our XFactor prescription here on all available reliable historical information and calculated a series of averages based on differing time periods in order to determine an estimate of a reasonable, demanding XFactor. We have not limited ourselves to a simple average of the past five years. Second, it is not clear at this time that mechanical extrapolation of historical productivity growth will continue to be a stable predictor of productivity growth following the 1996 Act. As BellSouth and US West point out, competition in the market for access services is likely to grow in the future. Because it is difficult to predict with certainty how competition will develop under the 1996 Act, or whether our price cap plan will remain reasonable, it is unclear whether any moving average formula would continue to produce reasonable XFactors as competition grows. Thus, although we are certain that we have based our XFactor prescription on a reliable estimate of LEC productivity growth, and that our XFactor captures a reasonable portion of underlying productivity gains, we are not confident that there is any predetermined XFactor calculation that will always produce reliable productivity growth estimates without further analysis, or that should be deemed presumptively correct indefinitely.  Y44166. In the Price Cap Fourth Further Notice, we noted that we scheduled the first performance review to begin about three years after we adopted price cap regulation. We also sought comment on whether three years provides adequate data on which to base a performance review, or whether we should wait to develop more historical data on which to  Y4base the review.p xPQ'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13675 (para. 107).p Contrary to BellSouth, we conclude that we should schedule the next performance review to provide certainty for the industry. We conclude that we should initiate the next performance review about two years from now. This will give us an opportunity to observe how competition affects the incumbent LECs' performance under the price cap plan, and to make any necessary adjustments before the price cap plan leads to unreasonably high or low rates.  Y74167. Some commenters maintain that a moving average is useful for smoothing out  Y 4TFP as measured on an annual basis.x X xP)!'ԍ Bell Atlantic Comments at 910; Ameritech Comments at 6; GTE Comments at 2831.x By adopting a fixed XFactor based on a series of multiyear averages, we have smoothed out past volatility and ensured that any future yearly volatility in TFP will not affect the XFactor. Southwestern Bell and BellSouth contend that a moving average replicates the effects of a competitive market, in that it permits carriers to retain productivity benefits for a short period of time, and then flows through those benefits" B0*&&aa""  Y4to consumers.m xPy'ԍ Southwestern Bell Comments at 2122; BellSouth Reply, Att. at 4142.m We find that a moving averagebased XFactor might replicate the effects of competition, but only if the moving average formula continually produces reasonable estimates of expected LEC productivity growth. As we explained above, we cannot conclude on the basis of this record that there is such a moving average formula. Bell Atlantic opposes performance reviews, arguing that as long as earnings are used to check the performance of price caps from time to time, the perverse incentives of rateofreturn  Yv4regulation will not be eliminated completely.SvX xP 'ԍ Bell Atlantic Comments, Kahn Aff. at 910.S Bell Atlantic argues that this blunts efficiency incentives, and tends to shift the risk of investment from shareholders to  YH4ratepayers.KH xP 'ԍ Bell Atlantic, Kahn Aff. at 1012.K We share Bell Atlantic's concern about eliminating the perverse incentives of rateofreturn regulation, but do not agree that holding a performance review will significantly affect the beneficial incentives that should flow from the pure price cap regime we are here adopting. We have eliminated sharing requirements based on LEC earnings, and  Y 4we have declined, in the Access Reform First Report and Order, many parties' suggestions that we reinitialize access rates based on LECs' individual rates of return. In addition, we plan to focus in our next performance review on ensuring, to the extent possible, that we do not substantially undermine each price cap incumbent LEC's incentives to improve its efficiency. For instance, we would plan to make adjustments based on demonstrated industrywide performance or other generic factors, rather than adjustments that are tied to a  Yb4particular price cap incumbent LEC's interstate earnings.Ubx xP'ԍ See also Section VIII.A., infra.U C:\DOCUMENT\4THORD\V C:\DOCUMENT\4THORD\VI I  Y4 VI. COMMON LINE ISSUES ă  X4 A. Common Line Formula  Y4168. Common lines are the local subscriber "loops" linking the customer's telephone to the local exchange office. Although common line costs are nontraffic sensitive, the original IPart 69 access charge rules require that a portion of the cost is recovered through per minute rates. After recovery of a portion of common line costs through flat rates charged to end users, referred to as end user common line (EUCL) charges or subscriber line charges (SLCs), the remaining common line costs are recovered by carrier common line"OC0*&&aa #" (CCL) charges that are assessed on IXCs and other access customers based on minutes of  Y4use. xPb'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13680 (para. 130), citing LEC Price Cap Order, 5 FCC Rcd at 6793 (paras. 5657).  Y4169. Because common line costs are nontraffic sensitive, growth in demand leads to  Y4a reduction in average perminute common line costs. Therefore, in the LEC Price Cap  Y4Order, we established a PCI formula for the common line basket that differed from the PCI formula we established for the other three baskets, to ensure that carrier common line  Y_4charges declined as common line demand increased.f_  xP0 'ԍ LEC Price Cap Order, 5 FCC Rcd at 6795 (paras. 7173).f Specifically, we added a term, "g/2," to the common line PCI formula, to represent half the growth in demand per line in the prior  Y14year.71 xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6795 (para. 73). The Commission did not adopt a common line formula based on an average of the perline and perminute approaches, because in some circumstances this  xP"'would have produced the anomalous result of CCL rates increasing in response to increases in demand. Id. at 6795 (paras. 7173). The mathematics of the common line formula are explained in detail in Appendix E of the  xP'LEC Price Cap Order, 5 FCC Rcd at 694244.7 This was because we originally concluded that both LECs and IXCs have the ability to influence common line growth, and that both LECs and IXCs should benefit from  Y 4increases in demand.e `  xP'ԍ LEC Price Cap Order, 5 FCC Rcd at 6795 (paras. 6870).e In the Price Cap Fourth Further Notice, we noted that using an XFactor based on TFP in the common line formula might tend to doublecount demand growth. We therefore sought comment on whether reliance on TFP would warrant  Y 4eliminating g/2 from the common line formula.t  xP_'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13680 (paras. 13435).t We also sought comment generally on revising the existing balanced 5050 common line PCI formula, in the event we decided to  Y4retain a separate formula.s  xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 1368081 (para. 136).s  Yb4170. In the Access Reform First Report and Order, we adopt for price cap incumbent LECs a common line rate structure that will recover almost all common line costs through flat charges on subscribers and on IXCs. LECs will phase out the perminute CCL over a period of one to three years. We also decide to apply to the common line basket the formula that we use for the trafficsensitive and trunking baskets as soon as the perminute CCL  Y4charge has been phased out.e  xP$'ԍ Access Reform First Report and Order, Section III.A.4.e Thus, any doublecounting that results from our adoption of a  Y4TFPbased XFactor will be shortlived. Furthermore, we decide in the Access Reform First"D 0*&&aa"  Y4Report and Order that eliminating g/2 prior to the elimination of perminute CCL charges might create unnecessary rate churn. Accordingly, we will not address common line formula issues further in this Order.  X4 B. Reliance on Forecasted Data  Yv4171. Background. For price cap companies and other large incumbent LECs, CCL rates are calculated using forecasts of the amounts that will be recovered from SLCs. In the  YH4Price Cap Fourth Further Notice, we sought comment on whether it would be more accurate to base CCL rates on historical (previous year) rather than projected data for SLC  Y 4revenues.p   xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13681 (para. 137).p  Y 4172. Discussion. Southwestern Bell and MCI support using forecasted data,e  X xP'ԍ Southwestern Bell Comments at 3738; MCI Comments at 2324. e while  Y 4US West and USTA support using historical data.[   xPn'ԍ US West Comments at 2627; USTA Comments at 4546.[ We have decided to continue to rely on  Y 4forecasted EUCL data in developing CCL rates. In our companion Access Reform First  Y 4Report and Order, we revise our current common line rate structure rules, which now require LECs to recover most of their nontrafficsensitive loop costs through trafficsensitive loop rates, to reflect more closely the manner in which costs are incurred. Therefore, we have substantially revised our common line rate structure rules to reduce perminute CCL charges, and have adopted rules to phase out CCL charges within the next two or three years. We see no need to make other substantial revisions to the CCL charge calculation method, such as switching from historical to forecasted data, when these charges will be phased out within a relatively short time.  X4  VII. EXOGENOUS COST ISSUES \  Y4173. Background. The Commission has determined that certain costs incurred by LECs that are caused by administrative, legislative, or judicial requirements beyond their control, and not otherwise reflected in the PCI, should result in an adjustment to the PCI to ensure that the price cap formula does not lead to unreasonably high or unreasonably low  YN4rates. Nx xPw"'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13681 (para. 138), citing LEC Price Cap Order, 5 FCC Rcd at 6807. Our rules currently list eight cost changes that may be afforded exogenous treatment"NE 0*&&aa"  Y4under the appropriate conditions.  xPy'ԍ Section 61.45(d)(1) of the Commission's Rules, 47 C.F.R.  61.45(d)(1). In addition to these rules, exogenous treatment for cost changes resulting from revisions in the Uniform System of Accounts (USOA) or Generally Accepted Accounting Principles (GAAP) is not permitted unless those revisions result in an economic  xP'cost change for the LEC. LEC Price Cap Performance Review, 10 FCC Rcd at 908990 (paras. 29294). In the Price Cap Fourth Further Notice, we noted that many if not all of the cost changes currently treated exogenously would be reflected in a moving average TFPbased XFactor. We sought comment on whether it was possible to fashion an XFactor that would incorporate all the cost changes listed as exogenous in our rules, and if not, which exogenous cost changes would remain outside the XFactor  Y4calculation.t xP 'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13681 (paras. 13840).t Because we have decided against adopting a moving average at this time, this issue is moot, and we will not discuss the comments filed in response to this issue.  YH4174. In its pleadings filed in the LEC Price Cap Performance Review, MCI suggested limiting exogenous cost treatment to Commissionordered changes that result in shifting costs between the interstate and intrastate jurisdictions, or between regulated and  Y 4nonregulated accounts.z @ xP'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 9087 (para. 287).z We also invited comment on MCI's suggestion in the Price Cap  Y 4Fourth Further Notice.q  xPm'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13681 (para. 141). q  Y 4175. Discussion. We have decided not to adopt MCI's recommendation. We adopted the exogenous cost mechanism to ensure that the price cap formula does not lead to  Y4unreasonably high or unreasonably low rates.y`  xP'ԍ See LEC Price Cap Order, 5 FCC Rcd at 6807 (para. 166). y Because of this, we have never strictly limited exogenous cost treatment to the cost changes listed in our rules. Rather, we have retained the discretion to consider extending exogenous cost treatment to "other extraordinary  YK4cost changes that the Commission shall permit or require."K  xP'ԍ See Section 61.45(d)(1)(vi) of the Commission's Rules, 47 C.F.R.  61.45(d)(1)(vi). Adopting MCI's proposal  Y44would eliminate this discretion. In a future Order in this Access Reform proceeding, we will be developing a marketbased approach to regulating access rate levels as competition  Y4develops. We will also separately address issues related to embedded cost recovery in a competitive environment. In light of these ongoing proceedings, in which we will both work within and go beyond our current price cap regime, we do not find it advisable at this time to"F 0*&&aav" limit the flexibility we have allowed within our price cap plan to deal with unusual  Y4circumstances.  xPb'ԍ In reaching this conclusion, we do not interpret MCI's argument as implying that rates never change in competitive markets, as US West suggests. We understand MCI to mean that firms in competitive markets cannot change their rates unilaterally, but rather change their rates only in response to market forces. Accordingly, we find that it would not be reasonable to interpret MCI's proposal in this manner.  Y4176. According to Frontier, it is inconsistent to require exogenous treatment of cost decreases such as expired reserve deficiency amortizations, while denying exogenous cost treatment of cost increases such as changes in the treatment of OPEB costs. Frontier argues  Yv4further that neither of those cost changes affects the LEC's discounted cash flow.Dv xP 'ԍ Frontier Comments at 1112.D We conclude that the expiration of reserve deficiency amortizations is distinguishable from the change in the treatment of OPEB costs for purposes of exogenous cost determinations. The reserve deficiency amortizations had begun under rateorreturn regulation, and were embedded in the initial price cap indices that had taken effect on January 1, 1991. To ensure that ratepayers under price cap regulation would not be required permanently to bear these temporary rate increases, we directed LECs to make downward exogenous cost adjustments  Y 4to their price cap indices upon the expiration of those reserve deficiency amortizations. @ xP'ԍ See LEC Price Cap Order, 5 FCC Rcd at 6808 (para. 173); LEC Price Cap Reconsideration Order, 6  xP'FCC Rcd at 267374 (paras. 7880). See also Access Reform First Report and Order, Section IV.C.2. Given that we had granted a temporary rate increase under our rateofreturn regime, failing to end that rate increase would have given LECs an unintended and undeserved windfall. Thus, our action to decrease rates is simply the second half of an action that began when we  Yy4approved a temporary rate increase. For reasons we explained in the LEC Price Cap  Yb4Performance Review, we found that the change in OPEB accounting no longer warranted the price cap equivalent of a rateofreturn amortization, and that it was no longer necessary to use the exogenous cost mechanism of price cap regulation to permit that temporary rate  Y4increase to continue. xPf'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 909596 (paras. 30708). The court held that our  xP.'treatment of OPEB costs was reasonable. Bell Atlantic v. FCC, 79 F.3d at 1204.   Y4`0 VIII. OTHER ISSUES ă  X4 A. Application of the New Price Cap Formula to Incumbent LEC PCIs  Y4177. In the LEC Price Cap Performance Review, we required the incumbent LEC price cap industry to adjust its PCIs in the 1995 annual access tariff filings, so that the PCIs `would be at the levels they would have been at if the minimum XFactor had been 4.0"fG 0*&&aa/" percent since 1991. The Commission based its decision to do so on further evidence showing that one of the productivity studies upon which it had developed the original XFactor had included anomalous data from 1984 that had resulted in an understatement of the  Y4LEC industry's historical productivity growth. xP4'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 905354 (paras. 208209).  The Commission stressed that, under price caps, "LECs were supposed to become more efficient if they wished to exceed the earnings they would have been permitted under rate of return regulation, [and] [r]atepayers were to  Yv4benefit from rates reduced to the level that would provide this challenge."wvX xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9070 (para. 246). w Although it did not order a reduction "based solely on the observation that LECs have experienced high  YH4earnings under price caps,"wH xP 'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9069 (para. 245). w the Commission noted that its underestimation of LEC productivity meant that "[s]ome portion of the LECs' increased earnings," which were high,  Y 4was "obtained without any productivity improvements."w x xPC'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9070 (para. 246). w We found that such a result was counter to the balance between ratepayer and shareholder interests that had been intended under price caps, and we concluded that a prospective downward adjustment to the price cap indices was necessary to prevent the effects of the erroneously low productivity factor from  Y 4being permanently embedded in the indices.~  xPw'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 906970 (paras. 24546). ~ The court of appeals upheld our adjustment  Y 4on judicial review in Bell Atlantic v. FCC.   xP'ԍ Bell Atlantic v. FCC, 79 F.3d 1195 (D.C. Cir. 1996). See also, Administrators of the Tulane  xP'Educational Fund v. Shalala, 987 F.2d 790, 797 (D.C. Cir. 1993), cert. denied, 114 S.Ct. 740 (1994) (upholding Medicare "price cap" adjustment designed to avoid "permanently ingraining misclassified and nonallowable costs in future reimbursements to health care providers").  Yy4178. At the time the we made this prospective adjustment in the LEC Price Cap  Yb4Performance Review, we also expressly and repeatedly indicated that the revised XFactor  YK4employed to make that adjustment was an interim number.K  xP|'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 9050 (para. 198), 9054 (para. 211), 9055 (paras. 21314), 905859 (paras. 22324) (emphasizing "interim" nature of revised plan). We stated that we intended to  Y44complete our performance review inquiry into the appropriate noninterim productivity  Y4number "expeditiously."x xP#'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 9050 (para. 198). x Our action in this Order prescribing a new 6.5 percent XFactor essentially constitutes the completion of our 1995 performance review with respect to the appropriate XFactor. As described above, we conclude that the TFP methodology that we"Hh0*&&aa" have now developed is a more accurate method of measuring productivity performance than we have previously used and demonstrates that the interim XFactor that we adopted in 1995 understates LEC industry productivity growth.  Y4179. Similar to our action in the LEC Price Cap Performance Review, we here conclude that allowing all of the past two years of understated productivity to become permanently ingrained in LEC PCIs would not strike the proper balance between stockholder and ratepayer interests. At the same time we wish to limit harm to LEC productivity incentives that could result from the perception that our regulatory policies unnecessarily lack  Y14constancy. In this regard, our repeated emphasis that the XFactor adopted in the LEC Price  Y 4Cap Performance Review was "interim" should reasonably have put carriers on notice that another adjustment of the type we had adopted in that order would be possible perhaps beginning with the 1995 tariff year, the first year under the interim XFactor. On the other hand, we anticipated the interim period to be of shorter duration. The longer period of reliance on the interim price cap plan has prompted a longer period of relative uncertainty  Y 4than intended./ X  xP 'ԍ We had intended to complete action to replace the interim XFactor before the 1996 annual access tariff filings, but were unable to meet that internal timetable as a result of the demands required to meet numerous statutory deadlines established in the 1996 Act./ We conclude that an adjustment to the incumbent LECs' PCIs would reasonably balance ratepayer interests with our incentivebased regulatory policies in these circumstances. Accordingly, we require each price cap LEC to adjust its PCIs, effective July 1, 1997, to the levels for the 199798 tariff year that would have been in effect had we  YK4adopted the 6.5 percent XFactor in time to become effective with the LECs' 1996 annual tariff filings. This adjustment would have no effect on revenues and earnings for the 1996 Y497 tariff year that is, like the adjustment upheld by the court in Bell Atlantic, the adjustment we require in this Order has no retroactive effect. This adjustment is also a more moderate approach than either of the specific reinitialization options for which we sought  Y4comment in the Access Reform Notice.U! xPq'ԍ Access Reform Notice at paras. 22330.U  Y4180. To achieve the benefits of which they are capable, price cap regulation should not replicate rateofreturn regulation. Therefore, in the next performance review, we would plan to focus on ensuring, to the extent possible, that any adjustments to our rules would not substantially undermine each price cap incumbent LEC's incentives to improve its efficiency, particularly if similar adjustments may be made in other future performance reviews. For instance, we would prefer to make adjustments based on demonstrated industrywide performance or other generic factors, rather than adjustments that are tied to a particular price cap incumbent LEC's interstate earnings. "Ix!0*&&aa "Ԍ Y4181. Adjustments based on industrywide performance or similar factors would not destroy each price cap incumbent LEC's incentives to improve its efficiency, as would an approach of resetting each incumbent LEC's interstate prices to earn a predetermined rate  Y4of return, an approach we reject today in the Access Reform First Report and Order.f" xP4'ԍ Access Reform First Report and Order, Section IV.B.2.c.f Rather, such an "industrywide" approach would set up a relative performance/reward system, in which each price cap incumbent LEC would have incentives to strive to outperform the rest of the industry. Because no price cap incumbent LEC is very large relative to the industry as a whole, none determines industrywide averages by its own actions. Consequently, each price cap incumbent LEC would have strong incentives to improve its efficiency even if adjustments to the XFactor or other price cap rules based on industrywide performance were imminently expected.  X 4 B. Video Dialtone Basket  Y 4182. In September 1995, the Commission adopted an Order requiring price cap  Y 4carriers to establish a separate price cap basket for video dialtone services.#x X xP'ԍ Price Cap Performance Review for Local Exchange Carriers, Third Further Notice of Proposed  xPx'Rulemaking, CC Docket No. 941, 10 FCC Rcd 11098, 11101 (para. 15) (1995) (Price Cap Third Further  xP@'Notice). Video dialtone service consists of: (1) a basic transmission service available on a nondiscriminatory basis to multiple video programmers and a means by which customers of video programmers can obtain access to any or all video programming offered over the transmission platform; and (2) optional enhanced and other  xP'noncommon carrier products and services related to video dialtone. Price Cap Third Further Notice, 10 FCC Rcd at 1109899 (para. 2). We also  decided that costs and revenues from video dialtone services should be excluded from the  Yy4calculation of a LEC's sharing obligations until the costs for those services exceed de  Yb4minimis levels.n$b xP'ԍ Price Cap Third Further Notice, 10 FCC Rcd at 11105 (para. 35).n We sought comment on how to define "de minimis" for these purposes.h%b(  xP;'ԍ Third Further Notice, 10 FCC Rcd at 11106 (paras. 3942).h The 1996 Act, however, cancelled all Commission actions taken in the video dialtone docket. Instead, LECs are now permitted to participate in video markets as cable operators, through provision of common carrier video services, or as operators of noncommon carrier "open  Y4video systems."&  xPo!'ԍ 1996 Act, 47 U.S.C.  653. See Implementation of Section 302 of the Telecommunications Act of 1996, CS Docket No. 9646, 11 FCC Rcd 14639 (1996). Therefore, we hereby terminate the video dialtone portion of this  Y4proceeding we initiated in the Price Cap Third Further Notice. "J&0*&&aa\"Ԍ X4 uC. Miscellaneous Issues  Y4183. NCTA and MFS recommend "promoting competition" rather than investing the  Y4time and resources necessary to complete this rulemaking.]'X xP4'ԍ NCTA Reply at 4; MFS Reply at 13. Similarly, ICA suggests that "promoting competition" and then conducting performance reviews to determine which services to remove from price cap regulation would be less administratively burdensome than reviewing moving average XFactor calculations. ICA Comments at 9. ] As explained in Section II.C. of uthis Order, our decisions here play a critical role in restructuring regulation to match a developing competitive marketplace. This Order joins recently adopted procompetitive, deregulatory rules implementing Section 251 and related provisions of the 1996 Act, and is  Y_4interrelated with the Access Reform First Report and Order. Thus, conforming our price cap regulations to the paradigm of the 1996 Act has not precluded us in any way from "promoting competition." Furthermore, until the telecommunications market can become competitive enough to warrant removing all services from price cap regulation, it is important that the price cap plan replicate as nearly as possible the incentives of a competitive market.  Y 4184. AT&T asserts that service quality has declined while the LECs have increased their productivity in the past, and recommends reflecting service quality changes in TFP  Y4calculations.f( xP)'ԍ AT&T Comments at 24 and App. A at 6365; AT&T Reply at 3435.f BellSouth argues that AT&T's assertion is inconsistent with the  Yy4Commission's conclusion in the LEC Price Cap Performance Review that service quality has  Yb4not declined significantly,)bx xP'ԍ BellSouth Reply at 1213, citing LEC Price Cap Performance Review, 10 FCC Rcd at 9121 (para. 365). and that it would be unreasonable to assume that LECs would  YK4permit service quality to decline when competition is beginning to develop.H*K xP'ԍ BellSouth Reply, Att. at 3135.H In the LEC  Y44Price Cap Performance Review, we addressed this issue and found that there were no  Y4significant changes in service quality since we adopted price caps.+ xPf'ԍ LEC Price Cap Performance Review, 10 FCC Rcd at 8988 (para. 62), 9121 (para. 365). Nothing in this record convinces us to alter this conclusion. Therefore, we conclude that TFP adjustments for  Y4service quality are not necessary at this time., (  xP 'ԍ We will soon be releasing an Order addressing price cap LEC service quality issues. See Policy and Rules Concerning Rates for Dominant Carriers and Amendment of Part 61 of the Commission's Rules to Require Quality of Service Standards in Local Exchange Carrier Tariffs, Memorandum Opinion and Order, CC Docket No. 87-313, FCC No. 97-168 (adopted May 14, 1997).  "K,0*&&aav"Ԍ Y4185. ICA advocates requiring access customers to flow through to those customers'  Y4end users the reductions in the access charges they pay attributable to PCI reductions.;- xPb'ԍ ICA Comments at 9.; We have determined that there are no longer any dominant carriers in the market for  Y4interexchange services,.X xP'ԍ Motion of AT&T Corp. to be Reclassified as a NonDominant Carrier, Order, 11 FCC Rcd 3271 (1995). and that longdistance carriers have been passing through access  Y4charge reductions in the past.y/ xP= 'ԍ See LEC Price Cap Performance Review, 10 FCC Rcd at 8987 (para. 61).y We see nothing to indicate that market forces will not compel IXCs to flow through access charge reductions. We note that at least one IXC has committed to flow through to its long distance consumers all access charge reductions  Y_4resulting from the access chargerelated decisions we adopt today.F0X_x xP 'ԍ We also note that AT&T has made specific commitments to reduce its basic schedule rates, which are  xPP'often used by lowvolume customers. See Ex Parte Letter from Gerald M. Lowrie, Senior Vice President, AT&T, to Reed E. Hundt, Chairman, FCC, May 3, 1997.F  Y14186. Cincinnati Bell claims that the XFactors in the interim plan are too high for  Y 4small and midsized LECs.G1  xPc'ԍ Cincinnati Bell Comments at 7.G Cincinnati Bell also complains that prohibiting LECs electing price caps to ever revert to rateofreturn regulation discourages some small and midsized  Y 4LECs from adopting price caps, and recommends requiring only a fouryear commitment.G2 (  xP'ԍ Cincinnati Bell Comments at 8.G Issues related to incentive regulation for small and midsized LECs are beyond the scope of this proceeding.  Y4187. Some LECs argue that the passage of the 1996 Act necessitates resolution of the  Yy4issues on which we sought comment in the Price Cap Second Further Notice.t3y  xP'ԍ Ameritech Reply at 7; BellSouth Reply at 6; Southwestern Bell Reply at 35.t We have  Yb4invited further comment on several Price Cap Second Further Notice issues in the Access  YK4Reform Notice, and plan to resolve the issues in a subsequent Order in the Access Reform proceeding.  Y4188. Bell Atlantic asserts that high capacity access services are now competitive  Y4enough to remove from price cap regulation.@4XH  xP#'ԍ Bell Atlantic Comments at 1718. Bell Atlantic also includes with its comments an affidavit of Alfred Kahn, pointing out the pernicious effects of continuing to regulate a service after it has become competitive.  xPx%'See Bell Atlantic Comments, Kahn Aff. @ Bell Atlantic also recommends eliminating"Lh40*&&aa"  Y4the new services test.F5 xPy'ԍ Bell Atlantic Comments at 19.F USTA and Ameritech maintain that, since AT&T has been found to be nondominant, services in the interexchange basket should be removed from price cap  Y4regulation.X6X xP'ԍ USTA Comments at 47; Ameritech Reply at 7 n.12.X Pacific maintains that LECs should be permitted more common line pricing  Y4flexibility.@7 xPT'ԍ Pacific Reply at 1415.@ NCTA assert that the price cap plan does not adequately protect against cross Y4subsidization.98x xP 'ԍ NCTA Reply at 2.9 We sought comment on the new services test, pricing flexibility, and  Y4extending streamlined or nondominant treatment to LECs in the Price Cap Second Further  Yv4Notice and the Access Reform Notice, and we will address those issues in subsequent Orders  Y_4in the Access Reform proceeding.  Y14189. CCTA asserts that a moving average TFPbased XFactor might give LECs the ability to manipulate costs, and thus might lead to crosssubsidization. CCTA therefore  Y 4recommends adopting cost allocation rules for cable services.g9  xP'ԍ CCTA Reply at 2228. See also NCTA Reply, Att. A at 15.g Because we are not adopting a moving averagebased XFactor at this time, we need not determine whether any cost allocation rules for cable services are necessary.  Y 4190. On February 23, 1996, Ad Hoc filed a motion alleging that USTA had not provided sufficient information to enable other parties to review USTA's economic studies. Ad Hoc requested us either to compel USTA to provide the information, or to place no  Yb4weight on USTA's study, as we stated we would do in the Price Cap Fourth Further  YK4Notice.:K xP'ԍ See Price Cap Fourth Further Notice, 10 FCC Rcd at 13662 (para. 15). USTA asserted that it did provide Ad Hoc with all the data reasonably necessary to review its study. We did not rely on the parts of USTA's study that Ad Hoc claimed were not adequately supported on the public record. Therefore, we dismiss Ad Hoc's motion. C:\DOCUMENT\4THORD\VI "M( :0*&&aah"Ԍ Y4 C:\DOCUMENT\4THORD\END 3'3'Standard3'3'StandardHPLAS5SI.PRSx  (N I  Y4 IX. PROCEDURAL ISSUES ă  X4 A. Tariff Filing Requirements  Y4191. We hereby direct price cap LECs to file tariffs making adjustments to their rates to reflect the revisions to the price cap plan we adopt in this Order. Any carriers making Ionly rate reductions must file their tariff revisions no later than June 25, 1997, to take effect July 1, 1997. Other LECs must file their tariff revisions no later than June 17, 1997. We also direct price cap LECs to file revised tariff review plans (TRPs) containing adjustments to their PCIs, APIs, and SBIs no later than June 2, 1997.  X 4  uB. Final Regulatory Flexibility Act Certification   Y 4192. In the Price Cap Fourth Further Notice, we certified that the Regulatory  Y 4Flexibility Act (RFA)8;X  xP!'ԍ See 5 U.S.C.  601 et seq. The RFA was amended by the Contract With America Advancement Act of 1996, Pub.L. No. 104121, 110 Stat. 847 (1996) (CWAAA). TitleII of the CWAAA is the Small Business Regulatory Enforcement Fairness Act of 1996 (SBREFA).8 did not apply to this rulemaking proceeding because none of the rule uamendments under consideration would have a significant economic impact on a substantial  Yz4number of small entities.<z xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13682 (para. 149); see also 5 U.S.C.  601(3). Carriers subject to price cap regulation for local exchange access affected by the rule amendments adopted in this Fourth Report and Order and Second Report and Order are generally large corporations or the affiliates of such corporations. No party commented specifically in response to the analysis in our certification.  Y4193. In passing the 1996 Act, Congress sought to establish "a procompetitive, de Y4regulatory national policy framework" for the United States telecommunications industry.=x xP'ԍ Telecommunications Act of 1996, Pub.L.No. 104104, 110 Stat. 56 (1996) (to be codified at 47 U.S.C.  xP' 151 et seq.). These fundamental changes in the structure and dynamics of the telecommunications industry wrought by the 1996 Act now necessitate that the Commission review its existing access charge regulations to ensure that they are consistent and compatible with the 1996 Act's comprehensive changes. The rule revisions we adopt based on the record developed in the  Y}4Price Cap Fourth Further Notice and the Access Reform Notice will facilitate the deregulatory policy established in the 1996 Act. In particular, our elimination of sharing obligations removes a major impediment to deregulating individual interstate access services at the time competitive conditions warrant. "!N=0*&&aa!"Ԍ Y4194. The rules we adopt in this Fourth Report and Order and Second Report and Order are applicable only to LECs subject to price cap regulation. Currently, 13 incumbent  Y4LECs are subject to price cap regulation. We tentatively concluded in the Price Cap Fourth  Y4Further Notice that the price cap LECs are not "small business concerns" because they are  Y4generally large corporations or affiliates of such corporations.p> xP'ԍ Price Cap Fourth Further Notice, 10 FCC Rcd at 13682 (para. 149).p We hereby affirm this analysis.  Y_4195. The Commission will send a copy of this final certification, along with this Fourth Report and Order and Second Report and Order, in a report to Congress pursuant to the Small Business Regulatory Enforcement Fairness Act of 1996, 5 U.S.C.  801(a)(1)(A), and to the Chief Counsel for Advocacy of the Small Business Administration, 5 U.S.C.   Y 4605(b). A copy of this certification will also be published in the Federal Register.2? X xP 'ԍ Id.2  Y 4  - X. ORDERING CLAUSES ă  Y 4196. Accordingly, IT IS ORDERED, pursuant to authority contained in Sections 4(i), 4(j), 201205, 303(r), and 403 of the Communications Act of 1934, as amended, 47 U.S.C.  154(i), 154(j), 201205, 303(r), 403, and Section 553 of Title 5, United States Code, that Part 61 of the Commission's Rules, 47 C.F.R. Part 61, IS AMENDED as set forth in  YL4Appendix C.  Y4197. IT IS FURTHER ORDERED that the provisions in this Order will be effective June 17, 1997. We find good cause under 5 U.S.C.  553(d)(3) to make the rules effective less than thirty days after publication, because the local exchange carriers subject to price cap regulation must file tariffs by June 17, in order for them to be effective on July 1, 1997, as required by Section 69.3 of the Commission's rules, 47 C.F.R.  69.3. In addition, to ensure that the local exchange carriers subject to price cap regulation have actual notice of these rules immediately following their release, we are serving those entities by overnight mail.  YO4198. IT IS FURTHER ORDERED that local exchange carriers subject to price cap regulation SHALL FILE tariffs and revised tariff review plans in accordance with the requirements set forth above. These requirements are subject to review by the Office of Management and Budget, and will be effective upon that approval." O?0*&&aa"Ԍ Y4yř199. IT IS FURTHER ORDERED that the motion filed by Ad Hoc Telecommunications Users Committee on February 23, 1996, IS DISMISSED.  Y_4 hhCFEDERAL COMMUNICATIONS COMMISSION  Y 4 hhCWilliam F. Caton  Y 4 hhCActing Secretary y .C:\DOCUMENT\4THORD\END "P?0*&&aab"  Q @A-@    Y4 C:\DOCUMENT\4THORD\APP.A 3'3'StandardHPLAS5SI.PRSx  3'3'StandardHPLAS5SI.PRSXwLP (NQ   @A-A-@  Y4R APPENDIX A ă  Y4 I. Comments filed January 16, 1996  Yx4 1. Ad Hoc Telecommunications Users Committee (Ad Hoc)  Ya4 2. American Petroleum Institute (API)  YJ4 3. The Ameritech Operating Companies (Ameritech)  Y34 4. AT&T Corporation (AT&T)  Y 4 5. The Bell Atlantic Telephone Companies (Bell Atlantic)  Y 4 6. The BellSouth Telephone Companies (BellSouth)  Y 4 7. Cincinnati Bell Telephone Company (Cincinnati Bell)  Y 4 8. Frontier Corporation (Frontier)  Y 4 9. General Services Administration (GSA)  Y 4 10. GTE Service Corporation (GTE)  Y4 11. International Communications Association (ICA)  Y{4 12. Lincoln Telephone and Telegraph Company (Lincoln)  Yd4 13. MCI Telecommunications Corp. (MCI)  YM4 14. The NYNEX Telephone Companies (NYNEX)  Y6415. Pacific Bell and Nevada Bell (Pacific)  Y416. Southwestern Bell Telephone Company (Southwestern Bell)  Y417. Southern New England Telephone Company (SNET)  Y418. Sprint Corporation (Sprint)  Y419. Time Warner Communications Holdings, Inc. (Time Warner)  Y420. Telecommunications Resellers Association (TRA)  Y421. United States Telephone Association (USTA)  Y422. US West Communications, Inc. (US West)   Yg4 II. Replies filed March 1, 1996  Y:4 1. Ad Hoc  Y#4 2. Ameritech  Y 4 3. API  Y4 4. AT&T  Y4 5. Bell Atlantic  Y 4 6. BellSouth  Y!4 7. Cincinnati Bell  Y"4 8. California Cable Television Association (CCTA)  Y#4 9. Frontier  Yk$4 10. GSA  YT%4 11. GTE "T%Q?0*&&aa*"Ԍ Y4 12. LDDS WorldCom (LDDS)  Y4 13. Lincoln@X xPb'ԍ Subsequent to the filing of this reply, Lincoln changed its name to Aliant Communications Co. For the purposes of this Order, we refer to Lincoln's 1997 pleadings as "Aliant 1997 Comments" or "Aliant 1997 Reply."  Y4 14. MCI  Y415. MFS Communications Company (MFS)  Y416. National Cable Television Association (NCTA)  Y417. NYNEX  Yv418. Pacific  Y_419. Sprint  YH420. Southwestern Bell  Y1421. TRA  Y 422. USTA  Y 423. US West   X 4 III. Comments filed January 29, 1997, and Replies filed February 14, 1997  Y 4XThese comments and replies are listed in Appendix A of our companion Access  Y4Reform First Report and Order.q(#  Yy4    YK4  C:\DOCUMENT\4THORD\APP.A "KR@0*&&aaT"   @A-B-@  Y4 !C:\DOCUMENT\4THORD\APPB.1! S APPENDIX B ă  X4#O PLEADING SUMMARIES \  Y`4}  III. XFACTOR CALCULATION ISSUES ă  X34 B. XFactor Approaches  X 4 1. Methods for Estimating the XFactor  X 4 ` ` a. TFP  Y 4 "/1. USTA asserts that both Ad Hoc and AT&T also base their recommendations on a  Y4 xTFP method.@9 xP 'ԍ USTA Reply at 6.9 MCI notes that the TFP methods proposed by Ad Hoc, AT&T, and USTA result  x@in different XFactor recommendations, and argues that TFP calculations are inexact and  Yd4 xpotentially controversial.dX xPm'ԍ MCI Reply at 89. See also API Reply at 2 (any price cap plan should ensure consider benefit and be reasonably simple and verifiable). USTA alleges that MCI does not oppose a TFPbased XFactor in  YM4 x@general, but only USTA's application of TFP.9M xP'ԍ USTA Reply at 6.9 Frontier contends that both USTA's and  Y64 xAT&T's XFactor recommendations seem extreme.A6@ xP''ԍ Frontier Reply at 1 n.2.A Cincinnati Bell asserts that the data  x;collection required for TFP calculations might be burdensome, and might discourage small and  Y4 xgmidsized LECs from adopting price cap regulation.F xP'ԍ Cincinnati Bell Reply at 56.F GTE argues that TFP is a "robust"  xmeasure of productivity because it produces results comparable to the TFP results reached by  Y4Ad Hoc and AT&T.4X`  xP 'ԍ GTE Reply at 67. Ad Hoc and AT&T propose higher XFactors than USTA because they advocate including an input price differential and making an adjustment for any differences in interstate and intrastate productivity growth. These issues are discussed further below.4  X4 ` ` b. Historical Revenue Approach "S 0*&&aaM"Ԍ Y4 "2. Several parties oppose the Historical Revenue Approach because it creates the  Y4 xperverse incentives created by rateofreturn regulation.#X xPb'ԍ USTA Comments at 810 and App. C at 2329; US West Comments at 19; NYNEX Comments at 2425; GTE Comments at 3133; Southwestern Bell Comments at 1819; BellSouth Comments at 2426; Bell Atlantic Comments at 1516; NYNEX Reply at 17; USTA Reply at 21.# Lincoln and NYNEX oppose the  xHistorical Revenue Approach because its incorporation of Part 36 and 69 rules makes the model  Y4 xadministratively burdensome.S xPT'ԍ Lincoln Comments at 10; NYNEX Reply at 17.S NYNEX also contends that accountingbased rules are a poor  Y4measure of a firm's economic performance.; x xP 'ԍ NYNEX Reply at 18.;  Yv4 "3. GSA supports the Historical Revenue Approach because it believes that it incorporates  xboth TFP growth and the input price differential, although it does not identify either of these  YH4 xkseparately.= H xP'ԍ GSA Comments at 34.= GSA argues that this approach is simpler than either AT&T's or USTA's TFP  Y14 xbapproach.  1 xPz'ԍ GSA Reply at 8. Although it does not support TFP, GSA states it would prefer AT&T's model over  xPB'USTA's model because it includes an input price differential and an interstate TFP adjustment. Id. at 7.  GSA denies that the Historical Revenue Approach recreates the incentives of rate Y 4 xQofreturn regulation, at least when updated on a moving average basis.8   xP'ԍ GSA Reply at 8.8 TRA supports this  xapproach because it would produce an XFactor that would give LECs the strongest incentive  Y 4to lower rates.=  xP'ԍ TRA Comments at 67.=  X 4 ` ` c. Historical Price Approach  Y4 "}4. A number of commenters maintain that the Historical Price Approach is inferior to  Yy4 xHTFP because it is not a direct measure of productivity.y xP:'ԍ USTA Comments at 10 and App. C at 3031; NYNEX Comments at 25; GTE Comments at 3334; Southwestern Bell Comments at 19; Bell Atlantic Comments at 1617. Some parties argue that this approach  Yb4 xis not reliable because of discontinuities in the available time series.bh xP{"'ԍ NYNEX Comments at 25; USTA Comments at 11; GTE Comments at 3435. See also US West Comments at 19 (adequate data for this approach is not publicly available). GTE and Southwestern  YK4 x;Bell also criticize this approach as too sensitive to the 1984 data point.cK xP%'ԍ Southwestern Bell Comments at 20; GTE Comments at 35 n.64.c USTA maintains that,"KTP0*&&aa"  xin theory, productivity growth can be measured using changes in output and input prices or in  xoutput and input quantities. USTA also argues that the Commission's results are not accurate  x7because they are based on Part 36 and 69 accounting rules, and not based on total company  Y4 xdata.R xP4'ԍ USTA Comments, App. C at 2932. R NYNEX argues that this method does not lend itself to updating through a moving  Y4average.>X xP'ԍ NYNEX Comments at 25.>  Yv4 "t5. BellSouth and Lincoln oppose the Historical Price Approach because its incorporation  Y_4 xof Part 36 and 69 rules makes it administratively burdensome.Z_ xP 'ԍ BellSouth Comments at 27; Lincoln Comments at 10.Z Nevertheless, if the  x@Commission were to adopt a fixed XFactor rather than one based on a moving average,  xBellSouth would support using the SpavinsLande longterm study that was included in the  Y 4 xHistorical Price Approach.X x xPC'ԍ BellSouth Comments at 32. BellSouth maintains that the SpavinsLande method would result in an XFactor of 2.1 percent if based on data from 1929 to 1993, and 2.4 percent if based only on postdivestiture data.  xP'Id. ICA argues that the Historical Price Approach would be less  xbadministratively burdensome than USTA's original TFP model because it does not rely on non Y 4publicly available data to the same extent as USTA's original TFP calculation.=  xP5'ԍ ICA Comments at 59.= ` `   X 4 ` ` d. Other XFactor Methods  Y4 "6. NYNEX and USTA oppose adoption of the current interim price cap plan as the long  Yy4 xterm plan, in part because it imposes sharing obligations on some LECs.Ry(  xPR'ԍ NYNEX Comments at 27; USTA Comments at 6.R US West suggests  xextending the interim plan for one or two years, so that the Commission can consider US West's  x;longterm proposal discussed below, and consider the effect of the Telecommunications Act of  Y44 xM1996 on the price cap plan.{4  xP'ԍ US West Comments at 35; US West Reply at 910. See also NYNEX Reply at 28.{ NYNEX and USTA maintain that the combined Historical  xbPrice/Historical Revenue approach would create the same disincentives for productivity growth  Y4 xUas the Historical Revenue approach as proposed by AT&T.VH  xP"'ԍ NYNEX Comments at 26; USTA Comments at 1112.V Frontier supported this approach  Y4 xDin its comments on a "preliminary" basis.D xPx%'ԍ Frontier Comments at 3 n.3.D USTA asserts that an econometric estimation of"Uh0*&&aa"  xproductivity growth would not pass through gains resulting from economies of scale, and argues  xthat any econometric model sophisticated enough to be economically meaningful would not be  Y4relatively simple.d xPK'ԍ USTA Comments at 68. See also NYNEX Comments at 27.d  Y4 "7. US West suggests freezing the PCIs at their current levels as a means of simplifying  Y4 xthe price cap plan.TX xP'ԍ US West Comments at 35; US West Reply 45.T US West argues that growing competition will be adequate to protect  xconsumers' interests, and that a more rigorous price cap plan might distort competition, or force  Y_4 xDprices low enough to deter entry.U_ xP 'ԍ US West Comments at 5; US West Reply at 69.U US West asserts that AT&T supported a similar plan in  YH4 xH1990.Hx xPq'ԍ US West Comments at 5 n.8, citing LEC Price Cap Order, 5 FCC Rcd at 6796 (para. 80). AT&T replies that US West's assumptions regarding competition are unsupported and  Y14 xspeculative.=1 xP'ԍ AT&T Reply at 6364.= AT&T and GSA also oppose US West's plan because it would in effect reduce  Y 4 xthe XFactor to be equal to GDPPI.M  xPc'ԍ AT&T Reply at 6465; GSA Reply at 7.M Pacific attaches to its reply a California PUC opinion,  xin which the California PUC did freeze the PCIs in its jurisdiction for three years. Specifically,  xbthe California PUC found that, while the record before it was not sufficient to project the level  Y 4 xand speed of competition growth in its jurisdiction,L (  xP'ԍ California PUC Opinion at 42.L that growth is likely to be sufficient to  Y 4 xbrestrain prices enough to warrant setting the XFactor equal to GDPPI.Z!  xP''ԍ California PUC Opinion at 46, 5152, 6669.Z CCTA discounts the  xCalifornia PUC's conclusions as based on speculative and anecdotal evidence, and observes that  Y4the California Administrative Law Judge (ALJ) reached different conclusions.="H  xP'ԍ CCTA Reply at 1011.=  Yb4 "8. US West also suggests retaining the interim plan until the 1997 annual access filings  YK4 xare due, to give the Commission adequate time to consider its proposal.B#K xP!'ԍ US West Comments at 910.B BellSouth  x!recommends retaining the interim plan for another year, to permit the Commission to focus on"4Vh#0*&&aa"  Y4 xrulemakings mandated by the 1996 Act.B$ xPy'ԍ BellSouth Reply at 56. B CCTA recommends delaying any major changes to  Y4the price cap plan until we can see how the 1996 Act affects productivity growth.=%X xP'ԍ CCTA Reply at 1819.=  Y4 "9. Based on calculating the anticipated rate of return that would have made it  xxadvantageous for a LEC to choose the 5.3 percent XFactor rather than 4.0 percent, and the  ximplicit XFactor that would have produced that rate of return, MCI concludes that the LECs  Yv4 xelecting 5.3 percent anticipated an implicit XFactor of at least 8.54 percent.;&v xP 'ԍ MCI Reply at 911.; MCI also asserts  xbthat the breakeven point under the original price cap plan, without sharing, was 11 percent, so  YH4 x MCI recommends setting the XFactor between 8.5 percent and 11 percent.<'Hx xPq'ԍ MCI Reply at 1114.< Similarly, Ad Hoc  xasserts that the breakeven point in the interim plan between 4.0 percent and 5.3 percent is an  Y 4 xanticipated rate of return of between 13.24 percent and 13.42 percent.E(  xP'ԍ Ad Hoc Reply, Att. at 2728.E Many LECs reply that  x|their XFactor selection does not reflect expected productivity growth, but rather an aversion to  Y 4 xsharing.)  xP5'ԍ Lincoln Reply at 67; Bell Atlantic Reply at 1011; NYNEX Reply at 12; Pacific Reply at 34. On the other hand, Sprint claims that an XFactor of 9.9 percent in the original price  Y 4cap plan would have lowered the LECs' rates of return to 4.07 percent.<* (  xP'ԍ Sprint Reply at 17.<  X 4 2. Direct Approach  Yy4 "& 10. GTE argues that the Commission included an economywide inflation measure such  xQas GDPPI in the original price cap formula because there was no industryspecific inflation  YK4 xmeasure available at the time.y+K  xP'ԍ GTE Comments at 6, citing LEC Price Cap Order, 5 FCC Rcd at 679293.y GTE also recommends removing GDPPI from the price cap  xformula and basing the PCI on the difference between changes in LEC input prices and changes  Y4 xin TFP growth., H  xP"'ԍ GTE Comments at 69 and App. A. Alternatively, GTE would support retaining GDPPI and setting the XFactor equal to the difference between economywide TFP growth and LEC TFP growth. GTE asserts that this formula is equivalent to its proposal, because it assumes that the longrun TFP input price differential is 0. GTE Comments at 10 and App. C; GTE Reply at 2021.  Ameritech, Sprint, and Lincoln make similar proposals.-0 xP%'ԍ Ameritech Comments at 46; Ameritech Reply at 2; Sprint Comments at 59; Lincoln Comments at 7. Sprint and GTE"W-0*&&aa"  xxclaim that this approach simplifies the PCI formula, and eliminating the economywide terms  xfrom the PCI formula eliminates sources of potential inaccuracy in measuring productivity  Y4 xUgrowth or input price changes.g. xPK'ԍ Sprint Comments at 8; Sprint Reply at 37; GTE Reply at 1820.g Sprint and Ad Hoc also argue that eliminating economywide  x;data from the PCI formula would eliminate problems that could result from delays in reporting  Y4 xBLS statistics.]/X xP'ԍ Sprint Comments at 89; Ad Hoc Comments, Att. at 45.] Sprint argues that any general measure of inflation will not reflect accurately  xthe price changes in a specific industry, and estimates that using GDPPI in the original price  xcap formula, without an explicit input price differential, created an upward bias of about 1.5  Y_4 xpercent per year.L0_ xP 'ԍ Sprint Reply, Att. A at 47, 1316.L Sprint also denies that GDPPI is in fact an "economywide" measure of  xxinflation, because interindustry transactions are excluded. Sprint contends that sales to final  Y14 xdemand, measured by GDP, represents only one third of the economy.G11x xPZ'ԍ Sprint Reply, Att. A at 2427.G Ameritech and Sprint  Y 4note that a direct approach is consistent with the TFP method employed by the ICC.e2  xP'ԍ Ameritech Comments at 46; Sprint Reply, Att. A at 7, 1012.e  Y 4 " 11. Bell Atlantic opposes this approach, because it would incorporate an input price  Y 4 x^differential. Bell Atlantic opposes the input price differential for reasons discussed below.F3  xP'ԍ Bell Atlantic Comments at 17.F  x7AT&T argues that the Direct Approach would eliminate only noncontroversial terms in the  x|formula which can be based on publicly available data, and so does not in fact simplify the PCI  Y4 xformula.=4(  xPi'ԍ AT&T Reply at 6163.= According to BellSouth, if we adopt this approach, we should also adopt a fiveyear  Yy4 xmoving average.E5y  xP'ԍ BellSouth Comments at 1617.E Ad Hoc would support this approach only if an objective method to measure  Yb4 x!LECspecific input price changes could be developed.H6bH  xP['ԍ Ad Hoc Comments, Att. at 4546.H Sprint discusses a means to develop a  YK4LECspecific price index in detail.G7K xP!'ԍ Sprint Reply, Att. A at 1723.G "4Xh70*&&aa"Ԍ Y4 " 12. Sprint recommends requiring LECs to reduce their PCIs by either 1.1 percent or 2.1  Y4 xDpercent. Sprint would retain sharing requirements for LECs selecting 1.1 percent.<8 xPb'ԍ Sprint Reply at 23.< Sprint  xcontends that, based on inflation levels from 1991 to 1994, the 1.1 percent adjustment would be  Y4 x3approximately equal to a 4.5 percent XFactor.<9XX xP'ԍ Sprint Reply at 2324. Sprint also estimates that LEC TFP grew at about 3.85 percent from 1985 to 1991. The fiveyear moving average economywide TFP growth ranged from 0.0 percent to 0.38 percent from  xPT'1984 to 1993. Sprint Reply, Att. A at 4344.< Sprint argues that this would represent  Y4 xexpected total company productivity growth.<:x xP 'ԍ Sprint Reply at 24.< Sprint would base its nosharing option of 2.1  xQpercent on a 0.5 adjustment for the differences between interstate and intrastate productivity  xgrowth, and a consumer productivity dividend of 0.5 percent, that would be reduced by .125  Y_4percent in each of the following four years.?;_ xP'ԍ Sprint Reply at 2425.?  X14 C. TFP Calculation Issues  X 4 2. TFP Models Placed in Current Record  X 4` ` a. USTA's Simplified TFP   Y 4 "" 13. USTA maintains that its simplified TFP model provides the best possible balance  xof providing LECs incentives to improve their efficiency and maintaining just and reasonable  Yy4 xrates.><y xP'ԍ USTA Comments at 46.> Pacific cites a recent California Public Utilities Commission (California PUC) opinion  xfinding that TFP lies between 1.8 percent and 2.6 percent, and concluding that the TFP study  xconducted by USTA's consultant in this proceeding was more persuasive than other studies  Y44projecting productivity growth over 5 percent.= 4(  xP 'ԍ Pacific Reply at 23, 1416, citing Investigation on the Commission's Own Motion Into the Second Triennial Review of the Operations and Safeguards of the IncentiveBased Regulatory Framework for Local  xP'Exchange Carriers, I.9505047, Decision 9512052 (Dec. 20, 1995) (California PUC Opinion). Pacific  xPe 'attaches a copy of the California PUC Opinion to its reply.  Y4 " 14. NCTA and CCTA question whether LECs will have difficulty maintaining their  x;historical levels of productivity, given that Pacific claimed that the infrastructure improvements  xit made in anticipation of providing video dialtone services would result in efficiency gains in"Y=0*&&aav"  Y4 xtelephone service provision.N> xPy'ԍ NCTA Reply at 56; CCTA Reply at 34.N CCTA also theorizes that the LECs' productivity growth might  xbhave been depressed from 1990 to 1994, while the LECs faced sharing requirements under the  Y4 xkoriginal price cap plan, and while some LECs were investing in video dialtone technology.=?X xP'ԍ CCTA Reply at 1214.=  xSome parties argue that, since most price cap LECs elected the 5.3 percent XFactor in the  x|interim plan, the Simplified TFP model does not adequately measure the LECs' expected future  Y4productivity growth when it produces an XFactor of 3 percent.@ xP& 'ԍ LDDS Comments at 34; Ad Hoc Reply at 2 and Att. at 39; MCI Reply at 56; NCTA Reply at 6; API Reply at 12. We discuss more specific criticisms of the Simplified TFP Model below.  Y_4 "15. USTA also claims that its TFP method is comparable to that used by the Bureau of  YH4 xLabor Statistics (BLS).@AH@ xP9'ԍ USTA Comments at 3334.@ Several LECs support using USTA's simplified TFP model.B H xP'ԍ NYNEX Comments at 1218, and Apps. A, B, and C; Southwestern Bell Comments at 13, 56, 1718; BellSouth Comments at 24; Bell Atlantic Comments at 89; Pacific Comments at 12; SNET Comments at 2;  xPY'Ameritech Comments at 34; NYNEX Reply at 35. See also US West Comments at 67; US West Reply at 1012 (supporting USTA's proposal as an alternative to its own proposal). USTA  xand other parties assert that USTA has improved its model by relying on publicly available  Y 4 xdata.C  xP'ԍ USTA Comments at 34; BellSouth Comments at 9; Southwestern Bell Comments at 35; USTA Reply at 7; Bell Atlantic Reply at 2; NYNEX Reply at 45; GTE Reply at 46. MCI argues that USTA has not eliminated all the nonpublicly available data from its  xmethod, noting that USTA refers to unpublished data for its economic stock adjustment factors,  Y 4and depreciation rates from Jorgenson, in its TFP Review Plan.D  xP'ԍ MCI Reply at 67, citing USTA Comments, Att. B at Chart MISC1, rows 500620. See also TRA Reply at 45; Ad Hoc Reply, Att. at 4143.  X 4` ` b. AT&T's Performance Based Model  Y4 "16. Southwestern Bell and US West criticize this approach because it relies on  Yy4 xaccounting measures rather than "economic" measures.aEyh xP!'ԍ Southwestern Bell Reply at 911; US West Reply at 1213.a Some LECs contend that an XFactor  Yb4 xas high as AT&T suggests would be confiscatory.Fb xP $'ԍ Pacific Reply at 3. See also Sprint Reply at 17 (AT&T's XFactor in original price cap plan would have reduced the LECs' average rate of return to 5.69 percent.) BellSouth asserts that AT&T's suggested  xXFactor is inconsistent with the 5.54 percent it suggested on the basis of the Historical Revenue"KZPF0*&&aa"  x^Model, which AT&T argued would have been adequate to limit the industry average rate of  Y4return to 11.25 percent.BG xPb'ԍ BellSouth Reply at 78. B  X4 ` ` c. Ad Hoc's TFP Approach  Y4 "17. Sprint claims that the XFactor suggested by Ad Hoc overstates interstate  x|productivity, and that using that XFactor in the original price cap plan would have lowered the  Y_4LECs' rates of return to 4.07 percent.<H_X xPh 'ԍ Sprint Reply at 17.<  X14 3. Output Index Issues  X 4` ` a. Mathematical Construction of Output Indices  Y 4 "y18. In its simplified TFP model, USTA uses a Tornquist method to develop output  Y 4 xquantity indices.@I  xPW'ԍ USTA Comments at 1415.@ USTA uses an approximation of a chainlinked Paasche method to develop  Y 4 xxoutput price indices.@J x xP'ԍ USTA Comments at 1415.@ To calculate output quantities, USTA deflates booked revenues by its  xapproximated Paasche Price Indices. USTA contends that a chainweighted Paasche Price Index  xwould be theoretically superior to a traditional fixedweight Laspeyres and fixedweight Paasche  Yb4 xPrice Indices.DKb xP'ԍ USTA Comments, Att. A at 5.D USTA also provides a mathematical formula purporting to show that there is  xHlittle percentage difference in the price index derived from its approximated Paasche Index and  Y44a true chainlinked Paasche price index.HL4 xP}'ԍ USTA Comments, Att. A at 3639.H  Y4 "19. AT&T favors using the Fisher Ideal Index to construct the output indices, rather than  x the Tornquist Index used by USTA. AT&T argues that, unlike the Tornquist Index method used  xin USTA's model, the Fisher Ideal Index can accommodate the introduction or withdrawal of  xUservices during the period covered by the index. AT&T also claims that the Fisher Ideal Index  xgives the same result for TFP growth whether the computations are constructed from price  Y4 x@indices or from quantity indices.FM(  xPl$'ԍ AT&T Comments, App. B at 56.F AT&T measures output directly, based on minutes of  xinterstate access, number of end user access lines and special access lines as reported in ARMIS. "|[ M0*&&aa_"  xAT&T asserts that this direct measurement of output results in more accurate output measures  Y4than deflating revenues as it asserts USTA does.HN xPb'ԍ AT&T Comments, Att. A at 7273.H  Y4 "c20. BellSouth argues that BLS currently uses a Tornquist index, and that in any case,  Y4 xxit is unlikely that any of the highly aggregated service categories would ever move to zero.sOX xP'ԍ BellSouth Reply, Att. at 3031. See also USTA Reply, Att. A at 89.s  xSome parties assert that the choice of index construction method has little effect on TFP  Yv4 xVresults.Pv xP 'ԍ USTA Reply, Att. A at 89; Southwestern Bell Reply at 11; Bell Atlantic Reply, Att. 1 at 14. USTA also contends that the Tornquist Index has been more widely used in  Y_4 xproductivity research than the Fisher Ideal Index.CQ_x xP 'ԍ USTA Reply, Att. A at 89.C Sprint asserts that AT&T overstates  xinterstate output by 1.6 percent, because it divides trafficsensitive revenue requirement by  Y14 xnumber of lines rather than number of minutes of use.=R1 xP'ԍ Sprint Reply at 89.= Sprint also asserts that AT&T  x.overstates intrastate output by 0.9 percent by omitting intraLATA usage in calculating state toll  Y 4 xoutput.=S  xPL'ԍ Sprint Reply at 89.= Sprint contends that USTA's measurement of common line output is inconsistent,  xbecause it measures carrier common line usage in minutes and end user common line usage in  Y 4 xknumber of access lines.?T (  xP'ԍ Sprint Comments at 10.? Ad Hoc also advocates developing output quantity indices directly  Y 4 xbased on number of lines and minutes of use.VUX  xP''ԍ Ad Hoc Comments, Att. at 1718; Ad Hoc Reply at 5 and Att. at 26. Ad Hoc also criticizes the output indexes in USTA's original TFP model. Ad Hoc Comments, Att. at 17. Because USTA has adopted a different method to develop output indexes, we will not consider Ad Hoc's comments on this issue here. V USTA asserts that its and AT&T's output  xmeasurement are the same except for special access, and that measuring special access output  Y4in terms of number of lines is too simplistic.DV xP'ԍ USTA Reply, Att. A at 912.D  Xb4` ` b. Number of Output Catgories  Y44 "&21. USTA establishes seven output price and quantity indices, based on aggregations of  Y4 xrevenue categories in ARMIS 4302.Wh xP6%'ԍ These output categories are local service, long distance service, interstate end user access, interstate switched access, interstate special access, intrastate access, and miscellaneous. USTA Comments at 15. USTA contends that it is not possible to develop more"\W0*&&aa"  Y4 xdisaggregated output categories using publicly available data.=X xPy'ԍ USTA Comments at 15.= US West support USTA's output  Y4 xcategorization.@YX xP'ԍ US West Comments at 11.@ GTE argues that indices should be disaggregated only to the point where the  Y4 xservices within each index have roughly the same growth rates.?Z xPk'ԍ GTE Comments at 1516.? AT&T includes only three  xoutput indices, because its model is designed to measure interstate productivity growth rather  Y4than total company TFP as USTA's model measures.f[x xP 'ԍ The interstate or total company TFP issue is discussed below.f  Yv4 "}22. USTA claims that AT&T excludes the services in USTA's miscellaneous services  xcategory, and that this overestimates TFP by 0.4 percent from 198894, and 0.5 percent from  YH4198994.J\H xP'ԍ USTA 1997 Comments, Att. 6 at 8.J  X 4` ` c. Weighting of Output Categories  Y 4 "23. AT&T recommends weighting the output indexes on a marginal cost basis, arguing  x|that revenue weights will not approximate more economically meaningful marginal cost weights  Y 4 xuntil competition has developed further.f]  xP'ԍ AT&T Comments at 2324 and App. A at 6063; AT&T Reply at 34.f BellSouth asserts that AT&T improperly assumes that  xfully distributed costs can be used as a surrogate for longrun marginal costs, and so in effect  Y4 x assumes that the LECs can achieve no economies of scale.H^(  xPi'ԍ BellSouth Reply. Att. at 2930.H GTE replies that costbased weights  Yy4 x!for output categories might tend to recreate the incentives of rateofreturn regulation.:_y  xP'ԍ GTE Reply at 79.: Some  xparties assert that developing costbased weights for output indexes would be difficult and  YK4 xcontentious.`KH  xPD 'ԍ USTA Comments at 16; BellSouth Comments at 1011; USTA Reply, Att. A at 1213; Bell Atlantic Reply, Att. 1 at 13. USTA and US West contend that revenueweighting creates a more ambitious  xbenchmark for LECs, because they believe costbased weights place more emphasis on the  Y4 xoutput categories with slower growth.Ua xPn$'ԍ USTA Comments at 16; US West Comments at 12.U US West claims that booked revenues are a reasonable"]0a0*&&aa"  Y4 xand publicly available substitute for billed revenues.Ab xPy'ԍ US West Comments at 11. A USTA contends that, unless we use revenue weights for  xthe output indexes, LECs increasing their productivity will not be rewarded with increases in  Y4revenue.EcX xP'ԍ USTA Reply, Att. B at 2527.E  X4 4. Input Index Issues  X_4` ` a. Capital  X14` `  (2) Capital Stock  Y 4 "24. USTA's simplified TFP model measures capital stock with the perpetual inventory  xmodel it used in its original model. Specifically, USTA states that it established a benchmark  xvalue of capital based on 1984 plant and equipment using replacement values and USTA's  Y 4 xeconomic depreciation rates.Td  xPW'ԍ USTA Comments at 2021 and App. A at 1516.T To incorporate the effects of depreciation into the benchmark  xcapital value, USTA adjusts its benchmark capital stock by an economic stock adjustment factor,  xwhich is the ratio of economic value to book value, derived by dividing the U.S. BEA  Yy4 xHreplacement cost measures by the BEA quantity of capital stock measures.Neyx xP'ԍ USTA Comments at 21 and App. A at 16.N USTA states that  xcapital stock should be based on replacement costs rather than original costs, because original  xcosts measurements are based on depreciation assumptions that differ from economic  Y44depreciation.=f4 xP'ԍ USTA Comments at 21.= AT&T bases its capital stock on net book value.Hg4 xP}'ԍ AT&T Comments, App. A at 7071.H  Y4 "25. USTA states that it replaced its TPIs, based on proprietary data, with asset price  xindices currently published by BEA. USTA asserts that the use of BEA asset price indices in  Y4 xplace of TPIs has virtually no effect on LEC TFP.@h(  xP!'ԍ USTA Comments at 2122.@ Ad Hoc and Lincoln also support using  Y4 xBLS or BEA data in place of TPIs.hi  xP*$'ԍ Ad Hoc Comments, Att. at 2526, 4243; Lincoln Comments at 34.h US West and GTE support the perpetual inventory"^H i0*&&aam"  Y4 xbmethod used in USTA's model, and claim that BLS also employs this method.Wj xPy'ԍ US West Comments at 14; GTE Comments at 1819.W Ad Hoc does  xnot oppose USTA's perpetual inventory method itself, only the data on which USTA relied in  Y4its original TFP study.EkX xP'ԍ Ad Hoc Comments, Att. at 27.E AT&T also supports the perpetual inventory method.El xPk'ԍ AT&T Comments, App. B at 12.E  Y4 "26. USTA and GTE maintain that the basing depreciation costs on six asset categories  Y4 x is reasonable, observing that BEA also uses broad asset classifications to measure depreciation.Qmx xP 'ԍ USTA Comments at 20; GTE Comments at 18.Q  x.These commenters also assert that it would be very timeconsuming or impossible to gather the  Y_4data necessary to calculate depreciation rates for 30 capital accounts.Qn_ xP'ԍ USTA Comments at 20; GTE Comments at 18.Q  X14` `  (3) Adjustments to Capital Stock  Y 4 "g27. Ad Hoc and AT&T criticize Jorgenson's "economic" depreciation analysis on which  xUSTA relied in its original TFP study, as well as its simplified study. Ad Hoc and AT&T state  xthat Jorgenson's analysis was based on a 1981 article by Hulten and Wykoff, which in turn was  xbased on data ending in 1971, and examined depreciation on business assets for the economy as  Y 4 xQa whole rather than on telecommunications equipment specifically.GoX  xP'ԍ Ad Hoc Comments, Att. at 2021; Ad Hoc Reply, Att. at 33; AT&T Comments at 22, App. A at 4749,  xP'App. B at 9; AT&T Reply at 3234. But see AT&T Reply, App. B at 4849 ("hyperbolic decay model" used by BLS inferior to "geometric decay model" used by Jorgenson).G Ad Hoc notes that the  xdepreciation study on which USTA relied estimated the depreciation rates for broad groups of  x7asset classes which combined telecommunications equipment with other kinds of equipment,  Yb4 xbased on averages of those asset classes.Hpb  xP'ԍ Ad Hoc Comments, Att. at 2122.H Ad Hoc also notes that the depreciation rates in this  x;study are lower than either the prescribed depreciation rates or the rates advocated by LECs in  xdepreciation represcription proceedings, and argues that underestimating depreciation artificially  Y4 xreduces TFP growth and the XFactor.EqH  xP"'ԍ Ad Hoc Comments, Att. at 23.E Sprint alleges that USTA's depreciation rates  Y4 x|overweight capital input prices.>r xP$'ԍ Sprint Comments at 9.> NYNEX responds that USTA's depreciation study is sound,  xQbecause it avoids creating "asymmetry" between the measurement of LEC capital inputs and"_hr0*&&aa"  Y4 x^economywide capital inputs.>s xPy'ԍ NYNEX Reply at 1011.> USTA and Bell Atlantic assert that USTA adopted only the  xodepreciation method developed in the 1981 article, and substituted the most recent BEA data on  Y4equipment lifetimes to develop depreciation rates.ktX xP'ԍ USTA Reply, Att. A at 1920; Bell Atlantic Reply, Att. 1 at 1112.k  Y4 "V28. Some commenters argue that the depreciation rates should be those prescribed by  Y4 xthe Commission.u xP& 'ԍ MCI Comments at 1819; Ad Hoc Comments, Att. at 20; AT&T Comments at 22; Ad Hoc Reply at 5. Ad Hoc maintains that the Commission's prescribed depreciation rates are  Yv4 xdesigned to reflect the actual rate of plant retirement.Hvvx xP 'ԍ Ad Hoc Comments, Att. at 2223.H MCI asserts that the Commission's  x|prescribed depreciation rates in fact adequately reflect the economic life of the LECs' plant and  YH4 xequipment.PwH xP'ԍ MCI Comments at 1819; MCI Reply at 7. P MCI also includes a study of depreciation rates to support its conclusions.?xH xP'ԍ MCI Comments, App. A. ? In  xparticular, MCI notes that depreciation reserve deficiencies are not excessively high at this  Y 4time.y (  xP'ԍ See, e.g., MCI Comments, App. A at 14. See also NCTA Reply at 78.  Y 4 "}29. Several commenters claim that MCI's depreciation study assumes what it purports  Y 4 xoto prove, that the Commission's prescribed depreciation lives are not unreasonably long.z  xP>'ԍ USTA Reply, Att. D at 12; Southwestern Bell Reply at 1516 and App. A at 12; US West Reply at 2728; NYNEX Reply at 11. US  xWest asserts that the amount of reserve deficiency is not indicative of whether depreciation lives  Y 4 x7are reasonable.@{  xPh'ԍ US West Reply at 2324.@ US West also asserts that MCI proposes updating depreciation rates only  xevery four years, and that this is inconsistent with the current simplified depreciation prescription  Yy4 xprocess.=|y xP 'ԍ US West Reply at 25.= USTA asserts that MCI underestimates the current depreciation reserve deficits.S}y0 xPZ"'ԍ USTA Reply, Att. C at 1819, Att. D at 13.S  xoSpecifically, according to USTA, several LECs have stopped using FASB 71, and this resulted"b`}0*&&aa"  xin almost $39 billion in additional depreciation reserve deficiencies for the seven BOCs, GTE,  Y4Frontier, and SNET.C~ xPb'ԍ USTA Reply, Att. D at 68.C  Y4 "30. USTA argues that the Commission's prescribed depreciation rates are not  x"economic" depreciation rates, because they are based on the past history of LEC net salvage  Y4 xrates, retirements, and remaining lives, rather than the economic obsolescence of capital.X xP'ԍ USTA Comments at 1819; USTA Reply, Att. D at 26. See also US West Comments at 1314; GTE Comments at 17; BellSouth Comments at 1314; Southwestern Bell Comments at 9 and App. A at 24; USTA Reply, Att. C at 1718; Bell Atlantic Reply, Att. 1 at 7; NYNEX Reply at 18; US West Reply at 25, 27; GTE  xP 'Reply at 10.  Southwestern Bell also cites a number of revisions to the prescribed depreciation rates that made  xP 'the rates inconsistent with "economic" depreciation rates Southwestern Bell Comments at 910, citing, e.g., Amortization of Depreciation Reserve Imbalances of Local Exchange Carriers, CC Docket No. 87447, 3 FCC Rcd 984, 98688 (paras. 1725) (1988); Amendment of Part 31 (Uniform System of Accounts for Class A and Class B Telephone Companies) so as to permit depreciable property to be placed in groups comprised of units with expected equal life for depreciation under the straight-line method, Docket No. 20188, 83 F.C.C.2d 267 (1980).   xSouthwestern Bell maintains that LECs need to depreciate their plant and equipment now so that  Y_4 xthey can modernize their networks to provide more sophisticated services.H_  xP'ԍ Southwestern Bell Reply at 67.H Southwestern Bell  x!also denies that it advocates accelerated depreciation to get current ratepayers to finance future  Y14 xdeployment of newer plant.1  xPb'ԍ Southwestern Bell Reply at 78. See also Bell Atlantic Reply, Att. 1 at 12 (asserting that even BEA lifetimes might not be fast enough to reflect economic obsolescence completely). On the other hand, USTA asserts that current customers have  Y 4 xalways had to finance future technological improvements.E  xP'ԍ USTA Reply, Att. D at 1314.E Some parties argue that  xdepreciation prescriptions are relevant only in enforcing rateofreturn regulations or calculating  Y 4 xsharing obligations.o h xP'ԍ USTA Reply at 1718; GTE Reply at 1112; Pacific Reply at 1314.o GTE claims that Jorgenson assisted BEA with updating its depreciation  Y 4 xlifetimes.<  xP~'ԍ GTE Comments at 17.< Some commenters also argue that it is not fair to require LECs to use longer  x^depreciation lives than IXCs or cable companies are permitted to use for the same or similar  Y 4 xplant and equipment.  xP"'ԍ NYNEX Comments at 1819; GTE Reply at 1011; Southwestern Bell Reply at 46; Ameritech Reply at 34; USTA Reply, Att. D at 811. US West alleges that the Commission's depreciation rates are longer" a0*&&aa"  Y4 xbthan those reported by the LECs to the Securities and Exchange Commission (SEC).@ xPy'ԍ US West Reply at 2425.@ Pacific  xoargues that, since the price cap rules prohibit carriers from passing depreciation rate changes to  xratepayers, the Commission has no reason to base the XFactor on prescribed depreciation  Y4rates.@X xP'ԍ Pacific Reply at 1314.@  Y4 "31. Some parties note that, under the 1996 Act, the Commission is no longer required  xHto prescribe depreciation rates, and so should not mandate prescribed depreciation rates in TFP  Y_4 xmeasurement._ xP 'ԍ Ameritech Reply at 4; GTE Reply at 1112, citing 1996 Act. See also USTA Comments at 20. MCI replies that, regardless of whether the Commission continues to prescribe  YH4depreciation rates, it will probably continue to retain some oversight over depreciation rates.8Hx xPq'ԍ MCI Reply at 7.8  X 4` `  (4) Hedonic Adjustments  Y 4 "32. AT&T and Ad Hoc argue that technological developments since the early 1980s have  xmade it possible for LECs to increase their productivity growth substantially, and that some of  xthis productivity growth might not be captured completely by examining changes in the prices  Y 4 xor quantities of capital inputs.  xP`'ԍ Ad Hoc Comments at 2627 and Att. at 3642; AT&T Comments, App. A at 5158; AT&T Reply at 34; Ad Hoc Reply, Att. at 27. Ad Hoc maintains that GDPPI does not make adjustments for  Y4 xchanges in quality.E`  xP'ԍ Ad Hoc Comments, Att. at 29.E Ad Hoc states that the Commission should either adopt a price deflator  xUother than GDPPI that would take these technological improvements into account explicitly, or  Yb4 x adopt an input price adjustment and retain the consumer productivity dividend.Fb  xP'ԍ Ad Hoc Comments, Att. at 42. F Ad Hoc makes  x;no recommendation at this time as to how to adjust for technological improvements, but asserts  xZthat, if this adjustment was a 10 percent annual decrease in the price indices for the input  xcategories which include computers, then this would increase the XFactor by about 0.4  Y4percent.<X  xP7"'ԍ Ad Hoc Comments, Att. at 5758. In its reply, Ad Hoc claimed that a 10 percent hedonic adjustment would increase the XFactor by 1.0 when based on data from 1990 to 1994, or 1.1 percent when based on 1989 to 1993, or from 1989 to 1994. Ad Hoc Reply at 4 and Att. at 3637. < (Indices reflecting the effects of technology changes are called "hedonic" indices.) "b0*&&aa"Ԍ Y4 "M 33. Several commenters argue that AT&T and Ad Hoc have not adequately justified the  Y4 xUlevel of their recommended hedonic adjustments. xPb'ԍ USTA Reply, Att. A at 1718; Southwestern Bell Reply at 14; GTE Reply at 1213; Sprint Reply at 9; NYNEX Reply at 16; BellSouth Reply, Att. at 12. Lincoln also asserts that, by using deflated  x@revenues to measure outputs and inputs, USTA's model captures the majority of hedonic  Y4 xeffects.H  xP'ԍ Lincoln Reply at 12 and Att. B.H Some commenters also contend that it would be unreasonable to make hedonic  xadjustments to LEC input data without making such adjustments to the economywide input  Y4 xdata. xP 'ԍ USTA Reply at 12 and Att. A at 18; BellSouth Reply, Att. at 69; Southwestern Bell Reply at 15; NYNEX Reply at 16; Lincoln Reply at 1213. Lincoln and BellSouth contend that calculating accurate hedonic adjustments would  Yv4 xQrequire complicated and potentially controversial econometric models.`v xP/'ԍ Lincoln Reply at 1213; BellSouth Reply, Att. at 1213.` BellSouth and Bell  x^Atlantic maintain that AT&T's hedonic adjustment to the capital input results in an offsetting  YH4 xQadjustment to its input price differential, and so has no overall effect.#XH xP'ԍ BellSouth Reply, Att. at 1011; Bell Atlantic Reply, Att. 1 at 910. See also Sprint Reply at 9 (in a direct approach using only LECspecific data, any hedonic adjustment would affect input prices and TFP equally, and so would be superfluous).# On the other hand,  Y14CCTA supports making some hedonic adjustment.D1  xP'ԍ CCTA Reply at 1516, 1718.D  X 4` `  (5) The Flow of Capital Services  Y 4 "!34. USTA and US West assert that it is standard practice to impute capital services from  xcapital stock rather than capital consumption, and that it would be unreasonable to equate capital  Y 4 xservices provided with loss of capital efficiency, as they claim the Commission did.j H  xP'ԍ USTA Comments at 2223 and App. A at 21; US West Comments at 14. j USTA  x;analogizes telecommunications to a light bulb. According to USTA, a light bulb provides light  Yy4 x7at the same level of efficiency regardless of its age, until the bulb burns out.Ly xP 'ԍ USTA Comments, Att. A at 21. L AT&T also  xclaims that imputing the flow of capital services to be proportional to the aggregate stock is  xQconsistent with economic theory. AT&T claims further that capital consumption is a cost of  xocapital rather than a measure of capital input, and so should not be used as a measure of capital  Y4input.Fh xP6%'ԍ AT&T Comments, App. B at 13. F"c0*&&aa"Ԍ X4ԙ` `  (6) Implicit Rental Price  Y4 ""35. USTA asserts that its implicit rental price is based on a wellaccepted theory of  Y4 xcapital and can be updated on a timely basis.= xP4'ԍ USTA Comments at 23.= US West and GTE support USTA's method of  Y4 xdeveloping implicit rental prices.ZX xP'ԍ US West Comments at 1415; GTE Comments at 1920.Z GTE also contends, however, that the implicit rental price  Y4 x.introduces volatility to input prices.< xP& 'ԍ GTE Comments at 20.< USTA and US West suggest using a threeyear moving  Yv4average for the implicit rental price.Xvx xP 'ԍ USTA Comments at 23; US West Comments at 1415.X  YH4 "<#36. For purposes of calculating the implicit rental price in its simplified TFP method,  xoUSTA bases the cost of capital on the implicit cost of capital embedded in National Income and  x!Product Account data, claiming that this is the closest approximation of the opportunity cost of  Y 4 xcapital that can be based on publicly available data.@  xP'ԍ USTA Comments at 1617.@ USTA also asserts that its revised cost  xoof capital includes both debt and equity costs, and so is an improvement over the cost of capital  Y 4 xin its original TFP Model.   xP'ԍ USTA Reply at 8. See also USTA Comments at 17. A number of parties criticize USTA's original TFP study because it used Moody's Public Utility Bond yields to determine the cost of capital, which incorrectly excludes the cost of equity. Ad Hoc, App. at 18; AT&T Comments at 1819 and App. A at 4547; USTA Comments at 17; Southwestern Bell Comments at 7 n.12.  US West argues that the National Income and Product Accounts  Y 4 xtreat LEC cost of capital and the economywide cost of capital symmetrically.C  xP'ԍ US West Comments at 1213.C Ad Hoc argues  xthat an economywide measure of the cost of capital is not appropriate for LECs because the  Y4 xgeneral economy is more competitive than the LEC industry is currently.P xPQ'ԍ Ad Hoc Reply at 45 and Att. at 2932. P GTE agrees that  x!the cost of capital should include both debt and equity costs, but would support basing the cost  Yb4 x.of capital on either Moody's Utility Bond yields or National Account data.<b xP!'ԍ GTE Comments at 16.< In its comments,  xAd Hoc suggests adjusting Moody's Bond yields to reflect the fact that taxes apply only to  xreturns on equity, not interest paid on debt, although it supports AT&T's cost of capital measure  Y4in its reply.K0 xP%'ԍ Ad Hoc Comments, Att. at 19.K"d0*&&aa"Ԍ Y4 "ԙ$37. AT&T maintains that USTA's original model assumed a fixed cost of capital, and  xthen adjusted capital stock to a costminimizing level. AT&T and Ad Hoc also assert that this  Y4 xtreatment does not measure the actual level of capital input. xPK'ԍ AT&T Comments at 1920 and App. A at 3145; AT&T Reply at 32; Ad Hoc Reply, Att. at 2829. Therefore, rather than relying  xon any implicit rental price calculation, AT&T bases the weight placed on its capital input index  xrelative to labor and materials on the price cap LECs' actual earnings. Specifically, AT&T  xbases the weight of the labor input index on total compensation, the weight of the materials input  x7index on a materials price index, discussed further below, and the wight of the capital input  xtindex on total revenues minus the sum of total labor compensation and materials expense.  xAccording to AT&T, USTA's approach in effect allocates a fixed amount of revenue to capital,  x|and this results in a guaranteed return on capital regardless of performance. AT&T argues this  Y 4 xUcreates the same incentives as rateofreturn regulation.@ X xP# 'ԍ AT&T Comments at 2022.@ Ad Hoc asserts that USTA's cost of  Y 4 xbcapital measurement results in understating the input price differential.B  xP'ԍ Ad Hoc Reply, Att. at 30.B AT&T's model treats  Y 4 xthe LECs' actual returns as an input cost that must be attributed to capital, labor, and material.T x xP'ԍ AT&T Comments at 2022 and Att. A at 3147.T  xUAT&T measures the cost of capital as equal to the amount by which total revenues exceed total  Y 4 xcosts.=  xPw'ԍ AT&T Comments at 21.= AT&T asserts that its method of calculating the cost of capital is closer to BLS's  Y 4 xmethod than USTA's method is.B  xP'ԍ AT&T Reply, App. B at 48.B Ad Hoc supports AT&T's method of basing the weights  Y4 xassigned to the three input indices on earnings.E(  xPi'ԍ Ad Hoc Reply, Att. at 2728.E Sprint alleges that USTA's definition of  Yy4 xcapital costs results in overweighting capital input prices.>y  xP'ԍ Sprint Comments at 9.> Sprint maintains that USTA's  x*opportunity cost of capital is not reasonable, because most telecommunications capital assets  xcannot be sold outside the telecommunications industry, and so USTA's treatment overstates the  Y44weight given to the capital input index relative to the labor and materials indices.D4H  xP-!'ԍ Sprint Reply, Att. A at 30.D  Y4 "%38. USTA and a number of LECs assert that AT&T's weighting of the capital input  x;index replicates the incentives of rateofreturn regulation, because it results in limiting carriers"e0*&&aa"  Y4 xto a particular rate of return. xPy'ԍ USTA Reply at 2021; Att. A at 17, Att. C at 46; NYNEX Reply at 1516; BellSouth Reply, Att. at 2329; GTE Reply at 910; Bell Atlantic Reply at 3; Southwestern Bell Reply at 10. USTA also claims that AT&T's cost of capital fluctuates with  xthings such as changes in demand or booking the costs of an early retirement program, and  Y4 xasserts that it is unreasonable to permit this fluctuation in the cost of capital.K  xP'ԍ USTA Reply, Att. B. at 89, 1112.K USTA maintains  xthat it is inappropriate to use total revenue to estimate cost of capital in industries with non Y4 xconstant returns to scale.B xP 'ԍ USTA Reply, Att. A at 16.B USTA and Bell Atlantic contend that AT&T uses the book value  Y4 xof capital, while the replacement value of capital is more economically meaningful.@ xP~ 'ԍ USTA Reply, Att. A at 2021, Att. B at 67, 911, Att. C at 1415; Bell Atlantic Reply, Att. 1 at 67. USTA  x*and NYNEX reply that it is reasonable to assume that firms in the telephone industry adjust  Y_4 xcapital inputs to costminimizing levels.U_ xP'ԍ USTA Reply, Att. C at 16; NYNEX Reply at 10.U USTA also asserts that it is difficult to estimate the  xweight to assign to an input when it is not being used at its costminimizing level, and that this  xshould not be used unless there is a strong indication that inputs are not being used at an optimal  Y 4 xlevel in a particular industry.E `  xP+'ԍ USTA Reply, Att. A at 1516.E Finally, USTA contends that AT&T's model contains several  Y 4careless mistakes.E  xP'ԍ USTA Reply, Att. B at 1213.E  Y 4 ""&39. MCI and TRA argue that the Commission has determined that the LECs' cost of  xHcapital is 11.25 percent, and the LECs should be required to continue to use this cost of capital  Y 4 xuntil the Commission revises its determination.X  xP'ԍ MCI Comments at 1718; TRA Reply at 5. MCI also claims that, if the Commission were to conduct a  xP'represcription proceeding, it would find that the cost of capital has fallen to 9.54 percent. MCI Comments at 18 n.29. TRA also argues that relying on the cost of  xcapital determined by the Commission would be less administratively burdensome than trying  Yy4 xto recalculate the cost of capital in every annual access filing.8y xP 'ԍ TRA Reply at 5.8 Some LECs oppose adopting  xxthe prescribed rate of return as the cost of capital because it tends to tie the price cap plan to  YK4 xrateofreturn regulation.qK0 xP,$'ԍ US West Comments at 13; GTE Comments at 1617; BellSouth Comments at 13.q Southwestern Bell argues that the prescribed rate of return was not"Kf0*&&aa"  Y4 xconsistent over time.?X xPy'ԍ Southwestern Bell Comments at 7. Southwestern Bell also asserts that some parties in earlier phases of this proceeding did not use a consistent approach when comparing the LECs' cost of capital with the costs of capital in other industries. Southwestern Bell Comments at 78. ? US West argues that a rateofreturn represcription proceeding is  Y4 xadministratively burdensome.e xP'ԍ US West Comments at 13. See also USTA Comments at 18.e Ad Hoc and US West observe that, because the Commission  xdoes not represcribe the rate of return annually, it may not be an accurate measure of the cost  Y4 xof capital every year.cx xP 'ԍ US West Comments at 13; Ad Hoc Comments, Att. at 19.c US West observes that BEA does update its cost of capital annually.A xPt 'ԍ US West Comments at 13. A  x BellSouth and USTA deny that the prescribed rate of return is the "opportunity cost" of debt and  xequity, and claim that USTA's use of the National Income and Product Accounts results in a  Yv4 xcloser approximation.1Xv xP'ԍ BellSouth Comments at 12; BellSouth Reply, Att. at 2526; USTA Comments at 1718; citing Barbeau,  xP'Grimm, Phillips and Selzer, Railroad Cost Structure Revisited, 28 Transportation Research Forum 237 (1987); USTA Reply, Att. B at 45.1 On the other hand, Bell Atlantic asserts that the Commission's  xQprescribed rate of return is an "economic" rate of return rather than an "accounting" rate of  YH4return, because it is based on cash flows and market values.CH  xP'ԍ Bell Atlantic Reply at 10.C  Y 4 "Z'40. AT&T claims that USTA appears to use average tax rates in its implicit rental price,  xxand that this is less reasonable than using estimated marginal tax rates, as AT&T claims BLS  Y 4 xuses.B H  xP'ԍ AT&T Reply, App. B at 49.B Bell Atlantic alleges that AT&T's tax treatment of debt and equity implicitly assumes  Y 4 xthat the pretax cost of debt is equal to the posttax cost of equity.L  xP^'ԍ Bell Atlantic Reply, Att. 1 at 78.L USTA asserts that it bases  xtaxes on the tax expenses reported in Form M, and that its method adequately accounts for the  Y 4 xdifferences between the tax treatment of debt and equity.E h xP'ԍ USTA Reply, Att. A at 1315.E Sprint claims that the implicit rental  xprice analysis used by USTA was developed to assist in tax analysis at the firm or division level,  xand argues that pretax capital consumption provides a more accurate measure of productivity.  xSprint also claims that USTA distorts the value of capital relative to labor and materials by  YK4treating those two inputs as before taxes.HK xP$'ԍ Sprint Reply, Att. A at 2932. H "4g0*&&aa"Ԍ Y4 "<(41. USTA opposes AT&T's method of equating total cost and total revenue. USTA  xmaintains that this improperly assumes that LECs always earn no more than their opportunity  Y4 x7cost of capital.K xPK'ԍ USTA 1997 Comments, Att. 6 at 56.K USTA also maintains that by assuming that cost equals revenue, AT&T's  Y4 xmodel measures past changes in prices rather than past changes in productivity.KX xP'ԍ USTA 1997 Comments, Att. 6 at 67.K USTA claims  x% that AT&T's measure of the cost of capital overstates the XFactor by 1.7 percent from 198894,  Y4and 2.2 percent from 198994.I xP& 'ԍ USTA 1997 Comments, Att. 6 at 7.I  X_4` ` b. Labor  Y14 ")42. USTA asserts that creating more disaggregated labor indices would complicate the  Y 4 xTFP calculations without improving their accuracy.| x xPC'ԍ USTA Comments at 23. See also GTE Comments at 2021; US West Comments at 15.| USTA also contends that management  xand nonmanagement hours are not publicly available data, and so replaces USTA's two labor  Y 4 xindices in its original TFP study with one index, number of employees as reported in ARMIS.|  xP'ԍ USTA Comments at 2324. See also GTE Comments at 20; US West Comments at 15.|  x% USTA observes that creating only one labor index moots the issue of how to weight two or more  Y 4 xcategories.=  xP'ԍ USTA Comments at 24.= Finally, USTA maintains that the simplified TFP method captures the effects of  Y 4"outsourcing" in the materials index.= (  xP'ԍ USTA Comments at 24.=  Yy4 "V*43. Sprint contends that USTA improperly compares LECspecific laborcost growth  xkwith BLS data for the economywide costs of labor. According to Sprint, it would be more  x@appropriate to compare the economywide BLS data with BLS data for labor costs in the  xtransportation and public utilities industries. Sprint argues that USTA has incorrectly concluded  x|that the LECs' labor costs have grown more quickly than for the economy as a whole, when in  Y4fact those labor costs have grown more slowly than for the economy as a whole.G  xPo!'ԍ Sprint Reply, Att. A at 3741.G  Y4 "+44. Ad Hoc claims that USTA's treatment of OPEB accounting changes and voluntary  xearly retirement programs should be amortized over some period, to avoid overstating the actual"hH 0*&&aa"  Y4 xgrowth of labor inputs, and thus understating TFP growth.k xPy'ԍ Ad Hoc Comments, Att. at 28. See also Sprint Reply at 910.k GTE replies that Ad Hoc's  xdetermining which labor inputs were incurred prudently or imprudently would treat labor inputs  Y4 xxinconsistently with other inputs.X xP'ԍ GTE Reply at 14. See also Lincoln Reply at 11 (determining whether to include or exclude any given input cost might make TFP calculations unnecessarily complex). USTA and GTE claim that booking costs associated with  Y4 x*OPEBs and voluntary retirement programs is consistent with GAAP and RAO Letter 24. xP 'ԍ USTA Reply at 1819; GTE Reply at 1314, citing RAO Letter 24, 9 FCC Rcd 1676 (Com. Car. Bur., Accounting and Audits Div., 1994).  xxAccording to Lincoln, if LECs are not permitted to claim OPEB costs as an exogenous cost,  Y4 xthey should be permitted to include OPEB costs in their labor input costs.@ xPF 'ԍ Lincoln Reply at 1011.@ Lincoln contends  xthat it would be unreasonable to exclude the costs associated with voluntary retirement programs  Y_4 xowhile including the efficiencies gained by reducing the number of employees.@_ xP'ԍ Lincoln Reply at 1112.@ USTA asserts  xthat any further amortization would not change the amount of labor inputs, but would simply  Y14 xUsmooth the data. USTA contends that smoothing is not necessary in this case.=1(  xP 'ԍ USTA Reply at 1819.= According to  xLincoln, the XFactor will not be based on expected future levels of inputs, so onetime costs  Y 4should not skew the results.=  xPl'ԍ Lincoln Reply at 11.=  X 4` ` c. Materials  Y 4 "@,45. USTA and some LECs argue that creating disaggregated materials indices would be  xoa very complicated task, that there are no publicly available data on which to base such indices,  Yy4 x and assert that GDPPI is a reasonable proxy for materials prices.iyH  xPr'ԍ USTA Comments at 25; US West Comments at 16; GTE Comments at 21.i Sprint and AT&T deny that  Yb4 x GDPPI is an accurate surrogate for LEC materials input prices.Wb xP 'ԍ Sprint Reply at 10; AT&T Reply, App. B at 48. W Sprint provides data showing  xHthat the inputs used most by LECs are not the same as those reflected the most in GDPPI, and  x7that using GDPPI for materials prices grossly overstates the change in material input prices  Y4experienced in telecommunications.th xP6%'ԍ Sprint Reply, Att. A at 3236. See also Ad Hoc Comments, Att. at 29.t"i0*&&aa"Ԍ Y4 "[ԙ-46. AT&T developed a LECspecific materials input price index based on BLS  Y4 xUinterindustry accounts for the goods and services it believes are purchased by LECs.H xPb'ԍ AT&T Comments, App. A at 1819.H USTA  x*replies that AT&T's materials index is based on complex and unverified calculations, and is  Y4based only on transactions between telecommunications firms and other firms.NX xP'ԍ USTA Reply at 20 and Att. A at 2122.N  Y4 "M.47. USTA claims that AT&T's materials price index includes data from IXC purchases,  xand purchases of radio and television broadcasters, and so is not a good proxy for purchases  Y_4 xmade by LECs.O_ xP 'ԍ USTA 1997 Comments, Att. 6 at 2023. O USTA claims that this overestimates the XFactor by 0.4 percent from 1988 YH4 x94, and 0.9 percent from 198994.NHx xPq'ԍ USTA 1997 Comments, Att. 6 at 2023. N AT&T admits that its materials price index is not perfect,  Y14but claims that it is much better than USTA's use of GDPPI.Z1 xP'ԍ AT&T Reply in CC Docket No. 96262, App. G at 30.Z  X 4` ` d. Weighting of Materials and Labor Indices  Y 4 "V/48. USTA claims that AT&T improperly calculates materials expense because it used  x*the change in depreciation reserves instead of actual recorded depreciation and amortization  x expense, and total compensation instead of wage, salary, and benefit expense. USTA claims that  xmaterials expense is underestimated because total compensation includes labor costs capitalized  xin the construction of new facilities that are not included in total operating expense. USTA  xclaims that changes in depreciation reserves understates depreciation expense and thus causes an  xoverstatement of materials expense. USTA claims that labor expense is overstated by total  xcompensation. USTA maintains further that misstating labor and materials expenses results in  xxmisstating the weight placed on the capital input index, because capital is weighted residually  xby subtracting the weights places on labor and materials from total revenues. USTA claims that  x!these alleged errors in AT&T's model are offsetting, and so have no effect on the XFactor in  xAT&T's model. USTA claims further that these errors result in an understatement of 0.2  x|percent in TFP for the period from 1988 to 1994, and an understatement of 0.3 percent for the  Y4 xperiod from 1989 to 1994.M xP!'ԍ USTA 1997 Comments, Att. 6 at 1720.M In its 1997 reply, AT&T states that it has switched to depreciation  xand amortization expense, rather than using change in depreciation reserves as it had  Y|4previously.L|(  xPU%'ԍ AT&T 1997 Reply, App. G at 3435. L !X C:\DOCUMENT\4THORD\APPB.1! "|j 0*&&aaQ"Ԍ X4 !C:\DOCUMENT\4THORD\APPB.2!  Y4D. Other XFactor Calculation Issues  X4 1. Input Price Differential  Y4 "049. Several parties support including the shortterm input price differential. xP'ԍ US West Comments at 7; AT&T Comments at 1112 and App. A at 617; AT&T Reply at 811 and App. B at 1519; US West Reply at 13; GSA Reply at 57; NCTA Reply at 78; CCTA Reply at 1516. Ad Hoc  xargues that rates in competition would reflect only shortterm input price differential rather than  xthe general inflation rate, and so the input price differential information preceding divestiture  YI4 xUis not relevant.gI  xP 'ԍ Ad Hoc Comments, Att. at 3034; Ad Hoc Reply, Att. at 1213. g According to Ad Hoc and other parties, the local exchange industry is much  x!more capital intensive than the economy as a whole. Ad Hoc also maintains that USTA's data  xindicates that labor input prices have grown more rapidly than capital input prices from 1984  xto 1992, and concludes from this that LEC input prices must have grown more slowly than  Y 4economywide input prices.  xPN'ԍ Ad Hoc Comments, Att. at 3435; Ad Hoc Reply, Att. at 1617. See also GSA Reply at 6; AT&T Reply, App. B at 78; CCTA Reply at 1617.  Y 4 "150. AT&T calculated the input price differential for the period from 1985 to 1994, using  x.BLS statistics rather than relying on data from Christensen's study as the Commission did, and  Y4 x.found it to be 2.54 percent.T xPJ'ԍ AT&T Comments at 1213 and App. A at 1722.T Ad Hoc contends that the input price differential for the period  xfrom 1984 to 1993 is 2.1 percent based on USTA's data, or 3.4 percent based on USTA's data  Yc4 x.corrected for certain errors alleged by Ad Hoc.Bc xP'ԍ Ad Hoc Reply, Att. at 12.B Ad Hoc contends that USTA's conclusions  YL4 xkare based on improper use of dummy variables.EL(  xP%'ԍ Ad Hoc Reply, Att. at 1825.E BellSouth alleges that AT&T improperly  Y54 xcompares input price levels rather than growth in input prices.Q5  xP'ԍ BellSouth Reply, Att. at 1314. Q BellSouth and Bell Atlantic  xassert that AT&T's hedonic adjustment results in overstating capital input growth, which in turn  Y4 xunderstates capital input price increases, and so artificially inflates the input price differential.H  xP#'ԍ BellSouth Reply, Att. at 89; Bell Atlantic Reply, Att. 1 at 89. See also Ad Hoc Reply, Att. at 18.  x.According to Bell Atlantic, adjusting for the effects of AT&T's hedonic adjustment reduces its"k0*&&aa"  Y4 x|input price differential from 2.54 percent to 0.91 percent. xPy'ԍ Bell Atlantic Reply, Att. 1 at 1011. See also USTA Reply, Att. B at 2223 (removing effects of hedonic adjustment results in input price differential of 0.28 percent). USTA asserts that 2.54 percent is  Y4 xnot statistically significant.F  xP'ԍ USTA Reply, Att. B at 2324. F When Sprint compared its price indexes for capital, labor, and  xmaterials to its economywide input price index, it found that the fiveyear moving averages for  Y4the period from 1985 to 1993 ranged from 1.64 percent to 0.84 percent.G xP 'ԍ Sprint Reply, Att. A at 4143.G  Y4 "251. Most of the LECs argue that the longrun input price differential is not statistically  Yv4 xQdifferent from zero.v@ xPg 'ԍ USTA Comments at 26 and App. C at 36; US West Comments at 7, 16; Southwestern Bell Comments at 11; NYNEX Comments at 21; BellSouth Comments at 1416; Bell Atlantic Comments at 1112; Lincoln Comments at 4; Ameritech Comments at 45; GTE Comments at 11 and App. B, App. F; NYNEX Reply at 5;  xP'USTA Reply, Att. A at 2325; Pacific Reply at 4, citing California PUC Opinion at 6869. USTA contends that the model it presented to the California PUC contained some revisions, but these revisions were only updating the model, and they had minor effects on the results of the model. USTA Reply, Att. A at 2831. According to USTA, AT&T places too much emphasis on the point  x!estimate of 2.2 percent, and not enough emphasis on the fact that zero is within the 95 percent  YH4 x&confidence interval.EH  xP'ԍ USTA Reply, Att. B at 1719.E USTA also asserts that AT&T's and Ad Hoc's results stem from  xdifferences in the method by which certain data series are collected, rather than any real long Y 4 xterm input price differential.= H  xP'ԍ USTA Reply at 1113.= USTA claims that the Commission did not place adequate weight  Y 4 xon a February 1995 ex parte statement, which purports to show that there has been very little  xdifference between LEC input price changes and economywide input price changes from 1948  Y 4 x&to 1992.n  xP^'ԍ USTA Comments at 2627. See also USTA Reply, Att. A at 2628. n Some parties allege that the Commission committed methodological errors in  Y 4 xAppendix F of the LEC Price Cap Performance Review. h xP'ԍ USTA Comments at 26 and App. C at 1014; GTE Comments at 1114; Southwestern Bell Comments at 12; Pacific Comments at 6. AT&T argues that USTA's LEC  xinput prices for capital and materials are closely related to GDPPI, and so artificially reduces  Y4 xothe input price differential.E xP#'ԍ AT&T Reply, App. B at 2528.E AT&T alleges that there are discrepancies between USTA's data  xand the data it used for the period from 1949 to 1984, and questions whether USTA did in fact"ylP0*&&aa"  Y4 xUtake its input price data from BLS.P xPy'ԍ AT&T Reply at 1920 and App. B at 813.P AT&T also alleges that USTA has improperly used total  xprivate sector data for the period from 1985 to 1993, rather than total private nonfarm sector  Y4 xUdata.EX xP'ԍ AT&T Reply, App. B at 1113.E AT&T claims that the Commission did consider the data in USTA's February 1995 ex  Y4 xUparte statement.= xPT'ԍ AT&T Reply at 1216.= AT&T replies that USTA's criticism of the data used by the Commission in  xHAppendix F is irrelevant, because the Commission focused on the post1984 period, and found  Y4a statistically significant input price differential using both sets of data relied on by USTA.rx xP 'ԍ AT&T Reply, App. B at 1415. See also Ad Hoc Reply, Att. at 1415.r  Y_4 "3352. A number of LECs assert that the input price differential was a temporary effect of  YH4 x!divestiture, and lasted only from 1984 to 1989.H xP'ԍ USTA Comments at 26 and App. C at 610; BellSouth Comments at 1416; Bell Atlantic Comments at 1213 and Att. 2; Lincoln Comments at 47 and Att. A; Bell Atlantic Reply at 45 and Att. 1 at 12. AT&T disagrees.=H`  xPY'ԍ AT&T Reply at 2021.= AT&T alleges that the  xUdata Bell Atlantic used to support this point are not the same as the data used in USTA's study,  x*and that the regression analyses Bell Atlantic conducted cannot be interpreted to support the  Y 4 xproposition that the input price differential was a temporary effect of divestiture.E  xP'ԍ AT&T Reply, App. B at 2025.E Ad Hoc  xoargues that divestiture was a major change in the industry, and that it is unreasonable to assume  Y 4 xthat such a change would result in merely a temporary change.B  xP'ԍ Ad Hoc Reply, Att. at 13.B In its reply, USTA claims that  xHthe input price differential is not related to divestiture at all, and that the input price differential  Y 4 xstarted to increase in 1980 and began declining in 1990.E  xPh'ԍ USTA Reply, App. B at 1415.E Ad Hoc also maintains that it is  xinconsistent for USTA to focus on TFP growth only since 1984, but to focus on longterm input  Yy4 xtprice differences.y xP 'ԍ Ad Hoc Comments, Att. at 4345; Ad Hoc Reply at 3 and Att. at 1113. See also TRA Reply at 34 (use of longterm data for input price differential hides the effects of divestiture.) USTA and Bell Atlantic reply that only use of longterm input price  Yb4differential data can provide an accurate picture of LEC input price trends.kb xP $'ԍ USTA Reply at 1011 and Att. A at 2226; Bell Atlantic Reply at 4.k "Km0*&&aa"Ԍ Y4 "453. Some parties assert that USTA's study was not designed to measure input price  xdifferential, and so the Commission's use of USTA's study in Appendix F did not produce  Y4 xUreliable results. xPK'ԍ Lincoln Comments at 4; Southwestern Bell Comments at 11; Southwestern Bell Reply at 1113; USTA Reply at 12 n.4. Ad Hoc denies that the Commission's results are not reliable simply because  Y4USTA did not intend its study to be used to derive the input price differential.?  xP'ԍ Ad Hoc Reply at 1314.?  Y4 "554. Several parties assert that the XFactor should represent a prediction of the LECs'  xachievable future productivity growth, and that including the input price differential in the X Y_4 xFactor would make it too volatile to have any predictive power, and could cause rate churn.`X_ xP 'ԍ Pacific Comments at 36; Pacific Reply at 4; US West Comments at 16; Lincoln Comments at 4;  xP 'NYNEX Comments at 22; NYNEX Reply at 6; USTA Reply, Att. A at 2226. See also Southwestern Bell Reply at 15 (past input price differential should not be relevant for setting future XFactor). `  x;AT&T contends that the Commission considered whether volatility in input prices was so great  xthat the input price differential was not statistically different from zero, and found this argument  Y 4 xunsupported by the data in the record.=  xP'ԍ AT&T Reply at 1618.= Some LECs assert that AT&T improperly assumes that  x!they are asserting that changes in GDPPI are identical to changes in LEC input prices. These  xbcommenters agree that the two are not identical, but argue that the differences balance out over  Y 4 xthe long run. `  xP'ԍ USTA Reply at 9 and Att B at 1617, 1921; Bell Atlantic Reply, Att. 1 at 56; GTE Reply at 2122; BellSouth Reply, Att. at 15. US West and GSA would not oppose using a fiveyear moving average for the  Y 4 x3input price differential.V  xP''ԍ US West Comments at 16; GSA Reply at 6.V USTA replies that using a moving average for the input price  Y 4differential would not cause it to be significantly different from zero.@ H  xP'ԍ USTA Reply, Att. at 21.@  Yy4 "}655. US West and GSA note that the input price differential tends to pass through unit  Yb4 xQcost reductions.fb xP 'ԍ US West Comments at 7; US West Reply at 13; GSA Reply at 57.f Pacific argues that including the input price differential for this reason is  YK4 xinappropriate.?Kh xPd#'ԍ Pacific Comments at 6.? GTE contends that including the input price differential adds a term to the PCI  Y44formula, thus complicating the formula.?4 xP%'ԍ GTE Comments at 1415.? "4n0*&&aa"Ԍ X4ԙ 2. Adjustment to XFactor for InterstateOnly Activity  X4` ` b. Discussion  Y4 "p756. Legal Considerations. AT&T argues that basing interstate rates on total company  xUTFP calculations would exceed our jurisdiction under Section 2(b) of the Communications Act,  Yv4 x 47 U.S.C.  152(b).@v xP'ԍ AT&T Comments at 1415.@ AT&T and other parties also contend that Smith and its progeny requires  x.carriers to make some reasonable allocation of its property between the interstate and intrastate  YH4 xjurisdictions, regardless of whether the Commission is employing rateofreturn regulation.HXHX xPQ 'ԍ Ad Hoc Comments at 67; AT&T Comments at 1517; MCI Reply at 8; Ad Hoc Reply at 89; TRA  xP 'Reply at 56; LDDS Reply at 45; AT&T Reply at 3031, citing, e.g., Smith v. Illinois Bell Telephone Co.,  xP '282 U.S. 133 (1930) (Smith).H  xAT&T argues that the difficulty in distinguishing interstate from intrastate productivity growth  Y 4 xdoes not justify adopting an inaccurate XFactor method.f x xPC'ԍ AT&T Reply at 2627, 29. See also API Reply at 4, 79.f TRA and Ad Hoc assert that the  xinability of measuring interstate TFP growth is cause to reject TFP as a method for calculating  Y 4the XFactor.W  xP'ԍ TRA Comments at 36; Ad Hoc Reply, Att. at 11.W  Y 4 "857. USTA contends that the Commission in the First Report and Order considered and  xrejected arguments that basing the XFactor on total company TFP might exceed the  Y4 xCommission's jurisdiction.= xP'ԍ USTA Comments at 29.= USTA and other parties also assert that relying in part on  xintrastate data in regulating interstate rates does not mean that the Commission is attempting to  Yb4 xregulate intrastate rates, and so such reliance does not violate Smith.b(  xP;'ԍ USTA Comments at 2930. See also Sprint Reply at 1314; US West Reply at 2933; Bell Atlantic  xP'Reply at 8, citing NARUC v. FCC, 737 F.2d at 1112. BellSouth claims that  xuse of total company TFP does not exceed the Commission's jurisdiction because TFP is merely  xone component in the PCI formula. TFP by itself does not determine whether any particular  Y4 xtariff rate is just and reasonable, according to BellSouth.E  xPN!'ԍ BellSouth Comments at 1819.E A number of commenters reply that  Y4 xDSmith requires only that the Commission limit its regulations to interstate services, not that it  Y4 xxis precluded from considering total company data.k xP$'ԍ NYNEX Reply at 89; Sprint Reply at 1314; Pacific Reply at 1213.k USTA maintains that Smith limits only"o0*&&aa"  Y4 xstate jurisdictions, and has no effect on Federal agencies.m xPy'ԍ USTA Reply at 1516, citing MCI v. FCC, 750 F.2d at 141.m USTA and Southwestern Bell argue that  Y4 x|AT&T's interpretation of Smith would have precluded the Commission from including GNPPI  Y4 x!in the original price cap formula.\X xP'ԍ USTA Reply at 1617; Southwestern Bell Reply at 10.\ GTE and Sprint note that the Commission has historically  xexamined total company data when determining the LECs' cost of capital for prescribing the rate  Y4of return for interstate services.M xP& 'ԍ GTE Reply at 32; Sprint Reply at 14.M  Y_4 "958. Systematic Downward Bias. Some parties argue that interstate productivity has  x;grown faster than total company productivity, and so basing TFP on total company data would  Y14 xtend to create downward bias in productivity growth measurements.1x xPZ'ԍ TRA Comments at 36; Ad Hoc Comments, Att. at 4648; API Comments at 45; AT&T Comments at 1314, 17; NCTA Reply at 78; TRA Reply at 3; API Reply at 36; LDDS Reply at 5; Ad Hoc Reply, Att. at  xP'67; MCI Reply at 8; GSA Reply at 45; AT&T Reply at 2126, and App. C at 35. See also NYNEX Comments at 2021 (although interstate TFP may not be economically meaningful, higher interstate output growth may warrant some TFP adjustment). AT&T asserts that this  xMdifference results in part in a difference in labor inputs required to provide interstate and  Y 4 xintrastate services.J  (  xP'ԍ AT&T Reply at 24 and App. C at 7.J AT&T also contends that the LECs' interstate services have a higher  xmarkup than their intrastate services, and so make a greater contribution to productivity  Y 4 xgrowth.q   xP>'ԍ AT&T Reply, App. C at 67. See also NYNEX Reply at 9.q CCTA argues that intrastate productivity growth is likely to be less than interstate  xxproductivity growth because some states employ rateofreturn regulations or impose sharing  Y 4 x|obligations, both of which tend to blunt efficiency incentives.=  H  xP'ԍ CCTA Reply at 1112.= Sprint suggests basing such an  Y4 xadjustment on marginal or incremental costs.?  xP'ԍ Sprint Reply at 1718.? BellSouth asserts that capital inputs have grown  x^faster than labor or materials inputs. According to BellSouth, if interstate services are more  xcapitalintensive than intrastate services, then AT&T's assumption that interstate and intrastate  YK4input growth are equal would tend to overestimate interstate input growth.H Kh xPd#'ԍ BellSouth Reply, Att. at 2023.H "4p 0*&&aa"Ԍ Y4 ":59. Ad Hoc and API argue that basing the XFactor on total company TFP might give  Y4 xLECs a windfall unless the states also adopt regulations based on total company data.[ xPb'ԍ Ad Hoc Comments, Att. at 4849; API Comments at 5.[  xbBellSouth contends that the Commission and state regulatory authorities have never coordinated  xtheir ratemaking methods before, and adopting a TFPbased XFactor would not require such  Y4coordination now.jX xP'ԍ BellSouth Comments at 1920. See also USTA Comments at 30.j  Yv4 "_;60. Various commenters maintain that there is no economically meaningful way to  xdevelop separate interstate and intrastate production functions, or to allocate joint and common  YH4 xcosts between the interstate and intrastate jurisdictions. H xP 'ԍ USTA Comments at 2729 and App. C at 1417; GTE Comments at 2122; Bell Atlantic Comments at 1314; BellSouth Comments at 1718; Lincoln Comments at 910; NYNEX Comments at 1819; Southwestern Bell Comments at 1214; US West Comments at 7, 17; Pacific Reply at 1012; GTE Reply at 2930; US West Reply at 2829; Bell Atlantic Reply at 67 and Att. 1 at 34; BellSouth Reply, Att. at 1516. AT&T and Ad Hoc argue that it is  x7possible to develop an interstate TFP measurement, by developing an interstate output index  xUbased on interstate services, and assuming that interstate inputs and intrastate inputs grow at the  Y 4 x!same rate.  xP'ԍ AT&T Comments, App. A at 2327; AT&T Reply at 2628, App. B at 3443, App. C at 11; Ad Hoc  xPL'Comments, Att. at 4950; Ad Hoc Reply at 3, 89, Att. at 811. See also API Comments at 6. Ad Hoc argues that, because separations rules require a relatively constant share  xof total investment and expenses, approximately 25 percent, to be allocated to the interstate  xjurisdiction, it is reasonable to assume that interstate and intrastate input growth are equal for  Y 4 xpurposes of calculating an interstate TFP adjustment.  (  xP'ԍ Ad Hoc Comments, Att. at 4950; Ad Hoc Reply at 3, 89, Att. at 8. According to Ad Hoc, the investment allocation to the interstate jurisdiction has fluctuated between 25.10 percent and 25.48 percent from 1991 to 1994, and expenses between 23.70 percent and 24.35 percent over this period. Ad Hoc Comments,  xP'Att. at 50. API asserts that USTA has not  Y 4 xemployed economically meaningful data to develop its intrastate output indexes.\  xPh'ԍ API Reply at 67, citing USTA Comments at 14.\ Ad Hoc  xalleges that some LECs have calculated intrastate TFP measures in proceedings before state  Yy4public service commissions.Ey xP 'ԍ Ad Hoc Reply, Att. at 1011.E "bq00*&&aa"Ԍ Y4 "I<61. In their replies, several commenters assert that there is no basis for assuming that  Y4 x|interstate input growth and intrastate input growth are equal. X xPb'ԍ USTA Reply at 1314; Lincoln Reply at 9; Bell Atlantic Reply at 7 and Att. 1 at 45; Southwestern Bell Reply at 10; US West Reply at 29 and Att. A at 57; GTE Reply at 3032; NYNEX Reply at 78; BellSouth Reply, Att. at 1620.  According to USTA, if it were  x*possible to separately measure interstate and intrastate productivity growth, faster growth in  xxinterstate outputs might have resulted in faster growth in interstate inputs, so that there might  Y4not be any difference between interstate and intrastate TFP growth.H xP= 'ԍ USTA Comments, App. C at 2021.H  Xv4  iF'` ` c. TFP Adjustment for Differences in Regulated and Nonregulated  X_4Productivity Growth (#  Y14 "=62. USTA asserts that, to the extent that Part 64 rules identify nonregulated costs that  x*are not joint or common with regulated costs, it is possible to develop a separate production  Y 4 x3function for nonregulated services.} x xP,'ԍ USTA Comments, App. C at 2122. See also Southwestern Bell Comments at 1415.} USTA and Southwestern Bell also claim that any  Y 4 xallocation of joint and common regulated and nonregulated costs is inherently arbitrary.g  xP'ԍ Southwestern Bell Comments at 15; USTA Comments, App. C at 22.g  xxAccording to BellSouth, basing the XFactor on the industrywide average, and employing a  xbfiveyear moving average, would make it difficult for a LEC to benefit from strategic activities  Y 4 xsuch as investing in unprofitable unregulated business activities.E  xP'ԍ BellSouth Comments at 2122.E Ad Hoc claims that the initial  x^investment required to begin providing certain nonregulated services or video services could  Yy4increase capital inputs, and thus decrease measured TFP growth.Hy(  xPR'ԍ Ad Hoc Comments, Att. at 5051.H  XK4` ` d. Reporting  Y4 ">63. BellSouth opposes expanding reporting requirements to include total company data.  xBellSouth argues that the reporting requirements need not be any more extensive than the TFP  Y4 xReview Plan attached to USTA's comments.f  xPX"'ԍ BellSouth Comments at 20, citing USTA Comments, App. B.f In general, Southwestern Bell recommends  x@eliminating reporting requirements, which it contends are relevant only for rateofreturn  Y4regulation or sharing.H  xP%'ԍ Southwestern Bell Comments at 3233. See also USTA Comments at 3031; Ameritech Reply at 6. "r0*&&aaz"Ԍ  X4 3. Effect of Universal Service and Other Subsidy Programs on LEC TFP ` `  Y4 " ?64. A number of commenters argue that total company TFP captures the effects of any  Y4 x@universal service fund or subsidy programs, and so no special adjustments are needed. xP'ԍ Southwestern Bell Comments at 1516; GTE Comments at 25; USTA Comments at 3132; US West Comments at 18.  xBellSouth contends that changes in universal service fund requirements are treated exogenously,  Yv4 xand supports continuing this treatment.Bv  xPG 'ԍ BellSouth Comments at 22.B CCTA notes the 1996 Act mandates universal service  xfund revisions, and asserts that the Commission is considering universal service fund issues in  YH4another proceeding.^H xP 'ԍ CCTA Reply at 21, citing 1996 Act, Section 254.^  X 4 4. Inclusion of Other Firms in Study  Y 4 "@65. Ad Hoc and API recommend including data from other industries in the TFP  Y 4 xocalculations, to limit LECs' ability to adjust their productivity to influence the XFactor.Z  @ xP'ԍ Ad Hoc Comments, Att. at 52; API Comments at 78.Z API  xalso argues that LECs are not yet subject to meaningful competition, and including data from  Y 4more competitive industries would cause the XFactor to replicate a competitive market better.=!  xP('ԍ API Comments at 67.=  Yy4 ""A66. Other parties argue that it would be difficult at best for a LEC acting by itself to  Yb4 x|manipulate its productivity growth to influence the industry average TFP.a"b`  xPs'ԍ BellSouth Comments at 2223; Frontier Comments at 5 n.7.a Other commenters  xargue that including nonLEC data in the TFP calculation would make the XFactor a less  Y44 xaccurate measure of LEC productivity growth.W#4  xP'ԍ US West Comments at 18; GTE Comments at 2324.W NYNEX opposes collecting nonLEC data  Y4 xbecause it would be administratively burdensome.$  xPN!'ԍ NYNEX Reply at 1112. See also Southwestern Bell Comments at 1617; Ad Hoc Comments, Att. at 52 (do not oppose including other firms in the TFP calculation, but do not believe adequate data are available). GTE argues that including other industries  x7would be inconsistent with the Commission's treatment of AT&T's XFactor, and with ICC  Y4 x precedent.<% xPx%'ԍ GTE Comments at 23.< Because it might be difficult to collect data from other industries, API recommends"sh%0*&&aa"  x!resolving any other issues regarding the calculation of the XFactor in a way that results in the  Y4highest possible XFactor.=& xPb'ԍ API Comments at 89.=  X4 5. Consumer Productivity Dividend  Y4 "IB67. AT&T argues that both its and USTA's models rely in part on data from periods  xpreceding the adoption of price caps, and argues that the CPD is still necessary to encourage  Y_4 xHproductivity growth higher than that under rateofreturn regulation.'_X xPh 'ԍ AT&T Comments at 3536; AT&T Reply at 41. See also MCI Comments at 7 (consumer productivity dividend necessary to help drive rates to economic costs). USTA and GTE assert  xxthat retaining the CPD to capture part of any additional productivity growth that might result  Y14 xUfrom eliminating sharing would be arbitrary.Q(1 xP'ԍ USTA Comments at 13; GTE Reply at 3435.Q USTA also alleges that the CPD simply forces  Y 4 xQprices down rather than increasing efficiency incentives.x) @ xP 'ԍ USTA Comments at 1314. See also USTA Reply at 46; Frontier Reply at 4.x In addition, GTE and BellSouth  Y 4claim that there was no principled basis on which to select 0.5 percent as the CPD.\*  xP'ԍ GTE Comments at 3536; BellSouth Reply, Att. at 39.\  Y 4 "IC68. Several parties assert that the CPD was adopted originally because of uncertainty  x regarding whether the XFactors in the original price cap plan would transfer a sufficient portion  x% of the benefits of lower unit costs to customers, or to ensure that productivity growth under price  x|caps exceeds growth under rateofreturn regulation. These commenters maintain that the CPD  xin the original price cap plan has served its intended purpose, and that it is no longer  Yb4 xnecessary.+b`  xPs'ԍ USTA Comments at 1214 and App. C at 33; GTE Comments at 36; Bell Atlantic Comments at 13; NYNEX Comments at 2728; USTA Reply at 25; Bell Atlantic Reply at 56; GTE Reply at 33; Frontier Reply  xP'at 34; NYNEX Reply at 14; Frontier Comments at 7, citing Policy and Rules Concerning Rates For Dominant Carriers, Further Notice of Proposed Rulemaking, CC Docket No. 87313, 3 FCC Rcd 3195, 340708 (para. 386) (1988). Ameritech expects increased competition in the future to obviate the need for a  YK4 xCPD.>,K xP !'ԍ Ameritech Reply at 4.> USTA argues that the price cap plan properly balances shareholder and ratepayer  Y44 xbinterests without the CPD.:-4 xP#'ԍ USTA Reply at 26.: Other parties argue that the simplified TFP method of calculating  x/the XFactor proposed by USTA, together with a moving average, would transfer all"t0-0*&&aa"  Y4 xproductivity gains to consumers, and so eliminates the need for the CPD.Y.  xPy'ԍ USTA Comments at 13; US West Comments at 1920; Bell Atlantic Comments at 13; Ameritech Comments at 8; BellSouth Comments at 28, Att. 1, Att. 2; Southwestern Bell Comments at 2021; NYNEX Comments at 28; USTA Reply at 2526; NYNEX Reply at 1415; Bell Atlantic Reply at 6; BellSouth Reply, Att. at 3839.Y Ad Hoc denies that  Y4basing the XFactor on a moving average would be an effective substitute for the CPD.B/ xPJ'ԍ Ad Hoc Reply, Att. at 40.B  Y4 "cD69. GTE does not expect LECs to be able to achieve productivity growth 0.5 percent  Y4 xhigher than historical levels.S0@ xP 'ԍ GTE Comments at 3637; GTE Reply at 3334.S AT&T argues that the LECs have installed new technology in  xrecent years, and expect the LECs to discover more efficient uses for that technology as time  Yv4 x7goes on.R1v xP'ԍ AT&T Comments at 3536; AT&T Reply at 42.R AT&T also replies that the CPD is a realistic estimate of additional productivity  Y_4growth that LECs should be expected to be able to achieve.=2_`  xPp'ԍ AT&T Reply at 4243.=  X14 6. Effects of Access Reform  Y 4 " E70. According to USTA, productivity estimates based on historical studies overstate the  Y 4 xproductivity potential of pricecap LECs under competition.C3  xP'ԍ USTA 1997 Comments at 19. C According to USTA, as  xincumbent LECs lose customers to competition, their output will decline, and as a result their  xmeasured productivity will decline. Therefore, USTA recommends basing the XFactor on a  x}fiveyear moving average of the TFP, so that reductions in productivity resulting from  Y4 xcompetition would be reflected in the XFactor.C4  xP'ԍ USTA 1997 Comments at 20. C USTA claims that the TFP differential (TFP  x3of LECs minus TFP for US economy as whole) is 2.7 percent, and will decrease by 0.4  xpercentage points each year if the Commission adopts USTA's recommendations for  YK4 xrestructuring the CCL charge and the TIC.5K xP !'ԍ USTA 1997 Comments at 21. See also USTA 1997 Reply at 4142; US West 1997 Comments at 4649; SWBT 1997 Reply at 37. Most incumbent LECs support USTA.6XKh xPd#'ԍ BA/NYNEX 1997 Comments at 5860; BellSouth 1997 Comments at 50 n.93; SNET 1997 Comments at 2830; US West 1997 Comments at 4649; Aliant 1997 Reply at 34; BellSouth 1997 Reply at 4142; SNET 1997 Reply at 2425.  xbBA/NYNEX argues that productivity growth will decrease as a result of competition unleashed"4u60*&&aa"  xby the 1996 Act, and so basing the XFactor on a fiveyear moving average TFP would likely  Y4 x overstate future achievable productivity.t7 xPb'ԍ BA/NYNEX 1997 Comments at 59. See also US West 1997 Comments at 46.t Alternatively, BA/NYNEX argues that we could rely  x;on a fixed TFPbased XFactor for a short period of time, until Bell competition will enable us  Y4 xIto deregulate incumbent LECs completely.f8X xP'ԍ BA/NYNEX 1997 Comments at 59; BA/NYNEX 1997 Reply at 2930. f GTE and SNET contend that growth in  x;competition and recovering more costs through flat rather than usage sensitive rates, will likely  Y4depress measured TFP growth.^9 xP& 'ԍ GTE 1997 Comments at 5758; SNET 1997 Reply at 2526.^  Y_4 "F71. AT&T notes that it recommended at least 8.8 percent in its pleadings filed in  YH4 xresponse to the Price Cap Fourth Further Notice.:Hx xPq'ԍ AT&T 1997 Comments at 70. In its reply, AT&T increases its XFactor recommendation to 9.0 percent, on the bases of updated data. AT&T 1997 Reply at 35 and Att. G. Several commenters recommend setting the  x!XFactor at 9.9 percent, on the basis of the pleadings of the CARE Coalition filed in response  Y 4 xto the Price Cap Fourth Further Notice.;  xP'ԍ API 1997 Comments at 2728; ICA 1997 Comments at 4; WorldCom 1997 Comments at 91; API 1997 Reply at 18. Ad Hoc also recommends increasing the XFactor  Y 4 xfor the reasons it explained in its comments in the Price Cap Fourth Further Notice.< (  xP'ԍ Ad Hoc 1997 Comments at 70; Ad Hoc 1997 Reply at 714. Ad Hoc also replies that its Price Cap  xP'Fourth Further Notice pleadings discredited USTA's XFactor studies. Ad Hoc 1997 Reply at 914. MCI also  xsupports increasing the XFactor to 9.9 percent, but only for five years, after which MCI argues  Y 4 xthat the XFactor should be based on TFP.A=  xP'ԍ MCI 1997 Comments at 25.A A number of price cap LECs maintain that the  xkXFactors recommended by AT&T and MCI greatly exceed their actual productivity growth  Y 4 x&under price cap regulation.>  xPh'ԍ BellSouth 1997 Comments at 50; BA/NYNEX 1997 Reply at 2729; SWBT 1997 Reply at 3739; Aliant 1997 Reply at 3. USTA has identified several purported computational and  xxmethodological errors in AT&T's, MCI's, and Ad Hoc's XFactor proposals in its pleadings  Yy4 x!filed in response to the Price Cap Fourth Further Notice.p?yh xP!'ԍ USTA 1997 Reply at 4244. See also BA/NYNEX 1997 Reply at 3031.p Ad Hoc recommends making any  xfundamental changes to price cap regulation in the price cap proceeding, and focusing on access  YK4 x.reform in this proceeding.B@K xP$'ԍ Ad Hoc 1997 Reply at 78.B According to GTE, AT&T and Ad Hoc maintain that incumbent  xLECs' interstate productivity is greater than their intrastate productivity, and included in their"4v@0*&&aa"  xXFactor recommendations an interstate TFP adjustment to account for this alleged difference  xin productivity. GTE further opposes any interstate TFP adjustment, because there incumbent  xLECs provide interstate and intrastate services using the same network, and so it would make  Y4no economic sense to assume that interstate productivity is greater than intrastate productivity.AA xP4'ԍ GTE 1997 Reply at 2728.A  Y4 " G72. PacTel and Aliant propose setting the XFactor equal to GDPPI.iBX xP'ԍ PacTel 1997 Comments at 4142; Aliant 1997 Comments at 8. i Sprint argues  x|that the Commission should discontinue the use of the current productivity factor for all baskets  xexcept common line, once all access charges have been reduced to geographically deaveraged  YH4 xTELRIC levels.FCH xP 'ԍ Sprint 1997 Comments at 53. F AT&T anticipates that access reform would increase productivity growth,  Y14because reducing rates to costbased levels would stimulate demand.BD1x xPZ'ԍ AT&T 1997 Reply at 3536.B  Y 4  IV. PRICE CAP STRUCTURE ISSUES ă  X 4 B. Sharing Obligations  X 4 1. FlowThrough Mechanism  Yz4 "H73. Several parties maintain that a moving average ensures that all reductions in unit  Yc4 x&costs are eventually passed through to access customers.Ec xP'ԍ USTA Comments at 40; Southwestern Bell Comments at 22; Ameritech Comments at 7; USTA Reply at 2324; BellSouth Reply, Att. at 3841; NYNEX Reply at 13, 19; GTE Reply at 38; Bell Atlantic Reply at 12. Ad Hoc emphasizes that it is  ximportant to include some flowthrough mechanism in the price cap plan, and recommends either  Y54 xsharing, the consumer productivity dividend (CPD), or both.cF5`  xPF'ԍ Ad Hoc Comments, Att. at 6264; Ad Hoc Reply, Att. at 40. c Ad Hoc and AT&T maintain  xthat the fiveyear moving average with a twoyear lag would flow through productivity  Y4improvements more slowly than the a competitive market would.]G  xP 'ԍ Ad Hoc Comments, Att. at 6668; AT&T Reply at 5052.]  Y4 "pI74. SNET argues that competition has become strong enough to act as a passthrough  Y4 xmechanism.=H  xP$'ԍ SNET Comments at 13.= GSA disagrees, and supports retaining sharing until competition is sufficiently"wH0*&&aaz"  Y4 x;developed to warrant removing price cap constraints.?I xPy'ԍ GSA Comments at 1011.? BellSouth asserts that the Commission  xhas placed excessive emphasis on unit costs. BellSouth also maintains that competition has  x.driven some rates to efficient levels, regardless of unit costs, and that we should not attempt to  Y4 xorecapture past productivity gains.CJX xP'ԍ BellSouth Comments at 89.C Ameritech opposes requiring LECs to pay a "premium" in  xthe form of a higher XFactor for the elimination of sharing, and alleges that any "premium"  Y4would be unreasonable given that competition is likely to increase in reaction to the 1996 Act.@K xP& 'ԍ Ameritech Reply at 56.@  X_4 2. Backstop Mechanism  Y14 "J75. Some parties maintain that, unless we can be certain that the XFactor is accurate,  Y 4 xkwe should retain a backstop mechanism.L x xPC'ԍ TRA Comments at 78; Ad Hoc Comments, Att. at 6869; TRA Reply at 8; Frontier Reply at 23. AT&T argues that we should retain sharing as a  Y 4 xbackstop mechanism until we gain experience with a TFPbased XFactor.qM  xP'ԍ AT&T Reply at 4445, 4748, 52 n.106. See also Ad Hoc Reply at 6.q Ad Hoc argues  xbthat, without sharing, there is no way to determine whether access rates are just and reasonable  Y 4 xxor excessive when compared with the LECs' cost of capital.N  xP'ԍ Ad Hoc Comments at 78. Ad Hoc also maintains that it would be less concerned about the elimination  xP'of sharing if the XFactor were sufficiently high and if the consumer productivity dividend were retained. Id. MCI and Ad Hoc assert that  x^some backstop mechanism is necessary in the longterm plan because they believe XFactors  Y 4 xohave been set too low in the past.O  xPH'ԍ MCI Comments at 2021; Ad Hoc Comments, Att. at 6062. Specifically, MCI argues that the sharing mechanism is necessary to force rates to economic costs. MCI Comments at 19. ICA argues that firms in competitive markets use earnings  xto measure their performance, and so LECs have no basis for opposing an earningsbased  Yy4backstop mechanism in the price cap plan.^PyH  xPr'ԍ ICA Comments at 78. See also LDDS Reply at 4.^  YK4 "<K76. USTA, Bell Atlantic and US West maintain that a moving average is adequate to  Y44 x*replace the backstop function of sharing.Q4 xP"'ԍ USTA Comments at 40; Bell Atlantic Comments at 56; US West Comments at 2425; USTA Reply at 24. Some commenters assert that, to the extent that  xparties advocate sharing to prevent overearnings, those arguments are inconsistent with the"x0Q0*&&aa"  Y4 xtheory underlying price caps.R xPy'ԍ USTA Reply at 46 and Att. C at 67; GTE Reply at 3536; Bell Atlantic Reply at 89, 12, citing AT&T  xPA'Performance Review, 8 FCC Rcd at 6970. These parties also argue that accounting rates of return are not  xan accurate reflection of performance, and that any measure of performance should be based on  Y4 xHan "economic" rate of return.nS  xP'ԍ Bell Atlantic Reply at 910; GTE Reply at 3637; USTA Reply, Att. C at 813. USTA claims that the Commission recognized the difference between economic and accounting costs when it revised the exogenous  xP3'cost rules in the LEC Price Cap Performance Review. USTA Reply, Att. C at 12, citing LEC Price Cap  xP'Perfromance Review, 10 FCC Rcd at 909091 (para. 295). USTA also claims that the "economic" rate of  xP 'return for the LECs from 1991 to 1994 was 8.94 percent. USTA Reply, Att. C at 1314, 2223.n NYNEX maintains that the court has rejected contentions that  Y4 xHsharing must be retained to ensure just and reasonable rates.T xP< 'ԍ NYNEX Reply at 21, citing National Rural Telecom Association v. FCC, 988 F.2d 174 (1993). Some parties reply that there is  xsufficient data in the record, and that the Commission has sufficient experience with price cap  Y4 xregulation, that a backstop mechanism is no longer necessary.kU`  xP'ԍ USTA Reply at 24; BellSouth Reply, Att. at 3940; GTE Reply at 37.k GTE argues that sharing is not  Yv4 xnecessary because TFP will produce accurate XFactors.<Vv  xP'ԍ GTE Comments at 40.< BellSouth also argues that any  xfurther need for sharing as a backstop mechanism should be outweighed by concerns over  YH4 x? blunting efficiency incentives.HWH  xPy'ԍ BellSouth Reply, Att. at 4042.H According to NYNEX, Congress identified price cap regulation  xas a mechanism to encourage infrastructure investment when it adopted the 1996 Act, and  Y 4eliminating sharing would further encourage infrastructure investment.X  xP'ԍ NYNEX Reply at 21, citing Section 706(a) of the Telecommunications Act of 1996, 47 U.S.C.  706(a).  X 4 3. LowEnd Adjustment Mechanism  Y 4 "L77. AT&T advocates eliminating the lowend adjustment mechanism because it has not  Y 4 xbproved necessary to protect LECs from underearnings.UY  xP'ԍ AT&T Comments at 3940; AT&T Reply at 5354.U AT&T alleges that some LECs have  xabused the lowend adjustment mechanism by, for example, using it to recoup expenses incurred  Yy4 xduring voluntary corporate downsizing.RZy0 xPZ"'ԍ AT&T Comments at 40; AT&T Reply at 5354.R A number of LECs advocate eliminating the lowend  Yb4 xadjustment mechanism as an unneeded vestige of rateofreturn regulation.[b xP$'ԍ USTA Comments at 43; US West Comments at 25; Southwestern Bell Comments at 3435; BellSouth Comments at 41; Frontier Comments at 10; US West Reply at 34. USTA and AT&T"by[0*&&aa"  x!argue that LECs facing potential underearnings may make an abovecap tariff filing, or seek a  xwaiver of the price cap rules, and so it is not necessary to retain the lowend adjustment  Y4mechanism.d\ xPK'ԍ USTA Comments at 43; AT&T Comments at 41; AT&T Reply at 54.d  Y4 "gM78. NYNEX and Bell Atlantic assert that, if we retain sharing, we should also retain the  Y4 xlowend adjustment mechanism for regulatory symmetry.Y]X xP'ԍ NYNEX Reply at 22; Bell Atlantic Reply at 1112.Y NYNEX also denies that it has ever  Yv4 xkabused the lowend adjustment mechanism.>^v xP 'ԍ NYNEX Reply at 2223.> Finally, NYNEX asserts that the Commission  Y_4 x;considered and rejected in the LEC Price Cap Perfromance Review contentions that abovecap  YH4filings make the lowend adjustment mechanism superfluous._Hx xPq'ԍ NYNEX Reply at 23, citing LEC Price Cap Perfromance Review, 10 FCC Rcd at 905859 (para. 223).  X 4 C. Number of XFactors`  (#  Y 4 " N79. Several parties recommend establishing multiple XFactors, maintaining that one X xFactor would not adequately account for the fact that LECs face different circumstances in their  Y 4 x service regions.`  xPw'ԍ SNET Comments at 7, 911; Lincoln Comments at 1112; AT&T Comments at 3031; US West Comments at 8, 2122; NYNEX Comments at 7; US West Reply at 1415; Lincoln Reply at 3. Sprint argues that more than one XFactor is necessary because not all LECs'  Y 4 xproductivity growth will meet or exceed the industry average.a `  xP'ԍ Sprint Comments at 10. See also US West Reply at 1314 (a single XFactor unfairly rewards or penalizes LECs at each end of the range). Lincoln asserts that a single  Y4 xxXFactor might discourage nonprice cap LECs from adopting price caps.<b  xP'ԍ Lincoln Reply at 3.< Cincinnati Bell  x!agrees with Lincoln, and recommends establishing a separate set of XFactor options for small  Yb4and midsized LECs.HcbH  xP['ԍ Cincinnati Bell Reply at 35. H  Y44 "O80. NYNEX proposes multiple XFactors and permitting carriers that lower barriers to  xcompetitive entry to use a lower XFactor, arguing that this would encourage the development"zc0*&&aa"  Y4 xbof competition.id@ xPy'ԍ NYNEX Comments at 45; NYNEX Reply at 28. Specifically, NYNEX recommends permitting carriers to use a lower XFactor if they have met certain items listed in the "competitive checklist" on which we sought  xP 'comment in the Second Further Notice. NYNEX Comments at 11, citing Second Further Notice, 11 FCC Rcd at 906 (para. 108). NYNEX would permit a LEC to use an XFactor of 75 percent of the baseline XFactor if it has met the checklist criteria in 75 percent of the service area, and at least one competitor is operational in the region. NYNEX would permit a LEC to use an XFactor of 60 percent of the baseline XFactor if there is a "competitive presence" in areas representing 40 to 50 percent of the LEC's business access lines. NYNEX  xP'Comments at 11. i Ameritech and SNET make similar proposals.ZeX xP 'ԍ SNET Comments at 69; Ameritech Comments at 1012. Similarly, Pacific argues that it has already removed barriers to entry in its region, and argues that it should be permitted to choose a lower XFactor now rather than delaying while it goes through some certification process. Pacific Comments at 89.Z Because NYNEX believes  x^that productivity growth is affected by competition, it also advocates permitting LECs to use  xdifferent XFactors in different parts of their service areas, and different XFactors for switched  Y4 xand special access services.f  xP\'ԍ NYNEX Comments at 12. See also Pacific Reply at 67, citing California PUC Opinion at 4041, 43, 4849. Pacific argues that requiring carriers to use the same XFactor  xin both competitive and noncompetitive parts of their service regions prevents LECs from  xlowering rates in their competitive regions and making up this revenue shortfall in non Yv4 xcompetitive regions.WgvH  xPo'ԍ Pacific Comments at 78; Pacific Reply at 56.W MCI contends that there is no evidence that LECs' productivity varies  Y_4by geographic area.<h_ xP'ԍ MCI Comments at 26.<  Y14 "P81. A number of commenters support only one XFactor because it would obviate the  Y 4 xneed for sharing as a matching mechanism.i h xP3'ԍ Southwestern Bell Comments at 25, 27, 33; BellSouth Comments at 4041 and Att. 1 at 11; Bell Atlantic Reply at 1213; BellSouth Reply, Att. at 4243. Some LECs maintain that one XFactor better  xreplicates the incentives of a competitive market, because it gives everyone an incentive to  Y 4 x|achieve productivity growth higher than the industry average.j  xP]'ԍ GTE Comments at 3739; Bell Atlantic Comments at 1112; BellSouth Comments at 34, 37; Bell Atlantic Reply at 12. Similarly, Ad Hoc argues that  xpermitting less productive LECs to choose a lower XFactor enables those LECs to avoid the  Y 4 x@penalty that inefficiency would bring in a competitive market.@k  xP#'ԍ Ad Hoc Comments at 89.@ BellSouth observes that  xkvariations in productivity growth among LECs may be caused by factors other than regional" {k0*&&aa"  Y4 xxeconomic differences, and many of those factors are within the LECs' control.El xPy'ԍ BellSouth Comments at 3637.E BellSouth  xassumes the purpose of multiple XFactors would be to create an "equality of outcomes" among  Y4 xLECs, and argues that this could substantially decrease efficiency incentives.VmX xP'ԍ BellSouth Comments at 3637, Att. 1 at 2224.V BellSouth  x;maintains that developing a set of "economically meaningful" XFactors other than the baseline  Y4 xXFactor would be complex and controversial.Mn xP= 'ԍ BellSouth Comments, Att. 1 at 1120.M GTE argues that one XFactor would be  Y4consistent with the approach adopted by the ICC.<ox xP 'ԍ GTE Comments at 38.<  X_4 V. UPDATING THE XFACTOR Đ\  Y14Q82. Several parties maintain that a moving average ensures that the XFactor accurately reflects the LECs' potential productivity growth, and so eliminates the need for  Y 4sharing as a backstop mechanism,p  xP'ԍ USTA Comments at 3435; BellSouth Comments at 3840; Bell Atlantic Comments at 910; SNET Comments at 1213; Ameritech Comments at 10; US West Comments at 20; NYNEX Reply at 1213. and the need for scheduled performance reviews.qX `  xP'ԍ USTA Comments at 3435; GTE Comments at 44; Southwestern Bell Comments at 24, 40; Ameritech Comments at 13; BellSouth Comments a 3031; US West Comments at 20; NYNEX Reply at 1314; Bell Atlantic Reply at 3. Some commenters maintain that a moving average is useful for smoothing out volatility in  Y 4TFP.xr  xP'ԍ Bell Atlantic Comments at 910; Ameritech Comments at 6; GTE Comments at 2831.x Southwestern Bell and BellSouth contend that a moving average replicates the effects of a competitive market, in that it permits carriers to retain productivity benefits for a short  Y 4period of time, and then flows through those benefits to consumers.ms  xPh'ԍ Southwestern Bell Comments at 2122; BellSouth Reply, Att. at 4142.m Bell Atlantic opposes performance reviews, arguing that as long as earnings are used to check the performance of price caps from time to time, the perverse incentives of rateofreturn regulation will not be  Yb4eliminated completely.Stb xP!'ԍ Bell Atlantic Comments, Kahn Aff. at 910.S Bell Atlantic argues that this blunts efficiency incentives, and tends  YK4to shift the risk of investment from shareholders to ratepayers.KuK0 xP,$'ԍ Bell Atlantic, Kahn Aff. at 1012.K "4|u0*&&aa"Ԍ Y4R83. Some parties maintain that a moving average gives LECs an incentive to  Y4manipulate their costs to reduce their shortterm measured productivity growth.Mv xPb'ԍ AT&T Comments at 34; TRA Reply at 7.M Some parties argue that an XFactor based on a moving average does not give LECs an incentive to lower rates to "economic costs," but merely measures how much the LECs have cut their  Y4rates in the past.uwX xP'ԍ MCI Comments at 1112; TRA Comments at 67; LDDS Reply at 4; TRA Reply at 7.u USTA and a number of LECs assert that an individual LEC's behavior would have limited effect on a fiveyear moving average, and so the incentives for LECs to increase efficiency would outweigh any benefit that a LEC might achieve by limiting its  Y_4productivity growth.x_ xP 'ԍ USTA Comments at 35; BellSouth Comments at 30; USTA Reply at 27; NYNEX Reply at 13; GTE Reply at 25; BellSouth Reply, Att. at 38.  Y14S84. AT&T contends that a moving average, with or without a lag, will understate the LECs' productivity in the current period, and so deprive consumers of some of the benefits  Y 4of productivity growth.@y @ xP'ԍ AT&T Comments at 3334.@ AT&T also opposes a moving average to the extent that the parties supporting it base their support on adopting USTA's method of calculating the X Y 4Factor.:z  xPV'ԍ AT&T Reply at 52.: USTA maintains that a moving average would flow through the benefits of  Y 4productivity growth more quickly than performance reviews.={ `  xP'ԍ USTA Reply at 2627.= BellSouth replies that updating the XFactor only in periodic performance reviews would not necessarily result in  Y4an accurate XFactor in any given tariff year.H|  xP1'ԍ BellSouth Reply, Att. at 3536.H BellSouth also points out that a moving average would tend to understate productivity only while productivity growth continues to increase, and that a moving average would overstate productivity growth during declining  YK4periods.H}K  xP|'ԍ BellSouth Reply, Att. at 3638.H  Y4T85. MCI maintains that recalculating TFP annually is likely to be more administratively burdensome than conducting a performance review every four years, and asserts that reviewing annual TFP filings would as administratively burdensome as reviewing  Y4cost and demand projections in a rateofreturn filing.{~ xP%'ԍ MCI Comments at 1417. See also TRA Reply at 78; Ad Hoc Reply, Att. at 40.{ GSA agrees that updating TFP"}~0*&&aa" studies on a moving average basis would be burdensome, and recommends using the moving  Y4average to update XFactors based on the Historical Revenue Approach.; xPb'ԍ GSA Reply at 810.; Some parties contend that this performance review has been a long and burdensome proceeding, and doubt  Y4that a moving average mechanism would be more burdensome.iX xP'ԍ GTE Reply at 2425. See also BellSouth Reply, Att. at 38.i USTA maintains that its  Y4TFP Review Plan simplifies calculating the moving average.; xP= 'ԍ USTA Reply at 78.; USTA also supports updating  Y4the moving average annually.=x xP 'ԍ USTA Comments at 36.=  Y_4U86. Sprint maintains that neither AT&T's nor USTA's models are sufficiently developed to ensure reasonable results or to flow through unit cost reductions when updated annually, and recommends adopting a fixed interstate productivity offset for the next four  Y 4years.l  xP'ԍ Sprint Comments at 1920, 2627. See also Ad Hoc Reply at 6.l Sprint suggests that input prices are too volatile to give a fiveyear moving average  Y 4a significant advantage over a fixed offset.?  xPL'ԍ Sprint Comments at 20.? Sprint also opposes a moving average because it argues that Commission review of access rates will be more important as LECs and IXCs  Y 4enter each others' markets.< (  xP'ԍ Sprint Reply at 27.<  Y 4V87. AT&T recommends conducting "performance reviews" annually, and conducting a complete performance review every three years, to ensure that incentive regulation is still functioning properly in light of subsequent developments in the telecommunications  Yb4industry.}b  xP'ԍ AT&T Comments at 4648; AT&T Reply at 52 n.106. See also US West Reply at 36.} GSA would schedule the next performance review in 1998.LXbH  xP['ԍ GSA Reply at 12. GSA originally recommended scheduling the next performance review in 1997. GSA Comments at 9. GSA reasoned that the Commission might have to focus on implementing the 1996 Act in 1997, and so recommended scheduling the next performance review in 1998. GSA Reply at 12. L֠ BellSouth  YK4maintains that there is no need to schedule another performance review now.BKh xPd#'ԍ BellSouth Comments at 33.B BellSouth expects the telecommunications industry to be competitive enough to warrant eliminating"4~0*&&aa"  Y4price caps before the next performance review might become necessary.F xPy'ԍ BellSouth Comments at 29, 44.F Alternatively, US West recommends scheduling a performance review in three to five years, to assess the level  Y4of competition.fX xP'ԍ US West Comments at 28. See also NYNEX Comments at 23.f US West maintains that a performance review is not necessary if we adopt  Y4its proposal to freeze the PCIs at their current levels.= xPT'ԍ US West Reply at 36.=  Y4 VI. COMMON LINE ISSUES  X`4B. Reliance on Forecasted Data  Y24W88. Southwestern Bell recommends continuing to use forecasted data if we retain a separate common line formula, because historical data would be based in part on "Part 69  Y 4revenue requirement calculations."O x xP-'ԍ Southwestern Bell Comments at 3738. O US West and USTA recommend using historical data, to make the common line formula consistent with the price cap formula for the other  Y 4baskets.[  xP'ԍ US West Comments at 2627; USTA Comments at 4546.[ MCI does not oppose basing the hypothetical EUCL per minute charges on  Y 4historical data, as long as the CCL rates continue to be based on the proposed EUCL rates.?  xP'ԍ MCI Comments at 2324.? AT&T recommends basing carrier common line rates on historical growth rates of interstate access services for the previous eight years, extrapolated into the prospective price cap  Yz4period by a linear trend.Ez(  xPS'ԍ AT&T Comments, App. B at 46.E Pacific opposes this recommendation.=z  xP'ԍ Pacific Reply at 15.=  XL4  VII. EXOGENOUS COST ISSUES \  Y4 " X89. MCI argues that the only cost changes warranting exogenous treatment are changes  xin separations rules and rules governing the allocation of costs between the regulated and non xregulated accounts. According to MCI, firms facing competition must determine how to face  Y4 x|cost changes without changing their prices, and price cap regulation should reflect this.PH  xP$'ԍ MCI Comments at 25; MCI Reply at 1718.P MCI  xalso argues that this rule change would conserve the administrative resources consumed by"0*&&aa"  Y4 xdetermining whether to treat a particular cost change exogenously or endogenously.S xPy'ԍ MCI Comments at 2526; MCI Reply at 1718.S TRA  Y4 xsupports MCI's recommendation.;X xP'ԍ TRA Reply at 910.; A number of commenters oppose MCI's exogenous cost  Y4 xsuggestion. xPk'ԍ USTA Comments at 4647; Sprint Comments at 1415; US West Reply at 3435; Frontier Reply at 6; USTA Reply at 2930. USTA notes that the Commission created a procedure in the LEC Price Cap  Y4 xPerformance Review for considering whether to treat a cost change exogenously. Because of  xcthis, USTA maintains that restricting exogenous cost treatment as MCI proposes is not  Y4 xnecessary.@ xP~ 'ԍ USTA Comments at 4647, citing First Report and Order, 10 FCC Rcd at 9099 (para. 316). USTA and Pacific reply that it would be unreasonable to grant exogenous  xtreatment to some cost changes beyond the carriers' control and not otherwise reflected in the  Y_4 x^price cap formula, but not other cost changes.U_ xP'ԍ USTA Reply at 2930; Pacific Reply at 1617.U According to US West, MCI assumes that  YH4 xprices remain static in competitive markets, and contends that this assumption is unreasonable.=H`  xPY'ԍ US West Reply at 35.=  xtIf the Commission does not adopt its TFPbased XFactor method, NYNEX recommends  Y 4retaining the existing exogenous cost rules.<  xP'ԍ NYNEX Reply at 30. < !C:\DOCUMENT\4THORD\APPB.2! " 0*&&aa "  Y4 / @B-C-@ C:\DOCUMENT\4THORD\APP.C 3'3'StandardHPLAS5SI.PRSXwLP 3'3'StandardHPLAS5SI.PRSx  (Q  Y4R APPENDIX C ă AMENDMENTS TO THE CODE OF FEDERAL REGULATIONS  Yw42 PART 61 TARIFFS ă 1. The authority citation continues to read as follows: Authority: Secs. 1, 4(i), 4(j), 201205, and 403 of the Communications Act of 1934, as amended; 47 U.S.C. 151, 154(i), 154(j), 201205, and 403, unless otherwise noted. 2. Section 61.45(b)(1) and (2) are amended to read as follows:  Y 4  61.45 Adjustments to the PCI for Local Exchange Carriers  X|4 * * * * *  YN4(b) * * * X` ` (1) Notwithstanding the value of X defined in  61.44(b), the X value applicable to the baskets specified in  61.42(d)(2), (3), and (6) shall be 6.5%. (# X` ` (2) For the basket specified in  61.42(d)(4), the value of X, for all local exchange carriers subject to price cap regulation, shall be 3.0%.(#  Y4 3. Section 61.45(c) is amended by revising paragraph (c)(1) and adding new language at the end of paragraph (c)(2) to read as follows:  Y;4  Y 4  61.45 Adjustments to the PCI for Local Exchange Carriers  X4 * * * * * X` ` (c)(1) Subject to paragraphs (c)(2) and (e) of this section, adjustments to local exchange carrier PCIs for the basket designated in 61.42(d)(1) shall be made pursuant to the following formula: (# * * *  YV%4 "V%0*&&aa*"Ԍ Y4X = ` ` productivity factor of 6.5%, * * * X` ` (2) * * * (# For the purposes of this paragraph, and notwithstanding the value of X defined in  61.44(b), the X value applicable to the basket specified in  61.42(d)(1), shall be 6.5%.  Y14 3'3'StandardHPLAS5SI.PRSx  3'3'StandardHPLAS5SI.PRSx  ( 4. Section 61.45(d)(2) is redesignated as 61.45(d)(2)(i), and new subparagraph (d)(2)(ii) is added to read as follows:  Y 4  61.45 Adjustments to the PCI for Local Exchange Carriers  X 4 * * * * * (d) * * * ` ` (2) * * * ` `  (ii) Local exchange carriers specified in  61.41(a)(2) or (a)(3) shall not  Y4be subject to the sharing mechanism set forth in the Commissions Second  Y4Report and Order in Common Carrier Docket No. 87313, FCC 90314, adopted September 19, 1990, with respect to earnings accruing on or after July 1, 1997. This rule has no effect on any sharing obligation of any local exchange carrier relating to earnings accrued before July 1, 1997.(#` 5. Section 61.45(h) is deleted and reserved. C:\DOCUMENT\4THORD\APP.C "80*&&aa "   @C-D-@  sN C:\DOCUMENT\4THORD\APP.D   #\  P6G; dP#OAppendix D  sN# \  P6G; dP# Estimation of TFP Under FCC Rules# Xj\  P6G; ynXP#у  sN# \  P6G; dP#1@FCC Synthesis# Xj\  P6G; ynXP#у   a 4# |\  P6G; _P#IC. Anthony Bush D{and RLori Huthoefer "0*&&aa"  a4. I. INTRODUCTION Đ\  X24# Xj\  P6G; ynXP# In this Appendix, we present the methodology used by the FCC's staff to estimate LEC Total Factor Productivity ("TFP") and input prices, and to calculate the LEC TFP and  X4input price differentials used in the FCC's LEC price cap Xfactor.  yPf 'ԍ #X\  P6G;ɒP# This paper benefitted from discussions with FCC Consultant Dr. P.J. Dhrymes, and from considerable assistance by FCC Staff members Jay Atkinson, Christopher Barnekov and Brad Wimmer. We calculate TFP based on the LEC regulated books of account, excluding miscellaneous services. Thus, our measure of total factor productivity is an approximation of the productivity of all LEC activities. Our calculations are for the period 1985 through 1995. We largely base our calculations on a simplification and correction of AT&T's implementation of the Fisher Ideal Index methodology, but incorporate certain aspects of USTA's methodology as well. Our TFP estimates embody what we believe to be the best practices proposed by the parties in this proceeding. For example, we used a modification of USTA's method of calculating materials expense. We also employed the perpetual inventory model proposed by USTA, although our implementation differed from that of USTA. We chose to pair end user charges with access lines, as did USTA, instead of with CCL minutes, as did AT&T. As described below, we adjusted pre1988 data for the effects of 1988 changes in accounting rules using a methodology consistent with that of USTA's Christensen.  Our study is based on data publicly available from the FCC, BEA, and BLS, and on Christensen's data on capital/expense shifts. All these data are part of the public record in this proceeding. Our data are for the seven Regional Bell Operating Companies (RBOCs). Our 1985 base year benchmark capital stock is the net book accounting value of total plant in service. The weights in our input index are based on the shares of total factor payments of capital, labor, and material. Capital's share of total factor payments is based upon the authorized rate of return, actual earnings in excess of that rate of return, and the authorized rates for depreciation.  a4# |\  P6G; _P#  a42# |\  P6G; _P# II. INDICES USED # Xj\  P6G; ynXP#ѐ\ We constructed our input and output indices using the the Fisher Ideal Index. This index is the geometric average of the Laspeyres Index and the Paasche Index. For two periods (t = 0,1), the Fisher Ideal Quantity Index can be written as ""!0*&&aa!"Ԍ _ U!x)addddddd<addx)I_{o,`1} = [ ({SUM FROM {j=1} TO n P_{o,` j}`Q_{1,`j} } OVER {SUM FROM {j=1} TO n P_{o,` j}`Q_{o,`j}})~ ' ~({SUM FROM {j=1} TO n P_{1,` j}`Q_{1,`j} } OVER {SUM FROM {j=1} TO n P_{1,` j}`Q_{o,`j}}) ]^{1 over 2} ~~~~~~~~~~~~~~~(1)x6X@`7X@x6X@`7X@x6X@`7X@0IonIcjpPojQ"jnI+jpPojQto"j2 n cj P/ j Q j2 n +j P/ j Q o j,V1[(c18,t1,+18,,)/ ( c1 1 , 1] , +1 1 ,] ,()]N1NU2(W1)c+_'2 c2 +,<SISI < I I6U$(#(#(#(#_!!L#$  Hwhere #A 0c dddd_ddh xP_{t,`j}x6X@`7X@x6X@`7X@x6X@`7X@_P+t8+j+,#and #a 0c dddd_dd xQ_{t,`j}x6X@`7X@x6X@`7X@x6X@`7X@_Q+t8+j+,# are the price and quantity of good j, j = 1, ... n, at time t, t=0,1. In addition, it can be shown that the Fisher Ideal Quantity Index can be written as  $#x"7dddddZddrelative8 xI_{o,` 1}`=`[(SUM FROM {j=1} to n w_{o,`j}`{Q_{1,`j} OVER Q_{o,`j}} )~ '~{1 OVER {(SUM FROM {j=1} to n w_{1,`j}`{Q_{o,`j} OVER Q_{1,`j}} )}}]^{ 1 over 2}~~~~~~~~~~~~~~(2), x6X@`7X@x6X@`7X@x6X@`7X@Ioln\jCwoij Q0cj Q_o0_j@ n +j w= j fQV 2o2j bQ.j,81,[(\1 ,c1c,_,) p1x ( +1 1 , 2,V .1 .,q)]1U2(e2)U,l\m'@ +&I< [ < I $$(#(# (#(#!'#$where # 0cdddd_dd xw_{t,`j}x6X@`7X@x6X@`7X@x6X@`7X@_w+t8+j+,#is commodity j's share of revenue at time t, t=0,1.c  {P'ԍ #X\  P6G;ɒP#Kali S. Banerjee, Cost of Living Index Numbers (New York: Marcel Dekker, Inc., 1975), pp.320. If periods 0 and 1 are adjacent periods, Equation 2 is referred to as a Fisher Ideal Quantity Relative. Defining  # 0chdddd_dd xI_{o,`o}x6X@`7X@x6X@`7X@x6X@`7X@_I+o8+o+,#to be 1, a chained Fisher Ideal Quantity Index between periods 0 and t is the product of each of the Fisher Ideal Quantity Relatives between 0 and t:   #xddddd ddp xwRI_{o,`t}`=`I_{o,`o}` '` I_{o,`1}` ' `I_{1,`2}` '` ` ' `I_{t-1,`t} x6X@`7X@x6X@`7X@x6X@`7X@_I+o8+t,_I+oR+oF_I+o`_I _I +t\ +t+,+,+,l+1+1(+,+2 +1 +,__'_'_'z_ _'^ +w$(#(#(#(#!'#$Both our output and input indices are chained Fisher Ideal Quantity Indexes. We measure input prices by calculating a Fisher Ideal Price Relative, which compares aggregate input price levels to those for the previous period. The Fisher Ideal Price Relative is analogous to the Fisher Ideal Quantity Relative, and can be written as   &x"?#dddddddZddprrel.eqnx"I_{o,` 1}^{p}`=`[(SUM FROM {j=1} to n w_{o,`j}`{P_{1,`j} OVER P_{o,`j}} )~ '~{1 OVER {(SUM FROM {j=1} to n w_{1,`j}`{P_{o,`j} OVER P_{1,`j}} )}}]^{ 1 over 2} `~~~~~~~~~~~~(3)x6X@`7X@x6X@`7X@x6X@`7X@Inpoln\jCwoij P0cj P_o0_j@ n +j w= j fPV 2o2j bP.j,81,[(\1 ,c1c,_,) p1x ( +1 1 , 2,V .1 .,q)]1U2S(3C)l\m'@ +&I< [ < I &$(#(#(#(#!L#$k![0*&&aa La# !a P = dA  h  P  da   7'#78  P=    Ph$[ h   '# p L?##' ?# Ԍ ` ` In this case, the#!0cmadddd_dd@ xw_{t,`j}x6X@`7X@x6X@`7X@x6X@`7X@_w+t8+j+,# are shares of total payments to factors. Using this price index relative, the input price index is a chained Fisher Ideal Price Index.  Xx'_  III. CALCULATION OF OUTPUT INDICES ă  XJ4 A. Data Sources Our output indices are based on actual quantity measures from two Commission publications. Basic local service revenue, end user revenue, switched access revenue, special access revenue, state access revenue, _and total long distance network revenue are taken from  X 4the Commission's Statistics of Communications Common Carriers ("SOCC") for 1985 through 1995. We also took the number of local calls, special access lines, business access lines, residential access lines, and public access lines from SOCC. We measure state toll and intrastate access volumes by state dial equipment minutes, taken from the FCC Monitoring  X}4Reports.f}  yP'ԍ #X\  P6G;ɒP# In 1987 a Joint Board created a monitoring report to collect a variety of data, including dial equipment minutes (DEMs). We rely on the May 1993 through May 1996 Monitoring Reports for the intrastate DEMs and  yO'interstate switched access minutes (these reports include data for the prior years). See Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Establishment of a Program to Monitor the Impact of Joint Board Decisions, CC Docket Nos. 80286 and 87339, 7 FCC Rcd 4541.f Interstate switched access minutes are from the same Monitoring Reports.  XO4 B. Output Category Quantity Indices and Revenue Shares We constructed an interstate quantity index to measure growth of interstate services. We constructed this index using the following three physical quantities: access lines, interstate switched access minutes, and interstate special access lines. We measured access lines by the sum of business, public, and residential access lines. Axdddddddde -dd xCQw_{t,`j}`=`{R_{t,`j}} OVER {(SUM FROM {j=1} to n R_{t,`j})}~~~~~~~~~~~~~~~~ (4),x6X@`7X@x6X@`7X@x6X@`7X@!wtGjRctcj>n+jRt;j,Ic,v(+1,) ( 4 ) ,>+Y<ICService j's share of total revenue is  v$(#(#(#(#v!AL#$where #a 0cm#dddd_dd xR_{t,`j}x6X@`7X@x6X@`7X@x6X@`7X@_R+t8+j+,#is the revenue from interstate service j at time t.  We weighted growth in access lines by the End User Common Line revenue share of total interstate revenues. Growth in switched access minutes was weighted by the switchedy0*&&aaPma!ma@  Lt#0#eA     Pm#= )%a m#    access revenue share, and growth in special access lines was weighted by the special access revenue share. We then used equation 2 to construct Fisher Ideal Quantity Index Relatives. The composite Fisher Ideal Interstate Quantity Index is derived by chaining the Fisher Interstate index relatives. We used a completely analogous procedure to construct revenue shares and quantity indices for total local service and state toll/access service. State toll/access revenues are total toll service revenues plus intrastate access revenues. The physical units associated with total local service are the number of local calls. For state toll/access service, the physical units are state dial equipment minutes from the Monitoring Report.  X ' C. Total Output Index  X 4 We constructed the total company output index using the service quantity indices and revenue shares calculated as described above (for local service, intrastate toll/access, and interstate). We calculated interstate share of total revenue using the sum of end user revenue, switched access revenue (formerly called "carrier's carrier facilities revenues"), and interstate special access revenue. We then used Equation 2 to construct Fisher Ideal Quantity Index Relatives. Our total company output index is a chained Fisher Ideal Quantity Index.  a44# |\  P6G; _P# TPIV. INPUTSpp # Xj\  P6G; ynXP#  X>'  X'' A. Labor  X4 Our measure of the quantity and the cost of labor is based on annual accounting data for the number of employees and total labor compensation reported by the LECs in their ARMIS reports to the FCC. Our labor price index is created by dividing average compensation per employee for each year by the 1985 average compensation per employee .  We let  0dddd_ddx x TCOMP_{t}x6X@`7X@x6X@`7X@x6X@`7X@_TCOMPj+tdenote total compensation to labor in year t and  0Rdddd_dd xNEM_{t}x6X@`7X@x6X@`7X@x6X@`7X@_NEMz+tdenote the number  |DYyEof employees in year t. Compensation per employee,  0;"dddd_UddH xCPEM_{t}x6X@`7X@x6X@`7X@x6X@`7X@_CPEM+t, is  0;!dddd|Ddd x !CPEM_{t}`=`TCOMP_{t} OVER NEM_{t}x6X@`7X@x6X@`7X@x6X@`7X@!CPEMt0cTCOMP/t_NEM+tg ߇. The components of the labor price index are   C#xL&ddddd dd xM1,~~CPEM_{1986} OVER CPEM_{1985}`,`  `,~~CPEM_{1995} OVER CPEM_{1985}``.x6X@`7X@x6X@`7X@x6X@`7X@01,/1986+1985^,z, /1995 +1985F . cCPEM _CPEMcCPEM_CPEMC$(#(#(#(#!'#$ a%0*&&aa#P !x  PR! R    P;"# ;"H  P;! y$;!  L&'#p)L&   Ԍ X' B. Materials Our materials quantities are derived by dividing materials expense by a materials price index. Materials expenses for 1985 through 1987 must be adjusted for two accounting changes that became effective in 1988. First, beginning in 1988 all expenses from nonregulated services that had joint and common costs with regulated services were reported in operating expenses. Second, certain plant investments that formerly were capitalized began to be expensed in the year they were incurred. Accordingly we adjusted 1985 through 1987 expenses upward to put them on a basis comparable to the accounting expense recorded from 1988 onward. Our adjustments of materials expense for 1985 through 1987 follow the work of USTA's Christensen. No party objected to or replicated Christensen's method of adjusting  X 4materials expense.  yPN'ԍ#X\  P6G;ɒP# USTA's updated study submitted in the Access Charge Reform, Notice of Proposed Rulemaking, CC Docket No. 96262, began with 1988 and thus needed no adjustment. Christensen's adjustment is based on data from a ninecompany sample. We calculated our adjustment factor by dividing the sum of annual reported operating expense plus Christensen's adjustment by reported operating expenses for the years 19851987. These percentages are used to adjust 1985 through 1987 operating expenses of the RBOCs.  bMathematically, we can express our adjustment as follows: Let ! 0 dddd_Edd x OPREXP_{t}x6X@`7X@x6X@`7X@x6X@`7X@_OPREXP+t  denote the composite (ninecompany) operating expense in year t from the Revised Christensen Study  (1995). We let  A 0 ' gdddd_Edd x ADDEXP_{t}x6X@`7X@x6X@`7X@x6X@`7X@_ADDEXP+t  be the additional materials expense resulting from both the regulated/nonregulated change and the capital/expense shift (the data we used are shown in Chart D8a). The adjustment to RBOC operating expense is  ~a#xddddd ddP xnRBOCEXP_{t}^{Adj} `= `({OPREXP_{t}`+`ADDEXP_{t}} OVER {OPREXP_{t}})` ' `RBOCEXP_{t}~~, t`=`1985,~1986,~1987x6X@`7X@x6X@`7X@x6X@`7X@!RBOCEXP:AdjitcOPREXP/t cADDEXP` /t_OPREXP~ +t RBOCEXP1tt c[ '7( )1,1985,u1986U,%1987 $(#(#~(#(#!a'#$where   0!dddd_dd x RBOCEXP_{t}x6X@`7X@x6X@`7X@x6X@`7X@_RBOCEXPZ+t is the unadjusted operating expense of the RBOCs at time t. Materials expense is total adjusted operating expense minus the sum of total labor compensation, depreciation, and amortization expense.!0*&&aaP~! P' g3#A ' g  '#!a P  P!_ >#!  Ԍ  #xadddddU*dd  xVMATERIALS_{t}`=`RBOCEXP_{t}^{Adj}`-`(Depreciation_{t} +Amortization_{t}) -TCOMP_{t}``.x6X@`7X@x6X@`7X@x6X@`7X@_ MATERIALSJ+t>_RBOCEXPAdj:t _ DepreciationN+t_ Amortization+t_TCOMPN+t_ __~_6 _(_)_.$(#(#(#(#!'#$We deflate materials expense to derive materials quantities using the materials price  X4index developed by AT&T's Norsworthy and placed in the record by AT&T.  yP'ԍ #X\  P6G;ɒP# Comments of AT&T, Price Cap Performance Review, CC Docket 941, Jan. 11, 1996, Appendix A: Statement of Dr. John R. Norsworthy. This index is based on those categories of expenditures from the BLS National Input/Output Tables that are more narrowly focused on materials purchases of communications industries than is the economywide GDPPI measure of inflation. We replicated the index using the same BLS  XH4data AT&T used in an ex parte filing received on April 11, 1996.H!  yP 'ԍ #X\  P6G;ɒP#AT&T Ex Parte Letter of April 11, 1996.  AT&T's materials price index is a Tornquist index calculation, where the logarithmic percentage changes are replaced  X 4by arithmetic percentage changes.=   yP}'ԍ#X\  P6G;ɒP# The most recent BLS Input/Output Table was for 1993. We determined the 1994 and 1995 materials price  yOF'index data points by extrapolating based on average growth in prior years.#X\  P6G;ɒP# =  X ' C. Capital We follow Ad Hoc, USTA's Christensen, and AT&T's Norsworthy in measuring capital based on the Perpetual Inventory Model. We use the Perpetual Inventory Model to remove embedded inflation that would distort the measurement of capital. We examine only one asset class because the record shows that the number of asset classes does not significantly affect estimated growth in TFP. Our application of the Perpetual Inventory Model relies on Commission depreciation rates, as do those of Ad Hoc and AT&T.  V4# Xj\  P6G; ynXP## |\  P6G; _P## |\  P6G; _P## Xj\  P6G; ynXP#PERPETUAL INVENTORY MODEL For a single asset class, the Perpetual Inventory Model is written as  N#xddddddd x =K_{t}`=`(1-  ) `'`K_{t-1}`+`I_{t} ~~~~~~~~~~~~~~~~~(5)x6X@`7X@x6X@`7X@x6X@`7X@_K+t}_K+t_I+t_n__'E+_~_(_1a_)+1) _( _5_)_ N$(#(#(#(#!'#$where  0!dddd_dd x K_{t}x6X@`7X@x6X@`7X@x6X@`7X@_K+tis the capital stock quantity at the of end year t and  is the average depreciation  X 4rate (calculated as discussed below). Investment, i.e. capital additions, measured in constant  (inflationadjusted) dollars is  0)U$dddd_ddX  x I_{t}x6X@`7X@x6X@`7X@x6X@`7X@_I+t. Following Christensen, Norsworthy, and Ad Hoc, we use 0*&&aaa'#a  '#!   P!j# !  P)U$&)U$X   book value of plant as the basis for calculating the benchmark (i.e. initial level) capital stock. In order to calculate constant dollar investment, we use chained Fisher asset prices from BEA to deflate capital additions.  V4CAPITAL ADDITION ADJUSTMENTS  X4 Our benchmark capital stock is based on the end of year 1985 book value. Because of the 1988 capital/expense shift, we must adjust both end of year 1985 total plant in service less accumulated depreciation and 19851987 capital additions. We use Christensens capital/expense shift factor to reduce capital additions for 1985 through 1987. For t = 1985,   1986, 1987, the adjusted capital additions, denoted ! 05zdddd_!*dd  x  CA_{t}^{Adj}x6X@`7X@x6X@`7X@x6X@`7X@_CAAdj:t, are  A#xmddddd!*dd(  x CA_{t}^{Adj}`=`CA_{t}` ' ` Fx6X@`7X@x6X@`7X@x6X@`7X@_CAAdj:t_CA+t_F$__'߀$(#(# (#(#!A'#$ where a 0-'dddd_edd  x CA_{t}x6X@`7X@x6X@`7X@x6X@`7X@_CA+t is the unadjusted capital additions and where F = 0.888 (taken from the Revised Christensen Study, 1995). We obtained unadjusted capital additions from FCC Form M.  V>4ASSET PRICES Since we have a single asset class, we construct a single composite asset price index. Following Ad Hoc, AT&T, and USTA, we obtained BEA asset prices. We obtained prices for three BEA asset categories: Communications Equipment (BEA's Table 7.8: ChainedType Price indexes for Private Purchases of Producers' Durable Equipment by Type, Line 7); Telecommunication Structures (BEA's Table 7.7: ChainedType Price Indexes for Private Purchases of Structure by Type, Line12); and a composite asset price for Producer Durables (BEA's Table 7.1, Line 39). We grouped our capital additions data into categories that correspond with the BEA asset categories, and calculated each category's share. (The capital/expense shift adjustment factor discussed above has no effect on the shares because it is multiplicative in nature and applies equally to all categories.) For our single asset, the Fisher Ideal Price Index Relative is 0*&&aaP5zkn!5z  m'#A m(   P'J a '   Ԍ v#xdadddddddprrel.eqn  x 8I_{o,` 1}^{A}`=`[(SUM FROM {j=1} to 3 w_{o,`j}^{A}`{P_{1,`j}^{A} OVER P_{o,`j}^{A}} )~ '~{1 OVER {(SUM FROM {j=1} to 3 w_{1,`j}^{A}`{P_{o,`j}^{A} OVER P_{1,`j}^{A}} )}}]^{ 1 over 2}~~~~~~~~~~~~~~~~~~~(6), x6X@`7X@x6X@`7X@x6X@`7X@MIA(ojCMwA(oi(j P,A0j PAso0sj ]j w oA= j Pr AV sosj _Pr A:j(,8(1,M[M(l$31 (,1,s,M) 1x (@ 3 ]1 1 , s,V :1 :,q)M] 12M(M6M) M,MlmM'@ ]&Iv [ v I =8ߵ$(#(#(#(#v!'#$where 7 0c dddd_*dd`  x  w_{t,`j}^{A}x6X@`7X@x6X@`7X@x6X@`7X@_wA:t8:j:,7is category j's share of the value of total capital additions. The price of category  hj at time t, t= 0, 1, is 7 0c dddd_*dd  x  P_{t,`j}^{A}x6X@`7X@x6X@`7X@x6X@`7X@_PA:t8:j:,7. From these relatives, we form a chained Fisher Price Index for our single asset. This price index is used to deflate adjusted capital additions in the Perpetual Inventory Model.  V 4  V 4BENCHMARK CAPITAL STOCK Our benchmark capital stock is derived using the FCC accounting relationship  #xddddddd0  x ;TPIS.BOY_{t}` + `CA_{t}` - ` Retires_{t} = TPIS.EOY_{t}x6X@`7X@x6X@`7X@x6X@`7X@_TPISj_BOY+t_CA+t_Retires +t _TPIS _EOYz+t_. _.8__B _$(#(#(#(#!'#$Beginning of year Total Plant in Service is, 0dddd_5dd x  TPIS.BOY_{t}x6X@`7X@x6X@`7X@x6X@`7X@_TPISj_BOY+t_.,in period t, and end of year TPIS is  ,! 0ydddd_5dd ! x  TPIS.EOY_{t}x6X@`7X@x6X@`7X@x6X@`7X@_TPISj_EOY+t_.,. We incorporated adjusted capital additions, which results in a revised  A 0dddd_ ddh " x Q$TPIS.EOY_{t}~~, t`=`1985,~1986,~1987x6X@`7X@x6X@`7X@x6X@`7X@_TPISj_EOY+tJ_t_._,f_1985F_, _1986 _, _1987_Q. We then obtain our benchmark capital stock by subtracting accumulated depreciation from revised 1985 TPIS. As is standard practice in TFP studies, we do not include land when forming the benchmark capital stock. We do not apply USTA's economic stock adjustment factors because such factors assume asset lives that are inconsistent with Commission depreciation rates.  X 4DEPRECIATION RATES  Each Perpetual Inventory Model in this record used depreciation rates that are constant over time. In Christensens model depreciation rates vary by asset class, but for each asset class the depreciation rate does not vary over time. The revised version of AT&Ts PerformanceBased Model relies on estimates of Commission depreciation rates for six assetQ%0*&&aaB$_a'#( a  P = n  `   P n   '##0   P}y    Py 5! y !    P0A h "!  classes, but for each asset class the depreciation rate is constant and obtained by averaging over time. Simplifying Norsworthys approach, we calculated the Commissions timeinvariant depreciation rate for our single asset class. In year t, we calculated the average depreciation rate as  va#x ddddd dddepr # x +H _{t} `=` {DEPR.ACRLS_{t}} over {((TPIS.BOY_{t}`+`TPIS.EOY_{t}) /2)} x6X@`7X@x6X@`7X@x6X@`7X@! tcDEPRmcACRLS /t_TPIS_BOY{+to_TPIS _EOY/ +t_c._(C_(_.O _. _) _/o _2 _)+ߨ$(#(#v(#(#!a'#$where  0zdddd_dd8$ x   _{t}x6X@`7X@x6X@`7X@x6X@`7X@_ +tis the composite depreciation rate in period t. In year t, the depreciation accruals  are 0 06dddd_%dd% x DEPR.ACRLS_{t}x6X@`7X@x6X@`7X@x6X@`7X@_DEPRj_ACRLS+t_.0. Our constant depreciation rate is  X 4#xddddddd& x {5  `=`{(SUM FROM {t=1} to 11 _{t})} over 11 ~~,x6X@`7X@x6X@`7X@x6X@`7X@!  Cd^oI{(111)t811*,tt{$(#(# (#(#!'#$which is the average depreciation rate for the period 1985 through 1995.  V4# Xj\  P6G; ynXP#  SERVICE FLOWS CAPITAL INPUT QUANTITIES# Xj\  P6G; ynXP#   Following Christensen, we compute a quantity index of capital services. At time t, the capital input quantity is denoted  ~Vxm dddddddd*Uddp'x{Capital ~Input~Quantity_{t}`=` {Capital~Stock~Quantity_{t-1}} over {Capital~Stock~Quantity_{t=1984}}, ~~t= 85',`  ,`95'x6X@`7X@x6X@`7X@x6X@`7X@!CapitalInputqQuantity1 t cCapitalxcStock(cQuantity/t` _Capital_Stock_Quantityp+tt 8/+ u!/%!C /1+1984m,85,,595V H 0M dddd_ dd( x Capital~ Input~ Quantity_{t}x6X@`7X@x6X@`7X@x6X@`7X@_Capital_Inputb_Quantity" +tH, and   $ $ $: $ $!L#$!x%ddddddddeEdd@)xaCapital~Stock~Quantity_{84}`=`{Capital~Stock~Quantity_{85}`-`Investment_{85}} OVER {1`-`  }~,x6X@`7X@x6X@`7X@x6X@`7X@!CapitalStockqQuantity <CapitalP<Stock<Quantity< Investment1 848585681, v<8. R8 The 1984 capital stock is calculated from the 1985 benchmark, as  ~CyE$ $ $ $ $!!L#$where ,A0)dddd~Cdd*xSInvestment_{85}`=`{Current~Dollar~Investment_{85}`} OVER {Asset~Price~Index _{85}},x6X@`7X@x6X@`7X@x6X@`7X@! InvestmentPcCurrent cDollar c Investment;_Asset _Price _Index85/85+85,$3,=#0*&&aa" '#a #" Pz6 z8$#  P6  6%$  '#$&%  L ##*m p'&   P? ('   L%#(e! %@)( P)^,A )*) Ԍ This calculation follows the practice of Christensen in his Revised Study (1995) and AT&T's April 16, 1997 Study.      X4# Xj\  P6G; ynXP# D. AGGREGATE INPUT INDEX # Xj\  P6G; ynXP# Having constructed input indices for all three factors of production, we use equation 2 to aggregate them into an aggregate input index. In order to use equation 2, we need each factor's share of total costs. The payment to labor is total compensation, the payment to materials is materials expense, and following AT&T, the payment to capital is property   income. At time t, property income is denoted a 0cdddd_Udd+ x PINC_{t}x6X@`7X@x6X@`7X@x6X@`7X@_PINC+t, and is calculated as   #x ddddd ddx, x Y3PINC_{t}`=` Revenue_{t}`-`MATERIALS_{t}`-`TCOMP_{t}x6X@`7X@x6X@`7X@x6X@`7X@_PINC+t_Revenue.+t"_ MATERIALSZ +tN _TCOMP+tX__ _Y$(#(# (#(#!'#$The sum of total payments to each of the factors of production is denoted by TPAY. For each factor of production, we calculate shares of TPAY as follows. At time t, labor's share is  |D5yE 0dddd|D?dd- x >&w_{t,`1}^{*}`=`TCOMP_{t} OVER TPAY_{t}x6X@`7X@x6X@`7X@x6X@`7X@!wtvcTCOMP/t_TPAY+t:,G1Y>߻. Materials' share is 0Sdddd|DddH. x F*w_{t,`2}^{*}`=`MATERIALS_{t} OVER TPAY_{t}x6X@`7X@x6X@`7X@x6X@`7X@!wtvc MATERIALS/t_TPAY+t:,G2\YF. Capital's share is  |DyE 0Udddd|Ddd/ x <%w_{t,`3}^{*}`=`PINC_{t} OVER TPAY_{t}x6X@`7X@x6X@`7X@x6X@`7X@!wtvcPINCV/tv_TPAYV+t:,G3#Y<߹. Our aggregate input index relative is  v xd~ddddddddddrelativ2.eqn0xd=I_{o,` 1}^{*}`=`[(SUM FROM {j=1} to 3 w_{o,`j}^{*}`{Q_{1,`j}^{*} OVER Q_{o,`j}^{*}} )~ '~{1 OVER {(SUM FROM {j=1} to 3 w_{1,`j}^{*}`{Q_{o,`j}^{*} OVER Q_{1,`j}^{*}} )}}]^{ 1 over 2}~~~~~~~~~~~~~~~~~(7), x6X@`7X@x6X@`7X@x6X@`7X@MI(ojCMw(oi(j Q0j Qso0sj ]j w= j QV sosj _Q:jMl,mM'@ ] or r (,8(1,M[M(l$31 (,1,s,M) 1x (@ 3 ]1 1 , s,V :1 :,q)M] 12M(mM7M)]M,&Iv [ v I ==ߺ$(#(#(#(#v!L#$  For labor, [! 0t#dddd_;*dd1 x Q_{t,`j=1}^{*}x6X@`7X@x6X@`7X@x6X@`7X@_Q:t8:j::,:1[is the number of employees, and for materials, [A 0at#dddd_;*dd2 x Q_{t,`j=2}^{*}x6X@`7X@x6X@`7X@x6X@`7X@_Q:t8:j::,:2[is deflated  materials expense. For capital, [a 0f%dddd_;*ddP3 x Q_{t,`j=3}^{*}x6X@`7X@x6X@`7X@x6X@`7X@_Q:t8:j::,:3[is the capital input quantity. The aggregate input index is a chained Fisher Ideal quantity index.  a#4- # |\  P6G; _P#V. MEASURED TFP # Xj\  P6G; ynXP#ѐ\$0*&&aa# Pcac+*  '#)  x,+  P U -,  PS9USH.-  PU> U/.   L#E" ~0/   Pt# e%n! t#10 Pat#ce%nA at#21 Pf%W'na f%P32 ԌWe calculated the percentage change in measured TFP based on our total output and total input chainedlinked Fisher Ideal Indices. For a given year, the percentage change in TFP is simply the percentage change in output minus the percentage change in input, where all percentage changes are logarithmic percentage changes. We report our FCC synthesis percentage changes in TFP in Chart D1. To obtain the TFP Differential, we subtracted TFP growth in the general economy from LEC TFP growth. We used the BLS estimate of Nonfarm Business Sector Multifactor  XH4ProductivityH  yP 'ԍ #X\  P6G;ɒP# Bureau of Labor Statistics, Office of Productivity and Technology, Net Multifactor Productivity and Costs, Nonfarm Business Sector (Excluding Government Enterprises), Table NFB4a, January 17, 1996. as our measure of general TFP growth. The most recent published data in this series is for 1994. We estimated the 1995 growth as the average of the five most recent years.  a 4 # |\  P6G; _P# VI. INPUT PRICE DIFFERENTIALS # Xj\  P6G; ynXP#ѐ\  X 4 Our XFactor includes both the difference between LEC TFP and TFP for the entire economy and an Input Price Differential. We calculated a RBOC input price index using our labor price index, AT&T's materials price index, and a capital price index based on the methodology proposed by AT&T. With only one asset, the rental price is property income  X4divided by the real capital stock used in that period., i.e., the capital stock quantity. #!  yPU'ԍ#X\  P6G;ɒP# Calculating an implicit price (rental) of capital by dividing returns to capital by the real capital stock, is  yO'undertaken by Dhrymes (1990). See Phoebus J. Dhrymes, "The Structure of Production Technology: Evidence  {O'from the LED Sample I," in Bureau of Census 1990 Annual Research Conference Proceedings, U.S. Department of Commerce, Bureau of the Census, 1990.  The resulting data is normalized, with 1985 as the base year.   >Let  0Wdddd_dd4 x v_{t}x6X@`7X@x6X@`7X@x6X@`7X@_v+t be the rental price of capital in period t.  #x[ddddddd 5 x !v_{t}`=`PINC_{t} OVER K_{t-1}x6X@`7X@x6X@`7X@x6X@`7X@!vtcPINC/t,_K+t+#D+1!ߞ$(#(#(#(#!'#$The price index for capital is8 0cdddd_*dd6 x  P_{t,`3}^{*}x6X@`7X@x6X@`7X@x6X@`7X@_P:t:,8:38, t = '85, ..., '94 which is   !#x dddddkdd7 x 01,~v_{86} over v_{85},~ ...~,`v_{95} over v_{85}x6X@`7X@x6X@`7X@x6X@`7X@01,+/86++85,.0..x,/95+85**$cv_vAcvA_v!$(#(#(#(#!'#$4  0*&&aatPW ZW43 ['# [ 54  Pi  65   '#$ 76  ԌUsing our factor shares of total payments and equation 3, the Fisher Ideal Input price relative is  v#xd3dddddxddprrel.eqnX8 x AI_{o,` 1}^{**}`=`[(SUM FROM {j=1} to 3 w_{o,`j}^{*}`{P_{1,`j}^{*} OVER P_{o,`j}^{*}} )~ '~{1 OVER {(SUM FROM {j=1} to 3 w_{1,`j}^{*}`{P_{o,`j}^{*} OVER P_{1,`j}^{*}} )}}]^{ 1 over 2} ~~~~~~~~~~~~~~~~~~~~(8)x6X@`7X@x6X@`7X@x6X@`7X@MI(ojCMw(oi(j P0j Pso0sj ]j w= j PV sosj _P:jMl,mM'@ ] or r (,8(1,M[M(l$31 (,1,s,M) 1x (@ 3 ]1 1 , s,V :1 :,q)M] 12M(uM8M)&Iv [ v I =A߾$(#(#(#(#v!'#$The price index of factor j, j = 1,2, 3, is8! 0c dddd_*dd9 x P_{t,`j}^{*}x6X@`7X@x6X@`7X@x6X@`7X@_P:t8:j:,8. From these relatives, we derive our chained Fisher Ideal Input Price Index. Our Input Price Differential is obtained by subtracting growth in our Input Price Index from growth in general input prices. As our measure of general input price growth, we used the BLS Nonfarm Business Sector Input Price Index. This is from the same source as, and is developed in conjunction with, BLS's measure of general TFP growth. Again, the most recent published data is for 1994 and we estimated 1995 input price growth as the average of the five prior years.  `kA# |\  P6G; _P# iResults # Xj\  P6G; ynXP#у  X^4The attached charts present our TFP and Input Price Differential calculations, and the development of our underlying input, output, and input price indices. C:\DOCUMENT\4THORD\APP.D G 0*&&aae3'# 3X87 P n!  98   X4   "Q ""Q" "Q  "Q ""Q" "Q  "Q ""Q" "Q  "Q @D-@ "Q # Xj\  P6G; ynXP#  `(#kMay 7, 1997  b4PS Statement of  b4 Commissioner James H. Quello   X'\RE: FEDERALSTATE JOINT BOARD ON UNIVERSAL SERVICE (CC Docket No. 9645), ACCESS CHARGE REFORM (CC Docket No. 96262), and PRICE CAP PERFORMANCE REVIEW FOR LOCAL EXCHANGE  Xj 'CARRIERS (CC Docket No. 941).  xToday, the Commission has established rules to implement the Universal Service provisions of  xthe Telecommunications Act of 1996, as well as rules to restructure the access charge system  X 4 xpwhile also initiating reductions in the levels of those access charges. I have believed throughout  xmy participation in the debates regarding universal service and access reform that, as much as  xpossible, we should seek to ensure that consumers experience the benefits of our actions. To this  xEsame end, we should try to avoid the possibility that total bills for groups of consumers could  x8increase as a result of implementing new universal service programs and moving into a new  X4access charge regime.  Xm4 Universal Service  X?4 x" This Commission now has taken steps to establish processes for the administration of universal  xservice funds in a way that allows the commitments represented in this section of the 1996  xVTelecommunications Act to be fulfilled. We have labored to develop a reasonable plan that will  xprovide necessary and sufficient funds for schools and libraries as well as other universal service  xprograms. We also have sought to avoid collection of funds beyond those legitimately needed  xto help make new and important services available to students and teachers in inner city, suburban  xand rural schools from Takoma Park, D.C., to Tacoma, Washington, from McAllen, Texas to Mackinac Island on the Upper Peninsula of Michigan.  xWe have achieved this balance by establishing funding necessary to begin the program at a  xIreasonable level, with a provision that allows schools and libraries to begin the program January  x81, 1998. By this time, we would hope that participating groups will have had the opportunity  xto develop their plans. Our decision to start the program with lower funding in the first six  xmonths, increasing in the following years, gives the program early constraint, with flexibility at  xlater periods when greater demand is likely to develop. As a result, I believe this decision  xprovides for new universal service funding within the limits of what consumers around the country are willing to pay.  x The issue of what consumers are prepared to pay has been a very difficult one. The need for our  xattention to the issue, however, has been clearly expressed in many ways. It has required the  x_Commission to balance the need for programs involved in universal service that are critically"s' 0*((z%"  ximportant to the future of this country with their cost. In this respect, this universal service  xproceeding is one of the most important decisions in this agency's history. At the same time, we  xhave heard a consistent message from around the country that consumers and businesses are not  xEnecessarily willing to pay for these services through higher total bills for telecommunications services.  xWith respect to funding for health care subsidies, we have endeavored to make sure that rural,  xnonprofit health care facilities have sufficient funding to meet the needs for providing services  xEin communities that otherwise might not have the same resources that are available in urban communities.  xThere also are many other policy and market issues that will need to be resolved in a new  xuniversal service environment. For instance, I believe it remains to be seen how cable and  xwireless industries will continue to develop to play a greater role in the telecommunications  xhservices that will meet future universal service needs. As these developments occur, the  xCommission may continue to monitor the equity of contribution and recovery of universal service  xfunds by paging services as well as the extent to which wireless services in general should contribute for intrastate services.  XK4 Access Reform  xThe Commission's actions today on access reform involve two components: (1) several structural  x3changes that will cause access components to move to more reasonable categories and to become  xVsubject to competition where possible; and (2) reductions in the current level of access charges,  xlargely accomplished through revision of the productivity and sharing mechanism in LEC price caps.  x@Where this decision changes the structure of end user charges, as in our treatment of business and  xresidential customers, and consumers with second or multiple lines, I believe our decisions should  Xe4 xbe and are characterized by balance. As a result of this necessary reform of the access  x<payment structure, charges should remain within reasonable bounds and should help to promote the development of competition and consumer benefits.  xI also believe this Commission would be remiss in our regulatory duties to the American public  xand responsibilities to our licensees if we were to restructure universal service without  xcconcurrently engaging in access charge reform. We have talked about this step for quite some  xVtime. Many parties have expressed their views in a very public fashion as to whether or not this  x<step is warranted, or to what degree access charges should be reduced. I believe that this step  x/to restructure and reduce the level of access charges is the right thing to do and this is the right time to do it.  x&The consumers and users of telecommunications services are the intended beneficiaries of today's  xactions regarding access reform. Now that these decisions are adopted, I believe it will become  X#'4 x#clear that we have done our best to ensure that consumers do not bear the burden of "#' 0*((%"  ximplementing the new universal service program and access charge reform. Our actions also  x+represent a fundamental part of the Commission's effort to facilitate competition in the local  x/exchange marketplace, in this case by reducing access charges paid to LECs by interexchange carriers.  xThe primary vehicle for this reduction is the decision to change the existing combinations of  xproductivity factors, or "xfactors", and sharing options to a single productivity factor of 6.5%  xEaccompanied by no sharing obligation. As a result, this decision continues the Commission's  xefforts to move away from the lingering remnants of rate of return regulation for local exchange  xcarriers. Today's decision will complete the movement of price cap LECs away from the sharing obligations that were part of the past system.  X 4Looking to the Future I want to emphasize that today's actions represent a first step in many respects.  xIConcerning universal service, this is not a day to declare victory. There is much left to be done  xby the Commission, the states, temporary and permanent fund administrators, school districts,  xlibraries, health care facilities, parties developing cost models, and telecommunications companies  xIseeking to provide services and enter new markets. This is definitely an important day, but the  xhreal effort is just beginning. That effort will require investment, planning, training in using  xIservices, and community, professional, and corporate involvement, and it will only be successful  x/after the continuing involvement, in community after community, by the many parties who have so diligently participated in this proceeding.  xThe Commission's action to increase the productivity factor not only results in reduced access  xcharges in the first year, but also in further reductions in access charges in subsequent years. In  xanother respect, it may very well become necessary very soon for the Commission to consider  xhhow to supplement today's decision to allow for pricing flexibility by LECs as competition  xIdevelops to a greater level in the local marketplace. One possible way to provide that flexibility  x might be through relaxing the 6.5% productivity factor where LECs can meet criteria to demonstrate sufficient competition.  xAt the same time, later steps might also include the potential for checks and balances in the event  xthat competition in the local exchange marketplace does not develop as soon as some seem to  xZexpect. Once again, down the road the Commission may need to consider more specific measures  xRto ensure that the platforms necessary for competition truly are available. It is my hope that those steps won't be necessary.  xcFinally, some parties have warned recently that any actions by this Commission to lower access  x&charges may cause LECs to seek to raise local phone rates. That matter will become an issue for  xstate commissions, and it is my hope that they will respond to any efforts to raise local rates by  xensuring that consumers ultimately benefit from federal and state actions to implement the Telecommunications Act of 1996 and any related decisions."#' 0*((%"  X4    ` `  hhCq# Xj\  P6G; ynXP#pp  *May 7, 1997  X4# Xj\  P6G; ynXP#  X'? Separate Statement of %Commissioner Susan Ness  Xv4 \  V14Re: Universal Service; Access Reform; Price Cap Review  X 4 Today we reach another milestone in our efforts to secure for consumers the myriad benefits made possible by the Telecommunications Act of 1996. We are steadfastly fulfilling the tasks assigned to us by Congress in a manner that will prove the wisdom and realize the vision of this landmark legislation. Our pursuit has many facets. We must eliminate impediments to competition, ensure fair rules of engagement for all market participants, safeguard the interests of residential consumers, especially those with limited incomes and those in high cost areas, promote economic efficiency, and lower prices to consumers. Today's orders represent substantial progress on all these fronts. Much of what we are doing is driven by law and by economics. But the results of our decisions have a human face: XWill a poor family in Appalachia be able to summon the police or fire department in an emergency?(# XWill a critically ill patient in a remote region of Montana have her tumor quickly and accurately diagnosed?(# XWill a curious highschool freshman have an opportunity to view Thomas Jefferson's valedictory letter, in his own aged but still powerful hand? (# XWill an elderly widow be less hesitant to break her loneliness with longer and more frequent calls to her greatgrandchildren? (# Today brings us closer to a day when these questions can all be answered "yes." Fifteen months after enactment of the Telecommunications Act, the transition to a new industry paradigm remains far from complete. The road is not straight, or smooth, or free from peril. But a steady course and a shared determination can bring us to the desired destination. We still have far to travel to resolve issues of support for highcost areas. I believe we have a sound plan and a clear timetable for implementation, but we still face two main"( 0*0*0*&" obstacles. The proxy models, already impressive feats of cost engineering, still require further refinement before they can reliably be used to target federal cost support. And a new consensus must be achieved before support essential to maintain affordable telephone service in highcost states can be drawn from states with lesser need, as I believe the Congress of the  X4United States clearly intended. In the meantime, we can make only incremental changes in the implicit subsidies that currently support the highcost services provided by large price cap telephone companies. For the smaller rural companies, change will come even more gradually. This is consistent with Congress's expectation that competition would arrive more quickly in the cities and the suburbs. In the interim, we recognize that rural economies must not face unnecessary dislocations. The need to avoid harmful dislocations, while also encouraging beneficial change, is crucial to much of what we are doing in the access reform and price cap orders. We are implementing many changes that will help to ensure an orderly transition from monopoly to fair and efficient competition. In particular, the recovery of more costs through flatrated charges instead of usagesensitive charges will reduce the exposure of incumbent telephone companies to "cherrypicking" by new entrants, even as they also expand the range of customers likely to be offered competitive alternatives. Completion of the conversion to a threepart rate structure for tandemswitched transport will eliminate a historical artifact, but allow time for affected carriers to adjust. The new Xfactor more accurately reflects the productivity gains that can reasonably be expected from price cap carriers, while avoiding radical reduction of telephone company access revenues and proposals that would have unfairly penalized those companies that have most assiduously conducted themselves in accordance with the incentives we deliberately created. We prefer to rely on marketplace forces rather than regulation to drive investment decisions and price reductions. Some will fault us for not acting more aggressively; others will complain that we are too heavyhanded. My own view is that each decision, and all of the many issues in these orders, has been approached with balance and sensitivity, fairness and principle. Not everyone will be satisfied. But no one can say that we have not read the law, considered economic theories and business realities, consulted our consciences, and sought to achieve as much fairness as is humanly possible. I readily confess that I cannot muster the same passion for restructuring the arcane and impenetrable Transport Interconnection Charge as for devising a completely new regime to provide discounts for schools and libraries to access telecommunications and information services. Though I am fully committed to full realization of all of the universal service provisions, the SnoweRockefellerExonKerry provisions reflect an especially bold vision. "#' 0*((%" For our part, we have used our creativity to harness the magic of competition to reduce the costs of the support program, created incentives to ensure only prudent use of supported services, targeted discounts to minimize the danger of a widening gap between information haves and havenots, and sought at every turn to maintain our commitment to competitive neutrality. Even more important, we have sought to leave crucial decisions in the hands of educators and librarians, scattered throughout the country, rather than in the hands of Washingtonbased administrators. And, best of all, we have arranged a smooth takeoff that will avoid creating unsustainable financial burdens on carriers and consumers, allowing competition and growth and declining prices rather than rate increases to supply the necessary funds. In this area, as in the others addressed by today's orders, we have applied all our energy, and all our skill, to make the best decisions, based on our current knowledge and the law. A continuing commitment to constructive dialogue by all interested parties telephone companies, long distance companies, wireless companies, small businesses, large businesses, residential consumers, state regulators, and members of Congress is critical to continued progress. At the end of the day, fairness to all parties and demonstrable benefits to consumers are the standards by which we will all be judged. "4 0*((D"  \4    k!# Xxjp P7SXP#May 7, 1997 (# SEPARATE STATEMENT OF   COMMISSIONER RACHELLE B. CHONG  \4   \_4\Re:XPrice Caps Performance Review for Local Exchange Carriers, Fourth Report and Order, CC Docket 941.(#  \ 4Along with the Access Charge Reform and Universal Service orders, today's Price Caps decision adopts muchneeded reforms which I believe to be very important to the progressive deregulation of incumbent LECs as competition increases. I write separately to express my strong support for this item, and to highlight some of the key aspects of the decision. In this decade, price cap regulation has been an effective tool to ensure that rates are just, reasonable and not unduly discriminatory. Price caps will continue to keep access charges in check as we transition towards an access charge regime based on forwardlooking economic costs. As competition develops, however, we will gradually deregulate incumbent LEC interstate access services by removing services from price caps where actual competition has arisen. The price cap plan we adopt today contains a challenging unitary Xfactor of 6.5 percent annually. While picking an Xfactor is not an exercise that brings one to a state of metaphysical certitude, I feel confident that the Xfactor we have chosen is a reasonable one and wellsupported by the record. We have selected this Xfactor after very careful analysis of the growth rate of incumbent LEC total factor productivity (TFP) and the rate of change of LEC input prices. I believe the new Xfactor of 6.5 will be a more reliable measure of incumbent LEC potential productivity gains than our interim price cap plan, which offered three Xfactors, some with sharing obligations. In the unlikely event we have made the Xfactor too challenging for some LECs, we retain our low end adjustment mechanism. I view this mechanism as a wise safety net. To ensure that consumers share in LEC efficiency increases, we have added a 0.5 Consumer Productivity Dividend (CPD) to the Xfactor. I recognize that some have argued that the CPD was initially adopted as a way to flow through the first benefits of the price cap plan to access charge customers, and that it may be time to bid the CPD a fond farewell. Given the current state of competition in most price cap LEC markets, we have decided to continue use of the CPD as a way to ensure that productivity gains realized by the LEC will be shared between ratepayers and shareholders. In the future, however, a Commission may decide that competition has progressed to the stage where a CPD mechanism could be safely discarded because market forces will provide consumers with the benefit of the LEC's productivity. " ( 0*0*0*%"ԌFinally, I am particularly pleased that this Report and Order puts a stake through the heart of "sharing," the requirement that incumbent LECs earning more than specified ratesofreturn must "share" half or all of the amount above those ratesofreturn with their access customers in the form of lower rates the following year. Since sharing continues the inefficiencies of a rateofreturn era, I have long believed that a system of pure price caps  \4without sharing would be preferable.Z  \4ԍ#Xxjp P7SXP#  See, e.g., In the Matter of Price Cap Performance Review for Local Exchange Carriers, Separate Statement of Commissioner Rachelle B. Chong, First Report and Order, 10 FCC  \4Rcd 8961, 9251 (1995).#x6X@`7X@#Z I believe that we have correctly found today that sharing tends to blunt the efficiency incentives we sought to create through the price cap plan.  \H4 "Q